8008

Which of the following situations are not suitable for applying parametric VaR:

I. Where the portfolio’s valuation is linearly dependent upon risk factors

II. Where the portfolio consists of non-linear products such as options and large moves are involved

III. Where the returns of risk factors are known to be not normally distributed
A . I and II
B . II and III
C . I and III
D . All of the above

View Answer

Answer: B

Explanation:

Parametric VaR relies upon reducing a portfolio’s positions to risk factors, and estimating the first order changes in portfolio values from each of the risk factors. This is called the delta approximation approach. Risk factors include stock index values, or the PV01 for interest rate products, or volatility for options. This approach can be quite accurate and computationally efficient if the portfolio comprises products whose value behaves linearly to changes in risk factors. This includes long and short positions in equities, commodities and the like.

However, where non-linear products such as options are involved and large moves in the risk factors are anticipated, a delta approximation based valuation may not give accurate results, and the VaR may be misstated. Therefore in such situations parametric VaR is not advised (unless it is extended to include second and third level sensitivities which can bring its own share of problems).

Parametric VaR also assumes that the returns of risk factors are normally distributed – an assumption that is violated in times of market stress. So if it is known that the risk factor returns are not normally distributed, it is not advisable to use parametric VaR.

Which of the following is not a credit event under ISDA definitions?
A . Restructuring
B . Obligation accelerations
C . Rating downgrade
D . Failure to pay

View Answer

Answer: C

Explanation:

According to ISDA, a credit event is an event linked to the deteriorating credit worthiness of an underlying reference entity in a credit derivative. The occurrence of a credit event usually triggers full or partial termination of the transaction and a payment from protection seller to protection buyer.

Credit events include

– bankruptcy,

– failure to pay,

– restructuring,

– obligation acceleration,

– obligation default and

– repudiation/moratorium.

A rating downgrade is not a credit event.

Which of the following are measures of liquidity risk

I. Liquidity Coverage Ratio

II. Net Stable Funding Ratio

III. Book Value to Share Price

IV. Earnings Per Share
A . III and IV
B . I and II
C . II and III
D . I and IV

View Answer

Answer: B

Explanation:

In December 2009 the BIS came out with a new consultative document on liquidity risk.

Given the events of 2007 – 2009, it has been clear that a key characteristic of the financial crisis was the inaccurate and ineffective management of liquidity risk

The paper two separate but complementary objectives in respect of liquidity risk management: The first objective relates to the short-term liquidity risk profile of institution, and the second objective is to promote resiliency over longer-term time horizons.

The paper identifies the following two ratios – you should be aware of these – though I am not sure if these will show up in the PRMIA exam:

If an institution has $1000 in assets, and $800 in liabilities, what is the economic capital required to avoid insolvency at a 99% level of confidence? The VaR in respect of the assets at 99% confidence over a one year period is $100.
A . 200
B . 1000
C . 100
D . 1100

View Answer

Answer: C

Explanation:

The economic capital required to avoid insolvency is just the asset VaR, ie $100. This means that if the worst case losses are realized, the institution would need to have a buffer equivalent to those losses which in this case will be $100, and this buffer is the economic capital.

The actual value of liabilities is not relevant as they are considered ‘riskless’ from the institution’s point of view, ie they will be taken at full value. In this particular case, the institution has $200 in capital which is more than the economic capital required. Therefore Choice ‘c’ is the correct answer.

Which of the following best describes economic capital?
A . Economic capital is the amount of regulatory capital mandated for financial institutions in the OECD countries
B . Economic capital is the amount of regulatory capital that minimizes the cost of capital for firm
C . Economic capital reflects the amount of capital required to maintain a firm’s target credit rating
D . Economic capital is a form of provision for market risk losses should adverse conditions arise

View Answer

Answer: C

Explanation:

Economic capital is often calculated with a view to maintaining the credit ratings for a firm. It is the capital available to absorb unexpected losses, and credit ratings are also based upon a certain probability of default. Economic capital is often calculated at a level equal to the confidence required for the desired credit rating. For example, if the probability of default for a AA rating is 0.02%, and the firm desires to hold an AA rating, then economic capital maintained at a confidence level of 99.98% would allow for such a rating. In this case, economic capital set at a 99.8% level can be thought of as the level of losses that would not be exceeded with a 99.8% probability, and would help get the firm its desired credit rating.

