FRM I 2016 - VaR Quiz 4 - New

5/28/2016 FRM I 2016: VaR Quiz 4 New
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VaR Quiz 4 New
Review of attempt 1
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Started on Saturday, 28 May 2016, 11:29 AM
Completed on Saturday, 28 May 2016, 11:29 AM
Time taken 5 secs
Raw score 0/26 (0%)
Grade 0 out of a maximum of 10
1
Marks: 1 Suppose you are a Risk Manager and you are required to find the probability of default of Bonds. Given the
following ratings transition matrix, calculate the twoperiod cumulative probability of default for a 'B' credit.
Choose one a. 5.0%
answer.
b. 4.75%
c. 8.0%
d. 9.75%
The correct answer is D
The first period probability of default for a Brated bond is 5%. In second period the probability of default is the
probability of surviving year 1 and defaulting in year 2.
The year 2 probability of default = (0.05 x 0.02) + (0.85 x 0.05) + (0.05 x 0.08) = 4.75%. Therefore, the two
period cumulative probability of default = 5% + 4.75% = 9.75%.
Incorrect
Marks for this submission: 0/1.
2
Marks: 1 Which of the following area are typically focused on by rating agencies when assigning credit ratings?
I.Competitive position of the firm in its industry
II.Management quality
III.Fairness of employee performancebased compensation
IV.Financial policy of the firm
Choose one a. I & III
answer.
b. I, II & III
c. I, II & IV
d. All the above
The correct answer is C
Although compensation schemes may be evaluated, the “fairness” of such schemes is not material consideration
in the rating process.
Incorrect
3
Marks: 1 Mr. Johnson FRM is a portfolio manager in XYZ ltd. His client is Mr. Hill who wants to invest some of his savings
into Bonds and have set criteria for investing into bonds that, he only want to invest in investment grade rating
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5/28/2016 FRM I 2016: VaR Quiz 4 New
from at least 2 recognized bond rating agencies. You are considering an investment in one of three different
bonds. Which, if any, of the bonds listed below would meet Mr. Hill investment guidelines?
Choose one a. Bond A carries an S&P rating of BB and a Moody’s rating of Baa3
answer.
b. Bond B carries an S&P rating of BBB and a Moody’s rating of Baa3
c. Bond C carries an S&P rating of BBB and a Moody’s rating of Ba
d. None of the above
The correct answer is B
An investment grade bond has an S&P rating BBB or above and a Moody's rating of Baa3 or above.
Incorrect
4
Marks: 1 “The obligor’s capacity to meet its financial commitment on the obligation is still strong.” What is the rating of
this issue if this statement is given out by S&P?
Choose one a. AA
answer.
b. A
c. BBB
d. BB
AArated: The obligor’s capacity to meet its financial commitment is very strong.
Arated: The obligor’s capacity to meet its financial commitment is still strong.
BBBrated: Adverse economic or changing circumstances are more likely to lead to a weakened capacity of the
obligor to meet its financial commitment on the obligation.
BBrated: Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness
to meet its financial commitment on the obligation.
Incorrect
5
Marks: 1 Given the 1 year transition matrix below, what is the probability that a company that is currently A rated will
default over a given 2 year period and a company that is currently B rated will default over a given 1 year period?
Choose one a. Company A Default 10.25% / Company B Default 10%
answer.
b. Company A Default 10.25% / Company B Default 18.5%
c. Company A Default 18.5% / Company B Default 10%
d. Company A Default 18.5% / Company B Default 20%
The correct answer is A
After year 1 there is a 5% chance of default for Company A and 85% chance of still being A and a 10% Chance of
being a B. In year 2 there is a 10% chance of default if it was B rated (or 10% x 10% = 1%) and a 5% chance of
default if it was A rated (85% x 5% = 4.25%). The total probability is therefore 10.25%.
After year 1 there is a 10% chance of default for Company B.
Incorrect
6
Marks: 1 Mr. Tatum is evaluating USD based bond investments issued by the 4 companies below. According to his
investment guidelines, he may only invest in companies that have an investment grade rating from two
recognized credit agencies and are located in a country with favorable sovereign risk quality (i.e., countries in
which common sovereign risk probability models indicate a low probability of debt rescheduling). Assuming the
company is located in all the four countries, which (country, company) pair would be the most appropriate
investment?
