Chapter 11 Testbank

Student: ___________________________________________________________________________

1.

Migration analysis is a method to:

A. manage loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for unusual
declines
B. measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for unusual
declines
C. measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for normal
declines
D. manage loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for normal
declines

2.

The term ‘transition matrix’ refers to a matrix that provides a measurement of the probability of a loan:

A. being upgraded over some period

B. being downgraded over some period
C. defaulting over some period
D. All of the listed options are correct.

3.

Limits set on the maximum loan size that can be made to an individual borrower are referred to as:
A.

maximum damage limits.

B.

concentration limits.

C.

syndication limits.

D.

minimisation limits.

4.

Which of the following statements is true?

A. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups’ performance
are negatively correlated.
B. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups’ performance
are highly correlated.
C. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups’ performance
are not correlated.
D. FIs may set an aggregate limit of more than the sum of two individual industry limits if two industry groups’
performance are negatively correlated.

5.

Consider the following hypothetical transition matrix:

 Which of the following statements is true?

A.

A borrower with a risk grade of 2 at the beginning of the year has a 3% probability of being downgraded to a risk grade of 3.

B.

A borrower with a risk grade of 3 at the beginning of the year has a 0.04% probability of being upgraded to a risk grade of 1.

C.

A borrower with a risk grade of 2 at the beginning of the year has a 12% probability of being downgraded to a risk grade of 1.

D.

A borrower with a risk grade of 2 at the beginning of the year has an 85% probability of being upgraded to a risk grade of 1.

6.

Which of the following statements is true?

A. FIs typically increase their concentration limits to increase exposures to others.

B. FIs typically set concentration limits to reduce exposures to certain industries and increase exposures to others.
C. FIs typically set concentration limits to reduce their exposure to individual borrowers.
D. FIs typically decrease their concentration limits to decrease exposures to others.

7.

Which of the following statements is true?

A. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital divided by
(one divided by the loss rate).
B. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital divided by
(one multiplied by the loss rate).
C. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital multiplied by
(one divided by the loss rate).
D. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital multiplied by
(one multiplied by the loss rate).

8.

Assume that the maximum loss as a percentage of capital is 12% of an FI’s capital to a particular sector and that the amount lost
per dollar of defaulted loans in this sector is 35%. What is the concentration limit (round to two decimals)?

A. 12% (1/0.35) = 34.29%

B. 35% (1/0.12) = 4.2%
C. 12% / (1 + 0.35) = 8.89%
D. 35% / (1 + 0.12) = 31.25%

9.

Assume that the maximum loss as a percentage of capital is 9% of an FI’s capital to a particular sector and that the amount
recovered per dollar of defaulted loans in this sector is 70%. What is the concentration limit (round to two decimals)?

A. 9% (1/0.7) = 12.86%
B. 9% [1/(1-0.7)] = 30.00%
C. 70% / (1/0.09) = 6.30%
D. (100% - 70%) / (1/0.09) = 2.70%

10.

Assume that the maximum loss as a percentage of capital is 12% of an FI’s capital to a particular sector. The FI’s concentration
limit on this sector 35%. What is the sector's loss rate (round to two decimals)?
A. 4.20%
B. 23.00%
C. 34.29%
D. 2.92%

11.

Assume that an FI’s concentration limit on a particular sector is 15% and that the sector’s loss rate is 25%. What is the maximum
loss as a percentage of the FI’s capital (round to two decimals)?

A. 1.67%
B. 0.60%
C. 10.00%
D. 3.75%

12.

Minimum risk portfolio refers to a combination of assets:

A. and liabilities that reduces the variance of portfolio returns to the lowest feasible level.
B. that leverages the variance of portfolio returns to the optimal level.
C. that reduces the variance of portfolio returns to the lowest feasible level.
D. that reduces the variance of portfolio returns to zero.

13.

Moody’s Analytics is a model that:

A.

was developed by the KMV Corporation and now owned and operated by Moody’s.

B.

measures the expected return on a loan to a borrower, the risk of a loan to a borrower and the correlation of default risks between loans
made to a borrower and other borrowers.

C.

seeks to estimate an efficient frontier for loans.

D. All of the listed options are correct.

14.

Which of the following statements is true?

A. Systematic loan loss risk is a measure of the sensitivity of loan losses in personal loans relative to the losses in
commercial loans.
B. Systematic loan loss risk is a measure of the sensitivity of loan losses of a particular borrower relative to the losses in
an FI’s loan portfolio.
C. Systematic loan loss risk is a measure of the sensitivity of loan losses in commercial loans relative to the losses in
personal loans.
D. Systematic loan loss risk is a measure of the sensitivity of loan losses in a particular business sector relative to the
losses in an FI’s loan portfolio.

15.

The Basel Committee on Banking Supervision considers regulatory loan concentration limits to individual borrowers as an issue of
granularity. Which of the following statements is true in this context?
A. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted by the FI to
reflect its levels of portfolio concentration or diversification.
B. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted up or down to
reflect the levels of portfolio concentration or diversification.
C. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted up to reflect
the levels of portfolio diversification.
D. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted down to reflect
the levels of portfolio concentration.

16.

Which of the following statements is true?

A. FIs can reduce profitability by taking advantage of the law of small numbers in their investment decisions.
B. FIs can reduce profitability by taking advantage of the law of large numbers in their investment decisions.
C. FIs can reduce risk by taking advantage of the law of small numbers in their investment decisions.
D. FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.

17.

Which of the following statements is true?

A. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
diversify considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated.
B. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its size, an FI can diversify
considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated.
C. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
diversify considerable amounts of credit risk as long as the returns on different assets are perfectly correlated.
D. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
diversify considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated.
18.

Consider the following table with information on the weightings and expected returns of two assets held by an FI.

What is the expected return on the portfolio (round to two decimals)?

A.

(0.35 + 12.35) (0.65 + 10.25) = 1.80%

B.

(0.35 + 0.65) (12.35 + 10.25) = 22.60%

C. (12.35 + 10.25) / 2 = 11.30%

D.

0.35 12.35 + 0.65 10.25 = 10.99%

19.

Consider the following table with information on the weightings and expected returns of three assets held by an FI.

What is the expected return on the portfolio (round to two decimals)?

A.

(0.15 12.35 + 0.55 10.25 + 0.30 15.75) / 3 = 4.07%

B.

(0.15 12.35 + 0.55 10.25 + 0.30 15.75) 3 = 36.66%

C.

0.15 12.35 + 0.55 10.25 + 0.30 15.75 = 12.22%

D. (12.35 + 10.25 + 15.75) / 3 = 12.78%

20.

