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FRM Part II · FRM Exam Part II · Credit Risk

A bank's IRB portfolio has a one-year PD of 2%, LGD of 40% and EAD of USD 50 million. Under the Basel IRB framework, the capital requirement is designed to cover which component of credit loss, and what is the expected loss for this exposure?

Expected loss is 2% × 40% × USD 50 million, which equals USD 0.4 million. IRB capital is calibrated to cover unexpected loss at a 99.9% confidence level, while expected loss is addressed through provisions and pricing rather than through the capital requirement.

  1. AUnexpected loss only; expected loss is USD 0.4 millionCorrect
  2. BExpected loss only; expected loss is USD 0.4 million
  3. CUnexpected loss only; expected loss is USD 1.0 million
  4. DExpected loss only; expected loss is USD 20 million

Explanation

EL = PD × LGD × EAD = 0.02 × 0.40 × 50 = USD 0.4 million. The IRB capital formula is calibrated to unexpected loss at a 99.9% confidence level, with expected loss handled via provisions. Option C ignores LGD (0.02×50=1.0).

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