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NEW QUESTION 110
Credit exposure for derivatives is measured using
- A. Current replacement value
- B. Forward looking exposure profile of the derivative
- C. Standard normal distribution
- D. Notional value of the derivative
Answer: B
Explanation:
Explanation
Current replacement values are a very poor measure of the credit exposure from a derivative contract, because the future value of these instruments is unpredictable, ie is stochastic, and the range of values it can take increases the further ahead in the future we look. Therefore it is common for credit exposures for derivatives to be measured using forward looking exposure profiles, which are distributions of the expected value of the derivative at the time horizon for which credit risk is being measured. To be conservative, a high enough quintile of this distribution is taken as the 'loan equivalent value' of the derivative as the exposure.Choice 'c' is the correct answer.
The notional value of derivative contracts generally tends to be quite high and unrelated to their economic value or the counterparty exposure. Therefore notional value is irrelevant.
NEW QUESTION 111
Which of the following risks and reasons justify the use of scenario analysis in operational riskmodeling:
I. Risks for which no internal loss data is available
II. Risks that are foreseeable but have no precedent, internally or externally III. Risks for which objective assessments can be made by experts IV. Risks that are known to exist, but for which no reliable external or internal losses can be analyzed
V. Reducing the complexity of having to fit statistical models to internal and external loss data VI. Managing the capital estimation process as to produce estimates in line with management's desired capital buffers.
- A. I, II, III and IV
- B. V
- C. I, II and III
- D. All of the above
Answer: A
Explanation:
Explanation
All the reasons and risks presented above are valid reasons for using scenario analysis, except V and VI - ie, the need to reduce the complexity of calculations is not a valid reason for using scenario analysis. Similarly, making operational risk capital estimates match management's desired capital allocation targets is also not a valid reason. Capital calculations are intended to provide adequate capital for managing the risk from operations, regardless of what management may desire them to be.
NEW QUESTION 112
Which of the following objectives are targeted by rating agencies when assigning ratings:
I. Ratings accuracy
II. Ratings stability
III. High accuracy ratio (AR)
IV. Ranked ratings
- A. II and III
- B. III and IV
- C. I and II
- D. I, II and III
Answer: C
Explanation:
Explanation
Rating agencies target both accuracy and stability when they assign ratings. These two objectives can sometimes conflict, so a balance needs to be struck between the two. Rating agencies do not target anyparticular 'accuracy ratio' or rankings. Therefore Choice 'c' is the correct answer.
NEW QUESTION 113
The sensitivity (delta) of a portfolio to a single point move in the value of the S&P500 is $100. If the current level of the S&P500 is 2000, and has a one day volatility of 1%, what is the value-at-risk for this portfolio at the 99% confidence and a horizon of 10 days? What is this method of calculating VaR called?
- A. $4,660, Monte Carlo simulation VaR
- B. $14,736, historical simulation VaR
- C. $4,660, parametric VaR
- D. $14,736, parametric VaR
Answer: D
Explanation:
Explanation
If the current level of the S&P 500 is 2000, and a single day volatility is 1%, and the delta (ie change in portfolio value from a one point change) is $100, then the 1 day volatility for the portfolio in dollars is 2000 *
1% * $100 = $2,000.
At the 99% confidence level, the value of the inverse cumulative density function for the normal distribution is
2.33 (=NORMSINV(99%), in Excel). Therefore the 1 day VaR will be 2.33 * $2000 =$4,660. Extending it to
10 days using the square root of time rule, we get the 10 day VaR as equal to SQRT(10)*4660 = $14,736.
Since this method of calculating VaR relies upon a delta approximation of a risk factor (in this case the S&P500), it is the parametric approach to calculating VaR (the other methods being historical simulation, and Monte Carlo simulation).
The
2015 Handbook provides an excellent example of parametric (and other) VaR calculations in Chapter 3 of Volume III of Book 3. The spreadsheet used for the illustration can be downloaded from
http://www.prmia.org/prm-exam/handbook-resources.
NEW QUESTION 114
Which of the following best describes a 'break clause ?
