Explanation:
A is correct. In CreditMetrics, a Monte Carlo simulation is carried out to model how the ratings of loans in a portfolio change during the year.
B is incorrect. On each simulation trial, a number is sampled from a standard normal distribution, not a uniform distribution. Specifically, each probability in the table is mapped to a range of critical values of the standard normal distribution, and the sampled value is compared to these ranges to determine the year-end rating.
C is incorrect. The bank's portfolio of loans is valued at the beginning of a one-year period. In each simulation trial, the ratings of all borrowers at the end of the year are determined, and the portfolio is revalued accordingly. The annual credit loss is then calculated as the difference between the initial portfolio value and the simulated end-of-year portfolio value.
D is incorrect. While CreditMetrics is a widely used model for credit risk measurement, it is not the model recommended by the Basel Committee for regulatory capital purposes. The Basel II framework, for instance, allows banks to use internal models (including CreditMetrics) under certain conditions, but does not mandate it specifically. The Basel Committee recommends the use of the standardized approach or the foundation/advanced internal ratings-based (IRB) approaches for regulatory capital calculations, depending on the jurisdiction and regulatory context.
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Question 95 of 100
A credit risk manager at a bank is presenting to a group of newly hired analysts on the use of the CreditMetrics model for measuring risk in the loan portfolio and determining its credit risk capital. As an example of how the model could be applied, the manager considers a loan with a rating of A in the portfolio and presents the following table of rating transition probabilities:
| Rating transition | Probability (%) |
|---|---|
| Remains A-rated | 88 |
| A to B-rated | 7 |
| A to C-rated | 3 |
| Default | 2 |
Which of the following statements about the CreditMetrics model would the manager be correct to make?
A
The CreditMetrics model uses the outcomes of many simulation trials to generate a distribution of credit losses on the loan.
B
If a sample from a uniform distribution produces a critical value corresponding to the 90 percentile point of the distribution, the loan will be considered to have a rating of B at the end of the year.
C
The annual credit loss on the loan is calculated as the expected loss on the loan given the default probability provided in the table.
D
CreditMetrics is the model recommended by the Basel Committee for use in determining regulatory capital.