2024

FRM
®

PART II
PRACTICE EXAM II
Table of Contents

Introduction to 2024 FRM Part II Practice Exam #2................................................... 2

2024 FRM Part II Practice Exam #2 – Statistical Reference Table .......................... 4
2024 FRM Part II Practice Exam #2 – Special Instructions and Definitions ............ 5
2024 FRM Part II Practice Exam #2 – Candidate Answer Sheet ............................. 7
2024 FRM Part II Practice Exam #2 – Questions ..................................................... 8
2024 FRM Part II Practice Exam #2 – Answer Key ................................................ 54
2024 FRM Part II Practice Exam #2 – Answers & Explanations ............................ 55

1
Introduction

The FRM Exam is a practice-oriented examination. Its questions are derived from a
combination of theory, as set forth in the core readings, and “real-world” work experience.
Candidates are expected to understand risk management concepts and approaches and
how they would apply to a risk manager’s day-to-day activities.

The FRM Exam is also a comprehensive examination, testing a risk professional on a number
of risk management concepts and approaches. It is very rare that a risk manager will be faced
with an issue that can immediately be slotted into one category. In the real world, a risk
manager must be able to identify any number of risk-related issues and be able to deal with
them effectively.

The 2024 FRM Part II Practice Exam #1 and #2 have been developed to aid candidates in
their preparation for the FRM Exam in May and November 2024. These Practice Exams are
based on a sample of questions from prior FRM Exams and are suggestive of the questions
that will be on the 2024 FRM Part II Exam.

The 2024 FRM Part II Practice Exam #2 contains 80 multiple-choice questions, the same
number of questions that the actual 2024 FRM Exam Part II will contain. As such, this
Practice Exam was designed to allow candidates to calibrate their preparedness both in
terms of material and time.

The 2024 FRM Practice Exams do not necessarily cover all topics to be tested in the 2024
FRM Exam as any test samples from the universe of testable possible knowledge points.
However, the questions selected for inclusion in the Practice Exams were chosen to be
broadly reflective of the material assigned for 2024 as well as to represent the style of
question that the FRM Committee considers appropriate based on assigned material.

For a complete list of current topics, core readings, and key learning objectives,
candidates should refer to the 2024 FRM Exam Study Guide and 2024 FRM Learning
Objectives.

Core readings were selected by the FRM Committee to assist candidates in their review of
the subjects covered by the Exam. Questions for the FRM Exam are derived from the core
readings. It is strongly suggested that candidates study these readings in depth prior to
sitting for the Exam.

2
Suggested Use of Practice Exams:

To maximize the effectiveness of the practice exams, candidates are encouraged to follow
these recommendations:

1. Plan a date and time to take the practice exam.

• Set dates appropriately to give sufficient study/review time for the practice
exam prior to the actual exam.

2. Simulate the test environment as closely as possible.

• Take the practice exam in a quiet place.
• Have only the practice exam, candidate answer sheet, calculator, and writing
instruments (pencils, erasers) available.
• Minimize possible distractions from other people, cell phones, televisions, etc.;
put away any study material before beginning the practice exam.
• Allocate 4 hours to complete FRM Part I Practice Exam and 4 hours to complete
FRM Part II Practice Exam and keep track of your time. The actual FRM Exam Part I
and FRM Exam Part II are 4 hours each.
• Complete the entire exam and answer all questions. Points are awarded for correct
answers. There is no penalty on the FRM Exam for an incorrect answer.
• Follow the FRM calculator policy. Candidates are only allowed to bring certain types
of calculators into the exam room. The only calculators authorized for use on the
FRM Exam in 2024 are listed below; there will be no exceptions to this policy. You
will not be allowed into the exam room with a personal calculator other than the
following: Texas Instruments BA II Plus (including the BA II Plus Professional),
Hewlett Packard 12C (including the HP 12C Platinum and the Anniversary Edition),
Hewlett Packard 10B II, Hewlett Packard 10B II+ and Hewlett Packard 20B.

3. After completing the FRM Practice Exams

• Calculate your score by comparing your answer sheet with the practice exam answer
key.
• Use the practice exam Answers and Explanations to better understand the correct
and incorrect answers and to identify topics that require additional review. Consult
referenced core readings to prepare for the exam.
• Remember: pass/fail status for the actual exam is based on the distribution of
scores from all candidates, so use your scores only to gauge your own progress
and level of preparedness.

