FRM FRM Credit Risk 2 — Questions and Answers
Question 1: Under the Basel II Internal Ratings-Based (IRB) approach, banks must estimate which of the following inputs?
- PD, LGD, EAD, and effective maturity (Correct answer)
- Only PD for each borrower rating grade
- PD and the market-implied recovery rate
- LGD and EAD based on historical averages only
Correct answer: PD, LGD, EAD, and effective maturity
The IRB approach requires banks to estimate PD, LGD, EAD, and maturity (M) using internal models subject to regulatory validation.
Question 2: What does the term 'credit migration risk' refer to?
- The risk that a borrower's credit rating changes, altering the value of a credit exposure (Correct answer)
- The risk that a borrower defaults unexpectedly without a prior rating downgrade
- The risk associated with transferring credit risk to a third party through securitization
- The risk of regulatory changes affecting credit risk capital requirements
Correct answer: The risk that a borrower's credit rating changes, altering the value of a credit exposure
Credit migration risk arises because bond or loan values change as issuers move between rating categories, even if no default occurs.
Question 3: What is the purpose of a Credit Valuation Adjustment (CVA)?
- To adjust the fair value of a derivative to account for counterparty default risk (Correct answer)
- To correct the book value of loans for expected credit losses
- To add a premium to bond yields reflecting issuer default probability
- To reserve capital for unexpected losses under Basel III
Correct answer: To adjust the fair value of a derivative to account for counterparty default risk
CVA represents the market value of counterparty credit risk embedded in a derivatives portfolio and reduces the risk-free value of the contract.
Question 4: In a collateralized debt obligation (CDO), which tranche bears losses first?
- Equity tranche (Correct answer)
- Mezzanine tranche
- Senior tranche
- Super senior tranche
Correct answer: Equity tranche
The equity tranche absorbs first losses up to its notional amount, acting as credit protection for more senior tranches in the CDO structure.
Question 5: What is the key feature of a Collateralized Loan Obligation (CLO)?
- It pools corporate leveraged loans and issues tranched securities backed by loan cash flows (Correct answer)
- It is a derivative contract that transfers credit risk of a single reference loan
- It bundles retail mortgages into pass-through certificates sold to investors
- It is a credit facility extended by a syndicate of banks to a single borrower
Correct answer: It pools corporate leveraged loans and issues tranched securities backed by loan cash flows
CLOs are structured finance vehicles that hold diversified pools of leveraged corporate loans and issue debt tranches with varying risk/return profiles.
Question 6: Which measure captures the potential future exposure of a derivatives portfolio under adverse market movements?
- Potential Future Exposure (PFE) (Correct answer)
- Current Exposure (CE)
- Credit Valuation Adjustment (CVA)
- Expected Positive Exposure (EPE)
Correct answer: Potential Future Exposure (PFE)
PFE measures the worst-case exposure at a given confidence level over a specified future period, used to set credit limits for derivatives counterparties.
FRM FRM Credit Risk 2
Under the Basel II Internal Ratings-Based (IRB) approach, banks must estimate which of the following inputs?