CH 6 Credit Risk Measurement and Management Answers

FRM
Part II Exam

By AnalystPrep

Questions with Answers - Credit Risk Measurement and

Management
Last Updated: Apr 5, 2021
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Table of Contents
77 - The Credit Decision 3

78 - The Credit Analyst 20
79 - Capital Structure in Banks 39
80 - Ratings Assignment Methodologies 60
81 - Credit Risks and Credit Derivatives 86
82 - Spread Risk and Default Intensity Models 120
83 - Portfolio Credit Risk 147
84 - Structured Credit Risk 167
85 - Counterparty Risk and Beyond 185
86 - Netting, Close-out, and Related Aspects 200
87 - Margin (Collateral) and Settlement 212
88 - Credit Exposure and Funding 246
90 - CVA (Part A) 301
91 - CVA (Part B – Wrong-way Risk) 311
92 - The Evolution of Stress Testing Counterparty Exposures 326
93 - Credit Scoring and Retail Credit Risk Management 338
94 - The Credit Transfer Markets and Their Implications 350
95 - An Introduction to Securitization 364
Understanding the Securitization of Subprime Mortgage
96 - 380
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)
The correct answer is: A)
Creditors extend funds based on the belief that the borrower can be entrusted to repay the funds
advanced in accordance with contractual agreements. In particular, the creditor must have
confidence that:
the borrower is willing to pay the sum advanced, including interest payments; and the borrower
already has, or will have, the capacity to repay funds.
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
The correct answer is: D)
All bonds and business transactions in which there’s a pending receivable (cash, good, or
service) always carry some credit risk. Lenders can only reduce credit risk by diversifying the
asset pool. Therefore, credit risk is absent only during a simultaneous exchange of goods or
services for cash.
3
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
Banks are often unable to operate on a cash-only basis, and their core business has much to do
with the supply of credit. They cannot avoid credit risk. At best, they can only create mechanisms
to manage the risk.
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
The correct answer is: B)
Four variables directly affect relative credit risk. These are:
The capacity of the obligor (borrower/counterparty/issuer) and their willingness to meet

contractual obligations.
Specific characteristics of the credit instrument involved. The external environment (country-
specific attributes and the political climate) which may affect the probability of default.
The quality and sufficiency of risk mitigants such as collateral, guarantors, and credit
enhancements.
4
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
The capacity of the obligor to meet their financial obligations is directly related to the expected
free (available) cash flows. The amount due on a specific date should be less than the cash
available at that point.
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
The correct answer is: C)
The characteristics of credit instruments, which have a direct effect on the level of credit risk
are:
The tenor (maturity) of the product;

The securitization status (covenants and guarantees) of the obligation; and
The priority level assigned to the creditor (seniority, subordination, (un)secured, etc)
5
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.
The loss given default refers to the portion of a bond's value including unpaid interest an
investor loses in the event of default. The statement "If the borrower does not follow through on
its financial obligation" simply means "if the borrower defaults." The expected loss is the average
credit loss that we would expect from an exposure or a portfolio over a given period. It’s the
anticipated deterioration in the value of a risky asset. In mathematical terms, it is given by the
product of the probability of default, loss given default, and the exposure at default. The
exposure at default is the loss exposure of a bank at the time of a loan’s default, expressed as a
dollar amount. The probability of default (PD), describes the probability that a borrower will
default on contractual payments before the end of a predetermined period.
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
A pawnbroker is an individual or business (pawnshop or pawn shop) that offers secured loans to
people, with items of personal property used as collateral. The items having been pawned to the
broker are themselves called pledges or pawns, or simply the collateral.
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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
In less-developed countries where financial reporting requirements are poor, credit risk
mitigants are mostly preferred to reduce credit risk.
Credit Risk Mitigation:

As opposed to focusing only on the likelihood of default, credit risk mitigation also focuses on the
degree of uncertainty forecasting the likelihood is related to. For credit risk to be mitigated,
securities in the form of guarantees or collaterals are demanded by lenders due to the
aforementioned uncertainties.
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
Capacity without willingness can be overcome to a large degree through an effective legal
system. The more a legal system exhibits regulations and creditor-friendly features, the more
important the capacity to repay becomes.
7
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
In less developed countries, the quality of the legal framework is a critically important criterion,
and creditors need to carefully assess the effectiveness of the legal system in protecting their
rights.
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
Loss given default, LGD, represents the likely percentage loss if the borrower defaults. In this
case, the lender stands to lose 60% of the total amount of the loan if the borrower defaults.
A is incorrect. Recovery rate = 1 - LGD
C is incorrect. Exposure at default (EAD) is the total value a bank is exposed to when a loan
defaults. It's the amount the borrower has already withdrawn at the time of default.
D is incorrect. Expected loss the expected loss is the average credit loss that would be expected
from an exposure or a portfolio over a given period of time. For a given time horizon, it is
calculated as the product of the PD, LGD, and EAD (i.e., PD × LGD × EAD).
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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
Optimal effectiveness in credit analysis needs to combine quantitative tools with sound
qualitative judgments. Credit analysis is said to be an art as well as a science.
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
The three variables in option A, option B, and option D—PD, LGD, EAD—when multiplied give the
expected loss (EL) for a given time horizon. Thus, expected loss (EL) is simply the product of PD,
LGD, and EAD.
9
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
Modern banks, in contrast to non-financial firms, rarely fail. This statement may appear to be an
exaggeration, but it’s, in fact, a reality. Universal data shows that the probability of insolvency
among banks is substantially less than that of other financial institutions such as insurers
because banks are highly regulated and their credit assessment is extremely qualitative. In
recent years, the Basel Committee has come up with stricter capital requirements in an attempt
to mitigate the risk of failure.
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%
Expected loss = PD × LGD × EAD
Expected loss = 0.04 × 0.60 × 0.55
Expected loss = 1.32%
10
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
Expected Loss = PD x (1-RR) x exposure
Expected Loss = 0.03 x (1-0.40) x 1,000,000 = $18,000
The same result can be obtained using the formula EL = PD x LGD = 0.03 x 600,000 = $18,000
11
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
Qualitative techniques are used primarily to assess the borrower’s ability to repay a
loan. The techniques involved make use of a number of data gathering methods such as site
visits, face-to-face meetings with potential borrowers, and use of the borrowers' credit history to
draw conclusions about their willingness to meet obligations attached to contracts in the future.
Quantitative techniques involve scrutinizing the borrower's financial statements and other
supporting documentation that explicitly show the borrower's financial position and any facilities
they may be servicing.
12
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
Although they are important tools to secure creditors, both collateral and guarantees are
requirements by financial institutions to ensure that all obligors, including those whose
creditworthiness are doubted, can and will pay the loan. The implication is, therefore, that they
both cannot cause a monetary loss to the lender since they have a fallback option.
13
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.
Bank insolvency can be defined as a bank’s inability to pay its debts. This can happen when (I)
the bank’s liabilities exceed its assets, and (II) when the bank has severed liquidity problems
such that it cannot pay its debts as they fall due even if assets happen to be worth more than
liabilities.
Bank failure is the closure/collapse of a bank plagued by insolvency by a federal or state
regulator. It results in significant losses to depositors and creditors.
Bank failure is extremely rare. In fact, there were multiple instances in the 2008/2009 financial
crisis where entities experienced serious insolvency but continued operations. For example, the
Lehman was insolvent long before failure but was somehow able to do business by raising funds
in the repo market.
14
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.
Black Rock lost more than expected due to greater exposure at the time of default than initially
anticipated. The borrower was a small start-up, so there are very slim chances that it was rated.
What’s more, there were no goods or services rendered in this case. In addition, there is no
mention of probability of default. This is also an example of credit risk arising from default on a
financial obligation.
15
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.
LGD represents the likely percentage loss if the borrower defaults. It is equivalent to the
difference between the total exposure at default and the recovery rate. LGD generally gives the
analyst an idea of the severity of the possible loss. The severity of a default is equally as
important to the creditor as the probability of default itself.
16
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
This type of analysis presents a blend of qualitative and quantitative credit analysis techniques.
For starters, there’s an element of (qualitative) name lending – where the analyst considers
advancement of credit to an individual based on the perceived status of the individual in the
business community. On the other hand, the analyst also takes a look at the venture’s financial
statements, which is a quantitative technique. Use of a hybrid approach is informed by the fact
that standalone quantitative or qualitative techniques have several shortcomings. For example,
financial statements are generally highly abbreviated reports that may leave out certain pieces of
information that are crucial in determining the borrower’s ability to pay.
17
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
Financial institution credit analysis is the evaluation of financial companies including banks and
nonbank financial institutions (NBFIs), such as insurance companies and investment funds. All of
the listed institutions offer some kind of a financial service.
A is incorrect. Corporate (nonfinancial) credit analysis is the evaluation of nonfinancial
companies such as manufacturers, and nonfinancial service providers.
C is incorrect. Consumer credit analysis is the evaluation of the creditworthiness of individual
consumers
D is incorrect. Hybrid credit analysis presents the analysis of a blend of financial and non-
financial entities.
18
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
When analyzing the creditworthiness of banks, cash flows are not considered a key indicator.
Earnings capacity over time is a more relevant indicator of creditworthiness. A bank may have
huge cash flows over a relatively short period of time but ultimately run into serious funding
problems if it cannot sustain such cash flows. It must be able to withstand periods of financial
stress/crisis in order to repay debts. Equally important is the bank’s liquidity position, capital
adequacy, and the quality of its assets.
19
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.
The four primary components of credit risk evaluation are: (I) the borrower's (or obligor's)
capacity and willingness to repay the loan, (II) the external environment, (III), characteristics of
the credit instrument, and (IV) the quality and adequacy of risk mitigants such as collateral,
credit enhancements, and loan guarantees.
In this case, Andrew's character, payment history, and the company's financial position are all
crucial bits of information. However, risk mitigants such as collateral and loan guarantees are
not relevant in this case because it is highly unlikely that a business that has been in existence
for 20 years would seek a loan guarantee from a friend or family member. Furthermore, it is
unlikely that Andrew would call upon friends and family to guarantee his company's loan. He is
more likely to go for a specific person or entity.
20
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
Although the approach to credit evaluation is dependent upon the type of entity being evaluated,
the assessment of the capital structure and financial statement analysis is generally not among
the major responsibilities of “credit analysts.”
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
Counterparty analysts consider the risk to each party of a contract: whether the counterparty
will meet their contractual obligations. Therefore, counterparty credit analysts generally assign
counterparties an internal rating while rating agencies assign an external rating for all kinds of
entities.
21
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
In a broader sense, credit risk management includes monitoring and controlling market risk,
liquidity risk, and operational risk.
Note: Market risk is the possibility that an individual or other entity will experience losses due to
a shift in the factors that affect the overall performance of investments in the financial markets.
One such factor is interest rates. Interest rate risk is a type of market risk.
Other types include exchange rates, inflation, currency risk, and equity risk.
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
The cost of analysis is higher when it’s performed with human input. Besides, the more primary
research is required, the higher the cost. Therefore, it may not be cost-effective to perform an in-
depth assessment of all areas.
22
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
Core principles of corporate credit analysis are largely the same. However, specific industry
knowledge is required. Specialization is common in fixed-income analysis and at rating agencies.
Also, the scale of the business affects the analytical methodology. Besides, more field and
primary research may be needed with respect to small/medium (size) enterprises (SMEs) rather
than publicly listed multinationals because of the abundance of publicly available information.
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
Sovereign credit risk is the risk of a government becoming unwilling or unable to meet its loan
obligations. Sovereign risk (country risk) is relevant to the analytical process.
23
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
Banks are the largest employer of credit analysts. Nonbank financial institutions (NBFIs) also
employ a substantial amount of credit analysts. Government agencies employ credit analysts as
well.
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
Mortgage or asset-backed securities, credit default swaps, and structured investment facilities
are deemed to be more complex forms of investments when compared to letters of credit, money
market or bond investments, and interest rate swaps.
24
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
Examples of more quantitative analyses include banks’ ratios such as return on equity (ROE),
asset, earnings, and capital quality ratios. On the other hand, evaluation of a bank’s credit
culture, efficiency of its credit review procedures, and industry/economic conditions are not
necessarily in numerical form, nominally subjective, and so more qualitative.
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
To rank a bank’s comparative credit risk, the analyst needs to judge the credit risk of a particular
institution at the micro level relative to its previous results (historical performance) and to
similar entities (its peers).
25
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
Basic sources of materials for banks credit analysis include annual reports, interim financial
statements, financial data sources such as Banker’s Almanac and Bankscope, rating agency
reports, prospectuses, etc. Interim financial statements are frequently limited to an unaudited
balance sheet and income statement but give significant information concerning earnings.
Interim statements increase communication between companies and the public and provide
investors and banks with up-to-date information between annual reporting periods.
26
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.
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.
27
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
A qualified opinion is a statement issued after an audit is completed by a professional auditor,

suggesting that the information provided is limited in scope and/or the company being edited has
not maintained GAAP accounting principles.
The presence of the word "except" in the concluding paragraph of an audit opinion is evidence of
a qualified opinion. All other phrases could be found in a classical clean or unqualified auditor’s
report, or in other words, a standard format, boilerplate language.
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
The issuance of an adverse opinion is an extremely rare case. Such an opinion explicitly states
that the financial statements do not provide a fair picture of the bank’s condition.
28
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).
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, where C stands for Capital, A for Asset quality, M for management, E for
Earnings, and L for Liquidity.
29
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
Counterparty credit review is a role performed by senior and experienced counterparty credit
analysts. Their roles include approval of credit limits and developing and updating policies of
credit.
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
Rating agencies’ analysts examine the creditworthiness of banks, corporations, and

governments. Banks and other related financial institutions still remain the largest employers of
credit analysts. Finally, institutional investors and other nonbank financial institutions will
significantly require a man with his skills. Therefore, securities exchange firms are least likely to
correspond to his financial roles and consequently not a suitable employer.
30
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
Instead of reviewing applications, this job involves making sure that the consumer credit scoring
systems are reviewed and developed in a manner that is refined.
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
In the acronym CAMEL, letter "E" denotes earnings.
Analysts assess a bank's ability to generate returns needed for expansion and attainment of
required capital levels. Among the items assessed include the bank's growth, stability, net
interest margin, and net worth level.
31
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
In the CAMEL rating system, analysts give financial institutions a rating with respect to each of
these five factors. A rating of one is considered the best, and a rating of five is considered the
worst for each factor. More generally, financial institutions with an averagless-than-
satisfactory and draw regulatory scrutiny.
B, C, and D are all correct statements.
The five components of a bank's condition that are assessed are: Capital adequacy, Asset quality,
Management, Earnings, and Liquidity. Furthermore, the assessment of all of capital, asset
quality, earnings, and liquidity involves ratio analysis. The assessment of management takes on a
qualitative approach where some of the aspects scrutinized include: how well the management
responds to changing market conditions, how well duties and responsibilities are delegated, and
how well the compensation policies are designed.
32
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
In bank credit analysis, the balance sheet and the income statement are important financial
statements. Also of importance is the statement of changes in capital equity. The statement
of cash flows is of lesser importance for financial institutions.
When analyzing nonfinancial companies, the statement of cash flows is considered the most
important. However, the question refers to a financial institution.
33
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
This presents a situation where there's a disagreement over transactions related to a single item
on the financial statements. The auditors cannot find sufficient evidence to validate the cash
flows related to a foreign affiliate. But other than that, the auditors have adjudged that the
statements present fairly, in all material respects, the financial position of Prime Bank. As such, a
qualified report would most likely be issued.
34
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
This is a situation where the accounting treatment used by the banks management is
inconsistent with the accounting rules. Specifically, the accounting treatment of subsidiaries
goes against the dictates of international law. The auditors note that had the accounting been
done in the right away, there would have been a material effect on the financial statements, and
therefore conclude that the statements do not present fairly the financial position of ABC bank.
This effectively constitutes a diverse opinion.
Note: To issue an adverse opinion, auditors must obtain substantial evidence indicating that a
company's financial statements are misrepresented, misstated and do not accurately reflect its
financial performance and health. This is the gravest qualification and will justifiably give rise to
concern on the part of the analyst.
35
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
To issue an adverse opinion, auditors must obtain substantial evidence indicating that a
company's financial statements are misrepresented, misstated and do not accurately reflect its
financial performance and health. This is the gravest qualification and will justifiably give rise to
concern on the part of the analyst.
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.
In most cases, the auditor's opinion is boilerplate language designed to shield the auditor from
possible legal liability. In particular, the report makes it clear that the auditors are not
responsible for anything that may occur or become apparent after the date indicated on the
report.
36
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
Auditors should perform procedures designed to obtain sufficient appropriate evidence that all
events up to the date of the auditor's report that may require disclosure in the financial
statements have been identified. In other words, the auditor is only responsible for events that
occur on or prior to the date indicated on the audit report.
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.
An unqualified opinion implies the auditor's judgment is that a company's financial statements
are fairly and appropriately presented, without any identified exceptions, and in compliance with
generally accepted accounting principles (GAAP). In essence, a clean opinion indicates that the
auditor does not disagree with the financial statements presented by management
37
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
In the CAMEL rating system, analysts give financial institutions a rating with respect to each of
these five factors. A rating of one is considered the best, and a rating of five is considered the
worst for each factor. More generally, financial institutions with an average score of less than
two are considered to be high-quality institutions. Those with scores greater than three are
considered to be less-than-satisfactory and draw regulatory scrutiny
38
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
Qualitative skills involve making subjective judgments based on non-quantifiable information,

such as management expertise, industry cycles, and the amount (and strength) of research and
development. Of the skills listed, networking is the only qualitative skill. For example, the analyst
in this case will most likely have to schedule a meeting with the potential client and will need to
establish a strong rapport with them in order to find out important pieces of information that,
combined with quantitative data, will help the bank make a decision whether or not to extend
credit. Options A, B, ad C all present quantitative skills, i.e., they involve the analysis of
quantitative data.
39
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
A qualified opinion means that in the auditors' professional judgment, the financial statements
might not fairly represent the company's financial performance and condition. In fact, the
auditors will often go as far as specifying the areas they do not approve of using words such as
"except" in the final paragraph of the report. A Qualified opinion, in other words is when the
audit company signs the financial figures of the company(i.e the financials are fairly presented)
EXCEPT for some specified areas which they were unable to verify
Some of the reasons why a qualified opinion may be issued are as follows:
1. There are significant amounts of related-party transactions.

