Practice Exam · 2018. 1. 1. · The 2017 FRM Practice Exams do not necessarily cover all topics to...

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FRM® Part II

Practice Exam

FinancialRiskManagerExamination(FRM)PartIIPracticeExam

TableofContentsIntroductionto2017FRMPartIIPracticeExam..............................................................22017FRMPartIIPracticeExam–StatisticalReferenceTable.........................................42017FRMPartIIPracticeExam–SpecialInstructionsandDefinitions............................52017FRMPartIIPracticeExam–CandidateAnswerSheet............................................62017FRMPartIIPracticeExam–Questions...................................................................72017FRMPartIIPracticeExam–AnswerKey...............................................................412017FRMPartIIPracticeExam–Answers&Explanations...........................................42

VER11/18/16

IntroductionTheFRMExamisapractice-orientedexamination.Itsquestionsarederivedfromacombinationoftheory,assetforthinthecorereadings,and“real-world”workexperience.Candidatesareexpectedtounderstandriskmanagementconceptsandapproachesandhowtheywouldapplytoariskmanager’sday-to-dayactivities.TheFRMExamisalsoacomprehensiveexamination,testingariskprofessionalonanumberofriskmanagementconceptsandapproaches.Itisveryrarethatariskmanagerwillbefacedwithanissuethatcanimmediatelybeslottedintoonecategory.Intherealworld,ariskmanagermustbeabletoidentifyanynumberofrisk-relatedissuesandbeabletodealwiththemeffectively.The2017FRMPartIandPartIIPracticeExamshavebeendevelopedtoaidcandidatesintheirpreparationfortheFRMExaminMayandNovember2017.ThesePracticeExamsarebasedonasampleofquestionsfrompriorFRMExamsandaresuggestiveofthequestionsthatwillbeinthe2017FRMExam.The2017FRMPartIPracticeExamcontains100multiple-choicequestionsandthe2017FRMPartIIPracticeExamcontains80multiple-choicequestions,thesamenumberofquestionsthattheactual2017FRMExamPartIand2017FRMExamPartIIwillcontain.Assuch,thePracticeExamsweredesignedtoallowcandidatestocalibratetheirpreparednessbothintermsofmaterialandtime.The2017FRMPracticeExamsdonotnecessarilycoveralltopicstobetestedonthe2017FRMExamasanytestwillsamplefromtheuniverseoftestablepossibleknowledgepoints.However,thequestionsselectedforinclusioninthePracticeExamswerechosentobebroadlyreflectiveofthematerialassignedfor2017aswellastorepresentthestyleofquestionthattheFRMCommitteeconsidersappropriatebasedonassignedmaterial.Foracompletelistofcurrenttopics,corereadings,andkeylearningobjectivescandidatesshouldrefertothe2017FRMExamStudyGuideand2017FRMLearningObjectives.CorereadingswereselectedbytheFRMCommitteetoassistcandidatesintheirreviewofthesubjectscoveredbytheExam.QuestionsfortheFRMExamarederivedfromthecorereadings.ItisstronglysuggestedthatcandidatesstudythesereadingsindepthpriortosittingfortheExam.SuggestedUseofPracticeExamsTomaximizetheeffectivenessofthepracticeexams,candidatesareencouragedtofollowtheserecommendations:1. Planadateandtimetotakethepracticeexam.

Setdatesappropriatelytogivesufficientstudy/reviewtimeforthepracticeexampriortotheactualexam.

2. Simulatethetestenvironmentascloselyaspossible.• Takethepracticeexaminaquietplace.• Haveonlythepracticeexam,candidateanswersheet,calculator,andwritinginstruments(pencils,erasers)available.• Minimizepossibledistractionsfromotherpeople,cellphones,televisions,etc.;putawayanystudymaterialbefore

beginningthepracticeexam.• Allocate4hourstocompleteFRMPartIPracticeExamand4hourstocompleteFRMPartIIPracticeExamandkeep

trackofyourtime.TheactualFRMExamPartIandFRMExamPartIIare4hourseach.

• Completetheentireexamandanswerallquestions.Pointsareawardedforcorrectanswers.ThereisnopenaltyontheFRMExamforanincorrectanswer.

• FollowtheFRMcalculatorpolicy.Candidatesareonlyallowedtobringcertaintypesofcalculatorsintotheexamroom.TheonlycalculatorsauthorizedforuseontheFRMExamin2017arelistedbelow,therewillbenoexceptionstothispolicy.Youwillnotbeallowedintotheexamroomwithapersonalcalculatorotherthanthefollowing:TexasInstrumentsBAIIPlus(includingtheBAIIPlusProfessional),HewlettPackard12C(includingtheHP12CPlatinumandtheAnniversaryEdition),HewlettPackard10BII,HewlettPackard10BII+andHewlettPackard20B.

3. AftercompletingtheFRMPracticeExams

• Calculateyourscorebycomparingyouranswersheetwiththepracticeexamanswerkey.• UsethepracticeexamAnswersandExplanationstobetterunderstandthecorrectandincorrectanswersandto

identifytopicsthatrequireadditionalreview.Consultreferencedcorereadingstopreparefortheexam.• Remember:pass/failstatusfortheactualexamisbasedonthedistributionofscoresfromallcandidates,souseyour

scoresonlytogaugeyourownprogressandlevelofpreparedness.

SpecialInstructionsandDefinitions

1. Unlessotherwiseindicated,interestratesareassumedtobecontinuouslycompounded.

2. Unlessotherwiseindicated,optioncontractsareassumedtobeononeunitoftheunderlyingasset.

3. VaR=value-at-risk

4. ES=expectedshortfall

5. GARCH=generalizedauto-regressiveconditionalheteroskedasticity

6. EWMA=exponentiallyweightedmovingaverage

7. CAPM=capitalassetpricingmodel

8. LIBOR=Londoninterbankofferrate

9. OIS=overnightindexedswap

10. CDS=credit-default-swap(s)

11. CCP=centralcounterpartyorcentralclearingcounterparty

12. MBS=mortgage-backed-security(securities)

13. CDO=collateralizeddebtobligation(s)

14. ERM=enterpriseriskmanagement

15. RAROC=risk-adjustedreturnoncapital

16. bp(s)=basispoint(s)

17. TheCEO,CFO,CIO,andCROarethechiefexecutive,financial,investment,andriskofficers,respectively.

18. Thefollowingacronymsareusedforselectedcurrencies:

Acronym Currency Acronym Currency AUD Australian dollar INR Indian rupee CAD Canadian dollar JPY Japanese yen CNY Chinese yuan MXN Mexican peso EUR euro SGD Singapore dollar GBP British pound sterling USD US dollar

2017FRMPartIPracticeExam–CandidateAnswerSheet

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1. Aninvestmentbankwithanactivepositionincommodityfuturesisusingthepeaks-over-threshold(POT)methodologyforestimatingVaRandES.Thebank’sriskmanagershavesetathresholdlevelof3.00%toevaluateexcesslosses.Thechoiceofthethreshold,theyargue,issuitableandconsistentwiththefindingthat5.00%oftheobservationsareinexcessofthethresholdvalue.Theriskmanagershaveconcludedthattheposition’sVaRusingthePOTmeasureis4.45%at99%confidencelevel.TheVaRestimateincorporatesthefollowingassumptionsgeneratedfromthemanagers’empiricalanalysis:Parameter Symbol ValueLossthreshold u 3%Numberofobservations N 740Numberofobservationsthatexceedthreshold n 37Scale β 0.75Shape(tailindex) ε 0.22

GiventheVaRvalueandtheparameterassumptions,whichofthefollowingiscorrect?

A. IncreasingthevalueofthetailindexlowersboththeESandtheVaRB. IncreasingthelossthresholdlevelincreasesboththeESandtheVaRC. ThevalueofESis4.57%D. ThevalueofESis5.71%

2. Ariskmanagerisestimatingthemarketriskofaportfoliousingboththenormaldistributionandthelognormaldistributionassumptions.Themanagergathersthefollowingdataontheportfolio:• Annualmean:15%• Annualvolatility:35%• Currentportfoliovalue:EUR4,800,000• Tradingdaysinayear:252

Whichofthefollowingstatementsiscorrect?

A. Lognormal95%VaRislessthannormal95%VaRatthe1-dayholdingperiodby0.13%B. Lognormal95%VaRislessthannormal95%VaRatthe1-yearholdingperiodby7.91%C. Lognormal99%VaRislessthannormal99%VaRatthe1-dayholdingperiodby1.43%D. Lognormal99%VaRislessthannormal99%VaRatthe1-yearholdingperiodby13.86%

3. AriskteamataninvestmentbankusestheKMVmodeltoestimatethedistancetodefaultandexpecteddefaultfrequencyinevaluatingdefaultconditionsofbothpotentialandexistingclientfirms.OnesuchclientcurrentlyhastotalassetsvaluedatUSD20billion,assetvolatilityof28%perannum,short-termdebtofUSD7billion,andlong-termdebtofUSD6billion.Theexpectedreturnonthefirm’sassetsis5%peryearandtheriskfreerateis1%peryear.Thefirmdoesnotpayanydividends.Theratingscheduleata1-yearhorizonisshowninthetablebelow:ExpectedDefaultFrequency(EDF) RatingClass0.02%–0.04% AAA0.04%–0.10% AA/A0.10%–0.19% A/BBB+0.19%–0.40% BBB+/BBB-0.40%–0.72% BBB-/BB0.72%–1.01% BB/BB-

Whatisthesuggestedcreditratingofthefirmata1-yearhorizonusingtheratingscheduleprovided?

A. AA/AB. A/BBB+C. BBB+/BBB-D. BBB-/BB

4. Ariskmanageriscomparingtheuseofparametricandnon-parametricapproachesforcalculatingVaRandisconcernedaboutsomeofthecharacteristicspresentinthelossdata.Whichofthefollowingconditionswouldmakenon-parametricapproachesthefavoredmethodtouse?

A. ScarcityofhighmagnitudelosseventB. SkewnessinthedistributionC. UnusuallyhighvolatilityduringthedataperiodD. Unusuallylowvolatilityduringthedataperiod

5. LMTBankhasenteredintoa1-yearCDScontractwithanendowmentfund.Accordingtothecontract,LMTBankwillpaytheendowmentfund75%ofthefacevalueofabondissuedbyGTEChemicalCorporationimmediatelyafteradefaultbyGTEChemical.TopurchasethisCDS,theendowmentfundwillpayLMTBanktheCDSspread,whichisapercentageofthefacevalue,onceattheendoftheyear.LMTBankestimatesthattherisk-neutraldefaultprobabilityforGTEChemicalis6%peryear.Therisk-freerateis3%peryear.Assumingdefaultscanonlyoccurhalfwaythroughtheyearandthattheaccruedpremiumispaidimmediatelyafteradefault,whatistheestimatefortheCDSspread?

A. 457basispointsB. 471basispointsC. 468basispointsD. 628basispoints

6. Ariskanalystatamid-sizehedgefundisevaluatingthecreditriskofseveraltradepositions.Thehedgefundspecializesincorporatedebtandrunsastrategythatutilizesbothrelativevalueandlong-onlytradesusingCDSandbonds.OneofthenewtradesatthehedgefundisaBBB-ratedlongbondvaluedatJPY10billion.Someofthehedgefund’snewestclients,includingtheBBB-ratebondholders,arerestrictedfromwithdrawingtheirfundsforfouryears.Theanalystiscurrentlyevaluatingtheimpactofvariousdefaultscenariostoestimatefutureassetliquidity.TheanalysthasestimatedthatthemarginalprobabilityofdefaultoftheBBB-ratedbondis5%inYear1,8%inYear2,15%inYear3,and24%inYear4.Whatistheprobabilitythatthebondmakescouponpaymentsfor4yearsandthendefaultsattheendofYear4?

A. 7.6%B. 13.1%C. 17.8%D. 20.4%

7. MDMBankisseekingtoenhanceitsenterpriseriskmanagementfunction.Inordertoachievethatobjectivethebankintroducesanewdecision-makingprocessbasedoneconomiccapitalthatinvolvesassessingsourcesofriskacrossdifferentbusinessunitsandorganizationallevels.Whichofthefollowingstatementsregardingthecorrelationsbetweentheserisksiscorrect?

A. Correlationsbetweenbusinessunitsareonlyrelevantindecidingtotalfirm-wideeconomiccapitallevels

andarenotrelevantfordecisionsattheindividualbusinessunitorprojectlevel.B. Correlationsbetweenbroadrisktypessuchascredit,market,andoperationalriskaregenerallywell

understoodandareeasytoestimateattheindividualfirmlevel.C. Theintroductionofcorrelationsintofirm-wideriskevaluationwillresultinatotalVaRthat,ingeneral,is

greaterthanorequaltothesumofindividualbusinessunitVaRs.D. Theintroductionofcorrelationsintotheriskevaluationofabank’sloanbookwillresultintotalcredit

VaRthat,ingeneral,islessthanorequaltothesumofindividualloancreditVaRs.

8. ApensionfundhasreportedthatitsassetsandliabilitieswerevaluedatUSD840millionandUSD450million,respectively,atyear-end2015.Theassetswerefullyinvestedinequitiesandcommodities.Thefund’sliabilities,constitutedentirelybyfixed-incomeobligations,hadamodifieddurationof12years.In2016,theglobalslumpincommoditypricesaffectedthepensionfundassets,specificallycausingitsinvestmentinequitiesandcommoditiestolose30%oftheirmarketvalue.However,thesurprisingmonetarypolicyactionofthegovernmentthatledtotheincreaseininterestrateshadapositiveeffectontheperformanceoffixed-incomesecurities,causingyieldsonthefund’sliabilitiestoriseby2.3%.Whatwasthechangeinthepensionfund’ssurplusin2016?

A. USD-325.8millionB. USD-127.8millionC. USD262.2millionD. USD390.0million

9. AwealthmanagementfirmhasaportfolioconsistingofUSD48millioninvestedinUSequitiesandUSD35millioninvestedinemergingmarketsequities.The1-day95%VaRforeachindividualpositionisUSD1.2million.ThecorrelationbetweenthereturnsoftheUSequitiesandemergingmarketsequitiesis0.36.Whilerebalancingtheportfolio,themanagerinchargedecidestosellUSD8millionoftheUSequitiestobuyUSD8millionoftheemergingmarketsequities.Atthesametime,theCROofthefirmadvisestheportfoliomanagertochangetheriskmeasurefrom1-day95%VaRto10-day99%VaR.Assumingthatreturnsarenormallydistributedandthattherebalancingdoesnotaffectthevolatilityoftheindividualequitypositions,byhowmuchwilltheportfolioVaRincreaseduetothecombinedeffectofportfoliorebalancingandchangeinriskmeasure?A. USD6.870millionB. USD8.248millionC. USD11.270millionD. USD12.482million

10. TheboardofdirectorsatBankPQPisevaluatingaproposalbyseniormanagementtorestructuretheoperationsofthebank.Ofkeyconcernisthefutureofthebank’sconsumerlendingdivision,whichhasaloanportfolioamountingtoEUR180million.Thebankfundsthedivisionpredominantlyusingunstableretailandwholesaledeposits.Inanalyzingthecreditriskconditionofthedivision,managementdeterminesthattheprobabilityofdefaultis8%,thelossgivendefaultis70%,andtheexposureatdefaultis100%oftheloanexposure.TheCEOisarguingthattheriskcapitalthathasbeensetasidetosupportconsumerlending,inlinewiththebank’sstatedriskappetite,istoohighcomparedtotheperformanceoftheotherbusinessdivisions.Thebankappliesthesamehurdlerateandeffectivetaxrateacrossallbusinesslines,anda1-yearhorizontomeasureparameterswhosevaluesareshowninthetablebelow:Item ValueConsumerLendingDivision: Economiccapital EUR135.0millionReturnontheloanportfolio 14.0%Returnonriskcapital 3.0%Costofdebtcapital 6.0%Operatingdirectcosts EUR1.595millionTransfers EUR0.0million BankPQP: Hurdlerate 8.0%Equitymarketreturn 7.0%Risk-freerate 3.0%Equitybeta 1.05Effectivetaxrate 32.0%

Assumingearningscorrelationsbetweenthevariousdivisionsarethesameandthemainobjectiveofeachdivisionistoaddvalueforthebank’sshareholders,whichofthefollowingrecommendationsoftheboardiscorrect?

A. ClosedowntheconsumerlendingdivisionbecausetheadjustedRAROCislessthantherisk-freerateB. ClosedowntheconsumerlendingdivisionbecauseRAROCislessthanthehurdlerateC. KeeptheconsumerlendingdivisionbecausetheadjustedRAROCisgreaterthantherisk-freerateD. KeeptheconsumerlendingdivisionbecauseRAROCisgreaterthanthehurdlerate

11. Acreditmanagerwhoiswellversedinlessonslearnedfromthe2007–2009subprimemortgagecrisisintheUSisoverseeingthestructuredcreditbookofabankinordertoidentifypotentialfrictionsinthesecuritizationprocess.Whichofthefollowingisacorrectcombinationofapotentialfrictioninthesecuritizationprocessandanappropriatemechanismtomitigatethatfriction?

A. Frictionbetweentheassetmanagerandtheinvestor:Adverseselectionproblem.Thisproblemcanbemitigated

bytheassetmanagerchargingduediligencefeestotheinvestor.B. Frictionbetweenthearrangerandtheoriginator:Modelerrorproblem.Thisproblemcanbemitigatedbythe

arrangerprovidingacreditenhancementtothesecuritieswithitsownfunding.C. Frictionbetweentheinvestorandcreditratingagencies:Principal-agentconflict.Thisproblemcanbe

mitigatedbyrequiringcreditratingagenciestobepaidbyoriginatorsandnotbyinvestorsfortheirratingservices.

D. Frictionbetweentheservicerandthemortgagor:Moralhazardproblem.Thisproblemcanbemitigatedbyrequiringthemortgagortoescrowfundsforinsuranceandtaxpayments.

12. Ariskmanagerisbacktestingacompany’s1-day99.5%VaRmodelovera1-yearhorizonata95%confidencelevel.Assuming250daysinayear,what isthemaximumnumberofdaily lossesexceedingthe1-day99.5%VaRthat isacceptabletoconcludethatthemodeliscalibratedcorrectly?

A. 3B. 5C. 15D. 19

13. Aportfoliomanagerismappingafixed-incomeportfoliointoexposuresonselectedriskfactors.Themanagerisanalyzingthecomparablemechanicsandriskmeasurementoutputsofprincipalmapping,durationmapping,andcash-flowmappingthatcorrespondtotheaverageportfoliomaturity.Whichofthefollowingiscorrect?

A. Principalmappingconsiderscouponandprincipalpayments,andtheportfolioVaRusingprincipalmappingis

greaterthantheportfolioVaRusingcash-flowmapping.B. DurationmappingdoesnotconsiderintermediatecashflowsandtheportfolioVaRusingdurationmappingisless

thantheportfolioVaRusingprincipalmapping.C. Cash-flowmappingconsidersthetimingoftheredemptioncashflowpaymentsonly,andtheportfolioVaRusing

cashflowmappingislessthantheportfolioVaRusingdurationmapping.D. Cash-flowmappingconsidersthepresentvaluesofcashflowsgroupedintomaturitybuckets,andthe

undiversifiedportfolioVaRusingcash-flowmappingisgreaterthantheportfolioVaRusingprincipalmapping.

14. ACROofahedgefundisaskingtheriskteamtodevelopaterm-structuremodelthatisappropriateforfittinginterestratesforuseinthefund’soptionspricingpractice.Theriskteamisevaluatingamongseveralinterestratemodelswithtime-dependentdriftandtime-dependentvolatilityfunctions.Whichofthefollowingisacorrectdescriptionofthespecifiedmodel?

A. IntheHo-Leemodel,thedriftoftheinterestrateprocessispresumedtobeconstant.B. IntheHo-Leemodel,whentheshort-termrateisaboveitslong-runequilibriumvalue,thedriftispresumedtobe

negative.C. IntheCox-Ingersoll-Rossmodel,thebasis-pointvolatilityoftheshort-termrateispresumedtobeproportionalto

thesquarerootoftherate,andshort-termratescannotbenegative.D. IntheCox-Ingersoll-Rossmodel,thevolatilityoftheshort-termrateispresumedtodeclineexponentiallytoa

constantlevel.

15. AportfoliostrategistforahedgefundislookingtomitigatecounterpartycreditriskexposuretoLLG,anA-ratedfirm.CurrentlythehedgefundhasthefollowingderivativecontractswithfirmLLG:

Contract

ContractValue(SGD)X 20,000,000Y 40,000,000Z 16,000,000W 1,500,000

Giventheinformation,whatisthemostappropriatecreditriskmitigationtechniquethatthehedgefundshoulduseinthiscase?A. Implementanettingscheme.B. Usecredittriggers.C. SellcreditdefaultswapsonLLG.D. Increasecollateral.

16. Amid-sizedinvestmentbankconductsseveraltrades.Aspartofitsriskcontrol,ithasenteredintonettingagreementson8equitytradepositionswithanaveragecorrelationof0.28.Thefirmbelievesthatitcanimproveuponthediversificationbenefitofnettingbyajudiciouschoiceofnumberofexposureswithafavorablecorrelationcoefficient.Whichofthefollowingtradecombinationswouldincreasethefirm’sexpectednettingbenefitthemostfromthecurrentlevel?

TradeCombination NumberofPositions AverageCorrelationABC 4 0.25LMN 7 0.15PQR 13 –0.06TUV 15 –0.04

A. TradecombinationABCB. TradecombinationLMNC. TradecombinationPQRD. TradecombinationTUV

17. AportfoliomanagerisinterestedinacquiringStockGILaspartofanexistingportfolio.However,themanagerisconcernedaboutthelevelofliquidityriskandproceedstoestimateliquidityadjustedVaRforthestock.ThemanagerobservesaquoteforStockGILandreportsthatthemidpointofitscurrentbestbidandbestaskpricesisAUD66.StockGILhasanestimateddailyreturnvolatilityof0.27%andaveragebid-askspreadofAUD0.18.Usingtheconstantspreadapproachona30,000sharepositionandassumingthereturnsofStockGILarenormallydistributed,whatisthecorrectestimateforthestock’sliquidity-adjusted1-day99%VaR?

A. AUD2,700B. AUD5,400C. AUD12,400D. AUD15,100

18. Amanagerisevaluatingtherisksofaportfolioofstocks.Currently,theportfolioisvaluedatCNY136millionandcontainsCNY12millioninstockY.ThestandarddeviationofreturnsofstockYis18%annuallyandthatoftheoverallportfoliois23%annually.ThecorrelationofreturnsbetweenstockYandtheportfoliois0.42.Assumingtheriskanalystusesa1-year95%VaRandthatreturnsarenormallydistributed,howmuchisthecomponentVaRofstockY?

A. CNY0.817millionB. CNY1.492millionC. CNY2.110millionD. CNY3.553million

QUESTIONS19AND20REFERTOTHEFOLLOWINGINFORMATION

XYZ,asmallinvestmentmanagementfirm,specializesinstructuringsmallbusinessloansandsellingthegovernmentguaranteedportiontootherinstitutionalinvestorswhileretainingtheriskierportionsforhighnetworthinvestors.XYZfundsitsoperationsbyengaginginovernightrepurchaseagreements(repos)withthreefirms,butprimarilywithABC,afirmthatspecializesinpoolingfundsfromcommunitybanksandlocalgovernmentagenciesandinvestingtheminshort-term,high-quality,government-securedinvestments.Lastweek,XYZwasinformedbyABCthatitslinehadbeenfrozen.XYZlearnedthatABChadbeendefraudedbyRepoCo.,anotherrepoborrower,whohadprovidedfalsedocumentationofnon-existentcollateralofgovernment-guaranteedloans.ABCfearedarunbyitsinvestorsasnewsofthefraudspread.Thediagrambelowillustratesthepartiesinvolved:

19. TheuseofacentralclearinghousetohandlethetransactionsexecutedbetweenXYZ'smainfundingsource,ABCandABC'sclient,RepoCo.,wouldlikelyhaveresultedinareductionin:A. ABC'sfundingliquidityrisk.B. RepoCo.'sdefaultrisk.C. XYZ'slendingrisk.D. ABC'soperationalrisk.

20. ByusingaclearinghousetohandletherepotransactionsbetweenABCandRepoCo.,obligationsowedbetweenthe

twocouldhavebeennettedoncethefraudulentdocumentationwasdiscovered.Whichofthefollowingisthemostappropriatetypeofnettingtouseinthissituationandwhatwouldbealikelyadditionalimpactfromusingthisnetting?A. Paymentnettingwouldbeused,whichwouldreduceABC'scounterpartyrisk,butthisriskwouldbetransferredto

othercreditorsoutsidetheclearinghouse.B. Paymentnettingwouldbeused,whichwouldreduceRepoCo.'scounterpartyrisk,butABC'scounterpartyriskwould

beincreased.C. Closeoutnettingwouldbeused,whichwouldreduceABC'scounterpartyrisk,butthisriskwouldbetransferredto

othercreditorsoutsidetheclearinghouse.D. Closeoutnettingwouldbeused,whichwouldreduceRepoCo.'scounterpartyrisk,butABC'scounterpartyriskwould

beincreased.

21. Ariskanalystatafundmanagementcompanyisdiscussingwiththeriskteamthegapsinthecompany’sriskmeasurementsystem.Amongtheissuestheyhaveidentifiedistheunderstandingthatfailingtoanticipatecashflowneedsisoneofthemostseriouserrorsthatafirmcanmake.Addressingsuchaproblemdemandsthatagoodliquidity-at-risk(LaR)measurementsystembeanessentialpartofthebank'sriskmanagementframework.WhichofthefollowingstatementsconcerningLaRiscorrect?

A. Afirm'sLaRtendstodecreaseasitscreditqualitydeclines.B. Forahedgedportfolio,theLaRcandiffersignificantlyfromtheVaR.C. HedgingusingfutureshasthesameimpactonLaRashedgingusinglongoptionpositions.D. ReducingthebasisriskthroughhedgingdecreasesLaR.

22. Pillar1oftheBaselIIframeworkallowsbankstousevariousapproachestocalculatethecapitalrequirementsforcreditrisk,operationalrisk,andmarketrisk.WhichofthefollowingBaselIIapproachesallowsabanktoexplicitlyrecognizediversificationbenefits?

A. ThebasicindicatorapproachforoperationalriskB. TheinternalratingsbasedapproachforcreditriskC. TheinternalmodelsapproachformarketriskD. Thestandardizedapproachforoperationalrisk

23. Theriskauditcommitteeofamutualfundisreviewingaportfolioconstructiontechniqueproposedbyanewportfoliomanager.Themanagerhasrecentlybeenallocatedcapitaltomanageforanequityriskclass.TheFundtypicallygrantsitsportfoliomanagersflexibilityinselectingandimplementingappropriateportfolioconstructionproceduresbutrequiresthatanymethodologyadoptedfulfilskeyriskcontrolobjectivessetbythefirm.Whichofthefollowingportfolioconstructiontechniquesanditscapabilityforriskcontrolinportfolioconstructioniscorrect?

A. Quadraticprogrammingallowsforriskcontrolthroughparameterestimationbutgenerallyrequiresmanymore

inputsestimatedfrommarketdatathanothermethodsrequire.B. Thescreeningtechniqueprovidessuperiorriskcontrolbyconcentratingstocksinselectedsectorsbasedon

expectedalpha.C. Whenusingthestratificationtechnique,riskcontrolisimplementedbyoverweightingthecategorieswithlower

risksandunderweightingthecategorieswithhigherrisks.D. Whenusingthelinearprogrammingtechnique,riskiscontrolledbyselectingtheportfoliowiththelowestlevelof

activerisk.

24. AnanalystreportsthefollowingfundinformationtotheadvisorofapensionfundthatcurrentlyinvestsingovernmentandcorporatebondsandcarriesasurplusofUSD10million:

Pension Assets LiabilitiesAmount(USDmillion) 180 140Expectedannualgrowthrate 6% 10%Modifiedduration 14 8Annualvolatilityofgrowth 25% 12%

Toevaluatethesufficiencyofthefund'ssurplus,theadvisorestimatesthepossiblesurplusvaluesattheendofoneyear.Theadvisorassumesthatannualreturnsonassetsandtheannualgrowthoftheliabilitiesarejointlynormallydistributedandtheircorrelationcoefficientis0.68.Theadvisorcanreportthat,withaconfidencelevelof95%,thesurplusvaluewillbegreaterthanorequalto:

25. Aduediligencespecialistatacompanyisevaluatingtheriskmanagementprocessofahedgefundinwhichthecompanyisconsideringmakinganinvestment.Whichofthefollowingstatementsbestdescribescriteriausedforsuchanevaluation?

