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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A credit risk manager at a bank states that the bank's loan loss provisions and loan pricing should be set to cover expected loss, while economic capital is held against unexpected loss. Which statement best describes unexpected loss in this framework?

Unexpected loss is the volatility, usually the standard deviation, of credit losses around the expected loss. Expected loss is the average loss priced and provisioned for, while capital is held against unexpected loss, which captures the risk that actual losses exceed the average.

  1. AThe average loss over the cycle, computed as PD times LGD times EAD
  2. BThe variability (standard deviation) of credit losses around the expected lossCorrect
  3. CThe loss recovered after default through collateral liquidation
  4. DThe loss arising only from rating downgrades without any default

Explanation

Expected loss is the mean loss (PD x LGD x EAD) and is treated as a cost of doing business. Unexpected loss measures the volatility of losses around that mean, and capital is held to absorb it. The first option describes expected loss, not unexpected loss.

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