FRM Part I · FRM Exam Part I · Corporate Bonds
A bond investor estimates that a corporate bond has a one-year probability of default of 3% and a recovery rate of 40% of face value. Using the standard expected loss framework with exposure of USD 2,000,000, what is the expected loss over one year?
Expected loss is PD times LGD times exposure. With a 40% recovery rate, LGD is 60%, so the loss is 0.03 x 0.60 x 2,000,000 = USD 36,000. Using the recovery rate in place of LGD gives the wrong figure of USD 24,000.
- AUSD 36,000Correct
- BUSD 24,000
- CUSD 60,000
- DUSD 1,200,000
Explanation
Expected loss = PD x LGD x EAD. LGD = 1 - 40% = 60%. EL = 0.03 x 0.60 x 2,000,000 = 36,000. USD 24,000 wrongly uses the recovery rate (0.03 x 0.40 x 2,000,000) instead of the loss given default.
Did you get it right without looking?
One question tells you little. A timed set on Corporate Bonds shows your real accuracy, how long you take and where you lose marks.
More Corporate Bonds questions
- A bond with a USD 100 million face value has a sinking fund that retires USD 10 million of par each year by lottery at par, starting in year…
- A 2-year annual-pay corporate bond with a face value of $100 and a 6% coupon trades at a yield to maturity of 8.00%. The risk-free (Treasury…
- During a market stress episode, dealers reduce their corporate bond inventories while many investors try to sell. Which outcome is most cons…
- Two bonds from the same issuer have identical maturity and coupon. Bond A is a recent USD 2 billion issue with an active dealer market; Bond…
- A one-year zero-coupon corporate bond yields 6.50% (annual compounding) while the risk-free one-year rate is 4.00%. Assuming a recovery rate…
- A portfolio manager observes that a senior unsecured bond has a one-year default probability of 3% and a loss given default of 55%. The same…