Credit Risk Analysis Exam 1 Practice Test

Covenants are clauses in a loan agreement that constrain what a borrower can or must do. They protect the lender’s downside by limiting actions that could increase default risk, such as taking on more debt, paying large dividends, selling key assets, or entering risky ventures without approval. They also require ongoing monitoring, like keeping certain financial ratios within set thresholds, so the lender has early warning and can demand corrective action or declare default if breached. This keeps the borrower’s behavior aligned with the lender’s risk tolerance and preserves value. The other options don’t fit because early repayment refers to prepaying debt, which can alter risk rather than limit actions; price of risk describes compensation for risk, not a contractual clause; and leverage is a metric used within covenants, not a contractual provision itself.