CHap 7 IMD (mixte)
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Questions and Answers

What does a high amount of borrowing encourage in a borrower?

  • Risky behavior (correct)
  • Increased financial responsibility
  • Improved credit ratings
  • More cautious spending

Credit risk is considered less important than operational risk for companies and financial institutions.

False (B)

Name one manifestation of credit risk.

Counterparty default

The size of the loan affects the __________ of the loan.

<p>riskiness</p> Signup and view all the answers

Match the following expressions with their explanations:

<p>Counterparty default = Failure to meet obligations on a loan Change in the rating of the underlying asset = Alteration in perceived asset value Change in the rating of the issuer = Modification in creditworthiness of the issuer Variation of the signature spread = Fluctuation in bond margin</p> Signup and view all the answers

What is a credit default swap (CDS)?

<p>A contract that pays upon the occurrence of a credit event (D)</p> Signup and view all the answers

A credit event must always be a price change.

<p>False (B)</p> Signup and view all the answers

What happens to the payment of the protection buyer in the event of default?

<p>The payment is suspended.</p> Signup and view all the answers

What does the term 'attachment point' refer to in a CDS tranche?

<p>The minimum loss threshold (C)</p> Signup and view all the answers

A credit event may include a default on ______ or interest.

<p>payment</p> Signup and view all the answers

A Senior CDS Basket covers losses incurred by a portfolio up to a certain amount.

<p>False (B)</p> Signup and view all the answers

Match the following credit events with their definitions:

<p>Default on payment = Failure to pay principal or interest Bankruptcy = Inability to meet debt obligations Restructuring of debt = Modification of terms of an existing obligation Moratorium = Delay in payment of debts</p> Signup and view all the answers

What is the primary function of the CDX indices?

<p>To represent North American companies and Emerging Markets.</p> Signup and view all the answers

What does the premium of a CDS on a bond represent?

<p>The risk of default associated with the bond (B)</p> Signup and view all the answers

The _______________ point is the threshold at which compensation begins for losses in a tranche.

<p>attachment</p> Signup and view all the answers

What is the purpose of the tranches on index?

<p>To form expectations about default correlations (D)</p> Signup and view all the answers

The premium of a CDS must be greater than the credit spread of the underlying bond.

<p>False (B)</p> Signup and view all the answers

What financial events led to the standardization of the credit event process by ISDA?

<p>Defaults of Russia and Argentina.</p> Signup and view all the answers

The premium for a tranche is calculated based on the difference between the detachment point and the attachment point.

<p>True (A)</p> Signup and view all the answers

At what threshold the tranche mentioned in the example ceases to exist?

<p>EUR 42 M</p> Signup and view all the answers

Match the indices with their respective regions:

<p>CDX = Emerging Markets Itraxx = Rest of the world</p> Signup and view all the answers

What is the coupon rate paid by the Bank to the pension fund each semester?

<p>5% (B)</p> Signup and view all the answers

What type of risk does a cash account help to mitigate?

<p>Delinquency risk (A)</p> Signup and view all the answers

The Fund pays a premium of Euribor 6M minus a margin of 80 bp to the Bank.

<p>False (B)</p> Signup and view all the answers

Seller's guarantees are only available in cash.

<p>False (B)</p> Signup and view all the answers

What is the purpose of a Composite Swap?

<p>A synthetic investment on a foreign index with currency risk exposure.</p> Signup and view all the answers

What is one mechanism used to address currency risk?

<p>Swaps</p> Signup and view all the answers

In a standard swap, a synthetic investment is created in a __________ index.

<p>local</p> Signup and view all the answers

Which of the following statements about total return swaps is correct?

<p>Standard Swaps allow for synthetic investments in local indices. (A)</p> Signup and view all the answers

A _____ rating needs a reserve of 8%.

<p>AAA</p> Signup and view all the answers

What is an example of credit enhancement?

<p>Cash reserves (B)</p> Signup and view all the answers

What is the EURIBOR 6M premium paid by the Fund to the Bank?

<p>Euribor 6M + 80 bp</p> Signup and view all the answers

Match the following terms with their definitions:

<p>Standard Swap = Creates a synthetic investment in a local index Composite Swap = Synthetic investment on a foreign index with currency risk Euribor = Interest rate benchmark Coupon = Periodic payment to bondholders</p> Signup and view all the answers

Match the following ratings with their required reserves:

<p>BBB = 0.75% A = 3% AA = 5% AAA = 8%</p> Signup and view all the answers

Interest Rate Swaps are used to manage currency risk.

