Credit Risk Management Practice Exam

Which term describes the likelihood of a borrower failing to meet their debt obligations?

1. Exposure

2. Probability of default

3. Loss rate

4. Earnings

The correct answer is: Probability of default

The term that describes the likelihood of a borrower failing to meet their debt obligations is referred to as the probability of default. This concept is crucial in credit risk management as it quantifies the risk that a borrower will not be able to fulfill their repayment commitments. Probability of default is typically expressed as a percentage and is derived from historical data and various factors that influence a borrower's ability to repay, such as credit history, income stability, and economic conditions. Understanding the probability of default helps lenders assess the risk associated with a loan or credit decision. It feeds into various credit risk models, allowing financial institutions to set appropriate interest rates, reserve capital for potential losses, and make informed lending decisions. In contrast, exposure refers to the total amount of risk that a lender faces if the borrower defaults, while loss rate refers to the amount of loss incurred as a percentage of total loans. Earnings relate to the profitability of an entity and are not directly linked to the likelihood of default. These distinctions highlight why the probability of default is the most relevant term in assessing credit risk.