PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 251:

  In respect of operational risk capital calculations, the Basel II accord recommends a confidence level and time horizon of:

  A. 99.9% confidence level over a 10 day time horizon
  B. 99% confidence level over a 10 year time horizon
  C. 99% confidence level over a 1 year time horizon
  D. 99.9% confidence level over a 1 year time horizon
  D. 99.9% confidence level over a 1 year time horizon

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  Explanation

  Choice 'd' represents the Basel II requirement, all other choices are incorrect.

• Question 252:

  When modeling severity of operational risk losses using extreme value theory (EVT), practitioners often use which of the following distributions to model loss severity:

  I - The 'Peaks-over-threshold' (POT) model II - Generalized Pareto distributions III - Lognormal mixtures IV - Generalized hyperbolic distributions

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

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  Explanation

  The peaks-over-threshold model is used when losses over a given threshold are recorded, as is often the case when using data based on external public sources where only large loss events tend to find a place. The generalized Pareto

  distribution is also used when attempting to model loss severity using EVT. Lognormal mixtures and generalized hyperbolic distributions are not used as extreme value distributions.

  Choice 'd' is the correct answer.

• Question 253:

  If the default hazard rate for a company is 10%, and the spread on its bonds over the risk free rate is 800 bps, what is the expected recovery rate?

  A. 40.00%
  B. 20.00%
  C. 8.00%
  D. 0.00%
  B. 20.00%

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  Explanation

  The recovery rate, the default hazard rate (also called the average default intensity) and the spread on debt are linked by the equation Hazard Rate = Spread/(1 - Recovery Rate). Therefore, the recovery rate implicit in the given data is = 1 8%/10% = 20%.

• Question 254:

  Which of the following statements are true in relation to Monte Carlo based VaR calculations:

  I - Monte Carlo VaR relies upon a full revalution of the portfolio for each simulation II - Monte Carlo VaR relies upon the delta or delta-gamma approximation for valuation III - Monte Carlo VaR can capture a wide range of distributional assumptions for asset returns IV - Monte Carlo VaR is less compute intensive than Historical VaR

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

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  Explanation

  Monte Carlo VaR computations generally include the following steps:

  1.Generate multivariate normal random numbers, based upon the correlation matrix of the risk factors

  2.Based upon these correlated random numbers, calculate the new level of the risk factor (eg, an index value, or interest rate)

  3.Use the new level of the risk factor to revalue each of the underlying assets, and calculate the difference from the initial valuation of the portfolio. This is the portfolio PandL.

  4.Use the portfolio PandL to estimate the desired percentile (eg, 99th percentile) to get and estimate of the VaR.

  Monte Carlo based VaR calculations rely upon full portfolio revaluations, as opposed to delta/delta-gamma approximations. As a result, they are also computationally more intensive. Because they are not limited by the range of instruments and the properties they can cover, they can capture a wide range of distributional assumptions for asset returns. They also tend to provide more robust estimates for the tail, including portions of the tail that lie beyond the VaR cutoff. Therefore I and III are true, and the other two are not.

• Question 255:

  When compared to a medium severity medium frequency risk, the operational risk capital requirement for a high severity very low frequency risk is likely to be:

  A. Higher
  B. Lower
  C. Zero
  D. Unaffected by differences in frequency or severity
  C. Zero

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  Explanation

  High frequency and low severity risks, for example the risks of fraud losses for a credit card issuer, may have high expected losses, but low unexpected losses. In other words, we can generally expect these losses to stay within a small expected and known range. The capital requirement will be the worst case losses at a given confidence level less expected losses, and in such cases this can be expected to be low. On the other hand, medium severity medium frequency risks, such as the risks of unexpected legal claims, 'fat-finger' trading errors, will have low expected losses but a high level of unexpected losses. Thus the capital requirement for such risks will be high. It is also worthwhile mentioning high severity and low frequency risks - for example a rogue trader circumventing all controls and bringing the bank down, or a terrorist strike or natural disaster creating other losses - will probably have zero expected losses and high unexpected losses but only at very high levels of confidence. In other words, operational risk capital is unlikely to provide for such events and these would lie in the part of the tail that is not covered by most levels of confidence when calculating operational risk capital. Note that risk capital is required for only unexpected losses as expected losses are to be borne by PandL reserves. Therefore the operational risk capital requirements for a low severity high frequency risk is likely to be low when compared to other risks that are lower frequency but higher severity. Thus Choice 'c' is the correct answer.

