PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 121:

  Which of the following formulae describes CVA (Credit Valuation Adjustment)? All acronyms have their usual meanings (LGD=Loss Given Default, ENE=Expected Negative Exposure, EE=Expected Exposure, PD=Probability of Default, EPE=Expected Positive Exposure, PFE=Potential Future Exposure)

  A. LGD * ENE * PD
  B. LGD * EPE * PD
  C. LGD * EE * PD
  D. LGD * PFE * PD
  B. LGD * EPE * PD

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  Explanation

  The correct definition of CVA is LGD * EPE * PD. All other answers are incorrect. CVA reflects the adjustment for counterparty default on derivative and other trading book transactions. This reflects the credit charge, that neeeds to be reduced from the expected value of the transaction to determine its true value. It is calculated as a product of the loss given default, the probability of default and the average weighted exposure of future EPEs across the time horizon for the transaction. The future exposures need to be discounted to the present, and occasionally the equations for CVA will state that explicitly. Similarly, in some more advanced dynamic models the correlation between EPE and PD is also accounted for. The conceptual ideal though remains the same: CVA=LGD*EPE*PD.

• Question 122:

  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
  A. that return on equity is not adjusted for risk

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  Explanation

  The major problem with using return on equity 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 equity does 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 create liquidity issues, but this does not affect the effectiveness of ROE as a measure of performance.

• Question 123:

  Which of the following is not an example of a risk concentration?

  A. Large combined positions in assets affected by different risk factors that are highly correlated
  B. Origination of a large number of SIVs with exposures to the same asset class, where the SIVs are separate legal entities without recourse to the originator
  C. Material amounts of treasury obligations held as collateral provided by a single counterparty
  D. Location of a portfolio's assets in a single country but spread across different industries
  C. Material amounts of treasury obligations held as collateral provided by a single counterparty

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  Explanation

  Choice 'd' represents a risk concentration due to excessive exposure to a single country, even though spread across different industries as the risk factors (economy, exchange rate, interest rate, political risk etc) are the same for all companies in the country. Choice 'a' represents a risk concentration because even though the risk factors are different, they are highly correlated and therefore effectively behave as one. These undetected correlations proved to be fatal to many financial institutions during the credit crisis. Choice 'b' represents a risk concentration as was borne out by the recent credit crisis. Large banks had to take over the obligations of SIVs they had created, even though the SIVs were separate legal entities with no legally enforceable recourse to the originating bank. This had to be done for moral and reputational reasons, and banks had to absorb the losses of these supposedly separate vehicles. Choice 'c' does not represent a risk concentration, in fact it is not a risk at all because it refers to collateral held, even though the collateral may have been provided by the same counterparty. In this case the risk is to the party providing the collateral (in case the party holding the collateral rehypothecates or sells the collateral and is unable to return it). Therefore Choice 'c' is the correct answer. The BCBS document on stress testing provides a very nice articulation of risk concentration, and the relevant text from that document is produced verbatim here: [Risk concentration] may arise along different dimensions: single name concentrations; concentrations in regions or industries; concentrations in single risk factors; concentrations that are based on correlated risk factors that reflect subtler or more situation-specific factors, such as previously undetected correlations between market and credit risks, as well as between those risks and liquidity risk; concentrations in indirect exposures via posted collateral or hedge positions; concentrations in off-balance sheet exposure, contingent exposure, non-contractual obligations due to reputational reasons.

• Question 124:

  Financial institutions need to take volatility clustering into account:

  I - To avoid taking on an undesirable level of risk II - To know the right level of capital they need to hold III - To meet regulatory requirements IV - To account for mean reversion in returns

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

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  Explanation

  Volatility clustering leads to levels of current volatility that can be significantly different from long run averages. When volatility is running high, institutions need to shed risk, and when it is running low, they can afford to increase returns by taking on more risk for a given amount of capital. An institution's response to changes in volatility can be either to adjust risk, or capital, or both. Accounting for volatility clustering helps institutions manage their risk and capital and therefore statements I and II are correct. Regulatory requirements do not require volatility clustering to be taken into account (at least not yet). Therefore statement III is not correct, and neither is IV which is completely unrelated to volatility clustering.

• Question 125:

  The probability of default of a security during the first year after issuance is 3%, that during the second and third years is 4%, and during the fourth year is 5%. What is the probability that it would not have defaulted at the end of four years from now?

