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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 331
In the context of structured credit, the 'expected loss' approach to CDO tranche rating (used by Moody's) differs from the 'probability of first dollar loss' approach (used by S&P) in that:
Select an option first.
Correct answer: B — Expected loss approach rates tranches based on the expected loss (PD × LGD) of the tranche; probability approach rates based only on the probability of any loss occurring — these can give different ratings for identical tranches with different loss severity profiles.
Explanation: Rating methodology difference: a tranche with 10% probability of loss but 0.1% EL (loss is very small when it occurs) vs another with 10% probability of loss and 50% EL (catastrophic when it occurs) — same PD, very different EL. Expected loss method (Moody's) differentiates; probability method (older S&P approach) does not. This is why same-rated tranches from different agencies can have very different risk.
Question 332
A 'CDO warehouse' is used during the CDO ramp-up phase to:
Select an option first.
Correct answer: B — Allow the CDO manager/arranger to accumulate the reference portfolio (loans or bonds) before the CDO is formally issued, with the arranger taking the risk during accumulation.
Explanation: CDO warehouse: the arranger funds purchase of reference assets on its balance sheet (warehouse line of credit) while the CDO structure is being set up. This creates 'warehouse risk' for the arranger — if credits deteriorate during accumulation, the arranger bears the mark-to-market loss before the CDO is closed. A is a physical logistics metaphor; C and D are incorrect.
Question 333
A portfolio of 100 leveraged loans has a 99.9% credit VaR of $80m and an expected loss of $20m. The 'unexpected loss' at 99.9% confidence is:
Select an option first.
Correct answer: C — $60m
Explanation: Unexpected Loss = Credit VaR − Expected Loss = $80m − $20m = $60m. Capital is held for UL; provisions cover EL. A is total VaR; B adds EL to VaR; D is just EL.
Question 334
In a stressed credit environment, CLO equity tranches are most vulnerable because:
Select an option first.
Correct answer: B — They are the first to absorb losses, and in a stressed environment, rising defaults reduce portfolio income (as CDs are removed) and par value, potentially eliminating all distributions to equity investors.
Explanation: CLO equity stress: (1) rising defaults reduce portfolio par (OC ratio falls, cash flows diverted to senior) → less income for equity; (2) manager's par building capacity diminishes; (3) if OC tests fail continuously, equity receives nothing and eventually CLO is wound down. A, C, D are wrong.
Question 335
The primary reason that 'RMBS' (Residential Mortgage-Backed Securities) spreads widened dramatically in 2007-2008 was:
Select an option first.
Correct answer: B — A combination of deteriorating mortgage underwriting standards, falling US house prices, rising delinquencies and defaults, and sudden investor loss of confidence in rating agency assessments of underlying loan quality.
Explanation: 2007-08 RMBS crisis: (1) subprime/Alt-A underwriting deterioration (stated income, high LTV, teaser rates); (2) US housing price decline starting 2006; (3) prepayment models failed (expected refinancing didn't occur when house prices fell); (4) rating agencies had underestimated correlation and LGD — AAA-rated tranches suffered losses. A, C, D were contributing factors but B captures the core drivers.
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Question 336
A 'fixed recovery CDS' differs from a standard CDS in that:
Select an option first.
Correct answer: B — In a fixed recovery CDS, the recovery rate is fixed upfront (e.g., at 40% for corporate credits) rather than determined by the post-default auction, eliminating recovery rate uncertainty from the transaction.
Explanation: Fixed recovery CDS: recovery is agreed at inception rather than determined by the post-default auction. This separates recovery risk from default risk, allowing investors to specifically trade recovery rates. The protection buyer receives (1 − Fixed recovery) × Notional regardless of the actual auction outcome. A is wrong; C applies to full notional protection only; D is wrong.
Question 337
In structured finance, a 'cash flow CDO' generates returns for investors through:
Select an option first.
Correct answer: B — The scheduled cash flows (interest and principal repayments) from the underlying portfolio of loans or bonds, distributed according to the waterfall.
