This question assesses the understanding of the structural differences between private, bilateral lending (like a syndicated bank loan) and public, multilateral capital markets (like a bond issuance). The key concept is how moving from a closed negotiation with a few specialist lenders to an open market with many generalist investors affects the cost of capital. Public markets, regulated for transparency and disclosure under frameworks like the Securities and Futures Ordinance (SFO), attract a wider pool of capital. This increased demand and competition among investors can lead to more favourable borrowing terms (a lower yield) for the issuer. The explanation should focus on the relationship between market breadth, transparency, investor type, and the resulting cost of funds, contrasting it with the nature of private bank lending.

This question assesses the understanding of working capital requirements and their impact on a company’s credit quality. Working capital requirements are calculated as (Accounts Receivable + Inventory – Accounts Payable). This figure represents the cash a company needs to fund its operating cycle. In the scenario, Accounts Receivable (a use of cash, as sales are made but not yet paid for) and Inventory (a use of cash, as it’s paid for but not yet sold) are growing faster than Accounts Payable (a source of cash, as goods are received but not yet paid for). This disparity leads to an increase in the company’s working capital requirements. A rising need for working capital implies that the company’s internal operations are consuming more cash. To meet this need, the company must rely on external sources of funding, such as bank loans or lines of credit. This increased reliance on external financing can strain the company’s liquidity and increase its financial risk, which are negative factors in a credit assessment.

In financial markets, uncertainty and mistrust directly impact the price of risk. When investors are skeptical about the information provided by a borrower, or when a security lacks standard risk indicators like a credit rating, they demand a higher return to compensate for the increased perceived risk. This is reflected in a higher required yield. The yield-spread curve is a critical tool for pricing bonds, but it relies on three key inputs: the reference market (cohort), maturity, and credit rating. For an unrated bond, a direct application of the curve is not possible. Instead, practitioners find suitable benchmarks (e.g., rated bonds from similar companies or sectors) and then adjust the yield upwards to account for specific negative factors such as the lack of a rating, poor liquidity, and negative market sentiment. The idea of setting a credit risk premium for a single bond to neutralize a potential default is flawed; the premium is properly established by considering the default profile of a diversified portfolio of similarly-risked securities. While theoretical models exist, they are generally considered too laborious for practical, day-to-day pricing.

Statement I is correct. A key rationale for the existence of domestic or regional credit rating agencies (CRAs) is their ability to provide analysis that is sensitive to local market conditions. This includes cultural, social, and economic factors that a large, overseas-based agency might not fully capture, leading to a more nuanced assessment of creditworthiness. Statement II is also correct. The major international CRAs (like S&P, Moody’s, and Fitch) have a significant historical advantage. They are deeply embedded in the ‘market psyche’—investors and issuers are accustomed to their ratings—and are formally integrated into many global and national regulatory frameworks, creating a high barrier to entry for new competitors. Statement III is correct. To overcome the challenges mentioned in Statement II, such as a lack of historical data and brand recognition, smaller CRAs often form strategic partnerships, affiliations, or associations with the major agencies. This allows them to leverage the global reach and credibility of the established player. Statement IV is incorrect. The text and historical records indicate the opposite. The US regulatory system began formally incorporating credit ratings into securities law in the 1970s, with roots going back to the 1930s. European regulators began to rely on them more heavily as a quasi-regulatory mechanism later, particularly under the Basel Accords. Therefore, statements I, II and III are correct.

To accurately perform arithmetic operations on credit ratings, such as calculating a weighted average default propensity for a portfolio, the ratings must represent a quantifiable measure. This type of rating is known as a cardinal rating, as it corresponds to a specific, back-tested probability of default. Ordinal ratings, in contrast, only provide a relative ranking of creditworthiness (e.g., A is better than BBB) without assigning a specific probability value. Therefore, attempting to average ordinal ratings would be mathematically inappropriate. While distinctions between issuer and issue ratings, or fundamental and structured ratings, are important in credit analysis, the essential characteristic for this specific calculation is the quantifiable, probabilistic nature of the rating.

