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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 31
A borrower's 'leverage ratio' in credit analysis is most commonly expressed as:
Select an option first.
Correct answer: B — Total debt / EBITDA or Total debt / Total equity.
Explanation: Leverage ratios in credit analysis: Debt/EBITDA (the most common — measures years of earnings needed to repay debt), Debt/Equity, Net Debt/EBITDA. A is the equity ratio; C is the profit margin; D is the current (liquidity) ratio.
Question 32
The 'current ratio' in credit analysis measures:
Select an option first.
Correct answer: B — Current assets divided by current liabilities — a measure of short-term liquidity.
Explanation: Current ratio = Current assets / Current liabilities. A ratio > 1 means the firm can cover short-term liabilities with short-term assets. A is leverage; C is interest coverage; D is ROA.
Question 33
Which of the following is the most accurate definition of 'credit enhancement'?
Select an option first.
Correct answer: B — A structural or contractual mechanism that improves the credit quality of an obligation, reducing the probability or severity of loss for the creditor.
Explanation: Credit enhancements improve the credit profile: collateral, guarantees, over-collateralisation, subordination, reserve accounts, excess spread. They reduce LGD and/or PD from the creditor's perspective. A confuses yield with quality; C and D are specific techniques, not the general definition.
Question 34
In retail credit risk, a FICO or credit score primarily measures:
Select an option first.
Correct answer: B — A statistical prediction of the borrower's likelihood of defaulting on a credit obligation within a specified period.
Explanation: Credit scores (FICO, VantageScore) are statistical models using payment history, credit utilisation, length of credit history, credit mix, and new inquiries to predict default probability. They are ordinal risk rankings, not direct PD estimates. A, C, D are separate underwriting inputs.
Question 35
Which of the following best describes 'default' in a credit risk context?
Select an option first.
Correct answer: B — A borrower fails to make a scheduled payment of principal or interest, or breaches a material covenant.
Explanation: Default events: (1) failure to pay (missed payment of 90+ days), (2) material covenant breach, (3) bankruptcy/insolvency filing, (4) debt restructuring. A is a rating action; C is a price event; D is a financial stress indicator (not itself a default).
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Question 36
A 'credit default swap' (CDS) is best described as:
Select an option first.
Correct answer: B — A bilateral contract where the protection buyer pays a periodic premium and receives a contingent payment from the protection seller if a specified credit event occurs.
Explanation: CDS: protection buyer pays a fixed spread (e.g., 150bp/year × notional) to the protection seller. If the reference entity experiences a credit event (default, restructuring), the seller pays (1 − Recovery rate) × Notional to the buyer. A is an interest rate swap; C is a bond option; D is a floating-rate loan.
Question 37
The 'reference entity' in a CDS contract is:
Select an option first.
Correct answer: B — The company or sovereign whose credit risk is being transferred by the contract.
Explanation: The reference entity is the third party whose credit risk is referenced by the CDS — neither the buyer nor seller, but the company/sovereign on whose debt the contract provides protection. A is the protection buyer; C is the market maker; D is the CCP.
Question 38
A credit analyst states that the 'credit spread duration' of a bond portfolio is 4.5 years. This means:
Select an option first.
Correct answer: B — The portfolio's value will change by approximately 4.5% for each 100 basis point change in credit spreads.
Explanation: Credit spread duration (also called spread duration): the sensitivity of the bond's price to a 100bp parallel shift in credit spreads. CS01 = Spread duration × Portfolio value × 0.01%. A is average life/maturity; C is interest rate duration; D is historical data.
Question 39
Which of the following is a 'leading indicator' of credit deterioration for a corporate borrower?
Select an option first.
Correct answer: B — Rising leverage combined with declining interest coverage and deteriorating cash flow generation.
Explanation: Leading indicators of credit stress: rising debt levels with falling earnings quality, deteriorating DSCR, declining free cash flow, covenant stress. A is backward-looking; C is a concurrent market signal; D is a lagging indicator (downgrades follow deterioration).
Question 40
'Expected Loss' (EL) in a credit portfolio represents:
Select an option first.
Correct answer: B — The statistical average or mean credit loss over a given time horizon.
Explanation: EL = PD × LGD × EAD = the mean of the loss distribution. It is priced into lending margins and covered by provisions, not regulatory capital. A is a VaR concept; C is worst-case loss; D is unexpected loss.
Question 41
'Unexpected Loss' (UL) in a credit portfolio is:
Select an option first.
Correct answer: B — The volatility (standard deviation) of credit losses around the expected loss — the portion that bank regulatory capital must cover.