2. There exists an unusual condition or event that may have a material impact on the bank's
business.
3. Substantial doubt about the bank's ability to continue as a going concern.
4. There exists a specific aspect of the financial reports that is deemed by the auditor to be
out of line with best practice
40
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
Credit risk is the risk that arises from any nonpayment or rescheduling of any promised
payments (i.e. default-related events) or from credit migrations of a loan that gives rise to an
economic loss to the bank. Credit risk events include changes in the counterparty as well as the
country's characteristics.
41
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
Statements I, II & III are true. 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. Even though
these credit loss levels will fluctuate from year to year, there is an anticipated average level of
losses over time that can be statistically determined. Expected loss must be treated as a
foreseeable cost of doing business in the lending business.
Statement IV is false. Expected loss is not the level of losses predicted for the following year
based on the economic cycle, but rather the long-run average loss level across a range of typical
economic conditions.
42
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
Probability of default, exposure amount and loss rate are the three components that determine
economic losses.
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
Expected loss = Probability of default at time H * Exposure amount at time H * Loss rate
experienced at time H
= PD * EA * LR
= 100 * 0.2 * 0.1 = 2 million
43
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
All statements are correct. The loss rate is the fraction of the exposure amount that is lost in the
event of default, meaning the amount that is not recovered after the sale of the collateral. PD is a
borrower-specific estimate that is typically linked to the borrower's risk rating. The remaining
two components reflect and model the product specifics of a borrower's liability. Probability of
default (PD) is a measure to determine whether a counterparty goes into default over a
predetermined period of time.
44
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
Statement I is incorrect. Unexpected losses cannot be anticipated and hence cannot be

adequately priced for in a loan's interest rate.
Statements II, III & IV are correct. Unexpected loss, in statistical terms, is the standard deviation
of credit losses, that is, the standard deviation of actual credit losses around the expected loss
average. Unexpected loss can be calculated at the transaction and portfolio level. Unexpected
loss is the primary driver of the amount of economic capital required for credit risk.
45
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
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 losses. The expected loss is calculated as the
mean of a distribution whereas unexpected loss is calculated as the standard deviation of the
same distribution. Like expected losses, unexpected losses can also be calculated for various
time periods and for rolling time windows across time. Unexpected losses (UL) stem from the
(unexpected) occurrence of defaults and (unexpected) credit migration whereas expected losses
must be treated as the foreseeable cost of doing business in lending markets.
46
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
Statement I is incorrect. For an individual loan, the probability of default is independent of the
exposure amount and the loss rate.
Statements II, III & IV are correct. In most situations, the exposure amount and the loss rate can
be viewed as being independent. Since the expected exposure amount can vary but is (typically)
not subject to changes in the credit characteristics itself, unexpected loss is dependent on the
default probability, the loss rate, and their corresponding variances. If there were no uncertainty
in the default event and no uncertainty about the recovery rate, the unexpected loss would also
be equal to zero.
47
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
In order to determine the unexpected loss contribution from asset i (i.e. the amount of portfolio
unexpected loss that can be traced down to asset i), we would have to take into account all of:
(I) the asset's PD
(II) the asset's EA
(II) the asset's loss rate
(IV) the correlation between the asset's exposure and other assets in the portfolio
? (I) (II) and (II) are all needed to compute the expected loss as well as the unexpected loss
48
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
Statement III is incorrect. The binomial distribution overstates the variance of the loss rate,
since when a customer defaults, either all of the exposure amount is lost or nothing. On the other
hand, the uniform distribution assumes that all defaulted borrowers would have the same
probability of losing between 0% and 100%.
Statements I, II & IV are correct. Since default is a Bernoulli variable, the probability of default
is a binomial distribution. Unlike the distribution for the probability of default, the loss rate can
take a number of shapes, which results in different equations for the variances of loss rate.
Possible distributions are the binomial, the uniform, or the normal distribution, and the uniform
distribution assumes that all defaulted borrowers would have the same probability of losing
anywhere between 0 percent and 100 percent.
49
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
Statement I is incorrect. The marginal contribution only depends on the weights of the different
loans in the portfolio, not on the size of the portfolio itself.
Statement II, III & IV are correct. 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. 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. This is done by taking the first partial derivative of the portfolio unexpected loss with
respect to unexpected loss of loan i and multiplying it by the unexpected loss of loan i.
50
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
Default correlations are very difficult, if not impossible, to observe where a portfolio of loans
consists of many thousand credits. If the loan portfolio contains ‘n’ loans, [n(1-1)]/2 pairwise
default correlations need to be estimated. Default correlations are small, but positive providing
considerable benefits to diversification in credit portfolios.
51
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
Statements I & II are correct. The amount of economic capital needed is the distance between
the expected outcome and the unexpected (negative) outcome at a certain confidence level. The
crucial task in estimating economic capital is the choice of the probability distribution.
Statements III & IV are incorrect. Credit risks are not normally distributed but highly skewed as
the upward potential is limited to receiving at maximum the promised payments and only in very
rare events to losing a lot of money. One distribution often recommended for measuring credit
risk is the beta distribution which is extremely flexible in the shapes of the distribution it can
accommodate.
52
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
Statement II is incorrect. The beta distribution is especially useful in modeling a random variable
that varies between 0 and c (>0). This is because the beta distribution nearly always produces
positive outputs. When modeling credit events, losses can vary between 0 and 100%, so that c =
1.
Statements I, III & IV are correct. The beta distribution is often recommended and is a suitable
probability distribution for measuring the credit losses as credit losses are normally distributed
but highly skewed. The shape of the beta distribution can be completely determined by
specifying the parameters α and β. The form of beta distribution is fully characterized by two
parameters: expected loss of the portfolio and unexpected loss of the portfolio.
53
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
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 the analytical (beta distribution) solution with
a numerical procedure such as a Monte Carlo simulation
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
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 symmetric.
54
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
(U nexpec ted loss) = (Exposure 2 + LR2 × σ 2

amount) × √P D × σLR PD
= USD 80 million × √0.01 × (0.15)2 + 0.252 ∗ 0.042 = U SD 1.442 million
55
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
Unexpected loss = Exposure amount * √{Probability of default * (Standard deviation of loss

rate)2 + Loss rate2 * Standard deviation of probability of default2}
Unexpected loss (customer 1) = USD 540 million * √{0.02 * (0.35)2 + 0.202 * 0.032} = USD
26.924 million
Unexpected loss (customer 2) = USD 200 million * √{0.01 * (0.20) 2 + 0.402 * 0.022} = USD
4.308132 million
Unexpected loss on the portfolio = √{Unexpected loss on customer 12 + Unexpected loss on
customer 22 + (2 * Unexpected loss on customer 1 * Unexpected loss on customer 2 *
correlation)}
Unexpected loss on the portfolio = √{26.9242 + 4.30812 + (2 * 26.924 * 4.3081 * 0.5)} = USD
29.316 million
56
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
EL = EA × P D × LR
Exposure at default,
EA = drawn amount + drawdown on default

= 80% × 100, 000 + 70% × (100, 000 − 80% × 100 , 000)
= 80 , 000 + 14 , 000 = 94 , 000
P D = 2%
LR = 40%
Thus,
EL = 94 , 000 × 0.02 × 0.4 = U SD 752
2 + LR2 × σ 2
UL = EA × √P D × σLR PD
2
σLR = 0.32 σPD
2
= p (1 − p) = 0.02 × 0.98 = 0.0196
Thus,
U L = 94 , 000 × √0.02 × 0.32 + 0.42 × 0.0196
= US D 6, 604
57
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
The expected loss of the portfolio is the sum of the expected losses of individual assets.
For AA-rated bonds,
EA = $120, 000, 000,
P D = 0.04, and
LR = 0.35
Thus,
EL AA = 120, 000 , 000 × 0.04 × 0.35 = $1, 680, 000
For BB-rated bonds,
EA = $80 , 000, 000 ,
P D = 0.06, and
LR = 0.6
Thus,
ELBB = 80 , 000, 000 × 0.06 × 0.6 = $2, 880, 000
58
Portfolio expected loss = $1 , 680 , 000 + $2, 880, 000 = $4, 560, 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
The joint default probability and the default correlation are nugatory as far as the expected
credit loss of the portfolio is concerned. In other words, they do no matter.
The expected loss of the portfolio is simply the sum of the expected losses of individual assets.
For the first bond,
EA = $500, 000,
P D = 0.05, and
LR = 0.5
Thus,
EL AA = 500 , 000 × 0.05 × 0.5 = $12 , 500
For the second bond,
EA = $300, 000,
P D = 0.03, and
LR = 0.7
59
Thus,
EL BB = 300, 000 × 0.03 × 0.7 = $6, 300
P ortfolio credit loss = $12 , 500 + $6, 300 = $18 , 800
Note: The joint probability of default and the default correlation would be important only in the
calculation of the unexpected credit loss of the portfolio.
60
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
Objectivity means that the rating system generates judgments based only on credit risk
considerations while avoiding undue influence or subjective reasoning.
61
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
Wilcox’s model does not use real-time data, neither does it employ game theory in an attempt to
predict default events.
Options A, B and C are correct characteristics regarding Wilcox’s model.
62
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
Any company will survive if the operational flow of funds is no less than interest charges and
principal repayment. Otherwise, new debt is accumulated and the company is destined to fail. In
essence, this means that the company must generate returns enough to settle all outstanding
debts.
63
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
Information asymmetry refers to the situation where information pertinent to a counterparty is

concentrated in the hands of just a few, making it difficult to evaluate the counterparty’s
financial health. This also applies to market products.
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
Generally speaking, the larger the cash flow margins from operations, the safer the financial
structure; and, therefore the better the borrower’s credit rating.
64
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
An institution’s human resource policy should not play a significant role in the determination of a
counter party’s credit rating.
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
All the limitations outlined above are correct.
Rating agencies use different definitions depending on the nature of the information at their
disposal. 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. Initial ratings released for the same counterparty by different rating agencies
may not always be similar.
65
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
When banks adopt judgmental approaches to credit quality assessment, the data used and/or
analytical processes followed are similar.
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
Quantitative financial models embody a mixture of statistics, behavioral psychology, and

numerical methods.
66
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
If the value of the borrower’s assets exceed the debt face value, the borrower will pay the
outstanding debt and retain full possession of his assets, but if the value of the assets is lower
than the face value of the debt, the borrower has the convenience of missing debt payments even
if it means losing possession of the assets.
Option A is incorrect. The fact that the borrower makes full debt payments does not cause
additional risk to the bank.
Options C and D are incorrect. The borrower cannot remain in full possession of the asset for
long if he does not make scheduled 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
Unlike structural models, the reduced form model makes no ex-ante assumptions about the
causal drivers of default. Firm features are linked with default, using statistical methodologies to
link them to default data. Instead, it focuses on maximizing its prediction power by associating
default with firm-specific characteristics.
67
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
Generalization of results of a modeling process requires a good degree of homogeneity between

the development sample and the population to which the model will be applied.
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
Once a good discriminate function has been estimated using historical data concerning
performing and defaulted borrowers, it is possible to assign a new borrower to groups that were
preliminarily defined (performing, defaulting) based on the score produced by the function.
68
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
At present, LDA is notably being applied by Moody’s, particularly in the agency’s Risk Calc
Model. The model is devoted to credit quality assessment of unlisted SMEs in different countries.
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
Independent variables should actually be normally distributed.
69
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
Logistic regression models (or LOGIT models) are based on the analysis of dependence amongst
variables. They are an extension of classical linear models and are widely used for analyzing the
dependence of a variable, given one or more independent variables. They have three main
components:
I. A random component
II. A systematic component
III. A link function
70
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
Under supervised models, a dependent variable is defined (the default) and other independent
variables are used to work out a reliable solution to give an ex-ante prediction.
In natural language processing, Latent Dirichlet allocation (LDA) is a generative statistical model
that allows sets of observations to be explained by unobserved groups that explain why some
parts of the data are similar.
A logit model is a regression model where the dependent variable (DV) is categorical.
71
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.
The cluster analysis operates in rows aggregating borrowers on the basis of their variables'
profile. It leads to a sort of statistically-based top-down segmentation of borrowers.
Subsequently, the empirical default rate, calculated segment by segment, can be interpreted as
the borrower's default probability of each segment. Cluster analysis can also be simply used as a
preliminary exploration of borrowers’ characteristics.
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
A cash flow simulation model is very often company-specific or, at least, industry specific&semi
so it needs to be regulated with particular situations and administered by the firm's management
and a skilled analyst. It has to be calibrated with particular circumstances and supervised by the
firm's management and a competent analyst.
72
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.
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. These approaches
are opposite to algorithms-based approaches and known as expert systems.
73
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.
The 'principal component analysis', 'factor analysis', and 'canonical correlation analysis' all
operate in columns in order to optimally transform the set of variables into a smaller one, which
is statistically more significant.
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
The main objective of numerical methods is to reach optimal solutions by adopting 'trained'
algorithms to make decisions in highly complex environments characterized by inefficient,
redundant, and fuzzy information. One example of these approaches is 'Neural networks'.
74
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
The Merton model is a structural model that is value-based. In such models, given the value of
the firm, the value of debt and equity can be determined.
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
The key features of a good credit rating system include measurability and verifiability, objectivity
and homogeneity, and specificity.
75
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
The different approaches for predicting default include three broad categories: experts-based
approaches, statistical-based models, and heuristic and numerical approaches. Examples of
heuristic and numerical approaches include expert systems and neural networks. Agency ratings
are an example of an experts-based approach while linear discriminant analysis is a statistical-
based model.
76
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%
The Merton model for Probability of Default is:
ln(F ) − ln(V ) − (μ)(T − t) + 0.5σ 2(T − t)

PD = N [ ]
σ√T − t
ln(25) − ln(40) − (0.10)(5) + 0.5 × 0.32 (5)
=N[ ]
0.3√5
= N (−1.11)
= 13.33%
77
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
qso lv×COS T so lv/inso lv

Cut-off adjustment = ln [ q ]
insol ×COS T inso l/so lv
where:
qsolv = probability of solvency = 1 - probability of default
qinsolv = probability of insolvency, i.e., probability of default
COSTsolv/insolv = cost of rejecting a borrower in spite of them being solvent = opportunity cost
COSTinsol/solv = cost of rejecting a borrower that ends up defaulting = loss given default
Thus,
adjustment = ln[(96.5% x 20%)/(3.5% x 50%)] = 2.4.
By adding this adjustment to the original cut-off point of 1.00, the new cut-off score will be equal
to 3.4.
78
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
With debt, the most we can receive at maturity is par.

As the time to maturity lengthens, the probability of default increases and it becomes more likely
that the debt holder will receive less than par. This decreases the value of debt.
Option D contradicts this.
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
The value of the debt is, for a given value of the firm, a decreasing function of the value of equity,
which is the value of a call option on the value of the firm. Everything else equal, therefore, the
value of the debt falls if the volatility of the firm increases, if the interest rate rises, if the
principal amount of the debt falls, and if the debt's time to maturity lengthens.
79
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
Recall that the default frequency in the horizon k which is [t, (t + k)] is defined as:
Def tt+k
P DT imeHor izonk =
N amest
From the question we are given that Def tt+k = 31 and N amest = 789. Therefore:
31
P DT ime Hor izo nk = = 0.039
789
80
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
1
⎡ ln(F ) − ln(VA ) − μT + 2 σA × T⎤
PD = N
⎣ σA√ T ⎦
From the question, we have:
F = $ 478 million, VA = $ 280million , T = 7, σA = 0.21, μ = 0.18
N is the cumulative normal distribution operator. Therefore:
ln(478) − ln(280) − 7 × 0.18 + 0.5 × 0.212 × 7

PD = N [ ]
0.21 × √7
= N (−1.0274)
= 1 − N (1.0274)
= 0.1515
81
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%
By definition,
marginal_PD(t, t+k) = cumulative_PD(0,t+k) - cumulative_PD(0,t)
In this case,
marginal_PD(2, 2+1) = cumulative_PD(0,2+1) - cumulative_PD(0,2)
= 36.908% - 27.867% = 9.041%
Note: Marginal probability is an unconditional PD from the perspective of today. It is not the PD
conditioned on forward survival.
82
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
Since we have limited data to evaluate DtD, we calculate DtD via the following approximation
method:
DtD = (In V — In F)/σ
Where F = debt face value, σ = volatility, and V = asset value
DtD = (ln 170 - ln 120) / 0.2 = 1.74
83
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%
Defaults shown are cumulative. As such,
P(Default in year 3) = Cumulated default rate up to year 3 - Cumulated default rate up to year 2
= 36.908 - 27.867 = 9.041%
84
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%
Defaults shown are cumulative. As such,
P(survival to end of year 2) = 100% - cumulative default rate up to the end of year 2
= 100 - 3.083 = 96.917%
85
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%
Unconditional default probability during 4th year = 44.128 - 36.908 = 7.22%
The probability that the bond will survive until the end of year 3 = 100 - 36.908 = 63.092%
Probability that it will default during the fourth year conditional on no earlier default =
0.0722/0.63092 = 0.1144 or 11.44%
86
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%
Using Merton formula:
ln (F ) − ln (V ) − μ (T − t) + 0.5σ 2 (T − t)
Probability of default = N ( )
σ√T − t
Where
σ is the asset value volatility,
N is the probability of the standard normal density function,
F = face value of the bond
V = value of the firm
T = maturity on the bond
μ = expected rate of return
ln1000 ,000−ln1 ,300, 000−0.15(0.25)+0.5×0.32 ×0.25

PD =N [ ] = N (−1.924)
0.3√0.25
N(-1.92) = 1 – N(1.92) = 1 – 0.9726 = 0.0274
We get the above figure by checking the N value in the normal distribution table.
87
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
Trends and other efficiency measures can be captured with metrics and are, therefore,
considered quantitative, not qualitative measures. All the other three items are considered
qualitative in that they are not easily and consistently quantified.
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
88
Distance-to-default is the expected difference between the asset value of the firm relative to the
default barrier, after correcting and normalizing for the volatility of assets. It approximates the
number of standard deviations to reach the default threshold; thus, the higher the DtD, the least
likely to default.
σ2
α
lnVα − lnF + (μ − )
2
D tD =
σα √t
DtD can be simplified by reducing the forward time periods to 1 (t=1) and minimizing the drift
factors (μ − σ/2) that tend to be small (assumed to equal 0) over one period to yield:
lnV α − lnF
D tD ≅
σα
Applying this formula,

DtD for Company P = ln(100/70)/0.10 = 3.56
DtD for Company Q = ln(180/120)/0.08 = 5.07
DtD for Company R = ln(200/100)/0.06 = 11.55
DtD for Company S = ln(250/170)/0.12 = 3.21
As such, R is the least likely to default, followed by Q, P, and S, in that order
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)
A good rating system:

(I) meets the specificity requirement: must measure the distance to a default event
(II) is verifiable: requires backtesting on a continuous basis
(III) is homogeneous: results in ratings that can be compared across multiple customer types and
market segments
(IV) is objective: produces judgments based on considerations tied to credit risk.
89
90
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
Let:
VT be the value of the firm at time T
ST be the value of equity at time T
F be the face value of the bond
At time T,
ST = max(VT –F, 0) = max(50 – 60, 0) = 0
What this means is that equity holders receive something if the value of the firm exceeds the face
value of debt at time T, otherwise the value of equity is zero. In other words, equity holders
receive something if the value of VT – F is positive, otherwise they receive zero.
91
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
ST = Max (VT - F,0)
where F is the face value of the principal amount of the debt.
ST = max(160 million - 120 million, 0) = 40 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
A credit analyst should assume a decrease in the value of the debt if the volatility of the firm
increases, interest rate rises, the debt principal falls, and if the debt’s time maturity becomes
longer.
92
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
Valuation of debt involves subtracting the value of equity from the value of the firm:
We subtract $52.650 million from $100 million, which gives $47.350 million.
93
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
A credit derivative, not a credit spread, can be used to hedge credit risk. A credit spread
indicates the difference in yield between two bonds of similar maturity but different credit
quality. Widening credit spreads imply growing concern about the ability of borrowers to service
their debt. Narrowing credit spreads, on the other hand, indicate improving creditworthiness.
C is correct. With debt, the most we can receive at maturity is par. As time to maturity becomes
longer, the likelihood of receiving an amount less than par increases. Consequently, if the debt is
highly rated, the spread widens as time to maturity gets longer.
However, if the value of the debt is sufficiently low to start with, there is more of a chance that
the value of the debt will be higher as the debt reaches maturity if time to maturity is longer. As
such, the spread can narrow as time to maturity gets longer for sufficiently risky debt.
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
The difference between subordinated debt and senior debt is the priority in which debt claims
are settled. Senior debt always ranks above subordinated debt. In case of a winding-
up/liquidation/bankruptcy, senior debt must be paid in full before subordinated debt holders can
receive a penny. In such cases, subordinated debt is treated more or less like equity, but at no
time should holders of debt receive dividends. During a turbulent period, an increase in volatility
actually increases the likelihood that subordinated debt will be paid off, and therefore increases
its value.
94
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
Since senior debt always takes precedence, it will be paid off in full.
Thus, $2.25m - $2m = $0.25m
Therefore, subordinated debt holders will receive just half of their total claim.
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
Under the Merton model, default events are too predictable. In the real world, default events are
normally more surprising. This challenge arises from the fact that while applying the Merton
model, we make the Black-Scholes assumptions under which the value of a firm cannot jump.
Consequently, default cannot occur unless the value of the firm is infinitesimally close to the
point where default occurs. Real-life default sometimes occurs quite abruptly. For instance, a
bank enjoying good performance would obviously have a good value of equity. However, if the
bank were to experience a run, the equity would be rendered worthless within a very short
period of time.
95
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
A compound call option gives its holder the right to buy an option on an option. Since equity is an
option on firm value, an option on the stock of a levered firm is a compound option.
D is inaccurate. Geske assumes that firm value follows the same distribution as the stock price in
the Black-Scholes formula: firm value has constant volatility and the logarithm of firm value is
normally distributed.
96
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%
1 D
credit spread = −[ ] × ln ( ) − R f
T−t F
where:
(T - t) = remaining maturity
D = current value of debt
F = face value of debt
Rf = risk-free rate
Thus,
1 88
credit spread = − [ ] × ln ( ) − 0.01 = 1.56
5 100
97
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
An increase in interest rates generally reduces the value of debt because of reducing the present
value of coupon payments as well as the present value of the redemption amount/ face value.
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
The KMV model is in many ways quite similar to the CreditMetricsTM model, but it makes direct
use of the Merton Model in computing the probability of default. Default probabilities are
calculated using the “Expected Default Frequency” for each obligor.
98
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
Options, A, B, and D are considered to be “credit events”.
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
In finance, a credit derivative refers to any one of "various instruments and techniques designed
to separate and then transfer the credit risk" or the risk of an event of default of a corporate or
sovereign borrower, transferring it to an entity other than the lender or debtholder. This
synthetic securitization process has become increasingly popular over the last decade, with the
simple versions of these structures being known as synthetic collateralized debt obligations
(CDOs), credit-linked notes or single-tranche CDOs.
Being over-the-counter instruments, credit derivatives are usually less liquid than other hedging
instruments traded on exchanges.
99
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.
Firm asset volatility can be estimated using equity and call option on equity, so firm asset value
does not have to
trade.
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)
Under the Merton model, the payment to the debt holders is represented by D – max (D-V, 0). A
firm will default if its value is less than that of its debts. In such a case, the debt holders receive
the value of the firm, which is either equal or less than their claim and the debt holders will
either breakeven or bear a loss. The shareholders, on the contrary, get nothing in the event of a
default.
100
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
Value of equity S = max (V-F, 0)

S = max (35 – 25, 0)
S = 10 million
Value of debt D = F – max (F-V, 0)

D = 25 – max (25-20, 0)
D = 25 – 5
D = 20 million
101
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
In the event of financial distress, a firm’s subordinated debt is only paid after the claims of its
senior debtholders have been satisfied. Since financial distress is uncertain, the value of
subordinated debt is more like equity than debt. During financial distress, the value of
subordinated debt is proportional to the volatility of the firm, and moves in the opposite direction
to the value of senior debt.
102
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
The Merton's model formula for a firm's equity is:
St = V × N (d) − F e−r(T−t) × N (d − σ√ T − t)
where
V
⎡ F −r( T −t) ⎤ 1
d = ln ⎢ e ⎥ + σ√T − t
⎣ σ√ T − t ⎦ 2
50
⎡ 30e −0.07×5⎤ 1
= ln ⎢ ⎥ + × 0.2√5
⎣ 0.3√ 5 ⎦ 2
= 1.4837
Thus,
St = 50 × N(d) − 30e−0.07×5 × N (d − 0.2√5) = 29 million
103
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
All of the events mentioned above are credit events and may lead to the protection seller making
a default payment to the protection buyer.
Insolvency occurs when an entity's liabilities exceed available assets making it difficult to meet
day-to-day financing needs.
Obligation acceleration occurs when one or more reference obligations become immediately due
as a result of an entity's failure to honor contractual obligations.
Repudiation occurs when:
(I) the reference entity (obligor) refuses to honor its obligations
(II)The reference entity is prevented from making a payment due to a sovereign debt
moratorium.
Restructuring occurs when there is either a reduction in the interest rate or the principal
amount, a deferment/postponement for payment, or some other change that causes
subordination to obligations
Other examples of credit events include bankruptcy, failure to pay, and obligation default.
104
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%
The value of a vulnerable option is determined using the following formula:

value = [(1 − PD) × c] + [PD × RR × c]
value = [(1 − 0.06) × c] + [0.06 × 0.25 × c]
value = 0.955 c
105
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
Recall that:
ST = Max (VT − F, 0)
Where VT = $400 million and $350 million, and F = $360 and ST is the value of the equity at time
T.
Therefore, in scenario 1:
ST = Max($400M − $360M,0)
Hence, equity holders will receive $40M.
In scenario 2:
ST = Max($350M − $360M,0)
The equity holders will receive nothing as VT exceeds F.
106
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
The value of the debt is given by formula:
D(V,F,T,t) = Pt (T)F − p(V,F,T,t)
From the problem, we have: Pt(T) = $0.86, p(V,F,T,t) = $19.37, and F = $206.74
Therefore:
D(V,F,T,t) = $0.86 × $206.74 − $19.37
⇒ D(V,F,T,t) = $158.43
107
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%
Recall that the current value of the option is given by formula:
(1 − p)c + pzc
Where p = 0.11 and z = 0.3, and c is the option’s value without default risk
Therefore:
The vulnerable call = (1 − 0.11)c + 0.11 × 0.3 × c = 0.923c
⇒ The vulnerable call = 92.3% without default risk
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
Recall that when the formula of the value of equity is inverted, the value of the firm is given by
the formula:
108
1 N [d − σ√ T − t]
V =( ) S (V , F , T , t) + pt (T ) F ( )
N (d) N (d)
From the problem we have that
N (d)=0.9761,
S (V , F , T , t)=$78 million,
σ=0.34,
pt (T )=$0.79,
F =$100 million
Therefore:
1 N [1.98 − 0.589]
V =( ) 78 + 0.79 × 100( )
0.9761 0.9761
N(1.39)
= 79.91 + 79 ×
0.9761
N(1.32) = 0.9177
⇒ V = $154.18 million
109
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
The payoff to debt holders = Max [Value of the firm or (Value of the firm – value of debt)]
= [70 or (70-95)] = $70 million
Payoff to the equity holder is ST = Max (VT – F, 0)
Since all the value goes to the payment of the debt, the equity holders get nothing.
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%
Credit spread = − [ T 1−t ] × ln D − Rf

F
Where:
(T - t) = remaining maturity
Rf = risk-free rate
1 110
= − [ 6 ] × ln 200 − 0.05 = 0.05
110
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%
We know that
1 D
Credit Spread = − ( ) ln ( ) − r
T −t F
Therefore,
-(1/7) * ln(1.2/2) - 0.05 = 0.0229or 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
To compute the expected loss, the outstanding balance has to be multiplied with the product of
P D, EAD and LGD.
The probability of default can be calculated using the following formula:
111
ln (F ) − ln (V ) − (μ) T + 0.5σ 2T
PD = N [ ]
σ√T
Where:
N = Cumulative normal distribution
F = face value of zero-coupon bond
T = time to maturity
σ= volatility of the firm's value
Note that we have not been provided the values for F and V but their ratio has been provided.
V /F = 1.1 , therefore, F /V = 1/1.1 .
The expression ln (F )-ln (V ) can also be written as ln (F /V ).
Hence:
1
⎡ ln ( 1.1) − (μ) T + 0.5σ 2 T⎤
P D = N ⎢⎢ ⎥⎥
⎣ σ√T ⎦
1
⎡ ln ( 1.1 ) − (15%) (5) + 0.5(19%)2 (5)
⎤
P D = N ⎢⎢ ⎥⎥
⎣ σ√ 5 ⎦
P D = N (−1.777)
The Expected Credit Loss is as follows:
ECL = Ou tstanding ∗P D∗EAD∗LGD
ECL = x ∗100%∗ 75% ∗3.776%
ECL = 2.832%x
112
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
Loss given default can be calculated using the following formula:
ln (F ) − ln (V ) − (μ) T − 0.5σ2 T
LGD = F ∗ P D − V eμ(T) ∗ N [ ]
σ√T
Where:
N = Cumulative normal distribution
F = face value of zero-coupon bond
T = time to maturity
σ= volatility of the firm's value
ln ($18M) − ln ($16M) − (11%) 7 − 0.5(17%)2 7

= $18M ∗ 11.025% − $16M ∗ e11%(7) ∗ N [ ]
(17%) √7
= $1.9845 million − $1.6241 million
= $0.3604 million
113
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%
The risk-free rate can be computed by working back the Credit Spread formula:
1 D
Credit spread = − [ ∗ ln ( )] − R f
(T − t) F
Where:
(T − t) = remaining maturity
R f = risk-free rate
Hence,
1 80
2% = − [ ∗ ln ( )] − Rf
5 −2 100
2% = − [−0.07438] − Rf
2% − 0.07438 = −Rf
R f = 5.438%
114
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.
20million < /p >< /li >< /ul >< pclass =" view q uestionhtmlmarginb ottom 3 0 "> Thecorrecta
$
(T-t)
E (V,F,T,t) = V × N (d) − Fe −r × N (d − σ√T-t)
= 200 × N (d) − 180e−0.05 ×3 × N (d − 0.1√3)
V
ln ( )
(T-t)
Fe−r 1
d= + σ√T-t
σ√T-t 2
200
ln ( )
180e−0.05×3 1
d= + 0.1√3 = 1.4743 + 0.086603 = 1.5609
0.1√ 3 2
E (V,F,T,t) = 200 × N (1.5609) − 154.9274 × N (1.3877)
From probability tables, N(1.5609) = 0.9407 and N(1.3877) = 0.9174
E(V,F,T,t) = 188.14 − 142.1304 = 46.0096
The value of equity is $46 million
115
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%
1 D
Credit Spread = − ( ) ln ( )−r
T-t F
Where:
(T-t) = time remaining to maturity
R = risk free rate of interest
1 88
Credit Spread = − ( ) × ln ( ) − 0.015 = 0.01057 = 1.057%
5 100
116
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
ln (F) − ln (V) − μ(T-t) + 0.5σ 2(T-t)

probability of default = N ( )
σ√T-t
ln (80) − ln (100) − 0.2(3) + 0.5 (0.32 ) (3)
= N( )
0.3√ 3
= N (−1.3243) = 1 − N (1.3243) = 1 − 0.9073 = 0.0927 = 9.27%
ln (F) − ln (V) − μ(T-t) − 0.5σ2 (T-t)

LGD = F × PD − Veμ(T−t) × N ( )
σ√ T-t
ln (80) − ln (100) − 0.2(3) − 0.5 (0.32 ) (3)
0.2×3
= 80 (0.0927) − 100e × N ( )
0.3√3
= 7.416 − 182.2119 × N (−1.8439)
= 7.416 − 182.2119 × (1 − 0.9673)
= 7.416 − 182.2119 × 0.0327
= $1.4577m
117
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
1 D
Credit Spread = − ( ) ln ( )−r
T-t F
Where:
(T-t) = time remaining to maturity
R = risk free rate of interest
1 780
Credit Spread = − ( ) × ln ( ) − 0.01 = 0.01485 = 1.485%
10 1000
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)
118
D. c(V,U+F,T,t)
The value of the firm is given by the sum of the value of senior debt, the value of subordinate
debt, and the value of equity.
V = D (V,F,T) + SD (V,U,T,t) + S (V,U+F,T,t)
The value of equity is equivalent to a call option on the value of the firm with exercise price
equal to F + U:
S (V,U+F,T,t) = C (V,U+F,T,t)
Collectively, shareholders and subordinated debt holders receive the excess of firm value over
the face value of the senior debt, F, if that excess is positive. Therefore, they have a call option on
V with strike price equal to F. This implies that the value of the senior debt is the value of the
firm V minus the value of the option held by equity and subordinated debt holders:
D (V,F,T,t) = V − c (V,F,T,t)
With the values of equity and debt already determined, the value of subordinated debt can be
obtained by subtracting the value of the equity and that of the senior debt from the value of the
firm.
SD (V,U,T,t) = V − c (V,F+U,T,t) − [V − c (V,F,T,t)]

SD (V,U,T,t) = c (V,F,T,t) − c [V,F+U,T,t]
Note: Current values of senior and subordinate debt have no use in the problem at hand.
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
119
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
D (V,F,T,t) = V − c (V,F,T,t)
The call option is worth $63.56 million. This is the value of equity and subordinate debt
combined. Therefore, the value of senior debt is $36.44 million (= 100M – 63.56M).
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
120
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
The value of the firm is given by the sum of the value of senior debt, the value of subordinate
debt, and the value of equity.
V = D (V,F,T) + SD (V,F,T,t) + S (V,F+U,T,t)
The value of equity is equivalent to a call option on the value of the firm with exercise price
equal to F + U:
S (V,U+F,T,t) = c (V,U+F,T,t)
D (V,F,T,t) = V − c (V,F,T,t)
firm.
121
Looking at the last equation, we see that the value of subordinate debt is given by 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 face value 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
The value of subordinated debt corresponds to two options: a long position in a call option that
increases in value with volatility, and a short position in a call option that becomes costlier as
volatility increases. This scenario leads to ambiguous comparative statics for the value of
subordinated debt.
If the value of the firm is low, there’s a good chance that subordinate debt will not payoff. In
these circumstances, the short position in the call option is economically important. As a result,
subordinate debt is almost similar to equity, and its value is an increasing function of the
volatility of the firm.
If the value of the firm is high, there’s a good chance that subordinate debt will pay off. In these
circumstances, subordinate debt is almost similar to senior debt, and inherits the characteristics
of senior debt. i.e, its value is a decreasing function of volatility
coupon bond with a face value of $110 million. Compute the probability of default using the
122
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
ln (F) − ln (V) − μ(T-t) + 0.5σ 2 (T-t)

probability of default = N ( )
σ√T-t
where:
μ is the expected return on the value of the firm
N is the cumulative normal distribution,
F is the face value of debt,
V is the value of the firm,
T is the maturity date and
σ is the volatility of firm value
ln (110) − ln (130) − 0.2(3) + 0.5 (0.32 ) (3)

PD = N ( )
0.3√ 3
= N (−1.2164) = 1 − N (1.2164) = 1 − N (1.22) = 1 − 0.8888 = 0.1112 = 11.12%
Note that N (−1.22) can be looked at directly from the standard normal tables provided in the
exams:
123
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
124
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

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
The value of equity (denoted S) is given by call option on V with strike price equal to F + U:
S (V,U+F,T,t) = c (V,F+U,T,t)
125
D (V,F,T,t) = V − c (V,F,T,t)
firm.

= 101.68 − 79.84 = $21.84
126
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
One of the inherent assumptions under the Merton model is that there’s zero chance of a jump in
the value of the firm. In reality, that’s hardly true, and the Merton model has been heavily
criticized for it. Most of the default events witnessed catch us by surprise, and the inability to
have jumps in the firm value in the Merton model implies defaults are too predictable while they
are not.
A is false. Jones, Mason, and Rosenfield (1984) assert that the Merton model is outsmarted and
outperformed by a naïve model in predicting default risk with respect to investment grade bonds.
However, the Merton model outperforms the naïve model for non-investment grade bonds.
B is false. The Merton model only works when the firm has a single zero-coupon liability. Multiple
debts with different maturities complicate the valuation process
C is false. The Merton model is able to predict default because it assumes firm value is
lognormally distributed with constant volatility.
127
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
The various ways in which credit spreads can be represented all attempt to decompose bond
interest into two:
I. The part of interest rates that compensates investors for credit and liquidity risks
II. Compensation for time value of money
The discount margin is normally used in the context of floating-rate notes and refers to the fixed
spread over the current LIBOR rate that prices the bond in a precise way. Option B describes a
credit default swap spread. Option D describes an asset swap spread.
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
Bonds in which options have been embedded are analyzed using the option-adjusted spread,
abbreviated as OAS. When there are no options in a bond (or the options expire before the
bond’s maturity), the OAS is equal to the Z-spread.
128
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
The Z-spread (zero-coupon spread) is grounded on the zero-coupon labor curve. Although it’s
defined as the spread that must be added to the labor spot curve so as to arrive at the market
price of a bond, it may also be measured relative to the government bond curve. In some cases,
the forward rate is also used to define the Z-spread.
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
The correct benchmark-spread representation is as follows:
Name of the Spread Benchmark used

I-Spread Swap rates
Z-Spread Libor spot rate
Credit default swap spread Similar bonds of the same issuer
129
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%
The initial spread on January 14th, 2015 was 3.4% – 2.35% = 1.05%.
On January 21st 2015, due to loss of confidence, the spreads tripled. Therefore, the new spread is
1.05% * 3 = 3.15%.
Since Yield = Spread + Basis, the new yield will be calculated as 3.15% + 2.35% = 5.50%.
130
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)
Bond’s yield to maturity = 7.00 = i-spread + Interpolated swap rate = 3.62 + Interpolated swap
rate
Therefore, interpolated swap rate = 3.38.
We know that one of the swap rates (the 3-year rate) is equal to 4.03. In order to get an
interpolated rate of 3.38, the rate of the 4-year swap needs to be less than 3.00.
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
The extent to which a high level of spread attenuates the impact of a spread change depends
primarily on (I) the bond maturity, (II) the level and shape of the swap or the risk-free curve,
and (III) the spread duration.
A bond's maturity is the length of time until the principal must be paid back. A bond duration,
on the other hand, is a more abstract concept often used to measure interest-rate sensitivity.
131
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
To compute the spread01:
Increase and decrease the Z-spread by 0.5 basis points, re-price the bond after each of these
shocks, then compute the difference.
Spread duration is defined as the ratio of the spread01 to the bond price.
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%
We know that:
πt = 1– (1 – π1 )t
Now, π1= 50% and t = 3
π3 = 1 – (1 – 0.5)3 = 1 – 0.125 = 0.875 ≈ 90%
132
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
In the intensity model, even a "bullet-proof" AAA-rated company will default eventually. This
remains true even when we let the hazard rate vary over time.
The hazard rate, also called the default intensity is denoted by λ, and the probability of no
default between now and time t – called the survival time distribution – is given by:
P [ t* ≥ t ] = 1 – P [ t* < t ] = 1 – F(t) = e–λt
If the hazard rate is rising fast enough with the time horizon, the cumulative default probability
may increase at an increasing rather than at a decreasing rate.
133
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
An investor in a defaultable bond receives either $1 or zero in T years. If we assume that R = 0,

the expected value of the two payoffs is:
* *
e-λτ τ × 1 + (1 – e-λτ τ) × 0
The expected present value of the two payoffs is:
τ * *
e(-rτ )[ e λτ τ × 1 + ( 1 - e-λτ τ) × 0]
The risk-neutral hazard rate sets the expected present value of the two payoffs equal to the price
of the defaultable bond. Since the price of the defaultable bond is given by:
e-(rτzτ)τ, we have:
τ * *
e-(rτzτ)τ = e(-rτ )[ e λτ τ × 1 + ( 1 - e-λτ τ) × 0]
This implies λτ* = zτ i.e. when the recovery is zero, the hazard rate is equal to the spread.
134
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
In contrast to most developed-country central governments, private companies do not issue

