Financial Risk Management Credit Risk Analysis 2 — Questions and Answers
Question 1: What is a 'credit rating migration matrix' used for in credit risk?
- Estimating recovery rates on defaulted bonds
- Quantifying the probability of a borrower moving from one credit rating to another over a given period (Correct answer)
- Measuring the market risk of a bond portfolio
- Calculating the duration of a fixed income instrument
Correct answer: Quantifying the probability of a borrower moving from one credit rating to another over a given period
A migration matrix shows historical transition probabilities between credit rating categories (e.g., AAA to AA, BBB to default) over a one-year horizon.
Question 2: What is 'credit spread' in fixed income markets?
- The difference between a bond's coupon rate and its face value yield
- The yield difference between a corporate (or risky) bond and a risk-free government bond of the same maturity (Correct answer)
- The bid-ask spread on corporate bond trades
- The difference between spot and forward credit default swap premiums
Correct answer: The yield difference between a corporate (or risky) bond and a risk-free government bond of the same maturity
The credit spread compensates investors for taking on default risk relative to a risk-free benchmark; wider spreads indicate higher perceived credit risk.
Question 3: What is 'default correlation' and why does it matter for credit portfolios?
- The correlation between a bond's credit spread and its duration
- The tendency of multiple borrowers to default at the same time, which affects portfolio credit losses during economic downturns (Correct answer)
- The relationship between PD and LGD for individual borrowers
- The correlation between credit ratings assigned by different agencies
Correct answer: The tendency of multiple borrowers to default at the same time, which affects portfolio credit losses during economic downturns
High default correlation means losses are concentrated — when one borrower defaults, others tend to default too, making diversification less effective and tail losses worse.
Question 4: What is the Z-score model (Altman) primarily used for?
- Measuring interest rate risk of a bond portfolio
- Predicting the probability of corporate bankruptcy using financial ratios (Correct answer)
- Estimating recovery rates in leveraged buyouts
- Calculating the VaR of a credit portfolio
Correct answer: Predicting the probability of corporate bankruptcy using financial ratios
Altman's Z-score combines five financial ratios (profitability, leverage, liquidity, solvency, activity) into a single score to predict corporate financial distress within two years.
Question 5: What is the difference between 'investment grade' and 'speculative grade' (junk) bonds?
- Investment grade bonds always have higher coupons than speculative grade bonds
- Investment grade bonds (BBB-/Baa3 and above) have lower default risk and require less regulatory capital than speculative grade (BB+ /Ba1 and below) (Correct answer)
- Speculative grade bonds are only issued by governments
- Investment grade bonds cannot be traded in secondary markets
Correct answer: Investment grade bonds (BBB-/Baa3 and above) have lower default risk and require less regulatory capital than speculative grade (BB+ /Ba1 and below)
The investment grade / speculative grade divide at BBB-/Baa3 is a critical regulatory boundary affecting institutional investor mandates, capital requirements, and market access.
Question 6: What does 'counterparty credit risk' (CCR) refer to in derivatives?
- The risk that a central clearinghouse defaults on a futures contract
- The risk that the counterparty to an OTC derivative contract defaults before the contract matures, resulting in a replacement cost loss (Correct answer)
- The risk that a bond issuer calls the bond before maturity
- The risk that collateral margins are insufficient to cover mark-to-market losses
Correct answer: The risk that the counterparty to an OTC derivative contract defaults before the contract matures, resulting in a replacement cost loss
CCR is bilateral — either counterparty could default — and the exposure varies over time with the mark-to-market of the derivative, unlike loans with fixed exposures.
Financial Risk Management Credit Risk Analysis 2
What is a 'credit rating migration matrix' used for in credit risk?