Financial Risk Management Credit Risk Management 1 — Questions and Answers
Question 1: What are the three key components of credit risk exposure?
- PD, LGD, and EAD (Correct answer)
- VaR, CVaR, and stress test
- Duration, convexity, and DV01
- CDS spread, recovery rate, and credit rating
Correct answer: PD, LGD, and EAD
Credit risk is defined by Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD).
Question 2: What does Loss Given Default (LGD) represent?
- The total exposure outstanding at the time of default
- The percentage of exposure a lender loses after recovery efforts (Correct answer)
- The probability that a borrower will default within one year
- The market value of collateral securing a loan
Correct answer: The percentage of exposure a lender loses after recovery efforts
LGD is the proportion of the exposure that is permanently lost after accounting for recoveries and costs, typically expressed as a percentage.
Question 3: A credit default swap (CDS) is primarily used to:
- Speculate on interest rate movements
- Transfer credit risk of a reference entity from protection buyer to protection seller (Correct answer)
- Hedge foreign exchange exposure in cross-border lending
- Reduce operational risk in loan processing
Correct answer: Transfer credit risk of a reference entity from protection buyer to protection seller
A CDS allows a protection buyer to transfer the credit risk of a reference entity to a protection seller in exchange for periodic premium payments.
Question 4: Under Basel III, what is the Internal Ratings-Based (IRB) approach used for?
- Setting market risk capital for trading books
- Calculating credit risk capital using bank-estimated risk parameters (Correct answer)
- Determining operational risk losses from internal models
- Establishing liquidity coverage ratios
Correct answer: Calculating credit risk capital using bank-estimated risk parameters
The IRB approach allows banks to use their own models to estimate PD, LGD, and EAD for calculating regulatory capital against credit risk.
Question 5: What is counterparty credit risk (CCR)?
- The risk that a bond issuer defaults before maturity
- The risk that a counterparty defaults before settlement of a derivatives transaction (Correct answer)
- Credit risk arising from sovereign government debt
- The risk of credit rating downgrades in a bond portfolio
Correct answer: The risk that a counterparty defaults before settlement of a derivatives transaction
CCR is the risk that a derivatives counterparty fails to fulfill its obligations before the final settlement of the transaction's cash flows.
Question 6: A bond rated 'BB' by S&P is classified as:
- Investment grade with low default risk
- Speculative grade (junk) below investment grade (Correct answer)
- In default or near default
- Prime quality with the highest credit rating
Correct answer: Speculative grade (junk) below investment grade
BB is below the BBB− investment grade threshold, placing it in the speculative (high-yield or junk) category with elevated default risk.
Financial Risk Management Credit Risk Management 1
What are the three key components of credit risk exposure?