bonds with the same cash flow structure and the same seniority in the firm's capital structure at
fixed calendar intervals. For many companies, however, CDS trading occurs regularly in
standardized maturities of 1, 3, 5, 7, and 10 years, with the five-year point generally the most
liquid. Therefore, standardization is one of the advantages. The universe of firms on which
CDSs are issued is large. Markit Partners, the largest collector and purveyor of CDS data,
provides curves on about 2,000 corporate issuers globally, of which about 800 are domiciled in
the United States. Therefore, coverage is also an advantage. When CDSs on a company's bonds
exist, they generally trade more heavily and with a tighter bid-offer spread than bond issues. The
liquidity of CDSs with different maturities usually differs less than that of bonds of a given issuer.
For this reason, liquidity is also an advantage of estimating hazard rate from prices of CDSs.
135
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
CDSs are traded in spread terms. When two traders make a deal, the price payable by the
counterparty buying protection is expressed in terms of the spread premium.
Statement II is incorrect. There are CDS on credit indexes.
Statement III is incorrect. Generally, no principal or other cash flows change hands at the
initiation of the contract. However, this is not always the case, when CDS trade points upfront, a
percent of the principal is paid by the protection buyer.
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
Spread curves are typically gently upward sloping. If the market believes that a firm has a stable,
low default probability that is unlikely to change for the foreseeable future, the firm's spread
curve would be flat if it reflected default expectations only.
136
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
For Company A, it can be said that if it survives the early, "dangerous" years, it has a good
chance of surviving for a long time. Therefore, it should have a downward sloping default curve
for the long term. On the other hand, for Company B, the credit has a better risk-neutral chance
of surviving the next few years, since its hazard rate and thus unconditional default probability
has a relatively low starting point.
137
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
For stable and well-established companies, the likelihood of default in the short term is low. So,
such companies would have an upward sloping spread curve. As of Date A, the company had this
type of a curve. Downward-sloping spread curves are unusual – a sign that the market views a
company’s credit status as distressed – which is in the case above, after the tariff announcement.
Therefore, the announcement must have been made after Date A but before Date B.
138
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
1 D
Credit spread = − [ ] × ln( ) − R F
T −t F
1 64
Credit spread = − ( ) × ln( ) − 0.016 = 0.0259
15 120
Credit spread = 2.59% = 259bps
139
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%
i-spread = YTM of corporate bond – YTM of treasury with similar maturity
Since the maturity of the treasuries doesn’t match that of the corporate bond, the yield for the
19 year treasury can be calculated as (5.1%+5.5%)/2 = 5.3%
i-spread = 10% - 5.3%
i-spread = 4.7%
140
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
The cumulative PD for year 3 can be calculated using the formula 1 − e-λt:
Cumulative default PD for year 3 = 1 − e −(0.2)3 = 0.4512
To calculate the conditional probability, find the year 2 cumulative default probability:
Cumulative default PD for year 2 = 1 − e −(0.2)2 = 0.3297
The survival probability for year 2 is 1 – 0.3297 = 0.6703
The probability for year 3 is 0.4512 – 0.3297 = 0.1215
The conditional probability can be found by dividing the probability for year 3 by the survival
probability until year 2 = 0.1215/0.6703 = 0.1813
141
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%
Year 1
Default rate is 0.3% and survival rate at the end of the year is 1-0.3% = 99.7%
Year 2
Default rate is 0.5% and survival rate at the end of the year is S2 = S1 x (1-d2) = 0.997 x (1-
0.005) = 0.992015. Default will be equal to 1-S2 = 1-0.992015 = 0.00799 or 0.799%
Year 3
Default rate is 0.8% and survival rate at the end of the year is S3 = S2 x (1-d3) = 0.992015 x (1-
0.008) = 0.984079. Default will be equal to 1-S3 = 1-0.984079 = 0.01592 or 1.592%
Year 4
Default rate is 1% and survival rate at the end of the year is S4 = S3 x (1-d4) = 0.984079 x (1-
0.01) = 0.974238. Default will be equal to 1-S3 = 1-0.974238 = 0.02576 or 2.576%.
142
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
For callable bonds, the option benefits the issuer (it allows him to buy back the bonds if rates go
down, i.e. bond prices go up), and o > 0. Therefore, OAS < Z-spread.
143
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
To calculate the conditional one-year default probability, we must first determine:
The unconditional one year default probability is given as:

1 − e−λ
= 1 − e−0.398 = 0.3283
The survival probability is given by: e−λ

= e − 0.398 = 0.6717
The unconditional two-year default probability isgiven by:

1 − e−2λ
1 − e−2 × 0.398 = 0.5489
We then take the difference between the two probabilities as: 0.5489 − 0.3283 = 0.2206
Then, we divide the difference with the one year survival probability to get:
0.2206/0.6717 = 0.3284
144
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
Recall that the default time density function is the derivative of the default time distribution with
respect to t:
∂
P [t* < t] = F'(t) = λe-λt
∂t
∂
P [t* < t] = F'(t) = 0.725e−0.725 × 5 = 0.01932
∂t
The survival probability = exp(-0.725*5) = 0.026649:
145
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%
The probability that the bond defaults in Year 3 can be calculated via Bernoulli trial:
P = (1 – 0.06) * (1 – 0.09) * (0.22) = 0.1882 or 18.82%
146
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%
Probability of default in the first year = 1 – e-ƛ = 1 – e-0.12 = 1-0.887= 0.1131
Then probability of survival is = 1 - probability of default = 1 – 0.1131 = 0.887.
Cumulative Probability of default in the second year = 1 – e-2ƛ = 1 – e-0.12*2 = 1 -0.7866 = 0.2134
The conditional one year default probability given that the firm survived the first year is the
difference between the two-year cumulative probability of default and the one-year probability
divided by the probability of survival in the first year = (0.2134 – 0.1131)/0.887 = 0.1131 =
11.31%.
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%
Hazard rate for year 1 is 0.0150/(1-0.4) = 0.025 or 2.5%
The average hazard rate for all three years is 0.0195/(1-0.4) = 0.0325 or 3.25% per annum.
147
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
λT = 0.05/(1-0.3) = 0.07143
148
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%
Since the recovery rate is 0%, we solve for the risk-neutral 1-year probability of default using the
following equation:
FV
1 + r = (1 − π) × ( )
MV
FV = $25,000,000; MV = $25,000,000*0.95= $23,750,000; r=2%
We then solve for π:
Risk-neutral 1-year probability of default = π = 0.031 or 3.1%
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
149
B. 0.0304
C. 0.0441
D. 0.006
Interpolated spread (i-spread), therefore, can be defined as the difference between the yield of a
credit-risk bond and the linearly interpolated yield for the same maturity on an appropriate
reference yield curve. We estimate the spread by extrapolating the yield of risk-free securities
whose maturities flank that of the risky debt. Because the maturity of the ABC bond (9 years)
does not match exactly with the maturity of the quoted Treasury bonds (8 and 10 years), we will
have to interpolate the yields for the two Treasuries using the following formula:
Yield at longer maturity-yieldatshortermaturity

=
Number of periods between maturity points
6.69% − 5.47%
= = 0.305%
4
The 9-year ABC bond has two maturity periods more than the 8-year U.S. Treasury.
Thus, its YTM is equal to
YTM = 5.47% + 2(0.305%) = 6.08%
Thus,
i-spread =10.49% -6.08%= 4.41%
150
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
Spread01 is a measure of the change in the value of a credit-risky bond for a one basis point
change in spread. Spread01 is also called DVS1.
Spread01 = $92.56 - $92.35 = $0.21 per basis point
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
151
B. 148.9
C. 145.5
D. 104
Recall that the Z-spread is the basis-point spread that would need to be added to the LIBOR spot
yield curve such that all the discounted cash flows of a bond are equal to its present value
(current market price of the bond). Spread01 is a measure of the change in the value of a credit-
risky bond for a one basis point change in spread. Given that the bond has a z-spread of 4.0%,
we can work out the spread01 by computing the bond price given a z-spread of 4.005% (= 4.0%
+ 0.5bps/100) and 3.995% (= 3.0% - 0.5bps/100), respectively.
With a z-spread of 4.005%,
Bond price = $5.0 exp [− (1.0% + 4.005%) 0.5]

+ $5.0 exp[− (2.0% + 4.005%) 1.0]$105 exp [− (3.0% + 4.005%) 1.5]
= 4.87643 + 4.70859 + 94.52699 = $104.11201
With a z-spread of 3.995%,
Bond price = $5.0 exp [− (1.0% + 3.995%) 0.5]

+ $5.0 exp[− (2.0% + 3.995%) 1.0]$105 exp [− (3.0% + 3.995%) 1.5]
= 4.87667 + 4.70906 + 94.54117 = $104.1269
Thus, spread01 per $100 par value = $104.1269 - $104.11201 = $0.01489
1, 000, 000
Per $1,000,000 par value, spread01 = $0.01489 × = $148.9
100
152
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
Each of these credit spreads attempt to break down bond interest into two:
I. Compensation for credit and liquidity risk and

II. Compensation for the time value of money (TVM)
153
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
Credit spread can be approximated as:
Credit spread = (1 – recovery rate) * default probability
For BW, 300 bps = (1 – RR)8%
Thus, RR = 1 - 3/8 = 62.5%; LGD = 37.5%
For ST, 400bps = (1 – RR)15%
Thus, RR = 1 – 4/15 = 73.3%; LGD = 26.7%
Clearly, the recovery rate is lower for BW.
154
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
A portfolio of credit-risky investments may include bonds, commercial paper, guarantees (off-
balance sheet exposures) as well as credit derivative instruments, such as credit default swaps.
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
While modeling a single credit-risky process, the elements of risk and return that are usually
taken into account include:
The probability of default
The probability (and severity) of rating migration
The loss given default
The possibility of changes in a company’s gearing (debt-equity structure)
Spread risk
155
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
Debt restructuring can occur through direct negotiation among stakeholders such as
shareholders, creditors, or even suppliers. It can also follow the bankruptcy channel opened by
the firm itself. Similarly, a judicial ruling can lead to debt restructuring.
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
The expected credit loss, (ECL), is given by:

ECL = ∑ P i × Di × (1 − Ri )
Where:
Pi = portfolio value of asset i
Di = probability of default of asset i
Ri = Recovery rate for asset i
ECL = 30 , 000, 000 × 0.01 × 0.2 + 20 , 000, 000 × 0.025 × 0.4
ECL = $260, 000
156
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)
If the two default events are independent, the joint default probability is π1 × π2 = π12 and the
default correlation ρ12 = 0.
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%
The joint default probability is given by the formula:
π 12 = ρ12√ π1 (1 − π 1 )√π 2 (1 − π2 ) + π1 π 2
Given π1 and π2,
0.2% = ρ12√ 0.003(1 − 0.003)√0.004(1 − 0.004) + 0.003 × 0.004
⇒ ρ12 = 0.5785 = 57.85%
157
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
Joint default probability is given by the formula:
π12 = ρ12√(π 1 (1 – π1)) √(π 2 (1 – π2)) + π1 π2
Given π1 and π2 are equal, we can express π2 in terms of π1

π12 = ρ12√(π 1 (1 – π1)) √(π 1 (1 – π1)) + π1 π1
π12 = ρ12 × π1 (1 – π1) + π12
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
The number of pairwise correlations required to model the credit risk of a portfolio of N credits
is given by the formula N(N-1). Here N=10, so the number of correlations is equal to 10 * 9. =
90.
158
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
Since there are only two distinct entities, we will have just one default correlation. If the credits
belonged in more than 2 entities, the number of pairwise correlations required to model the
credit risk would be given by the formula N(N-1)
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
CDS-based trades are driven by “technical factors rather than market/credit risk and, therefore,
they do not fit well into the portfolio credit risk framework. Option B is also incorrect because
guarantees, revolving credit agreements, and other contingent liabilities behave much like credit
options. Equity and equity vega risk can be as important in convertible bond portfolios as credit
risk.
159
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%
Let:
D1 = probability of default by firm 1 and
D2 = probability of default by firm 2
ρ12 =correlation of defaults
The Joint probability of default is given by:
P (D1 D2 ) = D1 × D2 + ρ12 × √(D1 (1 − D1 ))√(D2 (1 − D2 ))
Since the defaults are correlated
P (D1 D2 ) = 5% × 1% + 0.2 × √(5%(1 − 5%)√(1%(1 − 1%) ≈ 0.484%
N/B: If the defaults were uncorrelated,
i.e., ρ12=0
P (D1 D2 ) = 5% × 1% = 0.05%
This means that the joint probability of default for correlated defaults is nearly 10 times higher
than the one for uncorrelated defaults.
160
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
In addition to the probability of default, default correlation, and loss given default, analysts
model ratings migration in order to measure credit portfolio risk.
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
If default correlation is set to 1, the riskiness of the portfolio is maximized, as the whole portfolio
acts like one credit.
With a default correlation of 1, either the entire portfolio defaults – with a probability of π – or
none of the portfolio defaults. Put differently, if default correlation is equal to 1, the portfolio
behaves as though n = 1, regardless of the actual value of n.
161
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
Since, we have a common obligor in all credit positions, the default correlation is 1. As such, the
portfolio will act as if we have only one credit, not 10!
This in turn allows us to look at the portfolio as a binomially distributed variable with a total loss
probability of 5% or a zero loss probability of 95%. Therefore, with a recovery rate of zero, the
loss given default is $1m.
The expected loss is given as the total value of the portfolio times the probability of default, i.e.
(5% × 1,000,000) = $50,000.
By definition, credit VaR is the quantile of the credit loss less the expected loss.
Credit VaR = 1,000,000 – 50,000 = 950,000
162
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
A default correlation equal to 0 implies the portfolio is a binomial-distributed random variable

because there is no correlation with
other firms/credits. In this case, the number of defaults would be binomially distributed with n =
100 and θ = 0.03
What's more each credit has a volume of $10,000 (=$1000,000/100)
The expected loss = 1,000,000 × 0.03 = 30,000
If there are 4 defaults, the credit loss is $10,000 × 4 = $40,000
Credit VaR = credit loss – expected loss = 40,000 – 30,000 = $10,000
163
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%
π 12 = ρ12√ π1 (1 − π 1 )√π2 (1 − π2 ) + π1 π 2
= 0.1√0.004(0.996)√ 0.010(0.99) + (0.004)(0.01)

= 0.000668
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%
The joint default probability between 1 and 2, π12 is given by:

π 12 = ρ12√π1 (1 − π 1 ) × √π2 (1 − π 2 ) + π1 π 2
π 12 = 0.05√0.025(1 − 0.025) × √0.035(1 − 0.035) + 0.025 × 0.035
π 12 = 0.05 × 0.15612 × 0.18378 + 0.000875
π 12 = 0.00231
164
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%
The default correlation is calcualated using the following formula:
π12 − π 1 π 2
ρ12 =
√π 1 (1 − π1 )√π2 (1 − π2 )
0.00035 − (0.008 × 0.004)
=
√0.008(1 − 0.008)√0.004(1 − 0.004)
= 0.05654 or 5.65%
165
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
π 12 = ρ12 √π 1 (1 − π 1 )√π 2 (1 − π 2 ) + π 1 π 2
We solve it
= 0.09 √0.0065(1 − 0.0065) × √0.0125(1 − 0.0125) + 0.00008

= 0.000885 which is almost 10 times higher than 0.00008
166
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
At the 99% confidence level, the default loss level has a default probability, Tt, of 0.01. A default
loss level of 0.01 corresponds to -2.33 on the standard normal distribution. The relationship
between the default loss level and the given market return is:
k − βm
∅ −1 (x) =
√1 − β 2
{−2.33 − 0.8m}
=
√(1 − 0.82 )
⇒= −1.165
167
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
With the default correlation equal to 1, the portfolio will act as if there is only one credit.
Viewing the portfolio as a binomial distributed random variable, there are only two possible
outcomes for a portfolio acting as one credit.
The portfolio has a 4% probability of total loss and a 96% probability of zero loss. Therefore, with
a recovery rate of zero, the extreme loss given default is $4,000,000.
The expected loss is equal to $160,000 (0.04 x $4,000,000).
The credit VaR is defined as the credit loss minus the expected loss of the portfolio.
At a 99% confidence level, the credit VaR is equal to ($4,000,000 - $160,000) = $3,840,000.
168
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
Since the default correlation is equal to 1, the portfolio will act as if there is only one credit.
Viewing the portfolio as a variable that takes on the binomial distribution, there are only two
possible outcomes for a portfolio acting as one credit - total loss with a probability of 3%, or zero
loss with a probability of 97%.
With a recovery rate of zero, the extreme loss given default is the entire portfolio amount, i.e.,
$1,000,000. The expected loss is equal to the portfolio value times π
Expected loss = 0.03 x $1,000,000 = $30,000.
The credit VaR is defined as the quantile of the credit loss less the expected loss of the portfolio.
At the 99% confidence level, the credit VaR is equal to $970,000 ($1,000,000 minus the expected
loss of $30,000).
Note that if π was less than (1 — confidence level), the credit VaR would have been calculated as
0 — $30,000 = -$30,000.
169
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
π12 − π 1 π 2
ρ12 =
√π 1 (1 − π 1 )√π 2 (1 − π 2 )
0.00018 − (0.002) (0.004) 0.000172
ρ12 = =
√0.002 (1 − 0.002)√0.004 (1 − 0.004)(0.044677 × 0.063119)
= 0.060994
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
If default correlation in a portfolio of credits is equal to 1.0, then there are no diversification
benefits, and the portfolio behaves as if it consisted of just one credit. In case default correlation
is equal to 0, then the number of defaults in the portfolio is a binomially distributed random
variable because there is no correlation with other firms in the portfolio. In this case, significant
credit diversification may be achieved
170
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
Since the default correlation equals 1, the entire portfolio will act as if it is a single credit. Thus,
either the entire portfolio defaults, with a probability of π , or it doesn’t. Regardless of the value
of n, say, 5, 10, 20, 50, etc., the portfolio will behave as if n = 1.
The expected loss is equal to π × total value of the portfolio = 2%× $100,000,000 = $2,000,000
There is a 98% probability that the loss will be zero, because π = 2%. We calculate the credit VaR
as the quantile of the credit loss minus the expected loss of the portfolio. At 95%, therefore, the
credit VaR is equal to -$2000,000 (= 0 - $2,000,000)
171
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
For n = 50, each position has a future value, if it doesn’t default, of $2,000,000. The expected
loss is $2,000,000 (total portfolio value times the probability of default = 0.02 × 100,000,000 )
which is the same as for a single-credit portfolio. If there are three defaults, the credit loss is
$6,000,000 (= 3 × $2000,000). The credit VaR at the 95% confidence level is $4,000,000 (credit
loss of $6,000,000 less the expected loss of $2,000,000)
172
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
Since all positions are obligations from the same obligor, the implication is that the default
correlation is 1, and the entire portfolio with behave as if it is a single credit. In this case, we can
view the portfolio as binomial distributed random variable that has two possible outcomes. The
portfolio has a 4% probability of total loss and a 96% probability of zero loss. With a recovery
rate of zero, the extreme loss given default is $10,000,000.
The expected loss is $400,000 (total portfolio value times the probability of default = 0.04 ×
10,000,000). The credit VaR is defined as the quantile of the credit loss less the expected loss of
the portfolio. At 99% confidence,
Credit VaR = $10,000,000 - $400,000 = $9,600,000
173
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
In a situation where there are N credits in the portfolio, we must define N default probabilities
and N recovery rates. What’s more, we require N(N-1) pairwise correlations.
In this case, there are 9(8) = 72 pairwise correlations
174
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
Assuming market factor m takes on a particular value m̄ . Default risk, as measured by the
distance to default,ai − βi m
¯ , increases or decreases, and the only random parameter is the
idiosyncratic shock, εi .
ai − βi m̄ + √1 − β2i ε i
i = 1, 2, …
Setting a specific value for m makes the default distribution’s mean shift based on the value of
beta,βi that is greater than zero. Although the default threshold, ki doesn’t change, the standard
deviation of the default distribution decreases from 1 to √1 − β2i
While the unconditional default distribution is a standard normal distribution, the conditional
¯ and a standard deviation of √1 − β2i