  A. 12.00%
  B. 88.53%
  C. 88.00%
  D. 84.93%
  D. 84.93%

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  Explanation

  The probability that the security would not default in the next 4 years is equal to the probability of survival at the end of the four years. In other words, =(1 - 3%)*(1 - 4%)*(1 - 4%)*(1 - 5%) = 84.93%. Choice 'd' is the correct answer.

• Question 126:

  Which of the following techniques is used to generate multivariate normal random numbers that are correlated?

  A. Simulation
  B. Markov process
  C. Cholesky decomposition of the correlation matrix
  D. Pseudo random number generator
  C. Cholesky decomposition of the correlation matrix

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  Explanation

  A PRNG (pseudo random number generators of the kind included in statistical packages and Excel) is used to generate random numbers that are not correlated with each other, ie they are random. A Markov process is a stochastic model that depends only upon its current state. Simulation underlies many financial calculations. None of these directly relate to generating correlated multivariate normal random numbers. That job is done utilizing a Cholesky decomposition of the correlation matrix. Specifically, a Cholesky decomposition involves the factorization of the correlation matrix into a lower triangular matrix (a square matrix all of whose entries above the diagonal are zero) and its transpose. This can then be combined with random numbers to generate a set of correlated normal random numbers. This technique is used for calculating Monte Carlo VaR.

• Question 127:

  When performing portfolio stress tests using hypothetical scenarios, which of the following is not generally a challenge for the risk manager?

  A. Building a consistent set of hypothetical shocks to individual risk factors
  B. Building a positive semi-definite covariance matrix
  C. Considering back office capacity to deal with increased transaction volumes
  D. Evaluating interrelationships between counterparties when considering liquidity risks
  C. Considering back office capacity to deal with increased transaction volumes

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  Explanation

  Choice 'c' relates to operational risk and process capabilities, generally not a concern when evaluating market risk of a portfolio. Choice 'a', Choice 'b' and Choice 'd' represent real concerns for the risk manager when building stress tests for the value of a portfolio. Choice 'a' is relevant because certain shocks may be inconsistent with each other, and therefore implausible. For example, an increase in futures prices may be inconsistent with without spot prices and/or interest rates increasing according to the no-arbitrage condition. Choice 'b' is relevant when modeling a covariance matrix in a stressed situation with higher correlations, as a hypothetical covariance matrix which is not positive semi-definite may give absurd results (negative variance). Choice 'd' is relevant as liquidity risks may affect the price that can be realized for positions held.

• Question 128:

  Which of the following credit risk models considers debt as including a put option on the firm's assets to assess credit risk?

  A. The actuarial approach
  B. The CreditMetrics approach
  C. The contingent claims approach
  D. CreditPortfolio View
  C. The contingent claims approach

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  Explanation

  The correct answer is Choice 'c'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:

  1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.

  2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.

  3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.

  4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.

  5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

• Question 129:

  Which of the following statements is a correct description of the phrase present value of a basis point?

  A. It refers to the present value impact of 1 basis point move in an interest rate on a fixed income security
  B. It refers to the discounted present value of 1/100th of 1% of a future cash flow
  C. It is another name for duration
  D. It is the principal component representation of the duration of a bond
  A. It refers to the present value impact of 1 basis point move in an interest rate on a fixed income security

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  Explanation

  This is a trick question, no great science to it. Remember that the 'present value of a basis point' refers to PV01, which is the same as BPV (basis point value) referred to in the PRMIA handbook. In other textbooks, the same term is also variously called 'DV01' (dollar value of a basis point). Remember these other terms too. PV01, or the present value of a basis point, is the change in the value of a bond (or other fixed income security) from a 1 basis point change in the yield. PV01 is calculated as (Price

  * Modified Duration/10,000).

  Therefore Choice 'a' is the correct answer.

• Question 130:

  When building a operational loss distribution by combining a loss frequency distribution and a loss severity distribution, it is assumed that:

  I - The severity of losses is conditional upon the number of loss events II - The frequency of losses is independent from the severity of the losses III - Both the frequency and severity of loss events are dependent upon the state of internal controls in the bank

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

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  Explanation

  When a operational loss frequency distribution (which, for example, may be based upon a Poisson distribution) and a loss severity distribution (for example, based upon a lognormal distribution), it is assumed that the frequency of losses and the severity of the losses are completely independent and do not impact each other. Therefore statement II is correct, and the others are not valid assumptions underlying the operational loss distribution.