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NEW QUESTION 52
Which of the following describes rating transition matrices published by credit rating firms:
- A. Realized frequencies of migration from one credit rating to another over a one year period
- B. Probabilities of default for each credit rating class
- C. Expected ex-ante frequencies of migration from one credit rating to another over a one year period
- D. Probabilities of ratings transition from one rating to another for a given set of issuers
Answer: A
Explanation:
Explanation
Transition matrices are used for building distributions of the value of credit portfolios, and are the realized frequencies of migration from one credit rating to another over a period, generally one year. Therefore Choice
'd' is the correct answer.
Since they represent an actually observed set of values, they are not probabilities nor are they forward looking ex-ante estimates, though they are often used as proxies for probabilities. Choice 'a' and Choice 'c' are not correct. They include more than information on just defaults, therefore Choice 'b' is not correct.
NEW QUESTION 53
For a corporate issuer, which of the following can be used to calculate market implied default probabilities?
I. CDS spreads
II. Bond prices
III. Credit rating issued by S&P
IV. Altman's scoring model
- A. II and III
- B. I and II
- C. I, II and III
- D. III and IV
Answer: B
Explanation:
Explanation
Generally, the probability of default is an input into determining the price of a security. However, if we know the market price of a security, we can back out the probability of default that the market is factoring into pricing that security. Market implied default probabilities are the probabilities of default priced into security prices, and can be determined from both bond prices and CDS spreads. Credit ratings issued by a credit agency do not give us 'market implied default probabilities', and neither does an internal scoring model like Altman's as these do not consider actual market prices in any way.
Therefore Choice 'b' is the correct answer and the others are not.
NEW QUESTION 54
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 55
A cumulative accuracy plot:
- A. measures rating accuracy
- B. measures accuracy of default probabilities observed empirically
- C. is a measure of the correctness of VaR calculations
- D. measures the accuracy of credit risk estimates
Answer: A
Explanation:
Explanation
A cumulative accuracy plot measures the accuracy of credit ratings assigned by rating agencies by considering the relative rankings of obligors according to the ratings given. Choice 'd' is the correct answer.
NEW QUESTION 56
Which of the following situations are not suitable for applying parametric VaR:
I. Where the portfolio's valuation is linearly dependent upon risk factors II. Where the portfolio consists of non-linear products such as options and large moves are involved III. Where the returns of risk factors are known to be not normally distributed
- A. II and III
- B. All of the above
- C. I and III
- D. I and II
Answer: A
Explanation:
Explanation
Parametric VaR relies upon reducing a portfolio's positions to risk factors, and estimating the first order changes in portfolio values from each of the risk factors. This is called the delta approximation approach. Risk factors include stock index values, or the PV01 for interest rate products, or volatility for options. This approach can be quite accurate and computationally efficient if the portfolio comprises products whose value behaves linearly to changes in risk factors. This includes long and short positions in equities, commodities and the like.
However, where non-linear products such as options are involved and large moves in the risk factors are anticipated, a delta approximation based valuation may not give accurate results, and the VaR may be misstated. Therefore in such situations parametric VaR is not advised (unless it is extended to include second and third level sensitivities which can bring its own share of problems).
Parametric VaR also assumes that the returns of risk factors are normally distributed - an assumption that is violated in times of market stress. So if it is known that the risk factor returns are not normally distributed, it is not advisable to use parametric VaR.
NEW QUESTION 57
Which of the following measures can be used to reduce settlement risks:
- A. escrow arrangements using a central clearing house
- B. increasing the timing differences between the two legs of the transaction
- C. providing for physical delivery instead of netted cash settlements
- D. all of the above
Answer: C
Explanation:
Explanation
increasing the timing differences between the two legs of the transaction will increase settlement risk and not reduce it. Using escrow arrangements, such as central clearing houses to settle transactions (eg the DTCC in the United States) reduces settlement risk. Cash settlements based on netting arrangements reduce settlement risk, while physical delivery combined with gross cash payments increase it.
Therefore Choice 'a' is the correct answer.
NEW QUESTION 58
Which of the following best describes the concept of marginal VaR of an asset in a portfolio:
- A. Marginal VaR is the contribution of the asset to portfolio VaR in a way that the sum of such calculations for all the assets in the portfolio adds up to the portfolio VaR.
