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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 211
A 'CDO manager' who is 'discretionary' versus 'static' CLO manager:
Select an option first.
Correct answer: A — Discretionary managers select credits; static managers do not trade after issuance.
Explanation: Managed (discretionary) CLO: active management during reinvestment period — manager buys/sells loans within guidelines. Static CLO: portfolio fixed at inception, no trading (only held to maturity or prepayment). Most modern CLOs are managed, allowing portfolio optimisation. B, C, D are wrong.
Question 212
A 'structured covered bond' differs from a traditional covered bond primarily in that:
Select an option first.
Correct answer: A — It uses an SPV to provide bankruptcy remoteness to the cover pool.
Explanation: Structured covered bond: uses an SPV (like securitisation) rather than statutory covered bond framework. The SPV holds the cover pool, providing bankruptcy remoteness similar to ABS. Traditional covered bonds (A) rely on legislative frameworks (Pfandbrief law, UK regime) where the issuing bank retains assets on balance sheet. B, C, D are not defining distinctions.
Question 213
In ABS structures, 'credit card receivables' securitisation differs from mortgage ABS because:
Select an option first.
Correct answer: B — Credit card receivables are revolving (new receivables continuously replace repaid balances during the revolving period) and have very short individual tenors — creating different prepayment and portfolio stability dynamics.
Explanation: Credit card ABS: revolving pool — as cardholders repay, new purchases replace old receivables. During revolving period, the trust maintains constant pool balance. After the amortisation trigger, new receivables stop entering the pool. Short-duration receivables (weeks-months) mean rapid portfolio turnover vs 25-year mortgages. A, C, D are incorrect.
Question 214
The 'deal sponsor' in a CLO transaction is:
Select an option first.
Correct answer: B — The investment manager that sets up the CLO structure, manages the loan portfolio, and typically invests in a meaningful portion of the equity tranche to align incentives with investors.
Explanation: CLO sponsor/manager: creates the CLO vehicle, selects/manages loans, typically retains equity (risk retention compliance + alignment of interest). Earns management fees (senior/subordinated) and participates in equity upside. A is rating agency; C is warehouse lender; D is CLO trustee.
Question 215
In structured credit, the 'mezzanine carry trade' involves:
Select an option first.
Correct answer: B — Purchasing mezzanine CDO or CLO tranches (typically BBB-BB rated) to earn their relatively high spread income, while accepting the risk of being in the middle of the loss distribution.
Explanation: Mezzanine carry: buying mezzanine notes (typically BB-rated CLO tranches at SOFR+500-900bp or BBB at SOFR+200-350bp) to earn above-investment-grade returns while accepting: (1) first loss after equity is exhausted; (2) limited liquidity; (3) complexity risk. Popular with insurance companies and credit hedge funds seeking yield. A, C, D are different strategies.
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Question 216
The 'over-the-counter' (OTC) CDS market has shifted significantly toward central clearing because:
Select an option first.
Correct answer: B — Post-2008 regulatory reforms (Dodd-Frank, EMIR) mandated central clearing for standardised CDS to reduce systemic counterparty credit risk, increase transparency, and enable multilateral netting.
Explanation: Mandatory clearing (Dodd-Frank Title VII, EU EMIR): standardised index CDS (CDX, iTraxx) and most single-name CDS must be cleared through CCPs (CME, LCH). Benefits: (1) multilateral netting reduces gross bilateral exposure; (2) daily margining limits risk; (3) CCP default fund provides additional protection; (4) price transparency. A, C, D are incorrect.
Question 217
In credit risk, a 'quanto CDS' references credit risk of one entity but pays in a different currency. The additional risk compared to a standard CDS is:
Select an option first.
Correct answer: B — The correlation between the reference entity's default probability and the exchange rate — if the default and currency depreciation are positively correlated (wrong-way risk), the hedge is less effective.
