Part 1. Circle TRUE or FALSE (20 points – 20 minutes)
11 questions, 2 points for each good answer, cap at 20 points
Q1. The New England Patriots is the best and most admired NFL team in the world
TRUE TRUE
Q2. Risk managers are part of the 2nd line of defense of the risk governance framework
TRUE FALSE
Q3. There are 3 main drivers to calculate the expected loss: exposure, default probability and (1 – recovery)
TRUE FALSE
Q4. “Dynamic credit exposure” refers to a credit exposure stemming from a bank’s line of credit to an investment-grade company, a product also known as a “revolver”
TRUE FALSE
Q5. Rating agencies assign credit ratings purely based on analysis of financial statements
TRUE FALSE
Q6. A company rated A is supposed to be financially stronger than a company rated BBB
TRUE FALSE
Q7. Probability of defaults are dependent on economic cycles
TRUE FALSE
Q8. Risk managers work either on the private side or on the public side, the latter applies to government employees, hence the name “public side”
TRUE FALSE
Q9. Credit default swaps are insurance products
TRUE FALSE
Q10. A credit portfolio is typically characterized by a high chance (frequency) of losing a small amount of money and a low chance of losing lose a lot (severity) of money
TRUE FALSE
Q11. A good risk manager always says “yes” to a new transaction
FALSE FALSE
Part 2: Short problems (40 points – 50 minutes)
Q1. 12 points (15 minutes)
QC Bank set up a 5-year, $300 million credit facility for Queens Department Store (QDP). The facility is a revolver, i.e., QDP can draw and pay back monies whenever they want. The facility has the following characteristics:
Commitment fee: 30 bps p.a. Interest rate: LIBOR +25 bps p.a.
QDP rating: BBB (S&P Global Rating)
QDP’s typical draw rate on their credit facility: 20%
Data for 5 years (%)
Q1.a. What is the formula (NOT THE VALUES) to be used by QC Bank’s credit risk management to calculate the expected loss generated by the facility to QDP? (4 points)
Q1.b. What are the values to be used by QC Bank’s credit risk management to calculate the expected loss generated by the facility to QDP? (4 points)
Q1.c. What is the expected loss for this facility? (4 points)
Q2. 13 points – (15 minutes) Queens Electric Co. (QE) manufactures its products in Queens (New York – USA) and sells them all over the world. They invoice all their clients in their local currency but all their costs are in USD. They recently signed a large contract with a Swiss client Zurich Edison (ZE), who will pay in CHF (Swiss Franc). QE’s Chief Financial Officer decided to hedge the entire exposure. They buy a foreign exchange future contract from QC Bank (QCB).
Main features of the contract:
• 500 power generators
• CHF 2,000 each
• Payment term: 1 year
• USD/CHF rate on FOREX future contract: USD 1 = CHF 0.80
Q2.a. What is QE’s credit exposure on ZE generated by the sale of QE generators to ZE? (5 points)
Q2.b. Does QE have a credit risk on its bank QCB generated by the FOREX future contract? If yes, is the credit risk amount constant during the 1-year lifetime of the future contract? (5 points)
Q2.c. Three months after entering the FOREX future contracts, the CHF’s value compared to the USD declined to USD 1 = CHF 0.90. What is the credit exposure of QE on QCB on that day? How is it called? (5 points)
Q3. 15 points – (20 minutes)
QC Bank (QCB) has a pretty large credit portfolio generated by various commercial and investment banking activities with clients and other banks. They employ a team dedicated to the management of their credit portfolio. One of the mandates of this team is to produce a loss distribution of the portfolio. At the end of April 2021, the distribution was the figure below.
The expected loss was $14 million and, within a 99.9% confidence interval, the losses were
$52 million.
Q3.a. Explain the shape of the loss distribution (3 points)
Q3.b. Calculate the amount of unexpected loss (3 points)
Q3.c. Calculate the amount of economic capital that the bank needs to support this credit portfolio (2 points)
Q3.d. In the figure below, the distribution at the end of April 2021 is represented in red and the distribution one year earlier was represented in blue. Is the situation at the end of April 2021 better or worse than one year ago for the bank? Please explain, yes or no answer is not sufficient (5 points)
Q3.e. What actions they took may explain the change of shape? (2 points)
Part 3: Case Study (40 points, 10 questions, 4 points each – 50 minutes)
In this exercise, your is to answer the 10 questions. Be very precise to receive maximum points.
On her way to work, Jane, CEO of Best Boilers (BB), a major manufacturer of industrial equipment based in Pierre (South Dakota), was listening to her favorite show on the radio. The news was not good. The COVID-19 pandemic was spreading fast, non-essential businesses were forced to close to protect people from becoming sick and a global economic downturn seemed inevitable.
Jane thought it was time to invite her senior leadership to review the major risks BB was exposed to. She asked her assistant to arrange a meeting for the following week and to invite CFO, General Counsel, Head of the 3 business segments and Chief Risk Officer. “Be well prepared to provide me with a detailed review of the main financial risks we are facing and how we are mitigating them” was added to the invitation.
Jane started by questioning John, the CFO, about BB’s cash position:
• Jane: “John, how much cash do we have now?”
• John: “Roughly $700 million which is comfortable”
• Jane: “Comfortable as long as our profits remain stable. Can we borrow more?”
• John: “Sure, we have a $1.5 billion credit line and we drew only $300 million so we can get up to $1.2 billion tomorrow if you wish?”
Q1 – How is such a credit facility called?
• Jane: “Let’s call Bill at South Dakota Bank (SDK) and let them know”
John dialed Bill’s number and Jane made the request. Bill acknowledged the request, confirmed that the credit line was not fully drawn and that he would get back to Jane later in the day.
Q2 – Calculate SDK’s UGD – usage given default – in percentage terms, when the drawn amount is (a) $300 million (b) $1.5 billion
(a)
(b)
Q3 – Bill is not comfortable as many customers are asking for the same and he has not paid too much attention to BB’s business recently. Can he refuse? Hint: think of the concept of covenants.
• Jane: “OK, what about our clients?”
• John: “We carry roughly $500 million of receivables at any time so we can expect delayed payments and a few defaults”
• Jane: “We have to be careful with our customers’ credit worthiness. Can we strengthen our guidelines and make sure that credit decisions are made at the appropriate level?”
Q4 – Explain the concept of guidelines
Q5 – How can they be strengthened at Jane’s request?
Jane: “Ashley, any innovation in the risk management world to protect our receivables?”
• Ashley: “Well, I mentioned in the past Credit Insurance and Credit Derivatives (CDS) but no one was interested! It’s still an option.”
• Jane: “You’re right, we should have paid more attention. I understand Credit Insurance, but I thought there were some issues with CDS, like regular valuation which would have an impact on our P&L?”
Q6 – What is credit insurance?
Q7 – What is Jane referring to when she says: “like regular valuation which would have an impact on our P&L”
• Jane: “OK, next is foreign exchange. I heard some concerns that the dollar may lose value against the euro and the yen. What would it mean for us?”
• Barbara, Head of Asia Pacific (APAC): “It’s very good for my P&L, I like it”
Q8 – Explain why Barbara’s P&L would benefit for a devaluation of the dollar against the yen
• John: “Sure Barbara but remember we purchase future contracts to protect our yen exposure, a devaluation may not impact your APAC’s P&L but BB’s P&L due to mark-to-market accounting”
Q9 – Explain John’s statement
• Jane: “Would we have to post collateral?”
Q10 – Explain Jane’s concerns
• Jane: “Anything else? No? OK, thank you all and let’s meet weekly going forward”