FRM Part II: Credit Risk Measurement and Management Flashcards

Comprehensive vocabulary flashcards covering the core principles, metrics, and models of Credit Risk Measurement and Management as presented in the Reading 19-41 lecture notes.

Credit Risk

The probability that one party (e.g., a creditor) will lose money if a counterparty fails to honor its financial obligation due to an inability to repay, an unwillingness to repay, or nontimeliness of honoring the obligation.

Insolvency

A scenario where a counterparty's liabilities exceed its assets, resulting in negative equity.

Default

A scenario where a counterparty fails to meet its contractual obligations, commonly due to the inability or unwillingness to pay when an obligation is due.

Bankruptcy

A legal procedure where an entity, typically in default, seeks legal protection through a court which then negotiates with management, creditors, and other stakeholders.

Three Lines of Defense

A governance framework for risk management consisting of: 1. Business owners (manage risks), 2. Enterprise risk management, compliance, and legal (monitor/oversee), and 3. Internal and external auditors (independent monitoring).

Limits (Credit Lines)

The maximum loss an organization is willing to accept in absolute dollar terms, which can be assigned to individual counterparties, sectors, industries, or countries.

Asset Classification

The process of assigning bank assets to credit risk grades based on their likelihood of repayment, typically categorized as: Standard, Specially mentioned, Substandard, Doubtful, or Loss.

Expected Loss (EL)

The anticipated dollar loss if a borrower defaults, calculated as: $EL = EA \times PD \times LR$ (Exposure Amount $\times$ Probability of Default $\times$ Loss Rate).

Unexpected Loss (UL)

The variation in expected loss, representing the variability of potential losses modeled as standard deviation: $UL = EA \times \text{multiplier}$, where multiplier is a function of the variance of PD and LR.

Economic Capital

The excess capital reserves a bank needs to buffer itself from unexpected losses, derived as the distance between the unexpected outcome and the expected outcome for a given confidence level.

CAMEL System

A tool used for evaluating the financial condition of a bank based on five factors: Capital adequacy, Asset quality, Management, Earnings, and Liquidity.

Capital Adequacy Ratio (CAR)

A measure of a bank's capital relative to its risk, expressed as: $\text{CAR} = \frac{\text{Capital}}{\text{Risk-Weighted Assets}}$.

Merton Model

An option pricing model that views the market value of firm equity as a call option on the firm's assets with a strike price equal to the face value of the outstanding debt.

Risk-Adjusted Return on Capital (RAROC)

A ratio used to measure loan performance, calculated as: $\text{RAROC} = \frac{\text{Loan Revenues}}{\text{Capital at Risk}}$.

Through-the-Cycle Approach

A long-term credit rating philosophy covering at least one full business cycle, typically used by major credit rating agencies to provide stable ratings less sensitive to short-term events.

Point-in-Time Approach

An internal credit rating philosophy focusing on the current scenario over a short horizon (up to one year), typically more volatile as it captures real-time default risk.

Sovereign Default Spread

The difference between the yield of a riskier sovereign bond and a riskless sovereign bond yield (e.g., U.S. Treasury bond yield).

Credit Default Swap (CDS)

A credit derivative where a protection buyer makes periodic fixed payments (CDS spread) to a protection seller in exchange for a payoff if a predefined credit event occurs.

CDS-Bond Basis

The difference between the CDS spread and the bond yield spread: $\text{Basis} = \text{CDS spread} - \text{Bond yield spread}$.

Hazard Rate

Also known as default intensity, it is a measure of the probability of default in a short period of time conditional on no earlier default.

Credit Value at Risk (Credit VaR)

The credit loss over a certain time horizon that will not be exceeded given a specific level of confidence, defined as the quantile of the credit loss less the expected loss.

Credit Valuation Adjustment (CVA)

The present value of the expected cost to a financial institution if a counterparty defaults: $-LGD \times \text{sum of (Discounted expected exposure} \times \text{Marginal default probability)}$.

Debt Valuation Adjustment (DVA)

The present value of the expected cost to the counterparty if the financial institution itself defaults, representing a benefit to the institution.

Wrong-Way Risk (WWR)

The risk that arises when the probability of default by a counterparty is positively correlated with the credit exposure to that counterparty.

Right-Way Risk (RWR)

A favorable association where any interrelationship between exposure and default probability produces an overall decrease in counterparty risk.

Novation

The process under central clearing of replacing the nonperforming side of a bilateral contract with a new counterparty, specifically the Central Counterparty (CCP).

Trade Compression

A process seeking to reduce the gross notional amount and the number of OTC derivative trades while maintaining the same net exposure.

Initial Margin

The collateral amount posted upfront that is independent of any subsequent variation margin, representing a level of overcollateralization.

Haircut

A discount applied to the value of posted collateral to account for price volatility and ensure the value sufficiently covers borrowing even if prices fall.

Potential Future Exposure (PFE)

An estimate of the mark-to-market value at a specific point in the future based on a high confidence level, representing the maximum expected credit risk exposure.

Margin Period of Risk (MPoR)

The effective time between a collateral call and the receipt/liquidation of that collateral, subdivisions include predefault, macro-hedging, and auctions.

Securitization

The process of pooling credit-sensitive assets and creating new securities whose cash flows are based on the underlying loans or credit claims.

Equity Tranche

The junior-most slice of a securitization structure that absorbs the first losses and receives residual cash flows after senior and mezzanine claims are satisfied.

Waterfall Structure

The rules and conditions governing the order in which cash flows from a collateral pool are distributed to different tranches in a securitization.

Constant Prepayment Rate (CPR)

A methodology for estimating prepayments in mortgage-backed securities, calculated as: $\text{CPR} = 1 - (1 - \text{SMM})^{12}$, where SMM is single monthly mortality.