AIM 1: Define, calculate and interpret the measure of expected credit loss for an individual credit and loan-line instrument.

Which of the following formulas defines Expected Loss?

A) Exposure × Recovery rate × Probability of default.

B) Exposure × Loss given default × (1 ? Probability of default).

C) Exposure × (1 ? Recovery rate) × Probability of default.

D) Exposure × (1 ? Loss given default) × (1 ? Probability of default).

The correct answer is C

Since 1 ? Recovery rate = Loss given default, Exposure × (1 ? Recovery rate) × Probability of default is correct.

AIM 3: Explain how credit downgrade or loan default affects the loan return.fficeffice" />

Which statement best describes the return to loans after ratings change?

A) Loan returns are asymmetric since the lender only partially absorbs the downside losses.

B) Loan returns are asymmetric as the lender absorbs all the downside losses and none of the upside.

C) Loan returns are symmetric as the lender absorbs all the downside losses and absorb the upside. 

D) Loan returns are symmetric as the lender enjoys upside benefits.

The correct answer is B

Lenders absorb all losses in default but receive no upside if the borrower improves in credit quality.

AIM 4: Distinguish between expected and unexpected loan loss.

1、Which of the following is TRUE concerning capital adequacy levels?

A) Expected loss is equally as important as unexpected loss in determining capital adequacy levels.

B) Unexpected loss is less important than expected loss in determining capital adequacy levels.

C) Expected loss is less important than unexpected loss in determining capital adequacy levels.

D) Expected loss is more important than unexpected loss in determining capital adequacy levels.

The correct answer is C

Unexpected loss is more important in determining capital adequacy levels since the bank needs to stay solvent during the infrequent periods where actual losses deviate significantly from expected losses.

2、Unexpected loss is defined as the risk of:

A) expected losses matching actual losses.

B) expected losses exceeding actual losses.

C) actual losses exceeding expected losses.

D) actual losses minimizing expected losses.

The correct answer is C

Unexpected loss is the possibility that actual losses are significantly larger than expected, i.e. mathematical average.

AIM 5: Define exposures, adjusted exposures, commitments, covenants, and outstandings.

1、Bank X has contractually agreed to a $20,000,000 credit facility with Bank Y. Y will immediately access 40% of the commitment. Bank X has no experience with Bank Y and conservatively estimates drawdown in default to be 75%. Calculate the adjusted exposure for Bank X.

A) $12,000,000.

B) $8,000,000.

C) $15,000,000.

D) $17,000,000.

The correct answer is D

Adjusted exposure  = OS + (COM ? OS) × UGD 

  = $8,000,000 + ($12,000,000) × (0.75) 

  = $17,000,000 

2、Which statement best describes commitments and outstandings?

A) Outstandings includes loans but not bonds.

B) Outstandings represent the maximum possible credit exposure to the lender. 

C) Commitments represent credit available at the lenders’ request.

D) Borrowers can draw down on the commitment up to 100% at their discretion.

The correct answer is D

Borrowers have the option to draw down on the full commitment as long as no covenants have been breached.

3、Which of the following statements about covenants is CORRECT? Covenants:

A) decrease adjusted exposure by increasing recovery rates.

B) decrease adjusted exposure by decreasing recovery rates.

C) increase adjusted exposure by decreasing commitments.

D) decrease adjusted exposure by increasing commitments.

The correct answer is A

Covenants are designed to limit drawdowns as the financial condition of the borrower deteriorates. Covenants do not affect commitments as they are set at initiation of the loan.

AIM 6: Distinguish between the effects drawn and undrawn portion commitments, respectively have on exposure.

1、The risk-free portion of the bank’s exposure is defined as:

A) (1 ? α) × drawn funds.

B) α × credit line.

C) (1 ?α) × credit line.

D) α × drawn funds.

The correct answer is C

Since α represents percent of funds drawn down, you can eliminate two of the answer choices. The risky exposure is the amount of drawn funds so (1 ? α) denotes the amount of the total credit line not used and hence not exposed to risk.

2、ABC Bank has a $5,000,000 commitment to XYZ Corporation. XYZ has currently drawn down α > 0 on its commitment. In addition, the loss given default is estimated at 40%. Which of the following statements is TRUE?

A) ABC’s exposure is greater than ABC’s commitment.

B) XYZ’s exposure is less than XYZ’s commitment.

C) ABC’s exposure is less than ABC’s commitment.

D) XYZ’s exposure is greater than XYZ’s commitment.

The correct answer is C

Exposure is maximized if 100% of funds are drawn down with no recovery, i.e. LGD = 100%. Since LGD = 40%, commitment of funds to XYZ (from ABC) is greater than adjusted exposure.

AIM 7: Explain how covenants change the impact of exposures.

To estimate recovery rates from credit risk models, which of the following is required?

A) Analysis of covenants to determine asset seniority.

B) Analysis of covenants to determine asset uniqueness.

C) Collateral value but no analysis of covenants.

