2 - Credit Risk Measurement & Management

Question 1

Define credit risk and explain how it arises using examples.

Answer 1

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Question 2

Explain the components of credit risk evaluation.

Answer 2

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Question 3

Describe, compare, and contrast various credit risk mitigants and their role in credit analysis.

Answer 3

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Question 4

Compare and contrast quantitative and qualitative techniques of credit risk evaluation.

Answer 4

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Question 5

Compare the credit analysis of consumers, corporations, financial institutions, and sovereigns.

Answer 5

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Question 6

Describe quantitative measurements and factors of credit risk, including probability of default, loss given default, exposure at default, expected loss, and time horizon.

Answer 6

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Question 7

Compare bank failure and bank insolvency.

Answer 7

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Question 8

Describe the quantitative, qualitative, and research skills a banking credit analyst is expected to have.

Answer 8

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Question 9

Assess the quality of various sources of information used by a credit analyst.

Answer 9

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Question 10

Explain the capital adequacy, asset quality, management, earnings, and liquidity (CAMEL) system used for evaluating the financial condition of a bank.

Answer 10

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Question 11

Evaluate a bank’s economic capital relative to its level of credit risk.

Answer 11

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Question 12

Identify and describe important factors used to calculate economic capital for credit risk: probability of default, exposure, and loss rate.

Answer 12

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Question 13

Define and calculate expected loss (EL).

Answer 13

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Question 14

Define and calculate unexpected loss (UL).

Answer 14

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Question 15

Estimate the variance of default probability assuming a binomial distribution.

Answer 15

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Question 16

Calculate UL for a portfolio and the UL contribution of each asset.

Answer 16

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Question 17

Describe how economic capital is derived.

Answer 17

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Question 18

Explain how the credit loss distribution is modeled.

Answer 18

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Question 19

Describe challenges to quantifying credit risk.

Answer 19

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Question 20

Explain the key features of a good rating system.

Answer 20

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Question 21

Describe the experts-based approaches, statistical-based models, and numerical approaches to predicting default.

Answer 21

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Question 22

Describe a rating migration matrix and calculate the probability of default, cumulative probability of default, marginal probability of default, and annualized default rate.

Answer 22

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Question 23

Describe rating agencies’ assignment methodologies for issue and issuer ratings.

Answer 23

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Question 24

Describe the relationship between borrower rating and probability of default.

Answer 24

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Question 25

Compare agencies’ ratings to internal experts-based rating systems.

Answer 25

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Question 26

Distinguish between the structural approaches and the reduced-form approaches to predicting default.

Answer 26

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Question 27

Apply the Merton model to calculate default probability and the distance to default and describe the limitations of using the Merton model.

Answer 27

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Question 28

Describe linear discriminant analysis (LDA), define the Z-score and its usage, and apply LDA to classify a sample of firms by credit quality.

Answer 28

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Question 29

Describe the application of a logistic regression model to estimate default probability.

Answer 29

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Question 30

Define and Interpret cluster analysis and principal component analysis.

Answer 30

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Question 31

Describe the use of a cash flow simulation model in assigning ratings and default probabilities and explain the limitations of the model.

Answer 31

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Question 32

Describe the application of heuristic approaches, numeric approaches, and artificial neural networks in modeling default risk and define their strengths and weaknesses.

Answer 32

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Question 33

Describe the role and management of qualitative information in assessing probability of default.

Answer 33

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Question 34

Using the Merton model, calculate the value of a firm’s debt and equity and the volatility of firm value.

Answer 34

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Question 35

Explain the relationship between credit spreads, time to maturity, and interest rates and calculate credit spread.

Answer 35

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Question 36

Explain the differences between valuing senior and subordinated debt using a contingent claim approach.

Answer 36

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Question 37

Explain, from a contingent claim perspective, the impact of stochastic interest rates on the valuation of risky bonds, equity, and the risk of default.

Answer 37

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Question 38

Compare and contrast different approaches to credit risk modeling, such as those related to the Merton model, CreditRisk+, CreditMetrics, and the KMV model.

Answer 38

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Question 39

Assess the credit risks of derivatives.

Answer 39

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Question 40

Describe a credit derivative, credit default swap, and total return swap.

Answer 40

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Question 41

Explain how to account for credit risk exposure in valuing a swap.

