Topics covered in Credit Risk Measurement & Management of FRM Part 2

Credit Risk Measurement and Management is one of the six broad topics that GARP tests in its FRM Part 2 exam. This broad topic has 20% weight in the exam, which means out of 80 questions asked, you may expect 16 questions from this section. This area focuses on a candidate’s understanding of credit risk management, focusing on structured finance and credit products such as collateralized debt obligations and credit derivatives.

The broad areas of knowledge covered in readings related to Credit Risk Measurement and Management include the following:

• Credit analysis
• Default risk: quantitative methodologies
• Expected and unexpected loss
• Credit VaR
• Counterparty risk
• Credit derivatives
• Structured finance and securitization

There are eighteen chapters or readings in this section. If you go through the GARP specified learning objectives (LOs) for this section, you will find a good mix of computational and non-computational LOs. As GARP generally asks tricky questions from the non-computational LOs, non-computational LOs are to be equally emphasized to score well in this section.

Let me now take you through the essence of each of the eighteen chapters or readings and identify the concepts that GARP might test on the exam day.

Chapter 1: The Credit Decision

This chapter furnishes an overview of the credit analysis process. Credit risk can stem from multiple sources, including default, an increased probability of default, failure to perform on a prepaid obligation, more severe losses than expected resulting from greater exposure than anticipated, or lesser recoveries than expected given a default. On the exam day, GARP might test your ability to:

• Compare and contrast the credit analysis process for consumers (i.e., individuals), nonfinancial firms, financial firms, and to a lesser degree for sovereigns.
• Distinguish between the probability of default (PD), the loss given default (LGD), the exposure at default (EAD), and the overall expected loss (EL).

Note that it is simple to measure losses in hindsight but difficult to forecast. Financial institutions become more likely to fail in the time of crisis. Credit analysts must figure out where a financial institution features on a continuum between perfectly creditworthy and bankrupt.

Chapter 2: The Credit Analyst

This chapter emphasizes the role and tasks performed by a banking credit analyst. On the exam day, GARP might test your understanding of the following:

• Objectives of the analyst (e.g., risk management, investment selection) as well as the difference between primary and secondary research
• Quantitative and qualitative skills that an analyst must possess to be successful.
• Key sources of information, such as the annual report, auditor’s report, and company financial statements, used by credit analysts.

Chapter 3: Capital Structure in Banks

This chapter discusses the bottom-up approaches to determining economic capital for credit risk and issues concerning that approach. As a bank holds many assets, one should examine the expected and unexpected loss in a portfolio setting.

The portfolio expected loss equals the sum of the individual expected losses, while the portfolio unexpected loss is substantially less than the sum of the individual unexpected losses because of diversification effects. The unexpected loss is a fraction of the total exposure amount. Default and credit migration increase the unexpected loss of a risky asset. On the exam day, GARP might test your understanding of:

• The calculations of expected loss, unexpected loss, and the risk contribution of each asset in the portfolio
• How the economic capital is used to cover unexpected losses

Chapter 4: Rating Assignment Methodologies

The emphasis of this chapter is on the assessment of default risk and assigning ratings as a tool for quantifying this risk. On the exam day, GARP might test your understanding of:

• The relationship between default probability and ratings.
• How are ratings derived for issues and issuers?
• How do ratings migrate over time?
• How are various default probabilities calculated?
• What defines a good rating system?

The default can be anticipated using different approaches: experts-based (heuristic), reduced form (statistical and numerical), structural (the Merton model), linear discriminant analysis, logistic regression models, cluster analysis, principal component analysis, and cash-flow simulations. On exam day, GARP might test your understanding of the advantages and limitations of each of the approaches above, as well as the similarities and differences among them. As these approaches are heavily quantitative, it is essential to factor in qualitative information while analyzing any default probability.

