CRA CRA Credit Risk & Counterparty Exposure 1 — Questions and Answers
Question 1: Which metric measures the maximum potential loss a firm could face from a counterparty defaulting on its obligations?
- Credit Value Adjustment (CVA)
- Potential Future Exposure (PFE) (Correct answer)
- Expected Positive Exposure (EPE)
- Loss Given Default (LGD)
Correct answer: Potential Future Exposure (PFE)
Potential Future Exposure (PFE) represents the maximum credit exposure at a given confidence level over a specified time horizon.
Question 2: In credit risk analysis, LGD stands for:
- Liquidity Gap Determination
- Loss Given Default (Correct answer)
- Leverage Gross Discounting
- Loan Grade Distribution
Correct answer: Loss Given Default
Loss Given Default (LGD) is the percentage of an exposure that a lender loses when a borrower defaults, after accounting for recoveries.
Question 3: A credit analyst wants to estimate the likelihood that a borrower will fail to meet its debt obligations within one year. Which parameter does this describe?
- Exposure at Default (EAD)
- Loss Given Default (LGD)
- Probability of Default (PD) (Correct answer)
- Recovery Rate (RR)
Correct answer: Probability of Default (PD)
Probability of Default (PD) quantifies the likelihood that a borrower defaults within a defined time horizon, typically one year.
Question 4: Which credit risk framework allows banks to use internal models to estimate PD, LGD, and EAD for capital calculations?
- Standardized Approach
- Internal Ratings-Based (IRB) Approach (Correct answer)
- Credit Default Swap Model
- Credit VaR Model
Correct answer: Internal Ratings-Based (IRB) Approach
The Internal Ratings-Based (IRB) Approach under Basel II/III permits banks to use their own risk estimates for calculating minimum capital requirements.
Question 5: What is a Credit Default Swap (CDS) primarily used for in risk management?
- Hedging interest rate risk
- Transferring credit risk to another party (Correct answer)
- Diversifying equity portfolios
- Managing liquidity gaps
Correct answer: Transferring credit risk to another party
A Credit Default Swap (CDS) is a derivative contract that transfers the credit risk of a reference entity from the protection buyer to the protection seller.
Question 6: Wrong-Way Risk (WWR) in counterparty credit risk occurs when:
- Credit exposure decreases as counterparty creditworthiness deteriorates
- Credit exposure increases as counterparty creditworthiness deteriorates (Correct answer)
- Market risk and credit risk move in opposite directions
- Collateral value increases when default probability rises
Correct answer: Credit exposure increases as counterparty creditworthiness deteriorates
Wrong-Way Risk exists when exposure to a counterparty is adversely correlated with the counterparty's credit quality, increasing loss severity at default.
CRA CRA Credit Risk & Counterparty Exposure 1
Which metric measures the maximum potential loss a firm could face from a counterparty defaulting on its obligations?