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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A bank's credit analyst states that a borrower's expected loss on a term loan is 1.2% of exposure. The loan has an exposure at default of $5,000,000 and a loss given default of 40%. Assuming the estimates are consistent, what is the borrower's one-year probability of default?

The probability of default is 3.00%. Expected loss as a share of exposure equals PD multiplied by LGD, so dividing the 1.2% expected loss rate by the 40% loss given default gives 3.00%. EAD cancels out because the loss is expressed as a percentage.

  1. A0.48%
  2. B2.40%
  3. C3.00%Correct
  4. D6.00%

Explanation

Expected loss = PD x LGD x EAD. As a percentage of exposure, EL% = PD x LGD, so PD = 1.2% / 0.40 = 3.00%. Dividing by 0.40 is the correct step; 2.40% results from multiplying 1.2% by 2, and 0.48% results from multiplying 1.2% by 0.40 instead of dividing.

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