PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 271:

  Which of the following statements is true?

  I - If no loss data is available, good quality scenarios can be used to model operational risk II - Scenario data can be mixed with observed loss data for modeling severity and frequency estimates III - Severity estimates should not be created by fitting models to scenario generated loss data points alone IV - Scenario assessments should only be used as modifiers to ILD or ELD severity models

  A. I
  B. I and II
  C. III and IV
  D. All statements are true
  B. I and II

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  Explanation

  There are multiple ways to incorporate scenario analysis for modeling operational risk capital - and the exact approach used depends upon the quantity of loss data available, and the quality of scenario assessments. Generally:

  -

  If there is no past loss data available, scenarios are the only practical means to model operational risk loss distributions. Both frequency and severity estimates can be modeled based on scenario data.

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  If there is plenty of past data available, scenarios can be used as a modifier for estimates that are based solely on data (for example, consider the MAX of the loss estimates at the desired quantile as provided by the data, and as indicated by

  scenarios)

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  If high quality scenario data is available, and there is sufficient past data, one could mix scenario assessments with the loss data and fit the combined data set to create the loss distribution. Alternatively, both could be fitted with severity

  estimates and then the two severities could be parametrically combined.

  In short, there is considerable flexibility in how scenarios can be used. Statement I is therefore correct, and so is statement II as both indicate valid uses of scenarios.

  Statement III is not correct because it may be okay to create severity estimates based on scenario data alone.

  Statement IV is not correct because while using scenarios as modifiers to other means of estimation is acceptable, that is not the only use of scenarios.

• Question 272:

  The results of 'desk-level' stress tests cannot be added together to arrive at institution wide estimates because:

  A. Desk-level stress tests tend to ignore higher level risks that are relevant to the institution but completely outside the control of the individual desks.
  B. Desk-level stress tests focus on desk specific risks that may be minor or irrelevant in the larger scheme at the institution level.
  C. Desk-level stress tests tend to focus on extreme movements in risk parameters (such as volatility) without considering economy wide scenarios that may represent more realistic and consistent situations for the institution.
  D. All of the above
  C. Desk-level stress tests tend to focus on extreme movements in risk parameters (such as volatility) without considering economy wide scenarios that may represent more realistic and consistent situations for the institution.

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  Explanation

  All the above listed reasons are valid explanations as to why an institution level stress test cannot be estimated by merely summing up the results of the stress tests of the individual desks.

• Question 273:

  In the case of historical volatility weighted VaR, a higher current volatility when compared to historical volatility:

  A. will not affect the VaR estimate
  B. will increase the confidence interval
  C. will decrease the VaR estimate
  D. will increase the VaR estimate
  D. will increase the VaR estimate

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  Explanation

  When calculating volatility weighted VaR, returns are adjusted by a factor equal to the current volatility divided by the historical volatility, ie the volatility that existed during the time period the returns were earned. If the current volatility is

  greater than the historical volatility (also called contemporary volatility), then it has the effect of increasing the magnitude of any past returns (whether positive or negative). This in turn increases the VaR. Consider an example: if the current

  volatility is 2%, and a return of -5% was earned at a time when the volatility was 0.8%, then the volatility weighted return would be 12.5% (=-5% x 2%/0.8%). Clearly, this has the effect of increasing the VaR.

  Choice 'd' is therefore the correct answer.

• Question 274:

  As the persistence parameter under GARCH is lowered, which of the following would be true:

  A. The model will give lower weight to recent returns
  B. High variance from the recent past will persist for longer
  C. The model will react faster to market shocks
  D. The model will react slower to market shocks
  C. The model will react faster to market shocks

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  Explanation

  The persistence parameter, , is the coefficient of the most recent day's returns in GARCH calculations. A higher value of the persistence parameter tends to 'persist' the prior value of variance for longer. Consider an extreme example - if the persistence parameter is equal to 1, the variance under GARCH will never change in response to returns.

  

• Question 275:

  If a borrower has a default probability of 12% over one year, what is the probability of default over a month?

  A. 12.00%
  B. 1.00%
  C. 2.00%
  D. 1.06%
  D. 1.06%

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  Explanation

  Let the probability of default over a month be p. Therefore the probability of survival at the end of 12 months would be (1 - p)^12. Since the one year probability of default is 12%, we know that the probability of survival is 88%. Putting (1 - p) ^12 = 88% and solving for p, we get p = 1.06%. Therefore Choice 'd' is the correct answer.

• Question 276:

  As part of designing a reverse stress test, at what point should a bank's business plan be considered unviable (ie the point where it can be considered to have failed)?

