Chapter 4: Credit Risk

Question 1

What is credit risk at it’s most basic level?

Answer 1

Not being repaid on a loan

Question 2

What is the party with the financial obligation called?

Answer 2

The obligor

Question 2

What are the two forms of credit risk?

Answer 2

Counterparty Risk
Issuer Risk

Question 3

What is the goal of credit risk management?

Answer 3

Maximise risk-adjusted rate of return by maintaining credit risk exposure limits

Question 4

What is counterparty risk?

Answer 4

The risk that a counterparty fails to fulfil its contractual obligations

Question 5

What is issuer risk?

Answer 5

The risk that the issuer of a bond could default on its obligations to pay coupons or principal

Question 6

What is concentration risk?

Answer 6

When a institution has a uneven distribution to individual issuers

Question 7

What is single-name concentration

Answer 7

Exposure to individual issuer

Question 8

What is sectorial concentration?

Answer 8

Exposure to a single sector

Question 9

How can settlement risk occur with FX forwards contracts?

Answer 9

Time zone difference meaning the payments are made at different times.

Question 10

What is pre-settlement risk?

Answer 10

Where an institution defaults before settlement of the transaction if the transaction has a positive economic value to the other party.

Question 11

What is an example of pre-settlement risk?

Answer 11

Agreeing to purchase 100 shares at $10. If the price goes to $15 after and the counterparty defaults the buyer is exposed to pre-settlement risk even if no cash has been sent.

Question 12

What is Systemic Risk?

Answer 12

Breakdown of the entire financial system rather than an individual firm.

Question 13

What makes systemic risk possible?

Answer 13

Close interlinkages between different parts of the financial system

Question 14

What is a credit risk boundary issue?

Answer 14

Operational risks to be considered when banks are developing their credit administration areas.

Question 15

What are the three credit risk boundary issues areas?

Answer 15

1: Internal Processes
2: Systems
3: People

Question 16

What are the three basic techniques for measuring credit risk?

Answer 16

1. Credit Exposure
2. Credit Risk Premium
3. Credit Ratings

Question 17

What is credit exposure?

Answer 17

The amount that can potentially be lost if a debtor defaults.

Question 18

What is potential future exposure?

Answer 18

Estimate of the likely loss at some point in the future
E.g. If debtor defaults and collateral is stock, the value will change

Question 19

How can potential future exposure be calculated?

Answer 19

Statistical techniques such as VaR

Question 20

What is credit risk premium?

Answer 20

It’s the difference between the interest rate a firm pays when it borrows and the interest rate on a default-free security such as a government bond.

Question 21

What is the relationship between credit risk premium and credit ratings?

Answer 21

The higher the credit rating, the lower the chance of default thus a lower credit risk premium.

Question 22

What did the Basel Accord introduce for credit risk calculation?

Answer 22

A standardised approach for credit rating.

Question 23

What is a sovereign credit rating?

Answer 23

Take into account overall economic conditions of a country, including political stability.

Question 24

What are some criticisms of rating agencies?

Answer 24

1. Not fast enough 2. Conflict of interest 3. Possibility of error

Question 25

What is the Expected Loss Calculation?

Answer 25

EL = PD * EAD * LGD

Question 26

What is PD?

Answer 26

Probability of Default (%)

Question 27

What is EAD?

Answer 27

Exposure at Default (Amount)

Question 28

What is LGD?

Answer 28

Loss Given Default (%)

Question 29

What is RR?

Answer 29

Recovery rate, 100% - LGD How much of your loan you can recover in case of default

Question 30

What is a Credit Event?

Answer 30

No specific definition. Bankruptcy, insolvency, credit-rating downgrade

Question 31

What is Wrong Way Risk

Answer 31

Exposure to a counterparty is adversely correlated with the credit quality of that counterparty

Question 32

What is an example of wrong way risk?

Answer 32

A company using its own stock as collateral on a loan, as risk of the counterparty defaulting decreases so will the value of the collateral.

Question 33

What is a Non-Performing Asset?

Answer 33

Loans whose repayments are not being made on time. Usually 90 days

Question 34

What is a credit limit?

Answer 34

Maximum limit for all aspects of credit exposure set by institutions

Question 35

What are the 4 main limitations of credit risk measurement?

Answer 35

1. Using simplified calculations for potential exposure 2. Time period not factored - risk of default increases with time exposure 3. Diversification not factored in - 20 As may be less risky better than one AAA 4. Probabilities are used which are not always accurate

Question 36

What is an underwriting standard?

Answer 36

Standards that institutions apply to borrowers to evaluate creditworthiness.

Question 37

What is used when evaluating businesses for underwriting loans?

Answer 37

Financial statements Earnings Industry Analysis Loan terms

Question 38

What is a Guarantee?

Answer 38

To make a bond more attractive issuers can arrange for another entity to guarantee their loan.

Question 39

What is a netting agreement?

Answer 39

Combining opposite transactions into one to reduces settlement risk.

Question 40

What is collateral?

Answer 40

An asset held by the lender on behalf of the obligor, as security for a loan.

Question 41

What is a Credit Default Swap? CDS

Answer 41

Essentially insurance for a loan. If a bank makes a loan they can pay a premium to a third party who will make them whole if the the loan defaults.

Question 42

What is a Collateralized Debt Obligation? CDO

Answer 42

ASK CHAT GPT NO IDEA

Question 43

How can you limit credit exposure to a particular counterparty?

Answer 43

Through CDs, you can mitigate the risk by paying a premium to a third party.

Question 44

What is a loan sale?

Answer 44

Instead of collecting regular income off a loan a lender can choose to sell the loan to receive a lump sum payment

Question 45

What is a central counterparty?

Answer 45

Acts as the guarantor of all transactions, protecting members from default. Acts as a simultaneous counterparty - E.g. CREST

Question 46

What is a collateral adequacy calculation?

Answer 46

When a short position is taken often collateral is offered for the value of the shares borrowed. In case of the value of the collateral falling a fee is charged, this fee is based on the volatility of the collateral. E.g. If $100 million IBM shares are lent, and government bonds are offered as collateral, how much collateral should be lodged with the lending firm? $100m + ($100m x 3%) = $103m

Question 47

What does a credit risk management function do?

Answer 47

Manages credit risk by Setting credit policy Performing credit analysis on counterparty Assessing risk events