Credit Risk Measurement and Management

• Topic 01

  Credit Analysis Fundamentals

  42 questions
• Topic 02

  Credit Ratings and Agencies

  37 questions
• Topic 03

  Structural Credit Models

  29 questions
• Topic 04

  Reduced-Form Credit Models

  30 questions
• Topic 05

  Credit Default Swaps

  30 questions
• Topic 06

  Securitisation and Credit Risk

  28 questions
• Topic 07

  Counterparty Risk Management

  39 questions
• Topic 08

  Portfolio Credit Risk

  28 questions
• Topic 09

  Sovereign Credit Risk

  29 questions
• Topic 10

  Credit Risk Regulation: Basel Framework

  28 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. What does 'notching' mean in credit rating practice, and in which direction are senior secured issues typically notched relative to the issuer credit rating?

   • A
     Notching adjusts an issue (instrument) rating relative to the issuer rating to reflect its position in the capital structure; senior secured issues are typically notched above the issuer credit rating because they have priority claim on assets in a default
     Correct answer
   • B
     Notching adjusts issue ratings to reflect different currencies; senior secured USD issues are notched above equivalent EUR issues because USD is a reserve currency
   • C
     Notching refers to the process of assigning a rating outlook (positive, stable, negative) to an issue; senior secured issues receive a 'positive' notch to indicate expected upgrade
   • D
     Notching means expressing a rating on a plus/minus scale (e.g., BBB+, BBB, BBB−); senior secured issues are notched downward because they have higher interest payment obligations
   Explanation

   Notching is the adjustment of an issue (instrument) rating relative to the issuer credit rating to reflect the specific security's position in the capital structure and its expected recovery in default:

   • Senior secured issues: Typically rated 1–2 notches above the issuer credit rating because they have priority claim on specific collateral in a bankruptcy, resulting in higher expected recovery
   • Senior unsecured issues: Generally at or near the issuer credit rating
   • Subordinated/junior debt: Typically 1–2 notches below the issuer credit rating because they rank behind senior claims, resulting in lower expected recovery

   For example, if the issuer credit rating is BB, senior secured bonds might be rated BB+ or BB+/BBB−, while subordinated notes might be rated B+ or B. CDS typically references the senior unsecured issuer rating.

2. A bank uses a 1-year transition matrix to calculate expected credit loss (ECL) for a B-rated corporate loan. The 1-year default probability from the matrix is 7%. The loan has a face value of $10M, and the bank assumes a recovery rate of 40%. The bank also has a 2-year version of the same loan but wants to calculate the 2-year ECL. Explain why simply multiplying the 1-year ECL by 2 would be incorrect, and describe the correct approach.

   • A
     Multiplying 1-year ECL by 2 overstates 2-year ECL for B-rated borrowers because high-yield borrowers have declining marginal default rates over time; the correct approach uses the recovery rate squared
   • B
     Simply doubling 1-year ECL ignores intermediate rating migrations: in year 2, the borrower may have migrated to CCC (higher PD) or BBB (lower PD) before defaulting; the correct approach uses the 2-year transition matrix (M²) to find the 2-year default probability, then applies EL = PD(2yr) × LGD × EAD
     Correct answer
   • C
     Multiplying 1-year ECL by 2 is the correct and standard approach under IFRS 9; the transition matrix is only relevant for regulatory capital calculations, not ECL provisioning
   • D
     The correct approach is to use the 2-year default probability from the matrix and multiply by the remaining balance at year 2, discounting at the risk-free rate; year 1 ECL and year 2 ECL are independent additive amounts
   Explanation

   1-year ECL = PD(1yr) × LGD × EAD = 7% × 60% × \$10M = \$420,000

   Why 2 × \$420,000 = \$840,000 is wrong:

   • The 2-year ECL is NOT simply 2 × annual ECL
   • In year 2, default can only occur if the borrower survives year 1
   • Year 2 PD = Survival in year 1 × Conditional default probability in year 2 = (1 − 7%) × 7% = 6.51%
   • Year 2 ECL = 6.51% × 60% × \$10M = \$390,600 (discounted back)
   • Lifetime ECL (2-year) ≈ \$420,000 + PV(\$390,600) < \$840,000

3. Which of the following best describes the legal mechanism by which the ISDA Master Agreement reduces counterparty credit risk upon a counterparty's default?

   • A
     Close-out netting: all transactions under the Master Agreement are terminated simultaneously and their MTM values are netted into a single amount owed by or to the defaulting counterparty.
     Correct answer
   • B
     Novation: each trade is transferred to a central counterparty upon default, removing bilateral exposure.
   • C
     Compression: offsetting trades are eliminated, reducing the number of outstanding contracts.
   • D
     Payment netting: all scheduled cash flows on a given date are netted into a single payment, eliminating settlement risk.
   Explanation

   The ISDA Master Agreement's most important credit risk mitigation feature is close-out netting. Upon a defined event of default, all outstanding transactions under the Master Agreement are immediately terminated and their mark-to-market values are aggregated into a single net payable or receivable. This prevents the cherry-picking of only in-the-money contracts that would otherwise occur in bankruptcy. Payment netting, while also present in ISDA, refers to netting cash flows on scheduled payment dates — a different, smaller benefit.