GARP Updated 2016-FRR Exam Questions and Answers by diego

Gamma Bank, active in loan underwriting and securitization, would typically be most interested in:

Expected Loss: The anticipated average loss from defaults in the credit portfolio.

Unexpected Loss: The potential variability or deviation from the expected loss, critical for understanding the risk beyond average expectations.

Duration and factor sensitivities are more relevant to market risk rather than direct credit risk.

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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.

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How Finance Works: "The risk that the borrower would fail to make full and timely repayments of its financial obligations over a given time horizon typically refers to the probability of default."

ThetaBank's default risk assessment involves calculating the joint probability of default for the two mortgage companies and comparing it to the independent risk model.

Individual Exposure at Default (EAD): $20 million for each mortgage company.

Loss Given Default (LGD): 100%

Probability of Default (PD): 10% for each mortgage company.

Joint Probability of Default: 5%

For independent risks, the joint probability of default for two independent events is the product of their individual probabilities:

\text{Joint Probability (Independent)} = PD_1 \times PD_2 = 0.10 \times 0.10 = 0.01 \text{ (or 1%)}

Given that ThetaBank predicts the joint probability at 5%, the independent model would have underestimated the actual probability by:

5%−1%=4%5%−1%=4%

Therefore, the underestimated probability is:

4%−2%=2%4%−2%=2%

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Range options, also known as "corridor options" or "double no-touch options," have two strike prices. The payoff for a range option depends on the price of the underlying asset remaining within a specified range between the two strike prices during the life of the option. This dual strike price structure is what distinguishes range options from other types of options.