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NEW QUESTION 64
Under the contingent claims approach to measuring credit risk, which of the following factors does NOT affect credit risk:
- A. Cash flows of the firm
- B. Leverage in the capital structure
- C. Volatility of the firm's asset values
- D. Maturity of the debt
Answer: A
Explanation:
Explanation
Under the contingent claims approach, credit risk is modeled as the value of a put option on the value of the firm's assets with a strike equal to the face value of the debt and maturity equal to the maturity of the obligation. The cost of credit risk is determined by the leverage ratio, the volatility of the firm's assets and the maturity of the debt. Cash flows are not a part of the equation. Therefore Choice 'a' is the correct answer.
NEW QUESTION 65
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. Right after inception
- B. Roughly three-quarters of the way towards maturity
- C. At maturity
- D. Indeterminate from the given information
Answer: C
Explanation:
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.
NEW QUESTION 66
Loss provisioning is intended to cover:
- A. Expected losses
- B. Unexpected losses
- C. Both expected and unexpected losses
- D. Losses in excess of unexpected losses
Answer: A
Explanation:
Explanation
Loss provisioning is intended to cover expected losses. Economic capital is expected to cover unexpected losses. No capital or provisions are set aside for losses in excess of unexpected losses, which will ultimately be borne by equity.
Choice 'd' is the correct answer.
NEW QUESTION 67
Which of the following distributions is generally not used for frequency modeling for operational risk
- A. Negative binomial
- B. Binomial
- C. Gamma
- D. Poisson
Answer: C
Explanation:
Explanation
Frequency modeling is performed using discrete distributions that have a positive integer as a resultant - this allows for the number of events per period of time to be modeled. Of the distributions listed above, Poisson, negative binomial and binomial can be used for modeling frequency distributions. The Poisson and negative binomial distributions are encountered the most in practice.
The gamma distribution is a continuous distribution and cannot be used for frequency modeling.
NEW QUESTION 68
Which of the following formulae correctly describes Component VaR. (p refers to the portfolio, and i is the i-th constituent of the portfolio. MVaR means Marginal VaR, and other symbols have their usual meanings.)
- A. III
- B. I
- C. I and II
- D. II
Answer: C
Explanation:
Explanation
The first two formulae describe component VaR. The last formula is the formula for Marginal VaR. Therefore I and II is the correct answer.
Component VaR is a VaR decomposition technique that allows the total VaR for a portfolio to be broken down and attributed to the components of a portfolio. The total of the component VaR for each constituent of a portfolio is equal to the VaR for the portfolio. This property is extremely useful as opposed to the standalone VaR for each constituent taken alone as it can be used for allocating trading budgets.
NEW QUESTION 69
Between two options positions with the same delta and based upon the same underlying, which would have a smaller VaR?
- A. the position with a higher theta
- B. both positions would have an identical VaR
- C. the position with a higher gamma
- D. the position with a lower gamma
Answer: C
Explanation:
Explanation
The second order approximation of the VaR of an options position is given by [Option delta x Underlying's VaR - Option gamma/2 x (Underlying's VaR)^2]. Therefore, a higher gamma reduces VaR and a lower gamma increases VaR. Hence Choice 'b' is the correct answer.
NEW QUESTION 70
The Altman credit risk score considers:
- A. A historical database of the firms that have defaulted
- B. A historical database of the firms that have survived
- C. A combination of accounting measures and market values
- D. A quadratic approximation of the credit risk based on underlying risk factors
Answer: C
Explanation:
Explanation
A computation of Altman's Z-score considers the following ratios:
- Working capital to total assets
- Retained earnings to total assets
- EBIT to total assets
- Market cap to debt
- Sales to total assets
Nearly all the numbers above are accounting measures derived straight from the balance sheet or the income statement. Market capitalization is a market driven number. Therefore Choice 'c' is the correct answer as the Altman credit risk score considers both accounting and market based measures.
Altman's score, though computationally straightforward and intuitively easy to understand, was introduced in the late sixties and has been very accurate in predicting corporate bankruptcies, which is why it continues to be used extensively.
NEW QUESTION 71
Under the actuarial (or CreditRisk+) based modeling of defaults, what is the probability of 4 defaults in a retail portfolio where the number of expected defaults is 2?
- A. 4%
- B. 18%
- C. 2%
- D. 9%
Answer: D
Explanation:
Explanation
The actuarial or CreditRisk+ model considers default as an 'end of game' event modeled by a Poisson distribution. The annual number of defaults is a stochastic variable with a mean of and standard deviation equal to .
The probability of n defaults is given by (^n e^-) /n!, and therefore in this case is equal to (=2^4 * exp(-2))/FACT(4)) = 0.0902.
Note that CreditRisk+ is the same methodology as the actuarial approach, and requires using the Poisson distribution.