D) Liquidity of collateral but no analysis of covenants.

The correct answer is A

Recovery rates will depend on collateral value (liquidity, uniqueness, etc.) and seniority. Uniqueness is determined by the secondary markets not covenants. No analysis of covenants but collateral value or liquidity of collateral are incorrect since seniority is an important factor in estimating recovery rates.

AIM 10: Explain credit optionality.

Credit optionality on a commitment is best viewed as:

A) call option for the lender.

B) put option for the borrower.

C) call option for the borrower.

D) put option for the lender.

The correct answer is C

The commitment fee gives the borrower the right, but not the obligation, to draw down on the commitment at any time.

AIM 11: Define, calculate and interpret the expected loss on a loan.

1、Identify the effect of increasing LGD on expected loss.

A) No effect.

B) Increase.

C) Decrease.

D) LGD is not a component of expected loss.

The correct answer is B

Expected loss is calculated as follows: EL = AE × LGD × EDF. Therefore, increasing LGD directly increases expected loss.

2、Identify the effect of decreasing adjusted exposure on expected loss.

A) Decrease.

B) No effect.

C) Increase.

D) LGD is not a component of expected loss.

The correct answer is A

Expected loss is calculated as follows: EL = AE × LGD × EDF. Therefore, decreasing AE will directly decrease expected loss.

3、If the adjusted exposure for Bank X is $15 million, the probability of default is 2%, and the recovery rate is 20%, what is the expected loss for Bank X?

A) $60,000.

B) $300,000.

C) $3,000,000.

D) $240,000.

The correct answer is

We can calculate the expected loss as follows.

EL = AE × EDF × LGD

EL = ($15,000,000) × (0.02) × (0.80)

= $240,000.

4、Given the following information, compute the loss given default and recovery rate.

§       Expected loss = $200,000.

§       Exposure = $5,000,000.

§       Probability of loss = 5%.

Loss given default             Recovery rate

A)        0.20                                0.80

B)        0.02                                0.08

C)        0.80                                0.20

D)        0.08                                0.02

The correct answer is C

$200,000 = $5,000,000 × (1 ? RR) × (0.05). Therefore, the recovery rate = 20% and loss given default = 80%.

5、Bank A has extended a commitment of $10,000,000 and assessed a probability of default of 5%. The loss given default based on historical data is estimated to be 30%. Bank B has extended a $5,000,000 commitment to a company with a lower credit quality. A default rate of 10% and loss given default of 20% is estimated. For Bank A to have a lower expected loss than Bank B, which of the following is TRUE? The recovery rate of:

A) Bank B’s loan will decrease to 90%.

B) Bank B’s loan will increase to 80%.

C) Bank A’s loan will increase to 90%.

D) Bank A’s loan will decrease to 80%.

The correct answer is C

Expected loss = AE × LGD × PD.

ELA = $10M × 5% × 30% = $150,000.

ELB = $5M × 10% × 20% = $100,000.

Bank A and Bank B have initial recovery rates of 70% and 80%, respectively. A decrease in Bank A’s loan to 80% is incorrect since 80% would be an increase in recovery rate. When recovery rate of Bank A increases to 90%, ELA = $10M × 5% × 10% = $50,000.

6、For a given loan portfolio, which of the following will unambiguously increase expected loss?

A) Decrease recovery rate and increase probability of default.

B) Increase recovery rate and increase probability of default.

C) Decrease recovery rate and decrease probability of default.

D) Increase recovery rate and decrease probability of default.

The correct answer is A

Increasing the recovery rate and decreasing the probability of default will decrease expected loss. Decreasing/increasing the recovery rate and decreasing/increasing the probability of default are ambiguous. Decreasing recovery rates AND increasing the probability of default will definitely increase expected loss.

7、For a given loan portfolio, which of the following will NOT increase expected loss?

A) Decrease recovery rate and decrease probability of default.

B) Increase recovery rate and increase probability of default.

C) Decrease recovery rate and increase probability of default.

D) Increase recovery rate and decrease probability of default.

The correct answer is D

Decreasing the recovery rate and increasing the probability of default will increase expected loss. Decreasing/increasing the recovery rate and decreasing/increasing the probability of default may increase or decrease expected loss depending on the relative change in the factors. Finally, increasing the recovery rate and decreasing the probability of default will unambiguously DECREASE expected loss.

AIM 12: Describe how to parameterize credit risk models.

Which of the following is (are) NOT a disadvantage to parameterizing a credit risk model?

I.           Private borrowers can cross-check with public credit rating agencies.

II.         Internal loss estimates are biased estimators of external loan losses.

III.        Outstandings and commitments are typically observable.

A) I only.

B) I and II only.

C) III only.

D) II and III only.

The correct answer is C

Statement I is incorrect because private borrowers cannot cross check with public rating agencies. Statement II is a disadvantage to parameterizing credit risk models since any one bank only views its own loss history and not the population of loan losses. Statement III is correct and so the observable nature of commitments outstandings is a straightforward factor to parameterize.