This question assesses the understanding of legitimate concerns various market participants have regarding the organizational structure, governance, and processes of Credit Rating Agencies (CRAs), as governed by principles in the SFC’s Code of Conduct for Persons Providing Credit Rating Services.

Statement I is correct. Institutional investors, as major users of credit ratings, are concerned with the reliability and comparability of ratings. Inconsistent application of methodologies across different analytical groups within a CRA would undermine the integrity of the ratings and make it difficult for investors to compare credit risk across sectors, which is a legitimate concern.

Statement II is correct. Corporate issuers are directly affected by the ratings assigned to them. A transparent and fair process is a key concern. The absence of a formal, accessible appeals mechanism for issuers who believe the rating was based on factual errors or a misapplication of methodology is a valid governance and procedural issue.

Statement III is correct. Regulators, such as the SFC, place significant emphasis on the corporate governance of CRAs to mitigate conflicts of interest. A lack of sufficient independent oversight on the board is a major regulatory concern, as independent directors are crucial for ensuring that the CRA’s commercial interests do not compromise the quality and integrity of its rating process.

Statement IV is incorrect. This reflects a misunderstanding of the function of a credit rating. A credit rating is an opinion on the long-term creditworthiness of an entity or security, not a real-time reflection of market price or liquidity. While CRAs are expected to conduct ongoing surveillance, they are not expected to update ratings in response to intraday market price fluctuations. Therefore, statements I, II and III are correct.

When assessing credit risk, lenders prioritize the predictability and stability of a borrower’s ability to repay debt. A mature company, operating in a stable economy, typically has a long, documented history of earnings and cash flow. This track record provides a reliable basis for forecasting future performance, thereby reducing the uncertainty for the lender. In contrast, a high-growth company, especially in a volatile or emerging sector, presents significant uncertainty. While its growth potential may be high, its cash flows are often less predictable, and its business model may be unproven over a full economic cycle. This inherent volatility translates to higher perceived credit risk. Lenders compensate for this increased risk by offering less favorable terms, such as higher interest rates or stricter covenants, or by declining to lend altogether. The cost of capital itself can become a risk factor, as higher interest payments consume a larger portion of the company’s earnings, leaving less for reinvestment and creating a tighter margin for error.

This question assesses the understanding of key financial ratios used in credit analysis, specifically components of the Altman Z-score model for predicting corporate financial distress. The model combines several ratios to create a comprehensive picture of a company’s financial health. The ratio of Working Capital to Total Assets (T1) is a measure of short-term liquidity. The ratio of Retained Earnings to Total Assets (T2) reflects cumulative profitability and the age of the firm, indicating its ability to finance operations through past profits. The ratio of EBIT to Total Assets (T3) measures the underlying operational profitability generated from the company’s asset base, irrespective of tax and leverage effects. When analyzed collectively, these three ratios provide a multi-dimensional view covering liquidity, long-term financial stability, and current profitability. This combination is a powerful tool for assessing the likelihood of a company facing insolvency or bankruptcy, which is a primary concern for credit analysts, lenders, and investors conducting due diligence. Other options are less comprehensive: one focuses solely on short-term liquidity (covered by T1 alone), another on asset turnover (which is a different ratio, Sales/Total Assets), and the last on market valuation (which typically involves market price data, not just accounting figures).

A rating transition matrix is a statistical tool used in credit risk management. It presents the probability of a debt instrument’s credit rating changing from one level to another over a specific period, typically one year. Its primary function is to model ‘ratings volatility’ or ‘migration risk’—the likelihood of upgrades or downgrades. This is distinct from a bond default study, which specifically measures the historical frequency of actual default events (i.e., the transition to a ‘Default’ rating). While a transition matrix includes the probability of moving to a default state, its main value lies in showing the probabilities for all possible rating changes, not just default. Therefore, it answers the question of how likely a bond’s rating is to change, rather than only focusing on the ultimate risk of non-payment.

Statement I is correct because domestic rating agencies are often better positioned to understand and incorporate local cultural, social, and economic nuances into their credit analysis, which might be overlooked by standardized global models. Statement II is also correct as a key driver for the establishment of local CRAs is the desire for national economies to exert more control over their financial systems and reduce reliance on the methodologies and potential biases of major, often US-based, agencies. Statement IV is correct because as domestic capital markets mature, local regulators often encourage or even mandate the use of ratings from domestic agencies to foster local market infrastructure and ensure ratings are aligned with local regulations. Statement III is incorrect; the major international CRAs generally have a significant competitive advantage due to their long history, extensive historical default data, and sophisticated modelling capabilities, which presents a major challenge for new or smaller domestic agencies. Therefore, statements I, II and IV are correct.

