PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 241:

  The standard error of a Monte Carlo simulation is:

  A. Zero
  B. The same as that for a lognormal distribution
  C. Proportional to the inverse of the square root of the sample size
  D. None of the above
  C. Proportional to the inverse of the square root of the sample size

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  Explanation

  When we do a Monte Carlo simulation, the statistic we obtain (eg, the expected price) is an estimate of the real variable. The difference between the real value (which would be what we would get if we had access to the entire population) and

  that estimated by the Monte Carlo simulation is measured by the 'standard error', which is the standard deviation of the difference between the 'real' value and the simulated value (ie, the 'error'). As we increase the number of draws in a

  Monte Carlo simulation, the closer our estimate will be to the true value of the variable we are trying to estimate. But increasing the sample size does not reduce the error in a linear way, ie doubling the sample size does not halve the error,

  but reduces it by the inverse of the square root of the sample size. So if we have a sample size of 1000, going up to a sample size of 100,000 will reduce the standard error by a factor of 10 (and not 100), ie, SQRT(1/100) = 1/10. In other

  words, standard error is proportional to 1/N, where N is the sample size.

  Therefore Choice 'c' is correct and the others are incorrect.

• Question 242:

  For a loan portfolio, unexpected losses are charged against:

  A. Credit reserves
  B. Economic credit capital
  C. Economic capital
  D. Regulatory capital
  B. Economic credit capital

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  Explanation

  Credit reserves are created in respect of expected losses, which are considered the cost of doing business. Unexpected losses are borne by economic credit capital, which is a part of economic capital. This question is a bit nuanced - and 'economic capital' would generally be a good answer as well. However, taking a rather beady eyed view of the terminology and distinguishing between 'economic credit capital' which is a subset of 'economic capital', we can say that 'economic credit capital' is a more appropriate Choice 'a's the question relates to credit losses.

• Question 243:

  If F be the face value of a firm's debt, V the value of its assets and E the market value of equity, then according to the option pricing approach a default on debt occurs when:

  A. F > V
  B. V < E
  C. F < V
  D. F - E < V
  A. F > V

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  Explanation

  According to the option pricing approach developed by Merton, the shareholders of a firm have a put on the assets of the firm where the strike price is equal to the face value of the firm's debt. This is just a more complicated way of saying that the debt holders are entitled to all the assets of the firm if these assets are insufficient to pay off the debts, and because of limited liability of the shareholders of a corporation this part payment will fully extinguish the debt. A firm will default on its debt if the value of the assets falls below the face value of the debt. Therefore Choice 'a' is the correct answer. All other choices are incorrect. (There are two ways to consider this sort of optionality, and I have mentioned only one for this question:

  1. The equity holders can sell the assets of the firm to the debt holders at a price equal to the face value of the debt, ie a put. (ie they can extinguish their liability to the debt holders in full by handing them the assets of the firm, effectively selling them the assets at the value of the debt)

  2. The equity holders have a long position in a call option where they can keep the assets of the firm by paying a price equal to the face value of the debt (ie, they can pay off the debt holders and keep the assets) For this question, perspective 1 applies but you should be aware of the second one too as a question may reference that view point.)

• Question 244:

  Which of the following is a most complete measure of the liquidity gap facing a firm?

  A. Residual liquidity gap
  B. Liquidity at Risk
  C. Marginal liquidity gap
  D. Cumulative liquidity gap
  A. Residual liquidity gap

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  Explanation

  Marginal liquidity gap measures the expected net change in liquidity over, say, a day. It is just equal to the liquidity inflow minus liquidity outflow. The cumulative liquidity gap measures the aggregate change in liquidity from a point in time, in

  other words it is just the summation of the marginal liquidity gap for each of the days included in the period under consideration. The residual liquidity gap goes one step further and adds available 'opening balance' of liquidity to the cumulative

  liquidity gap to reveal the days or times when the net liquidity is most at risk.

