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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 271
The 'junior-senior tranche correlation trade' in a CDO involves:
Select an option first.
Correct answer: B — Buying protection on an equity or junior tranche and selling protection on a senior tranche (or vice versa) to express a view on default correlation — profiting from correlation increasing or decreasing.
Explanation: Correlation trade: buying equity protection (short equity/long correlation) + selling senior protection (short senior/short correlation) creates a position that profits from rising default correlation (equity tranche becomes less risky in high correlation as all-or-nothing; senior tranche becomes riskier as all default together). A, C, D describe different positions.
Question 272
In the 'waterfall' of a CLO, 'overcollateralisation tests' (OC tests) work by:
Select an option first.
Correct answer: B — If the ratio of asset par value to note face value falls below a specified trigger level, diverting interest cash flows from junior tranches to redeem senior notes — effectively 'curing' the OC breach by paying down senior liabilities.
Explanation: OC test: if Portfolio par / Note face value < OC trigger level, the waterfall diverts cash that would otherwise flow to equity or junior note holders toward repayment of senior notes. This deleverages the CLO structure in response to credit losses, protecting senior investors. A describes the test ratio; C and D are not OC test mechanics.
Question 273
A 'risk retention' requirement in securitisation regulations requires the originator to:
Select an option first.
Correct answer: B — Retain at least 5% of the economic interest in a securitisation to align originator incentives with investor interests — ensuring the originator maintains 'skin in the game'.
Explanation: Risk retention (EU Securitisation Regulation, US Dodd-Frank): originators must retain ≥5% of economic interest, typically as the equity tranche or a horizontal slice. This addresses the originate-to-distribute moral hazard that contributed to poor lending quality pre-2008. A, C, D are other regulatory requirements.
Question 274
A structured credit analyst observes that the 'spread on spread' (the difference between mezzanine CDS tranche spread and senior CDS tranche spread) has widened significantly. This most likely indicates:
Select an option first.
Correct answer: B — An increase in perceived default correlation — as correlation rises, mezzanine tranches become riskier relative to senior tranches, widening the mezzanine-senior spread.
Explanation: Spread dynamics: higher correlation → mezzanine more likely to be hit (losses cluster into middle of the loss distribution); senior also becomes riskier but relative to mezzanine, mezzanine spread widens more. A and C describe improving conditions; D is possible but not what the spread differential directly indicates.
Question 275
The 'credit spread on a CLO senior tranche' above government bonds compensates investors primarily for:
Select an option first.
Correct answer: B — Complexity premium, structural uncertainty, limited secondary market liquidity, and a small residual credit risk — not primarily for expected default losses (which are very low for AAA CLO tranches).
Explanation: AAA CLO tranche spreads (typically 100-200bp over SOFR): the spread is NOT primarily for default risk (AAA CLO tranches rarely default). It compensates for: (1) complexity and model risk, (2) lack of secondary market liquidity, (3) structural uncertainty (manager quality, reinvestment risk), (4) regulatory capital costs for bank buyers. A underestimates the spread; C and D are specific risks, not the primary driver.
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Question 276
'Negative convexity' in mortgage-backed securities arises because:
Select an option first.
Correct answer: B — MBS holders are effectively short a prepayment call option — when rates fall, borrowers prepay and the investor must reinvest at lower rates, preventing the full price appreciation that a standard bond would experience.
Explanation: MBS negative convexity: the embedded prepayment option belongs to borrowers (they can refinance). MBS investors are short this option. When rates fall: prepayments accelerate → MBS price appreciation is capped → price-yield curve becomes concave (negative convexity). A is wrong; C is a different instrument feature; D is a general bond price-spread relationship.
Question 277
A 'senior tranche' in a CDO is characterised by:
Select an option first.
Correct answer: B — The highest seniority — it is the last to absorb losses and typically receives the lowest yield in the structure.
Explanation: Senior tranche: last to take losses (most credit-protected), first in the cash flow waterfall (paid before junior tranches), lowest yield. Equity tranche = first loss, highest yield/risk. A reverses the yield relationship; C describes the equity tranche; D is a common feature but not the defining characteristic.
