Financial Risk Management Credit Risk Analysis 2

Question 1

What is a 'credit rating migration matrix' used for in credit risk?

Accepted Answer

Quantifying the probability of a borrower moving from one credit rating to another over a given period

Answer

A migration matrix shows historical transition probabilities between credit rating categories (e.g., AAA to AA, BBB to default) over a one-year horizon.

Question 2

What is 'credit spread' in fixed income markets?

Accepted Answer

The yield difference between a corporate (or risky) bond and a risk-free government bond of the same maturity

Answer

The credit spread compensates investors for taking on default risk relative to a risk-free benchmark; wider spreads indicate higher perceived credit risk.

Question 3

What is 'default correlation' and why does it matter for credit portfolios?

Accepted Answer

The tendency of multiple borrowers to default at the same time, which affects portfolio credit losses during economic downturns

Answer

High default correlation means losses are concentrated — when one borrower defaults, others tend to default too, making diversification less effective and tail losses worse.

Question 4

What is the Z-score model (Altman) primarily used for?

Accepted Answer

Predicting the probability of corporate bankruptcy using financial ratios

Answer

Altman's Z-score combines five financial ratios (profitability, leverage, liquidity, solvency, activity) into a single score to predict corporate financial distress within two years.

Question 5

What is the difference between 'investment grade' and 'speculative grade' (junk) bonds?

Accepted Answer

Investment grade bonds (BBB-/Baa3 and above) have lower default risk and require less regulatory capital than speculative grade (BB+ /Ba1 and below)

Answer

The investment grade / speculative grade divide at BBB-/Baa3 is a critical regulatory boundary affecting institutional investor mandates, capital requirements, and market access.

Financial Risk Management Practice Test

Financial Risk Management Practice Test

Financial Risk Management Credit Risk Analysis 2