8010

For a 10 year interest rate swap, what would be the worst time for a counterparty to default (in terms of the maximum likely credit exposure)
A . 10 years
B . Right after inception
C . 2 years
D . 7 years

View Answer

Answer: D

Explanation:

Right after inception’ is incorrect as the interest rate swap (IRS) would be valued at close to zero right after inception and the credit risk would be minimum. Choice ‘a’ (ie 10 years, at maturity) is incorrect as at maturity there would be no more cash flows to exchange, and the replacement value of the contract would again be close to zero.

Therefore the worst time for the counterparty to default is somewhere between inception and maturity – in fact the range of possible outcomes for the contract increases with the passage of time, and we should find the worst time to default to be a later date. However, towards maturity, the value of the contract starts to go towards zero again, and the maximum value is reached around 7 years. 2 years is too early for the maximum to be reached for the10 year IRS, and therefore choice a is the correct answer.

Which of the following risks and reasons justify the use of scenario analysis in operational risk modeling:

I. Risks for which no internal loss data is available

II. Risks that are foreseeable but have no precedent, internally or externally

III. Risks for which objective assessments can be made by experts

IV. Risks that are known to exist, but for which no reliable external or internal losses can be analyzed

V. Reducing the complexity of having to fit statistical models to internal and external loss data

VI. Managing the capital estimation process as to produce estimates in line with management’s desired capital buffers.
A . I, II and III
B . I, II, III and IV
C . V
D . All of the above

View Answer

Answer: B

Explanation:

All the reasons and risks presented above are valid reasons for using scenario analysis, except V and VI – ie, the need to reduce the complexity of calculations is not a valid reason for using scenario analysis. Similarly, making operational risk capital estimates match management’s desired capital allocation targets is also not a valid reason. Capital calculations are intended to provide adequate capital for managing the risk from operations, regardless of what management may desire them to be.

A corporate bond maturing in 1 year yields 8.5% per year,while a similar treasury bond yields 4% .

What is the probability of default for the corporate bond assuming the recovery rate is zero?
A . 4.15%
B . 4.50%
C . 8.50%
D . Cannot be determined from the given information

View Answer

Answer: A

Explanation:

The probability of default would make the future cash flows from both the bonds identical. If p be the probability of default, the cash flows from the risky corporate bond would be = (cash flows in the event of default x probability of default) + (cash flows without default x (1 – probability of default)) => p*0 + (1 – p)*(1 + 8.5%) = (1 – p)*1.085.

The cash flows from the treasury bond would be 1.04. These two should be equal, ie, 1.04 = (1-p)*1.085, implying p = 4.15%.

(Note: The above is a simplification intended for the exam. In reality investors would demand a ‘credit risk premium’ for the corporate bond over and above the expected default loss rate. They are unlikely to be happy with just being compensated with exactly the expected default loss rate plus the risk-fre rate because the expected default loss rate itself is uncertain. They would demand some premium over and above what the default rate alone might mathematically imply above the risk free rate. In this question, this credit risk premium is ignored.)

Which of the following statements are true?

I. Risk governance structures distribute rights and responsibilities among stakeholders in the corporation

II. Cybernetics is the multidisciplinary study of cyber risk and control systems underlying information systems in an organization

III. Corporate governance is a subset of the larger subject of risk governance

IV. The Cadbury report was issued in the early 90s and was one of the early frameworks for corporate governance
A . I, II and IV
B . I and IV
C . II and III
D . All of the above

View Answer

Answer: B

Explanation:

Governance structures specify the policies, principles and procedures for making decisions about corporate direction. They distribute rights and responsibiliies among stakeholders that typically include executive management, employees, the board etc. Statement I is therefore correct.

"Cybernetics is a transdisciplinary approach for exploring regulatory systems, their structures, constraints, and possibilities. In the 21st century, the term is often used in a rather loose way to imply "controlof any system using technology" (Wikipedia). Governance literature has been affected by cybernetics, which is not the same thing as information security or cyber security. Statement II is incorrect.

Corporate governance includes risk governance, and not the other way round. Therefore statement III is incorrect.

