PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 51:

  Under the credit migration approach to assessing portfolio credit risk, which of the following are needed to generate a distribution of future portfolio values?

  A. The forward yield curve
  B. A specified risk horizon
  C. A rating migration matrix
  D. All of the above
  D. All of the above

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  Explanation

  The credit migration approach to assessing portfolio credit risk involves obtaining a distribution of future portfolio values from the ratings migration matrix. First, the frequencies in the matrix are used as probabilities, and expected future values of the securities belonging to each rating category are calculated. These are then discounted to the present using the discount rate appropriate to the 'future' rating category. This gives us a forward distribution of the value of each security in the portfolio. These are then combined using the default correlations between the issuers. The default correlation between the issuers is often proxied using asset returns, and recognizing that default occurs when asset values fall below a certain threshold. A distribution for the future value of the portfolio is generated using simulation, and from this distribution the Credit VaR can be calculated. Thus, we need the migration matrix, the risk horizon from which the present values need to be calculated, and the forward yield curve or the discount curve for each rating category for the risk horizon. Thus, Choice 'd' is the correct answer.

• Question 52:

  The principle underlying the contingent claims approach to measuring credit risk equates the cost of eliminating credit risk for a firm to be equal to:

  A. the cost of a call on the firm's assets with a strike equal to the value of the debt
  B. the value of a put on the firm's assets with a strike equal to the value of the debt
  C. the probability of the firm's assets falling below the critical value for default
  D. the market valuation of the firm's equity less the value of its liabilities
  B. the value of a put on the firm's assets with a strike equal to the value of the debt

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  Explanation

  Under the contingent claims approach, a firm will default on its debt when the value of its assets fall to less than the face value of the debt. Debt holders can protect themselves against such an event by buying a put on the assets of the firm,

  where the strike price is equal to the value of the debt. In other words, Risky Debt + Put on the firm's assets = Risk free debt. This is because if the value of the assets is greater than the value of the debt, they will be paid in full. If the value of

  the assets is lower than the value of the debt, they will exercise the put and be paid in full.

  Therefore the value of the put on the firm's assets with a strike equal to the value of the debt represents the cost of eliminating credit risk. Choice 'b' is the correct answer. Note that it is improbable that a put on the firm's assets is available in

  real life to debt holders. However, the same effect can be synthetically achieved by using the shares of the firm as a proxy for its assets, and shorting an appropriate number of shares. Such a synthetic put will require frequent readjustments.

• Question 53:

  If the 99% VaR of a portfolio is $82,000, what is the value of a single standard deviation move in the portfolio?

  A. 50000
  B. 35248
  C. 134480
  D. 82000
  B. 35248

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  Explanation

  Remember that VaR is merely a multiple of the portfolio's standard deviation. The multiple is determined by the confidence level, and for a 99% confidence level this multiple is 2.3264 (=-NORMSINV(1%) in Excel). Therefore one standard

  deviation at this level of confidence would be equal to VaR/2.3264. In addition to the Z-value at 99% confidence, you should also remember what the Z value is for a 95% level of confidence, as PRM questions may expect you to know these. The standard Windows calculator allowed in the exam does not

  allow you to calculate these, so it is safer to just remember these values.

• Question 54:

  Which of the following attributes of an investment are affected by changes in leverage:

  A. Information ratio
  B. risk and return
  C. Sharpe ratio
  D. All of the above
  B. risk and return

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  Explanation

  Changing leverage does not affect the Sharpe ratio or the Information ratio. However, leverage magnifies both risk and return. Therefore Choice 'b' is the correct answer.Recall that Sharpe ratio is the ratio of the excess returns (over the risk free rate) of an investment to its standard deviation, and the information ratio is the ratio of the 'alpha' returns to the standard deviation of such returns.

• Question 55:

  Which of the following is not one of the 'three pillars' specified in the Basel accord:

  A. Market discipline
  B. Supervisory review
  C. National regulation
  D. Minimum capital requirements
  C. National regulation

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  Explanation

  The three pillars are minimum capital requirements, supervisory review and market discipline. National regulation is not a pillar described under the accord. Choice 'c' is the correct answer.

• Question 56:

  Which of the following are valid techniques used when performing stress testing based on hypothetical test scenarios:

  I - Modifying the covariance matrix by changing asset correlations II - Specifying hypothetical shocks III - Sensitivity analysis based on changes in selected risk factors IV - Evaluating systemic liquidity risks

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

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  Explanation

  Each of these represent valid techniques for performing stress testing and building stress scenarios. Therefore d is the correct answer. In practice, elements of each of these techniques is used depending upon the portfolio and the exact situation.

