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FRM Part II · FRM Exam Part II · Governance

A bank sets a portfolio limit so that expected loss on its corporate book does not exceed 0.80% of exposure. The book has USD 5,000 million of exposure in three segments: Segment A USD 2,000 million with PD 1.0% and LGD 40%; Segment B USD 2,000 million with PD 2.0% and LGD 50%; Segment C USD 1,000 million with PD 3.0% and LGD 60%. Treating EAD as the exposure, what is the portfolio expected loss and does it comply with the limit?

Portfolio expected loss is USD 46 million, or 0.92% of exposure, which breaches the 0.80% limit. It is computed as 8 million for Segment A plus 20 million for Segment B plus 18 million for Segment C, each being exposure times PD times LGD.

  1. AUSD 46 million (0.92%); breaches the limitCorrect
  2. BUSD 40 million (0.80%); complies exactly
  3. CUSD 46 million (0.92%); complies
  4. DUSD 33 million (0.66%); complies

Explanation

EL(A) = 2,000 x 1% x 40% = 8m. EL(B) = 2,000 x 2% x 50% = 20m. EL(C) = 1,000 x 3% x 60% = 18m. Total = 46m, which is 0.92% of 5,000m and exceeds the 0.80% limit (USD 40m). Omitting LGD would give a wrong figure, and the stated compliance would not hold.

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