PASS PRO Questions

PASS PRO - Copyright 2004 Inmarkets Ltd - Licensed to Raymond chen Ò ³Â ë£ ¬1/85
Print Close
PASS PRO Questions
1.
Based on historical data from S&P, the 1-year default probability for A-rated firms is CLOSEST
to:
A. 0.05%.
B. 0.5%.
C. 1%.
D. 5%.
2.
A portfolio manager owns $18 million worth of AA-rated bonds and $10 million worth of BB-
rated bonds. The one-year default probabilities of these bonds are 2 percent and 6 percent
respectively and are independent of each other.
The estimated recovery rates for these bonds are 65 percent and 35 percent respectively.
Based on these assumptions, the one-year expected credit loss from this portfolio is CLOSEST
to:
A. 0.42.
B. 0.44.
C. 0.52.
D. 0.96.
3.
Based on historical data from S&P, the 1-year default probability for AA-rated firms is CLOSEST
to:
A. 0.01%.
B. 0.1%.
C. 1%.
D. 10%.
4.
Which of the following is TRUE in relation to the dividend test provision?
A. It prevents the firm from paying any dividends.
B. It prevents the firm from issuing new debt to pay dividends.
C. It prevents the firm from draining its capital via excessive dividends.
D. It upholds the right of shareholder to received their dividends in the event of a merger.
5.
http://my.passpro.com/inmarkets/passpro/index.cfm?event=questions.... 2004-08-03
Baa-rated firms have been observed to have a probability of default of 0.25, 80 and 1.4 percent
during years 1, 2, and 3 from the present. The probability that a Baa-rated firm will default
within the next three years is CLOSEST to:
A. 41.84%.
B. 80.28%.
C. 80.33%.
D. 81.65%.
6.
Consider a firm that has a cumulative default probability over 9 years of 18 percent and a
marginal probability of default in the 10th year of 9 percent. The cumulative default probability
of this firm over 10 years will be:
A. 21.29%.
B. 23.65%.
C. 25.38%.
D. 27.00%.
7.
BBB-rated firms have default rates of 0.2% over the first year and 6.6% the year after. The
cumulative default probability of such firms over the two years is CLOSEST to:
A. 0.01%.
B. 6.79%.
C. 6.80%.
D. 6.81%.
8.
Ba-rated firms have been observed to have probability of default of 0.8, 1.4 and 2.1 percent
during years 1, 2, and 3 from present. The probability that a Ba-rated firm will default within
the next three years is CLOSEST to:
A. 1.43%.
B. 3.47%.
C. 4.24%.
D. 4.30%.
9.
A trader has long positions of $100 million and $300 million on two securities that have default
probabilities of 6 percent and 10 percent respectively. If the joint probability of default is 2
percent and the recovery rate is 55 percent, the total expected loss due to credit defaults over
the next year is CLOSEST to:
A. $12.60 million.
B. $18.72 million.
C. $19.39 million.
D. $19.80 million.
10.
BBB-rated firms have default probability of 0.2% over a period of one year. Based on this
information the default probability over the next quarter will be CLOSEST to:
A. 0.05%.
B. 0.45%.
C. 0.50%.
D. 1.50%.
11.
B-rated firms have been observed to have probability of default of 1.9, 3.4 and 5.8 percent
during years 1, 2, and 3 from present. The probability that a B-rated firm will default within the
next three years is CLOSEST to:
A. 3.71%.
B. 9.00%.
C. 10.73%.
D. 11.10%.
12.
Based on historical data from Moody's, the 1-year default probability for B-rated firms is
CLOSEST to:
A. 0.1%.
B. 0.3%.
C. 1.4%.
D. 4.5%.
13.
The position of a lender is most similar to a:
A. long put.
B. long call.
C. short put.
D. short call.
14.
A portfolio consists of ten A-rated bonds that have a one-year default probability of 1.12% and
no correlation between them. What is the probability that the portfolio will suffer no loss over
this period?
A. 89%.
B. 91%.
C. 93%.
D. 95%.
15.
The ratio of the default probability of an A-rated issuer over the default probability of a AAA-
rated issuer generally:
A. remains constant over time.
B. increases with the time horizon.
C. decreases with the time horizon.
D. may increase or decrease depending on the given industrial sector.
16.
Based on historical data from S&P, BBB-rated firms were 22 times as likely to default over a 1-
year period than an AA-rated firm. What is this ratio likely to be over the 10-year horizon?
A. 5
B. 20
C. 35
D. 50
17.
Ba-rated firms have been observed to have constant probability of default of 2 percent each
year over a 10-year horizon. The probability that a Ba-rated firm will default at some point
within ten years is CLOSEST to:
A. 18.29%.
B. 19.34%.
C. 19.66%.
D. 20.00%.
18.
B-rated firms have been observed to have constant probability of default of 2 percent each year
over a 10-year horizon. The probability that a B-rated firm will default at some point within ten
years is CLOSEST to:
A. 17.02%.
B. 18.29%.
C. 19.59%.
D. 20.00%.
19.
Which of the following is TRUE in relation to affirmative covenants?
A. They prohibit the borrower from issuing new debt.
B. They prohibit the borrower from paying dividends above a limit to shareholders.
C. They require the borrower to take actions to service the debt and maintain collateral.
D. They prohibit the borrower from paying dividends under certain circumstances to
shareholders.
20.
The negative pledge clause in bond covenants contains:
I. else clause.
II. unless clause.
III. exceptions section.
IV. prohibitions section.
A. I and II.
B. II and III.
C. I, II, and III.
D. II, III, and IV.
21.
Which of the following is TRUE in relation to negative covenants?
A. They prohibit the borrower from undertaking new lines of business.
B. They prohibit the borrower from certain actions such as issuing new debt.
C. They require the borrower to adhere to all the terms and conditions of the loan.
D. They require the borrower to take actions to service the debt and maintain collateral.
22.
Which of the following is a measure of short-term solvency?
A. Current ratio.
B. Times interest coverage.
C. Debt to capitalization ratio.
D. Total debt to earnings ratio.
23.
Which of the following are included in the 'four Cs' of credit analysis?
I. Capacity.
II. Correlation.
III. Character.
IV. Collateral.
A. I and II.
B. II and III.
C. I, III and IV.
D. II, III, and IV.
24.
Baa-rated firms have been observed to have probability of default of 0.4, 0.75 and 1.3 percent
during years 1, 2, and 3 from present. The probability that a Baa-rated firm will default within
the next three years is CLOSEST to:
A. 0.82%.
B. 2.04%.
C. 2.43%.
D. 2.85%.
25.
Ba-rated firms have been observed to have a constant probability of default of 2 percent each
year over a 10-year horizon. The probability that a Ba-rated firm will default at some point
within 10 years is CLOSEST to:
A. 9.88%.
B. 12.71%.
C. 18.29%.
D. 20.00%.
26.
Bank B lends $10 million to Company C for six months and receives $12 million worth of US
Treasuries as collateral. The 6-month default probability of the Company C is 2 percent and the
6-month 99% VaR on the Treasuries is $2 million. Assuming that the performance of Company
C is not affected by interest rates, the probability of Bank B not recovering the full principal of
the loan is most will be closest to:
A. 0.002%.
B. 0.02%.
C. 0.2%.
D. 2%.
27.
A bank has a loan book with four A-

rated borrowers and two BB-rated
borrowers. Using S&P's default
probabilities given on the right and
assuming the defaults to be
independent, the probability that none
of the bank's customers will default
within the next year is CLOSEST to:
A. 95.81%.
B. 97.83%.
C. 98.95%.
D. 99.82%.
28.
A bank has a loan book with one A-

rated borrower and one B-rated
borrower. Using S&P's default
independent, the probability that both
A. 0.0023%.
B. 0.04%.
C. 5.78%.
D. 5.82%.
29.
A bank has a loan book with four BB-

rated borrowers and two B-rated
independent, the probability that at
least one of the bank's customers will
default within the next year is
CLOSEST to:
A. 6.77%.
B. 14.83%.
C. 15.68%.
D. 26.38%.
30.
A bank has a loan book with four AA-

rated borrowers and two BBB-rated

CLOSEST to:
A. 0.23%.
B. 0.45%.
C. 0.48%.
D. 0.92%.
31.
If a default has occurred, which of the following would you expect to have the highest rate of
recovery?
A. Senior secured.
B. Junior subordinated.
C. Senior subordinated.
D. All of the above has similar recovery rates.
32.
If the price of a zero coupon risk-free bond, maturing in five years, is 60.653066. The
instantaneous default rate is 5% with no recovery in the case of default. What is the continuous
compounded yield on a risky 5-year zero?
A. 14.50%.
B. 15.00%.
C. 15.50%.
D. None of the above.
33.
Consider a curve where the value of a convertible bond is on the y-axis and the x-axis has the
value of the issuer's common stock. This curve would most closely resemble:
A. a long forward position on the stock.
B. a short forward position on the stock.
C. a long put option position on the stock.
D. a short call option position on the stock.
34.
Bank B lends $10 million to Company C for six months and receives guarantee from an
unrelated Bank G for the full principal of the loan. The 6-month default probability of the
Company C is 2 percent and that of Bank G is 0.5 percent. The probability of Bank B not
recovering the full principal of the loan will be closest to:
A. 0.01%.
B. 0.5%.
C. 1.5%.
D. 2%.
35.

A. 76.60%.
B. 88.20%.
C. 88.56%.
D. 94.14%.
36.
Suppose that the yield on 1-year Treasury zero is 2% and the constant, cumulative probability
of default on AAA bonds is 1%. If the recovery rate in the case of default is zero, what is the
continuous compounded yield on AAA 1-year zero?
A. 2.98%.
B. 3.00%.
C. 3.01%.
D. 3.03%.
37.

A. 0.0023%.
B. 0.23%.
C. 0.04%.
D. 5.82%.
38.
PASS PRO - Copyright 2004 Inmarkets Ltd - Licensed to Raymond chen Ò ³Â ë£ ¬
10/85
rated bonds. The one-year default probabilities of these bonds are 1.5 percent and 5 percent
to:
A. 0.58.
B. 0.75.
C. 1.00.
D. 1.75.
39.
Bank B lends $25 million to Company C for twelve months and receives $30 million worth of US
Treasuries as collateral. The 12-month default probability of the Company C is 4 percent and
the 12-month 99% VaR on the Treasuries is $7 million. Assuming that the performance of
Company C deteriorates with the rise in interest rates, the probability of Bank B not recovering
the full principal of the loan will be:
A. between 0.04% and 0.2%.
B. between 0.04% and 4%.
C. between 0.2% and 4%.
D. above 4%.
40.

rated borrower and one BB-rated
A. 0.04%.
B. 0.21%.
C. 1.01%.
D. 1.05%.
41.
A trader has long positions of $50 million and $70 million on two securities that have default
probabilities of 2 percent and 3 percent respectively. If the joint probability of default is 2
percent and the recovery rate is 60 percent, the total expected loss due to credit defaults over
the next year is CLOSEST to:
A. $0.28 million.
B. $2.17 million.
C. $2.18 million.
11/85
D. $2.20 million.
42.
Bank B lends $10 million to Company C for six months and receives $12 million worth of US
Treasuries as collateral. The 6-month default probability of the Company C is 2 percent and the
6-month 99% VaR on the Treasuries is $2 million. Assuming that the performance of Company
C improves with the rise in interest rates, the probability of Bank B not recovering the full
principal of the loan will be:
A. less than 0.02%.
B. 0.02%.
C. between 0.02% and 2%.
D. 2%.
43.

rated borrowers and two BB-rated
CLOSEST to:
A. 1.05%.
B. 2.17%.
C. 3.18%.
D. 4.19%.
44.
Bank B lends $20 million to Company C for six months and receives $24 million worth of
Company C's stock as collateral. The 6-month default probability of Company C is 5 percent and
the 6-month 99% VaR on the company's stock is $4 million. The probability of Bank B not
recovering the full principal of the loan will be closest to:
A. 0.05%.
B. 0.5%.
C. 2.5%.
D. 5%.
45.
The marginal default probability of a bond is estimated to be secularly declining over the next
ten years. What is the most likely current rating of the bond?
A. AAA.
B. AA.
12/85
C. B.
D. Insufficient information.
46.
rated bonds. The one-year default probabilities of these bonds are 2 percent and 7 percent
to:
A. 0.94.
B. 0.96.
C. 1.20.
D. 2.14.
47.
The rate of default for a bond is 5% per annum. What is probability that the bond will not be in
default after three years?
A. 15.0%.
B. 85.0%.
C. 85.7%.
D. Insufficient Information.
48.
A bank has a loan book with one BB-

