Credit Risk Management Practice Exam

How is a higher borrower rating generally related to the probability of default?

1. Higher rating indicates a higher probability of default

2. Higher rating indicates no relationship to probability of default

3. Higher rating indicates a lower probability of default

4. Higher rating indicates a variable probability of default

The correct answer is: Higher rating indicates a lower probability of default

A higher borrower rating reflects the creditworthiness of the borrower, which is a key determinant in assessing the likelihood that they will default on their obligations. When a borrower receives a high rating, it indicates that they have a strong financial position, reliable income streams, good credit history, and responsible management of their obligations. Consequently, this strong profile leads to a lower probability of default. This negative correlation is fundamental to credit assessment frameworks. Credit rating agencies and financial institutions utilize these ratings as benchmarks to determine risk levels associated with lending to various borrowers. A borrower with a high rating is typically perceived as having a lower risk, thus implying they are less likely to default on their loans. This principle is critical in managing credit risk, as it allows lenders to make informed decisions about the extent of exposure they are willing to undertake with different borrowers.