3
4
Special Instructions and Definitions
1. Unless otherwise indicated, interest rates are continuously-compounded annual rates.
2. Unless otherwise indicated, option contracts are assumed to be on one unit of the underlying asset.
3. ALCO = asset-liability committee
4. bp(s) = basis point(s)
5. CAPM = capital asset pricing model
6. CCP = central counterparty or central clearing counterparty
7. CD = certificate of deposit
8. CDO = collateralized debt obligation(s)
9. CDS = credit default swap(s)
10. CEO, CFO, CIO, CRO, and CTO: chief executive, financial, investment, risk, and technology officers,
respectively
11. CVA = credit value adjustment
12. ERM = enterprise risk management
13. ES = expected shortfall
14. ETF = exchange-traded fund
15. EWMA = exponentially weighted moving average
16. GARCH = generalized auto-regressive conditional heteroskedasticity
17. GDP = gross domestic product
18. IT = information technology
19. LIBOR = London interbank offered rate
20. MBS = mortgage-backed-security(securities)
21. NAV = net asset value
22. OECD = Organization for economic cooperation and development
23. OIS = overnight indexed swap
24. OTC = over-the-counter
25. RAROC = risk-adjusted return on capital
26. SOFR = secured overnight financing rate
27. VaR = value-at-risk
28. SPV = special purpose vehicle

5
29. The following acronyms are used for selected currencies:

Acronym Currency Acronym Currency

AUD Australian dollar GBP British pound sterling
BRL Brazilian real HKD Hong Kong dollar
CAD Canadian dollar INR Indian rupee
CHF Swiss franc JPY Japanese yen
CNY Chinese yuan SGD Singapore dollar
EUR euro USD US dollar

6
 2024 FRM Part II Practice Exam #2 – Candidate Answer Sheet

1. 21. 41. 61.

2. 22. 42. 62.

3. 23. 43. 63.

4. 24. 44. 64.

5. 25. 45. 65.

6. 26. 46. 66.

7. 27. 47. 67.

8. 28. 48. 68.

9. 29. 49. 69.

10. 30. 50. 70.

11. 31. 51. 71.

12. 32. 52. 72.

13. 33. 53. 73.

14. 34. 54. 74.

15. 35. 55. 75.

16. 36. 56. 76.

17. 37. 57. 77.

18. 38. 58. 78.

19. 39. 59. 79.

20. 40. 60. 80.

7
1. Question A group of newly hired investment analysts at a large wealth management firm is
undergoing training on the company’s investment practices. Part of the training
focuses on hedge fund investments and addresses how the firm evaluates the risk
management processes and procedures of a hedge fund being considered for
investment. The analysts learn that the firm performs comprehensive due diligence
on the hedge fund’s investment environment, as well as on its operational
environment and business practices. Which of the following is correct about a hedge
fund investor’s due diligence on the operational environment of a hedge fund?

A An investor should assess the qualifications of the fund’s investment team members
but does not need to do the same for other fund personnel.
B An investor should investigate the fund’s compliance practices but does not need to
ensure that the fund has an in-house compliance function.
C An investor should review the fund documents but does not need to verify with the
fund’s law firm whether they are responsible for the content of these documents.
D An investor should ask if the fund uses third-party service providers but does not
need to inquire about the fund’s relationships with these service providers.

2. Question A risk manager in the stress testing group at a large bank is presenting at a
conference about best practices in stress testing operational risk. The manager
compares different types of stress testing approaches, including macroeconomic
stress testing, parameter stress testing, and reverse stress testing. The manager
then discusses the most suitable applications of each stress testing approach.
Which of the following statements is the most appropriate use of the
macroeconomic stress testing approach?

A Assessing potential changes in dependencies between different measurable and

immeasurable risks faced by the bank
B Stress testing the operational resilience of different important business services
provided by the bank
C Analyzing the impact of a three-standard-deviation increase in interest rates on the
modeled value of the bank’s bond portfolio
D Determining how severe a financial market crisis would need to be in order to result
in the bank’s insolvency

8
3. Question A market-maker on the foreign exchange (FX) desk at an investment bank has been
asked to provide a quote for an FX call option that expires in 7 months. The option
has a strike price (K) to spot price (S0) ratio of 1.075. The market-maker references
the following implied volatility surface when creating the quote:

Strike price to spot price ratio (K/S0)

Time to
expiration 0.90 0.95 1.00 1.05 1.10
1 month 9.25 8.55 8.05 8.70 9.45
3 months 9.10 8.70 8.30 8.75 9.15
6 months 9.45 9.05 8.70 9.10 9.45
1 year 9.65 9.50 9.35 9.55 9.75

What implied volatility should the market-maker use to create the quote?

A 9.18%
B 9.28%
C 9.34%
D 9.65%

4. Question A midsize bank specializing in residential mortgages and credit cards is planning to
offer a new commercial loan product. The bank has an existing credit rating model
for its residential mortgage products which has performed well and has been
successfully back-tested over several years, but the CRO considers whether the
bank should develop and implement a new model for the commercial loan product.
In addition, the CRO wants to ensure that the bank follows best practices for the
development, validation, and implementation of any models that it uses. Which of
the following actions should the CRO recommend that the bank take?

A Apply the strongly performing existing model to the new commercial loan product
given the model’s successful track record.
B Develop a new model for the commercial loan product and avoid the use of
qualitative or judgmental adjustments to the model’s quantitative output.
C Make the model development team responsible for validating all of the bank’s
models that are currently operational.
D Perform sensitivity analysis on all models used by the bank to identify market
conditions under which they might perform poorly.

