Question #1 of 36 Question ID: 1473562

Credit scores and credit ratings are both:

A) cardinal rankings.
B) qualitative ratings.
C) ordinal rankings.

Explanation

Credit scores and credit ratings are both ordinal rankings.

(Module 28.3, LOS 28.b)

Question #2 of 36 Question ID: 1473561

Credit scores are most likely to be used for:

A) sovereign bonds.
B) small businesses.
C) ABS.

Explanation

Credit scores are used for individuals and small businesses. Credit ratings are used for
corporate, quasi-government, and sovereign bonds as well as for secured debt (ABS).

(Module 28.3, LOS 28.b)

Question #3 of 36 Question ID: 1473581

Which of the following factors is least likely a determinant of term structure of credit
spreads?

A) Existence of off-balance sheet liabilities.

B) Equity market volatility.
C) Financial conditions in the market.
Explanation

Term structure of credit spread is influenced by credit quality, financial conditions, market
demand and supply, and equity market volatility.

(Module 28.6, LOS 28.g)

Question #4 of 36 Question ID: 1473578

Zack Ma is evaluating a 10-year, 4% Tesa bond. Ma has calculated the CVA on the bond to be
$1.19 per $100 par. Ma is considering the impact of a new patent granted to Tesa. After
careful analysis, Ma concludes that the probability of default would most likely decrease on
the bond. After incorporating the revised probability in his analysis, Ma will most likely
conclude that:

A) both the CVA and the credit spread will be higher.

B) both the CVA and the credit spread will be lower.
only the credit spread will be lower; the impact on CVA will depend on changes
C)
in benchmark rates.

Explanation

CVA and credit spreads are positively related to probability of default.

(Module 28.6, LOS 28.f)

Question #5 of 36 Question ID: 1473563

Higher rated bonds have lower:

A) returns.
B) credit spreads.
C) price.

Explanation

Higher rated bonds have lower spreads. Price and return depends on other factors (e.g.,
coupon rate, maturity, risk-free rate).

(Module 28.3, LOS 28.b)

Question #6 of 36 Question ID: 1473566

Under the structural model, owning equity in a company is equivalent to:

A) long position in a call option on the assets of the company.

B) short position in a put option on the assets of the company.
C) long position in a call option on the firm’s debt.

Explanation

Equity investors have economic position equivalent to a long position in a call option on
the assets of the company with a strike price equal to the face value of debt.

(Module 28.4, LOS 28.d)

Question #7 of 36 Question ID: 1473560

Alan Barding is a bank analyst currently reviewing data on the credit scores of 3 individuals
who have applied for a bank loan. The credit scores for the 3 individuals are shown below:

Individual Credit score

A 700

B 440

C 350

Which of the following conclusions is Barding least likely to draw?

A) Individual B is less likely to default than individual C.

B) Individual A has a lower credit risk than individual B.
C) Individual C is twice as likely to default as individual A.

Explanation

Credit scores are ordinal rankings. Individual C is more likely to default than individual A,
but it cannot be concluded that A is twice as likely.

(Module 28.3, LOS 28.b)

Question #8 of 36 Question ID: 1473570

Which key input into a reduced form model can be estimated using a regression model?

A) Default intensity.
B) Loss intensity.
C) Recovery rate.

Explanation

Default intensity is the probability of default over the next time period and can be
estimated using regression models.

(Module 28.4, LOS 28.d)

Question #9 of 36 Question ID: 1586269

Perez Zinta has collected the following information on a 3-year, 3% corporate bond.

Year Exposure LGD PD PS Expected Loss DF PV of Expected Loss

1 103.96 41.585 1.80% 98.200% 0.749 0.9756 0.73

2 103.49 41.395 1.77% 96.432% 0.732 0.9518 0.70

3 103.00 41.200 1.74% 94.697% 0.715 0.9286 0.66

CVA 2.091

Given a 3-year risk-free rate of 1.50%, Calculate the IRR of the bond assuming that default
occurs in year 2.

