Credit Risk Management Trivia 4 — Questions and Answers
Question 1: What is 'wrong-way risk' in the context of credit derivatives and counterparty credit risk?
- Risk that the counterparty defaults at the worst possible time when exposure is highest (Correct answer)
- Risk of taking the wrong position in a CDS trade
- Risk that credit ratings are assigned incorrectly
- Risk of wrong settlement procedures for derivatives
Correct answer: Risk that the counterparty defaults at the worst possible time when exposure is highest
Wrong-way risk occurs when exposure to a counterparty is positively correlated with the counterparty's default risk, so the exposure is highest precisely when default is most likely.
Question 2: Which U.S. regulatory framework requires banks to conduct annual stress tests to assess capital adequacy?
- Dodd-Frank Act (DFAST) (Correct answer)
- Volcker Rule
- Community Reinvestment Act
- Bank Holding Company Act
Correct answer: Dodd-Frank Act (DFAST)
The Dodd-Frank Act Stress Testing (DFAST) framework requires U.S. banks with over $100 billion in assets to conduct annual stress tests and report results publicly.
Question 3: What does a 'negative pledge clause' in a loan agreement protect against?
- Borrower defaulting on payments
- Borrower pledging assets as collateral to other lenders (Correct answer)
- Borrower prepaying the loan early
- Borrower changing its business operations
Correct answer: Borrower pledging assets as collateral to other lenders
A negative pledge clause prevents the borrower from granting security interests to other creditors, protecting existing lenders' unsecured position from being subordinated.
Question 4: In structured credit, what is a 'waterfall' payment structure?
- A declining schedule of loan payments over time
- The priority order in which cash flows are distributed to different tranches (Correct answer)
- A method for calculating prepayment speeds
- A stress test that simulates cascading defaults
Correct answer: The priority order in which cash flows are distributed to different tranches
A waterfall defines the sequential priority by which principal and interest payments are distributed to different tranches, with senior tranches paid before subordinate ones.
Question 5: Which credit risk measure represents the average loss in the worst percentage of scenarios beyond the VaR threshold?
- Expected Loss
- Conditional VaR (CVaR) (Correct answer)
- Unexpected Loss
- Credit VaR
Correct answer: Conditional VaR (CVaR)
Conditional VaR (CVaR), also called Expected Shortfall, measures the average loss in scenarios that exceed the VaR threshold, capturing tail risk more comprehensively than VaR alone.
Question 6: What is the primary purpose of a 'credit bureau' in the consumer lending ecosystem?
- To set interest rate ceilings on consumer loans
- To collect and report individual borrower credit histories to lenders (Correct answer)
- To insure banks against consumer loan defaults
- To regulate fair lending practices under the ECOA
Correct answer: To collect and report individual borrower credit histories to lenders
Credit bureaus (Equifax, Experian, TransUnion) collect, maintain, and report consumer credit histories to help lenders assess individual creditworthiness.
Question 7: Which term describes the practice of banks selling loan portfolios to special purpose vehicles that issue asset-backed securities?
- Factoring
- Securitization (Correct answer)
- Syndication
- Novation
Correct answer: Securitization
Securitization involves transferring loan pools to an SPV that issues tranched securities backed by the cash flows from those loans, moving credit risk off the bank's balance sheet.
Credit Risk Management Trivia 4
What is 'wrong-way risk' in the context of credit derivatives and counterparty credit risk?