Financial Risk Management Credit Risk Management 2 — Questions and Answers
Question 1: What is 'concentration risk' in a credit portfolio?
- Risk from holding too many small-denomination loans
- Excessive exposure to a single borrower, sector, or geography (Correct answer)
- The risk that credit spreads widen across all sectors simultaneously
- Risk from concentrating loan maturities within one quarter
Correct answer: Excessive exposure to a single borrower, sector, or geography
Concentration risk arises when a portfolio is overly exposed to a single name, industry, or region, limiting the benefits of diversification.
Question 2: What is a credit migration matrix used for in credit risk management?
- Mapping loan applications to credit officers for review
- Estimating the probability that a borrower's credit rating will change over time (Correct answer)
- Calculating the interest rate to charge on variable-rate loans
- Allocating ALLL reserves across loan categories
Correct answer: Estimating the probability that a borrower's credit rating will change over time
A credit migration (transition) matrix shows the historical probability of moving from one credit rating to another over a given horizon.
Question 3: Net Present Value (NPV) of a CDS from the protection buyer's perspective is zero at inception because:
- No upfront payment is made in standard CDS contracts
- The present value of the premium leg equals the present value of the protection leg at fair spread (Correct answer)
- CDS contracts always settle at par value
- Mark-to-market rules prohibit initial gains or losses on derivatives
Correct answer: The present value of the premium leg equals the present value of the protection leg at fair spread
At inception, the CDS spread is set so that the PV of expected premium payments equals the PV of expected default protection payouts.
Question 4: What is 'credit VaR' (CVaR in the credit context)?
- The expected credit loss under normal conditions
- The difference between worst-case credit loss and expected credit loss at a given confidence level (Correct answer)
- The current mark-to-market value of a credit derivative portfolio
- Basel III's standardized formula for credit risk capital
Correct answer: The difference between worst-case credit loss and expected credit loss at a given confidence level
Credit VaR measures the unexpected credit loss—the excess of worst-case over expected losses at a specified confidence level—used to set economic capital.
Question 5: Recovery rate in credit risk is most accurately defined as:
- The interest rate recovered on a defaulted loan after workout
- The fraction of exposure a lender recovers after a borrower defaults (Correct answer)
- The speed at which a borrower's credit rating improves post-default
- The haircut applied to collateral in repo transactions
Correct answer: The fraction of exposure a lender recovers after a borrower defaults
Recovery rate is the portion of the outstanding exposure that is ultimately collected through asset liquidation, restructuring, or legal proceedings.
Question 6: In a collateralized loan obligation (CLO), tranching is used to:
- Divide the loan pool by geography and sector
- Create securities with different risk/return profiles by allocating losses sequentially (Correct answer)
- Reduce the credit risk of the underlying loans before securitization
- Match loan cash flows to fixed quarterly payment schedules
Correct answer: Create securities with different risk/return profiles by allocating losses sequentially
Tranching creates senior, mezzanine, and equity tranches where lower tranches absorb losses first, providing credit enhancement to senior tranches.
Financial Risk Management Credit Risk Management 2
What is 'concentration risk' in a credit portfolio?