<p>False (B)</p> Signup and view all the answers

The Fund experiences a loss on securities paid to the Bank as part of the __________.

<p>premium</p> Signup and view all the answers

What is the value of the asset pool mentioned?

<p>€1,000</p> Signup and view all the answers

What is a primary risk associated with a mortgage-backed security (MBS)?

<p>Interest rate risk (A)</p> Signup and view all the answers

Delinquency refers to a situation where mortgage payments are made regularly on time.

<p>False (B)</p> Signup and view all the answers

Name one type of risk related to the asset pool of mortgage-backed securities.

<p>Credit risk</p> Signup and view all the answers

A fixed-rate mortgage portfolio typically consists of repayments made in __________.

<p>constant annuities</p> Signup and view all the answers

Match the following risks related to mortgage-backed securities with their descriptions:

<p>Credit risk = Delinquency and default Interest rate risk = Maturity mismatch and prepayment risk Currency risk = Effects of exchange rate fluctuations Liquidity risk = Difficulty in selling the asset quickly</p> Signup and view all the answers

What happens when interest rates decline in relation to mortgage-backed securities?

<p>More borrowers might refinance their mortgages. (C)</p> Signup and view all the answers

Prepayment risk occurs when borrowers pay off their loans early, which can harm MBS holders.

<p>True (A)</p> Signup and view all the answers

What is the simplest structure of a mortgage-backed security?

<p>Mortgage pass-through</p> Signup and view all the answers

Flashcards

Moral Hazard Principle

The tendency for a borrower to take on more risk when the loan amount is high, because they may not be fully responsible for the consequences of their actions.

Credit Risk Magnitude

The chance of a borrower defaulting on a loan, increasing with the size of the loan.

Counterparty Default

A situation where a party in a financial agreement fails to meet its obligations.

Signature Spread

The difference in interest rates between the interest rates for a particular type of bond from different issuers.

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Credit Risk

The risk that a borrower will fail to repay a loan.

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Credit Default Swap (CDS)

A contract where a buyer of protection pays a regular fee, and if a credit event occurs, the payment is suspended.

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Credit Event (CDS)

An event that triggers payment obligations in a CDS contract. Examples include default, bankruptcy, or restructuring.

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CDS Premium

The cost of hedging credit risk in a CDS contract, expressed as a percentage of the contract's nominal value.

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Deliverable Securities

Securities that can be exchanged in a credit default swap (CDS) transaction.

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Term Structure of Margins

How CDS premiums change based on the maturity date of the contract.

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Default on Payment

Failure to make a payment as agreed upon (principal or interest).

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Standardization of CDS

The process of creating consistent rules and guidelines for credit default swaps.

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Subordinated CDS Basket

Covers losses on a portfolio up to a specific limit.

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Senior CDS Basket

Covers losses on a portfolio exceeding a certain amount, protecting against larger losses.

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CDS Basket Slice

A portion of a CDS basket that covers losses within a specific range.

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Attachment Point (k)

The minimum loss threshold for a CDS basket slice. Compensation begins only when losses exceed this point.

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Detachment Point (K)

The maximum loss threshold for a CDS basket slice. Compensation stops when losses exceed this point.

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CDX & ITraxx

Major credit indices used to track default risk. CDX: North America, ITraxx: Europe and Rest of the World.

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Index Tranche: Protection in the first n defaults

Provides protection against a specific number of defaults in a basket, up to a certain percentage of the portfolio's value.

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Index Tranche Application

Example: A EUR 700M basket, with a 3% attachment point and 6% detachment point. A 150 bp premium is paid on the tranche (K-k).

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Total Return Swap

A derivative contract where one party agrees to pay the other party the total return on an underlying asset, usually a bond or stock index. The payment is typically made in exchange for a fixed interest rate or a floating rate tied to a benchmark.

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Standard Swap

A type of total return swap that allows investors to create a synthetic investment in a local index, mimicking the performance of the underlying asset without actually owning it.

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Composite Swap

A type of total return swap that allows investors to create a synthetic investment in a foreign index, converting the return to the investor's currency.

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Basket Leg

The portion of a total return swap that represents the return on the underlying asset, which can include interest payments (such as coupons) and capital gains or losses on the asset.

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Interest Leg

The portion of a total return swap that represents the fixed or floating rate paid by one party to the other, typically based on a benchmark interest rate.

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Euribor 6M

A benchmark interest rate for the Eurozone, representing the average interest rate at which banks lend to each other for a six-month period.

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Coupon Payments

Regular payments made by a bond issuer to the bondholder, often represented as a percentage of the bond's face value.

