PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 291:

  Which of the following are ordered correctly in the order of debt seniority in a bankruptcy situation?

  I - Equity, Subordinate debt, Senior debt II - Senior debt, Preferred stock, Equity III - Secured debt, Accounts payable, Preferred stock IV - Secured debt, DIP financing, Equity

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

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  Explanation

  In a bankruptcy, equity ranks last. Preferred equity is one level above equity. Senior debt gets paid out first compared to junior debt, and secured debt is paid out first to the extent of the asset securing it (after which it counts as unsecured debt). Accounts payable and other short term liabilities are treated like unsecured creditors. Debtor-in- possession (DIP) financing ranks higher than any other asset as it is financing secured after the bankruptcy to continue the business. Based on the above, statement I does not represent a correct ordering of seniority as equity is paid last. Similarly, DIP financing receives higher priority than even secured debt, and therefore statement IV is incorrect. Therefore the only correct statements are II and III and Choice 'a' is the correct answer.

• Question 292:

  Which of the following statements are true:

  I - The set of UoMs used for frequency and severity modeling should be identical II - UoMs can be grouped together into larger combined UoMs using judgment based on the knowledge of the business III - UoMs can be grouped together into combined UoMs using statistical techniques IV - One may use separate sets of UoMs for frequency and severity modeling

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

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  Explanation

  One may use separate UoMs for frequency and severity modeling, for example, a combined UoM may be used for estimating the frequency of cyber attacks in a scenario, while the severity may be modeled using a more granular line-ofbusiness UoM. Therefore statement I is false, while statement IV is true.Statement II is correct, UoMs can be grouped together into larger units based on the facts relating to the business, controls and the business environment. Similarly, UoMs can be grouped together based on statistical clustering techniques using the 'distance' between the units of measure and combining UoMs that are closer to each other. In addition, it is also possible to combine both business knowledge and statistical algorithms to combine UoMs.

• Question 293:

  Which of the following are true:

  I - Delta hedges need to be rebalanced frequently as deltas fluctuate with fluctuating prices.

  II - Portfolio managers are right to focus on primary risks over secondary risks.

  III - Increasing the hedge rebalance frequency reduces residual risks but increases transaction costs.

  IV - Vega risk can be hedged using options.

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

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  Explanation

  Delta is non-linear with respect to prices for a number of securities such as bonds, options and other derivatives. It changes with changes in prices, and any hedge initially undertaken becomes quickly mismatched. Therefore delta hedges need to be managed quite actively and kept up-to-date. Therefore I is true.Primary risks comprise most of the risk in a position, and therefore portfolio managers are right to focus on them over secondary risks. Therefore II is true.The greater the hedge rebalance frequency, the lower is the hedge mismatch at any point in time, and therefore residual risks would be lower. However, rebalancing hedges requires rebalance trades to be done, and these involve transaction costs. Generally, a reasonable balance needs to be struck between the frequency of rebalances (a lower frequency increases residual risk, but this residual risk is not directionally biased) and the costs of rebalancing. III is correct.Vega risk is the risk arising due to changes in prices due to changes in volatility. Options carry vega risk. Therefore any hedges against vega risks can only be obtained using other options positions. (Vega risk may also be hedged using other volatility based products, eg an OTC volatility swap, or a VIX futures type product.)

• Question 294:

  Which of the following best describes economic capital?

  A. Economic capital is the amount of regulatory capital mandated for financial institutions in the OECD countries
  B. Economic capital is the amount of regulatory capital that minimizes the cost of capital for firm
  C. Economic capital reflects the amount of capital required to maintain a firm's target credit rating
  D. Economic capital is a form of provision for market risk losses should adverse conditions arise
  C. Economic capital reflects the amount of capital required to maintain a firm's target credit rating

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  Explanation

  Economic capital is often calculated with a view to maintaining the credit ratings for a firm. It is the capital available to absorb unexpected losses, and credit ratings are also based upon a certain probability of default. Economic capital is often calculated at a level equal to the confidence required for the desired credit rating. For example, if the probability of default for a AA rating is 0.02%, and the firm desires to hold an AA rating, then economic capital maintained at a confidence level of 99.98% would allow for such a rating. In this case, economic capital set at a 99.8% level can be thought of as the level of losses that would not be exceeded with a 99.8% probability, and would help get the firm its desired credit rating. Choice 'c' is the correct answer. Economic capital does not target minimizing the cost of capital, nor is it a provision for losses arising from market risk. The concept of economic capital is unrelated to where an institution or firm is based, therefore Choice 'a' is incorrect as well.

• Question 295:

  For a FX forward contract, what would be the worst time for a counterparty to default (in terms of the maximum likely credit exposure)

  A. At maturity
  B. Roughly three-quarters of the way towards maturity
  C. Indeterminate from the given information
  D. Right after inception
  A. At maturity

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  Explanation

  With the passage of time, the range of possible values the FX contract can take increases. Therefore the maximum value of the contract, which is when the credit risk would be maximum, would be at maturity. (Note that this is different than an interest rate swap whose value at maturity approaches zero.) Therefore Choice 'a' is the correct answer and the others are incorrect.

