FRM Part I · FRM Exam Part I · Corporate Bonds
A corporate bond has a one-year probability of default of 2.0% and an expected recovery rate of 40% of exposure at default. The exposure at default is USD 5,000,000. Assuming a single-period model and that recovery is a fixed fraction of exposure, what is the expected loss over the year?
Expected loss is USD 60,000. Loss given default is 60% (one minus the 40% recovery rate), so multiplying the 2% default probability, 60% loss severity and USD 5 million exposure gives USD 60,000. Ignoring recovery would overstate the loss at USD 100,000.
- AUSD 40,000
- BUSD 60,000Correct
- CUSD 100,000
- DUSD 200,000
Explanation
Loss given default = 1 - 0.40 = 60%. Expected loss = PD x LGD x EAD = 0.02 x 0.60 x 5,000,000 = USD 60,000. USD 100,000 ignores recovery (PD x EAD). USD 40,000 wrongly uses the recovery rate instead of LGD.
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