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Capital Gains or Losses

Changes in the market value of an asset, such as a bond, resulting from fluctuations in interest rates or other market factors.

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Delinquency

A situation where a borrower misses a loan payment.

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Default

When a borrower fails to make a loan payment and stops repaying the loan entirely.

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Interest Rate Risk

The risk that changes in market interest rates will affect the value of an investment.

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Maturity Mismatch

When the time period for repayment of a loan is different from the time period for the underlying assets that are used to secure the loan.

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Prepayment Risk

The risk that a borrower will repay a loan faster than expected, especially if interest rates decline.

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Mortgage Backed Securities (MBS)

Securities backed by a pool of mortgages.

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Mortgage Pass-Through

A type of MBS where all interest and principal payments from the underlying mortgages are passed through to the holders of the MBS.

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Delinquency Risk

The risk that a borrower will be late with payments on their loan, but eventually pay it back in full.

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Default Risk

The risk that a borrower will not be able to repay their loan, even after the loan term has ended.

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Seller's Guarantees

Promise by the Seller to compensate buyers if the asset fails to perform as expected.

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Credit Enhancement

Measures taken to lower a borrower's default risk, making the loan more attractive to lenders.

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Currency Swap

An agreement to exchange cash flows in one currency for cash flows in another currency, mitigating currency risk.

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Interest Rate Swap

An agreement to exchange interest payments on a fixed-rate loan for interest payments on a floating-rate loan, managing interest rate risk.

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Reserve Funds in SPV

Money held by a Special Purpose Vehicle (SPV) to cover potential losses from the underlying assets, increasing the credit rating.

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Rating Agency Criteria

Standards used by agencies to assess the creditworthiness of a borrower or a financial instrument.

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Study Notes

Credit Risk and Management

  • Credit risk is a significant concern in the banking industry
  • Measurement and management of credit risk are crucial
  • Derivative instruments are used for managing credit risk

Major Categories of Risk

  • Market risk
  • Liquidity risk
  • Operational risk
  • Credit risk

Main Sources of Vulnerability to Credit Risk

  • Macroeconomic risks
  • Credit growth
  • Valuation of credit risk (liquidity premium)
  • The potential risk
  • The growing risk

Credit Risk: Definition and Measurement

  • A debt is paid based on an interest rate
  • This compensates the lender for the loss of liquid assets
  • The cost of money increases with the loan term
  • The risk-free interest rate (r) represents the return on safe investments
  • Government securities are often used as a benchmark for risk-free returns

The Extent of Credit Risk

  • The magnitude increases proportionally with the amount of debt
  • Today, credit risk is the most significant risk for corporations and financial institutions.

Manifestations of Credit Risk

  • Counterparty default
  • Change in rating of the underlying asset
  • Change in rating of the issuer
  • Variation in the spread of the signature

Rating Agencies

  • Rating agencies assess credit risk by assigning ratings
  • This reduces information asymmetry between borrowers and lenders
  • Major rating agencies include Standard & Poor's, Moody's, and Fitch Ratings

Ratings on Long-Term Securities

  • Ratings are used to categorize the level of creditworthiness.
  • Ratings are applied to debt instruments to gauge credit risk.
  • Rating agencies like S&P, Moody's, and Fitch use letter ratings like AAA, AA, A, BBB to classify the instruments

Expected Loss

  • Calculation of expected loss considers the probability of defaulting on a borrowed amount
  • The calculation is done for various time horizons, for example, one year or two years.
  • Actuarial and risk-neutral valuation methods are used to calculate expected loss.

Credit Derivatives

  • A financial instrument whose cash flows depend on the issuer's credit quality
  • These instruments include credit default swaps (CDS) and instruments based on credit spreads
  • CDS are used to hedge credit risk exposure
  • Strategies can include hedging, portfolio management, investment, and speculation

Securitization

  • Securitization is a financial technique where assets are pooled to create new securities
  • The process allows the issuing of new securities with periodic repayments
  • This enables the conversion of illiquid assets into liquid ones
  • The process involved creating a new legal entity (SPV) to hold the assets
  • Then, debt securities are issued to investors
  • A variety of assets can be securitized, such as real estate loans, business loans, and other receivables
  • Securitization can have different motivations like obtaining access to financial markets or lowering the risk-weighted assets
  • There are various types of structures and players involved, including legal constraints

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Credit Risk & Management Through Derivatives PDF

Description

This quiz explores the essential concepts of credit risk and its management within the banking sector. It covers measurement techniques, major categories of risk, and the sources of vulnerability associated with credit risk. Test your understanding of how derivative instruments can mitigate these risks.

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