PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 11:

  For a bank using the advanced measurement approach to measuring operational risk, which of the following brings the greatest 'model risk' to its estimates:

  A. Choice of an incorrect distribution for loss event frequencies
  B. Insufficient number of simulations when building the loss distribution
  C. Choice of incorrect parameters for loss severity distributions
  D. Aggregation risk, from selecting an incorrect value of estimated correlations between different operational risk estimates
  D. Aggregation risk, from selecting an incorrect value of estimated correlations between different operational risk estimates

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  Explanation

  The greatest model risk when calculating operational risk capital comes from incorrect assumptions about correlations between different operational risks for which standalone risk calculations have been made. Generally, the correlation can be expected to be positive, and would therefore vary between 0 and 1. These two values determine the 'bounds' between which the total operational risk capital would lie, and these bounds are generally quite far apart. Therefore the total value of the operational risk capital is very sensitive to the value chosen for the correlation, and this is the source of the biggest model risk under the AMA.

• Question 12:

  Under the basic indicator approach to determining operational risk capital, operational risk capital is equal to:

  A. 15% of the average gross income (considering only the positive years) of the past three years
  B. 15% of the average net income (considering only the positive years) of the past three years
  C. 25% of the average gross income (considering only the positive years) of the past three years
  D. 15% of the average gross income of the past five years
  A. 15% of the average gross income (considering only the positive years) of the past three years

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  Explanation

  Choice 'a' is the correct answer. According to the Basel II document, banks using the Basic Indicator Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha, and currently 15%) of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.

• Question 13:

  What is the combined VaR of two securities that are perfectly positively correlated.

  A. The difference of the two VaRs.
  B. The sum of the individual VaRs of the two securities.
  C. The root of the sum of squares of the individual VaRs of the two securities.
  D. Combined VaR cannot be derived using the available information.
  B. The sum of the individual VaRs of the two securities.

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  Explanation

  Choice 'b' is the correct answer. When two securities have a correlation of +1, they are effectively the same security. In such cases, the standard deviations of the two securities are additive, which means the VaRs can simply be added

  together to get the combined VaR. All the other choices are incorrect.

  Choice 'c' in particular would have been correct if the securities were completely uncorrelated, ie if they had a correlation of zero. Choice 'a' would have been correct if their correlation were -1.

• Question 14:

  Under the KMV Moody's approach to calculating expecting default frequencies (EDF), firms' default on obligations is likely when:

  A. expected asset values one year hence are below total liabilities
  B. asset values reach a level below short term debt
  C. asset values reach a level below total liabilities
  D. asset values reach a level between short term debt and total liabilities
  D. asset values reach a level between short term debt and total liabilities

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  Explanation

  An observed fact that the KMV approach relies upon is that firms do not default when their liabilities exceed assets, but when asset values are somewhere between short term liabilities and the total liabilities. In fact, the 'default point' in the KMV methodology is defined as the short term debt plus half of the long term debt. The difference between expected value of the assets in one year and this 'default point', when expressed in terms of standard deviation of the asset values, is called the 'distance-to-default'. Therefore Choice 'd' is the correct answer. The other choices are incorrect.

• Question 15:

  The EWMA and GARCH approaches to volatility clustering can be applied to VaR calculations using:

  A. historical simulations
  B. analytical VaR
  C. Monte Carlo simulations
  D. all of the above
  D. all of the above

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  Explanation

  The EWMA and GARCH approaches to volatility clustering are independent of the method used to calculate VaR. Therefore Choice 'd' is the correct answer

• Question 16:

  Which of the following statements is true:

  I - When averaging quantiles of two Pareto distributions, the quantiles of the averaged models are equal to the geometric average of the quantiles of the original models based upon the number of data items in each original model.

  II - When modeling severity distributions, we can only use distributions which have fewer parameters than the number of datapoints we are modeling from.

  III - If an internal loss data based model covers the same risks as a scenario based model, they can can be combined using the weighted average of their parameters.

  IV If an internal loss model and a scenario based model address different risks, the models can be combined by taking their sums.

  A. II and III
  B. III and IV
  C. I and II
  D. All statements are true
  D. All statements are true

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  Explanation

  Statement I is true, the quantiles of the averaged models are equal to the geometric average of the quantiles of the original models. Statement II is correct, the number of data points from which model parameters are estimated must be greater than the number of parameters. So if a distribution, say Poisson, has one parameter, we need at least two data points to estimate the parameter. Other complex distributions may have multiple parameters for shape, scale and other things, and the minimum number of observations required will be greater than the number of parameters. Statement III is true, if the ILD data and scenarios cover the same risk, they are essentially different perspectives on the same risk, and therefore should be combined as weighted averages. But if they cover completely different risks, the models will need to be added together, not averaged - which is why Statement IV is true.

• Question 17:

  The risk that a counterparty fails to deliver its obligation upon settlement while having received the leg owed to it is called:

  A. Pre-settlement risk
  B. Credit risk
  C. Replacement risk
  D. Settlement risk
  D. Settlement risk

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  Explanation

  Choice 'd' is the correct answer. Settlement risk, as the name suggests, arises upon settlement when one of the parties delivers its obligation under the transaction and the other does not. Consider a EUR/USD FX forward contract maturing in a month. At maturity, one of the parties will deliver EURs and the other USDs. If one party fails to deliver, then it constitutes a very large risk to the other party. This risk is much larger than pre-settlement risk, because the amount at risk is the entire notional and not just the replacement value. Of course, settlement risk exists for a very short period of time, no more than a number or hours or a day. There is no such thing as 'replacement risk', and credit risk is a larger category of which settlement risks is one component. Settlement risk is the most appropriate answer.

• Question 18:

  Which of the following belong in a credit risk report?

  A. Exposures by country
  B. Exposures by industry
  C. Largest exposures by counterparty
  D. All of the above
  D. All of the above

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  Explanation

  All the listed variables are relevant to management monitoring the credit risk profile of an institution, therefore Choice 'd' is the correct answer.

• Question 19:

  Conditional default probabilities modeled under CreditPortfolio view use a:

  A. Power function
  B. Altman's z-score
  C. Probit function
  D. Logit function
  D. Logit function

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  Explanation

  Conditional default probabilities are modeled as a logit function under CreditPortfolio view. That ensures the resulting probabilities are 'well behaved', ie take a value between 0 and 1. The probability may be expressed as = 1/ (1 + exp(I)), where I is a country specific index taking various macro economic factors into account.

• Question 20:

  Once the frequency and severity distributions for loss events have been determined, which of the following is an accurate description of the process to determine a full loss distribution for operational risk?

  A. A firm wide operational risk distribution is generated by adding together the frequency and severity distributions
  B. A firm wide operational risk distribution is generated using Monte Carlo simulations
  C. A firm wide operational risk distribution is set to be equal to the product of the frequency and severity distributions
  D. The frequency distribution alone forms the basis for the loss distribution for operational risk
  B. A firm wide operational risk distribution is generated using Monte Carlo simulations

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  Explanation

  Once the frequency distribution has been determined (for example, using the binomial, Poisson or the negative binomial distributions) and the severity distribution has also been determined (for example, using the lognormal, gamma or other functions), the loss distribution can be produced by a Monte Carlo simulation using successive drawings from each of these two distributions. It is assumed that the severity and frequency are independent of each other. The resulting distribution gives a distribution showing the losses for operational risk, from which there Op Risk VaR can be determined using the appropriate percentile.Therefore Choice 'b' is the correct answer.