• Question 256:

  Which of the following are valid approaches for extreme value analysis given a dataset:

  I - The Block Maxima approach II - Least squares approach III - Maximum likelihood approach IV - Peak-over-thresholds approach

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

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  Explanation

  For EVT, we use the block maxima or the peaks-over-threshold methods. These provide us the data points that can be fitted to a GEV distribution. Least squares and maximum likelihood are methods that are used for curve fitting, and they have a variety of applications across risk management.

• Question 257:

  The frequency distribution for operational risk loss events can be modeled by which of the following distributions:

  I - The binomial distribution II - The Poisson distribution III - The negative binomial distribution IV - The omega distribution

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

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  Explanation

  The binomial, Poisson and the negative binomial distributions can all be used to model the loss event frequency distribution. The omega distribution is not used for this purpose, therefore Choice 'a' is the correct answer. Also note that the negative binomial distribution provides the best model fit because it has more parameters than the binomial or the Poisson. However, in practice the Poisson distribution is most often used due to reasons of practicality and the fact that the key model risk in such situations does not arise from the choice of an incorrect underlying distribution.

• Question 258:

  If the annual default hazard rate for a borrower is 10%, what is the probability that there is no default at the end of 5 years?

  A. 39.35%
  B. 50.00%
  C. 59.05%
  D. 60.65%
  D. 60.65%

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  Explanation

  A default hazard rate is the rate of default in a continuous time setting. This question is asking for probability of survival at the end of 5 years. The formula to calculate the probability of survival at the end of t years where the default hazard rate is is e^(- *t) (or in Excel, =exp(-*t). Therefore the correct answer is Choice 'd'. (It may be tempting to infer that if the probability of survival at the end of 1 year is 90% (1 - 10%), then the probability of survival in 5 years would be 90%^5. However this reasoning is not correct for the reason that the given rate is not the discrete rate of default, but the hazard rate which is nothing but the continuously compounded rate of default.)

• Question 259:

  If E denotes the expected value of a loan portfolio at the end on one year and U the value of the portfolio in the worst case scenario at the 99% confidence level, which of the following expressions correctly describes economic capital required in respect of credit risk?

  A. E - U
  B. U/E
  C. U
  D. E
  A. E - U

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  Explanation

  Economic capital in respect of credit risk is intended to absorb unexpected losses. Unexpected losses are the losses above and beyond expected losses and up to the level of confidence that economic capital is being calculated for. The capital required to cover unexpected losses in this case is E - U, and therefore Choice 'a' is the correct answer. This question does raise an important point - are expected losses a part of economic capital, or are they not? Different text books say different things, and sometimes they say both the things. I have tried to take an approach that uses what I read in the PRMIA handbook. This writeup - http://www.riskprep.com/all-tutorials/37-exam-3/111-credit-var-an-intuitiveunderstanding - may help clarify things further.

• Question 260:

  Which of the following are elements of 'group risk':

  I - Market risk II - Intra-group exposures III - Reputational contagion IV - Complex group structures

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

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  Explanation

  The term 'group risk' has been defined in the FSA document 08/24 on stress testing as the risk that a firm may be adversely affected by an occurrence (financial or non- financial) in another group entity or an occurrence that affects ther group as a whole. These risks may occur through:

  -reputational contagion,

  -financial contagion,

  -leveraging,

  -double or multiple gearing,

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  concentrations and large exposures (particularly intra-group). Thus, the insurance sector may be considered a group, and a firm may suffer just because another group firm has had losses or reputational issues. The FSA statement goes on to identify some elements of group risk as follows:

  -

  intra-group exposures (credit or operational exposures through outsourcing or service arrangements, as well as more standard business exposures);

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  concentration risks (from credit, market or insurance risks which could put a strain on capital resources across entities simultaneously);

  -

  contagion (reputational damage, operational or financial pressures); and

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  complex group structures (with dependencies, complex split of responsibilities and accountabilities). Therefore Choice 'a' is the correct answer and the rest of the choices are incorrect.