This question tests the interpretation of key financial ratios used in credit and solvency analysis, such as those in the Altman Z-score model.

Statement I is correct. The ratio of Working Capital to Total Assets (T1) is a primary measure of a company’s short-term liquidity. A low and declining ratio indicates that current assets are not significantly greater than current liabilities, suggesting potential difficulty in meeting short-term obligations as they fall due.

Statement II is correct. The ratio of Retained Earnings to Total Assets (T2) reflects the cumulative profitability of a company over its lifetime. A high and stable ratio signifies that the company has historically been profitable and has reinvested a significant portion of its earnings back into the business, building its asset base.

Statement III is correct. The ratio of Earnings Before Interest and Taxes to Total Assets (T3) measures a company’s operational profitability relative to its total assets. It indicates how efficiently a company is using its assets to generate earnings. A positive but declining trend suggests that while the company is still profitable at an operating level, its core business efficiency is deteriorating.

Statement IV is incorrect. While a strong history of profitability (indicated by T2) is a significant strength, it does not ‘fully mitigate’ or negate current operational and liquidity risks. The declining operational efficiency (T3) and poor liquidity (T1) are serious warning signs that must be addressed independently. Past success does not guarantee future performance or solvency. An analyst must consider all indicators together. Therefore, statements I, II and III are correct.

The credit quality assessment of structured securities, such as Collateralized Debt Obligations (CDOs), differs significantly from that of traditional corporate bonds. While a corporate bond rating assesses the default risk of a single entity, a structured security’s rating depends on the performance of a diverse pool of underlying assets. Credit Rating Agencies (CRAs) use complex statistical models to evaluate these products. A critical input into these models is the assumption about the correlation of defaults among the assets in the pool. The models often rely on historical data which may not capture the dynamics of a severe, market-wide crisis. During such systemic events, the assumption of low or moderate correlation can break down, as defaults become highly correlated across different assets and sectors. This underestimation of correlation risk is a primary reason why a highly-rated structured product can experience catastrophic losses that were not predicted by its initial rating, surprising many market participants who relied on that assessment.

Traditional sovereign credit rating systems have faced criticism for potentially favoring larger, more established governments over those in emerging markets. A key piece of empirical evidence supporting this is that while investment-grade government debt has historically shown a near-zero default rate, only a very small number of sovereigns, primarily from developed nations, achieve the highest possible ratings (e.g., AAA/Aaa). This suggests that the models may not fully capture the creditworthiness of all entities equally. To address this and create a more robust, forward-looking analysis, a proposed alternative is to evaluate the sovereign as if it were an ‘asset manager’. This approach shifts the focus from purely historical fiscal metrics to the government’s effectiveness in achieving strategic objectives. The evaluation would be based on its success in meeting targets related to growing the economy, attracting high-quality businesses, promoting internal resource development, and maintaining overall stability, with progress measured against its own historical benchmarks.

This question assesses understanding of the key requirements under the SFC’s Code of Conduct for Persons Providing Credit Rating Services (CRA Code), which governs Type 10 regulated activity.

Statement I is correct. Part 1 of the CRA Code, ‘Quality and Integrity of the Rating Process’, mandates that CRAs must establish policies and procedures to ensure the quality of their ratings. This includes ongoing monitoring of rated entities and timely updates to ratings based on new information.

Statement II is incorrect. Part 2, ‘Independence and Avoidance of Conflicts of Interest’, strictly prohibits analysts from participating in the determination of a credit rating for any entity in which they have a financial interest. Simple internal disclosure is insufficient to mitigate this fundamental conflict of interest.

Statement III is correct. Part 3, ‘Responsibilities to the Investing Public and Rated Entities’, emphasizes transparency. It requires CRAs to disclose their ratings publicly and in a timely fashion, providing enough context and rationale for users to understand their meaning, limitations, and the basis upon which they were formed.

Statement IV is incorrect. While establishing an ombudsman function is required under Part 4, ‘Disclosure of the Code of Conduct and Communication with Market Participants’, this part also explicitly requires a CRA to publish its methodologies, procedures, and assumptions on its website to promote transparency and allow users to evaluate its work. Keeping methodologies confidential for intellectual property reasons would be a direct violation of this principle. Therefore, statements I and III are correct.

