PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 161:

  Which of the following is a valid approach to determining the magnitude of a shock for a given risk factor as part of a historical stress testing exercise?

  I - Determine the maximum peak-to-trough change in the risk factor over the defined period of the historical event II - Determine the minimum peak-to-trough change in the risk factor over the defined period of the historical event III - Determine the total change in the risk factor between the start date and the finish date of the event regardless of peaks and troughs in between IV - Determine the maximum single day change in the risk factor and multiply by the number of days covered by the stress event

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

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  Explanation

  Stress events rarely play out in a well defined period of time, and looking back it is always difficult to put exact start and end dates on historical stress events. Even after that is done, the question arises as to what magnitude of a change in a particular risk factor (for example interest rates, spreads, or exchange rates) are reasonable to consider for the purposes of the stress test.

  Statements I and III correctly identify the two approaches that are acceptable and used in practice - the risk manager can either take the maximum adverse move - from peak to trough - in the risk factor, or alternatively he or she could consider the change in the risk factor from the start of the event to the end as defined for the purposes of the stress test. Between the two, the approach mentioned in statement III is considered slightly superior as it produces more believable shocks.

  Statement II is incorrect because we never want to consider the minimum, and statement IV is not correct as it is likely to generate a shock of a magnitude that is not plausible. Therefore Choice 'b' is the correct answer.

• Question 162:

  Which of the following carry greater counterparty risk: a forward contract on a 10 year note, or a commercial paper carrying a AA credit rating with identical maturity and notional?

  A. The forward contract has greater credit risk as its future gains are unknown
  B. Credit risk can not be compared in these terms
  C. They both carry the same credit risk
  D. The commercial paper has greater credit risk as the entire notional is outstanding
  D. The commercial paper has greater credit risk as the entire notional is outstanding

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  Explanation

  The commercial paper has greater credit risk as the entire notional is outstanding. On the forward contract, only the replacement value of the contract, which normally would be a mere fraction of the notional, would be at risk. Therefore Choice 'd' is the correct answer.

• Question 163:

  The daily VaR of an investor's commodity position is $10m. The annual VaR, assuming daily returns are independent, is ~$158m (using the square root of time rule). Which of the following statements are correct?

  I - If daily returns are not independent and show mean-reversion, the actual annual VaR will be higher than $158m.

  II - If daily returns are not independent and show mean-reversion, the actual annual VaR will be lower than $158m.

  III - If daily returns are not independent and exhibit trending (autocorrelation), the actual annual VaR will be higher than $158m.

  III - If daily returns are not independent and exhibit trending (autocorrelation), the actual annual VaR will be lower than $158m.

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

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  Explanation

  In the case of mean reversion, the actual VaR would be lower than that estimated using the square root of time rule. This is because gains over a period would be followed by losses so that the price can revert to the mean. In such cases, the

  autocorrelation between subsequent periods is effectively negative. This means the combined VaR over the periods would be lower.

  In the case of positive autocorrelation, the actual VaR would be higher than that estimated using the square root of time rule for exactly the opposite reason than that described for the mean-reverting case. (Recall that Variance (A + B) =

  Variance(A) + Variance(B) + 2*Correlation*StdDev(A)*StdDev(B). In cases where correlation is zero, the variance can simply be added together (which is the case for iid observations). In cases where the correlation is negative, the combined

  variance (and therefore standard deviation and also VaR) will be lower; and where correlation is positive, the combined variance (and therefore standard deviation and also VaR) will be higher.) Therefore statement II is correct, and so is

  statement III. Choice 'c' is the correct answer.

• Question 164:

  In setting confidence levels for VaR estimates for internal limit setting, it is generally desirable:

  A. that actual losses exceed the VaR estimates on only the rarest of occasions
  B. that actual losses very frequently exceed the VaR estimates
  C. that actual losses never exceed the VaR estimates
  D. that actual losses exceed the VaR estimates with some reasonably observable frequency that is neither too high nor too low
  D. that actual losses exceed the VaR estimates with some reasonably observable frequency that is neither too high nor too low

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  Explanation

  If the confidence levels for a VaR estimate are set too high, there may never be any exceedences, ie actual losses will never exceed VaR estimates. For limit setting, we want actual losses to exceed the VaR estimates enough number of times as during the year so that the limits are considered seriously. If the VaR estimate is exceeded too many times, or never, then it is unlikely to be considered seriously. Therefore Choice 'd' is the correct answer.

  The other answers are incorrect as they either require the VaR to be too high (ie zero or rare excess loss situations) or too low (ie there will be too many cases of excess loss situations to be taken seriously).

• Question 165:

  Which of the following is not a measure of risk sensitivity of some kind?

  A. PL01
  B. Convexity
  C. CR01
  D. Delta
  A. PL01

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  Explanation

  Measures of risk sensitivity include delta, gamma, vega, PV01, convexity and CR01, among others. They allow approximating the change in the value of a portfolio from a change (generally small) in one of the underlying risk factors. Risk

  sensitivity measures are derivatives of the value of the portfolio, calculated with respect to the risk factor. Some risk sensitivity measures are second derivatives, and allow a more precise calculation of the change in the value of the portfolio.

