Charta is on Google Play: practise on the go. Get the app
Charta

Set out which entities carry credit risk and the situations in which they become exposed to it.

FRM® Part II · Credit Risk Measurement and Management · Fundamentals of Credit Risk · FRM2.CR.1.d

The idea

Any party that is owed something in future carries credit risk, and the position can change as values move. Banks and other lenders are exposed to borrowers. Bondholders, funds and pension plans are exposed to issuers. Corporates that sell on credit are exposed to their customers, through receivables. Derivative counterparties are exposed to each other, although only the party with positive market value has an exposure at that moment. Depositors are exposed to the bank holding their money, except where deposits are insured. A beneficiary of a guarantee, credit insurance or a credit default swap is exposed to the guarantor or protection seller, so hedging replaces one credit risk with another. In clearing, members are exposed to the central counterparty and it to them. Insurers carry reinsurance recoverables. The test is simple: ask who has a claim on whom, because the claimant bears the risk.

A practice question

From the question bank, with the reason each wrong option is wrong.

A manufacturer sells goods to a retailer on 60-day payment terms. The manufacturer's credit exposure to the retailer is best measured by:

  1. The retail price of the goods now held in the retailer's stores.Why not: The retail price reflects the retailer's inventory value, not the amount the retailer owes the manufacturer.
  2. The manufacturer's total cost of goods sold for the year.Why not: Annual cost of goods sold is a flow measure and is unrelated to what the retailer currently owes.
  3. The retailer's total liabilities to all of its creditors.Why not: The retailer's total liabilities include debts to others; the exposure is only what it owes the manufacturer.
  4. The unpaid invoice amounts owed by the retailer. - correct

Selling on credit creates a claim on the buyer, shown as accounts receivable. The exposure is the outstanding invoice amount.

A harder one

A bank buys credit default swap protection from an insurer on a corporate loan it holds. After the purchase, which statement best describes the bank's credit exposures?

  1. Only to the borrower, because the CDS transfers all of the credit risk away from the bank entirely.Why not: Ignores that the bank now relies on the protection seller to pay, so counterparty credit risk is added.
  2. Only to the protection seller, because the loan has been hedged.Why not: The bank still owns the loan, so it remains exposed to the borrower if the seller does not perform.
  3. It remains exposed to the borrower and is newly exposed to the protection seller, who may fail to pay. - correct
  4. To neither, because a CDS settles in cash.Why not: Cash settlement is paid by the protection seller, which can itself fail; hedging does not remove credit risk.

Hedging with a CDS replaces part of the borrower risk with risk on the protection seller. The bank loses only if the seller also fails to pay, but it is exposed to both.

The hardest tier

A bank holds a USD 30 million loan to Company X, guaranteed in full by its parent, Company Y. Over one year, X has a probability of default of 4 percent and Y of 2 percent, and the two defaults are independent. Assuming the guarantee is honoured whenever Y is solvent, the probability that the bank suffers a credit loss is closest to:

  1. 6.00 percentWhy not: Adds the two probabilities, as if the bank lost money if either defaulted, which ignores the guarantee.
  2. 5.92 percentWhy not: Uses the probability that at least one of X and Y defaults; the guarantee means a loss arises only if both do.
  3. 4.00 percentWhy not: Ignores the guarantee entirely and counts only the probability that X defaults.
  4. 0.08 percent - correct

The bank loses only if X defaults and Y fails to honour the guarantee. With independence: 0.04 x 0.02 = 0.0008 = 0.08 percent. Positive correlation between X and Y would raise this probability.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Fundamentals of Credit Risk