A. 0.0481%.
B. 0.0582%.
C. 0.0588%.
D. 0.0683%.
49.
A bank has a loan book with four BBB-

13/85

A. 76.04%.
B. 87.48%.
C. 87.92%.
D. 93.97%.
50.
A bank has a loan book with four BB-

A. 73.62%.
B. 84.32%.
C. 85.17%.
D. 93.23%.
51. Let's assume the recovery rate is 60%. The credit spread is 6%. What is the probability of
observing no default?
A. 10%.
B. 85%.
C. 90%.
D. 100%.
52. Assume the default rate is continuously compounded at 5% (hazard rate). The yield on
risky bond is 7%. What is the risk-free rate? Assume no recovery.
A. 1.65%.
B. 1.90%.
C. 2.00%.
D. 2.10%.
53. A zero coupon bond has five years to maturity. If the bond defaults, we expect to receive
25% of the value, measured in today's money terms, after a period of three years from the
scheduled maturity of the bond. Which of the following shows the recovery rate to be used in
the analysis of credit spreads?
A. 25%.
14/85
B. 25 % x (1+ rf) ^5 ; where rf is the risk-free rate.
C. 25% / (1 + rf) ^3; where rf is the risk-free rate.
D. 25% / (1 + rf ) ^ 8; where rf is the risk-free rate
54. Which of the following statements are TRUE?
A. As the recovery rate increases, the credit spread increases.
B. As the recovery rate increases, the credit spread decreases.
C. As the loss given default increases, the credit spread decreases.
55. The risk-free rate is 10%. The recovery rate for analytics is taken at 50%. The actual
recovery is expected at the end of three years from normal maturity date of the bond. What is
amount expected to be recovered on a $5m holding where default is observed?
A. $1.8783m.
B. $2.5000m.
C. $3.3275m.
56. The default rate for a one-year bond is 5% and the prevailing risk-free rate is 1%.
Assuming the default rate is the discrete rate and there is no chance of any recovery, what is
the required yield for this risky debt?
A. 5.31%.
B. 6.00%.
C. 6.25%.
D. 6.31%.
57. The default rate for a one-year bond is 5%. Assume the default rate is discrete rate and
there is no chance of any recovery. The risk-free rate is 1%. What is the credit spread expected
on a risky debt?
A. 5.31%.
B. 6.00%.
C. 6.25%.
D. 6.31%.
58. Your analysis shows that if a risky bond defaults, we can expect to recover 2,102.02 per
10,000 of face value, after a period of five years from the scheduled maturity date of the bond?
The yield curve for risk-free debt is flat at 1.00%. What is the LGD ratio for this debt?
A. 20.00%.
B. 21.02%.
C. 22.09%.
59. Let's assume the recovery rate is 40% and the default rate is 10%. What is the
15/85
approximate credit spread for this bond?
A. 60 % x 40% = 2.4%.
B. 40% x 10 % = 4%.
C. 60% x 10% = 6%.
D. 90% x 10% = 9%.
60. Let's consider a hazard rate (continuously compounded default rate) of 5%. What is the
probability that the bond will NOT be in default at the end of year 1.
A. 95.12%
B. 95.00%
C. 94.88%
61.
B-rated firms have been observed to have constant probability of default of 4 percent each year
over a 5-year horizon. The probability that a Ba-rated firm will default at some point within five
years is CLOSEST to:
A. 15.64%.
B. 16.26%.
C. 18.46%.
D. 20.00%.
62.
A Poisson distribution of defaults has an average of 6. What is the probability that there will be
6 defaults over the next year?
A. 6.5%.
B. 10.1%.
C. 16.1%.
D. 50.0%.
63. Which of the following statements are TRUE for CREDITRISK+?
A. It incorporates the effects of default correlations by using default rate volatilities and sector
analysis.
B. It uses default correlations as a direct input.
C. Both of the above.
64.
Which of the following is not an objection to the CreditRisk+ model?
A. Computationally intensive.
16/85
B. Assumes no relationship between credit and market risk.
C. Cannot accommodate products that have non-linear payoffs.
D. Assumes constant exposures that are unaffected by changes in credit quality.
65.
CreditRisk+ model makes the assumption that the bankruptcy and recovery process is:
A. exogenous.
B. endogenous.
C. normally distributed.
D. lognormally distributed.
66.
The current values of a firm's assets and liabilities are 200 million and 160 million respectively.
If the asset values are expected to grow by 40 million and liability values by 30 million within a
year and if the annual standard deviation of these values is 50 million, the distance from default
in the KMV model would be closest to:
A. 0.8 standard deviations.
B. 1.0 standard deviations.
C. 1.2 standard deviations.
D. Cannot not be determined.
A. It is assumed that the probability of default is not a function of time or age of the bond.
B. The number of defaults occurring in any one period is assumed to be independent of the
number of defaults occurring in any past period.
I. The mean and the variance of a Poisson Distribution are the same.
II. The mean and the volatility of a Poisson Distribution are the same.
III. The volatility of the Poisson distribution is given by ( Mean ^ 0.5).
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
A. If a portfolio has a small number of assets (independent exposures), the CREDITRISK+ will
loose meaning as the correlations cannot be modeled properly for small number of
exposures.
17/85
B. If a portfolio has a small number of assets (N=independent exposures), the CREDITRISK+

will loose meaning as P(n) for all n > N will be large and cannot be ignored.
70.
A credit manager discovers that the defaults by sub-investment grade clients of his bank follow
a Poisson distribution, with an average number of defaults in the year equal to 7. What is the
probability that there will be 6 defaults over the next year?
A. 12.1%.
B. 12.8%.
C. 13.5%.
D. 14.9%.
I. The analytical approaches are verifiable as they make ex-ante predictions about the behavior
of variables, which can be later proven right or wrong.
II. The actuarial approach makes assumptions about the effect of the volatility of the assets of
the firm and the leverage on the probability of default and on the recovery rates once default
happens.
III. The analytical approaches, such as contingent claim analysis, make assumptions about the
effect of the volatility of the assets of the firm and the leverage on the probability of default and
on the recovery rates once default happens.
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
72.
A. 0.00%
B. 1.80%
C. 3.80%
D. 5.80%
73.
A. 4.5%.
B. 6.5%.
C. 8.0%.
18/85
D. 11.0%.
74. Which of the following statements are TRUE for distribution assumed in CREDITRISK+? The
mean of the Poisson distribution:
A. follows a normal distribution.
B. follows another poisson distribution.
C. follows a gamma distribution.
D. is constant.
75.
Which of the following is not an advantage of the CreditRisk+ model?
A. Easy to implement.
B. Requires little data.
C. Only requires default probability and exposures.
D. Assumes no relationship between credit and market risk.
76.
A. 8.15%.
B. 9.15%.
C. 10.54%.
D. 12.54%.
77.
A. 0.0%.
B. 1.8%.
C. 4.2%.
D. 10.3%.
78.
A. 1.1%.
B. 1.8%.
C. 2.6%.
19/85
D. 2.9%.
A. The exposures are reduced by the expected loss amounts and these new exposures are used
to calculate credit risk.
B. The recovery rate is modeled as a normal distribution.
C. The recovery rate is modeled as a gamma distribution.
D. The recovery rate is modeled as poisson distribution with mean following a gamma
distribution
A. The actuarial approach (CREDITRISK +) ignores the risk of credit migration; hence it may
underpredict the credit risk of a portfolio with a short investment horizon.
B. The actuarial approach (CREDITRISK +) ignores the risk of credit migration; hence it may
overpredict the credit risk of a portfolio with short investment horizon.
C. The actuarial approach (CREDITRISK +) does not ignore the risk of credit migration.
I. The actuarial approach does not make any theoretical assumptions on the probability of
default.
II. CreditRisk+ assumes the probability distribution for the number of defaults over any period
of time follows a Poisson distribution.
III. In the actuarial approach, the timing of default is assumed to take the investors by
surprise, as it is a random process.
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
82.
A. 1.2%.
B. 3.3%.
C. 5.2%.
D. 7.1%.
83. The recovery rate worked out in the analytical model is the:
A. current present value.
B. cash value of the inflows, without any discounting.
20/85
C. present value of future inflows, discounted on the day of scheduled maturity date of the
bond.
84.
Calculate the estimated default frequency (EDF) for a KMV credit risk model using the data
given below (all figures in millions).
Assets Liabilities
Market value 210 180
Book value 205 190
Standard deviation 10 5
of returns
A. 0.001.
B. 0.006.
C. 0.023.
D. 0.067.
85. Credit risk is NOT an increasing function of:
A. level of debt.
B. risk-free interest rate.
C. time to maturity of debt.
D. standard deviation of asset returns.
86.
Assets Liabilities
Book value 150 145
of returns
A. 10.6%.
B. 15.9%.
C. 33.8%.
D. 43.4%.
87.
Which of the following is FALSE regarding the KMV methodology?
A. KMV estimates asset volatility from stock prices.
B. KMV does not assume that equity markets are efficient.
C. KMV measures the distance to default based on the market value of assets and default
points.
D.
KMV uses normal distribution tables to read the probability associated with the distance to
21/85
default.
88.
Assets Liabilities
Book value 150 140
of returns
A. 2.3%.
B. 6.7%.
C. 15.9%.
D. 30.9%.
89.
The estimated default frequency in KMV model are calculated using:
I. bond spreads.
II. asset volatilities.
III. balance sheet items
IV. Monte Carlo simulation.
A. I and II.
B. I and IV.
C. II and III.
D. III and IV.
90.
Assets Liabilities
Book value 640 600
of returns
A. 0.1%.
B. 2.3%.
C. 21.2%.
D. 57.9%.
91.
Assets Liabilities
22/85
Book value 220 240

of returns
A. 0.023.
B. 0.036.
C. 0.977.
D. 0.986.
92.
Assets Liabilities
Book value 205 190
of returns
A. 4.0%.
B. 6.7%.
C. 26.6%.
D. 35.4%.
93.
Assets Liabilities
Book value 180 165
of returns
A. 11.5%.
B. 27.4%.
C. 34.5%.
D. 57.9%.
94.
Which following have the lowest probability of retaining their rating over a 1-year period?
A. AAA Bond.
B. AA Bond.
C. BBB Bond.
D. CCC Bond.
95.
23/85
Consider the impact of credit rating migration on the bid-offer spread of a risky bond. Which of
the following is TRUE?
A. A downgrade is expected to decrease the bid-offer spread.
B. A downgrade is expected to increase the bid-offer spread.
C. Whether a downgrade would decrease or increase the bid-offer spread depends on the
starting credit rating. It cannot be predicted.
96.
The default correlations in CreditMetrics model are:
A. assumed to be zero.
B. estimated from equity correlations.
C. estimated from actual loan defaults.
D. estimated from Monte Carlo simulation.
97.
B. estimated from bond spreads.
C. estimated from equity correlations.
D. estimated from Monte Carlo simulation.
98.
The probability that an AAA bond will be downgraded in one year is estimated to be 0.1%. If
you are holding 20 AAA bonds, with equal weights and independent credit risks, what is the
probability that there will be at least one downgrade in one year?
A. 0.1% x 20=2.00%.
B. 1 - (1-0.1%)^20 =1.98%.
C. (1+0.1%)^20-1 =2.019%.
D. 0.1% x (20+19+18+. . . .+3+2+1) =21%.
99.
CreditMetrics considers assets or portfolios in terms of:
A. their diversification.
B. their likelihood of default.
C. changes in credit quality over time.
D. their likelihood of default and in terms of changes in credit quality over time.
100.
24/85
Consider a transition matrix that displays the credit rating migration from a rating at the start
of the period to one at the end of the period. As the frequency of observations is increased (the
time slice size is reduced), the probability of no migration:
A. increases.
B. decreases.
C. can increase or decrease randomly.
D. can increase or decrease depending on starting rating.
101.
Which of the following is TRUE regarding the CreditMetrics approach?
A. CreditMetrics uses the full distribution of portfolio values of a credit portfolio.
B. CreditMetrics uses a transition matrix to estimate the likelihood of credit events.
C. CreditMetrics uses equity price correlations to estimate correlations between credit events.
D. CreditMetrics is a parametric tool to calculate VAR, which uses standard deviation to read
VAR from an assumed normal distribution.
102.
Which of the following is generally TRUE with regard to collateralized bond obligations (CBOs)?
The weighted average rating of the collateral:
A. is same as that of the securities issued.
B. is lower than that of the securities issued.
C. is higher than that of the securities issued.
D. may be higher or lower than that of the securities issued depending on the number of
tranches.
103.
In case of CreditMetrics, the marginal VAR of an exposure is NOT a function of:
A. the size of the exposure.
B. the current credit state of the exposure.
C. the estimated recovery value in case of default.
D. the volatility of the equity price.
104.
The correlations used for credit portfolios by the CreditMetrics model are derived from:
A. S&P ratings.
B. Barra's beta.
C. Stock market.
D. Bond spreads.
25/85
105.
According to Standard and Poor's, what are the approximate odds for the default of a BB rated
bond over a ten-year period?
A. 1 in 4.
B. 1 in 10.
C. 1 in 20.
D. 1 in 50.
106.
The weighted average rating of the collateral pool used to structure collateralized bond
obligations:
A. is same as that of the securities issued.
B. is lower than that of the securities issued.
C. is higher than that of the securities issued.
D. may be higher or lower than that of the securities issued depending on the number of
tranches.
107.
Which of the following statements regarding CBOs is TRUE?
A. The equity tranche of the CBO has the least risk of default.
B. The fair value of the bonds issued is less than the collateral.
C. The total risk of the issued securities is more than that of the collateral pool.
D. The z-spread of the low risk tranche must be greater than that of the collateral pool.
108.
The default correlations in CreditMetrics model are estimated from:
A. actual loan defaults.
B. equity correlations.
C. Monte Carlo simulation.
D. bond spreads to treasury.
109.
According to Standard and Poor's, what are the approximate odds for the default of a BB-rated
bond over a five-year period?
A. 1 in 2.
B. 1 in 4.
C. 1 in 8.
D. 1 in 16.
26/85
110.
Which of the following countries has the worst rating according to the most important ratings
agencies?
A. Peru.
B. Brazil.
C. Mexico.
D. Argentina.
111.
B. estimated from equity correlations.
C. estimated from Monte Carlo simulation.
D. estimated from historical correlation of loan defaults.
112.
3-month LIBOR rate is 7.5 percent, while the government bills rate (both on simple interest
basis) is 6.5 percent. Assuming that the recovery rate for inter-bank loans is 60 percent, what
is the quarterly default probability of a LIBOR deposit?
A. 0.59%.
B. 0.93%.
C. 1.55%.
D. 2.33%.
113.
Consider a 5-year interest rate swap with notional of $500 million. Over a horizon of one year,
the returns are normally distributed and the volatility in the market value of the swap is $40
million. To compute expected default loss, you need to know:
I. the expected default rate of the counterparty.

