FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk
A loan has a recovery rate of 35% in the event of default. If the PD is 5% and EAD is USD 2 million, what is the expected loss?
LGD is one minus the recovery rate, so it is 65%. Expected loss is 5% x 65% x USD 2 million, which equals USD 65,000. Using the recovery rate instead of LGD would understate the loss at USD 35,000.
- AUSD 35,000
- BUSD 65,000Correct
- CUSD 70,000
- DUSD 100,000
Explanation
LGD = 1 - recovery rate = 65%. EL = 0.05 x 0.65 x 2,000,000 = USD 65,000. USD 35,000 wrongly uses the recovery rate as LGD. USD 100,000 ignores recovery.
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