CRA CRA Credit Risk & Counterparty Exposure 2 — Questions and Answers
Question 1: The Z-score model developed by Edward Altman is used to predict:
- Market volatility
- Corporate bankruptcy probability (Correct answer)
- Interest rate movements
- Commodity price risk
Correct answer: Corporate bankruptcy probability
Altman's Z-score combines five financial ratios to produce a score that predicts the probability of corporate bankruptcy within two years.
Question 2: In a credit portfolio, concentration risk refers to:
- High diversification across multiple sectors
- Excessive exposure to a single borrower, sector, or region (Correct answer)
- Using derivatives to hedge credit losses
- Applying stress tests to individual loans
Correct answer: Excessive exposure to a single borrower, sector, or region
Concentration risk arises from large exposures to a single obligor, industry, or geography, making the portfolio vulnerable to correlated defaults.
Question 3: Which document outlines the terms under which collateral is exchanged between two parties in an OTC derivatives transaction?
- ISDA Master Agreement
- Credit Support Annex (CSA) (Correct answer)
- Loan Covenant Agreement
- Basel Netting Agreement
Correct answer: Credit Support Annex (CSA)
The Credit Support Annex (CSA) is a legal document that governs the posting and management of collateral in OTC derivative transactions under the ISDA framework.
Question 4: Expected Credit Loss (ECL) under IFRS 9 requires that loan loss provisions be recognized:
- Only after a default event occurs
- At loan origination and updated throughout the life of the loan (Correct answer)
- Solely based on historical loss averages
- When a loan is more than 90 days past due
Correct answer: At loan origination and updated throughout the life of the loan
IFRS 9 mandates a forward-looking ECL model where provisions are recognized at origination and revised based on changes in credit risk over the loan's life.
Question 5: A netting agreement in counterparty credit risk allows institutions to:
- Increase gross exposure by combining trades
- Offset positive and negative mark-to-market values across trades with the same counterparty (Correct answer)
- Transfer credit risk to a third-party guarantor
- Eliminate collateral posting requirements
Correct answer: Offset positive and negative mark-to-market values across trades with the same counterparty
Netting agreements allow firms to net positive and negative exposures with a counterparty, reducing the overall credit exposure in the event of default.
Question 6: Credit VaR differs from Market VaR primarily because it:
- Uses shorter time horizons and assumes normal distributions
- Focuses on losses from credit events, which are rare but severe, with non-normal distributions (Correct answer)
- Only applies to sovereign debt exposures
- Does not require a confidence level specification
Correct answer: Focuses on losses from credit events, which are rare but severe, with non-normal distributions
Credit VaR measures unexpected credit losses at a given confidence level, but unlike market VaR, it deals with fat-tailed, skewed distributions due to default event rarity.
CRA CRA Credit Risk & Counterparty Exposure 2
The Z-score model developed by Edward Altman is used to predict: