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NEW QUESTION 104
If the 1-day VaR of a portfolio is $25m, what is the 10-day VaR for the portfolio?
- A. $250m
- B. $7.906m
$79.06m - C. Cannot be determined without the confidence level being specified
Answer: A
Explanation:
Explanation
The 10-day VaR is = $25m x SQRT(10) = $79.06m. Choice 'b' is the correct answer.
NEW QUESTION 105
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. It cannot capture linear relationships between risk factors.
- B. The univariate Gaussian model fails to fit to the empirical distributions of risk factors, notably their fat tails and skewness.
- C. 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.
- D. Determining the covariance matrix becomes an extremely difficult task as the number of risk factors increases.
Answer: A
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 106
Under the standardized approach to calculating operational risk capital, how many business lines are a bank's activities divided into per Basel II?
- A. 0
- B. 1
- C. 2
- D. 3
Answer: A
Explanation:
Explanation
In the Standardized Approach, banks' activities are divided into eight business lines: corporate finance, trading
& sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Therefore Choice 'c' is the correct answer.
NEW QUESTION 107
There are two bonds in a portfolio, each with a market value of $50m. The probability of default of the two bonds are 0.03 and 0.08 respectively, over a one year horizon. If the default correlation is 25%, what is the one year expected loss on this portfolio?
- A. $5.26m
- B. $5.5mc
- C. $11m
- D. $1.38m
Answer: B
Explanation:
Explanation
We will need to calculate the joint probability distribution of the portfolio as follows.Probability of the joint default of both A and B =
The marginal probabilities (ie the standalone probabilities of default of the two bonds) are known, and if we can calculate the probability of joint defaults of the two bonds, we can calculate the rest of the entries. We then multiply the probabilities with the expected loss under each scenario and add them up to get the total expected loss.
The calculations are shown below. The expected loss is $5.5m, and therefore the correct answer is Choice 'd'.
NEW QUESTION 108
Which of the following steps are required for computing the aggregate distribution for a UoM for operational risk once loss frequency and severity curves have been estimated:
I. Simulate number of losses based on the frequency distribution
II. Simulate the dollar value of the losses from the severity distribution III. Simulate random number from the copula used to model dependence between the UoMs IV. Compute dependent losses from aggregate distribution curves
- A. I and II
- B. III and IV
- C. All of the above
- D. None of the above
Answer: A
Explanation:
Explanation
A recap would be in order here: calculating operational risk capital is a multi-step process.
First, we fit curves to estimate the parameters to our chosen distribution types for frequency (eg, Poisson), and severity (eg, lognormal). Note that these curves are fitted at the UoM level - which is the lowest level of granularity at which modeling is carried out. Since there are many UoMs, there are are many frequency and severity distributions. However what we are interested in is the loss distribution for the entire bank from which the 99.9th percentile loss can be calculated. From the multiple frequency and severity distributions we have calculated, this becomes a two step process:
- Step 1: Calculate the aggregate loss distribution for each UoM. Each loss distribution is based upon and underlying frequency and severity distribution.
- Step 2: Combine the multiple loss distributions after considering the dependence between the different UoMs. The 'dependence' recognizes that the various UoMs are not completely independent, ie the loss distributions are not additive, and that there is a sort of diversification benefit in the sense that not all types of losses can occur at once and the joint probabilities of the different losses make the sum less than the sum of the parts.
Step 1 requires simulating a number, say n, of the number of losses that occur in a given year from a frequency distribution. Then n losses are picked from the severity distribution, and the total loss for the year is a summation of these losses. This becomes one data point. This process of simulating the number of losses and then identifying that number of losses is carried out a large number of times to get the aggregate loss distribution for a UoM.
Step 2 requires taking the different loss distributions from Step 1 and combining them considering the dependence between the events. The correlations between the losses are described by a 'copula', and combined together mathematically to get a single loss distribution for the entire bank. This allows the 99.9th percentile loss to be calculated.
NEW QUESTION 109
Which of the following does not affect the credit risk facing a lender institution?
- A. The state of the economy
- B. The applicability or otherwise of mark to market accounting to the institution
- C. The degree of geographical or sectoral concentration in the loan book
- D. Credit ratings of individual borrowers
Answer: B
Explanation:
Explanation
The state of the economy, credit quality of individual borrowers and concentration risk are all factors that affect the credit risk facing a lender. Mark to market accounting does not change the credit risk, or the underlying economic reality facing the institution. Therefore Choice 'b' is the correct answer.
NEW QUESTION 110
Which of the following are elements of 'group risk':
I. Market risk
II. Intra-group exposures
III. Reputational contagion
IV. Complex group structures
- A. I and IV
- B. I and II
- C. II and III
- D. II, III and IV
Answer: D
Explanation:
Explanation
The term 'group risk' has been defined in the FSA document 08/24 on stress testing as the risk that a firm may be adversely affected by an occurrence (financial or non-financial) in another group entity or an occurrence that affects ther group as a whole. These risks may occur through:
- reputational contagion,
- financial contagion,
- leveraging,
- double or multiple gearing,
- concentrations and large exposures (particularly intra-group).