Explanation: Cash flow CDO: investors are repaid from natural asset cash flows (coupons and scheduled principal). Contrast with 'market value CDO' (investors repaid from portfolio liquidation proceeds). Modern CLOs are predominantly cash flow structures because they provide more predictable repayment. A is market value CDO; C and D are not CDO income sources.
Question 338
The 'long credit / short rates' combination trade in credit markets typically involves:
Select an option first.
Correct answer: B — Buying corporate bonds while selling Treasury futures or entering pay-fixed interest rate swaps — isolating the credit spread return and removing interest rate risk.
Explanation: Duration-neutral credit trade: long corporate bond (credit exposure + duration exposure) + short Treasury futures or pay-fixed IRS (removes duration exposure). The net position is long only the credit spread, immune to parallel rate moves. A adds rate duration; C is a relative value credit trade; D is a hedging strategy.
Question 339
A senior CLO note investor is evaluating the 'reinvestment risk' of a CLO in its reinvestment period. This risk refers to:
Select an option first.
Correct answer: B — The risk that the CLO manager reinvests principal proceeds into lower-quality or lower-spread loans, potentially reducing portfolio quality and note coverage over time.
Explanation: Reinvestment risk for CLO investors: manager has discretion over reinvestment within guidelines. If they trade into: (1) lower-spread loans (reducing WAS → less income buffer); (2) lower-rated loans (increasing WARF → higher default probability). Senior note investors monitor this through regular reports and covenants. A is rate risk; C is extension risk; D is key man risk.
Question 340
Under Basel III, the minimum Common Equity Tier 1 (CET1) ratio required is:
Select an option first.
Correct answer: B — 4.5% of risk-weighted assets (RWA).
Explanation: Basel III minimum CET1 = 4.5% of RWA. Plus Capital Conservation Buffer (2.5%) = 7.0%. Plus Countercyclical Buffer (0-2.5%) and G-SIB surcharge add further. Total capital minimum = 8.0% RWA (including Tier 2). A uses total assets (leverage ratio concept); C is total capital minimum; D includes conservation buffer.
Question 341
The Basel III 'Capital Conservation Buffer' (CCB) of 2.5% is held to:
Select an option first.
Correct answer: B — Provide an additional buffer above the minimum ratio that restricts capital distributions (dividends, buybacks) when eroded, incentivising capital preservation during stress.
Explanation: CCB: a buffer above the 4.5% CET1 minimum. When eroded (CET1 between 4.5% and 7%), automatic distribution restrictions (dividends, AT1 coupons, bonuses) activate to rebuild capital. It prevents banks from distributing capital at the worst possible time. A, C, D are other risk categories or provisions.
Question 342
The 'Standardised Approach' (SA) for credit risk under Basel calculates risk-weighted assets based on:
Select an option first.
Correct answer: B — Fixed risk weights assigned by regulators based on the borrower's credit rating or asset class (e.g., 0% for sovereign, 20% for banks, 100% for corporates).
Explanation: SA: uses prescribed risk weights (0%, 20%, 50%, 75%, 100%, 150%) based on counterparty type and external credit rating. No internal model required. IRB approaches (A) use bank-estimated parameters. C and D are not SA inputs.
Question 343
The Foundation IRB (F-IRB) approach for credit risk requires banks to estimate:
Select an option first.
Correct answer: A — Only their own PD; LGD, EAD, and maturity are prescribed by supervisors.
Explanation: Foundation IRB: banks estimate PD internally (using their internal rating models); supervisors prescribe LGD (45% for unsecured senior), EAD (via prescribed CCFs), and maturity (2.5 years). Advanced IRB (B) allows banks to estimate all four parameters.
Question 344
The Advanced IRB (A-IRB) approach for credit risk allows banks to use their own estimates of:
Select an option first.
Correct answer: B — PD, LGD, EAD, and effective maturity for corporate, bank, and sovereign exposures.
Explanation: A-IRB: banks estimate all four key parameters (PD, LGD, EAD, M) using their own validated internal models, subject to minimum data requirements and supervisory approval. Asset correlation (C) is prescribed by Basel formula, not bank-estimated. A and D are too restrictive.
Question 345
Under Basel's credit risk framework, 'risk-weighted assets' (RWA) are calculated as:
Select an option first.
