PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 1:

  Which of the following objectives are targeted by rating agencies when assigning ratings:

  I - Ratings accuracy II - Ratings stability III - High accuracy ratio (AR) IV - Ranked ratings

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

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  explanation:

  Explanation

  Rating agencies target both accuracy and stability when they assign ratings. These two objectives can sometimes conflict, so a balance needs to be struck between the two. Rating agencies do not target any particular 'accuracy ratio' or rankings. Therefore Choice 'c' is the correct answer.

• Question 2:

  Which of the following statements are true in relation to the current state of the financial network?

  I - Interconnectivity between countries has reduced while that between institutions in the same country has increased significantly II - The degrees of separation between institutions has gone up III - The average path length connecting any two given institutions has shrunk IV - Knife-edge dynamics imply that systemic risk arises from the financial system flipping from risk sharing to risk spreading

  A. II and III
  B. I and IV
  C. III and IV
  D. I and II
  C. III and IV

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  explanation:

  Explanation

  Over the past decade or so, systemic risk has been increased by vastly increasing network complexities resulting from greater interconnectivity between institutions as well as countries. Therefore statement I is incorrect. Statement II is incorrect and statement III is correct because the average path length between institutions, or their degree of separation where they are not directly dealing with each other but through other counterparties to which they are exposed (analogous to 6 degrees of separation, or the 'small world' property), has shrunk and not increased. Statement IV correctly describes knife edge dynamics, which is another way of waying that the financial network displays a tipping point property.

• Question 3:

  What would be the consequences of a model of economic risk capital calculation that weighs all loans equally regardless of the credit rating of the counterparty?

  A. Create an incentive to lend to the riskiest borrowers II. Create an incentive to lend to the safest borrowers III. Overstate economic capital requirements IV. Understate economic capital requirements
  B. III only
  C. I and IV
  D. II and III
  E. I only
  B. III only

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  explanation:

  Explanation

  If capital calculations are done in a standard way regardless of risk (as reflected by credit ratings), then it creates a perverse incentive for the lenders' employees to lend to the riskiest borrowers that offer the highest expected returns as there

  is no incentive to 'save' on economic capital requirements that are equal for both safe and unsafe borrowers.

  Therefore statement I is correct.

  Given that the portfolio of such an institution is likely to then comprise poor quality borrowers, and economic capital would be based upon 'average' expected ratings, it is likely to carry lower economic capital given its exposures. Therefore any

  such economic risk capital model is likely to understate economic capital requirements. Therefore statement IV is correct.

  Statements II and III are incorrect and Choice 'b' is the correct answer.

• Question 4:

  Which of the following formulae correctly describes Component VaR. (p refers to the portfolio, and i is the i-th constituent of the portfolio. MVaR means Marginal VaR, and other symbols have their usual meanings.)

  

  A. III
  B. II
  C. I
  D. I and II
  D. I and II

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  explanation:

  Explanation

  The first two formulae describe component VaR. The last formula is the formula for Marginal VaR. Therefore I and II is the correct answer. Component VaR is a VaR decomposition technique that allows the total VaR for a portfolio to be broken down and attributed to the components of a portfolio. The total of the component VaR for each constituent of a portfolio is equal to the VaR for the portfolio. This property is extremely useful as opposed to the standalone VaR for each constituent taken alone as it can be used for allocating trading budgets.

• Question 5:

  Which of the following statements is true?

  I - If no loss data is available, good quality scenarios can be used to model operational risk II - Scenario data can be mixed with observed loss data for modeling severity and frequency estimates III - Severity estimates should not be created by fitting models to scenario generated loss data points alone IV - Scenario assessments should only be used as modifiers to ILD or ELD severity models

  A. I
  B. I and II
  C. III and IV
  D. All statements are true
  B. I and II

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  explanation:

  Explanation

  There are multiple ways to incorporate scenario analysis for modeling operational risk capital - and the exact approach used depends upon the quantity of loss data available, and the quality of scenario assessments. Generally:

  -

  If there is no past loss data available, scenarios are the only practical means to model operational risk loss distributions. Both frequency and severity estimates can be modeled based on scenario data.

  -

  If there is plenty of past data available, scenarios can be used as a modifier for estimates that are based solely on data (for example, consider the MAX of the loss estimates at the desired quantile as provided by the data, and as indicated by

  scenarios)

  -

  If high quality scenario data is available, and there is sufficient past data, one could mix scenario assessments with the loss data and fit the combined data set to create the loss distribution. Alternatively, both could be fitted with severity

  estimates and then the two severities could be parametrically combined.

  In short, there is considerable flexibility in how scenarios can be used. Statement I is therefore correct, and so is statement II as both indicate valid uses of scenarios.

  Statement III is not correct because it may be okay to create severity estimates based on scenario data alone.

  Statement IV is not correct because while using scenarios as modifiers to other means of estimation is acceptable, that is not the only use of scenarios.

