PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 141:

  Which of the following statements are correct:

  I - A training set is a set of data used to create a model, while a control set is a set of data is used to prove that the model actually works II - Cleansing, aggregating or ensuring data integrity is a task for the IT department, and is not a risk manager's responsibility III - Lack of information on the quality of underlying securities and assets was a major cause of the collapse in the CDO markets during the credit crisis that started in 2007 IV - The problem of lack of historical data can be addressed reasonably satisfactorily by using analytical approaches

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

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  Explanation

  Statement I is correct. Data is often divided into two sets - a 'training set' that is used to create and fine-tune the model while the 'control set' is used to prove that the model works on sample data. Back testing is then perfomed using actual data that becomes available over time, or may already be available as historical data. Statement II is incorrect. A risk manager often spends a great deal of time in managing data, and ensuring that the data being used is accurate enough for the purpose it is being used for. A risk manager can expect to spend a good part of his or her team's time in cleansing data. While he or she can try to get the IT processes and systems to produce correct data in the first place so it requires minimal subsequent cleansing or validation, this task is likely to remain a key part of a risk manager's role for quite some time in the future given the challenges nearly all organizations face in managing risk data. Statement III is correct. There was not enough granular data available on the underlying components of some of the derivative debt securities whose markets dried up during the crisis that began in 2007. This was because investors became increasingly unsure of what the value of these securities, such as CDOs was, leading to market seizure and firesale prices. Statement IV is not correct. There is no easy solution to the lack of enough historical data, which is used to create as well as test models, and construct stress scenarios. Analytical approaches are not a good enough substitute for real market data. During the recent crisis, many instruments had rather short histories and there was not enough data available, and risk managers and portfolio managers relied upon analytical approaches to value and price them. Many of the assumptions that underpinned these approaches were untested in the real world and turned out to be incorrect. Therefore Choice 'c' is the correct answer and the rest are incorrect.

• Question 142:

  For identical mean and variance, which of the following distribution assumptions will provide a higher estimate of VaR at a high level of confidence?

  A. A distribution with kurtosis = 8
  B. A distribution with kurtosis = 0
  C. A distribution with kurtosis = 2
  D. A distribution with kurtosis = 3
  A. A distribution with kurtosis = 8

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  Explanation

  A fat tailed distribution has more weight in the tails, and therefore at a high level of confidence the VaR estimate will be higher for a distribution with heavier tails. At relatively lower levels of confidence however, the situation is reversed as the heavier tailed distribution will have a VaR estimate lower than a thinner tailed distribution. A higher level of kurtosis implies a 'peaked' distribution with fatter tails. Among the given choices, a distribution with kurtosis equal to 8 will have the heaviest tails, and therefore a higher VaR estimate. Choice 'a' is therefore the correct answer. Also refer to the tutorial about VaR and fat tails.

• Question 143:

  Which of the following is not a credit event under ISDA definitions?

  A. Restructuring
  B. Obligation accelerations
  C. Rating downgrade
  D. Failure to pay
  C. Rating downgrade

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  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.

• Question 144:

  Which of the following statements is true?

  I - It is sufficient to ensure that a parent entity has sufficient excess liquidity to cover a liquidity shortfall for a subsidiary.

  II - If a parent entity has a shortfall of liquidity, it can always rely upon any excess liquidity that its foreign subsidiaries might have.

  III - Wholesale funding sources for a bank refer to stable sources of funding provided by the central bank.

  IV - Funding diversification refers to diversification of both funding sources and funding tenors.

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

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  Explanation

  It is not generally sufficient to ensure the adequacy of liquidity across a group - ie it is not appropriate to just add up the sources and needs for liquidity across multiple entities in a group. This is because there can be restrictions on transferring liquidity between entities, particularly when the entities are located across borders. In cases where transfers of liquidity are permitted, there may be settlement delays in transferring funds from one entity to another. Therefore both statements I and II are incorrect. Wholesale funding sources refers to the temporary interbank funding sources that need to be rolled over on very short intervals, often as short as overnight. These are not stable sources for long term funding. Statement III is therefore false. Statement IV is correct as funding diversification refers to diversification of both funding sources and the duration for which the amounts are borrowed, ie tenor diversity. Statement IV is the only correct statement and therefore Choice 'a' is the correct answer.

• Question 145:

  The estimate of historical VaR at 99% confidence based on a set of data with 100 observations will end up being:

  A. the extrapolated returns of the last 1.64 observations
  B. the worst single observation in the data set
  C. the weighted average of the top 2.33 observations
  D. None of the above
  B. the worst single observation in the data set

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  Explanation

  The VaR in this case will be the top quintile of observations. In this case, since there are exactly 100 observations, this would mean the worst return would become the VaR. Therefore Choice 'b' is the correct answer. Choice 'a' and Choice 'c' make no sense. This highlights that at higher confidence levels, fewer and fewer observations impact the VaR if we are using historical simulation based VaR.

