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Hull: Options, Futures, and Other Derivatives, Ninth Edition
Chapter 24: Credit Risk
Multiple Choice Test Bank: Questions with Answers
1. Suppose that the cumulative probability of a company defaulting by years
one, two, three and four are 3%, 6.5%, 10%, and 14.5%, respectively. What
is the probability of default in the fourth year conditional on no earlier
default?
A. 4.5%
B. 5.0%
C. 5.5%
D. 6.0%
Answer: B
The unconditional PD for the fourth year is 14.5% minus 10% or 4.5%.
The probability of n

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Hull: Options, Futures, and Other Derivatives, Ninth EditionChapter 24: Credit Risk Multiple Choice Test ank: !uestions ith #ns ers
1.Suppose that the cumulative probability of a company defaulting by years one, two, three and four are 3%, 6.5%, 10%, and 1.5%, respectively. !hat is the probability of default in the fourth year conditional on no earlier default #..5%$.5.0%.5.5%&.6.0% #nswer' $ (he unconditional )& for the fourth year is 1.5% minus 10% or .5%. (he probability of no earlier default is *0%. (he )& conditional on no earlier default is therefore 0.05+0.*0.05 or 5%-.!hich of the following is usually used to dene the recovery rate of a bond #.(he value of the bond immediately after default as a percent of its facevalue$.(he value of the bond immediately after default as a percent of the sum of the bond/s face value and accrued interest.(he amount nally realied by a bondholder as a percent of face value&.(he amount nally realied by a bondholder as a percent of the sum of the bond/s face value and accrued interest#nswer' # (he recovery rate for a bond is usually dened as the value of the bond immediately after a default as a percent of its face value. (his is in spite of the fact that the bond holder/s claim in the event of a default in many urisdictions is the face value plus accrued interest. 3.!hich of the following is true #.2is neutral default probabilities are usually much lower than real world default probabilities$.2is neutral default probabilities are usually much higher than real world default probabilities.2is neutral and real world probabilities must be close to each other if there are to be no arbitrage opportunities&.2is4neutral default probabilities cannot be calculated from &S spreads #nswer' $2is neutral default probabilities are usually greater than real world default probabilities.
.# haard rate is 1% per annum. !hat is the probability of a default during therst two years #.-.00%$.-.0-%.1.*%&.1.*6% #nswer' (he probability of no default is e
0.017-
0.*0-. (he probability of default is one minus this or 0.01* 8i.e., 1.*%9.5.!hich of the following is true#.(he default probability per year for a company always increases as we loo further ahead$.(he default probability per year for a company always decreases as weloo further ahead.Sometimes # is true and sometimes $ is true&.(he default probability per year is roughly constant for most companies#nswer' :or investment grade companies the probability of default tends to increase with time. :or non4investment grade companies the reverse is often true.6.!hich of the following is true#.onditional default probabilities are at least as high as unconditional default probabilities $.onditional default probabilities are at least as low as unconditional default probabilities.onditional default probabilities are sometimes lower and sometimes higher than unconditional default probabilities.&.(here is no di;erence between conditional and unconditional default probabilities because a company can only default once.#nswer' # (he conditional default probability for a future time period is the unconditional default probability divided by the probability of no earlier default. (he latter is less than or e<ual to one. #s a result the conditional probability is at least as great as the unconditional probability. =.>f a company/s ve year credit spread is -00 basis points and the recovery rate in the event of a default is estimated to be -0% what is the average haard rate per year over the ve years#.0.%$.1.-%
.1.%&.-.5%#nswer' & (he average haard rate is the credit spread divided by one minus the recovery rate. >n this case we get 0.0-+0.0.0-5 or -.5% .!hich of the following is true#.2ecovery rates are lower for investment grade companies$.2ecovery rates are higher for non4investment grade companies.2ecovery rates are negatively correlated with default rates&.2ecovery rates are positively correlated with default rates#nswer' !hen default rates are high in the economy, recovery rates tends to below*.!hich of the following is true#.(he asset swap spread is a measure of e?cess of the bond yield over the @>S rate$.(he asset swap spread is a measure of e?cess of the bond yield over the A>$@2+swap rate. #n asset swap e?changes the actual return on the asset for A>$@2 plusa spread&.Bone of the above#nswer' $ (he asset swap spread is a measure of the e?cess of the bond yield over A>$@2. >n an asset swap the promised cash Cows 8not the actual cash Cows9 on a bond are e?changed for A>$@2 plus a spread10.(o be investment grade, a company has to have a credit rating of #.## or better$.# or better.$$$ or better&.$$ or better#nswer' ompanies with credit ratings of $$$ or better are investment grade.11.>n the Daussian copula model which of the following is true#.(he time to default for a company is assumed to be normally distributed. $.(he time to default for a company is assumed to be lognormally distributed
.(he time to default for a company is transformed to a normal distribution&.(he time to default for a company is transformed to a lognormal distribution#nswer' (he time to default for each company is transformed to a normal distribution on a percentile to percentile basis and the normal distributions are assumed to be multivariate normal.1-.!hich of the following is true #.Betting always leads to a reduction in a company/s e?posure to a counterparty$.Betting always leads to a company/s e?posure to a counterparty eitherstaying the same or going down.Betting always increases a company/s e?posure to a counterparty&.Betting can increase or reduce the e?posure#nswer' $Betting means that the derivatives portfolio with a counterparty is considered to be a single transaction in the event of a default. (his cannot increase the e?posure. >f there are transactions in the portfolio with both positive and negative values the e?posure will go down.13.!hich of the following is true#. &owngrade triggers are particularly valuable if they are widely used bya company/s counterparties$. &owngrade triggers become less valuable if they are widely used by acompany/s counterparties. &owngrade triggers are useless because their impact is always anticipated by the maret&. &owngrade triggers are a two4edged sword. >f company # has a downgrade trigger for company $ then company $ has a downgrade trigger for company ##nswer' $&owngrade triggers become less valuable if many of a company/s counterparties are using them 8as was the case with Enron and #>D9. (his is because the counterparties will re<uire either cash collateral, or transactions to be unwound, at the same time. (his can caus eteh company to fail.1.!hich of the following is true of Ferton/s model'#.(he e<uity is a call option on the assets $.(he assets are a call option on the debt.(he debt is a call option on the e<uity&.(he e<uity is a call option on the debt

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