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

From the bank's point of view, repricing the retail debt portfolio introduces risks primarily related to fluctuations in interest rates and bank spreads. When interest rates change, the cost of funds for the bank can fluctuate, which affects the interest margins (bank spreads). Additionally, the repricing of existing debt to match current market rates introduces direct exposure to interest rate volatility. Therefore, the risks associated with fluctuations in these areas are III. Interest rates and IV. Bank spreads.

The potential failure of a manufacturer to honor a warranty is a type of performance risk because it relates to the manufacturer's performance under the terms of the warranty contract. Conversely, the potential failure of a borrower to fulfill its payment requirements, including both the repayment of the amount borrowed (principal) and the contractual interest payments, is known as credit risk. Credit risk specifically deals with the likelihood of a borrower defaulting on their debt obligations.

ThetaBank's default risk assessment involves calculating the joint probability of default for the two mortgage companies and comparing it to the independent risk model.

Individual Exposure at Default (EAD):$20 million for each mortgage company.

Loss Given Default (LGD):100%

Probability of Default (PD):10% for each mortgage company.

Joint Probability of Default:5%

For independent risks, the joint probability of default for two independent events is the product of their individual probabilities:

\text{Joint Probability (Independent)} = PD_1 \times PD_2 = 0.10 \times 0.10 = 0.01 \text{ (or 1%)}

Given that ThetaBank predicts the joint probability at 5%, the independent model would have underestimated the actual probability by:

5%−1%=4%5%−1%=4%

Therefore, the underestimated probability is:

4%−2%=2%4%−2%=2%

References

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Impact of Lowering Spread:By lowering the spread on lower credit quality borrowers, the bank can achieve aggressive courting of new business, rapid growth, and higher losses in case of default due to the increased risk.

Exception:Lowering the spread will not lead to a lower probability of default. On the contrary, it typically attracts higher-risk borrowers, increasing the likelihood of default.

Asian options are path-dependent options, which means their payoff depends on the average price of the underlying asset over a certain period, rather than just the price at maturity. This characteristic makes them path-dependent because the path taken by the asset's price during the life of the option affects the payoff, unlike path-independent options which only depend on the final price at maturity.

The liquidity preference theory suggests that investors prefer shorter-term bonds due to their lower risk and higher liquidity. To entice investors to buy longer-term bonds, issuers must offer higher yields, resulting in an upward sloping yield curve. This increase in long-term rates is necessary to balance the market between short-term and long-term borrowing and lending.

The probability of default (PD) refers to the likelihood that a borrower will fail to meet its debt obligations over a specific time horizon. This is a core component in quantifying credit risk exposures.

Duration of default is not a commonly used term in credit risk analysis.

Exposure at default (EAD) measures the total value at risk in the event of default but does not directly refer to the likelihood of default.

Loss given default (LGD) measures the portion of the exposure that is lost when a borrower defaults but does not indicate the likelihood of default.

Futures contracts have several key characteristics that differentiate them from other types of financial instruments. The features include a fixed notional amount per contract, fixed dates for delivery, and daily margin calls to manage credit risk. Futures are standardized contracts traded on exchanges, not over-the-counter (OTC). OTC trading typically refers to securities or derivatives that are not listed on formal exchanges and are traded directly between parties, which is not a feature of futures contracts.

Credit risk refers to the risk that a borrower will default on any type of debt by failing to make required payments. It is typically a form of performance risk in a contractual relationship, where one party is at risk of loss due to another party's inability to fulfill financial obligations. This is distinguished from market risk (related to market prices), liquidity risk (related to the availability of funds), and other operational risks that companies might face.

The credit spread reflects the additional yield over the risk-free rate that investors demand to compensate for the risk of default. An increase in the probability of default of the issuer (I) would directly increase the credit spread as investors require more return for higher risk. Similarly, an increase in expected loss (IV) would increase the credit spread since the potential loss in the event of default is greater. On the other hand, a decrease in risk premium (II) or a decrease in loss given default (III) would typically lower the credit spread, not increase it.