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NEW QUESTION 193
A risk analyst analyzing the positions for a proprietary trading desk determines that the combined annual variance of the desk's positions is 0.16. The value of the portfolio is $240m. What is the 10-day stand alone VaR in dollars for the desk at a confidence level of 95%? Assume 250 trading days in a year.
- A. 0
- B. 1
- C. 2
- D. 3
Answer: D
Explanation:
Explanation
The z value at the 95% confidence level is 1.64. Since the variance is 0.16, the annual volatility is 40%.
Therefore the daily volatility is 40% x 10/250 = 8%. The VaR therefore is 8% x 1.64 x $240m = $31,488,000
NEW QUESTION 194
Which of the following correctly describes a reverse stress test:
- A. Stress tests that are prescribed and conducted by a regulator in addition to the tests done by a bank
- B. A stress test that requires a role reversal between risk managers and the risk taking business units in order to determine credible scenarios
- C. A stress test that considers only qualitative factors that go beyond mathematical modeling to examine feedback loops and the effect of macro-economic fundamentals
- D. Stress tests that start from a known stress test outcome and then ask what events could lead to such an outcome for the bank
Answer: D
Explanation:
Explanation
Generally, stress tests consider a shock or a severe scenario in order to determine the 'what-if' that circumstance were to materialize. They focus on the outcome based upon a set of shocks. In a reverse stress test, the outcome is assumed to be known (generally something as severe as bankruptcy, non-compliance with capital requirements etc), and the test is intended to work out what shocks or events would lead to such an outcome.
Reverse stress tests therefore start from a known stress test outcome (such as breaching regulatory captial ratios, illiquidity or insolvency) and then asking what events could lead to such an outcome for the bank. This can be quite a challenging task. Principle 9 laid out in the BCBS document on stress testing (May 2009) (which is part of the PRM syllabus effective March 1, 2010) lays down the expectations relating to reverse stress tests.
Therefore Choice 'a' is the correct answer. All the other choices are nonsensical.
NEW QUESTION 195
According to Basel II's definition of operational loss event types, losses due to acts by third parties intended to defraud, misappropriate property or circumvent the law are classified as:
- A. External fraud
- B. Execution delivery and system failure
- C. Internal fraud
- D. Third party fraud
Answer: A
Explanation:
Explanation
Choice 'c' is the correct answer. Refer to the detailed loss event type classification under Basel II (see Annex 9 of the accord). You should know the exact names of all loss event types, and examples of each.
NEW QUESTION 196
Credit exposure for derivatives is measured using
- A. Standard normal distribution
- B. Forward looking exposure profile of the derivative
- C. Notional value of the derivative
- D. Current replacement value
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 197
Calculate the 99% 1-day Value at Risk of a portfolio worth $10m with expected returns of 10% annually and volatility of 20%.
- A. 0
- B. 1
- C. 2
- D. 3
Answer: A
Explanation:
Explanation
Be wary of questions asking you to calculate VaR where the mean or expected returns are different from zero.
The VaR formula of z-value times standard deviation needs to have an adjustment for the expected return [ie use VaR = z-value times standard deviation minus expected return]. In this case, the standard deviation for 1 day for the portfolio is =SQRT(1/250)*20%*$10m = $126,491. The VaR is therefore (2.326 * $126,491) - ($10,000,000 * 10% * 1/250) = $290,218.
NEW QUESTION 198
Which of the following are likely to be useful to a risk manager analyzing liquidity risk for an international bank?
I. Information on liquidity mismatches
II. Funding concentration
III. Lending concentration
IV. A report on illiquid assets
- A. I, II and IV
- B. I and II
- C. III and IV
- D. I, II, III and IV
Answer: D
Explanation:
Explanation
All of the listed reports (or information) would be useful to a risk manager analyzing liquidity risk. Therefore Choice 'c' is the correct answer. Additionally, reports on assets brought on margin (that may result in collateral or margin calls), trading exposures to different counterparties, reports on financial health, share price and credit ratings of key counterparties will also be useful.
