Credit Risk Management Practice Exam

What is the expected loss (EL) formula in credit risk measurement?

1. EL = PD + LGD + EAD

2. EL = PD * EAD * LGD

3. EL = LGD + EAD - PD

4. EL = (PD + LGD) / EAD

The correct answer is: EL = PD * EAD * LGD

The expected loss (EL) formula in credit risk measurement is formulated as EL = PD * EAD * LGD. Here, PD stands for Probability of Default, EAD represents Exposure at Default, and LGD indicates Loss Given Default. This formula effectively captures the three key components that contribute to potential credit losses. - Probability of Default (PD) measures the likelihood that a borrower will default on their obligations. - Exposure at Default (EAD) indicates the total value exposed to loss at the time of default, which could be the outstanding loan balance or the amount drawn from a credit line. - Loss Given Default (LGD) is the proportion of the exposure that is likely to be lost in the event of default. By multiplying these three factors together, you arrive at the expected loss, providing a quantitative estimate of potential losses an institution may face due to credit risk. This formula is widely adopted in credit risk management and regulatory frameworks, as it offers a clear and structured approach to assessing potential losses from credit exposure. In summary, the correct answer accurately reflects how expected loss is calculated, integrating the essential factors that determine the overall risk exposure in credit transactions.