PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 151:

  Which of the following correctly describes a reverse stress test:

  A. Stress tests that start from a known stress test outcome and then ask what events could lead to such an outcome for the bank
  B. A stress test that considers only qualitative factors that go beyond mathematical modeling to examine feedback loops and the effect of macro-economic fundamentals
  C. Stress tests that are prescribed and conducted by a regulator in addition to the tests done by a bank
  D. A stress test that requires a role reversal between risk managers and the risk taking business units in order to determine credible scenarios
  A. Stress tests that start from a known stress test outcome and then ask what events could lead to such an outcome for the bank

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  Explanation

  Generally, stress tests consider a shock or a severe scenario in order to determine the 'what-if' that circumstance were to materialize. They focus on the outcome based upon a set of shocks. In a reverse stress test, the outcome is assumed to be known (generally something as severe as bankruptcy, non-compliance with capital requirements etc), and the test is intended to work out what shocks or events would lead to such an outcome.

  Reverse stress tests therefore start from a known stress test outcome (such as breaching regulatory captial ratios, illiquidity or insolvency) and then asking what events could lead to such an outcome for the bank. This can be quite a challenging task. Principle 9 laid out in the BCBS document on stress testing (May 2009) (which is part of the PRM syllabus effective March 1, 2010) lays down the expectations relating to reverse stress tests.

  Therefore Choice 'a' is the correct answer. All the other choices are nonsensical.

• Question 152:

  Which of the following statements are true?

  I - Retail Risk Based Pricing involves using borrower specific data to arrive at both credit adjudication and pricing decisions II - An integrated 'Risk Information Management Environment' includes two elements - people and processes III - A Logical Data Model (LDM) lays down the relationships between data elements that an organization stores IV - Reference Data and Metadata refer to the same thing

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

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  Explanation

  Statement I is correct. Retail Risk Based Pricing (RRBP) involves the use of borrower specific data (such as FICO scores, average balances etc) to arrive at credit decisions. These 'retail' credit decisions may include decisions on whether to grant a line of credit, a mortgage, issue a credit card, or any of the various other retail activities a bank may be dealing with. At the same time, this data can also be used to price the product, in addition to providing a yes or no credit decision

  so that risky borrowers are charged more than less risky borrowers.

  Statement II is not correct, because an integrated Risk Information Management Environment includes three elements - people, processes and technology (and not just people and processes). Statement III is correct. An LDM is a blue print of

  an organization's data, and describes the relationships between the various data elements. Statement IV is not correct because reference data and metadata are not the same thing. Reference data refers to relatively static data, such as

  customer name (while actual transactions may not be so static). Metadata refers to data about data, and is stored in a data dictionary.

  Therefore Choice 'b' is the correct answer and the rest are incorrect.

• Question 153:

  Which of the following statements are true:

  I - It is usual to set a very high confidence level when estimating VaR for capital requirements.

  II - For model validation, very high VaR confidence levels are used to minimize excess losses.

  III - For limit setting for managing day to day positions, it is usual to set VaR confidence levels that are neither too low to be exceeded too often, nor too high as to be never exceeded.

  IV - The Basel accord requirements for market risk capital require the use of a time horizon of 1 year.

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

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  Explanation

  This questions deals with the appropriate levels of the holding period and confidence levels for VaR estimates. These depend upon the use the VaR estimate is intended to be put to - so when calculating VaR levels for capital requirements, or for maintaining credit ratings, very high levels of confidence are generally used. On the contrary, when setting limits or validating a model, a few excess loss situations are not only acceptable but actually desirable, and therefore lower levels of confidence are used.When it comes to the holding period, that may be mandated, as it is under Basel II as being a 10 day period. For other cases, it may be a horizon roughly corresponding to a period in which positions may be liquidated in an orderly day, which could be just one day for highly liquid markets, or a week or more for larger positions in illiquid markets.Therefore statements I and III are true and the others are false. Therefore the only correct answer is Choice 'b'.

• Question 154:

  A zero coupon corporate bond maturing in an year has a probability of default of 5% and yields 12%. The recovery rate is zero. What is the risk free rate?

