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Free Questions › FRM › Credit Risk Measurement and Management
Free FRM Credit Risk Measurement and Management Practice Questions & Answers
400 exam-style Credit Risk Measurement and Management questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 1
Credit risk is best defined as:
Select an option first.
Correct answer: B — The risk that a borrower or counterparty will fail to fulfil a financial obligation.
Explanation: Credit risk is the potential for loss when a borrower or counterparty cannot or will not honour their financial obligations. A is interest rate risk; C is operational risk; D is market risk. Credit risk is the dominant risk in lending and fixed income portfolios.
Question 2
The three fundamental components of expected credit loss are:
Select an option first.
Correct answer: A — PD, LGD, and EAD.
Explanation: Expected Loss = PD × LGD × EAD. PD (Probability of Default), LGD (Loss Given Default), and EAD (Exposure at Default) are the building blocks of all credit risk quantification. B relates to bond pricing; C and D are not the standard EL formula components.
Question 3
Probability of Default (PD) measures:
Select an option first.
Correct answer: B — The likelihood that a borrower will fail to meet its debt obligations within a specified time horizon.
Explanation: PD is the statistical probability that a credit event (default) occurs within a given horizon (typically one year). LGD (A) measures recovery-related loss; EAD (C) is the outstanding balance; D is a coupon rate.
Question 4
Loss Given Default (LGD) is correctly calculated as:
Select an option first.
Correct answer: B — 1 − Recovery Rate.
Explanation: LGD = 1 − Recovery Rate. If 40% of the outstanding balance is recovered after default, LGD = 60%. A is a partial EL formula; C has no standard meaning; D is unrelated.
Question 5
Exposure at Default (EAD) for a term loan with a current balance of $5 million and no undrawn commitment is:
Select an option first.
Correct answer: B — Exactly $5 million — the outstanding principal.
Explanation: For a fully drawn term loan, EAD equals the outstanding principal balance. Accrued interest may be added in some frameworks (A) but the base is $5m. Collateral reduces LGD, not EAD (C, D).
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Question 6
Which of the following credit risk types is unique to derivative contracts?
Select an option first.
Correct answer: B — Pre-settlement counterparty credit risk — the risk that the counterparty defaults before the contract expires, and the mark-to-market value is positive to the holder.
Explanation: Derivative counterparty credit risk (pre-settlement risk) arises from the mark-to-market exposure — if the counterparty defaults when the derivative is 'in the money' to the holder, that MTM value is lost. A is a subset; C applies to loans; D is a liquidity risk.
Question 7
A 'through-the-cycle' (TTC) credit rating aims to:
Select an option first.
Correct answer: B — Provide a stable rating across a full economic cycle, smoothing out cyclical fluctuations.
Explanation: TTC ratings are designed to be stable — they represent long-run creditworthiness rather than current cyclical conditions. Point-in-time (PIT) ratings (A) incorporate current conditions. TTC ratings are used in Basel regulatory capital to avoid pro-cyclicality.
Question 8
A 'point-in-time' (PIT) credit assessment is characterised by:
Select an option first.
Correct answer: B — Sensitivity to current economic and financial conditions of the borrower.
Explanation: PIT assessments incorporate current macro and borrower conditions — they improve in booms and deteriorate in recessions. TTC (A) is designed to be cycle-stable. PIT is used in IFRS 9 expected credit loss provisioning.
Question 9
A credit rating 'notch' refers to:
Select an option first.
Correct answer: B — A single step on the detailed rating scale (e.g., A+ to A, or A to A−).
Explanation: A notch is one step in the granular rating scale. A full letter change (A to BBB) spans three notches. Notches are used to measure rating migration and the sensitivity of credit spreads.
Question 10
The investment-grade / speculative-grade boundary occurs at:
Select an option first.
Correct answer: C — BBB−/BB+
Explanation: BBB−/Baa3 is the lowest investment-grade rating. Below this (BB+/Ba1) is speculative grade ('junk'). This boundary triggers mandatory selling by many institutional mandates, amplifying price moves when bonds cross it ('fallen angel' effect).
Question 11
A credit rating 'outlook' of 'Negative' signals:
Select an option first.
