Credit Risk Management Practice Exam

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In the formula for expected loss (EL), which component represents the loss rate?

The correct answer is: LR

In the context of expected loss (EL) in credit risk management, the loss rate (LR) is a crucial component. The formula for expected loss can typically be represented as: EL = EAD × PD × LR Where: - EL stands for Expected Loss. - EAD is the Exposure at Default, representing the total value exposed to loss at the time of default. - PD is the Probability of Default, indicating the likelihood that a borrower will be unable to meet its debt obligations. - LR is the Loss Rate, which specifies the percentage of exposure that would be lost if a default occurs. The loss rate quantifies the impact of a default on the lender's financial position, defining what portion of the exposure would not be recovered in the event of default. This is a critical metric for assessing potential losses and is essential for effective credit risk management. Understanding the loss rate allows institutions to better estimate their expected losses and to set adequate capital reserves to counteract the risks associated with lending.