Which of the following statements is true?

A.

The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies between the values 1
r + 1, where r is the correlation coefficient.

B. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values 0 r + 1, where r is the correlation coefficient.
C. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values +1 r + 2, where r is the correlation coefficient.
D.

The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies between the values 1
r 0, where r is the correlation coefficient.

21.

Which of the following statements is true?

A. One advantage of using MPT for loans is that the returns on individual loans are normally distributed, meaning that the
upside returns are equal to the downside risks.
B. One objection to using MPT for loans is that the returns on individual loans are not normally distributed, meaning that
most loans have unlimited upside returns and long-tail downside risks.
C. One advantage of using MPT for loans is that the returns on individual loans are normally distributed, meaning that
most loans have unlimited upside returns and unlimited downside risks.
D. One objection to using MPT for loans is that the returns on individual loans are not normally distributed, meaning that
most loans have limited upside returns and long-tail downside risks.

22.

Which of the following statements is true?

A. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
exactly estimates the risk of the whole portfolio.
B. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
underestimates the risk of the whole portfolio.
C. If many loans have positive correlations of returns the sum of the individual credit risks of loans viewed independently
overestimates the risk of the whole portfolio.
D. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
overestimates the risk of the whole portfolio.

23.

Consider the following portfolio of assets:

What is the variance of the portfolio (round to two decimals)?

A.

(0.3)2(82.0%) + (0.7)2(76.0%) + (0.3)(0.7)(0.87) (9.06%)(8.72%) = 30.19

B.

(0.3)2(82.0%) + (0.7)2(76.0%) + [(0.3)(0.7)]2 (0.87) (9.06%)(8.72%) = 41.59

C.

(0.3)2(82.0%) + (0.7)2(76.0%) + 2(0.3)(0.7)(0.87) (9.06%)(8.72%) = 15.75

D.

(0.3)(82.0%) + (0.7)(76.0%) + 2(0.3)(0.7)(0.87) (9.06%)(8.72%) = 48.93

24.

Consider the following portfolio of assets:

What is the variance of the portfolio (round to two decimals)?

A.

(0.45)2(36.60%) + (0.55)2(76.56%) + (0.45)(0.55)(0.2) (6.05%)(8.75%) = 27.95

B.

(0.45)2(36.60%) + (0.55)2(76.56%) + 2(0.45)(0.55)(0.2) (6.05%) (8.75%) = 25.33

C.

(0.45)(36.60%) + (0.55)(76.56%) + 2(0.45)2(0.55)2 (0.2) (6.05%)(8.75%) = 57.28

D.

(0.45)(36.60%) + (0.55)(76.56%) + 2(0.45)(0.55)(0.2) (6.05%)(8.75%) = 53.34

25.

Consider the following portfolio of assets:

What is the expected return on the portfolio (round to two decimals)?

A. 0.3(13%) + 0.7(11%) = 11.60%

B. (13% + 11%) / 2 = 12.00%
C.

(0.3)2(13%) + (0.7)2(11%) = 6.56%

D.

[(0.3)2(13%) + (0.7)2(11%)] 2 = 13.12%

26.

Consider the following portfolio of assets:

What is the expected return on the portfolio (round to two decimals)?

A. (15% + 13%) / 2 = 14.00%

B.

(0.45)2(15%) + (0.7)2(13%) = 9.41%

C.

[(0.45)2(15%) + (0.7)2(13%)] 2 = 18.82%

D. 0.45(15%) + 0.7(13%) = 15.85%

27.

Which of the following statements is true?

A. The minimum risk portfolio generates the highest returns and is thus likely to be chosen by risk-seeking FI managers.
B. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-averse FI
managers.
C. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-seeking FI
managers.
D. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-indifferent FI
managers.

28.

Which of the following statements is true?

A. The objective of risk-indifferent FI managers is to minimise portfolio risk regardless of the portfolio’s return.
B. The objective of risk-indifferent FI managers is to minimise portfolio risk in turn for higher returns on the portfolio.
C. The objective of risk-averse FI managers is to minimise portfolio risk in turn for higher returns on the portfolio.
D. The objective of risk-averse FI managers is to minimise portfolio risk regardless of the portfolio’s return.

29.

Consider the following portfolio of assets:

What is the standard deviation of the portfolio (round to two decimals)?

A.

(0.3)(82.00) + (0.7)(76.00) = 8.82%

B.

(82.00) + (76.00) = 17.77%

C.
15.75 = 3.97%

D.
48.93 = 6.99%

30.

Consider the following portfolio of assets:

What is the standard deviation of the portfolio (round to two decimals)?

A.

(0.45)(36.60) + (0.55)(76.56) = 7.51%

B.

(36.60) + (76.56) = 14.80%

C.
57.28 = 7.57%

D.
25.33 = 5.03%

31.

The return (Ri) on a loan can be measured as follows:

A.

AISi E(Li), whereby E(Li) = (EDFi LGDi)

B.

AISi E(Li), whereby E(Li) = (EDFi / LGDi)

C.

AISi + E(Li), whereby E(Li) = (EDFi LGDi)

D.

AISi + E(Li), whereby E(Li) = (EDFi / LGDi)

32.

Which of the following statements is true?

A. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI less the annual spread between the
loan rate paid by the borrower and the FI’s cost of funds.
B. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI plus the annual spread between the
loan rate paid by the borrower and the FI’s cost of funds.
C. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI plus the loan rate paid by the
borrowers.
D. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI less the FI’s cost of funds.

33.

Which of the following statements is true?

A. The risk of a loan reflects the volatility of the loan’s default rate around its expected value times the amount lost given
default.
B. The product of the volatility of the default rate and the loss give default (LGD) is called the ‘unexpected loss’.
C. The product of the volatility of the default rate and the loss give default (LGD) is a measure of the loan’s risk.
D. All of the listed options are correct.

34.

Which of the following statements is true?

A. According to Moody’s Analytics, default correlations tend to be low and lie between 0.002 and 0.15.
B. According to Moody’s Analytics, default correlations tend to be high and lie between 0.42 and 0.65.
C. According to Moody’s Analytics, default correlations vary and thus no particular range can be stated.
D. None of the listed options are correct.

35.

Consider an FI holds two loans with the following characteristics:

What is the return on the loan portfolio (round to two decimals)?

A. 3.80%
B. 5.75%
C. 9.55%
D. 4.87%

36.

Consider an FI that holds two loans with the following characteristics:

What is the risk of the loan portfolio (round to two decimals)?