Explanation: UL = standard deviation of the credit loss distribution. Capital is held to absorb unexpected (adverse) losses beyond the EL. EL is covered by pricing/provisioning. A is through-the-cycle EL; C is event risk; D is a netting concept.
Question 42
Which of the following credit models was specifically developed to estimate default probability using a firm's equity price and balance sheet data?
Select an option first.
Correct answer: D — Both B and C, since they both use equity market data and balance sheet information.
Explanation: Both the Merton model (B) and KMV/EDF (C) use equity market prices (to infer asset value and volatility) combined with balance sheet data (to determine the default threshold = total liabilities). The Altman Z-score (A) uses financial ratios from accounting data only, not market prices.
Question 43
In the Merton structural model, default occurs when:
Select an option first.
Correct answer: B — The market value of the firm's assets falls below the face value of its debt at maturity.
Explanation: Merton (1974): treat equity as a call option on the firm's assets, with the debt face value as the strike price. At debt maturity, if Assets < Liabilities, the firm defaults (asset call is worthless). If Assets > Liabilities, shareholders receive the residual. A, C, D are observable signals but not the default condition in the model.
Question 44
What does 'Distance to Default' (DD) measure in the KMV model?
Select an option first.
Correct answer: B — The number of standard deviations the firm's asset value is from the default point — a higher DD means lower default probability.
Explanation: DD = (Asset value − Default point) / (Asset value × Asset volatility). Higher DD → more standard deviations to default → lower PD (EDF). KMV maps DD to an Estimated Default Frequency using a large empirical default database. A, C, D are not DD.
Question 45
A bank has a corporate loan with PD = 1.5%, LGD = 40%, and EAD = $20 million. The expected loss is:
Select an option first.
Correct answer: A — $120,000
Explanation: EL = PD × LGD × EAD = 1.5% × 40% × $20m = 0.006 × $20m = $120,000. B uses LGD=100%; C omits PD; D divides by 10.
Question 46
A borrower's annual PD is 2%. What is the approximate cumulative PD over 3 years, assuming independence?
Select an option first.
Correct answer: B — 5.88%
Explanation: Cumulative PD = 1 − (1−PD)^n = 1 − (0.98)^3 = 1 − 0.941 = 5.88%. A uses simple multiplication (3 × 2%); C overestimates; D is too low.
Question 47
In credit risk modelling, 'through-the-cycle' PD estimates are used in regulatory capital calculations because:
Select an option first.
Correct answer: B — They are more stable and reduce pro-cyclicality — capital requirements do not spike during recessions.
Explanation: TTC PDs are stable — they don't rise sharply in recessions. This prevents capital requirements from surging when banks most need to lend. PIT estimates (A) are more accurate for near-term default prediction (used in IFRS 9). C and D are incorrect.
Question 48
A bank uses historical data to estimate LGD. Which of the following factors most significantly influences LGD?
Select an option first.
Correct answer: B — The seniority of the debt and the quality/value of collateral.
Explanation: LGD is primarily driven by: (1) seniority in the capital structure (senior secured vs subordinated), (2) collateral quality and value, (3) bankruptcy process efficiency. Credit rating (A) affects PD more than LGD; currency (C) and maturity (D) are minor LGD drivers.
Question 49
The 'credit conversion factor' (CCF) for off-balance-sheet exposures (e.g., undrawn credit lines) is used to:
Select an option first.
Correct answer: B — Estimate the fraction of the undrawn commitment that is expected to be drawn before default, converting it to an equivalent on-balance-sheet EAD.
Explanation: CCF converts off-balance-sheet commitments to EAD: EAD = Drawn balance + CCF × Undrawn commitment. Borrowers under stress tend to draw down revolving facilities before defaulting. CCF ≈ 50-100% depending on facility type. A, C, D are incorrect descriptions.
Question 50
A revolving credit facility has $5 million drawn and $10 million undrawn. If CCF = 75%, the EAD is:
Select an option first.
Correct answer: B — $12.5 million
Explanation: EAD = Drawn + CCF × Undrawn = $5m + 75% × $10m = $5m + $7.5m = $12.5m. A ignores undrawn; C uses only undrawn × CCF; D uses only undrawn.
Question 51
In a ratings transition matrix, the row corresponding to an 'A'-rated borrower shows probability of 0.5% in the 'Default' column. This means:
Select an option first.
Correct answer: B — 0.5% of A-rated borrowers are expected to default within the transition period (usually 1 year).
