Credit Risk

### Which of the following best describes credit risk? - [ ] The risk of inflation eroding bond returns. - [ ] The risk of changes in interest rates adversely affecting bond prices. - [x] The likelihood that an issuer might default on its obligations. - [ ] The possibility of bond prices dropping due to market volatility. > **Explanation:** Credit risk refers specifically to the possibility that an issuer might fail to meet interest or principal payments, leading to a potential loss for investors. ### Which of the following expressions best represents expected loss? - [x] (Probability of Default) × (Loss Given Default) × (Exposure at Default) - [ ] (Risk-Free Rate) × (Duration) - [ ] (Yield Spread) × (Liquidity Premium) - [ ] (Recovery Rate) ÷ (Interest Coverage) > **Explanation:** Expected Loss = PD × LGD × EAD. This formula combines the chance of default, the proportion of exposure lost if default occurs, and the total amount at risk. ### A corporate bond has a 3% probability of default annually and an LGD of 50%. If you hold a $100,000 position in that bond, what is the annual expected loss? - [ ] $1,000 - [x] $1,500 - [ ] $3,000 - [ ] $5,000 > **Explanation:** Expected Loss = PD × LGD × Exposure = 0.03 × 0.50 × $100,000 = $1,500. ### The difference in yield between a corporate bond and a default-free government bond of the same maturity is known as what? - [x] Credit spread - [ ] LIBOR spread - [ ] Duration premium - [ ] Recovery rate > **Explanation:** The credit spread captures the extra yield demanded by investors to compensate for the credit risk associated with a particular issuer relative to a default-free benchmark. ### Which factor is most likely to widen credit spreads across most corporate bonds? - [ ] A broadly improving economic outlook - [x] A global liquidity crunch or risk-off environment - [x] A sudden surge in default fears - [ ] A drop in central bank policy rates > **Explanation:** Credit spreads often widen in risk-off environments or times of liquidity crunch when investors become more cautious. Investor appetite shifts toward safer assets, which drives up yields for riskier bonds, thereby widening spreads. ### During an economic expansion, credit spreads generally: - [ ] Widen significantly for all issuers. - [x] Tighten because investor risk appetite usually increases. - [ ] Become irrelevant as default risk disappears. - [ ] Remain fixed, unaffected by market conditions. > **Explanation:** In expansion phases, investors are often more willing to take on risk, so credit spreads tend to decrease (tighten). ### If a major scandal significantly increases a company's Probability of Default (PD) but the company's collateral value rises at the same time, what might happen to Loss Given Default (LGD)? - [ ] It will always rise above 80%. - [ ] It must offset the PD entirely. - [x] It might decrease because higher collateral value improves recovery. - [ ] It remains fixed, unaffected by collateral values. > **Explanation:** If the collateral value is higher, then in the event of default, investors might recover more, reducing LGD even though PD might have gone up. ### Issuer-specific factors that can lead to rapid widening of a bond’s credit spread include: - [x] Accounting scandals. - [ ] Benchmark Treasury yields dropping. - [ ] Investor risk appetite across all markets. - [ ] A general decline in commodity prices for non-related industries. > **Explanation:** An accounting scandal is a direct, issuer-specific event that can quickly raise an issuer’s perceived risk of default and cause credit spreads for that issuer to widen sharply. ### Which of the following statements best explains how macroeconomic conditions affect credit spreads? - [x] Recessions generally increase credit spreads as investors fear defaults. - [ ] Strong economic expansions always cause credit spreads to widen. - [ ] Macroeconomic conditions have no bearing on credit risk. - [ ] Credit spreads only move when inflation changes significantly. > **Explanation:** During recessions or economic contractions, default risk is perceived to be higher, causing credit spreads to widen as investors demand higher yields for taking on additional risk. ### True or False: Credit ratings from agencies are a flawless and real-time indicator of an issuer’s creditworthiness. - [ ] True - [x] False > **Explanation:** Credit ratings provide a helpful but sometimes lagging or incomplete view. They are not flawless and can be slow to adjust to new developments, so analysts should conduct their own comprehensive credit research as well.