- A. A break clause sets out the conditions under which the transaction will be terminated upon non-compliance with the ISDA MA
- B. A break clausedetermines the process by which amounts due on early termination will be determined
- C. A break clause gives either party to a transaction the right to terminate the transaction at market price at future date(s)
- D. A break clause describes rights and obligations when the derivative contract is broken
Answer: C
Explanation:
Explanation
A break close, also called a 'mutual put', gives either party the right to terminate a transaction at market price at a given date, or dates in the future. These are usually availed of in longer dated transactions, eg 10 years and over. For example, a 15-year swap might have a mutual put in year 5, and every 2 years thereafter.
All other choices are incorrect.
NEW QUESTION 115
Which of the following statements is true:
I. Expected credit losses are charged to the unit's P&L while unexpected losses hit risk capital reserves.
II. Credit portfolio loss distributions are symmetrical
III. For a bank holding $10m in face of a defaulted debt that it acquired for $2m, the bank's legal claim in the bankruptcy court will be $10m.
IV. Thelegal claim in bankruptcy court for an over the counter derivatives contract will be the notional value of the contract.
- A. III and IV
- B. I and III
- C. I, II and IV
- D. II and IV
Answer: B
Explanation:
Explanation
Statement I is true as expected losses are the 'cost ofdoing business' and charged against the P&L of the unit holding the exposure. When evaluating the business unit, expected losses are taken into account. Unexpected losses however require risk capital reserves to be maintained against them.
Statement II isnot true. Credit portfolio loss distributions are not symmetrical, in fact they are highly skewed and have heavy tails.
Statement III is true. The notional, or the face value of a defaulted debt is the basis for a claim in bankruptcy court, and not the market value.
Statement IV is false. In the case of over the counter instruments, the replacement value of the contract represents the amount of the claim, and not the notional amount (which can be very high!).
NEW QUESTION 116
If the odds of default are 1:5, what is the probability of default?
- A. 50.00%
- B. 12.00%
- C. 20.00%
- D. 16.67%
Answer: D
Explanation:
Explanation
Odds are the ratio between the probability of the occurence of an event to the probability that the event does not occur.
If odds are H, then p = H/(1 + H) and H = p/(1-p). In this case the odds are 1:5, or 1/5, therefore the correct answer is Choice 'a', equal to (1/5)/(1 + 1/5) = 1/6 = 16.67%. All other choices are incorrect.
NEW QUESTION 117
The sum of the stand alone economic capital of all the business units of a bank is:
- A. unrelated to the economic capital for the firm as a whole
- B. equalto the economic capital for the firm as a whole
- C. less than the economic capital for the firm as a whole
- D. more than the economic capital for the firm as a whole
Answer: D
Explanation:
Explanation
Economic capital is sub-additive, ie, because of the correlation being less than perfect between the risks of thedifferent business units, the total economic capital for the firm will be less than the sum of the EC for the individual business units. Therefore Choice 'b' is the correct answer.
In practice, correlations are difficult to estimate reliably, and banks often use estimates and corroborate their capital calculations with reference to a number of data points.
NEW QUESTION 118
Which of the following are valid approaches for extreme value analysis given a dataset:
I. The Block Maxima approach
II. Least squares approach
III. Maximum likelihood approach
IV. Peak-over-thresholds approach
- A. I and IV
- B. II and III
- C. I, III and IV
- D. All of the above
Answer: A
Explanation:
Explanation
For EVT, we use the block maxima or the peaks-over-threshold methods. These provide us the data points that can be fitted to a GEVdistribution.
Least squares and maximum likelihood are methods that are used for curve fitting, and they have a variety of applications across risk management.
NEW QUESTION 119
The CDS quote for the bonds of Bank X is 200 bps. Assuming a recovery rate of 40%, calculate the default hazard rate priced in the CDS quote.
- A. 2.00%
- B. 0.80%
- C. 5.00%
- D. 3.33%
Answer: D
Explanation:
Explanation
Hazard rate x Loss given default = CDS quote. In other words, Hazard rate x (1 - recovery rate) = CDS quote.
