PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 221:

  Which of the following are attributes of a robust stress testing programme at a bank?

  A. Data of appropriate quality and granularity
  B. Written policies and procedures
  C. Robust systems infrastructure
  D. All of the above
  D. All of the above

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  Explanation

  A bank's stress testing programme in relation to firm wide stress tests should document the type, frequency and the purpose of the programme, as well as methodologies for defining scenarios and the remedial actions envisaged. Choice 'b' is

  therefore a necessary attribute of a robust stress testing programme.

  The programme should be supported by a robust systems infrastructure that allows the execution of periodic as well as ad-hoc stress tests at the right level (business unit, as well as firm-wide) at the right level of detail or granularity. Choice 'c'

  also therefore is a valid choice.

  A related element is data quality - without which no stress tests can be be credible. Therefore all the choices listed are correct and Choice 'd' is the correct answer.

• Question 222:

  Which of the following statements are true:

  I - Capital adequacy implies the ability of a firm to remain a going concern II - Regulatory capital and economic capital are identical as they target the same objectives III - The role of economic capital is to provide a buffer against expected losses IV - Conservative estimates of economic capital are based upon a confidence level of 100%

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

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  Explanation

  Statement I is true - capital adequacy indeed is a reference to the ability of the firm to stay a 'going concern'. (Going concern is an accounting term that means the ability of the firm to continue in business without the stress of liquidation.) Statement II is not true because even though the stated objective of regulatory capital requirements is similar to the purposes for which economic capital is calculated, regulatory capital calculations are based upon a large number of ad-hoc estimates and parameters that are 'hard-coded' into regulation, while economic capital is generally calculated for internal purposes and uses an institution's own estimates and models. They are rarely identical. Statement II is not true as the purpose of economic capital is to provide a buffer against unexpected losses. Expected losses are covered by the PandL (or credit reserves), and not capital. Statement IV is incorrect as even though economic capital may be calculated at very high confidence levels, that is never 100% which would require running a 'risk-free' business, which would mean there are no profits either. The level of confidence is set at a level which is an acceptable balance between the interests of the equity providers and the debt holders.

• Question 223:

  Which of the following does not affect the credit risk facing a lender institution?

  A. The state of the economy
  B. The applicability or otherwise of mark to market accounting to the institution
  C. Credit ratings of individual borrowers
  D. The degree of geographical or sectoral concentration in the loan book
  B. The applicability or otherwise of mark to market accounting to the institution

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  Explanation

  The state of the economy, credit quality of individual borrowers and concentration risk are all factors that affect the credit risk facing a lender. Mark to market accounting does not change the credit risk, or the underlying economic reality facing the institution. Therefore Choice 'b' is the correct answer.

• Question 224:

  Calculate the 1-year 99% credit VaR of a portfolio of two bonds, each with a value of $1m, and the probability of default of 1% each over the next year. Assume the recovery rate to be zero, and the defaults of the two bonds to be uncorrelated to each other.

  A. 1980000
  C. 980000
  D. 20000
  C. 980000

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  Explanation

  This question requires the calculation of the credit VaR of the bonds - note that in the real exam the question may not refer to 'credit' VaR, but that can be inferred from the context, ie because the probability of default is provided, it can only be

  asking for the credit VaR. (Note the difference from the market risk VaR which is driven by interest rate changes affecting the value of the bonds - there are other questions addressing that calculation). Credit VaR = Expected Value - Worst

  case portfolio value at the selected percentile (ie the confidence level)

  Thus if we know the distribution of the portfolio value in the future, we can find out the value at the required percentile (in this case 99%), and the VaR will be the difference between this value and the expected value of the portfolio.

  An important piece of information provided is that the defaults are independent, ie they are not correlated. This means joint probabilities of default or survival can be easily found by multiplying the relevant probabilities. The following outcomes

  are possible:

  1.Both bonds default: Probability = 1% * 1% = 0.01%. Portfolio value = $0 (because both bonds have defaulted and there is zero recovery)

  2.One bond defaults and the other survives: Probability = 2 * 1% * 99% = 1.98%. Portfolio value = $1m (because one bond survives with a value of $1m and the defaulted bond has a value of $0). (Note that because there are two ways in

  which this can happen, ie bond 1 defaults, bond 2 survives; and bond 1 survives, bond 2 defaults, we need to multiply the probability by 2).

  3.Both bonds survive: Probability = 99% * 99% = 98.01%. Portfolio value = $2m. Expected value is therefore $1.98m (which is equal to 2 * $1m * (1 - 1%), or alternatively can also be obtained by multiplying the probabilities in the above three

  outcomes with the value associated with each).

  The future distribution of the value of the portfolio can be constructed from the three outcomes outlined above:

  a. Upto the 98.01th percentile the value of the portfolio is $2m, and the VaR is zero (being greater than the expected value, so there is nothing to lose) b. From the 98.01th percentile to the 99.99th percentile (98.01+ the next 1.98%), the value

  of the portfolio is $1m. VaR in this range is $0.98m (=$1.98m - $1m) c. From the 99.99th to the 100th percentile the value of the portfolio is $0, and the VaR is $1.98m. Since the question is asking for VaR at the 99% confidence level, it lies in

  the range in 'b' above, and therefore the VaR is $0.98m.

