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

Which statement about expected loss and unexpected loss is most accurate for a bank's loan portfolio?

Expected loss is the average anticipated credit loss, which banks cover through loan pricing and provisions. Unexpected loss is the variability of losses around that average, and the bank holds capital to absorb it.

  1. AExpected loss is the volatility of credit losses and is covered by economic capital
  2. BExpected loss is the average anticipated loss, typically covered by pricing and provisions, while unexpected loss reflects loss variability and is covered by capitalCorrect
  3. CUnexpected loss equals expected loss multiplied by the recovery rate
  4. DExpected loss is unaffected by the borrower's credit quality

Explanation

Expected loss is the mean loss, priced into spreads and provisioned. Unexpected loss is the standard deviation of losses around that mean, and capital buffers against it. The other options reverse or misstate these roles.

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