Chapter 5: Credit Risks and Credit Derivatives

The likely failure of a party to make an agreed-upon payment brings uncertainty for risk managers. The pricing of risky debt using the Merton model gives insight into predicting the probability of default and the amount of loss given the default. Additional approaches have been devised to assess the credit risk of portfolios and furnish estimates of a portfolio’s credit value at risk.

Credit derivatives provide the risk manager with the means that can be used to hedge credit risk exposures. This chapter discusses several models for evaluating and measuring credit risk, including examples of credit derivatives used to hedge credit risk exposure. For the exam day, be thorough with your understanding of firm equity and debt calculation under the Merton model.

Chapter 6: Spread Risk and Default Intensity Models

Investors need a return for taking credit risk, which is typically expressed relative to risk-free rates (e.g., yield spread, OAS, CDS spread). The default can be modelled with simple Bernoulli trials or more advanced intensity (hazard) models.

On the exam day, GARP might test your understanding of the:

• Relationship between hazard rates, cumulative default probability, and conditional default probability.
• Credit spread that approximately equals to loss given default times probability of default.

Chapter 7: Portfolio Credit Risk

This chapter discusses default correlation’s role in quantifying the default risk for a credit portfolio.

On the exam day, GARP might test your understanding of:

• The drawbacks of using default correlation.
• The single-factor model approach under the assumption that defaults are independent and returns are normally distributed.
• How to calculate the mean and standard deviation of the default distribution under the single-factor model conditional approach for correlations of 0 and 1 and the unconditional approach for correlations between 0 and 1.
• How VaR is determined using the single-factor model and copula methodology based on simulated terminal values.

Chapter 8. Structured Credit Risk

This chapter discusses common structured products, capital structure in securitization, structured product participants, a basic waterfall structure, and the impact of correlation.

On the exam day, GARP might test your understanding of:

• The qualitative impacts of changing default probability and default correlation for all tranches for the mean (average) and risk (credit VaR).
• Default sensitivity that is similar to DV01.
• The process for computing implied correlation is extracted from observable market prices.

Chapter 9. Counterparty Risk and Beyond

This chapter talks about the concept of counterparty credit risk and discusses techniques for mitigating and managing counterparty risk.

On the exam day, GARP might test your understanding of:

• The basic terminology related to counterparty risk and the definitions and differences among the various credit exposure metrics.
• The types of institutions that take on counterparty risk through trading.
• How institutions can mitigate and manage counterparty risk.

Chapter 10: Netting, Close-out, and Related Aspects

This chapter discusses different techniques to mitigate counterparty risk and credit exposure. Specifically, it discusses different ways to reduce current and potential credit exposure, e.g., termination features and netting and close-out features.

On the exam day, GARP might test your understanding of the following:

• Advantages and disadvantages of netting and termination features.
• Reset agreements, break clauses, walkaway clauses, and trade compression and how they are used.

Chapter 11: Margin (Collateral) and Settlement

This chapter discusses collateral and introduces different types of collateral, the features of a collateralization agreement and a credit support annex (one-way and two-way), and the reconciliation of collateral disputes.

For the exam day, be thorough with your understanding of the following:

• key parameters associated with collateral, e.g., threshold, initial margin, and the minimum transfer amount.
• Risks related to collateralization, include market risk, operational risk, and funding liquidity risk.

Chapter 12: Future Value and Exposure

This chapter describes credit exposures for various security positions. For the exam day, be thorough with your understanding of:

• Credit exposure metrics and their application.
• Potential future exposure (PFE) for the various asset classes
• How credit exposure and VaR methods compare
• Credit exposure factors.
• How payment frequencies and exercise dates impact exposure profiles.
• Netting tables and calculation of the netting factor.
• The impact of collateral attributes on credit exposure reduction and knowing the steps in the re-margin period.
• The difference between risk-neutral and real-world parameters in arbitrage models and risk management applications.

Chapter 13: CVA

The pricing of counterparty risk depends on the credit exposure and default probability of a counterparty.

