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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 91
Which of the following best describes 'credit risk transfer'?
Select an option first.
Correct answer: B — Moving credit exposure from the originating lender to third parties through instruments such as CDS, securitisation, guarantees, or loan sales.
Explanation: Credit risk transfer allows banks to reduce balance-sheet credit exposure, obtain regulatory capital relief, and diversify risk. Instruments include CDS (unfunded), securitisation (funded), guarantees, and loan participations. A is a write-off; C is equity conversion; D is an accounting reclassification.
Question 92
The primary purpose of a loan covenant in credit risk management is:
Select an option first.
Correct answer: B — To provide lenders with early warning signals and contractual rights to take protective action if the borrower's financial condition deteriorates.
Explanation: Covenants serve two purposes: (1) provide early warning of deterioration (financial covenant tests), (2) give lenders legal rights to accelerate, increase pricing, or require additional collateral. They are monitoring tools and protective mechanisms, not repayment guarantees. A is a step-up coupon feature; C is a guarantee; D is a transfer restriction.
Question 93
A 'syndicated loan' differs from a bilateral loan primarily because:
Select an option first.
Correct answer: B — A syndicated loan involves multiple lenders (a 'syndicate') providing funds to a single borrower under a common set of terms, with each lender holding a pro-rata share of the exposure.
Explanation: Syndicated loans: an arranger structures a large loan and invites multiple banks/investors to participate. Each lender holds a portion of the total facility. This allows banks to extend large credits while managing concentration risk. A, C, D are not defining characteristics.
Question 94
In credit risk, 'exposure netting' reduces risk by:
Select an option first.
Correct answer: B — Combining positive and negative mark-to-market values across multiple contracts with the same counterparty, so that only the net positive exposure is at risk in a default.
Explanation: Netting (bilateral netting via ISDA Master Agreement): if Bank A owes Counterparty B $30m on one trade and B owes A $50m on another, the net exposure = $20m (in A's favour). Without netting, A risks $50m. Netting dramatically reduces gross credit exposure in large derivative portfolios. A, C, D are incorrect.
Question 95
Which of the following financial ratios is most commonly used to assess short-term liquidity of a corporate borrower?
Select an option first.
Correct answer: B — Current ratio (Current assets / Current liabilities)
Explanation: Current ratio measures short-term liquidity — whether the borrower has enough current assets to cover current liabilities. Ratios below 1.0 signal short-term payment risk. A measures leverage; C measures debt service capacity; D measures equity return.
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Question 96
The 'net stable funding ratio' (NSFR) is a regulatory liquidity metric that:
Select an option first.
Correct answer: B — Requires banks to fund long-term illiquid assets with stable, longer-term funding sources, reducing structural liquidity risk.
Explanation: NSFR (Basel III): Available Stable Funding / Required Stable Funding ≥ 100%. It ensures banks don't rely excessively on short-term wholesale funding to finance long-term assets. This is a liquidity risk metric, not directly a credit risk metric. A, C, D are incorrect.
Question 97
A 'loan participation' allows a bank to:
Select an option first.
Correct answer: B — Sell an undivided interest in a loan to another investor while remaining the lender of record — transferring economic exposure but not legal ownership.
Explanation: Loan participation: the originating bank remains the lender of record (the borrower deals only with the original bank) but sells a participatory interest to another institution, transferring the economic credit risk. In a 'loan assignment', full legal title is transferred (C). A is a co-origination; D is loan consolidation.
Question 98
A 'non-performing loan' (NPL) is generally defined as:
Select an option first.
Correct answer: B — A loan where the borrower is 90 or more days past due on principal or interest payments, or where full repayment is considered unlikely.
Explanation: NPL definition (EBA, Basel): 90+ days past due or 'unlikely to pay' criteria. NPLs require higher provisions and additional regulatory capital. A is a below-market rate loan; C is a written-off loan (may overlap but not synonymous); D is an unrated loan.
