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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 301
A $500m CLO has the following tranche structure: AAA (75%), AA (10%), A (7%), BBB (5%), Equity (3%). The first 3% of portfolio losses are absorbed by:
Select an option first.
Correct answer: B — The equity tranche.
Explanation: Equity tranche = first 3% of pool notional = first-loss piece. As losses accumulate from $0 to $15m (3% × $500m), only equity holders suffer losses. Only after equity is fully absorbed do BBB holders begin to lose principal. AAA (A) is last to absorb losses.
Question 302
A CDO has a 5-year maturity. Portfolio default correlation increases from 15% to 40% due to a macro shock. The primary impact on tranche values is:
Select an option first.
Correct answer: B — The equity tranche MTM improves (correlation 'long' benefits) while the senior tranche MTM deteriorates (correlation 'short' suffers).
Explanation: Correlation dynamics: equity = long correlation (high correlation → either all survive giving equity high income, or all default simultaneously — but equity was already cheap to buy as first loss). Senior = short correlation (high correlation → more chance of tail event reaching senior). A, C, D are incorrect.
Question 303
The 'weighted average spread' (WAS) covenant in a CLO requires:
Select an option first.
Correct answer: B — The portfolio's weighted average credit spread to be at or above a minimum level, ensuring sufficient income to pay all note holders and cover expenses.
Explanation: WAS test: if the portfolio's average spread falls below the minimum, the CLO manager cannot invest in lower-spread (higher-quality) loans without violating the test. This protects investors by ensuring the portfolio generates sufficient income. A is not how WAS works; C and D are wrong.
Question 304
A credit analyst is evaluating the 'servicer quality' of a mortgage-backed security. The key dimensions assessed are:
Select an option first.
Correct answer: B — Operational capacity (technology, staffing), loss mitigation capabilities (foreclosure timeline, modification success), remittance accuracy, and financial stability of the servicer.
Explanation: Servicer quality assessment: (1) operational: systems, staffing, scalability; (2) loss mitigation: ability to minimise losses through forbearance, modifications, efficient foreclosure; (3) financial: stability of the servicer company; (4) track record: historical remittance accuracy and delinquency management. A is too narrow; C and D are less relevant.
Question 305
In the CDX IG index, if a constituent company defaults, the following happens:
Select an option first.
Correct answer: B — The defaulted credit is removed from the index and settled (protection buyers receive (1−Recovery rate) × their pro-rata share), with the index continuing with 124 names at a reduced notional.
Explanation: Index default handling: the defaulted name is settled (cash or physical settlement), and the index continues with the remaining names. Notional is reduced proportionally. Index investors receive credit event compensation on the defaulted name's 1/125 share. A, C, D are wrong.
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Question 306
The 'primary market' for leveraged loans involves:
Select an option first.
Correct answer: B — Syndicating new leveraged loans originated by arranging banks to institutional investors (CLOs, hedge funds, loan mutual funds) — this is the primary issuance process.
Explanation: Leveraged loan primary market: arranger bank originates the loan, structures it (tenor, spread, covenants), and syndicates to institutional investors via a roadshow/book build. The loan is then funded and held by the syndicate. Secondary trading (A) occurs after primary placement. C and D are not primary leveraged loan market mechanisms.
Question 307
A CLO manager 'ramping up' the portfolio means:
Select an option first.
Correct answer: B — Deploying the initial note proceeds by purchasing leveraged loans from the market during the defined ramp-up period (typically 3-6 months) before the CLO starts its reinvestment period.
Explanation: CLO ramp-up: after note issuance, the manager invests the proceeds into loans. During ramp-up, cash is held in money market instruments until loans are purchased. The CLO must reach target portfolio size and composition before the reinvestment period formally begins. A, C, D describe different activities.
Question 308
In a synthetic CDO, the 'funded' portion consists of:
Select an option first.
Correct answer: B — The tranches where investors have physically paid cash upfront, which is invested in collateral (typically government securities), and which would be used to pay credit losses on the reference portfolio.
Explanation: Funded tranches: investors deposit cash when purchasing notes. This cash is invested in high-quality collateral (govvies). If a credit event occurs, the collateral is liquidated to make the credit event payment. Unfunded tranches (super-senior) are committed credit lines — no cash upfront.