II. the expected recovery rate, given the default.
III. the history of rating changes of the counterparty, with analysis of the balance sheet to find
out leverage ratio.
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
114.
A bank is least likely to securitize loans in order to:
A.
27/85
reduce credit concentration.
B. reduce regulatory capital required.
C. reduce the duration of its asset portfolio.
D. create investment opportunities for smaller investors.
115.
Consider a par swap contract with a tenor of seven years, and DV01 is equal to 4,800 times its
term to maturity. Also assume that the movement of the term structure of interest rates is
stochastic, parallel, normally distributed with a constant annualised standard deviation of 75
bps. The maximum exposure of the swap at 99% confidence will be CLOSEST to:
A. 2,562,576.
B. 2,566,242.
C. 5,979,345.
D. 15,534,793.
116.
Consider the following scenario. You have four derivative contracts outstanding. Contract 1 is
with counterparty A and has a replacement value of +5. Contract 2 is with counterparty B and
has a replacement value of -2. Contract 3 is with counterparty B and has a replacement value
+1. Contract 4 is with counterparty A and has a replacement Value -1. What is the total
replacement value assuming netting is in place? Note: Each party has posted a margin of +1
with you.
A. Max(5-2+1-1,0) -2 = 3 -2 = 1.
B. (max(5-1,0) -1)+(max(-2+1,0)-1) = 2.
C. max(Max(5-1,0)-1,0)+max(max(-2+1,0)-1,0) = 3.
D. Max(5,0)+max(-2,0)+max(1,0)+max(-1,0) -2 = 6-2 = 4.
117.
Assuming the same notional amount, which of the following swaps is likely to have the highest
current credit exposure at the time specified?
A. 6-year currency swap with 4 years to maturity.
B. 7-year currency swap with 4 years to maturity.
C. 9-year interest rate swap with 3 years to maturity.
D. 12-year interest rate swap with 2 years to maturity.
118.
The 1-year risk-free zero coupon rate (annual compounding) is 8% and the risky zero coupon
rate is 9%. If the implied recovery rate is zero what is the implied 1-year default probability?
A. 0.917%.
B. 0.926%.
C. 0.957%.
28/85
D. 0.964%.
119.
The main differences between the credit assessment of a country as opposed to that of an
individual firm are:
I. the lack of accountability of firms.

II. the lack of credit diversification.
III. that countries can renege on their obligations.
IV. the need to analyze a country's willingness to pay.
A. I and III.
B. II and IV.
C. III and IV.
D. IV only.
120.
The 3-month LIBOR rate is 4 percent, while the government bills rate (both on simple interest
is the annual default probability of a LIBOR deposit?
A. 0.14%.
B. 0.19%.
C. 0.30%.
D. 0.55%.
121.
Consider a swap contract that has just been initiated with a term to maturity of 10 years. If the
DV01 of the swap is proportional to its term to maturity and the movement of the term
structure of interest rates is stochastic, parallel, normally distributed with a constant volatility,
the potential exposure of the swap will peak after:
A. 2.5 years.
B. 3.3 years.
C. 5.6 years.
D. 6.7 years.
122.
1-year notes issued by a firm are trading at the zero rate (semi-annual compounding) of 11%
while the risk free zero coupon rate is 7%. If the implied recovery rate is zero, what is the
implied 1-year default probability of the firm?
A. 3.604%.
B. 3.738%.
C. 3.756%.
D. 3.865%.
29/85
123.
Consider a 5-year interest rate swap with notional of $500 million. Over a horizon of one year,
the returns are normally distributed and the volatility in the market value of the swap is $40
million. The default rate of the counterparty is expected to be 5%. The recovery rate is
expected to be 80%. What is the default loss at 95% confidence?
A. $0.08 million.
B. $0.33 million.
C. $1.32 million.
D. $5.00 million.
124.
In comparison with a straight bond, a putable bond has:
A. lower credit risk.
B. lower market risk.
C. lower credit and market risk.
D. none of the above.
125.
Which of the following poses the least credit risk for a given borrower?
A. A loan obligation.
B. A bond issued by the firm.
C. A trade not payable by the firm.
D. All of the above pose the same level of risk.
126.
The 3-month LIBOR rate is 5.5 percent, while the government bills rate (both on simple interest
is the annual default probability of a LIBOR deposit?
A. 0.89%.
B. 1.23%.
C. 1.90%.
D. 3.52%.
127.
Firm A has 40 derivatives contract outstanding with Firm B. The net mark-to-market value of
these contracts is $50 million and gross mark-to-market value (sum of absolute values) is $90
million. The current credit exposure of Firm A to Firm B will be:
A. $70 million.
B. $90 million.
30/85
C. $120 million.
D. $140 million.
128.
Consider a trader who hedges an MBS position by purchasing $5 million worth of options in the
OTC market. The maximum potential credit exposure due to the options is likely to be:
A. close to zero.
B. lower than $5 million.
C. equal to $5 million.
D. higher than $5 million.
129.
The 1-year risk-free zero coupon rate (annual compounding) is 4% and the risky zero coupon
rate is 5%. If the implied recovery rate is zero what is the implied 1-year default probability?
A. 0.952%.
B. 0.962%.
C. 0.976%.
D. 0.983%.
130.
Which of the following investments is likely to create the highest credit exposure? Assume equal
principal amounts for all contracts.
A. 3-month USD FRA.
B. 10-year USD par bond.
C. 10-year USD fixed versus floating swap.
131.
A firm can reduce its credit exposure by:
I. diversifying its assets/liabilities.

II. dealing with higher quality counterparties.
III. setting up netting agreements with its counter-parties.
IV. taking long and short positions with different counterparties.
A. I and III.
B. I and IV.
C. II and III.
D. II and IV.
132.
31/85
A bank enters into a 5-year swap with a client to pay a fixed annual coupon of 7% in return for
semi-annual LIBOR. Two years later the client defaults, at which point the 3-year swap rate is
6%. The loss incurred by the bank as a percentage of the notional amount due to this default
will be CLOSEST to:
A. 0.0%.
B. 2.6%.
C. 3.0%.
D. 4.1%.
133.
The credit exposure of an interest rate swap differs from that of a bond in that the:
I. principal amount of the swap is not at risk.

II. value of a swap may be negative or positive.
III. swap may benefit from netting arrangements.
IV. full coupon amounts in the swap are not at risk.
A. I and III.
B. II and IV.
C. I, III and IV.
D. I, II, III and IV.
134.
Which classes of debt carry the highest rating for a particular borrower?
A. Secured bonds.
B. Preferred stock.
C. Secured bank loans.
D. Subordinated bonds.
135.
Consider a small fund taking positions in exchange-traded S&P 500 futures. Which of the
following statement is TRUE?
A. The clearing house has never defaulted, so credit risk is not a problem.
B. The fund has an exposure to its FCM (Futures Commission Merchant), so a credit evaluation
of the FCM is important.
C. Since the clearing house is the counterparty for all exchange-traded futures, there is no
credit risk in the operations of this fund.
136.
Firm A has 30 derivatives contract outstanding with Firm B. The net mark-to-market value of
these contracts is $40 million and gross mark-to-market value (sum of absolute values) is $90
million. The current credit exposure of Firm A to Firm B will be:
32/85
A. 25.
B. 65.
C. 90.
D. 130.
137.
Which of the following methods uses the Merton model to price credit risk derivatives?
A. Actuarial method.
B. Equity price method.
C. Credit spread method.
D. All of the above.
138.
Consider a 7-year bond that is trading at a yield of 7.33 percent and has a 4.5 percent
probability of default over one year with an expected 60 percent recovery rate. The upfront
payment for a 1-year credit default swap on this bond will be CLOSEST to:
A. 1.68%.
B. 1.83%.
C. 1.93%.
D. 2.52%.
139.
Which of the following are similarities between a credit default swap and a total return swap?
I. Both are credit derivatives.

