Credit Risk Measurement & Management

FRM® Part II, published weight 20%. Merton and reduced-form models, credit VaR, counterparty risk, CVA, CDOs.

What the outline covers

Credit analysis and the credit process; ratings and rating transitions
Structural and reduced-form default models; Merton model
Portfolio credit risk, default correlation and credit VaR
Counterparty risk, CVA/DVA/FVA and wrong-way risk
Netting, collateral and margining
Credit derivatives and credit default swaps
Securitisation, structured credit and CDOs
Basel credit risk capital frameworks; stress testing credit portfolios

Sample questions

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Question 1

Under the Merton model, an increase in the volatility of the firm’s assets will:

A. Increase equity value and decrease default probability
B. Increase equity value and increase default probability
C. Decrease equity value and increase default probability
D. Leave equity value unchanged

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B. Equity is a call on the firm’s assets, so higher asset volatility raises its value. It simultaneously raises the probability the assets fall below the debt.

Reading: Credit Risk — Structural Default Models

Question 2

Holding individual default probabilities constant, an increase in default correlation across a credit portfolio will:

A. Increase expected loss and increase credit VaR
B. Leave expected loss unchanged and increase credit VaR
C. Increase expected loss and leave credit VaR unchanged
D. Reduce both measures

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B. Expected loss depends only on individual PDs. Correlation fattens the tail of the loss distribution, which is what credit VaR measures.

Reading: Credit Risk — Portfolio Credit Risk

Question 3

A bank buys credit protection on a sovereign from a bank domiciled in that same sovereign. This is a clear example of:

A. Right-way risk
B. Wrong-way risk
C. Basis risk
D. Settlement risk

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B. The protection seller is most likely to default precisely when the protection is needed, so exposure and counterparty credit quality move adversely together.

Reading: Credit Risk — Counterparty Risk and CVA

Question 4

In a CDO structure, an increase in default correlation across the collateral pool will most likely:

A. Benefit the equity tranche and harm the senior tranche
B. Harm the equity tranche and benefit the senior tranche
C. Benefit both tranches
D. Have no effect on either tranche

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A. Higher correlation raises the probability of zero losses (helping equity) and of very large losses (harming senior). Senior tranches are effectively short correlation.

Reading: Credit Risk — Structured Credit and CDOs

Question 5

Which mechanism most directly reduces counterparty credit exposure without changing the underlying trades?

A. Increasing the notional
B. Close-out netting and collateral agreements
C. Extending the maturity
D. Widening the credit spread charged

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B. Netting offsets positive and negative exposures to the same counterparty, and collateral covers the residual. Neither alters the trades themselves.

Reading: Credit Risk — Netting, Collateral and Margining

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