Answer 41

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Question 42

Compare the different ways of representing credit spreads.

Answer 42

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Question 43

Compute one credit spread given others when possible.

Answer 43

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Question 44

Define and compute the Spread ‘01.

Answer 44

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Question 45

Explain how default risk for a single company can be modeled as a Bernoulli trial.

Answer 45

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Question 46

Explain the relationship between exponential and Poisson distributions.

Answer 46

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Question 47

Define the hazard rate and use it to define probability functions for default time and conditional default probabilities.

Answer 47

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Question 48

Calculate the unconditional default probability and the conditional default probability given the hazard rate.

Answer 48

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Question 49

Distinguish between cumulative and marginal default probabilities.

Answer 49

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Question 50

Calculate risk-neutral default rates from spreads.

Answer 50

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Question 51

Describe advantages of using the CDS market to estimate hazard rates.

Answer 51

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Question 52

Explain how a CDS spread can be used to derive a hazard rate curve.

Answer 52

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Question 53

Explain how the default distribution is affected by the sloping of the spread curve.

Answer 53

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Question 54

Define spread risk and its measurement using the mark-to-market and spread volatility.

Answer 54

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Question 55

Define and calculate default correlation for credit portfolios.

Answer 55

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Question 56

Identify drawbacks in using the correlation-based credit portfolio framework.

Answer 56

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Question 57

Assess the impact of correlation on a credit portfolio and its Credit VaR.

Answer 57

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Question 58

Describe the use of the single-factor model to measure portfolio credit risk, including the impact of correlation.

Answer 58

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Question 59

Define and calculate Credit VaR.

Answer 59

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Question 60

Describe how Credit VaR can be calculated using a simulation of joint defaults.

Answer 60

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Question 61

Assess the effect of granularity on Credit VaR.

Answer 61

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Question 62

Describe common types of structured products.

Answer 62

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Question 63

Describe tranching and the distribution of credit losses in a securitization.

Answer 63

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Question 64

Describe a waterfall structure in a securitization.

Answer 64

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Question 65

Identify the key participants in the securitization process and describe conflicts of interest that can arise in the process.

Answer 65

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Question 66

Compute and evaluate one or two iterations of interim cashflows in a three-tiered securitization structure.

Answer 66

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Question 67

Describe a simulation approach to calculating credit losses for different tranches in a securitization.

Answer 67

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Question 68

Explain how the default probabilities and default correlations affect the credit risk in a securitization.

Answer 68

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Question 69

Explain how default sensitivities for tranches are measured.

Answer 69

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Question 70

Describe risk factors that impact structured products.

Answer 70

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Question 71

Define implied correlation and describe how it can be measured.

Answer 71

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Question 72

Identify the motivations for using structured credit products.

Answer 72

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Question 73

Describe counterparty risk and differentiate it from lending risk.

Answer 73

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Question 74

Describe transactions that carry counterparty risk and explain how counterparty risk can arise in each transaction.

Answer 74

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Question 75

Identify and describe institutions that take on significant counterparty risk.

Answer 75

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Question 76

Describe credit exposure, credit migration, recovery, mark-to-market, replacement cost, default probability, loss given default, and the recovery rate.

Answer 76

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Question 77

Describe credit value adjustment (CVA) and compare the use of CVA and credit limits in evaluating and mitigating counterparty risk.

Answer 77

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Question 78

Identify and describe the different ways institutions can quantify, manage, and mitigate counterparty risk.

Answer 78

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Question 79

Identify and explain the costs of an OTC derivative.

Answer 79

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Question 80

Explain the components of the X-Value Adjustment (xVA) term.

Answer 80

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Question 81

Explain the purpose of an International Swaps and Derivatives Association (ISDA) master agreement.

Answer 81

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Question 82

Summarize netting and close-out procedures (including multilateral netting), explain their advantages and disadvantages, and describe how they fit into the framework of the ISDA master agreement.

Answer 82

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Question 83

Describe the effectiveness of netting in reducing credit exposure under various scenarios.

Answer 83

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Question 84

Describe the mechanics of termination provisions and trade compressions and explain their advantages and disadvantages.

Answer 84

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Question 85

Identify and describe termination events and discuss their potential effects on parties to a transaction.

Answer 85

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Question 86

Describe the rationale for collateral management.