Question 309
A 'distressed CDS' on a company trading at 500bp implies:
Select an option first.
Correct answer: B — The market prices significant default risk — at 500bp, the annual cost of protection is 5% of notional, implying the market sees meaningful near-term default probability.
Explanation: 500bp CDS spread: very elevated — associated with high-yield or near-distressed credits. Using PD ≈ Spread/LGD: at LGD=60%, PD ≈ 8.3%/year. At this spread, the market is pricing in significant near-term default risk. A describes investment-grade (typically 50-150bp); C and D are incorrect.
Question 310
The 'recovery rate in a credit event' under CDS is determined by:
Select an option first.
Correct answer: B — An ISDA-administered auction process where dealers submit bids for the defaulted reference entity's obligations, determining the 'final price' (recovery value).
Explanation: ISDA CDS auction: standardised post-credit-event settlement mechanism. Dealers provide two-way markets in the defaulted entity's obligations; the clearing price from the auction = the recovery rate. This prevents disputes and ensures uniform settlement across all CDS on that reference entity. A, C, D are prior estimates or non-standard settlement.
Question 311
A 'risk parity' strategy applied to credit portfolios involves:
Select an option first.
Correct answer: B — Weighting each credit position so that its contribution to total portfolio credit risk (e.g., credit VaR) is equal, rather than weighting by notional or market value.
Explanation: Risk parity in credit: each position sized so its marginal credit VaR contribution equals that of all others. This prevents a few large or high-spread names from dominating portfolio risk. A is equal notional (standard approach); C and D are different strategies.
Question 312
In credit portfolio management, 'credit delta' of a CDS measures:
Select an option first.
Correct answer: B — The change in CDS fair value (in dollars) for a 1bp change in the reference entity's credit spread.
Explanation: Credit delta (CS01) = ∂CDS_Value / ∂Spread. Used to: (1) compute P&L sensitivity to spread moves, (2) construct credit-neutral hedges. For a CDS with DV01-equivalent of $5,000 per basis point, a 10bp widening produces a $50,000 MTM gain for the protection buyer. A is IR delta (DV01); C and D are not standard definitions.
Question 313
A CLO that has breached its 'overcollateralisation test' (OC test) will:
Select an option first.
Correct answer: B — Divert interest payments that would normally flow to junior tranches and equity toward repayment of senior notes, deleveraging the structure until the OC test is cured.
Explanation: OC test breach: waterfall modification — interest payments that would go to mezzanine/equity are instead redirected to senior note principal amortisation. This deleverages the CLO (reduces senior note outstanding), improving OC ratios. After sufficient senior redemption, the test may be cured. A is incorrect (OC breach doesn't trigger note default); C is wrong; D may happen as a result of manager action but is not automatic.
Question 314
The 'Fitch vector model' and 'Moody's CDO rating methodology' differ primarily in:
Select an option first.
Correct answer: B — Their approach to modelling default correlation and portfolio stress — Fitch uses a vector approach (scenario analysis of loss combinations), while Moody's uses an expected loss framework with diversity scores and binomial expansion technique.
Explanation: Rating agency CDO methodologies: Moody's historically used the BET (Binomial Expansion Technique) with diversity scores; Fitch uses probability vector analysis; S&P uses CDO Evaluator. They differ in correlation modelling, stress scenarios, and recovery assumptions, leading to different tranche ratings for the same portfolio. A, C, D are incorrect.
Question 315
A 'credit index tranche' allows an investor to take a view on:
Select an option first.
Correct answer: B — Default correlation and the clustering of defaults within a specific loss band of the credit index — independent of the overall spread level.
Explanation: Index tranches: the investor is exposed only to losses within specific attachment/detachment points. If you buy protection on the 3-7% tranche, you profit if losses in the index fall between 3-7%. This isolates the correlation risk — not just overall spread risk — making it a pure correlation trade. A is untranched index; C and D are unrelated.
Question 316
The 'synthetic repo' market uses which instrument to create a synthetic lending/borrowing arrangement?
Select an option first.
Correct answer: B — Total return swaps (TRS) — the TRS receiver gains economic exposure to an asset without funding it, while the payer retains the asset but transfers the total return risk.
