Chapter 11 Testbank PDF

Chapter 11 - Testbank
Student: ___________________________________________________________________________
1. Migration analysis is a method to:
A. manage loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for unusual
declines.
B. measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for unusual
declines.
C. measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for normal
declines.
D. manage loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for normal
declines.
2. The term 'transition matrix' refers to a matrix that provides a measurement of the probability of a loan:
A. being upgraded over some period.
B. being downgraded over some period.
C. defaulting over some period.
D. All of the listed options are correct.
3. Limits set on the maximum loan size that can be made to an individual borrower are referred to as:
A. maximum damage limits.
B. concentration limits.
C. syndication limits.
D. minimisation limits.
4. Which of the following statements is true?
A. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups' performance
are negatively correlated.
B. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups' performance
are highly correlated.
C. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups' performance
are not correlated.
D. FIs may set an aggregate limit of more than the sum of two individual industry limits if two industry groups' performance

5. Consider the following hypothetical transition matrix:

Risk
grade
at
end
of
year
1 2 3 Default
Risk grade at beginning of year 1 0.85 0.10 0.04 0.01
2 0. 0.83 0.03 0.02
12
3 0. 0.13 0.80 0.04
03
Which of the following statements is true?
A. A borrower with a risk grade of 2 at the beginning of the year has a 3 per cent probability of being downgraded to a risk
grade of 3.
B. A borrower with a risk grade of 3 at the beginning of the year has a 0.04 per cent probability of being upgraded to a
risk grade of 1.
C. A borrower with a risk grade of 2 at the beginning of the year has a 12 per cent probability of being downgraded to a
risk grade of 1.
D. A borrower with a risk grade of 2 at the beginning of the year has an 85 per cent probability of being upgraded to a risk
grade of 1.

A. FIs typically increase their concentration limits to increase exposures to others.
B. FIs typically set concentration limits to reduce exposures to certain industries and increase exposures to others.
C. FIs typically set concentration limits to reduce their exposure to individual borrowers.
D. FIs typically decrease their concentration limits to decrease exposures to others.
A. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital divided by (one
divided by the loss rate).
B. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital divided by (one
multiplied by the loss rate).
C. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital multiplied by
(one divided by the loss rate).
D. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital multiplied by
(one multiplied by the loss rate).
8. Assume that the maximum loss as a percentage of capital is 12 per cent of an FI's capital to a particular sector and that
the amount lost per dollar of defaulted loans in this sector is 35 per cent. What is the concentration limit (round to two
decimals)?
A. 12%  (1/0.35) = 34.29%
B. 35%  (1/0.12) = 4.2%
C. 12% / (1 + 0.35) = 8.89%
D. 35% / (1 + 0.12) = 31.25%

the amount recovered per dollar of defaulted loans in this sector is 70 per cent. What is the concentration limit (round to
two decimals)?
A. 9%  (1/0.7) = 12.86%
B. 9%  [1/(1–0.7)] = 30.00%
C. 70% / (1/0.09) = 6.30%
D. (100% – 70%) / (1/0.09) = 2.70%
10. Assume that the maximum loss as a percentage of capital is 12 per cent of an FI's capital to a particular sector. The
FI's concentration limit on this sector 35 per cent. What is the sector's loss rate (round to two decimals)?
A. 4.20 per cent
B. 23.00 per cent
C. 34.29 per cent
D. 2.92 per cent.
11. Assume that an FI's concentration limit on a particular sector is 15 per cent and that the sector's loss rate is 25 per
cent. What is the maximum loss as a percentage of the FI's capital (round to two decimals)?
A. 1.67 per cent
B. 0.60 per cent
C. 10.00 per cent
D. 3.75 per cent
12. Minimum risk portfolio refers to a combination of assets:
A. and liabilities that reduces the variance of portfolio returns to the lowest feasible level.
B. that leverages the variance of portfolio returns to the optimal level.
C. that reduces the variance of portfolio returns to the lowest feasible level.
D. that reduces the variance of portfolio returns to zero.
13. KMV Portfolio Manager is a model that:
A. was developed by the KMV Corporation and purchased by Moody's in 2002.
B. measures the expected return on a loan to a borrower, the risk of a loan to a borrower and the correlation of default
risks between loans made to a borrower and other borrowers.
C. seeks to estimate an efficient frontier for loans.
A. Systematic loan loss risk is a measure of the sensitivity of loan losses in personal loans relative to the losses in
commercial loans.
B. Systematic loan loss risk is a measure of the sensitivity of loan losses of a particular borrower relative to the losses in
an FI's loan portfolio.
C. Systematic loan loss risk is a measure of the sensitivity of loan losses in commercial loans relative to the losses in
personal loans.
D. Systematic loan loss risk is a measure of the sensitivity of loan losses in a particular business sector relative to the
losses in an FI's loan portfolio.

15. The Basel Committee on Banking Supervision considers regulatory loan concentration limits to individual borrowers as
an issue of granularity. Which of the following statements is true in this context?
A. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted by the FI to
reflect its levels of portfolio concentration or diversification.
B. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted up or down to
reflect the levels of portfolio concentration or diversification.
C. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted up to reflect
the levels of portfolio diversification.
D. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted down to
reflect the levels of portfolio concentration.
A. FIs can reduce profitability by taking advantage of the law of small numbers in their investment decisions.
B. FIs can reduce profitability by taking advantage of the law of large numbers in their investment decisions.
C. FIs can reduce risk by taking advantage of the law of small numbers in their investment decisions.
D. FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.
A. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
diversify considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated.
B. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its size, an FI can diversify
considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated.
C. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
diversify considerable amounts of credit risk as long as the returns on different assets are perfectly correlated.
D. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
18. Consider the following table with information on the weightings and expected returns of two assets held by an FI.

Loan i

1 0.35 12.35%
2 0.65 10.25%
What is the expected return on the portfolio (round to two decimals)?
A. (0.35 + 12.35) – (0.65 + 10.25) = 1.80%
B. (0.35 + 0.65)  (12.35 + 10.25) = 22.60%
C. (12.35 + 10.25) / 2 = 11.30%
D. 0.35  12.35 + 0.65  10.25 = 10.99%

19. Consider the following table with information on the weightings and expected returns of three assets held by an FI.

Loan i

1 0.15 12.35%
2 0.55 10.25%
3 0.30 15.75%
A. (0.15  12.35 + 0.55  10.25 + 0.30  15.75) / 3 = 4.07%
B. (0.15  12.35 + 0.55  10.25 + 0.30  15.75)  3 = 36.66%
C. 0.15  12.35 + 0.55  10.25 + 0.30  15.75 = 12.22%
D. (12.35 + 10.25 + 15.75) / 3 = 12.78%

A. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values –1  r  + 1, where r is the correlation coefficient.
B. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values 0  r  + 1, where r is the correlation coefficient.
C. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values +1  r  + 2, where r is the correlation coefficient.
D. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values –1  r  0, where r is the correlation coefficient.
A. One advantage of using MPT for loans is that the returns on individual loans are normally distributed, meaning that the
upside returns are equal to the downside risks.
B. One objection to using MPT for loans is that the returns on individual loans are not normally distributed, meaning that
most loans have unlimited upside returns and long-tail downside risks.
C. One advantage of using MPT for loans is that the returns on individual loans are normally distributed, meaning that
most loans have unlimited upside returns and unlimited downside risks.
D. One objection to using MPT for loans is that the returns on individual loans are not normally distributed, meaning that
most loans have limited upside returns and long-tail downside risks.
A. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
exactly estimates the risk of the whole portfolio.
B. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
underestimates the risk of the whole portfolio.
C. If many loans have positive correlations of returns the sum of the individual credit risks of loans viewed independently
overestimates the risk of the whole portfolio.
D. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently

23. Consider the following portfolio of assets:

Loan i i i2

1 0.30 13% 9.06% 82.0% P12 = –0.87
2 0.70 11% 8.72% 76.0% 12 = –75.0%
What is the variance of the portfolio (round to two decimals)?
A. (0.3)2(82.0%) + (0.7)2(76.0%) + (0.3)(0.7)(–0.87)  (9.06%)(8.72%) = 30.19
B. (0.3)2(82.0%) + (0.7)2(76.0%) + [(0.3)(0.7)]2  (–0.87)  (9.06%)(8.72%) = 41.59
C. (0.3)2(82.0%) + (0.7)2(76.0%) + 2(0.3)(0.7)(–0.87)  (9.06%)(8.72%) = 15.75
D. (0.3)(82.0%) + (0.7)(76.0%) + 2(0.3)(0.7)(–0.87)  (9.06%)(8.72%) = 48.93

Loan i i i2
1 0.45 15% 6.05% 36.60% P12 = –0.2

2 0.55 13% 8.75% 76.56% 12 = –4.0%
A. (0.45)2(36.60%) + (0.55)2(76.56%) + (0.45)(0.55)(–0.2)  (6.05%)(8.75%) = 27.95
B. (0.45)2(36.60%) + (0.55)2(76.56%) + 2(0.45)(0.55)(–0.2)  (6.05%) (8.75%) = 25.33
C. (0.45)(36.60%) + (0.55)(76.56%) + 2(0.45)2(0.55)2
D. (–0.2)  (6.05%)(8.75%) = 57.28
E. (0.45)(36.60%) + (0.55)(76.56%) + 2(0.45)(0.55)(–0.2)  (6.05%)(8.75%) = 53.34

Loan i i i2

1 0.30 13% 9.06% 82.0% P12 = –0.87
2 0.70 11% 8.72% 76.0% 12 = –75.0%
A. 0.3(13%) + 0.7(11%) = 11.60%
B. (13% + 11%) / 2 = 12.00%
C. (0.3)2(13%) + (0.7)2(11%) = 6.56%
D. [(0.3)2(13%) + (0.7)2(11%)]  2 = 13.12%


Loan i i i2

1 0.45 15% 6.05% 36.60% P12 = –0.2
2 0.55 13% 8.75% 76.56% 12 = –4.0%
A. (15% + 13%) / 2 = 14.00%
B. (0.45)2(15%) + (0.7)2(13%) = 9.41%
C. [(0.45)2(15%) + (0.7)2(13%)]  2 = 18.82%
D. 0.45(15%) + 0.7(13%) = 15.85%

A. The minimum risk portfolio generates the highest returns and is thus likely to be chosen by risk-seeking FI managers.
B. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-averse FI
managers.
C. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-seeking FI
managers.
D. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-indifferent FI
managers.
A. The objective of risk-indifferent FI managers is to minimise portfolio risk regardless of the portfolio's return.
B. The objective of risk-indifferent FI managers is to minimise portfolio risk in turn for higher returns on the portfolio.
C. The objective of risk-averse FI managers is to minimise portfolio risk in turn for higher returns on the portfolio.
D. The objective of risk-averse FI managers is to minimise portfolio risk regardless of the portfolio's return.
Loan i i i2
1 0.30 13% 9.06% 82.0% P12 = –0.87

2 0.70 11% 8.72% 76.0% 12 = –75.0%
What is the standard deviation of the portfolio (round to two decimals)?
A. (0.3)(82.00) + (0.7)(76.00) = 8.82%
B. (82.00) + (76.00) = 17.77%
C. 15.75 = 3.97%
D. 48.93 = 6.99%

Loan i i i2
1 0.45 15% 6.05% 36.60% P12 = –0.2

2 0.55 13% 8.75% 76.56% 12 = –4.0%
A. (0.45)(36.60) + (0.55)(76.56) = 7.51%
B. (36.60) + (76.56) = 14.80%
C. 57.28 = 7.57%
D. 25.33 = 5.03%

31. The return (Ri) on a loan can be measured as follows:
A. AISi – E(Li), whereby E(Li) = (EDFi  LGDi)
B. AISi – E(Li), whereby E(Li) = (EDFi / LGDi)
C. AISi + E(Li), whereby E(Li) = (EDFi  LGDi)
D. AISi + E(Li), whereby E(Li) = (EDFi / LGDi)
A. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI less the annual spread between the
loan rate paid by the borrower and the FI's cost of funds.
B. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI plus the annual spread between the
C. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI plus the loan rate paid by the
borrowers.
D. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI less the FI's cost of funds.
A. The risk of a loan reflects the volatility of the loan's default rate around its expected value times the amount lost given
default.
B. The product of the volatility of the default rate and the loss give default (LGD) is called the 'unexpected loss'.
C. The product of the volatility of the default rate and the loss give default (LGD) is a measure of the loan's risk.
A. According to KMV, default correlations tend to be low and lie between 0.002 and 0.15.
B. According to KMV, default correlations tend to be high and lie between 0.42 and 0.65.
C. According to KMV, default correlations vary and thus no particular range can be stated.
D. None of the listed options are correct.

35. Consider an FI holds two loans with the following characteristics:
Loan i Annual spread between loan rate and FI's cost of Annual fees Loss to FI given Expected default

funds default frequency
1 0.45 3.5% 1.5% 30% 4% 12 = –0.20
2 0.55 4.5% 2.0% 25% 3%
What is the return on the loan portfolio (round to two decimals)?
A. 3.80 per cent
B. 5.75 per cent
C. 9.55 per cent
D. 4.87 per cent

36. Consider an FI that holds two loans with the following characteristics:

1 0.45 3.5% 1.5% 30% 4% 12 = –0.20
2 0.55 4.5% 2.0% 25% 3%
What is the risk of the loan portfolio (round to two decimals)?
A. 5.88 per cent
B. 10.01 per cent
C. 3.16 per cent
D. 4.26 per cent

Loan i Annual loan rate Annual FI's cost of Annual fees Loss to FI given Expected default

1 0.30 10.0% 4.5% 2.0% 25% 4% P12 = –0.25
2 0.70 11.0% 5.0% 1.5% 20% 3%
A. 6.50 per cent
B. 6.90 per cent
C. 13.40 per cent
D. 6.78 per cent


1 0.30 10.0% 4.5% 2.0% 25% 4% P12 = 0.25
2 0.70 11.0% 5.0% 1.5% 20% 3%
A. 4.90 per cent
B. 3.41 per cent
C. 4.16 per cent
D. 6.10 per cent

A. Partial applications of portfolio theory include loan volume based models and loan loss ratio based models.
B. Partial applications of portfolio theory include loan portfolio profitability based models and regulatory models.
C. Partial applications of portfolio theory include loan volume based models, loan loss ratio based models and regulatory
models.
D. Partial applications of portfolio theory include loan portfolio profitability based models and loan loss minimisation based
models.
A. Loan loss ratio based models rely on actual data and involve the estimation of the systematic loan loss risk of a
particular industry relative to the loan loss risk of an FI's total loan portfolio.
B. Loan loss ratio based models rely on historic data and involve the estimation of the systematic loan loss risk of a
C. Loan loss ratio based models rely on historic data and involve the estimation of the systematic loan loss risk of a
particular borrower relative to the loan loss risk of an FI's total loan portfolio.
D. Loan loss ratio based models rely on actual data and involve the estimation of the systematic loan loss risk of a
41. Which of the following is a major difference between forwards and futures?
A. Forwards are marked-to-market, while futures are not.
B. Futures are tailor made, while forwards are standardised.
C. The default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties
against credit risk, while this is not the case for forwards.
D. Forwards are marked-to-market, while futures are not, futures are tailor made, while forwards are standardised and the
default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against
credit risk, while this is not the case for forwards.
42. A forward contract:
A. has more credit risk than a futures contract.
B. is more standardised than a futures contract.
C. is marked to market more frequently than a futures contract.
D. has a shorter time to delivery than a futures contract.
43. Pure credit swaps are swaps by which an FI receives the:
A. par value of the loan on default in return for paying a periodic swap fee.
B. current value of the loan on default in return for paying a periodic swap fee.
C. residual value of the loan on default in return for paying a periodic swap fee.
D. outstanding interest payments on the loan on default in return for paying a periodic swap fee.
A. Total return swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap and
alternative arrangements do not exist.
B. Total return swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap, but
alternative arrangements exist.
C. Pure credit swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap and
D. Pure credit swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap, but

45. Which of the following is a major difference between a pure credit swap and a default option?
A. In a pure credit swap the premium payment on the swap is paid up front, while the fees of a default option are paid over
the life of the default option.
B. In a pure credit swap the premium payments on the swap are paid over the life of the swap, while the fee of a default
option is paid up front.
C. In a pure credit swap the premium payment on the swap is paid at maturity, while the fees of a default option are paid
over the life of the default option.
D. In a pure credit swap the premium payments on the swap are paid over the life of the swap, while the fee of a default
option is paid at maturity.
A. As with loans, swap participants deal with the credit risk of counterparties by setting bilateral limits on the notional
amount of swaps entered into.
B. As with loans, swap participants deal with the credit risk of counterparties by adjusting the fixed and/or floating rates by
including credit risk premiums.
C. As with loans, swap participants deal with the credit risk of counterparties by using Monte Carlo simulations to model
potential default risk.
D. As with loans, swap participants deal with the credit risk of counterparties by setting bilateral limits on the notional
amount of swaps entered into and as with loans, swap participants deal with the credit risk of counterparties by adjusting
the fixed and/or floating rates by including credit risk premiums.
47. Which of the following is not a reason for the credit risk on a swap to be less than the credit risk on a loan?
A. Swap contracts often extend beyond the maturity of normal loan contracts.
B. Swap payments can be netted across more than on contract.
C. Interest rate swaps involve interest, but not principal.
D. Swap contracts often extend beyond the maturity of normal loan contracts, swap payments can be netted across more
than on contract and Interest rate swaps involve interest, but not principal.
48. A pure credit swap:
A. is like buying credit insurance.
B. is like buying a multi-period credit option.
C. eliminates the interest rate risk contained in the total return swap.
D. is like buying credit insurance, is like buying a multi-period credit option and eliminates the interest rate risk contained
in the total return swap.
49. Which of the following is incorrect in relation to debt recovery rates?
A. Macro-economic factors are found to be significant in explaining recovery rates on defaulted bonds.
B. Macro-economic factors are found to be insignificant in explaining recovery rates on defaulted bonds.
C. Senior securities tend to have higher recovery rates than subordinated securities.
D. Industrial revenue bonds tend to have higher recovery rates than subordinated securities.
50. Loan sales and securitisation are increasingly seen as valuable tools in the management of credit risk. Which of the
following are not advantageous to FIs?
A. Loan sales and securitisation allow FIs to better manage their customer relationships.
B. Loan sales and securitisation create moral hazard issues and reduce scrutiny of off-balance sheet activities of FIs.
C. Loan sales and securitisation reduce FIs industry and/or geographical concentration risk.
D. Loan sales and securitisation allow FIs to separate their credit risk exposure from the lending process itself.

51. A transition matrix can be used to establish the probabilities that a currently rated borrower will be upgraded,
downgraded or will default over time.
True False
52. The concentration limit for a loan portfolio is calculated as the expected default frequency of the borrower multiplied
by (one divided by the loss rate).

True False
53. The relationship limit on diversification has also been called the 'paradox of credit'.
True False
54. Concentration limits are external limits set on the maximum loan size that can be made to an individual borrower.
True False
55. FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.
True False
56. An FI that invests 40 per cent of funds in a loan with an expected return of 10 per cent and 60 per cent of funds in a
loan with an expected return of 12 per cent can expect to earn 11 per cent on its portfolio.
True False
57. Minimum risk portfolios generally generate the highest returns.
True False
58. Using the KMV Portfolio Manager Model, the return on a loan can be calculated as the annual all-in-spread minus the
loss in the event of default.
True False
59. Using the KMV Portfolio Manager Model, the risk on a loan can be calculated as the volatility of the loan's default rate
times the loss in the event of default.
True False
60. Loan loss ratio based models estimate systematic loan losses by running a time-series regression of quarterly losses
of the ith sector's loss rate on the quarterly loss rate of an FI's total loans.
True False

61. Financial institutions do not use options to hedge credit risk exposures as credit risk is a natural risk that comes with
the core activities of the bank, namely lending.
True False
62. The most important swap contract in terms of quantity is the credit swap.
True False
63. Explain the following hypothetical table:
Risk
grad
e at
end
of
year
Defa
1 2 3 4
ult
Risk grade at beginning of year 1 0.86 0.08 0.03 0.02 0.01
0.
2 0 0.84 0.05 0.04 0.03
4
0.
3 0 0.08 0.81 0.05 0.04
2
0.
4 0 0.03 0.10 0.78 0.08
1
In this context, explain the concepts of loan migration and migration analysis.

64. Consider the following data for a two-asset portfolio:

Annual spread between loan rate and FI's cost Loss to FI given Expected default
Loan i Annual fees
of funds default frequency

1 0.35 4.5% 2.0% 35% 5% 12 = –0.28
2 0.65 5% 2.5% 30% 4%
Using the KMV Portfolio Manager Model:
a. calculate the returns for loans 1 and 2.
b. calculate the risk for loans 1 and 2.
c. calculate the return for the loan portfolio.
d. calculate the risk for the loan portfolio.
e. explain your findings in (a) to (d).

65. Explain the basic concept of loan loss ratio based models.

Chapter 11 - Testbank Key

1. Migration analysis is a method to:
A. manage loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for unusual
declines.
B. measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for unusual
declines.
C. measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for normal
declines.
D. manage loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for normal
declines.
Difficulty: Medium
Learning Objective: 11-01 The methods for measuring levels of loan concentration.
2. The term 'transition matrix' refers to a matrix that provides a measurement of the probability of a loan:
A. being upgraded over some period.
B. being downgraded over some period.
C. defaulting over some period.
Difficulty: Easy
3. Limits set on the maximum loan size that can be made to an individual borrower are referred to as:
A. maximum damage limits.
B. concentration limits.
C. syndication limits.
D. minimisation limits.
Difficulty: Easy
A. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups' performance
B. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups' performance
are highly correlated.
C. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups' performance
are not correlated.
D. FIs may set an aggregate limit of more than the sum of two individual industry limits if two industry groups' performance
Difficulty: Hard
5. Consider the following hypothetical transition matrix:

Risk
grade
at
end
of
year
1 2 3 Default
Risk grade at beginning of year 1 0.85 0.10 0.04 0.01
2 0. 0.83 0.03 0.02
12
3 0. 0.13 0.80 0.04
03
Which of the following statements is true?
A. A borrower with a risk grade of 2 at the beginning of the year has a 3 per cent probability of being downgraded to a
risk grade of 3.
B. A borrower with a risk grade of 3 at the beginning of the year has a 0.04 per cent probability of being upgraded to a
risk grade of 1.
C. A borrower with a risk grade of 2 at the beginning of the year has a 12 per cent probability of being downgraded to a
risk grade of 1.
D. A borrower with a risk grade of 2 at the beginning of the year has an 85 per cent probability of being upgraded to a risk
grade of 1.

Difficulty: Medium
A. FIs typically increase their concentration limits to increase exposures to others.
B. FIs typically set concentration limits to reduce exposures to certain industries and increase exposures to others.
C. FIs typically set concentration limits to reduce their exposure to individual borrowers.
D. FIs typically decrease their concentration limits to decrease exposures to others.
Difficulty: Easy
A. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital divided by (one
divided by the loss rate).
B. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital divided by (one
multiplied by the loss rate).
C. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital multiplied by
(one divided by the loss rate).
D. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital multiplied by
(one multiplied by the loss rate).
Difficulty: Medium
the amount lost per dollar of defaulted loans in this sector is 35 per cent. What is the concentration limit (round to two
decimals)?
A. 12%  (1/0.35) = 34.29%
B. 35%  (1/0.12) = 4.2%
C. 12% / (1 + 0.35) = 8.89%
D. 35% / (1 + 0.12) = 31.25%
Difficulty: Medium
the amount recovered per dollar of defaulted loans in this sector is 70 per cent. What is the concentration limit (round to
two decimals)?
A. 9%  (1/0.7) = 12.86%
B. 9%  [1/(1–0.7)] = 30.00%
C. 70% / (1/0.09) = 6.30%
D. (100% – 70%) / (1/0.09) = 2.70%
Difficulty: Medium
10. Assume that the maximum loss as a percentage of capital is 12 per cent of an FI's capital to a particular sector. The
FI's concentration limit on this sector 35 per cent. What is the sector's loss rate (round to two decimals)?
A. 4.20 per cent
B. 23.00 per cent
C. 34.29 per cent
D. 2.92 per cent.
Difficulty: Hard
11. Assume that an FI's concentration limit on a particular sector is 15 per cent and that the sector's loss rate is 25 per
cent. What is the maximum loss as a percentage of the FI's capital (round to two decimals)?
A. 1.67 per cent
B. 0.60 per cent
C. 10.00 per cent
D. 3.75 per cent
Difficulty: Hard
12. Minimum risk portfolio refers to a combination of assets:
A. and liabilities that reduces the variance of portfolio returns to the lowest feasible level.
B. that leverages the variance of portfolio returns to the optimal level.
C. that reduces the variance of portfolio returns to the lowest feasible level.
D. that reduces the variance of portfolio returns to zero.
Difficulty: Medium
Learning Objective: 11-02 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.
13. KMV Portfolio Manager is a model that:
A. was developed by the KMV Corporation and purchased by Moody's in 2002.
B. measures the expected return on a loan to a borrower, the risk of a loan to a borrower and the correlation of default
risks between loans made to a borrower and other borrowers.
C. seeks to estimate an efficient frontier for loans.
Difficulty: Medium
Learning Objective: 11-03 The use of MPT and how it applies in the Moody's KMV approach to lending.
A. Systematic loan loss risk is a measure of the sensitivity of loan losses in personal loans relative to the losses in
commercial loans.
B. Systematic loan loss risk is a measure of the sensitivity of loan losses of a particular borrower relative to the losses in
an FI's loan portfolio.
C. Systematic loan loss risk is a measure of the sensitivity of loan losses in commercial loans relative to the losses in
personal loans.
D. Systematic loan loss risk is a measure of the sensitivity of loan losses in a particular business sector relative to the
losses in an FI's loan portfolio.
Difficulty: Medium
Learning Objective: 11-04 The concentration of loans, loan volume and internal loan loss ratio concepts.
15. The Basel Committee on Banking Supervision considers regulatory loan concentration limits to individual borrowers as
an issue of granularity. Which of the following statements is true in this context?
A. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted by the FI to
reflect its levels of portfolio concentration or diversification.
B. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted up or down to
reflect the levels of portfolio concentration or diversification.
C. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted up to reflect
the levels of portfolio diversification.
D. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted down to
reflect the levels of portfolio concentration.
Difficulty: Hard
A. FIs can reduce profitability by taking advantage of the law of small numbers in their investment decisions.
B. FIs can reduce profitability by taking advantage of the law of large numbers in their investment decisions.
C. FIs can reduce risk by taking advantage of the law of small numbers in their investment decisions.
D. FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.
Difficulty: Medium
A. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
B. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its size, an FI can diversify
considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated.
C. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
diversify considerable amounts of credit risk as long as the returns on different assets are perfectly correlated.
D. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
Difficulty: Hard
18. Consider the following table with information on the weightings and expected returns of two assets held by an FI.

Loan i

1 0.35 12.35%
2 0.65 10.25%
A. (0.35 + 12.35) – (0.65 + 10.25) = 1.80%
B. (0.35 + 0.65)  (12.35 + 10.25) = 22.60%
C. (12.35 + 10.25) / 2 = 11.30%
D. 0.35  12.35 + 0.65  10.25 = 10.99%

Difficulty: Medium
19. Consider the following table with information on the weightings and expected returns of three assets held by an FI.

Loan i

1 0.15 12.35%
2 0.55 10.25%
3 0.30 15.75%
A. (0.15  12.35 + 0.55  10.25 + 0.30  15.75) / 3 = 4.07%
B. (0.15  12.35 + 0.55  10.25 + 0.30  15.75)  3 = 36.66%
C. 0.15  12.35 + 0.55  10.25 + 0.30  15.75 = 12.22%
D. (12.35 + 10.25 + 15.75) / 3 = 12.78%

Difficulty: Medium
A. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values –1  r  + 1, where r is the correlation coefficient.
B. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values 0  r  + 1, where r is the correlation coefficient.
C. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values +1  r  + 2, where r is the correlation coefficient.
D. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values –1  r  0, where r is the correlation coefficient.
Difficulty: Hard
A. One advantage of using MPT for loans is that the returns on individual loans are normally distributed, meaning that the
upside returns are equal to the downside risks.
B. One objection to using MPT for loans is that the returns on individual loans are not normally distributed, meaning that
most loans have unlimited upside returns and long-tail downside risks.
C. One advantage of using MPT for loans is that the returns on individual loans are normally distributed, meaning that
most loans have unlimited upside returns and unlimited downside risks.
D. One objection to using MPT for loans is that the returns on individual loans are not normally distributed, meaning that
most loans have limited upside returns and long-tail downside risks.
Difficulty: Hard
A. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
exactly estimates the risk of the whole portfolio.
B. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
underestimates the risk of the whole portfolio.
C. If many loans have positive correlations of returns the sum of the individual credit risks of loans viewed independently
D. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
Difficulty: Hard

Loan i i i2

1 0.30 13% 9.06% 82.0% P12 = –0.87
2 0.70 11% 8.72% 76.0% 12 = –75.0%
A. (0.3)2(82.0%) + (0.7)2(76.0%) + (0.3)(0.7)(–0.87)  (9.06%)(8.72%) = 30.19
B. (0.3)2(82.0%) + (0.7)2(76.0%) + [(0.3)(0.7)]2  (–0.87)  (9.06%)(8.72%) = 41.59
C. (0.3)2(82.0%) + (0.7)2(76.0%) + 2(0.3)(0.7)(–0.87)  (9.06%)(8.72%) = 15.75
D. (0.3)(82.0%) + (0.7)(76.0%) + 2(0.3)(0.7)(–0.87)  (9.06%)(8.72%) = 48.93

Difficulty: Hard
Loan i i i2
1 0.45 15% 6.05% 36.60% P12 = –0.2

2 0.55 13% 8.75% 76.56% 12 = –4.0%
A. (0.45)2(36.60%) + (0.55)2(76.56%) + (0.45)(0.55)(–0.2)  (6.05%)(8.75%) = 27.95
B. (0.45)2(36.60%) + (0.55)2(76.56%) + 2(0.45)(0.55)(–0.2)  (6.05%) (8.75%) = 25.33
C. (0.45)(36.60%) + (0.55)(76.56%) + 2(0.45)2(0.55)2
D. (–0.2)  (6.05%)(8.75%) = 57.28
E. (0.45)(36.60%) + (0.55)(76.56%) + 2(0.45)(0.55)(–0.2)  (6.05%)(8.75%) = 53.34
Difficulty: Hard

