PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 61:

  Which of the following statements is true in relation to the Supervisory Capital Assessment Program (SCAP):

  I - The SCAP is an annual exercise conducted by the Treasury Department to determine the health of key financial institutions in the US economy II - The SCAP was essentially a stress test where the stress scenarios were specified by the regulators III - Capital buffers calculated under the SCAP represented the amount of capital that the institutions covered by SCAP held in excess of Basel II requirements IV - The SCAP focused on both total Tier 1 capital as well as Tier 1 common capital

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

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  Explanation

  In the February of 2009, the Federal Reserve (which is the US central bank system) and other US banking regulators embarked on a simultaneous assessment of the capital held by the 19 largest US bank holding companies. This was an

  unprecedented exercise of a kind never undertaken before, and was known as the Supervisory Capital Assessment Program (SCAP). The purpose of the exercise was to determine the amount of additional capital (called the 'capital buffer')

  each of the institutions covered would need to ensure that it would have sufficient capital if the economy weakened more than was then expected. The idea was that these financial institutions would then raise additional capital equal to their

  respective capital buffers by the fourth quarter of 2009. Statement I is false on two counts: firstl the SCAP was conducted by the US central bank and other regulators, and not the 'Treasury Department' (the Treasury Department in the US is

  the equivalent of the Ministry of Finance in may other countries). Second, the SCAP was a one time exercise, and not annual.

  Statement II is correct. The regulators prescribed rates of losses on credit assets of different kinds and other macro-economic assumptions, and asked the banks to determine the extent of losses they would need to bear (in addition to

  calculating them independently too). Therefore the SCAP was a stress test where the scenario was prescribed by the regulators.

  Statement III is false. Capital buffer under the SCAP referred to the additional capital the banks would need to have certain ratios of capital, and not 'excess' capital. Statement IV is correct. The SCAP envisaged two capital targets: a Tier 1

  capital ratio in excess of 6% at the end of 2010; and a Tier 1 common capital ratio in excess of 4%. Therefore both the total Tier 1 capital and Tier 1 common capital were targeted.

  Therefore Choice 'c' is the correct answer.

• Question 62:

  Under the ISDA MA, which of the following terms best describes the netting applied upon the bankruptcy of a party?

  A. Closeout netting
  B. Chapter 11
  C. Payment netting
  D. Multilateral netting
  A. Closeout netting

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  Explanation

  Netting is the ability to set just the net balances when amounts are both owed and due. Netting can take many forms. Payment netting is netting between counterparties that owe moneys to each other in the same currency under the same transaction (or master agreement). Closeout netting is when parties settle a net amount for the value of all outstanding transactions upon the occurrence of an event of default such as bankruptcy. Multiateral netting involves a third party that sets off exposures across counterparties that owe moneys to each other. Closeout netting under the ISDA master agreement enables a party to terminate transactions early if an Event of Default or Termination Event occurs in respect of the other party. It involves the calculation and netting of the termination values of all transactions to produce a single amount payable between the parties. Closeout netting is therefore the correct answer.

• Question 63:

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

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

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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 64:

  A derivative contract has a negative current replacement value. Which of the following statements is true about its loan equivalent value for credit risk calculations over a 2-year horizon?

  A. Since the derivatives contract has a negative current replacement value, exposure will be zero.
  B. The credit exposure will be a given quintile of the expected distribution of the value of the derivatives contract in the future.
  C. The notional value of the derivatives contract should be used for loan equivalence calculations.
  D. The current exposure can be used for loan equivalence calculations as that is an unbiased proxy for the future value.
  B. The credit exposure will be a given quintile of the expected distribution of the value of the derivatives contract in the future.

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  Explanation

  The current exposure is negative, so there is no immediate credit exposure. However, since the price of the derivative is volatile, we can reasonably expect the value to be greater than zero sometime in the future. This is a stochastic variable which will have a distribution, and not just a unique value, in the future that will represent the credit exposure. Since there is no unique value, a conservative approach is to pick a quintile of the distribution, and use that as the future value of the derivative contract, with the assurance that the probability of the credit exposure exceeding that quintile is known and has been consciously selected. This number can then be converted to a loan equivalent amount for credit risk purposes. Therefore Choice 'b' is the correct answer. Choice 'a', Choice 'd' and Choice 'c' are incorrect for these reasons.

• Question 65:

  What would be the correct order of steps to addressing data quality problems in an organization?

  A. Assess the current state, design the future state, determine gaps and the actions required to be implemented to eliminate the gaps
  B. Articulate goals, do a 'strategy-fit' analysis and plan for action
  C. Design the future state, perform a gap analysis, analyze the current state and implement the future state
  D. Call in external consultants
  A. Assess the current state, design the future state, determine gaps and the actions required to be implemented to eliminate the gaps

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  Explanation

  The correct answer is choice 'a'

  The correct order of steps to addressing data quality problems in an organization would include:

  1.Assesing the current state

  2.Designing the future state, and

  3.Planning and implementation which would include identifying the gaps between the current and the desired future state, and implementation to address the gaps.

  Therefore Choice 'a' is the correct answer.

  Choice 'c' is incorrect because a gap analysis cannot be performed without understanding the 'as-is' (which results from understanding the current state). Choice 'b' is non-sensical, and Choice 'd' is a flippant option (though often used in real

  life situations by management as an easy (and ineffective) way to escape accountability for difficult problems)

• Question 66:

  Which of the following are valid methods for selecting an appropriate model from the model space for severity estimation:

  I - Cross-validation method II - Bootstrap method III - Complexity penalty method IV - Maximum likelihood estimation method

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

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  Explanation

  Once we have a number of distributions in the model space, the task is to select the "best" distribution that is likely to be a good estimate of true severity. We have a number of distributions to pick from, an empirical dataset (from internal or

  external losses), and we can estimate the parameters for the different distributions. We then have to decide which distribution to pick, and that generally requires considering both approximation and fitting errors.