A) -25.48%
B) -13.37%
C) -20.60%

Explanation

First calculate the VND: N=3, PMT = 3, FV = 100, I/Y = 1.50, PV = 104.37 = VND.

Price of the corporate bond = VND – CVA = 104.37 – 2.09 = 102.28

Cash flow in year 0 = -102.28, cash flow in year 1 = $3 (coupon, no default).

If the bond defaults in year 2, recovery = Exposure – LGD = 103.49 – 41.40 = 62.09 = cash
flow in year 2.

Enter the cash flows and calculate IRR = -20.60%.

(Module 28.1, LOS 28.a)

Question #10 of 36 Question ID: 1473579

If investors are expecting an impending recession, credit spreads would most likely:

A) widen.
B) remain unchanged.
C) narrow.

Explanation

Credit spreads change based on market's expectations. Impending recessions would lead
to upward revision in probability of default and lower recovery rate. Combined, these
revisions would lead to widening of credit spreads.

(Module 28.6, LOS 28.f)

Question #11 of 36 Question ID: 1473586

An investor in an ABS would face which risks on account of the ABS servicer?

A) Operational and concentration risk.

B) Operational and counterparty risk.
C) Credit and concentration risk.

Explanation

After origination, investors in secured debt face the operational and counterparty risk of
the servicer.

(Module 28.7, LOS 28.h)

Question #12 of 36 Question ID: 1473555

A corporate bond has one year to maturity with a probability of default of 2.05% and a
recovery rate of $32.00 per $100 par value. If an investor holds $100,000 of par value, what
is the expected loss?

A) $1,394.
B) $2,050.
C) $656.

Explanation

Expected = Probability of default × expected loss per $

loss × par value
= 0.0205 × (1 − 0.32) × $100,000
= $1,394

(Module 28.1, LOS 28.a)

Question #13 of 36 Question ID: 1473569

To analyze the credit risk of a company with significant off-balance sheet liabilities, which
credit model is most appropriate?

A) Econometric model.
B) Reduced form model.
C) Structural model.

Explanation

Structural models are not suitable when the company has complex balance sheets or
when there are significant off-balance sheet liabilities. Reduced form models would be
appropriate in such a situation.

(Module 28.4, LOS 28.d)

Philip Bagundang, CFA, is an experienced analyst working for the corporate credit
department of a global investment bank.

Bagundang is evaluating the proposed two-year, zero coupon, £100 par Shumensko bond.
Using a 2% probability of default assumption, Bagundang calculates the CVA on the bond to
be £1.820. Two-year, risk-free zero-coupon bonds currently yield 0.8%.

Bagundang is evaluating a three-year, zero-coupon bond issued by Alligator, Inc. Using a

hazard rate of 2% and estimated recovery rate of 70%, and a flat 2.5% benchmark yield
curve, a partial table of analysis is completed as shown in Exhibit 1.

Exhibit 1: Alligator, Inc. Bond

 Loss given Probability of Probability of Expected
Year Exposure
default survival default loss

1 95.18 28.55 98.00% 2.00% 0.5711

3 100.00 30.00 94.12%

Bagundang asks his assistant, Diane Monera, to summarize how structural models can be
viewed as options on the firm's assets. Monera states that shareholders have limited liability
and can, therefore, be viewed as having a long call option on the firm's assets with a strike
price equal to the par value of debt. In addition, she adds, debtholders can be viewed as
having a long position in a risk-free zero-coupon bond and a position in another instrument
she can't quite remember.

Finally, Bagundang asks Monera to prepare a short summary table of structural versus
reduced form models. Exhibit 2 shows her summary.

