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709.1. Pre-settlement credit risk (aka, credit risk) is the risk of loss due to default by a borrower
or counterparty and its basic quantitative drivers (or components ) are exposure at default
(EAD), default probability (PD, aka EDF), loss given default (LGD), default correlation, ρ,
concentration, and time horizon. About these components, which of the following statements is
TRUE?
a) Expected loss increases non-linearly with PD
b) Unexpected loss increases non-linearly with PD
c) The time horizons and probability distributions (of returns) between credit risk and
market risk are similar
d) Due to complexity, the best estimate of exposure at default (EAD) for derivatives
portfolios is the notional amount
709.2. Analyst Jennifer needs to make an assumption for exposure at default (EAD) in the case
of a revolving credit line that has been extended to a client, so that she can compute an
expected loss (EL) on the credit line. The credit limit (aka, commitment) is $20.0 million, of
which $6.0 million has been drawn (aka, outstanding). Her assumption, based on a single B-
rating equivalent for the Loan Equivalency Factor (LEQ; aka, usage given default, UGD) is
50.0%. Finally, her assumption for default probability (PD) is 5.0% and her assumption for loss
given default (LGD) is 75.0%. What is the expected loss (EL) on the credit line?
a) $487,500
b) $650,000
c) $750,000
d) Not enough information; i.e., we need σ(LGD).
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709.2. A. $487,500. Adjusted EAD = $6.0 mm + ($20.0 - 6.0) * 50.0% = $13.0 mm and EL =
EAD * PD * LGD = $13.0 mm * 5.0% * 75% = $487,500.
In regard to false choice (D), $2.30 million is the unexpected loss (UL) if the σ(LGD) happens to
be 30.0%., where UL = sqrt[PD * σ^2(LGD) + LGD^2*σ^2(PD)]*AE = sqrt(0.050*0.30^2 +
0.75^2*0.05*0.95)*$13.0 mm = $2.297 million
In regard to false (A), this is near to the risk contribution of Exposure #1 which is given by RC(1)
= UL(1) * [UL(1) + UL(2)*ρ(i,j)]/UL(P); in this case, RC(#1) = UL(#1) * [UL(#1) +
UL(#2)*ρ(#1,#2)]/UL(P) = $557,000 * [$557,000 + $726,000 * 0.20]/$1,000,000 = $391,125.
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710.1. The risk management staff at an investment bank uses the Merton model to estimate the
distance to default (DD) and expected default frequency (EDF) in evaluating default conditions
for both potential and existing client firms. One such client currently has total assets valued at
USD 20.0 billion, asset volatility, σ(A) of 28.0% per year, and debt with a face value of USD 12.0
billion. The expected return on the firm’s assets is 9.0% per year and the risk-free rate is 1.0%
per year. The firm does not pay any dividends. The rating schedule at a 1-year horizon is shown
in the table below: (inspired by GARP's 2017 P2 Question #3).
What is the suggested credit rating of the firm at a 1-year horizon using the provided rating
schedule?
a) A+/A-
b) BBB+/BBB-
c) B+/B-
d) CCC+/CCC-
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710.2. Below is plotted the cumulative survival time distribution under the assumption of a
constant hazard rate.
Each of the following statements about this plot is true EXCEPT which is false?
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710.3. Consider a five-year bond that pays 7.0% semi-annual coupon. If we assume the
upward-sloping risk-free zero rate curve shown below, where the zero rates are expressed with
continuous compounding, then the bond's price is $103.57 and its implied yield 6.07% per
annum with continuous compounding (which is equivalent to a yield of 6.16% with semi-annual
compounding):
However, assume the bond actually trades at par (that is, it's current price is $100.00). If we
recall that duration assumes a parallel shift in the rate curve (necessary given it is a single-
factor model), which is nearest the bond's z-spread when this bond prices at par?
a) 82 basis point
b) 117 basis points
c) 153 basis points
d) 204 basis points
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710.1. D. CCC+/CCC-. The distance to default, DD = 2.006 (i.e., approximately 2.0) and the PD
= 2.24%; given 2.0, we can use the so-called "68-95-99.7" rule (see
http://trtl.bz/68_95_997_rule) such that we know the PD answer is near to one-half of 5.0%.
Detailed calculations shown below.
710.2. C. False. Given a constant hazard rate of 14.0%, the conditional default probability
is 13.06% each year. For example, in year 2, the conditional PD = (24.42% - 13.06%)/86.94%
= 13.06%; in year 3, the conditional PD = (34.30% - 24.42%)/75.58% = 13.06%.
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The price difference is 100/103.57 - 1 = -3.45% and given a duration of 4.29 years, the
estimated yield shock is 3.45%/4.29 years = 80.3 basis points. Notice, too, that given the bond
is pricing at par, its semi-annual yield must equal 7.0% (i.e., must match its coupon rate), which
is an increase of 7.0% - 6.159% = 0.841% in the yield. Please note we do not expect this
duration-based difference to equal to the z-spread unless the spot rate curve happens to be flat,
which it is not here. The z-spread is the constant spread added to each zero rate that produces
the bond's price, so it is important to understand that the z-spread incorporates the shape of the
rate curve. Yet in this case, it's not a bad approximation. As shown below, the exact z-spread (if
we maintain the continuous compounding given by the zero rates) is equal to 8.19%.
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711.1. Suppose there are twenty (20) credits in a portfolio. Each credit has the same default
probability of 5.0% and the (pairwise) default correlations are all zero; that is, as defaults are
i.i.d. the portfolio is characterized by a binomial distribution, as displayed below. For example,
the probability of exactly five defaults is equal to C(20,5)*0.050^5*0.950^15 = 0.0022446 =
0.22%.
If the par value of each position is $100.0 million such that the total portfolio value is $2.0 billion,
and we assume the loss given default (LGD) is always 100.0%, then what is the 95.0% credit
value at risk (CVaR) of the portfolio?
a) Zero
b) $100.0 million
c) $200.0 million
d) $300.0 million
711.2. Consider a pair of credits, one B+ and the other B-rated, with default probability π(1) =
0.070 and π(2) = 0.110. If the defaults are uncorrelated, then the joint default probability π(12) =
0.070*0.110 = 0.00770. If, however, the default correlation is 0.20, then which is nearest to the
corresponding INCREASE in the joint default probability? (inspired by Malz' Example 8.1)
a) Zero: default correlation does not impact joint default probability
b) +0.00154 or 0.154% (to 0.924%)
c) +0.0160 or 1.60% (to 2.3667%)
d) +0.3800 or 38.0% (to 38.770%)
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711.3. Structured credit products (aka, portfolio credit products) are backed by credit-sensitive
(risky!) loans or bonds and tend to be characterized by the sequential distribution of credit
losses via tranches which can be categorized into three groups: equity, junior and senior. The
"waterfall" refers to the rules about how the cash flows from the collateral are distributed to the
various securities in the capital structure. According to Malz' analysis, each of the following is
true about structured credit risk EXCEPT which is false?
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711.3. D. False. A well-diversified credit portfolio does not eliminate systematic risk!
From Malz Chapter 8 (Structured Credit Risk): "Summary of Tranche Risks. On the basis of the
example, we can make a few generalizations about structured credit product risk. In Chapter 14,
we see that neglect of these risks played an important role during the subprime crisis, in its
propagation and in the losses suffered by individual institutions.
Systematic risk. Structured credit products can have a great deal of systematic risk, even
when the collateral pools are well-diversified. In our example, the systematic risk shows up in
the equity values and bond losses when default correlation is high. High default correlation is
one way of expressing high systematic risk, since it means that there is a low but material
probability of a state of the world in which an unusually large number of defaults occurs. Most
notably, even if the collateral is well-diversified, the senior bond has a risk of loss, and
potentially a large loss, if correlation is high. While its expected loss may be lower than that of
the underlying loan pool, the tail of the loss and the credit VaR are high, as seen in the
rightmost column of plots in Figure 9.4. In other words, they are very exposed to systematic risk.
The degree of exposure depends heavily on the credit quality of the underlying collateral and
the credit enhancement.
Tranche thinness. Another way in which the senior bond’s exposure to systematic risk is
revealed is in the declining difference between the senior bond’s credit VaRs at the 99 and 95
percent confidence levels as default probabilities rise for high default correlations. For the
mezzanine bond, the difference between credit VaR at the 99 and 95 percent confidence levels
is small for most values of π and ρ, as seen in Figure 9.3. The reason is that tranche is
relatively thin. The consequence of tranche thinness is that, conditional on the tranche suffering
a loss at all, the size of the loss is likely to be large.
Granularity can significantly diminish securitization risks. In Chapter 8, we saw that a portfolio of
large loans has greater risk than a portfolio with equal par value of smaller loans, each of which
has the same default probability, recovery rate, and default correlation to other loans. Similarly,
“lumpy” pools of collateral have greater risk of extreme outliers than granular ones. A
securitization with a more granular collateral pool can have a somewhat larger senior tranche
with no increase in credit VaR. A good example of securitizations that are not typically granular
are the many CMBS deals in which the pool consists of relative few mortgage loans on large
properties, or so-called fusion deals in which a fairly granular pool of smaller loans is combined
with a few large loans. When the asset pool is not granular, and/or correlation is high, the
securitization is said to have high concentration risk."
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712.1. Today Plextech Bank enters into a fairly priced interest rate swap ("fairly priced" implies
the value of the swap is zero at inception, T0) where Plextech Bank pays a fixed rate of 3.0%
per annum with semi-annual compounding in exchange for receiving six-month LIBOR from its
counterparty; in this way, Plexttech Bank is the fixed-rate payer. Interest payments are
exchanged every six months (twice a year). The notional amount is USD $100.0 million and the
tenor (swap life) is two years. When the bank enters the swap, the LIBOR/swap rate curve is flat
at 3.0% per annum with semiannual compounding. Six months later, the LIBOR/swap rate shifts
up by 50 basis points to 3.50%. At this time (T0 + 0.5 years), (immediately after the exchange)
the current exposure of the bank will be nearest to what?
a) Zero
b) +500,000
c) +724,500
d) +833,300
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712.2. Consider a netting set consisting of only two trades that tend to be negatively correlated,
as illustrated below under five scenarios:
The expected exposure (EE) should assume each scenario has equal weight, such that here
expected exposure is the simple average of the five scenario exposures. If we define the netting
factor as the ratio of net (i.e., with netting) expected exposure to gross (i.e., without netting)
expected exposure, then what is the netting factor?
a) 25.0%
b) 50.0%
c) 75.0%
d) 100.0%
712.3. About the potential future exposure (PFE) of various instruments, each of the following is
true EXCEPT which is false?
a) The PFE converges to zero at maturity for both the buyer and seller of a credit default
swap (CDS)
b) The PFE at maturity is greater for a long option position than the corresponding short
position on the same option
c) The PFE at maturity is greater for a cross-currency swap than an (vanilla) interest rate
swap with otherwise similar characteristics
d) For both the fixed-rate payer and floating-rate payer in a vanilla IRS, the PFE will diffuse
to a peak at approximately one-third the life of the swap and then amortize toward zero
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Answers:
712.1. C. +724,500. The calculations for the exact value ($724,496) are shown below,
valued under either approach. Note that as the fixed-rate payer (paying 3.0%), the increase in
the LIBOR/swap curve implies that the value of the swap increases for Plextech and decreases
for its counterparty such that Plextech will have positive current (credit) exposure but the
counterparty will have zero current exposure which, in the counterparty's case, is equal to
max(0, value). Note also that this answer can be guessed by noticing that the sum of payments,
before discounting, is $250,000 * 3 = $750,000, so we can expect the current exposure to
discounted (to present value) from $750,000.
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This scenario impacts the strong benefit of netting under negative correlations. As Gregory
writes (in xVA, 3rd edition), "Netting is essentially a diversification effect. When considering the
netting benefit of two or more transactions, the most obvious consideration is the correlation
between the future values (and therefore exposures also). A high positive correlation between
two transactions means that future values are likely to be of the same sign. This means that the
netting benefit will be small or even zero ... On the other hand, negative correlations are clearly
more helpful as future values are much more likely to have opposite signs and hence the netting
benefit will be stronger. We illustrate this in Table 7.2 ... "
712.3. A. False. For the CDS buyer (aka, protection buyer) the PFE is likely to jump to the
level of (1 - recovery rate; e.g., 60.0% if the recovery rate is 40.0%) because this is the
credit exposure if there is a credit event.
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713.1. In counterparty credit risk (CCR), exposure profiles plot credit exposure against time. The
metric is typically expected exposure (EE) or potential future exposure (PFE). Consider the
following four exposure profiles for (a) a vanilla fixed-for-floating interest rate swap, (b) a 5-year
loan, (c) a short European option position and (d) and long credit default swap; i.e., buying
protection which is synthetically short the reference:
Each of the (above) four profiles is a plausible credit exposure curve except which is FALSE?
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713.2. Each of the following statements about credit exposure metrics is true EXCEPT which is
false?
a) If both the initial (t = 0) expected exposure is zero and the final (t = maturity) expected
exposure is zero, then the expected positive exposure (EPE) must also be zero
b) Changing the confidence level (e.g., from 95.0% to 99.0%) DOES impacts potential
future exposure (PFE) and maximum PFE but impacts NEITHER expected exposure
(EE) NOR expected positive exposure (EPE)
c) Potential future exposure (PFE) should be retrieved from simulations of market variables
based on REAL-WORLD, historically-informed measures rather than a risk-neutral, no-
arbitrage framework informed by market data
d) Although expected exposure and (EE) and effective EE have a shape (i.e., forward
exposure curve) that varies over future time horizons, expected positive exposure (EPE)
and effective EPE (EEPE) average into single point estimates, and EEPE cannot be less
than EPE
713.3. A chief risk officer (CRO) asked her risk department to evaluate the bank’s 3-year
derivative exposure to a counterparty. The 1-year credit default swap (CDS) on the counterparty
is currently trading at a spread of 100 bps. The table below presents trade and forecast data on
the the expected exposure, collateral, CDS spread, and the recovery rate with respect to the
position:
Additionally, the CRO has presented the risk team with the following set of assumptions to use
in conducting the analysis:
The counterparty’s default probabilities follow a hazard rate process
The investment bank and the counterparty have signed a credit support annex (CSA) to
cover this exposure, which requires collateral posting throughout the life of the contract;
as illustrated above, projected posted collateral will be $10.0, $15.0 and 20.0 million,
respectively, in Years 1, Year 2, and Year 3.
The current risk-free rate of interest is 3.0% per annum with continuous compounding
and the term structure of interest rates is predicted to remain flat over the 3-year horizon
Given the information and the assumptions above, what is nearest the correct estimate for the
credit valuation adjustment (CVA) for this positon? Note: this question is inspired by GARP's
2017 P2 Practice Exam Question #76.
a) USD 868,800
b) USD 1.302 million
c) USD 2.580 million
d) USD 3.944 million
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Answers:
713.1. C. False. While a long option has an exposure curve that increases over time, a
short option does not have any exposure (so this exposure profile would apply to neither
a short nor long option position).
In regard to (A), (B) and (D), each is plausibly true for an exposure profile.
713.2. A. False. Expected positive exposure (EPE) is the weighted average of the
expected exposure over time, so it will be non-zero. For example, the EE of a vanilla interest
rate swap (with no principal exchange at maturity) begins and ends at zero, but the EPE is a
decidedly positive.
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714.1. According to Jon Gregory, wrong-way risk (WWR) is a subtle but potentially strong effect
and further WWR is "often a natural and unavoidable consequence of financial markets."
Wrong-way risk (WWR) generally describes an unfavorable co-dependency between exposure
and the credit quality of the counterparty. In more exact and operational terms, in a wrong-way
risk (right-way risk) the exposure increases (decreases) as the probability of the counterparty's
default increases (decreases). In this way, we can either say that wrong-way risk is a positive
correlation, or dependence, between exposure and default probability; or equivalently WWR is a
negative correlation between exposure and counterparty credit quality.
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714.2. Since the global financial crisis (GFC), there has been a push for better stress testing of
counterparty credit risk (CCR) exposures. In many cases, a financial institution will consider its
unilateral credit valuation adjustment (CVA) for stress testing which concerns the fact that its
counterparties could default under various market scenarios. But in addition, the financial
institution will evaluate its bilateral CVA, which adds the possibility of its own default to
counterparties.
According to David Lynch of the Board of Governors of the Federal Reserve, each of the
following is true--or at least GOOD ADVICE, EXCEPT which is not true?
a) As regulators shift derivative transactions to central clearing and there are consequently
fewer tools to measure and manage CCR, the bank should adopt EITHER a view of
CCR as a credit risk or a market risk but not both
b) Although stresses of current exposure are among the most common stress tests used in
counterparty credit, stressing current exposure has at least three drawbacks:
aggregation of the results is problematic; it does not account for the credit quality of the
counterparties; and it provides no information on wrong-way risk
c) For derivatives portfolios, stressed expected loss is likely to include the variable
expected positive exposure (EPE), which is the weighted average over time of expected
exposures (EE) where the weights are the proportion that an individual expected
exposure represents of the entire time interval; and, in turn, expected exposure (EE) is
the average of the distribution of exposures at any particular future date before the
longest-maturity transaction in the netting set matures
d) The "stress loss" for loan portfolio is the difference between an unconditional expected
loss and a stressed EL, EL(s) - EL, and it is the same for a derivatives portfolio except
the exposure at default (EAD) variable is replaced by expected positive exposure (EPE)
multiplied by an alpha, α, factor; in symbolic terms, EAD --> EPE*α
714.3. Gadgetron has a two-way credit support annex (CSA) with a counterparty covering a
portfolio that has just been marked to a value of $1,980,000 or $1.980 million. The collateral
terms include the following:
Initial margin: $250,000
Portfolio mark-to-market (MTM) value: +$1,980,000 (from Gadgetron's perspective)
Threshold: $1,000,000
Mark-to-market (MTM) of collateral already held: $770,000
Minimum transfer amount: $100,000
Rounding: $25,000 (always in favor of Gadgetron; i.e., round up a collateral call, round
down a collateral return by Gadgetron)
Which of the following is the collateral call amount that must be posted by Gadgetron's
counterparty?
a) -$25,000 (return of $25,000)
b) Zero
c) $225,000
d) $1,210,000
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Answers:
714.1. D. TRUE: We can quantitatively and effectively incorporate WWR into the CVA
formula at least three ways: by explicitly specifying a dependency between exposure and
default; by assuming a conditional exposure; or by assuming a conditional default
probability; i.e., linking PD parametrically to exposure
In regard to false (A), this approximation does NOT incorporate WWR into CVA
because it assumes independence between exposure and default probability
In regard to doubly false (B), first, WWR can be GENERAL (i.e., driven by macro-
economic relationships and/or SPECIFIC (driven by causal linkages between the
exposure/collateral and default of the counterparty); and "Regulators have identified both
general (driven by macro-economic relationships) and specific (driven by causal linkages
between the exposure/ collateral and default of the counterparty) WWRs as critical to
measure and control (Section 8.6.5). Not surprisingly, Basel III has made strong
recommendations over quantifying and managing WWR."
