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NEW QUESTION 195
Which of the following techniques is used to generate multivariate normal random numbers that are correlated?
- A. Cholesky decomposition of the correlation matrix
- B. Simulation
- C. Pseudo random number generator
- D. Markov process
Answer: A
Explanation:
Explanation
A PRNG (pseudo random 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 196
When combining separate bottom up estimates of market, credit and operational risk measures, a most conservative economic capital estimate results from which of the following assumptions:
- A. Assuming that market, credit and operational risk estimates are perfectly negatively correlated
- B. Assuming that market, credit and operational risk estimates are perfectly positively correlated
- C. Assuming that the resulting distributions have a correlation between 0 and 1
- D. Assuming that market, credit and operational risk estimates are uncorrelated
Answer: B
Explanation:
Explanation
If the risks are considered perfectly positively correlated, ie assumed to have a correlation equal to 1, the standard deviations can simply be added together. This gives the most conservative estimate of combined risk for capital calculation purposes. In practice, this is the assumption used most often.
If risks are uncorrelated, ie correlation is assumed to be zero, variances can be added or the standard deviation is the root of the sum of the squares of the individual standard deviations. This obviously gives a number lower than that given when correlation is assumed to be +1.
Similarly, assumptions of negative correlation, or any correlation other than +1 will give a standard deviation number that is smaller and therefore less conservative. Choice 'b' is the correct answer.
NEW QUESTION 197
Which of the following is a valid approach to determining the magnitude of a shock for a given risk factor as part of a historical stress testing exercise?
I. Determine the maximum peak-to-trough change in the risk factor over the defined period of the historical event II. Determine the minimum peak-to-trough change in the risk factor over the defined period of the historical event III. Determine the total change in the risk factor between the start date and the finish date of the event regardless of peaks and troughs in between IV. Determine the maximum single day change in the risk factor and multiply by the number of days covered by the stress event
- A. IV only
- B. I and III
- C. II and IV
- D. I, II and IV
Answer: B
Explanation:
Explanation
Stress events rarely play out in a well defined period of time, and looking back it is always difficult to put exact start and end dates on historical stress events. Even after that is done, the question arises as to what magnitude of a change in a particular risk factor (for example interest rates, spreads, or exchange rates) are reasonable to consider for the purposes of the stress test.
Statements I and III correctly identify the two approaches that are acceptable and used in practice - the risk manager can either take the maximum adverse move - from peak to trough - in the risk factor, or alternatively he or she could consider the change in the risk factor from the start of the event to the end as defined for the purposes of the stress test. Between the two, the approach mentioned in statement III is considered slightly superior as it produces more believable shocks.
Statement II is incorrect because we never want to consider the minimum, and statement IV is not correct as it is likely to generate a shock of a magnitude that is not plausible. Therefore Choice 'b' is the correct answer.
NEW QUESTION 198
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. 4.50%
- C. Cannot be determined from the given information
- D. 8.50%
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 199
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. 12.5%
- D. 150%
Answer: A
Explanation:
Explanation
The capital adequacy ratio, also called the minimum capital requirement for credit risk per Basel II is 8% of risk weighted assets. The other choices are incorrect.
NEW QUESTION 200
Which of the following statements is correct in relation to liquidity risk management?
I. Pricing for products that do not impact the balance sheet need not reflect the cost of maintaining liquidity II. Time horizons for liquidity risk management are impacted by both regulatory requirements and the speed at which new sources of liquidity can be tapped III. Collateral management is an important aspect of liquidity risk management IV. The maturity period of various instruments in the capital structure has a significant impact on liquidity needs
- A. I and II
- B. II and III
- C. III and IV
- D. II, III and IV
Answer: D
Explanation:
Explanation
All product pricing should reflect the cost of maintaining the liquidity required to support a product. This is regardless of the accounting treatment for the product, ie irrespective of whether the product is on or off balance sheet. Therefore statement I is incorrect.
The time horizon to consider for liquidity risk management is determined taking into account a number of factors, which include both the speed at which new sources of liquidity can be generated and any applicable regulatory requirements. Statement II is correct.
Managing collateral, both collateral received and collateral posted with counterparties, is an important aspect of liquidity risk management as liquidity problems often manifest themselves in the form of margin calls requiring collateral to be posted. Statement III is therefore correct.
The maturity period of the different sources of capital funding for a bank, for example equity capital, preferred shares, long term debt etc quite clearly has a significant impact on liquidity needs. Stable sources of funds such as equity or preferred capital, or debt that is not maturing shortly help the liquidity position. Statement IV is therefore correct.
Choice 'b' is the correct answer.
NEW QUESTION 201
Which of the following assumptions underlie the 'square root of time' rule used for computing VaR estimates over different time horizons?