Question 278
A 'mezzanine tranche' in a CDO sits:
Select an option first.
Correct answer: B — Between the equity (first-loss) and senior tranches — it absorbs losses after equity is exhausted but before senior tranches are affected.
Explanation: Mezzanine: the middle layer, absorbing losses between the attachment point (equity exhausted) and the detachment point (senior begins to absorb). Typically rated BBB to BB, offering moderate yield for moderate risk. A is above senior (incorrect); C is below equity (doesn't exist); D is unrelated.
Question 279
The 'attachment point' of a mezzanine CDO tranche at 5% means:
Select an option first.
Correct answer: B — The tranche starts incurring principal losses when cumulative portfolio losses exceed 5% of the total pool notional.
Explanation: Attachment point: the lower boundary of a tranche's loss exposure. At 5% attachment, the first 5% of portfolio losses are absorbed by the equity tranche. Only after losses exceed 5% does the mezzanine tranche begin to lose principal. A relates to cash flows; C is a different mechanism; D is maturity.
Question 280
A CDS 'credit event' of 'failure to pay' is triggered when:
Select an option first.
Correct answer: B — The reference entity fails to make a scheduled payment of principal or interest after a grace period, above a minimum threshold amount.
Explanation: ISDA Failure to Pay: the reference entity misses a principal or interest payment on any obligation, after a grace period (typically 30 days for bonds), above a payment threshold (typically $1m). A is a rating event; C is a succession event; D is an equity market event.
Question 281
A 'CDS on CDS' (or 'CDS swaption') gives the holder:
Select an option first.
Correct answer: A — The right to buy or sell a CDS contract at a specified spread on a future date.
Explanation: CDS swaption: an option to enter into a CDS at a specified spread (strike) on the swaption expiry date. If spreads have widened beyond the strike, the swaption is in-the-money for the payer (protection buyer). Used to express forward volatility views on credit. B is volatility hedging; C is standard CDS settlement; D is a forward-starting CDS (different instrument).
Question 282
The spread on a newly issued 5-year CDX IG index (125 IG corporates) widens from 60bp to 80bp. This means:
Select an option first.
Correct answer: B — The cost of buying protection on the investment-grade basket has increased — the market perceives higher credit risk across IG corporates.
Explanation: CDX spread widening = market pricing higher credit risk across the IG universe. Protection buyers now pay 80bp/year (up from 60bp). Existing holders of long credit (short protection) mark-to-market losses as the index widens. A is opposite; C is interest rate; D is incorrect.
Question 283
A 'reference portfolio' in a synthetic CDO is:
Select an option first.
Correct answer: B — The list of reference entities and notional amounts on which the SPV has sold CDS protection, defining the credit risk profile of the synthetic CDO.
Explanation: Synthetic CDO: the SPV sells CDS protection on a specified reference portfolio of credits. Cash flows consist of CDS premium income (from the reference portfolio) less any credit event payments. The reference portfolio defines the underlying credit risk. A is cash CDO; C is the collateral (government bonds pledged against super-senior risk); D is historical data.
Question 284
A 'negative basis trade' in credit involves:
Select an option first.
Correct answer: B — Buying a bond (earning the bond spread) and buying CDS protection on the same issuer at a tighter spread — profiting from the difference where the bond yield exceeds the CDS spread.
Explanation: Negative basis = bond spread > CDS spread. Negative basis trade: (1) long bond (earn higher spread), (2) buy CDS protection (pay lower spread). The net position is credit-risk neutral but earns the basis (difference between bond spread and CDS spread). A buys both (long credit); C is short both; D describes negative carry.
Question 285
The 'loan-to-value' (LTV) ratio in commercial real estate lending is important because:
Select an option first.
Correct answer: B — It measures collateral coverage — a lower LTV means the loan is a smaller fraction of the property's value, providing a larger buffer against property price declines before the lender faces losses.
Explanation: LTV = Loan balance / Property value. Lower LTV → more equity cushion → lower LGD for the lender. If LTV = 60% and property falls 20%, new LTV = 75% — still secured. At LTV = 80% and 20% fall, new LTV = 100% — lender fully exposed. A is rental yield (different metric); C and D are related but not what LTV directly measures.
