Credit Risk Management Credit Risk Management MCQ 3 — Questions and Answers
Question 1: Which risk mitigation technique involves transferring the first loss tranche of a loan portfolio to investors through a structured product?
- Credit insurance
- Collateralized Loan Obligation (CLO) (Correct answer)
- Netting agreement
- Credit limit compression
Correct answer: Collateralized Loan Obligation (CLO)
A CLO securitizes a pool of loans and sells tranches to investors, transferring first-loss and other risk layers away from the originating bank.
Question 2: What does a 'wrong-way risk' exposure in counterparty credit risk describe?
- An exposure where collateral value is negatively correlated with counterparty creditworthiness (Correct answer)
- An exposure that increases when interest rates rise
- An exposure with no netting benefit
- An exposure denominated in a foreign currency
Correct answer: An exposure where collateral value is negatively correlated with counterparty creditworthiness
Wrong-way risk occurs when exposure to a counterparty is positively correlated with their probability of default, increasing loss severity.
Question 3: A bank uses the Standardized Approach for credit risk. A corporate loan with a BBB rating receives what risk weight under Basel III?
- 20%
- 50%
- 100% (Correct answer)
- 150%
Correct answer: 100%
Under the Basel III Standardized Approach, unrated and BBB-rated corporate exposures generally receive a 100% risk weight.
Question 4: What is the primary purpose of a loan covenant in credit risk management?
- To set the interest rate for the life of the loan
- To provide early warning triggers that protect the lender if the borrower's financial health deteriorates (Correct answer)
- To define the tax treatment of interest payments
- To establish the loan's amortization schedule
Correct answer: To provide early warning triggers that protect the lender if the borrower's financial health deteriorates
Covenants are contractual conditions that give lenders early-warning signals and remedies if a borrower's financial position weakens.
Question 5: In stress testing a credit portfolio, what is the primary objective of a 'reverse stress test'?
- To identify the worst historical loss scenario
- To work backwards from a predefined failure outcome to find scenarios that could cause it (Correct answer)
- To test the portfolio under average economic conditions
- To maximize regulatory capital relief
Correct answer: To work backwards from a predefined failure outcome to find scenarios that could cause it
Reverse stress testing starts with a catastrophic outcome (e.g., insolvency) and identifies what scenarios could plausibly cause it.
Question 6: Which of the following best describes 'credit migration risk'?
- The risk that a borrower relocates to a different country
- The risk that a counterparty's credit rating changes, affecting the value of outstanding exposures (Correct answer)
- The risk of cross-border regulatory differences
- The risk that loan collateral is moved to a different jurisdiction
Correct answer: The risk that a counterparty's credit rating changes, affecting the value of outstanding exposures
Credit migration risk is the risk that a borrower's credit quality changes (upgrades or downgrades), altering the mark-to-market value of loans or bonds.
Question 7: A portfolio manager applies credit VaR at a 99.9% confidence level over a one-year horizon. This metric is best used to:
- Price individual loan facilities
- Determine regulatory minimum capital under Pillar 1
- Set economic capital buffers to absorb unexpected credit losses (Correct answer)
- Calculate expected loss reserves for accounting purposes
Correct answer: Set economic capital buffers to absorb unexpected credit losses
Credit VaR at high confidence levels quantifies unexpected losses and is used to set economic capital to absorb tail credit risk.
Credit Risk Management Credit Risk Management MCQ 3
Which risk mitigation technique involves transferring the first loss tranche of a loan portfolio to investors through a structured product?