Financial Risk Manager Part 1
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Of the following statements, select the one(s) that is (are) most likely true with regards to a loan portfolio:
i) Lowering the recovery rate + Increasing the default probability = an increase expected loss
ii) Increasing the recovery rate + Increasing the default probability = an increase expected loss
iii) Lowering the recovery rate + Lowering the default probability = an increase expected loss
Other Sources
Community
UAnonymous
A
i only
B
ii only
C
iii only
D
i and ii only
E
i and iii only
F
i, ii and iii
Explanation:
Expected loss in a loan portfolio is calculated as: Expected Loss = Probability of Default × Loss Given Default × Exposure at Default.
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Probability of Default (PD): The likelihood that a borrower will default.
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Loss Given Default (LGD): The proportion of the exposure that is lost if a default occurs, which is related to the recovery rate (LGD = 1 − Recovery Rate).
For statement (i): Lowering the recovery rate increases LGD, and increasing PD increases the likelihood of default. Both factors increase expected loss.
For statement (ii): Increasing the recovery rate decreases LGD, but increasing PD increases expected loss. However, depending on the magnitude, the net effect can still be an increase in expected loss if PD increase outweighs the LGD decrease.
For statement (iii): Lowering the recovery rate increases LGD, and lowering PD decreases expected loss. However, if the LGD increase is significant enough, it can still result in an increase in expected loss.
Given the assumptions in the question, all three scenarios are considered to result in an increase in expected loss, hence the correct answer is F.
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