Question 286
The 'structured finance' market segment primarily refers to:
Select an option first.
Correct answer: B — Financial instruments created by pooling assets and repackaging the cash flows into new securities with different risk characteristics, including securitisation, CDOs, and CLOs.
Explanation: Structured finance: ABS, MBS, CDOs, CLOs, CMBS, covered bonds. These involve: (1) asset pooling; (2) risk tranching (creating multiple risk levels from one pool); (3) credit enhancement. The complexity and opacity of structured products was central to the 2008 crisis. A is commercial banking; C is sovereign; D is equity derivatives.
Question 287
In a 'CLO' (Collateralised Loan Obligation), the 'equity tranche' holder (or 'residual note' holder) typically earns:
Select an option first.
Correct answer: B — The residual cash flow after all senior and mezzanine note holders are paid — potentially very high returns in good markets, with significant loss in severe credit downturns.
Explanation: CLO equity: receives all residual cash flows (income + principal) after senior and mezzanine notes are repaid. In a well-performing CLO, equity can earn 15-20%+ returns. In a stressed scenario, equity is wiped out first. This is the high-risk, high-potential-return position. A is a bond description; C reverses seniority/return relationship; D does not exist.
Question 288
A 'CDS index roll' occurs every:
Select an option first.
Correct answer: B — March and September, when the major CDS indices (CDX, iTraxx) are restructured — removing defaulted or downgraded names and adding new constituents — creating a new 'on-the-run' series.
Explanation: CDS index rolls: March 20 and September 20 — the biannual restructuring of CDX and iTraxx indices. A new 'on-the-run' series replaces the previous 'off-the-run' series. The old series remains tradeable but liquidity migrates to the new on-the-run series. A, C, D are incorrect.
Question 289
In credit derivatives, 'accrued premium' at termination means:
Select an option first.
Correct answer: B — If a credit event occurs between coupon dates, the protection buyer must pay the pro-rated portion of the quarterly premium that has accrued since the last payment date.
Explanation: Accrued premium: when a credit event triggers CDS settlement, the protection buyer pays the fraction of the quarterly coupon accrued since the last payment. E.g., if the event occurs 45 days into a 90-day quarter, the buyer pays half the quarterly premium. A reverses direction; C and D are wrong.
Question 290
A 'super-senior' tranche in a synthetic CDO has which characteristic?
Select an option first.
Correct answer: B — It sits above the AAA senior tranche in the capital structure, taking losses only after all other tranches are wiped out — typically unfunded and representing the last risk to be hit.
Explanation: Super-senior: above the rated senior tranche, last to take losses. In practice, very thin spread is paid on super-senior (often sold to banks as off-balance-sheet protection or to monoline insurers). The monoline insurance of super-senior tranches created massive wrong-way risk exposure in 2008. A reverses the yield-seniority tradeoff; C and D are wrong.
Question 291
An 'originator' in a securitisation is responsible for:
Select an option first.
Correct answer: B — Creating (originating) the underlying loans or assets, transferring them to the SPV, and typically continuing to service them post-securitisation.
Explanation: Originator: creates the pool of loans/assets, executes the true sale to the SPV, often retains servicing responsibilities, and under risk retention rules must retain ≥5% economic interest. A is the rating agency; C is credit enhancer; D is the underwriter/placement agent.
Question 292
A 'special purpose vehicle' (SPV) in securitisation is structured as a 'bankruptcy-remote' entity to:
Select an option first.
Correct answer: B — Ensure that if the originator goes bankrupt, the assets in the SPV cannot be claimed by the originator's creditors — protecting investors from the originator's insolvency.
Explanation: Bankruptcy remoteness: legal separation of SPV from originator. Key features: (1) SPV has separate legal existence; (2) true sale opinion (assets genuinely transferred); (3) non-petition clause (SPV creditors cannot petition originator into bankruptcy); (4) SPV has no independent business operations (no risk of its own insolvency). A, C, D are not the purpose.
Question 293
A 'servicer' in a mortgage-backed security defaults on its servicing obligations. This creates:
Select an option first.
Correct answer: B — Operational risk — cash flows may be disrupted, borrower communications interrupted, and delinquency management impaired until a replacement servicer is appointed.