II. Both involve transfer of market risk.
III. Both can be used to reduce capital requirements.
IV. Both can used to provide enhanced return to the investor.
A. I and II.
B. II and III.
C. I, III and IV.
D. II, III and IV.
140.
Consider an A-rated institution that funds itself in the wholesale market at LIBOR + 90bps.
Which of the following is the most attractive instrument for this firm to take exposure to an
AAA-corporate issuer?
A. Credit swap.
B. Floating rate note.
C. Credit-linked note.
D. Fixed coupon bond.
33/85
141.
Which of the following is TRUE with regard to the Jarrow-Lando-Turnbull Model for pricing credit
spreads?
A. JLT attempts to model recovery rates.
B. JLT assumes perfect correlation between rating migration and interest rates.
C. In the case of default, JLT assumes that the recovered money is received at the time of
default.
142.
A firm has two outstanding bond issues: a 5 percent coupon bond with one year to maturity
trading at a spread of 71 bps over the Treasuries and a 9 percent coupon bond with ten years
to maturity trading at a spread of 220 bps over the Treasuries. The 1-year and 10-year
treasuries are trading at 4% and 5% respectively. Both bonds rank pari passu and have an
estimated recovery rate of 30%. What is the minimum upfront premium that a dealer will
charge to sell a one-year credit swap to an owner of the 10-year bond?
A. 68 basis points.
B. 71 basis points.
C. 212 basis points.
D. 220 basis points.
143.
Which of the following is an on-balance sheet instrument?
A. Credit swap.
B. Total return swap.
C. Credit-linked note.
144.
An institutional investor enters total return swap in which it receives the return due to a
Eurobond versus paying LIBOR. This exposes the investor to:
I. default risk.
II. interest rate risk.
III. equity market risk.
IV. credit rating migration risk.
A. II and III.
B. I, II and IV.
C. I, III and IV.
145.
34/85
Consider a bond with a 1-year hazard rate of 10% and a recovery rate of 50%. Current 1-year
riskless zero is 9%. After one year, it can be assumed that the 1-year rate can be either 7% or
11% with equal probability. What is the spread for this risky bond using Duffle-Singleton Model
(1995)?
A. 0.25%.
B. 0.5%.
C. 1.0%.
D. 5.0%.
146.
Which of the following is NOT a drawback of Jarrow-Lando-TurnBull Model?
A. It assumes that the riskless rate and defaults are uncorrelated.
B. It assumes that all securities with same rating will have the same the spreads.
C. It models the process of default as a progression from a better rating to a worse rating and
so on.
D. All of the above
147.
A bank purchases a 1-year European style credit default option on $175 million notional worth
of 9-year 8% semi-annual coupon bonds that are trading at a spread of 80 bps over Treasuries.
The strike level of the option is 110 bps. At the expiration of the option credit spread widens to
140 bps and the Treasury yield rises by 30 bps to 4.5%. The payout from the option will be
CLOSEST to:
A. 0.
B. 3,615,500.
C. 7,315,000.
D. 11,100,250.
148.
Two NY-based banks entered into a credit derivative contract to compensate the actual credit
loss suffered by one party in consideration of annual fee paid by it to the second party. In this
situation, which of the following is correct?
A. As per UK law, this is a wager and so the contract is void.
B. As per the State of NY Insurance Department, this is an insurance contract.
C. As per the State of NY Insurance Department, this is not an insurance contract, but a
financial derivative.
149.
Which of the following would increase the value of a credit default swap from the perspective of
a Protection Buyer?
A. A rise in interest rates.
35/85
B. A fall in interest rates.
C. A rise in the probability of default on the underlying security.
D. A fall in the probability of default on the underlying security.
150.
A bank purchases a 1-year European-style credit default option on $75 million notional worth of
9-year 8% semi-annual coupon bonds that are trading at a spread of 80 bps over Treasuries.
The strike level of the option is 125 bps. At the expiration of the option, the credit spread
widens to 160 bps and the Treasury yield rises by 25 bps to 4.5%. The payout from the option
will be CLOSEST to:
A. 0.
B. 1,784,300.
C. 4,149,000.
D. 5,498,250.
151.
A firm has two outstanding bond issues: a 4 percent coupon bond with one year to maturity
trading at a spread of 142 bps over Treasuries and a 6 percent coupon bond with ten years to
maturity trading at a spread of 410 bps over the Treasuries. The one year and ten year
Treasuries are trading at 4% and 5% respectively. Both the bonds rank pari passu and have an
estimated recovery rate of 30%. What is the minimum upfront premium that a dealer will
charge to sell a one-year credit swap to an owner of the 10-year bond?
A. 137 basis points.
B. 142 basis points.
C. 394 basis points.
D. 410 basis points.
152.
Which of the following instruments is not considered to be a credit derivative by the BIS?
A. Convertible bond.
B. Total return swap.
C. Credit default swap.
D. Credit spread put option.
153.
A bank holds 60 million euros worth of 7-year 8 percent coupon bonds that are trading at a
clean price of 105.39. The bank is worried by the exposure due to these bonds but cannot
offload them into the market for the fear of upsetting the client. Therefore, it purchases a Total
Return Swap (TRS) in which it receives annual LIBOR + 120 bps in return for the bond
payments. For the first year the LIBOR sets at 7 percent and by the end of the year the clean
price of the bonds as fallen to 99.35. The net receipt/payment for the bank in the TRS will be:
A. Pay $3.50 million.
36/85
B. Pay $3.74 million.
C. Receive $3.50 million.
D. Receive $3.74 million.
154.
Assume you are using Duffle-Singleton Model (1995). If the 1-year hazard rate is 10%, what is
the probability of default?
A. 9.52%.
B. 10.00%.
C. 10.48%.
155.
The buyer of credit put option is exposed to:
A. credit risk.
B. market risk.
C. both market and credit risk.
D. neither market nor credit risk.
156.
The pricing of which of the following instruments does not account for recovery risk?
A. Total return swap.
B. Floating rate note.
C. Credit spread option.
D. Credit sensitive note.
157.
A bank purchases a 1-year European-style credit default option on $80 million notional worth of
5-year 8% semi-annual coupon bonds that are trading at a spread of 80 bps over Treasuries.
The strike level of the option is 100 bps. At the expiration of the option credit spread widens to
150 bps and the Treasury yield rises by 15 bps to 4.5%. The payout from the option will be
CLOSEST to:
A. 0.
B. 1,478,400.
C. 2,078,400.
D. 2,532,000.
158.
Which of the following can be accomplished by the use of credit derivatives?
37/85
I. Leveraged speculation.
II. Credit risk diversification.
III. Allowing institutions with low cost of capital to reduce credit exposure.
IV. Allowing institutions with high cost of capital to invest in corporate credit.
A. I and II.
B. III and IV.
C. II, III and IV.
159.
Which of the following can be accomplished by the use of credit derivatives?
I. Leveraged speculation.
II. Credit risk diversification.
III. Allowing institutions with low cost of capital to reduce credit exposure.
IV. Allowing institutions with high cost of capital to invest in corporate credit.
A. I and II.
B. III and IV.
C. II, III and IV.
160.
Which counter-party suffers a credit exposure due to a credit derivative?
A. Protection Seller.
B. Protection Buyer.
D. Neither of the above.
161.
Consider a 5-year bond that is trading at a yield of 7.72 percent and has a 3.2 percent
probability of default over one year with an expected 45 percent recovery rate. The upfront
payment for a 1-year credit default swap on this bond will be CLOSEST to:
A. 1.34%.
B. 1.63%.
C. 1.79%.
D. 1.90%.
A. The margining system performs an important economic function of allowing pure price
discovery devoid of credit risk elements.
B. Margins allow access to derivatives markets for low-rated players, who otherwise would have
to pay high credit-related mark-ups on the derivatives contracts in the OTC market.
38/85
C. Margins allow the clearing corporation to guarantee a large volume of outstanding interest,
on a relatively low capital base.
163.
What is the main drawback of using credit triggers to control credit risk?
A. They require constant monitoring.
B. They may not stand up in court and may therefore be ineffective.
C. They can make a bad situation worse for a party in difficulty and thus can actually increase
credit risk.
D. None of the above
164.
The National Stock Exchange of India introduced bond futures trading in 2003. In the past,
interest rate volatility in India had been very high, especially during international currency
crises. However, this volatility is currently low. Which of the following positions would you agree
the most?
A. While determining initial margin at 99% 1-day VAR, the interest rate volatility of the past
crises needs to be ignored as the regime has clearly shifted.
B. While determining initial margin at 99% 1-day VAR, the interest rate volatility of the past
crises needs to be accounted if these events have occurred in the recent past and could
recur.
C. We need to have an additional factor measuring (and possibly predicting) pressure on

currency. The decision to include or exclude high volatility samples can then be made on a
real-time basis.
I. No margin account pays any interest.

II. Some brokers pay interest on the margin account balances.
III. Some brokers accept deposit of T-Bills in lieu of cash, for variation margin.
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
166. A short futures position has an initial margin of 4,000 and a maintenance margin of 2,500.
If the balance in the margin account is 2,000, what is the variation margin that needs to be
deposited?
A. 1,500.
B. 2,000.
C. 2,500.
D. 4,000.
39/85
A. A short futures position will receive a margin call in case of sharp price declines in the
market.
B. A call option buyer has to post margin in relation to the option premium.
168.
Which of the following circumstances will help the most to reduce counterparty exposure by
posting collaterals by the counterparty?
A. The counterparty posts cash collateral.
B. The counterparty posts as collateral, bonds issued by it, whose value is guaranteed by the
counterparty's subsidiary.
C. The counterparty posts collateral, whose value depends on the same variable as the
underlying for the derivative.
D. The counterparty offers another derivative contract as collateral that has been entered into
earlier with the counterparty and is currently in the money for that counterparty.
169. Which of the following statements are TRUE for margining systems prevailing in most
exchange-traded futures markets?
A. The margins are a function of the credit rating and the open position of any trader.
B. The margins are a function of ONLY the credit rating of any trader.
C. The margins are a function of ONLY the open position of any trader.
A. Margin accounts for long positions are a mirror image of the margin accounts of the short
positions.
B. The cost of a margin account is always lower for a winning position compared with mirror
loosing position.
171.
Which one of the following is NOT a credit risk-reducing feature on exchange-traded

derivatives?
A. Credit triggers.
B. Margin requirements.
C. Organized clearing house.
172.
40/85
In calculating the initial margin requirement for exchange-traded futures, which of the following
factors is NOT considered?
A. Volatility of the underlying.
B. Credit rating of the trading party.
173. What is a sequential cherry picking?
A. This is a hypothetical method for closing out open derivatives contracts as and when they
come into profit. Administrators of a failed party may theoretically resort to this behavior,
resulting in severe losses for the counterparty.
B. This is a method of closing out all the profitable deals on the basis their position on the day
of the default.
C. This is a method of closing out all the profitable deals on the basis their position on the day
of the choosing of the administrator.
D. This is a method of closing out all the profitable deals on the basis their position on the day
of the mutually agreed between the administrator and the counterparty of a failed
organization.
I. The credit exposure on derivatives contracts can be thought of as an option written with the
strike price of zero.
II. The option on a portfolio is never more valuable than a portfolio of individual options.
III. The option on a portfolio is always more valuable than portfolio of individual options.
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
175. Which of the following is TRUE?
A. The value of option on a portfolio of securities increases as the correlation increases.
B. The value of option on a portfolio of securities increases as the correlation decreases.
C. There is no relationship between the value of option on a portfolio and the correlation.
D. The value of option on a portfolio of securities increases as the correlation increases when
correlation is above 0, otherwise the value of option on a portfolio of securities increases as
the correlation decreases.
A. Current BIS norms do not recognize the netting agreements.
B. BIS norms recognize the netting agreements after making adjustments for the fact that
courts may disallow netting.
C. BIS norms recognize the agreements after making adjustments for the fact that correlations
can be unstable.
D.
41/85
All of the above.
177. Assume all the derivatives are struck at fair market prices between two counterparties,
which have a netting agreement in place. One of the parties is an AAA-rated bank and the
another is a BBB-rated bank. In terms of economic capital, which of the two will have the
highest savings from the netting agreement?
A. The BBB-rated bank.
B. The AAA-rated bank.
C. Both parties will have equal benefits.
D. Depends on the actual price movement.
178. Assume a situation where a derivatives dealer has entered into two different derivatives
contracts with a single counterparty. Contract No.1 has a mark-to-market of $10,000, while
Contract No. 2 has a mark-to-market of -$10,000. Assume the counterparty undergoes
liquidation at this stage. If the recovery rate is 10%, what is the REALISED cost of NOT having
a netting agreement in place?
A. $1,000.
B. $9,000.
C. $10,000.
D. $18,000.
179.
In the netting arrangement, which of the following contracts would NOT be netted with other
contracts?
A. Short positions in options.
B. Short positions in forwards.
C. Short positions in currency swaps.
D. Short positions in interest rate swaps.
180.
Which of the following is worse for a surviving counterparty in the event of a default with a
netting arrangement in place?
A. The court enforces a close-out netting in a freezing snapshot scenario.
B. The court allows the running of all derivatives contracts and picks contracts with positive
values for settlements.
C. Both are equally bad.
A. The maximum benefit of netting is derived when the changes in value of the derivatives
positions are highly-positively correlated.
B. The maximum benefit of netting is derived when the changes in value of the derivatives
positions are highly-negatively correlated.
42/85
C. The benefits of netting depend only on the credit rating of counterparty and NOT on any
other parameter.
182.
Which of the following is NOT true?
A. Bilateral netting is important for OTC derivatives
B. Bilateral netting is recognized by Basle 1994 norms.
C. Bilateral netting is included in ISDA agreements since 1992.
D. Exchange-traded futures are a good example of the success of bilateral netting.
183.
Which of the following affects the probability of default?
I. Size of transaction.
II. Term of transaction.
III. Estimated recovery rate.
IV. Credit rating of transaction counter-party.
A. I and III.
B. II and IV.
C. II, III and IV.
184.
Consider a portfolio of five equally-weighted bonds. Each bond has default probability of 5% per
annum and the defaults are independent of each other. What is the probability that this
portfolio will see its first default by the end of second year? Assume the same default
probabilities for first and second years for the surviving bonds.
A. 17.50%.
B. 22.62%.
C. 40.13%.
185.
Which of the following models is LEAST suitable for pricing credit derivatives?
A. Merton.
B. Jarrow-Turnbull.
C. Duffie-Singleton.
D. Heath-Jarrow-Morton.
186.
43/85
Credit provisions of a lending institution must cover for:
I. expected credit loss.

II. VaR of the portfolio.
III. non-performing loans.
IV. unexpected credit loss.
A. I and III.
B. II and IV.
C. I, III and IV.
187.
Consider a portfolio of five equally-weighted bonds. Each bond has a default probability of 5%
per annum and the defaults are independent of each other. What is the probability that this
portfolio will see its first default in the second year? Assume the same default probabilities for
first and second years for the surviving bonds.
A. 17.50%.
B. 22.62%.
C. 77.38%.
188.
What is the expected loss on a $60 million portfolio containing five bonds, each of which has a
1-year default probability of 2.5 percent and recovery rate of 60 percent?
A. $0.5 million.
B. $0.6 million.
C. $0.9 million.
D. $1.5 million.
189.
The distribution of credit losses is:
A. symmetrical.
B. positively skewed.
C. negatively skewed.
D. symmetrical with fat tails.
190.
The framework for corporate risk developed by Robert Merton suggests that:
A. equity holders have written a put option in favor of bondholders.
B. bondholders have written a call option in favor of equity holders.
44/85
C. the equity price is nothing but the option premium for options on the assets of the firms.
D. none of the above.
191.
What is the expected loss on a $30 million portfolio containing eight bonds, each of which has a
A. $0.27 million.
B. $0.38 million.
C. $0.46 million.
D. $0.84 million.
192.
1-year default probability of 3 percent and recovery rate of 45 percent?
A. $0.21 million.
B. $0.27 million.
C. $0.33 million.
D. $0.60 million.
193.
1-year default probability of 4 percent and recovery rate of 40 percent?
A. $0.16 million.
B. $0.18 million.
C. $0.24 million.
D. $0.40 million.
194.
A stock has an annual expected return of 22% and annual volatility of 10%. What is the 95%
VaR of this stock over one quarter?
A. -2.75%.
B. 0.50%
C. 1.38%.
D. 13.75%.
195.
Which of the following statements is TRUE with regards to bilateral closeout netting
agreements?
A. They are generally difficult to enforce.
45/85
B. They are only used for contracts with emerging market countries.
C. They are only used for foreign exchange and commodity contracts.
D. They are used by financial market participants for netting exposures across a variety of
contacts.
196.
You are holding two forward positions: long yen against USD with a large US bank and short
yen against USD with a medium-sized French bank. Both positions mature in three months and
are for 100 million USD each. Which of the following best describes the credit risk that is faced
by you?
Assume equal probability of yen up or down movements. Assume equal probability of default by
any of the two banks at 1%. Assume both the legs to be at the money currently. Assume no
recovery.
A. NIL, as the positions are equal and opposite.
B. Potential credit exposure on forward x Probability of default.
C. Potential credit exposure on forward x Probability of default x 2.
D. Potential credit exposure on forward x Probability of default x 0.5.
197.
Which of the following in NOT an issue in the active risk management of a credit book?
A. Serial correlations.
B. Limited number of issuers.
C. Illiquidity of the underlying.
D. Need to maintain client relationship.
198.
The distribution of credit losses is:
A. symmetrical.
B. skewed to the left.
C. skewed to the right.
D. symmetrical with fat tails.
199.
The capital that a lending institution retains in excess of credit provision covers for:
I. expected credit loss.