We can therefore calculate the hazard rate for this problem as 200 bps/(1 - 40%) = 3.33%.
NEW QUESTION 120
For a hypotherical UoM, the number of losses in two non-overlapping datasets is 24 and 32 respectively. The Pareto tail parameters for the two datasets calculated using the maximum likelihood estimation method are 2 and 3. What is an estimate of the tail parameter of the combined dataset?
- A. 2.57
- B. 2.23
- C. 0
- D. Cannot be determined
Answer: A
Explanation:
Explanation
For a number of processes, including many in finance, while a distribution such as the normal distribution is a good approximation of the distribution near the modal value of the variable, thesame normal distribution may not be a good estimate of the tails. For this reason, the Pareto distribution is one of the distributions that is often used to model the tails of another distribution. Generally, if you have a set of observations, and you discard all observations below a threshold, you are left with what are called 'exceedances'. The threshold needs to be reasonably far out in the tail. If from each value of the exceedances you subtract the threshold value, the resulting dataset is estimated bythe generalized Pareto distribution.
The Pareto distribution has a 'shape parameter'. The average of two Pareto distributions with tail parameters 1 and 2 ( is a Greek character, pronounced as 'sai' (saa-eee)), is the weighted average of 1 and 2 with weights proportional to the number of observations in the datasets underlying the distributions.
NEW QUESTION 121
If F be the face value of a firm's debt, V the value of its assets and E the market value of equity, then according to the option pricing approach a default on debt occurs when:
- A. V < E
- B. F - E < V
- C. F > V
- D. F < V
Answer: C
Explanation:
Explanation
According to the option pricing approach developed by Merton, the shareholders of a firm have a put on the assets of the firm where the strike price is equal to the face value of the firm's debt. This is just a more complicated way of saying that the debt holders are entitled to all the assets of the firm if these assets are insufficient to pay off the debts, and because of limited liability of the shareholders of a corporation this part payment will fully extinguish thedebt.
A firm will default on its debt if the value of the assets falls below the face value of the debt. Therefore Choice
'a' is the correct answer. All other choices are incorrect.
(There are two ways to consider this sort of optionality, and I have mentioned only one for this question:
1. The equity holders can sell the assets of the firm to the debt holders at a price equal to the face value of the debt, ie a put. (ie they can extinguish their liability to the debt holders in full by handing them the assets of the firm, effectively selling them the assets at the value of the debt)
2. The equity holders have a long position in a call option where they can keep the assets of the firm by paying a price equal to the face value of the debt (ie, they can pay off the debt holders and keep the assets) For this question, perspective 1 applies but you should be aware of the second one too as a question may reference that view point.)
NEW QUESTION 122
Economic capital under the Earnings Volatility approach is calculated as:
- A. Expected earnings/Required rate of return for the firm
- B. [Expected earningsless Earnings under the worst case scenario at a given confidence level]/Required rate of return for the firm
- C. Earnings under the worst case scenario at a given confidence level/Required rate of return for the firm
- D. Expected earnings/Specific risk premium for the firm
Answer: B
Explanation:
Explanation
The Earnings Volatility approach to calculating economic capital is a top down approach that considers economic capital as being the capital required to make for the worst case fall in earnings, and calculates EC as equal to the worst case decrease in earnings capitalized at the rate of return expected of the firm. The worst case decrease in earnings, or the earnings-at-risk can only be stated at a given confidence level, and is equal to the Expected Earnings less Earnings under the worst case scenario.
NEW QUESTION 123
Which of the following best describes Altman's Z-score
- A. A regression of probability of survival against a given set of factors
- B. A numerical computation based upon accounting ratios
- C. A standardized z based upon the normal distribution
- D. A calculation of defaultprobabilities
Answer: B
Explanation:
Explanation
Choice 'c' correctly describes Altman's z-score. All other choices are incorrect.
NEW QUESTION 124
Which of the following statements are true:
I. Credit VaR often assumes a one year time horizon, as opposed to a shorter time horizon for market risk as credit activities generally span alonger time period.
