Aug 05

Expected value (Quant: Stat)

by David Harper, CFA, FRM, CIPM

FRM |

Learning objective: List and discuss properties of expected value

The seven properties (given by Gujarati) of expected value are the following (‘a’ and ‘b’ are constants):

ev_3.2

In regard to (4) above, consider expected loss (EL) in Credit Risk (e.g., Ong readings). In the FRM, we typically assume:

Expected loss (EL, %) = PD * LGD

Note per (4) that E[PD*LGD] does not equal E(PD)*E(LGD), unless the variables are independent (i.e., unless PD and LGD are independent. Same as without correlation or covariance). Therefore, in the Credit Risk readings, just like the Basel II internal ratings-based (IRB) approach to credit risk, we are assuming independence between PD and LGD.

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