Chapter 7

Question 1

What is default risk?

Answer 1

Default risk is the risk that a borrower will fail to repay a loan or other debt obligation.

Question 2

Name three main risk factors that drive default risk.

Answer 2

1. Borrower’s creditworthiness: A borrower with a poor credit history or weak financial position is more likely to default.
2. Economic conditions: A recession or other economic downturn can increase the risk of default.
3. Industry-specific factors: Certain industries are more vulnerable to default than others, depending on factors such as competition, regulation, and technological change.

Question 3

What are typical components of loan interest rates?

Answer 3

1. Risk-free rate: The rate of return on a risk-free investment, such as a government bond.
2. Credit spread: A premium added to the risk-free rate to compensate the lender for the risk of default.
3. Operating costs: Costs incurred by the lender in originating and servicing the loan.
4. Profit margin: The lender’s desired profit on the loan.

Question 4

How can expected loss (EL) from default risk be calculated?

Answer 4

EL is calculated as the product of the exposure value, the probability of default (PD), and the loss given default (LGD).

Question 5

What is unexpected loss (UL) and how is it different from expected loss?

Answer 5

UL represents the potential deviation of actual losses from the expected loss due to the volatility of PD and LGD. It is calculated using the exposure value, the PD, the LGD, the volatility of LGD, and the volatility of PD.