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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 241
'Securitisation arbitrage' in CDOs refers to:
Select an option first.
Correct answer: B — Structuring a CDO where the yield on the asset pool exceeds the blended cost of the issued tranches plus fees, generating an 'arbitrage' profit for the equity tranche holder.
Explanation: CDO arbitrage: asset yield (e.g., 8%) > liability cost (e.g., 5% blended) + expenses → excess spread goes to equity. The 'arbitrage' refers to this spread capture, not a true risk-free arbitrage. CDO equity investors earn high returns by being leveraged long the credit portfolio. A, C, D describe different strategies.
Question 242
In the context of structured credit, 'cliff risk' refers to:
Select an option first.
Correct answer: B — The sudden, sharp increase in losses when portfolio defaults exceed a threshold level — tranches below the attachment point are wiped out and the next tranche is exposed.
Explanation: Cliff risk: CDO tranches have binary-like payoff — the tranche is protected until cumulative losses exceed its subordination level (cliff) and then experiences rapid loss. Junior tranches experience cliff risk when the first losses hit; senior tranches experience cliff risk when junior buffers are exhausted.
Question 243
A 'constant proportion debt obligation' (CPDO) is a leveraged credit strategy that:
Select an option first.
Correct answer: B — Dynamically adjusts its exposure to a credit index using leverage to target a specified return, with leverage increasing as the net asset value declines.
Explanation: CPDO: uses leverage to sell protection on a credit index (e.g., CDX IG), targeting a high nominal yield. As NAV falls (credit losses), leverage increases to maintain yield targets — a procyclical strategy that can unwind rapidly in credit crises. A is passive investing; C is CDO structure; D is sovereign-specific.
Question 244
In ABS (Asset-Backed Securities), the 'servicer' is responsible for:
Select an option first.
Correct answer: B — Collecting payments from the underlying borrowers, managing delinquencies and defaults, and passing through cash flows to the SPV/investors.
Explanation: Servicer: manages the day-to-day administration of underlying assets — billing, collections, loss mitigation (forbearance, modification), and remittance to the trust. A is originator/underwriter; C is the loan originator/portfolio manager; D is credit enhancement provider.
Question 245
A CDO squared (CDO²) has as its collateral:
Select an option first.
Correct answer: B — Tranches from other CDOs — it is a CDO whose reference portfolio consists of CDO tranches rather than direct loans or bonds.
Explanation: CDO²: collateral = tranches of other CDOs. This creates extreme leverage and correlation complexity — the performance depends on second-order default correlations. CDO² dramatically amplify losses when underlying CDOs perform poorly simultaneously, as was seen in 2008. A, C, D are first-generation CDO collateral.
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Question 246
In a 'tranche' of a CDO, the 'attachment point' refers to:
Select an option first.
Correct answer: B — The level of cumulative portfolio losses at which the tranche first begins to incur losses.
Explanation: Tranche definition: attachment point (lower loss boundary) and detachment point (upper loss boundary). The tranche is exposed only to losses between its attachment and detachment points. An equity tranche has attachment = 0% (takes first losses from 0%). A mezzanine tranche at 3-7% attachment begins losing when cumulative losses exceed 3% of the portfolio.
Question 247
A 5-year CDS on Company X has a spread of 250 basis points. Assuming $10 million notional and quarterly premium payments, the quarterly premium payment is:
Select an option first.
Correct answer: A — $62,500
Explanation: Annual premium = 250bp × $10m = 2.5% × $10m = $250,000. Quarterly = $250,000 / 4 = $62,500. B is annual; C is annual with wrong calculation; D is monthly.
Question 248
Under CDS cash settlement (auction settlement), the protection buyer receives:
Select an option first.
Correct answer: B — (1 − Final price determined by the ISDA auction) × Notional — the compensation for the mark-to-market loss implied by the post-default bond price.
Explanation: Cash settlement: auction determines the recovery value of the reference entity's bonds. Settlement = (1 − Auction price / 100) × Notional. If Auction price = 35 (35 cents on dollar, implying 65% loss), payment = 65% × Notional. A is physical settlement; C is incorrect; D ignores recovery.
