PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 111:

  According to the implied capital model, operational risk capital is estimated as:

  A. Operational risk capital held by similar firms, appropriately scaled
  B. Total capital less market risk capital less credit risk capital
  C. Capital implied from known risk premiums and the firm's earnings
  D. Total capital based on the capital asset pricing model
  B. Total capital less market risk capital less credit risk capital

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  Explanation

  Operational risk capital estimated using the implied capital model is merely the capital that is not attributable to market or credit risk. Therefore Choice 'b' is the correct answer. All other responses are incorrect.

• Question 112:

  Under the CreditPortfolio View approach to credit risk modeling, which of the following best describes the conditional transition matrix:

  A. The conditional transition matrix is the unconditional transition matrix adjusted for the state of the economy and other macro economic factors being modeled
  B. The conditional transition matrix is the transition matrix adjusted for the risk horizon being different from that of the transition matrix
  C. The conditional transition matrix is the unconditional transition matrix adjusted for probabilities of defaults
  D. The conditional transition matrix is the transition matrix adjusted for the distribution of the firms' asset returns
  A. The conditional transition matrix is the unconditional transition matrix adjusted for the state of the economy and other macro economic factors being modeled

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  Explanation

  Under the CreditPortfolio View approach, the credit rating transition matrix is adjusted for the state of the economy in a way as to increase the probability of defaults when the economy is not doing well, and vice versa. Therefore Choice 'a' is the correct answer. The other choices represent nonsensical options.

• Question 113:

  An investor enters into a 5-year total return swap with Bank A, with the investor paying a fixed rate of 6% annually on a notional value of $100m to the bank and receiving the returns of the SandP500 index with an identical notional value. The swap is reset monthly, ie the payments are exchanged monthly. On Jan 1 of the fourth year, after settling the last month's payments, the bank enters bankruptcy. What is the legal claim that the hedge fund has against the bank in the bankruptcy court?

  A. $100m
  B. $6m
  C. The replacement value of the swap
  D. $0, as all payments on the swap are current
  C. The replacement value of the swap

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  Explanation

  According to ISDA standard definitions, the legal claim for OTC derivatives is the current replacement value of the contract. Therefore Choice 'c' is the correct answer. None of the other choices are correct.

• Question 114:

  Concentration risk in a credit portfolio arises due to:

  A. A high degree of correlation between the default probabilities of the credit securities in the portfolio
  B. A low degree of correlation between the default probabilities of the credit securities in the portfolio
  C. Issuers of the securities in the portfolio being located in the same country
  D. Independence of individual default losses for the assets in the portfolio
  C. Issuers of the securities in the portfolio being located in the same country

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  Explanation

  Concentration risk in a credit portfolio arises due to a high degree of correlation between the default probabilities of the issuers of securities in the portfolio. For example, the fortunes of the issuers in the same industry may be highly correlated, and an investor exposed to multiple such borrowers may face 'concentration risk'. A low degree of correlation, or independence of individual defaults in the portfolio actually reduces or even eliminates concentration risk. The fact that issuers are from the same country may not necessarily give rise to concentration risk - for example, a bank with all US based borrowers in different industries or with different retail exposure types may not face practically any concentration risk. What really matters is the default correlations between the borrowers, for example a lender exposed to cement producers across the globe may face a high degree of concentration risk.

• Question 115:

  According to the Basel framework, reserves resulting from the upward revaluation of assets are considered a part of:

  A. Tier 3 capital
  B. Tier 2 capital
  C. Tier 1 capital
  D. All of the above
  B. Tier 2 capital

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  Explanation

  According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves. Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt. Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority.

• Question 116:

  A stock that follows the Weiner process has its future price determined by:

  A. its current price, expected return and standard deviation
  B. its standard deviation and past technical movements
  C. its expected return and standard deviation
  D. its expected return alone
  A. its current price, expected return and standard deviation

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  Explanation

  The change in the price of a security that follows a Weiner process is determined by its standard deviation and expected return. To get the price itself, we need to add this change in price to the current price. Therefore the future price in a Weiner process is determined by all three of current price, expected return and standard deviation.