Correct answer: B — A directional view on the rating over a 12-24 month horizon — the rating may be lowered if current trends continue.
Explanation: Outlook (Negative/Stable/Positive) is the rating agency's medium-term directional view (6-24 months). A 'Watch' or 'Review' (A) implies a near-term (90-day) potential action. C and D are unrelated to outlook.
Question 12
The 'credit spread' on a corporate bond represents:
Select an option first.
Correct answer: B — The additional yield above the risk-free rate that investors demand for bearing the credit risk of the issuer.
Explanation: Credit spread = YTM_corporate − YTM_risk_free. It compensates investors for: (1) expected credit loss (PD × LGD), (2) credit risk premium (compensation for uncertainty), and (3) liquidity premium. A is not a spread; C is bid-ask spread; D is a sector statistic.
Question 13
Recovery rate in the context of credit risk refers to:
Select an option first.
Correct answer: A — The percentage of the outstanding exposure that a lender recovers after a default event.
Explanation: Recovery rate = Amount recovered / EAD. LGD = 1 − Recovery rate. Recovery rates vary significantly by instrument seniority, collateral quality, and jurisdiction. B is collateral return; C describes 'cure rate'; D is the yield on comparable performing bonds.
Question 14
Which of the following instruments typically has the highest recovery rate in a corporate default?
Select an option first.
Correct answer: C — Senior secured loans.
Explanation: Recovery rates by seniority: Senior secured loans (~70-80%) > Senior unsecured (~40-50%) > Subordinated (~20-30%) > Equity (~0%). Secured creditors have priority claim on specific collateral assets. A, B, D have lower recovery due to lower seniority.
Question 15
'Settlement risk' in financial markets refers to:
Select an option first.
Correct answer: B — The risk that one party to a transaction completes its side of the exchange while the counterparty fails to deliver.
Explanation: Settlement risk (Herstatt risk) is the risk that one leg of a transaction is completed while the counterparty fails to deliver. This arises specifically at the moment of exchange. Pre-settlement risk (A) occurs during the life of the contract before settlement.
Question 16
A lender reduces credit risk by requiring a borrower to pledge assets as security. This is an example of:
Select an option first.
Correct answer: B — Credit enhancement through collateral.
Explanation: Collateral is a credit enhancement mechanism — if the borrower defaults, the lender seizes and liquidates the pledged assets to recover losses. This reduces LGD (not EAD). A is a different credit risk transfer technique; C and D are unrelated.
Question 17
Which of the following is NOT a standard method of credit risk mitigation?
Select an option first.
Correct answer: C — Increasing the notional amount of derivative contracts.
Explanation: Increasing notional increases gross exposure — it amplifies, not reduces, credit risk. Netting (A) reduces bilateral gross exposure to net exposure. Collateral (B) reduces LGD. Guarantees (D) transfer credit risk to the guarantor.
Question 18
The 'maturity effect' in credit risk refers to:
Select an option first.
Correct answer: B — The tendency for credit risk to increase with longer maturities because there is more time for credit quality to deteriorate.
Explanation: Longer maturity → more time for adverse changes in borrower creditworthiness → higher cumulative default probability → higher credit spread and credit VaR. A reverses the relationship; C applies post-maturity; D is a duration concept.
Question 19
In Basel credit risk terminology, a 'performing' loan is one where:
Select an option first.
Correct answer: B — The borrower is meeting all contractual obligations on time.
Explanation: A performing loan has no current default or significant credit deterioration. Non-performing loans (NPLs) typically involve missed payments of 90+ days. A describes a non-performing/defaulted loan; C and D are not definitions of 'performing'.
Question 20
A 'covenant' in a loan agreement is best described as:
Select an option first.
Correct answer: B — A contractual condition that restricts or requires specific borrower actions to protect the lender's position.
Explanation: Covenants are contractual protections: financial covenants (minimum coverage ratios, maximum leverage), affirmative covenants (maintain insurance, file accounts), and negative covenants (restrictions on additional debt, asset sales). A is a standard repayment term; C is a convertible debt feature; D is an events-of-default clause.
Question 21
A 'negative pledge' covenant restricts the borrower from:
Select an option first.
Correct answer: B — Pledging its assets as security to other creditors, which would subordinate the existing lender's claim.