Exhibit 2: Structural vs. Reduced Form Models

Structural Reduced Form

Default risk Exogenous Endogenous

Parameter estimation Option pricing theory Default intensity

Question #14 - 17 of 36 Question ID: 1531372

Based on Exhibit 1, and the stated risk-free rate on two-year zero-coupon bonds, the credit
spread on the Shumensko bond is closest to:

A) 0.12%.
B) 0.18%.
C) 0.95%.

Explanation
The credit valuation adjustment is the difference between the value of a risky bond and
the equivalent risk-free bond (VND).

A two-year risk free bond with a face value of £100 and a yield-to-maturity of 0.8% would
have a present value of £98.42.

The CVA on the Shumensko bond is £1.820 per £100 par value.

Bond value = VND – CVA = 98.42 – 1.82 = £96.60

Using TVM Keys:

N = 2; PMT = 0; FV = 100; PV = –96.60; CPT I/Y = ? = 1.75%

The credit spread is the difference between this value and the YTM of the equivalent risk-
free bond (0.8%) = 0.95%.

(Module 28.1, LOS 28.a)

Question #15 - 17 of 36 Question ID: 1531373

Based on Exhibit 1 and a par value of $100, the expected loss on the Alligator bond in year 2
is closest to:

A) $0.5718.
B) $0.5737.
C) $0.5789.

Explanation
The completed table is shown below:

Exhibit 1: Alligator, Inc. Bond

Loss given Probability of Probability of Expected

Year Exposure
default survival default loss

1 95.18 28.55 98.00% 2.00% 0.5711

2 97.56 29.27 96.04% 1.96% 0.5737

3 100.00 30.00 94.12% 1.92% 0.5762

The exposure in year 2 for a zero-coupon bond is the present value of par discounted at
the benchmark (risk-free) rate. $100 / (1.025). The loss given default is the exposure
multiplied by 1 – recovery rate. ($97.56 × 0.30). The probability of default is the hazard rate
of 2% multiplied by the previous year's probability of survival (2% × 98.00%).

The expected loss is the loss given default multiplied by the probability of default (1.96% ×
$29.27) = $0.5737.

(Module 28.1, LOS 28.a)

Question #16 - 17 of 36 Question ID: 1531374

In relation to structural models, the instrument that Monera cannot recall is most likely a:

A) long put with a strike price equal to the value of assets.

B) short put with a strike price equal to the value of debt.
C) short put with a strike price equal to the value of assets.

Explanation

Debtholders are viewed as having a long position in a riskless bond that pays X at time T
and simultaneously a short position in a European put option on company assets with a
strike price of X (equal to the face value of debt). In other words, debtholders receive
either the face value of debt if the company survives or X – (X – A) = A if the company
defaults (where A = the value of the assets of the company).

(Module 28.4, LOS 28.d)

Question #17 - 17 of 36 Question ID: 1531375

The summary provided in Exhibit 2 is best described as:

A) accurate.
B) inaccurate in regards to default risk.
C) inaccurate in regards to parameter estimation.

Explanation

Unlike structural models of credit risk, which treat default risk as an endogenous variable
(i.e., when the value of the assets is less than the face value of debt), reduced form models
do not explain why default occurs, instead they treat default as a randomly-occurring
(exogenous) variable. Reduced form models focus on the severity of loss given default.

(Module 28.4, LOS 28.d)

Question #18 of 36 Question ID: 1473556

Credit valuation adjustment is most likely:

A) the sum of present values of expected losses.

B) higher when the recovery rate is higher.
C) higher when the probability of survival is higher.

Explanation

Credit valuation adjustment (CVA) is the sum of present values of expected losses. CVA is
positively related to the probability of default and negatively related to probability of
survival and recovery rate.

(Module 28.1, LOS 28.a)

Question #19 of 36 Question ID: 1473558

If the annual hazard rate for a bond is 1.80%, the probability that the bond does not default
over the next three years is closest to:

A) 94.70%
B) 95.20%
C) 96.30%

Explanation

Probability of survival = (1 – 0.018)3 = 0.9470.