Explanation: Servicer failure is an operational risk — it doesn't directly cause borrower defaults, but disrupts cash flow remittance, loss mitigation, and investor reporting. Most securitisations have back-up servicer provisions to address this risk. A, C, D are incorrect.
Question 294
The 'diversity score' in a CDO measures:
Select an option first.
Correct answer: B — The number of independent credit exposures in the portfolio — a portfolio with high diversity (many uncorrelated names) has lower concentration risk than one with few highly correlated names.
Explanation: Diversity score: a metric (developed by Moody's) that converts a potentially correlated portfolio into an equivalent number of independent same-sized exposures. E.g., 100 loans across 10 highly correlated industries might have a diversity score of 40 (equivalent to 40 independent exposures). Higher diversity = lower concentration risk.
Question 295
In structured credit, 'tail risk' for a senior tranche arises from:
Select an option first.
Correct answer: B — The clustering of many defaults simultaneously (driven by high default correlation) — 'tail events' where cumulative losses reach the senior tranche's attachment point.
Explanation: Senior tranche tail risk: driven by correlation. In a high-correlation world, if many borrowers default simultaneously, losses cascade through equity, mezzanine, and eventually reach the senior tranche. This is a low-probability but very high-severity event — the tail risk. A is irrelevant to senior tranche; C and D are operational/structural issues.
Question 296
Which of the following is a primary risk of investing in CMBS (Commercial Mortgage-Backed Securities)?
Select an option first.
Correct answer: B — Refinancing risk — commercial mortgages are typically balloon-payment structures where the full principal is due at maturity; if the property market is weak, borrowers cannot refinance.
Explanation: CMBS refinancing risk: unlike residential mortgages (amortising), commercial mortgages often have balloon payments at maturity (5-7 years). If property values fall or credit markets tighten, refinancing the balloon becomes difficult → default. A overstates residential-style prepayment in CMBS; C is typically domestic; D is the SPV (originator is already separated).
Question 297
A 'cash CDO' differs from a 'synthetic CDO' in that the cash CDO:
Select an option first.
Correct answer: B — Physically acquires the reference bonds or loans, funding the purchase through note issuance to investors.
Explanation: Cash CDO: SPV physically acquires bonds/loans (using proceeds from note issuance). All income = coupon from physical assets. Synthetic CDO: SPV sells CDS protection without physically owning the assets. A is a cash flow description; C is synthetic; D is not a general rule.
Question 298
In a leveraged buyout (LBO) financing structure, 'second lien loans' sit:
Select an option first.
Correct answer: B — Below first lien debt but above senior unsecured bonds — they have a second-priority security interest in the same collateral as first lien lenders.
Explanation: LBO capital stack (top to bottom): (1) First lien TLB (most senior, secured), (2) Second lien (also secured but second priority), (3) Senior unsecured bonds, (4) PIK notes, (5) Mezzanine, (6) Equity. Second lien holders share collateral with first lien but get paid only after first lien is made whole. A, C, D are incorrect.
Question 299
A 'high-yield bond' is characterised by:
Select an option first.
Correct answer: B — A below-investment-grade corporate bond (rated BB+ or lower) offering higher yields to compensate investors for higher credit risk.
Explanation: High-yield (HY) bonds: speculative-grade corporate debt (below BBB−/Baa3). Higher yields compensate for higher PD and lower recovery. Typical characteristics: floating or fixed rate, various covenants (less restrictive than IG covenants), used in LBOs and growth company financing. A is a government bond (low yield); C is a long-duration IG bond; D describes a PIK or contingent payment instrument.
Question 300
The primary function of a 'credit rating' from an investor's perspective is:
Select an option first.
Correct answer: B — To provide an independent, comparative assessment of the relative credit risk of an issuer or instrument, enabling investors to make informed credit risk decisions.
Explanation: Credit ratings: ordinal, comparative risk opinions. They help investors: (1) compare credit risk across issuers and geographies; (2) satisfy investment mandates; (3) benchmark credit spread. They are NOT guarantees (A), do NOT set rates (C), and are an input to regulatory capital but not the same thing (D).
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