II. Credit losses in the banking book should be assessed on the basis of mark-to-market mode as opposed to the default-only mode.
III. The confidence level used in the calculation of credit capital is high when the objective is tomaintain a high credit rating for the institution.
IV. Credit capital calculations for securities with liquid markets and held for proprietary positions should be based on marking positions to market.
- A. II and III
- B. I, III and IV
- C. I and III
- D. I and II
Answer: B
Explanation:
Explanation
Statement I is correct as credit VaR calculations often use a one year time horizon. This is primarily because the cycle in respect of credit related activities, such as loan loss reviews, accounting cycles for borrowers etc last a year.
Statement II is false. There are two ways in which loss assessments in respect of credit risk can be made:
default mode, where losses are considered only in respect of default, and no losses are recognized in respect of the deterioration of the creditworthiness of the borrower (which is often expressed through a credit rating transition matrix); and the mark-to-market mode, where losses due to both defaults and credit quality are considered. The default mode is used for the loan book where the institution has lentmoneys and generally intends to hold the loan on its books till maturity. The mark to market mode is used for traded securities which are not held to maturity, or are held only for trading.
Statement III is correct. The confidence interval, or the quintile of losses used for maintaining credit ratings tends to be very high as the possibility of the institution's default needs to be remote.
Statement IV is correct too, for the reasons explained earlier.
NEW QUESTION 125
Which of the following statements are true:
I.Top down approaches help focus management attention on the frequency and severity of loss events, while bottom up approaches do not.
II. Top down approaches rely upon high level data while bottom up approaches need firm specific risk data to estimate risk.
III. Scenario analysis can help capture both qualitative and quantitative dimensions of operational risk.
- A. I only
- B. II only
- C. II and III
- D. III only
Answer: C
Explanation:
Explanation
Top down approaches do not consider event frequency and severity, on the otherhand they focus on high level available data such as total capital, income volatility, peer group information on risk capital etc. Bottom up approaches focus on severity and frequency distributions for events. Statement I is therefore not correct.
Top downapproaches do indeed rely upon high level aggregate data and tend to infer operational risk capital requirements from these. Bottom up approaches look at more detailed firm specific information. Statement II is correct.
Scenario analysis requires estimating losses from risk scenarios, and allows incorporating the judgment and views of managers in addition to any data that might be available from internal or external loss databases.
Statement III is correct. Therefore Choice 'b' is the correct answer.
NEW QUESTION 126
The cumulative probability of default for a security for 4 years is 11.47%. The marginal probability of default for the security for year 5 is 5% during year 5. What is the cumulative probability of default for the security for 5 years?
- A. None of the above
- B. 5.00%
- C. 15.90%
- D. 16.47%
Answer: C
Explanation:
Explanation
The cumulative probability of default for the security for the 5 years is [1 - (1 - probability of default upto year
4)*(1 - probability of default in year 5)]. An easier way to think about this is that the Probability of survival till year 5 = (Probability of survival till year 4 * Probability of survival during year 5). Using the relationship that probability of default = 1 - probability of survival, we can calculate the required probability in all cases.
In this case, the cumulative probability of default for the security for 5 years = 1 - (1 - 11.47%)*(1 - 5%) =
15.8695%, therefore Choice 'c' is the correct answer.
NEW QUESTION 127
For a loan portfolio, unexpected losses are charged against:
- A. Regulatory capital
- B. Economic capital
- C. Credit reserves
- D. Economic credit capital
Answer: D
Explanation:
Explanation
Creditreserves are created in respect of expected losses, which are considered the cost of doing business.
Unexpected losses are borne by economic credit capital, which is a part of economic capital. This question is a bit nuanced - and 'economic capital' wouldgenerally be a good answer as well. However, taking a rather beady eyed view of the terminology and distinguishing between 'economic credit capital' which is a subset of
'economic capital', we can say that 'economic credit capital' is a more appropriateChoice 'a's the question relates to credit losses.
NEW QUESTION 128
Which of the formulae below describes incremental VaR where a new position 'm' is added to the portfolio?
