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

Which statement best describes how expected loss and unexpected loss are treated in a bank's credit risk framework?

Expected loss is the average anticipated credit loss and is covered through risk-based pricing and provisions, while capital is held as a buffer against unexpected loss, which is the variability of losses around that average.

  1. AExpected loss is covered by pricing and provisions, while capital is held mainly against unexpected lossCorrect
  2. BExpected loss is covered mainly by economic capital, while unexpected loss is covered by provisions
  3. CBoth are covered only by regulatory capital because pricing cannot reflect losses
  4. DUnexpected loss equals the expected loss multiplied by the loss given default

Explanation

Expected loss is an anticipated cost of doing business, recovered through loan pricing and provisions. Capital acts as a buffer against unexpected loss, the volatility of losses around the mean. The option reversing the roles is wrong.

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