Explanation: Quanto CDS: pay in currency X but reference entity in currency Y. Additional risk: if the reference entity defaults and simultaneously the domestic currency (currency Y) depreciates (making the foreign currency payout more expensive), this creates wrong-way risk — the two adverse events compound each other. Standard CDS ignores this FX-credit correlation.
Question 218
A 'credit risk overlay' on an equity portfolio involves:
Select an option first.
Correct answer: B — Using CDS or credit index products to add credit spread risk exposure to a portfolio that would otherwise only have equity risk — earning additional carry from credit spreads.
Explanation: Credit overlay: adding credit exposure (long credit/short protection) to an equity portfolio to earn credit spread carry without disturbing the equity allocation. The credit overlay provides additional return (CDS premium income) while adding credit spread risk. A changes the portfolio type entirely; C uses equity options; D is leverage.
Question 219
A collateralised debt obligation (CDO) is best described as:
Select an option first.
Correct answer: B — A structured finance vehicle that pools a portfolio of credit-sensitive assets and issues multiple tranches of securities with different risk/return profiles.
Explanation: CDO: an SPV pools assets (bonds, loans, CDS) and issues tranches (equity, mezzanine, senior) with different seniority and risk. Equity absorbs first losses; senior tranches are last to take losses. A, C, D are different instruments.
Question 220
In a CDO structure, the 'waterfall' refers to:
Select an option first.
Correct answer: A — The sequential process by which cash flows from the underlying assets are distributed to different tranches — senior tranches are paid first, with residual cash flows flowing down to junior tranches.
Explanation: Waterfall: interest and principal payments flow from senior to junior tranches in order of seniority. If defaults occur, losses first reduce junior tranche value before affecting senior. This structural priority is the core credit enhancement mechanism. B, C, D describe different CDO features.
Question 221
A 'CLO' (Collateralised Loan Obligation) differs from a 'CDO' primarily in that:
Select an option first.
Correct answer: B — CLOs are backed specifically by a pool of leveraged loans (typically bank loans to speculative-grade corporate borrowers), while CDOs can be backed by a wider variety of credit-sensitive assets.
Explanation: CLO is a specific type of CDO where the collateral pool consists primarily of leveraged loans. CDOs is the broader category including CDOs backed by bonds (CBO), mortgages (MBS), ABS, or synthetic credit via CDS. A reverses the instrument types; C and D are incorrect.
Question 222
A 'synthetic CDO' uses credit default swaps rather than physical assets because:
Select an option first.
Correct answer: B — Synthetic CDOs allow the structure to reference credit risk without physically purchasing the underlying bonds, enabling larger volumes and more flexible portfolio selection.
Explanation: Synthetic CDO: the SPV sells CDS protection on a reference portfolio (instead of buying physical bonds). The SPV receives CDS premium income and is obligated to pay losses on reference credits. This allows referencing credits that may not be available in cash markets and enables unfunded structures. A is wrong; C and D are not the primary reasons.
Question 223
A 'mortgage-backed security' (MBS) is created by:
Select an option first.
Correct answer: B — Pooling a collection of mortgage loans and transferring them to an SPV, which issues securities backed by the mortgage cash flows.
Explanation: MBS securitisation: a pool of mortgages is sold (true sale) to an SPV, which funds the purchase by issuing MBS to investors. The SPV's assets (mortgage cash flows) back the securities. A is covered bonds (different structure); C and D are not MBS mechanisms.
Question 224
'Prepayment risk' in mortgage-backed securities arises because:
Select an option first.
Correct answer: B — Mortgage borrowers may repay their loans early (especially when interest rates fall), returning principal to MBS investors at a time when reinvestment rates are lower.
Explanation: Prepayment risk: when rates fall, borrowers refinance → MBS investors receive early principal return → must reinvest at lower rates. This creates 'negative convexity' — MBS prices rise less than expected when rates fall (prepayment caps upside). A is credit risk; C is servicer/operational risk; D is collateral/credit risk.
