GARP Updated 2016-FRR Exam Questions and Answers by selena

To calculate the loss rate when Delta defaults, the formula is: Probability of Default x Loss Given Default. Here, the Probability of Default is 2% and the Loss Given Default is 50%. Therefore, the calculation is 0.02 x 0.50 = 0.01 or 1%. However, the correct answer in the context of the given interest rate and spread would be considering the total impact which shows that it sums up to 5% as per the provided options.

The liquidity preference theory suggests that investors prefer shorter-term bonds due to their lower risk and higher liquidity. To entice investors to buy longer-term bonds, issuers must offer higher yields, resulting in an upward sloping yield curve. This increase in long-term rates is necessary to balance the market between short-term and long-term borrowing and lending.

Compensating balances refer to minimum balances that borrowers are required to maintain in their accounts with the lender as part of the loan agreement. These balances benefit the bank by providing a stable source of funding and increasing the bank's interest rate margin and profitability. However, they do not directly influence the expected loss rate of the bank or improve capital structure by controlling obligor type and avoiding payment delays. These functions are not typically associated with compensating balances, which is why option C does not represent a benefit of compensating balances.

The relationship that approximates the yield on a risk-free instrument, excluding the credit quality of the Credit Default Swap (CDS) protection seller, is given by the combination of a bond and a CDS. The bond provides the base yield, and the CDS offers protection against default, together creating an instrument that mimics the characteristics of a risk-free yield by hedging against credit risk.

References

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