According to the SFC’s Code of Conduct for Persons Providing Credit Rating Services (the ‘CRA Code’), transparency is a fundamental principle governing the activities of Credit Rating Agencies (CRAs). When a CRA intends to make a material change to its credit rating methodologies, procedures, or significant assumptions, it has a specific obligation to the market. The CRA Code requires the agency to publicly disclose the proposed changes, the rationale for them, and their likely effect on existing credit ratings. This disclosure should be made to the entire market, not just to a select group of rated entities, and preferably before the changes are implemented. This allows users of the ratings, such as investors and intermediaries, to understand the potential impact on their assessments and decisions. While internal governance and subsequent performance reviews are important operational aspects, the primary regulatory duty in this context is to ensure the market is fully and transparently informed about the evolution of the rating process itself.

The CAMELS framework is a standard methodology for assessing the financial health of a bank. Each letter in the acronym represents a key component of the analysis. Statement I is correct because ‘Capital Adequacy’ (C) directly involves evaluating a bank’s capital reserves against its risks, with regulatory minimums (like those from the HKMA based on Basel III) serving as a critical benchmark. Statement II is correct as ‘Asset Quality’ (A) focuses on the risks within a bank’s assets, primarily its loan book. Analyzing the credit risk and concentration of the lending portfolio is a fundamental part of this assessment. Statement III is also correct because ‘Earnings Quality’ (E) assesses the stability and sustainability of a bank’s profits. A successful shift to more diverse and stable fee-based income, rather than relying solely on interest rate spreads, indicates higher quality earnings. Statement IV is incorrect because the exposure to market movements, such as interest rate fluctuations, is evaluated under ‘Sensitivity to Market Risk’ (S), not ‘Liquidity Position’ (L). The ‘Liquidity Position’ component assesses the bank’s ability to meet its short-term cash flow obligations. Therefore, statements I, II and III are correct.

This question assesses understanding of the fundamental principles within the Code of Conduct for Persons Providing Credit Rating Services, which governs licensed CRAs in Hong Kong. The Code places paramount importance on the integrity, independence, and objectivity of the credit rating process. A rating analyst’s primary duty is to the market and investors, not to the entity being rated. This requires the analyst to conduct a thorough and impartial assessment based on all relevant and reliable information gathered during due diligence. Any attempt by an issuer to exert undue influence, whether through business incentives or by providing unsubstantiated information, must be resisted. The integrity of the rating depends on the analyst’s ability to form a judgment free from commercial pressures or conflicts of interest. Modifying analytical methodologies or accepting client projections without critical evaluation would compromise the quality and credibility of the rating, violating the core tenets of good governance and responsibility.

Statement I is correct. A credit rating is a forward-looking opinion on the relative credit risk of an entity or a specific debt instrument. It is not a guarantee of payment, nor is it a recommendation to purchase, sell, or hold a security. Statement II is correct. The Securities and Futures Commission (SFC) regulates credit rating agencies in Hong Kong. A core principle of the ‘Code of Conduct for Persons Providing Credit Rating Services’ is the preservation of analytical independence. This includes strict rules to manage conflicts of interest, such as prohibiting a CRA from providing advisory or consulting services to an entity that it also rates. Statement III is incorrect. The risk premium is the component of a bond’s yield that compensates investors for taking on credit risk (i.e., the risk of default by the issuer). The component that compensates for a potential lack of marketability or difficulty in selling the bond quickly is the liquidity premium. Statement IV is incorrect. The three primary inputs required to generate a yield-spread curve are a cohort of comparable securities, the maturities of those securities, and their credit ratings. While an issuer’s leverage ratio and a bond’s coupon rate are factors considered in the credit analysis process, they are not the direct inputs used to plot the curve itself. Therefore, statements I and II are correct.

This question assesses the understanding of the dynamic nature of credit ratings for structured securities, a key difference from traditional corporate bonds.