Question 249
A portfolio manager holds a long CDS position (protection buyer) with notional $50m, current spread 300bp, and original spread 200bp. The approximate mark-to-market gain is:
Select an option first.
Correct answer: C — Approximately $2.5 million (100bp × 5-year duration × $50m)
Explanation: MTM gain ≈ Change in spread × Duration × Notional = 100bp × 5 years × $50m = 0.01 × 5 × $50m = $2.5m. A is too small; B is 100bp × $50m without duration; D is the full notional.
Question 250
Which of the following correctly describes the 'iTraxx Europe' CDS index?
Select an option first.
Correct answer: B — An index of 125 European investment-grade corporate CDS, the primary benchmark for European credit markets.
Explanation: iTraxx Europe: 125 most liquid European IG corporate CDS, equally weighted, 5-year maturity, semi-annual roll. It is the key benchmark for European IG credit risk. CDX IG (A) is North American; iTraxx Crossover is European HY (D); specific sovereign indices exist separately (C).
Question 251
In a CLO, the 'reinvestment period' is the time during which:
Select an option first.
Correct answer: B — The CLO manager can reinvest principal repayments from existing loans into new loans, maintaining the portfolio balance.
Explanation: CLO reinvestment period (typically 4-5 years): the manager actively manages the portfolio, replacing repaid loans with new ones. After this period, the CLO enters the 'amortisation period' where principal is distributed to investors in order of seniority rather than reinvested.
Question 252
'Portfolio correlation' is the single most important determinant of which tranche in a CDO is most affected by a change in correlation?
Select an option first.
Correct answer: B — The equity tranche — it is most sensitive to correlation because it benefits from diversification in low-correlation environments but suffers in high-correlation environments.
Explanation: Equity tranche correlation sensitivity: (1) low correlation → losses spread among few names → equity likely wiped but total loss limited; (2) high correlation → either all survive (equity earns high income) or all default (equity wiped but expected fewer total losses in the binary outcome). Equity is 'long correlation.' Mezzanine is most complex; senior is 'short correlation.' A and D are wrong; C is oversimplified.
Question 253
A 'credit event' under ISDA documentation typically includes which of the following?
Select an option first.
Correct answer: B — Failure to pay, bankruptcy, and restructuring — three of the standard credit events defined in ISDA master agreements.
Explanation: ISDA standard credit events: Failure to Pay, Bankruptcy, Restructuring, Obligation Acceleration, Obligation Default, Repudiation/Moratorium. The most common are Failure to Pay and Bankruptcy. A rating downgrade (C) is not itself a credit event. A and D are not ISDA credit events.
Question 254
'Recovery locks' in CDS markets allow counterparties to:
Select an option first.
Correct answer: B — Fix the recovery rate assumption for settlement purposes, separating the market's default probability view from the recovery rate assumption.
Explanation: Recovery locks (recovery rate locks): a bilateral agreement to fix the recovery rate assumption for a given reference entity. This allows dealers and investors to separately trade default risk (PD) and recovery risk (RR), since CDS normally bundle both. A, C, D describe different mechanisms.
Question 255
A structured finance analyst is comparing a 'cash CDO' to a 'synthetic CDO'. The primary advantage of a synthetic CDO from the arranger's perspective is:
Select an option first.
Correct answer: B — Synthetic CDOs can be created without physically acquiring the reference bonds — the SPV references credit risk via CDS, enabling larger deals, faster execution, and access to credits not available in cash markets.
Explanation: Synthetic advantage: (1) no need to source physical bonds (unlimited scalability), (2) can reference any named credit even if no bonds are available, (3) faster execution (no bond acquisition), (4) can create partially funded structures. A, C, D are not the primary reason for using synthetics.
Question 256
A 'payment-in-kind' (PIK) toggle note is a leveraged finance instrument where:
Select an option first.
Correct answer: B — The issuer has the option to pay interest in cash or by issuing additional debt (PIK interest), allowing cash conservation during stress periods — at the cost of increasing total indebtedness.
