Financial Risk Management Credit Risk Analysis 1 — Questions and Answers
Question 1: What does 'Probability of Default' (PD) measure in credit risk?
- The loss given a default event
- The likelihood that a borrower will fail to meet its debt obligations within a specified time horizon (Correct answer)
- The exposure at default for a loan
- The recovery rate on a defaulted bond
Correct answer: The likelihood that a borrower will fail to meet its debt obligations within a specified time horizon
PD is the estimated probability that a borrower defaults within a given period, typically one year, and is a core input in credit risk models.
Question 2: In the credit risk formula Expected Loss = PD × LGD × EAD, what does LGD stand for?
- Loan Growth Differential
- Loss Given Default (Correct answer)
- Liquidity Gap Duration
- Leverage Gross Discount
Correct answer: Loss Given Default
Loss Given Default (LGD) represents the proportion of the exposure that is actually lost when a default occurs, equal to 1 minus the recovery rate.
Question 3: What is 'Exposure at Default' (EAD) for an undrawn revolving credit facility?
- Always zero because the facility has not been drawn
- The current drawn balance only
- An estimate of the outstanding amount at the time of default, including expected drawdowns before default (Correct answer)
- The total facility limit regardless of current utilization
Correct answer: An estimate of the outstanding amount at the time of default, including expected drawdowns before default
EAD for revolving facilities must account for the borrower's tendency to draw down available credit before defaulting, estimated via a Credit Conversion Factor (CCF).
Question 4: Which credit risk model uses equity prices and balance sheet data to estimate the distance-to-default?
- CreditMetrics (JP Morgan)
- KMV/Merton structural model (Correct answer)
- CreditRisk+ (Actuarial model)
- Altman Z-Score model
Correct answer: KMV/Merton structural model
The KMV model, based on Merton's structural framework, treats equity as a call option on firm assets and derives the distance-to-default from asset volatility and leverage.
Question 5: What is a Credit Default Swap (CDS)?
- A bond that converts to equity upon default
- A derivative where the protection buyer pays periodic premiums and receives a payment if a reference entity defaults (Correct answer)
- An exchange-traded futures contract on corporate bond spreads
- A loan participation agreement between two banks
Correct answer: A derivative where the protection buyer pays periodic premiums and receives a payment if a reference entity defaults
A CDS transfers credit risk from the protection buyer to the protection seller; the seller compensates the buyer for losses upon a defined credit event (default, restructuring, etc.).
Question 6: What does a 'wrong-way risk' mean in the context of counterparty credit risk?
- The risk that a hedge moves in the same direction as the exposure
- The risk that the counterparty's probability of default is positively correlated with the exposure value (Correct answer)
- The risk that the mark-to-market value of a derivative is always negative
- The risk that collateral posted decreases in value during a default event
Correct answer: The risk that the counterparty's probability of default is positively correlated with the exposure value
Wrong-way risk occurs when the creditworthiness of the counterparty deteriorates at the same time that exposure to that counterparty increases, amplifying credit loss.
Financial Risk Management Credit Risk Analysis 1
What does 'Probability of Default' (PD) measure in credit risk?