Explanation: Synthetic repo via TRS: (1) Payer holds the asset, receives fixed funding rate, pays total return (coupon + MTM) to receiver. Equivalent to a repo (lender holds asset as collateral, borrower gets cash). TRS is used when the physical repo market is illiquid or for off-balance-sheet purposes. A, C, D are different instruments.
Question 317
A CDO manager wishes to increase the portfolio's average credit quality by selling lower-rated loans and buying higher-rated ones. This is an example of:
Select an option first.
Correct answer: B — A defensive trading strategy — improving portfolio quality during credit deterioration to protect junior tranche holders and potentially cure failing quality tests.
Explanation: Defensive trading: selling deteriorating credits (risking downgrade, wider spreads) and buying higher-quality credits improves the WARating (weighted average rating factor) and WARF, potentially curing failing quality tests. This protects mezzanine and equity investors by stabilising the portfolio. A, C, D miss the defensive credit quality purpose.
Question 318
A 'bespoke tranche opportunity' (BTO) is a modern synthetic credit product that:
Select an option first.
Correct answer: B — Allows sophisticated investors to define a custom reference portfolio and tranche structure — gaining specific credit correlation exposure tailored to their views.
Explanation: BTO (formerly known as bespoke synthetic CDO): investor specifies: (1) reference portfolio; (2) tranche attachment/detachment; (3) maturity. Dealer creates the synthetic CDO tranche to these specs. Used by hedge funds and fixed income desks to take precise credit views. BTOs evolved from pre-2008 bespoke CDOs. A, C, D are incorrect.
Question 319
In credit risk portfolio management, 'single-name CDS' is used to hedge:
Select an option first.
Correct answer: B — The idiosyncratic credit risk of a specific issuer — for example, reducing concentrated exposure to a specific company.
Explanation: Single-name CDS hedge: buys protection on a specific issuer to reduce idiosyncratic concentration risk. E.g., a bank with $200m exposure to Company X buys $100m CDS protection on Company X — reduces net credit exposure to $100m. Index CDS (A) hedges systematic risk. C and D are different risk types.
Question 320
A bank holds a portfolio of corporate bonds and uses CDX IG to hedge the portfolio's systematic credit risk. The residual risk after the hedge is called:
Select an option first.
Correct answer: B — Basis risk — the difference in performance between the specific corporate bonds and the CDX IG index, which arises from differing compositions, liquidity, and name-specific factors.
Explanation: Basis risk in credit hedging: the CDX IG contains 125 equally-weighted names; the portfolio has specific names, weights, and credit quality differences. If the bank's specific bonds underperform the CDX (due to issuer-specific news), the CDX hedge won't fully compensate. C and D are specific risks not the hedging basis.
Question 321
A CLO's 'weighted average life' (WAL) test requires that:
Select an option first.
Correct answer: B — The weighted average time until principal repayment does not exceed a maximum level — ensuring the portfolio's maturity profile doesn't extend too long beyond the CLO note maturities.
Explanation: WAL test: the weighted average life of the loan portfolio must be ≤ maximum WAL threshold (e.g., ≤ 6 years). This prevents the CLO manager from loading up on long-dated loans that would mature after the CLO notes, creating maturity mismatch risk. A is WARF; C and D are other constraints.
Question 322
A 'toggle note' in leveraged finance is a form of 'payment-in-kind' (PIK) debt. This is most beneficial to:
Select an option first.
Correct answer: B — The borrower — it preserves cash during stress by allowing interest to be added to the principal rather than paid in cash, at the cost of increasing total indebtedness.
Explanation: PIK toggle: issuer can pay interest in cash or 'toggle' to PIK (capitalise). In stress (low cash generation), the issuer preserves cash by PIKing, but total debt grows. This increases the lender's ultimate credit risk but provides short-term cash flow relief. A, C, D are wrong.
Question 323
In CMBS analysis, a 'net operating income' (NOI) for a commercial property is calculated as:
Select an option first.
Correct answer: B — Gross rental income minus vacancy losses, operating expenses, and property management fees — the income available to service mortgage debt.
Explanation: NOI = Effective Gross Income (Gross rent − Vacancy − Credit loss) − Operating Expenses (insurance, maintenance, management, taxes — but NOT debt service or depreciation). NOI is the key input to DSCR (NOI / Debt service) and valuation (NOI / Cap rate). A is a valuation method; C and D are incorrect.
