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Answer: The probability of default of a derivative counterparty often increases as the bank's exposure at default with respect to that derivative position increases.
## Explanation **A is correct.** This describes **wrong-way risk**, which occurs when the probability of default of a counterparty increases as the bank's exposure to that counterparty also increases. This is particularly relevant for derivative positions where the counterparty may be more likely to default when the value of outstanding derivatives is negative to them (and positive to the bank). **B is incorrect.** Loss given default (LGD) is actually **positively correlated** with probability of default (PD). When PD increases, LGD typically also increases, meaning recovery rates decrease. **C is incorrect.** Banks are required to make both through-the-cycle and point-in-time estimates for **probability of default (PD)**, not loss given default (LGD), to comply with regulatory requirements and accounting standards. **D is incorrect.** For lines of credit, exposure at default (EAD) is conservatively estimated using the **customer's borrowing limit** (committed amount), not the current drawn amount, to account for potential future drawdowns before default.
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A risk analyst at a bank is calculating credit risk for various types of assets in the bank's portfolio. The analyst begins by estimating the parameters used as inputs to these calculations, and encounters several challenges while doing so. Which of the following will the analyst find to be correct regarding the estimated inputs for credit risk calculations?
A
The probability of default of a derivative counterparty often increases as the bank's exposure at default with respect to that derivative position increases.
B
The loss given default for a derivative transaction is typically negatively correlated with the counterparty's probability of default.
C
Banks must make both through-the-cycle and point-in-time estimates of loss given default to comply with both regulatory requirements and accounting standards.
D
Current exposure is typically used to estimate exposure at default for a line of credit in order to provide a conservative estimate.