- B. Marginal VaR describes the change in total VaR resulting from a $1 change in the value of the asset in question.
- C. Marginal VaR is the change in the VaR estimate for the portfolio as a result of including the asset in the portfolio.
- D. Marginal VaR is the value of the expected losses on occasions where the VaR estimate is exceeded.
Answer: B
Explanation:
Explanation
The correct answer is choice 'd'
Marginal VaR is just the change in total VaR from a $1 change in the value of the asset in the portfolio. All other answers are incorrect. Mathematically, it is expressed as follows, where VaRp is the VaR for the portfolio, and Vi is the value of the asset in question.
Other answers describe other VaR related concepts such as incremental VaR, Component VaR and Conditional VaR.
NEW QUESTION 59
A risk analyst attempting to model the tail of a loss distribution using EVT divides the available dataset into blocks of data, and picks the maximum of each block as a data point to consider.
Which approach is the risk analyst using?
- A. Expected loss approach
- B. Block Maxima approach
- C. Peak-over-thresholds approach
- D. Fourier transformation
Answer: B
Explanation:
Explanation
The risk analyst is using the block maxima approach. The data points that result will then be used to fit a GEV distribution.
Expected shortfall refers to the expected losses beyond a specified threshold. The peaks-over-threshold approach is an alternative approach to the block maxima approach, and involves considering exceedances above a threshold. Fourier transformation is not relevant in this context, and is a non-sensical option.
NEW QUESTION 60
Which of the following statements is correct?
- A. Market liquidity risk is idiosyncratic while funding liquidity risk is not
- B. Market liquidity risks present themselves in the form of higher bid offer spreads
- C. Dynamic simulations of liquidity needs require an assumption of counterparty risk remaining constant
- D. Funding liquidity risks present themselves in the form of an adverse market impact on prices from a trade
Answer: B
Explanation:
Explanation
Simulations of liquidity needs can be of various types: historical simulations, where the current positions are subjected to the kind of liquidity shocks experienced in the past; static simulations, where a static view of current positions, counterparty credit position, and the business is considered; and dynamic simulations where all factors are dynamically changed including counterparty credit standing, changes to the current portfolio and behavioural aspects of the business. Choice 'b' is incorrect as dynamic simulations require no such assumptions.
Liquidity risk is often thought of in terms of market liquidity risk and funding liquidity risk. Market liquidity risk relates to the the liquidity for a particular type of asset drying up. For example, during the 2007-2009 crisis a large number of corporate bonds and structured products became extremely illiquid. Market liquidity risk manifests itself in the form of higher bid offer spreads, higher pricde impact, and a reduction in the normal market size (ie, the 'normal' size of a trade for which a dealer quote is valid for). Therefore Choice 'd' is correct. Similarly, Choice 'a' is incorrect as adverse price impact results from market liquidity risk and not funding liquidity risk.
Market liquidity risk applies to the entire market and all its participants. It is not idiosyncratic. Therefore Choice 'c' is incorrect too. Funding liquidity risk on the other hand applies to an individual institution that is under liquidity stress in the sense of not being able to meet its obligations such as margin or collateral calls because of a lack of liquid assets. Thus it is funding liquidity that is idiosyncratic. Market liquidity risk often leads to funding liquidity risks materializing as firms are unable to get to the funds they were relying upon due to assets becoming illiquid.
NEW QUESTION 61
Which of the following are valid approaches to calculating potential future exposure (PFE) for counterparty risk:
I. Add a percentage of the notional to the mark-to-market value
II. Monte Carlo simulation
III. Maximum Likelihood Estimation
IV. Parametric Estimation
- A. I, III and IV
- B. I and II
- C. All of the able
- D. III and IV
Answer: B
Explanation:
Explanation
When a derivative position is entered into, its mark-to-market value is generally close to zero (though the notional may be high). With the passage of time, the derivative's value fluctuates in an unpredictable way, creating a counterparty exposure that may be difficult to estimate and risk manage. Counterparty risk in such cases is estimated based on Potential Future Exposure, which may be calculated using either:
a) Take the mark-to-market at present, and add a certain percentage of the notional, or b) Perform a Monte Carlo simulation, capturing the stochastic nature of the PFE.