Question 99
In credit risk, 'forbearance' refers to:
Select an option first.
Correct answer: B — A concession granted by a lender to a borrower experiencing financial difficulty — such as a payment holiday, interest rate reduction, or maturity extension — to help the borrower avoid default.
Explanation: Forbearance: the lender makes concessions it would not otherwise consider — indicating the borrower is in financial difficulty. Under IFRS 9, forbearance is a strong indicator of SICR (significant increase in credit risk) and typically triggers Stage 2 or Stage 3 classification.
Question 100
A 'credit scoring model' for retail loans typically uses which of the following as the primary input variables?
Select an option first.
Correct answer: B — Payment history, credit utilisation, length of credit history, types of credit, and recent credit inquiries.
Explanation: Retail credit scoring (FICO): the five factor categories are (1) payment history (~35%), (2) amounts owed/utilisation (~30%), (3) length of history (~15%), (4) credit mix (~10%), (5) new credit/inquiries (~10%). A is wealth data rarely used in scoring; C and D may have limited use but are not the primary inputs.
Question 101
The concept of 'credit exposure' differs from 'notional amount' in derivatives because:
Select an option first.
Correct answer: B — Credit exposure = the replacement cost of the derivative if the counterparty defaults (max(MTM, 0)), which can be far smaller than the notional amount that drives the contract's cash flows.
Explanation: Derivatives: notional is used to calculate cash flows but is rarely at risk. Credit exposure = current positive MTM (potential loss if counterparty defaults now). A $100m notional interest rate swap might have a credit exposure of only $2-5m (the MTM value). A is wrong; C is wrong; D is wrong (exposure
Question 102
A 'bilateral' credit exposure on a derivative means:
Select an option first.
Correct answer: B — Both counterparties face credit risk to each other — when the MTM is positive to one party, that party has credit exposure to the other.
Explanation: Bilateral CCR: the direction of MTM changes over time. When the swap MTM is +$5m to Bank A, A has exposure to B. If MTM flips to −$5m, B has exposure to A. Both parties are simultaneously exposed over the life of the contract, though only one is in the money at a given time.
Question 103
Which of the following best describes 'sovereign risk' versus 'country risk'?
Select an option first.
Correct answer: B — Sovereign risk is specifically the risk of a government defaulting on its own obligations; country risk is broader and includes political risk, transfer risk, currency risk, and legal risk affecting all entities in that country.
Explanation: Sovereign risk is a subset of country risk. Country risk encompasses: (1) sovereign default risk, (2) political risk (expropriation, instability), (3) transfer and convertibility risk (capital controls), (4) currency risk, (5) legal and regulatory risk. A company can face country risk even if the sovereign itself does not default.
Question 104
A bank's credit risk appetite is operationalised through:
Select an option first.
Correct answer: B — A system of credit policies, underwriting guidelines, portfolio limits, and individual transaction limits that constrain credit activity within approved risk boundaries.
Explanation: Credit risk appetite operationalisation: (1) credit policy (eligible borrower types, industries, geographies); (2) underwriting guidelines (minimum financial ratios, maximum LTV); (3) portfolio limits (sector, country, single-name concentrations); (4) transaction limits (maximum individual loan size). A, C, D are too narrow or regulatory.
Question 105
In retail mortgage lending, a 'loan-to-income' (LTI) ratio is used to:
Select an option first.
Correct answer: B — Assess the borrower's ability to repay by comparing the loan amount to the borrower's annual income — higher LTI ratios indicate higher default risk.
Explanation: LTI = Loan amount / Annual income. An LTI of 4.5× means the borrower owes 4.5 years of income. Higher LTI → more leveraged → harder to repay if income falls. Macroprudential authorities use LTI caps to restrain excessive mortgage lending. A, C, D are different metrics.
Question 106
A corporate bond has a yield of 6.5% and the equivalent Treasury bond yields 3.5%. Assuming LGD = 60%, the implied annual PD from the spread is approximately:
Select an option first.
