Expected Loss and Loss Given Default

[nitin3000]

An analyst is reviewing a bond for investment purposes. The bond is expected to have a default probability of 3%, with an expected loss of 75 basis points in the event of default. if the current risk free rate is 2%, what is the minimum coupon spread needed on the bond for its expected return to match the risk free rate.

a. 80 bp
b 120 bp
3 180 bp
d 240 bp

This question is from the 2016 sample FRM part 2 question paper

 

[David Harper CFA FRM]

@nitin3000 this question has been analyzed in (paid member) the discussion thread at https://forum.bionicturtle.com/threads/garp-2016-question-15-garp16-p2-15.10005/ i.e., @Siqueue wrote

"I agree that this question is worded badly. They state that the bond has "an expected loss of 75bps in the event of default." (emphasis mine)

I initially read this as the LGD was 75bps - as LGD is the loss in the event of default. I redid the calculations when I got a spread that was way too low assuming that the LGD was EL/PD but I wasted some time on it.

What was worse was that using the latter methodology still got me an answer (83.5bps) that wasn't in the options so I redid everything again to work out where my stupid mistake was coming in."

and I replied,

I fully agree with @Siqueue: "in the event of default" implies (by definition) that 75 bps is a loss given default, but the answer reveals that the setup assumptions are pd = 3%, lgd = 25%, recovery = 75% and EL = 3%*25% = 0.75%. So the question should say either "expected loss of 75 bps" (full stop) or "loss given default of 25%" Thanks,