Question 1

Pure credit swaps are swaps by which an FI receives the:

Accepted Answer

Pure credit swaps involve an arrangement where a financial institution (FI) receives the par value of a loan if the borrower defaults. In return, the FI pays a periodic fee to the counterparty of the swap. This setup is designed to protect the FI from the risk of default by transferring that risk to the swap counterparty.

Question 2

Which of the following statements is true?

Accepted Answer

Both statements in option D are true. Swap participants deal with credit risk by setting bilateral limits on the notional amount of swaps entered into, similar to how lenders set limits on the amount they will lend to a borrower. They also adjust the fixed and/or floating rates to incorporate credit risk premiums, similar to how lenders charge higher interest rates to borrowers with higher credit risk.

Question 3

The relationship limit on diversification has also been called the 'paradox of credit'.

Accepted Answer

This is true. The paradox of credit refers to the fact that too much diversification can actually increase risk rather than decrease it, as it becomes difficult to manage and monitor an increasingly complex portfolio.

Question 4

The concentration limit for a loan portfolio is calculated as the expected default frequency of the borrower multiplied by (one divided by the loss rate).

Accepted Answer

This is the correct formula for calculating concentration limit for a loan portfolio.

Question 5

Which of the following is a major difference between forwards and futures?

Accepted Answer

The major difference between forwards and futures is that the default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against credit risk, while this is not the case for forwards. Option A is incorrect as forwards are not marked-to-market, while futures are. Option B is incorrect as it is the opposite - forwards are tailor made, while futures are standardised. Option D is incorrect as it contains contradictory statements - forwards cannot be marked-to-market while being at the same time not marked-to-market.

Question 6

A transition matrix can be used to establish the probabilities that a currently rated borrower will be upgraded, downgraded or will default over time.

Accepted Answer

This is true. A transition matrix is a tool used to analyze the probability of a borrower's rating changing over time. It shows the likelihood of a borrower being upgraded, downgraded, or defaulting, and helps lenders and investors understand the overall credit risk of their portfolios.

Question 7

Using the KMV Portfolio Manager Model, the risk on a loan can be calculated as the volatility of the loan's default rate times the loss in the event of default.

Accepted Answer

The KMV Portfolio Manager Model calculates the value at risk (VaR) of a loan portfolio based on the volatility of the underlying default rates and the expected loss in the event of default. The formula for VaR is: VaR = Asset value x PD x LGD x N, where PD is the probability of default, LGD is the loss given default, and N is the number of loans in the portfolio. Therefore, the risk on a loan can be calculated as the product of PD and LGD, which represents the expected loss in the event of default. The volatility of the default rate is used to estimate the probability of default (PD) over a certain time horizon.

Question 8

Which of the following is a major difference between a pure credit swap and a default option?

Accepted Answer

A pure credit swap involves periodic premium payments over the life of the swap, while a default option typically involves an upfront fee. Therefore, option B is the major difference between the two instruments.

Question 9

Minimum risk portfolios generally generate the highest returns.

Accepted Answer

This statement is false. Generally, higher risk portfolios have the potential for higher returns, but also carry a higher risk of loss. Lower risk portfolios may have lower returns but are generally considered to be safer investments.

Question 10

A pure credit swap:

Accepted Answer

A pure credit swap is akin to buying credit insurance because it provides protection against credit default. It is also similar to buying a multi-period credit option because it offers the right, but not the obligation, to receive compensation for credit losses over multiple periods. Additionally, it eliminates the interest rate risk contained in the total return swap by isolating the credit risk component, thus focusing solely on the credit aspect without being affected by fluctuations in interest rates.

Question 11

Loan sales and securitisation are increasingly seen as valuable tools in the management of credit risk.Which of the following are not advantageous to FIs?

Accepted Answer

Loan sales and securitisation do not create moral hazard issues and reduce scrutiny on off-balance sheet activities of FIs. In fact, they increase transparency and disclosure requirements. However, they do provide advantages such as allowing FIs to better manage their credit risk exposure, reducing industry and/or geographical concentration risk, and separating credit risk exposure from the lending process.

Question 12

Loan loss ratio based models estimate systematic loan losses by running a time-series regression of quarterly losses of the ith sector's loss rate on the quarterly loss rate of an FI's total loans.