9
5. Question A portfolio manager at a US-based hedge fund has been searching for potential
return opportunities in the environment of declining global interest rates experienced
after the global financial crisis (GFC) of 2007-2009. The manager identifies the
existence of a positive cross-currency basis between two currencies and notes that
this positive basis has persisted since the GFC. What is the most appropriate
explanation for this persistence?

A The costs for arbitrageurs to finance their positions are increasingly reflected in the
basis.
B The costs of credit value adjustments have increased, as arbitrage positions
typically eliminate counterparty risks.
C Regulatory changes have permitted an increase in US banks’ speculative
proprietary trading activities.
D The addition of a liquidity risk cost to swap pricing is no longer required given the
decline in the overall level of interest rates in the global economy.

6. Question A credit risk analyst at a bank is using the Merton’s model to estimate the probability
of default (PD) of a non-dividend-paying company. The company’s debt consists of
only long-term zero-coupon bonds. The analyst gathers the following information:

Parameter Value
Value of the company's assets CAD 400 million
Face value of the company’s debt CAD 300 million
Expected rate of return of the value of company's assets 15%
Instantaneous volatility of the value of company's assets 25%
Annual interest rate 3%
Remaining time to maturity for the company’s debt 1 year

What is the PD of the company and a limitation of using the Merton model to predict
default of the company?

A The company’s PD is 3.03%, and a limitation of the Merton model is that it cannot
be applied to debt holdings maturing in more than 1 year.
B The company’s PD is 4.04, and a limitation of the Merton model is that it only
applies under the assumption that the value of the firm is normally distributed.
C The company’s PD is 5.20%, and a limitation of the Merton model is that it is costly,
especially for smaller firms, to continuously calibrate PD on historical series of
actual defaults.
D The company’s PD is 12.49%, and a limitation of the Merton model is that it is not
capable of continuously calibrating PD due to continually changing movements in
interest rates and market prices.

10
7. Question A regulatory capital analyst at a large European bank is studying the liquidity
horizons specified for different risk factors in the Fundamental Review of the
Trading Book (FRTB). The analyst examines how these liquidity horizons are
included in and impact the bank’s calculations of capital requirements. Which of the
following statements is correct?

A Under the standardized approach, the liquidity horizons of risk factors are
incorporated into market risk capital calculations through the risk weights
determined by the Basel Committee.
B When a bank uses the historical simulation approach, the impact of 1-day changes
in risk factors are scaled to the liquidity horizon for the risk factor by multiplying by
the square root of time.
C The standardized approach incorporates the diversification benefits between risk
factors with different liquidity horizons through the risk weights set by the Basel
Committee.
D The historical simulation approach estimates a liquidity-adjusted ES by assuming a
10-day liquidity horizon for all risk factors, since their behavior will most likely be
highly correlated during volatile market conditions.

8. Question An investor is comparing the performances of two portfolio managers who have
been allocated an equal amount of investment funds. The managers apply the same
strategy with the same constraints, and their portfolios are not diversified. The
investor gathers the following data about the two managers and the market index:

Market
Manager 1 Manager 2 index
Average return 32% 28% 22%
Beta with respect to market index 1.2 1.4 1.0
Standard deviation of returns 18% 14% 10%
Tracking error 8% 6% 0%

The risk-free rate of interest is 3%. Which of the following is an appropriate measure
to use and the correct conclusion to reach when comparing the performances of the
two managers?

A The Modigliani-squared measure, which shows that Manager 1 outperforms

Manager 2 by 2%
B The Modigliani-squared measure, which shows that Manager 2 outperforms
Manager 1 by 2%
C Treynor’s measure, which shows that Manager 1 outperforms Manager 2 by 6%
D Treynor’s measure, which shows that Manager 2 outperforms Manager 1 by 6%

11
9. Question A senior risk consultant is discussing different types of operational risk with a group
of managers at Bank JKY. During the discussion, the consultant describes the
seven Basel event categories for the classification of operational losses and
provides examples of losses in each of the categories. Which of the following
describes an operational loss that Bank JKY should classify in the Execution,
Delivery, and Process Management loss category?

A A client files a lawsuit against Bank JKY for a breach of fiduciary responsibility in the
client’s investment account, and Bank JKY pays a monetary settlement to the client.
B The data capture system of Bank JKY fails to capture correct market prices, causing
OTC derivative trades to occur at incorrect prices and resulting in significant losses.
C A rogue trader makes a series of unauthorized derivative trades, which are
liquidated by Bank JKY for a sizable loss after the trades are discovered.
D A corporate client of Bank JKY suffers a major financial loss from a cyber-attack and
is therefore unable to make payments on its debt to Bank JKY, which triggers a
default.

