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NEW QUESTION # 39
Which of the following is not a credit event under ISDA definitions?
- A. Rating downgrade
- B. Obligation accelerations
- C. Failure to pay
- D. Restructuring
Answer: A
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 eventusually 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 # 40
According to the Basel II framework, subordinated term debt that was originally issued 4 years ago with amaturity of 6 years is considered a part of:
- A. Tier 3 capital
- B. Tier 1 capital
- C. None of the above
- D. Tier 2 capital
Answer: D
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 issued originally for 5 years or longer.
Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority. This only includes short term subordinated debt originally issued for 2 or more years.
An interesting thing to note is the difference between 'subordinated term debt' under Tier 2 and the 'short term subordinated debt' under Tier 3. The distinction is based upon the years to maturity at the time the debt was issued. The remaining time to maturity is not relevant. For the subordinated term debt included under Tier 2, the amount that can be counted towards capital is reduced by 20% for every year when the debt is due within 5 years. This takes care of the time to maturity problem for Tier 2subordinated debt. For Tier 3 short term subordinated debt, this is not an issue because debt will only qualify for Tier 3 if it has a lock-in clause stipulating that the debt is not required to be repaid if the effect of such repayment is to take the bank below minimum capital requirements.
NEW QUESTION # 41
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 # 42
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. III
- B. II
- C. I and II
- D. I
Answer: C
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 # 43
The capital adequacy ratio applied to risk weighted assets for the calculation of capital requirements for credit risk per Basel II is:
- A. 8%
- B. 100%
- C. 150%
- D. 12.5%
Answer: A
Explanation:
Explanation
The capital adequacy ratio, also called the minimum capital requirement for credit risk per Basel II is 8% of riskweighted assets. The other choices are incorrect.
NEW QUESTION # 44
Which of the following techniques is used to generate multivariate normal random numbers that are correlated?
- A. Simulation
- B. Pseudo random number generator
- C. Cholesky decomposition of the correlation matrix
- D. Markov process
Answer: C
Explanation:
Explanation
A PRNG (pseudorandom number generators of the kind included in statistical packages and Excel) is used to generate random numbers that are not correlated with each other, ie they are random. A Markov process is a stochastic model that depends only upon its current state. Simulation underlies many financial calculations.
None of these directly relate to generating correlated multivariate normal random numbers. That job is done utilizing a Cholesky decomposition of the correlation matrix.
Specifically, a Cholesky decomposition involves the factorization of the correlation matrix into a lower triangular matrix (a square matrix all of whose entries above the diagonal are zero) and its transpose. This can then be combined with random numbers to generate a set of correlated normal random numbers. This technique is used for calculating Monte Carlo VaR.
NEW QUESTION # 45
For creditrisk calculations, correlation between the asset values of two issuers is often proxied with:
- A. Transition probabilities
- B. Default correlations
- C. Equity correlations
- D. Credit migration matrices
Answer: C
Explanation:
Explanation
Asset returns are relevant for credit risk models where a default is related to the value of the assets of the firm falling below the default threshold. When assessing credit risk for portfolios with multiple credit assets, it becomes necessary to know the asset correlations of the different firms. Since this data is rarely available, it is very common to approximate asset correlations using equity prices. Equity correlations are used as proxies for asset correlation, therefore Choice 'c' is the correct answer.
NEW QUESTION # 46
An error by a third party service provider results in a loss to a client that the bank has to make up. Such as loss would be categorized per Basel IIoperational risk categories as:
- A. Execution delivery and process management
- B. Business disruption and process failure
- C. Outsourcing loss
- D. Abnormal loss
Answer: A
Explanation:
Explanation
Choice 'a' 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 # 47
Which of the following is not one of the 'three pillars' specified in the Basel accord:
- A. Supervisory review
- B. National regulation
- C. Market discipline
- D. Minimum capital requirements
Answer: B
Explanation:
Explanation
The three pillars are minimum capital requirements, supervisory review and market discipline. National regulation is not a pillar described under the accord. Choice 'c' is the correct answer.
NEW QUESTION # 48
Which of the following credit risk models considers debt as including a put option on the firm's assets toassess credit risk?
- A. The actuarial approach
- B. CreditPortfolio View
- C. The CreditMetrics approach
- D. The contingent claims approach
Answer: D
Explanation:
Explanation
The correct answer is Choice 'c'. 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 # 49
The CDS rate on a defaultable bond is approximated by which of the following expressions:
- A. Credit spread x Loss given default
- B. Loss given default x Default hazard rate
- C. Hazard rate x Recovery rate
- D. Hazard rate / (1 - Recovery rate)
Answer: B
Explanation:
Explanation
The CDS rate is approximated by the [Loss given default x Default hazard rate]. Thus Choice 'b' is the correctanswer.
Note that this is also equal to the credit spread on the reference bond over the risk free rate. Therefore credit spreads and CDS rates are generally the same. Also, 'loss given default' is nothing but (1 - Recovery rate). This can besubstituted in the formula for the credit spread to get an alternative expression that directly refers to the recovery rate. Therefore all other choices are incorrect.
NEW QUESTION # 50
Which of the following is not a parameter to be determined by the risk manager that affects the level of economic credit capital:
- A. Probability of default
- B. Confidence level
- C. Definition of credit losses
- D. Risk horizon
Answer: A
Explanation:
Explanation
Three parameters define economic credit capital: the risk horizon, ie the time horizon over which the risk is being assessed; the confidence level, ie the quintile of the loss distribution; and the definition of credit losses, ie whether mark-to-market losses are considered in addition to default-only losses. The probability of default is not a parameter within the control of the risk manager, but an input into the capital calculation process that he has to estimate. Therefore Choice 'c' is the correct answer.