Answer 86

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Question 87

Describe the terms of a collateral agreement and features of a credit support annex (CSA) within the ISDA Master Agreement including threshold, initial margin, minimum transfer amount and rounding, haircuts, credit quality, and credit support amount.

Answer 87

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Question 88

Describe the role of a valuation agent.

Answer 88

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Question 89

Describe the mechanics of collateral and the types of collateral that are typically used.

Answer 89

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Question 90

Explain the process for the reconciliation of collateral disputes.

Answer 90

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Question 91

Explain the features of a collateralization agreement.

Answer 91

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Question 92

Differentiate between a two-way and one-way CSA agreement and describe how collateral parameters can be linked to credit quality.

Answer 92

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Question 93

Explain aspects of collateral including funding, rehypothecation, and segregation.

Answer 93

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Question 94

Explain how market risk, operational risk, and liquidity risk (including funding liquidity risk) can arise through collateralization.

Answer 94

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Question 95

Describe the various regulatory capital requirements.

Answer 95

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Question 96

Describe and calculate the following metrics for credit exposure: expected mark-to-market, expected exposure, potential future exposure, expected positive exposure and negative exposure, effective expected positive exposure, and maximum exposure.

Answer 96

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Question 97

Compare the characterization of credit exposure to VaR methods and describe additional considerations used in the determination of credit exposure.

Answer 97

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Question 98

Identify factors that affect the calculation of the credit exposure profile and summarize the impact of collateral on exposure.

Answer 98

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Question 99

Identify typical credit exposure profiles for various derivative contracts and combination profiles.

Answer 99

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Question 100

Explain how payment frequencies and exercise dates affect the exposure profile of various securities.

Answer 100

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Question 101

Explain the general impact of aggregation on exposure, and the impact of aggregation on exposure when there is correlation between transaction values.

Answer 101

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Question 102

Describe the differences between funding exposure and credit exposure.

Answer 102

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Question 103

Explain the impact of collateralization on exposure and assess the risk associated with the remargining period, threshold, and minimum transfer amount.

Answer 103

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Question 104

Assess the impact of collateral on counterparty risk and funding, with and without segregation or rehypothecation.

Answer 104

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Question 105

Explain the motivation for and the challenges of pricing counterparty risk.

Answer 105

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Question 106

Describe credit value adjustment (CVA).

Answer 106

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Question 107

Calculate CVA and CVA as a spread with no wrong-way risk, netting, or collateralization.

Answer 107

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Question 108

Evaluate the impact of changes in the credit spread and recovery rate assumptions on CVA.

Answer 108

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Question 109

Explain how netting can be incorporated into the CVA calculation.

Answer 109

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Question 110

Define and calculate incremental CVA and marginal CVA and explain how to convert CVA into a running spread.

Answer 110

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Question 111

Explain the impact of incorporating collateralization into the CVA calculation, including the impact of margin period of risk, thresholds, and initial margins.

Answer 111

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Question 112

Describe debt value adjustment (DVA) and bilateral CVA (BCVA).

Answer 112

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Question 113

Calculate DVA, BCVA, and BCVA as a spread.

Answer 113

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Question 114

Describe wrong-way risk and contrast it with right-way risk.

Answer 114

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Question 115

Identify examples of wrong-way risk and examples of right-way risk.

Answer 115

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Question 116

Discuss the impact of collateral on wrong-way risk.

Answer 116

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Question 117

Identify examples of wrong-way collateral.

Answer 117

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Question 118

Discuss the impact of wrong-way risk on central counterparties (CCPs).

Answer 118

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Question 119

Describe the various wrong-way modeling methods including hazard rate approaches, structural approaches, parametric approaches, and jump approaches.

Answer 119

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Question 120

Explain the implications of central clearing on wrong-way risk.

Answer 120

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Question 121

Explain the motivation for and the challenges of pricing counterparty risk.

Answer 121

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Question 122

Describe credit value adjustment (CVA).

Answer 122

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Question 123

Calculate CVA and CVA as a spread with no wrong-way risk, netting, or collateralization.

Answer 123

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Question 124

Evaluate the impact of changes in the credit spread and recovery rate assumptions on CVA.

Answer 124

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Question 125

Explain how netting can be incorporated into the CVA calculation.

Answer 125

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Question 126

Define and calculate incremental CVA and marginal CVA and explain how to convert CVA into a running spread.