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

• Question 225:

  Which of the following are considered asset based credit enhancements?

  I - Collateral II - Credit default swaps III - Close out netting arrangements IV - Cash reserves

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

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  Explanation

  Credit enhancements come in two varieties: counterparty based, where the exercise of the credit enhancement requires a third party to pay, and this includes guarantees and CDS contracts. Asset based credit enhancements are based upon a physical asset in possession, and these include collateral and balances owed on other trades or transactions, and availed through close out netting arrangements. Of the listed choices, I and III are asset based credit enhancements, and II is third party based. Cash reserves are not credit enhancements (unless held as collateral).

• Question 226:

  The sum of the stand alone economic capital of all the business units of a bank is:

  A. less than the economic capital for the firm as a whole
  B. more than the economic capital for the firm as a whole
  C. equal to the economic capital for the firm as a whole
  D. unrelated to the economic capital for the firm as a whole
  B. more than the economic capital for the firm as a whole

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  Explanation

  Economic capital is sub-additive, ie, because of the correlation being less than perfect between the risks of the different business units, the total economic capital for the firm will be less than the sum of the EC for the individual business units.

  Therefore Choice 'b' is the correct answer.

  In practice, correlations are difficult to estimate reliably, and banks often use estimates and corroborate their capital calculations with reference to a number of data points.

• Question 227:

  Which of the following situations are not suitable for applying parametric VaR:

  I - Where the portfolio's valuation is linearly dependent upon risk factors II - Where the portfolio consists of non-linear products such as options and large moves are involved III - Where the returns of risk factors are known to be not normally distributed

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

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  Explanation

  Parametric VaR relies upon reducing a portfolio's positions to risk factors, and estimating the first order changes in portfolio values from each of the risk factors. This is called the delta approximation approach. Risk factors include stock index values, or the PV01 for interest rate products, or volatility for options. This approach can be quite accurate and computationally efficient if the portfolio comprises products whose value behaves linearly to changes in risk factors. This includes

  long and short positions in equities, commodities and the like.

  However, where non-linear products such as options are involved and large moves in the risk factors are anticipated, a delta approximation based valuation may not give accurate results, and the VaR may be misstated. Therefore in such

  situations parametric VaR is not advised (unless it is extended to include second and third level sensitivities which can bring its own share of problems). Parametric VaR also assumes that the returns of risk factors are normally distributed - an

  assumption that is violated in times of market stress. So if it is known that the risk factor returns are not normally distributed, it is not advisable to use parametric VaR.

• Question 228:

  Which of the following is not a parameter to be determined by the risk manager that affects the level of economic credit capital:

  A. Risk horizon
  B. Confidence level
  C. Probability of default
  D. Definition of credit losses
  C. Probability of default

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  Explanation

  Three parameters define economic credit capital: the risk horizon, ie the time horizon over which the risk is being assessed; the confidence level, ie the quintile of the loss distribution; and the definition of credit losses, ie whether mark-tomarket losses are considered in addition to default-only losses. The probability of default is not a parameter within the control of the risk manager, but an input into the capital calculation process that he has to estimate. Therefore Choice 'c' is the correct answer.

• Question 229:

  Which of the following are valid criticisms of value at risk: I - There are many risks that a VaR framework cannot model II - VaR does not consider liquidity risk III - VaR does not account for historical market movements IV - VaR does not consider the risk of contagion

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

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  Explanation

  Risks such as abrupt changes to a firm's business model caused by legislation, or the introduction of capital controls in foreign countries where a firm in invested, geo-political risks etc are not modelable in the traditional sense. These risks

  cannot be modeled using VaR. Therefore statement I is correct.

  VaR indeed does not consider liquidity risk, it is only concerned with the standard deviation of portfolio returns. Statement II is a valid criticism. Statement III is not correct, as VaR can consider historical price movements. Statement IV is

  correct, as VaR does not consider systemic risk or the risk of contagion.

• Question 230:

  Which of the following assumptions underlie the 'square root of time' rule used for computing VaR estimates over different time horizons?

  I - the portfolio is static from day to day II - asset returns are independent and identically distributed (i.i.d.) III - volatility is constant over time IV - no serial correlation in the forward projection of volatility V - negative serial correlations exist in the time series of returns VI - returns data display volatility clustering

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

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  Explanation

  The square root of time rule can be used to convert, say a 1-day VaR to a 10-day VaR, by multiplying the known number by the square root of time to get the VaR over a different time horizon. However, there are key assumptions that underlie the application of this rule, and statements I to IV correctly state those assumptions. Statements V and VI are not correct, because the application of the square root of time rule requires the absence of serial correlations, and also the absence of volatility clustering (ie independence). Therefore Choice 'c' is the correct answer. The square root of time rule is also applied to convert volatility or standard deviation for one period to the volatility for a different time period. Remember that VaR is just a multiple of volatility, and therefore the assumptions that apply to the square root of time rule for VaR also apply to the same rule when used in the context of volatilities or standard deviation.