NEW QUESTION 199
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. 15.90%
- B. 16.47%
- C. None of the above
- D. 5.00%
Answer: A
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 200
Assuming all other factors remain the same, an increase in the volatility of the returns on the assets of a firm causes which of the following outcomes?
- A. An increase in the value of the callable debt of the firm
- B. A decrease in the value of the implicit put in in the debt of the firm
- C. An increase in the value of the equity of the firm
- D. A decrease in the value of the non-callable debt issued by the firm
Answer: D
Explanation:
Explanation
Some parts of this question draw upon contingent claims framework to the value of a firm. According to this framework, the relationship between the debt and equity holders of a firm can be viewed as follows: The equity holders have a call option on the assets of the firm with a strike price equal to the value of the debt, and the debt holders have sold them this call. This is so because should the value of the assets of the firm fall below the value of the debt, the equity holders can walk away by handing over the assets to the debt holders in full extinguishment of their claims. If the value of the firm's assets is greater than the value of debt, the equity holders will exercise their call option. At the same time, it is also possible to view the debtholders as holding an asset and having sold a put on the assets of the firm with a strike price equal to the value of the debt. If the value of the assets of the firm were to fall below the value of the debt, they will end up buying the assets at a price equal to the value of the debt.
An increase in the volatility of returns on the assets of a firm increases the volatility of the asset value. This means the likelihood that the asset value will go below the value of the debt of the firm will increase. Callable debt can be considered to be a summation of two separate securities: a regular debt, for which the firm pays interest and receives a principal loan; and a call option that the debt holders have sold to the firm allowing the firm to buy back the debt. In return, the firm pays an implied 'premium' to the debt holders who have agreed to buy the callable debt. Therefore the total payments by the company to callable debt holders is equal to the interest payments plus the premium payment for the option. An increase in asset volatility will increase the value of this option as it is likely that the assets will increase in value, and strengthen the company's credit, and lower its spread at which time it would like to repay the debt and refinance/roll over at the new lower rate.
Therefore an increase in volatility will increase the 'premium' demanded by the callable debt holders, thereby increasing the total yield and lowering the value of the callable debt. Therefore Choice 'b' (An increase in the value of the callable debt of the firm) is incorrect.
An increase in asset volatility will decrease the value of the firm as it is now riskier than before (higher standard deviation, same expected returns). Therefore Choice 'a' (An increase in the value of the equity of the firm) is false too.
The value of the implicit put in the debt of the firm will increase and not decrease as the volatility of the underlying assets increases. Therefore Choice 'c' (A decrease in the value of the implicit put in in the debt of the firm) is incorrect too.
Choice 'd' (A decrease in the value of the non-callable debt issued by the firm) is correct because higher asset volatility will increase the riskiness of the company's debt, making the required yield higher and decreasing its value.
NEW QUESTION 201
A corporate bond maturing in 1 year yields 8.5% per year, while a similar treasury bond yields 4%. What is the probability of default for the corporate bond assuming the recovery rate is zero?
- A. 4.15%
- B. 8.50%
- C. 4.50%
- D. Cannot be determined from the given information
Answer: A
Explanation:
Explanation
The probability of default would make the future cash flows from both the bonds identical. If p be the probability of default, the cash flows from the risky corporate bond would be
= (cash flows in the event of default x probability of default) + (cash flows without default x (1 - probability of default))
=> p*0 + (1 - p)*(1 + 8.5%) = (1 - p)*1.085.
The cash flows from the treasury bond would be 1.04. These two should be equal, ie,
1.04 = (1- p)*1.085, implying p = 4.15%.
(Note: The above is a simplification intended for the exam. In reality investors would demand a 'credit risk premium' for the corporate bond over and above the expected default loss rate. They are unlikely to be happy with just being compensated with exactly the expected default loss rate plus the risk-fre rate because the expected default loss rate itself is uncertain. They would demand some premium over and above what the default rate alone might mathematically imply above the risk free rate. In this question, this credit risk premium is ignored.)