A. 5.88%
B. 10.01%
C. 3.16%
D. 4.26%

37.

Consider an FI that holds two loans with the following characteristics:

What is the return on the loan portfolio (round to two decimals)?

A. 6.50%
B. 6.90%
C. 13.40%
D. 6.78%

38.

Consider an FI that holds two loans with the following characteristics:

 What is the risk of the loan portfolio (round to two decimals)?

A. 4.90%
B. 3.41%
C. 4.16%
D. 6.10%

39.

Which of the following statements is true?

A. Partial applications of portfolio theory include loan volume based models and loan loss ratio based models.
B. Partial applications of portfolio theory include loan portfolio profitability based models and regulatory models.
C. Partial applications of portfolio theory include loan volume based models, loan loss ratio based models and regulatory
models.
D. Partial applications of portfolio theory include loan portfolio profitability based models and loan loss minimisation
based models.

40.

Which of the following statements is true?

A. Loan loss ratio based models rely on actual data and involve the estimation of the systematic loan loss risk of a
particular industry relative to the loan loss risk of an FI’s total loan portfolio.
B. Loan loss ratio based models rely on historic data and involve the estimation of the systematic loan loss risk of a
particular industry relative to the loan loss risk of an FI’s total loan portfolio.
C. Loan loss ratio based models rely on historic data and involve the estimation of the systematic loan loss risk of a
particular borrower relative to the loan loss risk of an FI’s total loan portfolio.
D. Loan loss ratio based models rely on actual data and involve the estimation of the systematic loan loss risk of a
particular borrower relative to the loan loss risk of an FI’s total loan portfolio.

41.

Which of the following is a major difference between forwards and futures?

A. Forwards are marked to market, while futures are not.
B. Futures are tailor made, while forwards are standardised.
C. The default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties
against credit risk, while this is not the case for forwards.
D. Forwards are marked to market, while futures are not, futures are tailor made, while forwards are standardised and the
default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against
credit risk, while this is not the case for forwards.

42.

A forward contract:

A. has more credit risk than a futures contract.

B. is more standardised than a futures contract.
C. is marked to market more frequently than a futures contract.
D. has a shorter time to delivery than a futures contract.

43.

A digital default option is

A.

an option that pays the par value of a loan in the event of default.

B.

a call option whose payoff increases as a yield spread increases above a stated exercise spread.

C.

a call option on the loss ratio incurred in writing catastrophe insurance with a capped (or maximum) payout.

D. None of the listed options are correct.

44.

Pure credit swaps are swaps by which an FI receives the:

A. par value of the loan on default in return for paying a periodic swap fee
B. current value of the loan on default in return for paying a periodic swap fee
C. residual value of the loan on default in return for paying a periodic swap fee
D. outstanding interest payments on the loan on default in return for paying a periodic swap fee

45.

Which of the following statements is true?

A. Total return swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap and
alternative arrangements do not exist.
B. Total return swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap, but
alternative arrangements exist.
C. Pure credit swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap and
alternative arrangements do not exist.
D. Pure credit swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap, but
alternative arrangements exist.

46.

Which of the following is a major difference between a pure credit swap and a default option?

A. In a pure credit swap the premium payment on the swap is paid up front, while the fees of a default option are paid
over the life of the default option.
B. In a pure credit swap the premium payments on the swap are paid over the life of the swap, while the fee of a default
option is paid up front.
C. In a pure credit swap the premium payment on the swap is paid at maturity, while the fees of a default option are paid
over the life of the default option.
D. In a pure credit swap the premium payments on the swap are paid over the life of the swap, while the fee of a default
option is paid at maturity.

47.

Which of the following statements is true?

A. As with loans, swap participants deal with the credit risk of counterparties by setting bilateral limits on the notional
amount of swaps entered into.
B. As with loans, swap participants deal with the credit risk of counterparties by adjusting the fixed and/or floating rates by
including credit risk premiums.
C. As with loans, swap participants deal with the credit risk of counterparties by using Monte Carlo simulations to model
potential default risk.
D. As with loans, swap participants deal with the credit risk of counterparties by setting bilateral limits on the notional
amount of swaps entered into and as with loans, swap participants deal with the credit risk of counterparties by adjusting
the fixed and/or floating rates by including credit risk premiums.

48.

Which of the following is not a reason for the credit risk on a swap to be less than the credit risk on a loan?

A. Swap contracts often extend beyond the maturity of normal loan contracts.
B. Swap payments can be netted across more than on contract.
C. Interest rate swaps involve interest, but not principal.
D. Swap contracts often extend beyond the maturity of normal loan contracts, swap payments can be netted across more
than on contract and interest rate swaps involve interest, but not principal.

49.

A pure credit swap:

A.

is like buying credit insurance.

B.

is like buying a multi-period credit option.

C.

eliminates the interest rate risk contained in the total return swap.

D.

is like buying credit insurance, is like buying a multi-period credit option and eliminates the interest rate risk contained in the total return
swap.

50.

Which of the following is incorrect in relation to debt recovery rates?

A. Macroeconomic factors are found to be significant in explaining recovery rates on defaulted bonds.
B. Macroeconomic factors are found to be insignificant in explaining recovery rates on defaulted bonds.
C. Senior securities tend to have higher recovery rates than subordinated securities.
D. Industrial revenue bonds tend to have higher recovery rates than subordinated securities.

51.

Loan sales and securitisation are increasingly seen as valuable tools in the management of credit risk. Which of the following are
not advantageous to FIs?

A. Loan sales and securitisation allow FIs to better manage their customer relationships.
B. Loan sales and securitisation create moral hazard issues and reduce scrutiny of off-balance-sheet activities of FIs.
C. Loan sales and securitisation reduce FIs’ industry and/or geographical concentration risk.
D. Loan sales and securitisation allow FIs to separate their credit risk exposure from the lending process itself.
52.

Migration analysis is a method to measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings
class for unusual declines.

True False

53.

Migration analysis is a method to measure deposit concentration risk by tracking credit ratings of firms in particular sectors or
ratings class for usual declines.

True False

54.

Systematic loan loss risk is a measure of the sensitivity of loan losses in a particular business sector relative to the losses in an
FI’s loan portfolio.

True False

55.

Systematic loan loss risk is a measure of the sensitivity of loan losses in commercial loans relative to the losses in personal loans.

True False

56.

A transition matrix can be used to establish the probabilities that a currently rated borrower will be upgraded, downgraded or will
default over time.

True False

57.

The concentration limit for a loan portfolio is calculated as the expected default frequency of the borrower multiplied by (one
divided by the loss rate).
True False

58.