A. Becauseoftheoverwhelmingimportanceoftailrisk,thecompanyshouldnotinvestinthefundunlessitfully

accountsforfattailsusingextremevaluetheoryatthe99.99%levelwhenestimatingVaR.B. Today'sbestpracticesinriskmanagementrequirethatafundemployindependentriskserviceprovidersandthat

theseserviceprovidersplayimportantrolesinrisk-relateddecisions.C. Whenconsideringaleveragedfund,thespecialistshouldassesshowthefundestimatesrisksrelatedtoleverage,

includingfundingliquidityrisksduringperiodsofmarketstress.D. Itiscrucialtoassessthefund'svaluationpolicy,andingeneralifmorethan10%ofassetpricesarebasedon

modelpricesorbrokerquotes,thespecialistshouldrecommendagainstinvestmentinthefundregardlessofotherinformationavailableaboutthefund.

26. Apackagingmaterialsmanufacturerisconsideringaprojectthathasanestimatedrisk-adjustedreturnoncapital(RAROC)of15%.Supposethattherisk-freerateis3%peryear,theexpectedmarketrateofreturnis11%peryear,andthecompany'sequitybetais1.8.Usingthecriterionofadjustedrisk-adjustedreturnoncapital(ARAROC),thecompanyshould:

A. RejecttheprojectbecausetheARAROCishigherthanthemarketexpectedexcessreturn.B. AccepttheprojectbecausetheARAROCishigherthanthemarketexpectedexcessreturn.C. RejecttheprojectbecausetheARAROCislowerthanthemarketexpectedexcessreturn.D. AccepttheprojectbecausetheARAROCislowerthanthemarketexpectedexcessreturn.

27. Aderivativetradingfirmonlytradesderivativesonrarecommodities.Thecompanyandahandfulofotherfirms,allofwhomhavelargenotionaloutstandingcontractswiththecompany,dominatethemarketforsuchderivatives.Thecompany’smanagementwouldliketomitigateitsoverallcounterpartyexposure,withthegoalofreducingittoalmostzero.Whichofthefollowingmethods,ifimplemented,couldbestachievethisgoal?

A. EnsuringthatsufficientcollateralispostedbycounterpartiesB. DiversifyingamongcounterpartiesC. Cross-productnettingonasinglecounterpartybasisD. Purchasingcreditderivatives,suchascreditdefaultswaps

28. ADBBankingCorporation,afrequentuserofswaps,oftenentersintotransactionswithHIPBank,amajorproviderofswaps.Recently,HIPBankwasdowngradedfromaratingofAtoaratingofA-,whileADBBankingCorporationwasdowngradedfromaratingofA-toaratingofBBB.Duringthistime,thecreditspreadforHIPBankhasincreasedfrom36bpsto144bps,whilethecreditspreadforADBBankinghasincreasedfrom114bpsto156bps.Whichofthefollowingisthemostlikelyactionthatthecounterpartieswillrequestontheircreditvalueadjustment(CVA)?

A. Thecreditqualitiesofthecounterpartieshavemigrated,butnotsignificantlyenoughtojustifyamendingexisting

CVAarrangements.B. HIPBankrequestsanincreaseintheCVAchargeitreceives.C. ADBBankingCorporationrequestsareductionintheCVAchargeitpays.D. CVAisnolongerarelevantfactor,andthecounterpartiesshouldmigratetousingothermitigantsof

counterpartyrisk.

29. Ariskanalystestimatesthatthehazardrateforacompanyis0.1peryear.Theprobabilityofsurvivalinthefirstyearfollowedbyadefaultinthesecondyearisclosestto:

A. 8.6%.B. 9.5%.C. 18.1%.D. 21.1%.

30. ComputingVaRonaportfoliocontainingaverylargenumberofpositionscanbesimplifiedbymappingthesepositionstoasmallernumberofelementaryriskfactors.Whichofthefollowingiscorrect?

A. USD/EURforwardcontractsaremappedontheUSD/EURspotexchangerate.B. Eachpositioninacorporatebondportfolioismappedonthebondwiththeclosestmaturityamonga

setofgovernmentbonds.C. Zero-coupongovernmentbondsaremappedongovernmentbondspayingregularcoupons.D. Apositioninthestockmarketindexismappedonapositioninastockwithinthatindex.

31. AriskmanagerisintheprocessofvaluingseveralEuropean-typeoptionpositionsonanon-dividend-payingstockXYZthatiscurrentlypricedatEUR30.Theimpliedvolatilityskew,estimatedusingtheBlack-Scholes-MertonmodelandthecurrentpricesofactivelytradedEuropean-styleoptionsonstockXYZatvariousstrikeprices,isshownbelow:

Strike Price (EUR)

AssumingthattheimpliedvolatilityatEUR30isusedtoconductthevaluation,whichofthefollowinglongpositionswillbeovervalued?

A. Anin-the-moneycallB. Anin-the-moneyputC. Anout-of-the-moneycallD. Anout-of-the-moneyput

32. Afinancialanalystispricinga5-yearcalloptionona5-yearTreasurynoteusingasuccessfullytestedpricingmodel.Currentinterestratevolatilityishighandtheanalystisconcernedabouttheeffectthismayhaveonshort-termrateswhenpricingtheoption.Whichofthefollowingactionswouldbestaddressthepotentialfornegativeshort-terminterestratestoariseinthemodel?

A. Whenshort-termratesarenegative,thefinancialanalystadjuststherisk-neutralprobabilities.B. Whenshort-termratesarenegative,thefinancialanalystincreasesthevolatility.C. Whenshort-termratesarenegative,thefinancialanalystsetstheratetozero.D. Whenshort-termratesarenegative,thefinancialanalystsetsthemean-revertingparameterto1.

33. AninvestmentbankhasbeenusingVaRasitsmainriskmeasurementtool.ESissuggestedasabetteralternativetouseduringmarketturmoil.WhatshouldbeunderstoodregardingVaRandESbeforemodifyingcurrentpractices?

A. ComparedtoVaR,ESleadstomorerequiredeconomiccapitalforthesameconfidencelevel.B. IfaVaRbacktestataspecifiedconfidencelevelisaccepted,thenthecorrespondingESwillalwaysbe

accepted.C. WhileVaRensuresthattheestimateofportfolioriskislessthanorequaltothesumoftherisksofthat

portfolio’spositions,ESdoesnot.D. WhileESismorecomplicatedtocalculatethanVaR,itiseasiertobacktestthanVaR.

QUESTION34REFERSTOTHEFOLLOWINGINFORMATION

AderivativetradingdeskatabankdecidesthatitsexistingVaRmodel,whichhasbeenusedbroadlyacrossthefirmforseveralyears,istooconservative.TheexistingVaRmodelusesahistoricalsimulationoverathree-yearlook-backperiod,weightingeachdayequally.AquantitativeanalystinthegroupquicklydevelopsanewVaRmodel,whichusesthedeltanormalapproach.ThenewmodelusesvolatilitiesandcorrelationsestimatedoverthepastfouryearsusingtheRiskMetricsEWMAmethod.Fortestingpurposes,thenewmodelisusedinparallelwiththeexistingmodelforsixweekstoestimatethe1-day99%VaR.Aftersixweeks,thenewVaRmodelhasnoexceedancesdespiteconsistentlyestimatingVaRtobeconsiderablylowerthantheexistingmodel'sestimates.Theanalystarguesthatthelackofexceedancesshowsthatthenewmodelisunbiasedandpressuresthebank’smodelevaluationteamtoagree.Followinganovernightexaminationofthenewmodelbyonejunioranalystinsteadofthecustomaryevaluationthattakesseveralweeksandinvolvesaseniormemberoftheteam,themodelevaluationteamagreestoacceptthenewmodelforusebythedesk.

34. Whichofthefollowingstatementsabouttheriskmanagementimplicationsofthisreplacementiscorrect?

A. Delta-normalVaRismoreappropriatethanhistoricalsimulationVaRforassetswithnon-linearpayoffs.B. Changingthelook-backperiodandweighingschemefromthreeyears,equallyweighted,tofouryears,

exponentiallyweighted,willunderstatetheriskintheportfolio.C. Thedeskincreaseditsexposuretomodelriskduetothepotentialforincorrectcalibrationand

programmingerrorsrelatedtothenewmodel.D. A99%VaRmodelthatgeneratesnoexceedancesinsixweeksisnecessarilyconservative.

35. Ahedgefundhasa25,000sharepositioninanundervaluedandrelativelyilliquidstockXYZthathasacurrentstockpriceofGBP48(expressedasthemidpointofthecurrentbid-askspread).ThedailyreturnforXYZhasameanof0%,anestimatedvolatilityof0.32%,andavolatilityspreadof0.0016.Theaveragebid-askspreadisGBP0.22.Theriskdivisionofthefundusuallyassumesthatthereturnsarenormallydistributedandestimatestheliquidityadjusted1-day95%VaRofthepositionusingtheconstantspreadapproach.SupposethattheCROaskstheriskdivisiontodeterminetheliquidityadjusted1-day95%VaRusingtheexogenousspreadapproachinstead.Assumingthevolatilityspreadmultiplierkof3,whatwouldbetheincreaseintheliquidityadjustment?

A. 43.65%B. 45.71%C. 69.61%D. 89.36%

36. TheBaselCommitteerecommendsthatbanksuseasetofearlywarningindicatorsinordertoidentifyemergingrisksandpotentialvulnerabilitiesintheirliquidityposition.Whichofthefollowingisanearlywarningindicatorofapotentialliquidityproblem?A. CreditratingupgradeB. IncreasedassetdiversificationC. RapidassetgrowthD. Positivepublicity

37. Largedealerbankshaveoftenfinancedsignificantfractionsoftheirassetsusingshort-term(overnight)repurchaseagreementsinwhichcreditorsholdbanksecuritiesascollateralagainstdefaultlosses.Thetablebelowshowsthequarter-endfinancingoffourbroker-dealerfinancialinstruments.AllvaluesareinUSDbillions. BankP BankQ BankR BankSFinancialInstrumentsOwned 656 750 339 835Pledgedascollateral 258 472 139 209Notpledged 398 278 200 626

Intheeventthatrepocreditorsbecomeequallynervousabouteachbank’ssolvency,whichbankismostvulnerabletoaliquiditycrisis?

A. BankPB. BankQC. BankRD. BankS

38. Duringatrainingseminar,asupervisoratFirmWdiscussesdifferenttypesofoperationalriskthatthefirmmayface,whichcouldbeintheshort-termoroverthelong-termperiod.WhichofthefollowingisanexampleofanoperationalrisklossbyFirmW?A. Afterasurpriseannouncementbythecentralbankthatinterestrateswouldincrease,

bondpricesfall,andFirmWincursasignificantlossonitsbondportfolio.B. ThedatacapturesystemofFirmWfailstocapturethecorrectmarketratescausing

derivativetradestobedoneatincorrectprices,leadingtosignificantlosses.C. Asaresultofanincreaseincommodityprices,thesharepriceofacompanythatFirmW

investedinfallssignificantly,causingmajorinvestmentlosses.D. AcounterpartyofFirmWfailstosettletheirdebttoFirmW,andindoingthis,theyarein

breachofalegalagreementtopayforservicesrendered.

39. Theriskmanagementgroupestimatesthe1-day99%VaRonalong-only,large-capequityportfoliousinga

varietyofapproaches.Adailyriskreportshowsthefollowinginformation:Approach 1-day99%VaR(EUR)Delta-Normal 300,000MonteCarloSimulation 332,000HistoricalSimulation 366,000

WhichofthefollowingisthemostlikelyexplanationforthevariationinVaRestimates?A. DataproblemsB. DifferencesinmodelassumptionsC. EndogenousmodelriskD. Programmingerrors

40. Ariskanalystisbuildingabank’senterpriseriskmanagementsystem.Duringtheprocess,theanalysttakesaninventoryoffirmrisksandcategorizestheserisksasmarket,credit,oroperational.Whichofthefollowingobservationsofthebank’sdatashouldbeconsideredunexpectedifcomparedtosimilarindustrydata?A. Theoperationalrisklossdistributionhasalargenumberofsmalllosses,andthereforearelativelylowmode.B. Theoperationalrisklossdistributionissymmetricandfat-tailed.C. Thecreditriskdistributionisasymmetricandfat-tailed.D. Themarketriskdistributionissimilartothedistributionofthereturnonaportfolioofsecurities.

41. Aregionalcommercialbankisconsideringaloantobefullyfundedentirelybydeposits,withthefollowingparameters:

• Loanamount:JPY3.2billion• Averageannualinterestratepaidondeposits:0.6%• Annualinterestrateonloan:4.5%• Expectedloss:3.0%offacevalueofloan• Annualoperatingcosts:0.3%offacevalueofloan• Economiccapitalneed:8.5%• Averagereturnoneconomiccapital:1.2%• Effectivetaxrate:34.0%Whatistherisk-adjustedafter-taxreturnoncapital(RAROC)forthisloan?A. 1.2%B. 1.8%C. 14.0%D. 21.2%

42. AbankusesVaRandstressedVaRmarketriskframeworkinlinewiththeBaselrequirements.Thebank’sinternalmodelsformarketriskhavegeneratedthefollowingriskmeasures(inUSDmillion)forthecurrenttradingbookpositions:

ConfidenceLevel

LatestAvailable10-dayVaR

LatestAvailable10-dayStressedVaR

Average10-dayVaRofPrevious60Days

Average10-dayStressedVaRofPrevious60Days

95.0% 228 498 255 55799.0% 441 1,009 416 1,11799.9% 568 1,295 531 1,383AssumingthesupervisoryauthorityhassetthemultiplicationfactorsforboththeVaRandstressedVaRvaluesto3,whatisthecorrectcapitalrequirementforgeneralmarketriskforthebank?

A. USD1,248millionB. USD1,533millionC. USD4,350millionD. USD4,599million

43. CompanyOBDhasanoutstandingzero-couponbondwith1yearremainingtomaturity.ThebondhasafacevalueofUSD1,000,000andarecoveryrateof0%.Thebondiscurrentlytradingat84%offacevalue.Assumingtheexcessspreadonlycapturescreditriskandthattherisk-freerateis2.5%perannum,whatistheapproximaterisk-neutral1-yearprobabilityofdefaultofCompanyOBD?A. 12%B. 14%C. 17%D. 19%

44. Aninsurancecompanyisconsideringtakingpositionsinvarioustranchesofacollateralizeddebtobligation(CDO).Thecompany’sCROpredictsthatthedefaultprobabilitywilldecreasesignificantlyandthatthedefaultcorrelationwillincrease.Basedonthisprediction,whichofthefollowingisagoodstrategytopursue?

A. Buytheseniortrancheandbuytheequitytranche.B. Buytheseniortrancheandselltheequitytranche.C. Selltheseniortrancheandselltheequitytranche.D. Selltheseniortrancheandbuytheequitytranche.

45. Afinancialinstitutionhasmanyopenderivativepositionswithaninvestmentcompany.Adescriptionandcurrentmarketvaluesaredisplayedinthetablebelow:

Position Price(USD)Longswaptions 29millionLongcreditdefaultswaps 11millionShortcurrencyderivatives 18millionShortinterestrateswaps 7million

Intheeventthattheinvestmentcompanydefaults,whatwouldbethelosstothefinancialinstitutionifnettingisusedcomparedtothelossifnettingisnotused?

A. LossofUSD11millionifnettingisused;lossofUSD25millionifnettingisnotusedB. LossofUSD11millionifnettingisused;lossofUSD40millionifnettingisnotusedC. LossofUSD15millionifnettingisused;lossofUSD25millionifnettingisnotusedD. LossofUSD15millionifnettingisused;lossofUSD40millionifnettingisnotused

46. AderivativetradingfirmsellsaEuropean-typecalloptiononstockJKJwithatimetoexpirationof9months,astrikepriceofEUR45,anunderlyingassetpriceofEUR67,andimpliedannualvolatilityof27%.Theannualrisk-freeinterestrateis2.5%.Whatisthefirm’scounterpartycreditexposurefromthistransaction?

A. EUR0.00B. EUR9.45C. EUR19.63D. EUR22.00

47. AnendowmentfundhassolddefaultprotectiononthemostseniortrancheofaCDO.IfthedefaultcorrelationbetweenassetsheldintheCDOdecreasessharply,assumingeverythingelseisunchanged,howwillthepositionoftheendowmentfundbeimpacted?

A. Itwilleitherincreaseordecrease,dependingonthepricingmodelusedandthemarketconditions.B. Itwillgainsignificantvalue,sincetheprobabilityofexercisingtheprotectionfalls.C. Itwilllosesignificantvalue,sincetheprotectionwillgainvalue.D. Itwillneithergainnorlosevalue,sinceonlyexpecteddefaultlossesmatterandcorrelationdoesnotaffect

expecteddefaultlosses.

48. Ahedgefundmanagesaportfolioofequityoptions.Amongthemareoptionswrittenbyafinancialinstitutiononitsownstock.Assumingthefinancialinstitutioncouldwriteoneofthefollowingoptions,whichoptionwouldgivethehighestwrong-wayrisk?A. Anin-the-moneycalloptionB. Anin-the-moneycalloptionC. Anout-the-moneycalloptionD. Anout-the-moneycalloption

49. Fourderivativecounterpartieshaveundertakenbilateralnettingarrangements.Theexhibitbelowpresentsasummaryoftheirbilateralmark-to-market(MtM)trades.Ifnettingagreementsexistbetweenallpairsofcounterpartiesshown,whatisthecorrectorderofnetexposurepercounterparty,fromhighesttolowest?

Mark-to-MarketTradesforFourCounterparties(USDmillion) OpposingCounterparty Q R SCounterpartyP TradeswithpositiveMtM 8 10 4 TradeswithnegativeMtM -6 -2 -4 P R SCounterpartyQ TradeswithpositiveMtM 15 6 7 TradeswithnegativeMtM -16 0 -8 P Q SCounterpartyR TradeswithpositiveMtM 6 4 8 TradeswithnegativeMtM -6 -5 -12 P Q RCounterpartyS TradeswithpositiveMtM 2 13 1 TradeswithnegativeMtM -2 -10 -1

A. P,Q,S,RB. Q,R,S,PC. R,Q,P,SD. S,P,Q,R

50. Interestrateandcurrencyswapsdisplaydifferingprofilesofpotentialfutureexposure(PFE)overtime.WhichofthefollowinggraphsisanaccuraterepresentationofatypicalPFEprofileforthecorrespondinginstrument?

51. Ariskanalystisexaminingafirm’sforeigncurrencyoptionpriceassumptions.Theobservedvolatilitysmilefora

particularforeigncurrencyoptionslopesprogressivelyhigherasanoptionmoveseitherintothemoneyoroutofthemoney.Comparedtothelognormaldistributionwiththesamemeanandstandarddeviation,thedistributionofoptionpricesonthisforeigncurrencyimpliedbytheBlack-Scholes-Merton(BSM)modelwouldhave:

A. Aheavierlefttailandalessheavyrighttail.B. Aheavierlefttailandaheavierrighttail.C. Alessheavylefttailandaheavierrighttail.D. Alessheavylefttailandalessheavyrighttail.

52. AwealthmanagementfirmhasINR56billioninassets.TheportfoliomanagercomputesthedailyVaRatvariousconfidencelevelsasfollows:

ConfidenceLevel VaR(INR)95.0% 226,665,00095.5% 230,197,50096.0% 234,000,00096.5% 244,237,50097.0% 253,012,50097.5% 261,787,50098.0% 272,317,50098.5% 286,357,50099.0% 304,785,00099.5% 333,157,500

WhatistheclosestestimateofthedailyESatthe97.5%confidencelevel?

A. INR262millionB. INR264millionC. INR292millionD. INR299million

53. Anewlyhiredriskanalystisbacktestingafirm’sVaRmodel.Previously,thefirmcalculateda1-dayVaRatthe95%confidencelevel.FollowingtheBaselframework,theriskanalystisrecommendingthatthefirmswitchtoa99%confidencelevel.Whichofthefollowingstatementsconcerningthisswitchiscorrect?

A. ThedecisiontoacceptorrejectaVaRmodelbasedonbacktestingresultsislessreliablewitha99%confidence

levelVaRmodelthanwitha95%confidencelevelmodel.B. The95%VaRmodelislesslikelytoberejectedusingbacktestingthanthe99%VaRmodel.C. Whenvalidatingwithbacktestingatthe90%confidencelevel,thereisasmallerprobabilityofincorrectly

rejectinga95%VaRmodelthana99%VaRmodel.D. Whenbacktestingusinga90%confidencelevel,thereisasmallerprobabilityofcommittingatypeIerror

whenbacktestinga95%VaRmodelthanwitha99%VaRmodel.

54. Ahedgefundriskmanagerislookingatvariousmodelsthatareflexibleenoughtoincorporatemeanreversionandriskpremiumintotermstructuremodeling.WhichofthefollowingiscorrectabouttheVasicekmodel?

A. Itincorporatesmeanreversionbutnotdriftintotheinterestratemodel.B. Itincorporatesmeanreversionintothemodelandallowsforariskpremiumasaconstantorchangingdrift.C. Itdoesnotincorporateriskpremiumandthetermstructureofinterestratevolatilityinthemodelisupward-

sloping.D. Itdoesnotincorporatemeanreversionintothemodelbutallowsforariskpremiumtobeappliedtointerest

ratesthatchangeovertime.

55. Ahedgefundthatrunsadistressedsecuritiesstrategyisevaluatingthesolvencyconditionsoftwopotentialinvestmenttargets.CurrentlyfirmRSTisratedBBandfirmWYZisratedB.ThehedgefundisinterestedindeterminingthejointdefaultprobabilityofthetwofirmsoverthenexttwoyearsusingtheGaussiandefaulttimecopulaundertheassumptionthataone-yearGaussiandefaultcorrelationis0.36.ThefundreportsthatxBBandxBaremappedabscisevaluesofthebivariatenormaldistributionpresentedinthetablebelow,whileQandNdenotethecumulativedefaultprobabilityandthestandardnormaldistribution,respectively:

ApplyingtheGaussiancopula,whichofthefollowingbestdescribesthederivationofthejointprobability(Q)thatfirmRSTandfirmWYZwillbothdefaultinyear2?

A. Q(xBB=0.0612)+Q(xB=0.1063)–Q(xBB=0.0612)*Q(xB=0.1063)B. Q(xBB=0.1133)+Q(xB=0.2969)–Q(xBB=0.1133)*Q(xB=0.2969)C. Q(xBB≤0.1133ÇxB≤0.2969)D. Q(xBB≤–0.8586ÇxB≤–0.2630)

DefaultTimeinYear

FirmRSTDefaultProbability

FirmRSTCumulativeDefaultProbabilityQBB(t)

FirmRSTCumulativeStandardNormalPercentilesN-1(QBB(t))

FirmWYZDefaultProbability

FirmWYZCumulativeDefaultProbabilityQB(t)

FirmWYZCumulativeStandardNormalPercentilesN-1(QB(t))

1 5.21% 5.21% –1.2104 19.06% 19.06% –0.56942 6.12% 11.33% –0.8586 10.63% 29.69% –0.26303 5.50% 16.83% –0.6443 8.24% 37.93% –0.05164 4.81% 21.64% –0.4893 6.10% 44.03% –0.10155 4.22% 25.86% –0.3672 4.03% 48.06% –0.2046

56. AriskcommitteeoftheboardofcompanyABCisdiscussingthedifferencebetweenpricingdeepout-of-the-moneycalloptionsonABCstockandpricingdeepout-of-the-moneycalloptionsontheUSD/GBPforeignexchangerateusingtheBlack-Scholes-Merton(BSM)model.Thecommitteeconsiderspricingtheseoptionsbasedontwodistinctprobabilitydistributionsofunderlyingassetpricesattheoptionexpirationdate:Alognormalprobabilitydistribution,oranimpliedrisk-neutralprobabilitydistributionobtainedfromthevolatilitysmileforoptionsofthesamematurity.Iftheimpliedrisk-neutralprobabilitydistributionisused,insteadofthelognormal,whichofthefollowingiscorrect?

A. ThepriceoftheoptiononABCwouldrelativelybehighandthepriceoftheoptiononUSD/GBPwould

relativelybelow.B. ThepriceoftheoptiononABCwouldrelativelybelowandthepriceoftheoptiononUSD/GBDwould

relativelybehigh.C. ThepriceoftheoptiononABCwouldrelativelybelowandthepriceoftheoptiononUSD/GBDwould

relativelybelow.D. ThepriceoftheoptiononABCwouldrelativelybehighandthepriceoftheoptiononUSD/GBDwould

relativelybehigh.

57. ACROisconcernedthatexistinginternalriskmodelsofafirm,whicharegovernedmainlybythecentrallimittheorem,arenotadequateinaddressingpotentialrandomextremelossesofthefirm.TheCROthenrecommendstheuseofextremevaluetheory(EVT).WhenapplyingEVTandexaminingdistributionsoflossesexceedingathresholdvalue,whichofthefollowingiscorrect?

A. Asthethresholdvalueisincreased,thedistributionofexceedancesconvergestoageneralizedPareto

distribution.B. Ifthetailparametervalueofthegeneralizedextreme-value(GEV)distributiongoestoinfinity,thentheGEV

essentiallybecomesanormaldistribution.C. ToapplyEVT,theunderlyinglossdistributionmustbeeithernormalorlognormal.D. Thenumberofexceedancesdecreasesasthethresholdvaluedecreases,whichcausesthereliabilityofthe

parameterestimatestoincrease.

58. IntheBaselframework,apenaltyisgiventobanksthathavemorethanfourexceptionstotheir1-day99%VaRoverthecourseofthelast250tradingdays.Whichofthefollowingcausesofexceptionsismostlikelytoleadtoapenalty?

A. Alargemoveininterestrateswascombinedwithasmallmoveincorrelations.B. Thebank’smodelcalculatesinterestrateriskbasedonthemediandurationofthebondsintheportfolio.C. Asuddenmarketcrisisinanemergingmarket,whichleadstolossesintheequitypositionsinthatcountry.D. Asuddendevastatingearthquakethatcausedmajorlossesinthebank’skeyareaofoperation.

59. Afundmanagerownsaportfolioofoptionsonanon-dividendpayingstockTUV.Theportfolioismadeupof7,500deepin-the-moneycalloptionsonTUVand40,000deepout-of-the-moneycalloptionsonTUV.Theportfolioalsocontains20,000forwardcontractsonTUV.Currently,TUVistradingatUSD76.Assuming252tradingdaysinayearandthevolatilityofTUVis18%peryear,whichofthefollowingamountswouldbeclosesttothe1-dayVaRoftheportfolioatthe99%confidencelevel?

A. USD25,056B. USD55,122C. USD386,609D. USD875,041

60. Aportfoliomanagerataninvestmentcompanyisevaluatingatwo-assetportfolioundermanagement.Theriskandreturndataontheassetsandtheportfolioareshowninthetablebelow:

AssetPositionValue(EURmillion)

ReturnStandardDeviation(%) Beta

HIJ 140 20.0 1.6KLM 160 12.0 0.8Portfolio 300 13.7 1.2

WhatisthemarginalVaRofassetHIJ;thepercentcontributionofassetKLMVaRtoportfolioVaR;andthe

portfolio’sestimateddiversifiedVaRatthe95%confidencelevel?

A. MarginalVaRofHIJ=0.1803;percentcontributionofassetKLMVaR=42.67%;portfoliodiversifiedVaR=USD0million

B. MarginalVaRofHIJ=0.1803;percentcontributionofassetKLMVaR=74.67%;portfoliodiversifiedVaR=USD3.5million

C. MarginalVaRofHIJ=0.3606;percentcontributionofassetKLMVaR=42.67%;portfoliodiversifiedVaR=USD10.0million

D. MarginalVaRofHIJ=0.3606;percentcontributionofassetKLMVaR=74.67%;portfoliodiversifiedVaR=USD21.5million

Afinancialriskconsultantassumesthatthejointdistributionofreturnsismultivariatenormalandcalculatesthefollowingriskmeasuresforatwo-assetportfoliomanagedbyamid-sizedinsurancecompany:

Asset Position(CNY) IndividualVaR

(CNY)MarginalVaR VaRContribution(CNY)

Financial 15,000,000 3,494,700 0.216 3,240,000Energy 15,000,000 6,999,300 0.462 6,931,238Portfolio 30,000,000 9,241,650 9,241,650

61. Iftheenergyassetisdroppedfromtheportfolio,whatwillbethereductioninportfolioVaR?

A. CNY2,242,350B. CNY3,494,700C. CNY5,746,950D. CNY6,999,300

62. SupposethattheriskconsultantdefinesriskcapitaloftheinsurancecompanybyVaR.Assumingamarketriskpremiumof4.5%andarisk-freeinterestrateof2.5%,whatisthecorrectestimateforthereturnonriskcapitalonthefinancialasset?

A. 5.7%B. 6.3%C. 7.0%D. 9.3%

63. Ananalystregressesthereturnsof300stocksagainstthereturnsofamajormarketindex.Theresultingpoolof300alphashasaresidualriskof15%andaninformationcoefficientof10%.Ifthealphasarenormallydistributedwithameanof0%,roughlyhowmanystockshaveanalphagreaterthan3.24%orlessthan-3.24%?