NEW QUESTION 72
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. II and IV
- B. I and II
- C. I, II and IV
- D. III and IV
Answer: B
Explanation:
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.
NEW QUESTION 73
Which of the following credit risk models focuses on default alone and ignores credit migration when assessing credit risk?
- A. The contingent claims approach
- B. The actuarial approach
- C. CreditPortfolio View
- D. The CreditMetrics approach
Answer: B
Explanation:
Explanation
The correct answer is Choice 'd'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:
1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.
2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.
3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.
4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.
5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).
NEW QUESTION 74
Which of the following statements are true:
I. A transition matrix is the probability of a security migrating from one rating class to another during its lifetime.
II. Marginal default probabilities refer to probabilities of default in a particular period, given survival at the beginning of that period.
III. Marginal default probabilities will always be greater than the corresponding cumulative default probability.
IV. Loss given default is generally greater when recovery rates are low.
- A. I, III and IV
- B. I and IV
- C. I and III
- D. II and IV
Answer: D
Explanation:
Explanation
Statement I is incorrect. A transition matrix expresses the probabilities of moving to a given set of ratings at the end of a period (usually one year) conditional upon a given rating at the beginning of the period. It does not make a reference to an individual security and certainly not to the probability of migrating to other ratings during its entire lifetime.
Statement II is correct. Marginal default probabilities are the probability of default in a given year, conditional upon survival at the beginning of that year.
Statement III is incorrect. Cumulative probabilities of default will always be greater than the marginal probabilities of default - except in year 1 when they will be equal.
Statement IV is correct. LGD = 1 - Recovery Rate, therefore a low recovery rate implies higher LGD.
NEW QUESTION 75
A bullet bond and an amortizing loan are issued at the same time with the same maturity and with the same principal. Which of these would have a greater credit exposure halfway through their life?
- A. The amortizing loan
- B. Indeterminate with the given information
- C. They would have identical exposure half way through their lives
- D. The bullet bond
Answer: D
Explanation:
Explanation
A bullet bond is a bond that pays coupons covering interest during the life of the bond and the principal at maturity. An amortizing loan pays the interest as well as a part of the principal with every payment. Therefore, the exposure of the amortizing loan continually reduces, and approaches zero towards the end of its life. The bullet bond will always have a higher exposure at any time during its life when compared to an equivalent amortizing loan. Hence Choice 'd' is the correct answer.
NEW QUESTION 76
Which of the following best describes economic capital?
- A. Economic capital reflects the amount of capital required to maintain a firm's target credit rating
- B. Economic capital is a form of provision for market risk losses should adverse conditions arise
- C. Economic capital is the amount of regulatory capital mandated for financial institutions in the OECD countries
- D. Economic capital is the amount of regulatory capital that minimizes the cost of capital for firm
Answer: A
Explanation:
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.
NEW QUESTION 77
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. $200mm
- B. $250mm
- C. $600mm
- D. $750mm
Answer: D
Explanation:
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.
NEW QUESTION 78
Which of the following methods cannot be used to calculate Liquidity at Risk?
- A. Monte Carlo simulation
- B. Scenario analysis
- C. Historical simulation
- D. Analytical or parametric approaches
Answer: D
Explanation:
Explanation
Analytical or parametric approaches are not useful at all for liquidity at risk calculations because there are no neat distributions available to parameterize the large number of factors that affect the calculations of liquidity inflows and outflows. Historical simulations, Monte Carlo and scenario analysis (which can complement historical scenarios) are all valid choices
NEW QUESTION 79
Which of the following statements are true:
I. Common scenarios for stress tests include the 1997 Asian crisis, the Russian default in 1998 and other well known economic stress situations.
II. Stress tests provide the assurance that an institution's worst case losses will be covered.
III. Performing stress tests is highly recommended but is not mandated under Basel II.
IV. Historical events can be modeled quite accurately as they have defined start and end dates.
- A. I only
- B. I, III and IV
- C. All of the above
- D. I and II
Answer: A
Explanation:
Explanation
Stress tests can cover known events, but since the future is unknown, and new events may be entirely different from what has happened in the past, they provide no assurance that an institution's worst case losses would be covered. Hence II is false.
Stress testing is required to be performed as part of Basel II, and therefore III is false.
Historical events do not have sharply defined start and end dates. Often, even after a crises ends, its after effects may continue to affect the markets for a long time. In such cases, it may be difficult to define the start and end of the crises. In many cases, the crises may persist for months or even years, making it difficult for the risk manager to identify a time period that covers the essence of the crises, and yet is focused enough to constitute a plausible scenario. Therefore IV is false too. Only I is true, and the correct answer is Choice 'b'.
