Credit Risk Management Practice Exam

How are credit limits used in counterparty risk management?

1. They manage risk at the portfolio level

2. They are applied at the individual trade level

3. They determine loan interest rates

4. They influence collateral requirements

The correct answer is: They manage risk at the portfolio level

In counterparty risk management, credit limits play a crucial role in managing exposure to potential defaults across various transactions. Establishing credit limits allows institutions to evaluate and monitor the risk associated with counterparties, ensuring that they do not exceed a predetermined risk threshold. When credit limits are set at the portfolio level, they effectively aggregate the credit exposure across multiple transactions and counterparties. This approach helps institutions manage overall risk and aligns with their risk appetite, allowing for a more comprehensive view of the credit risk within their portfolio. By doing so, institutions can mitigate the concentration of risk and maintain overall financial stability. The other options, while important in credit risk management, reflect different aspects of how credit limits are used. For instance, applying credit limits at the individual trade level represents a more granular approach to risk management but does not encompass the holistic perspective provided by portfolio-level management. The determination of loan interest rates relates to pricing risk rather than managing counterparty risk directly. Lastly, while credit limits can indeed influence collateral requirements, this is just one of many ways they function within the broader context of overall risk management strategies.