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    Question

    In credit risk modeling, which of the following elements

    must be assessed to calculate the potential expected loss faced by a bank? 1. Probability of Default (PD) 2. Loss Given Default (LGD) 3. Exposure at Default (EAD) 4. Expected Recovery Rate
    A 1, 2, and 3 Correct Answer Incorrect Answer
    B 2, 3, and 4 Correct Answer Incorrect Answer
    C 1, 3, and 4 Correct Answer Incorrect Answer
    D All of the above Correct Answer Incorrect Answer
    E None of the above Correct Answer Incorrect Answer

    Solution

    To quantify credit risk, banks focus on three key parameters that together determine the expected loss (EL): • Probability of Default (PD): The likelihood that a borrower will fail to meet their debt obligations within a specified time horizon. • Loss Given Default (LGD): The proportion of exposure that cannot be recovered once default occurs (i.e., the percentage loss). • Exposure at Default (EAD): The total outstanding value at risk at the moment the borrower defaults. Mathematically, the formula is: Expected Loss (EL)=PD×LGD×EAD The Expected Recovery Rate is related but not considered a core component of the EL calculation—it is essentially the complement of LGD.

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