The relationship limit on diversification has also been called the ‘paradox of credit’.

True False

59.

Concentration limits are external limits set on the maximum loan size that can be made to an individual borrower.

True False

60.

FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.

True False

61.

An FI that invests 40% of funds in a loan with an expected return of 10% and 60% of funds in a loan with an expected return of
12% can expect to earn 11% on its portfolio.

True False

62.

Minimum risk portfolios generally generate the highest returns.

True False

63.

Minimum risk portfolio refers to a combination of assets that reduces the variance of portfolio returns to the lowest feasible level.
True False

64.

Minimum risk portfolio refers to a combination of assets that leverages the variance of portfolio returns to the optimal level.

True False

65.

Using the Moody’s Analytics model, the return on a loan can be calculated as the annual all-in-spread minus the loss in the event
of default.

True False

66.

Using the Moody’s Analytics model, the risk on a loan can be calculated as the volatility of the loan’s default rate times the loss in
the event of default.

True False

67.

Loan loss ratio based models estimate systematic loan losses by running a time-series regression of quarterly losses of the ith
sector’s loss rate on the quarterly loss rate of an FI’s total loans.

True False

68.

Financial institutions do not use options to hedge credit risk exposures as credit risk is a natural risk that comes with the core
activities of the bank, namely lending.

True False
69.

A digital default option is an option that pays the par value of a loan in the event of default.

True False

70.

A digital default option is a call option whose payoff increases as a yield spread increases above a stated exercise spread.

True False

71.

The most important swap contract in terms of quantity is the credit swap.

True False

72.

In contrast to actual insurance policies, there is no requirement that the CDS buyer actually own the underlying reference
securities.

True False

73.

Consistent with actual insurance policies, the CDS buyer must own the underlying reference securities.

True False
74.

Explain the following hypothetical table:

In this context, explain the concepts of loan migration and migration analysis.
75.

Consider the following data for a two-asset portfolio:

Using the Moody’s Analytics model:

a. calculate the returns for loans 1 and 2.
b. calculate the risk for loans 1 and 2.
c. calculate the return for the loan portfolio.
d. calculate the risk for the loan portfolio.
e. explain your findings in (a) to (d).

76. Explain the basic concept of loan loss ratio based models.
Chapter 11 Testbank Key

1.

Migration analysis is a method to:

A. manage loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for unusual
declines
B. measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for unusual
declines
C. measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for normal
declines
D. manage loan concentration risk by tracking credit ratings of firms in particular sectors or ratings class for normal
declines

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

2.

The term ‘transition matrix’ refers to a matrix that provides a measurement of the probability of a loan:

A. being upgraded over some period

B. being downgraded over some period
C. defaulting over some period
D. All of the listed options are correct.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.
3.

Limits set on the maximum loan size that can be made to an individual borrower are referred to as:

A.

maximum damage limits.

B.

concentration limits.

C.

syndication limits.

D.

minimisation limits.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

4.

Which of the following statements is true?

A. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups’ performance
are negatively correlated.
B. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups’ performance
are highly correlated.
C. FIs may set an aggregate limit of less than the sum of two individual industry limits if two industry groups’ performance
are not correlated.
D. FIs may set an aggregate limit of more than the sum of two individual industry limits if two industry groups’
performance are negatively correlated.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

5.

Consider the following hypothetical transition matrix:

Which of the following statements is true?

A.

A borrower with a risk grade of 2 at the beginning of the year has a 3% probability of being downgraded to a risk grade of 3.

B.

A borrower with a risk grade of 3 at the beginning of the year has a 0.04% probability of being upgraded to a risk grade of 1.

C.

A borrower with a risk grade of 2 at the beginning of the year has a 12% probability of being downgraded to a risk grade of 1.

D.

A borrower with a risk grade of 2 at the beginning of the year has an 85% probability of being upgraded to a risk grade of 1.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

6.

Which of the following statements is true?

A. FIs typically increase their concentration limits to increase exposures to others.

B. FIs typically set concentration limits to reduce exposures to certain industries and increase exposures to others.
C. FIs typically set concentration limits to reduce their exposure to individual borrowers.
D. FIs typically decrease their concentration limits to decrease exposures to others.

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.
7.

Which of the following statements is true?

A. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital divided by
(one divided by the loss rate).
B. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital divided by
(one multiplied by the loss rate).
C. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital multiplied by
(one divided by the loss rate).
D. The concentration limit on a portfolio can be calculated as the maximum loss as a percentage of capital multiplied by
(one multiplied by the loss rate).

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

8.

Assume that the maximum loss as a percentage of capital is 12% of an FI’s capital to a particular sector and that the amount lost
per dollar of defaulted loans in this sector is 35%. What is the concentration limit (round to two decimals)?

A. 12% (1/0.35) = 34.29%

B. 35% (1/0.12) = 4.2%
C. 12% / (1 + 0.35) = 8.89%
D. 35% / (1 + 0.12) = 31.25%

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

9.

Assume that the maximum loss as a percentage of capital is 9% of an FI’s capital to a particular sector and that the amount
recovered per dollar of defaulted loans in this sector is 70%. What is the concentration limit (round to two decimals)?
A. 9% (1/0.7) = 12.86%
B. 9% [1/(1-0.7)] = 30.00%
C. 70% / (1/0.09) = 6.30%
D. (100% - 70%) / (1/0.09) = 2.70%

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

10.

Assume that the maximum loss as a percentage of capital is 12% of an FI’s capital to a particular sector. The FI’s concentration
limit on this sector 35%. What is the sector's loss rate (round to two decimals)?

A. 4.20%
B. 23.00%
C. 34.29%
D. 2.92%

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

11.

Assume that an FI’s concentration limit on a particular sector is 15% and that the sector’s loss rate is 25%. What is the maximum
loss as a percentage of the FI’s capital (round to two decimals)?
A. 1.67%
B. 0.60%
C. 10.00%
D. 3.75%

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

12.

Minimum risk portfolio refers to a combination of assets:

A. and liabilities that reduces the variance of portfolio returns to the lowest feasible level.
B. that leverages the variance of portfolio returns to the optimal level.
C. that reduces the variance of portfolio returns to the lowest feasible level.
D. that reduces the variance of portfolio returns to zero.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

13.

Moody’s Analytics is a model that:

A.

was developed by the KMV Corporation and now owned and operated by Moody’s.

B.

measures the expected return on a loan to a borrower, the risk of a loan to a borrower and the correlation of default risks between loans
made to a borrower and other borrowers.

C.

seeks to estimate an efficient frontier for loans.