Explanation: PIK toggle: issuer can 'toggle' between cash pay and PIK (where interest is capitalised as additional debt). Used in leveraged buyouts to reduce near-term cash interest burden. The tradeoff: debt increases over time if PIK is elected. A is cash pay; C is convertible note; D is zero-coupon bond.
Question 257
In asset-backed commercial paper (ABCP) programmes, the primary credit risk is:
Select an option first.
Correct answer: B — The credit quality of the underlying assets (receivables, loans, leases) held in the conduit — which are funded by short-term ABCP issuance.
Explanation: ABCP conduit: issues short-term CP to fund purchases of longer-term assets (receivables, mortgages, auto loans). Primary credit risk = quality of underlying assets. If assets perform poorly and CP cannot be rolled over, the liquidity facility provided by the sponsor bank is drawn. B is correct; A is secondary (bank provides liquidity but not primary risk); C and D are market risks.
Question 258
A leveraged loan is characterised by:
Select an option first.
Correct answer: B — A loan to a highly leveraged corporate borrower (typically rated below investment grade) with a floating interest rate, often used to fund leveraged buyouts.
Explanation: Leveraged loans: speculative-grade corporate loans (often Debt/EBITDA > 4×), floating rate (SOFR + spread), syndicated by banks, traded in the secondary market. Used in LBOs and debt refinancings. A is government-backed; C is an investment-grade bond; D is a high-LTV mortgage.
Question 259
The 'loan-to-value' (LTV) ratio in real estate lending measures:
Select an option first.
Correct answer: B — The ratio of the outstanding loan balance to the market value of the collateral property — a measure of collateral coverage.
Explanation: LTV = Loan balance / Property value. Lower LTV → more equity cushion → lower LGD. Typical maximum LTVs: residential ≤ 80%; commercial ≤ 65-70%. LTV rising above the original level (due to falling property prices) is a key early warning indicator.
Question 260
A 'credit default swap index tranche' product allows an investor to:
Select an option first.
Correct answer: B — Take a position specifically on the credit losses between defined attachment and detachment points of the index, expressing views on credit correlation and default clustering.
Explanation: Index tranches (e.g., CDX IG 0-3%, 3-7%): allow investors to buy or sell protection on specific loss tranches of the index. The 0-3% tranche is the equity (first-loss); 15-100% is the senior (last-loss). This enables correlation trading and precise credit position sizing. A is untranched index CDS; C is physical bond trading; D is incorrect.
Question 261
In securitisation, 'true sale' refers to:
Select an option first.
Correct answer: B — The legal transfer of assets from the originator to the SPV such that they are 'bankruptcy remote' — creditors of the originator cannot claim the assets if the originator goes bankrupt.
Explanation: True sale opinion: legal analysis confirming that assets have been genuinely transferred (not pledged) to the SPV. Without true sale, in originator bankruptcy, creditors might 'claw back' the assets into the bankruptcy estate, destroying the securitisation's credit structure. A, C, D describe other aspects.
Question 262
'Covenant-lite' leveraged loans are characterised by:
Select an option first.
Correct answer: B — Reduced or absent maintenance financial covenants — the borrower has less restrictive monitoring, providing fewer early warning signals for lenders.
Explanation: Cov-lite loans lack maintenance covenants (e.g., minimum DSCR, maximum leverage) that would be tested quarterly. Lenders lose early warning signals and restructuring leverage. Cov-lite became dominant in leveraged loan markets pre-2008 and again in 2014-2022, particularly in LBO financing. A describes traditional covenanted loans; C and D are incorrect.
Question 263
A 'distressed debt' investment strategy involves:
Select an option first.
Correct answer: B — Acquiring the debt of financially stressed or defaulted companies at significant discounts, with the intent to profit from recovery through restructuring, recovery, or bankruptcy proceedings.
Explanation: Distressed debt investing: purchase defaulted or near-defaulted bonds/loans at 20-60 cents on the dollar, then: (1) participate in restructuring to recover more than the purchase price, (2) convert debt to equity in bankruptcy, (3) sell at a higher price as credit improves. A is investment-grade investing; C is equity short-selling; D is credit hedging.
Question 264
The 'Gaussian copula' model was widely used to price CDO tranches before 2008. Its fundamental flaw was:
Select an option first.