10. Question A fast-growing UK-based FinTech firm offers savings accounts, cryptocurrency
accounts, domestic bill payment services, and services that allow customers to
make payments in different currencies. A senior operations manager at the firm is
developing a plan to comply with new UK regulatory requirements for operational
resilience. Which of the following steps should the manager recommend that the
firm take to best comply with the regulatory expectations in this area?

A Develop an impact tolerance for each of the internal processes performed by the
firm.
B Identify important business services and map the dependencies between these
services.
C Calculate the 1-year 99.9% VaR for operational risk for each of the firm’s business
divisions and use this result to reserve additional capital for each division.
D Create an operational resilience team that is led by the IT department, with its other
members coming from the operational risk management, legal, and compliance
functions.

12
11. Question A consultant is reviewing the disclosures hedge funds are required to file with the
US Security and Exchange Commission. The consultant highlights how investors
can use these disclosures to identify and manage fraud risk. Which of the following
statements is correct?

A Disclosures of past regulatory or legal violations are not effective in predicting fraud
because circumstances almost always change.
B There is not enough evidence to conclude that investors of hedge funds are
compensated for fraud risk by receiving higher returns.
C Regulatory and legal prohibitions prevent fraud, and insufficient requirements on
disclosure of violations cause fraud.
D Regulatory and legal violation disclosures benefit only a small fraction of investors
who have access to high-cost contemporaneous data.

12. Question An analyst on the fixed-income desk at Bank PNMS has been asked to complete
the construction of a zero-coupon bond price tree that was started by another team
member. The analyst is given an interest rate tree of semi-annual spot interest rates
quoted on an annualized basis, and the partially completed price tree, both with
semi-annual time steps, as shown below (time t in years and price P in USD):

When completing the price tree, which of the following is a correct estimate of price
P(1,1)?

A USD 954.15
B USD 954.81
C USD 956.25
D USD 956.92

13
13. Question An external auditor is reviewing the modeling processes used by a US-based bank
to model operational losses as part of the bank’s capital planning process. Using
guidelines set by the Federal Reserve with respect to capital planning, which of the
following processes or assumptions would the auditor find most appropriate?

A Assuming a high positive correlation between operational loss severity and equity
index movements during normal market conditions
B Using a net charge-off model to predict shorter-term credit losses and a roll-rate
model to predict losses over a longer time horizon
C Modeling operational losses by projecting an annual loss estimate and then evenly
distributing the losses across the four quarters of the year
D Incorporating forward-looking factors and idiosyncratic risk exposures into stressed
operational loss estimates

14. Question An operational risk manager at a large retail bank is asked to review the framework
for the bank’s risk mitigation controls. As part of this review, the manager classifies
the risk controls as preventive, detective, corrective, or directive. Which of the
following should the manager classify as a directive control?

A An employee training program that explains the policies and procedures for
reviewing new account applications
B A notification to a credit card customer about a potentially fraudulent transaction on
that customer’s account
C An implementation of an antivirus software update across all of the bank’s IT
systems
D A dual-factor authentication protocol that is used to control access to critical
business systems

14
15. Question An analyst at a commercial bank is evaluating how the bank applies historical
simulation (HS) to estimate VaR and ES. The analyst focuses on the approaches
used for weighting past return observations, including the age-weighted, volatility-
weighted, correlation-weighted, and filtered HS approaches. Which of the following
statements is correct regarding the given weighting approach?

A The age-weighted approach typically specifies that observations that occurred after
the cutoff date are given an equal weight while observations that occurred before
the cutoff date are given a weight of zero.
B The volatility-weighted approach adjusts historical returns in the sample by
increasing them if the historical volatility forecast was higher than the current
volatility forecast, and decreasing them if the historical volatility forecast was lower
than the current volatility forecast.
C The correlation-weighted approach uses matrix multiplication to adjust historical
portfolio returns so that these returns reflect current volatilities and current
correlations.
D The filtered HS approach allows the historical returns data to be trimmed or
customized based on day of the week, magnitude of return, or any other
characteristic of the data.

16. Question A portfolio manager is revising an equity portfolio with the goal of attaining the
optimal portfolio on the portfolio’s efficient frontier. The manager believes this goal
can be achieved by replacing a stock in the portfolio with a new stock that is not part
of the existing portfolio and keeping the portfolio value constant. The manager
considers the following alternative actions:

• Action 1: Sell the stock with the highest marginal VaR and purchase an
equivalent value of a new stock that would have the lowest marginal VaR in
the portfolio.
• Action 2: Sell a particular stock and purchase an equivalent value of a new
stock, which would cause the ratio of expected excess returns to portfolio
beta for all stocks in the portfolio to be equal.
• Action 3: Sell a particular stock and purchase an equivalent value of a new
stock, which would cause the portfolio betas of all stocks in the portfolio to
be equal.
• Action 4: Sell a particular stock and purchase an equivalent value of a new
stock, which would significantly decrease the portfolio standard deviation
without changing the average excess portfolio return.

Which of the actions above would create an optimal portfolio?

