Chapter 8

Question 1

What is liquidity risk?

Answer 1

Liquidity risk is the risk that a company will not be able to meet its short-term financial obligations when they come due.

Question 2

What are the two main types of liquidity risk?

Answer 2

1. Funding liquidity risk: The risk that a company will not be able to obtain funding to meet its obligations.
2. Market liquidity risk: The risk that a company will not be able to sell its assets quickly enough or at a fair price to meet its obligations.

Question 3

Name three factors that can contribute to liquidity risk.

Answer 3

1. Mismatches in maturity: Having a large amount of short-term debt coming due while holding illiquid long-term assets.
2. Dependence on a small number of funding sources: Relying heavily on a single bank or other funding source can create vulnerability.
3. Loss of confidence: A decline in market confidence or a negative credit rating can make it difficult to obtain funding.

Question 4

What is the difference between expected loss (EL) and unexpected loss (UL) in credit risk management?

Answer 4

Expected loss (EL) is the average loss anticipated from credit defaults, calculated as EL = Exposure × Probability of Default × Loss Given Default. Unexpected loss (UL) represents the potential deviation from EL due to volatility in default rates and recovery rates. UL is typically larger than EL and is used to determine economic capital requirements.

Question 5

Explain the concept of Loss Given Default (LGD) and its importance in credit risk assessment.

Answer 5

Loss Given Default (LGD) is the proportion of exposure that is lost when a borrower defaults. It’s calculated as (1 - Recovery Rate). LGD is crucial in credit risk assessment as it directly impacts the expected loss calculation and helps determine appropriate pricing and capital allocation for loans.

Question 6

What is credit scoring and how is it used in managing default risk?

Answer 6

Credit scoring is a statistical method used to predict the probability of default for a borrower. It typically involves assigning numerical scores based on various factors such as credit history, income, and debt levels. Banks and financial institutions use credit scores to assess creditworthiness, make lending decisions, and price loans according to risk.

Question 7

How does portfolio diversification affect credit risk?

Answer 7

Portfolio diversification in credit risk management involves spreading loans across different borrowers, industries, and geographic regions. This reduces the impact of individual defaults on the overall portfolio. Diversification can lower unexpected losses and improve the risk-return profile of the loan portfolio, although it doesn’t eliminate systematic credit risk.