Reading 37: Risk Management －LOS k standards, credit, limits

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 12: Risk Management
Reading 37: Risk Management
LOS k: Demonstrate the use of exposure limits, marking to market, collateral, netting arrangements, credit standards, and credit derivatives to manage credit risk.

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The practice that imposes current credit risk on a periodic basis to lower potential credit risk is called:

A) potentiality.

B) marking to market.

C) netting.

D) creation of special purpose vehicles.

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Answer and Explanation

Marking to market is the best answer. This reduces potential credit risk by converting what would otherwise be potential credit risk to current credit risk. The credit risk becomes current insofar as the counterparty is required to provide additional collateral immediately (rather than in the future).

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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) netting.

B) collateralizing.

C) special purposing.

D) marking to market.

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Answer and Explanation

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.

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A subsidiary of a parent company that is capitalized in a way that results in a high credit rating, with the objective of allowing the subsidiary to engage in activities where a high credit rating is an advantage would be called:

A) a collateral mortgage obligation.

B) a special purpose vehicle.

C) a netting vehicle.

D) collateralization.

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Answer and Explanation

Special purpose vehicles are subsidiaries set up by a parent company to engage in certain transactions. Generally, they are separate from the parent organization and not liable for the debt of the parent company. They are capitalized in a way that results in a high credit rating, and can, therefore, engage in transactions that the parent cannot.