A Action 1
B Action 2
C Action 3
D Action 4

15
17. Question A regional commercial bank is considering a loan with the following parameters that
would be fully funded by deposits:

• Loan amount: CNY 3.8 billion

• Average annual interest rate paid on deposits: 0.6%
• Annual interest rate received on loan: 4.1%
• Expected loss: 3.0% of face value of loan
• Annual operating costs: 0.3% of face value of loan
• Economic capital required to support the loan: 15.0%
• Average pre-tax return on economic capital: 2.0%
• Effective tax rate: 38%
• Other transfer costs: CNY 0

What is the after-tax RAROC for this loan?

A 0.31%
B 2.07%
C 3.33%
D 10.07%

18. Question The head of the structured securities desk at an investment bank directs all
derivatives traders on the desk to use trade compressions on all eligible trades to
reduce counterparty risk. One of the analysts decides to use trade compression on
a portfolio of single-name CDS contracts with the same maturity and transacted with
two counterparties, as presented in the table below, to estimate the investment
bank’s compressed notional value:

Reference Notional Bank’s Coupon

Counterparty credit (EUR million) position (bps)
Digital Long
NUMU Inc. 9 180
Corporation protection
Digital WKL Long
6 150
Corporation Company protection
WKL Short
NUMU Inc. 7 150
Company protection

What is the notional value of the investment bank’s net contract on compressed
trades only?

A EUR 1 million
B EUR 2 million
C EUR 8 million
D EUR 15 million

16
19. Question An option pricing analyst at an investment bank has been asked to write a report
examining the relationship between option prices and implied volatility curves. The
analyst notes that the implied volatility curves of different underlying assets often
have different shapes and explains the reasons why this occurs. Which of the
following statements can correctly be included in the report?

A The implied volatility smile commonly seen in equity options is due to the higher
probability of a greater than three standard deviation price change than would be
expected if prices are lognormally distributed.
B The implied volatility smile commonly seen in foreign exchange rate options is due
to the higher probability of a price change of between one and two standard
deviations from the mean than would be expected if prices are lognormally
distributed.
C Demand for option protection against steep drops in equity prices leads to higher
prices in out-of-the-money puts relative to out-of-the-money calls, which creates a
downward-sloping implied volatility skew in these options.
D Demand for option protection against the impact of unexpected central bank
announcements on foreign exchange rates leads to higher prices, and higher
implied volatilities, for at-the-money options relative to out-of-the-money options.

17
20. Question An investment fund uses risk budgeting as part of its risk management process.
Risk is calculated and monitored using delta-normal VaR at the 99% confidence
level. The fund’s total principal of EUR 100 million is invested across four asset
classes comprised of European stocks, non-European stocks, European bonds,
and non-European bonds. The total volatility profile of the fund is maintained at 5%.
Information on the four asset classes is given below:

Correlation
Average
Asset classes Weight return Volatility 1 2 3 4
European
1 40% 12.99% 9.25% 1.00 -0.05 -0.07 -0.03
stocks
Non-
2 European 12% 10.82% 11.91% -0.05 1.00 0.02 -0.01
stocks
European
3 22% 5.10% 5.76% -0.07 0.02 1.00 0.02
bonds
Non-
4 European 26% 10.53% 11.94% -0.03 -0.01 0.02 1.00
bonds

What is the sum of the risk budgets that should be allocated to the four asset
classes?

A EUR 11.64 million

B EUR 22.12 million
C EUR 38.86 million
D EUR 100.0 million

18
21. Question A wealth management firm has JPY 86 billion in assets under management. The
portfolio manager computes the daily VaR at various confidence levels as follows:

Confidence
VaR (JPY)
Level
95.0% 397,463,000
95.5% 401,682,500
96.0% 406,224,500
96.5% 418,453,000
97.0% 428,934,000
97.5% 439,415,500
98.0% 451,993,000
98.5% 468,763,000
99.0% 490,773,000
99.5% 524,663,000

What is the closest estimate of the daily ES at the 97.5% confidence level?

A JPY 398 million

B JPY 400 million
C JPY 484 million
D JPY 497 million

22. Question The treasurer of a regional bank is concerned that the bank may not be properly
compensated for the services it provides to its depositors and asks a manager to
assess a price for these services. The manager applies cost-plus pricing for all
depository services and uses the following data for pricing the automated teller
machine (ATM) service:

• Operating expense per ATM visit: USD 0.25

• Estimated overhead cost allocated per ATM visit: USD 0.35
• Profit required per ATM visit: USD 0.05
• The bank’s target return on capital: 15%

What is the correct amount for the bank to charge per ATM visit according to the
cost-plus pricing model?