Statement I is correct. Unlike corporate bonds which are often rated ‘through-the-cycle’, structured product tranches are subject to ongoing surveillance. Their ratings are highly sensitive to the actual performance (defaults and recoveries) of the underlying collateral pool. As realized losses change, the ratio of credit enhancement to remaining expected loss changes, which can lead to significant rating upgrades or downgrades over the security’s life.

Statement II is also correct. Credit enhancement (CE) is the protective layer for a tranche, composed of elements like subordination, excess spread, and reserve funds. This is a finite buffer. As defaults occur in the underlying asset pool and lead to realized losses, this CE is consumed or ‘depleted’. The reduction in available CE directly increases the risk exposure of the tranche, hence altering its risk profile.

Statement III is incorrect. This describes the rating methodology for corporate bonds, not structured products. The ‘through-the-cycle’ approach is not applicable here; structured product ratings are expected to be dynamic and reflect the current health of the collateral and the remaining CE.

Statement IV is incorrect. The final performance is determined by the actual cumulative defaults and recoveries over the entire life of the security, not the initial projections. The initial projections are merely an estimate used for structuring and initial rating. If actual losses exceed these projections, the investor may suffer a loss, which is precisely why ongoing surveillance is critical. Therefore, statements I and II are correct.

This question assesses the understanding of fundamental credit analysis concepts, including credit quality, risk premium, and the critical distinction between delinquency and default.
Statement I is correct. The higher yield offered by the speculative-grade bond is primarily a risk premium. This premium is the additional return investors demand to compensate for the greater perceived likelihood that the issuer will fail to make its payments (i.e., a higher default risk) compared to a highly-rated issuer.
Statement II is incorrect. Delinquency, which is the failure to make a payment on time, is a financial event but does not automatically constitute a legal default. Default is a formal declaration, often made by the lender or bond trustee after a grace period, that the borrower is not expected to repay. A single missed payment is a technical breach that may be ‘cured’ and does not typically trigger an immediate write-off.
Statement III is correct. An investor whose primary objective is capital preservation would prioritize investments with a high likelihood of repayment. The utility company’s bond, being highly-rated, has a higher credit quality and a lower perceived distance from default, making it a more suitable choice for this risk tolerance.
Statement IV is incorrect. While the risk-free rate is the benchmark, virtually all corporate debt, regardless of its high rating, carries some level of credit risk. Therefore, statements I and III are correct.

When assessing a sovereign’s ability to meet its debt obligations, a critical distinction is made between debt denominated in the local currency and debt denominated in a foreign currency. A sovereign government with monetary sovereignty can, in theory, always create more of its own currency to pay off local currency debts, although this may lead to high inflation. However, for debt denominated in a foreign currency (e.g., US dollars), the government cannot print that currency. It must earn or otherwise acquire the foreign exchange through channels such as exports, foreign direct investment, or by drawing down its official foreign currency reserves. Therefore, the most direct and crucial indicator of a sovereign’s capacity to service its foreign currency debt is its access to and stock of that foreign currency. Factors like the government’s domestic taxation power, while fundamental to its overall fiscal health, only generate local currency. Political stability and the health of the domestic financial system are important components of a comprehensive sovereign credit analysis, but the immediate ability to make payments on foreign debt hinges on the availability of the required foreign currency.

The Code of Conduct for Persons Providing Credit Rating Services (CRA Code), administered by the SFC, places a strong emphasis on maintaining the independence and integrity of the credit rating process. A fundamental requirement is that Credit Rating Agencies (CRAs) must have robust policies and procedures to identify, manage, and eliminate or mitigate conflicts of interest. A situation where an analyst, or a close family member, has a significant financial or personal relationship with the entity being rated is a direct conflict of interest. The CRA’s primary obligation in such a circumstance is to ensure the objectivity of the rating is not compromised. The most effective way to achieve this is by removing the conflicted individual from any participation in the rating action. While disclosure is an important principle, it is not a substitute for managing a direct conflict. Similarly, adding supervisory layers does not fully remove the potential for bias. The responsibility for managing the conflict rests with the licensed corporation first and foremost.