5/28/2016 FRM I 2016: VaR Quiz 4 New
Choose one a. (Greece, Cap Capital)
answer.
b. (Italy, Bank Holdings)
c. (Portugal, Ben Financial)
d. (India, Leaf Holdings)
An investment grade bond has S&P rating BBB or above or Moody’s ratings Baa or above.
The larger the ratio of imports to foreign exchange reserves the higher the probability of default resulting in a
rescheduling of payments (Import ratio)
The larger the hard currency debt repayment is in relation to export revenues, the greater the probability of
rescheduling debt (Debt service ratio)
Incorrect
7
Marks: 1 An investor holds a portfolio of USD 50 million. This portfolio consists of Arated bonds (USD 10 million) and
BBBrated bonds (USD 40 million). Assume that the oneyear probabilities of default for Arated and BBBrated
bonds are 2% and 6% respectively, and that they are independent. If the recovery value for Arated bonds in the
event of default is 80% and for BBBrated bonds is 50%, what is the oneyear expected credit loss from this
portfolio?
Choose one a. USD 1,240,000
answer.
b. USD 1,200,000
c. USD 2,010,000
d. USD 2,218,000
Expected Loss = Default rate * Loss given default
Expected Loss = Default rate * Portfolio size * (1 Recovery Rate)
Expected Loss from A Bonds = 0.02 * 10,000,000 * (1 0.80) = 40,000
Expected Loss from B Bonds = 0.06 * 40,000,000 * (1 0.50) = 1,200,000
Total Expected Loss = 40,000 + 1,200,000 = 1,240,000
Incorrect
8
Marks: 1 Which of the following loans has the lowest credit risk?
Choose one a. Loan A
answer.
b. Loan B
c. Loan C
d. Loan D
The 1 year probability of default needs to be adjusted to the remaining term using the formula [(1d_month)12
= (1d_annual)]. We multiply the monthly PD with the loss given default (LGD) to get the expected percentage
loss (EL%):
5/28/2016 FRM I 2016: VaR Quiz 4 New
As shown, loan C has the lowest EL%.
Incorrect
9
Marks: 1 A company has been offered a USD 50 million term loan to be fully repaid only at maturity 2 years later. The
bank estimates that it will recover only 65% of its exposure if the borrower defaults and that the likelihood of that
happening is 0.2%. What is the banks’ expected loss one year later?
Choose one a. USD 40000
answer.
b. USD 35000
c. USD 350000
d. USD 175000
After one year, the expected loss is:
Loss = P(default) * exposure * (loss given default) = 0.002 * 50,000,000 * (1 0.65) =35000
Maturity is irrelevant here since the loan is to be repaid fully in 2 years.
Incorrect
10
Marks: 1 Assume ABN Amro Bank, having a capital of USD 800 million and it wants to limit its losses in the energy sector
to 12% and in the construction sector to 15% of its capital. The LGD rates for the energy and construction
sectors are respectively 55% and 75%. If ABM Amro Bank wants to strictly adhere to its concentration limit
policy, the maximum permitted loan amount to the energy and construction sectors will be:
Choose one a. Energy USD 174 mn / Construction USD 160 mn
answer.
b. Energy USD 160 mn / Construction USD 174 mn
c. Energy USD 155 mn / Construction USD 160 mn
d. Energy USD 174 mn / Construction USD 189 mn
Concentration Limit = Capital x (loss limit on capital / loss rate of the sector) Concentration Limit for Energy =
USD 800 million x (0.12 / 0.55) = USD 174,545,454
Concentration Limit for Constr. = USD 800 million x (0.15 / 0.7) = USD 160,000,000
Incorrect
11
Marks: 1 Unexpected loss (UL) represents the standard deviation of losses, and expected loss (EL) represents the average
losses over the same time horizon. Further define LGD as expected loss given default and EDF as expected default
frequency. Which of the following statements are true?