This question assesses the understanding of methodological differences among Credit Rating Agencies (CRAs) when rating complex structured finance products like Collateralized Debt Obligations (CDOs). Statement I is correct because CRAs can use different approaches for stress testing. One may prefer historical simulations (e.g., replicating the Great Depression), while another may use a statistical approach based on probability distributions (e.g., lognormal), leading to different outcomes. Statement II is also correct as CRAs may define their rating levels against different performance benchmarks. For instance, an ‘AA’ rating from one agency might signify a certain probability of default, while for another, it might represent a specific level of expected loss on the security. Statement III is correct because, for non-securitization products like CDOs, the initial loss estimate is inferred from the ratings of the underlying assets, not from empirical pool data. This makes the model highly sensitive to assumptions, such as the recovery rate applied to those assets, and slight variations in this assumption between CRAs can result in different Expected Loss (EL) figures and, consequently, different ratings. Statement IV is incorrect because it misapplies a concept specific to Asset-Backed Commercial Paper (ABCP). While short-term liquidity facilities are critical for ABCP, they are primarily for liquidity risk, not credit enhancement (unless it’s a ‘fully-supported’ conduit, which is less common). For a standard term CDO, a liquidity facility is not a typical feature or a form of credit enhancement that would be a primary driver of a long-term credit rating difference. Therefore, statements I, II and III are correct.

The quasi-regulatory role of Credit Rating Agencies (CRAs) was formally established in the United States by the Securities and Exchange Commission (SEC) in 1975. Through an amendment to the Securities Exchange Act of 1934 (specifically Rule 15c3-1), the SEC created a special designation called the Nationally Recognized Statistical Rating Organization (NRSRO). The primary purpose of this designation was to identify the specific CRAs whose ratings could be used by registered broker-dealers for the purpose of calculating their net capital requirements. This rule effectively embedded NRSRO ratings into the regulatory framework for broker-dealer capital adequacy. While other regulatory actions occurred earlier, such as the Comptroller of the Currency’s use of ratings in 1931 which established the ‘investment grade’ concept for banks, the specific formalization for broker-dealer capital calculations came with the creation of the NRSRO framework. Later legislation, like the Credit Rating Agency Reform Act of 2006, was enacted to reform this system by establishing clearer guidelines for NRSRO qualification and empowering the SEC to regulate their internal processes and conflicts of interest.

Sovereign credit ratings assess a government’s ability and willingness to meet its debt obligations in full and on time. Statement I is correct because a sovereign’s access to foreign exchange is critical for servicing debt denominated in foreign currencies. Without sufficient foreign reserves, a country may face a liquidity crisis and be unable to make payments, even if it is solvent on paper. Statement II is correct as political stability and the effectiveness of institutions are fundamental to a sovereign’s willingness to pay. Unstable political environments can lead to unpredictable policy changes, social unrest, and a potential repudiation of debt. Statement IV is also correct. The risk of sovereign interference, such as the imposition of capital or exchange controls, can directly prevent the transfer of funds for debt repayment, impacting both the sovereign itself and private entities within its jurisdiction. Statement III is incorrect; while the performance of a domestic stock market can reflect general economic sentiment, it is not a direct or primary indicator of a government’s fiscal health or its capacity to service debt. Government revenues, debt-to-GDP ratios, and fiscal policy are far more direct measures. Therefore, statements I, II and IV are correct.

The Code of Conduct for Persons Providing Credit Rating Services (CRA Code) sets out specific public disclosure requirements for Credit Rating Agencies (CRAs) to ensure transparency and user comprehension. Statement I is correct because the CRA Code mandates that a rating announcement must clearly state whether the rated entity participated in the credit rating process. Statement III is also correct as the CRA must provide sufficient information for users to understand the rating, which includes explaining the meaning of its rating symbols and the inherent limitations of any credit rating. Statement IV is correct because CRAs are required to publicly disclose their policies regarding the timeliness of rating updates, including their definition of ‘timeliness’ and the schedule for reviews. However, Statement II is incorrect. While the basis of a structured rating must be disclosed, the CRA Code explicitly prohibits the public disclosure of confidential information obtained from the rated entity. Disclosing the complete proprietary cash flow model and all non-public data would be a serious breach of confidentiality. Therefore, statements I, III and IV are correct.

