Credit Risk Management Practice Exam

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What is meant by 'spread risk' in credit risk management?

The risk of changing interest rates
The change in value of risky securities from changing spreads
The fluctuation in currency exchange rates
The risk of default by different asset classes

The correct answer is: The change in value of risky securities from changing spreads

'Spread risk' in credit risk management refers specifically to the change in value of risky securities as a result of changing spreads. This concept is fundamental in understanding how the price of a security can be affected by changes in the yield spreads between different types of bonds and other financial instruments. When investors perceive a higher risk associated with a particular security compared to a benchmark (like government bonds), they demand a higher yield, which indicates a widening spread. Conversely, if the perceived risk decreases, the spread narrows. Changes in spreads can lead to significant fluctuations in the market value of securities, impacting overall portfolio performance. This understanding is crucial for credit risk managers as they evaluate the potential for losses based on the adjustments in market sentiment toward credit quality, particularly during times of economic uncertainty or stress. Preparing for these fluctuations allows risk managers to make more informed decisions about asset allocation and risk exposure.