Financial Risk Management Credit Risk Management

Question 1

What are the three key components of credit risk exposure?

Accepted Answer

PD, LGD, and EAD

Answer

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?

Accepted Answer

The percentage of exposure a lender loses after recovery efforts

Answer

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:

Accepted Answer

Transfer credit risk of a reference entity from protection buyer to protection seller

Answer

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?

Accepted Answer

Calculating credit risk capital using bank-estimated risk parameters

Answer

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)?

Accepted Answer

The risk that a counterparty defaults before settlement of a derivatives transaction

Answer

CCR is the risk that a derivatives counterparty fails to fulfill its obligations before the final settlement of the transaction's cash flows.

Financial Risk Management Practice Test