GARP 2016-FRR Exam With Confidence Using Practice Dumps

ThetaBank's default risk assessment involves calculating the joint probability of default for the two mortgage companies and comparing it to the independent risk model.

Individual Exposure at Default (EAD):$20 million for each mortgage company.

Loss Given Default (LGD):100%

Probability of Default (PD):10% for each mortgage company.

Joint Probability of Default:5%

For independent risks, the joint probability of default for two independent events is the product of their individual probabilities:

\text{Joint Probability (Independent)} = PD_1 \times PD_2 = 0.10 \times 0.10 = 0.01 \text{ (or 1%)}

Given that ThetaBank predicts the joint probability at 5%, the independent model would have underestimated the actual probability by:

5%−1%=4%5%−1%=4%

Therefore, the underestimated probability is:

4%−2%=2%4%−2%=2%

References

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When an asset manager for a large mutual fund engages in forward exchange transactions traded in a clearinghouse system, the primary risks that arise are exchange rate risk and credit risk. Exchange rate risk is inherent in any foreign exchange transaction due to potential fluctuations in the currency's value over time. Credit risk is also significant as it involves the possibility that the counterparty may default on their contractual obligations.

Comprehensive and Detailed In-Depth Explanation:

The recovery rate is the percentage of the original exposure recovered, adjusted for the time value of money and recovery costs. Here, the exposure at default (EAD) is USD 20 million, the gross recovery after one year is USD 10 million, and the recovery cost is USD 1 million. The recovery discount rate is 10%, reflecting the time value of money over one year.

Step-by-step calculation:

Net Recovery Amount:Gross recovery - Recovery costs = USD 10 million - USD 1 million = USD 9 million.

Present Value of Recovery:Since the recovery occurs after one year, discount the net recovery at 10%:PV = USD 9 million / (1 + 0.10) = USD 9 million / 1.1 ≈ USD 8.1818 million.

Recovery Rate:Divide the present value of the recovery by the original exposure:Recovery Rate = (USD 8.1818 million / USD 20 million) × 100 ≈ 40.91%, which rounds to 41%.

This aligns with Basel II/III definitions of Loss Given Default (LGD = 1 - Recovery Rate) and the discounting approach for recovery cash flows in credit risk models.