Financial Risk Manager Part 1

Explanation

Expected loss is the average credit loss that we would expect from an exposure over a given period of time. It is calculated as the product of the probability of default (PD), the loss given default (LGD), and the exposure at default (EAD). Expected loss is a key component of credit risk management and is used to estimate the amount of capital that a bank needs to hold to cover potential credit losses.

Unexpected loss is the amount of loss that actually exceeds the expected amount. It is the difference between the expected loss and the actual loss incurred. Unexpected loss is also known as the tail risk or the potential loss in extreme scenarios. It represents the risk that the actual losses may be much higher than the expected losses, which can have a significant impact on a bank's capital and profitability.

Why other options are incorrect:

• Choice B reverses the definitions of expected loss and unexpected loss.
• Choice C is incorrect because unexpected loss is quantitatively expressed as the difference between the expected loss and the actual loss incurred. It is not a nebulous or unquantifiable concept, but a specific measure used in financial risk management.
• Choice D is incorrect because unexpected loss is not a cumulative measure of expected losses over time. Instead, it is the difference between the expected loss and the actual loss incurred in a given period.