［2009 FRM］Short Practice ExamQ31--Q35

31. The Table below shows the bid/ask quotes by UBS for CDS spreads for companies A, B and C. CSFB has excessive credit exposure to Company C and wants to reduce it through the CDS market.

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Since the farthest maturity of its exposure to C is 3 years, CSFB buys a USD 200 million 3-year protection on C from UBS. In order to make its purchase of this protection cheaper, based on its views on companies A and B, CSFB decides to sell USD 300 million 5-year protection on Company A and to sell USD 100 million 1-year protection on Company B to UBS. What is the net annual premium payment made by CSFB to UBS in the first year?

A. USD 1.02 million

B. USD 0.18 million

C. USD 0.58 million

D. USD 0.62 million

Correct answer is A

For protection bought, CSFB must pay the ask price quoted; for protection sold, CSFB receives the buy price quoted.

For the protection on C bought, CSFB pays 200 * 0.0113 = 2.26 million.

For the protection on A and B sold, CSFB receives 300 * 0.0027 + 100 * 0.0043 = 1.24 million.  The net annual premium payment paid by CSFB in the first year is 1.02 million.

Reference: René Stulz, Risk Management & Derivatives.  Chapter 18.

32. A firm's assets are currently valued at $500 million and its current liabilities are $300 million. The standard deviation of asset values is $80 million. The firm has no other debt. What will be the approximate distance to default using the KMV calculation?

A. 2 standard deviations

B. 2.5 standard deviations

C. 6.25 standard deviations

D. Cannot be determined

Correct answer is B

Using the KMV calculation,

Distance to default = (asset value - liability value) / (standard deviation of asset value) = (500 - 300) / 80 = 2.5

Reference: Arnaud de Servigny and Olivier Renault, Measuring and Managing Credit Risk. Chapter 6.

33. If an investor holds a 5-year IBM bond, it will give him a return very close to the return of the following position:

A. A 5 year IBM credit default swap on which he pays fixed and receives a payment in the event of default.

B. A 5 year IBM credit default swap on which he receives fixed and makes a payment in the event of default.

C. A 5 year US Treasury bond plus a 5 year IBM credit default swap on which he pays fixed and receives a payment in the event of default.

D. A 5 year US Treasury bond plus a 5 year IBM credit default swap on which he receives fixed and makes a payment in the event of default.

Correct answer is D

Being long a bond of an issuer is equivalent to buying a Treasury bond and selling credit protection through a CDS.

Reference: René Stulz, Risk Management & Derivatives.  Chapter 18.

34. Which of the following credit risk models in Basel II attempts to recognize diversification effects through a granularity adjustment?

A. Standardized approach based on external credit ratings provided by external credit assessment institutions

B. Standardized approach based on internal portfolio credit risk model

C. Internal Rating Based approach using internal estimate of creditworthiness, subject to regulatory standards

D. All of the above

Correct answer is C

The Standardized approach does not recognize diversification effects.  Capital requirements under Internal Rating Based (IRB) approach are modified to reflect the overall diversification or "granularity" in a bank's loan portfolio.  The granularity adjustments construct a specific regulatory measure of diversification of a bank's portfolio.  This measure is then used to increase or decrease the baseline IRD regulatory capital requirements.  If the regulatory diversification measure indicates that a portfolio is well (poorly) diversified, the granularity adjustment decreases (increases) regulatory capital from the IRB baseline.  Under IRB banks estimate default probabilities of counterparties using their own methods subject to regulatory standards, which are then used with modified standardized inputs that come from the standardized approach.

Reference: Measuring and Managing Credit Risk, De Servigny and Renault, 2004.

35. Economic capital calculations for credit risk assume a recovery rate (defined as 1-loss rate). Recovery rates are dependent on the business model of the underlying counterparty and its asset volatility in value and size. Under normal anticipated circumstances which of the following types of companies will have the highest recovery rate?

A. An internet merchant of designer clothes

B. A hedge fund

C. An asset intensive manufacturing company

D. A commodities trader

Correct answer is C

The company with the highest recovery rate will be the company with the most tangible assets that can be valued in the event of default.  Utilities, for example, have high recovery rates because they have large amounts of tangible assets, such as generating plants.  Of the four choices ? internet merchant, hedge fund, asset intensive manufacturing company and commodity trader ? the asset intensive manufacturer would have the most tangible assets.  Thus, choice 'C' is the correct choice.

Reference: Measuring and Managing Credit Risk, De Servigny and Renault, 2004.

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