NEW QUESTION 202
Which of the following statements is true
I. If no loss data is available, good quality scenarios can be used to model operational risk II. Scenario data can be mixed with observed loss data for modeling severity and frequency estimates III. Severity estimates should not be created by fitting models to scenario generated loss data points alone IV. Scenario assessments should only be used as modifiers to ILD or ELD severity models.
- A. I and II
- B. III and IV
- C. I
- D. All statements are true
Answer: A
Explanation:
Explanation
There are multiple ways to incorporate scenario analysis for modeling operational risk capital - and the exact approach used depends upon the quantity of loss data available, and the quality of scenario assessments.
Generally:
- If there is no past loss data available, scenarios are the only practical means to model operational risk loss distributions. Both frequency and severity estimates can be modeled based on scenario data.
- If there is plenty of past data available, scenarios can be used as a modifier for estimates that are based solely on data (for example, consider the MAX of the loss estimates at the desired quantile as provided by the data, and as indicated by scenarios)
- If high quality scenario data is available, and there is sufficient past data, one could mix scenario assessments with the loss data and fit the combined data set to create the loss distribution. Alternatively, both could be fitted with severity estimates and then the two severities could be parametrically combined.
In short, there is considerable flexibility in how scenarios can be used.
Statement I is therefore correct, and so is statement II as both indicate valid uses of scenarios.
Statement III is not correct because it may be okay to create severity estimates based on scenario data alone.
Statement IV is not correct because while using scenarios as modifiers to other means of estimation is acceptable, that is not the only use of scenarios.
NEW QUESTION 203
Which of the following credit risk models relies upon the analysis of credit rating migrations to assess credit risk?
- A. The actuarial approach
- B. KMV's EDF based approach
- C. The CreditMetrics approach
- D. The contingent claims approach
Answer: C
Explanation:
Explanation
The correct answer is Choice 'b'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:
1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.
2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.
3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.
4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.
5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).
NEW QUESTION 204
A bank holds a portfolio of corporate bonds. Corporate bond spreads widen, resulting in a loss of value for the portfolio. This loss arises due to:
- A. Counterparty risk
- B. Liquidity risk
- C. Credit risk
- D. Market risk
Answer: D
Explanation:
Explanation
The difference between the yields on corporate bonds and the risk free rate is called the corporate bond spread.
Widening of the spread means that corporate bonds yield more, and their yield curve shifts upwards, driving down bond prices. The increase in the spread is a consequence of the market risk from holding these interest rate instruments, which is a part of market risk. If the reduction in the value of the portfolio were to be caused by a change in the credit rating of the bonds held, it would have been a loss arising due to credit risk.
Counterparty risk and liquidity risk are not relevant for this question. Therefore Choice 'c' is the correct answer.
NEW QUESTION 205
Which of the following is not a permitted approach under Basel II for calculating operational risk capital
- A. the basic indicator approach
- B. the advanced measurement approach
- C. the internal measurement approach
- D. the standardized approach
Answer: C
Explanation:
Explanation
The Basel II framework allows the use of the basic indicator approach, the standardized approach and the advanced measurement approaches for operational risk. There is no approach called the 'internal measurement approach' permitted for operational risk. Choice 'a' is therefore the correct answer.
NEW QUESTION 206
The 10-day VaR of a diversified portfolio is $100m. What is the 20-day VaR of the same portfolio assuming the market shows a trend and the autocorrelation between consecutive periods is 0.2?
- A. 141.42
- B. 154.92
- C. 0
- D. 1
Answer: B
Explanation:
Explanation
The square root of time rule cannot be applied here because the returns across the periods are not independent.
(Recall that the square root of time rule requires returns to be iid, independent and identically distributed.) Here there is a 'autocorrelation' in play, which means one period's returns affect the returns of the other period.
VaR is merely a multiple of volatility, or standard deviation, using the factor for the desired confidence level.