On the exam day, GARP might test your understanding of:

• How to calculate a credit value adjustment (CVA) in the presence of unilateral contracts.
• The concepts of incremental and marginal CVA
• How to estimate CVA as a spread.

The global financial crisis of 2007-2008 and the European sovereign debt crisis showed the significance of wrong-way risk and right-way risk. For instance, buyers of protection against bond defaults may experience an impressive gain in their position because of falling bond prices as a result of some macroeconomic events. However, at the same time, falling bond prices increase the risk exposure and default probability of a counterparty because of the adverse impact of macroeconomic events, resulting in an overall increase in counterparty risk.

This is an instance of wrong-way risk (WWR). Normal derivatives markets factor in right-way risk (RWR), in which hedges yield successful expected results. Macroeconomic events impact risk exposure and default probability in a favourable manner such that the overall expected counterparty risk decreases. On exam day, GARP might test your ability to explain both wrong-way risk and right-way risk as well as figure out these risks in transactions such as put options, call options, credit default swaps, foreign currency transactions, interest rate and currency swaps, and commodities.

Chapter 14: The Evolution of Stress Testing Counterparty Exposures

This chapter discusses counterparty credit risk measurement and management. It starts by differentiating between the various measures of exposure. Next, it talks about treating counterparty credit risk, both credit, and market risk. Then, it reviews the credit valuation adjustment (CVA) and stresses the CVA.

On the exam day, GARP might test your ability to:

• Describe a stress test that can be performed on both a loan portfolio and a derivatives portfolio.
• Calculate the stressed expected loss and stressed CVA.
• Distinguish the DVA from the CVA.

Chapter 15: Credit Scoring and Retail Credit Risk Management

This chapter talks about credit risk management, mainly from the perspective of the retail credit lender. For the exam day, pay special attention to the risks incurred by a lender and how credit scoring models can be used to factor in variables into an effective risk evaluation model.

While estimating risk and evaluating model performance is important, assessing credit applicants for potential profitability is equally important, if not more. Be thorough with your understanding of the role of a credit applicant as both a borrower and a potential client for other lender products. Also, GARP might test your understanding of the concept of risk-based pricing and how it has changed the way lenders price their products to different customers.

Chapter 16: The Credit Transfer Markets — and Their Implications

Securitized financial products were very popular before the 2007–2009 financial crisis. Although investors need to understand the inner workings and risk potential integral in any investment before adding it to a portfolio, more sophisticated assets such as securitized products call for even more scrutiny.

On the exam day, GARP might test your ability to:

• Identify flaws in the securitization of subprime mortgages.
• Explain the different techniques used to mitigate credit risk.
• Describe the different types and structures of credit derivatives, including credit default swaps (CDSs), first-to-default puts, total return swaps (TRSs), and asset-backed credit-linked notes (CLNs).
• Describe the structures of collateralized debt obligations (CDOs), synthetic CDOs, and single-tranche CDOs.

Chapter 17: An Introduction to Securitisation

Securitization refers to the process of selling cash-flow producing assets to a third-party special purpose entity (SPE), which in turn issues securities backed by the pooled assets. Mortgage-backed securities (MBSs) securitize residential mortgages where the property acts as collateral.

On the exam day, GARP might test your understanding of:

• The securitization process of selling cash-flow producing assets to a special purpose vehicle (SPV)
• The differences between amortizing, revolving, and master trust structures.
• The different types of credit enhancements.
• Definition and calculation of the various performance tools for different securitized structures.

Chapter 18: Understanding the Securitization of Subprime Mortgage Credit

This chapter talks about many important aspects of subprime markets. More specifically, it discusses seven frictions between market participants involving mortgagors, originators, arrangers, rating agencies, asset managers, and investors. One should thoroughly understand each friction’s information problem (moral hazard or adverse selection). Characteristics of subprime mortgages are also covered, including loan terms, performance, and subordination.

On the exam day, GARP might test your understanding of:

• Subprime mortgage securitization.
• The friction in the subprime market.
• The process of rating subprime securities.

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