In credit analysis, the life-cycle stage of a company is a critical factor, particularly when assessed against the backdrop of macroeconomic conditions. A mature company, having navigated various economic cycles, typically possesses established revenue streams, a stable customer base, and a proven business model. This history provides a degree of predictability to its cash flows, making it more resilient to economic shocks. Lenders and investors often view this stability and track record as indicators of lower credit risk. Conversely, a company in a high-growth phase, such as a startup, is inherently more volatile. Its future cash flows are less certain, it may be heavily reliant on continuous funding to sustain its growth, and its business model may not yet be fully proven. During periods of economic uncertainty, this volatility is magnified. The very need to finance rapid expansion makes the firm more vulnerable to tightening credit markets or unexpected downturns, thus increasing its perceived credit risk. While a mature firm might be less agile, its financial stability and established market position are generally considered more valuable attributes for creditworthiness in a volatile environment.

In structural credit models, like the Merton model, a company’s capital structure is analyzed using option pricing theory. The equity holders are seen as having a long call option on the company’s assets, with a strike price equal to the face value of the debt. Conversely, the position of a lender (or bondholder) is analogous to holding a risk-free bond and simultaneously being short a put option on the company’s assets. The lender has provided capital and, in return, faces the risk of default. If the value of the company’s assets falls below the value of its debt obligations at maturity, the equity holders will ‘exercise their put option’ by defaulting and handing over the remaining assets to the lender. The lender is thus obligated to accept these assets, which are worth less than the full amount owed. This payoff profile is identical to that of a writer (seller) of a put option. The credit spread earned by the lender is considered the premium received for selling this default protection.

Credit Rating Agencies (CRAs) provide independent opinions on the creditworthiness of debt issuers and their financial obligations. The primary value of these ratings lies in their role as a standardized, expert-based assessment. CRAs employ teams of analysts with deep industry knowledge and access to extensive data and analytical models, allowing them to conduct a more thorough and objective credit risk analysis than most individual investors could achieve on their own. This creates a common yardstick for comparing the relative default risk of different securities. It is crucial to understand that a credit rating is an opinion, not a guarantee of repayment or an assurance against default. Furthermore, while ratings significantly influence a bond’s market price and liquidity, they do not solely determine them; other factors like interest rate trends and market sentiment are also critical. Lastly, the role of a CRA is distinct from that of a financial regulator like the Securities and Futures Commission (SFC); a rating assesses credit risk and is not a form of regulatory approval for the sale of a security.

A rating transition matrix is a key tool in credit risk management that shows the probability of a debt instrument’s credit rating changing from one level to another over a specific period, typically one year. Statement I is correct because the primary function of the matrix is to quantify this ‘ratings volatility’—the likelihood of upgrades, downgrades, or the rating remaining stable. Statement III is also correct as it provides a practical example of what the matrix demonstrates; it gives the specific probability for a rating to move, for instance, from ‘BBB’ to ‘A’ (an upgrade) or to ‘BB’ (a downgrade). Statement II is incorrect because it describes a bond default study, which focuses exclusively on the historical rate of actual defaults, not on the full spectrum of rating changes. A rating transition matrix tracks all rating movements, which are by definition non-default events. Statement IV is incorrect because these matrices are constructed based on historical data of past rating changes, making them backward-looking analytical tools, not forward-looking economic forecasting models. Therefore, statements I and III are correct.

The Securities and Futures Ordinance (SFO) establishes ‘providing credit rating services’ as a Type 10 regulated activity. The SFC’s Code of Conduct for Persons Providing Credit Rating Services (CRA Code) applies specifically to entities that provide opinions on the creditworthiness of an entity or a financial instrument, i.e., credit rating agencies (CRAs). It does not apply to ‘special-function’ rating agencies that assess other factors.

Statement I describes a provider of Environmental, Social, and Governance (ESG) ratings. These ratings assess non-financial factors and do not constitute a credit opinion. Therefore, this service is not a Type 10 regulated activity and is not subject to the CRA Code.