This question assesses the understanding of the components that constitute a bond’s yield and the inputs for constructing a yield-spread curve. Statement I is correct; the risk-free rate (e.g., the yield on a government bond like a Hong Kong Exchange Fund Note) serves as the base rate upon which all other risks are priced. Statement II is correct; the risk premium is the additional return an investor demands for taking on the credit risk, which is the risk that the issuer may default on its payment obligations. Statement III is also correct; the liquidity premium compensates investors for holding a less liquid security that may be difficult to sell quickly without a significant price concession. Statement IV is incorrect. The three primary inputs required to generate a yield-spread curve are a cohort of comparable bonds (e.g., from the same industry), their respective maturities, and their credit ratings. The coupon rate is a feature of an individual bond, not a primary axis for constructing the market-wide trend line that is the yield-spread curve. Therefore, statements I, II and III are correct.

The question tests the fundamental concept of time value of money as applied to non-interest bearing instruments, such as a trade credit. Even though no explicit interest is stated, there is an implicit cost of capital or opportunity cost associated with receiving money in the future instead of today. This is handled by treating the instrument as a discount security.

Statement I is correct. The present value of a future cash flow is determined by discounting it back to the present using an appropriate discount rate. This process accounts for the time value of money. The formula is Present Value = Future Value / (1 + r)^n.

Statement II is correct. By offering a product on credit without charging explicit interest, the seller is effectively providing a short-term loan. The difference between the face value (the amount paid later) and the present value (what it’s worth today) represents the implicit interest or the financing cost embedded in the transaction.

Statement III is incorrect. This statement ignores the core principle of the time value of money. A sum of money to be received in the future is worth less than the same sum today because today’s money can be invested to earn a return.

Statement IV is incorrect. The discount factor is (1 + r)^-1 or 1/(1 + r). Multiplying the future value by (1 + r) would be compounding, which calculates a future value from a present value, not the other way around. Therefore, statements I and II are correct.

In fixed income analysis, the required yield on a bond is composed of a risk-free rate plus several premiums, most notably the credit risk premium and a liquidity premium. The credit risk premium compensates investors for the risk of the issuer defaulting on its obligations. This premium is not static; it is heavily influenced by market sentiment, the perceived quality of information, and sector-specific risks. When an event occurs that undermines investor confidence in a particular sector, even for issuers not directly involved, the perceived risk for all entities in that sector increases. This is due to information asymmetry and contagion risk. Consequently, rational investors will demand a higher level of compensation (a higher yield) to invest in new bonds from that sector. This higher required yield reflects the increased uncertainty and the potential for unforeseen losses. Relying solely on theoretical models is impractical in dynamic markets, and using a government bond yield without a significant risk adjustment would fail to account for the substantial credit risk.

Under the SFC’s Code of Conduct for Persons Providing Credit Rating Services, Credit Rating Agencies (CRAs) are required to establish and implement rigorous and systematic procedures to validate the quality of their credit rating methodologies. This process, often called back-testing, involves analyzing how well the ratings have performed historically. There are several key methods for this validation. One method involves creating rating transition matrices, which track the movement of ratings (upgrades, downgrades, or affirmations) over time to assess rating stability. Another common method is the cohort-based default study, which measures the incidence of default for each rating category, often segregated by maturity, to test the fundamental predictive power of the ratings. A third approach compares the CRA’s ratings to market-based indicators of credit risk, such as bond yields or credit default swap (CDS) spreads. This particular method is valuable because it provides an external, continuously updated ‘second opinion’ from the market itself, helping to gauge whether the CRA’s assessments are aligned with current market sentiment and pricing of risk.

The Capital Expenditure Ratio is calculated by dividing expenditures for long-term capital assets by the Cash Flow From Operations (CFFO). This ratio measures a company’s ability to fund its capital investments using cash generated from its core business activities. A ratio greater than 1.0 indicates that the company’s capital expenditures exceeded the cash it generated from operations.

Statement I is incorrect. A ratio of 1.3 means that for every $1 of cash generated from operations, the company spent $1.30 on capital assets. This signifies a cash deficit from operations relative to investment needs, not a surplus.

