PRMIA 8008 Online Practice Questions and Exam Preparation

PRMIA 8008 Online Questions & Answers

• Question 71:

  When the volatility of the yield for a bond increases, which of the following statements is true:

  A. The VaR for the bond decreases and its value increases
  B. The VaR for the bond increases and its value decreases
  C. The VaR for the bond decreases and its value is unaffected
  D. The VaR for the bond increases and its value stays the same
  D. The VaR for the bond increases and its value stays the same

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  Explanation

  The VaR of a fixed income instrument is given by Duration x Volatility of the interest rate x z-factor corresponding to the confidence level. Therefore as the volatility of the yield goes up, the value at risk for the instrument goes up. At the same

  time, the value of the bond is given by the present value of its future cash flows using the current yield curve. This value is unaffected by the volatility of the underlying interest rates. Therefore a change in volatility of interest rates does not

  affect the value of the bond.

  Therefore Choice 'd' represents the correct answer.

• Question 72:

  Which of the following cannot be used as an internal credit rating model to assess an individual borrower:

  A. Distance to default model
  B. Probit model
  C. Logit model
  D. Altman's Z-score
  A. Distance to default model

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  Explanation

  Altman's Z-score, the Probit and the Logit models can all be used to assess the credit rating of an individual borrower. There is no such model as the 'distance to default model', and therefore Choice 'a' is the correct answer.

• Question 73:

  Under the standardized approach to calculating operational risk capital under Basel II, negative regulatory capital charges for any of the business units:

  A. Should be ignored completely
  B. Should be offset against positive capital charges from other business units
  C. Should be included after ignoring the negative sign
  D. Should be excluded from capital calculations
  B. Should be offset against positive capital charges from other business units

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  Explanation

  According to Basel II, in any given year, negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit. Therefore Choice 'b' is the correct answer.

• Question 74:

  The accuracy of a VaR estimate based on a Monte carlo simulation of portfolio prices is affected by:

  I - The shape of the distribution of portfolio values II - The number simulations carried out III - The confidence level selected for the VaR estimate

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

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  Explanation

  VaR calculations look at the lower part of the distribution of future portfolio values, for example, if the desired confidence level is 95%, the cut-off for the VaR calculation will be at the bottom 5%; similarly at 1% for a 99% confidence level. The number of observations that will end up in these bottom ranges will be few and sparse, and therefore their accuracy will generally be lower than, say, the average where observations are more likely to be concentratred. If the shape of the distribution of future portfolio values is not symmetrical and has a long tail to the left, then this problem gets further exacerbated as there may be even fewer and less reliable simulated numbers at the 5% or 1% quintiles. Thus the shape of the distribution will affect the accuracy of a VaR estimate. The distribution for a short option position, for example, will have a long tail to the left, and the VaR number will be quite significantly affected by a few simulations. On the other hand, for a long option position where the long tail is to the right, and we are interested in the left tail which is better defined and ends at zero we are more likely to get a better VaR estimate. Therefore Statement I is correct. The number of simulations carried out directly affects the standard error, which is inversely proportional to the square root of the sample size (ie the number of simulations). THe accuracy of the VaR estimate can be increased by increasing the sample size (or reduced by reducing the sample size). Therefore Statement II is correct. The confidence level selected for the VaR estimate also affects the accuracy of the estimate. To intuitively understand this, consider this extreme example where the desired confidence level is 99.9% and there are 1000 observations. Therefore the VaR will be determined by the last value in the sample, and will therefore be quite fickle and dependent upon what chance produces as the lowest value in the simulation. But if for the same sample the confidence level desired were to be 90%, there would be 100 observations beyond the 90% cut-off and this would be a much more stable and accurate number. Therefore the confidence level selected for the VaR estimate is also a determinant of the accuracy of the VaR estimate derived from the simulation. Statement III is correct. Thus all statements are correct and Choice 'b' is the correct answer.

• Question 75:

  For the purposes of calculating VaR, an interest rate swap can be modeled as a combination of:

  A. two zero coupon bonds
  B. a fixed coupon bond and a floating rate note
  C. a fixed rate bond and a zero coupon bond
  D. a zero coupon bond and an interest rate swap
  B. a fixed coupon bond and a floating rate note

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  Explanation

  In an interest rate swap, the parties agree to exchanging interest rate payments, with one party being a fixed interest rate payer and the other paying floating rates. The party receiving fixed rates and paying floating can be considered to be long a fixed rate bond and short a floating rate note. Therefore an IRS can be modeled as a combination of a fixed coupon bond and a floating rate note. Choice 'b' is the correct answer.