VaR across time periods can be combined using the square root of time rule, in fact if returns were independent we could have easily calculated the VaR for the 20-day period as equal to $100m*SQRT(20/10) =
$141.4m
But in this case we need to account for the autocorrelation. We can do this akin to the way we combine the VaR of different assets that have a given correlation. Since we know that:
Variance (A + B) = Variance(A) + Variance(B) + 2*Correlation*StdDev(A)*StdDev(B).
The standard deviation, which the VaR is a multiple of, can be calculated by taking the square root of the variance.
Therefore the combined VaR over the two months will be equal to =SQRT( (100^2) + (100^2) +
2*0.2*100*100 )= $154.92m. All other answers are incorrect.
NEW QUESTION 207
Which of the following statements are true:
I. A transition matrix is the probability of a security migrating from one rating class to another during its lifetime.
II. Marginal default probabilities refer to probabilities of default in a particular period, given survival at the beginning of that period.
III. Marginal default probabilities will always be greater than the corresponding cumulative default probability.
IV. Loss given default is generally greater when recovery rates are low.
- A. I and IV
- B. I and III
- C. II and IV
- D. I, III and IV
Answer: C
Explanation:
Explanation
Statement I is incorrect. A transition matrix expresses the probabilities of moving to a given set of ratings at the end of a period (usually one year) conditional upon a given rating at the beginning of the period. It does not make a reference to an individual security and certainly not to the probability of migrating to other ratings during its entire lifetime.
Statement II is correct. Marginal default probabilities are the probability of default in a given year, conditional upon survival at the beginning of that year.
Statement III is incorrect. Cumulative probabilities of default will always be greater than the marginal probabilities of default - except in year 1 when they will be equal.
Statement IV is correct. LGD = 1 - Recovery Rate, therefore a low recovery rate implies higher LGD.
NEW QUESTION 208
The backtesting of VaR estimates under the Basel accord requires comparing the ex-ante VaR to:
- A. the Basel accord does not require banks to backtest VaR estimates
- B. ex-ante VaR calculated for the subsequent periods
- C. realized profit and loss for the period
- D. hypothetical profit and loss keeping the positions constant
Answer: C
Explanation:
Explanation
Basel II requires financial institutions to compare their ex-ante VaR estimates to actual realized P&L.
Therefore Choice 'd' is the correct answer. A bank may use hypothetical P&L based upon constant positions to validate its model, but that is not required for Basel II.
NEW QUESTION 209
Which of the following statements are true:
I. Shocks to risk factors should be relative rather than absolute if we wish to avoid a change in the sign of the risk factor.
II. Interest rate shocks are generally modeled as absolute shocks.
III. Shocks to volatility are generally modeled as absolute shocks.
IV. Shocks to market spreads are generally modeled as relative shocks.
- A. I and II
- B. I, II and III
- C. II and IV
- D. II only
Answer: A
Explanation:
Explanation
Suppose during a historical event interest rates rose from 2% to 2.25%. This can be understood as a change of either 25 basis points, or a change of 12.5%. When applied to the current portfolio when interest rates are
0.50%, we may model this 'shock' as either a rise to 0.75%, or 0.5625% (ie a rise of 12.5% over existing levels). The former is called an absolute shock, and the latter a relative shock.
I is true as relative shocks can never change the sign of a risk factor. Yet interest rate changes are modeled as absolute changes as relative shocks can get artificially amplified or attenuated if the current level of interest rates is too different from those that existed during the crisis being modeled. Therefore II is true. III and IV are false as volatility is modeled as a relative shock and spreads are modeled as absolute shocks.
NEW QUESTION 210
If the default hazard rate for a company is 10%, and the spread on its bonds over the risk free rate is 800 bps, what is the expected recovery rate?
- A. 0.00%
- B. 8.00%
- C. 40.00%
- D. 20.00%
Answer: D
Explanation:
Explanation
The recovery rate, the default hazard rate (also called the average default intensity) and the spread on debt are linked by the equation Hazard Rate = Spread/(1 - Recovery Rate). Therefore, the recovery rate implicit in the given data is = 1 - 8%/10% = 20%.