Statement II is correct. Since the CFFO was insufficient to cover the capital expenditures, the company must have sourced the additional funds from elsewhere. Common sources include external financing like taking on new loans (debt) or issuing new equity (shares), or by drawing down existing cash reserves.

Statement III is incorrect. Total asset turnover (Sales / Average Total Assets) is an efficiency ratio that measures how effectively a company uses its assets to generate sales. While related to overall business performance, it is not a direct measure of cash flow generation or the primary driver of the capital expenditure funding gap. A company could have high turnover but low profitability and weak CFFO.

Statement IV is correct. A consistent reliance on external financing to fund necessary capital projects (as indicated by a ratio > 1.0) creates a vulnerability. If the company’s ability to access debt or equity markets becomes restricted or more expensive, it could struggle to continue its expansion and meet its obligations, leading to potential liquidity pressures. Therefore, statements II and IV are correct.

A yield-spread curve is a graphical tool used in fixed-income analysis to show the relationship between yield and maturity for a group of bonds that share the same credit quality. This curve serves as a benchmark for pricing new bonds and evaluating the relative value of existing ones. To construct an accurate and relevant curve, an analyst must first identify a ‘cohort’ of securities that are genuinely comparable in terms of issuer type, industry, and other key features. The maturity of each bond is a critical variable, as it forms one of the primary axes of the curve, illustrating how the market prices risk over different time horizons. The credit rating is the essential element that defines the specific risk grade being analyzed, ensuring that all bonds plotted on the curve share a similar level of default risk. By plotting the yields of these carefully selected bonds against their respective maturities, a trend line emerges, representing the market’s required return for that specific class of credit risk.

The Code of Conduct for Persons Providing Credit Rating Services (the “CRA Code”) establishes a clear framework for the integrity of the rating process. A fundamental principle is that rating decisions are not made by a single individual. While a lead analyst is responsible for monitoring an entity and identifying new information that may impact its creditworthiness, the analyst’s role is to present their findings and recommendations. The ultimate decision to change a rating, place it on watch, or affirm it rests with a formally constituted rating committee. This committee-based approach ensures objectivity, diversity of opinion, and prevents any single analyst from having undue influence. Furthermore, the CRA Code places strict obligations on CRAs and their staff regarding the handling of confidential information received from issuers. This information must be used exclusively for the purpose of determining the credit rating and must be protected from unauthorised disclosure. Disseminating such information selectively to market participants before a formal rating announcement would be a severe breach of confidentiality and market integrity rules.

Statement I is correct. The long-term business model and credibility of a Credit Rating Agency (CRA) are fundamentally based on its reputation for providing independent, objective, and consistent credit risk assessments. This reputation is its primary asset.
Statement II is correct. CRAs occupy a unique position in the capital markets. Unlike issuers (sellers) who benefit from a higher perceived value, or investors (buyers) who may benefit from a lower price, a CRA’s role is to be a neutral arbiter of creditworthiness. This neutrality is a cornerstone of their function.
Statement III is incorrect. Providing information is a necessary part of the rating process, but it does not compel a CRA to issue a specific rating. The CRA must maintain its analytical independence and cannot guarantee a particular outcome. Doing so would compromise its integrity and violate the principles of objective assessment.
Statement IV is correct. Under the Securities and Futures Ordinance (SFO) in Hong Kong, ‘providing credit rating services’ is defined as Type 10 regulated activity. Any firm engaged in this business must be licensed and is subject to the oversight of the Securities and Futures Commission (SFC). Therefore, statements I, II and IV are correct.

This question assesses the understanding of the primary methods used by Credit Rating Agencies (CRAs) for back-testing, which is the process of validating how well their credit ratings have predicted defaults historically. Statement I describes cohort analysis or bond default studies, a fundamental validation method where default rates are tracked for different rating levels over time. Statement II refers to rating transition matrices, which are used to assess rating stability and the probability of a rating changing over a given period. Statement III describes the practice of comparing ratings to market-based indicators like bond yields or CDS spreads, which serves as an external, market-driven validation of the rating’s accuracy. Statement IV, however, describes a governance or compliance check related to managing conflicts of interest. While ensuring fee structures are appropriate is a critical regulatory requirement for CRAs under principles set by bodies like IOSCO and enforced by regulators such as the SFC, it is not a method for statistically back-testing the predictive performance of the ratings themselves. Therefore, statements I, II and III are correct.

