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

Which statement about expected loss and unexpected loss in credit risk measurement is correct?

Expected loss is the mean anticipated credit loss, covered through pricing and provisions, whereas unexpected loss is the volatility of losses around that mean and is covered by capital. The other options reverse these roles or wrongly remove PD and LGD from UL.

  1. AExpected loss is typically covered by pricing and provisions, while unexpected loss is the variability of losses around the expected level and is covered by capitalCorrect
  2. BExpected loss is covered by economic capital, while unexpected loss is covered by loan loss provisions
  3. CExpected loss equals the standard deviation of credit losses, and unexpected loss equals the mean loss
  4. DUnexpected loss is independent of PD and LGD and depends only on EAD

Explanation

Expected loss is the average anticipated loss and is treated as a cost of doing business via spreads and provisions. Unexpected loss is the volatility of loss around that mean and is absorbed by capital. The reversed statements confuse the roles, and UL does depend on PD and LGD.

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