Ch 5: Credit Risk Management

Question 1

__________________ is the risk of an economic loss from the failure of a counterparty to fulfill its contractual obligations. Its effect is measured by the cost of replacing cash flows if the other party defaults.

Answer 1

Credit Risk

Question 2

__________________ is the risk of loss due to the counterparty’s failure to perform on an obligation during the life of the transaction.

Answer 2

Presettlement Risk

Question 3

__________________ is due to the exchange of cash flows and is of a much shorter-term nature.

Answer 3

Settlement Risk

Question 4

______________. The institution can still cancel the transfer without the consent of the counterparty.

Answer 4

Revocable.

Question 5

______________. The payment has been sent but payment from the other party is not yet due.

Answer 5

Irrevocable.

Question 6

______________. The payment from the other party is due but has not actually been received.

Answer 6

Uncertain.

Question 7

______________. The counterparty payment has been received.

Answer 7

Settled.

Question 8

______________. It has been established that the counterparty has not made the payment.

Answer 8

Failed.

Question 9

Managing settlement risk requires unique tools, such as___________________________.

Answer 9

real-time gross settlement (RTGS) systems.

Question 10

These systems aim at reducing the time interval between the time an institution can no longer stop a payment and the receipt of the funds from the counterparty.

Answer 10

real-time gross settlement (RTGS) systems.

Question 11

______________, also called continuous-linked settlements, where payments are netted for a group of banks that belong to the system.

Answer 11

Multilateral Netting System

Question 12

_________________ are used to trade emerging-market currencies outside the jurisdiction of the emerging-market regime and are also settled in dollars.

Answer 12

Nondeliverable Forwards

Question 13

_________________ is a discrete state for the counterparty

Answer 13

Default

Question 14

________________ is the economic or market value of the claim on the counterparty, it is also called exposure at default (EAD) at the time of default.

Answer 14

Credit Exposure

Question 15

_________________ represents the fractional loss due to default. As an example, take a situation where default results in a fractional recovery rate of 30% only. LGD is then 70% of the exposure.

Answer 15

Loss Given Default (LGD)

Question 16

Presettlement risk only arises when the contract’s replacement cost has a positive value to the institution (i.e., is “in-the-money”). T or F?

Answer 16

True

Question 17

You have granted an unsecured loan to a company. This loan will be paid off by a single payment of $50 million. The company has a 3% chance of defaulting over the life of the transaction and your calculations indicate that if they default you would recover 70% of your loan from the bankruptcy courts. If you are required to hold a credit reserve equal to your expected credit loss, how great of a reserve should you hold?

Example 3

a. $450,000
b. $750,000
c. $1,050,000
d. $1,500,000

Answer 17

a. $450,000

Question 18

An investor holds a portfolio of $100 million. This portfolio consists of Arated bonds ($40 million) and BBB-rated bonds ($60 million). Assume that the one-year probabilities of default for A-rated and BBB-rated bonds are 3% and 5%, respectively, and that they are independent. If the recovery value for A-rated bonds in the event of default is 70% and the recovery value for BBB-rated bonds is 45%, what is the one-year expected credit loss from this portfolio?

Example 4

a. $1,672,000
b. $1,842,000
c. $2,010,000
d. $2,218,000

Answer 18

c. $2,010,000

Question 19

Calculate the probability of a subsidiary and parent company both defaulting over the next year. Assume that the subsidiary will default if the parent defaults, but the parent will not necessarily default if the subsidiary defaults. Also assume that the parent has a one-year probability of default of 0.50% and the subsidiary has a one-year probability of default of 0.90%

Example 5

a. 0.450%
b. 0.500%
c. 0.545%
d. 0.550%

Answer 19

b. 0.500%

Question 20

A portfolio manager has been asked to take the risk related to the default of two securities A and B. She has to make a large payment if, and only if, both A and B default. For taking this risk, she will be compensated by receiving a fee. What can be said about this fee?

Example 6

a. The fee will be larger if the default of A and of B are highly correlated.
b. The fee will be smaller if the default of A and of B are highly correlated.
c. The fee is independent of the correlation between the default of A and of B.
d. None of the above is correct.

Answer 20

a. The fee will be larger if the default of A and of B are highly correlated.

Question 21

21. A German bank lends €100 million to a Russian bank for one year and receives €120 million worth of Russian government securities as collateral. Assuming that the one-year 99% VAR on the Russian government securities is €20 million and the Russian bank’s one-year probability of default is 5%, what is the German bank’s probability of losing money on this trade over the next year?

Example 7

a. Less than 0.05%
b. Approximately 0.05%
c. Between 0.05% and 5%
d. Greater than 5%

Answer 21

c. Between 0.05% and 5%

Question 22

A portfolio consists of two (long) assets £100 million each. The probability of default over the next year is 10% for the first asset, 20% for the second asset, and the joint probability of default is 3%. Estimate the expected loss on this portfolio due to credit defaults over the next year, assuming 40% recovery rate for both assets.

Example 8

£18 million
£22 million
£30 million
None of the above

Answer 22

£18 million

Question 23

Consider an A-rated bond and a BBB-rated bond. Assume that the one-year probabilities of default for the A- and BBB-rated bonds are 2% and 4%, respectively, and that the joint probability of default of the two bonds is 0.15%. What is the default correlation between the two bonds?

Example 9

a. 0.07%
b. 2.6%
c. 93.0%
d. The default correlation cannot be calculated with the information provided.

Answer 23

b. 2.6%

Question 24

A portfolio of bonds consists of five bonds whose default correlation is zero. The one-year probabilities of default of the bonds are: 1%, 2%, 5%, 10% and 15%. What is the one-year probability of no default within the portfolio?

Example 10

a. 71%
b. 67%
c. 85%
d. 99%

Answer 24

a. 71%

Question 25

There are 10 bonds in a credit default swap basket. The probability of default for each of the bonds is 5%. The probability of any one bond defaulting is completely independent of what happens to the other bonds in the basket. What is the probability that exactly one bond defaults?

Example 11

a. 5%
b. 50%
c. 32%
d. 3%

Answer 25

c. 32%