Loan i i i2

1 0.30 13% 9.06% 82.0% P12 = –0.87
2 0.70 11% 8.72% 76.0% 12 = –75.0%
A. 0.3(13%) + 0.7(11%) = 11.60%
B. (13% + 11%) / 2 = 12.00%
C. (0.3)2(13%) + (0.7)2(11%) = 6.56%
D. [(0.3)2(13%) + (0.7)2(11%)]  2 = 13.12%

Difficulty: Medium

Loan i i i2

1 0.45 15% 6.05% 36.60% P12 = –0.2
2 0.55 13% 8.75% 76.56% 12 = –4.0%
A. (15% + 13%) / 2 = 14.00%
B. (0.45)2(15%) + (0.7)2(13%) = 9.41%
C. [(0.45)2(15%) + (0.7)2(13%)]  2 = 18.82%
D. 0.45(15%) + 0.7(13%) = 15.85%

Difficulty: Medium
A. The minimum risk portfolio generates the highest returns and is thus likely to be chosen by risk-seeking FI managers.
B. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-averse FI
managers.
C. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-seeking FI
managers.
D. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-indifferent FI
managers.
Difficulty: Medium
A. The objective of risk-indifferent FI managers is to minimise portfolio risk regardless of the portfolio's return.
B. The objective of risk-indifferent FI managers is to minimise portfolio risk in turn for higher returns on the portfolio.
C. The objective of risk-averse FI managers is to minimise portfolio risk in turn for higher returns on the portfolio.
D. The objective of risk-averse FI managers is to minimise portfolio risk regardless of the portfolio's return.
Difficulty: Medium
Loan i i i2
1 0.30 13% 9.06% 82.0% P12 = –0.87

2 0.70 11% 8.72% 76.0% 12 = –75.0%
A. (0.3)(82.00) + (0.7)(76.00) = 8.82%
B. (82.00) + (76.00) = 17.77%
C. 15.75 = 3.97%
D. 48.93 = 6.99%

Difficulty: Hard
Learning Objective: 11-08 How credit swaps help FIs manage credit risk.
Loan i i i2
1 0.45 15% 6.05% 36.60% P12 = –0.2

2 0.55 13% 8.75% 76.56% 12 = –4.0%
A. (0.45)(36.60) + (0.55)(76.56) = 7.51%
B. (36.60) + (76.56) = 14.80%
C. 57.28 = 7.57%
D. 25.33 = 5.03%

Difficulty: Hard
31. The return (Ri) on a loan can be measured as follows:
A. AISi – E(Li), whereby E(Li) = (EDFi  LGDi)
B. AISi – E(Li), whereby E(Li) = (EDFi / LGDi)
C. AISi + E(Li), whereby E(Li) = (EDFi  LGDi)
D. AISi + E(Li), whereby E(Li) = (EDFi / LGDi)
Difficulty: Hard
A. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI less the annual spread between the
B. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI plus the annual spread between the
C. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI plus the loan rate paid by the
borrowers.
D. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI less the FI's cost of funds.
Difficulty: Medium
A. The risk of a loan reflects the volatility of the loan's default rate around its expected value times the amount lost given
default.
B. The product of the volatility of the default rate and the loss give default (LGD) is called the 'unexpected loss'.
C. The product of the volatility of the default rate and the loss give default (LGD) is a measure of the loan's risk.
Difficulty: Hard
A. According to KMV, default correlations tend to be low and lie between 0.002 and 0.15.
B. According to KMV, default correlations tend to be high and lie between 0.42 and 0.65.
C. According to KMV, default correlations vary and thus no particular range can be stated.
D. None of the listed options are correct.
Difficulty: Medium
35. Consider an FI holds two loans with the following characteristics:

1 0.45 3.5% 1.5% 30% 4% 12 = –0.20
2 0.55 4.5% 2.0% 25% 3%
A. 3.80 per cent
B. 5.75 per cent
C. 9.55 per cent
D. 4.87 per cent

Difficulty: Hard

1 0.45 3.5% 1.5% 30% 4% 12 = –0.20
2 0.55 4.5% 2.0% 25% 3%
A. 5.88 per cent
B. 10.01 per cent
C. 3.16 per cent
D. 4.26 per cent

Difficulty: Hard

1 0.30 10.0% 4.5% 2.0% 25% 4% P12 = –0.25
2 0.70 11.0% 5.0% 1.5% 20% 3%
A. 6.50 per cent
B. 6.90 per cent
C. 13.40 per cent
D. 6.78 per cent

Difficulty: Hard

1 0.30 10.0% 4.5% 2.0% 25% 4% P12 = 0.25
2 0.70 11.0% 5.0% 1.5% 20% 3%
A. 4.90 per cent
B. 3.41 per cent
C. 4.16 per cent
D. 6.10 per cent

Difficulty: Hard
A. Partial applications of portfolio theory include loan volume based models and loan loss ratio based models.
B. Partial applications of portfolio theory include loan portfolio profitability based models and regulatory models.
C. Partial applications of portfolio theory include loan volume based models, loan loss ratio based models and regulatory
models.
D. Partial applications of portfolio theory include loan portfolio profitability based models and loan loss minimisation based
models.
Difficulty: Medium
A. Loan loss ratio based models rely on actual data and involve the estimation of the systematic loan loss risk of a
B. Loan loss ratio based models rely on historic data and involve the estimation of the systematic loan loss risk of a
C. Loan loss ratio based models rely on historic data and involve the estimation of the systematic loan loss risk of a
D. Loan loss ratio based models rely on actual data and involve the estimation of the systematic loan loss risk of a
Difficulty: Medium
41. Which of the following is a major difference between forwards and futures?
A. Forwards are marked-to-market, while futures are not.
B. Futures are tailor made, while forwards are standardised.
C. The default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties
against credit risk, while this is not the case for forwards.
D. Forwards are marked-to-market, while futures are not, futures are tailor made, while forwards are standardised and the
default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against
credit risk, while this is not the case for forwards.
Difficulty: Medium
Learning Objective: 11-06 The types of futures and options contracts that can be used to hedge credit risk.
42. A forward contract:
A. has more credit risk than a futures contract.
B. is more standardised than a futures contract.
C. is marked to market more frequently than a futures contract.
D. has a shorter time to delivery than a futures contract.
Difficulty: Easy
43. Pure credit swaps are swaps by which an FI receives the:
A. par value of the loan on default in return for paying a periodic swap fee.
B. current value of the loan on default in return for paying a periodic swap fee.
C. residual value of the loan on default in return for paying a periodic swap fee.
D. outstanding interest payments on the loan on default in return for paying a periodic swap fee.
Difficulty: Medium
Learning Objective: 11-09 The types of credit swaps.
A. Total return swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap and
B. Total return swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap, but
C. Pure credit swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap and
D. Pure credit swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap, but
Difficulty: Medium
45. Which of the following is a major difference between a pure credit swap and a default option?
A. In a pure credit swap the premium payment on the swap is paid up front, while the fees of a default option are paid over
the life of the default option.
B. In a pure credit swap the premium payments on the swap are paid over the life of the swap, while the fee of a default
option is paid up front.
C. In a pure credit swap the premium payment on the swap is paid at maturity, while the fees of a default option are paid
over the life of the default option.
D. In a pure credit swap the premium payments on the swap are paid over the life of the swap, while the fee of a default
option is paid at maturity.
Difficulty: Medium
A. As with loans, swap participants deal with the credit risk of counterparties by setting bilateral limits on the notional
amount of swaps entered into.
B. As with loans, swap participants deal with the credit risk of counterparties by adjusting the fixed and/or floating rates by
including credit risk premiums.
C. As with loans, swap participants deal with the credit risk of counterparties by using Monte Carlo simulations to model
potential default risk.
D. As with loans, swap participants deal with the credit risk of counterparties by setting bilateral limits on the notional
amount of swaps entered into and as with loans, swap participants deal with the credit risk of counterparties by adjusting
the fixed and/or floating rates by including credit risk premiums.
Difficulty: Medium
47. Which of the following is not a reason for the credit risk on a swap to be less than the credit risk on a loan?
A. Swap contracts often extend beyond the maturity of normal loan contracts.
B. Swap payments can be netted across more than on contract.
C. Interest rate swaps involve interest, but not principal.
D. Swap contracts often extend beyond the maturity of normal loan contracts, swap payments can be netted across more
than on contract and Interest rate swaps involve interest, but not principal.
Difficulty: Medium
48. A pure credit swap:
A. is like buying credit insurance.
B. is like buying a multi-period credit option.
C. eliminates the interest rate risk contained in the total return swap.
D. is like buying credit insurance, is like buying a multi-period credit option and eliminates the interest rate risk contained
in the total return swap.
Difficulty: Medium
49. Which of the following is incorrect in relation to debt recovery rates?
A. Macro-economic factors are found to be significant in explaining recovery rates on defaulted bonds.
B. Macro-economic factors are found to be insignificant in explaining recovery rates on defaulted bonds.
C. Senior securities tend to have higher recovery rates than subordinated securities.
D. Industrial revenue bonds tend to have higher recovery rates than subordinated securities.
Difficulty: Medium
50. Loan sales and securitisation are increasingly seen as valuable tools in the management of credit risk. Which of the
following are not advantageous to FIs?
A. Loan sales and securitisation allow FIs to better manage their customer relationships.
B. Loan sales and securitisation create moral hazard issues and reduce scrutiny of off-balance sheet activities of FIs.
C. Loan sales and securitisation reduce FIs industry and/or geographical concentration risk.
D. Loan sales and securitisation allow FIs to separate their credit risk exposure from the lending process itself.
Difficulty: Medium
Learning Objective: 11-12 How FIs use loan sales and securitisation to manage credit risk.
51. A transition matrix can be used to establish the probabilities that a currently rated borrower will be upgraded,
downgraded or will default over time.
TRUE
Difficulty: Easy
52. The concentration limit for a loan portfolio is calculated as the expected default frequency of the borrower multiplied
by (one divided by the loss rate).

TRUE
Difficulty: Easy
53. The relationship limit on diversification has also been called the 'paradox of credit'.
TRUE
Difficulty: Medium
54. Concentration limits are external limits set on the maximum loan size that can be made to an individual borrower.
TRUE
Difficulty: Easy
55. FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.
TRUE
Difficulty: Easy
56. An FI that invests 40 per cent of funds in a loan with an expected return of 10 per cent and 60 per cent of funds in a
loan with an expected return of 12 per cent can expect to earn 11 per cent on its portfolio.
FALSE
Difficulty: Medium
57. Minimum risk portfolios generally generate the highest returns.
FALSE
Difficulty: Easy
58. Using the KMV Portfolio Manager Model, the return on a loan can be calculated as the annual all-in-spread minus the
loss in the event of default.
FALSE
Difficulty: Medium
59. Using the KMV Portfolio Manager Model, the risk on a loan can be calculated as the volatility of the loan's default rate
times the loss in the event of default.
TRUE
Difficulty: Medium
60. Loan loss ratio based models estimate systematic loan losses by running a time-series regression of quarterly losses
of the ith sector's loss rate on the quarterly loss rate of an FI's total loans.
TRUE
Difficulty: Medium
61. Financial institutions do not use options to hedge credit risk exposures as credit risk is a natural risk that comes with
the core activities of the bank, namely lending.
FALSE
Difficulty: Medium
62. The most important swap contract in terms of quantity is the credit swap.
FALSE
Difficulty: Easy
63. Explain the following hypothetical table:
Risk
grad
e at
end
of
year
Defa
1 2 3 4
ult
Risk grade at beginning of year 1 0.86 0.08 0.03 0.02 0.01
0.
2 0 0.84 0.05 0.04 0.03
4
0.
3 0 0.08 0.81 0.05 0.04
2
0.
4 0 0.03 0.10 0.78 0.08
1
In this context, explain the concepts of loan migration and migration analysis.
Migration analysis uses information from the market to determine the credit risk of an individual loan or sectoral loans.
With this method, FI managers track credit ratings, such as S&P and Moody's ratings, of firms in particular sectors or
ratings classes for unusual declines to determine whether firms in a particular sector are experiencing repayment
problems. This information can be used to either curtail lending in that sector or to reduce maturity and/or increase
interest rates.
A loan migration (or transition) matrix seeks to reflect the historic experience of a pool of loans in terms of their credit-
rating migration over time. As such, it can be used as a benchmark against which the credit migration patterns of any new
pool of loans can be compared. For example from the above table, loans that began the year at credit rating 1, historically
(on average) 86 per cent have remained at credit rating 1, 8 per cent have been downgraded to a lower credit rating 2, 3
per cent have been downgraded to credit rating 3, 2 per cent have been downgraded to credit rating 4 and 1 per cent
have defaulted by the end of the year.
Also, loans that began the year at credit rating 2, historically (on average) 4 per cent have been upgraded to a higher
credit rating 1, 84 per cent have remained at credit rating 2, 5 per cent have been downgraded to credit rating 3, 4 per
cent have been downgraded to credit rating 4 and 3 per cent have defaulted by the end of the year. In the same fashion
the migration matrix for loans starting with credit ratings 3 and 4 can be explained.
Suppose that the FI is evaluating the credit risk of its current portfolio of loans of borrowers rated 2, and that over the last
few years a much higher percentage (say, 8 per cent) of loans has been downgraded to credit rating 3 and a higher
percentage (say, 5 per cent) has defaulted than is implied by the historic transition matrix. The FI may then seek to restrict
its supply of lower quality loans (e.g. those rated 2, 3 or 4) and concentrating more of its portfolio on high quality loans,
loans rated 1.
64. Consider the following data for a two-asset portfolio:

Annual spread between loan rate and FI's cost Loss to FI given Expected default
Loan i Annual fees
of funds default frequency

1 0.35 4.5% 2.0% 35% 5% 12 = –0.28
2 0.65 5% 2.5% 30% 4%
Using the KMV Portfolio Manager Model:
a. calculate the returns for loans 1 and 2.
b. calculate the risk for loans 1 and 2.
c. calculate the return for the loan portfolio.
d. calculate the risk for the loan portfolio.
e. explain your findings in (a) to (d).
a. The returns of loans 1 and 2:
R1 = (0.045 + 0.02) – [0.05  0.35] = 0.0475 or 4.75%
R2 = (0.05 + 0.025) – [0.04  0.30] = 0.063 or 6.30%
b. The risk for loans 1 and 2:
1 = [0.05(1 – 0.05)]½  0.35 = 0.07628 or 7.628%
2= [0.04(1 – 0.04)]½  0.30 = 0.05879 or 5.879%
c. The return for the loan portfolio:
Rp =0.35(4.75%) + 0.65(6.30%) = 5.76%
d. The risk for the loan portfolio:
p2 = (0.35)2(0.07628)2+ (0.65)2(0.05879)2+ 2(0.35) (0.65) (0.07628) (0.05879) = 0.0016017
Thus, p =

= 4.00%
e. The risk (or standard deviation of returns) of the portfolio, p(4%), is less than the risk of either individual asset (7.628%
and 5.879%, respectively). The negative correlation between the returns of the two loans (–0.28) results in an overall
reduction of risk when the two assets (loans) are put together in a loan portfolio.
65. Explain the basic concept of loan loss ratio based models.
A partial application of the Modern Portfolio Theory (MPT) is a model based on historic loan loss ratios. This model
involves estimating the systematic loan loss risk of a particular sector or industry relative to the loan loss risk of an FI's
total loan portfolio. This systematic loan loss can be estimated by running a time–series regression of quarterly losses of
the ith sector's loss rate on the quarterly loss rate of an FI's total loans:
Where  measures the loan loss rate for a sector that has no sensitivity to losses on the aggregate loan portfolio (that is,
its = 0) and i measures the systematic loss sensitivity of the ith sector loans to total loan losses.
For example, regression results showing that the consumer sector has a  of 0.2 and the real estate sector has a  of 1.4
suggest that loan losses in the real estate sector are systematically higher relative to the total loan losses of the FI (by
definition, the loss rate  for the whole loan portfolio is 1). Similarly, loan losses in the consumer sector are systematically
lower relative to the total loan losses of the FI.
Consequently, it may be prudent for the FI to maintain lower concentration limits for the real estate sector as opposed to
the consumer sector, especially as the economy moves towards a recession and total loan losses start to rise. The
implication of this model is that sectors with lower s could have higher concentration limits than high  sectors—since low
 loan sector risks (loan losses) are less systematic.
Chapter 11 - Testbank Summary
Category # of Question
s
Difficulty: Easy 10
Difficulty: Hard 18
Difficulty: Medium 34
Learning Objective: 11-01 The methods for measuring levels of loan concentration. 15
Learning Objective: 11-02 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans. 20
Learning Objective: 11-03 The use of MPT and how it applies in the Moody's KMV approach to lending. 14
Learning Objective: 11-04 The concentration of loans, loan volume and internal loan loss ratio concepts. 4
Learning Objective: 11-06 The types of futures and options contracts that can be used to hedge credit risk. 3
Learning Objective: 11-08 How credit swaps help FIs manage credit risk. 5
Learning Objective: 11-09 The types of credit swaps. 5
Learning Objective: 11-12 How FIs use loan sales and securitisation to manage credit risk. 1

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Chapter 11 - Testbank

1 0.45 15% 6.05% 36.60% P12 = –0.2

Loan i i i2

Loan i i i2

1 0.30 13% 9.06% 82.0% P12 = –0.87

1 0.45 15% 6.05% 36.60% P12 = –0.2

Loan i Annual spread between loan rate and FI's cost of Annual fees Loss to FI given Expected default

Loan i Annual spread between loan rate and FI's cost of Annual fees Loss to FI given Expected default

Loan i Annual loan rate Annual FI's cost of Annual fees Loss to FI given Expected default

Loan i Annual loan rate Annual FI's cost of Annual fees Loss to FI given Expected default

1 0.45 15% 6.05% 36.60% P12 = –0.2

Loan i i i2

Loan i i i2

1 0.30 13% 9.06% 82.0% P12 = –0.87

1 0.45 15% 6.05% 36.60% P12 = –0.2

Loan i Annual spread between loan rate and FI's cost of Annual fees Loss to FI given Expected default

Loan i Annual spread between loan rate and FI's cost of Annual fees Loss to FI given Expected default

Loan i Annual loan rate Annual FI's cost of Annual fees Loss to FI given Expected default

Loan i Annual loan rate Annual FI's cost of Annual fees Loss to FI given Expected default

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