CFA Level IFixed IncomeMedium
A bank has a $2,000,000 loan exposure to a corporate borrower. The one-year probability of default is estimated at 3%, and the recovery rate in default is expected to be 35%. The expected credit loss on this exposure over the next year is closest to:
- A$70,000
- B$60,000
- C$21,000
- D$39,000
Show answer & explanationAnswer & explanation
Correct answer: D. $39,000
Loss given default (LGD) = 1 − recovery rate = 1 − 0.35 = 0.65. Expected loss = Exposure × PD × LGD = $2,000,000 × 0.03 × 0.65 = $39,000.
Why the other options are wrong
- A. Overstates loss by using too high an implied LGD.
- B. Ignores the loss given default adjustment (uses PD × exposure only).
- C. Uses recovery rate instead of LGD in the calculation.
Expected Credit Loss
The anticipated loss on a credit exposure, calculated as Exposure at Default × Probability of Default × Loss Given Default (1 − recovery rate).
- LGD = 1 − Recovery Rate
- Higher PD or lower recovery rate increases expected loss
- Used by lenders and bond investors to price credit risk
Memory trick: Exposure times default odds times what you'll actually lose.