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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 61
A credit spread of 200 basis points over the risk-free rate on a 5-year bond implies an approximate risk-neutral annual PD (assuming LGD = 100%) of:
Select an option first.
Correct answer: B — 2.0%
Explanation: Approximation: Spread ≈ PD × LGD. With LGD = 100%: PD ≈ Spread = 2.0% per year. If LGD = 50%: PD ≈ 4.0% per year. A uses 0.1×spread; C uses 5×spread; D uses 10×spread.
Question 62
The 'credit spread puzzle' refers to the observation that:
Select an option first.
Correct answer: B — Corporate bond credit spreads are wider than can be explained by historical default losses alone — the excess reflects risk premia, liquidity premia, and tax effects.
Explanation: Empirically, credit spreads exceed the compensation for expected credit losses (PD × LGD). The difference reflects: (1) systematic credit risk premium, (2) liquidity premium, (3) tax effects, (4) jump-to-default risk. A reverses the observation; C is empirically false; D is approximately true in liquid markets but not always.
Question 63
Which of the following is the primary limitation of using only historical default rates to estimate future PD?
Select an option first.
Correct answer: B — Historical data reflects past economic cycles and may not capture future conditions, structural breaks, or rare but plausible scenarios not present in the sample.
Explanation: Historical PD limitation: backward-looking data from benign periods underestimates downturn PDs; data from severe downturns overstates normal-period PDs. Structural changes (regulatory reform, industry disruption) can invalidate historical relationships. A reverses the direction; C and D are factually incorrect.
Question 64
An EBITDA interest coverage ratio of 1.2× for a leveraged borrower indicates:
Select an option first.
Correct answer: B — The borrower is barely covering interest from operating earnings — a modest earnings decline could create interest payment difficulties.
Explanation: ICR = EBITDA / Interest expense. A ratio of 1.2× means only 20% headroom above interest obligations — very tight. Any revenue or margin decline could push the ratio below 1.0× (interest is not covered from operations). A overstates; C confuses ICR with leverage; D is a cash reserve metric.
Question 65
A structured credit analyst is reviewing a leveraged buyout (LBO). The primary credit concern in an LBO is:
Select an option first.
Correct answer: B — The dramatic increase in debt burden post-acquisition, which increases leverage and reduces debt service coverage, materially increasing default risk.
Explanation: In an LBO, private equity acquires a company using mostly debt, dramatically increasing leverage (often 6-8× EBITDA). The resulting interest burden may be barely covered by operating cash flows, making the credit highly sensitive to any earnings decline. A is a shareholder concern; C is pre-existing shareholders; D is FX risk.
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Question 66
The 'debt service coverage ratio' (DSCR) for project finance is defined as:
Select an option first.
Correct answer: B — Operating cash flow available for debt service / Total debt service (interest + principal).
Explanation: DSCR = Operating cash flow / (Interest + Principal repayments). For project finance, DSCR > 1.0× is required for the project to service debt from its own cash flows. A is ROA; C is a leverage ratio; D is asset turnover variant.
Question 67
A lender is assessing an asset-backed loan secured by commercial real estate. The most important credit metric is:
Select an option first.
Correct answer: B — The loan-to-value ratio (LTV) and debt service coverage ratio (DSCR).
Explanation: Commercial real estate credit: LTV measures collateral coverage (lower is safer); DSCR measures whether property income covers debt service. LTV ≤ 65-70% and DSCR ≥ 1.25× are typical thresholds. A is for consumer credit; C and D are less relevant for asset-backed loans.
Question 68
In retail credit risk management, a 'scorecard' is used to:
Select an option first.
Correct answer: B — Rank borrowers by their estimated default probability, enabling consistent, automated credit decisions at scale.
Explanation: Retail credit scorecards (FICO, application scorecards, behavioural scorecards) produce a numerical score that ranks borrowers by default probability. Lenders set accept/reject cut-offs and risk-based pricing based on scores. A, C, D oversimplify the credit decision.
Question 69
'Seasoning' in mortgage credit risk refers to:
Select an option first.
