Skip to content

FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A bank's loan has a PD of 4%, LGD of 50% and EAD of USD 2,000,000. Which statement about the loan's credit loss is correct?

Expected loss is 4% x 50% x USD 2 million = USD 40,000. It is a predictable cost covered through loan pricing and provisions, whereas capital is held against unexpected loss, the variability of losses around the expected level.

  1. AExpected loss is USD 40,000 and is normally covered by pricing and provisions, while unexpected loss is covered by capital.Correct
  2. BExpected loss is USD 40,000 and is normally covered by capital, while unexpected loss is covered by provisions.
  3. CExpected loss is USD 80,000 and is normally covered by pricing and provisions, while unexpected loss is covered by capital.
  4. DExpected loss is USD 100,000 and is normally covered by capital.

Explanation

EL = 0.04 x 0.50 x 2,000,000 = USD 40,000. Expected loss is treated as a cost of doing business, priced into spreads and provisioned; unexpected loss, the volatility around EL, is what capital absorbs. Reversing the roles is wrong.

Did you get it right without looking?

One question tells you little. A timed set on Fundamentals of Credit Risk shows your real accuracy, how long you take and where you lose marks.

Practise Fundamentals of Credit RiskFree diagnostic mock

More Fundamentals of Credit Risk questions