  A. Where EBITDA for the year is forecast to be negative
  B. Where large known losses have been incurred on the bank's positions
  C. When the regulatory capital of the bank has been exhausted
  D. When the realization of risks leads market participants to lose confidence in the bank as a counterparty or a business worthy of funding
  D. When the realization of risks leads market participants to lose confidence in the bank as a counterparty or a business worthy of funding

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  Explanation

  As part of a reverse stress test, a firm has to identify and assess the scenarios most likely to cause it to fail, or in other words using the language used by the FSA in the UK, for its current business plan to become unviable. A firm's business plan should be considered to become unviable at the point that crystallizing risks cause the market to lose confidence it it, with the consequence that counterparties and other stakeholders are unwilling to transact with it or provide capital to the firm and, where releant, that existing counterparties may seek to terminate their contracts. Recent experience suggests that this point is reached well before a firm's regulatory capital is exhausted. Large known losses, or negative EBITDA (earnings before interest , tax, depreciation and amortization) may be indicators or contribute to the loss of confidence, but do not of themselves make the current business plan unviable. Therefore Choice 'd' is the correct answer.

• Question 277:

  Which of the following is true in relation to Principal Component Analysis (PCA)?

  I - An n x n positive definite square matrix will have n-1 eigenvectors II - The eigenvalues for a correlation matrix can be derived from the corresponding values for the covariance matrix III - Principal components are uncorrelated to each other IV - PCA is useful as it allows 100% of the variation in a complex system to be explained by the first three principal components

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

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  Explanation

  An n x n positive definite square matrix will have n eigenvectors, and not n - 1. Therefore statement I is incorrect.

  A correlation and covariance matrix are related to each other through the matrix of standard deviations. If the covariance matrix is represented by V, the correlation matrix by C and D is the diagonal matrix of standard deviations, then V =

  DCD. However, there is no simple relationship between the eigenvalues of the two matrices, and it is not possible to derive the eigenvalues for one given the eigenvalues for the other. Therefore statement II is false. Principal components are

  uncorrelated to each other. That is correct, and in fact PCA is useful because of this being so. Statement III is therefore true. PCA does not explain 100% of the variation in a system with just three components - statement IV is false.

  (Remember though that most (though not 100%) of the variation in a system of term structures is explained by the first three components - trend, tilt and curvature).

  Thus Choice 'd' is the correct answer.

• Question 278:

  If EV be the expected value of a firm's assets in a year, and DP be the 'default point' per the KMV approach to credit risk, and be the standard deviation of future asset returns, then the distance-to-default is given by:

  

  A. Option A
  B. Option B
  C. Option C
  D. Option D
  D. Option D

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  Explanation

  The distance to default is the number of standard deviations that expected asset values are away from the default point. The expression in Choice 'd' represents distance to default. Choice 'd' is the correct answer. The other choices are incorrect.

• Question 279:

  If two bonds with identical credit ratings, coupon and maturity but from different issuers trade at different spreads to treasury rates, which of the following is a possible explanation:

  I - The bonds differ in liquidity II - Events have happened that have changed investor perceptions but these are not yet reflected in the ratings III - The bonds carry different market risk IV - The bonds differ in their convexity

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

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  Explanation

  When two bonds that appear identical in every respect trade at different prices, the difference is often due to differences in liquidity between the two bonds (the less liquid bond will be cheaper and yield higher), and also due to the fact that ratings from the major rating agencies do not generally react to day to day changes in the market. The market's perception of the differences in the two credits will cause a divergence in the prices. This has been an extremely visible

  phenomenon during the credit crisis of 2007-2009, where fixed income security prices have changed sharply for many securities without any changes in external credit ratings. Bonds carrying 'different market risk' is meaningless, and so is the

  difference in convexity (because the calculated convexity would be identical for similar bonds).

  Therefore Choice 'c' is the correct answer.

• Question 280:

  When estimating the risk of a portfolio of equities using the portfolio's beta, which of the following is NOT true:

  A. relies upon the single factor CAPM model
  B. use of the beta assumes that the portfolio is diversified enough so that the specific risks of the individual stocks offset each other
  C. explicitly considers specific risk inherent in the portfolio for risk calculations
  D. using the beta significantly eases the computational burden of calculating risk
  C. explicitly considers specific risk inherent in the portfolio for risk calculations

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  Explanation

  Using the beta for VaR calculations is a significant simplification based on the CAPM and the assumption that any specific risks are diversified away. The one thing a risk model based on the CAPM does not consider is the specific risk of individual stocks, because, as mentioned, these are considered to be offsetting each other so that the portfolio only carries market risk reflected in the beta. Therefore Choice 'c' is not true and therefore the correct answer.