Question 324
A structured credit analyst observes that iTraxx Crossover 5-year spreads have widened from 350bp to 500bp. The MTM impact on a $100m notional long credit (short protection) position with approximately 4-year CS01 is approximately:
Select an option first.
Correct answer: B — A loss of approximately $6 million.
Explanation: MTM loss for short protection (long credit): Loss ≈ −ΔSpread × Duration × Notional = −1.50% × 4 × $100m = −$6m. Spread widening is adverse for the short protection/long credit holder. A has wrong sign; C uses wrong duration; D uses only 10bp change.
Question 325
The 'correlation smile' in CDO tranche pricing refers to:
Select an option first.
Correct answer: B — The observation that the implied correlation extracted from equity tranche prices tends to be lower than that extracted from senior tranche prices — suggesting the market uses different effective correlations for different loss tranches, inconsistent with a single Gaussian copula model.
Explanation: Compound correlation (or base correlation) inconsistency: the Gaussian copula cannot simultaneously fit equity and senior tranche market prices with a single correlation parameter. The implied correlation differs across tranches — the 'correlation smile'. This led to the development of base correlation as a more consistent quoting convention.
Question 326
A portfolio manager constructs a 'long credit' position by selling protection on CDX IG and simultaneously buying protection on CDX HY to hedge sector-level risk. The net position is:
Select an option first.
Correct answer: B — Long investment-grade versus short high-yield credit — a 'quality trade' expressing the view that investment-grade will outperform high-yield on a relative basis.
Explanation: Relative value quality trade: short protection on IG (long IG credit) + long protection on HY (short HY credit) = long quality / short risk. Profitable if IG outperforms HY (e.g., in a risk-off environment where HY spreads widen more than IG). A is wrong; C and D are different hedges.
Question 327
A CLO manager faces a 'par building' problem when the portfolio's market value has declined below the original purchase price. In this situation, reinvesting principal proceeds into existing loans at below-par prices:
Select an option first.
Correct answer: B — Increases the portfolio par value by acquiring loans at a discount — if $10m par of loans is bought for $8m, the portfolio par increases by $10m for $8m of cash invested.
Explanation: Par building: buying loans at 80 cents on the dollar with $8m of cash adds $10m of par to the portfolio → increases OC ratios → potentially cures OC test breaches. This is a key tool CLO managers use when portfolios are stressed. A, C, D are incorrect.
Question 328
In CLO analysis, the 'reinvestment test' (typically minimum WAS or minimum WARF) constrains the CLO manager's ability to:
Select an option first.
Correct answer: B — Reinvest in new loans that would cause the portfolio to violate quality tests — e.g., the manager cannot invest in a loan that causes the weighted average spread to fall below the minimum WAS threshold.
Explanation: Reinvestment restrictions: during reinvestment, manager must ensure all trades keep quality tests passing. If minimum WAS = 350bp and current WAS = 355bp, the manager cannot buy a loan with spread < 350bp without violating the test. This constrains active management during credit deterioration. A is too broad; C and D are other CLO mechanics.
Question 329
The market for 'credit default swap options' (CDS options / swaptions) allows investors to:
Select an option first.
Correct answer: B — Buy or sell the option to enter into a CDS at a specified spread on the option expiry date — used to hedge volatility in CDS spreads or express forward views on credit.
Explanation: CDS options: payer option (right to pay fixed spread — gains when spreads widen) and receiver option (right to receive fixed spread — gains when spreads tighten). Used for credit vol hedging and expressing views on spread direction and volatility. European style (exercise only at expiry). A, C, D are not CDS option features.
Question 330
A structured credit product manager observes that the 'base correlation' at the 3% attachment point is 30% while at the 10% attachment point it is 45%. This upward-sloping base correlation smile implies:
Select an option first.
Correct answer: B — The market prices the 0-10% tranche with a higher effective correlation than the 0-3% tranche — reflecting that losses reaching higher attachment points require more systematic (correlated) shocks.
Explanation: Upward-sloping base correlation: the implied correlation increases with attachment point. This reflects that reaching higher attachment points requires more correlated defaults — a higher systematic factor shock. The base correlation framework was developed to resolve the compound correlation inconsistency. A, C, D are incorrect interpretations.
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