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Which of the following describes rating transition matrices published by credit rating firms:
Transition matrices are used for building distributions of the value of credit portfolios, and are the realized frequencies of migration from one credit rating to another over a period, generally one year. Therefore Choice 'd' is the correct answer.
Since they represent an actually observed set of values, they are not probabilities nor are they forward looking ex-ante estimates, though they are often used as proxies for probabilities. Choice 'a' and Choice 'c' are not correct. They include more than information on just defaults, therefore Choice 'b' is not correct.
Which of the following losses can be attributed to credit risk:
1. Losses in a bond's value from a credit downgrade
2. Losses in a bond's value from an increase in bond yields
3. Losses arising from a bond issuer's default
4. Losses from an increase in corporate bond spreads
Losses due to credit risk include the loss of value from credit migration and default events (which can be considered a migration to the 'default' category). Therefore Choice 'd' is the correct answer. Changes in spreads or interest rates are examples of market risk events.
[Discussion: It may be argued that losses from spreads changing could be categorized as credit risk and not market risk. The distinction between credit and market risk is never really watertight.
The reason I have called it market risk in this question is because spreads can change due to two reasons: first, due to the individual issuer going down in their credit rating (whether issued or perceived, as we have witnessed in Europe sovereign debt), and second due to the spread for the overall category changing due to macro fundamentals with nothing changing for the individual issuer. For example the spread between municipal bonds and treasuries may be small during boom times and may expand during recessions - regardless of how the individual issuer has been doing. Clearly, the first case is credit risk and the second is probably market risk.
A change in overall corporate bond spreads is something I would consider akin to a rate change - which is why I have called it as not a part of credit risk. But an alternative perspective may not be incorrect either.]
Under the standardized approach to calculating operational risk capital, how many business lines are a bank's activities divided into per Basel II?
In the Standardized Approach, banks' activities are divided into eight business lines: corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Therefore Choice 'c' is the correct answer.
For a loan portfolio, unexpected losses are charged against:
Credit reserves are created in respect of expected losses, which are considered the cost of doing business. Unexpected losses are borne by economic credit capital, which is a part of economic capital. This question is a bit nuanced - and 'economic capital' would generally be a good answer as well. However, taking a rather beady eyed view of the terminology and distinguishing between 'economic credit capital' which is a subset of 'economic capital', we can say that 'economic credit capital' is a more appropriate Choice 'a's the question relates to credit losses.
If two bonds with identical credit ratings, coupon and maturity but from different issuers trade at different spreads to treasury rates, which of the following is a possible
1. The bonds differ in liquidity
2. Events have happened that have changed investor perceptions but these are not yet reflected in the ratings
3. The bonds carry different market risk
4. The bonds differ in their convexity
When two bonds that appear identical in every respect trade at different prices, the difference is often due to differences in liquidity between the two bonds (the less liquid bond will be cheaper and yield higher), and also due to the fact that ratings from the major rating agencies do not generally react to day to day changes in the market. The market's perception of the differences in the two credits will cause a divergence in the prices. This has been an extremely visible phenomenon during the credit crisis of 2007-2009, where fixed income security prices have changed sharply for many securities without any changes in external credit ratings.
Bonds carrying 'different market risk' is meaningless, and so is the difference in convexity (because the calculated convexity would be identical for similar bonds).
Therefore Choice 'c' is the correct answer.
