Credit Risk: Measurement, Mitigation, and Exam Traps
Core concepts
Credit risk is the risk that a borrower or counterparty fails to meet an obligation. Candidates must be fluent in probability of default (PD), loss given default (LGD), exposure at default (EAD), and expected loss = PD × LGD × EAD. Understand the distinction between expected loss (priced into spreads and provisions) and unexpected loss (absorbed by capital). Know the rating-migration concept, credit valuation adjustment (CVA) for derivative counterparties, and the difference between default and downgrade risk. Be comfortable with credit risk mitigation: collateral (with haircuts and legal enforceability), guarantees, netting agreements, and credit derivatives. Understand concentration risk and how single-name and sector limits control it, and the role of loan-to-value ratios and debt service coverage in secured lending.
Traps to watch
Questions often blur PD and LGD: a low PD with high LGD can still produce meaningful expected loss. Watch for confusion between migration risk (rating change) and default risk. Another trap: assuming collateral eliminates risk-haircuts, wrong-way risk, and operational/legal failure to perfect the claim all leave residual exposure. Wrong-way risk (exposure rising as counterparty quality falls) is frequently tested. Also distinguish settlement risk from pre-settlement credit risk, and remember netting only reduces exposure where a valid close-out netting opinion exists.
Worked rule of thumb
If PD = 2%, LGD = 45%, and EAD = $10 million, expected loss = 0.02 × 0.45 × 10,000,000 = $90,000. Use this to sanity-check any answer: expected loss scales linearly with each factor, so a doubling of PD doubles EL. If an option implies EL outside the range set by the lowest and highest plausible factor combinations, reject it.