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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A risk analyst at a bank is explaining the standard decomposition of expected credit loss on a single loan. Which expression correctly states expected loss for a single exposure over a given horizon?

Expected loss is the product of probability of default, loss given default and exposure at default. Each component captures one dimension: how likely default is, how much of the exposure is lost, and how large the exposure is at default. Using recovery rate instead of LGD is wrong.

  1. AProbability of default multiplied by loss given default multiplied by exposure at defaultCorrect
  2. BProbability of default multiplied by exposure at default divided by loss given default
  3. CLoss given default multiplied by exposure at default divided by probability of default
  4. DProbability of default multiplied by the recovery rate multiplied by exposure at default

Explanation

Expected loss equals PD x LGD x EAD. Using the recovery rate instead of LGD (option D) would measure expected recovery rather than loss. The other options use division, which is not part of the relationship.

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