Credit Risk Management Credit Portfolio Management 2 — Questions and Answers
Question 1: What is Risk-Adjusted Return on Capital (RAROC) used for in portfolio management?
- Calculating regulatory minimum capital
- Comparing risk-adjusted profitability across business lines or deals (Correct answer)
- Estimating the probability of default on a loan
- Measuring interest rate sensitivity
Correct answer: Comparing risk-adjusted profitability across business lines or deals
RAROC divides risk-adjusted return by economic capital, enabling banks to compare profitability on a like-for-like basis across different risk levels.
Question 2: Credit Default Swaps (CDS) are used in portfolio management primarily to do what?
- Convert fixed-rate loans to floating-rate
- Transfer credit risk to a third party without selling the underlying loan (Correct answer)
- Generate fee income from loan origination
- Reduce interest rate duration
Correct answer: Transfer credit risk to a third party without selling the underlying loan
CDS allow banks to hedge credit exposure by transferring default risk to a protection seller, reducing concentration without disposing of the actual loan.
Question 3: What is a Collateralized Loan Obligation (CLO)?
- A bond backed by mortgage loans
- A securitization vehicle that pools corporate loans and issues tranched notes (Correct answer)
- A government-guaranteed loan facility
- A type of revolving credit facility
Correct answer: A securitization vehicle that pools corporate loans and issues tranched notes
A CLO is an asset-backed security that pools leveraged loans and issues multiple tranches with different risk/return profiles to investors.
Question 4: Which of the following best describes 'granularity' in a credit portfolio?
- The proportion of secured versus unsecured loans
- The degree to which exposures are diversified across many small obligors (Correct answer)
- The credit quality distribution from AAA to CCC
- The average maturity of loans in the portfolio
Correct answer: The degree to which exposures are diversified across many small obligors
Granularity refers to having many small exposures rather than few large ones; higher granularity reduces idiosyncratic concentration risk.
Question 5: What is the 'wrong-way risk' concept in credit portfolio management?
- Risk that a hedging strategy increases rather than reduces exposure
- Correlation where counterparty default probability increases as its exposure to you increases (Correct answer)
- The risk that portfolio models underestimate losses during benign periods
- Loss amplification from incorrect collateral valuation
Correct answer: Correlation where counterparty default probability increases as its exposure to you increases
Wrong-way risk occurs when credit exposure to a counterparty increases at the same time as the counterparty's default probability rises, amplifying credit risk.
Question 6: In the CreditMetrics framework, what drives changes in portfolio credit value?
- Changes in interest rate benchmarks only
- Borrower credit rating migrations and defaults over a one-year horizon (Correct answer)
- Changes in collateral market prices
- Fluctuations in loan origination volumes
Correct answer: Borrower credit rating migrations and defaults over a one-year horizon
CreditMetrics models portfolio value changes by simulating credit rating migrations and defaults, capturing both upgrade and downgrade impacts.
Credit Risk Management Credit Portfolio Management 2
What is Risk-Adjusted Return on Capital (RAROC) used for in portfolio management?