Explanation: Negative pledge: the borrower cannot grant security interests over its assets to third-party creditors, protecting the existing lender from being disadvantaged by subordination. A is a debt incurrence covenant; C is a restricted payments covenant; D is an asset sale covenant.
Question 22
The primary purpose of a credit committee within a bank is:
Select an option first.
Correct answer: B — To review, approve, and set limits on credit exposures, ensuring adherence to credit policy.
Explanation: Credit committees govern credit decision-making: approving individual credits, setting single-name and sector limits, reviewing the loan portfolio's quality, and ensuring consistency with risk appetite. A is a market risk/trading function; C is an ALM function; D is a capital planning function.
Question 23
Credit risk 'concentration' arises when:
Select an option first.
Correct answer: B — A portfolio has disproportionately large exposure to a single borrower, sector, region, or risk factor.
Explanation: Concentration risk: excessive exposure to a single entity or correlated group means that one adverse event can cause disproportionate portfolio losses. Diversification (A) reduces concentration. C and D are NIM and market conditions, not credit concentration.
Question 24
A 'credit limit' in institutional credit management represents:
Select an option first.
Correct answer: B — The maximum credit exposure a lender is willing to accept to a single counterparty or group.
Explanation: Credit limits are governance controls: maximum permissible exposure (single name, sector, country, product type). They translate risk appetite into operational boundaries. A, C, D are conditions or pricing, not the definition of a credit limit.
Question 25
Which of the following correctly explains why credit risk is asymmetric in its payoff profile?
Select an option first.
Correct answer: B — Lenders receive fixed coupon/principal cash flows when borrowers perform, but suffer large losses when borrowers default — limited upside but significant downside.
Explanation: Credit payoff asymmetry: the lender receives a capped return (contractual interest + principal) if the borrower performs, but can lose most or all of the principal upon default. This is the opposite of equity — limited upside, significant downside. A overstates lender upside; C is wrong; D confuses equity with debt.
Question 26
Which of the following is the best example of 'idiosyncratic' credit risk?
Select an option first.
Correct answer: B — A specific company defaulting due to management fraud.
Explanation: Idiosyncratic credit risk is firm-specific and not driven by broad economic conditions. Management fraud (B) is a company-specific event. A and D are systematic/sector credit risks; C is interest rate risk.
Question 27
The 'credit cycle' refers to:
Select an option first.
Correct answer: B — The tendency of credit conditions (lending standards, credit availability, and default rates) to fluctuate over time in a pattern correlated with the economic cycle.
Explanation: The credit cycle: in expansions, lending standards loosen, credit is abundant, and defaults are low. In contractions, standards tighten, credit contracts, and defaults spike. This pro-cyclicality can amplify economic cycles.
Question 28
'Adverse selection' in credit markets means:
Select an option first.
Correct answer: B — Riskier borrowers are more likely to seek credit at a given rate, causing the pool of actual borrowers to be riskier than the average applicant pool.
Explanation: Adverse selection (Akerlof 'lemons' problem): when lenders cannot perfectly observe borrower risk, riskier borrowers are more eager to borrow at a given rate, adverse-selecting into the loan pool. Lenders must charge a spread that covers the average risk, which over-prices safe borrowers and under-prices risky ones.
Question 29
'Moral hazard' in credit markets occurs when:
Select an option first.
Correct answer: B — After receiving a loan, a borrower takes on additional risk or reduces effort to repay, knowing the lender bears the downside.
Explanation: Moral hazard (post-contractual): once financing is obtained, the borrower's interests may misalign with the lender's (e.g., 'going for broke' with risky investments, reducing maintenance of pledged assets). Covenants, monitoring, and collateral are designed to mitigate moral hazard.
Question 30
Which of the following financial ratios is most commonly used to assess a corporate borrower's ability to service debt?
Select an option first.
Correct answer: B — Debt service coverage ratio (DSCR) or interest coverage ratio (ICR).
Explanation: Debt service coverage = EBIT (or EBITDA) / (Interest + Principal repayments). ICR = EBIT / Interest expense. These measure whether operating earnings are sufficient to cover debt obligations. A and D measure equity returns; C is a market valuation metric.
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