Credit Risk Management Professional 3 — Questions and Answers
Question 1: Which of the following best describes 'wrong-way risk' in counterparty credit risk management?
- Risk that collateral value increases when counterparty defaults
- Risk that exposure increases when the counterparty's credit quality deteriorates (Correct answer)
- Risk that netting agreements are unenforceable in a default scenario
- Risk from incorrect valuation models for derivatives
Correct answer: Risk that exposure increases when the counterparty's credit quality deteriorates
Wrong-way risk occurs when exposure to a counterparty is positively correlated with the counterparty's probability of default, increasing potential loss.
Question 2: A $10M revolving credit facility is 40% drawn at the time of default, with a Credit Conversion Factor (CCF) of 75% on the undrawn portion. What is the EAD?
- $4M
- $8.5M (Correct answer)
- $7.5M
- $10M
Correct answer: $8.5M
EAD = $4M drawn + (75% × $6M undrawn) = $4M + $4.5M = $8.5M.
Question 3: In the context of credit scoring, what is the primary purpose of a 'scorecard reject inference' technique?
- To remove low-quality applicants from training data
- To estimate the performance of previously rejected applicants (Correct answer)
- To adjust scores for macroeconomic changes
- To validate scorecard stability over time
Correct answer: To estimate the performance of previously rejected applicants
Reject inference techniques estimate what the default behavior of rejected applicants would have been, correcting the sample selection bias in scorecard development.
Question 4: Which stress testing approach applies a single severe but plausible macroeconomic scenario to estimate portfolio credit losses?
- Monte Carlo simulation
- Historical simulation
- Scenario analysis (Correct answer)
- Sensitivity analysis
Correct answer: Scenario analysis
Scenario analysis applies a specific macroeconomic narrative (e.g., severe recession) to estimate how the portfolio would perform under those conditions.
Question 5: A retail bank wants to segment its mortgage portfolio by expected credit performance. Which approach is most appropriate for developing segmentation?
- CAPM-based risk factor analysis
- Logistic regression scorecard development (Correct answer)
- Discounted cash flow analysis
- Duration matching
Correct answer: Logistic regression scorecard development
Logistic regression is the industry standard for developing credit scorecards that predict the probability of default and segment borrowers by risk.
Question 6: Under CECL (Current Expected Credit Loss), how does the timing of loss recognition differ from the prior incurred loss model?
- Losses are recognized only upon actual default
- Lifetime expected losses are recognized at loan origination (Correct answer)
- Losses are spread evenly over the loan term regardless of risk
- Losses are recognized when a loan is 90 days past due
Correct answer: Lifetime expected losses are recognized at loan origination
CECL requires banks to recognize the full lifetime expected credit loss at origination, rather than waiting for a loss trigger event as under the old incurred loss model.
Question 7: A credit risk manager is evaluating whether to purchase credit protection via a Credit Default Swap (CDS). Which factor most directly determines the CDS spread?
- The reference entity's interest rate sensitivity
- The reference entity's perceived probability of default and recovery rate (Correct answer)
- The notional amount of the underlying loan
- The counterparty bank's credit rating
Correct answer: The reference entity's perceived probability of default and recovery rate
CDS spreads reflect the market's assessment of the reference entity's default probability and expected recovery rate, essentially pricing the cost of protection.
Credit Risk Management Professional 3
Which of the following best describes 'wrong-way risk' in counterparty credit risk management?