• Question 6:

  A bullet bond and an amortizing loan are issued at the same time with the same maturity and with the same principal. Which of these would have a greater credit exposure halfway through their life?

  A. Indeterminate with the given information
  B. They would have identical exposure half way through their lives
  C. The amortizing loan
  D. The bullet bond
  D. The bullet bond

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  explanation:

  Explanation

  A bullet bond is a bond that pays coupons covering interest during the life of the bond and the principal at maturity. An amortizing loan pays the interest as well as a part of the principal with every payment. Therefore, the exposure of the amortizing loan continually reduces, and approaches zero towards the end of its life. The bullet bond will always have a higher exposure at any time during its life when compared to an equivalent amortizing loan. Hence Choice 'd' is the correct answer.

• Question 7:

  An operational loss severity distribution is estimated using 4 data points from a scenario. The management institutes additional controls to reduce the severity of the loss if the risk is realized, and as a result the estimated losses from a 1-in10-year losses are halved. The 1- in-100 loss estimate however remains the same. What would be the impact on the 99.9th percentile capital required for this risk as a result of the improvement in controls?

  A. The capital required will decrease
  B. The capital required will stay the same
  C. The capital required will increase
  D. Can't say based on the information provided
  C. The capital required will increase

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  explanation:

  Explanation

  This situation represents one of the paradoxes in estimating severity that one needs to be aware of - the improvement in controls reduces the weight of the body/middle of the distribution and moves it towards the tails (as the total probability under the curve must stay at 100%) and the distribution becomes more heavy tailed. As a result, the 99.9th percentile loss actually increases. instead of decreasing, creating a counterintuitive result. Therefore the correct answer is that the capital required will increase. If scenario analysis produces such a result, the analyst must question if the 1 in 100 year loss severity is still accurate. If the new control has reduced the severity in the body of the distribution, the question as to why the more extreme losses have not changed should be raised.

• Question 8:

  Which of the following are valid objectives of a reverse stress test:

  I - Ensure that a firm can survive for long enough after risks have materialized for it to either regain market confidence, restructure or be sold, or be closed down in an orderly manner,

  II - Discover the vulnerabilities of the current business plan,

  III - Better integrate business and capital planning,

  IV - Create a 'zero-failure' environment at the systemic level in the financial sector

  A. I and IV
  B. I, II and III
  C. II and III
  D. All of the above
  B. I, II and III

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  explanation:

  Explanation

  Statement I is true. According to the statement CP08/24: Stress and scenario testing (December 2008) issued by the FSA in the UK, an underlying objective of reverse stress tests is to ensure that a firm can survive long enough after risks have crystallized for one of the following to occur:

  - the market decides that its lack of confidence is unfounded and recommences transacting with the firm;

  -the firm down-sizes and re-structures its business;

  -

  the firm is taken over, or its business is transferred in an orderly manner; or

  -

  public authorities take the firm over, or wind down its business in an orderly manner. Statement II and III are true. The same statement clarifies the intention of the reverse stress testing requirement, which is to encourage firms to: explore more fully the vulnerabilities of theirbusiness model (including `tail risks'); make decisions that better integrate business and capital planning; and improve their contingency planning. Statement IV is incorrect. Since the question is asking for the statement which is NOT an objective for reverse stress tests, Choice 'b' is the correct answer. The same statement clarifies that the introduction of a reverse-stress test requirement should not be interpreted as indicating that the FSA is pursuing a `zero-failure' policy. In the FSA's view, such a policy is neither possible, nor desirable.

• Question 9:

  Which of the following is the best description of the spread premium puzzle:

  A. The spread premium puzzle refers to observed default rates being much less than implied default rates, leading to lower credit bonds being relatively cheap when compared to their actual default probabilities
  B. The spread premium puzzle refers to dollar denominated non-US sovereign bonds being priced a at significant discount to other similar USD denominated assets
  C. The spread premium puzzle refers to AAA corporate bonds being priced at almost the same prices as equivalent treasury bonds without offering the same liquidity or guarantee as treasury bonds
  D. The spread premium puzzle refers to the moral hazard implicit in the monoline insurance market
  A. The spread premium puzzle refers to observed default rates being much less than implied default rates, leading to lower credit bonds being relatively cheap when compared to their actual default probabilities

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  explanation:

  Explanation

  Choice 'a' is the correct answer. The other choices represent non-sensical statements.

• Question 10:

  For a given notional amount, which of the following carries the greatest counterparty exposure (assuming the same counterparty credit rating for each):

  A. A futures contract on an equity index
  B. A one year certificate of deposit
  C. A one year forward foreign exchange contract
  D. A one year interest rate swap
  B. A one year certificate of deposit

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  explanation:

  Explanation

  The exposure at default is the greatest for the certificate of deposit as the entire notional amount is exposed to the risk of default. The other choices represent derivatives for which the current replacement value, which would be far less than

  notional, would be the credit exposure.

  Said another way - if the counterparty were to default, the entire money in the CD would be at risk, whereas for the derivative contracts it would only be the replacement value that would be at risk.