P2 Focus Review: 3rd of 8 (Credit risk)

[David Harper CFA FRM]

P2 Focus Review, 3rd of 8 (Credit Risk): Videos, Practice Questions and Learning Spreadsheets

• The 3rd (of 8) Part 2 Focus Review video (Credit Risk) is located here.
• Associated practice question sets:
  • P2.T6. Ashcraft
  • P2.T6. Canabarro
  • P2.T6. Culp
• The learning spreadsheets will soon be published into a single consolidates (T6) workbook

Concepts

• Structured finance/securitization (subprime)
• Counterparty risk
• Credit derivatives

Structured finance/securitization (subprime)
Our chart summarizes the key players and the key elements. Understand the motivations to securitize (monetization, risk transfer, balance sheet, regulatory). I do recommend reading the Ashcraft case wholesale.

Counterparty risk
This is a growing sub-topic for obvious reasons. I would make sure you are familiar with:

• The concept of using MCS to project future exposures
• Popular models for each asset class. For example, can we use GBM for fixed income?
• The comparison of potential future exposure (PFE) to VaR and the key differences (1. exposure is a gain, not a loss, 2. the horizon is longer)
• Right-way and wrong-way exposure. Can you give several examples?

The FRM attention to CVA is new. I do expect question(s) on CVA. I included an example and question from our PQ. I think it's hard to understand until you work a numerical example.

Credit derivatives
Understand these not only mechanically but from the perspective of "what does each hedge?" (the likely exam perspective). In my opinion, most important are (all of these make regular appearances in the exam):

• Credit default swaps (CDS), and
• Total return swaps. Very popular GARP/FRM question. The most encompassing hedge.
• Basket CDS and CDO, emphasis on the role of default correlation
• Liability (capital) structure of tranches, emphasis on subordination as an internal credit enhancement