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CMA Final · Risk Management in Banking and Insurance · Introduction to Risk Management

Case: Kaveri Bank has an exposure at default (EAD) of Rs 200 crore to a corporate borrower group. The probability of default (PD) over one year is 2%, and the loss given default (LGD) is 40%. The bank also sets aside, through its pricing, a margin to cover the average loss on this exposure. If the unexpected loss is estimated at Rs 6 crore, what is the total of the expected loss and the unexpected loss that the bank should recognise as the credit loss measure for this exposure?

The combined measure is Rs 7.6 crore. Expected loss equals PD times LGD times EAD, which is 2% x 40% x Rs 200 crore, or Rs 1.6 crore. Adding the stated unexpected loss of Rs 6 crore gives Rs 7.6 crore in total.

  1. ARs 7.6 croreCorrect
  2. BRs 1.6 crore
  3. CRs 9.6 crore
  4. DRs 6 crore

Explanation

Expected loss = PD x LGD x EAD = 0.02 x 0.40 x 200 = Rs 1.6 crore. Adding the unexpected loss of Rs 6 crore gives Rs 7.6 crore. Rs 1.6 crore ignores the unexpected loss, and Rs 9.6 crore arises from wrongly using 0.02 x 0.40 x 200 as Rs 3.6 crore, or from double-counting.

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