Statement II describes a classic CRA operating in Hong Kong and rating local debt instruments. This activity falls directly within the definition of providing credit rating services and requires a Type 10 license from the SFC, making the entity subject to the CRA Code.

Statement III describes a special-function agency focused on the social impact and operational aspects of microfinance institutions, which is distinct from assessing their credit risk or ability to repay debt. This falls outside the scope of the CRA Code.

Statement IV describes a firm providing credit ratings on financial products within Hong Kong. This is a core activity regulated under the Type 10 regime, and the firm must comply with the CRA Code, regardless of whether the ratings are for retail or professional investors. Therefore, statements II and IV are correct.

This question assesses the understanding of structural models in credit analysis, which reframe a company’s capital structure using option theory.

Statement I is correct. Equity holders have a residual claim on the firm’s assets after all debts are paid. This is equivalent to holding a long call option on the firm’s assets with a strike price equal to the face value of the debt. If the asset value exceeds the debt, they ‘exercise’ the option by paying off the debt and keeping the residual. If not, they let the option expire worthless (i.e., default).

Statement II is correct. The debtholders (lenders) have a position analogous to writing (selling) a put option. They have sold the equity holders the right to ‘put’ the company’s assets to them if the asset value falls below the face value of the debt. In a default scenario, the lenders are forced to accept the firm’s assets, which are worth less than the debt they are owed.

Statement III is correct. In this framework, the face value of the firm’s debt is the critical threshold. It represents the amount the equity holders must ‘pay’ to retain control of the assets, making it the effective strike price of the call and put options.

Statement IV is incorrect. A fundamental principle of option pricing is that the value of an option increases with the volatility of the underlying asset. Since the equity is viewed as a call option on the firm’s assets, an increase in asset volatility would increase, not decrease, the value of the equity holders’ position. This is because the upside potential increases while the downside is limited to the initial investment. Therefore, statements I, II and III are correct.

The Basel Accords established a framework for bank capital regulation, requiring banks to hold a minimum amount of capital relative to their risk-weighted assets (RWA). The Capital Adequacy Ratio (CAR) is calculated as (Tier 1 Capital + Tier 2 Capital) / RWA. Securitization is a structured finance technique that allows a financial institution (the originator) to pool assets, such as auto loans or mortgages, and sell them to a legally separate entity known as a special purpose vehicle (SPV). The SPV then issues tradable, interest-bearing securities to investors, with the cash flows from the underlying assets used to pay the investors. A key objective of this process for the originating bank is regulatory capital relief. By achieving a ‘true sale’ of the assets to the SPV, the bank effectively transfers the credit risk associated with those assets off its balance sheet. This removal of assets results in a corresponding reduction in the bank’s total RWA. Since RWA is the denominator in the CAR calculation, a lower RWA leads to a higher CAR, all else being equal. While securitization also provides benefits like improved liquidity and a new funding source, its primary mechanism for improving regulatory capital adequacy is the reduction of risk-weighted assets.

This question assesses the fundamental principle of the inverse relationship between bond prices and market interest rates, a core concept in fixed income analysis. When prevailing market interest rates rise, newly issued bonds will offer higher coupon payments to attract investors. Consequently, existing bonds with lower, fixed coupon rates become less attractive in comparison. To make these older, lower-coupon bonds competitive in the secondary market, their price must decrease. This price reduction increases the bond’s yield-to-maturity for a new buyer, bringing it in line with the higher yields available on new bonds. The explanation lies in the concept of present value; the bond’s fixed future cash flows (coupons and principal) are discounted at the new, higher market rate, which results in a lower present value or market price.

This question assesses the fundamental distinctions between debt and equity investments. Statement I is incorrect; ownership rights and voting power are characteristic features of equity (shares), not debt (bonds). Bondholders are creditors to the company, not owners. Statement II is correct. Equity returns, such as dividends and capital appreciation, are variable and contingent on the company’s profitability and are not guaranteed. In contrast, bondholders are entitled to contractually fixed coupon payments, which are an obligation of the issuer. Statement III is incorrect. A ‘balloon loan’ is a specific type of debt instrument characterized by its principal repayment schedule, where a significant portion is paid at maturity. It is not related to equity instruments. Statement IV is correct. In the hierarchy of claims on a company’s assets, debt holders have priority over equity holders. In the event of bankruptcy or liquidation, creditors (including bondholders) must be repaid before any residual value is distributed to shareholders. Therefore, statements II and IV are correct.