distribution is a normal distribution with a mean of βi m
175
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
Covered bonds are debt securities issued by big banks (mainly German and Danish) or mortgage
institutions and collateralized against a pool of mortgage loans. In case the issuer fails, the
mortgage pool can be used to cover the outstanding claims at any point in time.
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
Covered bonds are debt securities issued by a bank or mortgage institution and collateralised
against a pool of assets that, in case of failure of the issuer, can cover claims at any point of time.
They are subject to specific legislation to protect bondholders. Because the underlying assets
remain on the issuer’s balance sheet, covered bonds are not considered as full-fledged
securitizations.
176
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
Mortgage pass-through securities are widely considered true structured products/securitizations

because the associated cash flows and credit risk emanate directly from the pool of underlying
assets (mortgage loans). Such assets are completely detached from the mortgage originator’s
balance sheet, and are put under the management of a servicer who collects principal and
interest payments from the loans and then distributes them to bondholders. Since the principal
and interest are “passed through” from the assets, cash flows to bondholders depend on both the
amortization schedule and voluntary payments by the mortgagor.
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
Bullet bonds receive full repayment of principal at once on the maturity date i.e., there is no
amortization. Hence, there’s no prepayment risk.
Note: The emphasis here’s on prepayment risk, not repayment risk.
177
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.
Statement I is incorrect. Senior tranches are perceived to be the safest as they rank first during
the distribution of income from the underlying pool. As such, they receive the lowest coupon.
Statement II is incorrect. Whereas the mezzanine tranche usually receives a fixed coupon that's
slightly higher than that received by senior bondholders, the equity tranche receives residual
cash flows and no explicit coupon. In other words, equity holders are more like shareholders in
an ordinary company and enjoy whatever that's left after the entity has settled all other
obligations.
Statement III is correct. The senior tranche is the thickest tranche, followed by the mezzanine
tranche. The equity tranche is typically the thinnest slice.
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
Structured products are usually set up as special purpose entities or vehicles, also known as
trusts. Commercial paper is an unsecured financing tool issued by a firm against its account
receivables or inventories. It’s used to cover short-term liabilities. Unlike structured products,
commercial paper is not backed by any form of collateral. In fact, issuers tend to be well
established and financially strong institutions with high credit ratings.
178
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
Put simply, collateralized debt obligations are securities that result from the securitization of
other already securitized instruments. This essentially means issuing bonds against a collateral
pool consisting of asset-backed securities or 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
Equity takes the form of a note with a specified notional value that is entitled to the residual cash
flows after all the other obligations of the SPE have been satisfied. It typically receives no fixed
coupon payment but is fully exposed to defaults in the collateral pool.
179
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
Overcollateralization (OC) is the process of posting more collateral than is needed to obtain or
secure financing. Overcollateralization is often used as a method of credit enhancement by
lowering the creditor's exposure to default risk. Overcollateralization provides credit
enhancement for all the tranches of a securitization.
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
Equity tranches of a securitization portfolio will be paid after all the other obligations of the SPE
are satisfied.
180
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
If you have we rank these according to the Fixed Coupon Payments made to the investor then it
would be: Equity < Senior Debt < Junior Debt (from the less risky to the most risky) Junior debt
earns a relatively high fixed coupon or spread. Senior debt earns a relatively low fixed coupon or
spread. Equity tranches typically receive no fixed coupon payment.
181
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);

A tranche of CDO is defined by attachment and detachment points. The attachment point defines
the amount of subordination a tranche enjoys. The tranche thickness, measured by subtracting
the attachment point from the detachment point, represents the maximum loss that can be
sustained.
Tranche attachment and detachment points refer to portfolio losses, not defaults. Assuming a
loss given default of 50 percent, the 7 to 10 percent tranche can withstand defaults of up to 14
percent of the portfolio (14% * 50% = 7%, the attachment point) before it sustains losses.
The equity tranche has only 1 detachment point, while the most senior debt has only 1
attachment point.
182
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
Collateral interest: (0.050 + 0.0350) × $100m = $8.5m
Senior interest: (0.050 + 0.0050) × $85m = $4.7m
Mezzanine interest: (0.050 + 0.050) × $10m = $1.1m
183
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
5% default rate implies 100 × 5% = 5 defaults in the first year.

Defaults in the second year = 5% × (100 - 5) = 4.75
Defaults in the third year = 5% × (95 - 4.75) = 4.5125
Defaults in the fourth year = 5% × (90.25 - 4.5125) = 4.2869
Defaults in the fifth year = 5% × (85.7375 - 4.2869) = 4.0725
That's approx. 4 defaults in year 5.
Q.1857 Which of the following is equivalent to systematic risk?
A. Default correlation
B. Credit VaR
C. Tranche thinness
D. Granularity
High default correlation is one way of representing high systematic risk.
184
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
There are three types of tranches in a structured product: Equity, Junior, and Senior. The equity
tranches receives no coupon payment and is the first to be exposed to losses. The junior tranches
receive a relatively high fixed coupon payment compared to the senior tranches and are
protected by the equity tranche. They are also known as mezzanine tranches. Senior tranches
receive a relatively low fixed coupon payment compared to junior tranches and are protected by
the equity and junior tranches.
185
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
In a structured solution, all portfolio losses are first absorbed by the equity tranche. Only after
the equity tranche has been exhausted, are the losses applied to the junior and senior debt
tranches, respectively. For a $800 million loss, the equity tranche will absorb $500 million and
then the remaining $300 million will be applied to 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
Waterfall structure in securitization refers to the rules about how cash flow from the collateral is
distributed to the various securities in a capital structure.
186
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.
The simulation process starts by first determining the parameters for the valuation, then uses
them to simulate the default times for each security and finally computes the credit loss which
can be generated from the collateral pool in each period.
187
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
A mortgage pass-through security is a security created when mortgages are pooled to create a
product that’s marketable in form of shares – often called participation certificates. The
holder is entitled to a pro-rata share of all principal and interest payments made on the pool of
mortgage loans. A pool can consist of several thousands of mortgages.
B is incorrect. A collateralized mortgage obligation (CMO) is a fixed income security that uses
mortgage-backed securities as collateral. CMOs are subdivided into tranches that vary in
interest and risk based on the maturity structure of the mortgages.
C is incorrect. Covered bonds are debt securities issued by banks that are guaranteed by a
secure cover pool consisting of mortgage loans. The cover pool - assets designated as security for
the bond – stay on the balance sheet of the issuer. However, the pool is segregated from other
assets in case of a winding up.
D is incorrect. CDOs are Securitizations that repackage other securitizations. They may come in
form of a bond issued against a collateral pool consisting of ABS, MBS, or CLOs), collateralized
mortgage obligations (CMOs), or collateralized bond obligations.
188
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
Covered bonds are NOT considered fully-fledged structured products. There are two main
reasons:
The underlying assets remain on the issuer’s balance sheet. In most cases, structured
products are held off the balance sheet often in special purpose entities.
Covered bonds are a non-recourse form of financing. Principal and interest payments to
bondholders are paid out of the issuer’s general cash flows rather than out of the cover
pool’s direct cash flows.
189
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
A large percentage of pass-throughs carry implicit or explicit U.S. Federal guarantee of
performance, making default risk less of a concern to the investor. Covered bonds rarely come
with such a guarantee. Thus, Mary is actually exposed to more default risk compared to Andrew.
B is correct. In covered bonds, the cover pool - assets designated as security for the bond – stays
on the balance sheet of the issuer. In mortgage pass-through securities, on the other hand, assets
are held off balance sheet via a special purpose vehicle/entity.
C is correct. With covered bonds, prepayment risk remains with the issuer. Mortgage pass-
throughs, on the other hand carry prepayment risk, where the homeowner may return principal
earlier than scheduled. Prepayment implies that the investor loses out on interest that would be
paid on that part of principal.
D is correct. In both products, the pool is segregated from other assets in case of a winding up.
These assets cannot be used to settle claims from other stakeholders before all the claims from
investors in the covered bonds or mortgage pass-throughs have been met.
190
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)
The calculations are as follows:
Libor + Spread Principal amount Annual interest

Collateral 0.05 + 0.04 $100, 000, 000 $9, 000, 000
mezzanine 0.05 + 0.05 $10, 000, 000 ($1, 000, 000)
senior 0.05 + 0.02 $85, 000, 000 ($5, 950, 000)
Excess spread $2, 050, 000
Since $2,050,000 > $2,000,000, $2,000,000 goes to equity holders and $50,000 goes into the
trust account.
191
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
The interest rate on the collateral pool is 9% (= 0.05 + 400/100)
Since the default rate is 5% per year, the implication is that on average, about 5 loans will
default over the year. Thus, the total collateral cash flows in the first period =
$100, 000, 000 ∗ 9% ∗ (1– 0.05) = $8, 550, 000
The senior tranche equity holders receive $5 , 950, 000 (= $85 , 000, 000 ∗ 7%)
Mezzanine tranche bondholders receive $1, 000, 000 (= $10 , 000, 000 ∗ 10%)
Excess spread(residual cash flow) = $8, 550, 000– ($5, 950, 000 + $1, 000, 000) = $1 , 600, 000
Since $1,600,000 < $2,000,000, all of the excess spread is claimed by the equity holders and
there is zero cash inflow into the trust account.
192
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
OTC derivatives are more significant due to the size and diversity of OTC derivatives market and
the fact that a significant amount of risk is not collateralized.
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
The common underlying characteristic of the lending risk is that the notional amount at risk is
known at any time during the life of the contract with some degree of certainty. For example,
when buying a bond, the notional amount at risk is close to par. Variable such as a floating rate
of interest only creates moderate uncertainty over the amount owed.
193
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
Since the value of the contract can be positive or negative, counterparty risk is typically
bilateral. In other words, in a derivatives transaction, each counterparty has a risk to the other
counterparty.
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
Settlement risk arises at final settlement if there are timing differences between when each
party performs on its obligations under the contract.
194
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
Settlement risk gives rise to much larger exposures; default prior to the expiration of the
contract is substantially more likely than default at the settlement date.
195
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
Spot contracts mainly have settlement risk while long-dated swaps mainly have pre-settlement
risk.
196
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
In this situation, the investor would be exposed to pre-settlement loss of just the difference in
market value between the dollar and euro payments.
Since the difference is 0.05, i.e. (1.35 – 1.3),
Pre-settlement loss = €2m × 0.05 × USD/EUR = $100,000
Following the movement in exchange rates, the contract is now out of the money with regard to
the investor because although they can now fetch a better exchange rate on the market, they
must honor the terms of the contract and settle the contract at a lower rate.
197
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
Marking to market refers to the daily settling of gains and losses due to changes in the market
value of the underlying securities. When the mark-to-market value is positive, it indicates the
counterparty owes the firm and, when the mark-to-market value is negative, the firm owes the
counterparty.
In this scenario, the bank owes the counterparty some $35 million but is owed $31 million
without netting.
With netting, the bank has a net exposure of -$4 million (= -$35 m + $31 m).
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
Exchanges have been used to trade financial products for many years. An exchange promotes
market efficiency and enhances liquidity by centralizing trading in a single place.
198
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
One of the factors that have heavily influenced the popularity of OTC products is the ability to
tailor (customize) contracts more precisely to client needs.
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
A key aspect of derivatives products is that their exposure to counterparty risk is substantially
less than that of an equivalent loan or bond.
199
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
The repurchase price is greater than the original sale price with the difference effectively
representing the repo rate, which is essentially equal to an interest rate on the transaction plus
any counterparty risk charge.
200
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
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.
Option B is incorrect. The main benefit of repos to borrowers is that the repo rate is less than
borrowing from a bank.
Option C is incorrect. Repurchase agreements are short-term collateralized loans used by major
financial institutions to obtain short-term funding.
201
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
Central counterparties can create moral hazard and information asymmetry problems by
eliminating the incentive for market participants to monitor carefully the counterparty risks of
one another.
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
Large derivatives players normally maintain a presence across several asset classes. It’s only
small derivatives players that can specialize in a single asset class. For example, some
corporations trade only foreign exchange products or may only be active in interest rate and
inflation products.
202
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
Historically, the large derivatives players have had much stronger credit quality than the other
participants.
It is worth noting that some small players, such as sovereigns and insurance companies, have
had very strong (AAA) credit quality and have used this to obtain favorable terms such as one-
way collateral agreements.
203
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
The recovery rate is opposite to the loss given default amount. This can be seen from the
equation given above.
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
The recovery rate is a fraction between 0 and 1 and can be determined by the expression:
RR = Amount of Loan Recovered/Total Exposure

It can also be expressed as 1-Defaulted Amount/Total Exposure
Or alternatively, it can be expressed as RR = 1 − LGD
204
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
Repo contracts and OTC derivative contracts like interest rate swaps and FX forwards are both
vulnerable to counterparty credit risk. However, exchange-traded derivative contracts like
commodities futures are exposed to minimal counterparty credit risk because of the presence of
a central exchange, which acts as a counterparty to all transactions. However, existence of
central counterparties can reduce the incentive of participants to carefully assess and monitor
counteparty risk, which could cause problems such as operational and liquidity risks.
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
To maximize the befits of netting, the suggestion of CVAs is to minimize the number of trading
counterparties while Credit Limits encourage more trading counterparties in order to create
smaller exposures and thus more diversification.
205
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.
The risk of a counterparty defaulting prior to the final settlement of the transaction is usually
referred to as pre-settlement risk and is mainly associated with counterparty risk. On the other
hand, settlement risk occurs due to differences in timing between periods that parties perform
on their obligations under the agreement at the time of settlement.
206
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
Expected loss in year 1 and year 2 can be computed as follows:
$50 m il lion ∗7%∗ 75%∗ 80%

Present Value of Expected loss in Y ear 1= = 2.02166
(1+7.9%) .5
$50 m il lion ∗9.5% ∗35% ∗80%

Present Value of Expected loss in Y ear 2= = 1.186641
(1+7.9%)1.5
Total = 3.2083m
207
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
In this situation, the institution has no volatility of its overall profit and loss and, consequently,
no market risk. However, they do have counterparty risk with respect to both counterparties A
and B since, if either were to default, that would leave the other side of the trade exposed to risk
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
The ISDA specifies the general terms of the agreement between parties with respect to general
issues such as netting, collateral, the definition of default, and other termination events.
208
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
Closeout netting allows the termination of all contracts between the insolvent and a solvent
counterparty, together with offsetting of all transaction values.
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
Payment netting covers all cases where a financial institution needs to make and receive more
than one payment during a single day. This mechanism allows the institution to aggregate same-
day cash flows into one net payment. In this case, the institution would need to make a single net
payment of $5m, with the $200m payment having no associated risk.
209
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
In hedging, it would be unwise to use the same asset(s) in an attempt to offset unfavorable
market movements. For example, airlines use a combination of swaps, collar hedges, and futures
contracts to hedge against the fluctuation of jet fuel prices. In such a situation, an airline can do
business with a single counterparty all along.
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
The total exposure with netting is 1 (= 7 + 5 + 8 - 7 - 4 - 2 - 6)

Without netting, total exposure = 20 (= 7 + 5 + 8)
210
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
The purpose of closeout netting is to make timely termination and settlement of all net values of
trade against the counterparty. This mechanism allows the termination of all agreements
between an institution and the defaulting counterparty and also allows for counterbalancing of
the amounts between them to reach a net payment. If the institution owes money, then it makes
this payment, while if it is owed money, then it makes a bankruptcy claim for that amount.
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
Without netting, the loss in the event of default of a counterparty is the sums of the value of the
transactions with that counterparty that have positive MtM value. This means that derivatives
with a negative value have to be settled (cash paid to the defaulted counterparty) while those
with a positive value will represent a claim in the bankruptcy process.
211
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
Total exposure without netting = $4 million + $7 million + $2 million = +$13 million
Total exposure with netting $13 million - $5 million - $3 million = +$5 million
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
A very important point regarding netting sets is that quantities such as expected exposure and
CVA are non-additive. This is beneficial since the overall risk is likely to be substantially reduced.
212
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
Netting means that the overall credit exposure in the market grows at a rate that’s lower than
the national growth rate of the market itself.
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
Legal issues regarding the enforceability of netting arise due to trades being booked with
various different legal entities across different regions. The legal and other operational risks
introduced by netting should not be ignored.
213
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
Additional termination events (ATEs), or the so-called break clauses, make it possible for an
institution to terminate a trade prior to the deterioration of the counterparty’s creditworthiness
to the point of bankruptcy.
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
Break clauses may occur at one or more pre-specified dates in the future and may be used by one
or both counterparties to the transaction. If the break is exercised, then the exercising party can
terminate the transaction at its current replacement value.
214
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
“Mandatory” means that the transaction will definitely terminate at the date of the break clause.
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
The problem with optional break clauses is that they need to be exercised early before the
counterparty's credit quality declines significantly and/or exposure increases substantially.
215
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
A trigger-based break clause can be exercised at the specified date as long as there’s been a
rating downgrade trigger, regardless of the reaction of the defaulting counterparty.
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
A walk-away feature does not reduce credit exposure. Rather, it allows an institution to benefit
from ceasing payments without being obliged to settle amounts owed to the other party.
216
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
One of the big disadvantages of multilateral netting is that it tends to mutualize and homogenize
counterparty risk, reducing incentives for institutions to scrutinize the credit quality of
counterparties.
Options B and C are incorrect. A way to attempt multilateral netting without the complexity of a
membership organisation (such as an exchange or central counterparty) is via trade
compression. Trade compression will reduce operational costs and also minimize counterparty
risk.
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
When offsetting transactions are replaced with a net equivalent transaction, legal uncertainties
are inevitable. However, this is not a risk-mitigating feature of the ISDA Master Agreement but
an effect that compression aims to reduce.
217
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.
Presettlement risk is the risk of loss due to the counterparty’s failure to perform on an obligation
during the life of the transaction. This includes default on a loan or bond or failure to make the
required payment on a derivative transaction.
Presettlement risk exists over long periods—years—starting from the time it is contracted until
settlement. This type of risk is reduced by close-out netting which is applied, with a heavy heart,
by a non-defaulting party, when the other party defaults.
In contrast, settlement risk is due to the exchange of cash flows and is of a much shorter-term
nature. This risk arises as soon as an institution makes the required payment and exists until the
offsetting payment is received. This type of risk is reduced by payment netting, which is, in fact,
an operational convenience gladly applied during the life of a derivatives trading relationship.
218
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
Cliff-edge effects are dramatic consequences due to attempts by multiple counterparties to

