Credit Risk Management Practice Exam

Which modeling approach considers that FX rates may jump upon default?

1. Intensive approach

2. Parametric approach

3. Jump approach

4. Structural approach

The correct answer is: Jump approach

The modeling approach that considers foreign exchange (FX) rates may experience jumps upon default is known as the jump approach. This approach recognizes that the value of assets, such as currencies, can have sudden and significant changes (or "jumps") in response to default events or other market shocks. In the context of credit risk, when a borrower defaults, the underlying assets can experience abrupt changes in value due to increased volatility, market reactions, or liquidity constraints. The jump approach explicitly incorporates these sudden movements into the modeling framework, allowing for a more realistic representation of the risks associated with defaults in foreign exchange markets. This approach stands out compared to other methodologies that either assume a continuous evolution of rates without taking sudden jumps into account or focus on different aspects of risk that do not specifically address the potential for abrupt changes in FX rates. Thus, the jump approach is particularly relevant when evaluating risks in environments where defaults can dramatically influence market behavior.