A. 5B. 15C. 30D. 45

64. Ariskanalystataninvestmentbankisreviewingthewayperformanceanalysisofhedgefundsandrealestatefundshavebeenconducted.Eachyear,wheneverahedgefundstopstrading,thehedgefundisremovedfromthedatabaseofhedgefunds.Also,becauseoftheadditionofnewassetstotherealestatefund,theliquidityofthatassetcategoryhasimprovedeachyearandtradinghasbecomemorefrequent.Whichofthefollowingbestdescribestheimpactsthesechangeshavehistoricallyhadonhedgefundandrealestatefundanalysesperformedusingthesedatabases?A. TheaverageSharperatioofhedgefundsisunderstatedandtheaverageSharperatioofrealestatefundshas

increased.B. TheaverageSharperatioofhedgefundsisoverstatedandtheaverageSharperatioofrealestatefundshas

decreased.C. Theaveragevolatilityofhedgefundsisoverstatedandtheaveragevolatilityofrealestatefundshas

decreased.D. Theaveragevolatilityofhedgefundsisunderstatedandtheaveragevolatilityofrealestatefundshas

increased.

65. Amoneymanagerwantstoinvestasmallamountofnewcapitalthathasrecentlycomeintoafund.Thefundisbenchmarkedtoanindexand,ratherthanaddinganewholding,themanagerisconsideringincreasingtheholdingsofoneofthefourassetswhoseperformances,duringthemostrecentevaluationperiod,aredescribedinthefollowingtable:Asset

PortfolioWeight

ActualReturn

VolatilityofReturn

BetatotheIndex

BDE 0.35 14% 19% 1.20JKL 0.30 13% 18% 0.90MNO 0.25 13% 16% 1.00STU 0.10 10% 10% 0.80

TheportfoliomanagerwantstoselecttheassetthathasthelowestmarginalVaRaslongasitsJensen’salphaisequaltoorgreaterthanthemarketriskpremium.Assumingtheriskfreerateis3%andthemarketreturnis8%,whichassetshouldtheportfoliomanagerselect?

A. AssetBDEB. AssetJKLC. AssetMNOD. AssetSTU

66. Ariskanalystataninsurancecompanyhasdeterminedthatacounterpartytothecompanyhasaconstantdefaultprobabilityof6%peryear.Whatistheprobabilityofthiscounterpartydefaultinginthethirdyear?

A. 4.98%B. 5.30%C. 5.64%D. 6.00%

67. Theboardofapensionfundisconsideringthefundingriskofitsdefinedbenefitplan.Whichofthefollowingstatementsaboutthepensionfund’sfundingriskiscorrect?A. Decreasesininterestrateswillreducefundingrisk.B. Fundingriskrepresentsthetruelong-termrisktotheplansponsor.C. Thefundingriskhasbeeneffectivelytransferredtotheemployees.D. Thelongerthehorizonforexpectedpayouts,thelowerthefundingrisk.

68. Aportfoliomanagerisevaluatingtheriskprofileforaportfolioofstocks.Currently,theportfolioisvaluedatCAD10.7millionandcontainsCAD2.1millioninstockSWZ.ThestandarddeviationofreturnsofstockSWZis17%annuallyandthatoftheoverallportfoliois13%annually.ThecorrelationofreturnsbetweenstockSWZandtheportfoliois0.4.Assumingtheportfoliomanagerusesa1-year99%VaRandthatreturnsarenormallydistributed,whatistheestimatedcomponentVaRofstockSWZ?

A. CAD162,972B. CAD234,906C. CAD253,992D. CAD332,152

69. AnewlyestablishedriskdivisionofaregionalfinancialinstitutionissettingupaMonteCarlosimulationmethodologytoestimatethefirm’saggregatelossdistribution.Whichofthefollowinglossfrequencyandlossseveritydistributionpairsisthemostappropriatetouse?

A. Binomialdistributionforfrequency,andPoissondistributionforseverity.B. Lognormaldistributionforfrequency,andWeibulldistributionforseverity.C. NegativeBinomialdistributionforfrequency,andParetodistributionforseverity.D. TransformedBetadistributionforfrequency,andNormaldistributionforseverity.

TheCROofBankLGX,anon-dividend-payingUS-basedbankispreparingareporttotheboardofdirectorsonthebank’scapitaladequacyandplanning.BankLGXissubjecttoboththeBaselframeworkandtheUSbankingrulesgoverningglobalsystemicallyimportantbanks(G-SIBs).ThebankclaimsthatitwasincompliancewithallthecapitalrequirementsinJanuary2016asallBaselIIIphase-inshavealreadyoccurred.TheCROisconductingtheanalysisforJanuary2017usingselectedandmostrecentannualperformancedata,whichareshowninthetablebelow:

Item Value(USDmillion)asofJanuary2017 CommonequityTier1(CET1)capital 1,515Preferredstock(noncumulative) 100Tier2capital 827Risk-weightedassets 26,395Totalassets 42,828Totalexposure 47,460

TheCROalsoreportstheminimumregulatorycapitalrequirementsundertherevisedcapitalframeworkaspresentedinthetablebelow.Thecapitalratiosalsoincludethecapitalconservationbufferof2.5%(phased-ininannualincrementsof0.75%,startingJanuary2016)andaG-SIBsurchargeof3.0%(phased-ininannualincrementsof0.625%,startingJanuary2016)ofrisk-weightedassetstobereachedbyJanuary2019:

January2016MinimumRatio

Capitalconservationbuffer 0.625% 1.25% 1.875% 2.5%G-SIBsurcharge 0.75% 1.5% 2.25% 3.0%CET1ratio 4.5% 5.25% 6.5% 10.0%Tier1capitalratio 6.0% 6.75% 8.0% 11.5%Totalcapitalratio 8.0% 8.75% 11.5% 13.5%Leverageratio 4.0% 4.0% 4.0% 4.0%

70. Giventheregulatorybenchmarkandthebank’sperformance,whichofthecapitalrequirementsdoesBankLGX

satisfyasofJanuary2017?

A. CET1capitalratioonlyB. LeverageratioonlyC. Tier1capitalratioandLeverageratioonlyD. TotalcapitalratioandCET1capitalratioonly

71. InviewingtheresultsofthiscapitalanalysisreportandotherconsiderationsforBankLGX’scapitalplanning,whichofthefollowingconclusionsiscorrect?

A. ThecapitalconservationbuffercanbemetbyanincreaseinTier2capital.B. Iftheexposureonderivativeassetpositionsdecreases,holdingotherfactorsconstant,Totalcapitalratio

woulddecrease.C. Theincreaseinthecreditvaluationadjustment(CVA)duetothebank’sassetcounterpartypositionswould

tendtoraisethebank’srisk-weightedassets.D. IfthebankraisesadditionalCET1capitalandinveststhesameamountingold,BankLGX’snetstablefunding

ratio(NSFR)willnotchange.

QUESTIONS72THROUGH75REFERTOTHEFOLLOWINGINFORMATION

InasurprisemonetarypolicyactiononAugust10,2015,thePeople’sBankofChinacutitsdailycurrencyreferencerateagainsttheUSD,resultinginalargedevaluationoftheCNYversustheUSD.Immediatelyaftertheannouncement,theCROofCMMBank(CMM),aninternationalbankwithheadquartersinShanghai,beganevaluatingtheimpactofthisandothereventsonthebank’sposition.

CMMhadoutstandinglong-termdebtdenominatedinUSDanddepositsdenominatedinCNY.AsignificantportionofCMM’slendingportfoliowasalsodenominatedinCNYandconsistedlargelyofloansandlinesofcredittoChinesemanufacturerswhowereheavilydependentonimportedrawmaterials.Otherloanstonon-ChinesefirmswithexposuretoChinaweredenominatedinUSD.Thebank’sportfolioinvestmentsincludedCNY-denominatedChineseTreasurysecuritiesandothersovereigndebt.

AportionofCMM’sretailcustomerbasehadinvestedonmarginintheChineseequitymarkets.Overthenextfewweeks,localstockmarketsexperienceddeclinesinshareprices.ManyofCMM’slargerretaildepositorsexperiencedmargincallsandhadbeguntodrawdowndemanddepositstomeetthem.Offsettingtheseoutflows,however,wereincreasesinthe3-month,6-monthand9-monthtermdepositbalancesatCMMofseverallargecorporatecustomers.TheresultwasthatCMM’soverallnetdepositflowhadbeenapproximatelyzero.

Asaresultofcreditdevelopmentselsewhereintheworld,severalofCMM’ssovereigndebtholdingsweredowngraded,somefromAAtoAandsomefromAtoBBB.Oneofthenoticeableoutcomeswasthatthebid-askspreadsonmanyofthesovereignbondsheldandtradedbyCMMwidened.Despitethesedevelopments,CMM’ssovereigndebtportfolioremainedexclusivelyinvestmentgradewithaweightedaverageratingofA+.

72. CMM’sCROwasconcernedaboutthebank’sliquiditypositionanddecidedtoreviewtheimpactofthedevaluationandothercapitalmarketeventsonitsnetstablefundingratio(NSFR).IgnoringanychangesinthemarketvalueofCMM’ssovereigndebtholdings,whichofthefollowingiscorrect?

A. TheNSFRwillnotbeimpactedbythesovereigncreditratingchangesbecausetheoverallsovereigndebtportfolioremainsinvestmentgrade.

B. TheNSFRwillbereducedbythesovereigncreditratingchangesbutthiseffectcanbeoffsetbysellingA-ratedsovereigndebtandinvestingtheproceedsingold.

C. TheNSFRwillnotbeimpactedbythechangeindemanddepositsbecausethebank’soveralldepositlevelisunchanged.

D. TheNSFRwillbereducedbythechangeindemanddepositsbutthiseffectcanbeoffsetbyissuingcommonstock.

73. Beforethedevaluation,CMM’stradingdeskhadestablishedashortcalloptionspositionontheCNY-USDexchangeratethatwasmadedelta-neutralthroughaspotUSDtransaction.Thepositionwasnolongerdelta-neutralafterthedevaluationcameintoeffectandthedeskwantedtotakestepstomakeitdelta-neutralagain.ThebankwasconcernedaboutwhetherthiswouldinvolvebuyingorsellingUSDandwhatimpactthismighthaveonliquidity.Thetraderwhoinitiatedthepositionsuggestedthat,onceitwasmadedelta-neutral,theshortcalloptionspositionwouldbeaneffectivewaytohedgethebank’slongCNYexposureagainstfurtherdevaluationsandthatthebankshouldconsiderincreasingthesizeofthepositionaccordingly.Inconsideringthissituation,whatshouldtheCROconclude?

A. ThebankwillhavetobuyUSDtomakethepositiondeltaneutral,butthedelta-neutralshortcalloptionspositionisnotaneffectivewaytohedgeanunderlyinglongCNYexposureagainstfurtherdevaluations.

B. ThebankwillhavetosellUSDtomakethepositiondeltaneutral,butthedelta-neutralshortcalloptionspositionisnotaneffectivewaytohedgeanunderlyinglongCNYexposureagainstfurtherdevaluations.

C. ThebankwillhavetobuyUSDtomakethepositiondeltaneutral,andthedelta-neutralshortcalloptionspositionisaneffectivewaytohedgeanunderlyinglongCNYexposureagainstfurtherdevaluations.

D. ThebankwillhavetosellUSDtomakethepositiondeltaneutral,andthedelta-neutralshortcalloptionspositionisaneffectivewaytohedgeanunderlyinglongCNYexposureagainstfurtherdevaluations.

74. CMMhadCNY-denominatedloansoutstandingtoTVR,amanufacturingfirmthatgenerateditsrevenueinCNY.Tohedgesomeofitsrisk,CMMhadboughtCDSprotectiononTVRfromabankfromthesamecountryasTVR,BankEP.IfthedefaultprobabilityofTVRandthedefaultcorrelationbetweenTVRandBankEPsuddenlyincreased,whichofthefollowingiscorrect?

A. ThevalueoftheCDSwillincreaseandCMMhasawrong-wayriskwithBankEP.B. ThevalueoftheCDSwilldecreaseandCMMhasawrong-wayriskwithBankEP.C. ThevalueoftheCDSwillincreaseandCMMhasaright-wayriskwithBankEP.D. ThevalueoftheCDSwilldecreaseandCMMhasaright-wayriskwithBankEP.

75. Theriskmanagementgroupnoticedthattheliquidity-adjustedVaRthatwasbeingreportedbythesovereigndebttradingdeskinHongKongwaslowerthanthatreportedbythesovereigndebttradingdeskinSingapore,evenonidenticalbondholdings.Whatcouldexplainthisdifferenceinliquidity-adjustedVaR?

A. TheHongKongdeskusestheconstantspreadapproachandtheSingaporedeskusestheexogenousspreadapproach.

B. TheHongKongdeskusestheexogenousspreadapproachandtheSingaporedeskusestheconstantspreadapproach.

C. BothdesksusetheendogenouspriceapproachbuttheHongKongdeskusesahighervalueforthepriceelasticityofdemandassumption.

D. BothdesksusetheendogenouspriceapproachbuttheHongKongdeskusesahighervalueforthetransactioncostassumption.

76. ACROataninvestmentbankhasaskedtheriskdepartmenttoevaluatethebank’s3-yearderivativeexposurepositionwithacounterparty.The1-yearCDSonthecounterpartyiscurrentlytradingataspreadof180bps.ThetablebelowpresentstradeandforecastdataontheCDSspread,theexpectedexposure,andtherecoveryrateonthecounterparty:

Year1 Year2 Year3Expectedexposure(AUDmillion) 15 15 15CDSspread(bps) 180 300 420Recoveryrate(%) 85 75 65

Additionally,theCROhaspresentedtheriskteamwiththefollowingsetofassumptionstouseinconductingtheanalysis:• Counterparty’sdefaultprobabilitiesfollowaconstanthazardrateprocess• Theinvestmentbankandthecounterpartyhavesignedacreditsupportannex(CSA)tocoverthis

exposure,whichrequirescollateralpostingofAUD13millionoverthelifeofthecontract• Thecurrentrisk-freerateofinterestis2%andthetermstructureofinterestrateswillremainflatover

the3-yearhorizon• CollateralandexposurevalueswillremainstableoverthelifeofthecontractGiventheinformationandtheassumptionsabove,whatisthecorrectestimateforthecreditvaluationadjustmentforthisposition?

A. AUD0.335millionB. AUD0.863millionC. AUD1.291millionD. AUD2.514million

77. TheCEOofalargebankhasreportedthatthebank’sframeworkformanagingoperationalriskareconsistentwithBaselIIandBaselIIImodelforoperationalriskgovernance.Whichofthefollowingactionsandprinciplesofthebankiscorrect?

A. ThebankconsidersidentificationandmanagementofriskasthesecondlineofdefenseB. Thebankconsidersindependentreviewandauditoftheriskprocessesandsystemsasthethirdlineof

defenseC. ThebankincludesdamagedreputationduetoafailedmergerinitsmeasurementofoperationalriskD. Thebankexcludesdestructionbyfireorotherexternalcatastrophesfromitsmeasurementofoperationalrisk

78. AriskmanagerhasaskedajunioranalysttoestimatetheimplieddefaultprobabilityforaBBB-rateddiscount

corporatebond.Relevantinformationonotherfixed-incomesecuritiesaregivenbelow:

• TheTreasurybond(arisk-freebond)yields4%peryear• Theone-yearBB-rateddiscountbondyields8%peryear• Thetwo-yearBB-rateddiscountbondyields11%peryear

IftherecoveryrateonaBBB-ratedbondisexpectedtobe0%,andthemarginaldefaultprobabilityinyearoneis6%,whichofthefollowingisthebestestimateoftherisk-neutralprobabilitythattheBBB-rateddiscountbonddefaultswithinthenext2years?

A. 6.31%B. 7.27%C. 12.22%D. 13.97%

79. Pensionfundmanagershavetodealwitharangeofpolicy,risk,andreturnrequirements.Whichofthefollowingstatementsaboutriskmanagementinthepensionfundindustryiscorrect?

A. Apensionplan’stotalVaRisequaltothesumofitspolicy-mixVaRandactivemanagementVaR.B. Pensionfundriskanalysisdoesnotconsiderperformancerelativetoabenchmark.C. Inmostdefined-benefitpensionplans,ifliabilitiesexceedassets,theshortfalldoesnotcreateariskforthe

plansponsor.D. Fromtheplansponsor’sperspective,nominalpensionobligationsaresimilartoashortpositioninabond.

80. Afinancialinstitutionhasatwo-waycollateralsupportannex(CSA)withacounterpartycoveringaportfoliovaluedatJPY400million.ThemarginingtermsofthecollateralizedportfolioincludeathresholdofJPY180million,aminimumtransferamountofJPY30million,andamarginperiodofriskof10days.Whichofthefollowingiscorrectregardingthesizeofcollateralinmitigatingthecounterpartyriskoftheportfolio?A. Alowerthresholdvalueisequivalenttoalargerportionofexposureprotectedbycollateral.B. Ashortermarginperiodofriskisequivalenttoasmallerportionofexposureprotectedbycollateral.C. Alowerindependentamountisequivalenttoalargerportionofexposureprotectedbycollateral.D. TheprotectionfromcollateralspecifiedintheCSAisuniformthroughoutthelifeoftheexposureprofile.

2017FRMPartIIPracticeExam–AnswerKey

1. B 21. B 41. C 61. C

2. B 22. C 42. D 62. A

3. D 23. A 43. B 63. B

4. B 24. B 44. D 64. B

5. C 25. C 45. B 65. B

6. C 26. C 46. A 66. B

7. D 27. A 47. B 67. B

8. B 28. C 48. D 68. D

9. D 29. B 49. A 69. C

10. C 30. A 50. B 70. D

11. D 31. C 51. B 71. C

12. A 32. C 52. D 72. D

13. B 33. A 53. A 73. A

14. C 34. C 54. B 74. B

15. D 35. B 55. D 75. A

16. C 36. C 56. B 76. C

17. D 37. B 57. A 77. B

18. B 38. B 58. B 78. C

19. D 39. B 59. B 79. D

20. C 40. B 60. C 80. A

1. Aninvestmentbankwithanactivepositionincommodityfuturesisusingthepeaks-over-threshold(POT)methodologyforestimatingVaRandES.Thebank’sriskmanagershavesetathresholdlevelof3.00%toevaluateexcesslosses.Thechoiceofthethreshold,theyargue,issuitableandconsistentwiththefindingthat5.00%oftheobservationsareinexcessofthethresholdvalue.Theriskmanagershaveconcludedthattheposition’sVaRusingthePOTmeasureis4.45%at99%confidencelevel.TheVaRestimateincorporatesthefollowingassumptionsgeneratedfromthemanagers’empiricalanalysis:Parameter Symbol ValueLossthreshold u 3%Numberofobservations N 740Numberofobservationsthatexceedthreshold n 37Scale β 0.75Shape(tailindex) ε 0.22GiventheVaRvalueandtheparameterassumptions,whichofthefollowingiscorrect?

A. IncreasingthevalueofthetailindexlowersboththeESandtheVaRB. IncreasingthelossthresholdlevelincreasesboththeESandtheVaRC. ThevalueofESis4.57%D. ThevalueofESis5.71%

Correctanswer:BExplanation:Biscorrect(ascanbeseenfromtheformulabelow),increasinguincreasesbothVaRandESevenifnmaybelowerasuincreases.Aisincorrect.IncreasingthetailparametervalueactuallyincreasesbothVaRandES.CandDareincorrect.Accordingtothepeaks-over-threshold(POT)riskmeasure,theVaRandES(inpercentage)arecomputedby(note:thefirstequationisnotnecessaryasthevalueofVaRisgiven):

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The4.57%istheresultwhenVaRisnotscaledby(1–ε)andissimplyaddedto(β–εu)/(1–ε).The5.71%istheresultobtainedwhenVaRisdividedby(1–ε)andthesecondpartoftheESvalue(i.e.,(β–εu)/(1–ε))isignored.Section:OperationalandIntegratedRiskManagementReference:KevinDowd,MeasuringMarketRisk,SecondEdition(WestSussex,England:JohnWiley&Sons,2005).Chapter7,ParametricApproaches(II):ExtremeValue.LearningObjective:Describethepeaks-over-threshold(POT)approach.

2. Ariskmanagerisestimatingthemarketriskofaportfoliousingboththenormaldistributionandthelognormaldistributionassumptions.Themanagergathersthefollowingdataontheportfolio:• Annualmean:15%• Annualvolatility:35%• Currentportfoliovalue:EUR4,800,000• Tradingdaysinayear:252

Whichofthefollowingstatementsiscorrect?

A. Lognormal95%VaRislessthannormal95%VaRatthe1-dayholdingperiodby0.13%B. Lognormal95%VaRislessthannormal95%VaRatthe1-yearholdingperiodby7.91%C. Lognormal99%VaRislessthannormal99%VaRatthe1-dayholdingperiodby1.43%D. Lognormal99%VaRislessthannormal99%VaRatthe1-yearholdingperiodby13.86%

Correctanswer:BExplanation:Annualreturn=0.15;Dailyreturn=0.15/252=0.000595Annualvolatility=0.35;Dailyvolatility=0.35/sqrt(252)=0.022048ThenormalVaRandlognormalVaR,inpercentageterms,arecalculatedasfollows(ignoringnegativesigns):1-daynormal95%VaR=(Rp–zs)=(0.000595–1.645*0.022048)=3.57%1-daylognormal95%VaR=(1–e[Rp–zs])=(1–exp[0.000595–1.645*0.022048])m=3.51%1-yearnormal95%VaR=(Rp–zs)=(0.15–1.645*0.35)=42.58%1-yearlognormal95%VaR=(1–exp[0.15–(1.645*0.35)])=34.67%Also,1-daynormal99%VaR=(Rp–zs)=(0.000595–2.326*0.022048)=5.07%1-daylognormal99%VaR=(1–e[Rp–zs])=(1–exp[0.000595–2.326*0.022048])=4.94%1-yearnormal99%VaR=(Rp–zs)=(0.15–2.326*0.35)=66.41%1-yearlognormal99%VaR=(1–exp[0.15–(2.326*0.35)])=48.53%Hence,1-dayholdingperiod:Lognormal95%VaRissmallerthanNormal95%VaRby:3.57–3.51=0.06%.So,Aisincorrect.(SeeexplanationforCbelow).1-yearholdingperiod:Lognormal95%VaRissmallerthanNormal95%VaRby:42.58–34.67=7.91%.So,Biscorrect.1-dayholdingperiod:Lognormal99%VaRissmallerthanNormal99%VaRby:5.07–4.94=0.13%.So,Cisincorrect(4.94–3.51=1.43%).1-yearholdingperiod:Lognormal99%VaRissmallerthanNormal99%VaRby:66.41–48.53=17.88%. So,Disincorrect(48.53–34.67=13.86%).ThenormalVaRandlognormalVaR,invalueterms,arecalculatedasfollows(ignoringnegativesigns):1-daynormal95%VaR=(Rp–zs)*V=(0.000595–1.645*0.022048)*4.8m=EUR171,2351-daylognormal95%VaR=(1–e[Rp–zs])*V=(1–exp[0.000595–1.645*0.022048])*4.8m=EUR168,2171-yearnormal95%VaR=(Rp–zs)*V=(0.15–1.645*0.35)*4.8m=EUR2,043,6001-yearlognormal95%VaR=(1–exp[0.15–(1.645*0.35)])*4.8m=EUR1,664,258Also,1-daynormal99%VaR=(Rp–zs)*V=(0.000595–2.326*0.022048)*4.8m=EUR243,3061-daylognormal99%VaR=(1–e[Rp–zs])*V=(1–exp[0.000595–2.326*0.022048])*4.8m=EUR237,242

1-yearnormal99%VaR=(Rp–zs)*V=(0.15–2.326*0.35)*4.8m=EUR3,187,6801-yearlognormal99%VaR=(1–exp[0.15–(2.326*0.35)])*4.8m=EUR2,329,264Hence,1-dayholdingperiod:Lognormal95%VaRissmallerthanNormal95%VaRby:171,235–168,217=EUR3,018.1-yearholdingperiod:Lognormal95%VaRissmallerthanNormal95%VaRby:2,043,600–1,664,258=EUR379,342.1-dayholdingperiod:Lognormal99%VaRissmallerthanNormal99%VaRby:243,306–237,242=EUR6,064.1-yearholdingperiod:Lognormal99%VaRissmallerthanNormal99%VaRby:3,187,680–2,329,264=EUR858,416.Section:MarketRiskMeasurementandManagementReference:KevinDowd,MeasuringMarketRisk,2ndEdition(WestSussex,England:JohnWiley&Sons,2005).Chapter3,EstimatingMarketRiskMeasures:AnIntroductionandOverview.LearningObjective:EstimateVaRusingaparametricapproachforbothnormalandlognormalreturndistributions.

3. AriskteamataninvestmentbankusestheKMVmodeltoestimatethedistancetodefaultandexpecteddefaultfrequencyinevaluatingdefaultconditionsofbothpotentialandexistingclientfirms.OnesuchclientcurrentlyhastotalassetsvaluedatUSD20billion,assetvolatilityof28%perannum,short-termdebtofUSD7billion,andlong-termdebtofUSD6billion.Theexpectedreturnonthefirm’sassetsis5%peryearandtheriskfreerateis1%peryear.Thefirmdoesnotpayanydividends.Theratingscheduleata1-yearhorizonisshowninthetablebelow:ExpectedDefaultFrequency(EDF) RatingClass0.02%–0.04% AAA0.04%–0.10% AA/A0.10%–0.19% A/BBB+0.19%–0.40% BBB+/BBB-0.40%–0.72% BBB-/BB0.72%–1.01% BB/BB-

Whatisthesuggestedcreditratingofthefirmata1-yearhorizonusingtheratingscheduleprovided?

A. AA/AB. A/BBB+C. BBB+/BBB-D. BBB-/BB

Correctanswer:DExplanation:Disthecorrectanswer.UsingtheKMVmodel,defaultvalueofdebt=Short-term+0.5*Long-termdebt.And,accordingtotheMertonModel,theprobabilityofdefaultataone-yearhorizon=N(-DD),whereDDisthedistancetodefaultand:

whereV=20;X=7+6/2=10;s=0.28;µ=0.05;T-t=1.Andso,PD=N(-2.5141)=N(-2.5)=0.62Section:CreditRiskMeasurementandManagementReference:ReneStulz,RiskManagement&Derivatives(Florence,KY:ThomsonSouth-Western,2002).Chapter18,CreditRisksandCreditDerivatives.LearningObjective:UsingtheMertonmodel,calculatethevalueofafirm’sdebtandequityandthevolatilityoffirmvalue.

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4. Ariskmanageriscomparingtheuseofparametricandnon-parametricapproachesforcalculatingVaRandisconcernedaboutsomeofthecharacteristicspresentinthelossdata.Whichofthefollowingconditionswouldmakenon-parametricapproachesthefavoredmethodtouse?

A. ScarcityofhighmagnitudelosseventB. SkewnessinthedistributionC. UnusuallyhighvolatilityduringthedataperiodD. Unusuallylowvolatilityduringthedataperiod

Correctanswer:B

Explanation:Biscorrect.Non-parametricapproachescanaccommodatefattails,skewness,andanyothernon-normalfeaturesthatcancauseproblemsforparametricapproaches.However,ifthedataperiodthatisusedinestimationincludesfewlossesorlosseswithlowmagnitude,non-parametricmethodswilloftenproduceriskmeasuresthataretoolow.Specifically,non-parametricapproachesproduceVaRandESthataretoolowifthedataperiodhasunusuallylowvolatility,andwouldproduceVaRandESthataretoohighifthedataperiodhasunusuallyhighvolatility.Henceparametricmethodswouldbemoreappropriateinthosesituations.Therefore,A,CandDareincorrect.Section:MarketRiskMeasurementandManagementReference:KevinDowd,MeasuringMarketRisk,2ndEdition(WestSussex,England:JohnWiley&Sons,2005).Chapter4,Non-parametricApproaches.LearningObjective:Identifyadvantagesanddisadvantagesofnon-parametricestimationmethods.

5. LMTBankhasenteredintoa1-yearCDScontractwithanendowmentfund.Accordingtothecontract,LMTBankwillpaytheendowmentfund75%ofthefacevalueofabondissuedbyGTEChemicalCorporationimmediatelyafteradefaultbyGTEChemical.TopurchasethisCDS,theendowmentfundwillpayLMTBanktheCDSspread,whichisapercentageofthefacevalue,onceattheendoftheyear.LMTBankestimatesthattherisk-neutraldefaultprobabilityforGTEChemicalis6%peryear.Therisk-freerateis3%peryear.Assumingdefaultscanonlyoccurhalfwaythroughtheyearandthattheaccruedpremiumispaidimmediatelyafteradefault,whatistheestimatefortheCDSspread?

