FRM FRM Credit Risk 1 — Questions and Answers
Question 1: Which of the following is the correct formula for Expected Loss (EL) in credit risk?
- EL = PD × LGD × EAD (Correct answer)
- EL = PD × EAD / LGD
- EL = LGD × EAD − PD
- EL = PD + LGD + EAD
Correct answer: EL = PD × LGD × EAD
Expected Loss equals the probability of default multiplied by loss given default and exposure at default, representing the mean credit loss.
Question 2: What does Loss Given Default (LGD) represent?
- The fraction of exposure that is lost when a borrower defaults, after recoveries (Correct answer)
- The total dollar amount lost when a counterparty defaults
- The probability that a borrower defaults within a given time horizon
- The market value of collateral held against a credit exposure
Correct answer: The fraction of exposure that is lost when a borrower defaults, after recoveries
LGD is expressed as a percentage of EAD and reflects the net loss after accounting for recoveries from collateral, guarantees, or bankruptcy proceedings.
Question 3: In the Merton model of credit risk, default occurs when:
- The value of the firm's assets falls below the value of its debt at maturity (Correct answer)
- The firm's stock price drops below its book value
- The firm misses a scheduled interest payment
- Credit spreads widen beyond a regulatory threshold
Correct answer: The value of the firm's assets falls below the value of its debt at maturity
The Merton structural model treats equity as a call option on firm assets and defines default as the event where assets are insufficient to repay debt at maturity.
Question 4: What is a Credit Default Swap (CDS)?
- A derivative contract where the protection seller compensates the buyer if a reference entity defaults (Correct answer)
- An exchange of fixed credit payments for floating interest rate payments
- A bond issued by a bank to transfer credit risk to investors
- A collateralized loan where the borrower pledges fixed-income assets
Correct answer: A derivative contract where the protection seller compensates the buyer if a reference entity defaults
A CDS provides credit protection: the buyer pays periodic premiums and receives a payment from the seller if the reference entity experiences a credit event.
Question 5: What is the CDS spread most closely related to?
- The market's implied probability of default of the reference entity (Correct answer)
- The risk-free interest rate adjusted for duration
- The coupon rate of the underlying reference bond
- The historical default frequency of similarly rated issuers
Correct answer: The market's implied probability of default of the reference entity
The CDS spread reflects the annual cost of credit protection and is directly linked to the market-implied default probability and loss given default.
Question 6: Which of the following best describes 'wrong-way risk' in derivatives counterparty credit risk?
- The risk that exposure to a counterparty increases at the same time the counterparty's creditworthiness deteriorates (Correct answer)
- The risk that a hedge fails because the hedging instrument moves in the wrong direction
- The risk of loss when a counterparty unexpectedly prepays a loan
- The risk that collateral posted by a counterparty loses value when markets are stressed
Correct answer: The risk that exposure to a counterparty increases at the same time the counterparty's creditworthiness deteriorates
Wrong-way risk occurs when the size of the exposure and the probability of counterparty default are positively correlated, amplifying potential losses.
FRM FRM Credit Risk 1
Which of the following is the correct formula for Expected Loss (EL) in credit risk?