Correct answer: A — 5.0%
Explanation: Spread = 6.5% - 3.5% = 3.0%. PD ≈ Spread / LGD = 3.0% / 60% = 5.0%. B uses Spread directly as PD (ignores LGD); C uses LGD/Spread; D is too high.
Question 107
A bank has 200 corporate loans each with PD = 0.5%, LGD = 40%, EAD = $5m, and zero default correlation. The portfolio expected loss is:
Select an option first.
Correct answer: B — $2,000,000
Explanation: Portfolio EL = n × PD × LGD × EAD = 200 × 0.5% × 40% × $5m = 200 × $10,000 = $2,000,000. A uses $500k (wrong multiplier); C divides; D uses full EAD.
Question 108
A credit analyst uses the Altman Z-score to evaluate a manufacturing company. The Z-score is 1.5. This suggests:
Select an option first.
Correct answer: B — The company is in the 'distress zone' (Z < 1.81) — high probability of financial distress or bankruptcy within 2 years.
Explanation: Altman Z-score zones: Z > 2.99 = safe; 1.81 < Z < 2.99 = grey zone; Z < 1.81 = distress zone. Z = 1.5 is below 1.81 → distress zone → high bankruptcy probability. C applies to Z between 1.81 and 2.99; A and D describe safe zone.
Question 109
A firm has total assets of $500m, total liabilities of $300m, and asset volatility of 25%. Under the Merton model, the Distance to Default (DD) is approximately:
Select an option first.
Correct answer: B — 1.6 standard deviations
Explanation: DD = (Asset value − Default point) / (Asset value × Asset volatility) = ($500m − $300m) / ($500m × 25%) = $200m / $125m = 1.6 standard deviations. A uses wrong denominator; C uses ($200m/$250m); D doubles the numerator.
Question 110
Two bonds have the same credit rating (BB) but Bond A has a 2-year maturity and Bond B has a 10-year maturity. Which bond has the higher credit spread and why?
Select an option first.
Correct answer: B — Bond B has a higher spread because longer maturity means more time for credit quality to deteriorate and more interest rate uncertainty.
Explanation: For the same credit rating, longer maturity = higher cumulative default probability over the life of the bond = higher credit spread. The term structure of credit spreads is typically upward-sloping for investment-grade credits. A and D reverse the relationship; C ignores maturity's impact on spread.
Question 111
A credit analyst estimates that a company's PD will double next year due to deteriorating industry conditions. If the company currently pays a CDS spread of 150bp (assuming LGD = 50%), the new CDS spread should be approximately:
Select an option first.
Correct answer: C — 300bp
Explanation: CDS spread ≈ PD × LGD. Current: 150bp = PD × 50% → PD = 3.0%. After doubling: PD = 6.0%. New spread = 6% × 50% = 3.0% = 300bp. A is unchanged; B is 1.33× (incorrect); D halves (wrong direction).
Question 112
Under the IFRS 9 ECL model, the 'probability-weighted ECL' for a borrower is calculated using:
Select an option first.
Correct answer: B — Multiple forward-looking macroeconomic scenarios (at minimum: base, upside, downside) weighted by their probability of occurrence.
Explanation: IFRS 9 requires unbiased, probability-weighted ECL using multiple macroeconomic scenarios. ECL = Σ(scenario probability × ECL under that scenario). A single scenario (A) is not IFRS 9 compliant. C is backward-looking; D is regulatory capital input, not IFRS 9.
Question 113
A bank's credit portfolio has EL = $100m and the 99.9% credit VaR = $800m. The Unexpected Loss (UL) that must be covered by regulatory capital is:
Select an option first.
Correct answer: C — $700m
Explanation: UL = Credit VaR − EL = $800m − $100m = $700m. Capital covers UL; EL is covered by provisions/pricing. A is total VaR; B adds EL to VaR (incorrect); D is just EL.
Question 114
Which of the following best explains the 'credit migration effect' on a bond portfolio's return?