(Module 28.1, LOS 28.a)

Question #20 of 36 Question ID: 1473567

Under the structural model, owning risky debt is equivalent to a long position in a similar
risk-free bond and a:

A) long position in a put option on the assets of the company.

B) short position in a put option on the assets of the company.
C) long position in a call option on the assets of the company.

Explanation

Risky debt ownership is economically equivalent to a long position in risk-free bond and a
short position in a put option on the assets of the company.

(Module 28.4, LOS 28.d)

Freeman LLC, is a large investment firm based on the East Coast of the United States. The
company manages a range of investment funds with several different objectives but focuses
mainly on fixed income investments. Josh Scowen is a credit analyst who has just taken up a
position with the firm and is currently familiarizing himself with the various models and
techniques used by Freeman.

Scowen's first task is to assess the present value of the expected loss (CVA) on a bond issued
by Dreamy, Inc., an online retailer of designer fashion products. The company expanded
rapidly two years ago, but business conditions have deteriorated recently. Scowen's
supervisor is concerned that the company may run into serious trouble soon.

Exhibit 1: Dreamy Bond

Par $1,000

Annual coupon 8%
Time to maturity 2 years

Note: the risk-free rate of return is 1.22% (assume a flat yield curve).

Freeman also makes extensive use of reduced form and structural models to assess credit
risk. Scowen's supervisor has asked him to review the details of the approaches Freeman
uses.

Scowen recalls using a reduced form model at a previous firm and believes that the
following three assumptions are valid:

Assumption 1: The company's liabilities can be modelled as a single zero-coupon bond.

Assumption 2: The risk-free interest rate is constant.

Assumption 3: The probability of default and the recovery rate are not constant.

Freeman has recently used a reduced form model to analyze the credit risk of a zero-coupon
bond issued by Sleepy, Inc. Exhibit 2 lists some of the details of the simple reduced form
model.

Exhibit 2: Sleepy Bond, Reduced Form Model

Coupon: Zero

Face value: $10,000

Time to maturity: 1 year

Hazard rate: 0.02

Loss given default: 35%

One-year, default-free, zero-coupon bond price ($1 par): 0.95

Credit valuation adjustment: 66.50

Scowen also has a background in option pricing theory from a previous role and is confident
that he can put this experience to good use when using a structural model. He believes that
structural models value risky debt of a company by deducting the value of a put option on a
company's assets from the value of otherwise identical risk-free debt.

Question #21 - 24 of 36 Question ID: 1473574

Using the information in Exhibit 1, the expected exposure after one year is closest to:

A) $1,146.98.
B) $1,023.76.
C) $1,066.98.

Explanation

The expected exposure is the present value (@ risk-free rate of 1.22%) of the remaining
cash flows on the bond. After one year, the remaining cash flow on the bond is the
currently due coupon payment of $80 (issuer would not default after paying the coupon)
plus the last coupon plus principal of $1080.

expected exposure = 80 + $1,080 / 1.0122 = $1,146.98.

(Module 28.5, LOS 28.e)

Question #22 - 24 of 36 Question ID: 1473575

Which of the assumptions stated by Scowen regarding the reduced form model is most
accurate?

A) Assumption 3.
B) Assumption 1.
C) Assumption 2.

Explanation

The assumptions of reduced form models include:

The risk-free interest rate is stochastic.

The state of the economy is stochastic and depends on macroeconomic variables.
The probability of default (default intensity) and the recovery rate depend on the
state of the economy and are not constant.

(Module 28.1, LOS 28.a)

Question #23 - 24 of 36 Question ID: 1489319

Using information in Exhibit 2, the value of the Sleepy Bond is closest to:

A) $9,433.50.
B) $9,566.27.
C) $9,500.00.

Explanation

The credit valuation adjustment is $66.50, which represents the difference between the
price of a risky bond and the equivalent risk-free bond. The one-year risk-free bond price
is $9,500 (for a $10,000 par value).

bond value = 9,500 – 66.50 = $9,433.50.

