Pass the GARP Financial Risk and Regulation 2016-FRR Questions and answers with ExamsMirror

Credit derivatives historically carry several specific types of risk:

Documentation Risk:The risk arising from the complexity and potential ambiguity in the legal documentation of credit derivative contracts.

Definition of Credit Events:The risk associated with the precise definition of what constitutes a credit event, such as a default, which can be subject to interpretation and affect payouts.

Occurrence of Credit Events:The actual risk that a credit event will occur, triggering the derivative contract.

Enterprise risk is a broader category that typically includes all risks faced by an enterprise, not just those associated with credit derivatives.

References

Verified information on credit derivative risks from the document ​

Range options, also known as "corridor options" or "double no-touch options," have two strike prices. The payoff for a range option depends on the price of the underlying asset remaining within a specified range between the two strike prices during the life of the option. This dual strike price structure is what distinguishes range options from other types of options.

Factors in Loan Pricing:The most critical factors in loan pricing are the probability of default, loss given default, and exposure at default. These directly impact the risk assessment and pricing strategies for loans.

Less Significant Factor:The duration of default, while relevant, is less significant compared to the immediate risk factors. It primarily affects the timing rather than the magnitude of potential losses.

The value of an option is influenced by several factors, including the perceived volatility of the underlying asset, in this case, foreign exchange rates. As the perceived future volatility of foreign exchange rates increases, the value of all options (both calls and puts) also increases. This is because higher volatility increases the likelihood that the option will end up in-the-money, thereby increasing its potential payoff. This relationship is fundamental to option pricing models, such as the Black-Scholes model, which incorporate volatility as a key input.

The value of foreign exchange options is influenced by several factors, including:

Change in the value of the underlying (I):This directly affects the option's intrinsic value.

Change in the perception of future volatility (II):Higher expected volatility increases the option's potential payoff.

Change in interest rates (III):This affects the cost of carrying positions in the underlying asset.

Passage of time (IV):This influences the time value of the option. All these factors collectively impact the pricing dynamics of options throughout the trading day.

Moral hazard occurs when one party in a contractual relationship can take risks because the consequences of those risks will be borne by another party. In this scenario, the credit associate is concerned that the obligor might use the loan proceeds for purposes not sanctioned by the lender, thereby increasing the risk of default. This situation is a classic example of moral hazard, where the obligor's behavior after receiving the loan could change in a way that increases the lender's risk without the lender having control over those actions.

When trading exotic options, various risks need to be considered. Spot foreign exchange risks (I) involve the risk associated with the current exchange rate fluctuations. Forward foreign exchange risks (II) pertain to the risks related to future exchange rate changes agreed upon in forward contracts. Plain vanilla options risks (III) include the standard risks associated with basicoption trading, such as volatility and time decay. Option-specific risks (IV) refer to the unique risks inherent in the specific exotic option being traded, such as path-dependency, barrier levels, and the complexity of modeling their payoffs. All these risks collectively impact the trading of exotic options.

The pricing of credit default swaps (CDS) is primarily influenced by:

Probability of Default:The likelihood that the underlying entity will default on its obligations.

Duration:The term or maturity of the CDS contract.

Loss Given Default:The expected loss if the underlying entity defaults.

Market spreads, while relevant to bond pricing and other instruments, are not a direct factor in the calculation of the pricing of CDS contracts.

References

Verified information on CDS pricing factors from the document ​

By foreign exchange market convention, spot foreign exchange transactions are typically settled on a T+2 basis, meaning the transactions are exchanged at the spot date based on the two-day rule. This means that the delivery of the currencies involved in the transaction takes place two business days after the trade date. This standard settlement period is used to ensure that there is enough time to manage the administrative tasks associated with the transaction.

Obligers may default simultaneously if they are harmed by exposure to similar risk factors, which means that an economic downturn or industry-specific issue affects multiple obligors at once.

Herd behavior can lead to simultaneous defaults as obligors might follow the same trend, leading to a cascading effect of defaults.

Sampling bias and speculative bias are not directly related to simultaneous defaults in the context of credit risk.