Statement I is correct. Larger, more creditworthy borrowers like Client X often have the negotiating power to secure loans with bullet repayment structures, where the entire principal is repaid at maturity. Conversely, for smaller or less-established borrowers like Client Y, lenders typically prefer amortizing loans to mitigate credit risk by receiving principal back incrementally over the loan’s life. Statement II is correct. Shifting from a bilateral bank loan to a multilateral public bond market exposes the offering to a wider pool of investors, increasing demand. The associated public disclosure requirements enhance transparency. This combination of increased demand and transparency can lead to more competitive pricing and a lower cost of capital for the issuer. Statement III is also correct. Features like step-up coupons are common in loan agreements to protect the lender. Tying the coupon increase to a negative credit event (like a rating downgrade) contractually compensates the lender for taking on higher risk. Statement IV is incorrect. The regulatory disclosure regime for a public bond issuance, governed by regulations such as the Companies (Winding Up and Miscellaneous Provisions) Ordinance and overseen by the SFC, is significantly more stringent and standardized than the due diligence for a private bilateral loan. This is because public bond markets cater to generalist investors who rely heavily on public disclosures, whereas a bank conducts its own deep, private due diligence. Therefore, statements I, II and III are correct.

This question tests the understanding of the ‘Five Cs of Credit’, a common framework used by lenders to evaluate a borrower’s creditworthiness. The five components are Character, Capacity, Capital, Collateral, and Condition. ‘Character’ refers to the borrower’s reputation and willingness to repay debt. ‘Capacity’ assesses the borrower’s ability to generate sufficient cash flow to service the loan. ‘Capital’ evaluates the borrower’s net worth and financial reserves. ‘Collateral’ pertains to the assets pledged as security for the loan. ‘Condition’ relates to the external factors, such as the economic climate, industry trends, and geopolitical events, as well as the specific terms, structure, and covenants of the loan itself. In the scenario provided, the advisor is not primarily focused on the company’s past repayment behavior (Character), its internal cash flow generation (Capacity), or its pledged assets (Collateral). Instead, the focus is on structuring the loan (covenants) to protect against external risks (supply chain disruptions, geopolitical tensions), which falls squarely under the assessment of ‘Condition’.

A thorough credit analysis involves balancing industry-wide risks with company-specific factors. Statement I is correct because industries with high cyclicality, capital intensity, and earnings volatility, such as semiconductor manufacturing, impose a structural constraint on the credit ratings of all participants. This concept is often referred to as a ‘rating band’ or ‘ceiling’ dictated by industry risk. Even a superior operator is still exposed to the same fundamental industry risks. Statement III is also correct as it reflects a core principle of good credit analysis: going beyond the quantitative data. Assessing qualitative factors like management’s strategic vision, operational excellence, and ability to manage through industry downturns is crucial for differentiating between companies and can justify a higher rating within the constrained industry band. Statement II is incorrect because a company’s consistent outperformance relative to its peers is a significant indicator of superior management, better processes, or a stronger competitive position; it should be a key focus of the analysis, not disregarded. Statement IV is incorrect because while strong covenants are beneficial for bondholder protection, they are defensive mechanisms. They do not, by themselves, alter the fundamental business risk profile to an extent that would allow a company to ‘break out’ of its industry’s typical rating category. A fundamental shift in the business model’s perceived risk is required for such a change. Therefore, statements I and III are correct.

In credit analysis, while industry-standard financial ratios provide a useful starting point, they must be applied with considerable professional judgment. Broad industry classifications, such as ‘technology’, often encompass diverse sub-sectors with fundamentally different business models, risk profiles, and capital structures. For instance, a software company with recurring subscription revenue operates very differently from a hardware manufacturer subject to inventory risk and cyclical demand. Furthermore, modern financing techniques, such as the securitization of receivables, can significantly alter a company’s balance sheet structure. This practice moves assets and related debt off-balance sheet, which can artificially improve certain leverage and liquidity ratios. A competent credit analyst must look beyond the surface-level numbers and adjust their analysis to account for these nuances, recognizing that a direct, unadjusted comparison using a single set of benchmarks could lead to a flawed assessment of creditworthiness.