• Question 146:

  Which of the following is not a limitation of the univariate Gaussian model to capture the codependence structure between risk factros used for VaR calculations?

  A. The univariate Gaussian model fails to fit to the empirical distributions of risk factors, notably their fat tails and skewness.
  B. Determining the covariance matrix becomes an extremely difficult task as the number of risk factors increases.
  C. It cannot capture linear relationships between risk factors.
  D. A single covariance matrix is insufficient to describe the fine codependence structure among risk factors as non-linear dependencies or tail correlations are not captured.
  C. It cannot capture linear relationships between risk factors.

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  Explanation

  In the univariate Gaussian model, each risk factor is modeled separately independent of the others, and the dependence between the risk factors is captured by the covariance matrix (or its equivalent combination of the correlation matrix and the variance matrix). Risk factors could include interest rates of different tenors, different equity market levels etc. While this is a simple enough model, it has a number of limitations. First, it fails to fit to the empirical distributions of risk factors, notably their fat tails and skewness. Second, a single covariance matrix is insufficient to describe the fine codependence structure among risk factors as non-linear dependencies or tail correlations are not captured. Third, determining the covariance matrix becomes an extremely difficult task as the number of risk factors increases. The number of covariances increases by the square of the number of variables. But an inability to capture linear relationships between the factors is not one of the limitations of the univariate Gaussian approach - in fact it is able to do that quite nicely with covariances. A way to address these limitations is to consider joint distributions of the risk factors that capture the dynamic relationships between the risk factors, and that correlation is not a static number across an entire range of outcomes, but the risk factors can behave differently with each other at different intersection points.

• Question 147:

  Which of the following is not true about the ISDA master agreement (ISDA MA):

  A. All transactions under the ISDA MA are considered separate obligations
  B. The ISDA MA describes the close out process
  C. The CSA (Credit Support Annex) is one of the parts of the ISDA MA
  D. The ISDA MA describes events of default, and termination events
  A. All transactions under the ISDA MA are considered separate obligations

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  Explanation

  The ISDA MA provides a template that can be used by market participants to document derivative transactions. It has a core section that applies always, and various schedules that can be agreed to by the parties. The ISDA MA considerably

  facilitates closing transactions once the ISDA MA has been has been negotiated, without requiring a renegotiation each time.

  A key feature of the ISDA MA is that it binds all transactions into a single net obligation. The ISDA Master 2002 states that "All transactions are entered into in reliance on the fact that this Master Agreement and all Confirmations form a single

  agreement between the parties ... and the parties would not otherwise enter into any Transactions." Therefore transactions under the ISDA MA are not considered separate obligations. The ISDA MA does indeed define close out processes,

  default and termination events, and the CSA is one of the parts of the MA that describes the collateral related agreement.

• Question 148:

  According to the Basel framework, shareholders' equity and reserves are considered a part of:

  A. Tier 3 capital
  B. Tier 1 capital
  C. Tier 2 capital
  D. All of the above
  B. Tier 1 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 149:

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

  A. its expected return alone
  B. its expected return and standard deviation
  C. its standard deviation and past technical movements
  D. its current price, expected return and standard deviation
  D. 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 150:

  When compared to a high severity low frequency risk, the operational risk capital requirement for a low severity high frequency risk is likely to be:

  A. Higher
  B. Zero
  C. Lower
  D. Unaffected by differences in frequency or severity
  C. Lower

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  Explanation

  High frequency and low severity risks, for example the risks of fraud losses for a credit card issuer, may have high expected losses, but low unexpected losses. In other words, we can generally expect these losses to stay within a small expected and known range. The capital requirement will be the worst case losses at a given confidence level less expected losses, and in such cases this can be expected to be low. On the other hand, medium severity medium frequency risks, such as the risks of unexpected legal claims, 'fat-finger' trading errors, will have low expected losses but a high level of unexpected losses. Thus the capital requirement for such risks will be high. It is also worthwhile mentioning high severity and low frequency risks - for example a rogue trader circumventing all controls and bringing the bank down, or a terrorist strike or natural disaster creating other losses - will probably have zero expected losses and high unexpected losses but only at very high levels of confidence. In other words, operational risk capital is unlikely to provide for such events and these would lie in the part of the tail that is not covered by most levels of confidence when calculating operational risk capital. Note that risk capital is required for only unexpected losses as expected losses are to be borne by PandL reserves. Therefore the operational risk capital requirements for a low severity high frequency risk is likely to be low when compared to other risks that are lower frequency but higher severity. Thus Choice 'c' is the correct answer.