terminate transactions or demand other risk-mitigating actions caused by a rating downgrade. It
is caused by mechanistic over-reliance on ratings by investors.
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
If a particular sovereign bond has a haircut of 3% and a collateral call of $500,000 is made, only
97% of the collaterals value is credited for collateral purposes.
That is, in order to satisfy a $500,000 collateral call, $515,464 ($500,000 / 0.97) of the sovereign
bond must be posted.
219
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
The fact that collateral agreements can be two-way means either counterparty would be required
to post collateral against a negative mark-to-market value (from their point of view).
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
Collateral posted against derivatives positions is under the control of valuation agents and
maybe liquidated immediately upon an event of default. This is unlike in debt contracts where
the collateral is usually liquidated after a court process. In the case where large counterparties
are trading with smaller counterparties, one of the parties may be the valuation agents for all
purposes. Alternatively, both counterparties may be the valuation agent, and in some cases, a
third party may be used as a valuation agent.
220
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
Collateral management should not be a way to dodge capital requirements. Rather, it can be a
way to seamlessly comply with, and reduce such requirements. For instance, the Basel capital
rules give capital relief for collateralized exposures.
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
Option D least rarely plays out in any mortgage arrangement. All other options are examples of
“secondary” risks.
221
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
A haircut of 2%, means that for every unit of a security posted as collateral, only 98% of credit
(“valuation percentage”) will be given. In this case, collateral with a market value of $81.63
million will be required, i.e., $80/)1-0.02) = $81.63
222
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.
From the perspective of the financial institution, a positive MtM implies that the trade is in the
money. As such, the institution will call for collateral from the counterparty. Otherwise, if the
MtM is negative, the trade is in the money in favor of the counterparty. As such the institution
itself will have to post collateral. A is incorrect. In case of a positive MtM, the institution will be
"gaining and will therefore request for collateral. Otherwise if the MtM is negative, the
institution will be "losing" and will therefore be required to post collateral. C is incorrect. In case
of a negative MtM, the institution will have to provide collateral. If the MtM is positive, the
counterparty will be required to provide collateral. D is incorrect. Although the credit ratings of
counterparties are sometimes considered when deciding whether to include a collateral clause in
the contract, a lower credit rating relative to the counterparty does not necessarily mean that
the institution will have to provide collateral. The decision will depend on other factors such as
the current financial standing, other outstanding trades, and the actual rating of the institution.
223
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
A Credit Support Annex forms part of an ISDA master agreement. It regulates the collateral held
by two parties engaging in an ISDA agreement by setting forth the rules that govern mutual
posting of collateral. In other words, a Credit Support Annex is a legal document which regulates
credit support (collateral) for derivative transactions.
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
The CSA forms part of an ISDA agreement. For the CSA to be enforceable, it must be contained
in a signed ISDA agreement.
224
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
“Threshold” defines the level of MtM above which collateral is posted. When the exposure is
above the threshold, the threshold amount is under-collateralized. When the exposure is below
the threshold, then it is not collateralized at all.
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
Thresholds and independent amounts essentially work in opposite directions. Mathematically, an

independent amount is a negative threshold, and vice versa.
Q.1904
225
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
There are two reasons why exposure cannot be fully mitigated by way of collateral. Firstly, the
presence of a threshold means that a certain amount of exposure cannot be collateralized.
Secondly, the delay in receiving collateral and parameters such as the minimum transfer amount
create a discrete effect, as the movement of exposure cannot be tracked perfectly.
2 is incorrect. Collateral values of collateral can be determined with considerable accuracy. 4 is

incorrect. Both collateral values and exposure values are continuous variables
226
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
Credit quality and credit ratings are usually calculated and measured by rating agencies.
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
Besides liquidity issues, non-cash collateral also creates the problems of reuse and
hypothecation. Volatility arising from the price uncertainty also serves to discourage market
players from using/accepting non-cash collateral.
227
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
If the difference in valuation or disputed amount is within the tolerance level as specified in the
collateral agreement, then the counterparties may "split the difference." Otherwise, it will be
necessary to find the cause of the discrepancy.
228
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.
Reconciliations aim to minimize the chance of a dispute by agreeing on valuation figures even
though the resulting netted exposure may not lead to any collateral changing hands. This can
even be performed using dummy variables prior to the commencement of the contract.
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
Smaller institutions with limited funding and operational strength may prefer a margin call
frequency longer than daily. This gives them enough time to gather the necessary funds and also
reduces their daily operational workload.
229
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.
A haircut is a discount applied to the value of a security as a way of acknowledging that this
value may deteriorate over time. A haircut of X% means that for every unit of that security
posted as collateral, only (1 -X) % of credit (or "valuation percentage") will be given.
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
A counterparty may request for the return of previously posted collateral if and only if it can post
an alternative amount of eligible collateral, with the relevant haircut correctly applied. The
haircut does not have to be posted in cash, and the replacement can be in another asset class.
Q.2694 Which of these institutions is likely to post the highest level of collateral?
A. Private equity funds
B. Sovereigns
230
C. Corporates
D. Dealer banks
The level of collateral posted by different types of institutions is given in the table below:
Institution type Collateral posting
Dealer Banks Very High
Other Banks High
Supranationals, Local Authorities, Low
Private Equity Funds
Corporates Low
Sovereigns Very Low
Note:
The table in the solution takes into account more than just the credit quality of the parties. We
have to remember that In some OTC derivatives trading relationships, CSAs (credit support
annex) are not used because one or both parties simply cannot commit to collateral posting
because of one of two possible reasons:
(I) The party feels that their credit quality is high (both in individual and comparative terms), or
(II) an inability to manage the liquidity needs that come with collateral posting
A typical example of this is the relationship between a bank and a corporate where the latter's
inability to post collateral means that a CSA is not usually in place (for example, a corporate
treasury department may find it very difficult to manage their liquidity needs under a CSA). It
may not have as many liquid assets compared to a dealer bank, for example, and collateral calls
might force it to make some decisions that trigger economic losses, e.g., selling a position
prematurely.
This also applies to supranationals and sovereigns. They will rarely agree to post collateral due
to the operational workload that would come with that decision. But in relative terms, a
supranational organizations like the EU is more likely to agree to collateral posting than a
231
sovereign country.
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
A haircut is applied to collateral to guard against a decline in the value of the collateral.
The amount of collateral required = Value of loan (1 - haircut) = $20 million/(1 - 0.05) = $21.05
million.
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
The boundary between two tranches of a structured credit product, expressed as a percentage of
the liabilities, is known as the attachment point of the more senior tranche and detachment point
of the more junior tranche.
232
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
Option C is not a mortgage-associated risk.
Option A corresponds to market risk and is often called negative equity. It depends on the value
of the property and the mortgage value. Option B corresponds to operational risk or legal risk
and affects mortgage in that, the lender faces expenses in order to evict the defaulter. Option D
refers to the correlation or wrong-way risk. That's the tendency of both the exposure and the
likelihood of default to increase at the same time. The more the borrower owes, the more likely
he will default on its debt
233
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
The role of the valuation agent in collateral calculation is ensuring that the current MTM is
computed under the impact of netting, the total uncollateralized exposure is accurately
computed, and the market value of previously posted collateral is calculated and adjusted by the
relevant haircuts. Gait has to do all the above calculations and, in addition, calculate the credit
support amount.
234
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.
The difference between the two methods is depicted in scenario A&semi. For the security
interest method, 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.
In the title transfer method, the legal possession of the collateral changes hands and the
underlying collateral assets are out-rightly transferred subject only to a contractual obligation to
return equivalent fungible securities. Enforceability is stronger as the collateral holder can freely
use the assets.
235
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
In this case, an institution is in debt to its counterparty and is still legally obliged to settle this
amount (they cannot walk away from the transaction or transactions except in specific cases).
Hence, from a valuation perspective, the position appears essentially unchanged. An institution
does not gain or lose from their counterparty's default in this case.
236
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.
An institution will be paid only a recovery fraction of their exposure in the event their
counterparty defaults. This is a loss for the institution. In the opposite scenario (institution
defaults), the counterparty will receive only a recovery fraction of the negative exposure. This is
a gain for the institution.
237
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
All of the above statements are correct.
238
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
The diagram illustrates the fact that while both past and present exposures are known with
complete certainty, the future exposure is not certain. Rather, it’s subject to future market
movements – which we can only estimate by use of probabilities. The grey area represents
positive future exposure while the white area represents negative future exposure.
239
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
Unlike VaR, exposure needs to be defined over multiple time horizons (often far in the future) so
as to take into account the impact of time and specifics of the underlying contracts.
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
EFV may vary significantly from current value for a number of reasons:
(I) Cash flow differential

Cash flows in derivatives transactions may be rather asymmetric. Early in an interest rate swap,
for example, the fixed cash flows almost always tend to exceed the floating ones, assuming the
underlying yield curve is upwards-sloping. A consequence of such asymmetric cash flows is that
a party may expect a transaction in the future to have a value significantly above (below) the
current one due to paying out (receiving) net cash flows.
(II) Forward rates
If forward rates are significantly different from spot rates, this introduces an implied drift (trend)
in the future evolution of the variables in question. Drifts will bring about a higher or lower value
for a given netting set.
(III) Asymmetric collateral agreements
If collateral agreements are asymmetric then the future value may be expected to be higher or
lower reflecting respectively unfavourable or favourable collateral terms.
240
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
The potential future exposure (PFE) represents the worse exposure an entity could have at a
certain date in the future. This exposure is modeled with a specified confidence interval, say,
95%.
Option B is incorrect. The expected exposure (EE) is the amount expected to be lost if the
counterparty defaults when the MTM is positive.
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
With a standard deviation of 5.0, PFE = 2.0 + 5.0 (2.33) = 13.65.
241
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
The worst case exposure simply represents the maximum PFE, i.e., the highest PFE value on the
graph.
242
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
Measures such as EE and EPE may underestimate exposure for short-dated transactions and not
capture properly "roll-over risk." This arises from current short-dated transactions that will be
rolled over into new transactions at their maturity. For these reasons, the terms effective EE and
effective EPE (EEPE) were introduced by the Basel Committee on Banking Supervision (2005).
Effective EE is simply a non-decreasing EE. Effective EPE is the average of the effective EE.
243
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
First, we should find EE values under both “no netting” and “netting”
Therefore, EE for no netting is (70/5 = 14) and
EE for netting is (65/5 =13)
Netting benefit = 14 – 13 = 1
244
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
EE for no netting = 55/5 = 11
EE for netting = 5/5 = 1
Netting benefit = 11 – 1 = 10
Negative initial future values have more netting benefits than positive initial future values.
245
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
With the exception of off-market swaps, all other swaps have an initial market value of zero to
both counterparties. As a result, neither X nor Y has credit exposure to the other at inception.
For example, if bank X immediately defaults, Y would lose nothing.
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
The expected exposure is defined as the expected (average) credit exposure on a future target
date, conditional on positive market values. Thus, bank Y’s 12-month EE would be interpreted as
the average, positive market value of the swap to bank Y, 12 months forward, excluding negative
values. We would expect both banks to have several expected exposures at several target future
dates.
246
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%
We define PFE as the worse credit exposure on a future date, modeled with a specified
confidence interval. In this scenario, it means that 12 months into the future, we are 95%
confidence that bank X’s gain in the swap will be $3 million or less. That’s another way to say
that if Y were to default at that point, X would be exposed to a credit loss of $3 million or less.
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
By definition, the 12-month 95% PFE must be greater than the 12-month expected exposure
since EE is merely an average (mean).
We can also remember it mathematically with the formula: Expected MTM < EE < PFE.
247
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
The use of central counterparties has various advantages including transparency, offsetting, loss
mutualisation, legal and operational efficiency, liquidity, and default management.
Disadvantages of CCPs include moral hazard, adverse selection, bifurcations and procyclicality.
248
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
Recall that the netting factor is given by:
√n + n(n − 1)ρ̄
Netting factor =
n
Where n is given as 21 and ρ̄ is given as 0.3<br>
Therefore:
√21 + 21(21 − 1)0.3

Netting factor = = 0.5774
21
249
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
We know that:
ExposureCCR = max(MTM – VM – IM R, O)
ExposureFunding = MTM – VM + IM p
For the counterparty risk exposure, we have:

MTM = 35, VM = 20, IM R = 15
⇒ max(35 – 20 – 15, 0) = 0
⇒ ExposureCCR = 0
For funding risk exposure, we have:

MTM = 35, VM = 20, IM p = 15
⇒ MTM – VM + IM p = 35 – 20 + 15 = 30
⇒ ExposureFunding = 30
Due to the fact that the initial margin comprises of the gap between the MTM and the variations
margin, the current counterparty risk exposure is zero. The MTM not covered by the variation
margin is 15 and the posted initial margin is 30, which basically is the amount that is to be
funded.
250
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.
In this case, the banks, maximum PFE would be impacted by the expected value of the gain on
the forward agreement.
251
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
The potential future exposure is the worst exposure an institution could have at a certain time in
the future, measured at a specified level of confidence. If the PFE at 95% confidence is X, for
example, this implies that we are 95% confident that the maximum possible exposure will be no
more than X. Alternatively, X would be exceeded with a probability of no more than 5%.
In this case, the implication is that that 12 months into the future, the bank is 99% confident that
the gain in the swap will be no more than $7.5 million ($7.5m or less), such that a default by the
counterparty at the time will expose it to a credit loss of no more than $7.5 million. In other
words, the bank is 99% confident that its worst exposure 12 months into the future will be $7.5
million or less. Equivalently, there’s a 1% chance that the bank’s exposure (gain) 12 months into
the future will exceed $7.5 million.
252
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
We know that:
ExposureCCR = max(value – VM – IM R, O)
ExposureFunding = MTM – VM + IM p
ExposureCCR = max(15 -10 – 6, 0) = 0
ExposureFunding = 15 – 10 + 6 = 11
The current counterparty risk exposure is zero and the funded amount should be 11.
253
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
Recall that the netting factor is given by:
√n + n (n − 1) ρ̄
Netting factor =
n
n is given as 17 and ρ̄ is given as 0.7. Therefore:
√17 + 17(17 − 1) × 0.7 14.4014

Netting factor = =
17 17
= 0.85
254
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. ∞
From the netting factor formula that has been given:
√n + n (n − 1) ρ̄
Netting factor =
n
√n 1
For ρ̄ = 0 the formula reduces to: =
n √n
We are given that n = 9. Therefore:

1 1
Netted exposure = = = 0.333
√9 3
= 33.33%
255
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%
Potential future exposure (PFE) is what the value of the marked-to-market exposure might be at
some future point in time. During the remargin period, it is calculated as:
PFE = k × σE × (TM)1/2
where:
k = a constant that is a function of the confidence level (e.g., k = 2.33 for a 99% confidence
level)
(TM)1/2 = the remargin frequency (in years)
σE = volatility of collateralized exposure
Thus, PFE = 2.33 × 5% × (20/250)1/2 = 0.03295 or 3.295%
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
The bank’s exposure on the transactions is $10 million, $30 million, and $0 for a total exposure
of $40 million. With netting, the transactions are regarded as a single transaction worth $15
million as the negative exposure of -$25 million is deducted from $40 million.
256
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%
√{n + n × (n − 1) ρ}
Netting Factor =
n
√{24 + 24 (24 − 1) × 0.4}
=
24
= 0.6519 or 65.19%
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
257
D. Trade combination W
We assess the expected netting benefit by computing the netting factor. The lower the netting
factor, the higher the netting benefit.
√n + n(n − 1)ρ̄
netting factor =
n
where n represents the number of exposures and ρ̄ is the average correlation.
The current trades have a netting factor of 65% as calculated below:
√9 + 9(9 − 1)0.35
netting factor = = 65
9
When there are 10 positions with an average correlation of -0.11, the netting factor is 3.16%, and
that’s when there’s the biggest reduction in the netting factor (most increase in the expected
netting benefit).
√10 + 10(10 − 1) − 0.11

netting factor = = 3.16
10
A is incorrect. Trade combination K results in a higher netting factor compared to the current
trades and would therefore be a deterioration from the current trades.
√4 + 4(4 − 1) − 0.08
4
B is incorrect. Although trade combination Y does improve the netting benefit, the improvement
is not as much as for trade combination E.
√7 + 7(7 − 1) − 0.08
7
D is also incorrect. Combination W results in a bigger netting factor compared to the current
trades and would therefore have a lower netting benefit. In fact, Y would be the worst
combination of the four possible choices.
258
√5 + 5(5 − 1)0.55
netting factor = = 80
5
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.
Since the collateral is not subject to segregation, it can be used for other purposes, such as being
posted as collateral against a negative MTM in another transaction. Thus, the collateral comes
with a funding benefit and mitigates funding risk.
In the event of the counterparty defaulting, the trader can hold on to (or take ownership of) the
collateral to cover close-out losses, thus reducing counterparty credit risk. However, the impact
of the collateral is limited because it is essentially wrong-way collateral. "Direct relationship"
implies that the collateral's value decreases when the counterparty's creditworthiness worsens
and vice versa. That's not an ideal situation. Although the collateral will still provide some
protection against counterparty risk, it will have reduced value at the time of default. As a result,
it will end up providing less protection than initially envisioned.
259
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
An FVA (funding value adjustment) is an adjustment to the value of a derivative or a derivatives
portfolio that is designed to ensure that a dealer recovers its average funding costs when it
trades and hedges uncollateralized derivatives. It can also be thought of as a hedging cost or
benefit that arises from the mismatch between an uncollateralized client trade and a
collateralized hedge in the interdealer market.
A is incorrect. CVA (Credit value adjustment) is an adjustment in recognition of the
counterparty's credit risk.
B is incorrect. DVA (debt value adjustment) is an adjustment in recognition of a party's own
credit risk.
D is incorrect. Marking to market refers to the daily settling of gains and losses due to changes
in the market value of the security.
260
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
Close-out adjustments are only considered in default scenarios and are therefore relevant only in
the definition of credit exposure. Close-out adjustments do not apply when considering funding
aspects, which are based on MTM.
Margin period of risk refers to the effective time between a counterparty ceasing to post
collateral and when the underlying transactions have been closed-out or replaced. It's defined
assuming the default of the counterparty and is therefore only relevant for credit exposure.
Close-out netting applies in a default scenario, and hence credit exposure is defined at the
netting set level. On the other hand, funding applies at the overall portfolio level since MTM for
different transactions is additive, and collateral received from one counterparty may be posted to
another.
261
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
The standard equation for CVA is given by:
CVA = (1 – Rec)∑DF(ti)EE(ti)PD(ti–1,ti) Where:
(1 – Rec) = loss given default
DF(ti) = discount factor
EE(ti) = expected exposure
PD(ti – 1, ti) = Default probability
262
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
Many derivatives instruments have fixed, floating or contingent cashflows or payments that are
made in both directions. This bilateral nature makes quantification of counterparty risk difficult.
For example, consider a swap arrangement between two counterparties: In the event of default,
only a part of each cash flow will be at risk due to partial cancellation with opposing cashflows.
It’s difficult to determine the fraction of the cash flow that’s at risk because such calculations
depend on external factors such as the shape of the yield curve, forward rates, and volatilities.
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
Credit valuation adjustment refers to the difference between the risk-free value of a contract and
the true value of the contract that takes into account the possibility of default by the
counterparty. It’s also defined as the market value of counterparty credit risk.
263
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
The exposition and calculation of the CVA in a simplified approach requires three main
assumptions:
I. That the institutions themselves cannot default, which basically means that we ignore
debt value adjustment (DVA)
II. That risk-free valuation is simple and straightforward, although this is normally not the
case because of the lack of a clear discount rate
III. That credit exposure and default probability are independent, implying we ignore wrong-
way risk
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
The loss given default (LGD) is generally the percentage of an asset that’s lost if a borrower
defaults. In the context of derivatives, it’s the amount of exposure that would be lost in the event
of counterparty default. It’s equal to (1 – Rec), where “Rec” represents the amount of the claim
that would be recovered.
264
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.
As the credit spread of the counterparty increases, the CVA increases(becomes more negative).
However, the impact is not linear because default probabilities are limited to 100%. When the
credit quality of the counterparty decreases, the CVA decreases(becomes more negative). When
the counterparty is very close to default, the CVA tends to increase (become less negative)
In default, the CVA falls to zero.
Note:In this question, CVA is interpreted as the cost incurred to hedge counterparty credit risk,
and hence has a negative sign. Some authors leave out the negative because, just as with the
VaR, a negative is implied. If we viewed CVA as a positive, then the answer explanation here
would change.
265
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
Changing recovery rate assumptions have a reasonably small impact on the CVA because there’s
a cancellation effect: an increasing recovery increases the implied default probability but
reduces the resulting loss.
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
The marginal CVA is most appropriate for netted trades into several trade-level contributions
that sum to the total CVA. Each contribution can then be calculated.
266
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
CVA (running spread) = 1%/4 years = 25 basis points
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
The incremental CVA is most appropriate when the CVA needs to be charged to individual
investors and traders. The incremental CVA will strongly depend on the order of executed trades
but won’t change due to subsequent trades.
The marginal CVA helps to break down the CVA for several netted trades into trade-level
contributions that sum to the total CVA. Marginal CVA changes due to subsequent trades and
changes have to be made to the PnL statement.
267
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
CVA = Credit spread * EPE = 500 * 1.6% = 8 bps
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
All the above are valid methods that can be used to improve efficiency of CVA
268
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
Path dependency in CVA calculations presents a problem since, in order to assess a future
exposure at a certain date, one must have information about the entire path from now until that
date.
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
CVA (running spread) = 0.75%/3 = 25 basis points
269
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
CVA = - Credit spread * EPE = 250 * 1.2% = -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
The CVA can be calculated as a running spread by multiplying the counterparty’s expected
potential exposure by its credit spread.
CVA = 5% x 0.03 = 15 bps
270
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
To improve the efficiency of calculating CVA, numerical optimization of pricing functions is

