For bonds with embedded options, like callable bonds, Macaulay duration (which assumes cash flows do not change) can be misleading. Effective duration accounts for how estimated cash flows change with interest rates (e.g., the increased likelihood of the bond being called if rates fall). The significant discrepancy signals that the optionality is materially affecting price sensitivity, making effective duration the correct metric for assessing interest rate risk in this scenario.

A key flaw of the Gaussian copula, famously implicated in the 2008 financial crisis, is its inability to adequately model tail dependence. It assumes extreme events for different entities are largely independent, leading to a significant underestimation of systemic risk and the likelihood of multiple correlated defaults during market stress. For a high-yield portfolio, capturing this clustering of defaults in downturns is critical.

Covenant tests like OC and Interest Coverage (IC) tests are triggers within the payment waterfall. A breach of the OC test for a given tranche typically triggers a ‘cash flow diversion’ or ‘interest diversion’ event. This means available funds that would normally go to pay interest (and sometimes principal) to junior tranches and the equity piece are redirected to pay down the principal of the more senior tranches first. This protects senior noteholders until the test is brought back into compliance.

Loss Given Default is primarily a function of the creditor’s seniority or priority of claim in the capital structure. A subordinated bank bond (Tier 2) ranks below senior unsecured creditors and above equity in a liquidation. The senior unsecured industrial bond, while from a lower-rated entity, holds a higher priority claim. Therefore, the subordinated bond (Bond Y) would typically experience a higher loss severity (higher LGD) than the senior bond, even from a higher-rated issuer, due to its structural subordination.

Under FRTB, a key criterion for classifying a risk factor as Non-Modelable (NMRF) is the lack of sufficient, continuous, and representative observable market data. The specific quantitative hurdle is having fewer than 24 real price observations over the prior year, with the additional qualifier that the observations are not equally spaced (i.e., there are long gaps, indicating illiquidity). This triggers a higher capital charge under the SA and imposes constraints on its use in internal models.

CVA is an adjustment to the fair value of a derivative or portfolio to account for the credit risk of the counterparty. It is essentially the market price of the risk that the counterparty might default in the future. It is calculated as the present value of the expected loss due to counterparty default. For uncollateralized trades, this risk is significant and must be priced into the valuation, making it a critical P&L and risk management concept.

While yield is important for return, it is not a direct or reliable indicator of liquidity vulnerability during stress. A high yield might correlate with riskier, less liquid assets, but it is not a measure of liquidity itself. The WAM (regulatory limit), the level of daily/weekly liquid assets (a direct liquidity buffer), and concentration risk (which affects the ability to sell assets quickly without moving the market) are all fundamental to assessing a fund’s ability to meet redemptions under pressure.

Debt capacity in an LBO context is forward-looking and covenant-driven. Lenders impose maintenance covenants (like Total Debt/EBITDA) that must be tested periodically. To ensure the company can survive a downturn without breaching covenants, analysts stress-test the model using a conservative, projected minimum EBITDA (e.g., through a recession scenario). The maximum debt is then calculated as this stressed EBITDA multiplied by the covenant threshold. Using LTM or historical figures does not account for future volatility.

Transition risk refers to the financial risks arising from the process of adjustment towards a lower-carbon economy. This includes policy/regulatory risks (like new carbon taxes or stricter emissions caps), technological risks, and market shifts. For a carbon-intensive utility, modeling the financial impact of plausible future carbon pricing or regulatory costs is a direct way to quantify transition risk in a credit assessment. Physical risk (option 1) is separate, relating to acute or chronic climate events.

For bonds with embedded options, like callable bonds, Macaulay duration (which assumes cash flows do not change) can be misleading. Effective duration accounts for how estimated cash flows change with interest rates (e.g., the increased likelihood of the bond being called if rates fall). The significant discrepancy signals that the optionality is materially affecting price sensitivity, making effective duration the correct metric for assessing interest rate risk in this scenario.0