Financial Risk Management Credit Risk Analysis

Question 1

What does 'Probability of Default' (PD) measure in credit risk?

Accepted Answer

The likelihood that a borrower will fail to meet its debt obligations within a specified time horizon

Answer

PD is the estimated probability that a borrower defaults within a given period, typically one year, and is a core input in credit risk models.

Question 2

In the credit risk formula Expected Loss = PD × LGD × EAD, what does LGD stand for?

Accepted Answer

Loss Given Default

Answer

Loss Given Default (LGD) represents the proportion of the exposure that is actually lost when a default occurs, equal to 1 minus the recovery rate.

Question 3

What is 'Exposure at Default' (EAD) for an undrawn revolving credit facility?

Accepted Answer

An estimate of the outstanding amount at the time of default, including expected drawdowns before default

Answer

EAD for revolving facilities must account for the borrower's tendency to draw down available credit before defaulting, estimated via a Credit Conversion Factor (CCF).

Question 4

Which credit risk model uses equity prices and balance sheet data to estimate the distance-to-default?

Accepted Answer

KMV/Merton structural model

Answer

The KMV model, based on Merton's structural framework, treats equity as a call option on firm assets and derives the distance-to-default from asset volatility and leverage.

Question 5

What is a Credit Default Swap (CDS)?

Accepted Answer

A derivative where the protection buyer pays periodic premiums and receives a payment if a reference entity defaults

Answer

A CDS transfers credit risk from the protection buyer to the protection seller; the seller compensates the buyer for losses upon a defined credit event (default, restructuring, etc.).

Financial Risk Management Practice Test

Financial Risk Management Practice Test

Financial Risk Management Credit Risk Analysis