A. 457basispointsB. 468basispointsC. 471basispointsD. 628basispoints

Correctanswer:CExplanation:ThekeytoCDSvaluationistoequatethepresentvalue(PV)ofpaymentstothePVofexpectedpayoffintheeventofdefault.Let:r=risk-freerate=3%s=CDSspread.π=probabilityofdefaultduringyear1=6%C=contingentpaymentincaseofdefault=75%d0.5=discountfactorforhalf-year=e-0.5*r=e-0.5*0.03=0.985112d1.0=discountfactorfor1-year=e-1.0*r=e-0.03=0.970446Therefore,tosolvefortheCDSspread(s):ThePVofpayments(premiumleg,whichincludesthespreadpaymentandaccrual)is:s*[0.5*d0.5*π+d1.0*(1-π)]=s*[0.029553+0.912219]=s*0.941772Thepayoffleg(intheeventofdefault)=C*d0.5*π=0.75*0.985112*0.06=0.044330EquatingthetwoPVsandsolvingforthespread:s*0.941772=0.044330Thus,s=0.047071oraspreadofapproximately471basispoints.Aisincorrect.Itconsiderscouponpaymentatyear-endandnotathalf-year.Bisincorrect.Itignoresthehalf-yearcouponpaymentonthepremiumleg.Disincorrect.Itusesacontingentpaymentincaseofdefaultof100%insteadof75%.Section:CreditRiskMeasurementandManagementReference:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter7,SpreadRiskandDefaultIntensityModels.LearningObjective:Comparethedifferentwaysofrepresentingcreditspreads.

6. Ariskanalystatamid-sizehedgefundisevaluatingthecreditriskofseveraltradepositions.Thehedgefundspecializesincorporatedebtandrunsastrategythatutilizesbothrelativevalueandlong-onlytradesusingCDSandbonds.OneofthenewtradesatthehedgefundisaBBB-ratedlongbondvaluedatJPY10billion.Someofthehedgefund’snewestclients,includingtheBBB-ratebondholders,arerestrictedfromwithdrawingtheirfundsforfouryears.Theanalystiscurrentlyevaluatingtheimpactofvariousdefaultscenariostoestimatefutureassetliquidity.TheanalysthasestimatedthatthemarginalprobabilityofdefaultoftheBBB-ratedbondis5%inYear1,8%inYear2,15%inYear3,and24%inYear4.Whatistheprobabilitythatthebondmakescouponpaymentsfor4yearsandthendefaultsattheendofYear4?

A. 7.6%B. 13.1%C. 17.8%D. 20.4%

Correctanswer:CExplanation:Ciscorrect.TheprobabilitythatthebonddefaultsinYear4canbemodeledasaBernoullitrialgivenbythefollowingequation,whereMPstandsformarginalprobability:P(DefaultatendofYear4)=(1–MPYear1default)*(1–MPYear2default)*(1–MPYear3default)*(MPYear4default)=(1–0.05)*(1–0.08)*(1–0.15)*(0.24)=0.1783=17.83%=17.8%.Aisincorrect.ItistheprobabilitythatthebonddefaultsinYear2.Bisincorrect.ItistheprobabilitythatthebonddefaultsinYear3.Disincorrect.ItincorrectlycomputestheprobabilityofdefaultinYear4as:(1–0.15)*0.24=20.4%.Section:CreditRiskMeasurementandManagementReferences:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter7,SpreadRiskandDefaultIntensityModels.LearningObjective:ExplainhowdefaultriskforasinglecompanycanbemodeledasaBernoullitrial.

7. MDMBankisseekingtoenhanceitsenterpriseriskmanagementfunction.Inordertoachievethatobjectivethebankintroducesanewdecision-makingprocessbasedoneconomiccapitalthatinvolvesassessingsourcesofriskacrossdifferentbusinessunitsandorganizationallevels.Whichofthefollowingstatementsregardingthecorrelationsbetweentheserisksiscorrect?

A. Correlationsbetweenbusinessunitsareonlyrelevantindecidingtotalfirm-wideeconomiccapital

levelsandarenotrelevantfordecisionsattheindividualbusinessunitorprojectlevel.B. Correlationsbetweenbroadrisktypessuchascredit,market,andoperationalriskaregenerallywell

understoodandareeasytoestimateattheindividualfirmlevel.C. Theintroductionofcorrelationsintofirm-wideriskevaluationwillresultinatotalVaRthat,in

general,isgreaterthanorequaltothesumofindividualbusinessunitVaRs.D. Theintroductionofcorrelationsintotheriskevaluationofabank’sloanbookwillresultintotalcredit

VaRthat,ingeneral,islessthanorequaltothesumofindividualloancreditVaRs.

Correctanswer:DExplanation:Discorrect.CreditVaR(CVaR)=VaR–EL.Lower(ornegative)correlationsamongloanassetsleadtoloweroverallVaRduetothediversificationeffect,whicheffectivelylowersCVaRsinceELisnotaffectedbycorrelations.Whencorrelationsareperfectlypositive(andequaltoone),thereisnodiversificationandloanportfolioVaRwillequalthesumoftheindividualloanVaRs.Choicesa,bandcareincorrect.Section:OperationalandIntegratedRiskManagementReference:BrianNoccoandRenéStulz,“EnterpriseRiskManagement:TheoryandPractice,”JournalofAppliedCorporateFinance18,No.4(2006):pp.8-20.LearningObjective:Describetheroleofandissueswithcorrelationinriskaggregation,anddescribetypicalpropertiesofafirm’smarketrisk,creditrisk,andoperationalriskdistributions.

8. ApensionfundhasreportedthatitsassetsandliabilitieswerevaluedatUSD840millionandUSD450million,respectively,atyear-end2015.Theassetswerefullyinvestedinequitiesandcommodities.Thefund’sliabilities,constitutedentirelybyfixed-incomeobligations,hadamodifieddurationof12years.In2016,theglobalslumpincommoditypricesaffectedthepensionfundassets,specificallycausingitsinvestmentinequitiesandcommoditiestolose30%oftheirmarketvalue.However,thesurprisingmonetarypolicyactionofthegovernmentthatledtotheincreaseininterestrateshadapositiveeffectontheperformanceoffixed-incomesecurities,causingyieldsonthefund’sliabilitiestoriseby2.3%.Whatwasthechangeinthepensionfund’ssurplusin2016?

Correctanswer:BExplanation:Biscorrect.Thechangeinthepensionfund’ssurplus(DS)fortheyear2016isequaltotheendingsurplus(S1)attheendof2016lesstheinitialsurplus(S0)attheendof2015.Thatis,DS=S1–S0.TheinitialsurplusiscalculatedasS0=A0–L0=840–450=USD390million,whereA0=thefirm’sinitialassetsandL0=thefirm’sinitialliabilities.NextwehavetocalculateS1,thesurplusattheendof2016.Giventhe30%declineintheequityandcommoditymarkets,thenewlevelofassetsA1attheendof2016isequalto:A1=(1–0.3)*840=USD588million.Sincethepercentagechangeinliabilityvalue=–DM*Dy,whereDM=modifiedduration=12;andDy=changeinyield=+2.3%,thenthenewlevelofliabilitiesL1attheendof2016canbecalculatedas:L1=[1–(DM*Δy)]*L0=[1–12*(+0.023)]*450=USD325.8millionThus,theendingsurplusfor2016=S1=A1–L1=588–325.8=USD262.2millionThereforethechangeinsurplusfor2016=DS=S1–S0=262.2–390=USD–127.8million(whichimpliesthepensionfundisactuallyinadeficitsituationattheendof2016).Aisincorrect.USD-325.8millionisthenegativeamountofliabilitiesatyear-end2016.Cisincorrect.USD262.8millionistheyear-end2016surplus.Disincorrect.USD390.0millionistheyear-end2015surplus.Section:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition(NewYork:McGraw-Hill,2007).Chapter17,VaRandRiskBudgetinginInvestmentManagement.LearningObjective:Describetheinvestmentprocessoflargeinvestorssuchaspensionfunds.

9. AwealthmanagementfirmhasaportfolioconsistingofUSD48millioninvestedinUSequitiesandUSD35millioninvestedinemergingmarketsequities.The1-day95%VaRforeachindividualpositionisUSD1.2million.ThecorrelationbetweenthereturnsoftheU.S.equitiesandemergingmarketsequitiesis0.36.Whilerebalancingtheportfolio,themanagerinchargedecidestosellUSD8millionoftheUSequitiestobuyUSD8millionoftheemergingmarketsequities.Atthesametime,theCROofthefirmadvisestheportfoliomanagertochangetheriskmeasurefrom1-day95%VaRto10-day99%VaR.Assumingthatreturnsarenormallydistributedandthattherebalancingdoesnotaffectthevolatilityoftheindividualequitypositions,byhowmuchwilltheportfolioVaRincreaseduetothecombinedeffectofportfoliorebalancingandchangeinriskmeasure?

A. USD6.870millionB. USD8.248millionC. USD11.270millionD. USD12.482million

Correctanswer:DExplanation:Discorrect.ThefirststepistocalculatetheVaRoftheoriginalportfoliooftwoequities,U.S.(u)andemergingmarkets(e).Thiscanbederivedbyusingthefollowingequation:

( )euueeup VaRVaRVaRVaRVaR ***222 r++=

where ρPA isthecorrelationcoefficient. (i)Initialposition:Theportfolio1-day95%VaR(beforetherebalancing)istherefore:

( ) millionUSDmillionUSDVaRp 979.197918.12.1*2.1*36.0*22.12.1 22 ==++=

(ii)Rebalancedposition:1-day95%VaR:Aftertherebalance,themarketvalueofthepositionintheU.S.equitiesisreducedby8/48=0.1667,soVaRuisnowequalto(1-0.1667)*(USD1.2million)=USD1.0million.Meanwhilethemarketvalueforthepositionintheemergingmarketequitieshasincreasedby8/35=0.2286sothatVaRAisnow(1+0.2286)*(USD1.2million)=USD1.474million.Hencethe1-day95%VaRofthenewportfolio(afterrebalancing)=USD3.234millionandiscalculatedasfollows:

( ) millionUSDmUSDVaRp 234.3234.30.1*474.1*36.0*20.1474.1 22 ==++=

(iii)Next,convertthe1-day95%VaRto10-day95%VaR:10-day95%VaR=(1-day95%VaR)*sqrt(10)/1=3.234x3.162278=USD10.227million.(iv)Finally,convertthe10-day95%VaRto10-day99%VaR:10-day99%VaR=(10-day95%VaR)*(2.326/1.645)=10.227x1.4140=USD14.461million.

Therefore,thequestionistocomparetheoriginal1-day95%VaR(USD1.979m)tothenewrebalanced10-day99%VaR(USD14.461).Thus,VaRwillincreaseby(14.461–1.979)million,orUSD12.482million.Aisincorrect.USD6.870millionistheincreaseinportfolioVaRifthe1-day95%unrebalancedportfolioVaRisconvertedtoa10-day99%VaR.Bisincorrect.USD8.249millionisthedifferencebetweenthe10-day95%VaRfortherebalancedportfolioandthe1-day95%VaRfortheunrebalancedportfolio.Cisincorrect.USD11.270millionisthedifferencebetweenthe10-day99%VaRfortherebalancedportfolioandthe1-day95%VaRfortherebalancedportfolio.Section:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition(NewYork:McGraw-Hill,2007).Chapter7:PortfolioRisk—AnalyticalMethods.LearningObjective:Define,calculate,anddistinguishbetweenthefollowingportfolioVaRmeasures:individualVaR,incrementalVaR,marginalVaR,componentVaR,undiversifiedportfolioVaR,anddiversifiedportfolioVaR.

10. TheboardofdirectorsatBankPQPisevaluatingaproposalbyseniormanagementtorestructuretheoperationsofthebank.Ofkeyconcernisthefutureofthebank’sconsumerlendingdivision,whichhasaloanportfolioamountingtoEUR180million.Thebankfundsthedivisionpredominantlyusingunstableretailandwholesaledeposits.Inanalyzingthecreditriskconditionofthedivision,managementdeterminesthattheprobabilityofdefaultis8%,thelossgivendefaultis70%,andtheexposureatdefaultis100%oftheloanexposure.TheCEOisarguingthattheriskcapitalthathasbeensetasidetosupportconsumerlending,inlinewiththebank’sstatedriskappetite,istoohighcomparedtotheperformanceoftheotherbusinessdivisions.Thebankappliesthesamehurdlerateandeffectivetaxrateacrossallbusinesslines,anda1-yearhorizontomeasureparameterswhosevaluesareshowninthetablebelow:Item ValueConsumerLendingDivision: Economiccapital EUR135.0millionReturnontheloanportfolio 14.0%Returnonriskcapital 3.0%Costofdebtcapital 6.0%Operatingdirectcosts EUR1.595millionTransfers EUR0.0million BankPQP: Hurdlerate 8.0%Equitymarketreturn 7.0%Risk-freerate 3.0%Equitybeta 1.05Effectivetaxrate 32.0%

Assumingearningscorrelationsbetweenthevariousdivisionsarethesameandthemainobjectiveofeachdivisionistoaddvalueforthebank’sshareholders,whichofthefollowingrecommendationsoftheboardiscorrect?

A. ClosedowntheconsumerlendingdivisionbecausetheadjustedRAROCislessthantherisk-freerateB. ClosedowntheconsumerlendingdivisionbecauseRAROCislessthanthehurdlerateC. KeeptheconsumerlendingdivisionbecausetheadjustedRAROCisgreaterthantherisk-freerateD. KeeptheconsumerlendingdivisionbecauseRAROCisgreaterthanthehurdlerate

Correctanswer:C

Explanation:

%0.8079993.0 ==±+----

==capitalEconomic

TransfersRORCTaxesELOCICERcapitalEconomicreturnExpectedRAROC

where:ER=Expectedrevenue=0.14x180,000,000=EUR25.2millionIC=Interestcosts=0.04x180,000,000=EUR7.2millionOC=Operatingcosts=EUR1.595millionEL=Expectedlosses=PDxLGDxEAD=0.06x0.6x1.0*180million=EUR6.48millionTaxes=(25.2–7.2–1.595–6.48)*(0.32)=EUR3.176millionRORC=Returnonriskcapital=0.03*135,000,000=EUR4.05millionTransfers=0

( ) ( ) %8.37993.337*05.19993.7* ==--=--= fm rRRAROCRAROCAdjusted b

Therefore,adjustedRAROCisgreaterthantherisk-freerate,sothecorrectdecisionistokeep(accept)theconsumerlendingdivisionasitcanaddvaluetothebank’sshareholders,onarisk-adjustedbasis.RAROCandthehurdlerateareaboutthesameand,usingthecriterion,theboardwouldbeindifferent.

Section:OperationalandIntegratedRiskManagementReference:MichelCrouhy,DanGalaiandRobertMark,TheEssentialsofRiskManagement,2ndEdition(NewYork:McGraw-Hill,2014).Chapter17,RiskCapitalAttributionandRisk-AdjustedPerformanceMeasurement.LearningObjective:ComputeandinterprettheRAROCforproject,loanorloanportfolio,anduseRAROCtocomparebusinessunitperformance;ComputetheadjustedRAROCforaprojecttodetermineitsviability.

11. Acreditmanagerwhoiswellversedinlessonslearnedfromthe2007–2009subprimemortgagecrisisintheUSisoverseeingthestructuredcreditbookofabankinordertoidentifypotentialfrictionsinthesecuritizationprocess.Whichofthefollowingisacorrectcombinationofapotentialfrictioninthesecuritizationprocessandanappropriatemechanismtomitigatethatfriction?

A. Frictionbetweentheassetmanagerandtheinvestor:Adverseselectionproblem.Thisproblemcanbemitigated

bytheassetmanagerchargingduediligencefeestotheinvestor.B. Frictionbetweenthearrangerandtheoriginator:Modelerrorproblem.Thisproblemcanbemitigatedbythe

arrangerprovidingacreditenhancementtothesecuritieswithitsownfunding.C. Frictionbetweentheinvestorandcreditratingagencies:Principal-agentconflict.Thisproblemcanbe

mitigatedbyrequiringcreditratingagenciestobepaidbyoriginatorsandnotbyinvestorsfortheirratingservices.

D. Frictionbetweentheservicerandthemortgagor:Moralhazardproblem.Thisproblemcanbemitigatedbyrequiringthemortgagortoescrowfundsforinsuranceandtaxpaymentsinordertoforestalltheriskofforeclosure.

Correctanswer:DExplanation:Discorrect.Thefrictionbetweentheservicerandthemortgagorisamoralhazardproblem.Theservicerandthemortgagordonotsharethefullconsequenceofbadoutcomes(e.g.,loanforeclosure,delinquencies).Themortgagortypicallyhaslimitedliability,andhaslittleincentivetoexpendeffortorresourcestomaintainapropertyclosetoforeclosure.Ontheotherhand,theservicerstrivestoworkininvestors’bestinterestbykeepingupwithpaymentofpropertytaxesandinsurance,andgenerallymaintainingtheproperty.Awaytomitigatethisfrictionistorequirethemortgagortoregularlyescrowfundsforinsuranceandtaxpaymentsinordertoforestalltheriskofforeclosure.Aisincorrect.Frictionbetweentheassetmanagerandtheinvestorisaprincipal-agentproblem.Theinvestorislesssophisticatedthantheassetmanager,doesnotfullyunderstandtheinvestmentstrategyoftheassetmanager,hasuncertaintyaboutthemanager’sability,anddoesnotobserveanyeffortthatthemanagermakestoconductduediligence.Someofthewaystomitigatethisfrictionisthroughtheuseofinvestmentmandate,andtheevaluationofmanagerperformancerelativetoitspeersorapeerbenchmark.Bisincorrect.Frictionbetweenthearrangerandoriginatorisanadverseselectionproblem.Itisoneofthekeyfrictionsintheprocessofsecuritizationinvolvinganinformationproblembetweentheoriginatorandarranger.Inparticular,theoriginatorhasaninformationadvantageoverthearrangerwithregardtothequalityoftheborrower.Withoutadequatesafeguardsinplace,anoriginatorcanhavetheincentivetocollaboratewithaborrowerinordertomakesignificantmisrepresentationsontheloanapplication.Dependingonthesituation,thiscouldbeeitherconstruedaspredatorylending(wherethelenderconvincestheborrowertoborrowtoolargeofasumgiventheborrower’sfinancialsituation)orpredatoryborrowing(theborrowerconvincesthelendertolendtoolargeasum).Tomitigatetheproblem,thearrangershouldhavesafeguardsinplace,includingcarryingoutathoroughduediligenceontheoriginatorandrequiringtheoriginatortohaveadequatecapitaltobuybackproblemloans.Cisincorrect.Frictionbetweentheinvestorandcreditratingagenciesisamodelerrorproblem.Investorsarenotabletoassesstheefficacyofratingagencymodelsand,so,aresusceptibletobothhonestanddishonesterrors.Worsestill,ratingagenciesarepaidbythearrangerandnotbytheinvestorsfortheiropinion,whichcreatespotentialconflictofinterest.Thisfrictioncanbemitigatedbyrequiringpublicdisclosureofthecriteria

forratingsanddowngrades,andforholdingratingagenciesaccountablefortheirreputation.Section:CreditRiskMeasurementandManagementReference:AdamAshcroftandandTilSchuermann,“UnderstandingtheSecuritizationofSubprimeMortgageCredit,”FederalBankofNewYorkStaffReports,No.318(March2008).LearningObjective:Identifyanddescribekeyfrictionsinsubprimemortgagesecuritization,andassesstherelativecontributionofeachfactortothesubprimemortgageproblems.

12. Ariskmanagerisbacktestingacompany’s1-day99.5%VaRmodelovera1-yearhorizonata95%confidencelevel.Assuming250daysinayear,whatisthemaximumnumberofdailylossesexceedingthe1-day99.5%VaRthatisacceptabletoconcludethatthemodeliscalibratedcorrectly?

A. 3B. 5C. 15D. 19

Correctanswer:AExplanation:TheriskmanagerwillrejectthehypothesisthatthemodeliscorrectlycalibratedifthenumberxoflossesexceedingtheVaRissuchthat:

( )96.1

TpppTx

whereprepresentsthefailurerateandisequalto1-0.995,or0.5%;andTisthenumberofobservations=250.Andz=1.96isthetwo-tailconfidencelevelquantile.If

( )96.1

250*005.01*005.0250*005.0

then,x=3.436.Sothemaximumnumberofexceedanceswouldbe3toconcludethatthemodeliscalibratedcorrectly.Section:MarketRiskMeasurementandManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition.(NewYork:McGraw-Hill,2007).Chapter6,BacktestingVaR.LearningObjective:Verifyamodelbasedonexceptionsorfailurerates.

13. Aportfoliomanagerismappingafixed-incomeportfoliointoexposuresonselectedriskfactors.Themanagerisanalyzingthecomparablemechanicsandriskmeasurementoutputsofprincipalmapping,durationmapping,andcash-flowmappingthatcorrespondtotheaverageportfoliomaturity.Whichofthefollowingiscorrect?

A. Principalmappingconsiderscouponandprincipalpayments,andtheportfolioVaRusingprincipalmappingis

greaterthantheportfolioVaRusingcash-flowmapping.B. DurationmappingdoesnotconsiderintermediatecashflowsandtheportfolioVaRusingdurationmappingis

lessthantheportfolioVaRusingprincipalmapping.C. Cash-flowmappingconsidersthetimingoftheredemptioncashflowpaymentsonly,andtheportfolioVaRusing

cashflowmappingislessthantheportfolioVaRusingdurationmapping.D. Cash-flowmappingconsidersthepresentvaluesofcashflowsgroupedintomaturitybuckets,andthe

undiversifiedportfolioVaRusingcash-flowmappingisgreaterthantheportfolioVaRusingprincipalmapping.

Correctanswer:BExplanation:Biscorrect.Withdurationmapping,aportfolioisreplacedbyazero-couponbondwithmaturityequaltothedurationoftheportfolio.Theriskofthehypotheticalzerosislessthantheriskofacouponbondofcomparablematurity.Therefore,theportfolioVaRusingdurationmappingislessthantheportfolioVaRusingprincipalmapping.Withprincipalmapping,oneriskfactorischosenthatcorrespondstotheaverageportfoliomaturity.Withdurationmapping,oneriskfactorischosenthatcorrespondstotheportfolioduration.Withcashflowmapping,theportfoliocashflowsaregroupedintomaturitybucketsandtheundiversifiedportfolioVaRusingcash-flowmappingislessthantheportfolioVaRusingprincipalmappingsinceprincipalmappingignorestheinterveningcouponpayments,thusoverstatingthetrueriskoftheportfolio.Section:MarketRiskMeasurementandManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition.(NewYork:McGraw-Hill,2007).Chapter11,VaRMapping.LearningObjective:Differentiateamongthethreemethodsofmappingportfoliosoffixedincomesecurities.

14. ACROofahedgefundisaskingtheriskteamtodevelopaterm-structuremodelthatisappropriateforfittinginterestratesforuseinthefund’soptionspricingpractice.Theriskteamisevaluatingamongseveralinterestratemodelswithtime-dependentdriftandtime-dependentvolatilityfunctions.Whichofthefollowingisacorrectdescriptionofthespecifiedmodel?

A. IntheHo-Leemodel,thedriftoftheinterestrateprocessispresumedtobeconstant.B. IntheHo-Leemodel,whentheshort-termrateisaboveitslong-runequilibriumvalue,thedriftispresumedtobe

negative.C. IntheCox-Ingersoll-Rossmodel,thebasis-pointvolatilityoftheshort-termrateispresumedtobeproportional

tothesquarerootoftherate,andshort-termratescannotbenegative.D. IntheCox-Ingersoll-Rossmodel,thevolatilityoftheshort-termrateispresumedtodeclineexponentiallytoa

constantlevel.

Correctanswer:CExplanation:Ciscorrect.IntheCIRmodel,thebasis-pointvolatilityoftheshortrateisnotindependentoftheshortrateasothersimplermodelsassume.Theannualizedbasis-pointvolatilityequals𝜎*sqrt(r)andthereforeincreasesasafunctionofthesquarerootoftherate.Short-termrateintheCIRmodelcannotbecomenegativebecauseofthecombinedpropertythat(i)basis-pointvolatilityequalszerowhenshort-termrateiszero,and(ii)thedriftispositivewhentheshort-termrateiszero.Section:MarketRiskMeasurementandManagementReference:BruceTuckmanandAngelSerrat,FixedIncomeSecurities,3rdEdition(Hoboken,NJ:JohnWiley&Sons,2011).Chapter9:TheArtofTermStructureModels:DriftLearningObjectives:Describemethodsofaddressingthepossibilityofnegativeshort-termratesintermstructuremodels;Constructashort-termratetreeundertheHo-LeeModelwithtime-dependentdrift.Reference:BruceTuckmanandAngelSerrat,FixedIncomeSecurities,3rdEdition(Hoboken,NJ:JohnWiley&Sons,2011).Chapter10:TheArtofTermStructureModels:VolatilityandDistribution.LearningObjective:Describetheshort-termrateprocessundertheCox-Ingersoll-Ross(CIR)andlognormalmodels.

15. AportfoliostrategistforahedgefundislookingtomitigatecounterpartycreditriskexposuretoLLG,anA-ratedfirm.CurrentlythehedgefundhasthefollowingderivativecontractswithfirmLLG:

Contract ContractValue(SGD)X 20,000,000Y 40,000,000Z 16,000,000W 1,500,000

Withtheinformationprovided,whatisthemostappropriatecreditriskmitigationtechniquethatthehedgefundshoulduseinthiscase?A. Implementanettingscheme.B. Usecredittriggers.C. SellcreditdefaultswapsonLLG.D. Increasecollateral.

Correctanswer:DExplanation:Increasingcollateralwouldeffectivelyreducecurrentcreditexposuredependingonthecontractparameters,mainlyminimumtransferamountandthreshold.Section:CreditRiskMeasurementandManagementReference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets(WestSussex,UK:JohnWiley&Sons,2012).Chapter3,DefiningCounterpartyCreditRisk.LearningObjective:Identifyanddescribethedifferentwaysinstitutionscanmanageandmitigatecounterpartyrisk.

16. Amid-sizedinvestmentbankconductsseveraltrades.Aspartofitsriskcontrol,ithasenteredintonettingagreementson8equitytradepositionswithanaveragecorrelationof0.28.Thefirmbelievesthatitcanimproveuponthediversificationbenefitofnettingbyajudiciouschoiceofnumberofexposureswithafavorablecorrelationcoefficient.Whichofthefollowingtradecombinationswouldincreasethefirm’sexpectednettingbenefitthemostfromthecurrentlevel?

TradeCombination NumberofPositions AverageCorrelationABC 4 0.25LMN 7 0.15PQR 13 –0.06TUV 15 –0.04

A. TradecombinationABCB. TradecombinationLMNC. TradecombinationPQRD. TradecombinationTUV

Correctanswer:CExplanation:Tradecombinationcisthecorrectanswer.Nettingfactorisexpressedas:

( )nnnn

factorNettingr1-+

Forthecurrentposition,whenn(numberofpositions)=8andr(correlationcoefficient)=0.28,

( ) ( )( )%83.60

828.018*881

factorNettingr

ciscorrect.Whenn=13andr=-0.06,thereisthemostreductioninnettingfactor,

( ) ( )( )%68.14

1306.0113*13131

factorNettingr

aisincorrect.Whenn=4andr=0.25,thereisonlyamodestnettingbenefit:

( ) ( )( )%14.66

525.014*441

factorNettingr

bisincorrect.Whenn=7andr=0.15,thereisreductioninnettingfactorbutnotasmuchasinc,

( ) ( )( )%10.52

715.017*771

factorNettingr

disincorrect.Whenn=15andr=–0.04,thereisareasonablereductioninnettingfactorbutnotasmuchasinc,

( ) ( )( )%13.17

1504.0115*15151

factorNettingr

Section:CreditRiskMeasurementandManagementReference:JonGregory(2012),CounterpartyCreditRisk:AContinuationChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons).Chapter8,CreditExposure.LearningObjective:Explaintheimpactofnettingonexposure,thebenefitofcorrelation,andcalculatethenettingfactor.

17. AportfoliomanagerisinterestedinacquiringStockGILaspartofanexistingportfolio.However,themanagerisconcernedaboutthelevelofliquidityriskandproceedstoestimateliquidityadjustedVaRforthestock.ThemanagerobservesaquoteforStockGILandreportsthatthemidpointofitscurrentbestbidandbestaskpricesisAUD66.StockGILhasanestimateddailyreturnvolatilityof0.27%andaveragebid-askspreadofAUD0.18.Usingtheconstantspreadapproachona30,000sharepositionandassumingthereturnsofStockGILarenormallydistributed,whatisthecorrectestimateforthestock’sliquidity-adjusted1-day99%VaR?