• Question 117:

  The backtesting of VaR estimates under the Basel accord requires comparing the ex-ante VaR to:

  A. hypothetical profit and loss keeping the positions constant
  B. the Basel accord does not require banks to backtest VaR estimates
  C. ex-ante VaR calculated for the subsequent periods
  D. realized profit and loss for the period
  D. realized profit and loss for the period

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  Explanation

  Basel II requires financial institutions to compare their ex-ante VaR estimates to actual realized PandL. Therefore Choice 'd' is the correct answer. A bank may use hypothetical PandL based upon constant positions to validate its model, but that is not required for Basel II.

• Question 118:

  For a US based investor, what is the 10-day value-at risk at the 95% confidence level of a long spot position of EUR 15m, where the volatility of the underlying exchange rate is 16% annually. The current spot rate for EUR is 1.5. (Assume 250 trading days in a year).

  A. 526400
  B. 2632000
  C. 1184400
  D. 5922000
  C. 1184400

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  Explanation

  The VaR for a spot FX position is merely a function of the standard deviation of the exchange rate. If V be the value of the position (in this case, EUR 15m x 1.5 = USD 22.5m), z the appropriate z value associated with the level of confidence desired, and be the standard deviation of the portfolio, the VaR is given by ZV. In this case, the 10-day standard deviation is given by SQRT(10/250)*16%. Therefore the VaR is =1.645*15*1.5*(16%*SQRT(10/250)) = USD 1.1844m. Choice 'c' is the correct answer.

• Question 119:

  Which of the following statements is true in respect of a non financial manufacturing firm?

  I - Market risk is not relevant to the manufacturing firm as it does not take proprietary positions II - The firm faces market risks as an externality which it must bear and has no control over III - Market risks can make a comparative assessment of profitability over time difficult IV - Market risks for a manufacturing firm are not directionally biased and do not increase the overall risk of the firm as they net to zero over a long term time horizon

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

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  Explanation

  A non-financial firm such as a manufacturing company faces market risks similar to those faced by financial firms, except perhaps for not being exposed to risks from the equity markets. Non financial firms commonly face interest rate risks in respect of their debts, commodity price risks in respect of their inputs and products, and foreign currency risks in respect of their overseas operations. It is therefore not correct to say that the manufacturing firm does not face market risk because it does not take proprietary positions. While decisions on positions may not be actively taken, positions in foreign exchange (eg, through overseas debtors owing foreign currency, or liabilities in foreign currencies to overseas suppliers), commodities (through exposure to the need for raw material and inventory of finished goods) and interest rates (through debt financed, whether at fixed or floating rates) exist and create market risk much in the same way as they would for a proprietary position. Therefore statement I is incorrect. While the firm faces market risks as an externality (as do financial firms for that matter, though often they seek such exposure to profit from their view on which way the externality will express itself), it is incorrect to say that these risks must be borne. They can be measured and hedged. Therefore statement II is incorrect. The results of a manufacturing firm will include gains and losses arising from exposure to market risk, and will cloud the true profitability of the business. A firm with significant unhedged overseas sales may show vastly different results across time periods due to the FX gains and losses, making comparative assessment of profitability difficult. Therefore statement III is correct. Market risks for a manufacturing firm may be directionally biased in terms of exposure, ie there may be a consistent 'long' position in a particular commodity that the firm produces, and a consistent 'short' position in the commodities consumed. In the same way, directional biases may exist in FX or interest rate exposures too. Regardless of the bias, the existence of market risk exposures increase the volatility of the income stream and make the firm more risky, even though the long term expected returns from such exposures is zero (ie, returns may be zero but standard deviation is not). Therefore statement IV is not correct as market risks form non financial firms do increase the overall risk of the firm.

• Question 120:

  For a group of assets known to be positively correlated, what is the impact on economic capital calculations if we assume the assets to be independent (or uncorrelated)?

  A. Economic capital estimates remain the same
  B. Estimates of economic capital go down
  C. Estimates of economic capital go up
  D. The impact on economic capital cannot be determined in the absence of volatility information
  B. Estimates of economic capital go down

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  Explanation

  By assuming the assets to be independent, we are reducing the correlation from a positive number to zero. Reducing asset correlations reduces the combined standard deviation of the assets, and therefore reduces economic capital.

  Therefore Choice 'b' is the correct answer.

  Note that this question could also be phrased in terms of the impact on VaR estimates, and the answer would still be the same. Both VaR and economic capital are a multiple of standard deviation, and if standard deviation goes down, both

  VaR and economic capital estimates will reduce.