Financial Risk Manager Part 1
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In a training session designed for new risk analysts at a retail bank, the concept of unexpected loss (UL) is being explained by a risk manager. To elucidate the calculation of UL, the manager provides data for a hypothetical loan portfolio:
- Principal amount of the loan portfolio: SGD 120 million
- Default rate of the portfolio: 2.5%
- Recovery rate: 30%
- 1-year 99% Value-at-Risk (VaR): SGD 9.6 million
- 1-year 99% Expected Shortfall (ES): SGD 14.8 million
Using the provided data, compute the 1-year unexpected loss (UL) for the loan portfolio at a 99% confidence level.
In a training session designed for new risk analysts at a retail bank, the concept of unexpected loss (UL) is being explained by a risk manager. To elucidate the calculation of UL, the manager provides data for a hypothetical loan portfolio:
- Principal amount of the loan portfolio: SGD 120 million
- Default rate of the portfolio: 2.5%
- Recovery rate: 30%
- 1-year 99% Value-at-Risk (VaR): SGD 9.6 million
- 1-year 99% Expected Shortfall (ES): SGD 14.8 million
Using the provided data, compute the 1-year unexpected loss (UL) for the loan portfolio at a 99% confidence level.
Explanation:
A is correct. Using the terminology of value-at-risk (VaR), the 1-year 99% unexpected loss of a portfolio is equal to its expected loss subtracted from its VaR with a 1-year time horizon and a 99% confidence level. The expected loss equals portfolio default rate * (1 - recovery rate) * exposure at default = 0.025 * (1 -0.3) * 120 = SGD 2.1 million. Therefore, the UL of this loan portfolio is 9.6 - 2.1 = SGD 7.5 million.