Correct answer: B — The tendency for mortgage default rates to follow a hump-shaped pattern — rising for the first 3-5 years then declining as weaker borrowers self-select out.
Explanation: Mortgage seasoning: default rates are low initially (screening effect), peak around years 3-5 (stressed borrowers reveal themselves), then decline (surviving loans are performed well). Seasoned mortgage pools have lower expected default rates than newly originated pools at the same LTV.
Question 70
The Debt-to-EBITDA ratio is commonly used in leveraged finance because:
Select an option first.
Correct answer: B — It provides a simple estimate of how many years of current earnings are needed to repay total debt, capturing both leverage and debt service capacity.
Explanation: Debt/EBITDA = leverage in years of cash earnings. Common thresholds: investment grade typically < 3×, leveraged loans typically 4-7×. At 5× Debt/EBITDA, the firm would need 5 years of full EBITDA to repay debt (all else equal). A is net profit margin; C is interest coverage; D is short-term liquidity.
Question 71
A bank's credit portfolio has 500 loans, each with PD = 1% and LGD = 40%. The default correlation between any two loans is 0.10. Under the Vasicek one-factor model, the portfolio's 99.9% credit VaR (unexpected loss) is primarily driven by:
Select an option first.
Correct answer: B — Both the systematic risk factor (common credit factor) and idiosyncratic firm-specific factors, with the systematic factor being the key driver of tail losses.
Explanation: Vasicek model: conditional on a systematic factor Z (the state of the economy), defaults are independent. The distribution of Z drives simultaneous default clustering. Credit VaR at 99.9% is determined by the conditional default rate under a very adverse Z scenario. With 500 loans, idiosyncratic risk is diversified, leaving systematic risk as the key driver.
Question 72
In the Merton model, as a firm's debt level increases (all else equal), what happens to its equity value and the implied PD?
Select an option first.
Correct answer: B — Equity value decreases (leverage effect) and PD increases (firm is closer to default point).
Explanation: Higher debt: (1) default point rises → firm's asset value is closer to threshold → higher PD; (2) equity (call on assets with higher strike) has less intrinsic value → equity value falls. This is the Merton leverage effect — high debt increases both default probability and equity volatility (distance to default decreases).
Question 73
A credit analyst estimates the 'asset value' and 'asset volatility' of a firm using the Merton model. Which of the following inputs are required?
Select an option first.
Correct answer: B — The firm's market capitalisation (equity value), equity volatility, total face value of debt, risk-free rate, and debt maturity.
Explanation: Merton calibration: solve two simultaneous equations for asset value (V_A) and asset volatility (σ_A) using: (1) Equity = BSM call option on assets (with known E, σ_E, D, r, T), and (2) σ_E × E = N(d₁) × σ_A × V_A. Inputs: market equity E, equity volatility σ_E, face value of debt D, risk-free rate r, maturity T.
Question 74
'Wrong-way risk' in credit risk management refers to:
Select an option first.
Correct answer: B — The adverse correlation between credit exposure and counterparty creditworthiness — exposure is highest precisely when the counterparty is most likely to default.
Explanation: Wrong-way risk: when a positive exposure to a counterparty increases as the counterparty's credit quality deteriorates. Example: buying CDS protection from a bank that is itself exposed to the same systemic risk as the reference entity. This correlation between exposure and default probability amplifies expected and unexpected losses.
Question 75
A portfolio manager uses a 'credit rating migration matrix' to estimate the 1-year distribution of portfolio credit losses. Which of the following is a key assumption that limits this approach?
Select an option first.
Correct answer: B — The migration matrix assumes the Markov property — future rating migration depends only on the current rating, not on the history of past migrations.
Explanation: Markov assumption: the probability of transitioning from rating A to rating B in year 2 depends only on the current rating, not on whether the borrower was upgraded or downgraded to reach the current rating. Empirically, rating momentum (recently downgraded firms have higher PD than stable same-rating firms) violates this assumption.