NEW QUESTION # 51
For a bank using the advanced measurement approach to measuring operational risk, which of the following brings the greatest 'model risk' to its estimates:
- A. Insufficient number of simulations when building the loss distribution
- B. Choice of incorrect parameters for loss severity distributions
- C. Aggregation risk, from selecting an incorrect value of estimated correlations between different operational risk estimates
- D. Choice of an incorrect distribution for loss event frequencies
Answer: C
Explanation:
Explanation
The greatest model risk when calculating operational risk capital comes fromincorrect assumptions about correlations between different operational risks for which standalone risk calculations have been made.
Generally, the correlation can be expected to be positive, and would therefore vary between 0 and 1. These two values determine the 'bounds' between which the total operational risk capital would lie, and these bounds are generally quite far apart. Therefore the total value of the operational risk capital is very sensitive to the value chosen for the correlation, and this is the source of the biggest model risk under the AMA.
NEW QUESTION # 52
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. I, II and IV
- B. II and IV
- C. I and III
- D. III and IV
Answer: C
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 # 53
Which of the following statements are true ?
I.Risk governance structures distribute rights and responsibilities among stakeholders in the corporation II. Cybernetics is the multidisciplinary study of cyber risk and control systems underlying information systems in an organization III. Corporate governance is a subset of the larger subject of risk governance IV. The Cadbury report was issued in the early 90s and was one of the early frameworks for corporate governance
- A. I, II and IV
- B. I and IV
- C. II and III
- D. All of the above
Answer: B
Explanation:
Explanation
Governance structures specify the policies, principles and procedures for making decisions about corporate direction. They distribute rights and responsibiliies among stakeholders that typically include executive management, employees, the board etc. Statement I is therefore correct.
"Cybernetics is a transdisciplinary approach for exploring regulatory systems, their structures, constraints, and possibilities. In the 21st century, the term is often used in a rather loose way to imply "controlof any system using technology" (Wikipedia). Governance literature has been affected by cybernetics, which is not the same thing as information security or cyber security. Statement II is incorrect.
Corporate governance includes risk governance, and not the other way round. Therefore statement III is incorrect.
The Cadbury Report, titled Financial Aspects of Corporate Governance, was a report issued in the UK in December 1992 by "The Committee on the Financial Aspects of Corporate Governance". The report is eponymous with the chair of the committee, and set out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures. Statement IV is therefore correct.
NEW QUESTION # 54
The difference between true severity and the best approximation of the true severity is called:
- A. Approximation error
- B. Estimation error
- C. Total error
- D. Fitting error
Answer: A
Explanation:
Explanation
This question relates to fitting a distribution to the true severity of the operational risk loss we are trying to model. The quality of the fit, or the precision of the fit, has two elements to the difference between the severity as represented by our model and the true severity. To understand this, consider the three data points below:
a. The true severity,
b. The best approximation of the true severity in the model space, and
c. The fit based on the dataset.
- True severity is what we are trying to model.
- The model space refers to the collection of analytical distributions (log-normal, burr etc) that we are considering to arrive at the estimate of the severity.
- The 'best approximation of the true severity in the model space' is reached byestimating the parameters of the distribution that optimizes the risk functional.
- The 'fit' is the actual parameter estimates we settle for with the distribution we have determined best fits the true estimate of our severity. When estimating parameters,we have various methods available for estimation - the least squares method, the maximum likelihood method, for example, and we can get different estimates depending upon the method we choose to use.
Our severity model will be different from the true severity, and the total difference can be split into two types of errors:
1. Fitting error, represented by 'c - b' above: The difference between the fit based on the dataset and the best approximation of the true severity is called 'fitting error', ie, a measure of the extent to which we could have estimated the parameters better.
2. Approximation error, represented by 'b - a' above: Approximation error is the difference between the true severity, and the best approximation of the true severity that can be achieved within the model space is called
'approximation error'.
One can reduce the approximation error by expanding the model space by adding more distributions. This will reduce the approximation error, but generally has the effect of increasing the fittingerror because the complexity of the model space increases, and there are more ways to fit to the true severity.
NEW QUESTION # 55
Which of the following are considered properties of a 'coherent' risk measure:
I. Monotonicity
II. Homogeneity
III. Translation Invariance
IV. Sub-additivity
- A. All of theabove
- B. I and III
- C. II and III
- D. II and IV
Answer: D
Explanation:
Explanation
All of the properties described are the properties of a 'coherent' risk measure.
Monotonicity means that if a portfolio's future value is expected to be greater than that of another portfolio, its risk should be lower than thatof the other portfolio. For example, if the expected return of an asset (or portfolio) is greater than that of another, the first asset must have a lower risk than the other. Another example:
between two options if the first has a strike price lower thanthe second, then the first option will always have a lower risk if all other parameters are the same. VaR satisfies this property.
Homogeneity is easiest explained by an example: if you double the size of a portfolio, the risk doubles. The linear scaling property of a risk measure is called homogeneity. VaR satisfies this property.
Translation invariance means adding riskless assets to a portfolio reduces total risk. So if cash (which has zero standard deviation and zero correlation with other assets) is added to a portfolio, the risk goes down. A risk measure should satisfy this property, and VaR does.
Sub-additivity means that the total risk for a portfolio should be less than the sum of its parts. This is a property that VaR satisfies most of thetime, but not always. As an example, VaR may not be sub-additive for portfolios that have assets with discontinuous payoffs close to the VaR cutoff quantile.
NEW QUESTION # 56
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