Credit Risk Management Practice Exam

What does the term 'default probability' signify?

1. The likelihood that a counterparty will fail to meet its obligations

2. The percentage of loans that typically go into default

3. The interest rate charged for high-risk borrowers

4. The historical default rates of different asset classes

The correct answer is: The likelihood that a counterparty will fail to meet its obligations

The term 'default probability' signifies the likelihood that a counterparty will fail to meet its obligations. This concept is crucial in credit risk management, as it quantifies the risk associated with lending or extending credit to an individual or entity. By assessing the probability of default, lenders and investors can make informed decisions about whether to engage in a financial transaction, how much to charge in interest, and how to structure their lending agreements. Understanding default probability aids in the pricing of risk and the management of a financial portfolio, allowing for better assessment of potential losses that could arise from defaults. It encompasses various factors including the creditworthiness of the borrower, market conditions, and economic indicators, which can help predict the likelihood of repayment failure. In contrast, other options speak to related but distinct concepts. The percentage of loans that typically go into default focuses on historical trends rather than the calculated likelihood for a specific counterparty at a given time. The interest rate charged for high-risk borrowers reflects the cost of borrowing influenced by perceived risk, rather than directly measuring the probability of default. Historical default rates of different asset classes offer insights into past performance but do not directly signify a specific counterparty's likelihood of default.