Statement I is correct. A key distinction between the two vehicles was their liability structure. While Asset-Backed Commercial Paper (ABCP) conduits primarily relied on issuing very short-term commercial paper that needed to be constantly rolled over, Structured Investment Vehicles (SIVs) had a more diversified capital structure, issuing a mix of short-, medium-, and long-term debt instruments. Statement II is also correct. Both structures were fundamentally designed as arbitrage vehicles. Their primary purpose was to generate profit from the spread between the higher yields on the long-term assets they held and the lower costs of their predominantly shorter-term funding. Statement III is correct as well. Both ABCP conduits and SIVs were intended to be ongoing entities with indefinite lifespans, unlike traditional Collateralized Debt Obligations (CDOs) which had a scheduled amortization. These vehicles were designed to wind down and liquidate their assets only if specific distress triggers, such as a significant decline in the market value of their assets, were breached. Statement IV is incorrect. Both SIVs and ABCP conduits were used to fund long-term assets to capture the yield premium. The primary structural difference was in their funding (liability) side, not the maturity of the assets they could hold. Therefore, statements I, II and III are correct.

A yield-spread curve is a graphical representation that illustrates the relationship between the yield spread over a benchmark (like a government bond) and the time to maturity for a specific class of bonds. Its primary purpose is to provide a market-based assessment of credit risk for different time horizons. To construct a meaningful curve, three fundamental inputs are required. First, a ‘cohort’ or a comparable group of issuers must be selected to ensure that the bonds being analyzed share similar characteristics (e.g., all are from the industrial sector or financial sector). This creates a consistent basis for comparison. Second, the ‘maturity’ or remaining term of the bonds is essential, as this typically forms the horizontal axis of the graph and is a key determinant of a bond’s yield. Third, the ‘credit rating’ is the critical input that defines the risk grade of the curve. A separate curve is plotted for each rating category (e.g., AAA, AA, A), allowing analysts to compare the compensation for risk across different maturities and between different credit qualities. Other factors like specific coupon rates, trading volumes, or broad macroeconomic indicators influence bond prices but are not the primary structural inputs for generating the yield-spread curve itself.

Statement I is correct. To perform arithmetic operations like calculating a weighted average default risk for a portfolio, the inputs must be quantitative. Cardinal ratings, which represent specific, back-tested default probabilities, are suitable for this purpose. Ordinal ratings are merely relative rankings (e.g., A is better than BBB) and cannot be mathematically averaged.

Statement II is incorrect. An issuer rating is a general, ordinal assessment of a company’s overall creditworthiness. It does not account for the specific structural features of a particular debt instrument. A deeply subordinated bond carries a higher risk of non-payment than a senior unsecured bond from the same issuer due to its lower priority in the capital structure. Therefore, the specific ‘issue rating’ for that subordinated bond, which would be lower than the issuer rating, must be used.

Statement III is correct. Structured securities, such as asset-backed securities (ABS), are typically financed off-balance sheet. Their repayment depends on the performance of a specific pool of assets (the collateral) and the integrity of the transaction’s structure, not on the general creditworthiness of the sponsoring entity (the originator). Therefore, the structured rating of the transaction is the relevant measure of risk, not the fundamental rating of the sponsor.

Statement IV is incorrect. Ordinal ratings represent a relative order of credit quality, not an absolute or linear scale of risk. It is conceptually flawed to perform arithmetic averaging on them. One cannot simply average ‘AA’ and ‘BBB’ to get ‘A’ because the incremental default risk between each rating step is not uniform. The correct method is to use the cardinal default probabilities associated with each rating to calculate a weighted-average probability. Therefore, statements I and III are correct.

Statement I is correct. A fundamental principle of securitization is ‘undivided interest,’ meaning all investors, regardless of their tranche, have a claim on the entire pool of underlying assets. The differentiation in risk comes from the payment priority (the waterfall), not from being allocated specific assets.

Statement II is correct. The equity tranche is the most subordinate part of the capital structure. It acts as a form of credit enhancement for the more senior tranches (Class A and B) because it is designed to absorb the first losses that arise from defaults in the asset pool. This protects the senior noteholders.

Statement III is correct. A key objective of securitization is to achieve ‘bankruptcy remoteness.’ By structuring the transfer of assets from the originator to the Special Purpose Entity (SPE) as a ‘true sale,’ the assets are legally separated from the originator. This insulates the SPE and its investors from the originator’s potential bankruptcy, and vice-versa.