I. EL increases linearly with increasing EDF.
II. EL is often higher than UL.
III. With increasing EDF, UL increases at a much faster rate than EL.
IV.The lower the LGD, the higher the percentage loss for both the EL and UL.
Choose one a. I only
answer.
b. I and II
c. I and III
d. II and IV
Statement I & III are correct, EL increases linearly with increasing EDF. UL increases much faster than EL with
increasing EDF
Incorrect
12
Marks: 1 Suppose you are a portfolio manager and your supervisor have asked you to examine some of the features of a
twoasset credit portfolio, consisting of two correlated credits, credit X and credit Y, let the following notation be
5/28/2016 FRM I 2016: VaR Quiz 4 New
given:
•RCX, RCY is the risk contribution of credit X and credit Y, respectively.
•ELXY, ELX, ELY is the expected loss of a portfolio consisting of credits X and Y, credit X, and credit Y,
respectively.
•ULXY, ULX, ULY is the unexpected loss of a portfolio consisting of credits X and Y, credit X, and credit Y,
respectively.
Using the notation above and assuming that the two assets’ defaults are correlated, which of the following
equations is correct?
Choose one a. ELXY = ELX + ELY
answer.
b. ULXY = ULX + ULY
c. ULXY > RCX + RCY
d. RCX + RCY > ULX + ULY
Two different risky assets with average losses due to a credit event at some time during the analysis horizon have
an aggregate average loss equal to the sum of the two average losses.
B is incorrect. The unexpected loss of the portfolio is not equal to the sum of the individual unexpected losses of
the risky assets that make up the aggregate portfolio due to (default) correlation. ULP = (ULA * ULA + ULB * ULB
+ 2 ULA * ULB*corr) 0.5
C is incorrect. The sum of all the risk contributions from all the assets in the portfolio is the portfolio unexpected
loss; ULP = RCA + RCB
D is incorrect. The portfolio unexpected loss is very much smaller than the sum of the individual unexpected
losses due to the diversification effect. ULP = (ULA * ULA + ULB * ULB + 2 ULA * ULB *corr) 0.5
Incorrect
13
Marks: 1 United Bank has given a loan with the following characteristics:
Total Commitment of $10 mn of which $6.5 mn is currently outstanding
Default Probability over Next 1 year is 2%
Drawdown upon default is assumed to be 70%
Loss Given Default is estimated to be 25%
What is the expected loss for the loan given by United Bank?
Choose one a. $ 50000
answer.
b. $ 32500
c. $ 47500
d. $ 44750
EL = Adj. Exposure x Expected Default Frequency x Loss Given Default
Adj. Exposure = Outstanding + (Commitment –Outstanding) x Drawdown on Default
= 6.5 mn + (10 mn – 6.5 mn) x 70% =$8.95 mn
EL = 8.95 mn x 2% x 25% = $ 44750
Incorrect
14
Marks: 1 XYZ Bank owns a portfolio of 20 BBB rated bonds with a value of $20 mn in each of the bonds. The one year
probability of default for each issuer is 7% and the recovery rate is 65% for each issue. The one year expected
loss of the XYZ Bank is:
Choose one a. $ 0.49 mn
answer.
b. $ 9.8 mn
c. $ 28 mn
d. $ 9.5 mn
Exposure = 20 x 20 mn = 400 mn
EL = 400 mn x 7% x (165%) = 9.8 mn
Correlation between issuer does not matter for computing Expected Losses
Incorrect
5/28/2016 FRM I 2016: VaR Quiz 4 New
15
Marks: 1 Global Bank has made a loan with the following characteristics:
Total Commitment of $5mn of which $4.2mn is currently outstanding
Probability of default is 1.5% over the next year
Drawdown assumed is 50%
Recovery rate assumed as 60%
Standard Deviation of EDF is 6% and of LGD 25%
What is the expected and unexpected loss of the Global Bank for this loan?
