Practice Questions: Hull, Risk Management and Financial Institutions, Chapters 17 & 19

Hull, Risk Management and Financial Institutions, Chapters 17 & 19 Practice Questions cover the following learning objectives:

Chapter 17. Estimating Default Probabilities

Compare agencies’ ratings to internal credit rating systems.
Describe linear discriminant analysis (LDA), define the Altman’s Z-score and its usage, and apply LDA to classify a sample of firms by credit quality.
Describe the relationship between borrower rating and probability of default.
Describe a rating migration matrix and calculate the probability of default, cumulative probability of default, and marginal probability of default.
Define the hazard rate and use it to define probability functions for default time as well as to calculate conditional and unconditional default probabilities.
Describe recovery rates and their dependencies on default rates.
Define a credit default swap (CDS) and explain its mechanics including the obligations of both the default protection buyer and the default protection seller.
Describe CDS spreads and explain how CDS spreads can be used to estimate hazard rates.
Define and explain CDS-bond basis.
Compare default probabilities calculated from historical data with those calculated from credit yield spreads.
Describe the difference between real-world and risk-neutral default probabilities and determine which one to use in the analysis of credit risk.
Using the Merton model, calculate the value of a firm’s debt and equity, the volatility of firm value, and the volatility of firm equity.
Using the Merton model, calculate distance to default and default probability.
Assess the quality of the default probabilities produced by the Merton model, the Moody’s KMV model, and the Kamakura model.

Chapter 19. Credit Value at Risk

Compare market risk value at risk (VaR) with credit VaR in terms of definition, time horizon, and tools for measuring them.
Define and calculate credit VaR.
Describe the use of rating transition matrices for calculating credit VaR.
Describe the application of the Vasicek model to estimate capital requirements under the Basel II internal-ratings-based (IRB) approach.
Interpret the Vasicek’s model, Credit Risk Plus (CreditRisk+) model, and the CreditMetrics ways of estimating the probability distribution of losses arising from defaults as well as modeling the default correlation.
Define credit spread risk and assess its impact on calculating credit VaR.