Thus, the insurance sector may be considered a group, and a firm may suffer just because another group firm has had losses or reputational issues.
The FSA statement goes on to identify some elements of group risk as follows:
- intra-group exposures (credit or operational exposures through outsourcing or service arrangements, as well as more standard business exposures);
- concentration risks (from credit, market or insurance risks which could put a strain on capital resources across entities simultaneously);
- contagion (reputational damage, operational or financial pressures); and
- complex group structures (with dependencies, complex split of responsibilities and accountabilities).
Therefore Choice 'a' is the correct answer and the rest of the choices are incorrect.
NEW QUESTION 111
A bank holds $10m of a corporate debt that it has purchased CDS protection against. What is the impact on the short term liquidity of the bank in the event of a default by the corporate on its bonds?
- A. No impact
- B. Cannot be determined without information on recovery rates
- C. An immediate reduction in available liquidity
- D. A short term increase in available liquidity
Answer: D
Explanation:
Explanation
The immediate impact of the default would be to improve the liquidity available in the short term due to the pay out from the CDSs.
It is also important to consider the impact on liquidity from the occurence of a default even in situations where CDS protection may not have been purchased. In such cases, there may be a nearer term payout in the form of the recovery rate. Of course, recovery payments are generally not realized for longer periods of time as court cases linger on, but there is a good likelihood that a payment, albeit lower in total, is likely to be realized sooner than the maturity of the bond in cases where the bond is a longer term bond. At the same time, any interest payments, and the final principal payment, which may have been included in liquidity projections, will not occur.
NEW QUESTION 112
Which of the following cannot be used as an internal credit rating model to assess an individual borrower:
- A. Distance to default model
- B. Probit model
- C. Logit model
- D. Altman's Z-score
Answer: A
Explanation:
Explanation
Altman's Z-score, the Probit and the Logit models can all be used to assess the credit rating of an individual borrower. There is no such model as the 'distance to default model', and therefore Choice 'a' is the correct answer.
NEW QUESTION 113
Which of the following statements is true in relation to collateral management?
I. A collateral management system need not consider the failure by counterparties to return collateral when due II. The extent to which counterparties may have rehypothecated collateral is not a consideration for a collateral management system III. Cash is an acceptable substitute for any type of collateral required to be posted IV. Haircuts do not apply to treasury issued instruments posted as collateral
- A. II and III
- B. I, II and III
- C. None of the statements is true
- D. I, II, III and IV
Answer: C
Explanation:
Explanation
Strong management of collateral, both receivable and payable, is emerging as an area requiring significant investment by financial institutions and asset managers in IT infrastructures and business processes. A bank needs to make collateral calls daily, based upon the P&L of the previous day, and likewise receives collateral calls from its counterparties. Just like cash, a bank needs to make sure that it does not run out of collateral to post when a call is received. Interestingly, based upon the agreements between banks and their mutual understanding, only certain types of instruments often qualify as valid collateral - and in such cases even cash is not acceptable if the right type of bond or other agreed security is not available to post. The operational challenges of managing collateral increase manifold due to 'rehypothecation', ie when collateral received from one counterparty gets posted out as collateral where it is due. In such cases, the bank should have the mechanisms to receive the right assets back in a timely way in case rehypothecated assets are to be returned.
The systems should be able to deal with delays, failures without impacting the ability of the bank to post collateral as needed. All of this requires major investments in IT and processes.
Statement I is not true as a bank is bound to post collateral to third parties when needed regardless of the failure of its counterparties to post collateral to it when owed. In the markets, failures by counterparties can and do happen, and a collateral management system needs to account for and keep a buffer for the fact that some collateral when due will not be received.
Statement II is not true as rehypothecation by counterparties of collateral posted increases the chances of the collateral not being received in time. The system should consider the need for liquidity to generate assets that can be posted as collateral when others have failed to return the collateral in a timely way.
Statement III is not correct as cash may not be acceptable to counterparties as collateral. From a practical point of view, they may not have the infrastructure to receive and account for cash as collateral. A Swiss bank, for example, may have an 'account' to receive US t-bills as collateral but may not even have a US dollar account to receive cash. Even if it did, the volumes of transactions going back and forth may make tracking and reconciliations impossible. Thus a bank should always make sure that it has the right type of collateral available to post.
Statement IV is incorrect as well, as treasury issued instruments are also subject to haircuts. Their value also fluctuates in response to changes in yields, and therefore they are subject to haircuts as well.
Thus none of the statements are correct and Choice 'd' is the correct answer.
NEW QUESTION 114
Which of the following is not an approach used for stress testing:
- A. Hypothetical scenarios
- B. Historical scenarios
- C. Monte Carlo simulation
- D. Algorithmic approaches
Answer: C
Explanation:
Explanation
Choice 'c' is the correct answer as Monte Carlo simulations are not used to generate stress scenarios. They are applicable to VaR calculations under certain situations, and are not used for stress tests. The other three represent valid approaches to stress testing.