The Cadbury Report, titled Financial Aspects of Corporate Governance, was a report issued in the UK in December 1992 by "The Committee on the Financial Aspects of Corporate Governance". The report is eponymous with the chair of the committee, and set out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures. Statement IV is therefore correct.

Which of the following cannot be used as an internal credit rating model to assess an individual borrower:
A . Distance to default model
B . Probit model
C . Logit model
D . Altman’s Z-score

View Answer

Answer: A

Explanation:

Altman’s Z-score, the Probit and the Logit models can all be used to assess the credit rating of an individual borrower. There is no such model as the ‘distance todefault model’, and therefore Choice ‘a’ is the correct answer.

A key problem with return on equity as a measure of comparative performance is:
A . that return on equity is not adjusted for risk
B . that return on equity are not adjusted for cash flows being different from accounting earnings
C . that return on equity measures do not account for interest and taxes
D . that return on equity ignores the effect of leverage on returns to shareholders

View Answer

Answer: A

Explanation:

The major problem with using return onequity as a measure of performance is that return on equity is not adjusted for risk. Therefore, a riskier investment will always come out ahead when compared to a less risky investment when using return on equity as a performance metric.

Return on equitydoes not ignore the effect of leverage (though return on assets does) because it considers the income attributable to equity, including income from leveraged investments.

Return on equity is generally measured after interest and taxes at the company wide level, though at business unit level it may use earnings before interest and taxes. However this does not create a problem so long as all performance being covered is calculated in the same way.

Cash flows being different from accounting earnings can createliquidity issues, but this does not affect the effectiveness of ROE as a measure of performance.

What would be the correct order of steps to addressing data quality problems in an organization?
A . Assess the current state, design the future state, determine gaps and the actions required to be implemented to eliminate the gaps
B . Articulate goals, do a ‘strategy-fit’ analysis and plan for action
C . Design the future state, perform a gap analysis, analyze the current state and implement the future state
D . Call in external consultants

View Answer

Answer: A

Explanation:

The correct answer is choice ‘a’

The correct order of steps to addressing data quality problems in an organization would include:

A bank’s detailed portfolio data on positions held in a particular security across the bank does not agree with the aggregate total position for that security for the bank .

What data quality attribute is missing in this situation?
A . Data completeness
B . Data integrity
C . Auditability
D . Data extensibility

View Answer

Answer: B

Explanation:

The term ‘data quality’ has multiple elements, ie, data in order to be considered of a high quality must have multiple attributes such ascompleteness, timeliness, auditability etc. Because this is not an exact science, every expert or text book will have a different view of what goes into data quality.

For our purposes however, we will stick to what the PRMIA study material specifies, and according to the study material the following are the elements that can be considered attributes that make for quality data:

Which of the following carry greater counterparty risk: a forward contract on a 10 year note, or a commercial paper carrying a AA credit rating with identical maturity and notional?
A . The forward contract has greater credit risk as its future gains are unknown
B . Credit risk can not be compared in these terms
C . They both carry the same credit risk
D . The commercial paper has greater credit risk as the entire notional is outstanding

View Answer

Answer: D

Explanation:

The commercial paper has greater credit risk as the entire notional is outstanding. On the forward contract, only the replacement value of the contract, which normally would be a mere fraction of the notional, would be at risk.

Therefore Choice ‘d’ is the correct answer.

A risk management function is best organized as:
A . integrated with the risk taking functions as risk management should be a pervasive activity carried out at all levels of the organization.
B . report independently of the risk taking functions
C . reporting directly to the traders, as to be closest to the point at which risks are being taken
D . a part of the trading desks and other risk taking teams

View Answer

Answer: B

Explanation:

The point that this question is trying to emphasize is the independence of the risk management function. The risk function should be segregated from the risk taking functions as to maintain independence and objectivity.

Choice ‘d’, Choice ‘c’ and Choice ‘a’ run contrary to this requirement of independence, and are therefore not correct. The risk function should report directly to senior levels, for example directly to the audit committee, and not be a part of the risk taking functions.