FRM Credit Risk Flashcards

What does 'recovery rate' represent in credit risk modeling?

Answer: The fraction of the outstanding exposure that is recovered after a borrower defaults

Recovery rate is the proportion of the defaulted exposure that creditors ultimately recover, with LGD equal to 1 minus the recovery rate.

Which credit risk model uses a factor model where asset correlations are driven by common market factors?

Answer: CreditMetrics / Vasicek one-factor model

The Vasicek one-factor model and CreditMetrics use a single or multi-factor framework where asset returns of different borrowers co-move through shared systematic factors.

What is the role of netting agreements in managing counterparty credit risk?

Answer: They allow positive and negative mark-to-market values across contracts to be offset, reducing net exposure

Legally enforceable netting agreements reduce credit exposure by allowing a single net payment obligation rather than settling each contract separately upon default.

What is a key assumption of the Altman Z-score model?

Answer: Financial ratios can predict corporate bankruptcy using a linear discriminant function

The Altman Z-score uses a weighted combination of five financial ratios in a linear discriminant model to separate distressed from healthy firms.

What distinguishes 'unexpected loss' (UL) from 'expected loss' (EL) in credit risk?

Answer: UL is the volatility around EL and represents the risk that actual losses exceed average losses

EL is the mean loss over a time horizon, while UL is the standard deviation of losses or the difference between a high-percentile loss and EL.

What is the purpose of the 'maturity adjustment' in the Basel IRB capital formula?

Answer: To increase capital requirements for longer-maturity exposures that have higher credit migration risk

Longer-maturity instruments are more exposed to credit migration and downgrade risk, so the maturity adjustment increases capital requirements for them.