Therefore I and II are valid choices. MLE and parametric estimation are not methods for calculating PFE.
NEW QUESTION 62
Which of the following is not a limitation of the univariate Gaussian model to capture the codependence structure between risk factros used for VaR calculations?
- A. The univariate Gaussian model fails to fit to the empirical distributions of risk factors, notably their fat tails and skewness.
- B. Determining the covariance matrix becomes an extremely difficult task as the number of risk factors increases.
- C. It cannot capture linear relationships between risk factors.
- D. A single covariance matrix is insufficient to describe the fine codependence structure among risk factors as non-linear dependencies or tail correlations are not captured.
Answer: C
Explanation:
Explanation
In the univariate Gaussian model, each risk factor is modeled separately independent of the others, and the dependence between the risk factors is captured by the covariance matrix (or its equivalent combination of the correlation matrix and the variance matrix). Risk factors could include interest rates of different tenors, different equity market levels etc.
While this is a simple enough model, it has a number of limitations.
First, it fails to fit to the empirical distributions of risk factors, notably their fat tails and skewness. Second, a single covariance matrix is insufficient to describe the fine codependence structure among risk factors as non-linear dependencies or tail correlations are not captured. Third, determining the covariance matrix becomes an extremely difficult task as the number of risk factors increases. The number of covariances increases by the square of the number of variables.
But an inability to capture linear relationships between the factors is not one of the limitations of the univariate Gaussian approach - in fact it is able to do that quite nicely with covariances.
A way to address these limitations is to consider joint distributions of the risk factors that capture the dynamic relationships between the risk factors, and that correlation is not a static number across an entire range of outcomes, but the risk factors can behave differently with each other at different intersection points.
NEW QUESTION 63
long bond position is hedged using a short position in the futures market. If the hedge performs as expected, then which of the following statements is most accurate:
- A. the investor will be able to avoid losses but will also forgo the gains on his positions
- B. None of the above
- C. the investor will be able to avoid losses and will also be able to keep the gains on his positions
- D. the investor will be able to avoid losses
Answer: A
Explanation:
Explanation
If the hedge performs as expected, then any P&L on the long bond position will be offset by identical losses (or gains) on the hedge.
Since hedges are never perfect, and some residual risk such as basis risk, the inability to enter into an unrounded number of futures contracts will remain. However, the bulk of the risk would be mitigated, and the investor will be able to avoid any losses but will also forgo any gains. Therefore choice b is the correct answer and the rest are incorrect.
NEW QUESTION 64
There are three bonds in a diversified bond portfolio, whose default probabilities are independent of each other and equal to 1%, 2% and 3% respectively over a 1 year time horizon. Calculate the probability that exactly 1 of the three bonds will default.
- A. 5.8%
- B. .011%
- C. 2%
- D. 0%
Answer: A
Explanation:
Explanation
The probability that only one of the three bonds will default is equal to the sum of the probabilities of the three scenarios where one bond defaults and the other two survive. This probability is given by 1%*(1 - 2%)*(1 -
3%) + (1 - 1%)*2%*(1 - 3%) + (1 - 1%)*(1 - 2%)*3% = 5.7818%. Choice 'c' is the correct answer.
NEW QUESTION 65
Which of the following represents a riskier exposure for a bank: A LIBOR based loan, or an Overnight Indexed Swap? Which of the two rates is expected to be higher?
Assume the same counterparty and the same notional.
- A. A LIBOR based loan; OIS rate will be higher
- B. Overnight Index Swap; LIBOR rate will be higher
- C. A LIBOR based loan; LIBOR rate will be higher
- D. Overnight Index Swap; OIS rate will be higher
Answer: C
Explanation:
Explanation
A LIBOR based loan requires cash to move from the lender to the borrower in the amount of the notional. The Overnight Index Swap requires only the exchange of interest payments, and therefore represents less risk.
Therefore the LIBOR based loan is a riskier exposure.
The LIBOR is generally higher than the OIS. In fact, the difference between the two, the LIBOR-OIS spread, is a standard measure of the risk premium in the market that goes up when the risk of default by counterparty banks is considered high. This is because when the market perceives the risk of default to be high, the participants need a risk premium to take on the default risk which is considerably lesser with the OIS.
