PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 171:

  The CDS rate on a defaultable bond is approximated by which of the following expressions:

  A. Hazard rate / (1 - Recovery rate)
  B. Loss given default x Default hazard rate
  C. Credit spread x Loss given default
  D. Hazard rate x Recovery rate
  B. Loss given default x Default hazard rate

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  Explanation

  The CDS rate is approximated by the [Loss given default x Default hazard rate]. Thus Choice 'b' is the correct answer.

  Note that this is also equal to the credit spread on the reference bond over the risk free rate. Therefore credit spreads and CDS rates are generally the same. Also, 'loss given default' is nothing but (1 - Recovery rate). This can be substituted

  in the formula for the credit spread to get an alternative expression that directly refers to the recovery rate.

  Therefore all other choices are incorrect.

• Question 172:

  Which of the following statements is true:

  I - Expected credit losses are charged to the unit's PandL while unexpected losses hit risk capital reserves.

  II - Credit portfolio loss distributions are symmetrical

  III - For a bank holding $10m in face of a defaulted debt that it acquired for $2m, the bank's legal claim in the bankruptcy court will be $10m.

  IV - The legal claim in bankruptcy court for an over the counter derivatives contract will be the notional value of the contract.

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

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  Explanation

  Statement I is true as expected losses are the 'cost of doing business' and charged against the PandL of the unit holding the exposure. When evaluating the business unit, expected losses are taken into account. Unexpected losses however

  require risk capital reserves to be maintained against them.

  Statement II is not true. Credit portfolio loss distributions are not symmetrical, in fact they are highly skewed and have heavy tails. Statement III is true. The notional, or the face value of a defaulted debt is the basis for a claim in bankruptcy

  court, and not the market value. Statement IV is false. In the case of over the counter instruments, the replacement value of the contract represents the amount of the claim, and not the notional amount (which can be very high!).

• Question 173:

  Which of the following statements are true:

  I - Stress tests should consider simultaneous pressures in funding and asset markets, and the impact of a reduction in liquidity II - Judging the effectiveness of risk mitigation techniques is not a part of stress testing III - A reverse stress test is useful for discovering hidden vulnerabilities and inconsistencies in hedging strategies IV - Reputational risk, which is explicitly excluded from the definition of operational risk under Basel II, should still be considered as part of stress tests.

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

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  Explanation

  All the statements in this question are directly based on the principles for effective stress testing as laid down in the BCBS document on stress testing issued in May 2009. Statement 1 is correct and is an almost verbatim reproduction of principle 10 as laid down in that document. Statement II is incorrect as it is contrary to principle 11 laid down in the same document. Statement III is correct as discovering hidden vulnerabilities and inconsistencies in hedging strategies is one of the objectives of reverse stress tests. Similarly, even though reputational risk is not really covered under any risk category under Basel II (as it is not a part of either market, credit or operational risk), principle 14 of this paper requires the mitigation of spill-over effects on market confidence of reputational risk when thinking about stress tests. Thus statements I, III and IV are correct and statement II is incorrect.

• Question 174:

  Which of the following measures can be used to reduce settlement risks: A. escrow arrangements using a central clearing house

  B. increasing the timing differences between the two legs of the transaction

  C. providing for physical delivery instead of netted cash settlements

  D. all of the above

  Correct Answer. C
  C

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  Explanation

  increasing the timing differences between the two legs of the transaction will increase settlement risk and not reduce it. Using escrow arrangements, such as central clearing houses to settle transactions (eg the DTCC in the United States)

  reduces settlement risk. Cash settlements based on netting arrangements reduce settlement risk, while physical delivery combined with gross cash payments increase it.

  Therefore Choice 'a' is the correct answer.

• Question 175:

  What percentage of average annual gross income is to be held as capital for operational risk under the basic indicator approach specified under Basel II?

  A. 0.125
  B. 0.08
  C. 0.12
  D. 0.15
  D. 0.15

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  Explanation

  Banks using the basic indicator approach must hold 15% of the average annual gross income for the past three years, excluding any year that had a negative gross income. Therefore Choice 'd' is the correct answer.

• Question 176:

  Which of the following would not be a part of the principal component structure of the term structure of futures prices?

