Credit Risk Management Credit Risk Management MCQ 5 — Questions and Answers
Question 1: Altman's Z-score model is primarily used to:
- Measure market risk in a trading book
- Predict corporate bankruptcy probability using financial ratios (Correct answer)
- Calculate regulatory capital for operational risk
- Estimate interest rate sensitivity of a bond portfolio
Correct answer: Predict corporate bankruptcy probability using financial ratios
Altman's Z-score combines five financial ratios to produce a score that predicts whether a firm is likely to go bankrupt.
Question 2: In the context of credit risk, 'exposure at default' (EAD) for an undrawn revolving credit facility is most significantly affected by:
- The borrower's current leverage ratio
- The credit conversion factor (CCF) applied to the undrawn commitment (Correct answer)
- The collateral type posted by the borrower
- The maturity of the revolving facility
Correct answer: The credit conversion factor (CCF) applied to the undrawn commitment
The CCF estimates how much of the undrawn commitment a borrower is likely to draw before defaulting, directly determining EAD.
Question 3: A bank's internal credit model is found to be systematically underestimating PDs during economic expansions. This is a classic symptom of:
- Model overfitting to training data
- Procyclicality in point-in-time rating models (Correct answer)
- Wrong-way risk in counterparty exposures
- Basis risk in hedging instruments
Correct answer: Procyclicality in point-in-time rating models
Point-in-time models underestimate risk in good times and overestimate it in downturns, creating procyclical capital requirements.
Question 4: Which of the following is the correct regulatory definition of 'default' under the Basel framework?
- A borrower misses any scheduled payment
- A borrower is 30 days past due on any material obligation to the bank
- A borrower is 90 days past due or the bank considers full repayment unlikely (Correct answer)
- A borrower's credit rating falls below BB-
Correct answer: A borrower is 90 days past due or the bank considers full repayment unlikely
Basel defines default as 90 days past due on a material credit obligation, OR when the bank judges full repayment unlikely without recourse to collateral.
Question 5: A credit analyst is reviewing a leveraged buyout (LBO) target. Which metric is most critical for assessing the target's ability to service its post-acquisition debt load?
- Price-to-Earnings (P/E) ratio
- EBITDA-to-debt service coverage (Correct answer)
- Return on Equity (ROE)
- Current ratio
Correct answer: EBITDA-to-debt service coverage
EBITDA-to-debt service coverage directly measures whether the target's operating cash flow can cover LBO-related interest and principal payments.
Question 6: Under the advanced IRB approach, which of the following parameters must banks estimate internally rather than using supervisory estimates?
- PD only
- PD and LGD only
- PD, LGD, and EAD (Correct answer)
- Only EAD
Correct answer: PD, LGD, and EAD
Under the Advanced IRB approach, banks provide their own internal estimates for PD, LGD, and EAD, subject to supervisory validation.
Question 7: A portfolio exhibits a default correlation of 0.8 between two large borrowers. Compared to a correlation of 0.1, the higher correlation primarily:
- Reduces the portfolio's expected loss
- Increases the portfolio's tail risk and unexpected loss (Correct answer)
- Has no effect on capital requirements
- Lowers the individual PDs of each borrower
Correct answer: Increases the portfolio's tail risk and unexpected loss
Higher default correlation means borrowers are more likely to default together, increasing joint-default probability and fattening the loss distribution tail.
Credit Risk Management Credit Risk Management MCQ 5
Altman's Z-score model is primarily used to: