CH 6 Credit Risk Measurement and Management 8KUA8G1F13

FRM
Part II Exam

By AnalystPrep

Questions - Credit Risk Measurement and Management
Last Updated: Apr 5, 2021
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© 2014-2021 AnalystPrep.
Table of Contents
77 - The Credit Decision 3

78 - The Credit Analyst 12
79 - Capital Structure in Banks 24
80 - Ratings Assignment Methodologies 34
81 - Credit Risks and Credit Derivatives 51
82 - Spread Risk and Default Intensity Models 66
83 - Portfolio Credit Risk 79
84 - Structured Credit Risk 89
85 - Counterparty Risk and Beyond 98
86 - Netting, Close-out, and Related Aspects 107
87 - Margin (Collateral) and Settlement 116
88 - Credit Exposure and Funding 139
90 - CVA (Part A) 164
91 - CVA (Part B – Wrong-way Risk) 172
92 - The Evolution of Stress Testing Counterparty Exposures 181
93 - Credit Scoring and Retail Credit Risk Management 188
94 - The Credit Transfer Markets and Their Implications 195
95 - An Introduction to Securitization 202
Understanding the Securitization of Subprime Mortgage
96 - 211
Credit
2
Reading 77: The Credit Decision
Q.1718 The word credit is derived from Latin word credere meaning “to entrust” or “to believe”.
Before a credit contract can be written, two fundamental principles require the creditor to
ensure that:
A. The borrower is willing to repay (reputation); and it has (or will have) the capacity to
pay (financial quality)
B. The borrower carries an acceptable credit risk (financial quality); and that default risk
is mitigated by securitization (guarantees or covenants)
C. The borrower’s reputation is confident (high willingness and reputation); and that
default risk is much lower than the market average (benchmarking)
D. The borrower’s financial condition is either equal to or higher than investment grade
(superior net worth); and that credit risk is assumed to be lower than that of other
comparable parties (acceptable credit risk)
Q.1719 Credit risk is the underlying risk factor in many business settings. In which of the
following cases is credit risk basically absent?
A. A well-diversified portfolio of bonds made up of secured AAA (the most secure rating
by S&P’s) rated corporate and government bonds
B. One party performs services for another and sends an invoice
C. One party makes an advance payment for goods pending delivery
D. The simultaneous exchange of goods for cash in a local grocery
Q.1720 Which industry is unable to avoid credit risk and why?
A. Automobile manufacturers because of the cyclical nature of their business
B. Manufacturers of electrical equipment because of intense market competition
C. Suppliers of giant retailers because of their extremely weak bargaining power
D. The banking industry because the acceptance of credit risk is an integral part of
operations
3
Q.1721 Most banks exercise subjective judgment while assessing the credit risk of a borrower,
using a variety of borrower information in the process. In deciding whether or not to disburse a
loan, which one of the following is not a direct variable affecting relative credit risk?
A. External conditions such as country risk and sector risk
B. Capital expenditure investment and financing policies
C. Capacity (volatility of earnings) and willingness (reputation)
D. Quality and sufficiency of risk mitigation instruments such as collateral and

guarantees
Q.1722 In evaluating an obligor’s capacity to repay, which of the following would be most
suitable when dealing with a corporate borrower?
A. Profitability ratios forecast by an independent consultant
B. Expected free cash flow levels for the credit period
C. Operational cash cycle days
D. Average and expected working capital days
Q.1723 The following are characteristics of credit instruments which have a direct effect on the
level of credit risk, EXCEPT:
A. The maturity of the product
B. The securitization status of the obligation
C. The potential effect of changes in market interest rates
D. The priority level assigned to the creditor
4
Q.1724 Ann Flanagan, works as a credit analyst at a U.S. bank. She's discussing potential loss
forecasts on a loan the bank made to a mid-sized tech startup with the institution's head of
credit. She makes the following comment: "If the borrower does not follow through on its
financial obligation, there will be a 70% loss." This is the:
A. expected loss.
B. loss given default.
C. exposure at default.
D. probability of default.
Q.1725 Credit risk mitigants such as guarantees, collaterals, pledges, or insurance reduce the
credit risk exposure of an obligor. In other words, collaterals protect against a borrower’s
default. Which of the following businesses commonly serves as an example of businesses that
accept a wide range of items as collateral?
A. A pawnbroker
B. A stockbroker
C. Peer-to-peer secured asset lenders
D. An auction officer
Q.1726 In less-developed countries where financial reporting requirements are poor and
essential credit analysis deemed more difficult, which of the following is the most favored
method of reducing lending risks?
A. Risk-based pricing and/or credit tightening
B. Hiring a respectable rating agency together with an independent due diligence

consultant
C. Diversification and insurance
D. Credit risk mitigants
5
Q.1727 In countries where legal systems have developed, which of the following elements of the
5 C’s (of credit analysis) would a credit analyst emphasize most?
A. The relative importance of the borrower's capacity to repay the loan
B. The relative importance of the borrower's character and willingness to repay the loan
C. The relative importance of the borrower's capital structure components like working
capital, net worth, and cash flow
D. The relative importance of the borrower's external conditions surrounding the

business under analysis
Q.1728 Which of the following is a fundamental risk, and therefore demands due emphasis
especially in emerging markets?
A. Legal and regulatory infrastructure
B. Volatility in profitability
C. Funding and liquidity risk
D. Volatility risk in market interest rates
Q.1729 Ann Jones is in the process of forecasting the potential loss on a loan her employer -
Eagle Trade Limited - made to a well-established corporate borrower. As per her estimates, there
will be a 60% loss if the borrower does not perform the financial obligation. This is the:
A. recovery rate
B. loss given default
C. exposure at default
D. expected loss
6
Q.1730 In evaluating the capacity to repay during credit analysis, which statement best
describes the importance of quantitative tools?
A. Estimation of capacity to pay is possible in most cases
B. Compared with other C’s in credit evaluation, only capacity to repay requires
quantitative methods under all circumstances
C. Capacity to repay actually deals less with quantitative data because of the required
interpretation of financial data
D. Optimal effectiveness in credit analysis must combine quantitative tools with

qualitative judgments
Q.1731 Credit and default risks in modern financial analysis are generally assumed to be
synonymous. In an effort to assess default risk, a financial risk analyst working for a Gulf-based
financial institution needs to estimate a regional food group’s expected loss (EL). Which of the
following would not be a direct constituent of expected loss in such calculations?
A. Probability of default (PD), expressed in percentage terms for the credit term
B. Loss given default (LGD) or severity of the default, expressed in percentage terms for
a specific time horizon
C. Expected securities (ES), i.e., covenants and/or international guarantees in absolute

terms
D. Exposure at default (EAD), expressed in absolute terms capped at a specific amount by

a credit insurance entity
Q.1732 Which of the following best explains why bank failures have historically been quite rare?
A. Modern banks, being different from other non-financial corporations, fail only during
financial crises
B. Banks have much better loss-absorption capacities because of high capital reserves
C. Banks cover their credit risk through securitization, such as covenants and guarantees
D. Banks are the most regulated and monitored institutions across the financial space
7
Q.2664 Given the following information about a loan portfolio, calculate its expected loss for a
one-year time horizon.
Probability of default 4%
Loss given default over a one year period 60%
Exposure at default 55%
A. 1.95%
B. 1.80%
C. 1.51%
D. 1.32%
Q.2685 Given the following information, calculate the expected loss.
Exposure $1 million
Recovery Rate 40%
Probability of default 3%
LGD $600, 000
A. $18,000
B. $12,000
C. $3,000
D. $7,200
8
Q.2866 "Rita Smith is a newly hired credit analyst at Exim Bank. As part of her overall
orientation process, she has been asked to help set up loan facilities for a few clients. One of the
clients, John Flanagan, is a renowned businessman with interests in oil and gas. Smith sets up a
meeting with John and is immediately impressed with his brilliance on matters business and his
vision for his soon to be operational startup specializing in textiles. Smith thinks the venture is a
great idea, and the two immediately discuss a loan offer. Particularly noteworthy is the revelation
that John has serviced in full multiple loan facilities in the past. He has also already recruited
professional personnel in key areas of the business. She takes the loan application back to the
bank and convinces the loan committee that Exim Bank is lucky to be able to do business with
someone with John’s reputation."
This is most likely an example of:
A. Extrapolation analysis technique
B. Qualitative analysis technique
C. Quantitative analysis technique
D. Historical analysis technique
Q.2867 The following are instances likely to lead to a monetary loss by a lending institution.
Which one is NOT correctly placed?
A. High likelihood of default on a financial obligation that counterparties are obligated to

honor
B. Due to lower than expected recovery or higher than expected exposure at the time of
default, a higher than expected loss severity may occur
C. The counterparty’s default with respect to the payment of funds for goods or services
that have already been advanced
D. The availability of guarantors and collateral assets to secure the loan
9
Q.3974 You are holding an online discussion with bank interns, focusing on the 2008/2009
financial crisis. You go over the issues associated with the collapse of the sub-prime mortgage
market. One intern asks if the crisis was driven by bank failure or bank insolvency. What is the
difference between the two?
A. Insolvency occurs when the government steps in to bail out an institution by providing
some liquidity injection. Bank failure is the event where the government fails to bail out a
bank.
B. Insolvency is the event that triggers protection of depositors’ balances by the Federal
Deposit Insurance Agency, FDIA. Bank failure is the when the FDIA fails to gather up
enough funds to cover all depositors.
C. Insolvency is the event where liabilities exceed assets, plunging the bank into
significant liquidity issues. Bank failure is the closure and collapse of a bank triggering
massive losses to depositors and other stakeholders.
D. Insolvency is a bank’s inability to meet its day to day funding needs. Bank failure
occurs when a lack of funding is so severe such that the bank is unable to pay its
employees and is forced into receivership.
Q.3975 Black Rock Credit, Inc., is an American tier I lender specializing in funding of small but
promising startups around the country. One such startup is Smart Tech, a Texas-based firm
specializing in computer hardware for some of the latest models. The firm has grown rapidly
over the past year and the top management at Black Rock is hugely impressed and confident that
the bank made a good credit decision. However, the firm’s upward trend recently hit a rough
patch following a protracted trade war between the U.S. and a foreign state, which happens to
be the firm’s main market. Smart Tech recently filed Chapter 11 bankruptcy. Black Rock had
initially estimated its exposure at default to be $2,500,000. Because of the Smart Tech’s rapid
growth and resulting increases in the line of credit, Black Rock has ultimately lost $4,000,000. In
terms of credit risk, this is an example of:
A. default on payment for good or services rendered
B. a more severe loss than expected due to a greater than expected exposure at the time
of default
C. a more severe loss than expected due to a higher than expected probability of default
D. a more severe loss than expected due to a ratings downgrade by rating agencies.
10
Q.3976 James is an experienced credit analyst at Black Rock Credit, Inc. The new financial year
is just commencing, and James is conducting a thorough review of the loan book and the
assumptions underlying the calculation of the expected loss. One of the parameters of focus is
the loss given default (LGD) since the bank has substantial credit default swaps outstanding. Of
the following, which best defines LGD?
A. LGD is the total initial exposure minus the recovery rate.
B. LGD is the probability of an outcome that’s worse than initially expected
C. LGD is the difference between the total exposure at default and the recovery rate
D. LGD is the probability of an outcome that’s more favorable than initially anticipated.
Q.3977 Rebecca Harington is a newly hired loan officer at Lexim Bank. As part of her orientation
and transition into her new role, her boss has told her that she needs to deliver a minimum of
five commercial loans this month. After a bit of networking, Rebecca meets John Bercow, a local
businessman famous for a range of thriving business around town. Everyone says John is
someone you want to meet. Rebecca sets up a meeting with John and is immediately impressed
with his business sense. John goes ahead to outline his vision for a relatively new business
venture he recently came up with and Rebecca agrees that it is a great transformative idea. She
also analyzes recent and forecasted financial statements for the venture and is convinced that
the future outlook is bright. She takes the loan application back to Lexim and convinces the loan
committee that John’s venture presents a wonderful business opportunity with someone with an
incredibly rare reputation. This is an example of:
A. Historical analysis technique
B. Quantitative analysis technique
C. Qualitative analysis technique
D. Hybrid technique
11
Q.3978 Faith McMahon serves as the lead credit analyst at Cruzero bank based in North
America. She has tasked the credit team with extensive analysis of the following entities:
Prime Bank, a relatively small lender and counterparty to several of Cruzero’s
outstanding repo contracts
Prudential Life, a life insurance firm
Gary and Gary Capital, a hedge fund with extensive investments spread out across the
globe
Blue Ray Limited, an investment bank.
The four institutions above present an opportunity for the team to conduct:
A. Corporate credit analysis
B. Financial credit analysis
C. Consumer credit analysis
D. Hybrid credit analysis
Q.3979 Enock Munford has embarked on an exercise aimed at determining the creditworthiness
of a local bank. The following are key areas he is likely to focus on EXCEPT?
A. Liquidity
B. Capital adequacy
C. Cash flows
D. Asset quality
12
Q.3980 Paul Brian, a credit analyst with Prime Bank, is considering the loan application of a
small company that deals in high voltage home and office security lights. The company has been
solely owned by Andrew smith for more than 20 years and has established a strong market lead
in three different markets. However, there’s been sustained advocacy for energy-saving electric
gadgets and recent legislation offers significant tax-related benefits for manufacturers of such
gadgets. In recent times, several new market entrants have popped up offering cheaper and
more advanced lighting solutions that are more in line with the goals of climate change advocacy
groups. As a result, the company’s sales have declined. After several months of research, the
company is considering selling a new set of lighting solutions. Andrew has borrowed from Prime
Bank before but currently does not have a balance outstanding with the bank. Which of the
following statements is not one of the four components of credit analysis Paul should be
evaluating when performing the credit analysis for this potential loan?
A. Andrew’s character and past payment history with the bank
B. The business environment, competition, and prevailing economic climate in the region
C. The company’s balance sheets and income statements for the last few years as well as
Andrew’s personal financial situation
D. The financial situation of Andrew’s family and close friends who could be called upon
to guarantee the loan.
13
Reading 78: The Credit Analyst
Q.1733 Which of the following is NOT a correct statement regarding the main responsibilities of
a “credit analyst”?
A. Reviewing loans and customer documentation
B. Developing collections scorecards and making basic mortgage calculations
C. The assessment of the capital structure and financial statement analysis.
D. Evaluating the creditworthiness of financial intermediaries, and therefore,

counterparty credit analysis
Q.1734 What is the main difference between the duties of counterparty credit analysts and those
of analysts working at rating agencies such as Moody’s, S&Ps, and Fitch?
A. Counterparty credit analysts generally assign counterparties an internal rating while

external rating agencies assign an unbiased external rating for all kinds of entities
B. Counterparty credit analysts are generally more senior than rating agency analysts
and so can approve or reject a particular transaction
C. Both counterparty credit analysts and external rating agency analysts may be called
upon to advise only on particular areas of credit risk exposures
D. Financial investment products such as stocks, options, bonds, and derivatives are
under the scope of rating agency analysts only
Q.1735 The role of most credit analysts is to facilitate risk management. In a broader sense,
which of the following three risks are included in credit risk management analysis?
A. Market risk, liquidity risk, and operational risk
B. Market risk, interest rate risk, and sovereign risk
C. Insolvency risk, liquidity risk, and operational risk
D. Insolvency risk, liquidity risk, and sovereign risk
14
Q.1736 A credits risk manager is working to assess the relevant credit risk of an entity using
both human input as well as automated mechanisms. Which of the following may not be a
reasonable tool in his/her fundamental credit analysis?
A. In-depth assessment of all possible areas
B. Application of a credit scoring model or mechanism
C. Research considering microeconomic as well as macroeconomic factors
D. Research on quantitative and qualitative criteria
Q.1737 Which statement about corporate credit analysis is incorrect?
A. Core principles of corporate credit analysis are quite the same, but specific industry
knowledge is valuable
B. Specific industry knowledge is emphasized for fixed-income analysis as well as rating

purposes
C. The scale of the business is an important determinant while selecting an analytical

methodology
D. More primary research may be needed with respect to publicly listed multinational
enterprises
Q.1738 Which of the following is not a correct statement about the banking crisis?
A. Sovereign risk is very hard to estimate because it is generally more political than
economic
B. Systematic risk refers to the strength and stability of the banking sector in a sovereign
nation
C. Systematic risk may be used synonymously with the risk of a banking crisis
D. Systematic risk may be a subset of sovereign risk
15
Q.1739 Which of the following is NOT a group that employs credit analysts?
A. Banks and institutional investors, i.e., pension funds and insurance firms
B. Nonbank financial institutions (NBFIs)
C. Government agencies
D. None of the above
Q.1740 There is a wide range of financial products that a bank offers to its customers, all of
which are subject to credit risk management analysis. Which of the following pairs of products
presents the most complex financial product when compared to other options?
A. Credit default swaps and preferred stocks
B. Letters of credit and complex money market investments
C. Structured investment facilities and asset-backed securities
D. Interest rate swaps and corporate bonds
Q.1741 Certain elements of credit analysis are inherently more qualitative in nature while others
are accepted as more quantitative. Which of the following pairs of analyses uses only
quantitative aspects of credit analysis?
A. Non-performing loan ratios; Return on equity
B. Analysis of a bank’s credit culture and historical performance; Evaluation of internal

controls
C. Evaluation of credit review procedures; Asset quality
D. Industry and economic conditions; Earnings quality
16
Q.1742 A UK-based financial institution needs to consider the credibility of a Turkish-Greek
bank. Analysts have already completed a substantial analysis of macro-level criteria that may
directly influence the bank’s credit risk profile. Which of the following micro-level analyses must
also be considered in analytical processes?
A. Comparing current results to historical performance as well as performance versus

peers
B. The analysis of rating reports by major rating agencies
C. Assessing government issues and the likelihood of government intervention
D. The quality of regulation and the evaluation of credit review procedures
Q.1743 In which of the following materials would a bank credit analyst find only basic unaudited
financial statements?
A. Annual reports
B. Interim financial statements
C. Electronic financial data sources or databases, i.e., Bankscope
D. Management Discussion & Analysis
Q.1744 Which of the following statements is correct?
A. Fundamental to any bank credit analysis are annual audited financial statements.
Besides, a bank visit is practically a prerequisite for the rating agency analyst. The
exception to this is in the case of unsolicited ratings.
B. Fundamental to any bank credit analysis is the bank visit. Besides, the auditor’s
report is practically a prerequisite for the rating agency analyst. The exception to this
occurs in the case of clean or unqualified opinion.
C. Fundamental to any bank credit analysis are notes from bank visits. Besides, the
financial audit report is practically a prerequisite for the rating agency analyst. The
exception to this occurs in the case of scarcity of time and budget.
D. Fundamental to any bank credit analysis is Detailed company and market data.
Besides, the bank visit is practically a prerequisite for the rating agency analyst. The
exception to this occurs when more detailed prospectuses are available.
17
Q.1745 Through the issuance of a qualified opinion, auditors would further limit an already
boilerplate language. Which of the following wordings/phrases would signal a qualified opinion in
the auditor’s report?
A. Any language that is out of the ordinary
B. Presence of the word “except” in the concluding paragraph
C. Financial statements are free from material misstatements
D. Evidence is examined on a “test basis,” implying that not all items are scrutinized
Q.1746 Considering the opinions of bank audit reports, qualifications are quite common in
practice. Which of the following is an extremely rare opinion, and one that’s considered a serious
red flag?
A. Any qualification about a discretionary change in accounting methods
B. Any material fraud or financial statement falsification perpetrated by the top

management
C. An adverse opinion
D. An intentional diversion from best practices in financial reports
Q.1747 Which of the following statement is most appropriate about sources of secondary
analysis?
A. Once all information, especially an appropriate auditor’s report over several years
(preferably 3 to 5 years) is complete, bank credit analysts almost universally make use of
a detailed market data system.
B. Once all information, especially an appropriate spreadsheet of the financials over

several years (preferably 3 to 5 years) is complete, bank credit analysts almost
universally make use of the CAMEL system.
C. Once all information, especially an appropriate unqualified opinion over several

years (preferably 3 to 5 years) is complete, bank credit analysts almost universally make
use of credit ratings.
D. Once all information, especially an appropriate financial quality report over several
years (preferably 3 to 5 years) is complete, bank credit analysts almost universally make
use of a scoring (between 1 to 5, and 1 being the best).
18
Q.2868 Stephen Gadwall is a junior credit analyst at Frantic Bank. A client applies for a loan and
the manager requires him to perform an analysis on the customer in order to ascertain her
creditworthiness. Which of the following roles does NOT fall in his job description?
A. Reviewing the client’s documentation to establish her loan status and confirm she
meets the basic requirement
B. Reviewing property appraisals with the relevant documentation and do the necessary
data entry
C. Performing basic mortgage calculations to validate the score-based approval
D. Preparation of counterparty credit review and approve credit limits while developing
updated credit policies and procedures
Q.2869 Mr. James Billups is a bank credit analyst who is looking for a new organization to work
for. Which of the following organization does NOT correspond to his functional roles and
therefore not a suitable employer?
A. Rating agencies
B. Securities exchange firms
C. Institutional investors like insurance companies and pension funds
D. Banks and related financial institutions
Q.2871 What is the role of credit modeling?
A. Analyzing consumer credit individual exposure
B. Monitoring exposures to counterparties
C. Reviewing and developing credit scoring structures of consumers that are most
refined
D. All the above
19
Q.3981 The CAMEL rating system is a recognized international rating system used by regulatory
banking authorities and counterparty analysts to rate financial institutions, according to the five
factors represented by its acronym. The letter "E" denotes:
A. Expertise
B. Earnings
C. Enterprise
D. Export
Q.3982 Simon Klein, FRM, is facilitating the orientation of newly recruited risk analysis interns
at Prime Bank. During the preliminary discussion, the team delves into the supervision of banks
and the role played by regulatory ratings and ratios. One of the interns asks about the CAMEL
rating system. Which of the following statements is most likely incorrect?
A. A rating of five is considered the best, and a rating of one is considered the worst
B. In the acronym CAMEL, letter "C" stands for Capital
C. All factors but the assessment of the quality of management are amenable to ratio
analysis
D. Assessing the quality of management usually involves the use of qualitative techniques
Q.3983 Tom Heaton, FRM, is a rating agency analyst. He is currently analyzing the financial
statements of a major bank. He's particularly keen on determining the creditworthiness of the
bank. The bank recently announced its plans to float a 5-year bond. Which of the following
financial statements would be least useful for the purpose at hand?
A. The cash flow statement
B. Balance sheet
C. Statement of changes in capital/equity
D. Statement of income
20
Q.3984 Emerson Brown, FRM, is a bank credit analyst who is examining the financial statements
of a bank. He notices the following two paragraphs in the auditor’s report: Paragraph I “…We
were unable to obtain audited financial statements supporting the bank’s investment in a foreign
affiliate stated at $25,000,000, or its equity in earnings of affiliate of $5,250,025.” Paragraph II
“In our opinion, except for the possible effects of the matters described in paragraph 1, the
financial statements present fairly, in all material respects, the financial position of Prime Bank
as of December 31 20X9.” Based on that information, which of the following audit report
opinions has the auditor most likely issued?
A. Qualified opinion
B. Unqualified opinion
C. Disclaimer of opinion
D. Adverse opinion
Q.3985 Chang Li, FRM, is a bank credit analyst in Beijing. He is examining the financial
statements of a local bank. She notices the following paragraph in the auditor's report: "The
company has not consolidated the financial statements of subsidiary X it acquired during 20X1
because it has not yet been able to ascertain the fair values of certain of the subsidiary's material
assets and liabilities at the acquisition date. This subsidiary is accounted for on a cost basis but
under international law, it should have been consolidated because it is controlled by the
company. Had this been done, many elements would have been materially affected. In our
opinion, the consolidated financial statements do not present fairly the financial position of ABC
bank and its subsidiaries as at December 21,20X1." Based on that information, which of the
following audit report opinions has the auditor most likely issued?
D. Adverse opinion
21
Q.3986 What type of opinion would an auditor express when, having obtained sufficient
appropriate audit evidence, the auditor concludes that misstatements, individually or in
aggregate, are both material and pervasive to the financial statements?
D. Adverse opinion
Q.3987 The audit report date on a standard unqualified report indicates:
A. the last day of the fiscal period.
B. the date on which the financial statements were filed with the relevant authorities
C. the last date on which the analyst may institute a lawsuit against either client or
auditor.
D. The last day of the auditor's responsibility for the review of significant events that
occurred subsequent to the date of the financial statements.
Q.3988 Ibrahim Diaz, FRM, is analyzing the financial statements of a potential client. The
balance sheet is dated December 31, 2020, the audit report is dated January 6, 2021, and both
were released on January 12, 2021. This indicates that the auditor's responsibility over the
financial condition of the audited client ends on:
A. December 31, 2020
B. January 1, 2020
C. January 6, 2021
D. January 12, 2021
22
Q.3989 Whenever an auditor issues an unqualified opinion, the implication is that the auditor:
A. does not know if the financial statements are presented fairly.
B. does not believe the financial statements are presented fairly.
C. believes the financial statements are presented fairly.
D. believes the financial statements are presented fairly “except for” a specific aspect of
them.
Q.3990 An analyst has just completed credit analysis of Exim Bank using the CAMEL credit
analysis method. Which of the following is most likely out of the range of possible overall scores
for the bank? A score of:
A. 1
B. 5
C. 8
D. 4
Q.3991 Sarah Hassan has just secured a job as a credit analyst at a local bank. As part of her
orientation process, she has been asked to determine the creditworthiness of Andrew Peters, a
local businessman famous around town for a range of thriving businesses. She has also been
asked to assist with ongoing research work on the current state of affairs in the banking sector
all over the globe. Which of the following is most likely a qualitative skill that Sarah might need?
A. The ability to read and interpret financial statements to perform a wide range of ratio
analysis
B. The skills to compute various statistical estimates such as the mean and variance,
conduct hypothesis tests and also construct confidence intervals so as to arrive at
reasonable informative conclusions.
C. The skills to compute and interpret macroeconomic data, e.g., GDP growth rates
D. Good networking skills in order to establish a strong rapport with clients and business
associates
23
Q.3992 In which of the following situations would the auditor most likely express a qualified
opinion?
A. There's substantial doubt as to the bank’s ability to continue as a going concern.
B. A specific accounting treatment used by management is inconsistent with accounting

rules.
C. There are significant amounts of related-party transactions
D. All the above
24
Reading 79: Capital Structure in Banks
Q.3644 Anton Cooper, a senior credit analyst, states the following to his fellow associates
regarding credit risk. Which of the following statements are true with regard to credit risk?
I. Credit risk is the risk that arises from any nonpayment of any promised payments
II. Credit risk is the risk that arises from any rescheduling of any promised payments
III. Credit risk is the risk that arises from credit migrations of a loan
IV. Credit risk events include changes in the counterparty characteristics but not changes in the
country characteristics
A. I & II only
B. I, II & III only
C. I, II & IV only
D. All of the above
Q.3645 Yusuf, a research scholar associated with Dale University, presents a report on expected
loss to the senior management of Glovsky Bank. He makes the following statement(s) in his
report:
Statement I: The expected loss is a certain amount of money a bank is expected to lose over a
pre-determined period of time when extending loans to its customers
Statement II: Even though credit loss levels will fluctuate from year to year, there is an
anticipated average level of losses over time that can be statistically determined
Statement III: Expected loss must be treated as a foreseeable cost of doing business in the
lending business
Statement IV: Expected loss represents the level of losses predicted for the following year based
on the economic cycle
Which of these statements are true?
A. I & II only
B. I, II & III only
C. II, III & IV only
D. I, II & IV only
25
Q.3666 Economic losses are determined using certain components. Which of the following is not
a component that determines economic losses?
A. Probability of default
B. Exposure amount
C. Loss rate
D. All of the three components determine Economic loss
Q.3667 American International Bank sanctioned a loan to a corporate client. The following
particulars are given in the credit note by credit analyst of the client:
Exposure amount = 100 USD million

Loss rate = 10%
Probability of default = 20%
What is the expected loss of the loan?
A. USD 2 million
B. USD 20 million
C. USD 10 million
D. USD 40 million
26
Q.3668 Rojan Ortiz, a senior credit risk analyst at Asiana Bank, discusses with his colleague
regarding the components of the economic losses. He makes the following statements with
regard to the components of the economic losses. Which of the following are true?
Statement I: The loss rate is the fraction of the exposure amount that is lost in the event of
default
Statement II: Probability of default is a borrower-specific estimate that is typically linked to the
borrower's risk rating
Statement III: Exposure amount and loss rate reflect and model the product specifics of a
borrower's liability
Statement IV: Probability of default (PD) is a measure to determine whether a counterparty goes
into default over a predetermined period of time
A. I & II only
B. I, II & III only
D. All of the above
Q.3669 A bank credit risk is preparing a manual on unexpected losses. Which of the following
statements can be captured in the manual with regard to unexpected loss?
I. It is important to price unexpected losses in a loan's interest rate adequately

II. Unexpected losses in statistical terms is the standard deviation of credit losses, that is, the
standard deviation of actual credit losses around the expected loss average
III. Unexpected loss can be calculated at the transaction and portfolio level
IV. Unexpected loss is the primary driver of the amount of economic capital required for credit
risk
A. I & II only
B. I, II & III only
D. All of the above
27
Q.3670 John Sutton, a newly recent finance graduate working at Asana Finance Ltd., approaches
his superior, George Shelton, to understand the differences and similarities between expected
losses and unexpected losses?. Gorge makes the following statements:
Statement I: The unexpected loss of a specific loan on a stand-alone basis (i.e., ignoring
diversification effects) can be derived from the components of expected loss
Statement II: Expected loss is calculated as the mean of a distribution whereas unexpected loss
is calculated as the standard deviation of the same distribution
Statement III: Like expected losses, unexpected losses can also be calculated for various time
periods and for rolling time windows across time
Statement IV: Unexpected losses stem from the (unexpected) occurrence of defaults and
(unexpected) credit migration whereasexpected losses must be treated as the foreseeable cost of
doing business in lending markets
Which of these statements are true?
A. Statements I & II only
B. Statements I, II & III only
C. Statements II, III & IV only
D. All of the above
Q.3671 Which of the following statements is/are true regarding unexpected losses for an
individual loan?
I. For an individual loan, the probability of default is dependent on the exposure amount and the
loss rate
II. In most situations, the exposure amount and the loss rate can be viewed as being independent
III. The unexpected loss is dependent on the default probability, the loss rate, and their
corresponding variances
IV. If there were no uncertainty in the default event and no uncertainty about the recovery rate,
the unexpected loss would be equal to zero
A. I & IV only
B. I, III & IV only
D. All of the above
28
Q.3672 ABX Bank Limited is holding a portfolio of loans. A risk manager wishes to determine the
unexpected loss contribution of loan asset i toward the portfolio unexpected loss. Which of the
following components would not be needed in that particular exercise?
A. The loan’s probability of default
B. The loan’s exposure amount
C. The correlation of the exposure to the rest of the portfolio
D. None - all of the above are necessary
Q.3673 Neeson, a quantitative analyst, is preparing a model for estimating unexpected losses. He
is incorporating appropriate distributions for the components of unexpected losses. Which of the
following are true with regard to the distributions of components of unexpected losses?
I. The probability of default is a binomial distribution

II. The loss rate can take a number of shapes, which results in different equations for the
variances of loss rate
III. The binomial distribution understates the variance of the loss rate as compared to the
uniform distribution
IV. The uniform distribution assumes that all defaulted borrowers would have the same
probability of losing anywhere between 0 percent and 100 percent
A. I & II only
B. I, II & III only
D. I, II & IV only
29
Q.3674 A bank is measuring the marginal contribution of each loan to the overall portfolio of
unexpected loss. In this context, which of the following statement(s) is/are true?
I. The marginal contribution depends on the weight of the loan in the portfolio, the correlation
between the loan and other loans in the portfolio, and the size of the portfolio itself
II. The marginal contribution of each loan is constant if the weights of each loan in the portfolio
are held constant when measuring unexpected loss at the portfolio level
III. To calculate the unexpected loss contribution of a single loan analytically, the marginal
impact of the inclusion of this loan on the overall credit portfolio risk is to be considered
IV. The following formula gives the unexpected loss contribution of loan i:
δU LP
ULC i = UL i ×
δ UL i
Where δ represents the partial derivatives.
A. I , II & III only
B. I, II & IV only
D. All of the above
Q.3675 Default correlations play an important in measuring the marginal contributions of a loan
to a loan portfolio. With regard to default correlations for a loan portfolio containing a large
number of loans:
A. Default correlations are very difficult, if not impossible, to observe
B. If the loan portfolio contains ‘n’ loans, [n(n-1)]/2 pairwise default correlations need to
be estimated
C. Default correlations are small, but positive providing considerable benefits to

diversification in credit portfolios
D. All of the above are true
30
Q.3676 Anston Walsh, a credit analyst at Grant Bank, is entrusted with the task of calculating the
economic capital for a portfolio of loans underwritten by the bank. Walsh based his task of
computing economic capital on the following assumptions/statements. Which of them are to be
considered in the computation to determine the most appropriate amount of economic capital?
Statement I: The amount of economic capital needed is the distance between the expected
outcome and the unexpected (negative) outcome at a certain confidence level
Statement II: The crucial task in estimating economic capital is the choice of the probability
distribution
Statement III: Credit risks are normally distributed
Statement IV: One distribution often recommended for measuring credit risk is the normal
distribution
A. I & II only
B. I, II & III only
C. I, III & IV only
D. All of the above
Q.3677 Australian Synergies Finance Limited uses beta distributions to measure credit risks. The
company states that the beta distribution helps in predicting the credit losses accurately. With
regard to the measurement of credit losses, which of the following statements are true?
I. The beta distribution is often recommended and is a suitable probability distribution for
measuring the credit losses
II. The beta distribution is especially useful in modeling a random variable that varies between -1
and +1
III. The shape of the beta distribution can be completely determined by specifying the
parameters α and β
IV. The beta distribution is fully characterized by two parameters: expected loss of the portfolio
and unexpected loss of the portfolio
A. I & II only
B. I, III & IV only
C. I, II & IV only
D. II, III & IV only
31
Q.3678 One of the key concerns in using beta distributions for measuring credit risks is the
difficulty in fitting the beta distribution exactly to the tail of the risk profile of the credit
portfolio. The tail fitting exercise is best accomplished by combining:
A. The normal distribution with a beta distribution
B. The beta distribution with a uniform distribution
C. The beta distribution with a Monte Carlo Simulation
D. The beta distribution with a VaR
Q.3679 The shape of the beta distribution is determined completely by specifying the parameters
α and β. If α = β, the shape of the beta distribution is:
A. Symmetric
B. U-shaped
C. Inverted
D. Skewed to the left
Q.3680 Five years ago, American Banking Group approved a loan to Hazard Corp. with a total
commitment of USD 120 million. Today, the outstanding balance of the loan is USD 80 million.
The credit risk department provided the following details with regard to the riskiness of the loan:
The standard deviation of the probability of default and the loss rate are 4 percent and
15 percent, respectively
The probability of default over the next year is 1%
The loss rate if the customer defaults is 25 percent
What is the unexpected loss for this loan today?
A. USD 2.163 million
B. USD 1.206 million
C. USD 0.769 million
D. USD 1.442 million
32
Q.3681 Nicolson Finance has taken credit exposure to two corporate clients. The credit risk
characteristics of these two loans have been provided below:
Loan to customer 1:
Sanctioned amount: USD 600 million
Exposure amount: USD 540 million
Probability of default over the next year: 2%
Loss rate if the customer defaults: 20%
Standard deviation of the probability of default: 3%
Standard deviation of the loss rate: 35%
Loan to customer 2:
Sanctioned amount: USD 300 million
Exposure amount: USD 200 million
Probability of default over the next year: 1%
Loss rate if the customer defaults: 40%
Standard deviation of the probability of default: 2%
Standard deviation of the loss rate: 20%
The correlation between the two loan accounts is 0.5.
What is the unexpected loss of the loan portfolio held by Nicolson Finance?
A. USD 31.23 million
B. USD 34.22 million
C. USD 29.316 million
D. USD 35.22 million
Q.3683 A bank has booked a loan with a total commitment amounting to $100,000. 80% of this
amount is currently outstanding. The default probability of the loan is assumed to be 2% for the
next year, and the loss given default (LGD) stands at 40%. The standard deviation of LGD is 30%.
Drawdown on default (i.e., the fraction of the undrawn loan) is assumed to be 70%. Determine
the expected and unexpected losses for the bank.
A. Expected loss = USD 640, unexpected loss = USD 5,621
B. Expected loss = USD 640, unexpected loss = USD 6,604
C. Expected loss = USD 752, unexpected loss = USD 6,604
D. Expected loss = USD 752, unexpected loss = USD 5,621
33
Q.3684 An investor holds a portfolio of $200 million. This portfolio consists of AA-rated bonds
($120 million) and BB-rated bonds ($80 million). Assume that the one-year probabilities of
default for AA-rated and BB-rated bonds are 4% and 6%, respectively, and that they are
independent. In the event of default, the recovery rate for AA-rated bonds is 65%, and the
recovery rate for BB-rated bonds is 40%. Determine the one-year expected credit loss from this
portfolio:
A. $1,680,000
B. $4,560,000
C. $4,500,000
D. $2,880,000
Q.3685 A portfolio consists of two bonds. The credit VaR – as defined by the bondholder – is the
maximum loss due to defaults at a confidence level of 99%, over a period of one year. The
probability that the two bonds jointly default is 2%, with a default correlation of 25%. The bond
value, default probability, and recovery rate are USD 500,000, 5%, and 50% for one bond, and
USD 300,000, 3%, and 30% for the other. Determine the expected credit loss of the portfolio:
A. USD 18,800
B. USD 12,500
C. USD 18,424
D. USD 12,424
34
Reading 80: Ratings Assignment Methodologies
Q.1774 As a general rule of thumb, credit ratings need to be based on objectivity, reliability,
measurability, and specificity. What does “objectivity” imply?
A. The credit ratings have to provide correct potentials in terms of default probabilities
and should be applicable to all credit customers
B. The credit rating system should create conclusions only based on credit risk
considerations and avoiding all other subjective considerations that can affect rating
decision
C. Credit ratings should be comparable among portfolios, market segments as well as

among different customers having the same consumption level
D. The credit rating system should measure the distance to the default event and should
consider all external information that can impact the rating of the relevant party
Q.1775 In the early days of credit rating analysis, Wilcox proposed a model to forecast business
failures by using accounting data. However, the model could not apply in practice because of
certain limitations. Which of the following represents is NOT one of the characteristics of
Wilcox’s model?
A. The implementation of the model marked the first time an intrinsically probabilistic
approach was applied to describe corporate default in financial analysis
B. According to the model, the default event is not exogenously assumed but originates
from a company’s characteristics, including profitability, capital, business turbulence,
and volatility
C. The model uses financial explanatory variables linked with business risk through
probability
D. The model combines the use of real-time data and the “game approach” making
prediction of the default event faster
35
Q.1776 The theory of “point of no return” plays an important role in credit analysis. In
mathematical terms, the theory is represented as:
ƏEBIT / ƏT ≥ [ Ə(OF+∆D) / ƏT ]
What does this expression imply?
A. A company can only survive if its flow of funds from its business operations is greater
than or equal to interest charges and principal repayment; otherwise, the company will
accumulate new debt and is certain to fail
B. A company can only survive if its flow of funds from its business operations is less than
interest charges and principal repayment; otherwise, new debt is accumulated leading to
failure
C. A company can only survive if its flow of funds from its business operations match
interest charges and principal repayment; otherwise, the company is likely to accumulate
new debt and fail
D. A company can only survive if its flow of funds from its business operations is less than
or equal to interest payments and principal repayment; otherwise, the company
accumulates new debt which most likely leads to failure
Q.1777 Nowadays, rating agencies aim to provide an accurate credit analysis of every party.
Their main purpose is to surmount the problem of information asymmetry. What does the term
“information asymmetry” refer to?
A. The availability of complete and transparent information to market participants for

accurate evaluation of the other party’s default risk
B. The unavailability of complete and transparent information to market participants for

accurate evaluation of a counterparty’s default risk
C. The unavailability of complete and transparent information to governments regarding

business entities
D. The unavailability of complete information for use by internal and external auditors so
as to accurately evaluate an entity’s chances of winding up
36
Q.1778 Rating agencies use different methods to analyze counterparties. Usually, the chosen
methodology depends on the nature of the party (corporation, government or small entity) and
the type of product the party offers. In particular, agencies make use of financial ratios to rate
the well-being of an entity relative to others. Keeping this in mind, what’s the general rule of
thumb for market participants when analyzing any party?
A. The larger the cash flows coming from operations, the safer the financial structure,
and therefore, the better the borrower’s credit rating
B. The smaller the cash flow margins coming from operations, the safer the financial
structure, and consequently, the better the borrower’s credit rating
C. The larger the debt accumulation for operations, the safer the financial structure, and
consequently, the better the borrower’s credit rating
D. The larger the cash flow margins coming from operations, the safer the financial
structure, and consequently, the better the borrower’s credit rating
Q.1779 Some of the traditional analytical areas considered during the credit analysis of a
counterparty include reputation, experience, reliability of management, and performance
recorded in different economic situations. However, a highly competitive environment has
resulted in additional areas being brought into the picture. Which of the following is NOT among
the new areas considered?
A. The quality of internal governance – the competency of board members and

management
B. Prospective hidden liabilities such as pension plans, EOBI insurances, and bonuses
C. Possible exposure of the counterparty to legal or institutional risks
D. A company’s human resource policy, including its hiring and retrenchment procedures
37
Q.1780 Despite being immensely helpful to investors, credit rating agencies are also associated
with a number of shortcomings. Which of the following presents an example of their limitations?
A. Rating agencies use different definitions depending on the nature of the information at
their disposal
B. The size of the population used by agencies to produce perceived frequencies can be
different, and therefore, many counterparties prefer to use only one to two official
ratings and ignore the rest
C. Initial ratings released for the same counterparty by different rating agencies may not
always be similar
D. All of the above
Q.1781 Banks use different approaches and models to analyze different customer segments.
Sometimes, their underlying processes are analogous. This implies that:
A. Analytical processes use similar data
B. When different banks assume judgmental approaches for credit quality assessment,
the data used for analysis and analytical processes are different
C. When different banks assume systematic models for credit quality assessment, the
same data are used for analysis and analytical processes
D. The processes used are quite different from one another
Q.1782 Quantitative models are used to predict certain consequences based on some predefined
assumptions. These models do not accurately predict future events but rather give the expected
outcome given certain conditions. Which statement from the following supports the quantitative
model approach?
A. Quantitative financial models represent a mixture of judgemental and numerical

methods which incorporate the experience of the credit analyst
B. Quantitative financial models represent numerical methods which incorporate

organizational behavior
C. Quantitative financial models represent a mixture of statistics, behavioral psychology,

and numerical methods which incorporate organizational behavior, economic events, and
market participants’ reactions
D. Quantitative financial models represent a mixture of judgmental and available data in

public to predict the future events of any particular counterparty
38
Q.1783 Even when asking for collateralized assets, the risk that the bank faces is that:
A. If the value of the asset is less than the face value of the debt, the borrower will pay
the outstanding debt and will remain in possession of his asset
B. If the value of the asset is less than the face value of the debt, the borrower will forfeit
possession of the asset and will fail to make future debt payments
C. Private property and some other personal assets owned by the borrower cannot be
seized in the event of default
D. If the value of the asset is less than the face value of the debt, the borrower will keep
possession of the asset and will fail to make future debt payments
Q.1784 Which of the following statements is true regarding the reduced form approach to credit
analysis?
A. The model purely relies on psychological methods to predict default events
B. The model does not make ex-ante assumptions about the default causal drivers
C. The model makes ex-ante assumptions about the default causal drivers
Q.1785 When any financial institution makes use of the reduced form approach, there’s an
element of risk because models intrinsically depend on the sample data used to estimate them.
Different sectors, organizational structures, and market conditions bring about differentiated
paths to default. As a result, model estimations in one environment can be totally ineffective in
another environment. Therefore:
A. Generalization of results demands a good amount of consistency between the

development sample and the population to which the model applies
B. Generalization of results is always inappropriate even within a homogeneous

population
C. Each model should use as large a sample as possible so as to widen applicability of

results
D. There’s need to build models that can be applied in just about any set of
circumstances
39
Q.1786 Which of the following statements is most likely true about the linear discriminate
analysis?
A. The analysis produces a non-linear scoring function
B. Variables are selected among a large set of accounting ratios, qualitative features, and
judgments with little regard to their statistical significance
C. The score produced by the function must lie between 0 and 1
D. When a good discriminate function is estimated using historical data regarding

performing and defaulted borrowers, we can assign any new borrower to a specific
predefined group based on the score produced by the function
Q.1787 The linear discriminate analysis (LDA) uses the Z-score to award a company either a
performing or an insolvency rating. At present, LDA is being used by:
A. Fitch Group’s rating agency
B. Moody’s rating agency
C. S&P’s rating agency
D. All rating agencies
Q.1788 While applying LDA, it’s possible to assign an incorrect score to a firm. To avoid such a
scenario, there are certain requirements that must be met. Which of the following is not one of
them?
A. Independent variables should not be normally distributed
B. There should be no heteroscedasticity
C. Low independent variables multi-colinearity
D. Homogeneous independent variables variance around groups’ centroids
40
Q.1789 Which of the following is NOT a component of logistic regression models (GLM)?
A. A random component, which specifies the target variable and associated probability
function
B. A systematic component, which identifies explanatory variables used in a linear

predictor function
C. A link function, which is a function of the mean of the target variable which the model
equates to the systematic component.
D. A judgmental component, which incorporates the analyst’s sentiments about the

model’s validity
Q.1790 LDA and LOGIT models are usually referred to as supervised models because:
A. They use an independent variable which is explicitly defined, and to find a reliable
solution, other independent variables are used, which consequently provides an ex-ante
prediction
B. They use a dependent variable which is explicitly defined, and to find a reliable
solution, other independent variables are used, which consequently provides an ex-ante
prediction
C. They incorporate the analyst’s subjective judgment
D. They use a dependent variable which is not defined, but in order to find a reliable
solution, other known dependent variables are used, which consequently provides an ex-
ante prediction
Q.1791 Which of the following statements is true about cluster analysis?
A. The cluster analysis works in columns, grouping borrowers based on their variables'
profile. This results in a sort of statistically-based top-down segmentation of borrowers.
This analysis is typically used for preliminary exploration of borrowers’ characteristics.
B. The cluster analysis works in rows to reduce a large set of variables into a small one,
which is statistically more significant.
C. The cluster analysis works in rows, grouping borrowers based on their variables'
profile. This results in a sort of statistically-based top-down segmentation of borrowers.
This analysis is typically used for preliminary exploration of borrowers’ characteristics.
D. The cluster analysis works in rows to optimally convert a large set of variables into a
small one, which is statistically more significant.
41
Q.1792 Which of the following statements is correct regarding future cash flow simulation
models?
A. A future cash flow simulation model is usually company-specific
B. A future cash flow simulation model can usually be used across several industries
C. A future cash flow simulation model is usually country-specific
D. A future cash flow simulation model depends in large part on the size of cash flows
Q.1793 In the modern world, other than statistical techniques, several other methods have been
used to predict default rates. These methods mostly borrow a lot from artificial intelligence and
have brought about a shift from traditional problem-solving methods that are based on decision
theory.
A good example of such methods is the heuristic method. Which of the following correctly
defines this method?
A. Heuristic methods use statistical procedures through standardized rules to achieve

solutions in difficult environments. New knowledge is created through a trial by error
method, rather than by statistical modeling.
B. Heuristic methods use human decision-making procedures and standardized rules to

achieve solutions in difficult environments. New knowledge is created through by
statistical modeling rather than trial and error.
C. Heuristic methods create new knowledge through a systematic method, rather than by
trial and error.
D. Heuristic methods use human decision-making procedures by applying them

appropriately through standardized rules to achieve solutions in difficult environments.
New knowledge is created through a trial by error method, rather than by statistical
modeling.
42
Q.1794 Which of the following best explains how the principal component analysis works?
A. The principal component analysis works in columns, grouping borrowers based on

their variables' profile.
B. The principal component analysis works in columns to optimally convert a large set of
variables into a smaller, more statistically significant one.
C. The principal component analysis works in rows, grouping borrowers based on their
variables' profile. This analysis results in a sort of statistically-based top-down
segmentation of borrowers.
D. The principal component analysis works in rows to convert a set of variables into a
smaller, more statistically significant one.
Q.1795 In recent years, other than statistical techniques, many other methods have been used to
find default prediction. Good examples are numerical methods. Which of the following best
describes numerical methods?
A. Numerical methods are the approaches whose purpose is to get optimal solutions by
using statistical and structured approaches to make decisions in extremely complex
environments characterized by redundant and inefficient information
B. Numerical methods are the approaches whose purpose is to get optimal solutions by
using qualified algorithms to make decisions in extremely complex environments
characterized by efficient information
C. Numerical methods are the approaches whose purpose is to get optimal solutions by
using qualified algorithms to make decisions in extremely complex environments
characterized by redundant and inefficient information
D. Numerical methods are the approaches whose purpose is to get optimal solutions by
using trial and error methods to make decisions in extremely simple environments
characterized by redundant and inefficient information
Q.2666 The Merton model is a (an):
A. Equity-based model
B. Market-based model
C. Value-based model
D. Cash-flow-based model
43
Q.2668 A good credit rating system has three key desirable features. Which one is not?
A. Measurability and verifiability
B. Objectivity and homogeneity
C. Scalability
D. Specificity
Q.2669 Which of the following is an example of a heuristic and numerical approach to predicting
default?
A. Agency ratings
B. Linear discriminant analysis
C. Neural networks
D. Cash flow simulations
Q.2674 Given the following information about a firm, calculate its probability of default using the
Merton model:
Value of the firm $40 million

Outstanding Debt $25million
Maturity of Debt 5 years
Interest Rate 7%
Volatitlity of the Firm 30%
Expected return of the firm 10%
A. 10.98%
B. 12.12%
C. 13.33%
D. 14.76%
44
Q.2675 A credit analyst is using linear discriminant analysis (LDA) to determine a Z-score cut-off
for differentiating default from solvency. Assume that the current cut-off point is 1.00, the
average default rate is 3.5%, the current assessment of loss given default is 50%, and the
opportunity cost is 20%. The new cut-off score after the Z-score cut-off adjustment is equal to:
A. 3.4
B. 1.2
C. 2.5
D. 2.4
Q.2676 All of the following statements about the value of debt under the the Merton Model are
true, except:
A. The value of debt increases as the value of the firm increases
B. The value of debt decreases as the volatility of the firm increases
C. The value of debt increases as the face value of the debt increases
D. The value of debt increases as the time to maturity increases
Q.2677 For a firm financed partly by debt and partly by equity, the value of debt:
A. increases if the volatility of the firm increases
B. increases if the face amount of debt falls
C. falls if its time to maturity lengthens
D. increases if the interest rate increases
45
Q.2875 A dataset given by an organization indicates that the number of issuers in a given time
horizon is 789, whereas the number of names that have defaulted in the same time horizon is 31.
From this information, an analyst is required to compute the probability of default. Which of the
following would be the correct probability?
A. 0.265
B. 0.039
C. 0.116
D. 0.215
Q.2876 Suppose that Logos International Company has an asset value of $280 million and was
issued a loan by Broadways Bank. The loan has 7 years remaining to reach maturity. We are also
informed that the face value of the debt is $478 million. The risk expected return is 18% and the
instantaneous assets value volatility is 21%. Compute the value of default probability following
the Merton approach and applying the Black Scholes Merton Formula.
A. 0.8980
B. 0.217
C. 0.1515
D. 0.055
46
Q.3009 From the given table, what is the probability of a bond rated Caa or below defaulting
during the third year?
Average cumulative default rates (%),1970-2012, from Moody's.

Term
1 2 3 4 5 7 10 15 20
(years):
Aaa 0.000 0.013 0.013 0.037 0.106 0.247 0.503 0.935 1.104
Aa 0.022 0.069 0.139 0.256 0.383 0.621 0.922 1.756 3.135
A 0.063 0.203 0.414 0.625 0.870 1.441 2.480 4.255 6.841
Baa 0.177 0.495 0.894 1.369 1.877 2.927 4.740 8.628 12.483
Ba 1.112 3.083 5.424 7.934 10.189 14.117 19.708 29.172 36.321
B 4.051 9.608 15.216 20.134 24.613 32.747 41.947 52.217 58.084
Caa-C 16.448 27.867 36.908 44.128 50.366 58.302 69.483 79.178 81.248
A. 36.908%
B. 9.041%
C. 52.124%
D. 45.949%
Q.3043 Tom is a risk analyst at a large U.S. bank. While analyzing credit risk for Trident
Industries he extracts the following available information from the company’s financial
statements:
Face value of debt: $120 Million,
Value of assets: $170 Million
He also estimates volatility of the company’s assets at 0.2
Given the above information, what’s Trident Industries’ distance to default for next year?
A. 1.74
B. 0.78
C. 4.37
D. 2.46
47
Q.3051 From the given below what is the probability of a bond rated Caa or below defaulting
during the third year?

Term
1 2 3 4 5 7 10 15 20
(years):
Aaa 0.000 0.013 0.013 0.037 0.106 0.247 0.503 0.935 1.104
Aa 0.022 0.069 0.139 0.256 0.383 0.621 0.922 1.756 3.135
A 0.063 0.203 0.414 0.625 0.870 1.441 2.480 4.255 6.841
Baa 0.177 0.495 0.894 1.369 1.877 2.927 4.740 8.628 12.483
Ba 1.112 3.083 5.424 7.934 10.189 14.117 19.708 29.172 36.321
B 4.051 9.608 15.216 20.134 24.613 32.747 41.947 52.217 58.084
Caa-C 16.448 27.867 36.908 44.128 50.366 58.302 69.483 79.178 81.248
A. 36.908%
B. 9.041%
C. 52.124%
D. 45.949%
48
Q.3052 John is the chief risk officer at a large European bank. While giving a presentation at a
quarterly board meeting he got stuck in calculating the probability relevant to the ‘Ba’ rated
bond surviving until the end of year 2. Using the below table what is the probability that the ‘Ba’
rated bond will survive until the end of year 2?

Term
1 2 3 4 5 7 10 15 20
(years):
Aaa 0.000 0.013 0.013 0.037 0.106 0.247 0.503 0.935 1.104
Aa 0.022 0.069 0.139 0.256 0.383 0.621 0.922 1.756 3.135
A 0.063 0.203 0.414 0.625 0.870 1.441 2.480 4.255 6.841
Baa 0.177 0.495 0.894 1.369 1.877 2.927 4.740 8.628 12.483
Ba 1.112 3.083 5.424 7.934 10.189 14.117 19.708 29.172 36.321
B 4.051 9.608 15.216 20.134 24.613 32.747 41.947 52.217 58.084
Caa-C 16.448 27.867 36.908 44.128 50.366 58.302 69.483 79.178 81.248
A. 94.576%
B. 98.888%
C. 96.917%
D. 95.805%
49
Q.3053 Smith Incorporated had an investment in a bond rated Caa by Moody’s. Assume you are a
risk analyst at Smith, and you’ve been asked to calculate the probability that the bond will
default during the fourth year, conditional on no earlier default. Your calculation based on data in
the table below is closest to:

Term
1 2 3 4 5 7 10 15 20
(years):
Aaa 0.000 0.013 0.013 0.037 0.106 0.247 0.503 0.935 1.104
Aa 0.022 0.069 0.139 0.256 0.383 0.621 0.922 1.756 3.135
A 0.063 0.203 0.414 0.625 0.870 1.441 2.480 4.255 6.841
Baa 0.177 0.495 0.894 1.369 1.877 2.927 4.740 8.628 12.483
Ba 1.112 3.083 5.424 7.934 10.189 14.117 19.708 29.172 36.321
B 4.051 9.608 15.216 20.134 24.613 32.747 41.947 52.217 58.084
Caa-C 16.448 27.867 36.908 44.128 50.366 58.302 69.483 79.178 81.248
A. 69.94%
B. 19.51%
C. 63.092%
D. 11.44%
Q.3054 The assets of company X are currently worth $1,300,000. In three months the company
has to repay $1,000,000 in debt. The expected volatility of the assets is 30% and the expected
rate of return on the value of the firm is 15%. What is the probability of default in three months
on the basis of the Merton model?
A. 2.74%
B. 1.77%
C. 6.16%
D. 5.61%
50
Q.3055 Assessing the probability of default requires several pieces of qualitative information.
Which of the following is NOT one of them?
A. Trends in throughput and other operational efficiency metrics
B. Management's education and experience
C. Diversification of products and customers locally and globally
D. Internal controls associated with financial reporting
Q.3056 A credit manager in the derivative division of a regional bank intends to use a simplified
version of the Merton model to monitor the relative vulnerability of its largest counterparties to
changes in their valuation and financial conditions. He is particularly interested in the default
risk of the four largest counterparties. The manager calculates the distance to default assuming
a 1-year horizon (t=1). The counterparties: Company P, Company Q, Company R, and Company S
belong to the same industry and have a zero-dividend policy. The table below summarizes
selected information on the companies:
Company P Q R S
Market value of Assets ($m) 100 180 200 250
Face value of debt ($m) 70 120 100 170
Annual volatility of asset values 10.0% 8.0% 6.0% 12%
Assume that the only liability for each firm is a zero-coupon bond maturing in 1 year, and the
approximation formula of the distance to default, what is the correct ranking of the
counterparties, from least likely to most likely to default?
A. S,Q,P,R
B. R,P,S,Q
C. S,P,R,Q
D. R,Q,P,S
51
Q.3057 Which of the following is least accurate? A good rating system:
A. results in ratings that can be compared across multiple customer types and market
segments.
B. provides judgments based solely on credit risk considerations.
C. accurately measures the distance from a default event
D. None of the above (All options are accurate)
52
Reading 81: Credit Risks and Credit Derivatives
Q.1796 A firm has a principal amount due on its zero-coupon bond of $60m and the firm has no
other creditors. This amount is due at time T. Suppose the value of the firm at time T is $50m.
Which of the following is closest to the value of equity at time T?
A. $ 0 million
B. -$ 10 million
C. $ 10 million
D. $ 110 million
Q.1797 A credit risk manager needs to evaluate the value of a call option. The firm under
investigation has a $120 million of debt payable to debt holders. As a rule, equity holders receive
something only if the firm value exceeds the face value of the debt. How much would be the
payoff of a call option supposing the firm has a value of $160 million at maturity?
A. $40 million
B. $0 million
C. -$40 million
D. $160 million
Q.1798 The value of the debt is a decreasing function of equity. Under what circumstances
should a credit analyst assume a decrease in the value of the debt?
A. If the interest rate decreases
B. If the volatility of the firm decreases
C. If the principal amount of the debt falls
D. If the time to maturity shortens
53
Q.1799 A credit risk analyst applies Merton’s formula for the calculation of the value of equity.
The firm under examination has the following information:
V, the value of the firm is $100 million;
F, the face value of the only zero-coupon bond is $80 million;
The value of equity is also calculated as $52.650 million.
What would be the value of debt?
A. $27.35 million
B. $47.35 millon
C. $48.40 million
D. The value of debt is dependent bond’s market interest rate; the information is not
sufficient
Q.1800 Which of the following statements is incorrect?
A. The credit spread represents the difference between the yields on risky debt and the
risk-free debt of similar maturity
B. Treasury notes or T-bonds are generally assumed to be risk-free instruments
C. For highly-rated debt,the credit spread increases as the time to maturity increases
D. Credit spreads can be used to hedge credit risk
Q.1801 Which of the following statements is correct regarding subordinated debt?
A. Subordinated debt ranks above senior debt in the event of winding up
B. Subordinated debt holders normally receive regular dividends, and rank alongside
equity holders in case of liquidation
C. If a company faces bankruptcy or liquidation, senior debt is prioritized over

subordinated debt
D. When a firm is experiencing financial difficulties, an increase in volatility decreases

the value of subordinated debt
54
Q.1802 A firm has 2 categories of debt: A and B. Debt A totals $2m and debt B amounts to
$0.5m. A is senior debt while B is subordinated debt. In case the company is liquidated, how
much will holders of debt B get, given that the firm has assets worth $2.25m at liquidation?
A. $0.75m
B. $0m
C. $2.5m
D. $0.25m
Q.1803 One of the downsides of using the Merton model to determine the value of debt/equity is
the fact that:
A. Calculations are too complex
B. The process requires considerable time and expertise
C. It does not take into account any outstanding derivative contracts, such as call options
D. Default events are too predictable
Q.1804 Which of the following is not a correct statement about the compound call option and its
formula, as propagated by Geske (1979)?
A. A compound option is an option to buy an option
B. Geske assumes that firm value follows the same distribution as the stock price in the
Black-Scholes formula
C. Geske believes that the logarithm of firm value is normally distributed
D. Geske assumes that firm value has non constant volatility
55
Q.1805 Assume that the face value on a firm’s zero-coupon debt with five years remaining to
maturity is equal to $100 million. Also assume that the current value of this debt is $88 million.
Compute the credit spread for this scenario if the risk-free rate (implied by the zero-coupon bond
price) is 1%.
A. 1.56%
B. 1.20%
C. 1.45%
D. 2.00%
Q.1806 Which of the following is not an appropriate statement about the reaction of
subordinated debt, senior debt, and the reaction of debt value to change in interest rates?
A. If the firm is unlikely to be in default, subordinated debt is effectively like senior debt
B. If the firm value is high and debt has low risk, subordinated loan behaves more like
senior debt
C. The increase in interest rates generally reduces the value of debt because of first
reducing the value of debt and secondly because of the adverse shock in firm values
D. An increase in interest rates increase the value of debt as well as the overall burden
on the company
A. Some models focus only on default and on the recovery in case of default
B. CreditRisk+ is based on techniques from the insurance industry to model extreme

events allowing only 2 outcomes: default or no default
C. CreditMetricsTM is a risk model similar to RiskMetricsTM and provides distribution of

the value of the portfolio or the VaR measure for the portfolio
D. The KMV model cannot be used to calculate the probability of default
56
Q.1808 For most credit derivatives, the payoff depends on the occurrence of a “credit event”.
Which of the following is not considered a credit event?
A. Failure to make a required payment
B. Restrictions that makes any party worse off
C. A serious legal disagreement on the definition of an essential term of the loan contract
D. Invoking a cross-default clause and/or bankruptcy
Q.1809 Which of the following does not properly describe a characteristic of credit derivatives?
A. Credit derivatives are designed as hedging instruments for credit risks
B. Credit derivatives are not traded on exchanges as they are over the counter
instruments
C. Credit default swaps compensate buyers for their loss due to default
D. Among hedging instruments, credit derivatives are the most liquid
Q.1810 The Merton model is used to predict default. It builds on several very strong assumptions
and its applicability is hampered by practical difficulties. Which of the following statements does
not correctly identify limiting assumptions or practical difficulties of using the model?
A. The Merton Model relies on a simplistic capital structure consisting of only one debt
issue.
B. The Merton Model asset value volatility cannot be estimated because firm value does
not trade.
C. The Merton Model assumes that debt does not pay a coupon while most publicly-trade
debt is coupon debt.
D. The Merton Model assumes a constant riskless interest rate.
57
Q.2667 Which of the following describes the payment to the debt holders of a company under the
Merton model?
A. V - max (V- D, 0)
B. V - max (D -V, 0)
C. D - max (V- D, 0)
D. D - max (D -V, 0)
Q.2670 Use the simple Merton model to find the value of a firm’s equity and debt in the following
scenarios.
I. The principal amount due on the firm’s debt is $25 million and the value of the firm is
$35 million. Find the value of the firm’s equity.
II. The principal amount due on the firm’s debt is $25 million and the value of the firm is
$20 million. Find the value of the firm’s debt.
A. $10 million and 0
B. 0 and $10 million
C. $10 million and $20 million
D. $20 million and $10 million
Q.2671 Which of the following statements is true?
A. When a firm is in financial distress, the value of its subordinate debt will behave like
equity
B. When a firm is in financial distress, the value of its subordinate debt will behave like
senior debt
C. When a firm is not in financial distress, the value of its subordinate debt will behave
like equity
D. None of these statements are true
58
Q.2672 Use the Merton model to find the value of a firm’s equity, given that its debt must be paid
in five years and the following information:
Value of the firm $ 50 million

Outstanding Coupon Debt $ 30 million
Interest rate 7%
Volatility of the firm 20%
A. $29.00 million
B. $28.42 million
C. $27.34 million
D. $29.80 million
Q.2678 Which of the following are not credit events?
I. Insolvency
II. Obligation acceleration
III. Repudiation
IV. Restructuring
A. I and II only
B. II, III, and IV only
C. I and IV only
D. None: All of the above are credit events
Q.2680 Find the value of a vulnerable option as a proportion of the value of a default-free option
if the probability of default is 6% and the recovery rate is 25%.
A. 96.0%
B. 96.5%
C. 95.0%
D. 95.5%
59
Q.2877 Assume Lenny and Mo Inc. has issued debt that requires it to make a payment of $360
million to debt holders at maturity. We are also told that the firm has no other creditors.
Compute the amount received by equity holders, if its total value at the maturity is $400 million
in scenario 1 and $350 million in the second scenario, respectively.
A. $40M in the first scenario and $10M in scenario 2
B. $76 in the first scenario and $19M in scenario 2
C. $40M in the first scenario and $0M in scenario 2
D. $51M in the first scenario and $10M in scenario 2
Q.2878 A firm has the price of a put with exercise price F as $19.37M and the face value of the
firm’s only zero-coupon debt maturing in one year is $206.74M. We are also informed that
today's price of a zero-coupon bond paying $1 in a year's time is $0.86. What is the value of the
debt of the firm?
A. $158.43
B. $163.27
C. $149.68
D. $151.25
Q.2879 Assuming that the probability of default for a firm is 0.11 and the recovery rate is 30
percent, compute the value of the vulnerable call without default risk.
A. 89.2%
B. 95.3%
C. 90.4%
D. 92.3%
60
Q.2880 3) Suppose that the equity of Alonso Transports is valued at $78 million and the
cumulative distribution function N (d) evaluated at d = 1.98. The face value of the firm’s only
zero coupon bond maturing in T years is $100 million.Calculate the value of the firm if its
volatility is 34% and price of a zero-coupon bond paying $1 in three years' time is $0.79 ( T – t is 3
years).
A. $200.63 million
B. $154.18 million
C. $156.37 million
D. $199.05 million
Q.3058 James Rodrigues is a risk analyst at a local Dutch firm. Using the Merton model he
estimates the value of the firm to be $70 million at the time when its debt matures. The face
value of firm’s debt is $95 million. The payoff to the debt holders and equity holders at the time
of maturity respectively are closest to:
A. $70 million to debt holders and $0 to equity holders
B. $0 to debt holders and $70 million to equity holders
C. $95 million to debt holders and $0 to equity holders
D. $70 million to Ddebt holders and $25 million to equity holders
Q.3060 Assume that the face value on a firm’s zero-coupon debt with six years remaining to
maturity is equal to $200 million. Assume further that the current value of this debt is $110
million. Compute the credit spread for this scenario if the risk-free rate (implied by the zero-
coupon bond price) is 5%.
A. 7.93%
B. 5.64%
C. 5%
D. 4.36%
61
Q.3061 A $2 million corporate bond has a remaining maturity of 7 years. Using the Merton
model, the current value of the bond is calculated as $1.2 million. Assuming that the risk-free
rate is 5%, credit spread for this bond is closest to:
A. 5.08%
B. 8.53%
C. 13.58%
D. 2.29%
Q.3193 A firm’s return for the next five years is expected to be 15% and the volatility of the
firm’s value is 19%. The firm has issued a zero-coupon bond which will mature in 5 years. The
value of the firm is 1.1 times the face value of the bond and the current interest rate is 7.5%.
Using the Merton Model, compute the expected loss to the holders of the bond if LGD is 75% and
EAD is 100%. Assume the value of the bond is x.
A. 2.832%x
B. 6.9%x
C. 7.202%x
D. 1.037%x
Q.3194 A firm has a value of $16,000,000. The firm has issued a zero-coupon bond with a face
value of $18,000,000 and at an interest yield of 7%. The bond will mature in 7 years. The
volatility of the firm’s value is 17% and the expected return on the firm is 11%. Using the Merton
model, what is the LGD to the bondholders if PD is 11.025% and EAD is 100%?
A. -$0.09million
B. $0.83 million
C. $0.5 million
D. $0.36 million
62
Q.3196 Assume that a five-year bond, with a face value of $100 million, has a market value of
$80 million. Two years have passed since the issuance of the bond. What is the risk-free rate if
the bond is trading at a 2% credit spread?
A. 9.438%
B. 7.97%
C. 5.438%
D. 4.97%
Q.4354 A firm has a current value of $200 million. It’s only outstanding debt is a 3-year zero-
coupon bond with a face value of $180 million. You have been given the following information:
Annual interest rate = 5%
Volatility of the value of the firm = 10%
Compute the value of equity
A. $42 million
B. $90 million
C. $46 million
D. $20 million
Q.4355 A firm has a zero coupon bond maturing in 5 years. Assume that the face value of this
debt is $100 million, with a current value of $88 million. Compute the credit spread assuming a
risk-free rate of 1.5%.
A. 1.057%
B. 0.5%
C. 0.025%
D. 1.025%
63
coupon bond with a face value of $80 million. Compute the expected LGD.
Current interest rate = 5%
Expected return on firm assets = 20%
Volatility of the firm = 30%
A. $1.520m
B. $1.2467m
C. $1.4577m
D. $0.927m
Q.4357 A corporate bond with a face value of $1,000 has a remaining maturity of 10 years. An
analyst uses the Merton model and computes the value of the bond as $780. Assuming that the
risk-free rate is equal to 1%, determine the credit spread for this bond.
A. 0.03
B. 0.01485
C. 0.018
D. 0.0125
Q.4358 A publicly traded firm has issued senior debt (denoted D) with a face value of F and a
current value of A. It has also issued subordinate debt (denoted SD) with a face value of U and a
current value of B. Both debts are scheduled to mature in exactly T years. The firm has also
issued ordinary equity (denoted S). If the total value of the firm is V, which of the following
expressions gives the payoff for subordinate debt?
A. c(V,F,T,t)-c[V,F+U,T,t)
B. c(V,F+U,T,t)-[V-c(V,F,T,t)]
C. V-c(V,F+U,T,t)
D. c(V,U+F,T,t)
64
Q.4359 A publicly traded firm valued at $100 million has subordinate debt (SD) with face value
of $20 million, and senior debt (D) with face value of $60 million, both maturing in 5 years. The
interest rate is 10 percent, and the volatility is 20 percent. This information is summarize in the
figure below:
Figure 1 – Summary of Data
Firm value V $100m

Face value of senior debt, F $60m
Face value of junior debt, U $20m
Time to maturity, T 5 years
Volatility of firm value, σ 20%
Interest rate, r 10%
An analyst has uses the Merton model to work out the value of a call option on the value of the
firm with exercise price equal to F [c(V,F,T,t)]. He obtains the following figures.
Figure 2 - Option with strike at F
Face value of debt $60m

d1 2.039
N(d)1 0.9793
d2 1.592
N(d)2 0.9443
c (V,F,T,t) 63.56
Determine the value of senior debt.
A. $3.56 million
B. $16.44 million
C. $20 million
D. $36.44 million
65
Q.4360 A publicly traded firm has issued senior debt (denoted D) with a face value of F and a
current value of A. It has also issued subordinate debt (denoted SD) with a face value of U and a
current value of B. Both debts are scheduled to mature in exactly T years. The firm has also
issued ordinary equity (denoted S). If the total value of the firm is V, which of the following gives
the payoff for the subordinate debt?
A. A long position in a call option on the firm with strike price equal to the face value of
senior debt, F, and a short position on a call option on the firm with a strike price equal to
the total principal due on total debt, U + F
B. A long position in a put option on the firm with strike price equal to the face value of
subordinate debt, U, and a short position on a put option on the firm with a strike price
equal to the total principal due on total debt, U + F
C. A long position in a call option on the firm with strike price equal to the face value of
total debt, F + U, and a short position on a call option on the firm with a strike price
equal to the face value of senior debt, F
D. A short position in a call option on the firm with strike price equal to the face value of
senior debt, F, and a long position on a call option on the firm with a strike price equal to
the total principal due on total debt, U + F
Q.4361 Which of the following statements is CORRECT?
A. The value of subordinate debt is an increasing function of the volatility of the firm
B. The value of subordinate debt is an decreasing function of the volatility of the firm
C. The value of subordinate debt exhibits an ambiguous relationship with the volatility of
the firm
D. The value of subordinate debt remains constant even as of the volatility of the firm
increases
66
coupon bond with a face value of $110 million. Compute the probability of default using the
Merton model.
Current interest rate = 5%
Expected return on firm assets = 20%
Volatility of the firm = 30%
A. 0.1452
B. 0.125
C. 0.1005
D. 0.1112
Q.4363 A publicly traded firm based in Kentucky, U.S., is valued at $150 million and issued has
subordinate debt (SD) with face value of $40 million, and senior debt (D) with face value of $80
million, both maturing in 5 years. The interest rate is 10 percent, and the volatility is 25 percent.
This information is summarized in the figure below:
Figure 1 – Summary of Data
Firm value V $150m

Face value of senior debt, F $80m
Face value of junior debt, U $40m
Time to maturity, T 5 years
Volatility of firm value, σ 25%
Interest rate, r 10%
An analyst has uses the Merton model to work out the value of (I) a call option on the value of
the firm with exercise price equal to F [c(V,F,T,t)], and (II) the value of (I) a call option on the
value of the firm with exercise price equal to F + U, c(V,F+U,T,t) He obtains the following figures.
Figure 2 - Option with strike at F
67
d1 1.99
Nd1 0.9767
d2 1.431
Nd2 0.9237
c (V,F,T,t) 101.68
Figure 3 - Option with strike at F+U

d1 1.584
Nd1 0.9434
d2 1.025
Nd2 0.8474
c (V,F+U,T,t) 79.84
Determine the value of subordinate debt.
A. $1.16 million
B. $21.68 million
C. $20 million
D. $21.84 million
Q.4364 Which of the following statements regarding the Merton model is CORRECT
A. The Merton model is outsmarted and outperformed by a naïve model in predicting

default risk with respect to noninvestment grade bonds
B. The Merton model does a good job at valuing a firm that has issued numerous debts
C. The Merton model is able to predict default because it assumes firm value is normally
distributed
D. The Merton model does not allow for default jumps in predicting the probability of
default
68
Reading 82: Spread Risk and Default Intensity Models
Q.1811 Spot rates, forward rates, and discount factors all have different representations of risk-
free rates. Similarly, credit spreads are represented in a number of equivalent ways. Which of the
following is not one of them?
A. Discount margin
B. Market premium of a CDS on similar bonds of the same issuer, expressed in basis
points
C. Yield to maturity
D. Quoted margin on the floating leg of an asset swap on a bond
Q.1812 Assume that a fund manager runs a special portfolio composed of option-embedded
bonds and, in their valuation, uses option-adjusted spreads. At some point in time – due to a
shocking event – all options expire but the bonds still have some time to maturity. For the fund
manager, which of the following spread representations will be the next best alternative for
valuation purposes?
A. Credit default swap spread
B. Asset-swap spread
C. Yield spread
D. Z-spread
Q.1813 Several benchmark curves can be utilized in the calculation of the zero-coupon spread.
One of the alternatives presented below cannot be used to define the Z-spread. Which one?
A. The forward curve
B. The zero-coupon LIBOR curve
C. The government bond curve
D. The quoted margin curve
69
Q.1814 Spread representations use several different benchmarks. Which of the following
benchmark/spread combinations is correct?
A. Name of the spread: Yield spread; Benchmark used: Non-government bond
B. Name of the spread: I-spread; Benchmark used: Plain vanilla interest rate
C. Name of the spread: Z-spread; Benchmark used: LIBOR spot rate
D. Name of the spread: Credit default swap spread; Benchmark used: Similar bonds of
the other issuers
Q.1815 On January 14th, 2015, a U.S. dollar-denominated bullet bond issued by Samsung had a
yield of 3.4 percent (nearest-maturity on-the-run). The Treasury note was trading at a yield of
2.35 percent. One week later, on January 21st, 2015, Samsung initiated a huge product recall
program on its S8 model smartphones following a battery problem. As a result, yield spreads on
all of its bonds tripled. If we assume that the nearest-maturity on-the-run Treasury note was still
trading at a yield of 2.35 percent, what was the new yield of the Samsung’s U.S. dollar-
denominated bullet bond on January 21st, 2015?
A. 5.75%
B. 5.50%
C. 5.40%
D. 5.30%
Q.1816 The i-spread of a class 1 bond maturing on January 20th, 2020 has been calculated as 362
bps. Today (March 30, 2017), the bond’s yield is 7.00% and the 3-year swap rate stands at
4.03%. Which of the following intervals most likely includes the 4-year swap rate used in the
calculation of the i-spread?
A. (2.00, 3.00)
B. (3.00, 4.00)
C. (4.00, 5.00)
D. (5.00, 6.00)
70
Q.1817 The spread-price relationship exhibits convexity, and the impact on the bond’s value is
heavily influenced by the size of the spread, with higher spreads combined with lower discount
factors producing the smallest impact. Which of the following is NOT among the parameters that
affect the impact of a spread change?
A. The bond duration
B. The level of the swap curve
C. The shape of the risk-free curve
D. The spread duration
Q.1818 A fund manager shocks the Z-spread of a fixed rate bond by +0.5 bps and then calculates
the new price of the bond. He repeats the procedure with -0.5 bps, noting down the difference
between the two resulting prices. What is the fund manager trying to calculate?
A. The mean spread level
B. The spread01
C. The spread duration
D. The incremental spread change
Q.1819 The consensus among market analysts is that there’s a 50% chance a certain company
will go bankrupt within one year. What is the probability that this company will be declared
bankrupt within 3 years?
A. 90%
B. 80%
C. 70%
D. 60%
71
Q.1820 Which one of the following statements is correct regarding the intensity model of
defaults?
A. All AAA-rated companies eventually go bankrupt
B. If hazard rates change, default can be avoided
C. Survival time is independent of default intensity
D. If the hazard rate is rising in the future, the cumulative default probability decreases
Q.1821 Under which of the following conditions would the hazard rate be equal to spread?
When:
A. Risk-neutral default probabilities are not too large
B. Risk-neutral (and physical) hazard rates have an exponential form
C. The recovery is zero
D. The annualized default probability is zero
Q.1822 Which of the following is not among the advantages of estimating hazard rates from
prices of credit default swaps (CDSs)?
A. Standardization
B. Coverage
C. Liquidity
D. Accuracy
72
Q.1823 Which of the following statements is (are) always true for credit default swaps (CDSs)?
I. CDSs are traded in spread terms, as “on spread” or “on basis”

II. CDSs are only created for single issuers of bonds like companies or sovereign entities
III. No principal or other cash flows change hands at the initiation of the contract
A. I only
B. I and II
C. II and III
D. I and III
Q.1824 If the market believes that a firm has a stable, low default probability that is unlikely to
change for the foreseeable future, and spread curves reflect only default expectations, which one
of the curve forms below shall we expect to see?
A. Upward sloping
B. Flat
C. Downward sloping
D. Convex
Q.1825 Two companies – A and B – are newly established within the same industry. Company A
was founded by an entrepreneur who is low in capital but has strong patents related to the
company’s operations. In contrast, Company B is a spin-off that has already established a
network of clients for its product. For a horizon of 10 years, how would you expect the spread
curves of the bonds of these two companies to look like?
A. Both of them will be flat
B. Downward sloping in the case of A and upward sloping in the case of B
C. Downward sloping in the case of B and upward sloping in the case of A
D. Both of them will be upward sloping
73
Q.1826 The default distributions computed from CDS curves of bonds of the biggest metal
trading company in the US on different dates are presented below:
Term Date A Date B
1 250 800
3 325 500
5 400 400
7 450 375
10 500 350
In the middle of the year, a new tariff on steel products – approved by the Senate – has forced the
company to reconsider its business model from scratch. When was the new tariff announced?
A. Date B < Announcement date < Date A
B. Date A < Announcement date < Date B
C. Date A < Date B < Announcement date
D. Date B < Date A < Announcement date
Q.2681 John Courtney, a credit analyst gathers the following information about a bond:
Face value $120
Years to maturity 15
Risk-free rate 1.6%
Courtney uses the Merton model to calculate the value of the bond as $64. What is the credit
spread for the bond?
A. 25.9 bps
B. 57.9 bps
C. 259 bps
D. 9 bps
74
Q.2686 A corporate bond has the following features:
Coupon 8% semiannual
Time to maturity 19 years
YTM 10%
A US treasury bond has the following features:
Coupon 4.5% semiannual
Time to maturity 18 years (YTM = 5.1%)
20 years (YTM = 5.5%)
What is the i-spread?
A. 4.5%
B. 5.5%
C. 4.7%
D. 4.9%
Q.2687 If the hazard rate is 0.20, what are the 3rd year cumulative default probability and
conditional default probability, respectively?
A. 0.4512 and 0.1813
B. 0.4512 and 0.1215
C. 0.3297 and 0.1813
D. 0.3297 and 0.1215
75
Q.2691 Assuming that defaults only occur at the end of the year, use the table below to calculate
the cumulative default rate at the end of each of the next four years.
Year Default Probability
1 0.300%
2 0.500%
3 0.800%
4 1.000%
A. 0.300%, 0.800%, 1.600%, 2.600%
B. 0.300%, 0.799%, 1.580%, 2.550%
C. 0.300%, 0.795%, 1.595%, 2.579%
D. 0.300%, 0.799%, 1.592%, 2.576%
Q.2881 The following are statements regarding the option-adjusted spread and the Z-Spread.
Which one is true?
A. OAS < Z-spread for a callable bond
B. OAS < Z-spread for a putable bond
C. OAS > Z-spread for a callable bond
D. All the above statements are true
Q.2882 If λ = 0.398, determine the conditional one-year default probability using the survival
through the first year.
A. 0.2568
B. 0.3568
C. 0.3284
D. 0.2215
76
Q.2883 Given that λ = 0.725 and t = 5 years, compute the marginal default probability and the
probability of no default sometime between now and t = 5 probability, respectively.
A. 0.32154 and -0.32154
B. 0.01932 and 0.026649
C. 0.23452 and -0.23452
D. 0.3117 and -0.3117
Q.3063 Michael Shekel is the head of the risk management group of Suarez Financial Group, one
of the biggest banking corporations in Argentina. He is currently evaluating the impact of
various default scenarios to estimate future asset liquidity. The manager has estimated that the
marginal probability of default of one of its bond with a notional principal of $55 million is 6% in
Year 1, 9% in Year 2, and 22% in Year 3. The bond pays 5% semiannually while the risk-free rate
is around 3%. What is the probability that the bond makes coupon payments for 3 years and then
defaults at the end of Year 3?
A. 56.75%
B. 66.72%
C. 18.82%
D. 17.12%
Q.3064 A hedge fund is considering taking positions in a bond issued by a large US

conglomerate. The fund’s chief economist predicts that the default probability will change
significantly as the duration of bond changes. The fund’s risk analyst estimates that the hazard
rate for the target company is 0.12 per year. Based on this data, the probability of survival in the
first year followed by a default in the second year is closest to:
A. 78.66%
B. 11.31%
C. 21.34%
D. 88.71%
77
Q.3065 Suppose that 1-year, 2-year, and 3-year bonds issued by a corporation yield 150, 180, and
195 basis points more than the risk-free rate, respectively. If the recovery rate is estimated at
40%, the average hazard rate for year 1 and the average hazard rate for all 3 years are
respectively closest to:
A. 3.25% and 7.95%
B. 2.5% and 3.25%
C. 1.25% and 2.5%
D. 1.25% and 1.25%
Q.3066 The three-year CDS on Petroblas Gas Company has a spread of 500 basis points. The
underlying nature of the business contains specialized equipment that has a limited resale
potential. Thus, a credit analyst projects a 30% recovery rate in default.
Calculate the hazard rate.
A. 0.02
B. 0.08
C. 0.05
D. 0.07143
Q.3067 Bob Woolmer is a risk analyst at Charming Pension Fund. He is responsible for managing
a big portfolio comprised of pension funds of government employees in the city of Berlin. Bob is
considering investing some of the funds in a 1-year maturity zero-coupon bond with a face value
of USD 25,000,000 and a 0% recovery rate issued by a local electricity utility company. The bond
is currently trading at 95% of its face value. Assuming the excess spread only captures credit
risk and that the risk-free rate is 2% per annum, the risk-neutral 1-year probability of default for
the electric utility company is closest to:
A. 1.1%
B. 5.1%
C. 3.1%
D. 2.0%
78
Q.4372 The following table presents information on two U.S. Treasuries and a corporate bond
issued by ABC Limited.
Bond Coupon rate Time to Price YTM

(semiannual) maturity
ABC 10% 9 95 10.49%
U.S. Treasury 1 6% 10 97 6.69%
U.S. Treasury 2 5% 8 97 5.47%
Determine the i-spread
A. 0.0255
B. 0.0304
C. 0.0441
D. 0.006
Q.4373 Assume that the current price of a bond is $92.45, and the z-spread currently stands at
202 basis points. The z-spread is increased and decreased by a 0.5 basis point margin, and the
price changes to $92.35 and $92.56, respectively. Determine the spread01 per $100 par value.
A. 0.21
B. 0.1
C. 0.17
D. 0.25
79
Q.4374 The risk-free spot rate curve is (unrealistically) steep and given by the following:
Time in years Spot rate

0.5 1.00%
1.0 2.00%
1.5 3.00%
2.0 5.00%
2.5 6.00%
3.0 7.00%
3.5 8.00%
4.0 10.00%
A 1.5 year bond issued by ABC Corporation pays a 10.0% semi-annual coupon is priced at
$104.12 per $100 par value, implying that its z-spread is round 4.00%. Specifically,
$104.12 = $5.0exp [− (1.0% + 4.0%) 0.5] + $5.0exp[− (2.0% + 4.0%) 1.0]

$105exp [− (3.0% + 4.0%) 1.5]
Determine the estimate of the bond’s spread01 (aka, DVCS) per $1,000,000 of par value.
A. 147.8
B. 148.9
C. 145.5
D. 104
Q.4375 We can represent credit spreads in a number of different ways, including yield spreads, i-
spreads, z-spreads, and asset swap spreads. In that regard, each of the following statements is
accurate EXCEPT one. which one?
A. Yield spread is the difference between the YTM of a credit-risky bond and that of a
benchmark government bond with the same or approximately the same maturity
B. The z-spread is the spread that must be added to the risk-free spot rate curve in order
to arrive at the market price of the bond
C. The asset-swap spread is the spread or quoted margin on the floating leg of an asset
swap on a bond
D. Each type of credit spread attempts to break down bond interest into compensation
for credit risk and liquidity risk only
80
Q.4376 An analyst is engaged in the analysis of two corporations, Brighter World Inc. (BW) and
Smart Tech plc (ST). The two have credit ratings of AAA and BBB, respectively, and 1-year
spreads of 300 basis points and 400 basis points. A reliable market analyst has published a
report indicating the two have default probabilities of 8% and 15%, respectively. Given this
information, which of the following statements about recovery rates is most likely correct?
A. The market-implied recovery rate is higher for BW
B. The market-implied recovery rates are equal
C. The loss given default is higher for BW
D. The market-implied recovery rate is lower for ST
81
Reading 83: Portfolio Credit Risk
Q.1827 A portfolio of credit-risky securities may contain several different instruments. Which one
of the instruments below is not a credit-risky security?
A. Bonds
B. Commercial paper
C. Guarantee
Q.1828 Which of the following is not among the factors taken into account when modeling a
single credit-risky position?
A. Default credit deterioration
B. Loss given default
C. Severity of rating migration
D. Probability of default
Q.1829 For distressed debt, the possibility of restructuring the firm’s debt is among the factors
that are taken into account when modeling a single credit-risky position. Which of the methods
stated below is not a debt restructuring strategy?
A. Negotiation with creditors
B. Bankruptcy process
C. Notifying the tax authorities
D. Judicial ruling
82
Q.1830 Albert Cook, FRM, owns a portfolio of bonds worth $50 million. This portfolio is made up
of AA-rated bonds ($30 million) and BB-rated bonds ($20 million). The 1-year probabilities of
default for AA-rated and BB-related bonds are 1% and 2.5%, respectively. Determine the 1-year
expected credit loss from Cook's portfolio, given that the recovery rate for AA bonds is 80%
while that of BB bonds is 60%.
A. $500,000
B. $260,000
C. $2,000,000
D. $200,000
Q.1831 If two firms have independent default events, which of the following expressions would
be non-zero?
A. ρ12√(π 1 (1 – π1))√(π 2 (1 – π2))
B. ρ12(π12 – π1π2) / [√(π 1 (1 – π1)) √(π 2 (1 – π2))]
C. π12 / π1
D. ρ12(π 1 + π 2 – π 12)
Q.1832 A pair of credits with BBB- and BBB+ ratings have default probabilities of 0.003 and
0.004 respectively. If the credits are correlated, what is the maximum allowed value of default
correlation such that a portfolio composed of only two of these credits has a default probability
less than 0.2%?
A. 54.28%
B. 58.28%
C. 55.59%
D. 57.85%
83
Q.1833 A pair of credits with BBA- and BBA+ ratings has equal default probabilities. If ρ12 is the
default correlation between them, find an appropriate expression for the joint default probability,
π12:
A. π12 = ρ12 × π1 (1 – π1) + π12
B. π12 = ρ12
C. π12 = π12
D. π12 = π13
Q.1834 Assume we have a portfolio of 10 credits and we wish to specify the default distribution.
What is the number of pairwise correlations required to accomplish this task?
A. 10
B. 20
C. 90
D. 110
Q.1835 Apple issues 8 five-year subordinate unsecured bonds with very close dates of maturity.
Similarly, Shell issues 2 five-year senior bonds with very close dates of maturity. A large
investment bank buys them all. Now, the bank wants to build a credit portfolio model. What is
the number of pairwise correlations required to accomplish this task?
A. 110
B. 90
C. 10
D. 1
84
Q.1836 Which of the statements presented below is most likely correct?
A. CDS-based trades are essentially market/credit risk-oriented
B. Guarantees, revolving credit agreements, and other contingent liabilities can be

examined within a portfolio credit risk framework
C. Convertible bonds have little or no market risk. Rather, they are credit risk-oriented
D. Equity and equity vega risk can be as important in convertible bond portfolios as
credit risk
Q.1837 The probability of default for firm 1 is 5%, and that of firm 2 is 1%. The default
correlation is 0.2.
Calculate the joint probability of default, given that the defaults are correlated.
A. 0.03%
B. 0.05%
C. 0.06%
D. 0.48%
Q.1838 Which of the following is not among the items that need to be modeled in order to
measure credit portfolio risk?
A. Default probability
B. Default correlation
C. Loss given default
D. Trends of default
85
Q.1839 A fund manager has a portfolio of credits that he finds too risky. Which of the following is
not among the options that could reduce the risk of the credit portfolio?
A. Buy some credits to reach a default correlation equal to 1
B. Sell some credits to improve diversification
C. Sell some credits to ensure that the portfolio default is a binomially distributed
random variable
D. Buy more credits to increase the cumulative recovery rate
Q.1841 A $1m portfolio of credits is divided into 10 credit positions. Each credit position in the
portfolio has a default probability of 5% and a recovery rate of zero. Each credit position is an
obligation from the same obligor. What is the credit VaR at 99% confidence for this portfolio?
A. $50,000
B. $950,000
C. $1 million
D. $0
Q.1842 A $1 million portfolio of credits is divided into 100 credits with each credit having default
probability represented by π. The default correlation is zero, and each credit is equally weighed.
If π = 0.03 and the 95th percentile of the number of defaults is given as 4, calculate the Credit
VaR.
A. $0.01 million
B. $0.004 million
C. $0.09 million
D. $0.001 million
86
Q.2693 Given the following information about two credits:
Probability of default of credit 1 π1 = 0.004

Probability of default of credit 2 π2 = 0.010
What is the joint probability of default if the default correlation is 10%?
A. 0.0668%
B. 0.0628%
C. 0.0453%
D. 0.0486%
Q.2884 Given the following:

π1 = 0.025
π2 = 0.035
ρ12 = 0.05
Determine the joint default probability of firms 1 and 2:
A. 0.23%
B. 0.5%
C. 0.45%
D. 0.15%
Q.3069 McLeod Bank has a portfolio of two credits, one rated CCC and the other rated BBB,
whose probabilities of default over time horizon t are 0.008 and 0.004, respectively. In addition,
assume there is a joint probability of 0.00035 that both credits will default over a time horizon t.
Using this information, what is the default correlation for this credit portfolio?
A. 5.65%
B. 7.86%
C. 4.34%
D. 5.23%
87
Q.3070 Consider a pair of credits, one BBB+ with a probability of default at 0.0065 and the other
BBB- rated with a probability of default 0.0125. If the defaults are uncorrelated, then the joint
probability of default is 0.00008. If, however, the default correlation is 9% then the joint default
probability will be closest to:
A. 0.0007
B. 0.0009
C. 0.00008
D. 0.0006
Q.3071 Aminov, a large Russian Bank, has a credit position that has a correlation to the market
factor of 0.8. What is the realized market value that is used to compute the probability of
reaching a default threshold at the 99% confidence level?
A. -1.842
B. -2.563
C. -1.165
D. -1.398
Q.3072 Zhong Hua is a risk analyst at a Chinese bank having a portfolio that has a notional value
of $4 million with 30 credit positions. Each of the credits has a default probability of 4% and a
recovery rate of zero. Each credit position in the portfolio is an obligation from the same obligor,
and therefore, the credit portfolio has a default correlation equal to 1. What is the credit value at
risk at the 99% confidence level for this credit portfolio?
A. $3.6 million
B. $0.16 million
C. $4 million
D. $3.84 million
88
Q.3073 Portfolio Y has a notional value of $1,000,000 with 30 credit positions. Each of the credits
has a default probability of 3% and zero recovery rate. In addition all credit positions in the
portfolio feature the same obligor. As a result, the credit portfolio has a default correlation equal
to 1. Determine the credit value at risk at the 99% confidence level for this credit portfolio.
A. $970,000
B. $980,000
C. $30,000
D. $200,000
Q.4365 An investment firm holds a position in two credits. The first credit is rated AAA with a
probability of default of 0.002 over the next time horizon t. The second credit is rated BBB with a
probability of default of 0.004 over a similar horizon. The joint probability of default over time
horizon t is 0.00018. Determine the default correlation for this portfolio:
A. 0.012475
B. 0.002400
C. 0.060994
D. 0.052200
Q.4366 A firm owns a portfolio of credits that exhibit a default correlation of 1. In this case,
A. The number of defaults is a binomially distributed variable with because there is no

correlation other firms in the portfolio
B. The number of defaults is Poisson distributed with a mean of 1 per unit time
C. The portfolio behaves as if it consisted of just one credit
D. Significant credit diversification may be achieved
89
Q.4367 A portfolio with a total value of $100,000,000 is made up of n credits. Each credit has a
default probability of π and a recovery rate of zero. This implies that in the event of default, the
position is wiped out and there’s total loss. Determine the credit VaR given the following:
The probability of default π = 2%
Default correlation = 1
Confidence level = 95%
A. $100,000
B. $-2,000,000
C. $1000,000
D. $0
Q.4368 A portfolio with a total value of $100,000,000 is made up of 50 credits. This implies each
credit has a future value of $2,000,000 if it doesn’t default. Default correlation is 0, π=0.02, and
the number of defaults is binomially distributed with parameters n = 50 and π = 0.02. The 95th
percentile of the number of defaults based on this distribution is 3. Determine the credit VaR.
A. $10,000,000
B. $6,000,000
C. $4,000,000
D. $2,000,000
Q.4369 A portfolio has a notional value of $10,000,000 with 10 credit positions. Each position
has a default probability of 4%. If default actually occurs, each position has a recovery rate of
zero. All positions are obligations from the same obligor. Determine the credit value at risk at the
99% confidence level for this portfolio.
A. $0
B. $9,600,000
C. $10,000,000
D. $5,000,000
90
Q.4370 A portfolio manager at an international investment firm is conducting a scheduled bi-
annual analysis of the firm’s total risk exposure based on outstanding market positions. He
intends to use the default correlation framework to measure the portfolio’s credit risk. Given that
the portfolio can be split into positions with 9 different firms, how many pairwise correlations are
there?
A. 72
B. 9
C. 81
D. 18
Q.4371 Jack Wilshire, FRM, uses the single factor model to estimate default risk. If he uses a
specific realized market value m̄, whhat is the mean and standard deviation of the conditional
distribution?
Mean Variance
A m̄ βi m̄
B m̄ √1 − β2i m̄
C βi m̄ √1 − β2i
D βi m̄ βim̄ + √1 − β2i εi
A. A
B. B
C. C
D. D
91
Reading 84: Structured Credit Risk
Q.1843 Consider the following statements about a certain type of bond:
I. - It is issued mainly by German and Denmark banks.

II. - Mortgage loans are aggregated into a pool, which is used to secure the bond.
The characteristics described above belong to:
A. Collateralized mortgage obligations
B. Covered bonds
C. Mortgage pass-through securities
D. Structured credit products
Q.1844 Which one of the following is not among the properties of covered bonds?
A. They are full-fledged securitizations
B. The principal and the interest are paid out of the general cash flows of the issuer
C. They are backed by issuer’s obligation to pay
D. The cash flow generated by the cover pool is used in payment of principal and interest
Q.1845 "Mortgage pass-through securities are repaid slowly but at an uncertain pace."
Is this statement true or false, and why?
A. True, because they are they structured credit products
B. False, they receive full repayment on one date
C. True, because of voluntary prepayments
D. False, cash flows depend only on amortization
92
Q.1846 Which of the following is not subject to prepayment risk?
A. Bullet bonds
B. Mortgage pass-through securities
C. Collateralized mortgage obligations
D. Covered bonds
Q.1847 A candidate makes the following statements concerning the capital structure in a
securitization program:
(I). The senior tranche typically receives the highest coupon.
(II). The mezzanine and equity tranche typically offer a fixed interest rate
(III). The equity tranche is typically the smallest tranche size.
A. Two statements are correct
B. All the statements are correct
C. Only one statement is correct
D. None of the statements is correct.
Q.1848 The following terms essentially refer to a common way in which structured products are
packaged. Which one does not?
A. Special purpose vehicle
B. Trust
C. Special purpose entity
D. Commercial paper
93
Q.1849 Some securities are created by “securitizing” other securitizations. Such instruments are
commonly known as:
A. Collateralized stock
B. Collateralized debt obligations
C. Commercial paper
D. Mortgage-backed securities
Q.1850 Which tranche of a securitization receives zero fixed coupon payment but is fully exposed
to defaults?
A. Equity
B. Junior debt
C. Senior debt
D. Capital stack
Q.1851 Which tranches of a securitization portfolio will be enhanced by an overcollateralization?
A. Senior tranches
B. Junior tranches
C. The reference portfolio
D. The whole portfolio
Q.1852 Which tranches of a securitization portfolio will be paid after all other obligations of the
SPE are satisfied?
A. Capital stack
B. Junior debt
C. Senior debt
D. Equity
94
Q.1853 Which one of the arrangements below correctly ranks senior debt, junior debt, and
equity, in terms of the amount of fixed coupon payments made to investors?
A. Equity < Junior debt < Senior debt
B. Junior debt < Equity < Senior debt
C. Junior debt < Senior debt < Equity
D. Equity < Senior debt < Junior Debt
Q.1854 Which one of the following is typically true with respect to the number of attachment and
detachment points of equity, mezzanine, and senior tranches?
A. Equity: (1 attachment, 0 detachment); Junior debt: (1 attachment, 1 detachment);

Senior debt: (0 attachment, 1 detachment)
B. Equity: (1 attachment, 0 detachment); Junior debt: (0 attachment, 0 detachment);

C. Equity: (0 attachment, 1 detachment); Junior debt: (1 attachment, 1 detachment);

D. Equity: (1 attachment, 0 detachment); Junior debt: (0 attachment, 0 detachment);

Q.1855 Suppose a swap curve is flat at 5%. Assume that the following principal and spread
characteristics apply to each of the collateral, mezzanine, and senior tranches:
Collateral: (&dollar;100m, 350 bps)
Mezzanine: (&dollar;10m, 500 bps)
Senior: (&dollar;85m, 50 bps)
How would annual interest amounts compare ignoring LIBOR?
A. Mezzanine > Collateral > Senior
B. Collateral > Mezzanine > Senior
C. Collateral > Senior > Mezzanine
D. Senior > Collateral > Mezzanine
95
Q.1856 A pool of loans has a default rate of 5%. If there are 100 individual loans at the
beginning, what is the number of expected defaults 5 years later?
A. 5
B. 4
C. 3
D. 2
Q.1857 Which of the following is equivalent to systematic risk?
A. Default correlation
B. Credit VaR
C. Tranche thinness
D. Granularity
Q.2706 All of the following statements about a structured credit are false, except:
A. The senior tranche receives a relatively higher fixed coupon payment compared to the
equity tranche
B. Junior debt earns a relatively higher fixed coupon payment compared to the equity
tranche
C. The equity tranche is protected by the junior tranche
D. Junior bonds are also known as mezzanine tranches
96
Q.2707 A structured solution worth $2 billion has the following capital structure:
Equity tranche $500 million
Junior debt $700 million
Senior debt $800 million
Which of the following statements correctly describes how an $800 million loss will be absorbed
by the different tranches?
A. All of the losses are absorbed by the senior tranche
B. $700 million is absorbed by the junior tranche and $100 million is absorbed by the
equity tranche
C. $500 million is absorbed by the equity tranche and $300 million is absorbed by the
senior tranche
D. $500 million is absorbed by the equity tranche and $300 million is absorbed by the
junior tranche
Q.2886 What best describes a waterfall structure in a securitization?
A. The excess spread when there is no default
B. A financial intermediary that aggregates underlying loans and design securitization

structure
C. Rules on how cash flows from the collateral are distributed to the various securities in
the capital structure
D. The process of creating a securitized credit product
97
Q.2887 Which of the following combination gives the correct simulation procedure and the role
of correlation?
A. Computing the credit losses, estimating parameters, generating default time

simulation.
B. Estimating parameters, generating default time simulations, computing the credit

losses.
C. Computing the credit losses, generating default time simulations, estimating

parameters.
D. Generating default time simulation, computing the credit losses, estimating

parameters.
Q.4395 Troy Dean, FRM, has invested in a mortgage backed security that entitles him to a pro
rata share of all principal and interest payments made on the underlying pool of mortgage loans.
Which of the following types of structured products has Dean invested in?
A. Mortgage pass-through
B. Collateralized mortgage obligation
C. Covered bond
D. Collateralized debt obligation
Q.4396 Which of the following is NOT a characteristic of covered bonds?
A. They are a non-recourse form of financing
B. The cover pool - assets designated as security for the bond – stay on the balance sheet
of the issuer
C. Assets in the cover pool cannot be used to settle claims from other stakeholders before
all the claims from covered bond holders have been met.
D. They are considered fully-fledged structured products
98
Q.4397 Mary Lincoln and Andrew Smith have invested in covered bonds and mortgage pass-
throughs, respectively. Based on this information, which of the following statements is incorrect?
A. Mary is exposed to default risk to a lesser extent compared to Andrew
B. Mary’s investment is held on the originator’s balance sheet, while Andrew’s is an off
the balance sheet investment.
C. Unlike Mary, Andrew is exposed to prepayment risk
D. In both products, the cover pools are segregated from other assets in case of a
winding up
Q.4398 A collateralized loan obligation is comprised of 100 identical leveraged loans with a par
value of $1,000,000 each, priced at par. The loans pay a fixed spread of 4% over one –month
Libor. The capital structure consists of senior, junior and equity tranches which are 85%, 10%,
and 5% of the pool, respectively. The spreads on the senior and mezzanine tranches are 200bps
and 500bps, respectively. Any spread exceeding $2,000,000 is diverted to the trust account.
Determine the cash flows to the mezzanine and excess trust account in the first period.
Assumptions:
The swap curve (“Libor”) is flat at 5%
There are no upfront, management, or trustee fees
The loans in the collateral pool and the liabilities are assumed to have a maturity of five
years.
All coupons and loan interest payments are annual, and occur at year-end
There are no defaults in the collateral pool
A. $1,000,000 (Mezzanine tranche), $50,000(Trust account)
B. $2,000,000 (Mezzanine tranche), $1,000,000(Trust account)
C. $2,050,000 (Mezzanine tranche), $0(Trust account)
D. $5,950,000 (Mezzanine tranche), $2,000,000(Trust account)
99
Q.4399 A collateralized loan obligation is comprised of 100 identical leveraged loans with a par
value of $1,000,000 each, priced at par. The loans pay a fixed spread of 400bps over one–month
LIBOR. The capital structure consists of equity, junior and senior tranches which are 5%, 10%,
and 85% of the pool, respectively. The spreads on the senior and mezzanine tranches are 200bps
and 500bps, respectively. Any spread exceeding $2,000,000 is diverted to the trust account.
Determine the amount deposited in the excess trust account at the end of the first period.
Assumptions:
The swap curve (“Libor”) is flat at 5%
There are no upfront, management, or trustee fees
All coupons and loan interest payments are annual, and occur at year-end
There annual default rate in the collateral pool is 5%
A. Cash inflow into the trust account: $2,000,000
B. cash inflow into the trust account: $1,600,000
C. Cash inflow into the trust account: $1,000,000
D. Cash inflow into the trust account: $0
100
Reading 85: Counterparty Risk and Beyond
Q.1858 Counterparty credit risk is one of the most important risk variables that can lead to
serious disturbances in financial markets. These risks are very complex to understand because of
their interaction with other financial risks. They typically arise from two broad classes of
financial products: over-the-counter derivatives and securities financing transactions. Between
these two classes, which one carries more counterpart risk (and why)?
A. OTC derivatives because of their sheer size, diversity and the fact that a large number
of products are not collateralized
B. Securities financing transactions because of their size and the fact that a large
number of transactions are unsecured
C. Securities financing transactions because of their large trading volume
D. OTC derivatives because of their low trading volume
Q.1859 Credit risk/lending risk is the risk that the borrower might be unable to repay borrowed
funds due to insolvency. Which of the following statements is incorrect about contracts with
credit risk?
A. The estimated amount at risk at any time during the lending period is usually
identified with a degree of certainty
B. A loan or credit card usually has a definite maximum usage capacity, which can be
assumed fully for the purpose of credit risk
C. In contractual agreements, only one party takes on lending risk
D. The value of the contract in the future, as viewed from the present, is uncertain
Q.1860 Which of the following statements is true about counterparty risk?
A. Counterparty risk is unilateral because only one counterparty bears a risk
B. Counterparty risk is bilateral because cash flows can be negative or positive and both
counterparties have a risk to the other counterparty.
C. The value of the contract in the future is certain
D. Counterparty risk is not uncertain but depends upon the value of the underlying
security which is fixed
101
Q.1861 What is your understanding of settlement risk?
A. The risk that arises at the time of final settlement when each party does not meet its
obligations under the contract without concern of time
B. The risk that arises at the end of settlement when one party defaults on its payments
C. The risk that arises at the time of final settlement if there are timing differences
between when each party performs on its obligations under the contract
D. The risk that arises when a counterparty refuses to repay the principal amount
borrowed
Q.1862 Settlement, as well as pre-settlement risk, should be taken into consideration when
measuring counterparty risk because both risks can lead to severe consequences. Settlement
risk can be more complex to measure when there is a substantial delivery period, like those in
commodity contracts.
From your understanding which statement is true concerning these two types of risk?
A. Settlement risk is significantly more likely to occur than pre-settlement risk
B. Settlement risk prior to the expiration of the contract is significantly more likely to
occur than default at the pre-settlement date
C. Both types of risk have somewhat equal probabilities of occurrence
D. Pre-settlement risk is significantly more likely to occur than default at the settlement
date
102
Q.1863 Which of the following statements is most likely true?
1. Spot contracts usually have settlement risk. On the other hand, long-dated swaps are
usually characterized by pre-settlement risk.
2. Spot contracts usually have a pre-settlement. On the other hand, long-dated swaps are
usually characterized by settlement risk.
3. All derivatives have an equal amount of settlement and pre-settlement risk irrespective
of the type of security under the contract.
4. Long-dated swaps usually have a pre-settlement. On the other hand, spot contracts are
usually characterized by settlement risk.
A. 1 and 4
B. 1 only
C. 4 only
D. 2 and 4
Q.1864 Let’s assume that an investor enters into a forward foreign exchange contract to
exchange €2m for $2.6m at a specified future date. In terms of settlement risk, the investor
would be exposed to a loss of $2.6m, which could only occur if €2m was paid, but the $2.6m was
not received. Suppose the exchange rate moved from 1.3 to 1.35. What would be the expected
pre-settlement loss?
A. €120,000
B. €100,000
C. $100,000
D. $120,000
103
Q.1865 A Bank has positions in four derivatives trades with a counterparty. From the bank's
perspective, the following are the mark-to-market (MtM) values of the four positions: -$20.0
million, -$15.0 million, +$14.0 million, and +$17.0 million. The bank and the counterparty have a
netting agreement between them. From the bank's perspective, what is the bank's exposure both
without netting and with netting?
A. zero without netting; -$4.0 m with netting
B. $35.0 m without netting; -$31 m with netting
C. $31.0 m without netting; -$4.0 m with netting
D. $4 m without netting; $3.0 m with netting
Q.1866 In today’s economy, many derivatives are exchange-traded. Which statement explains a
benefit of trading over an exchange?
A. An exchange encourages market efficiency and boosts liquidity through centralized

trading at a single place
B. An exchange encourages investors to make more profits by taking advantage of

arbitrage opportunities
C. An exchange is less congested compared to over-the-counter markets
D. An exchange encourages the clearing party to take a commission on each trade
Q.1867 A large number of derivatives are traded over-the-counter (OTC). OTC trading has
increased substantially in the last few years because of its benefits over exchanges. One of the
main reasons for this remarkable growth has been the emergence of new markets such as credit
derivatives. What is the other main reason for OTC markets growth?
A. OTC trading encourages market efficiency and boosts liquidity by centralized trading
at a single place
B. OTC trading enables market players to tailor contracts more accurately to client needs
C. OTC trading enables derivatives to be traded bilaterally and each party takes
counterparty risk
D. OTC trading does not enable the investors to change derivatives characteristics mid-
way through the contract
104
Q.1868 Over-the-counter derivatives have a wide variety of features, depending on their
characteristics and counterparty risk. Interest rate products are considered the most significant
products traded in OTC and comprise a significant portion of counterparty risk. What is the key
aspect of OTC derivatives?
A. Derivatives’ exposure to counterparty risk is considerably less than that of an

equivalent loan or bond
B. Derivatives’ exposure to credit risk is considerably more than that of an equivalent

loan or bond
C. An equivalent loan or bond’s exposure to credit risk is considerably less than that of
derivatives traded OTC
D. Derivatives are easily tradeable and have higher coupon payments than other
equivalent loans or bonds
Q.1869 Repurchase agreements have substantially grown in recent years in order to reduce the
cost of financing. To make these agreements risk-free and attractive, many market strategies
have been devised. In repo agreements, one party exchanges securities against cash with a
promise to repurchase the securities at a specified future date. These securities then act as
collaterals. Which of the following statements is true about the price of repurchase agreements?
A. The repurchase price is always lower than the original sale price with the difference
representing the repurchase agreement interest rate
B. The repurchase price is equal to the original sale price with zero repurchase
agreement interest rate
C. The repurchase price is always higher than the swap rates prevailing in the financial
market with the difference representing the repurchase agreement profit margin
D. The repurchase price is always higher than the original sale price with the difference
representing the repurchase agreement interest rate plus counterparty risk charge
105
Q.1870 Repos are increasingly trading in international money markets. Repos are usually loans
exchanged against securities which are taken as collaterals to mitigate credit risk. However,
some risk still remains: the seller may default by not repurchasing the securities at the due date.
Therefore, the buyer can recover the amount lent by liquidating the securities. However, the
securities may then have lost value due to market movements. In particular:
A. If the value of the collateral drops below the required margin, then the borrower may
be subject to a margin call, or the repo may be repriced in which the value of the loan is
reduced
B. The main benefit of repos to buyers is that the repo rate is higher than borrowing from
a bank
C. Repurchase agreements are long-term collateralized loans used by major financial

institutions to obtain funding
D. If the value of the security rises, the buyer will be at a loss; if the value decreases, the
borrower stands neither to benefit nor be at a loss
Q.1871 One of the problems associated with central counterparties is that:
A. They increase the incentive for each market participant to monitor carefully the
counterparty risks of one another
B. They can bring about moral hazard and information asymmetry issues by colluding
with some market participants to influence market movements
C. They can bring about moral hazard and information asymmetry problems by
eliminating the motivation for market participants to monitor the counterparty risks of
one another
D. They can reduce risk but ultimately result in lower trading volumes
Q.1872 Which of the following is not a characteristic of large derivatives players?
A. They may have a large number of OTC derivatives trades on their books
B. They can consolidate many clients and even trade with each other
C. They specialize in a single asset class
D. They may cover a variety of markets because of their large positions
106
Q.1873 Which of the following statements is true?
A. Medium derivatives players have much stronger credit quality and rating than the
other participants
B. Large derivatives players have much stronger credit quality and ratings than the other
participants.
C. Small derivatives players have much stronger credit quality and rating than the other
participants because they are exposed to smaller amount of risk
D. The credit quality and rating of large derivatives players is stronger than that of small
derivatives players but equal to that of medium players
Q.1874 Recovery rate is defined as the percentage of the outstanding amount which can be
recovered by the issuer at the time of default. The higher the recovery rate of any instrument,
the lesser the associated loss for the issuer. Another variable associated with the recovery rate is
loss given default, explained by the equation:
Loss Given Default = 1 - Recovery rate
Which of the following statements correctly describes the relationship between the two?
A. The higher the recovery rate from the counterparty, the lower the loss given default
amount
B. The higher the recovery rate from the counterparty, the higher will be the loss given
default amount
C. The lower the recovery rate from the counterparty, the lower will be the loss given
default amount
D. The recovery rate from the counterparty will always be equal to the loss given default
amount
Q.2684 Which of the following expressions can be used to find the recovery rate in percentage
terms?
A. 1– Defaulted Amount/Total Exposure
B. 1 – Total Exposure/LGD
C. Total Exposure/Defaulted Amount
D. 1 – LGD
107
Q.2689 Which of the following derivative products has the least counterparty risk?
A. Repos
B. Interest rate swaps
C. Commodities futures
D. FX forwards
Q.2890 In most cases, CVA and Credit Limits have been observed to work on a complementary
basis to quantify and manage counterparty risk. One of the choices given below shows how this
can be achieved. Pick the correct one.
A. CVA encourages the minimization of the number of trading counterparties while Credit
Limits encourage the number to be maximized
B. CVA encourages maximization of the number of trading counterparties whereas Credit

Limits encourage minimization of the said number
C. CVA focuses on evaluating counterparty risk at the portfolio level whereas Credit
Limits evaluate the risk at the counterparty level
D. CVA evaluates counterparty risk at the portfolio level while Credit Limits evaluate the
risk at the trade level
108
Q.2891 Differentiate between settlement risk and pre-settlement risk.
A. Settlement risk: the risk of a counterparty defaulting before the final settlement of
the transaction;
Pre-settlement risk: occurs due to differences in timing between periods that parties
perform on their obligations under the agreement at the time of settlement
B. Settlement risk: the risk due to the notional amount at risk prior to the lending
period, and is usually determined with a high degree of certainty;
Pre-settlement risk: arises due to the notional amount at risk during the lending period
and cannot be determined with a high degree of certainty.
C. Settlement risk: the risk arising because of the notional amount at risk during and
after the period of lending and can be certainly determined;
Pre-settlement risk: arises prior to the period of lending, due to the notional amount at
risk and can be determined with a high degree of certainty.
D. Settlement risk: arises due to timing differences between when each party fulfills
their obligations under the contract at the time of settlement;
Pre-settlement risk: the risk that counterparty will default before the transactions final
settlement.
Q.3191 Alpha Microfinance bank has a loan portfolio of $50 million with a maturity of two years.
The marginal probabilities of default, exposures at default, and loss rates in each of the two
years are as follows:
Marginal PD EAD LR
Y ear 1 7% 75% 80%
Y ear 2 9.50% 35% 80%
IRR of the loan portfolio is 7.9% and default occurs in the middle of the period.
What is the present value of the expected credit loss of the loan portfolio?
A. $2.5214m
B. $8.5700m
C. $7.7000m
D. $3.2083m
109
Reading 86: Netting, Close-out, and Related Aspects
Q.1875 The financial sector has devised a number of ways to mitigate counterparty risk and
reach a level of profit where there is no market risk. Suppose an institution undergoes a trade
transaction with counterparty A and hedges that contract with counterparty B. In this scenario,
we could say the institution has no market risk, but it does have counterparty risk with respect to
both A and B. What will happen if any of them defaults on their respective contract?
A. If either defaults, then the institution will have to cover that loss from another counter
party
B. If either defaults, then the institution will be sure to suffer losses on both contracts
C. If either defaults, then the institution will have to face risk exposure from the other
side of the trade
D. In this condition, both counterparties cannot default at the same time, which means
the institution’s investment is well guarded
Q.1876 The International Swaps and Derivatives Association (ISDA) is an organization for OTC
derivatives practitioners. Which of the statements below correctly defines the function of the
ISDA?
A. It defines the general terms between parties with respect to issues such as netting,
collateral, definition of default, and conditions for termination of the agreement
B. It defines the general terms between parties and specifies conditions that may lead to
the termination of the contract
C. It’s a single document for with which a counterparty can be sued in case of default
D. It outlines conditions in which both parties can terminate the contract and move on
with no loss or legal issues
110
Q.1877 What is the main purpose of closeout netting within the context of derivatives trading?
A. It gives an institution the opportunity to net cash flows happening on the same day
B. It permits the termination of all agreements between the insolvent and a solvent
counterparty by offsetting all the transaction values between them
C. It gives an institution the facility to net cash flows happening after a specified number
of days
D. It permits the termination of all agreements between two parties by only

compensating the victim party while at the same time punishing the defaulting party
Q.1878 Suppose an institution is required to make a $205m floating swap payment on day Y. On
that same day, assume the institution is due to receive a $200m fixed payment.
Applying payment netting, the institution would need to make a single net payment of:
A. $5m
B. $405m
C. $200m
D. $205m
Q.1879 In the modern market, it is possible to execute multiple trades with a single counterparty.
Which of the following situations is highly unlikely with respect to such trades?
A. Trades may involve hedges or partial hedges in order to have their values moving in
opposite directions
B. Trades may have unwinds, so that rather than canceling a transaction, the reverse
trade can be executed
C. Trades can be largely independent – they can be from different asset classes or even
have different underlyings
D. Trades can be largely dependent – they can be from the same asset class or even have
the same hedging instrument
111
Q.1880 Assume the following current marking to market values exist for Entity K, in seven
different transactions:
+7, +5, +8, -7, -4, -2, -6
What is the total exposure, with and without netting, respectively?
A. 19, 1
B. 1, 19
C. 20, 19
D. 1,20
Q.1881 Which of the following statements is correct with regard to closeout netting?
A. If an institution is obliged to pay an amount, then it has to make that payment,

whereas if it’s owed money, it has to write off the entire amount
B. If an institution is obliged to pay an amount, then it has to make that payment,

whereas if it’s owed money, then it makes a bankruptcy claim for that amount
C. If a financial institution obliged to pay an amount, then it has to go to court and

request an offset of the said amount against its own receivables
D. If an institution is obliged to pay an amount, then it has to make the payment, whilst if
it’s owed money, it has to use the courts to persuade the counterparty to settle its
obligation
Q.1882 The process of netting is a mechanism of controlling the exposure to a counterparty

across two or more transactions. Without this process, if the counterparty defaults, the loss is
the sums of the values of the dealings with that counterparty that have positive mark-to-market
values. This means that:
A. Derivatives having negative values have to be settled whereas the ones having positive
values signify a claim through the bankruptcy process
B. Derivatives with both positive and negative values have to be claimed through the
bankruptcy process
C. Derivatives with negative values have to be hedged afresh
D. Derivatives with positive value have to be liquidated immediately
112
Q.1883 Consider 5 different transactions with a counterparty B. The transactions have the
following MtM values: +4 million, +7 million, +2 million, -5 million, -3 million.
What will be the total exposure with and without netting?
A. +$13 million with netting and +$5 million without netting
B. +$13 million without netting and +$5 million with netting
C. +$7 million with without netting and +$2 million with netting
D. +$7 million with without netting and -$3 million with netting
Q.1884 Which of the following statements is true about netting sets?
A. Within a netting set, quantities such as expected exposure and CVA are non-
multiplicative results in reducing overall risk
B. Within a netting set, quantities such as expected exposure and CVA are additive
results in reducing overall risk
C. Within a netting set, quantities such as expected exposure and CVA are multiplicative
D. Within a netting set, quantities such as expected exposure and CVA are non-additive
Q.1885 The process of netting has significantly impacted the growth of OTC derivative markets.
Because every investor wants to reduce its risk to a minimum. Without netting, the current
liquidity and trading sizes of OTC markets cannot be achieved because:
A. Netting allows overall credit exposure to the market to grow at a rate that’s lower
than the current growth rate of the OTC market itself
B. Netting allows overall credit exposure to the market to grow at a higher rate than the
current growth of the OTC market itself
C. Netting allows overall credit exposure to the market to grow at a rate that’s equal to
the current growth rate of the OTC market itself
D. Netting allows the OTC market to grow at a rate that’s significantly less than the
overall credit exposure growth rate
113
Q.1886 Netting reduces the counterparty risk in the event of default and also reduces systematic
risk. However, it can also be problematic because:
A. Legal and other operational risks can arise
B. Liquidity risk can arise
C. Company-specific risks can increase
D. None of the above – no risk is associated with netting as the procedure itself is a risk-
reducing one
Q.1887 Long-term derivatives do present a problem because although the existing exposure may
be comparatively small and controllable, the long-term exposure could enlarge and become
unmanageable. To mitigate this problem, we can introduce break clauses which serve to:
A. Change terms of trade with a counterparty whose creditworthiness continually

worsens
B. Readjust product-specific parameters
C. Terminate a trade with the counterpart whose creditworthiness continually

deteriorates
D. Specify conditions that should warrant large-scale secondary hedging
Q.1888 Which of the following best describes the consequence of exercising a break clause in a
contract?
A. The defaulting party will have authority to terminate the transaction at its current
replacement value
B. The exercising party will have authority to terminate the transaction at its pre-defined
replacement value
C. The exercising party will have authority to trade the new transaction at a pre-defined
replacement value
D. The exercising party will have the authority to terminate the transaction at its current
replacement value
114
Q.1889 A mandatory break clause implies that:
A. The transaction will certainly terminate at the date of the break clause regardless of
the financial situations of both parties
B. The transaction will not terminate at the date of the break clause regardless of the
situations of both parties
C. Both parties have the option to terminate the trade transaction depending on the
creditworthiness of each party
D. The transaction will certainly terminate at the date of the break clause but give the
defaulting party an option to accept it or reject it
Q.1890 What makes optional break clauses more problematic to execute compared to mandatory
clauses?
A. These clauses should be exercised early before the counterparty's credit quality
deteriorates significantly and exposure decreases considerably
B. These clauses should be exercised early before the counterparty's credit quality
deteriorates significantly and exposure increases considerably
C. These clauses should be exercised early after the counterparty's credit quality
deteriorates significantly and exposure decreases considerably
D. These clauses should not be exercised early before the counterparty's credit quality
deteriorates to try and extend some goodwill to the other party
Q.1891 Which of the following is not a problem related to trigger-based break clauses?
A. Default probabilities and rating changes probabilities cannot be inferred from market
data
B. To compute default probabilities, one needs to get historical data which can be scarce
C. Ratings during many situations – especially in a financial crisis – have shown to be

exceptionally slow in responding to negative credit information
D. Trigger-based break clauses cannot be exercised at the specified date to avoid a

destructive fallout between counterparties
115
Q.1892 Some OTC derivatives have been recognized with some walk-away features. Such clauses
in agreements allow the institutions to terminate transactions with the counterparty in the event
of default. These types of clauses mainly do not reduce risk exposure but give certain benefits.
They allow an institution to:
A. Benefit from terminating payments without the need to settle amounts payable to the
counterparty
B. Terminate the contract and gain from the replacement cost estimated before the
transaction with the counterparty
C. Benefit from terminating payments and only pay net amounts to the counterparty
D. Benefit from terminating payments and institute legal proceedings against the
counterparty
Q.1893 Standard netting agreements are usually bilateral and work when there are only two
counterparties. To minimize risk when the trade is between more than two parties, multilateral
netting is brought in. Which of the following statements is (are) correct regarding multilateral
netting and trade compression.
A. Multilateral netting is likely to decrease motivations for institutions to analyze the

credit quality of counterparties
B. Trade compression is likely to increases counterparty risk
C. Trade compression is likely to increases operational costs
D. Both B and C
Q.2892 The following are risk-mitigating characteristics of the ISDA Master Agreement based on
the point of view of a counterparty. Which one is NOT?
A. Events of default and termination
B. The definition of the mechanics around the close-out process
C. Combination of all referenced transactions to one net obligation
D. Legal uncertainties around netting due to the replacement of offsetting transactions

with a net equivalent transaction
116
Q.2893 What is the major difference between payment netting and close-out netting?
A. Payment netting reduces settlement risk while closeout netting reduces pre-settlement
risk.
B. Payment netting reduces pre-settlement risk and close-out netting deals with
counterparty risk.
C. Payment netting reduces counterparty risk whereas close-out netting reduces

settlement risk.
D. None of the above.
Q.2895 Which of the following best describes cliff-edge effects in financial markets?
A. A situation where the market price of an asset suddenly falls following an adverse
event
B. An attempt by multiple counterparties to simultaneously sell debt instruments or

terminate some other transactions following a rating downgrade.
C. A sudden increase in the price of an asset following the publication of positive

information about the asset or the parent company.
D. All the above
Q.3076 Zhao Lee is a trader at the largest commercial bank in mainland China. He has a large
position in a US sovereign bond that has a haircut of 3% and is used for a collateral call of
$500,000. What amount of bond is needed for $500,000 to be credited?
A. $515,464
B. $485,000
C. $484,536
D. $500,000
117
Reading 87: Margin (Collateral) and Settlement
Q.1894 Collateralization, also known as margining, serves to reduce credit exposure and actually
offers more protection than netting. The fact that collateral agreements can be two-way implies
that:
A. Either counterparty would be required to submit collateral against a negative mark-to-

market value for hedging against risk
B. Both counterparties must provide collateral regardless of the mark-to-market value
C. Either counterparty can ask for the cancellation of the contract if the designated
collateral is unlawfully changed or sold
D. Either a counterparty or the regulator/clearinghouse can ask for an increase in

collateral if the financial health of the other counterparty significantly deteriorates
Q.1895 Which of the following statements is correct with regard to collaterals in derivatives
contracts?
A. The collateral is under the control of valuation agents and can be liquidated
immediately in event of default
B. The collateral is under the control of the counterparty and can be liquidated
C. The collateral is under the control of bankruptcy courts and cannot be liquidated
D. The collateral is under the control of the counterparty but cannot be liquidated
immediately after default; rather, there must be a legal process
Q.1896 Collateral management has several benefits. Which of the following is NOT among them?
A. To reduce credit exposure, hence allowing a party to pursue more business-like

ventures
B. To enable institutions to trade with a particular counterparty, e.g., one whose credit
rating is low
C. To give more competitive estimations of counterparty credit risk
D. To avoid capital requirements often imposed by regulators/governments
118
Q.1897 A collateralized position is analogous to a mortgaged house. To mitigate against default
risk, lenders may collateralize the property. Although that helps, it can as well result in further
risks. Which of the following does not qualify as an example of such “secondary” risks?
A. The risk that the value of the property in question might drop below the outstanding
value of the loan or mortgage
B. The risk that it might not be possible to sell the property in the open market
immediately after a default event
C. The risk that there is a strong dependence between the value of the property and the
default of the mortgagee
D. The risk that the mortgagee might be careless with the property, an outcome which
can significantly reduce its value below the outstanding value of the debt
Q.1898 Suppose there is a transaction between two parties – X and Y – where party X makes a
mark-to-market profit and party Y makes a mark-to-market loss. As such, Y is expected to post
collateral worth $80 million. If a haircut of 2% applies, how much will Y post?
A. $100 million
B. $82 million
C. $78 million
D. $81.63 million
Q.1899 Whenever an institution enters into a trade agreement with a counterparty, there is
always the risk of default. A collateral agreement limits risk exposure by posting of collateral by
the counterparty at risk of default. From the perspective of the financial institution, this implies
that:
A. In case of a positive MtM, an institution will provide collateral. On the other hand, if it
has negative MtM value, it will request collateral to reduce its risk exposure.
B. In the case of a positive MtM, the institution will request for collateral. If the MtM is
negative, the counterparty will request for collateral.
C. In case of a negative MtM, the institution will request for collateral. If the MtM is
positive, the counterparty will be required to provide collateral.
D. Collateral is a constant requirement if the institution has a lower credit rating

compared to the counterparty.
119
Q.1900 What is the main role of a Credit Support Annex?
A. To document the collateral posted by counterparties throughout the duration of a

derivative contract
B. To regulate the amount of time taken before a party at risk of insolvency makes a
formal declaration acknowledging its insolvency
C. To regulate the collateral held by the two parties in a derivatives contract
D. To document all the trades involving a given counterparty within a specified time
period, say, one year
Q.1901 A Credit Support Annex (CSA) governs all things collateral, except:
A. Timings and methods of the underlying valuations
B. The calculation of the amount of collateral that needs to be posted
C. Interest payments on collateral
D. The signing of the ISDA agreement
Q.1902 How does the “threshold” as stipulated in a CSA help investors to check on exposure
risk?
A. It defines the amount of collateral below which a contract cannot be entered into
B. It gives guidelines on how to liquidate collateral in case of a default event
C. It defines the level of MtM above which collateral is posted
D. It defines the level of MtM above which collateral must be liquidated
Q.1903 Which of the following statements correctly defines the relationship between thresholds
and independent amounts as used in a CSA?
A. Thresholds and independent amounts fundamentally move in the same direction
B. Thresholds and independent amounts fundamentally move in opposite directions
C. Thresholds and independent amounts are fundamentally equal
D. Thresholds are always less than or equal to independent amounts
120
Q.1904
This figure shows the impact of collateral on the risk exposure profile.
The figure helps to illustrate the fact that collateral cannot perfectly mitigate risk exposure
because of certain reasons. Which ones?
1. The presence of a threshold value implies that a certain amount of exposure cannot be
collateralized
2. It’s not possible to calculate accurate collateral values
3. Delays in receiving collateral and parameters such as the minimum transfer amount
generate a discrete effect because the movement of exposure cannot be traced perfectly
4. Collateral values are usually discrete, but exposure values can take on continuous
variables
A. 1 and 4
B. 1 and 3
C. 2 and 3
D. 3 only
121
Q.1905 Which of the following is not a role of valuation agents in collateral calculation?
A. To compute credit exposure in a trade agreement under the impact of netting
B. To calculate the market value of collateral previously posted
C. To calculate the delivery or return amount to be posted by either counterparty
D. To estimate the credit ratings for each counterparty prior to the commencement of any
agreement
Q.1906 The use of non-cash collateral in OTC derivative markets is often limited because:
A. Non-cash collateral brings about problems of reuse and hypothecation
B. The market price of non-cash collateral can be quite volatile
C. Non-cash collateral can bring about liquidity problems
D. All of the above are possible reasons
Q.1907 Collateral management is one of those banking areas that have yet to embrace
technology. It still relies heavily on manual processes and data standards. One of the problems
that results directly from such reliance manifests in the form of valuation disputes with regard to
previously posted collateral. Which of the following explanations correctly outlines how such a
dispute should be addressed?
A. If the disputed amount is higher than a certain acceptable level stated in the collateral
agreement, then the counterparties may "split the difference"
B. If the disputed amount is under a certain acceptable level stated in the collateral
agreement, then the counterparties may "split the difference"; otherwise, a case must be
filed against the defaulting party
C. If the disputed amount is under a certain acceptable level stated in the collateral
agreement, then the counterparties may "split the difference"; otherwise, it is
compulsory to find the cause of the difference
D. If the disputed amount is under a certain acceptable level stated in the collateral
agreement, parties should ignore it; otherwise, it is compulsory to find the cause of the
difference
122
Q.1908 Trade disputes between counterparties are common and when they occur, parties should
endeavor to act in a way that causes minimum losses or disruption. Therefore, rather than being
reactive at times of dispute, parties should aim to be proactive. Through which of the following
ways can this be best achieved?
A. Carrying out periodic reconciliations.
B. Comparing MtM quotations of several market makers.
C. Only using credible data sources when computing the market value of non-cash
collateral.
D. Setting a timeline that stipulates the maximum amount of time it should take to
resolve a dispute.
Q.1909 Although derivative markets are increasingly embracing daily margining, smaller
institutions may prefer longer margin call frequencies because:
A. Longer margin calls give them ample time to meet operational and funding
requirements
B. Longer margin calls give them ample time to re-evaluate and confirm the
“correctness” of collateral changes
C. Daily margin calls are only appropriate for markets that show little volatility
D. Daily margin calls increase chances of valuation disputes
Q.1910 Suppose a given security has a haircut of A%. This would mean that:
A. For each unit of that security posted as collateral, only A% of credit will be given.
B. For each unit of the security posted as collateral, only 1/(1 - A)% of the credit will be
given.
C. For each unit of the security posted as collateral, only (1 -A)% of the credit will be
given.
D. For each unit of the security posted as collateral, only (1 + A)% of the credit will be
given.
123
Q.1911 Sometimes, a counterparty may want securities posted as collateral returned. This only
happens if they can post:
A. A replacement that’s valid and whose value is equal to that of the collateral
withdrawn, but have to post the haircut in cash
B. A replacement and the other counterparty accepts the collateral substitution
C. A replacement in the exact same asset class as the collateral previously posted
D. An alternative amount of eligible collateral with equivalent value taking into account
the relevant haircut
Q.2694 Which of these institutions is likely to post the highest level of collateral?
A. Private equity funds
B. Sovereigns
C. Corporates
D. Dealer banks
Q.2708 What is the amount of collateral required for a repo transaction worth $20 million, which
has a probability of default of 7%, if a haircut of 5% is applied to the collateral?
A. $21.51 million
B. $18.60 million
C. $19.00 million
D. $21.05 million
124
Q.2712 Which of the following statements about structured credits is false?
A. The boundary between two tranches, expressed as a percentage of the total of the
liabilities, is known as the attachment point of the more junior tranche
B. The part of the capital structure below a bond tranche is referred to as its credit
enhancement
C. Overcollateralization occurs when the par amount of bonds sold is less than the par
amount of underlying collateral
D. Extension risk is the risk arising from loans prepaying slower than expected
Q.2896 Which of the following is NOT a mortgage-associated risk: the risk arising when a house
plays the role of collateral and being pledged against the borrowed value?
A. The risk of the property value in consideration falling below the outstanding of the
loan or mortgage
B. The risk of the mortgage lender facing legal obstacles and is, therefore, unable to
claim ownership of the property in case of default by the borrower
C. The risk of funding needs that arise due to collateral terms, especially when the
collateral needs to be segregated and cannot be rehypothecated
D. The risk of strong interdependence between the amount borrowed and the default of
the mortgagor
Q.2897 Jimmy Gait is a valuation agent. Which of the following does NOT define his role as a
valuation agent in collateral computation?
A. Computing the current mark-to-market under the impact of netting
B. Taking market data and market close time
C. Calculating the total uncollateralized exposure
D. Computing the market value of previously posted collateral and adjusting this by the
relevant haircuts
125
Q.2898 There are two practical methods of collateral transfer: security interest and title transfer.
Which of the following best depicts the difference between these two methods?
A. Securities interest: There is no changing hands by the collateral, but an interest in

collateral assets is acquired by the receiving party and can only use it under certain
contractually defined events.
Title transfer: There is changing hands by the legal possession of collateral and an
outright transfer of the underlying collateral assets, but with potential restrictions on
their usage. The collateral holder can use the assets freely and the enforceability is
stronger.
B. Securities interest: There is no outright transfer of collateral assets, but there are
potential restrictions on the usage of underlying collateral assets.
Title transfer: There is outright transfer of collateral assets, but there are no potential
restrictions on the usage of underlying collateral assets.
C. Securities interest: Legal possession of collateral changes hands and the underlying
collateral assets are transferred without potential restrictions to their usage.
Title transfer: The collateral does not change hands, but the receiving party acquires an
interest in the collateral assets.
126
Reading 88: Credit Exposure and Funding
Q.1929 The defining characteristic of credit exposure is related to whether the effective value of
the contract is positive or negative. If the value is negative, this implies that:
A. The institution is in debt and is legally obliged to settle this amount
B. The institution is owed by a counterparty, who is legally obliged to settle the amount
C. The institution is not legally obliged to settle its counterparty’s debt
D. The institution is under financial distress and the contract should be terminated
Q.1930 Which of the following best describes the concept of bilateral exposure in any contract
between an institution and the counterparty?
A. When the counterparty defaults, the institution is only paid a recovery fraction of their
exposure which is a loss for the institution. On the other hand, when the institution
defaults, the counterparty receives a recovery fraction of the negative exposure which is
a loss for the institution.
B. When the counterparty defaults, the institution is only paid a recovery fraction of their
a gain for the institution.
C. When the counterparty defaults, the institution only receives a recovery fraction of
their exposure which is a gain for the institution. On the other hand, when the institution
a loss for the institution.
D. When the counterparty defaults, the institution is only paid a recovery fraction of their
defaults, the counterparty is paid all of its exposure, which is a gain for the institution.
127
Q.1931 Which of the following statements about the closeout amount are correct?
I. One of the issues in determining the closeout amount is a time delay. Until an agreement
is reached, an institution cannot be sure of the precise amount owed or the value of their
claim as an unsecured creditor.
II. ISDA (2009) specifies that the closeout amount may include information related to the
creditworthiness of the surviving party.
III. In determining a closeout amount according to ISDA (2009), an institution should "act in
good faith and use commercially reasonable procedures in order to produce a
commercially reasonable result."
A. I and II
B. I and III
C. II and III
D. I, II and III
128
Q.1933 The diagram below illustrates past, current, and future exposure:
The diagram most likely illustrates the fact that:
A. Both the current and future exposure are not known with certainty
B. Future exposure can be predicted from past and present exposure
C. While current (and past) exposure is known with certainty, future exposure is largely
uncertain and can only be defined by probabilistic estimates of future market movements
D. While past exposure is known with certainty, current and future exposures are
uncertain and subject to probabilistic estimates of future market movements
Q.1934 It has been evident that Value at Risk (VaR) and exposure share some characteristics but
characterizing exposure is a bit more complex. This arises due to the fact that:
A. Exposure requires definition over multiple time horizons, unlike VaR
B. Exposure can take on both positive and negative values whereas VaR is always positive
C. Future VaR is always known with certainty but future exposure is not known
D. It’s easier to model future VaR than it is to model future exposure
129
Q.1935 One of the metrics used to quantify exposure is the expected future exposure (EFV), i.e.,
the expected value of the netting set at some point in the future. Which of the following is a
possible reason as to why the EFV may vary significantly from current value?
A. Cash flows may be asymmetric
B. Forward rates can be significantly different from current spot variables
C. Collateral agreements that are asymmetric
D. All of the above
Q.1936 Which of the following statements correctly defines the potential future exposure (PFE)
of a derivatives contract?
A. The credit exposure on a future date, modeled with a specified confidence interval
B. The expected credit exposure on a future date, conditional on positive market values
C. The minimum potential loss if the counterparty defaults
D. The difference between the expected exposure and the credit exposure on a future
date
Q.1937 Suppose that the future value is defined by a normal distribution with mean 2.0 and
standard deviation 5.0. At the 99% confidence level, the value of Z is 2.33. What would be the
value of the potential future exposure?
A. 13.65
B. 13.85
C. 11.65
D. 9.66
130
Q.1938 The graph below plots potential future exposure against time (in months):
The worst case exposure over the entire period would be represented by point:
A. X
B. Y
C. Z
D. X - Z
131
Q.1939 To overcome the shortcomings of expected exposure (EE) and expected positive exposure
(EPE), the Basel Committee in 2005 introduced two new terms: the effective expected exposure
(EEE) and the effective expected positive exposure (EEPE). What were the reasons behind these
changes?
A. EE and EPE may underestimate exposure for short-dated transactions and do not take
into account roll-over risk
B. EE and EPE may overestimate exposure for short-dated transactions and do not take
C. EE and EPE may underestimate exposure for long-dated transactions and do not take
D. EE and EPE may underestimate exposure for short-dated transactions and only take
Q.1941 From the following table, calculate the netting benefit.

Future Value Total Exposure
Trade 1 Trade 2 No Netting Netting
Scenario 1 30 10 40 40
Scenario 2 20 5 25 25
Scenario 3 5 -5 5 0
Scenario 4 -25 -25 0 0
Scenario 5 -15 -15 0 0
EE ? ?
A. 5
B. 1
C. 1.33
D. 2.5
132
Q.1942 From the following table, find the netting benefit along with an interpretation:
Future Value Total Exposure
Trade 1 Trade 2 No Netting Netting
Scenario 1 -30 35 35 5
Scenario 2 -25 15 15 0
Scenario 3 -15 5 5 0
Scenario 4 -25 -25 0 0
Scenario 5 -15 -15 0 0
EE ? ?
A. 5; initial negative future values have less netting benefits than positive initial future
values
B. 10; initial negative future values have less netting benefits than positive initial future
values
C. 5; initial negative future values have more netting benefits than positive initial future
values
D. 10; initial negative future values have more netting benefits than positive initial future
values
Q.1943 Two banks – X and Y – enter into an interest rate swap, where bank X pays a floating rate
and Y the fixed rate, based on a notional value of $50 million. Assume the swap has a term of 5
years.
Which of the following would most likely be true at the time of inception of the swap?
A. The market value would be $50 million to both X and Y
B. The market value would be zero to both X and Y
C. X would have a market value of zero while Y would have a market value of $50 million
with respect to the swap
D. Y would have a market value of zero while X would have a market value of $50 million
with respect to the swap
133
years.
How would you interpret bank Y’s 12-month expected exposure (EE)?
A. The average market value of the swap to bank Y, 12 months forward
B. The average positive market value of the swap to bank Y, 12 months forward,
excluding negative values
C. The maximum credit exposure to bank Y, 12 months forward
D. The market value of the swap to bank Y, 12 months forward, excluding negative values
Q.1945 Two banks - X and Y - enter into an interest rate swap, where bank X pays a floating rate
years.
Assume bank X has a 95% 12-month potential future exposure (PFE) of $3 million. This is
equivalent to saying that:
A. 12 months into the future, we are 95% confident that bank X’s gain in the swap will be
$3 million or more
B. 12 months into the future, we are 95% confident that bank X’s gain in the swap will be
$3 million or less
C. 12 months into the future, bank X’s loss in the swap will not have exceeded $3 million
D. 12 months into the future, bank X’s maximum gain in the swap will be $3 million, with
a probability of 95%
134
years.
Which of the following would most likely be true?
A. The 12-month 95% PFE must be less than the 12-month expected exposure
B. The 12-month 95% PFE must be greater than the 12-month expected exposure
C. The 12-month 95% PFE must be equal to the 12-month expected exposure
D. The 12-month 95% PFE must be less than or equal to the 12-month expected exposure
Q.2673 Which of the following is not a disadvantage of Central Counterparties (CCPs)?
A. Moral Hazard
B. Adverse Selection
C. Loss mutualisation
D. Procyclicality
Q.2899 Assuming that the future values follow a multivariate normal distribution, and the
number of exposures is given as 21, determine the netting factor if the average correlation is 0.3.
A. 0.70
B. 0.15
C. 0.58
D. 0.61
135
Q.2900 Let the current mark-to-market of a portfolio be $35 million. $20 million of variation
margin is held, and $15 million of initial margin is posted bilaterally. Calculate the counterparty
credit risk exposure and the exposure for funding risks, respectively.
A. Counterparty risk exposure: 0; Exposure for funding risks: 30
B. Counterparty risk exposure: 5; Exposure for funding risks: 27
C. Counterparty risk exposure: 30; Exposure for funding risks: 0
D. Counterparty risk exposure: 27; Exposure for funding risks: 5
Q.2901 The management of Wiki Bank has signed a 2-year FX forward agreement with GSO
traders to sell GBP against JPY at 150.95. All other factors remaining constant, one or more of
the below situations will increase the bank’s maximum peak potential future exposure (PFE)
towards GSO over the contract's life. Which one?
A. Increased volatility on the GBP/JPY spot rate
B. Increased default probability by GSO over the time period
C. Increased GBP interest rates
D. The expected value of the gain on the forward agreement.
136
Q.2902 Two banks, X and Y, enter into a vanilla interest rate swap with a notional value of $100
million. The banks will exchange payments at six months intervals for the swap's tenor (5 years).
Bank X is the floating rate payer and will pay the six-month Libor
Bank Y is the fixed rate payer and will pay the current swap rate of 5% per year.
Bank X has a 12-month potential future exposure of $7.5 million calculated at 99%
confidence. This implies that:
A. The bank is 1% chance that the bank’s worst exposure 12 months into the future will
be $7.5 million or less
B. 12 months into the future, bank X is confident that bank Y will have gained no more
than $7.5 million
C. 12 months into the future, the bank is 99% confident that the gain in the swap will be
no more than $7.5 million
D. 12 months into the future, the bank is 99% confident that the gain in the swap will be
at least $7.5 million
Q.2904 A portfolio has a current mark-to-market of 15 and 10 of variation margin is held. In

addition, the segregated initial margin is given as 6. Ignoring the close-out costs, determine the
counterparty credit risk exposure and the exposure for funding risks respectively.
A. Counterparty risk exposure: 0; Exposure for funding risks: 13
B. Counterparty risk exposure: 7; Exposure for funding risks: 0
C. Counterparty risk exposure: 13; Exposure for funding risks: 0
D. Counterparty risk exposure: 0; Exposure for funding risks: 11
Q.2905 Given that the number of exposure is 17 and the average correlation is 0.7, determine
the netting factor if the assumption is that the future values follow a multivariate normal
distribution.
A. 0.45
B. 0.85
C. 0.36
D. 0.97
137
Q.2906 Determine the netted exposure of 9 independent transactions that have equal volatility
supposing their mean is zero?
A. 9.00%
B. 43.17%
C. 33.33%
D. ∞
Q.3077 Calculate the worst-case change in the value of an exposure with 5% annual volatility
perfectly collateralized by cash over a 20-day remargin period. Assume 250 trading days in the
year and a 99% PFE confidence level.
A. -2.5%
B. -4.3%
C. 3.3%
D. -3.3%
Q.3078 ABT Holdings is a large commercial bank that has three uncollateralized transactions
with a counterparty worth +$10 million, +$30 million, and -$25 million. What will be the bank’s
exposure on the transactions if they are regarded as independent transactions and if there is a
netting agreement in place?
A. $15 million if independent and $15 million if netting is in place
B. $40 million if independent and $15 million if netting is in place
C. $40 million if independent and $40 million if netting is in place
D. $65 million if independent and $40 million if netting is in place
138
Q.3079 A specialist finance company has trade positions in rare commodities with other firms, all
of whom have large notional outstanding contracts. The company’s management would like to
calculate its netting factor on 24 commodity trade positions (that have netting agreements) with
an average correlation of 0.4. Based on this information, the netting factor is closest to:
A. 65.19%
B. 61.91%
C. 64.61%
D. 75.23%
Q.3080 A trading desk engages in a diverse range of trades. As part of its risk management
policies, every trade position the desk takes must have a netting agreement, and at the moment
is has 9 equity trade positions with an average correlation of 0.35. The chief trader feels there’s
room for even more diversification benefits if the desk manages to revise the existing agreement.
She has presented 4 potential trade combinations to the team for consideration, as illustrated
below:
Trade Combination Number of positions Average Correlation

K 4 0.25
W 7 −0.08
E 10 −0.11
W 5 0.55
Which of the above trade combinations would increase the trading desk’s expected netting
benefit the most from the current level? Assume that all of the potential trade positions are
normally distributed.
A. Trade combination K
B. Trade combination Y
C. Trade combination E
D. Trade combination W
139
Q.4867 In a derivatives contract between banks A and B, bank A posts collateral with the
following characteristics:
It does not need to be segregated
It can be rehypothecated
It has a direct relationship with the credit quality of the counterparty
Which of the following risks does the collateral help to mitigate?
A. Counterparty risk
B. Funding risk
C. Both counterparty risk and funding risk
D. Funding risk and limited counterparty risk.
Q.4868 An adjustment is needed to ensure that a dealer recovers its average funding costs when
it trades and hedges derivatives. This adjustment is known as:
A. CVA
B. DVA
C. FVA
D. Marking to market
Q.4869 The concept of funding costs and benefits has parallels with credit exposure. However,
there are some subtle differences. Which of the following is only relevant in the definition of
credit exposure?
A. Close-out
B. Margin period of risk
C. Close-out netting at the netting set level
D. All of the above
140
Reading 90: CVA (Part A)
Q.1963 Which of the following is not a component of the standard Credit Value Adjustment
(CVA)?
A. Potential future exposure (PFE)
B. Loss given default
C. Discount factor
D. Default probability
Q.1964 Which of the following best explains why the process of pricing counterparty risk for
derivatives is known to be dramatically difficult?
A. Most derivatives have contingent cash flows whose amounts cannot be predetermined
B. Derivatives involve two-way payments
C. Most derivative contracts have durations spanning several years
D. There are numerous transactions within a contract which make risk computation quite
difficult
Q.1965 Credit valuation adjustment (CVA) is defined as:
A. The market value of counterparty market risk
B. The difference between the potential future exposure (PFE) and the expected exposure
of a derivative contract
C. The market value of counterparty credit risk
D. The process of loading a premium onto the risk-free rate to account for various risks
such as interest rate risk, liquidity risk, and default risk
141
Q.1966 To simplify the understanding and computation of the credit value adjustment with
respect to transactions between an institution and its counterparty, we make the following
assumptions, EXCEPT:
A. The institution themselves cannot default
B. Risk-free valuation is straightforward
C. The credit exposure and default probability are independent
D. There are no externalities/social costs
Q.1967 An important part of CVA calculation is the loss given default (LGD). What does LGD
represent?
A. The amount of exposure expected to be recovered in the event of counterparty default
B. The amount of exposure expected to be lost in the event of counterparty default
C. The probability of counterparty default given that it defaulted on a previous contract
D. The probability of making a huge loss following a counterparty default event
Q.1968 Which of the following explanations best describes how credit spreads affect the credit
valuation adjustment (CVA)?
A. The CVA decreases as the credit spread increases, and when counterparty default is
very close, the CVA decreases at an accelerated rate
B. The CVA decreases as the credit spread increases but when counterparty default is
very close, the CVA decreases even more rapidly
C. The CVA decreases as the credit spread increases and when counterparty default is
very close, the CVA increases.
142
Q.1969 The impact of changing actual and settled recovery rates on the credit valuation
adjustment (CVA) is:
A. Unreasonably big
B. Reasonably small
C. Constant
D. Insignificant
Q.1970 In which of the following cases is the use of the marginal CVA most appropriate?
A. Pricing new transactions
B. Pricing trades transacted at different times
C. Pricing long-dated positions
D. Calculating the trade-level CVA contributions at a given time
Q.1971 An interest rate swap is expected to have a duration of 4 years. The upfront CVA is 1% of
the notional. The CVA as a running spread is approximately equal to:
A. 400 bps
B. 4 bps
C. 25 bps
D. 2.5 bps
143
Q.1972 John Lambert, FRM, makes the following comments:
I. The incremental CVA depends very much on the ordering of trades but is not affected by
subsequent trades
II. The marginal CVA changes when new trades are executed
Which of the above statements is (are) correct?
A. I only
B. II only
C. Both I and II
D. None
Q.1973 Given a credit spread of 500 basis points and 1.6% EPE, the credit value adjustment is
approximately equal to:
A. 312.5 bps
B. 80 bps
C. 31.25 bps
D. 8 bps
144
Q.1974 A good method of improving the efficiency of the Credit Value Adjustment (CVA)
calculation might be to speed up the underlying pricing functionality. Which of the following
methods can be used to achieve this?
I. Stripping out common functionality which does not depend on the underlying market
variables at a given point in time, for example, generation of cash flow and related
fixings
II. Numerical optimization of pricing functions
III. Use of approximations or grids
IV. Parallelization
A. Both I and II
B. Both II and III
C. II, III and IV
D. All of the above
Q.1975 Path dependency in CVA calculations is associated with one major problem. Which one?
A. In order to assess a future exposure at a certain date, it is necessary to have

information about the entire path from now until that date
B. It requires determining past exposure, which can be difficult in the absence of

credible, reliable data
C. In order to assess a future exposure at a certain date, too many paths can be difficult
to calculate
Q.1976 An interest rate swap that references a $10 million notional is expected to have a
duration of 3 years. The upfront CVA is 0.75% of the notional. The CVA as a running spread is
A. 250 bps
B. 75 bps
C. 12.5 bps
D. 25 bps
145
Q.1977 Given a credit spread of 250 basis points and 1.2% EPE, the credit value adjustment is
A. -30 bps
B. -8 bps
C. -5 bps
D. -3 bps
Q.2699 In a swap transaction, the counterparty’s expected potential exposure (EPE) is 5% and its
credit spread is 300 basis points. Calculate the CVA as a running spread
A. 800 bps
B. 167 bps
C. 200 bps
D. 15 bps
Q.2915 The first and most obvious method for improving the efficiency of CVA computation will
be to speed up the underlying pricing functionality. To achieve this, many models can be applied.
Which among the following methods is NOT applicable?
A. Numerical optimization of pricing functions
B. Use of grids and approximations
C. Stripping out of an uncommon functionality which is dependent on the underlying

market variables at a given point in time
D. Parallelization
146
Q.2916 Raul Gaucho Trading is trading firm from Brazil that needs to have a very quick idea on a
swap’s Bilateral Credit Value Adjustment (BCVA).The firm discovered that the expected positive
exposure (EPE) for a trade of this type is 13.6% with an expected negative exposure of 0.09. The
counterparty credit spread is found out to be around 267 bps and the credit spread of the
trader’s own institution is 191 basis points per annum. Which of the following is nearest to an
estimate of the BCVA?
A. -32.268 bps
B. -69.326 bps
C. -21.338 bps
D. --19.122 bps
Q.3084 Jerome Collins is a trader at a VXR Financial Group which has entered into a swap
agreement with Excellence Bank. VXR was recently downgraded from a rating of A to A-, while
Excellence was downgraded from A- to BBB. During this time, the credit spread for VXR
Financial Group has increased from 74 bps to 154 bps, while the credit spread for Excellence
Bank has increased from 128 bps to 176 bps. Assuming there is a CVA agreement between both
parties, by how much will the CVA spread need to be adjusted?
A. 32 bps
B. 54 bps
C. 22bps
D. 98 bps
Q.3085 Jon Boyle is a trader at a big German bank and needs a quick approximation of the CVA
spread on a swap. The risk management group at the bank comes up with an expected potential
exposure of 13%. The counterparty’s credit spread is around 225 basis points per year. Based on
this information, the CVA, as a running spread in percentage terms, is closest to:
A. 29.25%
B. 5.77%
C. 0.2925%
D. 0.577%
147
Q.3086 Timothy Charles is a risk analyst at Quartz Financial, a large investment company
situated in Cayman Island. He is currently analyzing a five-year payer interest rate swap with a
notional amount of $50 million, with a risky duration of 4.25 and a standalone CVA of $60,000.
Using this information, the additional running spread is closest to:
A. 9.18 bps
B. 14.82 bps
C. 12 bps
D. 2.82 bps
Q.3200 Beta-Clark has entered into a six-month interest rate swap with a manufacturing firm on
a notional of $1,000,000. The probability of default of the counterparty is 15%. The recovery rate
is 40% and the expected exposure is $55,000. What is the credit value adjustment as a running
spread if the risk-free rate is 4% and the risky duration is 0.495 years?
A. 0.793%
B. 0.476%
C. 0.962%
D. 1.000%
148
Reading 91: CVA (Part B – Wrong-way Risk)
Q.1978 Which of the following statements best defines wrong-way risk as used in the context of
derivatives?
A. An unfavorable dependence between exposure and counterparty credit quality
B. The likelihood that a counterparty’s risk profile will worsen after commencement of
the contract, increasing the chances of default
C. Positive correlation between exposure and the credit quality of a counterparty
D. The likelihood that a counterparty’s credit rating will be reduced during the contract,
increasing the chances of default
Q.1979 Which of the following statements stands true about wrong-way risk?
I. It manifests as an unfavorable dependence between exposure and counterparty credit

quality
II. The exposure is high when the counterparty is more likely to default
III. Wrong-way risk is often a natural and unavoidable consequence of financial markets
IV. It may often be a reasonable assumption to ignore wrong-way risk, but its manifestation
can be rather subtle and potentially dramatic
A. Both I and II
B. Both I and III
C. All of the above
149
Q.1980 In contrast to wrong-way risk, right-way risk does also exist. Which of the following
statements stands true about right way risk?
I. Right-way risk is defined as a favorable dependence between exposure and counterparty

credit quality
II. Right-way risk is less desirable than wrong-way risk
III. Right-way risk reduces credit value adjustment and counterparty risk
IV. Right-way risk is always equal and opposite to wrong-way risk
A. I and IV
B. I and III
C. All of the above
Q.1981 Wrong-way risk often occurs naturally and is sometimes unavoidable. Which of the
following cases provides a perfect example in support of this observation?
A. During an economic recession, mortgage providers usually face both falling property
prices and higher default rates by homeowners
B. When one major counterparty defaults, other counterparties within that market are
likely to follow suit
C. If a counterparty happens to incur heavy losses on a separate, unrelated contract, the

chances of defaulting on another different contract dramatically increase
D. All of the above
150
Q.1982 Cartogenes Investments is considering buying a special over-the-counter put option on
GigaBank’s stock from another Alamine Bank (the counterparty). Which of the following best
explains why such a move might be inappropriate especially with regard to wrong-way risk?
A. The put option will only be valuable if the stock of GigaBank goes up, in which case the
counterparty’s credit quality will likely be deteriorating
B. The put option will only be valuable if the stock of GigaBank goes down, in which case
the counterparty’s credit quality will likely be improving
C. The performance of GigaBank and Alamine Bank is likely to be correlated and an

increase in the value of the Put will most likely coincide with a deterioration in the credit
quality of Alamine Bank
D. Such a buy makes him prone to specific risks affecting banks
Q.1983 Consider an oil swap between an airline and its counterparty, where the company pays
cash flows based on a fixed oil price and receives cash flows based on an average spot price of
oil over a period. In recent times, the price of oil has increased significantly. The counterparty's
credit rating was also improved in recent times. With respect to the airline, the contract should
represent:
A. Wrong-way risk
B. Right-way risk
C. Both wrong-way and right-way risk
Q.1984 One of the challenges experienced when attempting to quantify wrong-way risk has a lot
to do with:
A. Difficult and time-consuming calculations
B. The need for high-level computer softwares that can sometimes be expensive
C. A lack of well-developed models
D. A lack of relevant historical data
151
Q.1985 Wrong-way risk is said to occur as a result of natural and unavoidable scenarios on
financial markets. Which of the following cases is (are) a result of wrong-way risk?
I. Losses suffered by dealers during the Asian crisis of 1997/1998 due a strong weakening
of their local currencies
II. The credit crisis of 2007/2008 which led to heavy losses for banks buying insurance from
so-called monolines
III. The fall of Lehman and AIG after the 2007/2008 credit crisis
A. I and II
B. I and III
C. All of the above
Q.1986 On day 1, Yamamoto PLC buys a put option with AY stock as the underlying from Wangdu
Inc. The option has the following details:
Strike price: $55
Type: European
Expiry: Day 30
Underlying: AY stock
On day 30, the put option is “in the money” with a value of $10. During the 30-day period,
Wangdu stock tumbled to $45 in part due to a loss in a major litigation regarding the commercial
production of a new drug. The loss triggered a downward adjustment of Wangdu’s credit rating.
This case serves as a good example of:
A. Specific wrong-way risk
B. Concentration risk
C. General wrong-way risk
152
Q.1987 Which of the following situations would lead to an increase in wrong-way risk? I. Players
in a given industry getting cover from a particular monoline insurer II. A borrower enlisting a
guarantor who doubles up as their business partner
A. II only
B. I only
C. Both I and II
D. Neither I nor II
Q.1988 The process of quantifying wrong-way risk requires modeling of the relationship between
default probability and exposure. Besides a lack of relevant historical data, the other common
pitfall that makes the process quite difficult has a lot to do with the fact that:
I. It requires expensive computer software to guarantee reliable results

II. It requires considerable investment of time and expertise
III. It is easy to misrepresent the dependency between credit spreads and exposure
A. II
B. I and III
C. III
153
Q.1989 On day 1, Bright Tech Inc. buys a call option with AY stock as the underlying from Digital
World Inc. The option has the following details:
Strike price: $40
Type: European
Expiry: Day 60
Underlying: AY stock
On day 60, the call option is “in the money” with a value of $10. During the 60-day period, Digital
World's stock rose to $50 buoyed by a win in a major litigation regarding production of newly
developed AI software
This case provides a good example of:
A. Wrong-way risk
B. Right-way risk
C. Specific wrong-way risk
D. General wrong-way risk
Q.1990 Wrong-way risk can be re-classified into two sub-categories: specific wrong-way risk and
general wrong-way risk. Which of the following statements best defines general wrong-way
risk?
A. The general relationship between exposure and default probability due to

macroeconomic factors
B. Wrong-way risk that arises due to counterparty specific issues
C. Positive correlation between exposure and counterparty default probability that is

attributable to a rating downgrade
D. Positive correlation between exposure and counterparty default probability that is

attributable to poor earnings
154
Q.1991 Which of the following best defines specific wrong-way risk?
A. Positive correlation between exposure and default probability due to macroeconomic

factors
B. Positive correlation between exposure and default probability due to specific, stand-
alone issues such as interest rates or poor earnings performance
C. Positive correlation between exposure and default probability due to counterparty

specific factors such as litigation, poor earnings, or even a rating downgrade
Q.1992 The correlation and parametric approaches can both be followed to incorporate general
wrong-way risk without a large computational burden and/or having to rerun the underlying
exposure simulations. However, both approaches require:
A. Complex algorithms and computerized random number generation
B. Collection of sample data
C. Calibration of parameters
D. Sensitivity testing
Q.2688 The risk that the exposure to a counterparty is adversely correlated with the credit
quality of that counterparty is known as:
A. Concentration risk
B. Settlement risk
C. Wrong-way risk
D. Credit migration risk
155
Q.2701 All of these statements are true, except:
A. Wrong-way risk will result in a decrease in the amount of the credit value adjustment
B. Wrong-way risk will result in a decrease in the value of the debt value adjustment
C. Right way risk will result in an increase in the amount of the debt value adjustment
D. Right way risk will decrease counterparty risk
Q.2917 Across different asset classes, wrong-way risk is contained by classic examples of trades
in derivatives. Which of the following best explains how a put option contains wrong-way risk
across the different asset classes?
A. All put options should be considered in terms of a potential weakening of the currency
and the credit quality of the counterparty should simultaneously deteriorate
B. A firm applying the put option in a swap in a strong economy may represent wrong
way risk due to the probable cut in the interest rate during a recession
C. In case of a strong relationship between the credit quality of the reference entity and
the counterparty, an extreme wrong-way risk contained in the put option will be
witnessed
D. Purchasing a stock’s put option where the underlying in question has fortunes highly
correlated to those of the counterparty is a case of wrong-way risk
156
Q.2918 Which of the following combination correctly depicts features of specific wrong-way risk
(WWR)?
I. Specific WWR are based on structural relationships that are not often captured via real-
world experience
II. Specific WWR are based on macro-economic behaviors
III. Specific WWR are difficult to model and risky to use naïve correlation assumptions
IV. Specific WWR can be potentially incorporated into models of pricing
V. Specific WWR should be qualitatively addressed through methods like stress testing
A. I, II and III
B. I, III and V
C. II, IV and V
D. All of the above
Q.2919 Hull and White proposed a more direct approach, using a functional relationship, by
parametrically linking default probability to the exposure. Which of the following is the
parametric approach correct suggestion by Hull and White?
A. Applying either an intuitive calibration based on a what-if scenario or calibrating the

relationship through historical information
B. Computing the value of portfolio for present-day dates and examining the connection
between this and the credit spread of the defaulter
C. An empirical estimate on the residual value of the historical data should be

approximated to obtain the magnitude of the jump
157
Q.4858 Which of the following is a drawback of the hazard rate approach to modeling wrong-way
risk?
A. It generates weak dependency between exposure and default. The WWR effects are
still not strong even when a strong correlation is used.
B. Calibrating the correlation between exposure and wrong-way risk is difficult.
C. It is not appropriate to assume that all the required information for defining the WWR
is contained in the original unconditional exposure distribution.
D. None of the above.
Q.4859 The following are statements regarding the structural approaches:
I. The approach requires that the dependency between the counterparty default time and
exposure distribution be specified
II. Exposure and default distribution are mapped separately into a bivariate distribution
III. Original unconditional values are sampled directly, and hence there is no need to
recalculate the exposures
Which of the above statements is/are true?
A. I only
B. I & II
C. I & III
D. All of the above
Q.4860 The following are the disadvantages of structural approaches to modeling wrong-way
risk. Which one is not?
A. Calibrating the correlation being talked about is difficult since the correlation is not
clear.
B. It is not appropriate to assume that all the required information for defining the WWR
is contained in the original unconditional exposure distribution.
C. None of the above.
D. All of the above.
158
Q.4861 Which of the following is not a feature of jump approaches to modeling wrong-way risk?
A. The jump factor is commonly known as the residual value (RV) factor of the currency.
It is assumed that currency depreciates by an amount (1-RV) at the counterparty's default
time and appropriate FX rate jumps.
B. An empirical estimate of the jump's magnitude through the residual value (RV) of the
sovereign defaults' currency is made based on 92 historical defaults.
C. Sovereigns with better ratings have a larger RV
D. It can be assumed that in the short-term, immediate sovereign default may result in a
large RV.
Q.4862 Consider the following statements regarding wrong way-risk modeling approaches.
I. An intuitive calibration based on a what-if scenario or using historical data to calibrate

the relationship may be applied
II. When calibration is achieved through historical data, portfolio value for dates in the past
needs to be calculated.
III. Involves linking default probability to the exposure by simple functions.
Which approach is being described above?
A. Parametric approach
B. Structural approach
C. Hazard rate approach
D. Jump approach
159
Q.4863 Which of the following best explains the impact of wrong-way risk on central
counterparties?
A. CCPs may be particularly prone to WWR because they rely so much on collateral as
protection.
B. There is a separation of credit risk and market risk, which may culminate in a situation
where collateral requirements ignore WWR!
C. For CDS in particular, CCPs are faced with an uphill task trying to quantify the WWR
component when setting initial margins and default fund contributions
Q.4864 Which of the following is an advantage of the structural approach to modeling wrong-way
risk?
A. Original unconditional values are sampled directly, and hence there is no need to
recalculate the exposures
B. It can be applied in cases where the hazard rate approach is not suitable to explain
empirical data.
C. None of the above
D. All of the above
Q.4865 What conclusions can we draw from the curve of CVA against the correlation between
counterparty default time and exposure?
A. CVA is reduced by negative correlation due to the effects of right way risk.
B. CVA is increased by positive correlation due to the effects of WWR.
C. The effect is stronger, and the CVA doubles when the correlation is about 0.50.
160
Reading 92: The Evolution of Stress Testing Counterparty Exposures
Q.1993 Which of the following best describes stress testing as used in the field of finance?
A. A simulation technique used to evaluate the potential impact on portfolio values of

extreme but plausible events or movements in a set of financial variables
B. A risk management tool that compares predicted results to actual observed results so
as to determine the reliability of prediction models
C. A simulation technique used on portfolios to test their reactions to different financial

situations
D. The process of administering hypothetical tests to a counterparty in order to estimate

their probability of default
Q.1995 Which of the following best describes expected exposure as used in counterparty credit
management?
A. The total of the distribution of exposures at a series of future dates before the longest-
maturity transaction in the netting set
B. The mean or average of the distribution of exposures at any specific date in the future
before maturity of the contract
C. The mean or average of the distribution of exposures at any particular future date
before the longest-maturity transaction in the netting set
D. The weighted average over time of exposures on all dates before the longest-maturity
transaction in the netting set
Q.1996 To be on the safe side, financial institutions are encouraged to treat counterparty credit
risk as a credit risk and also a market risk. What happens when an institution adopts only one
view by treating CCR as a credit risk?
The institution will most likely:
A. Face a slow but sure decline in its liquidity
B. Fail
C. Be exposed to changes in credit value adjustment (CVA)
D. Attract counterparties whose default probabilities are high
161
Q.1997 The Bank of Bafisa conducts a stress test where it assumes an equity market crash of
30%. The bank applies a stress test to each of its counterparties. How best would such a stress
test benefit the bank?
A. It would allow the bank to set aside sufficient provisions in its balance sheet
B. The bank would be able to rank all its counterparties in order of risk, from the least
risky to the riskiest
C. The bank would be able to estimate when the next equity crash would occur in the
future
D. The bank would be able to identify the counterparties that would be of concern in such
a stress event and estimate potential losses with respect to a counterparty
Q.1998 A bank enters into multiple derivative contracts with multiple counterparties. Which of
the following best explains how the bank can prepare for default so as to ensure any actual
default event inflicts minimum financial damage?
A. Through continuous monitoring of the credit rating of each counterparty; that way, the
bank would be able to single out parties with declining ratings and demand posting of
collateral to reflect the changes in exposure
B. By demanding to post huge amounts of collateral before the commencement of the

contract
C. Initiating litigation immediately after a counterparty shows signs of default
D. By gradually taking hedged positions in proportion to the counterparty’s probability of

default
Q.1999 Which of the following challenges is likely to be experienced when conducting stress
tests on current exposure?
A. A lack of relevant financial data
B. A lack of models tailored to simulate specific events
C. The test would not provide information on wrong-way risk
D. The costs involved could be unjustifiably high
162
Q.2000 Financial institutions often use stress tests on current exposure to analyze counterparty
credit. What needs to be done to create a stressed current value?
A. The financial institution assumes a scenario of underlying risk factor changes and re-
prices the portfolio under that scenario
B. The financial institution singles out major counterparties and subjects them to
rigorous credit testing, including analysis of recent financial information
C. The financial institution tests its worst case loss at a given level of confidence
D. The institution randomly selects a few counterparties and re-prices their exposures
assuming a given change in a market risk factor
Q.2001 Stress tests of current exposure are good for individual exposures but such tests are
associated with problems to do with aggregation. If we sum up the exposures to attain an
aggregate stress exposure, the result would be the expected loss assuming every counterparty
defaults. Would such results be relevant?
A. No, the aggregated results would clearly be an exaggeration of losses
B. Yes, the results would provide a bird’s eye view of maximum exposure
C. Yes, the results would effectively simulate a global crisis like that of 2007/2008
D. No, such results would ignore individual counterparties’ risks
Q.2002 When conducting stress tests to EPE, a bank needs not to consider aggregation with its
loan portfolio mainly because:
A. Loans are mostly responsive to market variables and consequently will not have any
variation in exposure because of changes in market variables
B. Loans are only sensitive to changes in interest rates changes
C. Loans are sufficiently collateralized and hence the risk of loss is minimal
D. Loans are insensitive to the market variables and thus their exposure is immune to
changes in such variables
163
Q.2003 Which of the following best defines expected positive exposure?
A. The expected exposure conditional on positive values
B. The distribution of positive exposures at any particular future date before the maturity
of the longest transaction
C. The weighted average over time of the expected exposure, where the weights are the
proportion that an individual expected exposure represents of the entire exposure
horizon time interval
D. The expected loss of the seller of the portfolio in case he is in the money and the
counterparty defaults.
Q.2005 When conducting stress tests, we can also test scenarios under which the institution
itself can default against its counterparty. That would effectively constitute:
A. Unilateral CVA
B. Bilateral CVA
C. Negative exposure from the institution’s point of view
D. General wrong-way risk
Q.2006 Sometimes, financial institutions use instantaneous shocks to market variables in an

attempt to determine how certain changes impact the EPE. The effect of such shocks on the EPE
depends on:
A. The degree of collateralization
B. The credit quality of counterparties
C. The size of cash flows
D. All the above
164
Q.2007 The following formula can be used to stress test the unilateral CVA:
CVAn = EEn(tj) × qn(tj-1, tj)
In this equation, what does EEn(tj) represent?
A. The expected exposure at time j, calculated under a real-world measure for

counterparty n
B. The potential exposure at time j, calculated under a risk-neutral measure for

counterparty n
C. The discounted expected exposure during the jth time period, calculated under a real-
world measure for counterparty n
D. The discounted expected exposure during the jth time period, calculated under a risk-
neutral measure for counterparty n
Q.2700 Which of these statements correctly defines peak exposure?
A. The larger of zero and the market value of a transaction (or portfolio of transactions);
it is the amount that will be lost if the counterparty defaults
B. The maximum amount of exposure expected to occur on a future date at a given level
of confidence.
C. The average of the distribution of exposures at any particular future date before the
longest maturity in the portfolio
D. The weighted average over time of the expected exposure
165
Q.2920 A risk manager from Switzerland wishes to have a very quick understanding of a swap’s
Bilateral Credit Value adjustment (BCVA). The manager discovers that the expected positive
exposure (EPE) for a trade of this type is 24.3% with an expected negative exposure of 11.6%.
Counterparty credit spread is around 354 bps and the credit spread of the manager’s own
institution is 207 basis points per annum. Compute BCVA from the perspective of the financial
institution.
A. 62.01 bps
B. 65 bps
C. 121 bps
D. 113 bps
Q.3045 A risk analyst at BJD Group is analyzing the group’s bond portfolio and wants to calculate
the stress loss for the portfolio. According to a risk management system report, the credit value
adjustment for the portfolio under normal market conditions is $4.3 million. At the same time the
credit value adjustments jumps to $76 million as the markets goes down by 30%. What is the
stress loss for BJD group?
A. $21.51 Million
B. $18.50 Million
C. $74.71 Million
D. $71.70 Million
166
Q.3087 A risk analyst is concerned about the losses to his portfolio consisting of two bonds
issued by Taylor Pharma and Simon Chemicals. The credit VaR for the portfolio is defined as the
maximum loss due to defaults at a confidence level of 95% over a one-year horizon.
Taylor Pharma’s bond has a value of $7 million with a default probability of 6% and a recovery
rate of 80%.
Simon Chemical’s bond has a value of $9 million, a default probability of 5%, and a recovery rate
of 90%.
Using this information, the expected loss for the portfolio is closest to:
A. $567,500
B. $309,500
C. $129,000
D. $ 180,094.6
Q.3088 A risk analyst is concerned about the losses to his portfolio consisting of two bonds
issued by Taylor Pharma and Simon Chemicals. The credit VaR for the portfolio is defined as the
maximum loss due to defaults at a confidence level of 95% over a one-year horizon. The
probability of joint default of the two bonds is 4.76%, and the default correlation is 0.8.
Taylor Pharma’s bond has a value of $7 million, default probability of 6% and a recovery rate of
80%.
Simon Chemical’s bond has a value of $9 million, default probability of 5% and a recovery rate of
90%.
If the stress probability of default on Taylor and Simon are 12% and 18%, respectively, the stress
loss on the loan portfolio is closest to:
A. $51,094.6
B. $330,000
C. $362,755.4
D. $201,000
167
Reading 93: Credit Scoring and Retail Credit Risk Management
Q.2008 Which of the following is not part of retail banking as specified in Basel guidelines?
A. Business loans with a total exposure of not more than 2 million Euros
B. Home mortgages
C. Home equity loans
D. Collection of deposits
Q.2009 Retail banking is used by small businesses and consumers to finance their properties and
small projects. Although most facilities are secured, a few are not. Which of the following loans
are normally unsecured?
A. Home mortgage loans
B. Home equity loans
C. Credit card revolving loans
D. Small business loans
Q.2010 Why is the credit exposure of retail banking different from that of corporate banking?
A. Credit exposures of retail banking arrive in large pieces but individual exposures by a
single consumer are not expensive enough to threaten the bank
B. Credit exposures of retail banking arrive in bite-pieces; hence, an individual

consumer’s exposure is not big enough to threaten the bank
C. Corporate exposures arrive in bite-pieces which must be repaid before a new facility
can be offered; hence, individual corporate exposures rarely threaten the bank
D. Credit exposures of corporates arrive in large pieces and each of which must be repaid
before a new facility can be offered; hence, individual corporate exposures rarely
threaten the bank
168
Q.2011 The Consumer Financial Protection Act (CFPA) requires banks to evaluate qualified
mortgages and the ability to pay. Which of the following characterizes a qualified mortgage?
A. The debt-to-income (DTI) ratio must be greater than 43%
B. It must not have excess upfront points or fees
C. It must have a minimum term of 30 years
D. It must have interest-only features
Q.2012 Retail lending entails offering facilities to a large group of borrowers in relatively small
amounts, thereby naturally bringing about diversification. However, certain lending behaviors
can erode the benefits of diversification and result in market-wide financial turmoils as
highlighted by the 2007/2008 financial crisis. Which of the following behaviors is likely to result
in less than perfect protection from systematic risks?
A. International lending
B. Relaxation of lending requirements
C. Multi-currency lending
D. Using the property advanced to the borrower as the sole source of collateral
Q.2013 How can banks protect themselves from the dark side of retail risk?
A. By totally avoiding provision of new products with an unproven risk profile
B. By increasing the amount of profit retained in the balance sheet to cater for possible
future losses resulting from adverse market movement
C. By making sure that only a limited number of their credit retail portfolios are
especially vulnerable to emerging risks
D. By holding a large number of government/local authority bonds
169
Q.2014 After the financial crisis of 2007/2008, all financial sectors including the banking sector
came up with new lending standards. Several reforms, regulations, and ad hoc entities were
established, such as the Consumer Financial Protection Bureau (CFPB). The CFPB requires:
A. Lenders to demand some collateral on top of collateralized property
B. Lenders to examine if the consumer has the ability to repay the mortgage; if a
mortgage is considered as a "qualified mortgage" then the creditor can trust the
borrower
C. Borrowers to examine the trustworthiness of banks before seeking financial help; if

the bank is "qualified” then they are trustworthy
D. Lenders to avoid products prone to foreign exchange risk
Q.2015 A change in consumer behavior can serve as a warning sign. Hence, by carefully and
diligently studying consumer trends, a bank can “ take notice of the smoke before the fire” and
reduce credit risk. After closely monitoring consumer behavior, what are some of the actions that
can be taken by the bank to reduce credit risk? The bank can:
I. Modify the rules governing the quantity of money it provides to existing customers to
lessen its risk exposures
II. Change its promotion strategies and consumer acceptance rules to lock out risky
customers
III. Add a risk premium to products by raising interest rates for certain kinds of customers
IV. Pre-emptively initiate legal proceedings against borrowers likely to default
A. I and II
B. I, II and III
C. I, III and IV
D. All of the above
170
Q.2016 Which of the following best explains why banks might ignore early warning signs of
borrower default?
A. A change of debt collection policies in response to such signs might put the bank on a
collision course with the authorities
B. All warning signs lead to actual defaults on the part of the borrower
C. A change of debt collection policy might trigger a logistical/human resource nightmare
D. Taking precautionary measures might steer the bank away from fast-growing,
apparently lucrative credit lines
Q.2017 What characterized the retail lending market in the run-up to the 2007/2008 financial
crisis?
A. Structured underwriting standards, high interest rates, and low competition among
lenders
B. Poorly structured underwriting standards, high interest rates, and high competition
among lenders
C. Poorly structured underwriting standards, low interest rates, and high competition
among lenders
D. Structured underwriting standards, high interest rates, and low competition among
lenders
Q.2018 A credit scoring model is defined as:
A. A statistical analysis of the probability of default of a borrower, taking into account

their past and present financial obligations
B. A statistical evaluation of a borrower’s creditworthiness by combining and converting

information from different sources into a credit score
C. A model that predicts the likelihood of borrower default by analyzing the borrower’s
credit history
D. A statistical evaluation of a borrower’s credit history in an attempt to predict if and

when they are expected to default on their obligations
171
Q.2019 Suppose a Chinese bank with over 500 branches spread out across China decides to build
a credit scoring model by leveraging its own consumer and commercial customer data. What
type of model would that be?
A. A credit bureau model
B. A pooled model
C. A custom model
D. An industry-wide model
Q.2020 John Friedman, FRM, works as a credit analyst at an American bank. A customer
approaches him seeking information about a certain mortgage offered by the bank. While
discussing the mortgage’s particulars, Friedman mentions that the mortgage is “full doc.” This
implies that:
A. The customer will have to declare in full all their existing financial obligations prior to
acceptance
B. The customer will have to make a down payment prior to acceptance
C. The mortgage will require proof of income and assets
D. The mortgage must be secured by the customer’s assets in full, i.e., assets must be
worth at least 100% of the amount disbursed
Q.2021 Credit bureaus store several files for each individual, and each file carries certain details
about the customer. Which of the following statements is false?
A. Identifying information is personal information and is used in credit scoring
B. An inquiry must be placed on the file whenever a credit file is assessed
C. Public information includes records from civil courts regarding issues such as
bankruptcies, fines, and tax liens
D. Tradeline information is assembled from the data sent to credit bureaus by credit
grantors on a monthly basis
172
Q.2022 After the 2007/208 financial crisis, banks have gradually transformed their policies from
traditional credit default scoring to product profit scoring. In particular, most have started to
employ “risk-based pricing” in their credit assessments. This new approach implies that:
A. Customers with diverse risk profiles should pay different interest rates and hence
different prices for the same product
B. Customers with diverse risk profiles should be aggregated and charged a level interest
rate for the same product
C. The interest rate payable on a product should be determined based only on customer
information, while ignoring the economic environment as a whole
D. Products should be priced based on systematic risks
Q.2922 The following credit scoring models are used for the purpose of scoring consumer credit
applications. Of the four below, which one is NOT applicable?
A. Waterfall model
B. Pooled models
C. Credit bureau score
D. Custom model
Q.2923 In measuring and monitoring the performance of a scorecard, the main aim of credit
scoring is to predict which application might be good or bad. To do that, the scorecard has to
assign a high score to good credits and a low score to bad ones. Which of the following does NOT
describe a scorecard?
A. Application scores support the initial decision whether to accept or reject new credit
application
B. Revenue scores aim at predicting the profitability of existing customers
C. Response scores predict the likelihood that a prospect will respond to an offer
D. Attrition scores predict the likelihood of claims from insured parties
173
Q.2924 A feature of most retail portfolios is that a rise in defaults is often signaled in advance by
a change in customer behavior which allows the bank to take preemptive action to reduce credit
risk. In such a case, which of the following option is a retail bank NOT allowed to take?
A. Price the risk by raising interest
B. Alter the rules governing the amount lent
C. Alter market strategy and customer acceptance rules
D. Liquidate some of its assets
174
Reading 94: The Credit Transfer Markets and Their Implications
Q.2023 Securitization is defined as:
A. Repackaging of loans and other assets into securities that can be sold to investors
B. The use of items whose purchase has been financed by a lender as securities in case
the borrower defaults
C. The process of acquiring the borrower’s assets in case of default, usually done with the
authority of a court of law
D. The conversion of debt instruments into equity
Q.2024 In the run-up to the 2007/2008 financial crisis, banks shifted quite significantly to the
“originate to distribute” model because of several reasons. Which of the following is not one of
them?
A. Originators benefited from greater capital efficiency, enhanced funding availability,

and lower earnings volatility
B. Investors benefited from a greater choice of investments, allowing them to diversify

and to match their investment profile more closely to their preferences
C. Borrowers benefited from the expansion in credit availability and product choice, as
well as lower borrowing costs
D. At the time, Basel committee regulations were against the traditional “buy and hold”
model
175
Q.2025 Despite all the good reasons cited by banks for shifting to the OTD model, a number of
weaknesses did arise. Which of the following was not among these weaknesses?
I. The OTD model increased the incentives for loan originators to monitor the
creditworthiness of the borrower
II. The transparency of credit risk took a downturn, and investors had very few sources of
credible, reliable information about their investments
III. The lack of transparency of the securitized structures made it difficult to monitor the
quality of the underlying loans and added to the fragility of the system
A. I and II
B. I and III
C. I
D. I, II and III
Q.2026 Which of the following best explains why most banks ignored the traditionally stable and
secure government bonds in favor of subprime mortgage-backed securities (prior to the 2008
financial crisis)?
A. Government bonds were in extremely short supply
B. The potential returns on subprime MBSs were much higher than the returns on bonds
C. In the years preceding the crisis, the default rate on government bonds had been
rapidly increasing, and banks felt the risk of loss was too high
D. Mortgage-backed securities were easier to buy/sell compared to government bonds
Q.2027 Which of the following is not a traditional credit risk enhancement technique?
A. Credit default swaps
B. Collateralization
C. Netting
D. Bond insurance
176
Q.2028 Over the last two decades or so, the portfolios of loans and other credit assets held by
banks have become increasingly more concentrated in less creditworthy obligors. There are two
main reasons as to why banks have had to contend with a concentration of low-quality credits.
One of them has a lot to do with:
A. Inadequate credit appraisals that are not detailed enough to separate creditworthy
clients from high-risk ones
B. The development of faulty models that do not produce reliable credit ratings of
borrowers
C. Mistrust between banks and accredited rating agencies such that they no longer share
information
D. Disintermediation of banks, which has resulted in credit-worthy clients seeking

financial support from alternative markets
Q.2029 Which of the following statements about loan syndication is incorrect?
A. In syndication, the loan is sold to third-party investors so that the originating or lead
banks reach their desired holding level for the deal at the time the initial loan deal is
closed
B. Syndicates operate in one of two ways: firm commitment (underwritten) deals, under
which the borrower is guaranteed the full face value of the loan, and "best efforts" deals
C. Syndicated loans are often called leveraged loans when they are issued at LIBOR plus
50 basis points or more
D. As a rule, loans that are traded by banks on the secondary loan market begin their life
as syndicated loans
177
Q.2030 As highlighted during the 2007/2008 financial crisis, OTD models can work and
successfully help to spread credit risk. However, there are a few issues that must be addressed
before that happens. These include:
I. Misaligned incentives along the securitization chain, driven by the search for short-term
profits
II. A lack of transparency about the risks underlying securitized products
III. Poor management of the risks associated with the securitization business, such as
market, liquidity, concentration, and pipeline risks
IV. Overreliance on credit ratings and other financial revelations made by credit rating
agencies
A. I, II and IV
B. I and III
C. I, II and III
D. All of the above
Q.2031 How best can a bank’s credit portfolio team manage the bank’s credit portfolio?
I. The use of syndication to distribute large loans to other banks, hence reduce credit risk
II. Rejecting loan applications from individuals in favor of investment-grade corporates
III. Reducing exposure by selling down loans or taking hedging positions
IV. Developing complex models to analyze customer information and produce reliable
estimates of the probability of default
A. All of the above
B. I, II and IV
C. II and III
D. I and III
178
Q.2032 An investment trust buys a $1 million corporate bond from a construction company. To
protect its investment, the trust buys a credit default swap worth $1 million from a hedge fund.
Which of the following statements is correct?
A. The investment trust will pay regular predetermined amounts to the construction
company, and in the event the society defaults, the hedge fund will have to pay
compensation to the investment bank of $1 million
B. If the construction company does default, it will receive a compensation of $1 million

from the hedge fund and use the money to settle its outstanding obligations to the
investment trust
C. The investment trust will be required to make regular payments to the hedge fund for
the duration of the CDS contract.
D. If the construction company defaults, it will be required to pay half of the total amount
outstanding, and the remaining amount will be covered by the hedge fund
Q.2033 Which of the following best explains why credit default swaps (CDSs) could be
considered more efficient in credit risk transfer compared to other strategies like guarantees
and letters of credit?
A. CDSs are unfunded
B. CDSs are highly customizable, hence they can be tailored to fit the needs of the buyer
and seller
C. CDSs are highly liquid since they can easily be sold on secondary markets
D. CDSs separate management of credit risk from the assets associated with the risk
179
Q.2034 Suppose a bank holds a portfolio of 6 high-yield loans rated B. Each loan has a nominal
value of $10 million and all loans will mature in 4 years. If the bank decides to buy a first-to-
default CDS with a term of 2 years, which of the following would likely be true?
A. The bank would receive compensation for all 4 loans in the event that one loan
defaults
B. If two default events occur in year 3, the bank would only receive compensation for
the first default event
C. The bank would only receive compensation on the condition that only one default
event occurs throughout the 6-year term of the loans
D. After the first default occurs (provided this happens within the first two years), the
bank would stop paying premiums and receive the difference of the principal amount and
the recovered value
Q.2035 Two banks – A and B – enter into a one year total return swap in which A receives the
LIBOR in addition to a fixed margin of 2%. Bank B, on the other hand, receives the total return of
the S&P 500 Index on a principal amount of $10 million.
What happens if LIBOR is 2.5% and the S&P 500 Index appreciates by 10%?
A. A pays B 5.5% and receives 4.5%
B. B pays A 10% and receives 4.5%
C. A pays B a netted amount equivalent to 5.5% of $550,000
D. B pays A a netted amount equivalent to 5.5% of $10 million
Q.2036 Two banks – A and B – enter into a one year total return swap in which A receives the
LIBOR in addition to a fixed margin of 2%. Bank B, on the other hand, receives the total return of
the S&P 500 Index on a principal amount of $10 million.
Suppose the S&P 500 Index falls by 10% while the LIBOR remains unchanged (2.5%). What
would happen?
A. B would pay A a netted amount equivalent to $450,000 million
B. A pays B a netted amount equivalent to $550,000
C. A pays B a netted amount equivalent to $1.45 million
D. B pays A a netted amount equivalent to $1.45 million
180
Q.2037 The Bank of India pools together its high-yield loans and repackages them into a financial
instrument for sale to other investors. The resulting instruments would most likely be known as:
A. Tranches
B. Collateralized bond obligations
C. Securitization
D. Collateralized loan obligations
Q.2925 In recent years, there has been a drastic change in how a bank credit function operates.
To optimize the risk/return profile of a portfolio, there are specific functions assigned to loan
portfolio management. Which one of these is NOT a way to manage a credit portfolio?
A. Selling and hedging high-risk, high-return loan assets to free up bank capital
B. Distribute large loans to other banks by means of primary syndication
C. Managing high-risk associated with the leveraged customers.
Q.2927 Just like any financial instrument, credit derivatives can be put to many purposes. Which
of the following does not match an end user application of credit derivatives?
A. Investor – access to previously unavailable markets
B. Corporations – hedging trade receivables
C. Government – reducing credit concentration
D. Banks – managing the risk profile of the loan portfolio
181
Q.4870 Which of the following is a characteristic of covered bonds?
A. They are issued through a special purpose entity, just like securitization instruments.
B. The investor has double recourse in the event of a default by the issuer.
C. They have a more thriving market in the U.S. compared to Europe.
D. Assets comprising the cover pool are not specified, but investors are guaranteed
payments even in a winding up.
Q.4871 The difference between funding CLOs and regular CLOs is that funding CLOS:
A. Are hived off the issuer’s balance sheet.
B. Have only two tranches – the senior tranche and subordinate tranche.
C. Have all their tranches rated by an external rating agency.
D. Do not adopt the laddered loss sharing mechanism, and any loss is shared equally
among tranches.
182
Reading 95: An Introduction to Securitization
Q.2038 Which of the following is the least important use of securitization to banks?
A. It allows banks to make secondary income on top of ordinary income generated by

assets
B. Banks may benefit from moving the default risk associated with the securitized debt
off their balance sheets.
C. It allows banks to convert assets that are otherwise not tradable into readily
marketable securities that can be traded in the secondary market
D. Banks are able to increase their overall liquidity and boost their financial standing
from the point of view of financial reporting
Q.2039 Despite the numerous advantages that normally come with securitization, the practice
was widely blamed for the financial turmoil that befell banks during the 2007/2008 financial
crisis. Which of the following best explains why this was the case?
A. There were very few investors in securitized assets
B. Banks allowed many subprime mortgage holders to borrow more on their loans than
their homes were worth
C. Banks failed to redistribute securitized products and instead assumed high credit risk
hoping to make huge profits
D. Banks failed to market securitized assets aggressively, which resulted in low demand
and eventually huge losses
Q.2040 Which of the following is least likely an application of special purpose vehicles (SPVs)?
A. Converting the currency of the underlying asset into a more acceptable currency in
the eyes of investors
B. Transforming illiquid assets such as trade receivables into tradable securities
C. Issuing credit-linked notes
D. Tax evasion
183
A. If the parent company becomes insolvent, the assets sold to a special purpose vehicle
can be impounded.
B. Most SPVs in the U.S. are incorporated as trusts while a majority of those in Europe
are incorporated as companies
C. The location of SPVs is determined in large part by the applicable taxation principles
D. If assets are removed from the balance sheet of the company and sold to the SPV, so
must all corresponding liabilities
Q.2043 There are various benefits of securitization for the originator. For instance, through
securitization, the originator can target and diversify funding courses. This allows businesses to
expand beyond their current corporate debt markets and bank lending to tap new investors and
markets. Which of the following is NOT a motivation for banks to use securitization?
A. To reduce maturity mismatches
B. To decrease cost of funding and diversify the funding mix
C. To support rapid growth in assets
Q.2044 Which of the following statement is true under Basel rules?
A. Under Basel I, all banks must hold at least $8 of capital for every $100 of risk-
weighted assets
B. Under Basel I, all banks must hold at most $10 of capital for every $100 of risk-
weighted assets
C. Under Basel I, all banks must hold at least $10 of capital for every $100 of risk-
weighted assets
D. Under Basel I, all banks must hold at most $8 of capital for every $100 of risk-
weighted assets
184
Q.2045 The process of securitization has several parties mandated to carry out different tasks.
Which of the following parties is incorrectly matched with its role?
A. The originator: To sell its assets to the SPV as a “true sale”
B. The issuer: To conduct due diligence on the originator and to facilitate securitization
C. Credit enhancement entity: To confer a rating to the securities issued by the vehicle of
securitization
D. The investor: To subscribe to the securities issued
Q.2046 A U.K bank wishes to securitize some of its bonds and loans via a special purpose vehicle.
The bank has never been involved in securitization in the past. Which of the following
securitization structures would not be appropriate for the bank?
A. An amortizing structure
B. A revolving structure
C. A master structure
Q.2047 In the process of securitization, the notes issued are structured in such manner that they
indicate pertinent risk domains of the specified pool of assets. The most junior note is impacted
by losses first, thereby it’s known as the first-loss What is the other name given to the first-loss
piece?
A. Equity piece
B. At-risk note
C. First-risk note
D. Junior piece
185
Q.2048 Which of the following credit enhancement techniques would be most appropriate when
the nominal value of assets in the pool is greater than the nominal value of issued securities?
A. Over-collateralization
B. Pool insurance
C. Excess spread
D. Margin step-up
Q.2049 High-Airways Ltd is an international airline with operations in Europe and Southern
America. The airline wishes to set up an offshore SPV for its ticket receivables.
Originator: High-Airways Ltd
Issuer: 'No 1 Airways Ltd'
Transaction: Ticket receivables; Bonds worth $100million; 3-tranche floating-rate
notes; Average life of 3.5 years; Legal maturity of 2018
Tranches:
Class 'N note (AA), LIBOR plus x bps
Class 'B' note (A), LIBOR plus y bps
Class 'E' note (BBB), LIBOR plus z bps
Arranger: ABC Securities Plc
In the above case scenario, ABC Securities Plc is undertaking due diligence on the securitized
assets. The company assesses the financial performance of High-Airways over a period of ten
years. Which of the followings figures would NOT be useful for ABC Securities Plc to assess the
performance of the airline company?
A. Sales per geographical region
B. Total ticket sales
C. Total assets owned by High-Airways Ltd
D. Total passengers over the past decade
186
Tranches:
The marketing approach of this securitization process has a number of steps:
I. The credit card ticket receivables (present plus future) of the airline are transferred to
Number 1 Airways Ltd
II. There is benchmarking of notes against current issues having somewhat comparable
asset classes, along with the unsecured market’s spread level
III. The syndication desk of investment bank attempts to situate the notes with institutional
investors. This is done by giving notes an indicative pricing for gauging investor
sentiment
Which of the following option shows the correct sequence of events?
A. I, II, III
B. II, III, I
C. III, I, II
D. I, III, II
187
Tranches:
Which of the following would not be a feature on the deal structure of such a process?
A. The sale of High-Airways Ltd ticket receivables (future) to an offshore SPV known as
'No 1 Airways Ltd'
B. Payments of interest and principal to shareholders of High-Airways Ltd
C. The issuance of notes by 'No 1 Airways Ltd' to fund the purchase of receivables
D. No 1 Airways Ltd' pledges its right to the future receivables to a Security Trustee, for
benefiting the bondholders
188
Q.2052 There are various ratios which can be used for assessing the performance of Credit Card
ABS. The three main types are the delinquency ratio, monthly payment rate (MPR), and default
ratio. Which of the following statements correctly defines the default ratio?
A. The value of overdue credit card receivables (beyond ninety days) as a proportion of
the total value of credit card receivables
B. The value of written off credit card receivables as a proportion of the value of total
credit card receivables
C. The proportion of interest and principal on the pool that is repaid in a particular time
period
D. The value of written off credit card receivables as a proportion of the total liability
Q.2053 Which of the following statements gives a notable difference between commercial
mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS)?
A. A CMBS is a recourse loan to the issuer as it is not secured
B. A CMBS is a non-recourse loan to the issuer as half of it is secured by the underlying

asset
C. A CMBS is a recourse loan to the issuer as only part of it is secured by the underlying
asset
D. A CMBS is a non-recourse loan to the issuer as it is fully secured by the underlying

asset
Q.2703 Calculate the Constant Prepayment Rate (CPR) for a MBS if the single month mortality
(SMM) is 0.45%.
A. 4.87%
B. 5.27%
C. 5.40%
D. 4.50%
189
Q.2705 Which of these are possible reasons for a bank to securitize part of its balance sheet?
I. Funding the assets it owns

II. Balance sheet capital management
III. Risk management and credit risk transfer
A. I and III only
B. I and II only
C. II and III only
D. All of the above
Q.2709 An ABS based on home equity loans is structured in the following manner:
Subordinated tranche 1 $50 million
Subordinated tranche 2 $50 million
Senior tranche $100 million
Collateral $220 million
What portion of a loss of $120 million will be absorbed by the senior tranche?
A. $120 million
B. $20 million
C. $0
D. $70 million
Q.2710 All of these are internal credit enhancements for a securitization structure, except:
A. Direct equity issue
B. Holdback
C. Excess spread
D. Letter of credit
190
Q.2711 Which of these is not an external credit enhancement?
A. Holdback
B. Letters of credit
C. Insurance
D. Credit default swaps
Q.2713 An ABS based on credit card receivables has the following composition:
Current receivables $25,200,000
Receivables over 30 days past due $8,250,000
Calculate the delinquency ratio of the ABS.
A. 2.93%
B. 3.47%
C. 5.16%
D. 3.47%
Q.2928 Which of the following is NOT a major reason by banks to securitize part or all of its
balance sheet?
A. To fund the assets owned by the bank
B. To manage the capital on its balance sheet
C. To access the sectors that are otherwise not open to the banks
D. To manage risks and transfer credit risk
191
Q.2929 Besides being used to securitize a firm's assets, a special purpose vehicle can also be
used to:
A. Transform illiquid assets into liquid ones
B. Issuing credit-linked notes
C. Converting the currency of underlying assets into another currency more acceptable
to investors
D. All of the above
Q.3046 Tahoma Bank manages the largest pool of consumer credit in the city of Minneapolis. It
issues its credit card to US consumers. The aging analysis of its receivables is provided
hereunder:
0-30 Days $600 Million
61-90 days $170 Million
121 days and more $60 Million
Total $1,210 Million
The bank prudently writes-off $35 million during the period.
Based on the above information the delinquency ratio and default ratio for Tahoma Bank are
closest to:
A. Delinquency ratio: 4.96%; Default ratio: 15.7%
B. Delinquency ratio: 2.89%; Default ratio: 4.96%
C. Delinquency ratio: 15.7%; Default ratio: 2.89%
D. Delinquency ratio: 10.7%; Default ratio: 3.84%
192
Q.3047 Consider the following asset backed security (ABS) structure:
Senior tranche: $150 million
Subordinated tranche A: $60 million
Subordinated tranche B: $20 million
If the assets in the pool are worth $250,000,000, what is the amount of overcollateralization and
at what amount of losses will senior tranche investors begin to lose money?
A. Overcollateralization: $20,000,000; Senior tranche investors' losses: $100,000,000
B. Overcollateralization: $40,000,000; Senior tranche investors' losses: $80,000,000
C. Overcollateralization: $20,000,000; Senior tranche investors' losses: $80,000,000
D. Overcollateralization: $60,000,000; Senior tranche investors' losses: $40,000,000
Q.3048 Trident Investments has invested $100,000 in a mortgage pool with scheduled monthly
principal payments of $28.61. The mortgage pool has a conditional prepayment rate (CPR) of 6%
and the pool is seasoned. Given this information, the single monthly mortality rate and the
estimated prepayment are closest to:
A. SMM: 0.005098; Prepayment: 509.92
B. SMM: 0.005113; Prepayment: 544.15
C. SMM: 0.005274; Prepayment: 529.25
D. SMM: 0.005143; Prepayment: 514.15
Q.3049 AMZ Ventures has invested in a mortgage pool. It has a $24 million principal balance
outstanding with the scheduled monthly principal payment. Using the Public Securities
Association (PSA) standard prepayment benchmark, the single monthly mortality rate (SMM) in
month 10, assuming 175% PSA, is closest to:
A. 0.002363
B. 0.002793
C. 0.002965
D. 0.002467
193
Q.3050 A risk analyst is reviewing various mortgage-backed securities (MBS) and is interested in
the calculation of single monthly mortality (SMM) rates. She is using the Public Securities
Association (PSA) standard prepayment benchmark. She calculates the SMM for month 22,
assuming a 140 PSA, to be 0.37%. She calculates the SMM for month 200, assuming a 90 PSA, to
be 0.46%. Determine whether she is correct in both her calculations.
A. She is correct for both calculations
B. She is correct for month 22, but incorrect for month 200
C. She is incorrect for both calculations
D. She is incorrect for month 22, but correct for the month 200
Q.3089 LinkFin Financial Corp is the biggest manager of special purpose vehicles managing
mortgage-backed securities backed by commercial mortgage in Hong Kong. It has a portfolio of
mortgage-backed securities that has net operating income from commercial mortgaged
properties equal to $68 million. The total debt payments for notes issued against these
mortgages is equal to $54 million. The total worth of assets in the mortgage pool is estimated to
be around $5 billion. Given this information, the debt service coverage ratio is closest to:
A. 1.26
B. 0.79
C. 0.0136
D. 0.0108
194
Q.3090 Happy Homes Realtors and Mortgagers (HHRM) is the manager of the largest real estate
mortgage pool in the city of Sydney. Its MBS is composed of four different pools of mortgages:
$24 million of apartment mortgages that yield 8.4%;
$32 million of villa mortgages that yield 7.0%;
$16 million of penthouse mortgages that yield 6.8%; and
$8 million of farmhouse mortgages that yield 5.6%.
Using the information above, the weighted average coupon for HHRM is closest to:
A. 6.95%
B. 7.24%
C. 5.7%
D. 7.6%
Q.3091 Jack and Morris Associates is the servicing agent of a large pool of commercial
mortgages in the city of Copenhagen. Their MBS portfolio is composed of the following four
different pools of mortgages:
$26 million of superstore mortgages that have a maturity of 82 days;
$67 million of office space mortgages that have a maturity of 169 days;
$22 million of cinema mortgages that have a maturity of 253 days; and
$17 million of restaurant mortgages that have a maturity of 336 days.
What is the weighted average maturity (WAM) of these mortgage pools?
A. 145 days
B. 210 days
C. 187 days
D. 273 days
195
Reading 96: Understanding the Securitization of Subprime Mortgage
Credit
Q.2054 A mortgage loan securitization is an intricate process involving various, diverse players.
Which of the following is a key friction between the arranger and third-parties in the mortgage
securitization process?
A. Predatory lending
B. Predatory borrowing
C. Adverse selection
D. Moral hazard
Q.2055 As an FRM student, you have been presented with a resolution of a friction as stated
below:
‘Require the mortgagor to regularly escrow funds for both insurance and property taxes. When
the borrower fails to advance these funds, the servicer is typically required to make these
payments on behalf of the investor.’
Considering the above resolution, which of the following frictions can be resolved using this
resolution?
A. Frictions between the servicer and the mortgagor: Moral hazard
B. Frictions between the arranger and third-parties: Adverse selection
C. Frictions between the asset manager and investor: Principal-agent
D. Frictions between the servicer and third-parties: Moral hazard
196
Q.2056 Which of the following is not among the five frictions that caused the subprime crisis of
2007/2008?
A. A lot of products offered to the borrower (subprime) are very intricate, giving room for
misrepresentation and misunderstanding
B. Investment mandates of the time did not sufficiently differentiate between corporate
and structured ratings
C. In the absence of the asset manager’s due diligence, the incentives of the arranger to
conduct their own due diligence are increased
D. A lack of disclosure of the criteria used to rate subprime MBSs
Q.2057 Which of the following best defines the term “credit rating”?
A. A comprehensive opinion and assessment of the creditworthiness of debt obligor’s

creditworthiness
B. The likelihood of default of a borrower, given as a percentage
C. An overall opinion of the financial health of products on offer in the market
D. A statement released to the investing public by rating agencies, identifying “in-the-

money” and “out-of-the-money” products
197
Q.2058 Corporate ratings and asset-backed securities (ABS) ratings are quite different. Which of
the following is NOT a valid difference?
A. Whereas corporate bond ratings are mainly derived on the basis of firm-specific risk
characteristics, ABS ratings take systematic risk into account
B. ABS ratings give the performance of a static pool, while corporate bond ratings refer
to the performance of a dynamic corporation
C. Unlike ABS ratings, corporate ratings rely explicitly on a forecast of economic

indicators
D. Whereas corporate ratings rely heavily on analytical judgment, ABS ratings rely
heavily on quantitative models
Q.2059 Which of the following asset classes fall into the non-agency category?
I. Jumbo asset class

II. Alt-A asset class
III. Subprime asset class
A. I
B. II
C. III
D. All of the above
198
Q.2060 The Interagency Expanded Guidance for Subprime Lending Programs presented a
definition of the Subprime borrower in 2001. Which of the following credit risk characteristics
must be displayed by a subprime borrower?
A. More than three 30-day delinquencies in the last 12 months
B. The debt service-to-income ratio must be 50% or greater
C. A least 2 bankruptcies in the last 5 years
D. A credit bureau risk score (FICO) of 300 or below, or other bureau or proprietary
scores with an equivalent default probability likelihood
Q.2061 In the run-up to the 2007/2008 financial crisis, rating agencies were exposed to a conflict
of interest while rating MBSs because:
A. Most agencies would rate MBSs and also invest in them, albeit privately
B. Clients of rating agencies relied heavily on ratings to sell securities
C. Rating agencies used ratings to sell securities
D. Agencies would be paid by the firms which created the securities being rated
Q.2062 Credit rating agencies play a significant role towards resolution of most frictions in the
securitization process. In the years leading up to the 2007/2008 financial crisis, it’s generally
accepted that investors in MBSs relied heavily on rating agencies while deciding whether or not
to invest. Which of the following best explains why this was the case?
A. Information available to investors regarding the MBSs would normally be insufficient
B. Credit rating agencies are expected to exercise due diligence before the issuance of
ratings
C. Credit rating agencies are supposed to be experts in credit risk evaluation
D. All of the above
199
Q.2063 At the height of the 2007/2008 subprime mortgage loan deterioration, a number of
lenders were accused of using coercive, unscrupulous, and sometimes purely exploitative actions
to convince borrowers to subscribe to mortgages on offer. Such a lending practice is known as:
A. Predatory lending
B. Predatory borrowing
C. Pro-borrowing practices
D. Unfair lending
Q.2064 The following are structural features designed to protect investors in subprime trusts
from losses of the underlying mortgage loans, EXCEPT:
A. Subordination
B. Excess spread
C. Performance triggers
Q.2065 The junior-most tranche of a securitization is always the first to absorb losses on the
mortgage loan pool. In the case of subprime mortgage loans, the junior-most tranche is usually
enhanced through:
A. The promise of high returns
B. Overcollateralization
C. Predatory lending
D. Provisions of discounts
200
Q.2066 Assume you have been given default rates for different horizons as prepared by a credit
rating agency. Which of the following would help you to decide if the rates are correct and
relevant?
A. A test of linearity
B. A test of monotonic increase
C. A test of hypothesis
Q.2067 Which of the following forms part of the subprime credit rating process?
A. Simulation of cash flows
B. Estimation of a loss distribution
C. Both A and B
D. Neither A nor B
Q.2068 Which of the following strategies would be most appropriate to mitigate the moral hazard
between the servicer and the credit rating agency?
A. Due diligence on the servicer by the credit rating agency
B. Holding talks with senior servicers
C. Frequent impromptu analysis of the servicer’s financial statements by the credit rating
agency
D. Procuring the services of an offshore servicer
Q.2682 Which of the following is NOT a common friction that arises with the use of credit
contracts?
A. Asymmetric information
B. Moral hazard
C. Adverse selection
D. Internalities
201
Q.2931 The securitization of mortgage loans is indeed a complex issue that involves a number of
different players. Which of the following is NOT a friction associated with the securitization
process?
A. Friction between the mortgagor and the originator
B. Friction between the arranger and third parties
C. Friction between the servicer and the mortgagor
D. Friction between the bank and the regulator
Q.2932 The Interagency Expanded Guidance for Subprime Lending Program describes some
characteristic that can be used to define subprime borrowers. Which of the following statement
does NOT fit this description?
A. Bankruptcy in the last five years
B. Lack of employment
C. A credit risk score of 660 or below
D. Foreclose or repossession in the prior 2 years
Q.2933 Subprime trust has different structural features designed to protect investors from
losses. Which of the following is NOT one of those features?
A. Shifting interest
B. Excess spread
C. Subordination
D. Securitization
202

CH 6 Credit Risk Measurement and Management 8KUA8G1F13

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Questions - Credit Risk Measurement and Management

Last Updated: Apr 5, 2021

77 - The Credit Decision 3

B. One party performs services for another and sends an invoice

C. One party makes an advance payment for goods pending delivery

D. The simultaneous exchange of goods for cash in a local grocery

Q.1720 Which industry is unable to avoid credit risk and why?

A. Automobile manufacturers because of the cyclical nature of their business

B. Manufacturers of electrical equipment because of intense market competition

C. Suppliers of giant retailers because of their extremely weak bargaining power

A. External conditions such as country risk and sector risk

B. Capital expenditure investment and financing policies

C. Capacity (volatility of earnings) and willingness (reputation)

D. Quality and sufficiency of risk mitigation instruments such as collateral and

A. Profitability ratios forecast by an independent consultant

B. Expected free cash flow levels for the credit period

C. Operational cash cycle days

D. Average and expected working capital days

A. The maturity of the product

B. The securitization status of the obligation

C. The potential effect of changes in market interest rates

D. The priority level assigned to the creditor

B. loss given default.

C. Peer-to-peer secured asset lenders

A. Risk-based pricing and/or credit tightening

B. Hiring a respectable rating agency together with an independent due diligence

C. Diversification and insurance

D. Credit risk mitigants

A. The relative importance of the borrower's capacity to repay the loan

D. The relative importance of the borrower's external conditions surrounding the

A. Legal and regulatory infrastructure

C. Funding and liquidity risk

D. Volatility risk in market interest rates

B. loss given default

A. Estimation of capacity to pay is possible in most cases

D. Optimal effectiveness in credit analysis must combine quantitative tools with

C. Expected securities (ES), i.e., covenants and/or international guarantees in absolute

D. Exposure at default (EAD), expressed in absolute terms capped at a specific amount by

Q.2685 Given the following information, calculate the expected loss.

This is most likely an example of:

A. Extrapolation analysis technique

B. Qualitative analysis technique

C. Quantitative analysis technique

D. Historical analysis technique

A. High likelihood of default on a financial obligation that counterparties are obligated to

D. The availability of guarantors and collateral assets to secure the loan

A. default on payment for good or services rendered

A. LGD is the total initial exposure minus the recovery rate.

B. LGD is the probability of an outcome that’s worse than initially expected

A. Historical analysis technique

B. Quantitative analysis technique

C. Qualitative analysis technique

Prime Bank, a relatively small lender and counterparty to several of Cruzero’s

outstanding repo contracts

Prudential Life, a life insurance firm

Blue Ray Limited, an investment bank.

A. Corporate credit analysis

B. Financial credit analysis

C. Consumer credit analysis

D. Hybrid credit analysis

A. Andrew’s character and past payment history with the bank

A. Reviewing loans and customer documentation