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Topics in the credit risk area will account for 25% of the questions on the exam. Credit risk topics are divided into four sections: measuring credit risk, counterparty risks, manage credit risk, and securitization. There is renewed emphasis this year on being able to calculate expected loss and unexpected loss as well as the application of credit derivative.

- Know how to compute the cumulative default probability over a multiyear period given the marginal default probability for each year. Be able to do this computation in both directions. The computation could be turned around if you were given a 1-year cumulative default probability and asked to solve for the quarterly marginal default probability.
- Note that if the rates on the corporate bond and Treasury bond are equivalent, the implied probability of repayment is 100%. Therefore, since corporate bond rates exceed Treasury bond rates, realistic implied probabilities of repayment will be less than 100%.
- When calculating the probability of default, be sure to use debt securities of the same maturity. Mismatching maturities will give incorrect implied probabilities. Also, if
*p*equals the implied probability of repayment, then 1-*p*equals the implied probability of default. Know how to make adjustments on a quarterly, semmiannual, or annual basis. - Memorize the fomula for the contractually promised gross return on a loan. Remember that this is a promised return, which is potentially different from the actual or realized return.
- Sovereign risk is the risk that a foreign government may default on a loan. There are five key variables that measure the probability of a foreign government rescheduling its debt payments; focus on the interpretation of these variables. Review the example for a multiyear restructuring agreement(MYRA).
- Memorize the formulas for expected loss and unexpected loss and be able to apply these concepts to a portfolio setting.
- Understanding the relationship between commitments and outstandings is vital toward correctly computing adjusted exposure which is utilized in the calculation of expected and unexpected loss.
- Know the difference between current, potential, and peak exposure for a derivative contract. Current and potential exposures are both essential for properly assessing credit risk.
- Know the difference between right-way and wrong-way exposures and be able to cite examples of each.
- The various forms of credit risk mitigants are important. Make sure you are familiar with terminology such as credit triggers, netting agreements, and liquidity puts.
- A credit valuation adjustment(CVA) adjusts payments to reflect changes in credit risk changes relative to the counterparties in derivative transactions.
- Understand the difference between the mean loss rate and the risk-neutral mean loss rate. The risk-neutral mean loss is an artificially higher loss rate that makes an investor indifferent between buying a risky security and a risk-free security with the same expected payoff. The risk-neutral mean loss rate is a key input to many credit risk pricing applications.
- Know the difference between managing the risks of a derivatives portfolio and managing the risks associated with traditional bank lending. Derivatives contracts have features that allow the fim to offset risks between counterparties or with a single counterparty(netting). Understand the various strategies used to offset these risks.
- Be familiar with purposes of external and internal ratings and know the process that is conducted to arrive at a particular rating.
- Learn the differences in default rate computations with various credit scoring models.
- Know that seniority and collateralization are two important factors that determine the recovery rates of bonds.
- Understand how the Merton model assesses the value of a firm's stocks and bonds. Know that the Merton model has some unrealistic assumptions, and that the KMV model uses the same basic approach, but relaxes some of the assumptions.
- The value of a firm's equity can be viewed as a long call on the firm's assets with a strike price equal to the value of a firm's debt, while the value of a firm's debt can be viewed as a risk-free bond and a short put on the firm's assets.
- Do not get lost with the ugly equations in the Merton model/firm value material. Focus on the concepts and the relationships between Merton model inputs and the value of debt and equity . The value of subordinate debt under high and low firm values is also important.
- Vulnerable options are options with default risk. Know how correlation impacts vulnerable options.
- Be familiar with the various credit risk portfolio models. Focus your attention on CreditMetrics, CreditPortfolio View, and CreditRisk+.
- Know the definitions of the numerous portfolio risk indicators. They include: expected loss, unexpected loss, VAR, economic capital, and expected shortfall.
- Be able to differentiate among credit derivative instruments(credit default swap, total return swaps, and structured instruments such as credit linked notes). All of those instruments provide the transfer of credit risk. Recognize that with a first to default swap, payment is only based on the first loan in a basket defaulting. First to default swaps and total return swaps seem to be a popular source of GARP questions.
- Be familiar with the characteristics of synthetic structures such as CLOs and CDOs(collateralized debt obligations) and review the variants of these two instruments, such as cash CDOs.
- Strategic capital allocation is the process of determining customized return objectives for different business units of the bank. Be familiar with the six methods of allocating economic capital, which include: stand-alone, scaling, internal betas, margnical capital, Arbitrage Pricing Theory, and fair value.
- Be familiar with the players in the securitization marketplace and explain their motivation for securitizing assets.
- It is important that
__FRM__candidates know how securitization may affect the financial condition of the originator. - Understand the frictions that exist in the subprime mortgage market. Expect a question or two on subprime mortgages given the relevance to the current U.S. housing market troubles.

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