NEW QUESTION 80
For a corporate bond, which of the following statements is true:
I. The credit spread is equal to the default rate times the recovery rate II. The spread widens when the ratings of the corporate experience an upgrade III. Both recovery rates and probabilities of default are related to the business cycle and move in opposite directions to each other IV. Corporate bond spreads are affected by both the risk of default and the liquidity of the particular issue
- A. III and IV
- B. IV only
- C. III only
- D. I, II and IV
Answer: A
Explanation:
Explanation
The credit spread is equal to the default rate times the loss given default, or stated another way, default rate times (1 - recovery rate). It is not equal to the default rate times the recovery rate. Therefore statement I is not correct.
When ratings are upgraded by rating agencies, the spread contracts and not widen. Therefore statement II is not correct.
Both recovery rates and probabilities of default are related to the business cycle, and they move in opposite directions. Economic recessions witness an increase in the default rate and a decrease in the recovery rate, and economic expansions result in a decrease in the default rate and an increase in the recovery rates when default does happen. Therefore statement III is correct.
Bond spreads incorporate both the risk of default, but also considerations of liquidity in the case of corporate bonds. Hence statement IV is correct.
NEW QUESTION 81
Which of the following is true for the actuarial approach to credit risk modeling (CreditRisk+):
- A. The approach is based upon historical rating transition matrices
- B. The approach considers only default risk, and ignores the risk to portfolio value from credit downgrades
- C. Default correlations between obligors are accounted for using a multivariate normal model
- D. The number of defaults is modeled using a binomial distribution where the number of defaults are considered discrete events
Answer: B
Explanation:
Explanation
The actuarial model considers defaults to follow a Poisson distribution with a given mean per period, and these are binary in nature, ie a default happens or it does not happen. The model does not consider the loss of value from credit downgrades, and focuses only on defaults. The model also does not consider default correlations between obligors. Therefore Choice 'c' is the correct answer.
The other choices are not true statements that would apply to the actuarial approach.
NEW QUESTION 82
Which of the following statements are true:
I. A high score according to Altman's Z-Score methodology indicates a lower default risk II. A high score according to the Probit or Logit models indicates a higher default risk III. A high score according to Altman's Z-Score methodology indicates a higher default risk IV. A high score according to the Probit or Logit models indicates a lower default risk
- A. II and III
- B. I and IV
- C. I and II
- D. III and IV
Answer: C
Explanation:
Explanation
A high score under the probit and logit models indicates a higher default risk, while under Altman's methodology it indicates a lower default risk. Therefore Choice 'd' is the correct answer.
NEW QUESTION 83
Which of the following statements is true in relation to a normal mixture distribution:
I. Normal mixtures represent one possible solution to the problem of volatility clustering II. A normal mixture VaR will always be greater than that under the assumption of normally distributed returns III. Normal mixtures can be applied to situations where a number of different market scenarios with different probabilities can be expected
- A. II and III
- B. I, II and III
- C. I and II
- D. III
Answer: D
Explanation:
Explanation
Normal mixtures address fat or heavy tails, not volatility clustering. Therefore statement I is not correct.
Statement II is not correct. Where VaR is calculated at low levels of confidence, VaR based on normal mixtures may be lower than that under a normal assumption. This is no different than for other fat tailed distributions.
Statement III is correct. In situations where multiple market scenarios can unfold with a given probability, and each scenario is normal, we can express the result with a normal mixture where the underlying normal distributions have the probabilities of the different scenarios.
NEW QUESTION 84
If A and B be two debt securities, which of the following is true?
- A. The probability of simultaneous default of A and B is greatest when their default correlation is 0
- B. The probability of simultaneous default of A and B is not dependent upon their default correlations, but on their marginal probabilities of default
- C. The probability of simultaneous default of A and B is greatest when their default correlation is negative
- D. The probability of simultaneous default of A and B is greatest when their default correlation is +1
Answer: D
Explanation:
Explanation
If the marginal probability of default of two securities A and B is P(A) and P(B), then the probability of both of them defaulting together is affected by the default correlation between them. Marginal probability of default means the probability of default of each security on a standalone basis, ie, the probability of default of one security without considering the other security.
The relationship that expresses the probability of joint default of the two is given by the following expression:
It is easy to see that in a situation where the Default Correlation of A & B = 0, ie, the defaults are independent, the combined probability of default is P(A)*P(B), exactly what we would intuitively expect. Also in the other extreme case where the default correlation is equal to 1 and P(A) = P(B) = p, ie the securities behave in an identical way, the expression resolves to just p, which is what we would expect.
From the above relationship, it is clear that the probability of joint default of A and B is the greatest when default correlation between the two is equal to 1, ie the securities behave in an identical way. Therefore Choice
'a' is the correct answer.
NEW QUESTION 85
If the duration of a bond yielding 10% is 6 years, the volatility of the underlying interest rates 5% per annum, what is the 10-day VaR at 99% confidence of a bond position comprising just this bond with a value of $10m?
Assume there are 250 days in a year.
- A. 0
- B. 1
- C. 2
- D. 3
Answer: A
NEW QUESTION 86
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