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FRM Part II · FRM Exam Part II · Derivatives

A bank's one-year expected positive exposure to a counterparty is USD 20 million. The counterparty's one-year default probability is 2%, and loss given default is 60%. Assuming exposure is independent of default, what is the expected credit loss, and how would wrong-way risk affect it?

Expected credit loss is USD 0.24 million (20 million times 2% times 60%). Wrong-way risk would increase it, because exposure tends to be larger precisely when the counterparty is more likely to default, so the independence assumption understates the loss.

  1. AUSD 0.24 million; wrong-way risk would increase itCorrect
  2. BUSD 0.40 million; wrong-way risk would decrease it
  3. CUSD 0.24 million; wrong-way risk would decrease it
  4. DUSD 0.12 million; wrong-way risk would increase it

Explanation

Expected loss = 20 x 0.02 x 0.60 = USD 0.24 million. Wrong-way risk means exposure tends to be high when the counterparty's default probability is high, so the true expected loss exceeds the independence estimate. USD 0.40 million omits LGD.

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