Question 225
A credit default swap's 'protection buyer' benefits most when:
Select an option first.
Correct answer: B — The reference entity experiences a credit event (default or restructuring), triggering payment from the protection seller.
Explanation: Protection buyer pays premium, receives payment upon credit event. They effectively hold a short position in the reference credit — they profit from credit deterioration (default or spread widening). A benefits the protection seller; C is unrelated; D increases the fair value of the existing CDS for the buyer but is different from actual settlement.
Question 226
The 'fair value' of a CDS protection contract increases when:
Select an option first.
Correct answer: B — The reference entity's credit spread widens — increasing the probability of a credit event and the expected payout.
Explanation: CDS fair value for the protection buyer increases with wider credit spreads (higher default probability → higher expected payout). Narrowing spreads (A) reduce CDS value for the buyer. Lower rates (C) have a second-order effect. Shorter tenor (D) reduces the remaining premium stream — generally reduces fair value.
Question 227
A 'total return swap' (TRS) on a bond allows the total return receiver to:
Select an option first.
Correct answer: B — Gain exposure to all economic returns (coupon + price changes) of the reference bond without purchasing it, while paying a floating rate to the total return payer.
Explanation: TRS: receiver gets all cash flows of the reference asset (coupons + price appreciation) and pays floating rate (e.g., SOFR + spread) to the payer. The receiver is economically long the asset without funding it. The payer retains the asset but has transferred the total return risk. A describes a CDS (credit risk hedge); C and D are incorrect.
Question 228
In a 'first-to-default' basket CDS, the protection buyer receives payment when:
Select an option first.
Correct answer: B — The first entity in the reference basket experiences a credit event — after which the contract terminates.
Explanation: First-to-default (FTD) CDS: pays when the first default occurs in the reference basket. After the first default, the contract terminates. The protection buyer is long the cheapest-to-default entity's risk. FTD is more expensive than single-name CDS on any individual entity in the basket (due to basket effect). A is last-to-default; C and D are not standard FTD definitions.
Question 229
A 'credit-linked note' (CLN) is:
Select an option first.
Correct answer: B — A debt instrument where the issuer's obligation to repay principal is contingent on the absence of a specified credit event — effectively embedding CDS risk in a funded note.
Explanation: CLN: investor funds the note; if a credit event occurs on the reference entity, the investor receives reduced (or no) principal. The issuer is effectively buying credit protection from the investor. CLNs combine funded investment with credit risk transfer. A is wrong; C and D are different instruments.
Question 230
'Over-collateralisation' in a structured finance transaction means:
Select an option first.
Correct answer: A — The SPV holds more assets than necessary to back the face value of issued securities, providing a cushion against asset losses.
Explanation: OC: if the asset pool is worth $120m and securities issued are $100m, OC ratio = 120%. The extra $20m absorbs losses before any tranche is affected. OC is one of several credit enhancement mechanisms. B, C, D describe different structures.
Question 231
The 'equity tranche' of a CDO is sometimes called the 'first-loss piece' because:
Select an option first.
Correct answer: B — It is the first to absorb portfolio losses, acting as a buffer for mezzanine and senior investors.
Explanation: Equity (first-loss) tranche: absorbs losses from the first dollar of portfolio loss up to its principal amount. Only after equity is exhausted do mezzanine investors begin to lose money. In exchange for absorbing first losses, equity investors receive the residual income (highest yield). A is true but not the definition of 'first-loss'; C reverses seniority; D is incorrect.
Question 232
In a CLO structure, the CLO manager's primary role is to:
Select an option first.
Correct answer: B — Select and actively manage the portfolio of leveraged loans within defined investment guidelines, with the goal of maximising returns while staying within risk constraints.
Explanation: CLO manager: selects loans for the portfolio (during the reinvestment period), monitors credit quality, trades in/out of positions within covenants, and manages the waterfall distribution. A is underwriting/placement agent; C is a guarantor; D is the loan servicer.