A. AUD2,700B. AUD5,400C. AUD12,400D. AUD15,100

Correctanswer:DExplanation:Thedaily99%VaR=66*30,000*(2.326*0.0027)=AUD12,434.80Theconstantspreadapproachaddshalfofthebid-askspread(asapercent)totheVaRcalculation,usingthefollowingformula:LiquidityCost(LC)=½*(Spread*P),whereSpreadisequaltotheactualspreaddividedbythemidpointandPisthevalueoftheposition.Thereforetheliquiditycost(LC)=0.5*(0.18/66)*66*30,000=AUD2,700;andLiquidity-adjustedVaR(LVaR)=VaR+LC=12,434.80+2,700=AUD15,134.80Section:OperationalandIntegratedRiskManagementReference:KevinDowd,MeasuringMarketRisk,2ndEdition(WestSussex,England:JohnWiley&Sons,2005).Chapter14,EstimatingLiquidityRisks.LearningObjective:DescribeandcalculateLVaRusingtheconstantspreadapproachandtheexogenousspreadapproach.

18. Amanagerisevaluatingtherisksofaportfolioofstocks.Currently,theportfolioisvaluedatCNY136millionandcontainsCNY12millioninstockY.ThestandarddeviationofreturnsofstockYis18%annuallyandthatoftheoverallportfoliois23%annually.ThecorrelationofreturnsbetweenstockYandtheportfoliois0.42.Assumingtheriskanalystusesa1-year95%VaRandthatreturnsarenormallydistributed,howmuchisthecomponentVaRofstockY?

A. CNY0.817millionB. CNY1.492millionC. CNY2.110millionD. CNY3.553million

Correctanswer:BExplanation:ThecomponentVaRforstockY(cVaRY)canbepresentedas:

YpYY VaRcVaR *,r= whereVaR=VaRofstockY;andrY,p=correlationcoefficientbetweenstockYandtheportfolio.LetwYrepresentthevalueofstockY;sYrepresentthestandarddeviationofstockYreturns;α(95%)representthe95%confidencefactorfortheVaRestimate,whichis1.645.Hence,VaRY=wY*σY*α(95%)=CNY12millionx0.18x1.645=CNY3.553million.Therefore,cVaRY=ρY,p*VaRY=0.42x3.553=CNY1.492millionSection:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition.(NewYork:McGraw-Hill,2007).Chapter7,PortfolioRisk:AnalyticalMethods.Learningobjective:Define,calculate,anddistinguishbetweenthefollowingportfolioVaRmeasures:individualVaR,incrementalVaR,marginalVaR,componentVaR,undiversifiedportfolioVaR,anddiversifiedportfolioVaR.

XYZ,asmallinvestmentmanagementfirm,specializesinstructuringsmallbusinessloansandsellingthegovernmentguaranteedportiontootherinstitutionalinvestorswhileretainingtheriskierportionsforhighnetworthinvestors.XYZfundsitsoperationsbyengaginginovernightrepurchaseagreements(repos)withthreefirms,butprimarilywithABC,afirmthatspecializesinpoolingfundsfromcommunitybanksandlocalgovernmentagenciesandinvestingtheminshort-term,high-quality,government-securedinvestments.Lastweek,XYZwasinformedbyABCthatitslinehadbeenfrozen.XYZlearnedthatABChadbeendefraudedbyRepoCo.,anotherrepoborrower,whohadprovidedfalsedocumentationofnon-existentcollateralofgovernment-guaranteedloans.ABCfearedarunbyitsinvestorsasnewsofthefraudspread.Thediagrambelowillustratesthepartiesinvolved:

19. TheuseofacentralclearinghousetohandlethetransactionsexecutedbetweenXYZ'smainfundingsource,ABCandABC'sclient,RepoCo.,wouldlikelyhaveresultedinareductionin:A. ABC'sfundingliquidityrisk.B. RepoCo.'sdefaultrisk.C. XYZ'slendingrisk.D. ABC'soperationalrisk.

Correctanswer:DExplanation:Ifitusesaclearinghouseandtheclearinghousemakesamistake(operationalrisk)likethatmadebyABC,ABCwillhaverecoursetotheclearinghouseanditwouldhave,therefore,reduceditsoperationalriskexposure.A.Incorrect.ABCisnotfundingfromRepoCo.B.Incorrect.TheuseofaclearinghousedoesnotchangeRepoCo.’sdefaultrisk–justABC’sexposuretoRepoCo.defaults.C.Incorrect.TheuseofaclearinghouseinthissituationdoesnotreduceXYZ’slendingrisk.Reference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter3–DefiningCounterpartyCreditRiskLearningObjective:Describecounterpartyriskanddifferentiateitfromlendingrisk.

20. ByusingaclearinghousetohandletherepotransactionsbetweenABCandRepoCo.,obligationsowedbetweenthetwocouldhavebeennettedoncethefraudulentdocumentationwasdiscovered.Whichofthefollowingisthemostappropriatetypeofnettingtouseinthissituationandwhatwouldbealikelyadditionalimpactfromusingthisnetting?A. Paymentnettingwouldbeused,whichwouldreduceABC'scounterpartyrisk,butthisriskwouldbetransferred

toothercreditorsoutsidetheclearinghouse.B. Paymentnettingwouldbeused,whichwouldreduceRepoCo.'scounterpartyrisk,butABC'scounterpartyrisk

wouldbeincreased.C. Closeoutnettingwouldbeused,whichwouldreduceABC'scounterpartyrisk,butthisriskwouldbetransferred

toothercreditorsoutsidetheclearinghouse.D. Closeoutnettingwouldbeused,whichwouldreduceRepoCo.'scounterpartyrisk,butABC'scounterpartyrisk

wouldbeincreased.

Correctanswer:CExplanation:Paymentnettingperthereadingisthesimplenettingofcashflowsdueonthesameday.Closeoutnettingoccursifthereisaneventofdefault,whichwouldincludeanincidenceoffraud.Oneoftheshortcomingsofclearinghouses,andcloseoutnettingaswell,isthattheotherparty,inthiscaseABCBank,jumpstotheheadofthequeuewithitsclaimonRepoCo.tothepossibledetrimentofothers,particularlythoseoutsidetheclearinghouseingeneral.Reference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter4–Netting,Compression,Resets,andTerminationFeaturesLearningObjective:Summarizenettingandclose-outprocedures(includingmultilateralnetting),explaintheiradvantagesanddisadvantages,anddescribehowtheyfitintotheframeworkoftheISDAmasteragreement.

21. Ariskanalystatafundmanagementcompanyisdiscussingwiththeriskteamthegapsinthecompany’sriskmeasurementsystem.Amongtheissuestheyhaveidentifiedistheunderstandingthatfailingtoanticipatecashflowneedsisoneofthemostseriouserrorsthatafirmcanmake.Addressingsuchaproblemdemandsthatagoodliquidity-at-risk(LaR)measurementsystembeanessentialpartofthebank'sriskmanagementframework.WhichofthefollowingstatementsconcerningLaRiscorrect?

A. Afirm'sLaRtendstodecreaseasitscreditqualitydeclines.B. Forahedgedportfolio,theLaRcandiffersignificantlyfromtheVaR.C. HedgingusingfutureshasthesameimpactonLaRashedgingusinglongoptionpositions.D. ReducingthebasisriskthroughhedgingdecreasesLaR.

Correctanswer:BExplanation:TheLaRcandiffersubstantiallyfromtheVaRinahedgedportfolio,andindifferentsituationscanbelargerorsmallerthantheVaR.Forexample,consideraportfoliowherefuturescontractsareusedtohedge.WhilethehedgecanreducetheVaRoftheportfolio,theLaRcanbelargerthantheVaRasthefuturescontractscreateanexposuretomargincallsandthepotentialforcashoutflows.Alternatively,insituationswherethehedginginstrumentsdonotresultinpotentialcashoutflowsoverthemeasurementperiod(e.g.aportfolioofEuropeanoptionswhichdonotexpireduringtheperiod),theLaRcanbesmallerthantheVaR.Section:OperationalandIntegratedRiskManagementReference:KevinDowd,MeasuringMarketRisk,2ndEdition(WestSussex,England:JohnWiley&Sons,2005).Chapter14,EstimatingLiquidityRisks.LearningObjective:Describeliquidityatrisk(LaR)andcompareittoVaR,describethefactorsthataffectfuturecashflows,andexplainchallengesinestimatingandmodelingLaR.

22. Pillar1oftheBaselIIframeworkallowsbankstousevariousapproachestocalculatethecapitalrequirementsforcreditrisk,operationalrisk,andmarketrisk.WhichofthefollowingBaselIIapproachesallowsabanktoexplicitlyrecognizediversificationbenefits?

A. ThebasicindicatorapproachforoperationalriskB. TheinternalratingsbasedapproachforcreditriskC. TheinternalmodelsapproachformarketriskD. Thestandardizedapproachforoperationalrisk

Correctanswer:CExplanation:Theinternalmodelsapproachallowsbankstouseriskmeasuresderivedfromtheirowninternalriskmanagementmodels,subjecttoasetofqualitativeconditionsandquantitativestandards.Intermsofriskaggregationwithinmarketrisk,banksareexplicitlyallowedtorecognizeempiricalcorrelationsacrossbroadmarketriskcategories,and,thus,diversificationbenefits.Section:OperationalandIntegratedRiskManagementReference:JohnHull,RiskManagementandFinancialInstitutions,4thEdition,(NewYork:JohnWiley&Sons,2015).Chapter15,BaselI,BaselII,andSolvencyII.LearningObjective:Describeandcontrastthemajorelements—includingadescriptionoftheriskscovered—ofthetwooptionsavailableforthecalculationofmarketrisk:StandardizedMeasurementMethodandInternalModelsApproach.

23. Theriskauditcommitteeofamutualfundisreviewingaportfolioconstructiontechniqueproposedbyanewportfoliomanager.Themanagerhasrecentlybeenallocatedcapitaltomanageforanequityriskclass.TheFundtypicallygrantsitsportfoliomanagersflexibilityinselectingandimplementingappropriateportfolioconstructionproceduresbutrequiresthatanymethodologyadoptedfulfilskeyriskcontrolobjectivessetbythefirm.Whichofthefollowingportfolioconstructiontechniquesanditscapabilityforriskcontrolinportfolioconstructioniscorrect?

A. Quadraticprogrammingallowsforriskcontrolthroughparameterestimationbutgenerallyrequiresmanymore

inputsestimatedfrommarketdatathanothermethodsrequire.B. Thescreeningtechniqueprovidessuperiorriskcontrolbyconcentratingstocksinselectedsectorsbasedon

expectedalpha.C. Whenusingthestratificationtechnique,riskcontrolisimplementedbyoverweightingthecategorieswithlower

risksandunderweightingthecategorieswithhigherrisks.D. Whenusingthelinearprogrammingtechnique,riskiscontrolledbyselectingtheportfoliowiththelowestlevelof

activerisk.

Correctanswer:AExplanation:Quadraticprogrammingrequiresmanymoreinputsthanotherportfolioconstructiontechniquesbecauseitentailsestimatingvolatilitiesandpair-wisecorrelationsbetweenallassetsinaportfolio.Quadraticprogrammingisapowerfulprocess,butgiventhelargenumberofinputsitintroducesthepotentialfornoiseandpoorcalibrationgiventhelessthanperfectnatureofmostdata.Ontheotherhand,thescreeningtechniquestrivesforriskcontrolbyincludingasufficientnumberofstocksthatmeetthescreeningparametersandbyweightingthemtoavoidconcentrationsinanyparticularstock.However,screeningdoesnotnecessarilyselectstocksevenlyacrosssectorsandcanignoreentiresectorsorclassesofstocksentirelyiftheydonotpassthescreen.Therefore,riskcontrolinascreeningprocessisfragmentaryatbest.Stratificationseparatesstocksintocategories(forexample,economicsectors)andimplementsriskcontrolbyensuringthattheweightingineachsectormatchesthebenchmarkweighting.Therefore,itdoesnotallowforoverweightingorunderweightingspecificcategories.Linearprogrammingdoesnotnecessarilyselecttheportfoliowiththelowestlevelofactiverisk.Rather,itattemptstoimproveonstratificationbyintroducingmanymoredimensionsofriskcontrolandensuringthattheportfolioapproximatesthebenchmarkforallthesedimensions.Section:RiskManagementandInvestmentManagementReference:RichardGrinoldandRonaldKahn,ActivePortfolioManagement:AQuantitativeApproachforProducingSuperiorReturnsandControllingRisk,2ndEdition(NewYork:McGraw-Hill,2000).Chapter14,PortfolioConstruction.LearningObjective:Evaluatethestrengthsandweaknessesofthefollowingportfolioconstructiontechniques:screens,stratification,linearprogramming,andquadraticprogramming.

24. AnanalystreportsthefollowingfundinformationtotheadvisorofapensionfundthatcurrentlyinvestsingovernmentandcorporatebondsandcarriesasurplusofUSD10million:

Pension Assets LiabilitiesAmount(USDmillion) 180 140Expectedannualgrowth 6% 10%Modifiedduration 14 8Annualvolatilityofgrowth 25% 12%

Toevaluatethesufficiencyofthefund'ssurplus,theadvisorestimatesthepossiblesurplusvaluesattheendofoneyear.Theadvisorassumesthatannualreturnsonassetsandtheannualgrowthoftheliabilitiesarejointlynormallydistributedandtheircorrelationcoefficientis0.68.Theadvisorcanreportthat,withaconfidencelevelof95%,thesurplusvaluewillbegreaterthanorequalto:

Correctanswer:BExplanation:Thelowerboundofthe95%confidenceintervalisequalto:ExpectedSurplus–(95%confidencefactor*VolatilityofSurplus).Therequiredvariablescanbecalculatedasfollows:Varianceofsurplus(Variances):

ALLALALLAAS VVVVV rssss *****2** 2222 -+= =1802*0.252+1402*0.122–2*180*140*0.25*0.12*0.68=1,279.08;andso,And,volatilityofsurplus(σS):σS=sqrt(1,279.80)=USD35.764million Thus,theexpectedsurplus=VA*(1+RA)–VL*(1+RL)=180*1.06–140*1.10=USD36.80million.Therefore,thelowerboundofthe95%confidenceinterval=36.80–1.645*35.764=USD-22.032million.Section:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition.(NewYork:McGraw-Hill,2007).Chapter17,VaRandRiskBudgetinginInvestmentManagement.LearningObjective:Distinguishamongthefollowingtypesofrisk:absoluterisk,relativerisk,policy-mixrisk,activemanagementrisk,fundingrisk,andsponsorrisk.

25. Aduediligencespecialistatacompanyisevaluatingtheriskmanagementprocessofahedgefundinwhichthecompanyisconsideringmakinganinvestment.Whichofthefollowingstatementsbestdescribescriteriausedforsuchanevaluation?

A. Becauseoftheoverwhelmingimportanceoftailrisk,thecompanyshouldnotinvestinthefundunlessitfully

accountsforfattailsusingextremevaluetheoryatthe99.99%levelwhenestimatingVaR.B. Today'sbestpracticesinriskmanagementrequirethatafundemployindependentriskserviceprovidersandthat

theseserviceprovidersplayimportantrolesinrisk-relateddecisions.C. Whenconsideringaleveragedfund,thespecialistshouldassesshowthefundestimatesrisksrelatedtoleverage,

includingfundingliquidityrisksduringperiodsofmarketstress.D. Itiscrucialtoassessthefund'svaluationpolicy,andingeneralifmorethan10%ofassetpricesarebasedon

modelpricesorbrokerquotes,thespecialistshouldrecommendagainstinvestmentinthefundregardlessofotherinformationavailableaboutthefund.

Correctanswer:CExplanation:Generallyspeaking,withaleveragedfund,aninvestorwillneedtoevaluatehistoricalandcurrentchangesinleverage,aswellasthelevelofliquidityoftheportfolio,particularlyduringtimesofmarketstress.Certainstrategiesmayinfactexposeaninvestortotailrisk,sowhileaninvestorshouldinquirewhetherthemanagerbelievesthattailriskexists,andwhetherornotitishedged,itisthenuptotheinvestortodecidewhethertoaccepttheriskunhedgedorhedgeitontheirown.Manyfundsemployindependentriskserviceproviderstoreportriskstoinvestors,butthesefirmsdonotgetinvolvedinriskrelateddecisionmaking.Andfinally,whileitisimportanttoknowwhatpercentageoftheassetsisexchange-tradedandmarkedtomarket,whatmightbeacceptablemaydifferdependingonthestrategyofthefund.Section:RiskManagementandInvestmentManagementReference:KevinR.Mirabile,HedgeFundInvesting:APracticalApproachtoUnderstandingInvestorMotivation,ManagerProfits,andFundPerformance(Hoboken,NJ:WileyFinance,2013).Chapter11,PerformingDueDiligenceonSpecificManagersandFunds.LearningObjective:Describecriteriathatcanbeevaluatedinassessingafund’sriskmanagementprocess.

26. Apackagingmaterialsmanufacturerisconsideringaprojectthathasanestimatedrisk-adjustedreturnoncapital(RAROC)of15%.Supposethattherisk-freerateis3%peryear,theexpectedmarketrateofreturnis11%peryear,andthecompany'sequitybetais1.8.Usingthecriterionofadjustedrisk-adjustedreturnoncapital(ARAROC),thecompanyshould:

A. RejecttheprojectbecausetheARAROCishigherthanthemarketexpectedexcessreturn.B. AccepttheprojectbecausetheARAROCishigherthanthemarketexpectedexcessreturn.C. RejecttheprojectbecausetheARAROCislowerthanthemarketexpectedexcessreturn.D. AccepttheprojectbecausetheARAROCislowerthanthemarketexpectedexcessreturn.

Correctanswer:CExplanation:ARAROC=(RAROC–Rf)/β=(0.15–0.03)/1.8=6.67%.Marketexcessreturn=Rm–Rf=0.11–0.03=8.0%.where: Rf=risk-freerateofreturn β=betaofcompanyequity Rm=marketrateofreturnAsARAROCislowerthanthemarketexcessreturn,theprojectshouldberejected.Section:OperationalandIntegratedRiskManagementReference:MichelCrouhy,DanGalaiandRobertMark,RiskManagement,2ndedition(NewYork:McGraw-Hill,2014).Chapter17,RiskCapitalAttributionandRisk-AdjustedPerformanceMeasurement.LearningObjective:ComputetheadjustedRAROCforaprojecttodetermineitsviability.

27. Aderivativetradingfirmonlytradesderivativesonrarecommodities.Thecompanyandahandfulofotherfirms,allofwhomhavelargenotionaloutstandingcontractswiththecompany,dominatethemarketforsuchderivatives.Thecompany’smanagementwouldliketomitigateitsoverallcounterpartyexposure,withthegoalofreducingittoalmostzero.Whichofthefollowingmethods,ifimplemented,couldbestachievethisgoal?

A. EnsuringthatsufficientcollateralispostedbycounterpartiesB. DiversifyingamongcounterpartiesC. Cross-productnettingonasinglecounterpartybasisD. Purchasingcreditderivatives,suchascreditdefaultswaps

Correctanswer:AExplanation:Counterpartyexposure,intheory,canbealmostcompletelyneutralizedaslongasasufficientamountofhighqualitycollateral,suchascashorshort-terminvestmentgradegovernmentbonds,isheldagainstit.Ifthecounterpartyweretodefault,theholderofanopenderivativecontractwithexposuretothatcounterpartywouldbeallowedtoreceivethecollateral.Cross-productnettingwouldonlyreducetheexposuretooneofthecounter-parties,andpurchasingcreditderivativeswouldreplacethecounterpartyriskfromtheindividualcounterpartieswithcounterpartyriskfromtheinstitutionwhowrotetheCDS.Section:CreditRiskMeasurementandManagementReference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets(WestSussex,UK:JohnWiley&Sons,2012).Chapter3,DefiningCounterpartyCreditRisk.LearningObjective:Identifyanddescribethedifferentwaysinstitutionscanmanageandmitigatecounterpartyrisk.

28. ADBBankingCorporation,afrequentuserofswaps,oftenentersintotransactionswithHIPBank,amajorproviderofswaps.Recently,HIPBankwasdowngradedfromaratingofAtoaratingofA-,whileADBBankingCorporationwasdowngradedfromaratingofA-toaratingofBBB.Duringthistime,thecreditspreadforHIPBankhasincreasedfrom36bpsto144bps,whilethecreditspreadforADBBankinghasincreasedfrom114bpsto156bps.Whichofthefollowingisthemostlikelyactionthatthecounterpartieswillrequestontheircreditvalueadjustment(CVA)?

A. Thecreditqualitiesofthecounterpartieshavemigrated,butnotsignificantlyenoughtojustifyamendingexisting

CVAarrangements.B. HIPBankrequestsanincreaseintheCVAchargeitreceives.C. ADBBankingCorporationrequestsareductionintheCVAchargeitpays.D. CVAisnolongerarelevantfactor,andthecounterpartiesshouldmigratetousingothermitigantsof

counterpartyrisk.

Correctanswer:CExplanation:BecauseADBBankingCorporationhasalowercreditratingthanHIPBank,itwouldtypicallypayaCVAchargetoHIPBankwhichwouldbeafunctionoftherelativecreditspreadbetweenthetwobanks.AfterthedowngradesofbothHIPBankandADBBankingCorporation,thecreditspreadbetweenthetwofirmsnarrowedfrom78bpsinitiallytoonly12bpsafterthedowngrades.Therefore,withthespreadmuchlowerbetweenthetwobanks,ADBBankingCorporationwouldbeinapositiontorequestareductionintheCVAchargethatitpays.Section:CreditRiskMeasurementandManagementReference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets(WestSussex,UK:JohnWiley&Sons,2012).Chapter12,"CreditValueAdjustment.”LearningObjective:Explainthemotivationforandthechallengesofpricingcounterpartyrisk.

29. Ariskanalystestimatesthatthehazardrateforacompanyis0.10peryear.Theprobabilityofsurvivalinthefirstyearfollowedbyadefaultinthesecondyearisclosestto:

A. 8.6%B. 9.5%C. 18.1%D. 22.1%

Correctanswer:BExplanation:Theprobabilitythatthefirmdefaultsinthesecondyearisconditionalonitssurvivingthefirstyear.Usingλtorepresentthegivenhazardrate,wecancalculatethecumulativeprobabilityofdefaultinthefirstyearusingtheformula1–exp(–1*λ)=1–exp(-0.10)=0.0952.Thus,probabilityofsurvivalinthefirstyear=1–0.0952=0.9048.Then,thecumulativeprobabilitythatthefirmdefaultsinthesecondyear=1–exp(–2*λ)=1–exp(-2*0.10)=0.1813,andtheconditionaloneyeardefaultprobabilitygiventhatthefirmsurvivedthefirstyearisthedifferencebetweenthetwoyearcumulativeprobabilityofdefaultandtheoneyearprobabilitydividedbytheprobabilityofsurvivalinthefirstyear=(0.1813–0.0952)/0.9048=0.0952=9.52%.Section:CreditRiskMeasurementandManagementReference:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter7,SpreadRiskandDefaultIntensityModels.LearningObjective:Definethehazardrateanduseittodefineprobabilityfunctionsfordefaulttimeandcondition-aldefaultprobabilities.

30. ComputingVaRonaportfoliocontainingaverylargenumberofpositionscanbesimplifiedbymappingthesepositionstoasmallernumberofelementaryriskfactors.Whichofthefollowingiscorrect?

A. USD/EURforwardcontractsaremappedontheUSD/EURspotexchangerate.B. Eachpositioninacorporatebondportfolioismappedonthebondwiththeclosestmaturityamonga

setofgovernmentbonds.C. Zero-coupongovernmentbondsaremappedongovernmentbondspayingregularcoupons.D. Apositioninthestockmarketindexismappedonapositioninastockwithinthatindex.

Correctanswer:AExplanation:MappingseveralUSD/EURforwardcontractstoUSD/EURspotexchangerateisanadequateprocess,becausealltheforwardpositionsareexposedtoasinglemajorriskfactor,whichistheUSD/EURspotexchangerate.However,thisisnotaperfectmapping(forinstance,thesensitivityofboththeforwardandthespotexchangeratestoaspecificriskfactorsuchaschangesininterestrates,maydiffer).Whilethesingleaggregationofexposureofthisriskfactorisacceptableforriskmeasurement,itisnotadequateforpricingoftheportfolio.Section:MarketRiskMeasurementandManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition(NewYork:McGraw-Hill,2007).Chapter11,VaRMapping.LearningObjective:ExplaintheprinciplesunderlyingVaRmapping,anddescribethemappingprocess.

31. AriskmanagerisintheprocessofvaluingseveralEuropean-typeoptionpositionsonanon-dividend-payingstockXYZthatiscurrentlypricedatEUR30.Theimpliedvolatilityskew,estimatedusingtheBlack-Scholes-MertonmodelandthecurrentpricesofactivelytradedEuropean-styleoptionsonstockXYZatvariousstrikeprices,isshownbelow:

Strike Price (EUR)

AssumingthattheimpliedvolatilityatEUR30isusedtoconductthevaluation,whichofthefollowinglongpositionswillbeovervalued?

A. Anin-the-moneycallB. Anin-the-moneyputC. Anout-of-the-moneycallD. Anout-of-the-moneyput

Correctanswer:CExplanation:Anout-of-the-moneycallhasastrikepriceabove30.Therefore,usingthechartabove,itsimpliedvolatilityislessthantheat-the-moneyvolatility,sousingtheat-the-moneyimpliedvolatilitywouldresultinpricinganout-of-the-moneycalloptionhigherthanitsfairprice.Section:MarketRiskMeasurementandManagementReference:JohnHull,Options,Futures,andOtherDerivatives,9thEdition(NewYork:Pearson,2014).Chapter20,VolatilitySmiles.LearningObjective:Comparetheshapeofthevolatilitysmile(orskew)totheshapeoftheimplieddistributionoftheunderlyingassetpriceandtothepricingofoptionsontheunderlyingasset.

32. Afinancialanalystispricinga5-yearcalloptionona5-yearTreasurynoteusingasuccessfullytestedpricingmodel.Currentinterestratevolatilityishighandtheanalystisconcernedabouttheeffectthismayhaveonshort-termrateswhenpricingtheoption.Whichofthefollowingactionswouldbestaddressthepotentialfornegativeshort-terminterestratestoariseinthemodel?

A. Whenshort-termratesarenegative,thefinancialanalystadjuststherisk-neutralprobabilities.B. Whenshort-termratesarenegative,thefinancialanalystincreasesthevolatility.C. Whenshort-termratesarenegative,thefinancialanalystsetstheratetozero.D. Whenshort-termratesarenegative,thefinancialanalystsetsthemean-revertingparameterto1.

Correctanswer:CExplanation:Negativeshort-terminterestratescanariseinmodelsforwhichtheterminaldistributionofinterestratesfollowsanormaldistribution.Theexistenceofnegativeinterestratesdoesnotmakemucheconomicsensesincemarketparticipantswouldgenerallynotlendcashatnegativeinterestrateswhentheycanholdcashandearnazeroreturn.Onemethodthatcanbeusedtoaddressthepotentialfornegativeinterestrateswhenconstructinginterestratetreesistosetallnegativeinterestratestozero.Thislocalizesthechangeinassumptionstopointsinthedistributioncorrespondingtonegativeinterestratesandpreservestheoriginalratetreeforallotherobservations.Incomparison,adjustingtheriskneutralprobabilitieswouldalterthedynamicsacrosstheentirerangeofinterestratesandthereforenotbeanoptimalapproach.Whenamodeldisplaysthepotentialfornegativeshort-terminterestrates,itcanstillbeadesirablemodeltouseincertainsituations,especiallyincaseswherethevaluationdependsmoreontheaveragepathoftheinterestrate,suchasinvaluingcouponbonds.Therefore,thepotentialfornegativeratesdoesnotautomaticallyruleouttheuseofthemodel.Section:MarketRiskMeasurementandManagementReference:BruceTuckman,FixedIncomeSecurities,3rdEdition(Hoboken,NJ:JohnWiley&Sons,2011).Chapter9,TheArtofTermStructureModels:Drift.LearningObjective:Describemethodsforaddressingthepossibilityofnegativeshort-termratesintermstructuremodels.

33. AninvestmentbankhasbeenusingVaRasitsmainriskmeasurementtool.ESissuggestedasabetteralternativetouseduringmarketturmoil.WhatshouldbeunderstoodregardingVaRandESbeforemodifyingcurrentpractices?

A. ComparedtoVaR,ESleadstomorerequiredeconomiccapitalforthesameconfidencelevel.B. IfaVaRbacktestataspecifiedconfidencelevelisaccepted,thenthecorrespondingESwillalwaysbeaccepted.C. WhileVaRensuresthattheestimateofportfolioriskislessthanorequaltothesumoftherisksofthat

portfolio’spositions,ESdoesnot.D. WhileESismorecomplicatedtocalculatethanVaR,itiseasiertobacktestthanVaR.

