Financial Risk Management Credit Risk Analysis 3

Question 1

What is a 'collateralized debt obligation' (CDO)?

Accepted Answer

A structured product that pools credit exposures and issues tranches with different seniority and risk profiles

Answer

A senior secured bank loan

Answer

An exchange-traded equity derivative

Answer

A government-guaranteed mortgage bond

Question 2

What is 'netting' in the context of counterparty credit risk?

Accepted Answer

Canceling out offsetting positive and negative mark-to-market values across multiple contracts with the same counterparty to reduce total exposure

Answer

The process of settling a defaulted derivative at par value

Answer

Combining multiple credit ratings into a single composite score

Answer

Reducing collateral requirements by posting higher-quality assets

Question 3

In Basel II/III, what does the 'internal ratings-based' (IRB) approach allow banks to do?

Accepted Answer

Use their own internal models to estimate PD, LGD, and EAD to calculate credit risk capital requirements

Answer

Use external credit agency ratings exclusively for capital calculation

Answer

Avoid holding any capital for investment grade exposures

Answer

Apply a flat 8% capital charge to all credit exposures regardless of risk

Question 4

What is 'recovery rate' in credit risk, and what is a typical value for senior unsecured bonds?

Accepted Answer

The fraction of the exposure recovered after default; typically 40% for senior unsecured bonds

Answer

The coupon recovery after a restructuring; typically 90%

Answer

The portion of a loan that is guaranteed; typically 100%

Answer

The rate at which credit spreads recover after a default event; typically 6 months

Question 5

What is 'Credit Value Adjustment' (CVA)?

Accepted Answer

The market value of counterparty credit risk embedded in a derivative, representing the expected cost of counterparty default

Answer

An adjustment to a bond's yield for its credit rating

Answer

A regulatory add-on to interest rate risk capital

Answer

The difference between quoted and fair value of a structured product

Question 6

What is a 'covered bond' and how does it differ from a standard bond in terms of credit risk?

Accepted Answer

A bond backed by a dedicated pool of high-quality assets (cover pool) that remains on the issuer's balance sheet, providing dual recourse to both issuer and collateral

Answer

A bond where the issuer's equity covers all losses; zero credit risk

Answer

A bond insured by a monoline insurance company

Answer

A bond where all coupon payments are collateralized by government securities