NEW QUESTION 115
Which of the following formulae correctly describes Component VaR. (p refers to the portfolio, and i is the i-th constituent of the portfolio. MVaR means Marginal VaR, and other symbols have their usual meanings.)
- A. I and II
- B. II
- C. III
- D. I
Answer: A
Explanation:
Explanation
The first two formulae describe component VaR. The last formula is the formula for Marginal VaR. Therefore I and II is the correct answer.
Component VaR is a VaR decomposition technique that allows the total VaR for a portfolio to be broken down and attributed to the components of a portfolio. The total of the component VaR for each constituent of a portfolio is equal to the VaR for the portfolio. This property is extremely useful as opposed to the standalone VaR for each constituent taken alone as it can be used for allocating trading budgets.
NEW QUESTION 116
Which of the formulae below describes incremental VaR where a new position 'm' is added to the portfolio?
(where p is the portfolio, 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 B
- C. Option D
- D. Option C
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 117
Which of the following statements is true in relation to a normal mixture distribution:
I. Normal mixtures represent one possible solution to the problem of volatility clustering II. A normal mixture VaR will always be greater than that under the assumption of normally distributed returns III. Normal mixtures can be applied to situations where a number of different market scenarios with different probabilities can be expected
- A. I and II
- B. II and III
- C. I, II and III
- D. III
Answer: D
Explanation:
Explanation
Normal mixtures address fat or heavy tails, not volatility clustering. Therefore statement I is not correct.
Statement II is not correct. Where VaR is calculated at low levels of confidence, VaR based on normal mixtures may be lower than that under a normal assumption. This is no different than for other fat tailed distributions.
Statement III is correct. In situations where multiple market scenarios can unfold with a given probability, and each scenario is normal, we can express the result with a normal mixture where the underlying normal distributions have the probabilities of the different scenarios.
NEW QUESTION 118
Which of the following is the most important problem to solve for fitting a severity distribution for operational risk capital:
- A. The fit obtained should reduce the combination of the fitting and approximation errors to a minimum
- B. Determine plausible scenarios to fill the data gaps in the internal and external loss data
- C. Empirical loss data needs to be extended to the ranges below the reporting threshold and above large value losses
- D. The risk functional's minimization should lead to a good estimate of the 0.999 quantile
Answer: D
Explanation:
Explanation
Ultimately, the objective of the operational risk severity estimation exercise is to calculate the 99.9th percentile loss over a one year horizon; and everything else we do with data, collecting loss information, modeling, curve fitting etc revolves around this objective. If we cannot estimate the 99.9th percentile loss accurately, then not much else matters. Therefore Choice 'a' is the correct answer.
Minimizing the combination of fitting and approximation errors is one of the things we do with a view to better estimating the operational loss distribution. Likewise, empirical loss data generally is range bound because corporations do not require employees to log losses less than an threshold, and high value losses are generally rare. This problem is addressed by extrapolating both large and small losses, something that impacts the performance of our model. Likewise, one of the objectives of scenario analysis is to fill data gaps by generating plausible scenarios. Yet while all these are real issues to address, the primary problem we are trying to solve is estimating the 0.999th quantile.
NEW QUESTION 119
Which of the following statements is true:
I. Basel II requires banks to conduct stress testing in respect of their credit exposures in addition to stress testing for market risk exposures II. Basel II requires pooled probabilities of default (and not individual PDs for each exposure) to be used for credit risk capital calculations
- A. II
- B. I
- C. I & II
- D. Neither statement is true
Answer: C
Explanation:
Explanation
The correct answer is choice 'b'
Both statements are accurate. Basel II requires pooled probabilities of default to be applied to risk buckets that contain similar exposures. Also, stress testing is mandatory for both market and credit risk.
NEW QUESTION 120
For the purposes of calculating VaR, an interest rate swap can be modeled as a combination of:
- A. a fixed coupon bond and a floating rate note
- B. two zero coupon bonds
- C. a zero coupon bond and an interest rate swap
- D. a fixed rate bond and a zero coupon bond
Answer: A
Explanation:
Explanation
In an interest rate swap, the parties agree to exchanging interest rate payments, with one party being a fixed interest rate payer and the other paying floating rates. The party receiving fixed rates and paying floating can be considered to be long a fixed rate bond and short a floating rate note. Therefore an IRS can be modeled as a combination of a fixed coupon bond and a floating rate note. Choice 'b' is the correct answer.
NEW QUESTION 121
The standalone economic capital estimates for the three uncorrelated business units of a bank are $100, $200 and $150 respectively. What is the combined economic capital for the bank?
- A. 0
- B. 1
- C. 2
- D. 3
Answer: B
Explanation:
Explanation
Since the business units are uncorrelated, we can get the combined EC as equal to the square root of the sum of the squares of the individual EC estimates. Therefore Choice 'a' is the correct answer.
[=SQRT(100^2+200^2+150^2)]
NEW QUESTION 122
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