II. VaR of the portfolio.
III. non-performing loans.
IV. unexpected credit loss.
A. I only.
B. II and IV.
46/85
C. I, III and IV.
200.
Consider a 5-year interest rate swap with a notional of $500 million. Over a horizon of one
year, the volatility in the market value of the swap is $40 million. Assume that the market value
follows a normal distribution. What is the average credit exposure?
A. $16 million.
B. $40 million.
C. $66 million.
D. $80 million.
201.
It has been observed that rating companies do have seasonality, i.e., a downgrade of one
issuer is more likely to be followed by a downgrade of another rather than a upgrade (especially
in a slow economy). If you are looking at the credit risk through the eyes of Robert Merton
(debt is a short put), which of the following is TRUE?
A. A slow economy reduces the absolute value of option delta, reducing the risk. On the other
hand, serial correlation reduces the benefits of diversification, increasing the risk.
B. A slow economy increases the absolute value of option delta, increasing the risk. This is
further compounded by serial correlations, reducing the benefits of diversification, and
further increasing the risk.
202.
Which of the following statement is TRUE?
A. The need for more diversification in the credit portfolio than in the equity portfolio.
B. The apparently low correlations in credit events compared to equity returns, significantly
increase the credit portfolio's systematic risk.
C. Since the bank loan market is the oldest of all financial markets, it is the most efficient in
terms of risk-return pay-off on a portfolio basis.
203.
What is the expected loss on a $14 million portfolio containing five bonds, each of which has a
A. $0.196 million.
B. $0.235 million.
C. $0.294 million.
D. $0.491 million.
47/85
204.
In the analytical framework developed by Robert Merton, which of the following is TRUE for
estimating the volatility of a firm's assets?
I. The firm's stock must be traded.

II. The firm's bonds must be actively traded.
III. The firm's assets must be liquid and easily tradable.
IV. There must be an active market in options on the firm's stock.
A. I and IV.
B. II and III.
C. I, II and III.
D. II, III and IV.
205.
Which of the following is used in portfolio credit risk models?
I. Credit spread curves

II. Past dividend history
III. Default correlations based on equity prices.
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
206.
Which of the following frameworks is least desirable for credit risk exposure management?
A. KMV.
B. RAROC.
C. CreditMetrics.
D. Credit Portfolio View
207.
Consider two portfolios: Portfolio I consists of 100 bonds, each rated AAA, all weighted equally;
and Portfolio II consists of 20 bonds, each rated A, all weighted equally. The 1-year default
probabilities of AAA and A bonds are 0.1% and 0.5% respectively in this country. Assume that
the event of default on any bond is independent of default on others. Which one of the following
statements is TRUE?
A. The probability of observing no default in Portfolio I is lower than in Portfolio II.
B. The probability of observing no default in Portfolio I is higher than in Portfolio II.
C. The probability of observing no default in Portfolio I is roughly the same as Portfolio II.
D. Insufficient information, we need to know the recovery rates.
48/85
208. For a given transaction, which of the following have a potential for higher losses?
A. Settlement Credit Risk.
B. Pre-Settlement Credit Risk.
C. For derivatives NOT involving exchange of principal and ONLY net exchange of payoffs, the
settlement credit risk is equal to pre-settlement credit risk. For all other transactions,
settlement credit risk involves higher potential losses than pre-settlement credit risk.
D. For derivatives NOT involving exchange of principal and ONLY net exchange of payoffs, the
settlement credit risk is equal to pre-settlement credit risk. For all other transactions,
settlement credit risk involves lower potential losses than pre-settlement credit risk.
209. Which of the following is FALSE?
A. Pre-settlement credit risk is the risk of loss of unrealized gains on unsettled contracts with
the defaulting participant.
B. Settlement credit risk is the risk of the loss of securities delivered or payments made to the
defaulting participant prior to detection of the default.
C. Principal risk is the risk of the loss of securities delivered or payments made to the defaulting
participant prior to detection of the default.
210. Which of the following statements is FALSE?
A. Access to CSD and CCP should be limited to the top quality players, to ensure there is no
credit risk for these central agencies.
B. CSD and CCP should have objective and publicly-disclosed criteria for participation that
permit fair and open access.
C. If central bank money is not used in the securities settlement, then steps must be taken to
protect CSD members from potential losses and liquidity pressures arising from the failure of
the cash settlement agent whose assets are used for that purpose.
211. Which of the following is NOT a technique for controlling principal risk?
A. Delivery versus Payment System.
B. Concept of Central Counterparty.
C. Legally Binding Netting.
212.
Which of the following stages of trade are most susceptible to settlement risk?
I. Revocable.
II. Irrevocable.
III. Uncertain.
IV. Settled.
A. I and II.
B. I, II and III.
49/85
C. II and III.
D. II, III and V.
213. Which of the following are TRUE?
I. Final settlement should occur no later than the end of the settlement day.
II. Intra-day or real-time finality should be provided where necessary to reduce risks.
III. Securities should be immobilized or dematerialized and transferred by book entry in CSD to
the greatest extent possible to reduce the settlement risk.
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
214.
The primary source of settlement risk in foreign exchange contracts comes from:
A. fluctuations in net value.
B. the exchange of notionals.
C. volatility of exchange rates against USD.
D. inability to deliver controlled currencies.
215. Which of the following statements is FALSE?
A. Securities lending and borrowing (or repurchase agreements and other economically
equivalent transactions) should be encouraged as a method for expediting the settlement of
securities transactions.
B. Securities lending and borrowing (or repurchase agreements and other economically
equivalent transactions) should be discouraged as it increases the chances of settlement
failure.
C. Securities should be immobilized or dematerialized and transferred by book entry in CSD to

the greatest extent possible to reduce the settlement risk.
216.
Which of the following stages of trade are most susceptible to settlement risk?
I. Revocable.
II. Irrevocable.
III. Uncertain.
IV. Failed.
A. I and II
B. II and III.
C. III and IV.
D. II, III and V.
50/85
217. Which of the following statements are FALSE?
I. The customers' securities must be available for the claims of a custodian's creditors.
II. Central bank money should not be used to settle the ultimate payment obligations arising
from securities transactions.
III. Assets used to settle the ultimate payment obligations arising from securities transactions
should carry little or no credit or liquidity risk
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
218. Which of the following statements are FALSE?
A. Compressing the time between trade execution and settlement can reduce the settlement
risk by reducing the replacement cost component of credit risk.
B. Compressing the time between trade execution and settlement can increase the settlement
risk by increasing the risk of wrong settlement, due to quick confirmations.
C. Implementing legally binding trade-netting systems reduces pre-settlement credit risk
219.
Which of the following types of securitization is most likely to involve the use of an SPV?
A. ADR.
B. Pass-through MBS.
C. Asset backed security.
D. Convertible obligations.
220. Which of the statements is TRUE for a SPV?
A. The convexity of the mezzanine tranche is higher than the senior tranche.
B. The convexity of the mezzanine tranche is lower than the senior tranche.
C. The convexity of the mezzanine tranche is the same as the senior tranche.
221.
An SPV can be used by a bank to remove:
I. legal exposure.
II. credit exposure due to an asset.
III. market exposure due to an asset.
A. I and II.
B. I and III.
C. II and III.
51/85
D. I, II and III.
222. Which of the following is an example of credit support for a SPV?
A. Subordinated interest retained by the issuer/originator.
B. Provision of excess cash flows.
C. Loan insurance.
223. Which of the following is NOT an example of credit support for the securitization process?
A. Loan insurance.
B. Surety bond.
C. Letter of credit.
224. Which of the following statements best describe the functions carried out by the financial
markets?
A. Depository functions; Investment functions; Credit functions; and Risk-Transformation

functions.
B. Trading functions; Value functions; Growth functions; and Credit functions.
C. Timing function; Style function; Performance function; and Risk mitigation function.
D. Liquidity function; Credit function; Timing function; and Trading function.
225. Which of the following statements is TRUE?
A. The credit rating agencies will want any prepayments to first go to the senior tranche.
B. The credit rating agencies will want any prepayments to first go to the mezzanine tranche.
C. The credit rating agencies will want any prepayments to first go to the equity tranche.
A. The nature of securitization process implies that the documentation is the same for all
classes of underlying securities.
B. The nature of securitization process implies that there must be real (tangible) asset which
must be offered as a security.
C. The long history of securitization means a healthy amount of data is available for all asset
classes.
227. Which of the following are important factors for evaluation of any structured finance?
I. The legal structure of the SPV.

II. The features of the underlying asset.
III. The quality of pool manager and authority to sell assets.
A. I and II.
52/85
B. I and III.
C. II and III.
D. I, II and III.
228. Which of the following statements are acceptable to you?
A. A wrong estimation of correlation matrix causes more grief than a wrong credit assessment
of a few instruments.
B. Acquisition of inversely correlated high-risk instruments will in fact improve the risk profile
and return on economic capital, by reducing the variability of returns, provided of course that
the instruments are priced correctly.
229. A CDO is designed with a senior tranche that has very low default risk. The holders of the
senior tranche will consequently hope for:
A. a diversified pool of borrowers.
B. concentrated pool of borrowers.
C. borrowers that are less creditworthy.
D. borrowers that are more creditworthy.
230. Which of the following statements best describe a pass-though certificate?
A. In this form of securitization, the assets are sold to a trust and investors buy shares of the
trust.
B. In this form of securitization the special purpose vehicle, issues debt to fund the purchase of
the pooled assets.
C. There is no difference between a pass-through and a pay-through structure.
I. ABS imposes pricing discipline in the originators of the assets.

II. ABS grants access to debt capital market for high-risk industries.
III. ABS grants freedom from regulatory constraints on proportion invested in high-yield assets.
A. I and II.
B. I and III.
C. II and III.
D. I, II and III.
232.
Why do banks set up special purpose vehicles for derivatives trading?
A. To satisfy regulators.
B. To reduce exposure to the parent firm.
53/85
C. To be able to offer an improved credit rating to clients.
PASS PRO Solutions
1. Correct answer: A
The chart on the right shows the

default rates provided by S&P.
Study Session: 3 - RA: 1
2. Correct answer: C
The expected credit loss = sum{Value of bond x Default probability x (1 - Default rate)} = $18
million x 2% x (1 - 65%) + $10 million x 6% x (1 - 35%) = $0.516.

default rates provided by S&P.
The dividend test provision is a part of the covenants in a credit agreement that prevents the
borrower from draining its capital via excessive dividends, and hence provides some assurance
to debtors that they will be paid before the shareholders.
54/85
The probability of survival over the next three years = (1 - 0.25%) x (1 - 80%) x (1 - 1.4%) =
19.67%. Therefore, the probability of default = 1 - 19.67% = 80.33%.
The probability of survival of the firm after 9 years = 1 - 18% = 82%. Therefore, the probability
that a default occurs in the 10th year = 82% x 9% = 7.38%. Therefore, the cumulative default
probability over 10 years = 18% + 7.38% = 25.38%.
7. Correct answer: B
There are two ways to approach this problem. In the first approach, we calculate the probability
of survival after two years = (1 - 0.2%) x (1 - 6.6%) = 93.21%. From this, we can calculate
the cumulative probability of default over the next two years = 1 - 93.21% = 6.79%.
In the second approach, the probability of a default occurring in the first year = 0.2%, and a
default occurring in the second year = 6.6% x (1 - 0.2%) = 6.59%. Therefore, the cumulative
probability = 0.2% + 6.59% = 6.79%.
The probability of survival over the next three years = (1 - 0.8%) x (1 - 1.4%) x (1 - 2.1%) =
There are three loss events in this problem.
Loss due to default by 1 but not by 2 = Amount_1 x (1 - Recovery_Rate) x

Default_Probability_1 x (1 - Default_Probability_2)
= 100 x (1 - 0.55) x 0.06 x (1 - 0.1) = 2.43

= 300 x (1 - 0.55) x 0.1 x (1 - 0.06) = 12.69
Loss due to default by both = (Amount_1 + Amount_2) x (1 - Recovery_Rate) x