In regard to false (C), this is an example of right-way risk: the long's exposure
increases with higher commodity prices. Says Gregory, "Commodity swaps. A
commodity producer (e.g. a mining company) may hedge the price fluctuation they are
exposed to with derivatives. Such a contract should represent right-way risk, since the
commodity producer will only owe money when the commodity price is high and when
their business should be more profitable. The right-way risk arises due to hedging (as
opposed to speculation)."
714.2. A. FALSE. Lynch says, "The treatment of CCR as a credit risk or CCR as a market
risk has implications for the organization of a financial institution’s trading activities and
the risk-management disciplines. Both treatments are valid ways to manage the portfolio, but
adoption of one view alone leaves a financial institution blind to the risk from the other view. If
CCR is treated as a credit risk, a bank can still be exposed to changes in CVA. A financial
institution may establish PFE limits and manage its default risk through collateral and netting,
but it still must include CVA in the valuation of its derivatives portfolio. Inattention to this could
lead to balance-sheet surprises. If CCR is treated as a market risk, dynamically hedging its CVA
to limit its market risk losses, it remains exposed to large drops in creditworthiness or the
sudden default of one of its counterparties. A derivatives dealer is forced to consider both
aspects."
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715.1. Both the credit default swap (CDS) and the total return swap (TRS, aka TRORS) can be
used to hedge risk, but the TRS is a more comprehensive hedge instrument. While the CDS
hedges credit risk--in particular, default risk and credit deterioration risk--the TRS hedges both
credit and market risk. Consider the mechanical similarities and differences, as illustrated below.
About the CDS and TRS, each of the following statements is true EXCEPT which is false?
a) The total return swap (TRS) is equivalent to a FUNDED credit default swap (CDS)
b) Upon a legitimate credit event in a CDS, the protection buyer stops paying the regular
premium and the protection seller pays notional multiplied by (one minus the recovery
rate); i.e., (1-RR)
c) In the TRS, the Receiver will pay its counterparty for depreciation in value of the
reference, but in some leveraged TRSs, the buyer holds the explicit option to default on
this obligation and abandon the collateral
d) The CDS is a first-to-default (1TD) put if the reference is a portfolio of credit-sensitive
assets and the credit (payoff) event is default of any one of the assets; in which case,
the spread will depend at least partly on the degree of pairwise correlation between
reference credits
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715.2. You are pricing (aka, valuation) a to-be newly issued mortgage-backed security (MBS)
where the mortgage pool has an original loan balance of $20.0 million. Due to lower interest
rates, your model makes an assumption of 235% Public Securities Association (PSA). Under
this assumption, which of the following is the nearest to the model's prepayments in the first
month (excluding the scheduled prepayment, of course)?
a) $3,336.40
b) $7,850.26
c) $40,000.00
d) $94,000.00
715.3. Consider the following schedule for a 60-month loan with an original principal balance of
$300,000 and yield of 5.0%. The loan fully amortizes (please note the schedule is truncated
such that months six through 56 are skipped).
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Answers:
715.1. A. False. The TRS is also unfunded, like the CDS. Instead, what is true is that a
credit-linked note (CLN) is the equivalent of, or at least very similar to, a funded CDS.
715.2. B. $7,850.26.
The 235 PSA implies 2.35 * 0.20% CPR = 0.470% CPR in the first month. Therefore, SMM = 1-
(1-0.00470)^(1/12) = 0.039251% = 0.00039251 such that the first month's (non-scheduled)
prepayment is expected to be 0.00039251 * $20,000,000 = $7,850.26. Recall:
715.3. D. False. The 5.0% per annum rate must be divided by 12, such that the mortgage
payment factor is given by [0.050/12*(1+0.050/12)^60]/[(1+0.050/12)^60 - 1] = 0.018871;
then the monthly payment is given by 0.018871 * $300,000 = $5,661.37 (as shown in the
PMT column).
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