Choose one a. Expected Loss $27600 & Unexpected Loss $ 178950
answer.
b. Expected Loss $27600 & Unexpected Loss $ 766280
c. Expected Loss $41400 & Unexpected Loss $ 178950
d. Expected Loss $41400 & Unexpected Loss $ 766280
Adj. Exposure = Outstanding + (Commitment –Outstanding) x Drawdown on Default
= 4.2 + (5 – 4.2) x 50% = $4.6 mn
Expected Loss = 4.6 x 1.5% x (160%) = $27600
Unexpected Loss = AE x Sqrt(EDF x Variance of LGD + LGD2 x Variance of EDF)
= 4.6 mn x Sqrt (1.5% x (25%)2 + (160%)2 x (6%)2 )
=4.6 mn x Sqrt (0.0015) = 4.6 mn x 0.0389 = $178957
Incorrect
16
Marks: 1 Which of the following arguments is NOT true? Key Risk Indicators should:
Choose one a. Anticipate operational risks
answer.
b. Be based upon historical loss data
c. Be an objective measure of operational risk
d. Be monitored over time to detect trends
Key risk indicators seek to quantify all aspects that are sought by the risk manager to enable riskbased decision
making. They serve as a gauge of potential downside outcomes. When applied risk key indicators are used to
identify important business vulnerabilities. The operational risk profile using the risk indicators should be
continually monitored, dynamic, and updated as often as new data (based on historical losses for example) are
collected. Key risk indicators are based on historical loss data, are monitored over time to detect trends, and need
to be an objective measure of operational risk. Key risk indicators do not anticipate operational risk.
Incorrect
17
Marks: 1 Which of the following outcomes is NOT associated with an operational risk process?
Choose one a. The sale of call options being booked as a purchase
answer.
b. A monthly volatility is inputted in a model that requires a daily volatility
c. A loss is incurred on an option portfolio because ex post volatility exceeded expected
volatility
d. A volatility estimate is based on a timeseries that includes a price that exceeds the
other prices by a factor of 100
Choices A, B, and D are outcomes that are associated with an operational risk process. Operational risk is the risk
of loss caused by failure in operational process or systems that support them. Equivalently, operational risk is the
breakdowns of people, processes, and systems within an organization. Given this definition, choices ‘A’, ‘B’, and
‘D’ are outcomes that are associated with an operational risk process.
Incorrect
18
Marks: 1 Which of the following are critical prerequisites to successfully implementing an operational risk indicator program
within an organization?
I.The firm needs to be able to identify risk profiles at various levels within the organization.
II. Involvement of line managers in developing the risk indicators
5/28/2016 FRM I 2016: VaR Quiz 4 New
III. Availability of a meaningful data pool (for example, transaction volume, financial data, efficient data collection
processes and procedures)
Choose one a. I and III only
answer.
b. I and II only
c. II and III only
d. I, II and III
All of the statements are true.
Incorrect
19
Marks: 1 You have been asked to help communicate to business unit managers some practical considerations in developing
key risk indicators (KRIs) and collecting data. Which of the following should not be on your list of talking points?
Choose one a. KRI definitions will consider the rationale for the risk indicator, description of the
answer. measurement criteria, and the sources of data.
b. KRIs must be continually validated and refined.
c. Select KRIs based on their data availability first and predictive value second.
d. Each KRI should be weighted in accordance with its significance, or predictive
capabilities
You would always select KRIs based on their predictive value first and data availability second.
Incorrect
20
Marks: 1 Which of the following statements are true?
I.To ensure higher effectiveness in managing operational risk, the operational risk manager’s compensation should
be linked to trader performance
II.Stoploss limits are less effective as an operational risk measure than exposure limits because exposure limits
consider future market risk movements while stoploss limits are backward looking
III.As annual audits of listed entities are regulatory and mandatory by nature, they should not be seen as a
material part of operational risk management
IV.The long option like feature of most traders’ compensation packages substantially increases operational risk
Choose one a. I, III and IV
answer.
b. II and IV
c. II only
d. IV only
Operational risk is increased if traders are highly compensated when they make big profits but do not lose the
same type of money when they incur losses (IV). They therefore take higher risks to obtain higher returns.
Incorrect
21
Marks: 1 Which of the following illustrates losses caused by Firm A’s operational risk exposure?
