Book 4_Fixed_READING 62_CREDIT RISK

Question 1

Credit risk

Answer 1

refers to the possibility that a borrower fails to make the scheduled interest payments or return of principal.

Question 2

Bottom-up credit analysis factors

Answer 2

include capacity, capital, collateral, character, and covenants.

Question 3

Top-down credit analysis factors

Answer 3

include country, conditions, and currency.

Question 4

A cross default clause

Answer 4

means that a default on one bond issue causes a default on all issues.

Question 5

A pari passu clause means

Answer 5

all bonds of a certain type rank equally in the default process

Question 6

Credit risk

Answer 6

measured through expected loss, which is the product of the probability of default and the loss given default

Question 7

Loss given default expressed as a rate

Answer 7

is also called loss severity, and equals one minus the recovery rate.
LGD% = (1 - recovery rate)

Question 8

Expected loss as a percentage

Answer 8

is an estimate of the credit spread investors should demand:
credit spread ≈ POD (probability of defaud) × LGD%

Question 9

Actual credit spread

Answer 9

= bond yield - government security yield

Question 10

High credit quality with a low probability of default.

Answer 10

A profitable company with high EBIT margin, high interest coverage ratio, low leverage multiples, and high cash flow to net debt

Question 11

More senior, secured debt

Answer 11

will have a smaller loss given default than junior, unsecured debt.

Question 12

Credit ratings

Answer 12

reflect a debt issuer or debt issue’s overall creditworthiness and assess the likelihood that debt will be fully paid back.

Question 13

investment grade and of lower credit risk

Answer 13

Ratings of BBB-/Baa3 and above

Question 14

non-investment grade (highyield) and of higher credit risk.

Answer 14

Ratings of BB+/Ba1 and below

Question 15

Investors should not rely exclusively on credit ratings from rating agencies for these reasons:

Answer 15

• Rating agencies cannot always judge credit risk accurately.
• Firms are subject to risk of unforeseen events that credit ratings do not reflect.
• Market prices of bonds often adjust more rapidly than credit ratings.

Question 16

An issue’s yield spread over its benchmark

Answer 16

reflects credit risk and liquidity risk.

Question 17

The level and volatility of yield spreads are affected by:

Answer 17

• the credit and business cycles,
• availability of capital from broker-dealers,
• the supply and demand for debt issues,
• and the financial performance of the bond issuer

Question 18

Yield spreads tend to narrow when

Answer 18

• the credit cycle is improving,
• the economy is expanding,
• financial markets and investor demand for new debt issues are strong

Question 19

Yield spreads tend to widen when

Answer 19

• the credit cycle, the economy, and financial markets are weakening,
• in periods when the supply of new debt issues is heavy or broker-dealer capital is insufficient for market making.

Question 20

The liquidity spread

Answer 20

• can be estimated as the difference between yields of a bond at bid and offer prices
• The remainder of the yield spread is considered credit spread.

Question 21

Given an expected change in spread, duration and convexity can be used to estimate the impact on price:

Answer 21

Change in full price of bond = -ModDur(deltaSpread) + 1/2 x convexity x (deltaSpread)^2

Question 22

Yield spread = liquidity spread + credit spread

Answer 22

• Calculate yield spread
• Calculate liqudity by the different yield at bid and offer price
• The remaining is the credit spread