Select an option first.
Correct answer: B — Changes in credit rating cause changes in credit spreads, which produce mark-to-market gains (upgrades) or losses (downgrades) even without a default event.
Explanation: Migration effect: an upgrade (e.g., B to BB) narrows spreads → bond price rises → capital gain. A downgrade → wider spreads → price falls → capital loss. CreditMetrics models both default and migration risk within the same framework. A is partially true but incomplete; C and D are wrong.
Question 115
The 'KMV model' maps 'Distance to Default' to 'Expected Default Frequency' (EDF) using:
Select an option first.
Correct answer: B — An empirically derived mapping from a large proprietary database of actual historical defaults, providing real-world (not risk-neutral) default probabilities.
Explanation: KMV innovation: rather than using N(-DD) from the normal distribution (Merton's approach), KMV uses an empirical mapping — at a given DD level, what percentage of companies actually defaulted historically? This produces more accurate, real-world EDFs. A is the theoretical Merton approach; C and D are not KMV inputs.
Question 116
Which credit risk indicator is most useful as a 'leading indicator' of corporate credit deterioration?
Select an option first.
Correct answer: B — Deteriorating trend in free cash flow coverage of debt service, rising leverage, and tightening financial covenant headroom.
Explanation: Leading indicators: deteriorating financial trends (falling FCF, rising leverage, covenant stress) anticipate future credit problems before they are reflected in ratings (lagging indicators) or equity prices. A is backward-looking; C is typically a lagging indicator; D is concurrent, not leading.
Question 117
In project finance credit analysis, the 'debt service coverage ratio' (DSCR) is calculated at the project level as:
Select an option first.
Correct answer: B — Net operating cash flow available for debt service / Total debt service (interest + principal).
Explanation: DSCR = (Revenue − Operating costs − Taxes) / (Interest + Principal). DSCR > 1.2× is typically required to provide a safety margin above break-even. For project finance, the lender relies solely on project cash flows (no recourse to sponsors typically). A is revenue/debt ratio; C is profit/equity; D is LTV.
Question 118
A bank lender receives a financial model showing a leveraged buyout borrower with a projected Debt/EBITDA of 7× at close. The primary credit concern is:
Select an option first.
Correct answer: B — The highly leveraged capital structure leaves little room for earnings decline — even a modest EBITDA shortfall could cause distress and difficulty servicing debt.
Explanation: LBO credit risk: at 7× Debt/EBITDA, interest payments may consume 50%+ of EBITDA. Any revenue or margin decline reduces the ability to service debt. Lenders stress-test EBITDA scenarios: how much can EBITDA fall before interest coverage drops below 1.0×? A, C, D are secondary concerns.
Question 119
In the context of credit risk, 'wrong-way risk' is most likely to arise in:
Select an option first.
Correct answer: B — A CDS where the reference entity is in the same industry and geographic market as the protection seller — adverse credit conditions for the reference entity also weaken the protection seller.
Explanation: Wrong-way risk: the monoline insurer example — providing CDS protection on mortgage-backed securities while being fully exposed to the same US housing market. When housing defaults increased, MBS values fell AND the monoline's own credit deteriorated simultaneously. A is normal bilateral CCR; C and D are other risk types.
Question 120
The 'through-the-cycle' versus 'point-in-time' distinction matters most in which context?
Select an option first.
Correct answer: B — Calibrating credit risk models — TTC produces stable, cycle-neutral PD estimates used in regulatory capital (avoiding procyclicality), while PIT estimates reflect current conditions and are used in IFRS 9 ECL provisioning.
Explanation: TTC vs PIT use cases: (1) TTC → stable regulatory capital (Basel IRB) — prevents capital amplifying economic cycles; (2) PIT → responsive IFRS 9 provisions — reflects current economic reality for accounting. Using PIT in regulatory capital would be highly procyclical; using TTC for IFRS 9 would understate near-term losses.
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