Statement IV is incorrect. The credit rating of a security issued by an SPE (like the Class A tranche) is based on the credit quality of the underlying asset pool, the sufficiency of its cash flows, and the structural protections (like subordination and other credit enhancements). It is deliberately de-linked from the corporate credit rating of the originator. Therefore, statements I, II and III are correct.

This question assesses understanding of the internal organizational and workflow requirements for Credit Rating Agencies (CRAs) under the Hong Kong Code of Conduct for Persons Providing Credit Rating Services (CRA Code). Statement I is a breach because the CRA Code explicitly prohibits rating teams from commenting on or providing advice on the design of structured finance products they are engaged to rate, as this creates a significant conflict of interest. Statement II is a breach because the independence of the compliance function is paramount. Tying the compensation of the Head of Compliance to the revenue of the rating business directly compromises this independence and objectivity. Statement III describes a compliant and recommended practice. The CRA Code requires a review function, staffed by senior and experienced personnel, to assess the feasibility of rating new and complex financial products. Statement IV is a breach because the CRA Code mandates that policies and procedures be established to review the past work of analysts who leave the CRA to join a financial firm with which they have had significant dealings. This is to identify any potential bias or issues of integrity. Simply archiving the work without a specific review does not meet this requirement. Therefore, statements I, II and IV are correct.

The calculation of total lifetime excess spread for a portfolio of amortizing assets requires careful consideration of the declining principal balance. Statement I is correct because simply multiplying the annual excess spread by the Weighted Average Maturity (WAM) assumes the spread is earned on the full initial principal for the entire period, which is not true for amortizing assets. This method ignores principal repayments and thus overstates the total spread. Statement II is also correct; the average life (tα) is a more appropriate measure. It represents the weighted-average time to the receipt of all principal payments and therefore provides a more accurate duration over which the spread is actually earned on the declining balance. Statement III is incorrect because the calculation of annual excess spread is not solely the difference between the asset yield (WAC) and the liability cost (weighted average cost of debt). It must also account for all senior expenses, such as servicer fees, trustee fees, and other administrative costs. These expenses reduce the net spread available to the structure. Statement IV is incorrect because for any amortizing asset pool, the average life (tα) will always be shorter than the Weighted Average Maturity (WAM), even with zero prepayments or defaults. This is because WAM measures the final maturity of the loans, whereas average life accounts for the fact that principal is being returned to investors throughout the life of the deal, not just at the end. Therefore, statements I and II are correct.

This question tests the understanding of the two primary methodologies for assigning credit ratings: the judgemental/consensus method and the automated/scoring system. Statement I is correct; the judgemental method, used by major Credit Rating Agencies (CRAs), relies on a rating committee’s collective experience to synthesize both quantitative and qualitative data. Statement II is also correct; automated systems use statistical models (like the Altman Z-score) that are built upon a few key, uncorrelated variables and require large historical datasets of both ‘good’ and ‘bad’ credits to be effective. Statement III is incorrect because it reverses the common application; the judgemental method is the standard for major corporate issuers, while automated scoring is more extensively used for consumer credit risk. Statement IV is incorrect as it misattributes a key strength; the ability to incorporate nuanced, qualitative, and forward-looking factors is a characteristic of the judgemental/consensus method, not the data-driven automated system. Therefore, statements I and II are correct.

The DuPont model deconstructs Return on Equity (ROE) into three key financial components: profitability, asset efficiency, and financial leverage. The formula is ROE = (Net Profit Margin) x (Asset Turnover) x (Equity Multiplier). The question asks to identify a strategy that specifically targets the asset efficiency component, which is measured by the Asset Turnover ratio (Sales / Total Assets). This ratio indicates how effectively a company is using its assets to generate revenue. A higher ratio suggests greater efficiency. Renegotiating with suppliers to lower costs directly impacts the Net Profit Margin (Net Income / Sales). Issuing debt to repurchase shares alters the capital structure, increasing the Equity Multiplier (Assets / Equity) and thus financial leverage. Increasing prices on all products would primarily affect the Net Profit Margin, assuming sales volume does not decrease proportionally. Implementing a system to reduce inventory levels while keeping sales constant directly improves the Asset Turnover ratio by lowering the ‘Assets’ part of the equation without decreasing the ‘Sales’ numerator, thus reflecting a more efficient use of the company’s asset base.