NEW QUESTION 66
Which of the following is true in relation to a Contingency Funding Plan (CFP)?
I. A CFP is like a disaster recovery plan to deal with a liquidity crisis II. A CFP should consider market stress conditions, but failures of payment systems are not relevant as they fall under the remit of operational risk III. Reputational damage may result if the market finds out that a firm has had to execute its CFP IV. Sources of emergency funding considered in the CFP should include the role of the central bank as the lender of last resort
- A. II and IV
- B. IV
- C. I, II and III
- D. I and III
Answer: D
Explanation:
Explanation
A CFP is indeed a disaster recovery plan to deal with a liquidity crisis. Therefore statement I is correct.
A CFP should consider market stress conditions, including wide scale failures of payment and settlement systems. Statement II is not correct.
It is true that reputational damage may result if a firm has to activate its CFP - therefore the plan should consider internal and external communications, the timing of information release and the groups within the firm who need to know about the implementation of the plan. Reputational damage can only make any existing liquidity problems worse. Statement III is correct.
Sources of emergency funding should not include funding from the central bank - unless as part of a regular lending facility. Its role as a lender of last resort can not be considered in a CFP. Statement IV is incorrect.
Therefore only statements I and III are correct.
NEW QUESTION 67
Which of the following data sources are expected to influence operational risk capital under the AMA:
I. Internal Loss Data (ILD)
II. External Loss Data (ELD)
III. Scenario Data (SD)
IV. Business Environment and Internal Control Factors (BEICF)
- A. All of the above
- B. III only
- C. I and II
- D. I, II and III only
Answer: A
Explanation:
Explanation
All four data sources are expected to be utilized as inputs as appropriate for operational risk calculations under the advanced measurement approach. Of these, the last one, BEICF, is slightly different from the rest as it does not yield data points that become the basis of curve fitting or other statistical computions underlying capital calculations. It includes items such as KRIs, risk assessments etc and allow the risk manager to assess the qualitative aspects of loss data.
NEW QUESTION 68
Which of the following distributions is generally not used for frequency modeling for operational risk
- A. Negative binomial
- B. Binomial
- C. Gamma
- D. Poisson
Answer: C
Explanation:
Explanation
Frequency modeling is performed using discrete distributions that have a positive integer as a resultant - this allows for the number of events per period of time to be modeled. Of the distributions listed above, Poisson, negative binomial and binomial can be used for modeling frequency distributions. The Poisson and negative binomial distributions are encountered the most in practice.
The gamma distribution is a continuous distribution and cannot be used for frequency modeling.
NEW QUESTION 69
A bullet bond and an amortizing loan are issued at the same time with the same maturity and with the same principal. Which of these would have a greater credit exposure halfway through their life?
- A. The amortizing loan
- B. Indeterminate with the given information
- C. They would have identical exposure half way through their lives
- D. The bullet bond
Answer: D
Explanation:
Explanation
A bullet bond is a bond that pays coupons covering interest during the life of the bond and the principal at maturity. An amortizing loan pays the interest as well as a part of the principal with every payment. Therefore, the exposure of the amortizing loan continually reduces, and approaches zero towards the end of its life. The bullet bond will always have a higher exposure at any time during its life when compared to an equivalent amortizing loan. Hence Choice 'd' is the correct answer.
NEW QUESTION 70
Which of the following best describes economic capital?
- A. Economic capital reflects the amount of capital required to maintain a firm's target credit rating
- B. Economic capital is a form of provision for market risk losses should adverse conditions arise
- C. Economic capital is the amount of regulatory capital mandated for financial institutions in the OECD countries
- D. Economic capital is the amount of regulatory capital that minimizes the cost of capital for firm
Answer: A
Explanation:
Explanation
Economic capital is often calculated with a view to maintaining the credit ratings for a firm. It is the capital available to absorb unexpected losses, and credit ratings are also based upon a certain probability of default.
Economic capital is often calculated at a level equal to the confidence required for the desired credit rating.
For example, if the probability of default for a AA rating is 0.02%, and the firm desires to hold an AA rating, then economic capital maintained at a confidence level of 99.98% would allow for such a rating. In this case, economic capital set at a 99.8% level can be thought of as the level of losses that would not be exceeded with a 99.8% probability, and would help get the firm its desired credit rating.