• Question 76:

  In January, a bank buys a basket of mortgages with a view to securitize them by April. Due to an unexpected lack of investors in the securitization market, it is unable to do so and is left with the exposure to the mortgages on its books. This is an example of:

  A. Market risk
  B. Wrong-way risk
  C. Basis risk
  D. Pipeline and warehousing risk
  D. Pipeline and warehousing risk

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  Explanation

  This is an example of pipeline and warehousing risk. Generally there is a lag between acquiring assets and securitizing them due to the legal work to be done, the work to be done by the ratings agencies and in finding investors. During this period, the bank is exposed to the underlying assets purchased, and this is the 'pipeline and warehousing' risk as these assets are in the pipeline and warehoused for intended subsequent sale. Generally this period tends to be short. However, during the credit crisis this became a significant source of risk as many banks were left exposed to risk they had intended to get rid of, but could not do so as the market dried up. The other choices are all incorrect.

  Note that pipeline and warehousing risk is also known as 'securitzation risk'. It means that funding from securitization cannot be relied upon as a matter of fact.

• Question 77:

  For a back office function processing 15,000 transactions a day with an error rate of 10 basis points, what is the annual expected loss frequency (assume 250 days in a year)

  A. 3750
  B. 0.06
  C. 37500
  D. 375
  A. 3750

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  Explanation

  An error rate of 10 basis points means the number of errors expected in a day will be 15 (recall that 100 basis points = 1%). Therefore the total number of errors expected in a year will be 15 x 250 = 3750. Choice 'a' is the correct answer.

• Question 78:

  Which of the following statements are true in relation to the current state of the financial network?

  I - Interconnectivity between countries has reduced while that between institutions in the same country has increased significantly II - The degrees of separation between institutions has gone up III - The average path length connecting any two given institutions has shrunk IV - Knife-edge dynamics imply that systemic risk arises from the financial system flipping from risk sharing to risk spreading

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

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  Explanation

  Over the past decade or so, systemic risk has been increased by vastly increasing network complexities resulting from greater interconnectivity between institutions as well as countries. Therefore statement I is incorrect. Statement II is incorrect and statement III is correct because the average path length between institutions, or their degree of separation where they are not directly dealing with each other but through other counterparties to which they are exposed (analogous to 6 degrees of separation, or the 'small world' property), has shrunk and not increased. Statement IV correctly describes knife edge dynamics, which is another way of waying that the financial network displays a tipping point property.

• Question 79:

  Which of the following is not a permitted approach under Basel II for calculating operational risk capital

  A. the internal measurement approach
  B. the basic indicator approach
  C. the standardized approach
  D. the advanced measurement approach
  A. the internal measurement approach

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  Explanation

  The Basel II framework allows the use of the basic indicator approach, the standardized approach and the advanced measurement approaches for operational risk. There is no approach called the 'internal measurement approach' permitted for operational risk. Choice 'a' is therefore the correct answer.

• Question 80:

  The 99% 10-day VaR for a bank is $200mm. The average VaR for the past 60 days is $250mm, and the bank specific regulatory multiplier is 3. What is the bank's basic VaR based market risk capital charge?

  A. $250mm
  B. $200mm
  C. $750mm
  D. $600mm
  C. $750mm

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  Explanation

  The current Basel rules for the basic VaR based charge for market risk capital set market risk capital requirements as the maximum of the following two amounts:

  1.99%/10-day VaR,

  2.Regulatory Multiplier x Average 99%/10-day VaR of the past 60 days The 'regulatory multiplier' is a number between 3 and 4 (inclusive) calculated based on the number of 1% VaR exceedances in the previous 250 days, as determined by

  backtesting.

  -

  If the number of exceedances is <= 4, then the regulatory multiplier is 3.

  -

  If the number of exceedances is between 5 and 9, then the multiplier = 3 + 0.2*(N-4), where N is the number of exceedances.

  -

  If the number of exceedances is >=10, then the multiplier is 4. So you can see that in most normal situations the risk capital requirement will be dictated by the multiplier and the prior 60-day average VaR, because the product of these two

  will almost often be greater than the current 99% VaR.

  The correct answer therefore is = max(200mm, 3*250mm) = $750mm. Interestingly, also note that a 99% VaR should statistically be exceeded 1%*250 days = 2.5 times, which means if the bank's VaR model is performing as it should, it will

  still need to use a reg multiplier of 3.