  Liquidity at Risk measures the expected time to survival at a certain confidence level applied to the firm's cash flows - and is not a measure of the liquidity gap.

  Therefore Choice 'a' is the correct answer.

• Question 245:

  Which of the following statements is true in relation to collateral management?

  I - A collateral management system need not consider the failure by counterparties to return collateral when due II - The extent to which counterparties may have rehypothecated collateral is not a consideration for a collateral management system III - Cash is an acceptable substitute for any type of collateral required to be posted IV - Haircuts do not apply to treasury issued instruments posted as collateral

  A. I, II and III
  B. I, II, III and IV
  C. II and III
  D. None of the statements is true
  D. None of the statements is true

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  Explanation

  Strong management of collateral, both receivable and payable, is emerging as an area requiring significant investment by financial institutions and asset managers in IT infrastructures and business processes. A bank needs to make collateral calls daily, based upon the PandL of the previous day, and likewise receives collateral calls from its counterparties. Just like cash, a bank needs to make sure that it does not run out of collateral to post when a call is received. Interestingly, based upon the agreements between banks and their mutual understanding, only certain types of instruments often qualify as valid collateral - and in such cases even cash is not acceptable if the right type of bond or other agreed security is not available to post. The operational challenges of managing collateral increase manifold due to 'rehypothecation', ie when collateral received from one counterparty gets posted out as collateral where it is due. In such cases, the bank should have the mechanisms to receive the right assets back in a timely way in case rehypothecated assets are to be returned. The systems should be able to deal with delays, failures without impacting the ability of the bank to post collateral as needed. All of this requires major investments in IT and processes. Statement I is not true as a bank is bound to post collateral to third parties when needed regardless of the failure of its counterparties to post collateral to it when owed. In the markets, failures by counterparties can and do happen, and a collateral management system needs to account for and keep a buffer for the fact that some collateral when due will not be received. Statement II is not true as rehypothecation by counterparties of collateral posted increases the chances of the collateral not being received in time. The system should consider the need for liquidity to generate assets that can be posted as collateral when others have failed to return the collateral in a timely way. Statement III is not correct as cash may not be acceptable to counterparties as collateral. From a practical point of view, they may not have the infrastructure to receive and account for cash as collateral. A Swiss bank, for example, may have an 'account' to receive US t- bills as collateral but may not even have a US dollar account to receive cash. Even if it did, the volumes of transactions going back and forth may make tracking and reconciliations impossible. Thus a bank should always make sure that it has the right type of collateral available to post. Statement IV is incorrect as well, as treasury issued instruments are also subject to haircuts. Their value also fluctuates in response to changes in yields, and therefore they are subject to haircuts as well. Thus none of the statements are correct and Choice 'd' is the correct answer.

• Question 246:

  If the annual variance for a portfolio is 0.0256, what is the daily volatility assuming there are 250 days in a year.

  A. 0.0101
  B. 0.4048
  C. 0.0006
  D. 0.0016
  A. 0.0101

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  Explanation

  If annual variance is 0.0256, then annual volatility (ie standard deviation) is 0.0256. Therefore the daily volatility will be 0.0256/250 = 1.01%. The other choices are not correct.

• Question 247:

  If the odds of default are 1:5, what is the probability of default?

  A. 16.67%
  B. 20.00%
  C. 12.00%
  D. 50.00%
  A. 16.67%

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  Explanation

  Odds are the ratio between the probability of the occurence of an event to the probability that the event does not occur.

  If odds are H, then p = H/(1 + H) and H = p/(1-p). In this case the odds are 1:5, or 1/5, therefore the correct answer is Choice 'a', equal to (1/5)/(1 + 1/5) = 1/6 = 16.67%. All other choices are incorrect.

• Question 248:

  Assuming all other factors remain the same, an increase in the volatility of the returns on the assets of a firm causes which of the following outcomes?