• Question 57:

  Which of the following distribution assumptions will produce the lowest probability of exceeding an extreme value, assuming identical means and variances?

  A. a normal distribution
  B. a distribution with kurtosis = 5
  C. a normal mixture distribution
  D. t-distribution
  A. a normal distribution

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  Explanation

  An 'extreme value' will be a value that will lie in the tails. We need to determine the distribution that will have the least weight in the tails so that the probability of exceeding this tail value is minimum across the given choices. The t-distribution, a distribution with kurtosis > 3 and a normal mixture distribution are all distributions with tails fatter than that for a normal distribution. A normal distribution will have the 'thinnest' tails among the choices and therefore the lowest probability of exceeding a given tail event value. A note about the t-distribution: Leptokurtic distributions (those that have kurtosis>3, ie kurtosis greater than that for a normal distribution) generally appear to have higher peaks on their PDF graphs. The t-distribution is flatter, and actually appears lower than a normal distribution, which may make one think that it has a lower kurtosis and therefore should have thinner tails than a normal distribution. But that is not so, and the "visual" inspection test fails for inferring the kurtosis from just looking a the shape of the distribution. The kurtosis of a t-distribution is given by the formula {3 + 6/(d - 4)}, where d is the degrees of freedom and d > 4. Therefore the kurtosis of a t-distribution is always greater than 3 as "6/(d-4)" will always be a positive number being added to 3. Therefore there is no conflict between a t-distribution having fatter tails than a normal distribution as it has a higher kurtosis, even though it appears 'lower' on a graph when superimposed with a normal distribution.

• Question 58:

  Company A issues bonds with a face value of $100m, sold at issuance at $98. Bank B holds $10m in face of these bonds acquired at a price of $70. What is Bank B's exposure to the debt issued by Company A?

  A. $10m
  B. $9.8m
  C. $7m
  D. $6.86m
  C. $7m

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  Explanation

  Bank B's exposure is measured by the price it paid for the bonds, which in this case is $7m ($10m x 70/100). Hence Choice 'c' represents the correct answer. (Note that the question is asking for 'exposure' and not the legal claim in the event of default. The legal claim in the event of default would be the full notional of $10m. ) The initial issue price and issue size are irrelevant.

• Question 59:

  Which of the following statements is the most appropriate description of feedback effects:

  A. The amplification of smaller initial shocks to one risk factor creating larger subsequent shocks through system-wide interactions between other risks, creating self-perpetuating downward stresses in the markets
  B. The lack of a comprehensive view of risk across credit, market and liquidity risks leading to an underestimation of correlations that tend to spike up in the event of a crisis
  C. The spread of contagion from the bankruptcy of one participant leading to a similar outcome for other market participants
  D. The revision of stress testing scenarios based upon management, business unit and regulatory feedback on the plausibility or otherwise of stress scenarios.
  A. The amplification of smaller initial shocks to one risk factor creating larger subsequent shocks through system-wide interactions between other risks, creating self-perpetuating downward stresses in the markets

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  Explanation

  Choice 'a' (The amplification of smaller initial shocks to one risk factor creating larger subsequent shocks through system-wide interactions between other risks, creating self-perpetuating downward stresses in the markets) is the most comprehensive description of 'feedback effects', as described in the BCBS document on stress testing. Choice 'c' is one manifestation of feedback effects, but does not describe the entire effect. Choice 'b' is not a description of 'feedback effects', but one of the various weaknesses in stress testing that was seen during the crisis. Choice 'd' is plain nonsensical. The BCBS paper provides a good and succinct description of feedback effect: how mortgage default shocks led to a deterioration of market prices of CDOs, followed by a drying up of the liquidity in these markets. This led to banks having to hold on to assets they intended to securitize (securitization and warehousing risk), and given the absence of transparency on who was exposed to what, banks refusing to lend to each other and a drying up of the wholesale funding market as well. All of this was additionally accompanied by a general flight to quality, households withdrawing money from money market funds creating a crisis in that market as well. At each stage, the initial shock was amplified and fed back into the system through interactions that had not been imagined by any market participant or regulator, leave alone risk managers.

• Question 60:

  Which of the following event types is hacking damage classified under Basel II operational risk classifications?

  A. Damage to physical assets
  B. External fraud
  C. Information security
  D. Technology risk
  B. External fraud

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  Explanation

  Choice 'b' is the correct answer. All other answers are incorrect. Refer to the detailed loss event type classification under Basel II (see Annex 9 of the accord). You should know the exact names of all loss event types, and examples of each.