Correctanswer:AExplanation:ExpectedshortfallisalwaysgreaterthanorequaltoVaRforagivenconfidencelevel,sinceESaccountsfortheseverityofexpectedlossesbeyondaparticularconfidencelevel,whileVaRmeasuresthemaximumexpectedlossatthatconfidencelevel.Therefore,ESwouldleadtoahigherlevelofrequiredeconomiccapitalthanVaRforthesameconfidencelevel.Inpractice,however,regulatorsoftencorrectforthedifferencebetweenESandVaRbyloweringtherequiredconfidencelevelforbanksusingEScomparedtothoseusingVaR.Section:MarketRiskMeasurementandManagementReference:BaselCommitteeonBankingSupervision,“MessagesfromtheAcademicLiteratureonRiskMeasurementfortheTradingBook,”WorkingPaperNo.19,January2011.LearningObjective:CompareVaR,expectedshortfall,andotherrelevantriskmeasures.

QUESTION34REFERSTOTHEFOLLOWINGINFORMATION

AderivativetradingdeskatabankdecidesthatitsexistingVaRmodel,whichhasbeenusedbroadlyacrossthefirmforseveralyears,istooconservative.TheexistingVaRmodelusesahistoricalsimulationoverathree-yearlook-backperiod,weightingeachdayequally.AquantitativeanalystinthegroupquicklydevelopsanewVaRmodel,whichusesthedeltanormalapproach.ThenewmodelusesvolatilitiesandcorrelationsestimatedoverthepastfouryearsusingtheRiskMetricsEWMAmethod.Fortestingpurposes,thenewmodelisusedinparallelwiththeexistingmodelforsixweekstoestimatethe1-day99%VaR.Aftersixweeks,thenewVaRmodelhasnoexceedancesdespiteconsistentlyestimatingVaRtobeconsiderablylowerthantheexistingmodel'sestimates.Theanalystarguesthatthelackofexceedancesshowsthatthenewmodelisunbiasedandpressuresthebank’smodelevaluationteamtoagree.Followinganovernightexaminationofthenewmodelbyonejunioranalystinsteadofthecustomaryevaluationthattakesseveralweeksandinvolvesaseniormemberoftheteam,themodelevaluationteamagreestoacceptthenewmodelforusebythedesk.

34. Whichofthefollowingstatementsabouttheriskmanagementimplicationsofthisreplacementiscorrect?

A. Delta-normalVaRismoreappropriatethanhistoricalsimulationVaRforassetswithnon-linearpayoffs.B. Changingthelook-backperiodandweighingschemefromthreeyears,equallyweighted,tofouryears,

exponentiallyweighted,willunderstatetheriskintheportfolio.C. Thedeskincreaseditsexposuretomodelriskduetothepotentialforincorrectcalibrationand

programmingerrorsrelatedtothenewmodel.D. A99%VaRmodelthatgeneratesnoexceedancesinsixweeksisnecessarilyconservative.

Correctanswer:CExplanation:GiventhequickimplementationofthenewVaRmodelandtheinsufficientamountoftestingthatwasdone,thedeskhasincreaseditsexposuretomodelriskduetotheincreasedpotentialforincorrectcalibrationandprogrammingerrors.ThissituationissimilartotheJPMorganLondonWhalecasein2012,whereanewVaRmodelwasveryquicklyintroducedforitsSyntheticCreditportfoliowithoutappropriatetimetotestthemodelinresponsetoincreasinglossesandmultipleexceedancesoftheearlierVaRmodellimitintheportfolio.Section:OperationalandIntegratedRiskManagementReference:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter11,AssessingtheQualityofRiskMeasures.LearningObjective:Describewaysthaterrorscanbeintroducedintomodels.

35. Ahedgefundhasa25,000sharepositioninanundervaluedandrelativelyilliquidstockXYZthathasacurrentstockpriceofGBP48(expressedasthemidpointofthecurrentbid-askspread).ThedailyreturnforXYZhasameanof0%,anestimatedvolatilityof0.32%andavolatilityspreadof0.0016.Theaveragebid-askspreadisGBP0.22.Theriskdivisionofthefundusuallyassumesthatthereturnsarenormallydistributedandestimatestheliquidityadjusted1-day95%VaRofthepositionusingtheconstantspreadapproach.SupposethattheCROaskstheriskdivisiontodeterminetheliquidityadjusted1-day95%VaRusingtheexogenousspreadapproachinstead,assumingthevolatilityspreadmultiplierkof3.Whatwouldbetheincreaseintheliquidityadjustment?

A. 43.65%B. 45.71%C. 69.61%D. 89.36%

Correctanswer:BExplanation:Beforeconsideringliquidityadjustment,the1-day95%VaRofthepositionisobtainedas:VaR=P[1–exp(µ–σz)]=GBP48*25,000*[1–exp(0–0.0032*1.645)]=GBP6,300.20TheliquidityadjustedVaR(LVaR)derivedusingtheconstantspreadapproachaddshalfofthebid-askspread(asapercent)totheVaRcalculation,usingthefollowingformula:LVaR=VaR+LiquidityCost(LC)=VaR+½*(Spread*P)whereSpreadisequaltotheactualspreaddividedbythemidpointandPisthevalueoftheposition.Therefore,Daily95%VaR=(48*25,000)*[1–exp(0–1.645*0.0032)]=GBP6,300.20Liquiditycost=(0.5)*(0.22/48)*(48*25,000)=GBP2,750Andso,LVaR=VaR+LC=GBP9,050.20andso,theliquidityadjustment=2,750/6,300.20=43.65%ofVaR. Usingtheexogenousspreadapproach,theliquiditycost(LC)isderivedbyLC=(0.5)(48*25,000)*[(0.22/48)+(3*0.0016)]=2,750+2,880=GBP5,630TheLVaRusingtheexogenousapproachwillbehigherthanLVaRobtainedusingtheconstantspreadapproachbyGBP5,630andso,theliquidityadjustment=5.630/6,300.20=89.36%ofVaR.Therefore,theincreaseintheliquidityadjustmentwhenusingtheexogenousapproachcomparedtousingtheconstantspreadapproach=89.36–43.65=45.71%

Section:OperationalandIntegratedRiskManagementReference:KevinDowd,MeasuringMarketRisk,SecondEdition(WestSussex,England:JohnWiley&Sons,2005).Chapter14,EstimatingLiquidityRisks.LearningObjective:DescribeandcalculateLVaRusingtheconstantspreadapproachandtheexogenousspreadapproach.

36. TheBaselCommitteerecommendsthatbanksuseasetofearlywarningindicatorsinordertoidentifyemergingrisksandpotentialvulnerabilitiesintheirliquidityposition.Whichofthefollowingisanearlywarningindicatorofapotentialliquidityproblem?A. CreditratingupgradeB. IncreasedassetdiversificationC. RapidassetgrowthD. Positivepublicity

Correctanswer:CExplanation:Rapidassetgrowthisanearlywarningofapotentialliquidityproblem.Positivepublicity,creditratingupgrade,andincreasedassetdiversificationareallnotearlywarningsofapotentialliquidityproblem.Section:OperationalandIntegratedRiskManagementReference:DarrellDuffie,TheFailureMechanicsofDealerBanks,JournalofEconomicPerspectives(2010,Volume24,Number1)pp.51-72.LearningObjective:Identifysituationsthatcancausealiquiditycrisisatadealerbankandexplainresponsesthatcanmitigatetheserisks.

37. Largedealerbankshaveoftenfinancedsignificantfractionsoftheirassetsusingshort-term(overnight)repurchaseagreementsinwhichcreditorsholdbanksecuritiesascollateralagainstdefaultlosses.Thetablebelowshowsthequarter-endfinancingoffourbroker-dealerfinancialinstruments.AllvaluesareinUSDbillions. BankP BankQ BankR BankSFinancialInstrumentsOwned 656 750 339 835Pledgedascollateral 258 472 139 209Notpledged 398 278 200 626

Intheeventthatrepocreditorsbecomeequallynervousabouteachbank’ssolvency,whichbankismostvulnerabletoaliquiditycrisis?

A. BankPB. BankQC. BankRD. BankS

Correctanswer:BExplanation:

BankP BankQ BankR BankSFinancialInstrumentsOwned 656 750 339 835Pledgedascollateral 258 472 139 209Notpledged 398 278 200 626FractionPledged 39% 63% 41% 25%

Aliquiditycrisiscouldmaterializeifrepocreditorsbecomenervousaboutabank’ssolvencyandchoosenottorenewtheirpositions.Ifenoughcreditorschoosenottorenew,thebankcouldlikelybeunabletoraisesufficientcashbyothermeansonsuchshortnotice,therebyprecipitatingacrisis.However,thisvulnerabilityisdirectlyrelatedtotheproportionofassetsabankhaspledgedascollateral.BankQismostvulnerablesinceithasthelargestdependenceonshort-termrepofinancing(i.e.thehighestpercentageofitsassetsoutofthefourbanksispledgedascollateral.Section:OperationalandIntegratedRiskManagementReference:DarrellDuffie,TheFailureMechanicsofDealerBanks,JournalofEconomicPerspectives(2010,Volume24,Number1)pp.51-72.LearningObjective:Identifysituationsthatcancausealiquiditycrisisatadealerbankandexplainresponsesthatcanmitigatetheserisks.

38. Duringatrainingseminar,asupervisoratFirmWdiscussesdifferenttypesofoperationalriskthatthefirmmayface,whichcouldbeintheshort-termoroverthelong-termperiod.WhichofthefollowingisanexampleofanoperationalrisklossbyFirmW?A. Afterasurpriseannouncementbythecentralbankthatinterestrateswouldincrease,

bondpricesfall,andFirmWincursasignificantlossonitsbondportfolio.B. ThedatacapturesystemofFirmWfailstocapturethecorrectmarketratescausing

derivativetradestobedoneatincorrectprices,leadingtosignificantlosses.C. Asaresultofanincreaseincommodityprices,thesharepriceofacompanythatFirmW

investedinfallssignificantly,causingmajorinvestmentlosses.D. AcounterpartyofFirmWfailstosettletheirdebttoFirmW,andindoingthis,theyarein

breachofalegalagreementtopayforservicesrendered.

Correctanswer:BExplanation:Biscorrect.InB,systemsfailureorincorrectsystemscausedtheproblem.Thelossesaredirectlyduetoanoperationalriskexposure.InAandC,anincreaseininterestratesandthefallinthevalueofaninvestment,respectively,arebothexamplesofmarketriskexposure.InD,failuretorepaydebt,isanexampleofcreditriskexposure.Section:OperationalandIntegratedRiskManagementReference:“PrinciplesfortheSoundManagementofOperationalRisk,”(BaselCommitteeonBankingSupervisionPublication,June2011).LearningObjective:Describetoolsandprocessesthatcanbeusedtoidentifyandassessoperationalrisk.

39. Theriskmanagementgroupestimatesthe1-day99%VaRonalong-only,large-capequityportfoliousingavarietyofapproaches.Adailyriskreportshowsthefollowinginformation:Approach 1-day99%VaR(EUR)Delta-Normal 300,000MonteCarloSimulation 332,000HistoricalSimulation 66,000

WhichofthefollowingisthemostlikelyexplanationforthevariationinVaRestimates?A. DataproblemsB. DifferencesinmodelassumptionsC. EndogenousmodelriskD. Programmingerrors

Correctanswer:BExplanation:VaRmeasureswillvaryaccordingtotheapproach(delta-normal,historicalsimulation,MonteCarlosimulation).Thevariationinthesevaluesdoesnotsuggestbiggerproblemswithdataorprogramming/implementationnoristhereanyreasontosuspectendogenousmodelrisk(e.g.,tradersgamingthesystemtolowerriskvalues).Section:OperationalandIntegratedRiskManagementReference:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter11,AssessingtheQualityofRiskMeasures.LearningObjective:Describehowhorizon,computationalandmodelingdecisionscanimpactVaRestimates.

40. Ariskanalystisbuildingabank’senterpriseriskmanagementsystem.Duringtheprocess,theanalysttakesaninventoryoffirmrisksandcategorizestheserisksasmarket,credit,oroperational.Whichofthefollowingobservationsofthebank’sdatashouldbeconsideredunexpectedifcomparedtosimilarindustrydata?A. Theoperationalrisklossdistributionhasalargenumberofsmalllosses,andthereforearelativelylow

mode.B. Theoperationalrisklossdistributionissymmetricandfat-tailed.C. Thecreditriskdistributionisasymmetricandfat-tailed.D. Themarketriskdistributionissimilartothedistributionofthereturnonaportfolioofsecurities.

Correctanswer:BExplanation:Biscorrect.StatementsA,C,andDareconsistentwithindustrydata.However,withoperationalrisk,theretendstobelargenumbersofsmalllossesandasmallnumberoflargelosses,sothedistributionisasymmetric(andfat-tailed).Section:OperationalandIntegratedRiskManagementReference:BrianNoccoandRenéStulz,EnterpriseRiskManagement:TheoryandPractice,JournalofAppliedCorporateFinance(Volume18,Number4,2006),pp.8–20.LearningObjective:DescribethedevelopmentandimplementationofanERMsystem,aswellaschallengestotheimplementationofanERMsystem.

41. Aregionalcommercialbankisconsideringaloantobefullyfundedentirelybydeposits,withthefollowingparameters:

• Loanamount:JPY3.2billion• Averageannualinterestratepaidondeposits:0.6%• Annualinterestrateonloan:4.5%• Expectedloss:3.0%offacevalueofloan• Annualoperatingcosts:0.3%offacevalueofloan• Economiccapitalneed:8.5%• Averagereturnoneconomiccapital:1.2%• Effectivetaxrate:34%Whatistherisk-adjustedafter-taxreturnoncapital(RAROC)forthisloan?A. 1.2%B. 1.8%C. 14.0%D. 21.2%

Correctanswer:CExplanation:Therisk-adjustedafter-taxreturnoncapital(RAROC)iscomputedby:

CapitalEconomicTaxesLossCostOperatingInterestIncomevenue

RAROC----+

Where:EconomicCapital=JPY3,200,000,000x0.085=JPY272,000,000Revenue=expectedrevenue=JPY3,200,000,000x0.045=JPY144,000,000 Income=returnoninvestedeconomiccapital=JPY3,200,000,000x0.012=JPY38,400,000 Interest=interestexpense=JPY3,200,000,000x0.006=JPY19,200,000 OperatingCost=JPY3,200,000,000x0.003=JPY9,600,000 Loss=expectedloss=JPY3,200,000,000x0.03=JPY96,000,000Taxes=(Rev+Inc–Int–OC–Loss)*(0.34)=(144,000,000+38,400,000–19,200,000–9,600,000–96,000,000)*(0.34)=(JPY57,600,000)*(0.34)=JPY19,584,400Therefore,numerator=JPY38,015,600andso,

%0.14%98.131398.0000,000,272600,015,38

====RAROC

Section:OperationalandIntegratedRiskManagementReference:MichelCrouhy,DanGalaiandRobertMark,TheEssentialsofRiskManagement,2ndEdition(NewYork:McGraw-Hill,2014).Chapter17,RiskCapitalAttributionandRisk-AdjustedPerformanceMeasurement.LearningObjective:ComputeandinterprettheRAROCforaproject,loan,orloanportfolio,anduseRAROCtocomparebusinessunitperformance.

42. AbankusesVaRandstressedVaRmarketriskframeworkinlinewiththeBaselrequirements.Thebank’sinternalmodelsformarketriskhavegeneratedthefollowingriskmeasures(inUSDmillion)forthecurrenttradingbookpositions:

ConfidenceLevel

LatestAvailable10-dayVaR

LatestAvailable10-dayStressedVaR

Average10-dayVaRofPrevious60Days

Average10-dayStressedVaRofPrevious60Days

95.0% 228 498 255 55799.0% 441 1,009 416 1,11799.9% 568 1,295 531 1,383AssumingthesupervisoryauthorityhassetthemultiplicationfactorsforboththeVaRandstressedVaRvaluesto3,whatisthecorrectcapitalrequirementforgeneralmarketriskforthebank?A. USD1,248millionB. USD1,533millionC. USD4,350millionD. USD4,599million

Correctanswer:DExplanation:Therevisedmarketriskcapitalrequirement(at99.0%level)is:MarketRiskCapital=max(VaRt-1,mc*VaR60-dayAvg)+max(sVaRt-1,ms*sVaR60-dayAvg)=max(441,3*416)+max(1,009,3*1,117)

=USD1,248million+USD3,351=USD4,599millionSection:OperationalandIntegratedRiskManagementReference:JohnHull,RiskManagementandFinancialInstitutions,4thEdition(NewYork:JohnWiley&Sons,2015).Chapter16,Basel2.5,BaselIII,andOtherPost-CrisisChanges.LearningObjective:Describeandcalculatethestressedvalue-at-riskmeasureintroducedinBasel2.5,andcalculatethemarketriskcapitalcharge.

43. CompanyOBDhasanoutstandingzero-couponbondwith1yearremainingtomaturity.ThebondhasafacevalueofUSD1,000,000andarecoveryrateof0%.Thebondiscurrentlytradingat84%offacevalue.Assumingtheexcessspreadonlycapturescreditriskandthattherisk-freerateis2.5%perannum,whatistheapproximaterisk-neutral1-yearprobabilityofdefaultofCompanyOBD?A. 12%B. 14%C. 17%D. 19%

Correctanswer:BExplanation:Thiscanbecalculatedbyusingtheformulawhichequatesthefuturevalueofariskybond

withyield(y)anddefaultprobability(p)toariskfreeassetwithyield(r).Thatis,1+r=(1–π)*(1+y)+πRwhereπ=ProbabilityofdefaultandR=RecoveryrateInthesituationwheretherecoveryrateisassumedtobezero,therisk-neutralprobabilityofdefaultcan

bederivedfromthefollowingequation:1+r=(1–π)*(FV/MV)whereMV=marketvalueandFV=facevalue.Therefore,n=1–[(1+r)(MV)/FV]Inputtingthedataintothisequationyieldsπ=1–[(1.025)*(0.84)/1,000,000]=0.1390=13.9%=14%.

Section:CreditRiskMeasurementandManagementReference:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter7,SpreadRiskandDefaultIntensityModels.LearningObjective:Calculaterisk-neutraldefaultratesfromspreads.

44. Aninsurancecompanyisconsideringtakingpositionsinvarioustranchesofacollateralizeddebtobligation(CDO).Thecompany’sCROpredictsthatthedefaultprobabilitywilldecreasesignificantlyandthatthedefaultcorrelationwillincrease.Basedonthisprediction,whichofthefollowingisagoodstrategytopursue?

A. Buytheseniortrancheandbuytheequitytranche.B. Buytheseniortrancheandselltheequitytranche.C. Selltheseniortrancheandselltheequitytranche.D. Selltheseniortrancheandbuytheequitytranche.

Correctanswer:DExplanation:Thedecreaseinprobabilityofdefaultwouldincreasethevalueoftheequitytranche.Also,adefaultoftheequitytranchewouldincreasetheprobabilityofdefaultoftheseniortranche,duetoincreasedcorrelation,reducingitsvalue.Thus,itisbettertogolongtheequitytrancheandshorttheseniortranche.Section:CreditRiskMeasurementandManagementReference:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter9,StructuredCreditRisk.LearningObjective:Explainhowthedefaultprobabilitiesanddefaultcorrelationsaffectthecreditriskinasecuritization.

45. Afinancialinstitutionhasmanyopenderivativepositionswithaninvestmentcompany.Adescriptionandcurrentmarketvaluesaredisplayedinthetablebelow:

Position Price(USD)Longswaptions 29millionLongcreditdefaultswaps 11millionShortcurrencyderivatives 18millionShortinterestrateswaps 7million

Intheeventthattheinvestmentcompanydefaults,whatwouldbethelosstothefinancialinstitutionifnettingisusedcomparedtothelossifnettingisnotused?

A. LossofUSD11millionifnettingisused;lossofUSD25millionifnettingisnotusedB. LossofUSD11millionifnettingisused;lossofUSD40millionifnettingisnotusedC. LossofUSD15millionifnettingisused;lossofUSD25millionifnettingisnotusedD. LossofUSD15millionifnettingisused;lossofUSD40millionifnettingisnotusedCorrectanswer:BExplanation:Nettingmeansthatthepaymentsbetweenthetwocounterpartiesarenettedout,sothatonlyanetpaymenthastobemade.Withnetting,theinvestmentfirmisnotrequiredtomakeeverypayout,hencethelosswillbereducedto:USD29million+USD11million–USD18million–USD7million=USD15million.Withoutnetting,thelossistheoutstandinglongposition:USD29million+USD11million=USD40million.Section:CreditRiskMeasurementandManagementReference:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter9,StructuredCreditRisk.LearningObjective:Explainhowthedefaultprobabilitiesanddefaultcorrelationsaffectthecreditriskinasecuritization.Reference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets(WestSussex,UK:JohnWiley&Sons,2012).Chapter4,Netting,Compression,Resets,andTerminationFeatures.LearningObjective:Describetheeffectivenessofnettinginreducingcreditexposureundervariousscenarios.

46. AderivativetradingfirmsellsaEuropean-typecalloptiononstockJKJwithatimetoexpirationof9months,astrikepriceofEUR45,anunderlyingassetpriceofEUR67,andimpliedannualvolatilityof27%.Theannualrisk-freeinterestrateis2.5%.Whatisthefirm’scounterpartycreditexposurefromthistransaction?

A. EUR0.00B. EUR9.45C. EUR19.63D. EUR22.00

Correctanswer:AExplanation:Sellinganoptionexposesthefirmtozerocounterpartycreditriskasthepremiumispaidupfront.However,buyinganoptionwouldexposethefirmtoacounterpartycreditrisk.ThecorrectansweristhereforeA.Alltheinformationnecessarytopricetheoptionisprovidedbutitisnotnecessary.Section:CreditRiskMeasurementandManagementReference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter3,DefiningCounterpartyCreditRisk.LearningObjective:Describetransactionsthatcarrycounterpartyriskandexplainhowcounterpartyriskcanariseineachtransaction.

47. AnendowmentfundhassolddefaultprotectiononthemostseniortrancheofaCDO.IfthedefaultcorrelationbetweenassetsheldintheCDOdecreasessharply,assumingeverythingelseisunchanged,howwillthepositionoftheendowmentfundbeimpacted?

A. Itwilleitherincreaseordecrease,dependingonthepricingmodelusedandthemarketconditions.B. Itwillgainsignificantvalue,sincetheprobabilityofexercisingtheprotectionfalls.C. Itwilllosesignificantvalue,sincetheprotectionwillgainvalue.D. Itwillneithergainnorlosevalue,sinceonlyexpecteddefaultlossesmatterandcorrelationdoesnot

affectexpecteddefaultlosses.

Correctanswer:BExplanation:Theseniortranchewillgainvalueifthedefaultcorrelationdecreases.Highcorrelationimpliesthatifonenamedefaults,alargenumberofothernamesintheCDOwillalsodefault.Lowcorrelationimpliesthatifonenamedefaults,therewouldbelittleimpactonthedefaultprobabilityoftheothernames.Therefore,asthecorrelationdecreases,thecumulativeprobabilityofenoughdefaultsoccurringtoexceedthecreditenhancementontheseniortranchewillalsodecrease.Hencetheinvestorwhohassoldprotectionontheseniortranchewillseeagain.

Section:CreditRiskMeasurementandManagementReference:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter9,StructuredCreditRisk.LearningObjective:Explainhowthedefaultprobabilitiesanddefaultcorrelationsaffectthecreditriskinasecuritization.

48. Ahedgefundmanagesaportfolioofequityoptions.Amongthemareoptionswrittenbyafinancialinstitutiononitsownstock.Assumingthefinancialinstitutioncouldwriteoneofthefollowingoptions,whichoptionwouldgivethehighestwrong-wayrisk?A. Anin-the-moneycalloptionB. Anin-the-moneyputoptionC. Anout-of-the-moneycalloptionD. Anout-of-the-moneyputoptionCorrectanswer:DExplanation:Discorrect.“Buyingaputoptiononastock(orstockindex)wheretheunderlyinginquestionhasfortunesthatarehighlycorrelatedtothoseofthecounterpartyisanobviouscaseofwrong-wayrisk”(CR2017,referencebelow).Thus,choicesAandCareruledout.Also,accordingtoCR2017,“anout-of-the-moneyputoptionwillhavemorewrong-wayriskthananin-the-moneyone.”ThatimpliesoptionDistheonlycorrectone.

Section:CreditRiskMeasurementandManagementReference:RenéStulz,RiskManagement&Derivatives(Florence,KY:ThomsonSouth-Western,2002).Chapter18,CreditRisksandCreditDerivatives.LearningObjective:Assessthecreditrisksofderivatives.

49. Fourderivativecounterpartieshaveundertakenbilateralnettingarrangements.Theexhibitbelowpresentsasummaryoftheirbilateralmark-to-market(MtM)trades.Ifnettingagreementsexistbetweenallpairsofcounterpartiesshown,whatisthecorrectorderofnetexposurepercounterparty,fromhighesttolowest?

Mark-to-MarketTradesforFourCounterparties(USDmillion) OpposingCounterparty Q R SCounterpartyP TradeswithpositiveMtM 8 10 4 TradeswithnegativeMtM -6 -2 -4 P R SCounterpartyQ TradeswithpositiveMtM 15 6 7 TradeswithnegativeMtM -16 0 -8 P Q SCounterpartyR TradeswithpositiveMtM 6 4 8 TradeswithnegativeMtM -6 -5 -12 P Q RCounterpartyS TradeswithpositiveMtM 2 13 1 TradeswithnegativeMtM -2 -10 -1

A. P,Q,S,RB. Q,R,S,PC. R,Q,P,SD. S,P,Q,RCorrectanswer:A

Explanation:Theproperlynettedamountsare:ForcounterpartyP:Q=8-6=$2;R=10-2=$8;S=4-4=0;forasumof$10.ForcounterpartyQ:P=15-16=-1=$0,R=6-0=$6;S=7-8=-1=$0;forasumof$6.ForcounterpartyR:P=6-6=$0;Q=4-5=-1=$0;S=8-12=-4=$0;forasumof$0.ForcounterpartyS:P=2-2=$0,Q=13-10=$3;R=1-1=$0;forasumof$3.Therefore,thecorrectsequenceofnetexposureamountspercounterparty,fromhighesttolowest,isP,Q,S,andR.Notethatanegativenettedamountmeansthecounterpartyhasnoexposure.

Section:CreditRiskMeasurementandManagementReference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter4,Netting,Compression,Resets,andTerminationFeatures.LearningObjective:Describetheeffectivenessofnettinginreducingcreditexposureundervariousscenarios.

50. Interestrateandcurrencyswapsdisplaydifferingprofilesofpotentialfutureexposure(PFE)overtime.WhichofthefollowinggraphsisanaccuraterepresentationofatypicalPFEprofileforthecorrespondinginstrument?

Correctanswer:B

Explanation:Theriskofcross-currencyswapsisdrivenbyalargefinalpayoff,andthustheprofileincreasesmonotonicallyuntilthematurityofthetrade.TheFXriskofthenotionalexchangedominatesthesmallcontributionduetointerestrateexposure.

Section:CreditRiskMeasurementandManagementReference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter8,CreditExposure.LearningObjective:Identifytypicalcreditexposureprofilesforvariousderivativecontractsandcombinationprofiles.

51. Ariskanalystisexaminingafirm’sforeigncurrencyoptionpriceassumptions.Theobservedvolatilitysmileforaparticularforeigncurrencyoptionslopesprogressivelyhigherasanoptionmoveseitherintothemoneyoroutofthemoney.Comparedtothelognormaldistributionwiththesamemeanandstandarddeviation,thedistributionofoptionpricesonthisforeigncurrencyimpliedbytheBlack-Scholes-Merton(BSM)modelwouldhave:

A. Aheavierlefttailandalessheavyrighttail.B. Aheavierlefttailandaheavierrighttail.C. Alessheavylefttailandaheavierrighttail.D. Alessheavylefttailandalessheavyrighttail.

Correctanswer:BExplanation:Forforeigncurrencyoption,theimplieddistributiongivesarelativelyhighpricefortheoption.Theimpliedvolatilityisrelativelylowforat-the-moneyoptionsbutitbecomeshigherastheoptionmoveseitherintothemoneyoroutofthemoney.Thus,theimplieddistributionhasheaviertailsthanthelognormaldistribution.Foranequityindexoptionpricedistribution,adownwardslopingvolatilityskewindicatesthatoutofthemoneyputsaremoreexpensivethanpredictedbytheBlack-Scholes-MertonmodelandoutofthemoneycallsarecheaperthanexpectedpredictedbytheBlack-Scholes-Mertonmodel.Theimplieddistributionofequityoptionshasheavierlefttailsandlessheavyrighttails,comparedtothelognormaldistribution.Section:MarketRiskMeasurementandManagementReference:JohnHull,Options,Futures,andOtherDerivatives,9thEdition(NewYork:Pearson,2014).Chapter20,VolatilitySmiles.LearningObjective:Comparetheshapeofthevolatilitysmile(orskew)totheshapeoftheimplieddistributionoftheunderlyingassetpriceandtothepricingofoptionsontheunderlyingasset.

