Module: | MODULE B: RISK MANAGEMENT
Q293: Consider the following statements regarding the sub-types of Credit Risk in banking operations:
1. Default risk occurs when a counterparty is unable or unwilling to fulfill their contractual payment obligations, by the stipulated due date.
2. Migration risk involves the potential financial loss, arising from a downward revision or downgrade, in the borrower's internal credit rating.
3. Settlement risk is completely eliminated, when foreign exchange transactions are executed across different, non-overlapping global time zones.
Which of the statements given above is/are correct?
2. Migration risk involves the potential financial loss, arising from a downward revision or downgrade, in the borrower's internal credit rating.
3. Settlement risk is completely eliminated, when foreign exchange transactions are executed across different, non-overlapping global time zones.
Which of the statements given above is/are correct?
✅ Correct Answer: A
The correct answer is A. Statement 1 is correct: Default Risk is the most fundamental component of credit risk.
It strictly refers to the borrower's inability, or outright unwillingness, to honor the principal or interest payment obligations on the due date.
Statement 2 is correct: Migration Risk (or Downgrade Risk) is the risk that a borrower's credit rating will be downgraded.
Even if they haven't defaulted yet, a lower rating requires the bank to hold more capital and higher provisions against that loan, resulting in a direct financial cost.
Statement 3 is incorrect: Different global time zones do NOT eliminate settlement risk; they actually *create* it.
This specific cross-zone settlement risk in FX markets is known as "Herstatt Risk." It occurs when one bank pays its currency leg during its business hours, but the counterparty defaults before their time zone opens for the reciprocal payment.
It strictly refers to the borrower's inability, or outright unwillingness, to honor the principal or interest payment obligations on the due date.
Statement 2 is correct: Migration Risk (or Downgrade Risk) is the risk that a borrower's credit rating will be downgraded.
Even if they haven't defaulted yet, a lower rating requires the bank to hold more capital and higher provisions against that loan, resulting in a direct financial cost.
Statement 3 is incorrect: Different global time zones do NOT eliminate settlement risk; they actually *create* it.
This specific cross-zone settlement risk in FX markets is known as "Herstatt Risk." It occurs when one bank pays its currency leg during its business hours, but the counterparty defaults before their time zone opens for the reciprocal payment.