Explanation: Transition matrix entries: rows = starting rating, columns = ending rating (or default). The 0.5% in the default column = 1-year PD for A-rated borrowers. A misreads the probability; C confuses spread and PD; D describes a specific downgrade probability.
Question 52
The Altman Z-score model predicts corporate bankruptcy using:
Select an option first.
Correct answer: B — A weighted combination of five financial ratios from accounting statements.
Explanation: Altman Z-score (1968): weighted sum of Working Capital/Assets, Retained Earnings/Assets, EBIT/Assets, Market Equity/Total Debt, Revenue/Assets. Scores below 1.8 indicate high bankruptcy risk; above 2.99 indicate low risk. A describes Merton/KMV; C describes empirical PD models; D is market data.
Question 53
The Merton model implies that equity can be valued as:
Select an option first.
Correct answer: B — A call option on the firm's assets with the debt face value as the strike price.
Explanation: Merton (1974): Equity = max(Assets − Debt, 0) at maturity, which is precisely the payoff of a European call option on the firm's assets with strike = debt face value. Shareholders exercise the call if Assets > Debt; otherwise they hand the firm to creditors. A is the put (which represents debt guarantee); C and D are incorrect.
Question 54
In the KMV model, the 'default point' is typically set at:
Select an option first.
Correct answer: B — Short-term debt plus 50% of long-term debt — reflecting the obligations most likely to trigger default in the near term.
Explanation: KMV empirically found that the default point (the asset value level triggering default) is best approximated by short-term liabilities + 50% of long-term liabilities, not total liabilities. This reflects the practical reality that long-term debt rarely causes immediate default unless due for renewal. A is total liabilities; C and D are equity-side measures.
Question 55
'Credit VaR' is defined as:
Select an option first.
Correct answer: B — The difference between the worst-case credit loss at a given confidence level and the expected credit loss.
Explanation: Credit VaR = Quantile loss (at confidence level α) − Expected Loss. It represents the unexpected loss at a given confidence level — the amount that capital must cover. A is EL; C is a default probability; D is capital (which is derived from credit VaR).
Question 56
A credit risk analyst says the portfolio's 99.9% credit VaR is $500 million and EL is $50 million. The economic capital required is approximately:
Select an option first.
Correct answer: B — $450 million
Explanation: Economic capital = Credit VaR − EL = $500m − $50m = $450m. Capital covers unexpected losses; EL is covered by provisioning/pricing. A adds EL to VaR; C is the gross VaR; D is just EL.
Question 57
A bank's loan has a PD of 2%, LGD of 50%, EAD of $10 million, and maturity of 3 years. Under Basel Advanced IRB, which of the following additional inputs is needed for the capital formula?
Select an option first.
Correct answer: B — A correlation parameter (ρ) determined by the supervisory formula based on PD.
Explanation: Basel IRB formula: K = LGD × N[...] using a prescribed asset correlation ρ = f(PD). For corporate exposures: ρ = 0.12×(1−e^(−50×PD))/(1−e^(−50)) + 0.24×(1−above). A, C, D are not inputs to the Basel capital formula.
Question 58
Which of the following best describes 'credit migration risk' in a bond portfolio?
Select an option first.
Correct answer: B — The risk of mark-to-market losses from a credit rating downgrade, even without a default event.
Explanation: Migration risk: a downgrade (e.g., from A to BBB) widens the credit spread → bond price falls → MTM loss in the trading book or economic loss in the banking book. CreditMetrics and similar models capture both default risk and migration risk. A is geographic; C is market structure; D is systematic spread risk.
Question 59
The 'recovery rate' for senior secured debt is typically higher than for senior unsecured debt because:
Select an option first.
Correct answer: B — Secured creditors have a specific claim over identified collateral assets, which take priority in liquidation.
Explanation: Secured lenders have a perfected legal claim over specific assets (property, equipment, receivables). In liquidation, secured creditors are paid first from those assets before unsecured creditors receive anything. A, C, D are incorrect — recovery is driven by collateral claim, not rate or maturity.
Question 60
In credit analysis, 'free cash flow to the firm' (FCFF) is important because:
Select an option first.
Correct answer: B — It represents the cash available to all capital providers (debt and equity) after reinvestment — the primary source of debt service and principal repayment.
Explanation: FCFF = EBIT × (1−tax rate) + D&A − ΔWorking Capital − CapEx. It is the cash available to service debt and equity after investing for growth. A is dividends (a subset); C is EBITDA (a proxy, not equal to FCFF); D is simplified operating cash flow.
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