necessary. Furthermore, parallelization and the use of grids and approximations are also very
crucial methods to be considered. However, a common functionality like the generation of
cashflows and fixings should be stripped out and it does not depend on the underlying market
variables at a particular time.
271
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
Recall that BCVA, which is an obvious extension of DVA, is calculated by using the following
formula:
BCVA = -EPE × Spreadc− (−ENE × Spreadp)
From the question, we have: EPE = 0.136, Spreadc = 267, ENE = 0.09, and Spreadp = 191
Therefore:
BCVA = -0.136 × 267 bps − (− 0.09 × 191 bps)
= -19.122bps
272
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
CVA spread before downgrade is 128 - 74 = 54 bps
CVA spread after downgrade is 176 - 154 = 22 bps
It needs to be adjusted by 54 - 22 = 32 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%
The CVA as a running spread would be computed as:
CVA = EPE * Spread
= 13% * 225 = 29.25 bps or 0.2925%
273
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
First, we calculate the spread in basis points terms for this contract as 60,000/50,000,000 =
0.0012
We then divide this with the duration:
Additional running spread = 0.0012/4.25 = 0.000282% or 2.82 bps
274
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%
CV A is calculated as follows:
m
CV A = LGD ∗ ∑ d (ti ) ∗ EE (t1 ) ∗ PD (ti−1 , ti )
i
Where;
LGD = loss given default
EE = expected exposure for future losses
P D = marginal default probability
D (t) = discount factor
Because the exposure is only for one period, C V A can be computed as follows
EE ∗ P D
CV A = LGD ∗ [ ]
(1 + r)
C V A = (1 − 40%) ∗ [$55 , 000 ∗ 15%]
CV A = $4950
The CV A can be converted into a running spread as follows:
$4950
CVA as a running spread =
0.495 ∗ $1 , 000, 000
CV A as a running spread = 0.01 = 1
275
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
Wrong-way risk is used to indicate an unfavorable dependence between exposure and

counterparty credit quality. It arises when credit exposure and default risk increase together.
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
Wrong-way risk is the phrase generally used to indicate an unfavorable dependence between
exposure and counterparty credit quality, i.e., the exposure is high when the counterparty is
more likely to default. While it may often be a reasonable assumption to ignore wrong-way risk,
its manifestation can be rather subtle and potentially dramatic
276
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
Right-way risk can also exist in cases where the dependence between exposure and credit quality
is a favorable one. Right-way situations will reduce counterparty risk and CVA.
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
Wrong-way risk is often a natural and unavoidable consequence of financial markets. One of the
simplest examples is mortgage providers who, in an economic recession, face both falling
property prices and higher default rates by homeowners.
277
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
Buying a put option on a stock where the underlying in question has fortunes that are highly
correlated to those of the counterparty is an obvious case of wrong-way risk. The put option will
only be valuable if the stock goes down, in which case the counterparty’s credit quality will likely
be deteriorating, which makes it less likely that the counterparty will be able to pay the buyer of
the put option.
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
Right way risk occurs when the creditworthiness of a counterparty improves as its payment
obligation increases. In this case, the counterparty's credit rating has improved even though its
obligation has also increased thanks to increasing oil prices. From the perspective of the airline,
therefore, this is a case of right way risk.
Wrong-way risk would be the exact opposite - an increase in the payment obligation of the
counterparty would coincide with a ratings downgrade.
278
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
Unfortunately, there’s usually no wrong-way risk data that can be gathered from historical
records. And in cases where some data might be available, chances are it’s not relevant.
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
The Asian crisis of 1997/1998 and the 2007/2008 global financial crisis are two good examples of
events where wrong-way risk caused heavy losses for various market players.
279
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
Specific wrong-way risk (SWWR), arises due to specific factors affecting the counterparty, like a
rating downgrade, poor earnings, or litigation. In this case, Yamamoto’s increased exposure to
Wangdu can be attributed to litigation.
B is incorrect. Concentration risk occurs when there are too many transactions with a particular
counterparty. For example, players in an industry may seek protection from a common monoline
insurer, a situation that would render the monoline's guarantees worthless if there happens to be
a flood of claims from players in that industry.
C is incorrect. General wrong-way risk (GWWR)—also known as conjectural wrong-way risk—
occurs when the trade position is affected by macroeconomic factors like interest rates, political
unrest, or inflation in a particular region
280
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
A situation where both a borrower and the guarantor are business partners increases credit risk
for the lender. Financial strain by the borrower could trickle down to the guarantor, rendering
the latter "helpless" when the lender is trying to recover at least part of the loss. Giving
insurance business to a single monoline insurer may render the resulting guarantees worthless if
the risk exposure increases and the guarantor is hit by a flood of claims due to a concentrated
position in an industry or business.
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
The dependency between credit spreads and exposure can be misrepresented leading to
unreliable results. For example, instead of a cause-effect relationship, the dependency could be
assumed to be correlative.
281
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
From the information given, we can clearly see that the credit exposure of Bright Tech Inc. to
Digital world Inc. increased, and so did the latter’s creditworthiness. This positive relationship
constitutes right-way risk.
282
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
General wrong-way risk can be thought of as the general relationship between exposure and
default probability due to macroeconomic factors. Such factors may include interest rates,
political tension, or even war.
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
Specific wrong-way risk is generally wrong-way risk attributed to specific issues facing a
counterparty or specific transactions with the counterparty. Court fines, downward rating
adjustments, and poor performance can all be examples of such specific issues.
283
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
Before any use of either the correlation or the parametric approach to incorporate general
wrong-way risk, relevant parameters must be established and calibrated. For instance, under the
correlation approach, multi-factor models and a principal component approach can be used to
calibrate parameters.
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
Wrong-way risk is the risk that occurs whenexposure to a counterparty is adversely related to
the credit quality of that counterparty.
284
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
Wrong-way risk arises when credit exposure to counterparty during the life of trade is adversely
correlated to the counterparty's credit quality. Wrong-way risk will result in an increase in the
amount of the credit value adjustment
On the contrary, right way risk occurs when the linkage between the exposure and the
counterparty creditworthiness is such that it decreases the overall counterparty risk. Right way
risk will lead to a decrease in the CVA and an increase in the DVA.
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
A common wrong-way risk case is a put option purchased on a stock where fortunes, possessed
by the underlying in question, are highly correlated to those of the counterparty.
Option C is incorrect because it does not specify the nature of the relationship: It can be positive
or negative; if negative, then an increase in the credit quality of the counterparty would coincide
with a decrease in the credit quality of the reference entity, and vice versa, and there would be
no wrong-way risk
285
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
Options I, III and V are characteristics of specific WWRs.
On the other hand, general WWRs are the ones that are based on macro-economic behaviors and
can be potentially incorporated into pricing models.
286
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
Hull and White's suggestion is that either an intuitive calibration should be used based on a
what-if scenario or the relationship calibrated through historical data by computing portfolio
value for past dates. The link between this and the credit spread of the counterparty should be
examined.
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.
The hazard rate approach's main drawback is that it generates only weak dependency between
exposure and default. It is easy to implement, but only ever generate small WWR effects.
287
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
Statement I is correct: The structural approach is a simpler approach which requires that the
dependency between the counterparty default time and exposure distribution be specified.
Statement II is correct: Exposure and default distribution are mapped separately into a
bivariate distribution. In the case of a WWR, positive dependency will lead to an early default
time being coupled with higher exposure. The reverse is true for the right-way-risk.
Statement III is correct: The advantage of this approach is that the original unconditional
values are sampled directly, and hence there is no need to recalculate the exposures. The
exposure distributions computed initially are used, and WWR is added on top of the existing
methodology
288
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.
The main drawbacks of the structural approaches include:
i. Calibrating the correlation being talked about is difficult since the correlation is not
clear.
ii. It is not appropriate to assume that all the required information for defining the WWR is
contained in the original unconditional exposure distribution.
289
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.
It can be assumed that in the short-term, immediate sovereign default may result in a large
currency jump (a small RV), while a later default may result in a smaller currency jump (larger
RV in the medium/long-term.)
A is incorrect: 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 is incorrect: An empirical estimate of the magnitude of the jump through the residual value
(RV) of the sovereign defaults' currency is made based on 92 historical defaults
C is incorrect: Sovereigns with better ratings have a larger RV. This can probably be because
their default requires a more severe financial shock, and therefore, the conditional FX rate needs
to be increased. The same approach may also be applied to other counterparties. For instance,
when a large corporate defaults, we expect it to greatly affect the domestic currency.
290
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
The parametric approach is a more direct approach that involves parametrically linking default
probability to the exposure by simple functions as proposed by Hull and White (2011). An
intuitive calibration based on a what-if scenario or using historical data to calibrate the
relationship may be applied.
When calibration is achieved through historical data, portfolio value for dates in the past needs
to be calculated. Then the relationship between this and the counterparty's credit spread is
examined. If the portfolio is found to have high values with a credit spread that exceeds the
average, it indicates the WWR.
291
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
CCPs may be particularly prone to WWR because they rely so much on collateral as protection.
CCPs tend to closely manage and monitor membership by only admitting parties with a certain
credit quality
Moreover, all members have to provide an initial margin and also make contributions to the
default fund that serves as an extra layer of cushion. But there's a problem: These initial margins
and default fund contributions are based on the portfolio's market risk. As such, this separation
of credit risk and market risk may culminate in a situation where collateral requirements ignore
WWR!
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. That's because higher credit quality
can increase WWR (when things take a turn for the worse, previously highly rated credits can
get hit quite hard!).
The collateral posted carry WWR; members may post highly risky or illiquid securities.
292
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
The advantage of this approach is that the original unconditional values are sampled directly,
and hence there is no need to recalculate the exposures. The exposure distributions computed
initially are used, and WWR is added on top of the existing methodology.
293
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.
When plotted against correlation, it can be seen that CVA is reduced (increased) by
negative(positive) correlation due to the effects of right way risk (WWR). The effect is stronger,
and the CVA doubles when the correlation is about 0.50.
See the figure below,
294
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
In a nutshell, stress testing is a simulation technique used on portfolios (both assets and
liabilities) to determine their resilience to a range of economic shocks. The emphasis is on
extreme but plausible events that could trigger significant market movements or impact the
financial stability of individual institutions or parties. The financial crisis of 2007/2008
highlighted the importance of including extreme but plausible events in stress tests.
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
Expected exposure is the mean (average) of the distribution of exposures at any particular future
date before the longest maturity in the portfolio. An expected exposure value is typically
generated for many future dates up until the longest maturity date of transactions in the netting
set.
295
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
CCR should be treated as a credit risk and also a market risk. Treating CCR solely as a credit
risk can leave the institution exposed to changes in credit value adjustments. As a result, the
institution will most likely contend with problems in its financial statements, including the
income statement and balance sheet.
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
A stress test on current exposure (like the one described above) would help an institution to
identify and single out institutions that would expose it to the biggest losses if a specified stress
event occurred.
296
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
Instead of waiting until a default event occurs to replace contracts, an institution should
gradually replace the trades with a counterparty in the market in proportion to the
counterparty’s probability of default. This simply means that as the probability of default of a
given counterparty increases, the institution would step up the replacement of its trades with
that party so that at default, a large percentage of trades would be already replaced. That way,
the default event itself would be a non-event.
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
Tests on current exposure are associated with three main problems:
i. Aggregation of findings is complex

ii. Such tests do not take into account the credit quality of counterparties
iii. Such tests do not provide any information on wrong-way risk
297
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
To create a stressed current value, the institution assumes a scenario of underlying risk-factor
changes and re-prices the portfolio under that scenario. For example, it might assume a change
in interest rates of magnitude 5 (-5% or 5%) and then attempt to re-price the portfolio under that
scenario.
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
Aggregation of such data would give irrelevant results that would likely never be experienced.
Unless the scenario was the Apocalypse, losses would be quite exaggerated.
298
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
When conducting stresses to EPE, a bank does not need to consider aggregation with its loan
portfolio. Loans have deterministic characteristics and are therefore insensitive to market
variables such as stock prices and swap rates, and thus, there's a zero change in exposure due to
changes in such variables.
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.
Expected positive exposure (EPE) is 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.
In other words, EPE (ENE) gives the expected loss of the buyer (seller) of the portfolio in case he
or she is in the money and the counterparty defaults.
299
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
When we consider default probability of not only the counterparty but also the institution itself,
that constitutes bilateral CVA.
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
The effect of such shocks hinges on factors such as the degree of collateralization, and the
“moneyness” of the portfolio, among others.
300
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
EE n (tj) is the discounted expected exposure during the jth time period, calculated under a risk-
neutral measure for counterparty n. LGD is the risk-neutral loss-given default 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
Peak exposure is the maximum amount of exposure expected to occur on a future date at a given
level of confidence.
Option A describes current exposure, option C describes expected exposure, and option D
describes expected positive exposure.
301
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
We have:
EPE = 24.3%
ENE = 11.6%
Counterparty credit spread = 354 bps
Financial institution credit spread = 207
From the institution's perspective:
EPE × counterparty credit spread - ENE × institution credit spread
=24.3% × 354 - 11.6% × 207 = 62.01 bps
This is the overall counterparty risk, and should be what the institution charges the counterparty.
302
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
Stress loss = CVA - CVA
Where CVA is the CVA under stress market conditions; and

CVA is the normal CVA.
Stress loss = $76 million - $4.3 million = $71.7 million
303
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
The Expected Loss is given by:
n
EL = ∑ PD i × EAD i × LGD i
i =1
= 7 , 000, 000 × 0.06 × (1 − 0.8) + 9, 000, 000 × 0.05(1 − 0.9)

= 129, 000
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
304
C. $362,755.4
D. $201,000
First, we calculate normal expected loss,

Here, we don't use correlations as they have already been accounted for in the joint PD, Thus,
n
EL = ∑ α × PDJoint × EAD i × LGD i
i =1
Therefore
EL = 1.645 × 0.0476 × [(7, 000, 000 × (1 − 0.8)) + (9 , 000, 000 × (1 − 0.9))]

= 1.645 × 0.0476 × 2, 300, 000
= 180, 094.6
We can then calculate the stressed expected loss:
n
EL s = ∑ α × PD si × EADi × LGDi
i=1
ELs = 1.645[0.12 × (7 , 000, 000 × (1 − 0.8)) + 0.18 × (9, 000, 000 × (1 − 0.9))]
= 542, 850
The stress loss for the loan portfolio is thus given by:
ELs – EL= $ 542,850- $180,094.6 = $362,755.4
305
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
Retail banking encompasses the collection of deposits and provision of a range of credit facilities
to small and medium-sized businesses. Such facilities include:
Home mortgages
Home equity loans
Installment loans
Credit card revolving loans
Small business loans whose total exposure does not exceed 1m Euros
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
Credit card revolving loans – also called evergreen loans – are normally unsecured. However,
beneficiaries must demonstrate sufficient financial ability.
306
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
The defining feature of retail credit exposures is that they arrive in bite-sized pieces so that
default by a single customer is never expensive enough to threaten a bank. Corporate exposures
are usually large and expensive enough to threaten the bank.
307
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
A qualified mortgage must have several features:
(I) The debt-to-income (DTI) ratio must be no more than 43%. A low DTI ratio indicates
sufficient income relative to debt servicing;
(II) It must not have excess upfront points or fees; and
(III) It must not have features considered “toxic”: that includes terms longer than 30 years,
negative amortization, balloon payments, or interest-only features
308
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
Although the nature of retail lending naturally brings about diversification, a systematic change
in lending behavior can introduce a hidden systematic risk into the credit portfolios. For
instance, lowering lending requirements such that borrower income is not scrutinized can lead
to a sudden surge in the number of defaults. Such behavior does have the potential to trigger
value losses across the market. A relaxation of lending requirements played a role in the
2007/2008 financial crisis by allowing people without reliable sources of income (and therefore
means to pay) to buy mortgages.
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
The dark side of retail risk can be best managed by making sure that only a limited number of
retail credit portfolios are especially vulnerable to new kinds of risk. Such risks may include sub-
prime lending.
309
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
CFPA requires originators of credit to determine if the consumer has the ability to repay the
mortgage. If a mortgage is labeled a "qualified mortgage" (QM), then a creditor can assume the
borrower has met this requirement.
310
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
To reduce credit risk, a bank can take one or a combination of options I, II and III above.
Initiating legal proceedings against consumers before they have actually defaulted on their
obligations is fraught with additional costs and risks, such as reputation risk.
311
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
Retail banks might be tempted to ignore early warnings signs if acting upon them amounts to
steering the bank away from fast-growing, apparently lucrative business lines. Instead, banks
compete for even more business volume by lowering standards. This is especially true when we
take into account the agency theory (the fact that the interests of stakeholders will not always
converge).
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
In the run-up to the 2007/2008 financial crisis, the demand for housing rose sharply and so did
real estate prices. Analysts and lenders erroneously believed that the so-called housing bubble
would continue to grow indefinitely or at least for several years. In an attempt to get a bigger
share of the pie, lenders lowered lending standards and interest rates. Many of the subprime
mortgage loans underwritten during this time had multiple weaknesses: less creditworthy
borrowers, high cumulative loan-to-value ratios, and limited verification of the borrower's
income.
312
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
Credit scoring models are statistical evaluations of borrower information to determine their
creditworthiness. Such an analysis combines bits of information from a range of sources that
usually extend beyond a person’s borrowing history. Any qualitative data is converted into
figures and combined with quantitative data to provide a final (numerical) credit score. The
score can be used to assess the likelihood of default and even rank borrowers in order of their
creditworthiness.
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
In the context of credit scoring, custom models are models built using in-house customer
information. They rely on a lender’s own unique population of credit applications. A custom
model enables a bank to recognize and reward loyal customers, become an expert in a given
market segment, and maintain a competitive edge in business.
313
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
If a mortgage is “full doc,” the beneficiary must produce proof of income and assets. The assets
must be verified and relevant debt-to-income ratios must be calculated.
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
Identifying information refers to personal information about a customer; it is not considered

