PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 201:

  Which of the following was not a policy response introduced by Basel 2.5 in response to the global financial crisis:

  A. Comprehensive Risk Model (CRM)
  B. Comprehensive Capital Analysis and Review (CCAR)
  C. Stressed VaR (SVaR)
  D. Incremental Risk Charge (IRC)
  B. Comprehensive Capital Analysis and Review (CCAR)

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  Explanation

  The CCAR is a supervisory mechanism adopted by the US Federal Reserve Bank to assess capital adequacy for bank holding companies it supervises. It was not a concept introduced by the international Basel framework.

  The other three were indeed rules introduced by Basel 2.5, which was ultimately subsumed into Basel III.

  Stressed VaR is just the standard 99%/10 day VaR, calculated with the assumption that relevant market factors are under stress.

  The Incremental Risk Charge (IRC) is an estimate of default and migration risk of unsecuritized credit products in the

  trading book. (Though this may sound like a credit risk term, it relates to market risk - for example, a bond rated A being downgraded to BBB. In the old days, the banking book where loans to customers are held was the primary source of

  credit risk, but with OTC trading and complex products the trading book also now holds a good deal of credit risk.

  Both IRC and CRM account for these.)

  While IRC considers only non-securitized products, the CRM (Comprehensive Risk Model) considers securitized products such as tranches, CDOs, and correlation based instruments. The IRC, SVaR and CRM complement standard VaR by

  covering risks that are not included in a standard VaR model. Their results are therefore added to the VaR for capital adequacy determination.

• Question 202:

  Which of the following credit risk models focuses on default alone and ignores credit migration when assessing credit risk?

  A. CreditPortfolio View
  B. The contingent claims approach
  C. The CreditMetrics approach
  D. The actuarial approach
  D. The actuarial approach

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  Explanation

  The correct answer is Choice 'd'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:

  1.CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.

  2.CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.

  3.The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.

  4.KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.

  5.CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

• Question 203:

  Which of the following is not a consideration in determining the liquidity needs of a firm (as opposed to determining the time horizon for liquidity risk)?

  A. Speed with which new equity can be issued to the owners
  B. Collateral
  C. Off balance sheet items
  D. The firm's business model
  A. Speed with which new equity can be issued to the owners

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  Explanation

  Managing liquidity requires understanding and providing for two things: the amount of liquidity needed to pay for all current obligations (in both normal and stressed scenarios), and determining the time horizon over which this liquidity should be available. The first is essentially a function of the business of the firm, and the assets and liabilities resulting from operations. The second considers other factors such as the speed with which new cash can be borrowed (eg, from the repo markets), the consequences are of running out of liquidity (eg, maybe only an overdrawn fee as opposed to bankruptcy), etc. In other words, liquidity risk management answers two questions: how much, and for how long. This question asks for identifying the factors that affect the 'how much' part. Choice 'd', Choice 'c' and Choice 'b' do affect the determination of the liquidity needs of the firm. Choice 'a' does not affect the liquidity needs, but the 'how long' part. Choice 'a' is therefore the correct answer.

• Question 204:

  Which of the following statements are true:

  I - Pre-settlement risk is the risk that one of the parties to a contract might default prior to the maturity date or expiry of the contract.

  II - Pre-settlement risk can be partly mitigated by providing for early settlement in the agreements between the counterparties.

  III - The current exposure from an OTC derivatives contract is equivalent to its current replacement value.

  IV - Loan equivalent exposures are calculated even for exposures that are not loans as a practical matter for calculating credit risk exposure.

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

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  Explanation

  Pre-settlement risk is the risk that one of the counterparties defaults prior to the date for the maturity of the transaction in question. This may be an unrelated default, in fact there may have been no default on that particular contract, but the party may have defaulted on its other obligations, or filed for bankruptcy. To deal with such cases and to protect the interests of both the parties, it is common to provide for immediate termination of positions and settlement based on the current replacement value of the contracts.

  Therefore statements I and II are correct.

  Statement III is correct as well - the exposure from an OTC derivative contract derives from its current replacement value, and not the notional. If the current replacement value is negative, then the credit exposure is considered equal to zero.

  Statement IV is correct as it is quite common to restate all exposures - those from credit lines, OTC derivatives etc - in loan equivalent terms prior to estimating credit risk.

• Question 205:

  When fitting a distribution in excess of a threshold as part of the body-tail distribution method described by the equation below, how is the parameter 'p' calculated.

  

  Here, F(x) is the severity distribution. F(Tail) and F(Body) are the parametric distributions selected for the tail and the body, and T is the threshold in excess of which the tail is considered to begin.

  A. p is a function of the reporting threshold and determined by the log-likelihood functional
  B. If there are K observations up to the tail threshold, then p = k*n
  C. p is a parameter estimated using either the sum of least squares or maximum likelihood estimation
  D. If there are N observations, of which K are up to T, then p = k/N
  D. If there are N observations, of which K are up to T, then p = k/N

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  Explanation

  p = k/N. If there are N observations of which K are upto T, then p = k/N allows us to have a continuous unbroken curve which gets increasingly weighted towards the distribution selected for the tail as we move towards the 'right', ie the higher

  values of losses.

  The other choices are incorrect and mostly nonsensical.

• Question 206:

  For an investor with a long position in market index futures, which of the following is a primary risk:

  A. Basis risk between futures and spot prices
  B. Movement in interest rates underlying the futures prices
  C. Risk that expected dividends will differ from realized dividend yields
  D. Increase or decrease in the level of the underlying index
  D. Increase or decrease in the level of the underlying index

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  Explanation

  This question emphasizes the difference between primary and secondary risks. Primary risks are the risks consciously undertaken, ie the risks whose premium the investor is trying to earn. Secondary risks are risks that accompany the

  primary risks that the investor will either hedge, or will ignore if they are small. It is important to watch out for secondary risks because they could become significant and offset the returns being sought even if the investor's market view is

  proved correct.