(where p is theportfolio, and V_i is the value of the i-th asset in the portfolio. All other notation and symbols have their usual meaning.) A)
B)
C)
D)
- A. Option A
- B. Option C
- C. Option B
- D. Option D
Answer: A
Explanation:
Explanation
Incremental VaR is the change in portfolio VaR resulting from a change in a single position. This is accurately described by VaR_(p+a) - VaR_p. The other answers are incorrect, and describe other concepts.
It is important to know and understand the ideas behind MVaR (marginal VaR), CVaR (component VaR) and iVaR (incremental VaR), and the differences between them.
NEW QUESTION 129
Under the CreditPortfolio View approach to credit risk modeling, which of the following best describes the conditional transition matrix:
- A. The conditional transition matrix is the unconditional transition matrix adjusted for probabilities of defaults
- B. The conditional transition matrix is the unconditional transition matrix adjusted for the state of the economy and other macro economic factors being modeled
- C. The conditional transition matrix is the transition matrix adjusted for the distribution of the firms' asset returns
- D. The conditional transition matrix is the transition matrix adjusted for the risk horizon being different from that of the transition matrix
Answer: B
Explanation:
Explanation
Under theCreditPortfolio View approach, the credit rating transition matrix is adjusted for the state of the economy in a way as to increase the probability of defaults when the economy is not doing well, and vice versa. Therefore Choice 'a' is the correct answer.The other choices represent nonsensical options.
NEW QUESTION 130
Which of the following was not a policy response introduced by Basel 2.5 in response to the global financial crisis:
- A. Comprehensive Capital Analysis and Review (CCAR)
- B. Incremental Risk Charge (IRC)
- C. Comprehensive Risk Model (CRM)
- D. Stressed VaR (SVaR)
Answer: A
Explanation:
Explanation
The CCAR is a supervisory mechanism adopted by the US Federal Reserve Bank to assess capital adequacy for bank holding companies it supervises. Itwas not a concept introduced by the international Basel framework.
The other three were indeed rules introduced by Basel 2.5, which was ultimately subsumed into Basel III.
Stressed VaR is just the standard 99%/10 day VaR, calculated with theassumption that relevant market factors are under stress.
The Incremental Risk Charge (IRC) is an estimate of default and migration risk of unsecuritized credit products in the trading book. (Though this may sound like a credit risk term, it relates to market risk - for example, a bond rated A being downgraded to BBB. In the old days, the banking book where loans to customers are held was the primary source of credit risk, but with OTC trading and complex products the trading book also now holds a good dealof credit risk. Both IRC and CRM account for these.) While IRC considers only non-securitized products, the CRM (Comprehensive Risk Model) considers securitized products such as tranches, CDOs, and correlation based instruments.
The IRC, SVaR and CRMcomplement standard VaR by covering risks that are not included in a standard VaR model. Their results are therefore added to the VaR for capital adequacy determination.
NEW QUESTION 131
What would be the consequences of a model of economic risk capital calculation that weighs all loans equallyregardless of the credit rating of the counterparty?
I. Create an incentive to lend to the riskiest borrowers
II. Create an incentive to lend to the safest borrowers
III. Overstate economic capital requirements
IV. Understate economic capitalrequirements
- A. I and IV
- B. I only
- C. II and III
- D. III only
Answer: A
Explanation:
Explanation
If capital calculations are done in a standard way regardless of risk (as reflected by credit ratings), then it creates a perverse incentive for the lenders' employees to lend to the riskiest borrowers that offer the highest expected returns as there is no incentive to 'save' on economic capital requirements that are equal for both safe and unsafe borrowers. Therefore statement I is correct.
Given that the portfolio of suchan institution is likely to then comprise poor quality borrowers, and economic capital would be based upon 'average' expected ratings, it is likely to carry lower economic capital given its exposures. Therefore any such economic risk capital model is likely to understate economic capital requirements. Therefore statement IV is correct.
Statements II and III are incorrect and Choice 'b' is the correct answer.
NEW QUESTION 132
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