Joint_Probability
= (100 + 300) x (1 - 0.55) x 0.02 = 3.6
Therefore the total expected loss = 2.43 + 12.69 + 3.6 = 18.72
55/85
Assuming a constant marginal default probability, Default probability over a quarter = 1 - (1 -

Default probability over a year)^(1/4) = 1 - (1 - 0.2%)^0.25 = 0.05%. However, the marginal
rate of default for high credits tends to rise with the time horizon. So, the default probability for
the immediate quarter is likely to be lower than the average of 0.0005.
12. Correct answer: D

default rates provided by Moody's.
The lender effectively sells an option that allows the borrower to give up its assets to the lender
in lieu of the loan, i.e. at the strike price equals the value of the loan.
The probability that none of the bonds out of the 10 in the portfolio will default = (1 - 1.12%)
^10 = 89.35%.
The ratio of the default probabilities

(both marginal and cumulative -
shown in the chart) of lower rated
firms to those of higher rated firms
falls with the time horizon.
56/85
The chart on the right shows that the

ratio of default probabilities falls over
time.
The probability of survival over the next ten years = (1 - 2%)^10 = 81.71%. Therefore, the
probability of default = 1 - 81.71% = 18.29%.
The probability of survival over the next ten years = (1 - 2%)^10 = 81.71%. Therefore, the
Affirmative covenants are terms that require the borrower to take actions to service the debt
and maintain collateral.
The negative pledge clause in bond covenants contains the "unless clause" and sections on
exceptions and prohibitions.
Negative covenants prohibit the borrower from taking certain actions such as issue new debt
that is senior to the existing one. However, they usually do not prevent the firm from
undertaking specific lines of business.
Short-term solvency is best measured by the current ratio or the acid test, both of which
measure the firm's ability to meet its short-term obligations.
Current ratio = Current assets / Current liabilities
57/85
Acid test = (Current assets - Inventories - Accruals - Prepaid items) / Current liabilities.
The four Cs of credit analysis are character, capacity, collateral, and covenants.
Character refers to the integrity of the management and its commitment to ensuring the
repayment of the loan.
Capacity refers to the availability of sufficient cash flow in the firm to repay the debt.
Collateral refers to the assets are pledged as security for the debt.
Covenants refers to the terms and conditions imposed by the credit agreement, which restrict
the borrower's ability to take actions that may have a negative impact on its credit quality.
The probability of survival over the next 10 years = (1 - 2%)^10 = 81.71%. Therefore, the
Bank B will not recover the full principal of the loan only if the Company C defaults and the
value of the collateral falls by $2 million (the probability of which is 1%).
Since the performance of Company C does not depend on interest rates, the events of default
by Company C and the extreme fall in the value of Treasures (more than $2 million) will be
independent. Therefore, the joint probability of both occurring together will be 2% x 1% =
0.02%.
Assuming independence of defaults,

the probability that none of the
borrowers will default together over
the next year = (1 - 0.04%)^4 x (1 -
1.01%)^2 = 97.83%.
58/85

the probability that all the borrowers
will default together over the next
year = 0.04% x 5.82% = 0.0023%

the next year = (1 - 1.01%)^4 x (1 -
5.82%)^2 = 85.17%. This implies
that the probability of at least one of
the borrowers defaulting = 1 -
85.17% = 14.83%

the next year = (1 - 0.01%)^4 x (1 -
0.22%)^2 = 99.52%. This implies
99.52% = 0.48%.
59/85
As per Moody's data, one can expect the highest recovery in senior secured.
Continuously compounded YTM on risky bond = -1 x ln(price of risk free zero)/time +

instantaneous default rate = -1 x ln(0.60653066)/5 +5% = 10% + 5% = 15%.
This calculation assumes that the recovery rate is zero.
The convertible bond curve resembles exactly the long forward curve. In the case of sharp price
drops below the exercise price, the chances of default increase. This leads to a higher
yield/lower price of the convertible bond. At the extreme, when the stock tends to zero, the CB
(or any bond issued by the issuer) will tend to zero. Thus, a convertible bond is similar (though
not an exact replica) to a long forward on the stock.
The Bank B will not recover the full principal of the loan only if the Company C and Bank G
default.
Therefore, the probability of the bank not recovering its full principal (joint probability of
default) should be close to 0.01% (=2% x 0.5%).

the next year = (1 - 0.04%)^4 x (1 -
5.82%)^2 = 88.56%.
AAA 1-year zero rate = (1 + default-free rate) / (1 - probability of default) = (1 + 2%) / (1 -

1%) - 1 = 3.03%.
Assuming the independence of
60/85
defaults, the probability that all the

the next year = 0.04% x 5.82% =
0.002328%
million x 1.5% x (1 - 60%) + $20 million x 5% x (1 - 30%) = $1.
value of the collateral falls by $5 million. Since the performance of Company C deteriorates with
the rise in interest rates, the events of default by Company C and an extreme fall in the value
of Treasures are positively correlated.
Next we need to determine the probability of a $5 million fall in Treasuries. We know that $7
million is the 99% VaR over the period, which corresponds to a quantile 2.326. Therefore, the
quantile for a $5 million loss will be 5 / 7 x 2.32 = 1.65, which itself corresponds to a 95%
confidence level. Thus, the probability of a $5 million fall in Treasuries is 5%.
In the absence of the exact correlation between these two events, we can say that the joint
probability (i.e. the probability of the bank losing money) should lie between 4% (if the value of
Treasuries falls at the same time as default by the company), and 4% x 5% = 0.2% (if the two
events are independent).

year = 0.04% x 1.01% = 0.0404%.
There are three loss events in this problem.
61/85

= 50 x (1 - 0.6) x 0.02 x (1 - 0.03) = 0.388

=70 x (1 - 0.6) x 0.03 x (1 - 0.02) = 0.8232
Loss due to default by both = (Amount_1 + Amount_2) x (1 - Recovery_Rate) x

Joint_Probability
= (50 + 70) x (1 - 0.6) x 0.02 = 0.96
Therefore the total expected loss = 0.388 + 0.8232 + 0.96 = 2.1712.
Since the performance of Company C improves with the rise in interest rates, the events of
default by Company C and an extreme fall in the value of Treasures (more than $2 million) will
be negatively correlated. Therefore, the joint probability of both occurring together will be lower
than 0.02%.
Note: the possibility of perfect correlation cannot be ruled out, so D could be the right answer
as well. However, this is highly unlikely and in the past exams GARP has assumed that if the
exact correlation is undefined, it would lie between the two extremes of 0 and 1.

the next year = (1 - 0.04%)^4 x (1 -
1.01%)^2 = 97.83%. This implies
97.83% = 2.17%.
However, in the event that the company defaults, it is highly likely that the value of the
collateral (the company's own shares) will also fall. Therefore, the probability of Bank B not
recovering the full principal of the loan is the same as the probability of default, i.e. 5%.
62/85
B-rated bonds have a high default probability in the near future, which declines in the distant
future.
million x 2% x (1 - 65%) + $26 million x 7% x (1 - 40%) = $1.204.
The probability of no-default = (1-0.05)^3 = 85.7%.

year = 1.01% x 5.82% = 0.058782%

the next year = (1 - 0.22%)^4 x (1 -
5.82%)^2 = 87.92%.

the next year = (1 - 1.01%)^4 x (1 -
5.82%)^2 = 85.17%.
63/85
Credit Spread = (approx.) loss given default multiplied by probability of default.

Hence, 6% = (1-60%) x prob(default).
Or Prob(default) = 6% / 40% = 15%
Hence prob(No Default) = 85%.Study Session: 3 - RA: 3
Risk-free rate = (1 + Risky Rate) x (1 - Default Probability) = (1 + 7%) x (1 - 5%) - 1 =

1.65%.Study Session: 3 - RA: 3
Note: 25% is expressed in today's money terms. Hence, we need to find the future value of this
term, at the time of scheduled maturity of the bond.Study Session: 3 - RA: 3
If all else remains constant, as the recovery rate increases the chances of losses decrease,
reducing the need for higher credit spreads.Study Session: 3 - RA: 3
The "present value" of cash recovery is 50% of $5m = $2.5m.

The "actual cash" expected to be recovered after three years is $2.5m x 1.1^3 =
$3.3275m.Study Session: 3 - RA: 3
In this case, the yield on risky bond is worked out as (1 + 1%) / (1 - 5%) - 1 = 1.01 / 0.95 - 1
= 6.31%.Study Session: 3 - RA: 3
Credit Spread = Yield on Risky Debt - Risk Free Rate = [(1 + 0.01) / (1 - 0.05)] -1 - 1% =
5.31%.Study Session: 3 - RA: 3
We need to find the present value recovery at the time of Scheduled Maturity. Hence, LGD =
(2,102.02 / 1.01^5) / 10,000 = 20.00%.Study Session: 3 - RA: 3
64/85
Approximate Credit Spread = Loss Given Default multiplied by probability of default. Hence,
(100%- 40%) x 10% = 6%Study Session: 3 - RA: 3
Probability of no default = exp(-5%) =95.1229%Study Session: 3 - RA: 3
The probability of survival over the next five years = (1 - 4%)^5 = 81.54%. Therefore, the
Probability of three defaults = [6^6 x exp(-6)] / fact(6) = [46656 x 0.002479] / 720 =

16.06%.
CREDITRISK+ does not model default correlations directly.Study Session: 3 - RA: 4
The big advantage of CreditRisk+ model is that it is not computationally intensive.
CreditRisk+ model assumes that bankruptcy and recovery processes are exogenous, i.e. driven
by external factors.
Distance from default = (Expected value of assets - Expected value of liabilities) / Standard
deviation = (240 - 190)/50 = 1.0.
Both the statements are true for CREDITRISK+.Study Session: 3 - RA: 4
For the Poisson distribution the mean and the variance are equal. Therefore, the volatility =
(variance ^ 0.5) = (mean ^ 0.5)Study Session: 3 - RA: 4
In the Poisson-Gamma Distribution, the probability of observing n defaults P(n), falls secularly
as n increases. For sufficiently large N, we can ignore P(n) for all n > N. It is not possible to
65/85
ignore P(n) for n > N if N is small in comparison with the mean.Study Session: 3 - RA: 4
Probability of three defaults = [7^6 x exp(-7)] / fact(6) = [117649 x 0.000912] / 720 =

14.9%.
The actuarial approach does not make assumption about the "causes" of the default. On the
other hand, the analytical approach does make an assumption about it.Study Session: 3 - RA: 4
Probability of three defaults = [5^10 x exp(-5)] / fact(10) = [9765625 x 0.006738] / 3628800

= 1.81%.
Probability of three defaults = [6^2 x exp(-6)] / fact(2) = [36 x 0.002479] / 2 = 4.46%.
In order to match the reality as closely as possible, the mean of the poisson process is
supposed to follow a gamma distribution.Study Session: 3 - RA: 4
The advantages of the CreditRisk+ model are that it is easy to implement and requires little
data. However, the fact that it assumes no relationship between credit and market risk is a
disadvantage.
Probability of exactly eight defaults = [6^8 x exp(-6)] / fact(8) = [1679616 x 0.002479] /

40320 = 10.33%.
66/85
The recovery rate is not modeled separately in the CREDITRISK+, save the adjustment of
reduction from the credit exposure.Study Session: 3 - RA: 4
The CREDITRISK + ignores the effect of credit migration on the value of a risky portfolio.Study
Session: 3 - RA: 4
All the above statements are TRUE.Study Session: 3 - RA: 4
The recovery rate in analytical model is the PV as of today. In most other models, it is the value
discounted on the day of default / scheduled maturity.Study Session: 3 - RA: 5
The distance between the current value of the assets and the book value of the liabilities = 210
- 190 = 20. Using the standard deviations in the return on assets this distance = 20 / 10 = 2
standard deviations. Thus the probability of default = cumulative probability of standard normal
distribution below -2, i.e. 2.3%.
In the context of the analytical model, credit risk is a decreasing function of risk-free interest
rate.Study Session: 3 - RA: 5
- 145 = 15. Using the standard deviations in the return on assets this distance = 15 / 12 =
1.25 standard deviations. Thus the probability of default = cumulative probability of standard
normal distribution below -1.25, i.e. 10.6%.
KMV does not use any parametric distribution to read the default probability.
67/85
The estimated default frequency in KMV model is calculated using balance sheet items and the
standard deviation of the assets.
- 190 = 60. Using the standard deviations in the return on assets this distance = 60 / 40 = 1.5
distribution below -1.5, i.e. 6.7%.
- 165 = 30. Using the standard deviations in the return on assets this distance = 30 / 25 = 1.2
distribution below -1.2, i.e. 11.5%.
The transition probabilities rise as the credit rating falls. CCC bonds will have the highest
probability of moving out of its original state.
68/85
A downgrade, especially unexpected one, is expected to increase the bid-offer spread

immediately after the announcement.
The default correlations in CreditMetrics model are estimated from equity correlations.
P(at least one default) = 1 - {[1 - P(1)] x [1 - P(2)] ? x [1 - P(20)]} = 1 - (1-0.1%)^20

