PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 231:

  Economic capital under the Earnings Volatility approach is calculated as:

  A. Expected earnings/Specific risk premium for the firm
  B. [Expected earnings less Earnings under the worst case scenario at a given confidence level]/Required rate of return for the firm
  C. Earnings under the worst case scenario at a given confidence level/Required rate of return for the firm
  D. Expected earnings/Required rate of return for the firm
  B. [Expected earnings less Earnings under the worst case scenario at a given confidence level]/Required rate of return for the firm

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  Explanation

  The Earnings Volatility approach to calculating economic capital is a top down approach that considers economic capital as being the capital required to make for the worst case fall in earnings, and calculates EC as equal to the worst case decrease in earnings capitalized at the rate of return expected of the firm. The worst case decrease in earnings, or the earnings-at-risk can only be stated at a given confidence level, and is equal to the Expected Earnings less Earnings under the worst case scenario.

• Question 232:

  Which of the following are valid approaches to calculating potential future exposure (PFE) for counterparty risk:

  I - Add a percentage of the notional to the mark-to-market value II - Monte Carlo simulation III - Maximum Likelihood Estimation IV - Parametric Estimation

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

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  Explanation

  When a derivative position is entered into, its mark-to-market value is generally close to zero (though the notional may be high). With the passage of time, the derivative's value fluctuates in an unpredictable way, creating a counterparty

  exposure that may be difficult to estimate and risk manage. Counterparty risk in such cases is estimated based on Potential Future Exposure, which may be calculated using either:

  a) Take the mark-to-market at present, and add a certain percentage of the notional, or b) Perform a Monte Carlo simulation, capturing the stochastic nature of the PFE. Therefore I and II are valid choices. MLE and parametric estimation are

  not methods for calculating PFE.

• Question 233:

  In estimating credit exposure for a line of credit, it is usual to consider:

  A. a fixed fraction of the line of credit to be the exposure at default even though the currently drawn amount is quite different from such a fraction.
  B. the full value of the credit line to be the exposure at default as the borrower has an informational advantage that will lead them to borrow fully against the credit line at the time of default.
  C. only the value of credit exposure currently existing against the credit line as the exposure at default.
  D. the present value of the line of credit at the agreed rate of lending.
  A. a fixed fraction of the line of credit to be the exposure at default even though the currently drawn amount is quite different from such a fraction.

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  Explanation

  Choice 'a' is the correct answer. Exposures such as those to a line of credit of which only a part (or none) may be drawn at the time of assessment present a difficulty when attempting to quantify credit risk. It is not correct to take the entire amount of the line as the exposure at default, and likewise the current exposure is likely to be too aggressively low a number to consider. While the borrower has an information advantage in that he would be aware of the deterioration in credit standing before the bank and would probably draw cash prior to default, it is unlikely that the entire amount of the line of credit would be drawn in all cases. In some cases, none may be drawn. In other cases, the bank would become aware of the situation and curtail or cancel access to the credit line in a timely fashion. Therefore a fixed proportion of existing credit lines is considered a reasonable approximation of the exposure at default against credit lines.

• Question 234:

  A bank prices retail credit loans based on median default rates. Over the long run, it can expect:

  A. Overestimation of risk and overpricing, leading to loss of market share
  B. A reduction in the rate of defaults
  C. Correct pricing of risk in the retail credit portfolio
  D. Underestimation and therefore underpricing of risk in it retail portfolio
  D. Underestimation and therefore underpricing of risk in it retail portfolio

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  Explanation

  The key to pricing loans is to make sure that the prices cover expected losses. The correct measure of expected losses is the mean, and not the median. To the extent the median is different from the mean, the loans would be over or underpriced. The loss curve for credit defaults is a distribution skewed to the right. Therefore its mode is less than its median which is less than its mean. Since the median is less than the mean, the bank is pricing in fewer losses than the mean, which means over the long run it is underestimating risk and underpricing its loans. Therefore Choice 'd' is the correct answer. If on the other hand for some reason the bank were overpricing risk, its loans would be more expensive than its competitors and it would lose market share. In this case however, this does not apply. Loan pricing decisions are driven by the rate of defaults, and not the other way round, therefore any pricing decisions will not reduce the rate of default.

• Question 235:

  Which of the following need to be assumed to convert a transition probability matrix for a given time period to the transition probability matrix for another length of time:

  I - Time invariance II - Markov property III - Normal distribution IV - Zero skewness

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

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  Explanation

  Time invariance refers to all time intervals being similar and identical, regardless of the effects of business cycles or other external events. The Markov property is the assumption that there is no ratings momentum, and that transition probabilities are dependent only upon where the rating currently is and where it is going to. Where it has come from, or what the past changes in ratings have been, have no effect on the transition probabilities. Rating agencies generally provide transition probability matrices for a given period of time, say a year. The risk analyst may need to convert these into matrices for say 6 months, 2 years or whatever time horizon he or she is interested in. Simplifying assumptions that allow him to do so using simple matrix multiplication include these two assumptions - time invariance and the Markov property. Thus Choice 'c' is the correct answer. The other choices (normal distribution and zero skewness) are non-sensical in this context.

