FRM Part 2 - Book 2 - Credit Risk (Part 2/2)

After completing this reading you should be able to:

• Explain the purpose of an ISDA master agreement.

• Summarize netting and close-out procedures (including multilateral netting), explain their advantages and disadvantages and describe how they fit into the framework of the ISDA master agreement.

• Describe the effectiveness of netting in reducing credit exposure under various scenarios.

• Describe the mechanics of termination provisions and trade compressions and explain their advantages and disadvantages.

• Identify and describe termination events and discuss their potential effects on parties to a transaction

After completing this reading you should be able to:

• Describe the rationale for collateral management.

• Describe the terms of a collateral and features of a credit support annex (CSA) within the ISDA Master Agreement including threshold, initial margin, minimum transfer amount and rounding, haircuts, credit quality, and credit support amount.

• Describe the role of a valuation agent.

• Describe the mechanics of collateral and the types of collateral that are typically used.

• Explain the process for the reconciliation of collateral disputes.

• Explain the features of a collateralization agreement.

• Differentiate between a two-way and one-way CSA agreement and describe how collateral parameters can be linked to credit quality.

• Explain aspects of collateral including funding, rehypothecation, and segregation.

• Explain how market risk, operational risk, and liquidity risk (including funding liquidity risk) can arise through collateralization.

After completing this reading you should be able to:

• Describe and calculate the following metrics for credit exposure: expected mark-to-market, expected exposure, potential future exposure, expected positive exposure and negative exposure, effective exposure, and maximum exposure.

• Compare the characterization of credit exposure to VaR methods and describe additional considerations used in the determination of credit exposure.

• Identify factors that affect the calculation of the credit exposure profile and summarize the impact of collateral on exposure.

• Identify typical credit exposure profiles for various derivative contracts and combination profiles.

• Explain how payment frequencies and exercise dates affect the exposure profile of various securities.

• Explain the impact of netting on exposure, the benefit of correlation, and calculate the netting factor.

• Explain the impact of collateralization on exposure and assess the risk associated with the remaining period, threshold, and minimum transfer amount.

• Assess the impact of collateral on counterparty risk and funding, with and without segregation or rehypothecation.

After completing this reading, you should be able to:

• Identify counterparty risk intermediaries, including central counterparties (CCPs), derivative product companies (DPCs), special purpose vehicles (SPVs), and monoline insurance companies (monolines) and describe their roles.

• Describe the risk management process of a CCP and explain the loss waterfall structure of a CCP.

• Compare bilateral and centrally cleared over-the-counter (OTC) derivatives markets.

• Assess the capital requirements for a qualifying CCP and discuss the advantages and disadvantages of CCPs.

• Discuss the impact of central clearing on credit value adjustment (CVA), funding value adjustment (FVA), capital value adjustment (KVA), and margin value adjustment (MVA).

After completing this reading, you should be able to:

• Explain the motivation for and the challenges of pricing counterparty risk.

• Describe credit value adjustment (CVA).

• Calculate CVA and the CVA spread with no wrong-way risk, netting, or collateralization.

• Evaluate the impact of changes in the credit spread and recovery rate assumptions on CVA.

• Explain how netting can be incorporated into the CVA calculation.

• Define and calculate incremental CVA and marginal CVA and explain how to convert CVA into a running spread.

• Explain the impact of incorporating collateralization into the CVA calculation.

• Describe debt value adjustment (DVA) and bilateral CVA (BCVA).

• Calculate BCVA and BCVA spread.

After completing this reading you should be able to:

• Describe wrong-way risk and contrast it with right-way risk.

• Identify examples of wrong-way risk and examples of right-way risk.

• Discuss the impact of collateral on wrong-way risk.

• Discuss the impact of wrong-way risk on central counterparties.

After completing this reading you should be able to:

• Differentiate among current exposure, peak exposure, expected exposure and expected positive exposure.

• Explain the treatment of counterparty credit risk (CCR) both as a credit risk and as a market risk and describe its implications for trading activities and risk management for a financial institution.

• Describe a stress test that can be performed on a loan portfolio and on a derivative portfolio.

• Calculate the stressed expected loss, the stress loss for the loan portfolio and the stress loss on a derivative portfolio.

• Describe a stress test that can be performed on CVA.

• Calculate the stressed CVA and the stress loss on CVA.

• Calculate the DVA and explain how stressing DVA enters into aggregating stress tests of CCR.

• Describe the common pitfalls in stress testing CCR.

After completing this reading, you should be able to:

• Analyze the credit risks and other risks generated by retail banking.

• Explain the differences between retail credit risk and corporate credit risk.

• Discuss the “dark side” of retail credit risk and the measures that attempt to address the problem.

• Define and describe credit risk scoring model types, key variables, and applications.

• Discuss the key variables in a mortgage credit assessment and describe the use of cutoff scores, default rates, and loss rates in a credit scoring model.

• Discuss the measurement and monitoring of a scorecard performance including the use of cumulative accuracy profile (CAP) and the accuracy ratio (AR) techniques.

• Describe the customer relationship cycle and discuss the trade-off between creditworthiness and profitability.

• Discuss the benefits of risk-based pricing of financial services.

After completing this reading, you should be able to:

• Discuss the flaws in the securitization of subprime mortgages prior to the financial crisis of 2007.

• Identify and explain the different techniques used to mitigate credit risk and describe how some of these techniques are changing the bank credit function.

• Describe the originate-to-distribute model of credit risk transfer and discuss the two ways of managing a bank credit portfolio.

• Describe the different types and structures of credit derivatives including credit default swaps (CDS), first-to-default puts, total return swaps (TRS), asset-backed credit-linked notes (CLN) and their application

After completing this reading, you should be able to:

• Define securitization, describe the securitization process and explain the role of participants in the process.

• Explain the terms over-collateralization, first-loss piece, equity piece and cash waterfall within the securitization process.

• Analyze the differences in the mechanics of issuing securitized products using a trust versus a special purpose vehicle (SPV) and distinguish between the three main SPV structures: amortizing, revolving and master trust.

• Explain the reasons for and the benefits of undertaking securitization.

• Describe and assess the various types of credit enhancements.

• Explain the various performance analysis tools for securitized structures and identify the asset classes they are most applicable to.

• Define and calculate the delinquency ratio, default ratio, monthly payment rate (MPR), debt service coverage ratio (DSCR), the weighted average coupon (WAC), the weighted average maturity (WAM) and the weighted average life (WAL) for relevant securitized structures.

• Explain the prepayment forecasting methodologies and calculate the constant prepayment rate (CPR) and the Public Securities Association (PSA) rate.

• Explain the subprime mortgage credit securitization process in the United States.

• Identify and describe key frictions in subprime mortgage securitization and assess the relative contribution of each factor to the subprime mortgage problems.

• Compare predatory lending and borrowing.