Explanation:
Step 1: Calculate Loss Given Default (LGD)
LGD = Exposure × (1 - Recovery Rate)
LGD = 105.80 × (1 - 0.60) = 105.80 × 0.40 = 42.32
Step 2: Calculate Expected Loss
Expected Loss = Probability of Default × LGD
Expected Loss = 0.015 × 42.32 = 0.6348
Step 3: Calculate Present Value of Expected Loss
PV of Expected Loss = Expected Loss / (1 + Risk-free Rate)
PV of Expected Loss = 0.6348 / (1 + 0.03) = 0.6348 / 1.03 = 0.6163
The present value of the expected loss is approximately 0.616, which matches option A.
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An analyst gathers the following information about a bond to calculate a credit valuation adjustment:
Exposure in Period 1: 105.80
Recovery Rate: 60%
Probability of Default: 1.5%
If the risk-free rate is 3% for this period, the present value of the expected loss is closest to:
A
0.616.
B
0.635.
C
0.925.
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