A USD 0.30
B USD 0.65
C USD 0.70
D USD 0.74

19
23. Question The treasurer of a US bank is concerned about potential future interest rate
increases by the Federal Reserve (FED) and their impact on the bank’s net worth.
After reviewing the bank’s stress testing framework, the treasurer asks a manager to
consider including an additional scenario in which the FED increases interest rates
by 200 bps and to perform duration analysis on the scenario. The manager gathers
information on the bank’s balance sheet and the duration of each asset and liability
item as provided below:

Amount Duration
(USD million) (years)
Assets
Cash 400 0
Federal funds loans 400 1.0
Government securities and mortgages 600 5.0
Loans and leases 1100 3.0
Total assets 2500
Liabilities
Interest-bearing deposits (marketable) 1000 0.5
Other borrowings 1200 4.0
Total liabilities 2200

Assuming the current level of interest rates is 2%, which of the following is a correct
statement for the manager to make regarding this stress scenario?

A A 200-bps increase in interest rates will cause the bank’s net worth to decrease by
USD 27.4 million.
B A 200-bps increase in interest rates will cause the bank’s net worth to decrease by
USD 52.4 million.
C Compared to the bank’s other balance sheet items, interest-bearing deposits will
experience the smallest change in value given a 200-bps increase in interest rates.
D In this scenario, utilizing USD 200 million of cash to first pay off USD 200 million of
other borrowings in response to a 200-bps increase in interest rates will cause the
value of the bank’s net worth to increase.

20
24. Question A treasurer at a US-based bank is reviewing the bank’s balance sheet and wants to
evaluate the sensitivity of the bank’s net worth to a potential change in interest
rates. The treasurer asks a manager to apply duration analysis to assess the impact
of a 100-bps change in interest rates on the bank’s net worth. Which of the following
is a correct statement for the manager to make?

A The percentage change in the value of an asset or liability resulting from a 100-bps
change in interest rates is directly proportional to its duration but is unaffected by
the corresponding percentage change in interest rates.
B Using USD 100 million of cash to pay a cash dividend will not affect the overall
asset duration of the bank.
C A prepayable mortgage loan has a higher duration than an identical non-prepayable
loan and is typically more sensitive to overall interest rate changes.
D The sensitivity of assets and liabilities to changes in interest rates is greater when
the coupon is lower, the duration is higher, or the overall level of interest rates is
lower.

25. Question The chief investment officer (CIO) of a large university endowment fund is
considering adding some illiquid assets to improve the performance of the
university’s investment portfolio. The CIO asks an investment manager to prepare a
report discussing the characteristics of illiquid asset returns. The manager reviews
the dynamics of illiquid assets and the determinants of their returns. Which of the
following is a correct statement for the manager to include in the report?

A Survivorship bias overstates reported returns of illiquid assets by reporting only the
returns of those funds that have achieved a return above a required threshold.
B Reporting bias overstates reported returns of illiquid assets because only the
returns of those funds that continue to remain in business over a given time period
are considered.
C Survivorship bias and reporting bias can theoretically be eliminated by including the
returns of the entire population of funds.
D Infrequent trading, although considered a bias, can still generate sufficient data for
accurate beta and correlation estimates.

21
26. Question A treasurer of a bank is assessing the different methods of pricing liquidity and is
concerned about the potential impact of applying each method. The treasurer asks
an analyst to review and evaluate the various approaches to liquidity transfer pricing
and to prepare a report with recommendations. Which of the following statements
would be correct for the analyst to include in the report?

A A zero-cost of funds approach tends to result in the bank holding long-term highly
illiquid assets funded by long-term stable liabilities.
B An average cost of funds approach tends to result in the greatest maturity
transformation for a bank’s balance sheet.
C A matched-maturity marginal cost of funds approach converts the bank’s fixed-rate
borrowing cost to a floating-rate borrowing cost.
D Both an average cost of funds approach and a zero-cost of funds approach
appropriately align the maturity of the bank’s lending and borrowing activities when
management compensation is based on net income.

27. Question A chief investment officer (CIO) of a large university endowment fund is considering
whether to add illiquid assets to the university’s investment portfolio. Before making
a decision, the CIO asks an investment analyst to review illiquidity risk premiums
across and within asset categories and to prepare a report with findings. Which of
the following statements is correct for the analyst to include in the report?

A Corporate bonds that trade less frequently or have larger bid-ask spreads have
lower returns than more liquid corporate bonds.
B Expected returns of illiquid assets can be overstated due to measurement biases.
C US Treasury instruments are the only assets that do not exhibit illiquidity risk
premium.
D Hedge funds that do not place restrictions on withdrawals exhibit higher returns.

22
28. Question A national regulator is developing a set of indicators to serve as warning signs that
the liquidity of the stock market could be decreasing. The regulator is particularly
concerned about the potential for a “liquidity black hole” to develop which could
destabilize the stock market. Which of the following observations would be of
greatest concern to the regulator as a signal of a potential liquidity black hole
occurring?

A A majority of large investors increasingly follow a trend-following trading strategy

B Brokerage firms purchase call options as a hedge against the sale of a large
number of put options to institutional investors.
C Portfolio managers sell stocks that have increased in value and reached their price
target.
D Bid-ask spreads for less liquid stocks become narrower.