Answer 126

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Question 127

Explain the impact of incorporating collateralization into the CVA calculation, including the impact of margin period of risk, thresholds, and initial margins.

Answer 127

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Question 128

Describe debt value adjustment (DVA) and bilateral CVA (BCVA).

Answer 128

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Question 129

Calculate DVA, BCVA, and BCVA as a spread.

Answer 129

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Question 130

Describe wrong-way risk and contrast it with right-way risk.

Answer 130

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Question 131

Identify examples of wrong-way risk and examples of right-way risk.

Answer 131

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Question 132

Discuss the impact of collateral on wrong-way risk.

Answer 132

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Question 133

Identify examples of wrong-way collateral.

Answer 133

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Question 134

Discuss the impact of wrong-way risk on central counterparties (CCPs).

Answer 134

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Question 135

Describe the various wrong-way modeling methods including hazard rate approaches, structural approaches, parametric approaches, and jump approaches.

Answer 135

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Question 136

Explain the implications of central clearing on wrong-way risk.

Answer 136

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Question 137

Analyze the credit risks and other risks generated by retail banking.

Answer 137

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Question 138

Explain the differences between retail credit risk and corporate credit risk.

Answer 138

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Question 139

Discuss the “dark side” of retail credit risk and the measures that attempt to address the problem.

Answer 139

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Question 140

Define and describe credit risk scoring model types, key variables, and applications.

Answer 140

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Question 141

Discuss the key variables in a mortgage credit assessment and describe the use of cutoff scores, default rates, and loss rates in a credit scoring model.

Answer 141

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Question 142

Discuss the measurement and monitoring of a scorecard performance including the use of cumulative accuracy profile (CAP) and the accuracy ratio techniques.

Answer 142

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Question 143

Describe the customer relationship cycle and discuss the trade off between creditworthiness and profitability.

Answer 143

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Question 144

Discuss the benefits of risk-based pricing of financial services.

Answer 144

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Question 145

Discuss the flaws in the securitization of subprime mortgages prior to the financial crisis of 2007-2009.

Answer 145

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Question 146

Identify and explain the different techniques used to mitigate credit risk and describe how some of these techniques are changing the bank credit function.

Answer 146

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Question 147

Describe the originate-to-distribute model of credit risk transfer and discuss the two ways of managing a bank credit portfolio.

Answer 147

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Question 148

Describe covered bonds, funding collateralized loan obligations (CLOs), and other securitization instruments for funding purposes.

Answer 148

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Question 149

Describe the different types and structures of credit derivatives including credit default swaps (CDS), first-to- default puts, total return swaps (TRS), asset-backed credit-linked notes (CLN), and their applications.

Answer 149

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Question 150

Define securitization, describe the securitization process, and explain the role of participants in the process.

Answer 150

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Question 151

Explain the terms over-collateralization, first-loss piece, equity piece, and cash waterfall within the securitization process.

Answer 151

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Question 152

Analyze the differences in the mechanics of issuing securitized products using a trust versus a special purpose vehicle (SPV) and distinguish between the three main SPV structures: amortizing, revolving, and master trust.

Answer 152

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Question 153

Explain the reasons for and the benefits of undertaking securitization.

Answer 153

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Question 154

Describe and assess the various types of credit enhancements.

Answer 154

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Question 155

Explain the various performance analysis tools for securitized structures and Identify the asset classes they are most applicable to.

Answer 155

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Question 156

Define and calculate the delinquency ratio, default ratio, monthly payment rate (MPR), debt service coverage ratio (DSCR), the weighted average coupon (WAC), the weighted average maturity (WAM), and the weighted average life (WAL) for relevant securitized structures.

Answer 156

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Question 157

Determine the notional value of the net contract resulting from trade compression and identify the counterparty with the net contract.

Answer 157

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Question 158

Explain the prepayment forecasting methodologies and calculate the constant prepayment rate (CPR) and the Public Securities Association (PSA) rate.

Answer 158

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Question 159

Explain the subprime mortgage credit securitization process in the United States.

Answer 159

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Question 160

Identify and describe key frictions in subprime mortgage securitization and assess the relative contribution of each factor to the subprime mortgage problems.

Answer 160

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Question 161

Compare predatory lending and borrowing.

Answer 161

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