NEW QUESTION 211
Which of the following is not a credit event under ISDA definitions?
- A. Obligation accelerations
- B. Failure to pay
- C. Restructuring
- D. Rating downgrade
Answer: D
Explanation:
Explanation
According to ISDA, a credit event is an event linked to the deteriorating credit worthiness of an underlying reference entity in a credit derivative. The occurrence of a credit event usually triggers full or partial termination of the transaction and a payment from protection seller to protection buyer. Credit events include
- bankruptcy,
- failure to pay,
- restructuring,
- obligation acceleration,
- obligation default and
- repudiation/moratorium.
A rating downgrade is not a credit event.
NEW QUESTION 212
Which of the following statements are correct:
I. A training set is a set of data used to create a model, while a control set is a set of data is used to prove that the model actually works II. Cleansing, aggregating or ensuring data integrity is a task for the IT department, and is not a risk manager's responsibility III. Lack of information on the quality of underlying securities and assets was a major cause of the collapse in the CDO markets during the credit crisis that started in 2007 IV. The problem of lack of historical data can be addressed reasonably satisfactorily by using analytical approaches
- A. I and III
- B. II and IV
- C. All of the above
- D. I, III and IV
Answer: A
Explanation:
Explanation
Statement I is correct. Data is often divided into two sets - a 'training set' that is used to create and fine-tune the model while the 'control set' is used to prove that the model works on sample data. Back testing is then perfomed using actual data that becomes available over time, or may already be available as historical data.
Statement II is incorrect. A risk manager often spends a great deal of time in managing data, and ensuring that the data being used is accurate enough for the purpose it is being used for. A risk manager can expect to spend a good part of his or her team's time in cleansing data. While he or she can try to get the IT processes and systems to produce correct data in the first place so it requires minimal subsequent cleansing or validation, this task is likely to remain a key part of a risk manager's role for quite some time in the future given the challenges nearly all organizations face in managing risk data.
Statement III is correct. There was not enough granular data available on the underlying components of some of the derivative debt securities whose markets dried up during the crisis that began in 2007. This was because investors became increasingly unsure of what the value of these securities, such as CDOs was, leading to market seizure and firesale prices.
Statement IV is not correct. There is no easy solution to the lack of enough historical data, which is used to create as well as test models, and construct stress scenarios. Analytical approaches are not a good enough substitute for real market data. During the recent crisis, many instruments had rather short histories and there was not enough data available, and risk managers and portfolio managers relied upon analytical approaches to value and price them. Many of the assumptions that underpinned these approaches were untested in the real world and turned out to be incorrect.
Therefore Choice 'c' is the correct answer and the rest are incorrect.
NEW QUESTION 213
According to the Basel framework, shareholders' equity and reserves are considered a part of:
- A. Tier 2 capital
- B. Tier 1 capital
- C. All of the above
- D. Tier 3 capital
Answer: B
Explanation:
Explanation
According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves.
Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt.
Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority.
NEW QUESTION 214
Conditional VaR refers to:
- A. the value at risk estimate for non-normal distributions
- B. expected average losses conditional on the VaR estimates not being exceeded
- C. expected average losses above a given VaR estimate
- D. value at risk when certain conditions are satisfied
Answer: C
Explanation:
Explanation
Conditional VaR is the expected average losses above a given percentile, or a given VaR estimate at the given level of confidence. For example, if we know what the 99% VaR is, we still do not know what we can expect our losses to be if this VaR loss estimate were to be exceeded. Conditional VaR provides the answer to this question by providing an estimate of the average or expected losses beyond 99% mark. Therefore Choice 'c' is the correct answer and the other choices are mostly non-sensical.
NEW QUESTION 215
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PRM Certification - Exam III: Risk Management Frameworks, Operational Risk, Credit Risk, Counterparty Risk, Market Risk, ALM, FTP - 2015 Edition Certification Sample Questions and Practice Exam: https://www.test4cram.com/8008_real-exam-dumps.html