  A. Curvature component
  B. Trend component
  C. Parallel component
  D. Tilt component
  C. Parallel component

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  Explanation

  The trend component refers to parallel shifts in the term structure, the tilt refers to changes in the shape of the term structure at the long and short ends, and the curvature refers to movements in the medium term part. The phrase 'parallel component' has no meaning and is not a part of the principal components in analyzing term structures. Changes in the term structure can also be analyzed as "level, slope and curvature", so you should be aware of this terminology as well to refer to the principal components of a term structure analysis.

• Question 177:

  The degree distribution of the nodes of the financial network is:

  A. non-linear
  B. best approximated by a beta distribution
  C. normally distributed
  D. long tailed
  D. long tailed

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  Explanation

  The 'degree' of a node in a network measures the number of links to other nodes. For the financial network, each market participant can be thought of as a node. The 'degree distribution' can be thought of as the histogram of the number of links for each node. The financial network has a degree distribution with rather long tails - and therefore Choice 'd' is the correct answer. The other choices are incorrect. Long tailed networks have the property that they are robust when affected by random disturbances, but susceptible to targeted attacks, for example on key hubs.

• Question 178:

  Which of the following statements are correct?

  I - A reliance upon conditional probabilities and a-priori views of probabilities is called the 'frequentist' view II - Knightian uncertainty refers to things that might happen but for which probabilities cannot be evaluated III - Risk mitigation and risk elimination are approaches to reacting to identified risks IV - Confidence accounting is a reference to the accounting frauds that were seen in the past decade as a reflection of failed governance processes

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

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  Explanation

  In statistics, which is relevant to risk management, a distinction is often drawn between 'frequentists' and 'Bayesians'. Frequentists rely upon data to draw conclusions as to probabilities. Bayesians consider conditional probabilities, ie, take

  into account what things are already known, and inject sometimes subjective a-priori probabilities into the calculations. Statement I describes Bayesians, and not frequentists. In reality however, the difference is merely academic. Risk

  managers use whichever technique best applies to the given situation without making it about ideology.

  The difference between 'Knightian uncertainty' and 'Risk' is similarly academic. Knightian uncertainty refers to risk that cannot be measured or calculated. 'Risk' on the other hand refers to things for which past data exists and calculations of

  exposure can be made. To give an example in the context of the financial world, the risk from a pandemic creating systemic failures from a failure of payment and settlement systems and the like is 'Knightian uncertainty', but the market risk

  from equity price movements can be modeled (albeit with limitations) and is calculable. Statement II is therefore correct. Once a risk is identified, it can be mitigated, accepted, avoided or eliminated, or transferred by way of insurance.

  Therefore statement III is correct. Confidence accounting is a conceptual idea that suggests that accounting statements make reference to ranges as opposed to point estimates in financial statements. For example, instead of saying that the

  pension obligation is $xx million, the company should say the pension obligation is in a range of $xx m - $yy m with a certain confidence level.

  Statement IV is therefore inaccurate.

• Question 179:

  Which of the following represents a riskier exposure for a bank: A LIBOR based loan, or an Overnight Indexed Swap? Which of the two rates is expected to be higher?

  Assume the same counterparty and the same notional.

  A. A LIBOR based loan; OIS rate will be higher
  B. Overnight Index Swap; LIBOR rate will be higher
  C. A LIBOR based loan; LIBOR rate will be higher
  D. Overnight Index Swap; OIS rate will be higher
  C. A LIBOR based loan; LIBOR rate will be higher

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  Explanation

  A LIBOR based loan requires cash to move from the lender to the borrower in the amount of the notional. The Overnight Index Swap requires only the exchange of interest payments, and therefore represents less risk. Therefore the LIBOR based loan is a riskier exposure. The LIBOR is generally higher than the OIS. In fact, the difference between the two, the LIBOR-OIS spread, is a standard measure of the risk premium in the market that goes up when the risk of default by counterparty banks is considered high. This is because when the market perceives the risk of default to be high, the participants need a risk premium to take on the default risk which is considerably lesser with the OIS.

• Question 180:

  Which loss event type is the failure to timely deliver collateral classified as under the Basel II framework?

  A. Clients, products and business practices
  B. External fraud
  C. Information security
  D. Execution, Delivery and Process Management
  D. Execution, Delivery and Process Management

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  Explanation

  Refer to the detailed loss event type classification under Basel II (see Annex 9 of the accord). You should know the exact names of all loss event types, and examples of each.