Question #1 (source 2006 #76):

Rank the following common credit risk mitigation options from greatest security to lowest security:

I. Parental guarantee

II. Letter of Credit

III. Securities as collateral (with a haircut parameter of 0%)

IV. Cash

• a. I, IV, III, II

• b. IV, III, II, I

• c. IV, II, III, I

• d. IV, II, I, III

Question #2 :

If an Exporter delivers goods immediately to an Importer and issues an invoice payable, the Exporter incurs credit risk via the trade receivable. The Exporter is the Obligee and the Importer is the Obligor.

Which of the following most directly consumes the debt capacity of the Importer (Obligor)?

• a. Letter of Credit

• b. Trade credit insurance

• c. Pure financial guarantee

• d. Wrap

Answer #1: C

Cash, Letter-of-credit, Securities as collateral, and Parental guarantee. A haircut parameter of 0% indicates a low-risk transaction and should be preferred over a parental guarantee. Parental guarantees can be difficult to enforce, a possibility of the parent company having financial distress as the subsidiary company and can take a substantial amount of time (and possibly court action) to collect.

Reference: Measuring and Managing Credit Risk, De Servigny and Renault, 2004.

Answer #2: A.

The letter of credit (LOC) represents financial capital of the Obligee that has been guaranteed by the bank; Insurance and guarantees, on the other hand, are obligations of the guarantor (the bank or insurance company that writes the protection). Whereas Insurance and guarantees are obligations of the guarantor, the LOC economically consumes the debt capacity of the Obligor. Consequently, the bank often requires the Obligor, that secures the LOC, to post collateral, but this is less common in the case of insurance and guarantees. Source: Culp, Structured Finance and Insurance.