Financial Risk Management Credit Risk Management 3 — Questions and Answers
Question 1: What is 'default correlation' and why does it matter in portfolio credit risk?
- The statistical link between credit ratings and default timing, used in Basel models
- The tendency for multiple borrowers to default at the same time, increasing portfolio loss volatility (Correct answer)
- The correlation between a firm's default probability and market interest rates
- The relationship between CDS spreads and equity volatility of the same issuer
Correct answer: The tendency for multiple borrowers to default at the same time, increasing portfolio loss volatility
Default correlation measures co-movement in defaults; high correlation means multiple defaults cluster together, dramatically increasing tail losses.
Question 2: Under the Basel III Standardized Approach for credit risk, a corporate loan with no external rating receives a risk weight of:
- 0%
- 50%
- 100% (Correct answer)
- 150%
Correct answer: 100%
Under Basel III's standardized approach, unrated corporate exposures receive a 100% risk weight for capital calculation purposes.
Question 3: What is 'potential future exposure' (PFE) in counterparty credit risk?
- The current mark-to-market loss on all defaulted counterparties
- The maximum expected exposure to a counterparty at a future date at a high confidence level (Correct answer)
- The expected average exposure over the remaining life of a derivatives contract
- The collateral shortfall that would occur if a counterparty defaults today
Correct answer: The maximum expected exposure to a counterparty at a future date at a high confidence level
PFE is the statistical worst-case future exposure (typically at 95% or 99% confidence) used for credit limit setting and capital calculations.
Question 4: A credit facility with a 'material adverse change' (MAC) clause protects the lender by:
- Requiring the borrower to increase collateral if market rates rise
- Allowing the lender to cancel or accelerate the loan if the borrower's condition significantly deteriorates (Correct answer)
- Fixing the interest rate for the loan term regardless of market changes
- Transferring credit risk to a guarantor if the borrower's rating falls below BB
Correct answer: Allowing the lender to cancel or accelerate the loan if the borrower's condition significantly deteriorates
A MAC clause gives lenders the right to withdraw or restructure facilities if the borrower experiences a significant deterioration in financial condition.
Question 5: Expected Credit Loss (ECL) under IFRS 9 requires banks to recognize:
- Credit losses only after a loan has been formally classified as non-performing
- Forward-looking 12-month or lifetime credit losses as soon as a loan is originated (Correct answer)
- Credit losses equal to the historical average annual charge-off rate times portfolio balance
- Loan loss provisions only when objective evidence of impairment exists
Correct answer: Forward-looking 12-month or lifetime credit losses as soon as a loan is originated
IFRS 9's ECL model requires immediate recognition of expected losses using forward-looking information, replacing the old incurred loss model.
Question 6: What is a credit enhancement in a structured finance transaction?
- An upgrade to the credit rating of the originator of the asset pool
- A mechanism such as overcollateralization or a reserve fund that protects investors from losses (Correct answer)
- A fee paid to rating agencies for assigning a higher rating to a security
- A swap used to convert fixed-rate loan cash flows to floating for ABS investors
Correct answer: A mechanism such as overcollateralization or a reserve fund that protects investors from losses
Credit enhancement mechanisms reduce expected losses for senior tranche holders, allowing securitized products to achieve higher ratings than the underlying collateral.
Financial Risk Management Credit Risk Management 3
What is 'default correlation' and why does it matter in portfolio credit risk?