Choice 'c' is the correct answer. Economic capital does not target minimizing the cost of capital, nor is it a provision for losses arising from market risk. The concept of economic capital is unrelated to where an institution or firm is based, therefore Choice 'a' is incorrect as well.
NEW QUESTION 71
CreditRisk+, the actuarial model for calculating portfolio credit risk, is based upon:
- A. the normal distribution
- B. the Poisson distribution
- C. the exponential distribution
- D. the log-normal distribution
Answer: B
Explanation:
Explanation
CreditRisk+ treats default as a binary event, ignoring downgrade risk, capital structures of individual firms in the portfolio or the causes of default. It uses a single parameter, or the mean default rate, and derives credit risk based upon the Poisson distribution. Therefore Choice 'c' is the correct answer.
NEW QUESTION 72
Which of the following risks were not covered in detail in most stress tests prior to the current crisis:
I. The behavior of complex structured products under stressed liquidity conditions II. Pipeline or securitization risk III. Basis risk in relation to hedging strategies IV. Counterparty credit risk
V. Contingent risks
VI. Funding liquidity risk
- A. II, III and V
- B. All of the above
- C. I, II, III, IV and VI
- D. I, IV and VI
Answer: B
Explanation:
Explanation
The BCBS publication 'Principles for sound stress testing practices and supervision' (May 2009) identifies all of the above as risks that were covered in insufficient detail in most stress tests prior to the current crisis.
Therefore Choice 'd' is the correct answer.
For the PRM exam, you should have read this document. You should also be familiar with all the above risk types as being contributors to the crisis, and know what each of these mean.
NEW QUESTION 73
Which of the following statements are true with respect to stress testing:
I. Stress testing results in a dollar estimate of losses
II. The results of stress testing can replace VaR as a measure of risk as they are better grounded in reality III. Stress testing provides an estimate of losses at a desired level of confidence IV. Stress testing based on factor shocks can allow modeling extreme events that have not occurred in the past
- A. II and III
- B. I, II and IV
- C. II, III and IV
- D. I and IV
Answer: D
Explanation:
Explanation
Any stress test is conducted with a view to produce a dollar estimate of losses, therefore statement I is correct.
However, these numbers do not come with any probabilities or confidence levels, unlike VaR, and statement III is incorrect. Stress testing can complement VaR, but not replace it, therefore statement II is not correct.
Statement IV is correct as stress tests can be based on both actual historical events, or simulated factor shocks (eg, a factor, such as interest rates, moves by say 10-z).
Therefore Choice 'a' is correct.
NEW QUESTION 74
The definition of operational risk per Basel II includes which of the following:
I. Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events II. Legal risk III. Strategic risk IV. Reputational risk
- A. II and III
- B. I and II
- C. I and III
- D. I, II, III and IV
Answer: B
Explanation:
Explanation
Operational risk as defined in Basel II specifically excludes strategic and reputational risk. Therefore Choice
'd' is the correct answer.
Note that Basel II defines operational risk as follows:
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.
NEW QUESTION 75
Which of the following represent the parameters that define a VaR estimate?
- A. confidence level and the underlying stochastic process
- B. confidence level and the holding period
- C. trading position and distribution assumption
- D. confidence level, the holding period and expected volatility
Answer: B
Explanation:
Explanation
VaR is specified by just two parameters - the holding period, and the confidence level. We speak of, for example, a 10-day VaR at the 95% confidence level. No other parameters are required. Therefore Choice 'd' is the correct answer and the others are incorrect.
NEW QUESTION 76
For a FX forward contract, what would be the worst time for a counterparty to default (in terms of the maximum likely credit exposure)
- A. Right after inception
- B. Roughly three-quarters of the way towards maturity
- C. At maturity
- D. Indeterminate from the given information
Answer: C
Explanation:
Explanation
With the passage of time, the range of possible values the FX contract can take increases. Therefore the maximum value of the contract, which is when the credit risk would be maximum, would be at maturity. (Note that this is different than an interest rate swap whose value at maturity approaches zero.) Therefore Choice 'a' is the correct answer and the others are incorrect.
NEW QUESTION 77
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