29. Question A manager at an asset management firm requests that an analyst calculate the cost
of liquidation of one of the fund’s stock positions. The position consists of 100,000
shares of company ABC and the stock has a current bid price of USD 53.5 and an
offer price of USD 54.5. The mean and standard deviation for the stock’s
proportional bid-offer spread is 0.0185 and 0.0250 respectively. The analyst
calculates the cost of liquidation for this entire stock position under a stressed
market scenario based on a 99% confidence level. What is the correct cost of
liquidation for this stock position?

A USD 49,950
B USD 99,900
C USD 206,955
D USD 413,910

23
30. Question An enterprise risk consultant is presenting about the management of risk associated
with third-party vendor relationships at a financial conference. To emphasize the
importance of understanding this risk and to illustrate lessons learned, the
consultant describes several past examples of large losses and data breaches
incurred by different financial institutions due to deficient or fraudulent third-party
vendor practices. One example provided is the large loss incurred by Capital One, a
US-based bank holding company, that resulted from its relationship with a third-
party vendor. Which of the following best describes the circumstances that led to the
loss in this case?

A The vendor provided an inaccurate loan pricing model to Capital One, which
incurred far greater default losses than expected.
B A bill payment system provided by the vendor failed for an extended period of time,
resulting in many Capital One customers canceling their accounts and causing
severe reputational impact.
C The vendor’s sales manager established extremely high incentives for its
representatives to sell Capital One products, resulting in regulatory fines for selling
inappropriate products to consumers.
D A former staff member of the vendor hacked into a database of Capital One’s
personal customer information that was stored on the vendor’s cloud services
platform and stole much of this information.

31. Question A portfolio manager at a pension fund is presenting on investment strategies during
a training for newly-hired portfolio analysts. The manager discusses low volatility
strategies, illustrates historical performance measures of firms that apply these
strategies, and draws attention to the benchmarks used. Which of the following
statements about low volatility strategies would be correct for the manager to make
during the presentation?

A The strategies tend to have significant alphas relative to standard market

capitalization benchmarks.
B The strategies tend to have negative alphas relative to dynamic factors such as
value or momentum.
C The strategies tend to generate high alphas over the risk-free rate but negligible
alphas over any other benchmark.
D The strategies tend to generate low alphas if the benchmark used is adjusted for
risk and high alphas otherwise.

24
32. Question A financial analyst is calculating the weighted average life (WAL) of the loans in an
MBS pool. The initial notional value outstanding of the MBS pool is USD 50 million.
The payment schedule and the assumed pool factor for the MBS are provided in the
table below:

Coupon Principal payment

payment date Dates Actual days Pool factor (USD million)
November
0 66 1.00 --
21, 2023
January
1 181 0.76 12
26, 2024
July
2 184 0.54 11
26,2024
January
3 183 0.38 8
26, 2025
July 25,
4 182 0.26 6
2025
January
5 183 0.18 4
24, 2026
July 25,
6 -- -- 9
2026

Assuming coupon payments are made semi-annually and there are 365 days in a
year, what is the WAL of the MBS pool?

A 1.06 years
B 1.24 years
C 2.12 years
D 2.68 years

33. Question A risk analyst at an investment bank has been asked to evaluate the bank’s risk
measurement process. The bank currently uses VaR as its primary risk measure,
but the analyst believes ES may be a better measure during periods of market
turmoil. When comparing VaR and ES, which of the following statements is correct?

A When estimating ES and VaR at the same confidence level, ES will always be
greater than VaR.
B If a VaR model backtest at a specified confidence level accepts the model, then the
corresponding ES model will also be accepted.
C While VaR ensures that the estimate of portfolio risk is less than or equal to the sum
of the risks of that portfolio’s positions, ES does not.
D While ES is more difficult to estimate than VaR, it is easier to backtest than VaR.

25
34. Question The CRO of a regional bank wants to ensure that the modeling assumptions used in
the bank’s economic capital models are sound. The CRO asks a member of the
validation team to review the bank’s process of assessing the interest rate risk in its
banking book and to validate the assumptions used in its interest rate models.
Which of the following assumptions would be most appropriate for the bank to
make?

A The bank changes the interest rate it offers to depositors by the full amount of any
change in market interest rates.
B The bank models its retail non-maturity deposits as floating-rate, putable bonds.
C The bank assumes that its residential mortgages exhibit positive convexity as
interest rates decrease.
D The bank models its interest rate risk in the banking book independently from its
credit risk.

35. Question The CRO of a large bank has asked a group of risk managers to prepare a plan to
implement the revisions to the Basel III guidelines finalized in December 2017. The
bank expects to qualify as a global systemically important bank (G-SIB) by the time
the revisions are implemented. Which of the following actions is most appropriate
for the bank to take to comply with the revised Basel lll guidelines?

A Introduce an internally created model to determine the bank’s operational risk

capital.
B Assign different credit risk weights for residential mortgages based on each
mortgage’s loan-to-value ratio.
C Apply the advanced internal rating-based approach for certain types of credit
exposures, such as exposures to banks and large corporations.
D Decrease the bank’s target level of its countercyclical buffer and its Basel III Tier 1
leverage ratio.

