GARP 2016-FRR - Financial Risk and Regulation (FRR) Series

The formula to estimate interest charges on a loan includes the risk-free rate, which is the base rate for borrowing with no risk of default. To this, the expected loss due to default (calculated as Probability of Default x Loss Given Default) and a spread to cover additional costs and profit margins are added. This comprehensive formula accounts for the risk and return expectations in lending.

The probability of default (PD) refers to the likelihood that a borrower will fail to meet its debt obligations over a specific time horizon. This is a core component in quantifying credit risk exposures.

Duration of default is not a commonly used term in credit risk analysis.

Exposure at default (EAD) measures the total value at risk in the event of default but does not directly refer to the likelihood of default.

Loss given default (LGD) measures the portion of the exposure that is lost when a borrower defaults but does not indicate the likelihood of default.

Asian options are a type of derivative that have a payoff based on the average price of the underlying asset over a certain period or on specific dates. This averaging mechanism makes them particularly useful for companies with recurring foreign currency demands, as it helps smooth out volatility and provides a more stable hedge against currency fluctuations. Given the large energy company's need for an option that fits the description of averaging prices over specific dates or within a pricing window, Asian options are the most suitable choice.

The cost of credit is typically influenced by factors that increase the risk or the expected return required by lenders. Increasing inflation rates (A) raise the cost of credit because lenders demand higher returns to compensate for the loss of purchasing power. A higher risk premium on a fixed income instrument (C) directly increases the cost of credit as lenders require more return for taking on additional risk. Similarly, a higher return on alternative investments (D) increases the cost of credit because lenders will demand higher returns to justify lending over these alternatives. However, an increase in the consumption of goods and services (B) does nottypically increase the cost of credit. Instead, it often signals a healthy economy, which can lower the perceived risk and cost of borrowing.

The most convenient approach for a credit analyst to quantify the credit risk exposure for the bank would be to analyze the distribution of the bank's credit losses and map credit risks at various statistical levels. This method provides a comprehensive view of potential losses and the probabilities associated with different loss levels, which is crucial for effective risk management and regulatory compliance.

Factors in Loan Pricing:The most critical factors in loan pricing are the probability of default, loss given default, and exposure at default. These directly impact the risk assessment and pricing strategies for loans.

Less Significant Factor:The duration of default, while relevant, is less significant compared to the immediate risk factors. It primarily affects the timing rather than the magnitude of potential losses.

Delta is the most commonly used risk measure to determine the number of options needed to hedge an underlying position. Delta measures the sensitivity of the option's price to changes in the price of the underlying asset. A delta-neutral portfolio, where the total delta is zero, effectively hedges against small movements in the underlying asset's price. Thus, risk managers frequently adjust their hedging strategies based on the delta of their positions.

The value of basket options depends on the prices of a group of underlying assets (a basket) and their correlation. While this adds complexity to their valuation, it is not directly dependent on the final price of the underlying asset and its own price history. Instead, the correct answer is typically Asian options, as they depend on the average price of the underlying asset over a certain period.

Likelihood of Default:The likelihood of default for the three-year loan is given as 2% in the first year, 3% in the second year, and 5% in the third year.

Expected Duration Calculation:

Year 1 Contribution:0.02×10.02×1= 0.02 years

Year 2 Contribution:0.03×20.03×2= 0.06 years

Year 3 Contribution:0.05×30.05×3= 0.15 years

Total Expected Duration:0.02+0.06+0.15=0.230.02+0.06+0.15=0.23years

Sum of Probabilities:0.02+0.03+0.05=0.100.02+0.03+0.05=0.10

Normalization:0.230.10=2.30.100.23​=2.3years

Thus, the expected duration is approximately 2.3 years, but considering the most significant weighted average, it is approximately 2.1 years.

The Black-Scholes model is the most widely used mathematical model for pricing European options. Developed by Fischer Black and Myron Scholes, it provides a theoretical estimate of the price of European-style options and is based on factors such as the current price of the underlying asset, the option's strike price, time to expiration, risk-free interest rate, and the asset's volatility. This model is particularly popular because of its relative simplicity and the accuracy of its predictions under a wide range of market conditions.