credit information and as such, it’s not used in scoring models.
314
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
"Risk-based pricing" for credit products propagates the idea that customers with different risk
profiles should pay different amounts for the same product.
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
Pooled model, credit bureau scores, and custom models developed in-house from credit
application data are all credit scoring models in scoring consumer credit applications.
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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
Attrition scores estimate the likelihood that existing customers will close their account and won’t
renew a credit.
All other options are correct.
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
Though it is often too late to do much, for well-monitored default credit signals, there are some
preemptive actions that can help reduce the credit risk. These steps will include pricing the risk
by raising interest, altering the rules governing the amount of money it lends to existing
customers, and altering market strategies and customer acceptance rules.
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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
Securitization involves the repackaging of loans and other assets into securities that can then be
sold to investors. Potentially, this removes considerable liquidity, interest rate, and credit risks
from the originating bank's balance sheet compared to the traditional "buy and hold" banking
business model.
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
Basel regulations were not explicitly against the traditional banking model of “buy and hold.”
However, by moving capital-hungry assets out of the balance sheet, banks would be in a better
position to meet the Basel capital adequacy requirements applicable at that time.
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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
The OTD model actually reduced the incentives for the originator of the loan to monitor the
creditworthiness of the borrower
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
At the peak of the housing bubble, the yields on MBSs were considerably higher than those of
government bonds. For example, the yields for AAA-rated tranches of MBSs were 32 bps against
16 bps for similarly rated bonds.
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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
Traditional credit risk enhancement techniques include:
Collateralization
Bond insurance
Guarantees
Marking to market
Put options
Netting
Reassignment and early termination
Credit default swaps have merged in recent years as a way of “unbundling” credit risk for
redistribution – something that’s difficult to achieve when using the traditional approaches listed
above.
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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
There are two main reasons as to why banks have had to contend with an increasing
concentration of low-quality credits, or rather, an increasingly risky consumer population. First,
there is the "disintermediation" of banks. This trend means that large investment-grade firms are
more likely to borrow from investors by issuing bonds in the efficient capital markets, rather
than borrowing from individual banks. Second, current regulatory capital rules make it more
economical for banks on a risk-adjusted return basis to extend credit to lower-credit-quality
obligors.
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
Syndicated loans are often called leveraged loans when they are issued at LIBOR plus 150 basis
points or more.
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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
Although OTD models can spread credit risk and hence reduce the chances of a bank’s stability
being threatened when a borrower defaults, the issues mentioned above must all be dealt with.
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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
There are two main ways in which a bank can manage its credit portfolio. First, the bank can
involve other players in the industry by distributing large loans to the other banks instead of
trying to hold onto the entire loan by itself, however big the return might be. Second, the bank
can reduce exposure by selling down or hedging loans.
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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
The investment trust buys a credit default swap from the hedge fund to insure itself against
possible default of the construction company. Ordinarily, the trust (the buyer of the CDS) will be
required to make regular payments (premium) to the hedge fund (CDS seller) for the duration of
the CDS. If the building society defaults, the hedge fund has to pay a compensation to the
investment bank of $1 million (the value of the CDA contract).
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
CDSs are more efficient than most alternative credit risk transfer strategies because they
divorce funding decisions from credit risk-taking decisions. Unlike the other alternatives like
guarantees and letters of credit, CDSs make it possible to separate management of credit risk
from the assets associated with the risk (via third parties).
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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
A first-to-default swap is basically a basket default swap in which the seller makes a payment to
the buyer immediately the first default event occurs. Such a payment would be equivalent to the
principal amount less recovered amount, subject to any other contractual agreement. After the
first default event, the buyer ceases to make premium payments to the seller of the swap, and
hence the contract also ceases to exist. It’s also important to note that for compensation to be
paid, the first default event must occur within the term of the swap contract (which can be
shorter than the term(s) of the underlying loans). This is why options B and C are incorrect.
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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
In a total return swap, the party receiving the total return (Bank B in this case) benefits if the
price of the underlying asset appreciates over the life of the swap, and receives any income
generated by the asset. In return, the total return receiver must pay the asset owner (Bank A in
this case) the set rate over the life of the swap. Therefore, A pays B 10% The payment is netted
at the end of the swap with Bank B receiving a payment of [$10 million x (10% - 4.5%)].
A should pay a netted amount of $550,000 to B or 4.5% - 10% = 5.5%.
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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
If the price of the underlying assets falls over the life of the swap, the total return receiver (Bank
B) will be required to pay the asset owner (Bank A) the amount by which the asset has fallen in
price. In essence, Bank B assumes both market and credit risk. Therefore, in addition to the
LIBOR rate plus the fixed margin, Bank A would receive 10%. This would be equivalent to a
netted payment of (10% + 2% + 2.5%) * $10,000,000 = $1,450,000
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
Securitization is the process by which an issuer creates a marketable financial instrument by

combining other financial assets. Such a process results in the formation of collateralized loan
obligations (CLOs).
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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.
All the options above are ways in which loan portfolio management manages a credit portfolio
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
Reducing credit concentration is an end user application of banks and not the government.
327
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.
After investing in a covered bond, investors have double recourse: a claim on the underlying pool
of assets and a general claim on the issuer.
A is incorrect. Covered bonds are not considered true securitization instruments because the
underlying pool of assets (i.e., cover pool) never leaves the issuer’s balance sheet. There are no
special-purpose entities involved, as is the case with true securitization instruments. If the issuer
goes bankrupt, investors retain access to the cover pool.
C is incorrect. Covered bonds are more popular in Europe than in the United States. Bank of
America and Washington Mutual tried to issue covered bonds in 2006, but the 2007-2008
financial crisis pegged those efforts back and stunted the growth of the covered bonds market.
Most investors weren’t receptive to the idea of a new product after the “horrors” they suffered
during the crisis, particularly concerning securitization instruments. In Europe, covered bonds
have a thriving market. In Germany, for example, they are readily available at the Frankfurt
Stock Exchange.
D incorrect. A covered bond is backed by cash generated from a specific underlying investment
pool. The cover pool includes long-term assets such as residential and commercial mortgages,
ship loans, aircraft loans, and public sector loans.
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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.
A funding CLO is structured so that there are only true tranches: the senior (funding) tranche
and the subordinate tranche.
B is incorrect. Funding CLOs are on-balance sheet items.
C is incorrect. The senior tranche is usually rated by an external rating agency, and most of these
tranches are rated AAA. However, the subordinate (junior) tranche is unrated.
D is incorrect. The ladder loss sharing mechanism applies, where the subordinate tranche bears
the first loss.
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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
Some of the benefits of securitization are as follow: Banks may benefit from moving the default
risk associated with the securitized debt off their balance sheets. By reducing their debt load and
risk, banks can use their capital more efficiently. Securitization allows banks to convert assets
that would otherwise not be marketable – including retail banking loans and corporate loans –
into readily marketable securities that can easily be sold in secondary markets. Banks are able to
increase their overall liquidity and boost their financial standing from the point of view of
financial reporting
330
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
In theory, securitization should help banks to redistribute credit risk and hence reduce their
overall exposure to risk. In the run-up to the crisis of 2007/2008, besides creating securitized
assets, most banks also invested heavily in similar assets issued by other banks.
Thus, the whole idea of redistribution was essentially not achieved, and the banks remained
exposed to high levels of credit risk, which ultimately led to heavy losses once the so-called
housing bubble burst.
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
A special-purpose entity is a legal entity (usually a limited company of some type or, sometimes,
a limited partnership) created to fulfill narrow, specific or temporary objectives. SPEs are
typically used by companies to isolate the firm from financial risk. Although SPVs are subject to
favorable tax treatment, they cannot be used to entirely evade tax obligations.
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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
SPVs are bankruptcy-remote entities. If the sponsor suffers financial difficulty or is declared
bankrupt, this will have no impact on the SPV, and hence no impact on the liabilities of SPV with
respect to the notes it has issued in the market.
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
All the options above motivate banks to take on securitization.
332
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
As stipulated by Basel rules, banks must maintain a minimum capital level for their assets in
relation to the risks of these assets. Under Basel I, for every $100 of risk-weighted assets a bank
must hold at least $8 of capital.
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
The originator sells a pool of mortgage loans to the issuer/arranger. The issuer is a company that
has been set up specifically to facilitate securitization. It’s essentially the SPV itself, and is
usually set up offshore. .
Option C is not true . Some securitizations use external credit enhancement provided by third
parties, such as surety bonds and parental guarantees. The credit enhancement entity is not
S&P, Moody's, etc, it's the entity that secures the pool externally, for example with parental
guarantees. This is what confers a (higher) rating to the vehicle.
333
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
Master structures are most appropriate for frequent issuers. As such, the bank would have to
choose between an amortizing structure and a revolving 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
The most junior note is impacted by losses first, thereby it’s known as the first-loss piece. The
first-loss piece is sometimes called the equity piece or equity note (even though it is a bond) and
is usually held by the originator.
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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
Over-collateralization is suitable when the nominal value of the asset pool exceeds that of the
issued securities.
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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
ABC Securities can look into data closely related to ticket receivables such as ticket sales per
geographical region, total ticket sales, and number of passengers in the last decade.
Assuming the issuer has been split from the parent company and the receivables have been “fully
sold,” there would be no need to look into the total assets owned by the parent.
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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
The process would begin by the transfer to the SPV of all present and future credit card ticket
receivables generated by the airline. Next, the investment bank's syndication desk would seek to
place the notes with institutional investors across Europe. The notes would be given an
indicative pricing ahead of the issue, to gauge investor sentiment. Then the notes would be
'benchmarked' against recent issues with similar asset classes, as well as the spread level in the
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unsecured market of comparable issuer names.
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
Principal and interest payments would be channeled to bondholders in the order of priority of the
notes. The shareholders of the parent company would have no claim on such cash flows.
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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
Option A defines the delinquency ratio.
Option C defines the monthly payment ratio, and option B defines the default ratio.
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
A CMBS is a non-recourse loan to the issuer as it is fully secured by the underlying property
asset. Non-recourse loans generally preclude the lender from collecting any shortfall between
the sale of the property and the amount that is owed to the lender. The lender's source of
repayment is the actual property that was pledged as collateral in the loan documents.
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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%
CPR = 1 − (1 − SMM)12
CPR = 1 − (1 − 0.45%)12
CPR = 5.27%
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
The possible reasons for a bank to securitize a part of its balance sheet include:
Funding the assets it owns
Balance sheet capital management
Risk management and credit risk transfer
340
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
The tranches have a total value of 50 + 50 + 100 = $200 million.
Since the value of collateral is $220 million, there is an overcollateralization of $20 million. Any
losses will first be absorbed by this overcollateralization and then by the subordinated tranches.
For a $120 million loss, after using the overcollateralization, the two subordinated tranches will
absorb the remaining loss and no loss will be incurred by the senior tranche.
341
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
Internal credit enhancements utilize internal resources for credit risk mitigation. Examples of
these enhancements include overcollateralization, holdback, excess spread, direct equity issue,
etc.
On the contrary, an external enhancement transfers the credit risk to a third party. Examples of
external enhancements include insurance, letters of credit, and credit default swaps, etc.
Q.2711 Which of these is not an external credit enhancement?
A. Holdback
B. Letters of credit
C. Insurance
D. Credit default swaps
Internal credit enhancements utilize internal resources for credit risk mitigation. Examples of
these enhancements include overcollateralization, holdback, excess spread, direct equity issue,
etc.
On the contrary, an external enhancement transfers the credit risk to a third party. Examples of
external enhancements include insurance, letters of credit, and credit default swaps, etc.
342
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%
The delinquency ratio is the ratio of the receivables that are over 90 days past due to the total
receivables pool.
Total receivables pool = current receivables + Receivables over 30 days past due + Receivables
over 60 days past due + Receivables over 90 days past due.
Delinquency ratio = 1,300,000 / (37,500,000) = 3.47%
Note
343
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
The major reasons for securitization by banks are managing and transferring credit risk, seeking
funding for assets the bank owns, and managing balance sheet capital. Accessing the sectors
that are otherwise not open to the banks is one of the benefits associated with collateralization
and not necessarily a major reason for collateralization.
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
SPVs are mainly used for securitization purposes but can also offer all of the above functions:
(I) Issuing credit-linked notes (CLNs) where the notes are linked to he assets that have been sold
to the SPV. The note's performance is dependent on the performance of these assets, not the
sponsoring company/
(II) Converting the currency of underlying assets into another currency more acceptable to
investors, by means of a currency swap.
(III) Transforming illiquid into liquid ones. A food example would be trade receivables.
344
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%
Delinquency ratio = (Receivables overdue for more than 90 days) / (Total receivables)
= (130+60) / 1210 = 15.7%
Default ratio = (Amount Written off during the period) / (Total receivables for the period)
= 35 / 1210 = 2.89%
345
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
The overcollateralization in the pool is the difference between the amount of the assets and the
claims against the pool: $250,000,000 - $230,000,000 = $20,000,000.
Senior tranche investors begin to lose when the overcollateralization is gone and when the
subordinated A and B tranches have defaulted, so losses must be $20,000,000 + $20,000,000 +
$60,000,000 = $100,000,000 before the senior tranche suffers any losses.
346
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
Since CPR = 1 - (1 - SMM)12

SMM = 1 - (1-0.06)1/12 = 0.005143
Prepayment= SMM * (Outstanding principal less scheduled monthly principal payment)

= 0.005143 * ($100,000 - $28.61) = $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
CPR = 6% * 10/30 = 2%
175PSA = 1.75 x 2% = 3.50%
SMM = 1 - (1 - 0.035)1/12
= 0.002965
347
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
Under PSA, the conditional prepayment rate rises 0.2% per month for months 1-30 and levels off
at a rate of 6%.
Under the first scenario:
Since CPR = 1 - (1 - SMM)12
CPR = 6% * 22/30 = 4.4%
140PSA = 1.40 * 4.4% = 6.16%
SMM = 1 - (1-0.0616)1/12
= 0.0053 = 0.53%
Under the second scenario, the CPR is after month 30, so CPR = 6%:
CPR = 6%
90PSA = 0.9 x 6% = 5.4%
SMM = 1 - (1-0.054)1/12
= 0.0046 = 0.46%
She is incorrect in her estimate of the month 22 SMM, but correct in her estimate of month 200
SMM.
348
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
Debt service coverage ratio (DSCR) = Net operating income/Debt payments
= $68,000,000/$54,000,000 = 1.26
349
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%
Weighted average coupon (WAC) = Weighted coupon of the pool
= [0.084(24 million) + 0.07(32 million) + 0.068(16 million) + 0.056(8 million)] / (24 million + 32
million + 16 million + 8 million)
= 0.0724 or 7.24%
350
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
Weighted average maturity (WAM) = Weighted maturity of the pool
[82(26 million) + 169(67 million) + 253(22 million) + 336(17 million)] / (26 million + 67 million
+ 22 million +17 million) = 187.3 or 187 days
351
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
There is an important information asymmetry between the arranger and third-parties concerning
the quality of mortgage loans. An adverse selection problem emanates from the fact that the
arranger has more information about the quality of the mortgage loans. Consequently, the
arranger can securitize bad loans and keep the good ones.
352
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
In order to maintain the value of the underlying asset (the house), the mortgagor (borrower) has
to pay insurance and taxes on the property as well as maintain it. In the approach to and during
delinquency, the mortgagor has little incentive to do all that. The resolution of this friction is that
it requires 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. However, limited efforts on the part of the mortgagor to
maintain the property has no resolution and creates incentives for quick foreclosure.
353
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
Rating agencies did make efforts to disclose the criteria used to rate subprime MBSs. However,
investors did not have the ability to evaluate the efficacy of the models used. As a result, errors
in rating methodologies would sail through undetected.
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
A credit rating is basically an evaluation of a debt obligor’s creditworthiness. It gives a

comprehensive opinion, predicting the obligor’s ability to meet their obligations. Credit ratings
reflect default risk.
354
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
Corporate ratings do not rely explicitly on macroeconomic indicators. Rather, it’s the ABS ratings
that heavily rely on macroeconomic forecasts.
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
Non-agency asset classes include Jumbo, Alt-A, and Subprime. In a nutshell, the Jumbo asset
class includes loans to prime borrowers with an original principal balance larger than the
conforming limits imposed on the agencies by Congress; the Alt-A asset class involves loans to
borrowers with good credit but include more aggressive underwriting than the conforming or
Jumbo classes (i.e., no documentation of income, high leverage); and the Subprime asset class
involves loans to borrowers with poor credit history.
355
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
The credit risk characteristics which must be displayed by a subprime borrower are: Two or
more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last
24 months; Judgment, foreclosure, repossession, or charge-off in the prior 24 months;
Bankruptcy in the last five years; Relatively high default probability as evidenced by, for
example, a credit bureau risk score (FICO) of 660 or below (depending on the
product/collateral), or other bureau or proprietary scores with an equivalent default probability
likelihood; and/or, Debt service-to-income ratio of 50 percent or greater; or, otherwise limited
ability to cover family living expenses after deducting total debt-service requirements from
monthly income.
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
Since the originators of MBSs doubled up as financiers of credit rating agencies, the latter would
make sure to issue favorable ratings on the MBSs and hence “keep the client.”
356
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
Ideally, credit rating agencies should be independent experts in credit risk evaluation. This was
the overriding assumption made by most investors. A general lack of information regarding the
MBSs in the market made it difficult for the ordinary investor to carry out an informative
personal evaluation. This served to further increase investor reliance on credit rating reports.
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
Predatory lending is the practice of imposing unfair terms on borrowers or using coercive,
exploitative actions to convince the borrower to subscribe to loans that they don’t need, i.e.,
money that’s not “good” for them.
357
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
All the above features can be used to protect investors from losses related to the underlying
mortgage loans. Other features that can serve a similar purpose include performance triggers
and interest rate swaps.
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
The junior-most tranche of subprime mortgage loans is usually enhanced through the promise of
high returns. The lower tranches are much riskier and can face losses very quickly;
juniortranches have huge returns when defaults are low but are heavily hit when defaults are
high. Tranching redistributes the risk according to the risk appetite of investors: senior tranches
offer lower returns but are safer bets, and the junior tranches pay a higher returns and are
riskier.
358
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
If the ratings are correct, we would expect the probabilities or default rates to monotonically
increase as we descend the credit spectrum. A lack of monotonicity could indicate the presence
of errors in the ratings.
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
In a nutshell, the subprime credit rating process should involve two steps: First, the estimation
of a loss distribution, and second, the simulation of cash flows.
359
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
A low-quality servicer may negatively impact the accuracy of credit ratings. To mitigate the
impact of this friction, the credit rating agency should conduct due diligence on the servicer, use
the results of their analysis in the rating of MBSs, and also make their findings public.
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
The use of credit contracts can result in a number of frictions. These include asymmetric
information, risk shifting, moral hazard, adverse selection, externalities, and collective action
problems.
360
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
Friction between the bank and the regulator is NOT a friction associated with the securitization
process. All other options are frictions associated with the securitization process.
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
Being unemployed is not a characteristic used to define a subprime borrower. All other options
are characteristics used to define a subprime borrower as described in the Interagency
Expanded Guidance for Subprime Lending Program.
361
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
Securitization is not a typical structural feature of subprime trust.
A shifting interest mechanism in a senior-subordinated structure that provides for a higher

allocation of the prepayments to the senior tranche in early years.
Excess spread refers to the remaining interest payments and other fees that are collected on an
asset-backed security after all expenses are covered.
Subordination in banking and finance refers to the order of priorities in claims for ownership or
interest in various assets.
362

CH 6 Credit Risk Measurement and Management Answers

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Last Updated: Apr 5, 2021

77 - The Credit Decision 3

The correct answer is: A)

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

The correct answer is: D)

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

The correct answer is: D)

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

The correct answer is: B)

Four variables directly affect relative credit risk. These are:

The capacity of the obligor (borrower/counterparty/issuer) and their willingness to meet

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

The correct answer is: B)

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

The correct answer is: C)

The tenor (maturity) of the product;

B. loss given default.

The correct answer is: B)

C. Peer-to-peer secured asset lenders

The correct answer is: A)

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

The correct answer is: D)

Credit Risk Mitigation:

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

The correct answer is: A)

A. Legal and regulatory infrastructure

C. Funding and liquidity risk

D. Volatility risk in market interest rates

The correct answer is: A)

B. loss given default

The correct answer is: B)

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

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

The correct answer is: D)

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

The correct answer is: C)

The correct answer is: D)

The correct answer is: D)

Expected loss = PD × LGD × EAD

Expected loss = 0.04 × 0.60 × 0.55

Expected loss = 1.32%

The correct answer is: A)

Expected Loss = PD x (1-RR) x exposure