FRM Credit Risk Flashcards

Under the Basel II Internal Ratings-Based (IRB) approach, banks must estimate which of the following inputs?

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.

What does the term 'credit migration risk' refer to?

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.

What is the purpose of a Credit Valuation Adjustment (CVA)?

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.

In a collateralized debt obligation (CDO), which tranche bears losses first?

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.

What is the key feature of a Collateralized Loan Obligation (CLO)?

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.

Which measure captures the potential future exposure of a derivatives portfolio under adverse market movements?

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.