Credit Risk Management Default and Recovery Analysis 2 — Questions and Answers
Question 1: What is a 'distressed debt' investment strategy?
- Buying highly rated bonds for yield enhancement
- Purchasing defaulted or near-default debt at a discount, expecting recovery or restructuring gains (Correct answer)
- Short-selling investment-grade bonds
- Lending to startups with no credit history
Correct answer: Purchasing defaulted or near-default debt at a discount, expecting recovery or restructuring gains
Distressed debt investors buy securities of financially troubled companies at deep discounts, profiting if the company recovers or assets are liquidated above the purchase price.
Question 2: What is the 'absolute priority rule' in bankruptcy?
- Management claims must be settled before creditors
- Senior creditors must be paid in full before junior creditors receive anything (Correct answer)
- Tax authorities are always the last to be paid
- Secured claims are waived during reorganization
Correct answer: Senior creditors must be paid in full before junior creditors receive anything
The absolute priority rule holds that senior creditors must be fully satisfied before any value flows to junior creditors or equity holders in a bankruptcy proceeding.
Question 3: Which statistic tracks the percentage of a cohort of bonds that have defaulted within a specific number of years?
- Marginal default rate
- Cumulative default rate (Correct answer)
- Conditional recovery rate
- Duration-weighted default frequency
Correct answer: Cumulative default rate
The cumulative default rate measures the total fraction of an initial cohort that has defaulted by a given point in time, regardless of when in the period the default occurred.
Question 4: In credit risk, what is a 'workout' process?
- Fitness programs for bank employees managing stress
- A negotiated restructuring or repayment plan for a defaulted or distressed loan (Correct answer)
- Automated loan origination using machine learning
- A process for upgrading borrowers' credit ratings
Correct answer: A negotiated restructuring or repayment plan for a defaulted or distressed loan
A workout is the internal bank process of managing and resolving a problem loan, involving negotiations with the borrower on restructuring, forbearance, or recovery.
Question 5: What is 'haircut' in the context of collateral valuation for credit risk?
- The interest rate discount given to a borrower with good credit
- A reduction applied to collateral market value to reflect liquidity and price risk (Correct answer)
- A fee charged by the borrower's legal team
- The origination fee deducted from loan proceeds
Correct answer: A reduction applied to collateral market value to reflect liquidity and price risk
A haircut is the percentage reduction applied to the market value of collateral to account for potential price declines and liquidity risk if the collateral must be liquidated.
Question 6: Which of the following is a primary driver of higher corporate bond default rates?
- Rising equity market valuations
- Recessions and tightening credit conditions (Correct answer)
- Decreasing benchmark interest rates
- Increasing foreign direct investment
Correct answer: Recessions and tightening credit conditions
Economic recessions and tight credit conditions cause rising unemployment and falling revenues, sharply increasing corporate default rates.
Credit Risk Management Default and Recovery Analysis 2
What is a 'distressed debt' investment strategy?