• Question 296:

  When considering a request for a loan from a retail customer, which of the following factors is relevant for a bank to consider:

  A. The other retail loans in its portfolio
  B. The credit worthiness of the retail customer
  C. The contribution this new loan would bring to total portfolio risk
  D. All of the above
  D. All of the above

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  Explanation

  The credit worthiness of the retail customer is certainly a factor for the bank to consider as it will need to price the loan to cover the expectation of default. At the same time, it will need to look at other loans in its portfolio as to avoid unacceptable concentration risk. A corollary of the same theme is that the bank will need to take a portfolio view of the loan request and consider its contribution to total portfolio risk. Therefore all the choices are appropriate considerations for the bank and Choice 'd' is the correct answer.

• Question 297:

  Which of the following statements is true?

  A. Only the drawn portions of credit facilities extended to clients by a bank count towards its liquidity exposure
  B. Under times of liquidity stress, both prepayments of loans extended and expected withdrawals from on-demand deposits will decrease
  C. Deterioration in the balance sheets of key counterparties is a concern for a liquidity manager even though it may not immediately affect a firm
  D. For an issuer of life insurance policies, longevity risk can lead to reserves falling short of payments due
  C. Deterioration in the balance sheets of key counterparties is a concern for a liquidity manager even though it may not immediately affect a firm

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  Explanation

  Deterioration in the balance sheets of key counterparties is a concern for a liquidity manager even though it may not immediately affect a firm, and this is true because counterparty failures may lead to liquidity shortfalls for an institution for no fault of its own. It is important for a liquidity risk manager to watch the health of key counterparties where exposure is concentrated and take timely steps to reduce it should the health deteriorate. Under times of liquidity stress, prepayments of loans extended will decline while withdrawals of demand deposits are likely to increase. Both will not decrease, and therefore Choice 'b' is incorrect. A bank is exposed to the undrawn portions of a line of credit extended to a borrower as the borrower, with superior information on its own finances, is likely to draw upon undrawn lines of credit thereby increasing the bank's exposure. Therefore Choice 'a' is incorrect. Generally, a portion of the undrawn part is counted towards a liquidity outflow. Longevity risk is the risk facing sellers of annuities that their clients will outlive their assumptions on their length of life, while mortality risk is the downside risk for an insurer that clients will die sooner than expected causing the reserves to fall short of what is needed. Therefore Choice 'd' is not correct as the opposite is true.

• Question 298:

  An asset has a volatility of 10% per year. An investment manager chooses to hedge it with another asset that has a volatility of 9% per year and a correlation of 0.9. Calculate the hedge ratio.

  A. 1
  B. 0.9
  C. 0.81
  D. 1.2345
  A. 1

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  Explanation

  The minimum variance hedge ratio answers the question of how much of the hedge to buy to hedge a given position. It minimizes the combined volatility of the primary and the hedge position. The minimum variance hedge ratio is given by the expression [ (x) / (y) ] * (x,y)]. Effectively, this is the same as the beta of the primary position with respect to the hedge. In this case, the hedge ratio is = 10%/9% * 0.9 = 1

• Question 299:

  Which of the following decisions need to be made as part of laying down a system for calculating VaR: I - How returns are calculated, eg absoluted returns, log returns or relative/percentage returns II - Whether VaR is calculated based on historical simulation, Monte Carlo, or is computed parametrically III - Whether binary/digital options are included in the portfolio positions IV - How volatility is estimated

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

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  Explanation

  While conceptually VaR is a fairly straightforward concept, a number of decisions need to be made to select between the different choices available for the exact mechanism to be used for the calculations. There is more than one way to calculate returns. Absolute returns may be relevant for risk factors where the size of the movement is unrelated to its current value. For other risk factors, the returns might scale with the size of the existing value of the risk factor, eg equity prices. The right return definition needs to be adopted for each risk factor, therefore 'I' is a correct choice. The risk analyst has a Choice 'b'etween parametric VaR, Monte Carlo, and historical simulation based VaR. 'II' therefore is one of the decisions that needs to be made (though historical simulation is the choice most often made). The decision as to what to include in a portfolio is not a decision that is affected by choices made for VaR calculations. 'III' is therefore not a correct answer. There are multiple ways to calculate volatility - including decisions on how long back in time to go for the data, and whether volatility clustering needs to be accounted for using EWMA or GARCH. Therefore 'IV' is a correct answer.

• Question 300:

  Ex-ante VaR estimates may differ from realized PandL due to:

  I - the effect of intra day trading II - timing differences in the accounting systems III - incorrect estimation of VaR parameters IV - security returns exhibiting mean reversion

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

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  Explanation

  Ex-ante VaR calculations can differ from actual realized PandL due to a large number of reasons. I, II and III represent some of them. Mean reversion however has nothing to do with VaR estimates differing from actual PandL. Therefore Choice 'c' is the correct answer.