AIM 1: Define terms related to counterparty risk.

1、When two counterparties have obligations to each other, the process that potentially reduces the credit risk of one counterparty to zero and lowers the credit risk of the other is known as:

A) collateralizing. 

B) special purposing. 

C) netting. 

D) marking to market. 

The correct answer is C

Netting is the process of consolidating the exposures between two parties to a single net exposure that one party bears. Marking to market would not apply to a case where two parties have obligations to each other.

AIM 2: Identify and explain the steps of using a Monte Carlo simulation engine to model potential future exposure to a counterparty, and discuss considerations for applying such a model to various market instruments.

1、The specification of a simulation model requires the selection of a stochastic process. The stochastic process is different depending on the underlying asset being evaluated. Which of the following are usually modeled with a jump-diffusion process?

  I. Commodities with low liquidity.

 II. Frequently traded equity securities.

III. Currencies of emerging market countries.

IV. Interest rates that are considered to be high.

A) I and IV only.

B) I, II and III only. 

C) I and III only.

D) I, II, III, and IV. 

The correct answer is C

Statements I and III are correct. Market instruments that are usually modeled using a lognormal distribution include: high interest rates, major currencies, commodities with a high degree of liquidity and equities with a high degree of liquidity. Equities and commodities that lack liquidity, and currencies of emerging market countries are modeled with a jump diffusion process. Low interest rates are sometimes assumed to follow a normal diffusion process

2、The specification of the simulation requires the selection of a stochastic process. The stochastic process is different depending on the underlying asset being evaluated. Which of the following are usually modeled with a lognormal distribution?

      I. Frequently traded equity securities.

     II. Commodities with low liquidity.

    III. Interest rates that are considered to be high.

    IV. Currencies of emerging market countries.

A) II and III.

B) I and III.

C) I, II, and III.

D) I, II, III, and IV.

The correct answer is B

Statements I and III are correct. Market instruments that are usually modeled using a lognormal distribution include the following: high interest rates, major currencies, commodities with a high degree of liquidity and equities with a high degree of liquidity. Equities and commodities that lack liquidity are modeled with a jump diffusion process, as well as currencies of emerging market countries. Low interest rates are sometimes assumed to follow a normal distribution.

AIM 5: Define a risk-neutral mean loss rate.

1、Which of the following are good proxies for the risk-neutral mean loss rate?

  I.  Counterparty’s credit spread.

 II.  Default swap rate paid by the protection buyer in a credit default swap.

III.  Difference between a bond’s yield and a treasury security with the same maturity.

A) II and III only.

B) I only. 

C) I and II only.

D) I, II, and III. 

The correct answer is C

Statements I and II are correct. The credit spread (the difference between the risky bond rate and the riskfree rate) is a proxy for the annualized risk-neutral loss rate. However, the difference between the bond yield and the treasury yield is incorrect because of the state tax exemption awarded to treasuries and the high degree of liquidity for treasuries. Another proxy for the risk-neutral mean loss rate is the default swap rate paid by the protection buyer in a credit default swap agreement.

2、The difference between the mean loss rate and the risk-neutral mean loss rate is the:

A) risk free rate.

B) probability of default times the recovery rate.

C) risk premia for accepting higher default risk.

D) probability of default times 1 minus the recovery rate. 

The correct answer is C

The risk-neutral mean loss rate is the rate where investors act as if they are risk neutral because the rate includes an artificially high mean loss rate that reflects a risk premia for accepting the higher default risk.

3、An artificially high mean loss rate that reflects a risk premia for accepting the higher default risk is called the:

A) mean loss rate. 

B) counterparty loss risk premia.

C) potential future exposure.

D) risk-neutral mean loss rate. 

The correct answer is D

Risk-neutral mean loss rate is the rate where investors act as if they are risk neutral because the rate includes an artificially high mean loss rate that reflects a risk premia for accepting the higher default risk.

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