Module: | MODULE B: RISK MANAGEMENT
Q375: Consider the following statements regarding the different components of Credit Risk:
1. Default Risk arises when a counterparty fails to meet its financial obligations on the due date.
2. Downgrade Risk refers to the probability of an upgrade in the credit rating of the borrower, leading to increased capital requirements.
3. Settlement Risk occurs when a bank delivers a security or cash to a counterparty, but the counterparty fails to deliver the corresponding asset.
Which of the statements given above is/are correct?
2. Downgrade Risk refers to the probability of an upgrade in the credit rating of the borrower, leading to increased capital requirements.
3. Settlement Risk occurs when a bank delivers a security or cash to a counterparty, but the counterparty fails to deliver the corresponding asset.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is correct: Default risk is the most common form of credit risk, defined as the failure of a borrower or counterparty to meet their financial obligations (principal or interest) as per agreed terms on the due date.
Statement 3 is correct: Settlement risk arises in foreign exchange or securities trading when one party delivers the asset or cash, but the counterparty fails to deliver their side of the agreement, often exacerbated by time-zone differences.
Statement 2 is incorrect: Downgrade Risk specifically refers to the deterioration (downgrade) of a borrower's credit quality or rating, not an upgrade.
A downgrade increases the Probability of Default (PD), forcing the bank to allocate more economic capital and increasing the cost of holding that asset.
Statement 3 is correct: Settlement risk arises in foreign exchange or securities trading when one party delivers the asset or cash, but the counterparty fails to deliver their side of the agreement, often exacerbated by time-zone differences.
Statement 2 is incorrect: Downgrade Risk specifically refers to the deterioration (downgrade) of a borrower's credit quality or rating, not an upgrade.
A downgrade increases the Probability of Default (PD), forcing the bank to allocate more economic capital and increasing the cost of holding that asset.