In this workout, we are asked to quantify the credit risk faced on two separate transactions through calculating a value for the expected loss. The first transaction looks at a corporate loan which has a bullet repayment term, which means that all of the borrowed amount will be repaid at the end of the life of the loan. The borrower has a BB credit rating and a one-year probability of default of 1.6%.

The loss given default for this particular counterparty and loan is 65%. To calculate the expected loss, we need to take the probability of default, which is given as 1.6%, multiply this by the exposure at default, since the $5 million loan is gonna be outstanding for the entire life of the loan it's gonna be the $5 million expressed as five in this particular example, so we need to multiply it by 1 million, and then also multiply by the final term here, the loss given default of 65%. This gives us an expected loss of $52,000.

Workout 2 asks us to calculate the expected loss for an interest rate swap, which has a total life of three years, or a tenor of three years, it's based on a notional principle of $250 million and the trade is with a counterparty that has a single A- credit rating. The exposure expected in one year's time is $5 million. This is not known today, it depends on the movements of interest rates over the subsequent year. And we are given a one-year probability of default of 0.4%.

This counterparty has a better credit rating and therefore has a lower probability of default. The loss given default for this interest rate swap is 40%. So again, to calculate the expected loss, we need to take the probability of default here, which is only 0.4%, multiply this by the exposure of default, which is not the notional principle on the interest rate swap but the expected exposure in one year's time, and again, that needs to be multiplied by $1 million to turn it into the absolute expected loss amount, and finally, multiplies by the loss given default of 40%. Which gives an expected loss of only $8,000. Significantly lower than the expected loss for workout 1, where the exposure at default in both workouts is $5 million but for the interest rate swap the counterparty has a significantly better credit rating, and the loss that we think we're gonna make if default happens, the loss given default, is lower in workout 2 at 40% compared to the 65% for workout 1.