Credit Risk
The topic of Credit Risk Measurement and Management accounts for 25% of the 2008 FRM exam (35 of the 140 exam questions). I should note that the FRM exam does not organize questions by topic area like the CFA exam does. The questions will appear in a random fashion and as a result you will need to quickly shift your focus. For example, you may go from one question where you interpret the skewness of the normal distribution to another question where you calculate the value of a credit default swap (a concept that is addressed in the credit risk material). Book 3 of our FRM Study Notes is devoted to the credit risk material and is divided into four sections:
- Measuring Credit Risk
- Counterparty Risks
- Managing Credit Risk
- Securitization
Measuring Credit Risk
There are a wide range of topics presented in this section and you will be required to memorize some equations along the way. This section starts out by evaluating both loan credit risk and sovereign risk. Knowing how to compute default probabilities is important here. This section then provides information on how external and internal credit ratings are established. Be prepared for an exam question on rating migration (i.e., the probability of moving from one rating to another). The crux of this section deals with the interpretation and calculation of expected and unexpected loss. These concepts appear in several readings throughout the credit risk material.
Counterparty Risks
There are two readings that deal with counterparty credit risk (e.g., credit risk arising from swap agreements). You’ll need to understand counterparty risk terminology and be able to evaluate a party’s potential future credit risk exposure. Ways to reduce counterparty risk involve netting and margin agreements, both of which are discussed in this section.
Managing Credit Risk
Two key topic areas in this managing credit risk section deal with credit derivatives and credit risk portfolio models. You will encounter instruments used to hedge credit risk exposures (i.e., credit derivatives) such as credit default swaps and total return swaps. Also, credit risk portfolio models such as CreditMetrics and CreditRisk+ appear in several places. There is a high probability that you will be tested on the characteristics of these credit risk portfolio models. Another important concept is the Merton model, which provides insight into predicting probability of default and the amount of loss given default.
Securitization
There are two readings in the FRM curriculum that deal with securitization. The first reading serves as an introduction to securitization and discusses terminology and additional credit risk protection via internal and external credit enhancements. The second reading is new to the curriculum and deals with subprime mortgage securitization. You should expect a question or two on this topic given the significance of the current subprime mortgage crisis.