FRM Part I · FRM Exam Part I · Corporate Bonds
A corporate bond has a one-year probability of default of 2.0%, an expected recovery rate of 40% of exposure at default, and an exposure of $5,000,000. What is the one-year expected loss?
The expected loss is $60,000. Expected loss equals default probability times exposure times loss given default, and loss given default is one minus the 40% recovery rate: 0.02 x 5,000,000 x 0.60. Using the recovery rate instead would wrongly give $40,000.
- A$60,000Correct
- B$40,000
- C$100,000
- D$2,000,000
Explanation
Expected loss = PD x EAD x LGD = 0.02 x 5,000,000 x (1 - 0.40) = 0.02 x 5,000,000 x 0.60 = $60,000. The $40,000 option mistakenly uses the recovery rate instead of the loss given default. The $100,000 option ignores recovery altogether.
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