When analyzing the credit strength of a financial institution like a commercial bank, specific metrics are used that differ from those for non-financial corporations. Statement I is correct because the Capital Adequacy Ratio (CAR) is a fundamental measure of a bank’s financial health, indicating its capacity to absorb unexpected losses with its available capital, as mandated by regulatory frameworks like Basel III. Statement III is correct as the Net Interest Margin (NIM) is a primary indicator of a bank’s profitability, measuring the difference between the interest income generated by financial assets and the interest paid out to their lenders. Statement IV is also correct because the Non-Performing Loan (NPL) Ratio is a critical measure of a bank’s asset quality, reflecting the percentage of its loan portfolio that is in default or close to being in default. Statement II is incorrect; the Inventory Turnover Ratio is a metric used for non-financial companies to measure how efficiently they manage their physical inventory, which is not applicable to a bank whose primary assets are financial instruments. Therefore, statements I, III and IV are correct.

The Code of Conduct for Persons Providing Credit Rating Services (“CRA Code”) sets out specific requirements for the internal organization of a Credit Rating Agency (CRA) to ensure integrity and manage conflicts of interest. Statement I is correct because the CRA Code mandates that the compliance function, including its reporting lines and compensation, must be independent of the CRA’s rating operations to avoid commercial pressures influencing compliance oversight. Statement II is correct as the Code explicitly prohibits rating teams from commenting on or providing advice on the design of structured finance products that the CRA is engaged to rate, which is a key measure to prevent conflicts of interest. Statement III is also correct; the Code requires CRAs to establish policies to review the past work of analysts who leave to join a financial firm with which they had significant dealings, to check for any potential bias or integrity issues. Statement IV, while potentially a good business practice, is not a specific requirement under the CRA Code. The Code focuses on ensuring continuity and avoiding bias in team assembly, but does not prescribe the specific professional backgrounds (such as legal) for team members. Therefore, statements I, II and III are correct.

According to the Fund Manager Code of Conduct (FMCC), a fund manager is ultimately responsible for the credit assessment of the instruments it invests in on behalf of a fund. While credit ratings from external agencies are a valuable tool, they do not absolve the fund manager of this responsibility. When a fund manager intends to rely on a credit rating from an agency that is not an internationally recognized name (like an NRSRO), it has a duty to perform its own due diligence on that credit rating agency. This due diligence should be thorough and documented, assessing factors such as the agency’s methodology, objectivity, transparency, resources, and track record. The fund manager must be satisfied that the agency’s standards are robust and its processes are credible before incorporating its ratings into the investment decision-making process. Simply disclosing the use of the rating or seeking pre-approval from the regulator for each instance is not the prescribed approach. The rules provide flexibility but place the onus of assessment squarely on the licensed fund manager.

A fundamental aspect of credit analysis is assessing factors beyond standard financial statements, especially when a company claims its business model mitigates inherent industry risks. Statement I is correct because the value of intangible assets, such as proprietary technology or strong brand recognition, is often not fully reflected on the balance sheet but can be a significant source of credit strength and competitive advantage. Statement II is also correct as the quality and track record of senior management are critical indicators of a company’s ability to navigate industry challenges, a point emphasized in assessing stewardship and experience. Statement IV is crucial; the core of the company’s argument rests on proving its business model genuinely insulates it from the sector’s typical volatility and capital intensity. The analyst must validate this claim to justify a rating outside the industry’s normal range. Statement III, however, is incorrect. A ratings trigger is a feature within a bond covenant that is activated by a rating change; it is a consequence of the rating action, not a factor that should influence the analyst’s independent assessment of the company’s fundamental credit quality. The analyst’s evaluation must precede and determine the outcome of such triggers, not be influenced by their existence. Therefore, statements I, II and IV are correct.