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FRM Part II · FRM Exam Part II · The Rise and Risks of Private Credit

A lender in a direct lending portfolio agrees to a loan amendment allowing a stressed borrower to pay interest in kind (PIK) instead of cash for two years. What is the most appropriate risk management view?

PIK accrual can hide deterioration: the debt balance grows, cash interest is not received, and borrower leverage rises while income is still recorded. The loan should be treated as higher credit risk and watched closely, because PIK is not equivalent to cash interest for liquidity.

  1. AThe amendment lowers credit risk because reported interest income continues
  2. BPIK accrual can mask deterioration, since debt balance grows and cash coverage weakens, so the loan should be monitored as a heightened credit riskCorrect
  3. CPIK toggles reduce valuation uncertainty because cash flows are fixed
  4. DPIK interest is equivalent to cash interest for liquidity purposes

Explanation

PIK interest adds to principal, increasing leverage and deferring cash receipt. Income may still be recognized, so reported performance can hide stress. It also reduces fund liquidity and raises loss given default exposure.

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