FRM Credit Risk Flashcards
6 cards from real FRM practice questions. Tap to flip, then mark Knew It or Still Learning — missed cards come back until you master them.
Read the first 6 FRM Credit Risk flashcards as text
Which of the following is the correct formula for Expected Loss (EL) in credit risk?
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.
What does Loss Given Default (LGD) represent?
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.
In the Merton model of credit risk, default occurs when:
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.
What is a Credit Default Swap (CDS)?
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.
What is the CDS spread most closely related to?
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.
Which of the following best describes 'wrong-way risk' in derivatives counterparty credit risk?
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.