Skip to content

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

A risk manager reviews a portfolio of loans to firms in a cyclical industry. In a downturn, defaults rise and collateral values fall at the same time. Which statement best describes the implication for the expected loss calculation EL = PD x LGD x EAD using average-through-the-cycle inputs?

Positive correlation between PD and LGD means the expected product exceeds the product of the averages. Using through-the-cycle average inputs therefore understates downturn losses, so stressed or downturn LGD should be used.

  1. AIt will likely understate the loss in a downturn because PD and LGD are positively correlated, so the product of averages is below the average of productsCorrect
  2. BIt will overstate losses because collateral and defaults offset each other
  3. CIt remains accurate because EL is linear in each input
  4. DIt will be unaffected because EAD absorbs any change in LGD

Explanation

The formula assumes independence. When PD and LGD are positively correlated, E[PD x LGD] exceeds E[PD] x E[LGD], so average inputs understate expected loss in stress. The offsetting claim has the wrong direction, and EAD does not absorb LGD changes.

Did you get it right without looking?

One question tells you little. A timed set on Fundamentals of Credit Risk shows your real accuracy, how long you take and where you lose marks.

Practise Fundamentals of Credit RiskFree diagnostic mock

More Fundamentals of Credit Risk questions