Which of the following statements is true:

Which of the following statements is true:

I. Expected credit losses are charged to the unit’s P&L while unexpected losses hit risk capital reserves.

II. Credit portfolio loss distributions are symmetrical

III. For a bank holding $10m in face of a defaulted debt that it acquired for $2m, the bank’s legal claim in the bankruptcy court will be $10m.

IV. The legal claim in bankruptcy court for an over the counter derivatives contract will be the notional value of the contract.
A . I and III
B . I, II and IV
C . III and IV
D . II and IV

View Answer

Answer: A

Explanation:

Statement I is true as expected losses are the ‘cost of doing business’ and charged against the P&L of the unit holding the exposure. When evaluating the business unit, expected losses are taken into account. Unexpected losses however require risk capital reserves to be maintained against them.

Statement II is not true. Credit portfolio loss distributions are not symmetrical, in fact they are highly skewed and have heavy tails.

Statement III is true. The notional, or the face value of a defaulted debt is the basis for a claim in bankruptcy court, and not the market value.

Statement IV is false. In the case of over the counter instruments, the replacement value of the contract represents the amount of the claim, and not the notional amount (which can be very high!).