Accepted Answer

Loan loss ratio based models do use time-series regression to estimate systematic loan losses by examining the loss rate of a sector and the total loans of a financial institution.

Question 13

Concentration limits are external limits set on the maximum loan size that can be made to an individual borrower.

Accepted Answer

Concentration limits are indeed external limits that restrict the maximum loan size that can be extended to an individual borrower. It is designed to limit the amount of exposure a lender has to a particular borrower and prevent the lender from having an excessive concentration of loans in any one area or with any one borrower.

Question 14

Which of the following is not a reason for the credit risk on a swap to be less than the credit risk on a loan?

Accepted Answer

The answer of Which of the following is not a...

Question 15

Which of the following is incorrect in relation to debt recovery rates?

Accepted Answer

The answer of Which of the following is incorrect in...

Question 16

FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.

Accepted Answer

The law of large numbers states that as the sample size increases, the results become more predictable and stable. FIs can use this principle to reduce the overall risk in their portfolio by diversifying their investments across a large number of assets. By doing so, they can minimize the impact of individual stock or bond performance on the overall portfolio returns.

Question 17

Which of the following statements is true?

Accepted Answer

Total return swaps are structured so that any capital gains or losses are paid at the end of the swap, but alternative arrangements such as periodic payments can also be negotiated between the parties. Pure credit swaps, on the other hand, do not involve the transfer of ownership or underlying asset and are typically settled at the end of the swap.

Question 18

A forward contract:

Accepted Answer

A forward contract has more credit risk than a futures contract because it is an agreement between two parties and there is no clearinghouse involved to guarantee the performance of both parties. In contrast, a futures contract is traded on an exchange and is subject to the clearinghouse, which helps to mitigate credit risk. The other options are incorrect: 
B) A futures contract is more standardised than a forward contract because it has specific contract specifications that are the same for all market participants. 
C) A futures contract is marked to market more frequently than a forward contract, as it is done daily to reflect the current market value of the contract. 
D) A forward contract may have a longer or shorter time to delivery than a futures contract, as the delivery date is agreed upon by the parties involved.

Question 19

An FI that invests 40 per cent of funds in a loan with an expected return of 10 per cent and 60 per cent of funds in a loan with an expected return of 12 per cent can expect to earn 11 per cent on its portfolio.

Accepted Answer

The answer of An FI that invests 40 per cent...

Question 20

Using the KMV Portfolio Manager Model, the return on a loan can be calculated as the annual all-in-spread minus the loss in the event of default.

Accepted Answer

The answer of Using the KMV Portfolio Manager Model, the...

Quiz 11: Credit Risk II: Loan Portfolio and Concentration Risk

Pure credit swaps are swaps by which an FI receives the:

Which of the following statements is true?

The relationship limit on diversification has also been called the 'paradox of credit'.

The concentration limit for a loan portfolio is calculated as the expected default frequency of the borrower multiplied by (one divided by the loss rate).

Which of the following is a major difference between forwards and futures?

A transition matrix can be used to establish the probabilities that a currently rated borrower will be upgraded, downgraded or will default over time.

Using the KMV Portfolio Manager Model, the risk on a loan can be calculated as the volatility of the loan's default rate times the loss in the event of default.

Which of the following is a major difference between a pure credit swap and a default option?

Minimum risk portfolios generally generate the highest returns.

A pure credit swap:

Loan sales and securitisation are increasingly seen as valuable tools in the management of credit risk.Which of the following are not advantageous to FIs?

Loan loss ratio based models estimate systematic loan losses by running a time-series regression of quarterly losses of the ith sector's loss rate on the quarterly loss rate of an FI's total loans.

Concentration limits are external limits set on the maximum loan size that can be made to an individual borrower.

Which of the following is not a reason for the credit risk on a swap to be less than the credit risk on a loan?

Which of the following is incorrect in relation to debt recovery rates?

FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.

Which of the following statements is true?

A forward contract:

An FI that invests 40 per cent of funds in a loan with an expected return of 10 per cent and 60 per cent of funds in a loan with an expected return of 12 per cent can expect to earn 11 per cent on its portfolio.

Using the KMV Portfolio Manager Model, the return on a loan can be calculated as the annual all-in-spread minus the loss in the event of default.