Choice ‘c’ is the correct answer. Economic capital does not target minimizing the cost of capital, nor is it a provision for losses arising from market risk. The concept of economic capital is unrelated to where an institution or firm is based, therefore Choice ‘a’ is incorrect as well.

Which of the following formulae describes Marginal VaR for a portfolio p, where V_i is the value of the i-th asset in the portfolio? (All other notation and symbols have their usual meaning.)

A)

B)

C)

D)

All of the above
A . Option A
B . Option B
C . Option C
D . Option D

View Answer

Answer: D

Explanation:

Marginal VaR of a component of a portfolio is the change in the portfolio VaR from a $1 change in the value of the component. It helps a risk analyst who may be trying to identify the best way to influence VaR by changing the components of the portfolio. Marginal VaR is also important for calculating component VaR (for VaR disaggregation), as component VaR is equal to the marginal VaR multiplied by the value of the component in the portfolio. Marginal VaR is by definition the derivative of the portfolio value with respect to the component i. This is reflected in Choice ‘a’ above. Using the definitions and relationships between correlation, covariance, beta and volatility of the portfolio and/or the component, we can show that the other two choices are also equivalent to Choice ‘a’. Therefore all the choices present are correct.

Which of the following would not be a part of the principal component structure of the term structure of futures prices?
A . Curvature component
B . Trend component
C . Parallel component
D . Tilt component

View Answer

Answer: C

Explanation:

The trend component refers to parallel shifts in the term structure, the tilt refers to changes in the shape of the term structure at the long and short ends, and the curvature refers to movements in the medium term part. The phrase ‘parallel component’ has no meaning and is not a part of the principal components in analyzing term structures.

Changes in the term structure can also be analyzed as "level, slope and curvature", so you should be aware of this terminology as well to refer to the principal components of a term structure analysis.

Under the standardized approach to calculating operational risk capital, how many business lines are a bank’s activities divided into per Basel II?
A . 7
B . 15
C . 8
D . 12

View Answer

Answer: C

Explanation:

In the Standardized Approach, banks’ activities are divided into eight business lines: corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Therefore Choice ‘c’ is the correct answer.

According to the Basel II standard, which of the following conditions must be satisfied before a bank can use ‘mark-to-model’ for securities in its trading book?

I. Marking-to-market is not possible

II. Market inputs for the model should be sourced in line with market prices

III. The model should have been created by the front office

IV. The model should be subject to periodic review to determine the accuracy of its performance
A . I, II and IV
B . II and III
C . I, II, III and IV
D . III and IV

View Answer

Answer: A

Explanation:

According to Basel II, where marking-to-market is not possible, banks may mark-to-model, where this can be demonstrated to be prudent. Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. When marking to model, an extra degree of conservatism is appropriate.

Supervisory authorities will consider the following in assessing whether a mark-to-model valuation is prudent:

• Senior management should be aware of the elements of the trading book which are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business.

• Market inputs should be sourced, to the extent possible, in line with market prices. The appropriateness of the market inputs for the particular position being valued should be reviewed regularly.

• Where available, generally accepted valuation methodologies for particular products should be used as far as possible.

• Where the model is developed by the institution itself, it should be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. It should be independently tested. This includes validating the mathematics, the assumptions and the software implementation.

• There should be formal change control procedures in place and a secure copy of the model should be held and periodically used to check valuations.

• Risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output.

• The model should be subject to periodic review to determine the accuracy of its performance (e.g. assessing continued appropriateness of the assumptions, analysis of P&L versus risk factors, comparison of actual close out values to model outputs).

• Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation.

The model should be created independent of the front office, and not by it. Therefore

statement III does not represent an appropriate choice. Choice ‘a’ is the correct answer.

The loss severity distribution for operational risk loss events is generally modeled by which of the following distributions:

I. the lognormal distribution

II. The gamma density function

III. Generalized hyperbolic distributions

IV. Lognormal mixtures
A . II and III
B . I, II and III
C . I, II, III and IV
D . I and III

View Answer

Answer: C

Explanation:

All of the distributions referred to in the question can be used to model the loss severity distribution for op risk. Therefore Choice ‘c’ is the correct answer.