Credit Risk Management Practice Exam

How can default risk for a single company be modeled according to Bernoulli trials?

1. As a success (no default) or failure (insolvency)

2. By calculating averages of previous defaults

3. Through complex financial derivatives

4. Using historical data only

The correct answer is: As a success (no default) or failure (insolvency)

Modeling default risk for a single company through Bernoulli trials focuses on the concept of binary outcomes. In this framework, default risk is represented as a discrete event where an outcome can either be a success or a failure. In the context of credit risk, a "success" would signify that the company does not default (stays solvent), while a "failure" would indicate that the company becomes insolvent. Bernoulli trials inherently involve events that have two possible outcomes, which aligns perfectly with the notion of company defaults—either the company meets its financial obligations, or it does not. This simplification is useful for assessing and quantifying the likelihood of default in a systematic and statistical manner. On the other hand, other options such as calculating averages of previous defaults, using complex financial derivatives, or relying solely on historical data do not encapsulate the binary nature of default risk as effectively as modeling it through Bernoulli trials. These alternatives may provide valuable insights or supplementary analysis, but they do not align with the straightforward binary framework that Bernoulli trials represent.