I.After a surprise announcement by the central bank that interest rates would increase, bond prices fall and Firm
A incurs a significant loss on its bond portfolio
II.The data capture system of Firm A fails to capture the correct market rates causing derivative trades to be
done at incorrect prices, leading to significant losses
III. As a result of a workers strike the share price of a company that Firm A invested in falls significantly, causing
major investment losses
IV.A counterparty of Firm A fails to settle their debt to Firm A and in doing this they are in breach of a legal
agreement to pay for services rendered resulting in a material exposure
Choose one a. I, II and IV only
answer.
b. II only
c. II and III only
5/28/2016 FRM I 2016: VaR Quiz 4 New
d. II, III and IV only
In (II), systems failure or incorrect systems caused the problem. The losses are directly due to an operational risk
exposure. (I) and (III), an increase in interest rates and the fall in the value of an investment, are both examples
of market risk exposure. (IV), failure to repay debt, is an example of credit risk exposure.
Incorrect
22
Marks: 1 Which of the following risks is not included in the Basel II definition of operational risk?
Choose one a. Legal Risk.
answer.
b. Reputation Risk.
c. Process Failure Risk.
d. Systems Failure Risk.
It is not an Operational Risk as per Basel II accord.
Incorrect
23
Marks: 1 Your supervisor is an expert in market and credit risk. He recruits you to manage the operational risk department.
He would like to use VaR to measure the firm’s operational risk and proposes that you use the same VaR
framework previously developed for market and credit risk. Which of the following arguments is a valid argument
for why it is difficult to estimate an operational VaR using the same framework as market and credit VaR?
Choose one a. Market risk events are easier to map to risk factors than operational risk events.
answer.
b. Quantitative methods for estimating operational risk VaR do not exist.
c. Market and credit VaRs are estimated using only a frequency distribution, but
operational VaR is estimated using both a frequency distribution and a severity
distribution.
d. Monte Carlo techniques cannot be used for an operational risk VaR because the
underlying risk factors are not normally distributed.
Operational losses are not easy to map to risk factors.
Incorrect
24
Marks: 1 Which of the following is true about stress testing?
Choose one a. It is used to evaluate the potential impact on portfolio values of unlikely, although
answer. plausible, events or movements in a set of financial variables.
b. It is a riskmanagement tool that directly compares predicted results to observed
actual results. Predicted values are also compared with historical data.
c. Both ‘a’ and ‘b’ above are true
d. None of the above are true
‘A’ describes ‘stress testing’. ‘B’ is not about ‘stress testing’.
Incorrect
25
Marks: 1 Mr. Johan is an associate risk manager at a bank, and he was concerned about the various risks faced by the
bank’s securitization transactions. Which of the following risks refers to a bank having to hold onto assets for
longer than planned and incurring financing costs as a result?
5/28/2016 FRM I 2016: VaR Quiz 4 New
Choose one a. Contingent Risk
answer.
b. Funding Liquidity Risk
c. Pipeline Risk
d. Wrongway Risk
Pipeline risk originates from market stress when a bank may not be able to complete the entire process of selling
the securities to the public through the issue – special purpose entities. Consequently, Pipeline risk arises because
market conditions may force the bank to warehouse underlying assets for longer than planned and therefore,
incurring financing costs.
Incorrect
26
Marks: 1 Suppose you are a Risk manager in your firm and after evaluating the results of stress testing, you are
recommending that the firm allocate additional economic capital and purchase selective insurance protection to
guard against particular events. In order to give management a fully informed assessment, what is important
that relates to this strategy?
Choose one a. While decreasing Liquidity Risk exposure, it will likely increase market risk exposure
answer.
b. While decreasing correlation risk exposure, it will likely increase credit risk exposure
c. While decreasing market risk exposure, it will likely increase credit risk exposure
d. While decreasing credit risk exposure, it will likely increase model risk exposure
‘C’ is correct, as it is related to the strategy.
Incorrect
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5/28/2016 FRM I 2016: VaR Quiz 4 New

EduPristine ► FRM I 2016 ► Quizzes ► VaR Quiz 4 New ► Review of attempt 1