D. All of the listed options are correct.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

14.

Which of the following statements is true?

A. Systematic loan loss risk is a measure of the sensitivity of loan losses in personal loans relative to the losses in
commercial loans.
B. Systematic loan loss risk is a measure of the sensitivity of loan losses of a particular borrower relative to the losses in
an FI’s loan portfolio.
C. Systematic loan loss risk is a measure of the sensitivity of loan losses in commercial loans relative to the losses in
personal loans.
D. Systematic loan loss risk is a measure of the sensitivity of loan losses in a particular business sector relative to the
losses in an FI’s loan portfolio.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.4 The concentration of loans, loan volume and internal loan loss ratio concepts.
15.

The Basel Committee on Banking Supervision considers regulatory loan concentration limits to individual borrowers as an issue of
granularity. Which of the following statements is true in this context?

A. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted by the FI to
reflect its levels of portfolio concentration or diversification.
B. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted up or down to
reflect the levels of portfolio concentration or diversification.
C. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted up to reflect
the levels of portfolio diversification.
D. The issue of granularity means that if banks hold relatively large exposures to an individual borrower or sector to a
reference portfolio they have devised, then risk weightings required in the capital to be held will be adjusted down to reflect
the levels of portfolio concentration.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

16.

Which of the following statements is true?

A. FIs can reduce profitability by taking advantage of the law of small numbers in their investment decisions.
B. FIs can reduce profitability by taking advantage of the law of large numbers in their investment decisions.
C. FIs can reduce risk by taking advantage of the law of small numbers in their investment decisions.
D. FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

17.

Which of the following statements is true?

A. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
diversify considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated.
B. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its size, an FI can diversify
considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated.
C. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
diversify considerable amounts of credit risk as long as the returns on different assets are perfectly correlated.
D. The fundamental lesson of modern portfolio theory (MPT) is that by taking advantage of its profitability, an FI can
diversify considerable amounts of credit risk as long as the returns on different assets are imperfectly correlated.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

18.

Consider the following table with information on the weightings and expected returns of two assets held by an FI.

What is the expected return on the portfolio (round to two decimals)?

A.

(0.35 + 12.35) (0.65 + 10.25) = 1.80%

B.

(0.35 + 0.65) (12.35 + 10.25) = 22.60%

C. (12.35 + 10.25) / 2 = 11.30%

D.

0.35 12.35 + 0.65 10.25 = 10.99%

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

19.

Consider the following table with information on the weightings and expected returns of three assets held by an FI.

What is the expected return on the portfolio (round to two decimals)?

A.

(0.15 12.35 + 0.55 10.25 + 0.30 15.75) / 3 = 4.07%

B.

(0.15 12.35 + 0.55 10.25 + 0.30 15.75) 3 = 36.66%

C.

0.15 12.35 + 0.55 10.25 + 0.30 15.75 = 12.22%

D. (12.35 + 10.25 + 15.75) / 3 = 12.78%

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

20.

Which of the following statements is true?

A.

The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies between the values 1
r + 1, where r is the correlation coefficient.

B. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values 0 r + 1, where r is the correlation coefficient.
C. The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies
between the values +1 r + 2, where r is the correlation coefficient.
D.

The correlation coefficient reflects the joint movement of asset returns or default risk in the case of loans and lies between the values 1
r 0, where r is the correlation coefficient.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

21.

Which of the following statements is true?

A. One advantage of using MPT for loans is that the returns on individual loans are normally distributed, meaning that the
upside returns are equal to the downside risks.
B. One objection to using MPT for loans is that the returns on individual loans are not normally distributed, meaning that
most loans have unlimited upside returns and long-tail downside risks.
C. One advantage of using MPT for loans is that the returns on individual loans are normally distributed, meaning that
most loans have unlimited upside returns and unlimited downside risks.
D. One objection to using MPT for loans is that the returns on individual loans are not normally distributed, meaning that
most loans have limited upside returns and long-tail downside risks.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.
22.

Which of the following statements is true?

A. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
exactly estimates the risk of the whole portfolio.
B. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
underestimates the risk of the whole portfolio.
C. If many loans have positive correlations of returns the sum of the individual credit risks of loans viewed independently
overestimates the risk of the whole portfolio.
D. If many loans have negative correlations of returns the sum of the individual credit risks of loans viewed independently
overestimates the risk of the whole portfolio.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

23.

Consider the following portfolio of assets:

What is the variance of the portfolio (round to two decimals)?

A.

(0.3)2(82.0%) + (0.7)2(76.0%) + (0.3)(0.7)(0.87) (9.06%)(8.72%) = 30.19

B.

(0.3)2(82.0%) + (0.7)2(76.0%) + [(0.3)(0.7)]2 (0.87) (9.06%)(8.72%) = 41.59

C.

(0.3)2(82.0%) + (0.7)2(76.0%) + 2(0.3)(0.7)(0.87) (9.06%)(8.72%) = 15.75

D.

(0.3)(82.0%) + (0.7)(76.0%) + 2(0.3)(0.7)(0.87) (9.06%)(8.72%) = 48.93

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

24.

Consider the following portfolio of assets:

What is the variance of the portfolio (round to two decimals)?

A.

(0.45)2(36.60%) + (0.55)2(76.56%) + (0.45)(0.55)(0.2) (6.05%)(8.75%) = 27.95

B.

(0.45)2(36.60%) + (0.55)2(76.56%) + 2(0.45)(0.55)(0.2) (6.05%) (8.75%) = 25.33

C.

(0.45)(36.60%) + (0.55)(76.56%) + 2(0.45)2(0.55)2 (0.2) (6.05%)(8.75%) = 57.28

D.

(0.45)(36.60%) + (0.55)(76.56%) + 2(0.45)(0.55)(0.2) (6.05%)(8.75%) = 53.34

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

25.

Consider the following portfolio of assets:

What is the expected return on the portfolio (round to two decimals)?

A. 0.3(13%) + 0.7(11%) = 11.60%
B. (13% + 11%) / 2 = 12.00%
C.

(0.3)2(13%) + (0.7)2(11%) = 6.56%

D.

[(0.3)2(13%) + (0.7)2(11%)] 2 = 13.12%

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

26.

Consider the following portfolio of assets:

What is the expected return on the portfolio (round to two decimals)?

A. (15% + 13%) / 2 = 14.00%
B.

(0.45)2(15%) + (0.7)2(13%) = 9.41%

C.

[(0.45)2(15%) + (0.7)2(13%)] 2 = 18.82%

D. 0.45(15%) + 0.7(13%) = 15.85%

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

27.

