Credit Risk Management Practice Exam

Which of the following is a method used to assess the expected loss (ELS) in a stressed environment?

1. Calculating peak exposure as a single value

2. Stressing the probability of default (PD)

3. Using the market value without adjustments

4. Evaluating only the historical average of losses

The correct answer is: Stressing the probability of default (PD)

The selected answer is correct because in a stressed environment, it is essential to evaluate how various factors can affect the likelihood of default, particularly the probability of default (PD). Stress testing involves simulating extreme but plausible adverse conditions that could impact borrowers' ability to repay their obligations. By stressing the PD, analysts can assess how changes in conditions or the economic environment might lead to higher defaults, which directly informs the calculation of expected loss (ELS). This method allows institutions to better prepare for potential downturns and adjust their risk management strategies accordingly. Stressing the PD can incorporate different scenarios such as economic recession, industry downturns, or other specific risks that could heighten the chances of default among borrowers. In contrast, calculating peak exposure as a single value would not capture the dynamic nature of risk in a stressed environment. It merely provides a snapshot rather than an assessment of potential changes in risk factors. Using the market value without adjustments overlooks necessary considerations, as market conditions can vary widely during stress periods. Evaluating only the historical average of losses does not account for changes in the economic landscape or the risk profile of borrowers, which makes it insufficient for realistically predicting future losses under stress. Thus, stressing the probability of default is a key approach in effectively gauging expected