=1.98%.
Note: P(1) = P(2) = ? = P(20) = 0.1%
CreditMetrics considers assets or portfolios in terms of their likelihood of default and in terms of
changes in credit quality over time.
As the time slice size is reduced, the probability that some event would take place in that time
slice starts to reduce and the probability of no migration starts to increase.
CreditMetrics is a parametric tool to calculate VAR, which uses standard deviation to read VAR
from an assumed normal distribution.
An issuer (SPV) needs to provide for a significantly higher collateral than the securities issued.
This excess collateral (or the equity tranche) absorbs a significant amount of the credit risk of
the pool of bond obligations and leaves the securities offered to investors with lesser risk and
hence a higher rating.
69/85
The volatility of equity price does not enter directly into the CreditMetric approach. It is true
that the correlations are based on equity price, but that is only an indirect effect.
CreditMetrics model uses correlations that are derived from stock price data.
The cumulative probability of default of a BB credit over a ten-year period is 23.4%.
An issuer (SPV) needs to provide for a significantly higher collateral than the securities issued.
This excess collateral (or the equity tranche) absorbs a significant amount of the credit risk of
the pool of bond obligations and leaves the securities offered to investors with lesser risk and
hence a higher rating.
The fair value of the bonds issued is less than the collateral.
The cumulative probability of default of a BB credit over a five-year period is 12.25%.
Argentina defaulted on its external debt over the past year and has the worst credit rating of all
Latin American countries.
70/85
(1 + Risky rate) x {1 - Default probability x (1 - Recovery rate)} = (1 + Risk-free rate)
Therefore Annual default probability = {1 - (1 + Risk-free rate) / (1 + Risky rate)} / (1 -

Recovery rate)
= {1 - (1 + 6.5%) / (1 + 7.5%)} / (1 - 60%) = 2.33%. The 3-month default probability = 1 -
(1 - 2.33%)^0.25 = 0.59%.
The expected default loss = expected exposure x 0.5 x default probability x (1 - recovery rate).
Securitization offers banks a way to reduce credit exposure to certain borrowers without
harming the business relationship with them. This is not an interest rate exposure management
tool - the duration is better handled using swaps, futures or options.
When the DV01 is proportional to the term to maturity, the potential credit exposure peaks at
the one third (T/3) of the way into the life of the swap. At this point, the Maximum credit
exposure = 2 x Alpha x Ratio {DV01/Time to maturity} x Standard deviation x (Tenor/3)^(3/2)
= 2 x 2.33 x 4,800 x 75 x (7/3)^(3/2) = 5,979,345.
First find out the total net exposure for each counterparty. If the result is positive, reduce by
the margin posted. Add for all counterparties.
The exposure profile of a currency swap is unbounded (unlike that of an interest rate swap) and
increases with time. The 7-year currency swap with four years to maturity has been in
existence for a longer time than the 6-year currency swap with four years to maturity.
Therefore, the 7-year swap is likely to have the higher current exposure.
Assuming a zero recovery rate, (1 + Risky zero coupon rate) x (1 - Default probability) = (1 +
Risk-free zero coupon rate).
71/85
Therefore, Default probability = 1- (1 + 8%) / (1 + 9%) = 0.917%.
The main differences between the credit assessment of a country as opposed to that of an
individual firm are that countries unlike individuals firms can rely on a potentially unlimited
source of cash (either in the form of higher taxes, or printing more money that devalues the
currency) to pay their domestic front.
On the foreign front, however, the credit analysts must consider both the ability (which is also a
factor with individual firms) and the willingness to pay debts (countries can renege on their
foreign debts without ending up in courts).
(1 + Risky zero coupon rate) x {1 - Default probability x (1 - Recovery rate)} = (1 + Risk-free

zero coupon rate)

Recovery rate)
= {1 - (1 + 3.8%) / (1 + 4%)} / (1 - 65%) = 0.55%.
If the DV01 is proportional to its term to maturity, the potential exposure peaks after one third
of the initial life of the contract.
Assuming a zero recovery rate and using semi-annual compounding, (1 + Risky zero coupon
rate/2)^2 x (1 - Default probability) = (1 + Risk-free zero coupon rate/2)^2.
Therefore Default probability = 1- (1 + 7%/2)^2 / (1 + 11%/2)^2 = 3.756%.
Worst case default loss = Worst case exposure x 0.5 x Default probability x (1 - Recovery rate)
= ($40 million x 1.65) x 0.5 x 5% x (1 - 80%) = $0.33 million.
The market risk of a putable bond is actually lower than that of a straight bond, as the putable
bond gives the investor an option to sell the bond back to the issuer at a fixed price in certain
situations (e.g. a merger or certain pre-specified dates).
72/85
However, the investor implicitly pays for this option by accepting a lower rate of interest on the
bond. As a result the credit risk of the putable bond is higher than that of a straight bond, as
the investor has more to lose (the bond as well as the option that has been paid for).
Loan obligations usually enjoy higher recovery rates, so they pose the lowest credit risk.
(1 + Risky zero coupon rate) x {1 - Default probability x (1 - Recovery rate)} = (1 + Risk-free

zero coupon rate)

Recovery rate)
= {1 - (1 + 4.2%) / (1 + 5.5%)} / (1 - 65%) = 3.52%.
Say that the sum of the positive MTM values is X and the sum of the negative MTM values is Y.
Then X + Y = $50 million and X - Y = $90 million. Solving these equations we get X = $70
million.
The potential credit exposure is at least equal to the initial value of the option, i.e. its purchase
price. The maximum credit exposure could be higher due to potential for the rise in the value of
the hedge.
Assuming a zero recovery rate, (1 + Risky zero coupon rate) x (1 - Default probability) = (1 +
Risk-free zero coupon rate).
Therefore Default probability = 1- (1 + 4%) / (1 + 5%) = 0.952%.
The exposure due to the bond is likely to be more than the principal amount. The exposures of
the FRA and the swap are less than the principal amounts as these are contracts for differences.
73/85
A firm can reduce its credit exposure by diversification and by making netting arrangements.
The credit quality of the counter-parties has no effect on the credit exposure, though it does
reduce the credit risk.
At the point of default, the bank is paying a rate of 7% when the prevailing market rate is 6%.
Therefore, the bank owes the client rather than the other way around. Due to the ISDA
agreement, the bank will probably have to pay the net value of the swap (after expenses) with
the client's creditor, but will not bear any loss.
The credit exposure of an interest rate swap (IRS) is a tiny fraction of the credit exposure due
to a bond with the same principal. The principal amount of the swap is not at risk (notional
amounts are not exchanged). And even the full value of the coupons is not at risk as only the
net difference between the fixed and the floating coupons is exchanged.
The swap can lead to a loss only if the default occurs when the contract is in-the-money and
has positive value (a bond always has a positive value). Moreover, many of the regular counter-
parties in the swaps market have netting agreements that reduce the credit exposure even
further by setting off swaps that have positive value (for the non-defaulting party) with those
that have negative value. Such arrangements are not available to bond holders.
Secured bank loans have the highest credit rating due to the fact that recovery rates are
typically highest for loans.
The clearing house guarantees trades among clearing members and NOT between the client and
the clearing member.
Say that the sum of the positive MTM values is X and the sum of the negative MTM values is Y.
Then X + Y = $40 million and X - Y = $90 million. Solving these equations we get X = $65
million.
The equity price method uses the Merton model to derive a fair price for the credit derivative.
74/85
The implied credit risk-free rate of this bond = (1 + Risky rate) x {1 - Default probability x (1 -
Recovery rate)} = (1 + 7.33%) x {1 - 4.5% x (1 - 60%)} - 1 = 5.398%.
The payment for the credit swap would be the difference between the risky rate and the risk-
free rate discounted back to the start of the year at the risk-free rate. Therefore the credit
default premium = (7.33% - 5.398%) / (1 + 5.398%) = 1.83%.
A total return swap involves the transfer of market risk as well as the credit risk of the
underlying securities, while the credit default swap only involves the transfer of credit risk.
This firm has a fairly high funding cost. Funding itself at 90 bps over LIBOR and lending to AAA
names at around LIBOR is a loss making strategy, which rules out the notes and the bond. The
only way this firm can make money is by selling credit protection via a credit swap that does
not require it to make a physical investment.
JLT does not attempt to model recovery rates. It assumes no correlation between rating
migration and interest rates.
Since all the bonds rank equally, they would default at the same time. Therefore, the dealer
could hedge a one-year credit swap on the firm (for whichever bond) by selling the one-year
bond and purchasing one-year Treasuries. This results in a cost of 71 bps at the end of the
year, or 68 bps upfront {= 71 / (1 + 4%)}.
A credit-linked note is an on-balance sheet instrument, while the others stay off-balance sheet.
In this swap the investor will receive the total return due to the Eurobond, i.e. coupons and any
deviation in price. Thus, they are exposed to interest rate risk, credit rating migration risk
(which will affect the price of the Eurobonds) and the risk of default.
75/85
Under D-S Model, Spread = Hazard rate x (1 - Recovery rate) =10% x 50% = 5%.
Major drawbacks of JLT include: the assumption that the riskless rate and the defaults are
uncorrelated; and that all securities with same rating will have same spreads.
The option payout is the difference between the bond value using the strike level and actual
value of the bonds.
Using the strike level the value of the bonds is 115.306 {on a bond calculator N=16, PMT=4,
FV=100, I%/yr=(4.5 + 1.1)/2}
The actual value of the bonds is 113.24 {on a bond calculator N=16, PMT=4, FV=100, I%/yr=
(4.5 + 1.4)/2}
Therefore, the payout = (115.306 - 113.24) / 100 x $175 million = $3.6155 million.
Since this contract seeks to compensate the actual loss, this is an insurance contract, as
payment is contingent on BOTH the credit event happening AND the party suffering loss. In
credit derivative, the payment is contingent ONLY on credit event happening.
A rise in the probability of default on the underlying security increases the chances of a
payment by the Protection Seller to the Protection Buyer. This increases the value of the swap
from the buyer's perspective.
value of the bonds.
Using the strike level, the value of the bonds is 114.267 {on a bond calculator N=16, PMT=4,
FV=100, I%/yr=(4.5 + 1.25)/2}
(4.5 + 1.6)/2}
76/85
Since all the bonds rank equally, they would default at the same time. Therefore, the dealer
could hedge a one-year credit swap on the firm (for whichever bond) by selling the one-year
bond and purchasing one-year Treasuries. This results in a cost of 142 bps at the end of the
year, or 137 bps upfront {= 142 / (1 + 4%)}.
A convertible bond has an embedded interest rate option, but no credit derivative element.
The notional amount of the TRS is 60 million euros. Therefore, the bank will receive the interest
payment linked to LIBOR:
60 million x (7% + 120 bps) = 4.92 million.
The bank will pay the fixed coupon plus the change in value of the bond:
60 million x 8% + 60 million x (99.35% - 105.39%) = 1.176 million.
Hence, the net amount that the bank will receive = 4.92 million - 1.176 million = 3.744 million.
Probability of default = [1 - exp(-hazard rate)] = [1 - exp(-0.10)] = 0.09516
The buyer of a credit put option has no exposure to market rates but the value of the put will
rise or fall with the movement in the underlying credit.
The value of all other instruments will depend on the estimate of the recovery rate.
value of the bonds.
Using the strike level the value of the bonds is 108.868 {on a bond calculator N=8, PMT=4,
FV=100, I%/yr=(4.5 + 1)/2}
77/85
(4.5 + 1.5)/2}
Credit derivatives allow the transfer of credit risk to the counter-parties that have the capacity
to bear this risk. Thus it is possible for banks that have a high concentration of credit risk to
reduce their exposure by purchasing credit protection on their clients (and perhaps diversifying
by selling protection on other parties). It also becomes possible for institutions that have a high
cost of capital to speculate on the underlying credits without actually contributing capital (apart
for making the necessary provisions for a credit event).
Credit derivatives allow the transfer of credit risk to the counter-parties that have the capacity
to bear this risk. Thus it is possible for banks that have a high concentration of credit risk to
reduce their exposure by purchasing credit protection on their clients (and perhaps diversifying
by selling protection on other parties). It also becomes possible for institutions that have a high
cost of capital to speculate on the underlying credits without actually contributing capital (apart
for making the necessary provisions for a credit event).
The Protection Seller obviously inherits credit exposure to the underlying credit in the contract.
Simultaneously the contract exposes the Protection Buyer to default by the Protection Seller.
The implied credit risk-free rate of this bond = (1 + Risky rate) x {1 - Default probability x (1 -
Recovery rate)} = (1 + 7.72%) x {1 - 3.2% x (1 - 45%)} - 1 = 5.824%.
The payment for the credit swap would be the difference between the risky rate and the risk-
free rate discounted back to the start of the year at the risk-free rate. Therefore, the credit
default premium = (7.72% - 5.824%) / (1 + 5.824%) = 1.79%.
All these statements about the margining systems are TRUE.Study Session: 3 - RA: 9
If used widely, a seemingly normal downgrade can put great pressure on the finances of the
company due to "Credit Triggers", leading to their possible collapse.
78/85
An unduly low margin would bankrupt the clearing house, while an unduly high margin would
kill trading interest. The best compromise would be statement C, where the clearing house can
change the measurement of VAR.
In order to reduce the cost of margining, some brokers either pay interest on margin account
balances or accept deposits of securities in lieu of cash.Study Session: 3 - RA: 9
Variation margin is the amount that needs to be deposited to ensure that the margin account
balance is restored to initial margin level, after the margin call is issued. Thus, variation margin
= 4,000 - 2,000 = 2,000.Study Session: 3 - RA: 9
A buyer of an option (Call or Put) has to post a margin based on the option premium.Study
Session: 3 - RA: 9
None the choices given, except cash, offer significant protection.
The traders are required to post margins, in relation to the open position, irrespective of their
creditworthiness.Study Session: 3 - RA: 9
There is no direct relationship between the margin accounts for a long position and for a short
position, if there are restrictions on withdrawal of profits. The cost of margin account is a
function of the price movement during the life of the contract and does NOT depend on the
closing price.Study Session: 3 - RA: 9
Credit triggers are used as a credit risk management tool in the OTC market.
The initial margin is calculated to cover expected loss. Consequently, it is not a function of
credit rating of the counterparty.
This method is not yet observed in real life, but remains a theoretical possibility.Study Session:
79/85
3 - RA: 10
The option on a portfolio can, at most, be equal in valuable to the portfolio of individual options,
when the correlation between the assets is a perfect 1.00%. Thus, the option on portfolio is
never more valuable than a portfolio of individual options.Study Session: 3 - RA: 10
As the correlation increases, the volatility of the portfolio increases. As the volatility increases,
the value of the option increases.Study Session: 3 - RA: 10
BIS norms recognize netting. BIS also recognize that correlations can be unstable. Hence, it
disallows 40% of the benefit of the netting.Study Session: 3 - RA: 10
The economic capital required for credit risk on the derivatives position is a function of the
credit exposure and the probability of default. The probability of default of BBB is higher than
AAA. Thus, for a given reduction in credit exposure, the fall in economic capital is higher for a
deal with BBB counter-party than AAA counterparty. Thus, the AAA-rated bank (whose
counterparty is BBB-rated) will benefit more from netting.Study Session: 3 - RA: 10
If the netting were in place, there is no payable / receivable on net basis from the
counterparties. However, without the netting, there is a receivable of $10,000, on which the
dealer will realize only 10%, resulting in a loss of 90% of 10,000, that is, $9,000.Study
Session: 3 - RA: 10
Short positions in options are obligations, ab initio, hence there is no netting.
In this case, even the contracts with negative values at the time of bankruptcy can turn positive
at the time of settlement and can cause losses for the surviving party.
When the positions are negatively correlated, the changes in the portfolio of positions is
minimized. This reduces the credit risk to a large extent.Study Session: 3 - RA: 10
Exchange-traded futures are examples of multi-lateral netting (both the buyer and the seller
net with the clearing house).
80/85
The probability of default is influenced by the term of transaction and the credit rating of
transaction counter-party. Size of transaction only affects the exposure.
The probability that this portfolio will see its first default by the end of second year = P[first
default in year 1] + P[first default in year 2] = P[first default in year 1] + P[no default in first
year] x P[at least one default in second year] = (1 - 0.95^5) + 0.95^5 x (1 - 0.95^5) =
40.13%.
Heath-Jarrow-Morton is not suitable for pricing credit derivatives, as it depends on continuous

