A bankruptcy risk and default risk b bankruptcy risk

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A. Bankruptcy risk and default risk. B. Bankruptcy risk and settlement risk. C. Default risk and downgrade risk. D. Default risk, downgrade risk, and settlement risk.
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Page 14 ©2015 Kaplan, Inc. Topic 1 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 1 C ONCEPT C HECKER A NSWERS 1. A Risk management is more concerned with the variability of losses, especially ones that could rise to unexpectedly high levels or ones that suddenly occur that were not anticipated (unexpected losses). Choice B is not correct because risk is not necessarily related to the size of the potential loss. For example, many potential losses are large but are quite predictable and can be provided for using risk management techniques. Choice C is not correct because the final step of the risk management process involves assessing performance and amending the risk mitigation strategy as needed. Choice D is not correct because the risk management process only involves risk transferring by one party and risk assumption by another counterparty. It is a zero-sum game so it does not result in overall risk elimination. 2. C Examining the impact of a dramatic increase in interest rates is an example of stress testing. Enterprise risk management makes use of measures such as stress testing. 3. A Loan defaults are increasing simultaneously while recovery rates are decreasing is an example of correlation risk. Correlation risk could drive up the potential losses to unexpected levels. In contrast, if lending losses are covered with a spread, given that there is sufficient information to compute such a spread, then the losses would likely be considered expected losses. 4. C Weak internal controls and lack of segregation of duties would represent a non-financial risk and be best described as an operational risk. Choice A is not correct because business risk focuses on the income statement (i.e., revenues too low and expenses too high). Choice B is not correct because legal and regulatory risk focuses on the risk of an entity being sued or the risk of unfavorable changes in the rules and laws that the entity must follow. Choice D is not correct because strategic risk focuses on significant new business investments or significant changes in an entity’s business strategy. 5. A The fact that the loan is secured by land and the building is now worth less than the amount of the loan outstanding subjects LBI to increased bankruptcy risk in the sense that the liquidation value of the collateral is insufficient to recover the loss if the loan defaults. The financial loss and the cash flow difficulties suggest that there is increased default risk for LBI as well. Downgrade risk does not apply here because Make It’s loan is not publicly traded and is unlikely to be rated by a recognized rating agency. Settlement risk does not apply here either because there is no exchange of cash flows at the end of the transaction that would be required to incur such risk. In this case, the loan is settled when Make It fully repays the principal balance owed.
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