Credit Risk Management Practice Exam

What does the single-factor model framework state regarding default loss?

1. The probability of a default loss is dependent on external market conditions

2. The unconditional probability of default loss is influenced by market returns

3. The impact of diversification is non-existent

4. The model assumes all defaults are independent events

The correct answer is: The unconditional probability of default loss is influenced by market returns

The single-factor model framework highlights that the unconditional probability of default loss can indeed be influenced by market returns. This concept arises from the understanding that defaults are not only random events but can be correlated with broader market movements. In this model, the systematic risk captured by the single factor—often viewed as market returns—affects the likelihood of default across different entities. When market conditions are favorable, the probability of default may reduce, while adverse conditions could heighten default risks. By recognizing that market returns play a role in influencing default probabilities, the model provides a more structured approach to managing credit risk, as it allows for the evaluation of how economic cycles can impact the likelihood of defaults. This understanding differentiates it from the notion of diversification, which is given less weight in the context of single-factor modeling, as the framework largely emphasizes the correlation between default risk and market returns instead of independent default events.