Which of the following statements is true?

A. The minimum risk portfolio generates the highest returns and is thus likely to be chosen by risk-seeking FI managers.
B. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-averse FI
managers.
C. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-seeking FI
managers.
D. The minimum risk portfolio does not generate the highest returns and is thus likely to be chosen by risk-indifferent FI
managers.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

28.

Which of the following statements is true?

A. The objective of risk-indifferent FI managers is to minimise portfolio risk regardless of the portfolio’s return.
B. The objective of risk-indifferent FI managers is to minimise portfolio risk in turn for higher returns on the portfolio.
C. The objective of risk-averse FI managers is to minimise portfolio risk in turn for higher returns on the portfolio.
D. The objective of risk-averse FI managers is to minimise portfolio risk regardless of the portfolio’s return.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

29.

Consider the following portfolio of assets:

What is the standard deviation of the portfolio (round to two decimals)?

A.

(0.3)(82.00) + (0.7)(76.00) = 8.82%

B.

(82.00) + (76.00) = 17.77%

C.
15.75 = 3.97%

D.
48.93 = 6.99%

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.8 How credit swaps help FIs manage credit risk.
30.

Consider the following portfolio of assets:

What is the standard deviation of the portfolio (round to two decimals)?

A.

(0.45)(36.60) + (0.55)(76.56) = 7.51%

B.

(36.60) + (76.56) = 14.80%

C.
57.28 = 7.57%

D.
25.33 = 5.03%

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

31.

The return (Ri) on a loan can be measured as follows:

A.

AISi E(Li), whereby E(Li) = (EDFi LGDi)

B.

AISi E(Li), whereby E(Li) = (EDFi / LGDi)

C.

AISi + E(Li), whereby E(Li) = (EDFi LGDi)

D.

AISi + E(Li), whereby E(Li) = (EDFi / LGDi)

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Hard
Est time: <1
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

32.

Which of the following statements is true?

A. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI less the annual spread between the
loan rate paid by the borrower and the FI’s cost of funds.
B. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI plus the annual spread between the
loan rate paid by the borrower and the FI’s cost of funds.
C. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI plus the loan rate paid by the
borrowers.
D. The annual all-in-spread (AIS) measures annual fees earned on the loan by the FI less the FI’s cost of funds.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

33.

Which of the following statements is true?

A. The risk of a loan reflects the volatility of the loan’s default rate around its expected value times the amount lost given
default.
B. The product of the volatility of the default rate and the loss give default (LGD) is called the ‘unexpected loss’.
C. The product of the volatility of the default rate and the loss give default (LGD) is a measure of the loan’s risk.
D. All of the listed options are correct.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

34.

Which of the following statements is true?

A. According to Moody’s Analytics, default correlations tend to be low and lie between 0.002 and 0.15.
B. According to Moody’s Analytics, default correlations tend to be high and lie between 0.42 and 0.65.
C. According to Moody’s Analytics, default correlations vary and thus no particular range can be stated.
D. None of the listed options are correct.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

35.

Consider an FI holds two loans with the following characteristics:

What is the return on the loan portfolio (round to two decimals)?

A. 3.80%
B. 5.75%
C. 9.55%
D. 4.87%

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

36.

Consider an FI that holds two loans with the following characteristics:

 What is the risk of the loan portfolio (round to two decimals)?

A. 5.88%
B. 10.01%
C. 3.16%
D. 4.26%

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

37.

Consider an FI that holds two loans with the following characteristics:

What is the return on the loan portfolio (round to two decimals)?

A. 6.50%
B. 6.90%
C. 13.40%
D. 6.78%

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.
38.

Consider an FI that holds two loans with the following characteristics:

What is the risk of the loan portfolio (round to two decimals)?

A. 4.90%
B. 3.41%
C. 4.16%
D. 6.10%

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

39.

Which of the following statements is true?

A. Partial applications of portfolio theory include loan volume based models and loan loss ratio based models.
B. Partial applications of portfolio theory include loan portfolio profitability based models and regulatory models.
C. Partial applications of portfolio theory include loan volume based models, loan loss ratio based models and regulatory
models.
D. Partial applications of portfolio theory include loan portfolio profitability based models and loan loss minimisation
based models.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.4 The concentration of loans, loan volume and internal loan loss ratio concepts.

40.

Which of the following statements is true?

A. Loan loss ratio based models rely on actual data and involve the estimation of the systematic loan loss risk of a
particular industry relative to the loan loss risk of an FI’s total loan portfolio.
B. Loan loss ratio based models rely on historic data and involve the estimation of the systematic loan loss risk of a
particular industry relative to the loan loss risk of an FI’s total loan portfolio.
C. Loan loss ratio based models rely on historic data and involve the estimation of the systematic loan loss risk of a
particular borrower relative to the loan loss risk of an FI’s total loan portfolio.
D. Loan loss ratio based models rely on actual data and involve the estimation of the systematic loan loss risk of a
particular borrower relative to the loan loss risk of an FI’s total loan portfolio.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

41.

Which of the following is a major difference between forwards and futures?

A. Forwards are marked to market, while futures are not.

B. Futures are tailor made, while forwards are standardised.
C. The default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties
against credit risk, while this is not the case for forwards.
D. Forwards are marked to market, while futures are not, futures are tailor made, while forwards are standardised and the
default risk of futures is significantly reduced by the futures exchange guaranteeing to indemnify counterparties against
credit risk, while this is not the case for forwards.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.6 The types of futures and options contracts that can be used to hedge credit risk.

42.

A forward contract:
A. has more credit risk than a futures contract.
B. is more standardised than a futures contract.
C. is marked to market more frequently than a futures contract.
D. has a shorter time to delivery than a futures contract.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: 1-3
Learning Objective: 11.6 The types of futures and options contracts that can be used to hedge credit risk.
Learning Objective: 11.8 How credit swaps help FIs manage credit risk.

43.

A digital default option is

A.

an option that pays the par value of a loan in the event of default.

B.

a call option whose payoff increases as a yield spread increases above a stated exercise spread.

C.

a call option on the loss ratio incurred in writing catastrophe insurance with a capped (or maximum) payout.

D. None of the listed options are correct.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 11.7 How futures and options can be used to hedge catastrophe risk.

44.

Pure credit swaps are swaps by which an FI receives the:

A. par value of the loan on default in return for paying a periodic swap fee
B. current value of the loan on default in return for paying a periodic swap fee
C. residual value of the loan on default in return for paying a periodic swap fee
D. outstanding interest payments on the loan on default in return for paying a periodic swap fee

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.8 How credit swaps help FIs manage credit risk.
Learning Objective: 11.9 The types of credit swaps.