Correct answer: B — Assuming zero tail dependence — assets that appeared uncorrelated in normal times became asymptotically independent in extreme scenarios, dramatically underestimating the probability of simultaneous large-scale defaults.
Explanation: Gaussian copula (Li 2000): models joint defaults via a multivariate normal distribution. Zero tail dependence: in the extreme tail, defaults are asymptotically independent. In 2008, simultaneous correlated defaults were dramatically underestimated. Student-t or Clayton copulas with positive tail dependence were more appropriate. A is an individual distribution assumption; C reverses the error; D is a valid input method.
Question 265
A 'delta-hedging' strategy for a CDO equity tranche position involves:
Select an option first.
Correct answer: B — Buying or selling single-name CDS or index CDS in proportion to the sensitivity (delta) of the equity tranche's value to changes in individual or index credit spreads.
Explanation: Equity tranche delta hedge: the tranche's MTM changes with credit spread movements. The hedge involves shorting (selling protection on) single-name CDS or the index in amounts proportional to the tranche's spread sensitivity. As spreads widen, the equity tranche loses value but the CDS hedge gains. A, C, D are not the standard delta hedge.
Question 266
In a 'CMBS' (Commercial Mortgage-Backed Security), the credit analysis focuses primarily on:
Select an option first.
Correct answer: B — Property-level cash flow stability (net operating income), loan-to-value ratios, and the diversity of property types and locations in the pool.
Explanation: CMBS credit analysis: (1) property-level NOI / debt service (DSCR), (2) LTV ratio (collateral coverage), (3) property type (office vs. retail vs. industrial) and geographic diversification, (4) lease terms and tenant quality. Individual owner creditworthiness (A) is important but secondary to property economics. C and D are not primary CMBS credit drivers.
Question 267
The 'CDO manager's ability to trade' during the reinvestment period is subject to which constraints?
Select an option first.
Correct answer: B — Investment guidelines including: minimum weighted average rating factor, maximum single-name concentration, minimum diversity score, and quality covenants that restrict trading if coverage tests are failing.
Explanation: CLO/CDO investment guidelines: the manager must maintain compliance with weighted average spread, WAL, WARF, diversity score, overcollateralisation tests, interest coverage tests, and concentration limits at all times. Violation of quality tests restricts trading until compliance is restored. A is wrong; C and D are incomplete.
Question 268
A 'leveraged loan' investor is concerned about 'spread compression risk'. This refers to:
Select an option first.
Correct answer: B — The risk that loan spreads narrow significantly in a benign credit environment, reducing the yield pickup versus investment-grade bonds and compressing total returns for leveraged loan funds.
Explanation: Spread compression risk: in benign credit conditions, strong demand for leveraged loans forces spreads tighter (e.g., from SOFR+500 to SOFR+350). This reduces prospective returns on new origination and marks up existing portfolios but reduces future income. A is spread widening (credit risk); C is base rate risk; D is call/prepayment risk.
Question 269
A synthetic CLO (sCLO) references credit risk through CDS rather than physical loans. The primary advantage of this structure over a cash CLO is:
Select an option first.
Correct answer: B — sCLOs can reference any leveraged loan in the market without requiring the CLO to physically acquire the loans, enabling faster execution and access to loans that may not be available for sale.
Explanation: Synthetic CLO advantages: (1) reference any loan, not just those sold by banks; (2) no physical acquisition needed — faster execution; (3) can reference very large diversified portfolios. A, C, D are not the primary reasons. Post-Dodd-Frank, synthetic structures faced regulatory scrutiny and declined in prevalence.
Question 270
In CDS documentation, 'succession events' occur when:
Select an option first.
Correct answer: B — The reference entity undergoes a corporate action (merger, spin-off, demerger) that changes its legal structure, triggering a determination of which entity the CDS should reference post-event.
Explanation: Succession events (ISDA): when a reference entity merges, demerges, or restructures, the succession determination committee decides whether the CDS follows the successor entity, splits among successors, or other outcomes. This protects both parties from the ambiguity of who is 'the reference entity' after a corporate action. A, C, D are different events.
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