Learning outcomes: Describe how economic capital is derived. Explain how the credit loss distribution is modeled. Describe challenges to quantifying credit risk.
Questions:
507.1. Which best describes the relationship between economic capital and unexpected loss?
a. Economic capital is a multiple of unexpected loss
b. Economic capital is unrelated to unexpected loss
c. Economic capital is equal to (synonymous with) unexpected loss
d. Economic capital is unexpected loss plus credit value at risk (CVaR)
507.2. About the modeling of the credit loss distribution, Schroeck explains: "The crucial task in estimating
economic capital is, therefore, the choice of the probability distribution ... One distribution often recommended and suitable for this practical purpose is the beta distribution. This kind of distribution is especially useful in modeling a random variable that varies between 0 and c (> 0). And, in modeling credit events, losses can vary between 0 and 100%, so that c = 1. The beta distribution is extremely flexible in the shapes of the distribution it can accommodate." (Source: Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions, (New York: Wiley, 2002))
Which of the following is TRUE about the beta distribution?
a. The beta distribution is flexible because it has four (4) parameters, one for each moment, allowing for precise calibration of tail (i.e., kurtosis)
b. In credit risk, the most convenient calibration of the beta distribution that is also sufficiently realistic is to set the shape parameters, alpha and beta, equal to each other
c. As the beta distribution is characterized by the portfolio's expected loss, EL(P) and unexpected loss, UL(P), the challenge is fitting the tail of the distribution which depends on the ratio EL(P)/UL(P)
d. The chief drawback of the beta distribution is that--even when it is accurately fitted--it gives us no way to determine the capital multiplier (CM), so the CM must be separately analyzed and, realistically, this often requires a different distribution
507.3. Schroeck illustrates the "bottom up" approach to the quantification of economic capital for credit risk. But he cautions "Despite the beauty and simplicity of the bottom-up (total) risk measurement approach just described, there are a number of caveats that need to be addressed." (Source: Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions, (New York: Wiley, 2002))
According to Schroeck, each of the following is a problem ("challenge") with the quantification of credit risk EXCEPT which is not?
a. This approach assumes that credits are illiquid assets
b. This approach does not give us a way to aggregate economic capital across the major risk types: credit, market and operational risk
c. In practice, to avoid undue complexity, these internal credit risk models tend to use only a one-year estimation horizon rather than multi-period horizon
d. While this approach considers default correlation with the same credit risk type, it assumes market and operational risk components are separated and are measured and managed in different departments with the bank
(Source: Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions, (New York: Wiley, 2002))
Answers here:
Questions:
507.1. Which best describes the relationship between economic capital and unexpected loss?
a. Economic capital is a multiple of unexpected loss
b. Economic capital is unrelated to unexpected loss
c. Economic capital is equal to (synonymous with) unexpected loss
d. Economic capital is unexpected loss plus credit value at risk (CVaR)
507.2. About the modeling of the credit loss distribution, Schroeck explains: "The crucial task in estimating
economic capital is, therefore, the choice of the probability distribution ... One distribution often recommended and suitable for this practical purpose is the beta distribution. This kind of distribution is especially useful in modeling a random variable that varies between 0 and c (> 0). And, in modeling credit events, losses can vary between 0 and 100%, so that c = 1. The beta distribution is extremely flexible in the shapes of the distribution it can accommodate." (Source: Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions, (New York: Wiley, 2002))
Which of the following is TRUE about the beta distribution?
a. The beta distribution is flexible because it has four (4) parameters, one for each moment, allowing for precise calibration of tail (i.e., kurtosis)
b. In credit risk, the most convenient calibration of the beta distribution that is also sufficiently realistic is to set the shape parameters, alpha and beta, equal to each other
c. As the beta distribution is characterized by the portfolio's expected loss, EL(P) and unexpected loss, UL(P), the challenge is fitting the tail of the distribution which depends on the ratio EL(P)/UL(P)
d. The chief drawback of the beta distribution is that--even when it is accurately fitted--it gives us no way to determine the capital multiplier (CM), so the CM must be separately analyzed and, realistically, this often requires a different distribution
507.3. Schroeck illustrates the "bottom up" approach to the quantification of economic capital for credit risk. But he cautions "Despite the beauty and simplicity of the bottom-up (total) risk measurement approach just described, there are a number of caveats that need to be addressed." (Source: Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions, (New York: Wiley, 2002))
According to Schroeck, each of the following is a problem ("challenge") with the quantification of credit risk EXCEPT which is not?
a. This approach assumes that credits are illiquid assets
b. This approach does not give us a way to aggregate economic capital across the major risk types: credit, market and operational risk
c. In practice, to avoid undue complexity, these internal credit risk models tend to use only a one-year estimation horizon rather than multi-period horizon
d. While this approach considers default correlation with the same credit risk type, it assumes market and operational risk components are separated and are measured and managed in different departments with the bank
(Source: Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions, (New York: Wiley, 2002))
Answers here:
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