Deck 24: Credit Risk

Question 1

Which of the following is true

A) Conditional default probabilities are at least as high as unconditional default probabilities
B) Conditional default probabilities are at least as low as unconditional default probabilities
C) Conditional default probabilities are sometimes lower and sometimes higher than unconditional default probabilities.
D) There is no difference between conditional and unconditional default probabilities because a company can only default once.

Answer 1

A
The conditional default probability for a future time period is the unconditional default probability divided by the probability of no earlier default.The latter is less than or equal to one.As a result the conditional probability is at least as great as the unconditional probability.

Question 2

A derivatives dealer has a single transaction with a company which is a long position in a five-year option.The Black-Scholes-Merton value of the option is $6.Suppose that the credit spread on five-year bonds issued by the company is 100 basis points.What is the dealer's CVA per option purchased from the counterparty?

A) $0.19
B) $1.19
C) $0.29
D) $1.29

Answer 2

C
The value of the option when the counterparty's credit risk is taken into account is 6e^−0.01×5=5.71 and so the CVA is 6−5.71 or $0.29 per option purchased

Question 3

Which of the following is true

A) Netting always leads to a reduction in a company's exposure to a counterparty
B) Netting always leads to a company's exposure to a counterparty either staying the same or going down
C) Netting always increases a company's exposure to a counterparty
D) Netting can increase or reduce the exposure

Answer 3

B
Netting means that the derivatives portfolio with a counterparty is considered to be a single transaction in the event of a default.This cannot increase the exposure.If there are transactions in the portfolio with both positive and negative values the exposure will go down.

Question 4

Which of the following is true

A) The default probability per year for a company always increases as we look further ahead
B) The default probability per year for a company always decreases as we look further ahead
C) Sometimes A is true and sometimes B is true
D) The default probability per year is roughly constant for most companies

Question 5

Which of the following is usually used to define the recovery rate of a bond?

A) The value of the bond immediately after default as a percent of its face value
B) The value of the bond immediately after default as a percent of the sum of the bond's face value and accrued interest
C) The amount finally realized by a bondholder as a percent of face value
D) The amount finally realized by a bondholder as a percent of the sum of the bond's face value and accrued interest

Question 6

Which of the following is true

A) The Gaussian copula model assumes that the defaults of different companies are independent.
B) The Gaussian copula model assumes that defaults, conditional on the value of a factor , are independent.
C) The Gaussian copula model assumes that the number of defaults is normally distributed.
D) None of the above.

Question 7

Which of the following is true

A) Downgrade triggers are particularly valuable if they are widely used by a company's counterparties
B) Downgrade triggers become less valuable if they are widely used by a company's counterparties
C) Downgrade triggers are useless because their impact is always anticipated by the market
D) Downgrade triggers are a two-edged sword. If company A has a downgrade trigger for company B then company B has a downgrade trigger for company A

Question 8

To be investment grade,a company has to have a credit rating of

A) AA or better
B) A or better
C) BBB or better
D) BB or better

Question 9

Which of the following is true

A) Recovery rates are lower for investment grade companies
B) Recovery rates are higher for non-investment grade companies
C) Recovery rates are negatively correlated with default rates
D) Recovery rates are positively correlated with default rates

Question 10

The credit spreads for a counterparty for 5 and 6 years are 2% and 2.2% respectively.The recovery rate is 60%.What is closest to the unconditional default probability for the sixth year?

A) 0.04
B) 0.05
C) 0.06
D) 0.07

Question 11

Which of the following is true?

A) Risk neutral default probabilities are usually much lower than real world default probabilities
B) Risk neutral default probabilities are usually much higher than real world default probabilities
C) Risk neutral and real world probabilities must be close to each other if there are to be no arbitrage opportunities
D) Risk-neutral default probabilities cannot be calculated from CDS spreads

Question 12

A hazard rate is 1% per annum.What is the probability of a default during the first two years?

A) 2.00%
B) 2.02%
C) 1.98%
D) 1.96%

Question 13

Which of the following is true of Merton's model:

A) The equity is a call option on the assets
B) The assets are a call option on the debt
C) The debt is a call option on the equity
D) The equity is a call option on the debt

Question 14

Suppose that the cumulative probability of a company defaulting by years one,two,three and four are 3%,6.5%,10%,and 14.5%,respectively.What is the probability of default in the fourth year conditional on no earlier default?

A) 4.5%
B) 5.0%
C) 5.5%
D) 6.0%

Question 15

Which of the following is true of Creditmetrics when it is used to calculate credit VaR

A) Creditmetrics takes defaults but not downgrades into account
B) Creditmetrics takes downgrades but not defaults into account
C) Creditmetrics considers neither defaults nor downgrades
D) Creditmetrics considers both defaults and downgrades

Question 16

If a company's five year credit spread is 200 basis points and the recovery rate in the event of a default is estimated to be 20% what is the average hazard rate per year over the five years

A) 0.4%
B) 1.2%
C) 1.8%
D) 2.5%

Question 17

Which of the following is true of Merton's model:

A) The strike price is the market value of the debt
B) The strike price is the market value of the equity
C) The strike price is the book value of the equity
D) The strike price is the face value of the debt

Question 18

Which of the following is true

A) The asset swap spread is a measure of excess of the bond yield over the OIS rate
B) The asset swap spread is a measure of excess of the bond yield over the LIBOR/swap rate
C) An asset swap exchanges the actual return on the asset for LIBOR plus a spread
D) None of the above

Question 19

Which of the following is true

A) A derivative dealer's CVA is the counterparty's DVA and vice versa
B) Collateral posted by the counterparty reduces CVA
C) Collateral posted by the dealer reduces DVA
D) All of the above

Question 20

In the Gaussian copula model which of the following is true

A) The time to default for a company is assumed to be normally distributed.
B) The time to default for a company is assumed to be lognormally distributed
C) The time to default for a company is transformed to a normal distribution
D) The time to default for a company is transformed to a lognormal distribution