Question 76
In credit risk, 'procyclicality' refers to:
Select an option first.
Correct answer: B — The amplification of economic cycles by credit conditions — easy credit in booms that fuels overheating, followed by credit tightening in recessions that deepens the downturn.
Explanation: Procyclicality: (1) in booms — lenders loosen standards, providing more credit, fuelling asset prices and growth; (2) in recessions — lenders tighten sharply, restrict credit, amplifying the downturn. Basel III countercyclical capital buffers and TTC rating calibration are designed to reduce procyclicality.
Question 77
A firm's Distance to Default (DD) is 2.0 standard deviations. Under the assumption of normally distributed asset returns, the implied PD is approximately:
Select an option first.
Correct answer: B — 2.3%
Explanation: PD ≈ N(−DD) = N(−2.0) ≈ 2.28% ≈ 2.3%. The probability that a standard normal variable is less than −2.0 = 2.28%. This is the risk-neutral PD under Merton/KMV. A uses DD directly; C is N(−1.0); D is N(0).
Question 78
A credit analyst is building a model to predict default using logistic regression. The primary advantage of logistic regression over linear regression for this application is:
Select an option first.
Correct answer: B — Logistic regression constrains predictions to the [0,1] interval, making them interpretable as probabilities of default — unlike linear regression which can produce predictions outside this range.
Explanation: Logistic regression: P(Default) = 1/(1+e^(−βX)), bounded between 0 and 1. Linear regression can produce negative probabilities or probabilities > 1, which are mathematically meaningless. Logistic regression is the standard for binary outcome (default/no default) credit models. A, C, D are incorrect.
Question 79
The 'information value' (IV) statistic in credit scoring measures:
Select an option first.
Correct answer: B — The predictive power of each independent variable in distinguishing defaulters from non-defaulters.
Explanation: IV = Σ (% Goods − % Bads) × WoE, where WoE = ln(% Goods / % Bads). IV measures how well each characteristic (e.g., payment history, utilisation) separates good accounts from bad accounts. IV > 0.3 is considered strong. A is R²; C is accuracy or AUROC; D is a single correlation.
Question 80
The 'Gini coefficient' in credit scoring is used to measure:
Select an option first.
Correct answer: B — The discriminatory power (rank-ordering ability) of a credit model — a Gini of 0 means no discriminatory power, a Gini of 1 means perfect separation of good and bad borrowers.
Explanation: Gini = 2 × (AUROC − 0.5). It measures how well the scorecard ranks borrowers from lowest to highest default probability. A random model has Gini = 0; a perfect model has Gini = 1. Gini of 0.6-0.8 is considered strong for retail credit. A is the macroeconomic Gini concept; C is portfolio default rate; D is concentration.
Question 81
'Stressed Expected Loss' in IFRS 9 provisioning uses:
Select an option first.
Correct answer: B — Forward-looking macroeconomic scenarios with probability weightings to produce a probability-weighted ECL estimate.
Explanation: IFRS 9 ECL: P(ECL) = Σ PD_scenario × LGD × EAD × probability_of_scenario. Multiple macro scenarios (base, upside, downside) are probability-weighted. This captures forward-looking macroeconomic information beyond historical averages. A is backward-looking; C is optimistic (wrong direction); D ignores macroeconomic forward-look.
Question 82
The 'probability of default conditional on the credit cycle' (downturn PD) is used in regulatory capital calculations because:
Select an option first.
Correct answer: B — Regulators require capital that is sufficient to survive a severe economic downturn, not just average conditions — downturn PDs reflect stress-period default rates.
Explanation: Basel IRB: capital must be sufficient for a 99.9% confidence level loss, which corresponds to a severe economic downturn. Downturn PD (or the correlation parameter that drives conditional default rates) ensures capital reflects stress-period conditions, not benign average conditions. A is a consequence, not the reason; C and D are wrong.
Question 83
Which of the following credit risk metrics best captures the 'jump to default' risk of a single bond?
Select an option first.