(Module 28.4, LOS 28.d)

Question #24 - 24 of 36 Question ID: 1473577

Scowen's comment regarding option pricing theory and structural models is best described
as:

A) accurate.
inaccurate, as structural models value risky debt by deducting the value of a call
B)
option on the company’s assets from the value of risk free debt.
inaccurate, as structural models value risky debt by adding the value of a put
C)
option on the company’s assets to the value of risk-free debt.

Explanation

Scowen's statement is correct. Under structural models:

value of risky debt = value of risk-free debt – value of put option on company assets

(Module 28.4, LOS 28.d)

Question #25 of 36 Question ID: 1473571

When assessing a company's credit risk using structural models, which of the following
statements is most accurate?
 Owning debt is economically equivalent to owning a European call option on the
A)
company’s assets.
Structural models do not account for the impact of interest rate risk of the value
B)
of a company’s assets.
Owning equity is economically equivalent to owning a risk free bond and
C)
simultaneously selling a put option on the assets of the company.

Explanation

Owning equity is economically equivalent to owning a European call option on the assets
of the company. Owning debt is economically equivalent to owning a risk free bond and
simultaneously selling a put option on the assets of the company. The structural model
assumes that risk-free rate is not stochastic (i.e., it assumes that risk-free rate is constant).

(Module 28.4, LOS 28.d)

Question #26 of 36 Question ID: 1473564

Fico scores are inversely related to the:

A) variety of credit types used.

B) length of credit history.
C) number of ‘hard’ inquiries.

Explanation

FICO scores are higher for those with: (a) longer credit histories (age of oldest account), (b)
absence of delinquencies, (c) lower utilization (outstanding balance divided by available
line), (d) fewer credit inquires, and (e) a variety of types of credit used.

(Module 28.3, LOS 28.b)

Question #27 of 36 Question ID: 1473568

Using the structural model, the value of the put option on the assets of the company is
equal to:

A) value of the risky bond minus value of the risk-free bond.

B) credit valuation adjustment of the bond.
C) the value of the call option on assets of the company.
Explanation

Under structural model the put option value = value of risk-free bond – value of the risky
bond = CVA.

(Module 28.4, LOS 28.d)

Question #28 of 36 Question ID: 1473580

Which of the following two securities are most likely used to calculate the term structure of
credit spreads?

A) A corporate issuer’s senior debt and the same issuer’s subordinated debt.
B) A corporate issuer’s zero coupon bond and a default free zero coupon bond.
A corporate issuer’s coupon paying bond and the same issuer’s zero coupon
C)
bond.

Explanation

If a zero coupon bond is not available an implied zero coupon bond price for the issuer
can be derived from the coupon paying bond price.

(Module 28.6, LOS 28.g)

Question #29 of 36 Question ID: 1480345

Which of the following statements regarding evaluating credit risk of Asset Backed Securities
(ABS) is least accurate?

Unlike for corporate debt, structural and reduced form models are not
A)
appropriate.
The analysis should entail consideration of the composition of the collateral
B)
pool and the cash flow waterfall.
Credit rating agencies do not use the same credit ratings for ABS as for
C)
corporate debt.

Explanation
Reduced form and structural models can be used as long as they take into account the
complex structure of the ABS. Secured debt is usually financed via a bankruptcy-remote
SPE. This isolation of securitized assets allows for higher credit rating and lower cost to the
issuer.

(Module 28.7, LOS 28.h)

Question #30 of 36 Question ID: 1473565

Mihor Kotak is evaluating the impact of a ratings upgrade on 1Team bonds. The bonds have
a modified duration of 5.88 and the current credit spread on the bonds is 60 bps. After the
upgrade, Kotak expects that the spreads will narrow by 15bps. Based on Kotak's
expectations, what will be the estimated change in the price of the bond if the upgrade
occurs?

