Sample Questions
Question 1
Easy
A credit rating transition matrix is BEST described as a tool that:
Solution
D is correct. A credit rating transition (or migration) matrix tabulates the empirical probability that an issuer currently in a given rating category will move to each other rating category, or to default, over a specified time horizon, typically one year. It is used in portfolio credit risk models such as CreditMetrics to drive mark-to-market changes from rating migrations.
Question 2
Medium
Which of the following exposures MOST CLEARLY illustrates SPECIFIC wrong-way risk rather than general wrong-way risk?
Solution
A is correct. Specific wrong-way risk exists when there is a structural, transaction-level link between the counterparty's creditworthiness and the exposure itself, beyond a general macroeconomic correlation. Buying CDS protection on Company X from a protection seller whose own credit is structurally tied to Company X (here through a controlling equity stake) creates exactly that link: deterioration in Company X simultaneously raises the protection's value (exposure) and impairs the seller's ability to perform.
Question 3
Hard
Under the Basel III bank capital framework, the conceptual distinction between Common Equity Tier 1 (CET1) capital and Tier 2 capital is MOST ACCURATELY characterized as the distinction between which of the following pairs?
Solution
B is correct. Basel III organizes regulatory capital by loss-absorption capacity. CET1 (and to a lesser extent Additional Tier 1) is designed to absorb losses while the bank remains a going concern, supporting continued operation without triggering resolution. Tier 2 instruments are subordinated debt and similar instruments that absorb losses only on a gone-concern basis, namely in resolution or liquidation, after equity and AT1 have been written down or converted. This going-concern versus gone-concern split is the organizing principle of the Basel capital stack.