• Question 236:

  Identify the correct sequence of events as it unfolded in the credit crisis beginning 2007:

  I - Mortgage defaults increased II - Collapse in prices of unrelated assets as banks tried to create liquidity III - Banks refused to lend or transact with each other IV - Asset prices for CDOs collapsed

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

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  Explanation

  According to a paper by the BCBS, here is an excellent summary of what happened. Based on this, Choice 'c' is the correct answer. "At the outset of the crisis, mortgage default shocks played a part in the deterioration of market prices of collateralised debt obligations (CDOs). Simultaneously, these shocks revealed deficiencies in the models used to manage and price these products. The complexity and resulting lack of transparency led to uncertainty about the value of the underlying investment. Market participants then drastically scaled down their activity in the origination and distribution markets and liquidity disappeared. The standstill in the securitisation markets forced banks to warehouse loans that were intended to be sold in the secondary markets. Given a lack of transparency of the ultimate ownership of troubled investments, funding liquidity concerns were triggered within the banking sector as banks refused to provide sufficient funds to each other. This in turn led to the hoarding of liquidity, exacerbating further the funding pressures within the banking sector. The initial difficulties in subprime mortgages also fed through to a broader range of market instruments since the drying up of market and funding liquidity forced market participants to liquidate those positions which they could trade in order to scale back risk. An increase in risk aversion also led to a general flight to quality, an example of which was the high withdrawals by households from money market funds."

• Question 237:

  An assumption regarding the absence of ratings momentum is referred to as:

  A. Ratings stability
  B. Time invariance
  C. Markov property
  D. Herstatt risk
  C. Markov property

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  Explanation

  Choice 'c' is the correct answer. The Markov property is the assumption that there is no ratings momentum, and that transition probabilities are dependent only upon where the rating currently is and where it is going to. Where it has come from, or what the past changes in ratings have been, have no effect on the transition probabilities. ('Herstatt risk' refers to settlement risk, and is irrelevant.)

• Question 238:

  Which of the following is not a possible early warning indicator in relation to the health of a counterparty?

  A. Negative publicity
  B. Credit rating downgrade
  C. A decline in the counterparty's corporate debt yield
  D. Falling stock price
  C. A decline in the counterparty's corporate debt yield

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  Explanation

  Negative publicity, a downgrade in the credit rating, a falling stock price are all pointers to potential credit problems, and the counterparty credit monitoring group of a bank should be using these as possible early indicators of an upcoming

  credit health problem. A decline in the yield of the debt issued by a counterparty means its spread is declining and the health of the credit is actually improving. Therefore a decline in the counterparty's corporate debt yield cannot be used as

  an indicator of potential credit problems.

  Choice 'c' is therefore the correct answer.

• Question 239:

  Which of the following best describes a 'break clause ?

  A. A break clause gives either party to a transaction the right to terminate the transaction at market price at future date(s)
  B. A break clause determines the process by which amounts due on early termination will be determined
  C. A break clause describes rights and obligations when the derivative contract is broken
  D. A break clause sets out the conditions under which the transaction will be terminated upon non-compliance with the ISDA MA
  A. A break clause gives either party to a transaction the right to terminate the transaction at market price at future date(s)

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  Explanation

  A break close, also called a 'mutual put', gives either party the right to terminate a transaction at market price at a given date, or dates in the future. These are usually availed of in longer dated transactions, eg 10 years and over. For example,

  a 15-year swap might have a mutual put in year 5, and every 2 years thereafter.

  All other choices are incorrect.

• Question 240:

  Who has the ultimate responsibility for the overall stress testing programme of an institution?

  A. Business Unit leaders
  B. The Risk Committee
  C. The Board
  D. Senior Management
  C. The Board

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  Explanation

  According to the first principle set out by the BCBS paper on stress testing, the Board has ultimate responsibility for the overall stress testing programme. Senior management is accountable for the implementation, management and oversight of the programme, but the overall responsibility stays with the Board of Directors of the institution. Therefore Choice 'c' is the correct answer. Additionally, this principle lays down that stress testing should be a part of the overall governance, ie support the strategic choices made as part of business planning; and be integrated with the risk management culture of the bank, ie stress tests should be used as an input for setting the risk appetite, exposure limits, and the capital and liquidity planning processes of the bank.