Correct answer: B — Exposure × Risk weight, where the risk weight reflects the credit risk of the counterparty.
Explanation: RWA = EAD × Risk weight. The risk weight (0-150%+) converts the nominal exposure into a capital-equivalent amount. Capital requirement = RWA × Minimum capital ratio (e.g., 8%). C is related to economic capital calculation; A and D are incorrect.
Question 346
The Basel 'output floor' introduced in Basel IV restricts IRB banks by:
Select an option first.
Correct answer: B — Requiring that IRB-calculated RWA must be at least 72.5% of the RWA calculated under the Standardised Approach, limiting the benefit of internal model optimisation.
Explanation: Output floor (Basel IV): RWA_IRB ≥ 72.5% × RWA_SA. This prevents banks from using sophisticated models to drive capital below a regulatory floor. It limits 'model shopping' but preserves the incentive for better internal risk measurement. A, C, D are incorrect.
Question 347
A 'Pillar 2' capital add-on under the Basel framework is imposed by:
Select an option first.
Correct answer: B — The supervisory authority, following the Supervisory Review and Evaluation Process (SREP), to cover risks not adequately captured by Pillar 1 minimum requirements.
Explanation: Pillar 2 SREP: supervisor imposes institution-specific capital add-ons for: concentration risk, interest rate risk in the banking book (IRRBB), model risk, reputational risk, and other risks not fully captured by Pillar 1. A is internal capital planning; C and D are not Pillar 2 mechanisms.
Question 348
'Credit risk mitigation' under Basel includes which of the following techniques?
Select an option first.
Correct answer: B — Collateral, netting agreements, guarantees, and credit derivatives — all of which reduce the effective credit exposure or risk weight.
Explanation: Basel CRM: (1) collateral (financial and physical) — reduces LGD; (2) netting — reduces EAD; (3) guarantees/credit derivatives — substitute the guarantor's risk weight for the obligor's; (4) on-balance-sheet netting for loans and deposits. A, C, D are individual components of the full CRM framework.
Question 349
Under Basel, 'counterparty credit risk' (CCR) applies to:
Select an option first.
Correct answer: B — Derivative and securities financing transactions where the exposure to the counterparty can change as market prices move.
Explanation: CCR is specific to OTC derivatives, exchange-traded derivatives, and SFTs (repo, securities lending). The exposure is 'two-sided' — it fluctuates with market prices. Regular loans have fixed, known exposure. A is too broad; C is a subset; D is retail credit risk (not CCR).
Question 350
The 'Credit Valuation Adjustment' (CVA) represents:
Select an option first.
Correct answer: B — The market value of the risk of counterparty default on OTC derivative contracts — the difference between the risk-free value and the value accounting for counterparty default risk.
Explanation: CVA = E[EAD × LGD × PD × discount factor] — the expected cost of counterparty default. CVA is charged to P&L and represents the mark-to-market of counterparty credit risk. Basel III introduced a CVA capital charge to protect against mark-to-market CVA losses (not just actual defaults). A is credit spread; C is OpRisk capital; D is provisions.
Question 351
'Systemic risk' in banking refers to:
Select an option first.
Correct answer: B — The risk that the failure of one financial institution triggers a cascade of failures across the financial system due to interconnectedness and contagion.
Explanation: Systemic risk = contagion: one bank's failure impairs others through direct exposures (interbank lending, CDS), market confidence effects, and asset fire sales. The 2008 crisis exemplified systemic risk when Lehman's failure cascaded globally. A is idiosyncratic bank risk; C is IT operational risk; D is regulatory risk.
Question 352
A 'Global Systemically Important Bank' (G-SIB) is subject to additional capital requirements because:
Select an option first.
Correct answer: B — G-SIBs' potential failure would have disproportionately large systemic consequences — the surcharge makes them internalise the social cost of their systemic importance.
Explanation: G-SIB surcharge: an additional CET1 buffer (1.0-3.5%) based on the institution's systemic importance score (size, interconnectedness, substitutability, complexity, cross-border activity). This reduces the probability of G-SIB failure and its systemic consequences. A, C, D are not the rationale.
Question 353
The 'countercyclical capital buffer' (CCyB) is designed to:
Select an option first.
