8010 Exam Dumps - Operational Risk Manager (ORM) Exam

A situation where a firm has more liabilities than assets does not necessarily implydefault, so long as the firm is able to pay its obligations when they come due. Therefore, short term debts have a greater bearing on a firm's default than longer term debt. However, this is not to say that merely having enough to pay off the short term debts (ie debts due within one year) is enough to avoid default. Over time, the long term debt will also be turning to short term debt, and it may not be possible for the firm to roll over its liabilities without lenders considering the long term debt. The KMV approach considers the entire short term debt and half of the long term debt as the critical value of assets below which default will be triggered. Therefore Choice 'c' is the correct answer.

The correct answer is Choice 'c'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:

1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.

2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.

3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.

4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.

5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

Choice 'a' is the correct answer. According to theBasel II document, banks using the Basic Indicator Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha, and currently 15%) of positive annual gross income. Figures for anyyear in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.

The credit spread is equal to thedefault rate times the loss given default, or stated another way, default rate times (1 - recovery rate). It is not equal to the default rate times the recovery rate. Therefore statement I is not correct.

When ratings are upgraded by rating agencies, the spread contracts and not widen. Therefore statement II is not correct.

Both recovery rates and probabilities of default are related to the business cycle, and they move in opposite directions. Economic recessions witness an increase in the default rate anda decrease in the recovery rate, and economic expansions result in a decrease in the default rate and an increase in the recovery rates when default does happen. Therefore statement III is correct.

Bond spreads incorporate both the risk of default, but also considerations of liquidity in the case of corporate bonds. Hence statement IV is correct.