  A. 5.26%
  B. 7.00%
  C. 5.00%
  D. 6.40%
  D. 6.40%

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  Explanation

  The probability of default would make the expected value of the future cash flows from both the corporate bond and the risk free bond 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))

  => 5%*0 + (1 - 5%)*(1 + 12%) = (1 + Rf).

  therefore Rf = 6.4%

  (In reality investors would demand a 'credit risk premium' 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.)

• Question 155:

  Which of the following is not a tool available to financial institutions for managing credit risk:

  A. Collateral
  B. Cumulative accuracy plot
  C. Third party guarantees
  D. Credit derivatives
  B. Cumulative accuracy plot

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  Explanation

  Collateral, limits to avoid credit exposure concentrations, termination rights based upon credit ratings, third party guarantees and credit derivatives are all tools or instruments that financial institutions use to manage their credit risk. A cumulative accuracy plot measures the accuracy of ratings, and is not a tool for managing credit risk. Therefore Choice 'b' represents the correct answer.

• Question 156:

  Which of the following risks were not covered in detail in most stress tests prior to the current crisis:

  I - The behavior of complex structured products under stressed liquidity conditions II - Pipeline or securitization risk III - Basis risk in relation to hedging strategies IV - Counterparty credit risk V - Contingent risks VI - Funding liquidity risk

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

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  Explanation

  The BCBS publication 'Principles for sound stress testing practices and supervision' (May 2009) identifies all of the above as risks that were covered in insufficient detail in most stress tests prior to the current crisis. Therefore Choice 'd' is the correct answer. For the PRM exam, you should have read this document. You should also be familiar with all the above risk types as being contributors to the crisis, and know what each of these mean.

• Question 157:

  Which of the following represent the parameters that define a VaR estimate?

  A. trading position and distribution assumption
  B. confidence level and the underlying stochastic process
  C. confidence level, the holding period and expected volatility
  D. confidence level and the holding period
  D. confidence level and the holding period

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  Explanation

  VaR is specified by just two parameters - the holding period, and the confidence level. We speak of, for example, a 10-day VaR at the 95% confidence level. No other parameters are required. Therefore Choice 'd' is the correct answer and the others are incorrect.

• Question 158:

  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
  D. 7 years

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  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 the 10 year IRS, and therefore choice a is the correct answer.

• Question 159:

  A loan portfolio's full notional value is $100, and its value in a worst case scenario at the 99% level of confidence is $65. Expected losses on the portfolio are estimated at 10%. What is the level of economic capital required to cushion unexpected losses?

  A. 25
  B. 65
  C. 10
  D. 35
  A. 25

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  Explanation

  Expected value = $90 ($100 - 10%)

  Value at 99% confidence level = $65

  Therefore economic capital required at this level of confidence = $90 - $65 = $25. Choice 'a' is the correct answer, the other choices are not. (We can also look at it this way as explained in section III.B.6.2.2 of the handbook:

  Economic capital is designed to absorb unexpected losses, which are equal to total losses at a given confidence level minus expected losses. (Expected losses are to be covered by credit reserves). Total losses are $100-$65=$35, and

  expected losses are 10%*$100=$10, therefore economic capital should be $35-$10=$25.)

• Question 160:

  As the persistence parameter under EWMA is lowered, which of the following would be true:

  A. The model will react slower to market shocks
  B. The model will react faster to market shocks
  C. High variance from the recent past will persist for longer
  D. The model will give lower weight to recent returns
  B. The model will react faster to market shocks

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  Explanation

  The persistence parameter, , is the coefficient of the prior day's variance in EWMA calculations. A higher value of the persistence parameter tends to 'persist' the prior value of variance for longer. Consider an extreme example - if the persistence parameter is equal to 1, the variance under EWMA will never change in response to returns. 1 - is the coefficient of recent market returns. As is lowered, 1 - increases, giving a greater weight to recent market returns or shocks. Therefore, as is lowered, the model will react faster to market shocks and give higher weights to recent returns, and at the same time reduce the weight on prior variance which will tend to persist for a shorter period.