8010 Exam Dumps : Operational Risk Manager (ORM) Exam

Note that events of default under the ISDA MA are caused by one of the parties that is considered 'atfault'. In contrast, "termination events" are events for which no one is at fault, for example changes in legislation, illegality etc that still justify termination of the transactions under the contract.

The ISDA MA describes the following 8 types of events of default:

1. failure of pay or deliver

2. breach of agreement

credit support default

4. misrepresentation

5. default under specified transaction

6. cross default

7. bankruptcy

8. merger without assumption

All of the options presented in the question are events of default.

The probability that only one of thethree bonds will default is equal to the sum of the probabilities of the three scenarios where one bond defaults and the other two survive. This probability is given by 1%*(1 - 2%)*(1 - 3%) + (1 - 1%)*2%*(1 - 3%) + (1 - 1%)*(1 - 2%)*3% = 5.7818%. Choice 'c' is the correct answer.

The easiest way to answer this question is to ignore the joint probability of default as thatis irrelevant to expected losses. The joint probability of default impacts the volatility of the losses, but not the expected amount. One way to think about it is to think of asset portfolios, where diversification reduces risk (ie standard deviation) butthe expected returns are nothing but the average of the expected returns in the portfolio. Just as the expected returns of the portfolio are not affected by the volatility or correlations (these affect standard deviation), in the same way the joint probability of default does not affect the expected losses. Therefore the expected losses for this portfolio are simply $1m x 10% + $1m x 15% = $250,000.

This can also be seen from the lens of a joint probability distribution as follows:

There are four possibilities for this portfolio:

- Only loan A defaults: loss of $1m: 9% probability

- Only loan B defaults: loss of $1m: 14% probability

- Both loan A and B default: loss of $2m: 1% probability

- Neither A nor B default: loss of $0m: 76% probability

Therefore the expected losses on the portfolio are ($1m x 9%) + ($1m x 14%) + ($2m x 1%) + ($0m x 76%) = $250,000.

(Notes: How is the above table calculated? The totals (10%, 90%, 15% and 85%) are filled in first. The top left cell (both A & B default) is given as 1%. We can now calculate the rest of the cells as the totals are known.)