52. AwealthmanagementfirmhasINR56billioninassets.TheportfoliomanagercomputesthedailyVaRatvariousconfidencelevelsasfollows:

ConfidenceLevel VaR(INR)95.0% 226,665,00095.5% 230,197,50096.0% 234,000,00096.5% 244,237,50097.0% 253,012,50097.5% 261,787,50098.0% 272,317,50098.5% 286,357,50099.0% 304,785,00099.5% 333,157,500

WhatistheclosestestimateofthedailyESatthe97.5%confidencelevel?

A. INR262millionB. INR264millionC. INR292millionD. INR299millionCorrectanswer:DExplanation:Anestimateoftheexpectedshortfall(ES)canbeobtainedbytakingtheaverageoftheVaRsforthevariousconfidencelevelsthataregreaterthan96.5%.Therefore,ES=(272,317,500+286,357,500+304,785,000+333,157,500)/4=INR299,154,375Section:MarketRiskMeasurementandManagementReference:KevinDowd,MeasuringMarketRisk,2ndEdition(WestSussex,England:JohnWiley&Sons,2005).Chapter3,EstimatingMarketRiskMeasures:AnIntroductionandOverview.LearningObjective:EstimatetheexpectedshortfallgivenP/Lorreturndata.

53. Anewlyhiredriskanalystisbacktestingafirm’sVaRmodel.Previously,thefirmcalculateda1-dayVaRatthe95%confidencelevel.FollowingtheBaselframework,theriskanalystisrecommendingthatthefirmswitchtoa99%confidencelevel.Whichofthefollowingstatementsconcerningthisswitchiscorrect?

A. ThedecisiontoacceptorrejectaVaRmodelbasedonbacktestingresultsislessreliablewitha99%

confidencelevelVaRmodelthanwitha95%confidencelevelmodel.B. The95%VaRmodelislesslikelytoberejectedusingbacktestingthanthe99%VaRmodel.C. Whenvalidatingwithbacktestingatthe90%confidencelevel,thereisasmallerprobabilityofincorrectly

rejectinga95%VaRmodelthana99%VaRmodel.D. Whenbacktestingusinga90%confidencelevel,thereisasmallerprobabilityofcommittingatypeIerror

whenbacktestinga95%VaRmodelthanwitha99%VaRmodel.

Correctanswer:AExplanation:TheconcepttestedhereistheunderstandingofthedifferencebetweentheVaRparameterforconfidence(here,namely95%vs.99%)andthevalidationprocedureconfidencelevel,andhowtheyinteractwithoneanother.Usinga95%VaRconfidencelevelcreatesanarrowerrejectionregionbyallowingagreaternumberofexceptionstobegenerated.Thisinturnincreasesthepowerofthebacktestingprocessandmakesforamorereliabletestthanusinga99%confidencelevel.Section:MarketRiskMeasurementandManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition.(NewYork:McGraw-Hill,2007).Chapter6,BacktestingVaR.LearningObjective:DefineandidentifytypeIandtypeIIerrors.

54. Ahedgefundriskmanagerislookingatvariousmodelsthatareflexibleenoughtoincorporatemeanreversionandriskpremiumintotermstructuremodeling.WhichofthefollowingiscorrectabouttheVasicekmodel?

A. Itincorporatesmeanreversionbutnotdriftintotheinterestratemodel.B. Itincorporatesmeanreversionintothemodelandallowsforariskpremiumasaconstantorchanging

drift.C. Itdoesnotincorporateriskpremiumandthetermstructureofinterestratevolatilityinthemodelis

upward-sloping.D. Itdoesnotincorporatemeanreversionintothemodelbutallowsforariskpremiumtobeappliedto

interestratesthatchangeovertime.

Correctanswer:BExplanation:ChoiceBiscorrect:theVasicekmodelincorporatesmeanreversion.Theflexibilityofthemodelalsoallowsforriskpremium,whichentersintothemodelasconstantdriftoradriftthatchangesovertime.Section:MarketRiskMeasurementandManagementReference:BruceTuckmanandAngelSerrat,FixedIncomeSecurities,3rdEdition(Hoboken,NJ:JohnWiley&Sons,2011).Chapter9,TheArtofTermStructureModels:Drift.LearningObjective:Constructashort-termratetreeundertheHo-LeeModelwithtime-dependentdrift.

55. Ahedgefundthatrunsadistressedsecuritiesstrategyisevaluatingthesolvencyconditionsoftwopotentialinvestmenttargets.CurrentlyfirmRSTisratedBBandfirmWYZisratedB.ThehedgefundisinterestedindeterminingthejointdefaultprobabilityofthetwofirmsoverthenexttwoyearsusingtheGaussiandefaulttimecopulaundertheassumptionthataone-yearGaussiandefaultcorrelationis0.36.ThefundreportsthatxBBandxBaremappedabscisevaluesofthebivariatenormaldistributionpresentedinthetablebelow,whileQandNdenotethecumulativedefaultprobabilityandthestandardnormaldistribution,respectively:

ApplyingtheGaussiancopula,whichofthefollowingbestdescribesthederivationofthejointprobability(Q)thatfirmRSTandfirmWYZwillbothdefaultinyear2?

A. Q(xBB=0.0612)+Q(xB=0.1063)–Q(xBB=0.0612)*Q(xB=0.1063)B. Q(xBB=0.1133)+Q(xB=0.2969)–Q(xBB=0.1133)*Q(xB=0.2969)C. Q(xBB≤0.1133ÇxB≤0.2969)D. Q(xBB≤–0.8586ÇxB≤–0.2630)

Correctanswer:DExplanation:Discorrect.Thejointprobabilityofdefaultismeasuredby“cumulativestandardnormalpercentiles.”Whatthecopulafunctiondoesisto:first,mapthecumulativedefaultprobabilityvalues(marginaldistributions)ofamultivariatedistribution-percentiletopercentile-toacumulativestandardnormaldistribution.Then,second,findthemappedabscise(x-axis)valuesofthecumulativestandardnormaldistribution.TheGaussiancopulaprocedureessentiallyassumesthatonlyasinglecorrelation(notacorrelationmatrix)cannowbeappliedtothemultivariatedistribution.Aisincorrect.ItexpressesthejointprobabilityofdefaultforfirmsRSTandWYZwhileignoringtheeffectofcorrelation.Bisincorrect.ItexpressesthejointprobabilityofdefaultforfirmsRSTandWYZwhileignoringtheeffectofcorrelationbutitalsoincorrectlyusescumulativedefaultprobabilitiesinsteadofdefaultprobabilitiesinthatformula.Cisincorrect.ItincorrectlyexpressesthejointprobabilityofdefaultoffirmsRSTandWYZbyusingcumulativedefaultprobabilitiesinsteadofthecumulativestandardnormalpercentiles.

DefaultTimeinYear

FirmRSTDefaultProbability

FirmRSTCumulativeDefaultProbabilityQBB(t)

FirmRSTCumulativeStandardNormalPercentilesN-1(QBB(t))

FirmWYZDefaultProbability

FirmWYZCumulativeDefaultProbabilityQB(t)

FirmWYZCumulativeStandardNormalPercentilesN-1(QB(t))

1 5.21% 5.21% –1.2104 19.06% 19.06% –0.56942 6.12% 11.33% –0.8586 10.63% 29.69% –0.26303 5.50% 16.83% –0.6443 8.24% 37.93% –0.05164 4.81% 21.64% –0.4893 6.10% 44.03% –0.10155 4.22% 25.86% –0.3672 4.03% 48.06% –0.2046

Section:MarketRiskMeasurementandManagementReference:GunterMeissner,CorrelationRiskModelingandManagement(NewYork:JohnWiley&Sons,2014).Chapter4,FinancialCorrelationModeling—Bottom-UpApproaches.LearningObjective:DescribetheGaussiancopulaandexplainhowtouseittoderivethejointprobabilityofdefaultoftwoassets.

56. AriskcommitteeoftheboardofcompanyABCisdiscussingthedifferencebetweenpricingdeepout-of-the-moneycalloptionsonABCstockandpricingdeepout-of-the-moneycalloptionsontheUSD/GBPforeignexchangerateusingtheBlack-Scholes-Merton(BSM)model.Thecommitteeconsiderspricingtheseoptionsbasedontwodistinctprobabilitydistributionsofunderlyingassetpricesattheoptionexpirationdate:Alognormalprobabilitydistribution,andanimpliedrisk-neutralprobabilitydistributionobtainedfromthevolatilitysmileforoptionsofthesamematurity.Iftheimpliedrisk-neutralprobabilitydistributionisused,insteadofthelognormal,whichofthefollowingiscorrect?

A. ThepriceoftheoptiononABCwouldrelativelybehighandthepriceoftheoptiononUSD/GBPwould

relativelybelow.B. ThepriceoftheoptiononABCwouldrelativelybelowandthepriceoftheoptiononUSD/GBDwould

relativelybehigh.C. ThepriceoftheoptiononABCwouldrelativelybelowandthepriceoftheoptiononUSD/GBDwould

relativelybelow.D. ThepriceoftheoptiononABCwouldrelativelybehighandthepriceoftheoptiononUSD/GBDwould

relativelybehigh.

Correctanswer:BExplanation:Theimplieddistributionoftheunderlyingequitypricesderivedusingthegeneralvolatilitysmileofequityoptionshasaheavierlefttailandalessheavyrighttailthanalognormaldistributionofunderlyingprices.Therefore,usingtheimplieddistributionofpricescausesdeep-out-of-the-moneycalloptionsontheunderlyingtobepricedrelativelylowcomparedwithusingthelognormaldistribution.Theimplieddistributionofunderlyingforeigncurrencypricesderivedusingthegeneralvolatilitysmileofforeigncurrencyoptionshasheaviertailsthanalognormaldistributionofunderlyingprices.Therefore,usingtheimplieddistributionofpricescausesdeep-out-of-the-moneycalloptionsontheunderlyingtobepricedrelativelyhighcomparedtousingthelognormaldistribution.Section:MarketRiskMeasurementandManagementReference:JohnHull,Options,Futures,andOtherDerivatives,9thEdition(NewYork:Pearson,2014).Chapter20,VolatilitySmiles.LearningObjective:Describecharacteristicsofforeignexchangeratedistributionsandtheirimplicationsonoptionpricesandimpliedvolatility.

57. ACROisconcernedthatexistinginternalriskmodelsofafirm,whicharegovernedmainlybythecentrallimittheorem,arenotadequateinaddressingpotentialrandomextremelossesofthefirm.TheCROthenrecommendstheuseofextremevaluetheory(EVT).WhenapplyingEVTandexaminingdistributionsoflossesexceedingathresholdvalue,whichofthefollowingiscorrect?

A. Asthethresholdvalueisincreased,thedistributionofexceedancesconvergestoageneralizedPareto

distribution.B. Ifthetailparametervalueofthegeneralizedextreme-value(GEV)distributiongoestoinfinity,thenthe

GEVessentiallybecomesanormaldistribution.C. ToapplyEVT,theunderlyinglossdistributionmustbeeithernormalorlognormal.D. Thenumberofexceedancesdecreasesasthethresholdvaluedecreases,whichcausesthereliabilityof

theparameterestimatestoincrease.

Correctanswer:AExplanation:AkeyfoundationofEVTisthatasthethresholdvalueisincreased,thedistributionoflossexceedancesconvergestoageneralizedParetodistribution.Assumingthethresholdishighenough,excesslossescanbemodeledusingtheGeneralizedParetodistribution.Ifthetailparametervalueofthegeneralizedextreme-value(GEV)distributiongoestozero,andnotinfinity,thentheGEVessentiallybecomesanormaldistribution.ToapplyEVT,theunderlyinglossdistributioncanbeanyofthecommonlyuseddistributions:normal,lognormal,t,etc.,andwillusuallybeunknown.Choosingthethresholdvalueneartheestimatedmeanoftheunderlyinglossdistributionisarbitraryandthismethodisnottypicallyemployed.Asthethresholdvalueisdecreased,thenumberofexceedancesincreases.Section:OperationalandIntegratedRiskManagementReference:KevinDowd,MeasuringMarketRisk,2ndEdition(WestSussex,England:JohnWiley&Sons,2005).Chapter7,ParametricApproaches(II):ExtremeValueLearningObjective:Describeextremevaluetheory(EVT)anditsuseinriskmanagement.

58. IntheBaselframework,apenaltyisgiventobanksthathavemorethanfourexceptionstotheir1-day99%VaRoverthecourseofthelast250tradingdays.Whichofthefollowingcausesofexceptionsismostlikelytoleadtoapenalty?

A. Alargemoveininterestrateswascombinedwithasmallmoveincorrelations.B. Thebank’smodelcalculatesinterestrateriskbasedonthemediandurationofthebondsintheportfolio.C. Asuddenmarketcrisisinanemergingmarket,whichleadstolossesintheequitypositionsinthat

country.D. Asuddendevastatingearthquakethatcausedmajorlossesinthebank’skeyareaofoperation.

Correctanswer:BExplanation:Inthecaseofabankthatchangedpositionsmorefrequentlyduringtheday,apenaltyshouldbeconsidered,butitisnotnecessarilygiven.Inthecaseofbadluck,nopenaltyisgiven,aswouldbethecaseforabankaffectedbyunpredictablemovementsinratesormarkets.However,whenriskmodelsarenotpreciseenough,apenaltyistypicallygivensincemodelaccuracycouldhaveeasilybeenimproved.Section:MarketRiskMeasurementandManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition.(NewYork:McGraw-Hill,2007).Chapter6,BacktestingVaR.LearningObjective:DescribetheBaselrulesforbacktesting.

59. Afundmanagerownsaportfolioofoptionsonanon-dividendpayingstockTUV.Theportfolioismadeupof7,500deepin-the-moneycalloptionsonTUVand40,000deepout-of-the-moneycalloptionsonTUV.Theportfolioalsocontains20,000forwardcontractsonTUV.Currently,TUVistradingatUSD76.Assuming252tradingdaysinayearandthevolatilityofTUVis18%peryear,whichofthefollowingamountswouldbeclosesttothe1-dayVaRoftheportfolioatthe99%confidencelevel?

A. USD25,056B. USD55,122C. USD386,609D. USD875,041

Correctanswer:BExplanation:WeneedtomaptheportfoliotoapositionintheunderlyingstockTUV.Adeepin-the-moneycallhasadeltaofapproximately1,adeepout-of-the-moneycallhasadeltaofapproximatelyzeroandforwardshaveadeltaof1.Thenetportfoliohasadelta(Dp)ofabout1*7,500+0*40,000+1*20,000=27,500andisapproximatelygammaneutral.Let:a=2.326(99%confidencelevel)S=pricepershareofstockTUV=USD76Dp=deltaoftheposition=27,500σ=volatilityofTUV=0.18Therefore,the1-dayVaRestimateat99%confidenceleveliscomputedasfollows:a*S*Dp*σ*sqrt(1/T)=(2.326)*(76)*(27,500)*(0.18/sqrt(252))=USD55,122.41Section:MarketRiskMeasurementandManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition(NewYork:McGraw-Hill,2007).Chapter11,VaRMapping.LearningObjective:Describethemethodofmappingforwards,forwardrateagreements,interestrateswaps,andoptions.

60. Aportfoliomanagerataninvestmentcompanyisevaluatingatwo-assetportfolioundermanagement.Theriskandreturndataontheassetsandtheportfolioareshowninthetablebelow:

AssetPositionValue(EURmillion)

ReturnStandardDeviation(%) Beta

HIJ 140 20.0 1.6KLM 160 12.0 0.8Portfolio 300 13.7 1.2

WhatisthemarginalVaRofassetHIJ;thepercentcontributionofassetKLMVaRtoportfolioVaR;andthe

portfolio’sestimateddiversifiedVaRatthe95%confidencelevel?

A. MarginalVaRofHIJ=0.1803;percentcontributionofassetKLMVaR=42.67%;portfoliodiversifiedVaR=USD0million

B. MarginalVaRofHIJ=0.1803;percentcontributionofassetKLMVaR=74.67%;portfoliodiversifiedVaR=USD3.5million

C. MarginalVaRofHIJ=0.3606;percentcontributionofassetKLMVaR=42.67%;portfoliodiversifiedVaR=USD10.0million

D. MarginalVaRofHIJ=0.3606;percentcontributionofassetKLMVaR=74.67%;portfoliodiversifiedVaR=USD21.5million

Correctanswer:CExplanation:VaRp=a*portfoliostandarddeviation*portfoliovalue=1.645*0.137*USD300,000,000=USD67,609,500MarginalVaRofAssetHIJ=(VaRp*βHIJ)/(portfoliovalue)=(USD67,609,500*1.6)/(USD300,000,000)=0.3606MarginalVaRofAssetKLM=(VaRp*βKLM)/(portfoliovalue)=(USD67,609,500*0.8)/(USD300,000,000)=0.1803TheVaRcontributionofeachassettoportfolioVaRisobtainedbycomputingtheircomponentVaR.RepresentingtheweightofeachassetbyW,thus,ComponentVaRofAssetHIJ=VaRp*βHIJ*WHIJ=USD67,609,500*1.6*(140/300)=USD50,481,760ComponentVaRofAssetKLM=VaRp*βKLM*WKLM=USD67,609,500*0.8*(160/300)=USD28,846,720Therefore,thepercentcontributionstoVaRofcomponentare:HIJcontribution=CVaRHIJ/VaRp=USD50,481,760/USD67,609,500=0.7467=74.67%=βHIJ*WHIJKLMcontribution=CVaRKLM/VaRp=USD28,846,720/USD67,609,500=0.4267=42.67%=βKLM*WKLM

Sumofstand-aloneassetVaRs=VaRHIJ+VaRKLM=USD1.645*0.2*140,000,000+1.645*0.12*160,000,000=USD46,060,000+USD31,584,000=USD77,644,000Therefore,theportfoliodiversifiedVaR=USD77,644,000–USD67,609,500=USD10,034,500

Section:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition(NewYork:McGraw-Hill,2007).Chapter7:PortfolioRisk—AnalyticalMethods.LearningObjective:Define,calculate,anddistinguishbetweenthefollowingportfolioVaRmeasures:individualVaR,incrementalVaR,marginalVaR,componentVaR,undiversifiedportfolioVaR,anddiversifiedportfolioVaR.

Afinancialriskconsultantassumesthatthejointdistributionofreturnsismultivariatenormalandcalculatesthefollowingriskmeasuresforatwo-assetportfoliomanagedbyamid-sizedinsurancecompany:

Asset Position(CNY) IndividualVaR

(CNY)MarginalVaR VaRContribution(CNY)

Financial 15,000,000 3,494,700 0.216 3,240,000Energy 15,000,000 6,999,300 0.462 6,931,238Portfolio 30,000,000 9,241,650 9,241,650

61. Iftheenergyassetisdroppedfromtheportfolio,whatwillbethereductioninportfolioVaR?

A. CNY2,242,350B. CNY3,494,700C. CNY5,746,950D. CNY6,999,300

Correctanswer:CExplanation:IfEnergyassetisdropped,theportfoliowillcontainonlyfinancialasset.ThenthenewportfolioVaRisthatofFinancialalone(CNY3,494,700),whichimpliesthatdroppingEnergyassetwillresultinareductioninportfolioVaRofCNY9,241,650–CNY3,494,700=CNY5,746,950

62. SupposethattheriskconsultantdefinesriskcapitaloftheinsurancecompanybyVaR.Assumingamarketriskpremiumof4.5%andarisk-freeinterestrateof2.5%,whatisthecorrectestimateforthereturnonriskcapitalonthefinancialasset?

A. 5.7%B. 6.3%C. 7.0%D. 9.3%

Correctanswer:AExplanation:MarginalVaRF=βF*(PortfolioVaR)/(PortfolioValue).So,ΒF=MarginalVaRF*PortfolioValue/PortfolioVaR=βF=(0.216*30,000,000)/(9,241,650)=0.7012;andExpectedreturnonFinancial=risk-freerate+(marketriskpremium)*βF*=2.5%+(4.5%)*0.7=5.7%VaRoftheFinancial=CNY3,494,700;andthereturn=0.057*(CNY15,000,000)=CNY855,000Therefore,thereturnonriskcapital=CNY855,000/CNY3,494,700=0.24447=24.5%Section:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition(NewYork:McGraw-Hill,2007).Chapter7:PortfolioRisk—AnalyticalMethods.LearningObjective:Define,calculate,anddistinguishbetweenthefollowingportfolioVaRmeasures:individualVaR,incrementalVaR,marginalVaR,componentVaR,undiversifiedportfolioVaR,anddiversifiedportfolioVaR.

63. Ananalystregressesthereturnsof300stocksagainstthereturnsofamajormarketindex.Theresultingpoolof300alphashasaresidualriskof15%andaninformationcoefficientof10%.Ifthealphasarenormallydistributedwithameanof0%,roughlyhowmanystockshaveanalphagreaterthan3.24%orlessthan-3.24%?

A. 5B. 15C. 30D. 45

Correctanswer:BExplanation:Thestandarddeviation(std)ofthealphas=ResidualRisk(volatility)xInformationCoefficient(IC)=0.15*0.10=0.0150.So,3.24%istwicethestandarddeviationofthealphas.Thealphasfollownormaldistributionwithmean0,soabout5%ofthealphasareoutoftheinterval[-3.24%,3.24%].Thetotalnumberofstocksis300,soroughlythereare15alphasthatareoutoftherange.Section:RiskManagementandInvestmentManagementReference:RichardGrinoldandRonaldKahn,ActivePortfolioManagement:AQuantitativeApproachforProducingSuperiorReturnsandControllingRisk,2ndEdition(NewYork:McGraw-Hill,2000).Chapter14,PortfolioConstruction.LearningObjective:Assesstheimpactofpracticalissuesinportfolioconstruction,suchasdeterminationofriskaversion,incorporationofspecificriskaversion,andproperalphacoverage.

64. Ariskanalystataninvestmentbankisreviewingthewayperformanceanalysisofhedgefundsandrealestatefundshavebeenconducted.Eachyear,wheneverahedgefundstopstrading,thehedgefundisremovedfromthedatabaseofhedgefunds.Also,becauseoftheadditionofnewassetstotherealestatefund,theliquidityofthatassetcategoryhasimprovedeachyearandtradinghasbecomemorefrequent.Whichofthefollowingbestdescribestheimpactsthesechangeshavehistoricallyhadonhedgefundandrealestatefundanalysesperformedusingthesedatabases?A. TheaverageSharperatioofhedgefundsisunderstatedandtheaverageSharperatioofrealestatefunds

hasincreased.B. TheaverageSharperatioofhedgefundsisoverstatedandtheaverageSharperatioofrealestatefunds

hasdecreased.C. Theaveragevolatilityofhedgefundsisoverstatedandtheaveragevolatilityofrealestatefundshas

decreased.D. Theaveragevolatilityofhedgefundsisunderstatedandtheaveragevolatilityofrealestatefundshas

increased.

Correctanswer:BExplanation:Aspoorperformersdropoutofthedatabase,theaverageperformanceincreases.Theremovalofpoorperformerscouldactuallyreduceaveragevolatilityandthecorrelationofreturns.TheSharperatiotendstogetinflatedduetosurvivorshipbias.Withinfrequenttrading,estimatesofvolatilities,correlations,andbetasaretoolowwhencomputedusingreportedreturns.Thus,Sharperatioswouldbehigherunderthecircumstances.Whentradingbecomesmorefrequent,theSharperatioswillbelowerin–duetohighervolatilities–incomparisonwiththoseunderinfrequenttradingcondition.Section:RiskManagementandInvestmentManagementReference:ZviBodie,AlexKane,andAlanJ.Marcus,Investments,10thEdition(NewYork:McGraw-Hill,2014).Chapter24,PortfolioPerformanceEvaluation.LearningObjective:Explainthedifficultiesinmeasuringtheperformanceofhedgefunds.Reference:AndrewAng,AssetManagement:ASystematicApproachtoFactorInvesting(NewYork:OxfordUniversityPress,2014),Chapter13,IlliquidAssets.LearningObjective:Assesstheimpactofbasesonreportedreturnsforilliquidassets.

65. Amoneymanagerwantstoinvestasmallamountofnewcapitalthathasrecentlycomeintoafund.Thefundisbenchmarkedtoanindexand,ratherthanaddinganewholding,themanagerisconsideringincreasingtheholdingsofoneofthefourassetswhoseperformances,duringthemostrecentevaluationperiod,aredescribedinthefollowingtable:Asset

PortfolioWeight

ActualReturn

VolatilityofReturn

BetatotheIndex

BDE 0.35 14% 19% 1.20JKL 0.30 13% 18% 0.90MNO 0.25 13% 16% 1.00STU 0.10 10% 10% 0.80

TheportfoliomanagerwantstoselecttheassetthathasthelowestmarginalVaRaslongasitsJensen’salphaisequaltoorgreaterthanthemarketriskpremium.Assumingtheriskfreerateis3%andthemarketreturnis8%,whichassetshouldtheportfoliomanagerselect?

A. AssetBDEB. AssetJKLC. AssetMNOD. AssetSTUCorrectanswer:BExplanation:FormarginalVaR,wecanderiveas:MarginalVaRofasseti=(VaRp/Valuep)*Betai=W*Betai(sinceWorVaRp/Valuepwillbethesameforalltheassets,implyingthatthesizeofbetawillactuallydeterminethelevelofmarginalVaRs).Jensen’salphameasureiscalculatedas:Alpha=Actualreturn–Expectedreturnbasedonsystematicrisk

=Actualreturn–(risk-freerate+(Marketreturn–risk-freerate)*Beta)Therefore,assetJKLhasthelowestMarginalVaRandthehighestalpha.

PortfolioWeight

ActualReturn

BetatotheIndex

MarginalVaR

ExpectedReturn

Jensen’sAlpha

BDE 0.35 14% 1.20 1.2W 9.0% 5.0%JKL 0.30 13% 0.90 0.9W 7.5% 5.5%MNO 0.25 13% 1.00 1.0W 8.0% 5.0%STU 0.10 10% 0.80 0.8W 7.0% 3.0%

Section:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition(NewYork:McGraw-Hill,2007).Chapter7-PortfolioRisk:AnalyticalMethods.LearningObjective:Explainthedifferencebetweenriskmanagementandportfoliomanagement,anddescribehowtousemarginalVaRinportfoliomanagement.

66. Ariskanalystataninsurancecompanyhasdeterminedthatacounterpartytothecompanyhasaconstantdefaultprobabilityof6%peryear.Whatistheprobabilityofthiscounterpartydefaultinginthethirdyear?

A. 4.98%B. 5.30%C. 5.64%D. 6.00%Correctanswer:BExplanation:Theprobabilityofdefaultinyear3=(1–0.06)(1–0.06)(0.06)=0.0530=5.30%.ChoiceAisincorrect.Itistheprobabilityofdefaultinyear4=(1–0.06)(1–0.06)(1–0.06)0.06)=0.0498=4.98%.ChoiceCisincorrect.Itistheprobabilityofdefaultinyear3=(1–0.055)(0.055)=0.0564=5.64%.ChoiceDisincorrect.Itissimplythedefaultprobabilityperyear,whichequals6.0%.Section:CreditRiskMeasurementandManagementReference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter10.DefaultProbability,CreditSpreads,andCreditDerivativesLearningObjective:Calculaterisk-neutraldefaultprobabilities,andcomparetheuseofrisk-neutralandreal-worlddefaultprobabilitiesinpricingderivativecontracts.

67. Theboardofapensionfundisconsideringthefundingriskofitsdefinedbenefitplan.Whichofthefollowingstatementsaboutthepensionfund’sfundingriskiscorrect?A. Decreasesininterestrateswillreducefundingrisk.B. Fundingriskrepresentsthetruelong-termrisktotheplansponsor.C. Thefundingriskhasbeeneffectivelytransferredtotheemployees.D. Thelongerthehorizonforexpectedpayouts,thelowerthefundingrisk.

Correctanswer:B

Explanation:Thetimehorizonofpayoutsdoesnoteliminatefundingrisk.Infactitisthemismatchbetweenassetsandliabilitiesthatcreatesfundingrisk.Inanlowinterestrateenvironmentthevalueofequitieswillrise,howeverthevalueoftheliabilitiesarelikelytoincreasemoretherebyexacerbatingfundingrisk.Fundingriskistransferredtoemployeeswithadefinedcontributionplan.Immunizingtheportfolio,essentiallymatchingdurationofassetsandliabilities,willreducefundingrisk.

