4.8 Credit Risk

4.8 Credit Risk

Question 1

PE2020Q96 / PE2021Q96 / PE2022Q96
A risk analyst at a growing bank is concerned about a loan exposure to a large manufacturing company which is losing significant market share in its industry. The analyst considers the use of different credit risk transfer mechanisms, including CDS, to manage this exposure. Which of the following statements correctly describes an appropriate benefit of using CDS in this situation?

A. They quantify the manufacturing company’s default risk and allow the bank to monitor changes in this risk on a real-time basis.
B. They provide an agreement to perlodically revalue the loan and transfer any net value change.
C. They require the manufacturing company to pay back the loan in full at an earlier point in time.
D. They allow the bank to offset its exposure to the company with loan exposures to other manufacturing companies.

Answer: A
Learning Objective: Compare different types of credit derivatives, explain how each one transfers credit risk, and describe their advantages and disadvantages.

CDS (or credit default swaps) are credit derivatives that quantify a company’s default risk and allow the bank to monitor changes in the company’s default risk on a real-time basis. This is an improvement over credit ratings, which only update assessments of companies’ default risk on a periodic basis.

B is incorrect. This would be a feature of marking-to-market/margining.

Cis incorrect. This would be an example of a termination/put option mechanism.

D is incorrect. CDS do not provide an offset using loan exposures to other counterparties. A separate transfer mechanism, netting, can be used to offset negative and positive exposures to the same counterparty but this statement does not correctly describe netting either.

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Question 2

PE2022Q38
A junior analyst at a banking supervisory agency is taking an internal training class on the Vasicek model. The analyst reviews the following equations related to the model:

$$U_i=aF+\sqrt{1-a^2{Z}_i}$$

Default rate as a function of $F=N\left(\frac{N^{-1}(PD)-aF}{\sqrt{1-a^2}}\right)$

Which of the following statements regarding the Vasicek model is correct?

A. The default probabilities of the individual loans in a portfolio are each mapped to the standard normal distribution $U_i$, of which values in the extreme right tail represent default.
B. A low value of the factor F indicates that the economy is strong, while a high value of $F$ represents economic weakness.
C. For corporate borrowers, the value of the factor $F$ is higher for loans to companies with more cyclical businesses.
D. The model coefficient $a$ directly relates to the correlations between the default probability distributions $U_i$ of the loans in the portfolio.

Answer: D
Learning Objective: Describe and apply the Vasicek model to estimate default rate and credit risk capital for a bank.

D is correct. The correlation between each pair of $U_i$ distributions is equal to $a^2$.

A is incorrect. The default probabilities are each mapped to the standard normally distributed variable $U_i$, however, values in the extreme left tail represent default. As such, low values of $F$ or $Z_i$ correspond with a higher likelihood of default.

B is incorrect. High values of $F$ indicate a strong economy, and low values of $F$ indicate a weak economy. As such, low values of $F$ correspond with a higher likelihood of default.

C is incorrect. $F$ is a common factor and is equal for all loans in the portfolio.

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Question 3

PE2022Q90
A risk analyst at a bank is calculating credit risk for various types of assets in the bank’s portfolio. The analyst begins by estimating the parameters used as inputs to these calculations, and encounters several challenges while doing so. Which of the following will the analyst find to be correct regarding the estimated inputs for credit risk calculations?

A. The probability of default of a derivative counterparty often increases as the bank’s exposure at default with respect to that derivative position increases.
B. The loss given default for a derivative transaction is typically negatively correlated with the counterparty’s probability of default.
C. Banks must make both through-the-cycle and point-in-time estimates of loss given default to comply with both regulatory requirements and accounting standards.
D. Current exposure is typically used to estimate exposure at default for a line of credit in order to provide a conservative estimate.

Answer: A
Learning Objective: Describe challenges to quantifying credit risk.

A is correct. This is what is termed wrong-way risk. This is the risk associated with the fact that a counterparty to a company may be more likely to default when the value of outstanding derivatives is negative to the counterparty (and therefore positive to the company).

B is incorrect. The loss given default is positively correlated with probability of default (recovery rate is negatively correlated with probability of default).

C is incorrect. Banks must make both through-the-cycle and point-in-time estimates of the probability of default, not the loss given default, to comply with both regulatory requirements and accounting standards.

D is incorrect. In the case of a line of credit, EAD can be conservatively estimated as the customer’s borrowing limit, not the current amount drawn down.

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Question 4

PE2022Q92
A fixed-income portfolio manager at a pension fund is investigating the information contained in credit ratings and credit default swap spreads. The manager reviews the literature on the subject and finds research by Hull, Predescu, and White examining the impact of rating changes on credit default swap spreads. According to this study, which of the following ratings actions is found to have the greatest impact on credit default swap spreads when announced?

A. Watchlist reviews for ratings upgrades
B. Ratings upgrades
C. Watchlist reviews for ratings downgrades
D. Ratings downgrades

Answer: C
Learning Objective: Describe the relationships between changes in credit ratings and changes in stock prices, bond prices, and credit default swap spreads.

C is correct. Hull, Predescu, and White (2004) looked at the impact of rating changes on credit default swap spreads and found that watchlist reviews for a downgrade contain significant information, but downgrades and negative outlooks to not. Positive rating events were much less significant. Generally, credit default swap changes seem to anticipate rating changes.

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