Correct answer: D — The bond's jump-to-default (JTD) sensitivity — the full loss given an immediate default, calculated as (1 − Recovery rate) × Notional − Current MTM value of the bond.
Explanation: JTD = the mark-to-market loss if the reference entity defaults tomorrow: (1−RR)×Notional minus any current gain already reflected in the bond price. CS01 (C) measures sensitivity to small spread changes; duration (A) measures interest rate sensitivity; spread duration (B) measures sensitivity to parallel spread moves.
Question 84
In the context of credit risk modelling, 'backtesting' a PD model means:
Select an option first.
Correct answer: B — Comparing the model's predicted default rates with actual observed default rates over a historical validation period to assess model accuracy.
Explanation: Backtesting: out-of-sample comparison of predicted PDs vs. realised defaults. A well-calibrated model should produce predicted PDs that match actual defaults statistically (e.g., Hosmer-Lemeshow test, binomial test). A describes forward testing; C is sensitivity analysis; D is benchmarking.
Question 85
A credit risk manager observes that a portfolio's expected loss increases in a recession while the capital required also rises. This is an example of:
Select an option first.
Correct answer: B — Procyclicality — risk measurements and capital requirements are correlated with the economic cycle, amplifying downturns.
Explanation: Procyclicality problem: in recessions, PDs rise → EL rises → capital requirements rise → banks must reduce lending exactly when the economy needs credit most. This amplifies the recession. Countercyclical capital buffers and TTC rating calibration are designed to reduce this effect. A is incorrect (diversification doesn't prevent EL increases); C and D don't address the procyclicality issue.
Question 86
A 'vintage analysis' of a loan portfolio examines:
Select an option first.
Correct answer: B — The default and loss performance of loans grouped by their origination period (vintage year) to identify patterns in underwriting quality over time.
Explanation: Vintage analysis: comparing the default rates and loss severity of loans originated in different years reveals whether underwriting standards changed over time (e.g., loans originated in 2006-07 showed much higher defaults than loans originated in 2003). Used in portfolio management, securitisation analysis, and regulatory review.
Question 87
The 'Hosmer-Lemeshow test' is commonly used in credit risk modelling to:
Select an option first.
Correct answer: B — Test whether the predicted default probabilities from a logistic regression model are well-calibrated to actual observed default rates across deciles of predicted probability.
Explanation: Hosmer-Lemeshow: calibration test for logistic regression. Groups predictions into deciles, compares expected defaults to actual within each group using a chi-squared statistic. A low test statistic (high p-value) indicates good calibration. A is macro factor modelling; C is AUROC/Gini; D is matrix granularity.
Question 88
Which of the following best explains why the 'credit spread' tends to be wider for less liquid bonds?
Select an option first.
Correct answer: B — Investors demand a 'liquidity premium' as additional compensation for the difficulty of selling the bond in the secondary market without significant price concession.
Explanation: Credit spread = expected loss compensation + credit risk premium + liquidity premium. Illiquid bonds (small issue size, infrequent trading) require a higher liquidity premium because the holder may be unable to exit at a fair price. A, C, D are not the reason for the liquidity premium specifically.
Question 89
In credit risk, the term 'obligor' refers to:
Select an option first.
Correct answer: B — The borrower or counterparty that is obligated to make payments under a credit obligation.
Explanation: Obligor = the borrower — the party that owes money or has a credit obligation. This is distinct from the guarantor (A), the bond trustee (C), or the CCP (D). 'Single-obligor concentration risk' refers to excessive exposure to one borrower.
Question 90
Which of the following correctly distinguishes 'expected loss' from 'economic capital' in bank credit risk management?
Select an option first.
Correct answer: B — Expected loss is the mean of the loss distribution (priced into margins and covered by provisions); economic capital is the additional buffer for unexpected losses at a given confidence level.
Explanation: EL = mean of loss distribution → covered by provisions/pricing. Economic capital = quantile of loss distribution − EL = unexpected loss at confidence level → covered by capital. A is wrong; C is always false (UL ≥ 0); D reverses the regulatory/internal distinction.
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