FRM FRM Credit Risk 1

Question 1

Which of the following is the correct formula for Expected Loss (EL) in credit risk?

Accepted Answer

EL = PD × LGD × EAD

Answer

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?

Accepted Answer

The fraction of exposure that is lost when a borrower defaults, after recoveries

Answer

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:

Accepted Answer

The value of the firm's assets falls below the value of its debt at maturity

Answer

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)?

Accepted Answer

A derivative contract where the protection seller compensates the buyer if a reference entity defaults

Answer

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?

Accepted Answer

The market's implied probability of default of the reference entity

Answer

The CDS spread reflects the annual cost of credit protection and is directly linked to the market-implied default probability and loss given default.

FRM Practice Test

FRM Practice Test

FRM FRM Credit Risk 1