CFA Level I · CFA Level I Exam · Credit Risk
A bond has a probability of default of 4% and a loss given default of 60%. Ignoring the time value of money, its expected loss is closest to:
Expected loss is about 2.4% of exposure. It equals the probability of default of 4% multiplied by the loss given default of 60%. Using the 40% recovery rate instead of the loss severity would wrongly give 1.6%.
- A1.6% of exposure
- B2.4% of exposureCorrect
- C4.0% of exposure
Explanation
Expected loss = probability of default × loss given default = 0.04 × 0.60 = 0.024, or 2.4%. Using 40% (the recovery rate) gives 1.6%, which is wrong. Using the default probability alone gives 4.0%.
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