Section:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition(NewYork:McGrawHill,2007).Chapter17,VaRandRiskBudgetinginInvestmentManagement.LearningObjective:Distinguishamongthefollowingtypesofrisk:absoluterisk,relativerisk,policy-mixrisk,activemanagementrisk,fundingrisk,andsponsorrisk.

68. Aportfoliomanagerisevaluatingtheriskprofileforaportfolioofstocks.Currently,theportfolioisvaluedatCAD10.7millionandcontainsCAD2.1millioninstockSWZ.ThestandarddeviationofreturnsofstockSWZis17%annuallyandthatoftheoverallportfoliois13%annually.ThecorrelationofreturnsbetweenstockSWZandtheportfoliois0.4.Assumingtheportfoliomanagerusesa1-year99%VaRandthatreturnsarenormallydistributed,whatistheestimatedcomponentVaRofstockSWZ?

A. CAD162,972B. CAD234,906C. CAD253,992D. CAD332,152Correctanswer:D

Explanation:Leta(99%)representthe99%confidencefactorfortheVaRestimate,whichis2.326,andrrepresentthecorrelationofstockSWZwiththeportfolio,whichis0.4,andVSWZrepresentthevalueofstockSWZ.Therefore,

VaRSWZ=VSWZ*sSWZ*a(99%)=CAD2,100,000x0.17x2.326=CAD830,382

ComponentVaRSWZ=r*VaRSWZ=0.4x830,382=CAD332,152.8

Section:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition.(NewYork:McGraw-Hill,2007).Chapter7:PortfolioRisk:AnalyticalMethods.LearningObjective:Define,calculate,anddistinguishbetweenthefollowingportfolioVaRmeasures:individualVaR,incrementalVaR,marginalVaR,componentVaR,undiversifiedportfolioVaR,anddiversifiedportfolioVaR.

69. AnewlyestablishedriskdivisionofaregionalfinancialinstitutionissettingupaMonteCarlosimulationmethodologytoestimatethefirm’saggregatelossdistribution.Whichofthefollowinglossfrequencyandlossseveritydistributionpairsisthemostappropriatetouse?A. Binomialdistributionforfrequency,andPoissondistributionforseverity.B. Lognormaldistributionforfrequency,andWeibulldistributionforseverity.C. NegativeBinomialdistributionforfrequency,andParetodistributionforseverity.D. TransformedBetadistributionforfrequency,andNormaldistributionforseverity.

Correctanswer:C

Explanation:PoissonandNegativeBinomialdistributionsareappropriateforlossfrequencywhilePareto,lognormal,GeneralizedGamma,TransformedBeta,orWeibulldistributions(fat-tailed),aregenerallyusedforlossseverity,

Section:OperationalandIntegratedRiskManagementReference:PhilippaX.Girling,OperationalRiskManagement:ACompleteGuidetoaSuccessfulOperationalRiskFramework(Hoboken:JohnWiley&Sons,2013).Chapter12.CapitalModeling.LearningObjective:Explainhowfrequencyandseveritydistributionsofoperationallossesareobtained,includingcommonlyuseddistributionsandsuitabilityguidelinesforprobabilitydistributions.

TheCROofBankLGX,anon-dividend-payingUS-basedbankispreparingareporttotheboardofdirectorsonthebank’scapitaladequacyandplanning.BankLGXissubjecttoboththeBaselframeworkandtheUSbankingrulesgoverningglobalsystemicallyimportantbanks(G-SIBs).ThebankclaimsthatitwasincompliancewithallthecapitalrequirementsinJanuary2016asallBaselIIIphase-inshavealreadyoccurred.TheCROisconductingtheanalysisforJanuary2017usingselectedandmostrecentannualperformancedata,whichareshowninthetablebelow:Item Value(USDmillion)asofJanuary2017 CommonequityTier1(CET1)capital 1,515Preferredstock(noncumulative) 100Tier2capital 827Risk-weightedassets 26,395Totalassets 42,828Totalexposure 47,460

TheCROalsoreportstheminimumregulatorycapitalrequirementsundertherevisedcapitalframeworkaspresentedinthetablebelow.Thecapitalratiosalsoincludethecapitalconservationbufferof2.5%(phased-inatanannualincrementsof0.75%,startingJanuary2016)andaG-SIBsurchargeof3.0%(phased-inatanannualincrementsof0.625%,startingJanuary2016)ofrisk-weightedassetstobereachedbyJanuary2019:

Capitalconservationbuffer 0.625% 1.25% 1.875% 2.5%G-SIBsurcharge 0.75% 1.5% 2.25% 3.0%CET1ratio 4.5% 5.25% 6.5% 10.0%Tier1capitalratio 6.0% 6.75% 8.0% 11.5%Totalcapitalratio 8.0% 8.75% 11.5% 13.5%Leverageratio 4.0% 4.0% 4.0% 4.0%

70. Giventheregulatorybenchmarkandthebank’sperformance,whichofthecapitalrequirementsdoesBankLGXsatisfyasofJanuary2017?

A. CET1capitalratioonlyB. LeverageratioonlyC. Tier1capitalratioandLeverageratioonlyD. TotalcapitalratioandCET1capitalratioonlyCorrectanswer:D

Explanation:Thebank’sCET1capitalratio=(CET1capital)/(risk-weightedassets)=(1,515/26,395)=5.74%.Thisratiomeetsandexceedsthe5.25%minimumCET1capitalrequirement;Thebank’sleverageratio=(Tier1capital)/(Exposure)=(1,515+100)/(47,460)=3.40%.Thisratiodoesnotmeetthe4.0%minimumleverageratiorequirement;Thebank’sTier1capitalratio=(Tier1capital)/(risk-weightedassets)=(1,515+100)/26,395)=6.12%.Thisratiodoesnotmeetthe6.75%minimumTier1capitalrequirement;Thebank’sTotalcapitalratio=(Totalcapital)/(risk-weightedassets)=(1,515+100+827)/26,395)=9.25%.Thisratiomeetsandexceedsthe8.75%minimumTotalcapitalrequirement;

71. InviewingtheresultsofthiscapitalanalysisreportandotherconsiderationsforBankLGX’scapitalplanning,whichofthefollowingconclusionsiscorrect?

A. ThecapitalconservationbuffercanbemetbyanincreaseinTier2capital.B. Iftheexposureonderivativeassetpositionsdecreases,holdingotherfactorsconstant,Totalcapitalratio

woulddecrease.C. Theincreaseinthecreditvaluationadjustment(CVA)duetothebank’sassetcounterpartypositions

wouldtendtoraisethebank’srisk-weightedassets.D. IfthebankraisesadditionalCET1capitalandinveststhesameamountingold,BankLGX’snetstable

fundingratio(NSFR)willnotchange.

Correctanswer:C

Explanation:Ciscorrect.IncreasingCVAchargeincreasestheamountofrisk-weightedassets.Aisincorrect.AccordingtoBasel,theconservationbuffercanonlybemetbyadditionalCET1capital.Bisincorrect.Derivativeexposure(aswellotheroff-balancesheetitems)arepartofthetotalexposure.Asexposuredeclines,Totalcapitalratioincreases(assumingnochangeinTotalcapital).Disincorrect.TheNSFR=(amountofstablefunding)/(requiredamountofstablefunding).CET1capital,whichgoestothenumerator,hasaweightof100%.Gold,whichgoestothedenominator,hasaweightof85%.Thus,theincreasetothenumeratoranddenominatorwillnotbeexactlythesame,sotheNSFRchanges.

Section:OperationalandIntegratedRiskManagement

Reference:JohnHull,RiskManagementandFinancialInstitutions,4rdEdition(NewYork:JohnWiley&Sons,2015).Chapter16.Basel2.5,BaselIII,andDodd-Frank.LearningObjective:DefineinthecontextofBaselIIIandcalculatewhereappropriate:• Tier1capitalanditscomponents• Tier2capitalanditscomponents• RequiredTier1equitycapital,totalTier1capital,andtotalcapital.Describeandcalculateratiosintendedtoimprovethemanagementofliquidityrisk,includingtherequiredleverageratio,theliquiditycoverageratio,andthenetstablefundingratio.

QUESTIONS72THROUGH75REFERTOTHEFOLLOWINGINFORMATION

InasurprisemonetarypolicyactiononAugust10,2015,thePeople’sBankofChinacutitsdailycurrencyreferencerateagainsttheUSD,resultinginalargedevaluationoftheCNYversustheUSD.Immediatelyaftertheannouncement,theCROofCMMBank(CMM),aninternationalbankwithheadquartersinShanghai,beganevaluatingtheimpactofthisandothereventsonthebank’sposition.

CMMhadoutstandinglong-termdebtdenominatedinUSDanddepositsdenominatedinCNY.AsignificantportionofCMM’slendingportfoliowasalsodenominatedinCNYandconsistedlargelyofloansandlinesofcredittoChinesemanufacturerswhowereheavilydependentonimportedrawmaterials.Otherloanstonon-ChinesefirmswithexposuretoChinaweredenominatedinUSD.Thebank’sportfolioinvestmentsincludedCNY-denominatedChineseTreasurysecuritiesandothersovereigndebt.

AportionofCMM’sretailcustomerbasehadinvestedonmarginintheChineseequitymarkets.Overthenextfewweeks,localstockmarketsexperienceddeclinesinshareprices.ManyofCMM’slargerretaildepositorsexperiencedmargincallsandhadbeguntodrawdowndemanddepositstomeetthem.Offsettingtheseoutflows,however,wereincreasesinthe3-month,6-monthand9-monthtermdepositbalancesatCMMofseverallargecorporatecustomers.TheresultwasthatCMM’soverallnetdepositflowhadbeenapproximatelyzero.

Asaresultofcreditdevelopmentselsewhereintheworld,severalofCMM’ssovereigndebtholdingsweredowngraded,somefromAAtoAandsomefromAtoBBB.Oneofthenoticeableoutcomeswasthatthebid-askspreadsonmanyofthesovereignbondsheldandtradedbyCMMwidened.Despitethesedevelopments,CMM’ssovereigndebtportfolioremainedexclusivelyinvestmentgradewithaweightedaverageratingofA+.

72. CMM’sCROwasconcernedaboutthebank’sliquiditypositionanddecidedtoreviewtheimpactofthedevaluationandothercapitalmarketeventsonitsnetstablefundingratio(NSFR).IgnoringanychangesinthemarketvalueofCMM’ssovereigndebtholdings,whichofthefollowingiscorrect?

A. TheNSFRwillnotbeimpactedbythesovereigncreditratingchangesbecausetheoverallsovereigndebtportfolioremainsinvestmentgrade.

B. TheNSFRwillbereducedbythesovereigncreditratingchangesbutthiseffectcanbeoffsetbysellingA-ratedsovereigndebtandinvestingtheproceedsingold.

C. TheNSFRwill not be impacted by the change in demand deposits because the bank’s overall depositlevelisunchanged.

D. The NSFR will be reduced by the change in demand deposits but this effect can be offset by issuingcommonstock.

Correctanswer:D

Explanation: The shift in the demand deposit base from retail demand deposits to wholesale demanddepositswithtermslessthanoneyearwouldreducetheNSFR.Thechangeinretaildepositbehaviorwouldlikelycauseashiftingofdemanddepositclassificationfrom“stable”to“lessstable”alsoreducingtheNSFR.The downward sovereign creditmigrationwould increase the RSF applied to these bonds and reduce theNSFR.Theissuanceofcommonstock,whichshouldbeclassifiedasTier1capital,wouldincreasetheNSFR.

LearningObjective:Summarizetheassetliabilitymanagementprocessatafractional-reservebank,includingtheprocessofliquiditytransformation.Reference: Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken, NJ: JohnWiley&Sons,2011).Chapter12-LiquidityandLeverage.Section:OperationalandIntegratedRiskManagement

Learning Objective:Define liquidity risk and describe factors that influence liquidity including the bid-askspread.Reference: Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, England: John Wiley & Sons,2005).Chapter14-EstimatingLiquidityRisks.Section:OperationalandIntegratedRiskManagementLearningObjective:Describeandcalculateratiosintendedtoimprovethemanagementofliquidityrisk,includingtherequiredleverageratio,theliquiditycoverageratio,andthenetstablefundingratio.LearningObjective:DefineinthecontextofBaselIIIandcalculatewhereappropriate:Tier1capitalanditscomponents,Tier2capitalanditscomponents,requiredTier1equitycapital,totalTier1capital,andtotalcapital.LearningObjective:DescribethemotivationsforandcalculatethecapitalconservationbufferandthecountercyclicalbufferintroducedinBaselIII.Reference:JohnHull,RiskManagementandFinancialInstitutions,4thEdition(Hoboken,NJ:JohnWiley&Sons,2015).Chapter16-BaselII.5,BaselIIIandOtherPost-CrisisChangesSection:OperationalandIntegratedRiskManagement

73. Before thedevaluation, CMM’s tradingdeskhadestablished a short call optionspositionon theCNY-USDexchangeratethatwasmadedelta-neutralthroughaspotUSDtransaction.Thepositionwasnolongerdelta-neutral after thedevaluation came intoeffect and thedeskwanted to take steps tomake itdelta-neutralagain.ThebankwasconcernedaboutwhetherthiswouldinvolvebuyingorsellingUSDandwhatimpactthismighthaveonliquidity.Thetraderwhoinitiatedthepositionsuggestedthat,onceitwasmadedelta-neutral,the short call options positionwould be an effectiveway to hedge the bank’s long CNY exposure againstfurther devaluations and that the bank should consider increasing the size of the position accordingly. Inconsideringthissituation,whatshouldtheCROconclude?

A. ThebankwillhavetobuyUSDtomakethepositiondeltaneutral,butthedelta-neutralshortcalloptionspositionisnotaneffectivewaytohedgeanunderlyinglongCNYexposureagainstfurtherdevaluations.

B. ThebankwillhavetosellUSDtomakethepositiondeltaneutral,butthedelta-neutralshortcalloptionspositionisnotaneffectivewaytohedgeanunderlyinglongCNYexposureagainstfurtherdevaluations.

C. ThebankwillhavetobuyUSDtomakethepositiondeltaneutral,andthedelta-neutralshortcalloptionspositionisaneffectivewaytohedgeanunderlyinglongCNYexposureagainstfurtherdevaluations.

D. ThebankwillhavetosellUSDtomakethepositiondeltaneutral,andthedelta-neutralshortcalloptionspositionisaneffectivewaytohedgeanunderlyinglongCNYexposureagainstfurtherdevaluations.

CorrectAnswer:A

Explanation:Ifthedeskhadsoldcalloptionsonthedollar,ithadtobebuydollarspottobedelta-neutral.Becausetheoptionsweremoreinthemoney,theirabsolutevaluedeltaincreased,sodollarshadtobebought.ThiseliminateschoicesBandD.Thedelta-neutralshort-calloptionspositionwould,atbestearntherisk-freerateifitwasdynamicallyhedged.StatichedgingwouldlikelyresultinlossesiftheCNYdevaluedfurther.Regardless,itwouldnotbeaneffectivehedgeforanunderlyinglongCNYexposure.

Learning Objective: Describe the method of mapping forwards, forward rate agreements, interest rateswaps,andoptions.Reference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition(NewYork:McGraw-Hill,2007).Chapter11–VaRMapping.Section:MarketRiskMeasurementandManagementLearningObjective:Differentiatebetweensourcesofliquidityrisk,includingbalancesheet/fundingliquidityrisk,systematicfundingliquidityrisk,andexplainhoweachoftheseriskscanariseforfinancialinstitutions.Reference: Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken, NJ: JohnWiley&Sons,2011).Chapter12-LiquidityandLeverageSection:OperationalandIntegratedRiskManagement

74. CMMhadCNY-denominated loansoutstanding toTVR,amanufacturing firmthatgenerated its revenue inCNY.Tohedgesomeofitsrisk,CMMhadboughtCDSprotectiononTVRfromabankfromthesamecountryas TVR, Bank EP. If the default probability of TVR and the default correlation between TVR and Bank EPsuddenlyincreased,whichofthefollowingiscorrect?

A. ThevalueoftheCDSwillincreaseandCMMhasawrong-wayriskwithBankEP.B. ThevalueoftheCDSwilldecreaseandCMMhasawrong-wayriskwithBankEP.C. ThevalueoftheCDSwillincreaseandCMMhasaright-wayriskwithBankEP.D. ThevalueoftheCDSwilldecreaseandCMMhasaright-wayriskwithBankEP.

CorrectAnswer:B

Explanation:Sincethedefaultprobabilityofthereferenceentity(TVR)wasincreasing,theCDSspreadwouldwiden.Andalso,with thecorrelationbetweenTVRandBankEP (thecounterparty) increasing, thepresentvalueoftheCDSforCMMwouldfall.So,theexposureofCMMwithregardtoCDSwasdecliningwhilethedefaultprobabilityofthecounterpartywasrising.Thisisawrong-wayrisk.

A is incorrect.ThevalueofCDSshoulddecreaseasexplained inbabove. C is incorrect.ThevalueofCDSwouldincreasebutCMMhadwrong-wayriskwithBankEPasexplainedinBabove.Disincorrect.ThevalueofCDSdecreasedasexplainedinB.

LearningObjective:Describefinancialcorrelationriskandtheareasinwhichitappearsinfinance.Reference: GunterMeissner,CorrelationRiskModelingandManagement, (NewYork: JohnWiley&Sons,2014).Chapter1-SomeCorrelationBasics.Section:MarketRiskMeasurementandManagement

LearningObjective:Identifyexamplesofwrong-wayriskandexamplesofright-wayrisk.Reference: JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallenge forGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter15-WrongWayRisk.Section:CreditRiskMeasurementandManagement

75. Theriskmanagementgroupnoticedthattheliquidity-adjustedVaRthatwasbeingreportedbythesovereigndebt trading desk in Hong Kong was lower than that reported by the sovereign debt trading desk inSingapore,evenonidenticalbondholdings.Whatcouldexplainthisdifferenceinliquidity-adjustedVaR?

A. The Hong Kong desk uses the constant spread approach and the Singapore desk uses the exogenousspreadapproach.

B. The Hong Kong desk uses the exogenous spread approach and the Singapore desk uses the constantspreadapproach.

C. BothdesksusetheendogenouspriceapproachbuttheHongKongdeskusesahighervalueforthepriceelasticityofdemandassumption.

D. Both desks use the endogenous price approach but the Hong Kong desk uses a higher value for thetransactioncostassumption.

CorrectAnswer:A

Explanation: As spreads widened, the exogenous spread approach would reflect this in higher liquidity-adjusted VaR, but the constant-spread approach would not. In the endogenous price approach, a highervalueforthepriceelasticityofdemandwouldresultinhigherVaR.Theendogenouspriceapproachnormallyignores transaction costs, but even if it incorporated them, lower transaction costs should result in lowerVaR.

Reference:KevinDowd,MeasuringMarketRisk,2ndEdition(WestSussex:JohnWiley&Sons,2005).Chapter14-EstimatingLiquidityRisksLearning Objective:Define liquidity risk and describe factors that influence liquidity including the bid-askspread.LearningObjective:Differentiatebetweenexogenousandendogenousliquidity.LearningObjective:Describethechallengesofestimatingliquidity-adjustedVaR(LVaR).Section:OperationalandIntegratedRiskManagement

76. ACROataninvestmentbankhasaskedtheriskdepartmenttoevaluatethebank’s3-yearderivativeexposurepositionwithacounterparty.The1-yearCDSonthecounterpartyiscurrentlytradingataspreadof180bps.ThetablebelowpresentstradeandforecastdataontheCDSspread,theexpectedexposure,andtherecoveryrateonthecounterparty:

Year1 Year2 Year3Expectedexposure(AUDmillion) 15 15 15CDSspread(bps) 180 300 420Recoveryrate(%) 85 75 65

Additionally,theCROhaspresentedtheriskteamwiththefollowingsetofassumptionstouseinconductingtheanalysis:• Counterparty’sdefaultprobabilitiesfollowaconstanthazardrateprocess• Theinvestmentbankandthecounterpartyhavesignedacreditsupportannex(CSA)tocoverthis

exposure,whichrequirescollateralpostingofAUD13millionoverthelifeofthecontract• Thecurrentrisk-freerateofinterestis2%andthetermstructureofinterestrateswillremainflatover

the3-yearhorizon• CollateralandexposurevalueswillremainstableoverthelifeofthecontractGiventheinformationandtheassumptionsabove,whatisthcorrectestimateforthecreditvaluationadjustmentforthisposition?

A. AUD0.335millionB. AUD0.863millionC. AUD1.291millionD. AUD2.514million

Correctanswer:AExplanation:Toderivethecreditvaluationadjustment(CVA),weusethestandardformula:

( )( )( )( )ttt

tt DFPDEERRCVA å

Where(atanytimet),• Thediscountfactor(DFt)isdeterminedfromtherisk-freerateof2%;and• Thehazardrate=Spread/(1–RR)=(180/10,000)/(1–0.85)=12%(trueforyears2and3);• Theprobabilityofdefault(PDt)isderivedfromitsrelationshipwiththeconstanthazardrate(l),

PD(t)=1–exp(-lt).Forinstance,PD(1)=1–exp(-0.12*1)=11.31%

PD(2)=1–exp(-0.12*2)=21.34%PD(3)=1–exp(-0.12*3)=30.23%

• CollateralamountsofAUD13millionforyear2andAUD13millionforyear3areconsidered.

Hence,therestofthederivationbecomes:

(ExpectedExposure,Collateral,andCVAinAUDmillion) Year0 Year1 Year2 Year3Probabilityofdefault(PD) 11.31% 21.34% 30.23%Discountfactor(DF) 0.9804 0.9612 0.9423Recoveryrate(RR) 85% 75% 65%Expectedexposure(EE) 15 15 15Collateral(C) 13 13 13EE’(netted) 2 2 2(1–RR)*(EE’)*(PD)*(DF) 0.0333 0.1026 0.1994CVA=S(1–RR)*(EE’)*(PD)*(DF) 0.335

Reference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter12,CreditValueAdjustment.LearningObjective:CalculateCVAandCVAspreadwithnowrong-wayrisk,netting,orcollateralization.ExplaintheimpactofincorporatingcollateralizationintotheCVAcalculation.Section:CreditRiskMeasurementandManagementReference:AllanMalz,FinancialRiskManagement:Models,History,andInstitutions(Hoboken,NJ:JohnWiley&Sons,2011).Chapter7,SpreadRiskandDefaultIntensityModels.LearningObjective:Definethehazardrateanduseittodefineprobabilityfunctionsfordefaulttimeandconditionaldefaultprobabilities.Section:CreditRiskMeasurementandManagement

77. TheCEOofalargebankhasreportedthatthebank’sframeworkformanagingoperationalriskareconsistentwithBaselIIandBaselIIImodelforoperationalriskgovernance.Whichofthefollowingactionsandprinciplesofthebankiscorrect?

A. ThebankconsidersidentificationandmanagementofriskasthesecondlineofdefenseB. Thebankconsidersindependentreviewandauditoftheriskprocessesandsystemsasthethirdlineof

defenseC. ThebankincludesdamagedreputationduetoafailedmergerinitsmeasurementofoperationalriskD. Thebankexcludesdestructionbyfireorotherexternalcatastrophesfromitsmeasurementofoperational

Correctanswer:BExplanation:Soundoperationalriskgovernance,accordingtoBasel,reliesonthreelinesofdefense:(i)Firstlineofdefense-businesslinemanagement,whichisresponsibleforidentifyingandmanagingtherisksinherentintheproducts,activities,processesandsystemsforwhichitisaccountable;(ii)Secondlineofdefence–anindependentcorporateoperationalriskmanagementfunction,generallycomplementingthebusinessline’soperationalriskmanagementactivities;(iii)Thirdlineofdefense–anindependentreview–reviewandauditofthebank’soperationalriskmanagementcontrols,processesandsystems.BaselIIandBaselIIIdefineoperationalrisk(inclusiveoftechnologicalrisk)as“theriskofdirectorindirectlossresultingfrominadequateorfailedinternalprocesses,peopleandsystemsorfromexternalevents.”Althoughanumberoffinancialinstitutionsaddreputationriskandstrategicrisk(e.g.,duetoafailedmerger)aspartofabroadeneddefinitionofoperationalrisk,theyarenotwithinthescopeofdefinitionbyBaselII/III.Section:OperationalandIntegratedRiskManagementReference:PrinciplesfortheSoundManagementofOperationalRisk,(BaselCommitteeonBankingSupervisionPublication,June2011).LearningObjective:SummarizethefundamentalprinciplesofoperationalriskmanagementassuggestedbytheBaselcommittee.

78. AriskmanagerhasaskedajunioranalysttoestimatetheimplieddefaultprobabilityforaBBB-rateddiscountcorporatebond.Relevantinformationonotherfixed-incomesecuritiesaregivenbelow:

• TheTreasurybond(arisk-freebond)yields4%peryear.• Theone-yearBB-rateddiscountbondyields8%peryear.• Thetwo-yearBB-rateddiscountbondyields11%peryear.

IftherecoveryrateonaBBB-ratedbondisexpectedtobe0%,andthemarginaldefaultprobabilityinyearoneis6%,whichofthefollowingisthebestestimateoftherisk-neutralprobabilitythattheBBB-rateddiscountbonddefaultswithinthenexttwoyears?

A. 6.31%B. 7.27%C. 12.22%D. 13.97%Correctanswer:CExplanation:(1+0.04)2=PD*0+(1–PD)*(1+0.11)2→PD=12.22%Section:CreditRiskMeasurementandManagementReference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter10,DefaultProbability,CreditSpreads,andCreditDerivativesLearningObjective:Calculaterisk-neutraldefaultprobabilities,andcomparetheuseofrisk-neutralandreal-worlddefaultprobabilitiesinpricingderivativecontracts.

79. Pensionfundmanagershavetodealwitharangeofpolicy,risk,andreturnrequirements.Whichofthefollowingstatementsaboutriskmanagementinthepensionfundindustryiscorrect?

A. Apensionplan’stotalVaRisequaltothesumofitspolicy-mixVaRandactivemanagementVaR.B. Pensionfundriskanalysisdoesnotconsiderperformancerelativetoabenchmark.C. Inmostdefined-benefitpensionplans,ifliabilitiesexceedassets,theshortfalldoesnotcreateariskfor

theplansponsor.D. Fromtheplansponsor’sperspective,nominalpensionobligationsaresimilartoashortpositioninabond.

Correctanswer:DExplanation:Liabilitiesatapensionfundaretypicallycomposedofaccumulatedbenefitobligations,measuredbythepresentvalueofallpensionbenefitsowedtoemployeesdiscountedbyanapproximateinterestrate.Whenliabilitiesconsistmostlyofnominalpayments,theirvalueingeneralwillbehavelikeashortpositioninalong-termbond.Section:RiskManagementandInvestmentManagementReference:PhilippeJorion,Value-at-Risk:TheNewBenchmarkforManagingFinancialRisk,3rdEdition.Chapter17,VaRandRiskBudgetinginInvestmentManagement.LearningObjective:Describetheinvestmentprocessoflargeinvestorssuchaspensionfunds.

80. Afinancialinstitutionhasatwo-waycollateralsupportannex(CSA)withacounterpartycoveringaportfoliovaluedatJPY400million.ThemarginingtermsofthecollateralizedportfolioincludeathresholdofJPY180million,aminimumtransferamountofJPY30million,andamarginperiodofriskof10days.Whichofthefollowingiscorrectregardingthesizeofcollateralinmitigatingthecounterpartyriskoftheportfolio?A. Alowerthresholdvalueisequivalenttoalargerportionofexposureprotectedbycollateral.B. Ashortermarginperiodofriskisequivalenttoasmallerportionofexposureprotectedbycollateral.C. Alowerindependentamountisequivalenttoalargerportionofexposureprotectedbycollateral.D. TheprotectionfromcollateralspecifiedintheCSAisuniformthroughoutthelifeoftheexposureprofile.Correctanswer:AExplanation:Aiscorrect.Thresholdistheamountofuncollateralizedexposure.Alowerthresholdvaluemeansalargerportionofexposureisprotectedbycollateral(SeeCR2017referencebelow).Similarly,Cisincorrectbecausealowerindependentamountisequivalenttoahigherthreshold.Thatcorrespondstoasmallerportionofexposureisprotected.Bisincorrectbecausethemarginperiodofriskistheeffectivetimeassumedbetweenacollateralcallandreceivingtheappropriatecollateral.Ithasnothingtodowiththeamountofcollateral.Disincorrect.Collateralhaslittleeffectatboththebeginningandendoftheexposureprofilewhenthereisathresholdcap.Section:CreditRiskMeasurementandManagementReference:JonGregory,CounterpartyCreditRiskandCreditValueAdjustment:AContinuingChallengeforGlobalFinancialMarkets,2ndEdition(WestSussex,UK:JohnWiley&Sons,2012).Chapter8-CreditExposure.LearningObjective:Explaintheimpactofcollateralizationonexposure,andassesstheriskassociatedwiththeremarginingperiod,threshold,andminimumtransferamount.

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