Correct answer: B — Accumulate capital during credit booms and release it during downturns, reducing the procyclical amplification of the credit cycle.
Explanation: CCyB (0-2.5% CET1): national authorities activate it when excessive credit growth creates systemic risk. During downturns, it is released, allowing banks to absorb losses without cutting lending. This countercyclical design directly addresses the procyclicality criticism of Basel II. A makes it permanent (wrong); C is too narrow; D is incorrect.
Question 354
Under Basel III, a 'Tier 2 capital' instrument typically has which characteristics?
Select an option first.
Correct answer: B — Minimum 5-year original maturity, subordinated to senior creditors, and absorbs losses only upon insolvency (gone-concern capital).
Explanation: Tier 2: subordinated debt, minimum 5-year original maturity, instruments that absorb losses in insolvency (gone-concern). AT1 (Additional Tier 1) has perpetual term (A) and fully discretionary coupon (D). Senior debt (C) is not regulatory capital. Tier 1 is going-concern; Tier 2 is gone-concern.
Question 355
'Recovery and Resolution Planning' (living wills) for G-SIBs requires:
Select an option first.
Correct answer: B — Banks to pre-plan how they can be resolved in an orderly manner without public funds, by identifying critical functions, removing barriers to resolution, and pre-positioning resources.
Explanation: Living wills (BRRD, Dodd-Frank): G-SIBs must demonstrate they can be resolved without systemic disruption or taxpayer funds. They must: (1) identify critical functions, (2) separate retail/wholesale banking where needed, (3) pre-position TLAC (Total Loss-Absorbing Capacity), (4) simplify group structure. A, C, D are not requirements.
Question 356
'TLAC' (Total Loss-Absorbing Capacity) for G-SIBs requires:
Select an option first.
Correct answer: B — A minimum amount of combined equity + long-term subordinated debt that can be 'bailed in' (written down or converted to equity) in resolution, protecting depositors and preventing taxpayer bailouts.
Explanation: TLAC: G-SIBs must hold ≥ 16-18% of RWA (phased in) in instruments eligible for bail-in (equity, AT1, Tier 2, and certain senior bonds). This creates loss-absorbing capacity in resolution. Bailing in TLAC holders — not taxpayers — absorbs losses. A is too narrow; C and D are not TLAC requirements.
Question 357
Which of the following is NOT one of the three Basel pillars?
Select an option first.
Correct answer: D — Mandatory credit insurance (Pillar 4).
Explanation: Basel framework has three pillars: Pillar 1 (minimum capital), Pillar 2 (supervisory review/ICAAP), Pillar 3 (market discipline/disclosure). There is no Pillar 4. A, B, C are genuine pillars.
Question 358
The 'Leverage Ratio' under Basel III is defined as:
Select an option first.
Correct answer: B — Tier 1 capital / Total exposure measure (on and off-balance-sheet, undiscounted).
Explanation: Leverage ratio = Tier 1 capital / Total Exposure ≥ 3%. It is a non-risk-based backstop — it treats all assets equally regardless of credit risk. This prevents banks from using internal models to achieve very low RWA while maintaining high absolute leverage. A and D are risk-based ratios; C is an accounting leverage measure.
Question 359
Credit governance at a bank refers to:
Select an option first.
Correct answer: B — The policies, processes, oversight structures, and risk appetite frameworks that govern how a bank identifies, measures, approves, and monitors credit risk.
Explanation: Credit governance encompasses: credit policy, approval authorities (individual approvers, credit committees), independent credit review, limit setting, portfolio monitoring, and escalation procedures. A is recovery/collections; C is accounting (IFRS 9); D is legal/enforcement.
Question 360
The 'three lines of defence' model in bank risk management assigns credit risk oversight to:
Select an option first.
Correct answer: B — (1) Business lines that originate credit (first line), (2) independent credit risk management (second line), and (3) internal audit (third line).
Explanation: Three lines: (1) First line = business units (relationship managers, traders) who own the risk and make credit decisions; (2) Second line = independent Risk Management function that sets standards and monitors; (3) Third line = Internal Audit that independently verifies controls. A, C, D are different governance structures.
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