Mock exam Credit Risk (answers)

Q1 Answer 2 (2.14%) (Remark : Probability of default in year 1 = 0.01. Probability of default in

year 2: P(D2 A1)P(A1) + P(D2 B1)P(B1) + P(D2 C1)P(C1)=0.01*0.90 + 0.02*0.07 +
0.05*0.02=0.0114. Cumulative probability of default = (1% + 1.14%)= 2.14%
Q2 Answer 3 (Baa3) (Remark Moodys equivalent of BBB-)
Q3 Answer 2(36.25%) (Remark : PND 6y = PND 5y * Marginal PND = (1-25%)*(1-15%)=0.6375
so PD=0.3625)
Q4 Answer 1 (48.8%) (Remark : PND 3y = PND 1y ^3 = (1-0.2)^3 = 0.512)
Q5 Answer 4 (1 in 2) (Remark : Not in the course but it is in the PRM handbook and the other
answers are too low)
Q6 Answer 2 (between 0.004% and 0.007%) (Remark : (1 PD1m)^12 = (1 - 0.06%) So, PD1m =
0.005%)
Q7 Answer 2 (770,000$) (Remark : Expected
0.7)+20,000,000*0.05*(1-0.5)= $770,000)

Loss

30,000,000*0.03*(1-

Q8 Answer 4 (0m$) (Remark : definition of netting : In the event of default, the two contracts
should be netted and the institution will have a net exposure of -$4m, meaning this money wil have
to be given to the administrators, so credit exposure is zero [only concern is liquidity issue])
Q9 Answer 2 (Sum of exposure in both the swaps) (Remark : the 2 swaps have a positive MtM so 2
is right)
Q10 Answer 4 (Unable to be determined) (Remark : We know only the net MtM. As there is no
netting agreement, we must use the sum of the absolute values of MtM, which cannot be
determined)
Q11 Answer 1 (Legal and Credit Risk) (Remark : Netting agreements reduce credit risk by
replacing all contracts with a single claim of value the net MtM. They also reduce Legal risk as all
the case laws involving ISDA can be used)
Q12 Answer 1 (Equity) (Remark : Haircut increase with market volatility so the haircut will be
more on equity as it is most volatile than bonds or bills)
Q13 Answer 4 (greater than 0.5m) (Remark : the maximum credit exposure is at least equal to the
exposure the day of the trade)
Q14 Answer 4 (Remark : EL = EAD * PD * LGD = MtM * default rate * LGD and LGD = 1
recovery rate. EL is not strictly speaking equal to credit risk, there is also the UL but this answer is
the best available)
Q15 Answer 2 (correlations of equity returns) (Remark : as a proxy of correlation of assets returns)
Q16 Answer 2 (I false, II true) (Remark : Monte Carlo is a numerical method, not a source of
models)

Q17 Answer 2 (20%) (Remark : Cf the Corporates table in the Standard Approach)
Q18 Answer 3 (50%) (Remark : Cf the Sovereigns table in the Standard Approach)
Q19 Answer 2 (Unexpected Loss) (Remark : Definition of UL)
Q20 Answer 2 (2.5 years) (Remark : It is a arbitrary decision of the Basel Committee)
Q21 Answer 4 (origination of various types of credit exposures) (Remark : Not fully covered in the
course but logical : originating deals can never be the responsibility of a risk control team)
Q22 Answer 2 (Negative coefficient) (Remark : the bigger the Z, the better. A high ratio of current
liabilities to current assets is bad, so it should push the Z in the negative values)
Q23 Answer 4 (498 318$) (Remark : The PD1y is transformed in a PD1m, using the formula (1PD1y)=(1-PD1m)^12. PD1m = 0.168%. The following table shows how to compute expected loss.
Default
Probability
Loss
PiLi
2 bonds
PD^2 = 0.00000282
1,000,000$
2.8$
1 bond
2 * PD * (1-PD)= 0.00335862
500,000$
1 679.4$
0 bond
(1-PD)^2= 0.99663854
0$
0$
Expected Loss = $1 682. A default of 1 bond ($500,000) is the total loss at the 99.9% confidence
level. Subtracting EL from $500,000, we get Credit VaR = $498,318)
Q24 Answer 1 (Top Down)
Q25 Answer 2 (one month after the announcement of default) (Remark : In reality, only true for big
companies, for which a bond market exist)
Q26 Answer 2 (Differences in recovery rates) (Remark : LGD is heavily dependant on the
bankruptcy law and therefore on the country)