Financial Risk Assessment Flashcards

In a reverse stress test, what is the primary objective?

Answer: To identify scenarios that would cause the institution to fail or breach critical thresholds

Reverse stress testing starts from a failure outcome and works backward to identify plausible scenarios that could cause that failure, exposing hidden vulnerabilities.

Which credit risk mitigation technique reduces exposure by netting positive and negative mark-to-market values across multiple contracts with the same counterparty?

Answer: Close-out netting

Close-out netting legally combines all positive and negative MTM values with a counterparty upon default, reducing gross exposure to net exposure.

A risk architect reviews a portfolio where assets and liabilities have a duration gap of +3 years. What risk does this imply?

Answer: Rising interest rates will reduce the institution's net worth

A positive duration gap means assets reprice or mature more slowly than liabilities, so rising interest rates reduce net interest income and economic value of equity.

Which model is used to estimate the probability of corporate default based on the firm's asset value relative to its debt obligations?

Answer: Merton Structural Model

The Merton Structural Model treats equity as a call option on firm assets; default occurs when asset value falls below the debt barrier, yielding an implied probability of default.

What does a high 'Loan-to-Value' (LTV) ratio indicate in the context of mortgage credit risk assessment?

Answer: Higher risk to the lender because collateral coverage is thin relative to the loan balance

A high LTV ratio means the loan balance is close to or exceeds the collateral value, leaving the lender with little cushion if the borrower defaults and collateral values fall.

Under IFRS 9, which stage classification applies to financial assets where credit risk has increased significantly since initial recognition but no objective evidence of default exists?

Answer: Stage 2 — Lifetime Expected Credit Loss

IFRS 9 Stage 2 requires lifetime ECL provisioning when credit risk has significantly increased since origination, even without a current default event.

Which financial risk assessment method evaluates a firm's ability to convert assets to cash quickly without significant loss, focusing on short-term obligations?

Answer: Liquidity stress testing

Liquidity stress testing assesses whether a firm holds sufficient liquid assets to meet short-term obligations under adverse conditions without forced asset sales at deep discounts.