Financial Risk Management Credit Risk Analysis 3

Question 1

What is a 'collateralized debt obligation' (CDO)?

Accepted Answer

A structured product that pools credit exposures and issues tranches with different seniority and risk profiles

Answer

A CDO repackages a pool of loans, bonds, or CDS into tranches (senior, mezzanine, equity) where losses are absorbed bottom-up, allowing investors to choose their preferred risk-return profile.

Question 2

What is 'netting' in the context of counterparty credit risk?

Accepted Answer

Canceling out offsetting positive and negative mark-to-market values across multiple contracts with the same counterparty to reduce total exposure

Answer

Legal netting agreements allow a firm to offset gains and losses across multiple trades with a defaulted counterparty, significantly reducing gross credit exposure.

Question 3

In Basel II/III, what does the 'internal ratings-based' (IRB) approach allow banks to do?

Accepted Answer

Use their own internal models to estimate PD, LGD, and EAD to calculate credit risk capital requirements

Answer

The IRB approach (foundation or advanced) lets banks use internal risk estimates to derive risk weights, resulting in more risk-sensitive capital requirements than the standardized approach.

Question 4

What is 'recovery rate' in credit risk, and what is a typical value for senior unsecured bonds?

Accepted Answer

The fraction of the exposure recovered after default; typically 40% for senior unsecured bonds

Answer

Recovery rates vary by seniority and collateral; senior unsecured bonds historically recover around 40 cents on the dollar, implying an LGD of approximately 60%.

Question 5

What is 'Credit Value Adjustment' (CVA)?

Accepted Answer

The market value of counterparty credit risk embedded in a derivative, representing the expected cost of counterparty default

Answer

CVA is the difference between the risk-free value of a derivative and its true value accounting for counterparty default risk; under Basel III banks must hold capital against CVA volatility.

Financial Risk Management Practice Test

Financial Risk Management Practice Test

Financial Risk Management Credit Risk Analysis 3