  Many risk sensitivities are represented by Greek letter, but not all.

  Delta () is a measure of the change in portfolio value based on a 1% change in the value of the underlying. Gamma () is a second order derivative that improves the calculation as part of a Taylor expansion. CR01 is a measure of the change

  due to a 1 basis point change in the credit spread. PL01 is not a measure of any kind of risk sensitivity, it does not mean anything.

• Question 166:

  The diversification effect is responsible for:

  A. VaR being applicable only to short term horizons
  B. the super-additivity property of market risk VaR assessments
  C. total VaR numbers being greater than the sum of the individual VaRs for underlying portfolios
  D. the sub-additivity property of market risk VaR assessments
  D. the sub-additivity property of market risk VaR assessments

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  Explanation

  Any good risk measure has the property that it is sub-additive, which means the whole is less than the sum of the parts. In the case of VaR, sub-additivity arises due to the diversification effect, or said differently, due to the correlation between different assets being less than one. Therefore Choice 'd' is the correct answer. Super-additivity is just the opposite of sub-additivity, ie, the whole is greater than the sum of the parts. Good risk measures do not have super-additivity. Therefore Choice 'b' is incorrect.

  Choice 'c' states the same thing as Choice 'b' in different words, and is incorrect. Choice 'a' is non-sensical and incorrect.

• Question 167:

  If P be the transition matrix for 1 year, how can we find the transition matrix for 4 months?

  A. By calculating the cube root of P
  B. By numerically calculating a matrix M such that M x M x M is equal to P
  C. By dividing P by 3
  D. By calculating the matrix P x P x P
  B. By numerically calculating a matrix M such that M x M x M is equal to P

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  Explanation

  Assuming time invariance and the Markov property, it is easy to calculate the transition matrix for any time period as P^n, where P is the given transition matrix for one period and n the number of time periods that we need to compute the new

  transition matrix for.

  However, when the new time period is less than the time period the matrix is available for, the only way to deriving a transition matrix for a partial period is to numerically calculate a matrix M such that M^n = P. Therefore Choice 'b' is the

  correct answer. Taking cube roots of a matrix is not a possible operation, dividing by 3 gives a matrix meaningless in this context, and P x P x P will give us the transition matrix for 3 years, not 1/3rd of a year.

• Question 168:

  Which of the following is true in relation to the application of Extreme Value Theory when applied to operational risk measurement?

  I - EVT focuses on extreme losses that are generally not covered by standard distribution assumptions II - EVT considers the distribution of losses in the tails III - The Peaks-over-thresholds (POT) and the generalized Pareto distributions are used to model extreme value distributions IV - EVT is concerned with average losses beyond a given level of confidence

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

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  Explanation

  EVT, when used in the context of operational risk measurement, focuses on tail events and attempts to build a distribution of losses beyond what is covered by VaR. Statements I, II and II are correct. Statement IV describes conditional VaR

  (CVAR) and not EVT.

  Choice 'c' is the correct answer.

• Question 169:

  According to the Basel II framework, subordinated term debt that was originally issued 4 years ago with a maturity of 6 years is considered a part of:

  A. Tier 2 capital
  B. Tier 1 capital
  C. Tier 3 capital
  D. None of the above
  A. 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 issued originally for 5 years or longer. Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority. This only includes short term subordinated debt originally issued for 2 or more years. An interesting thing to note is the difference between 'subordinated term debt' under Tier 2 and the 'short term subordinated debt' under Tier 3. The distinction is based upon the years to maturity at the time the debt was issued. The remaining time to maturity is not relevant. For the subordinated term debt included under Tier 2, the amount that can be counted towards capital is reduced by 20% for every year when the debt is due within 5 years. This takes care of the time to maturity problem for Tier 2 subordinated debt. For Tier 3 short term subordinated debt, this is not an issue because debt will only qualify for Tier 3 if it has a lock-in clause stipulating that the debt is not required to be repaid if the effect of such repayment is to take the bank below minimum capital requirements.

• Question 170:

  Which of the following is a measure of the level of capital that an institution needs to hold in order to maintain a desired credit rating?

  A. Shareholders' equity
  B. Economic capital
  C. Regulatory capital
  D. Book value
  B. Economic capital

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  Explanation

  Economic capital is a measure of the level of capital needed to maintain a desired credit rating. Regulatory capital is the amount of capital required to be held by regulation, and this may be quite different from economic capital. Book value is

  an accounting measure reflecting the assets minus liabilities as measured per accounting rules, this is often expressed per share. Shareholders' equity is a narrow term which is the amount of capital attributable to the shareholders and

  includes paid up capital and reserves but not long term debt or other non-equity funding.

  Therefore Choice 'b' is the correct answer.