  An investor in market index futures is betting that the index will rise. Index futures prices are largely driven by the spot value of the index, but are also affected by costs of carry. In particular, futures prices will be driven by interest rates,

  expected dividends, and any other factors that may cause the basis between spot and futures prices to diverge. These risks are secondary risks. In this question, Choice 'd' represents the primary risk, and Choice 'a', Choice 'b' and Choice 'c'

  are all secondary risks. Therefore Choice 'd' is the correct answer.

• Question 207:

  The VaR of a portfolio at the 99% confidence level is $250,000 when mean return is assumed to be zero. If the assumption of zero returns is changed to an assumption of returns of $10,000, what is the revised VaR?

  A. 240000
  B. 226740
  C. 273260
  D. 260000
  A. 240000

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  Explanation

  The exact formula for VaR is = -(Z + ), where Z is the z-multiple for the desired confidence level, and is the mean return. Now Z is always a negative number, or at least will certainly be provided the desired confidence level is greater than 50%

  , and is often assumed to be zero because generally for the short time periods for which market risk VaR is calculated, its value is very close to zero. Therefore in practice the formula for VaR just becomes -Z, and since Z is always negative,

  we normally just multiply the Z factor without the negative sign with the standard deviation to get the VaR. For this question, there are two ways to get the answer. If we use the formula, we know that -Z= 250,000 (as =0), and therefore -Z - =

  250,000 - 10,000 = $240,000. The other, easier way to think about this is that if the mean changes, then the distribution's shape stays exactly the same, and the entire distribution shifts to the right by $10,000 as the mean moves up by

  $10,000. Therefore the VaR cutoff, which was previously at - 250,000 on the graph also moves up by 10k to - 240,000, and therefore $240,000 is the correct answer.

  The other choices are intended to confuse by multiplying the z-factor for the 99% confidence level with 10,000 etc.

• Question 208:

  Which of the following are valid objectives of a reverse stress test:

  I - Ensure that a firm can survive for long enough after risks have materialized for it to either regain market confidence, restructure or be sold, or be closed down in an orderly manner,

  II - Discover the vulnerabilities of the current business plan,

  III - Better integrate business and capital planning,

  IV - Create a 'zero-failure' environment at the systemic level in the financial sector

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

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  Explanation

  Statement I is true. According to the statement CP08/24: Stress and scenario testing (December 2008) issued by the FSA in the UK, an underlying objective of reverse stress tests is to ensure that a firm can survive long enough after risks have crystallized for one of the following to occur:

  - the market decides that its lack of confidence is unfounded and recommences transacting with the firm;

  -the firm down-sizes and re-structures its business;

  -

  the firm is taken over, or its business is transferred in an orderly manner; or

  -

  public authorities take the firm over, or wind down its business in an orderly manner. Statement II and III are true. The same statement clarifies the intention of the reverse stress testing requirement, which is to encourage firms to: explore more fully the vulnerabilities of theirbusiness model (including `tail risks'); make decisions that better integrate business and capital planning; and improve their contingency planning. Statement IV is incorrect. Since the question is asking for the statement which is NOT an objective for reverse stress tests, Choice 'b' is the correct answer. The same statement clarifies that the introduction of a reverse-stress test requirement should not be interpreted as indicating that the FSA is pursuing a `zero-failure' policy. In the FSA's view, such a policy is neither possible, nor desirable.

• Question 209:

  Under the standardized approach to determining operational risk capital, operations risk capital is equal to:

  A. a fixed percentage of the latest gross income of the bank
  B. a varying percentage, determined by the national regulator, of the gross revenue of each of the bank's business lines
  C. 15% of the average gross income (considering only the positive years) of the past three years
  D. a fixed percentage (different for each business line) of the gross income of the eight specified business lines, averaged over three years
  D. a fixed percentage (different for each business line) of the gross income of the eight specified business lines, averaged over three years

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  Explanation

  Choice 'd' is the correct answer, as laid down in the Basel II document. The other choices are incorrect.

• Question 210:

  Which of the following statements are true:

  I - Stress testing, if exhaustive, can replace traditional risk management tools such as valueat-risk (VaR) II - Stress tests can be particularly useful in identifying risks with new products III - Stress testing is distinct from a bank's ICAAP carried out periodically IV - Stress testing is a powerful communication tool that can convey risks to decisionmakers in an organization

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

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  Explanation

  Stress testing provides an independent and complementary perspective to other risk management tools such as value-at-risk and economic capital. Both are tools that serve similar purposes but are not interchangeable. Stress testing, no matter how exhaustively done, can not replace other tools such as those based on analytical or historical models. It can provide a useful sense check to validate models and assumptions, but is not a replacement for traditional techniques. Therefore statement I is false. Stress testing can certainly help identify risks with new products for which historical data may be limited, and analytical models may be based upon many unproven assumptions. It can help challenge the risk characteristics of new products where stress situations have not been observed in the past. Therefore statement II is correct. ICAAP stands for the 'internal capital adequacy assessment process' performed by a bank (remember the acronym and its expansion). Stress testing is an integral part of a firm's ICAAP, and not distinct. It is one of the elements of the internal process. Therefore statement III is false. Statement IV is correct as stress testing is indeed a powerful tool that can communicate risks throughout the organization as the stress scenarios are easier to comprehend than arcane statistical models. They are also easier to explain to regulators, and are a powerful communication tool. Thus Choice 'c' is the correct answer.