A) 8.82%
B) 0.38%
C) 0.88%

Explanation

Change in spread (given) = – 15 bps

Δ%P = – (modified duration of the bond) × (Δ spread) = –5.88 × –0.0015 = –0.00882 or

0.88%. Since spread narrows, price will increase (i.e., a positive price change).

(Module 28.3, LOS 28.c)

Question #31 of 36 Question ID: 1473557

Calculate the CVA on a 1.75%, 1-year, $100 par annual pay bond with recovery rate of 70%
and probability of default of 2%. Assume that the 1-year risk-free rate is 2%.

A) $1.12
B) $1.89
C) $0.59

Explanation
Year Exposure LGD PD Expected Loss DF PV of Expected Loss
0 99.75 29.93 2.00% 0.60 0.9804 0.59

DF = PV of $1 using risk-free rate = 1 /1.02 = 0.9804. Exposure = 101.75/1.02 = 99.75. LGD =

Exposure × (1 – recovery rate) = 99.75 × 0.30. Expected loss = LGD × PD = 29.93 × 0.02.

(Module 28.1, LOS 28.a)

Question #32 of 36 Question ID: 1473584

As compared to otherwise identical corporate debt, securitized debt is least likely to have:

A) higher leverage for the issuer.

B) the same risk premium.
C) lower cost for the issuer.

Explanation

The isolated structure of securitized assets allows for higher leverage and lower cost to
the issuer. Investors also benefit from greater diversification, more stable cash flows and a
higher risk premium relative to similar rated general obligation bonds (due to higher
complexity associated with collateralized debt).

(Module 28.7, LOS 28.h)

Question #33 of 36 Question ID: 1473585

An ABS security backed by a highly granular collateral pool composed of hundreds of clearly
defined loans, analysis of collateral pool can be done using:

A) summary statistics for analyzing credit risk.

B) examination of individual loans.
C) distribution waterfall analysis.

Explanation

A highly granular pool would have hundreds of clearly defined loans, allowing for use of
summary statistics as opposed to investigating each borrower. A more-discrete pool of few
loans would warrant examination of each obligation separately. Distribution waterfall
analysis is part of evaluation of the ABS structure (and not collateral pool).

(Module 28.7, LOS 28.h)

Question #34 of 36 Question ID: 1473582

Upward sloping credit curve is most likely an indication of:

A) expectations of a recession.
B) upward sloping benchmark curve.
C) expectations of an economic expansion.

Explanation

Upward sloping credit curve indicates widening of spread as debt maturity increases. This
would be consistent with expectations of higher probability of default (or lower recovery
rate) in the longer-term, which would be consistent with expectations of a recession.

(Module 28.6, LOS 28.g)

Question #35 of 36 Question ID: 1473572

Zack Ma is evaluating a five-year, 4% Zem bond. Ma has calculated the CVA on the bond to
be $2.12 per $100 par. Current benchmark rates are flat at 3%. The credit spread on the
bond is closest to:

A) 0.21%
B) 0.97%
C) 0.46%

Explanation

First calculate the VND: N=5, PMT = 4, FV = 100, I/Y = 3. PV = 104.58 = VND.

Value of risky bond = VND – CVA = 104.58 – 2.12 = 102.46

YTM on risky bond: N=5, PV = -102.46, PMT = 4, FV = 100, I/Y = 3.46%

Credit spread = YTM (risky) – YTM (risk-free) = 3.46% – 3% = 0.46%.

(Module 28.5, LOS 28.e)

Question #36 of 36 Question ID: 1473587

As compared to other secured debt, investors in a covered bond have:

A) an embedded put option.
B) an embedded conversion option.
C) recourse rights.

Explanation

Covered bonds are backed by the collateral pool as well as by the issuer; investors in
covered bonds have recourse rights.

(Module 28.7, LOS 28.h)