Hull: Options, Futures, and Other Derivatives, Tenth Edition

Chapter 24: Credit Risk

Multiple Choice Test Bank: Questions with Answers

1. Suppose that the cumulative probability of a company defaulting by years one, two, three and
four are 3%, 6.5%, 10%, and 14.5%, respectively. What is the probability of default in the fourth
year conditional on no earlier default?
A. 4.5%
B. 5.0%
C. 5.5%
D. 6.0%

Answer: B

The unconditional PD for the fourth year is 14.5% minus 10% or 4.5%. The probability of no
earlier default is 90%. The PD conditional on no earlier default is therefore 0.045/0.9=0.05
or 5%

2. Which of the following is usually used to define the recovery rate of a bond?
A. The value of the bond immediately after default as a percent of its face value
B. The value of the bond immediately after default as a percent of the sum of the bond’s
face value and accrued interest
C. The amount finally realized by a bondholder as a percent of face value
D. The amount finally realized by a bondholder as a percent of the sum of the bond’s face
value and accrued interest

Answer: A

The recovery rate for a bond is usually defined as the value of the bond immediately after a
default as a percent of its face value. This is in spite of the fact that the bond holder’s claim
in the event of a default in many jurisdictions is the face value plus accrued interest.

3. Which of the following is true?

A. Risk neutral default probabilities are usually much lower than real world default
probabilities
B. Risk neutral default probabilities are usually much higher than real world default
probabilities
C. Risk neutral and real world probabilities must be close to each other if there are to be no
arbitrage opportunities
D. Risk-neutral default probabilities cannot be calculated from CDS spreads

Answer: B

Risk neutral default probabilities are usually greater than real world default probabilities.

4. A hazard rate is 1% per annum. What is the probability of a default during the first two years?
A. 2.00%
 B. 2.02%
C. 1.98%
D. 1.96%

Answer: C

The probability of no default is e−0.01×2 = 0.9802. The probability of default is one minus this or
0.0198 (i.e., 1.98%).

5. Which of the following is true

A. The default probability per year for a company always increases as we look further
ahead
B. The default probability per year for a company always decreases as we look further
ahead
C. Sometimes A is true and sometimes B is true
D. The default probability per year is roughly constant for most companies

Answer: C

For investment grade companies the probability of default tends to increase with time. For
non-investment grade companies the reverse is often true.

6. Which of the following is true

A. Conditional default probabilities are at least as high as unconditional default
probabilities
B. Conditional default probabilities are at least as low as unconditional default probabilities
C. Conditional default probabilities are sometimes lower and sometimes higher than
unconditional default probabilities.
D. There is no difference between conditional and unconditional default probabilities
because a company can only default once.

Answer: A

The conditional default probability for a future time period is the unconditional default
probability divided by the probability of no earlier default. The latter is less than or equal to
one. As a result the conditional probability is at least as great as the unconditional
probability.

7. If a company’s five year credit spread is 200 basis points and the recovery rate in the event of a
default is estimated to be 20% what is the average hazard rate per year over the five years
A. 0.4%
B. 1.2%
C. 1.8%
D. 2.5%

Answer: D

The average hazard rate is the credit spread divided by one minus the recovery rate. In this
 case we get 0.02/0.8=0.025 or 2.5%

8. Which of the following is true

A. Recovery rates are lower for investment grade companies
B. Recovery rates are higher for non-investment grade companies
C. Recovery rates are negatively correlated with default rates
D. Recovery rates are positively correlated with default rates

Answer: C

When default rates are high in the economy, recovery rates tends to be low

9. Which of the following is true

A. The asset swap spread is a measure of excess of the bond yield over the OIS rate
B. The asset swap spread is a measure of excess of the bond yield over the LIBOR/swap
rate
C. An asset swap exchanges the actual return on the asset for LIBOR plus a spread
D. None of the above

Answer: B

The asset swap spread is a measure of the excess of the bond yield over LIBOR. In an asset
swap the promised cash flows (not the actual cash flows) on a bond are exchanged for
LIBOR plus a spread

10. To be investment grade, a company has to have a credit rating of

A. AA or better
B. A or better
C. BBB or better
D. BB or better

Answer: C

Companies with credit ratings of BBB or better are investment grade.

11. In the Gaussian copula model which of the following is true

A. The time to default for a company is assumed to be normally distributed.
B. The time to default for a company is assumed to be lognormally distributed
C. The time to default for a company is transformed to a normal distribution
D. The time to default for a company is transformed to a lognormal distribution

Answer: C

The time to default for each company is transformed to a normal distribution on a

percentile to percentile basis and the normal distributions are assumed to be multivariate
normal.

12. Which of the following is true

 A. Netting always leads to a reduction in a company’s exposure to a counterparty
B. Netting always leads to a company’s exposure to a counterparty either staying the same
or going down
C. Netting always increases a company’s exposure to a counterparty
D. Netting can increase or reduce the exposure

Answer: B

Netting means that the derivatives portfolio with a counterparty is considered to be a single
transaction in the event of a default. This cannot increase the exposure. If there are
transactions in the portfolio with both positive and negative values the exposure will go
down.

13. Which of the following is true

A. Downgrade triggers are particularly valuable if they are widely used by a company’s
counterparties
B. Downgrade triggers become less valuable if they are widely used by a company’s
counterparties
C. Downgrade triggers are useless because their impact is always anticipated by the market
D. Downgrade triggers are a two-edged sword. If company A has a downgrade trigger for
company B then company B has a downgrade trigger for company A

Answer: B

Downgrade triggers become less valuable if many of a company’s counterparties are using
them (as was the case with Enron and AIG). This is because the counterparties will require
either cash collateral, or transactions to be unwound, at the same time. This can cause the
company to fail.

14. Which of the following is true of Merton’s model:

A. The equity is a call option on the assets
B. The assets are a call option on the debt
C. The debt is a call option on the equity
D. The equity is a call option on the debt

Answer: A

In Merton’s model the market value of the equity of a company is a call option on the
market value of the assets

15. Which of the following is true of Merton’s model:

A. The strike price is the market value of the debt
B. The strike price is the market value of the equity
C. The strike price is the book value of the equity
D. The strike price is the face value of the debt

Answer: D
 In Merton’s model, the strike price is the face value of the debt

16. Which of the following is true

A. The Gaussian copula model assumes that the defaults of different companies are
independent.
B. The Gaussian copula model assumes that defaults, conditional on the value of a factor ,
are independent.
C. The Gaussian copula model assumes that the number of defaults is normally distributed.
D. None of the above.

Answer: B

The Gaussian copula model is analyzed by noting that defaults conditional on a factor are
independent

17. A derivatives dealer has a single transaction with a company which is a long position in a five-
year option. The Black-Scholes-Merton value of the option is $6. Suppose that the credit spread
on five-year bonds issued by the company is 100 basis points. What is the dealer’s CVA per
option purchased from the counterparty?
A. $0.19
B. $1.19
C. $0.29
D. $1.29

Answer: C

The value of the option when the counterparty’s credit risk is taken into account is
6e−0.01×5=5.71 and so the CVA is 6−5.71 or $0.29 per option purchased

18. Which of the following is true

A. A derivative dealer’s CVA is the counterparty’s DVA and vice versa
B. Collateral posted by the counterparty reduces CVA
C. Collateral posted by the dealer reduces DVA
D. All of the above

Answer: D

A, B, and C are all true

19. The credit spreads for a counterparty for 5 and 6 years are 2% and 2.2% respectively. The
recovery rate is 60%. What is closest to the unconditional default probability for the sixth
year?
A. 0.04
B. 0.05
C. 0.06
D. 0.07

Answer: C
 The average hazard rate for the first five years is 0.02/(1-0.6)=0.05 or 5%. The average
hazard rate for the first six years is 0.022/(1-0.6)=0.055 or 5.5%. The probability of no
default during the first five years is therefore e -0.05×5=0.7788. The probability of no default
during the first six years is e-0.055×6 =0.7189. The probability of default during the sixth year is
therefore 0.7788−0.7189 or approximately 0.06.

20. Which of the following is true of Creditmetrics when it is used to calculate credit VaR
A. Creditmetrics takes defaults but not downgrades into account
B. Creditmetrics takes downgrades but not defaults into account
C. Creditmetrics considers neither defaults nor downgrades
D. Creditmetrics considers both defaults and downgrades

Answer: D

By working from the credit transition matrix Creditmetrics takes both downgrades and
defaults into account.