45.

Which of the following statements is true?

A. Total return swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap and
alternative arrangements do not exist.
B. Total return swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap, but
alternative arrangements exist.
C. Pure credit swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap and
alternative arrangements do not exist.
D. Pure credit swaps are typically structured in a way that any capital gains or losses are paid at the end of the swap, but
alternative arrangements exist.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.8 How credit swaps help FIs manage credit risk.

46.

Which of the following is a major difference between a pure credit swap and a default option?
A. In a pure credit swap the premium payment on the swap is paid up front, while the fees of a default option are paid
over the life of the default option.
B. In a pure credit swap the premium payments on the swap are paid over the life of the swap, while the fee of a default
option is paid up front.
C. In a pure credit swap the premium payment on the swap is paid at maturity, while the fees of a default option are paid
over the life of the default option.
D. In a pure credit swap the premium payments on the swap are paid over the life of the swap, while the fee of a default
option is paid at maturity.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.8 How credit swaps help FIs manage credit risk.

47.

Which of the following statements is true?

A. As with loans, swap participants deal with the credit risk of counterparties by setting bilateral limits on the notional
amount of swaps entered into.
B. As with loans, swap participants deal with the credit risk of counterparties by adjusting the fixed and/or floating rates by
including credit risk premiums.
C. As with loans, swap participants deal with the credit risk of counterparties by using Monte Carlo simulations to model
potential default risk.
D. As with loans, swap participants deal with the credit risk of counterparties by setting bilateral limits on the notional
amount of swaps entered into and as with loans, swap participants deal with the credit risk of counterparties by adjusting
the fixed and/or floating rates by including credit risk premiums.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.9 The types of credit swaps.

48.

Which of the following is not a reason for the credit risk on a swap to be less than the credit risk on a loan?
A. Swap contracts often extend beyond the maturity of normal loan contracts.
B. Swap payments can be netted across more than on contract.
C. Interest rate swaps involve interest, but not principal.
D. Swap contracts often extend beyond the maturity of normal loan contracts, swap payments can be netted across more
than on contract and interest rate swaps involve interest, but not principal.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.9 The types of credit swaps.

49.

A pure credit swap:

A.

is like buying credit insurance.

B.

is like buying a multi-period credit option.

C.

eliminates the interest rate risk contained in the total return swap.

D.

is like buying credit insurance, is like buying a multi-period credit option and eliminates the interest rate risk contained in the total return
swap.

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.9 The types of credit swaps.
50.

Which of the following is incorrect in relation to debt recovery rates?

A. Macroeconomic factors are found to be significant in explaining recovery rates on defaulted bonds.
B. Macroeconomic factors are found to be insignificant in explaining recovery rates on defaulted bonds.
C. Senior securities tend to have higher recovery rates than subordinated securities.
D. Industrial revenue bonds tend to have higher recovery rates than subordinated securities.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

51.

Loan sales and securitisation are increasingly seen as valuable tools in the management of credit risk. Which of the following are
not advantageous to FIs?

A. Loan sales and securitisation allow FIs to better manage their customer relationships.
B. Loan sales and securitisation create moral hazard issues and reduce scrutiny of off-balance-sheet activities of FIs.
C. Loan sales and securitisation reduce FIs’ industry and/or geographical concentration risk.
D. Loan sales and securitisation allow FIs to separate their credit risk exposure from the lending process itself.

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.12 How FIs use loan sales and securitisation to manage credit risk.

52.

Migration analysis is a method to measure loan concentration risk by tracking credit ratings of firms in particular sectors or ratings
class for unusual declines.
TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

53.

Migration analysis is a method to measure deposit concentration risk by tracking credit ratings of firms in particular sectors or
ratings class for usual declines.

FALSE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

54.

Systematic loan loss risk is a measure of the sensitivity of loan losses in a particular business sector relative to the losses in an
FI’s loan portfolio.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.4 The concentration of loans, loan volume and internal loan loss ratio concepts.

55.

Systematic loan loss risk is a measure of the sensitivity of loan losses in commercial loans relative to the losses in personal loans.
FALSE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: 1-3
Learning Objective: 11.4 The concentration of loans, loan volume and internal loan loss ratio concepts.

56.

A transition matrix can be used to establish the probabilities that a currently rated borrower will be upgraded, downgraded or will
default over time.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

57.

The concentration limit for a loan portfolio is calculated as the expected default frequency of the borrower multiplied by (one
divided by the loss rate).

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 11.1 The methods for measuring levels of loan concentration.

58.

The relationship limit on diversification has also been called the ‘paradox of credit’.
TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

59.

Concentration limits are external limits set on the maximum loan size that can be made to an individual borrower.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

60.

FIs can reduce risk by taking advantage of the law of large numbers in their investment decisions.

TRUE

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: <1
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

61.

An FI that invests 40% of funds in a loan with an expected return of 10% and 60% of funds in a loan with an expected return of
12% can expect to earn 11% on its portfolio.
FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

62.

Minimum risk portfolios generally generate the highest returns.

FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: <1
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

63.

Minimum risk portfolio refers to a combination of assets that reduces the variance of portfolio returns to the lowest feasible level.

TRUE

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: <1
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

64.

Minimum risk portfolio refers to a combination of assets that leverages the variance of portfolio returns to the optimal level.
FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: <1
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans.

65.

Using the Moody’s Analytics model, the return on a loan can be calculated as the annual all-in-spread minus the loss in the event
of default.

FALSE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

66.

Using the Moody’s Analytics model, the risk on a loan can be calculated as the volatility of the loan’s default rate times the loss in
the event of default.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.

67.

Loan loss ratio based models estimate systematic loan losses by running a time-series regression of quarterly losses of the ith
sector’s loss rate on the quarterly loss rate of an FI’s total loans.
TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Medium
Est time: <1
Learning Objective: 11.4 The concentration of loans, loan volume and internal loan loss ratio concepts.

68.

Financial institutions do not use options to hedge credit risk exposures as credit risk is a natural risk that comes with the core
activities of the bank, namely lending.

FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Medium
Est time: <1
Learning Objective: 11.6 The types of futures and options contracts that can be used to hedge credit risk.

69.

A digital default option is an option that pays the par value of a loan in the event of default.

TRUE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 11.7 How futures and options can be used to hedge catastrophe risk.

70.

A digital default option is a call option whose payoff increases as a yield spread increases above a stated exercise spread.
FALSE

AACSB: Analytic
Bloom's: Knowledge
Difficulty: Easy
Est time: <1
Learning Objective: 11.7 How futures and options can be used to hedge catastrophe risk.