  There are three methods that are generally used for selecting a model:

  1.The cross-validation method: This method divides the available data into two parts - the training set, and the validation set (the validation set is also called the 'testing set'). Parameter estimation for each distribution is done using the training

  set, and differences are then calculated based on the validation set. Though the temptation may be to use the entire data set to estimate the parameters, that is likely to result in what may appear to be an excellent fit to the data on which it is

  based, but without any validation. So we estimate the parameters based on one part of the data (the training set), and check the differences we get from the remaining data (the validation set).

  2.Complexity penalty method: This is similar to the cross-validation method, but with an additional consideration of the complexity of the model. This is because more complex models are likely to produce a more exact fit than simpler models,

  this may be a spurious thing - and therefore a 'penalty' is added to the more complex models as to favor simplicity over complexity. The 'complexity' of a model may be measured by the number of parameters it has, for example, a log-normal

  distribution has only two parameters while a body-tail distribution combining two different distributions may have many more.

  3.The bootstrap method: The bootstrap method estimates fitting error by drawing samples from the empirical loss dataset, or the fit already obtained, and then estimating parameters for each draw which are compared using some statistical

  technique. If the samples are drawn from the loss dataset, the technique is called a non-parametric bootstrap, and if the sample is drawn from an estimated model distribution, it is called a parametric bootstrap.

  4.Using goodness of fit statistics: The candidate fits can be compared using MLE based on the KS distance, for example, and the best one selected. Maximum likelihood estimation is a technique that attempts to maximize the likelihood of the

  estimate to be as close to the true value of the parameter. It is a general purpose statistical technique that can be used for parameter estimation technique, as well as for deciding which distribution to use from the model space.

  All the choices listed are the correct answer.

• Question 67:

  An error by a third party service provider results in a loss to a client that the bank has to make up. Such as loss would be categorized per Basel II operational risk categories as:

  A. Execution delivery and process management
  B. Outsourcing loss
  C. Business disruption and process failure
  D. Abnormal loss
  A. Execution delivery and process management

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  Explanation

  Choice 'a' is the correct answer. 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.

• Question 68:

  The key difference between 'top down models' and 'bottom up models' for operational risk assessment is:

  A. Top down approaches to operational risk are based upon an analysis of key risk drivers, while bottom up approaches consider causality in risk scenarios.
  B. Bottom up approaches to operational risk are based upon an analysis of key risk drivers, while top down approaches consider causality in risk scenarios.
  C. Bottom up approaches to operational risk calculate the implied operational risk using available data such as income volatility, capital etc; while top down approaches use causal factors, risk drivers and other factors to get an aggregated estimate of risk.
  D. Top down approaches to operational risk calculate the implied operational risk using available data such as income volatility, capital etc; while bottom up approaches use causal factors, risk drivers and other factors to get an aggregated estimate of risk.
  D. Top down approaches to operational risk calculate the implied operational risk using available data such as income volatility, capital etc; while bottom up approaches use causal factors, risk drivers and other factors to get an aggregated estimate of risk.

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  Explanation

  Top down approaches rely upon available data such as total capital, income volatility, peer group information etc and attempt to imply the capital attributable to operational risk. They do not consider firm specific scenarios or causal factors.

  Bottom up approaches on the other hand attempt to determine operational risk capital based upon an identification and quantification of firm specific risks. Bottom up approaches help determine a traditional loss distribution from which capital

  requirements can be determined at a given level of confidence.

  Therefore Choice 'd' is the correct answer.

• Question 69:

  A bank's detailed portfolio data on positions held in a particular security across the bank does not agree with the aggregate total position for that security for the bank. What data quality attribute is missing in this situation?

  A. Data completeness
  B. Data integrity
  C. Auditability
  D. Data extensibility
  B. Data integrity

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  Explanation

  The term 'data quality' has multiple elements, ie, data in order to be considered of a high quality must have multiple attributes such as completeness, timeliness, auditability etc. Because this is not an exact science, every expert or text book will have a different view of what goes into data quality. For our purposes however, we will stick to what the PRMIA study material specifies, and according to the study material the following are the elements that can be considered attributes that make for quality data:

  1.Integration

  2.Integrity

  3.Completeness

  4.Accessibility

  5.Flexibility

  6.Extensibility

  7.Timeliness

  8.Auditability I am not going to describe each of these here as that would be repetitive of the study material, but suffice it to say that the break-down of a number into its constituents should tie to the aggregate total. If that is not true, then the data lacks integrity - and therefore Choice 'b' is the correct answer. The other choices address other aspects of data quality but not this, and therefore are not correct.

• Question 70:

  A statement in the annual report of a bank states that the 10-day VaR at the 95% level of confidence at the end of the year is $253m. Which of the following is true:

  I - The maximum loss that the bank is exposed to over a 10-day period is $253m. II - There is a 5% probability that the bank's losses will not exceed $253m III - The maximum loss in value that is expected to be equaled or exceeded only 5% of the time is $253m IV - The bank's regulatory capital assets are equal to $253m

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

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  Explanation

  Statement I is not correct as VaR does not set an upper limit on losses. In this case, the bank expects the losses to exceed $253m 5% of the times, and the VaR number does not indicate any theoretical maximum amount of losses.Statement II is incorrect as there is a 95% (and not 5%) probability that the bank's losses will not exceed $253mStatement III is correct and describes VaR.Statement IV is incorrect, as regulatory capital is a more complex computation for which VaR is only one of the various input.Therefore Choice 'b' is the correct answer.