process and does not account for jumps.
The credit provisions alone must cover the actual and expected credit losses.
The firm's capital should additionally provide sufficient cushion for unexpected credit loss (VaR
is the deviation from the expected loss as well).
The probability that this portfolio will see its first default in second year = P[no default in first
year] x P[at least one default in second year] = 0.95^5 x (1 - 0.95^5) = 17.50%.
Expected loss = $60 million x 2.5% x (1 - 60%) = $0.6 million.
The distribution of credit losses is highly skewed to the left, as the probability of a zero loss (on
the right hand side falls to zero) but on the left hand side the tail extends out and there is
always the possibility of a large loss.
The bondholders have written a put option in favor of equity holders on the assets of the firm.
The equity price is the premium for this option.
81/85
Expected loss = $20 million x 3% x (1 - 45%) = $0.33 million.
Expected loss = $10 million x 4% x (1 - 40%) = $0.24 million.
VaR = Expected return - Alpha x Volatility x (Time period)^0.5 = 22% x 0.25 - 1.65 x 10% x
0.25^0.5 = -2.75%
Bilateral closeout netting agreements are used by financial market participants for netting
exposures across a variety of contacts.
On each contract your credit risk = Potential credit exposure on forward x Probability of default.
But logically, only one of the two will be in the money. Consequently, the portfolio credit risk is
limited to Potential credit exposure on forward x Probability of default.
The credit market has enough issuers. The problem lies in the illiquidity of the papers, possible
serial correlations in credit events and the need to accommodate clients.
The distribution of credit losses is highly skewed to the left, as the probability of a zero loss (on
the right hand side falls to zero) but on the left hand side the tail extends out and there is
always the possibility of a large loss.
82/85
The excess capital provides a cushion for unexpected credit loss (VaR is the deviation from the
expected loss as well).
The credit provision covers for the expected credit losses and bad loans.
Average or expected credit exposure is approximately = Volatility / ( 2 x Pi)^0.5 = $40 million /

(2 x 3.1415)^0.5 = $16 million.
A price falls (rating falls), the short put goes further out of money, increasing the absolute
value of delta.
Correlations between credit events are generally lower than those between equity returns. Thus
the benefits of diversification in credit portfolio are higher and there is a greater need to reduce
diversifiable risk.
One needs to estimate implied volatility of the underlying assets. For this purpose, one needs to
observe option prices. In the framework of Robert Merton, equity price = price of the put option
bought by equity holders.
Past dividend history is not used in any of the credit risk models.
Of the models given here, only the RAROC does not incorporate the effect of correlations.
83/85
Probability (no default in Portfolio I) = (1-0.1%)^100 =90.48%.

Probability (no default in Portfolio II) = (1-0.5%)^20 =90.46%.
Notes:
1. The question does not ask you to compute expected loss, so you do not need to know the
recovery rates.
2. Even though both portfolios have the same probability of not defaulting, the loss in the event
of a single default will be much lower in case of portfolio I than portfolio II. In this question, you
are not concerned with it. Hence the answer is counter-intuitive.
Since the losses in settlement credit risk are of the order of the principal involved, while in the
pre-settlement risk only the gains are lost, the settlement credit risk is higher in most
cases.Study Session: 3 - RA: 12
All of these statements are true. Settlement credit risk, as defined in option b, is also referred
to as principal risk.Study Session: 3 - RA: 12
Restricting the access to CSD and CCP will defeat the very purpose of these institutions.Study
Session: 3 - RA: 12
Netting is used for pre-settlement risk and NOT for principal risk.Study Session: 3 - RA: 12
Settlement risk occurs after the institution made the payment and before the offsetting
payment is received from the counter-party, which can occur during irrevocable and uncertain
status of a trade.
ALL of these statements are TRUE.Study Session: 3 - RA: 12
The main settlement risk in foreign exchange contracts occurs when a counter-party needs to
pay the notional in one currency in a given country and receive an equivalent amount in
another currency in a second country. This exposes the counter-party to the risk of losing the
entire notional amount.
This risk can be reduced by only exchanging the net value of the contract in one of the
currencies.
84/85
Securities lending and borrowing expedite the settlement of securities, hence must be
encouraged.Study Session: 3 - RA: 12
Settlement risk occurs after the institution made the payment and before the offsetting
payment is received from the counter-party, which can occur during irrevocable and uncertain
status of a trade.
Central bank money should be used, as far as possible to settle securities. The customers'
securities must be protected against the claims of a custodian's creditors.Study Session: 3 -
RA: 12
As long as the internal controls are commensurate with the level of activity, the compression of
the time between trade execution and settlement does not increase settlement risk.Study
Session: 3 - RA: 12
Asset backed securities are most likely to involve a bank putting together a pool of assets
(credit card loans) selling them to an SPV and issuing securities on the back of this collateral.
Since, the mezzanine tranche has lower pre-payment risk, it has higher convexity than the
senior tranche.Study Session: 3 - RA: 13
An SPV can be used by a bank to remove credit and market exposures due to an asset (but
only if it is a clean sale). However, just selling the assets to an SPV does not completely remove
legal exposure for the bank.
All of these techniques reduce the risks of the senior class. Hence, they are all examples of
credit support.Study Session: 3 - RA: 13
All of the above are examples of credit support, as they reduce the credit risk for the senior
debt.Study Session: 3 - RA: 13
Financial markets allow investors to store value, earn income on capital, borrow money and
trade away un-wanted risksStudy Session: 3 - RA: 13
85/85
The credit rating agencies will want any prepayments to first go to the senior tranche to avoid
the probability that the remaining pool does not become too risky for the remaining senior
tranche.Study Session: 3 - RA: 13
The documentation for each asset class is different. There is no need to have tangible assets for
creation of a SPV. For new asset classes, data availability is a problem.Study Session: 3 - RA:
13
All of these factors are important for the evaluation of any structured finance.Study Session: 3 -
RA: 13
When the credits are priced on the basis of their contribution to the portfolio risk, correlation
with existing assets becomes a critical factor for assessment.Study Session: 3 - RA: 13
The least credit-worthy loans have highest credit risk, but lowest pre-payment risk. Since the
senior tranche does not have credit risk, by design it has high pre-payment risk. In order to
reduce the pre-payment risk, the investors actually look for the least credit-worthy borrowers.
(Since the credit risk is borne by somebody else, the investor's RATIONAL behavior looks
irrational at the first glance).Study Session: 3 - RA: 13
A pass-through certificate is a form of securitization where the assets are sold to a trust and
investors buy shares in the trust.Study Session: 3 - RA: 13
All of the above statements are TRUE.Study Session: 3 - RA: 13
Banks often set up overcollateralized special purpose vehicles to get a AAA rating (if the parent
puts sufficient capital into the SPV it can get this rating irrespective of its own rating) that they
need to be able to deal in derivatives markets (many corporate clients will not deal with A-rated
banks).
PASS PRO™ , Expected Score™ , Adaptive Practice™ , Targeted Practice™ and Pick'N'Mix Test Creator™
are trademarks of Inmarkets Ltd.

PASS PRO Questions

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

PASS PRO Questions

Uploaded by

Copyright:

Available Formats

PASS PRO - Copyright 2004 Inmarkets Ltd - Licensed to Raymond chen Ò ³Â ë£ ¬1/85

PASS PRO Questions

Which of the following is TRUE in relation to the dividend test provision?

A. It prevents the firm from paying any dividends.

B. It prevents the firm from issuing new debt to pay dividends.

The position of a lender is most similar to a:

A. remains constant over time.

B. increases with the time horizon.

C. decreases with the time horizon.

D. may increase or decrease depending on the given industrial sector.

Which of the following is TRUE in relation to affirmative covenants?

A. They prohibit the borrower from issuing new debt.

The negative pledge clause in bond covenants contains:

C. I, II, and III.

D. II, III, and IV.

Which of the following is TRUE in relation to negative covenants?

A. They prohibit the borrower from undertaking new lines of business.

Which of the following is a measure of short-term solvency?

B. Times interest coverage.

C. Debt to capitalization ratio.

D. Total debt to earnings ratio.

C. I, III and IV.

D. II, III, and IV.

A bank has a loan book with four A-

A bank has a loan book with one A-

A bank has a loan book with four BB-

A bank has a loan book with four AA-

independent, the probability that at

D. All of the above has similar recovery rates.

D. None of the above.

A. a long forward position on the stock.

B. a short forward position on the stock.

C. a long put option position on the stock.

D. a short call option position on the stock.

A bank has a loan book with four A-

A bank has a loan book with one A-

A. between 0.04% and 0.2%.

B. between 0.04% and 4%.

C. between 0.2% and 4%.

A bank has a loan book with one A-

A. less than 0.02%.

C. between 0.02% and 2%.

A bank has a loan book with four A-

A bank has a loan book with one BB-

A bank has a loan book with four BBB-

of the bank's customers will default

A bank has a loan book with four BB-

B. 25 % x (1+ rf) ^5 ; where rf is the risk-free rate.

C. 25% / (1 + rf) ^3; where rf is the risk-free rate.

D. 25% / (1 + rf ) ^ 8; where rf is the risk-free rate

54. Which of the following statements are TRUE?

A. As the recovery rate increases, the credit spread increases.

B. As the recovery rate increases, the credit spread decreases.

C. As the loss given default increases, the credit spread decreases.

D. None of the above.

D. None of the above.

D. None of the above.

approximate credit spread for this bond?

C. 60% x 10% = 6%.

D. 90% x 10% = 9%.

D. None of the above.

63. Which of the following statements are TRUE for CREDITRISK+?

B. It uses default correlations as a direct input.