I. the portfolio is static from day to day
II. asset returns are independent and identically distributed (i.i.d.)
III. volatility is constant over time
IV. no serial correlation in the forward projection of volatility
V. negative serial correlations exist in the time series of returns
VI. returns data display volatility clustering
- A. I and II
- B. III, IV, V and VI
- C. I, II, V and VI
- D. I, II, III and IV
Answer: D
Explanation:
Explanation
The square root of time rule can be used to convert, say a 1-day VaR to a 10-day VaR, by multiplying the known number by the square root of time to get the VaR over a different time horizon. However, there are key assumptions that underlie the application of this rule, and statements I to IV correctly state those assumptions.
Statements V and VI are not correct, because the application of the square root of time rule requires the absence of serial correlations, and also the absence of volatility clustering (ie independence). Therefore Choice
'c' is the correct answer.
The square root of time rule is also applied to convert volatility or standard deviation for one period to the volatility for a different time period. Remember that VaR is just a multiple of volatility, and therefore the assumptions that apply to the square root of time rule for VaR also apply to the same rule when used in the context of volatilities or standard deviation.
NEW QUESTION 202
A cumulative accuracy plot:
- A. measures rating accuracy
- B. measures accuracy of default probabilities observed empirically
- C. measures the accuracy of credit risk estimates
- D. is a measure of the correctness of VaR calculations
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 203
Which of the following are considered counterparty based credit enhancements?
I. Collateral
II. Credit default swaps
III. Close out netting arrangements
IV. Guarantees
- A. I, II and IV
- B. I and III
- C. II and IV
- D. I and IV
Answer: C
Explanation:
Explanation
Credit enhancements come in two varieties: counterparty based, where the exercise of the credit enhancement requires a third party to pay, and this includes guarantees and CDS contracts. Asset based credit enhancements are based upon a physical asset in possession, and these include collateral and balances owed on other trades or transactions, and availed through close out netting arrangements.
Of the listed choices, I and III are asset based credit enhancements, and II and IV are third party based.
NEW QUESTION 204
Which of the following credit risk models relies upon the analysis of credit rating migrations to assess credit risk?
- A. KMV's EDF based approach
- B. The CreditMetrics approach
- C. The contingent claims approach
- D. The actuarial approach
Answer: B
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 205
Which of the following statements is true:
I. Recovery rate assumptions can be easily made fairly accurately given past data available from credit rating agencies.
II. Recovery rate assumptions are difficult to make given the effect of the business cycle, nature of the industry and multiple other factors difficult to model.
III. The standard deviation of observed recovery rates is generally very high, making any estimate likely to differ significantly from realized recovery rates.
IV. Estimation errors for recovery rates are not a concern as they are not directionally biased and will cancel each other out over time.
- A. II and IV
- B. I, II and IV
- C. III and IV
- D. II and III
Answer: D
Explanation:
Explanation
Recovery rates vary a great deal from year to year, and are difficult to predict. Therefore statement III is true.
Similarly, any attempt to predict these is hamstrung by a high standard error, which can be as high as the historical mean itself. The error does not cancel itself out due to the effect of the business cycle making the error directionally biased. Thus statement IV is false.
Statement II is true as these are all factors that make forecasting recovery rates for any credit risk model rather difficult. Statement I is false because recovery rates are difficult to predict and assumptions are not easy to make.
NEW QUESTION 206
Under the contingent claims approach to credit risk, risk increases when:
I. Volatility of the firm's assets increases
II. Risk free rate increases
III. Maturity of the debt increases
- A. I and II
- B. I and III
- C. II and III
- D. I, II and III
Answer: B
Explanation:
Explanation
Under the contingent claims approach, credit risk is evaluated as the value of the put on the firm's assets with a strike price equal to the face value of the debt and maturity equal to the maturity of the obligation. The Black Scholes model can then be used to value the put, and therefore an increase in volatility and the time to expiry (ie maturity) will increase the value of the debt. An increase in the risk free rate will actually reduce the value of the put, therefore statements I and III are correct and Choice 'b' is the correct answer.
NEW QUESTION 207
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. I and II
- B. All of the above
- C. III only
- D. I, II and III only
Answer: B
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 208
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 209
Which of the following belong in a credit risk report?
- A. All of the above
- B. Exposures by industry
- C. Largest exposures by counterparty
- D. Exposures by country
Answer: A
Explanation:
Explanation
All the listed variables are relevant to management monitoring the credit risk profile of an institution, therefore Choice 'd' is the correct answer.
NEW QUESTION 210
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 bullet bond
- B. They would have identical exposure half way through their lives
- C. Indeterminate with the given information
- D. The amortizing loan
Answer: A
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 211
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