CFA Level I · CFA Level I Exam · Credit Analysis for Corporate Issuers
A bond has an exposure of 2,000,000 at default, a recovery rate of 40%, and a probability of default of 3%. The expected loss is closest to:
Expected loss is about 36,000. Loss severity is 60% (one minus the 40% recovery rate), so loss given default is 1,200,000. Multiplying by the 3% default probability gives 36,000.
- A24,000
- B36,000Correct
- C80,000
Explanation
Loss severity = 1 − 0.40 = 60%. Loss given default = 2,000,000 × 0.60 = 1,200,000. Expected loss = 1,200,000 × 0.03 = 36,000. Using the recovery rate instead of severity gives 2,000,000 × 0.4 × 0.03 = 24,000, which is wrong.
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