71.

The most important swap contract in terms of quantity is the credit swap.

FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: <1
Learning Objective: 11.9 The types of credit swaps.

72.

In contrast to actual insurance policies, there is no requirement that the CDS buyer actually own the underlying reference
securities.

TRUE

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: <1
Learning Objective: 11.9 The types of credit swaps.

73.

Consistent with actual insurance policies, the CDS buyer must own the underlying reference securities.
FALSE

AACSB: Analytic
Bloom's: Application
Difficulty: Easy
Est time: <1
Learning Objective: 11.9 The types of credit swaps.
74.

Explain the following hypothetical table:

In this context, explain the concepts of loan migration and migration analysis.

Migration analysis uses information from the market to determine the credit risk of an individual loan or sectoral loans. With this method,
FI managers track credit ratings, such as S&P and Moody’s ratings, of firms in particular sectors or ratings classes for unusual declines
to determine whether firms in a particular sector are experiencing repayment problems. This information can be used to either curtail
lending in that sector or to reduce maturity and/or increase interest rates.
A loan migration (or transition) matrix seeks to reflect the historic experience of a pool of loans in terms of their credit-rating migration
over time. As such, it can be used as a benchmark against which the credit migration patterns of any new pool of loans can be
compared. For example from the above table, loans that began the year at credit rating 1, historically (on average) 86% have remained
at credit rating 1, 8% have been downgraded to a lower credit rating 2, 3% have been downgraded to credit rating 3, 2% have been
downgraded to credit rating 4 and 1% have defaulted by the end of the year.
Also, loans that began the year at credit rating 2, historically (on average) 4% have been upgraded to a higher credit rating 1, 84% have
remained at credit rating 2, 5% have been downgraded to credit rating 3, 4% have been downgraded to credit rating 4 and 3% have
defaulted by the end of the year. In the same fashion the migration matrix for loans starting with credit ratings 3 and 4 can be explained.
Suppose that the FI is evaluating the credit risk of its current portfolio of loans of borrowers rated 2, and that over the last few years a
much higher percentage (say, 8%) of loans has been downgraded to credit rating 3 and a higher percentage (say, 5%) has defaulted
than is implied by the historic transition matrix. The FI may then seek to restrict its supply of lower quality loans (e.g. those rated 2, 3 or
4) and concentrating more of its portfolio on high-quality loans, loans rated 1.

AACSB: Analytic
Bloom's: Comprehension
Difficulty: Hard
Est time: 10-15
Learning Objective: 11.1 The methods for measuring levels of loan concentration.
75.

Consider the following data for a two-asset portfolio:

Using the Moody’s Analytics model:

a. calculate the returns for loans 1 and 2.
b. calculate the risk for loans 1 and 2.
c. calculate the return for the loan portfolio.
d. calculate the risk for the loan portfolio.
e. explain your findings in (a) to (d).

a. The returns of loans 1 and 2:

R1 = (0.045 + 0.02) – [0.05 0.35] = 0.0475 or 4.75%
R2 = (0.05 + 0.025) – [0.04 0.30] = 0.063 or 6.30%
b. The risk for loans 1 and 2:
1 = [0.05(1 – 0.05)]½ 0.35 = 0.07628 or 7.628%
2 = [0.04(1 – 0.04)]½ 0.30 = 0.05879 or 5.879%
c. The return for the loan portfolio:
Rp = 0.35(4.75%) + 0.65(6.30%) = 5.76%
d. The risk for the loan portfolio:
2
p = (0.35)2(0.07628)2+ (0.65)2(0.05879)2+ 2(0.35) (0.65) (0.07628) (0.05879) = 0.0016017

Thus, sp =
= 4.00%
e. The risk (or standard deviation of returns) of the portfolio, p(4%), is less than the risk of either individual asset (7.628% and 5.879%,
respectively). The negative correlation between the returns of the two loans (–0.28) results in an overall reduction of risk when the two
assets (loans) are put together in a loan portfolio.

AACSB: Analytic
Bloom's: Application
Difficulty: Hard
Est time: 10-15
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending.
76. Explain the basic concept of loan loss ratio based models.

A partial application of the modern portfolio theory (MPT) is a model based on historic loan loss ratios. This model involves estimating
the systematic loan loss risk of a particular sector or industry relative to the loan loss risk of an FI’s total loan portfolio. This systematic
loan loss can be estimated by running a time–series regression of quarterly losses of the ith sector's loss rate on the quarterly loss rate
of an FI’s total loans:

Where a measures the loan loss rate for a sector that has no sensitivity to losses on the aggregate loan portfolio (i.e. its = 0) and i
measures the systematic loss sensitivity of the ith sector loans to total loan losses.
For example, regression results showing that the consumer sector has a of 0.2 and the real estate sector has a of 1.4 suggest that
loan losses in the real estate sector are systematically higher relative to the total loan losses of the FI (by definition, the loss rate for the
whole loan portfolio is 1). Similarly, loan losses in the consumer sector are systematically lower relative to the total loan losses of the FI.
Consequently, it may be prudent for the FI to maintain lower concentration limits for the real estate sector as opposed to the consumer
sector, especially as the economy moves towards a recession and total loan losses start to rise. The implication of this model is that
sectors with lower s could have higher concentration limits than high sectors—since low loan sector risks (loan losses) are less
systematic.

AACSB: Analytic
Bloom's: Comprehension
Difficulty: Hard
Est time: 10-15
Learning Objective: 11.4 The concentration of loans, loan volume and internal loan loss ratio concepts.
Chapter 11 Testbank Summary

Category # of Questions
AACSB: Analytic 76
Bloom's: Application 37
Bloom's: Comprehension 2
Bloom's: Knowledge 37
Difficulty: Easy 17
Difficulty: Hard 21
Difficulty: Medium 38
Est time: 1-3 51
Est time: 10-15 3
Est time: <1 22
Learning Objective: 11.1 The methods for measuring levels of loan concentration. 17
Learning Objective: 11.12 How FIs use loan sales and securitisation to manage credit risk. 1
Learning Objective: 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans. 22
Learning Objective: 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending. 14
Learning Objective: 11.4 The concentration of loans, loan volume and internal loan loss ratio concepts. 6
Learning Objective: 11.6 The types of futures and options contracts that can be used to hedge credit risk. 3
Learning Objective: 11.7 How futures and options can be used to hedge catastrophe risk. 3
Learning Objective: 11.8 How credit swaps help FIs manage credit risk. 5
Learning Objective: 11.9 The types of credit swaps. 7