  A. An increase in the value of the equity of the firm
  B. An increase in the value of the callable debt of the firm
  C. A decrease in the value of the implicit put in in the debt of the firm
  D. A decrease in the value of the non-callable debt issued by the firm
  D. A decrease in the value of the non-callable debt issued by the firm

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  Explanation

  Some parts of this question draw upon contingent claims framework to the value of a firm. According to this framework, the relationship between the debt and equity holders of a firm can be viewed as follows: The equity holders have a call option on the assets of the firm with a strike price equal to the value of the debt, and the debt holders have sold them this call. This is so because should the value of the assets of the firm fall below the value of the debt, the equity holders can walk away by handing over the assets to the debt holders in full extinguishment of their claims. If the value of the firm's assets is greater than the value of debt, the equity holders will exercise their call option. At the same time, it is also possible to view the debtholders as holding an asset and having sold a put on the assets of the firm with a strike price equal to the value of the debt. If the value of the assets of the firm were to fall below the value of the debt, they will end up buying the assets at a price equal to the value of the debt. An increase in the volatility of returns on the assets of a firm increases the volatility of the asset value. This means the likelihood that the asset value will go below the value of the debt of the firm will increase. Callable debt can be considered to be a summation of two separate securities: a regular debt, for which the firm pays interest and receives a principal loan; and a call option that the debt holders have sold to the firm allowing the firm to buy back the debt. In return, the firm pays an implied 'premium' to the debt holders who have agreed to buy the callable debt. Therefore the total payments by the company to callable debt holders is equal to the interest payments plus the premium payment for the option. An increase in asset volatility will increase the value of this option as it is likely that the assets will increase in value, and strengthen the company's credit, and lower its spread at which time it would like to repay the debt and refinance/roll over at the new lower rate. Therefore an increase in volatility will increase the 'premium' demanded by the callable debt holders, thereby increasing the total yield and lowering the value of the callable debt. Therefore Choice 'b' (An increase in the value of the callable debt of the firm) is incorrect. An increase in asset volatility will decrease the value of the firm as it is now riskier than before (higher standard deviation, same expected returns). Therefore Choice 'a' (An increase in the value of the equity of the firm) is false too. The value of the implicit put in the debt of the firm will increase and not decrease as the volatility of the underlying assets increases. Therefore Choice 'c' (A decrease in the value of the implicit put in in the debt of the firm) is incorrect too. Choice 'd' (A decrease in the value of the non-callable debt issued by the firm) is correct because higher asset volatility will increase the riskiness of the company's debt, making the required yield higher and decreasing its value.

• Question 249:

  When doing stress tests based on historical scenarios, if no appropriate historical scenarios exist for a security, it is most INAPPROPRIATE to:

  A. Estimate a shock factor based on other instruments that might be considered as proxies for such a security
  B. Leave the position unshocked
  C. Estimate a shock factor based upon extrapolation
  D. Estimate a shock factor based upon interpolation
  B. Leave the position unshocked

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  Explanation

  Where a historical shock factor does not exist for a security, for example because the security is new or was only thinly traded earlier, or because a particular emerging market was immature at the time of the historical scenario being

  considered, it is inappropriate to leave the position unshocked. By and large, the general rule to be followed when carrying out stress testing is to leave no position unshocked. Therefore Choice 'b' is the correct answer.

  Choice 'd', Choice 'a' and Choice 'c' all represent valid approaches to estimating a shock factor in such cases.

• Question 250:

  Regulatory arbitrage refers to:

  A. the practice of transferring business and profits to jurisdictions (such as those in other countries) to avoid or reduce capital adequacy requirements
  B. the practice of structuring a financial institution's business as a bank holding company to arbitrage the differing capital and credit rating requirements for different business lines
  C. the practice of investing and financing decisions being driven by associated regulatory capital requirements as opposed to the true underlying economics of these decisions
  D. All of the above
  C. the practice of investing and financing decisions being driven by associated regulatory capital requirements as opposed to the true underlying economics of these decisions

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  Explanation

  The correct answer is Choice 'c'. The other choices do not refer to 'regulatory arbitrage'.