Question 233
'Excess spread' in a securitisation refers to:
Select an option first.
Correct answer: B — The difference between interest income generated by the asset pool and the total interest paid on all issued notes — a credit enhancement buffer that absorbs losses before principal is affected.
Explanation: Excess spread = Asset yield − Liability cost − Expenses. It is the first line of defence against losses in securitisation — losses are charged against excess spread before touching principal of any tranche. A, C, D describe other concepts.
Question 234
A 'covered bond' differs from a securitisation because:
Select an option first.
Correct answer: B — In a covered bond, the issuing bank retains the assets on its balance sheet and investors have dual recourse — to the issuing bank and to the cover pool.
Explanation: Covered bonds (e.g., Pfandbriefe, UK covered bonds): assets stay on the bank's balance sheet; investors have a claim against both the bank (general recourse) and the cover pool (specific recourse). This dual recourse gives covered bonds AAA ratings with lower yield than securitisation. A describes securitisation (SPV); C and D are wrong.
Question 235
'Sovereign CDS' protects against which type of credit event?
Select an option first.
Correct answer: B — A national government's default, restructuring, or repudiation of its sovereign debt.
Explanation: Sovereign CDS reference entities are national governments (e.g., Greek, Italian, emerging market sovereigns). Credit events: failure to pay, restructuring, repudiation/moratorium. A is corporate CDS; C is bank default; D is not a standard CDS credit event.
Question 236
The 'cheapest-to-deliver' option in CDS physical settlement means:
Select an option first.
Correct answer: B — After a credit event, the protection buyer has the right to deliver any deliverable obligation (bond or loan) of the reference entity and receive par — incentivising delivery of the lowest-priced (most impaired) obligation.
Explanation: Physical settlement: protection buyer delivers a deliverable obligation and receives par from the seller. The buyer will choose the cheapest deliverable bond (lowest market price = highest loss). This option belongs to the protection buyer and affects CDS pricing and recovery rate assumptions. A, C, D are incorrect.
Question 237
A 'CDS index' such as CDX North America IG refers to:
Select an option first.
Correct answer: B — A standardised CDS contract that references an equally-weighted portfolio of 125 investment-grade North American corporate credits.
Explanation: CDX IG: equally weighted portfolio of 125 IG North American corporates. Buying protection on CDX IG provides portfolio-level credit protection. It is the most liquid credit derivative product. A is single-name CDS; C is the term structure; D is government-administered (incorrect).
Question 238
The 'delta' of a CDS contract measures:
Select an option first.
Correct answer: B — The change in the market value of the CDS for a 1bp widening of the credit spread (CS01).
Explanation: CDS delta (CS01) = change in CDS mark-to-market per 1bp spread widening. It is used for risk management — to understand the CDS book's sensitivity to credit spread movements. A describes the spread sensitivity of the premium (not exactly delta); C is event probability; D is IR sensitivity (DV01).
Question 239
In a 'bespoke' CDO, the reference portfolio is:
Select an option first.
Correct answer: B — A portfolio specifically designed by the arranger and investor, tailored to the investor's credit views and risk preferences.
Explanation: Bespoke CDOs: custom portfolios agreed between the dealer and a specific investor — the investor can express specific credit views, concentrations, or exclusions. Standardised CDOs use index portfolios (CDX, iTraxx). A, C, D are constraints that do not apply to bespoke structures.
Question 240
'Correlation trading' in structured credit refers to:
Select an option first.
Correct answer: B — Taking positions in CDO tranches or index tranches that express views on default correlation — high correlation benefits equity tranches (all-or-nothing payoff), while low correlation benefits senior tranches.
Explanation: Correlation is the key driver of CDO tranche values. Equity tranches are 'long correlation' (high correlation → either all survive or all default — equity prefers when all survive with high income). Senior tranches are 'short correlation' (low correlation → losses spread among junior tranches, not reaching senior). A, C, D are different concepts.
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