26
36. Question An analyst on a fixed-income desk of a large investment company is studying term
structure models that incorporate measures of volatility into the interest rate
process. The analyst focuses on the Cox-Ingersoll-Ross (CIR) model and its
treatment of volatility of the short-term interest rate. Which of the following
statements is correct regarding the yield volatility and basis-point volatility in the CIR
model?

A Periods of extremely low short-term interest rates are accompanied by high basis-
point volatility, which increases the possibility of negative interest rates in the CIR
model.
B In the CIR model, basis-point volatility is specified as a decreasing function of the
mean reversion factor.
C In the CIR model, yield volatility is specified as being constant while basis-point
volatility is allowed to vary.
D Basis-point volatility and yield volatility are used interchangeably to measure the
same volatility in the CIR model.

37. Question A credit analyst at a bank is asked to estimate the credit VaR (CVaR) for three loans
in the bank's credit portfolio. The analyst assembles the following loan information:

Maturity Exposure Loss given

Loan (years) (SGD) default S&P rating
S 2 55,000,000 0.8 BBB
T 3 36,000,000 0.9 BB-
U 4 50,000,000 0.7 A

In addition, the annual probability of default (PD) based on loan rating and maturity
is provided in the table below:

Loan maturity (years) 2 3 4

PD (investment grade) 1.5% 2.5% 3.5%
PD (non-investment grade) 5.0% 12.0% 18.0%

Assuming the 95th percentile of the unrecovered credit loss for the three loans are
the same, which of the following is correct about the comparison of the 95% CVaR
of the loans?

A CVaR of Loan S > CVaR of Loan U > CVaR of Loan T

B CVaR of Loan T > CVaR of Loan U > CVaR of Loan S
C CVaR of Loan T > CVaR of Loan S > CVaR of Loan U
D CVaR of Loan U > CVaR of Loan S > CVaR of Loan T

27
38. Question A credit risk manager at a bank is estimating the unexpected loss (UL) of the bank’s
portfolio of loans and the UL contributions of the individual loans to the overall
portfolio UL. The portfolio consists of a large number of loans and the manager
assumes that the loans have approximately the same characteristics and size, with
a constant pairwise default correlation of 0.32. Assuming the UL of each loan is
USD 10,500, what is the approximate UL contribution of each loan to the portfolio
UL?

A USD 0
B USD 1,075
C USD 3,360
D USD 5,940

39. Question A derivatives trader at an investment bank is considering how to hedge a relatively
illiquid 7-year USD interest-rate swap the bank just entered into as the fixed-rate
payer. The trader recognizes that any profit resulting from the bid-ask spread may
be lost if the trade is hedged with another illiquid 7-year swap and considers using
the more liquid 5-year and 10-year USD interest-rate swaps as a hedge. To
evaluate this possible hedge, the trader runs a two-variable regression model using
changes in the 5-year and 10-year swap rates to explain changes in the 7-year
swap rate. The regression model, regression results, and information about the
swaps are given below:

Δyt7 = α + β5Δyt5 + β10Δyt10 + εt

Number of observations 1255

R-squared 98.1%
Standard error 0.12
Regression coefficients Value Standard error
Constant (α) 0.0012 0.0030
Change in 5-year swap rate (β5) 0.2471 0.0025
Change in 10-year swap rate (β 10) 0.6536 0.0027

Swap tenor Swap fixed rate DV01

5-year 2.591% 0.061
7-year 2.492% 0.084
10-year 2.475% 0.115

What are the correct notional amounts of 5-year and 10-year swaps needed to
hedge a USD 100 million notional amount of 7-year swaps?

A USD 23.76 million of 5-year swaps, and USD 65.81 million of 10-year swaps
B USD 24.71 million of 5-year swaps, and USD 65.36 million of 10-year swaps
C USD 34.03 million of 5-year swaps, and USD 47.74 million of 10-year swaps
D USD 68.85 million of 5-year swaps, and USD 36.52 million of 10-year swaps

28
40. Question An individual investor reviews historical data on the performance of several
investment funds and decides to create a USD 1 million portfolio that mimics the
strategy of Fund CRN, which has consistently generated high alphas. The investor
gathers Fund CRN’s monthly returns over the last 10 years and regresses Fund
CRN’s monthly excess returns over the risk-free rate against the Fama-French
model’s three factors as well as a momentum factor. The investor obtains the
following statistically significant estimates:

Coefficient T-statistic
Alpha 0.08 2.10
MKT loading 0.55 6.72
SMB loading -0.63 4.35
HML loading 0.36 3.20
UMD loading -0.07 2.77
Adj R2 0.56

Which of the following positions is a component of the mimicking portfolio?

A USD 7,000 long position in stocks showing positive momentum

B USD 360,000 long position in value stocks
C USD 450,000 short position in T-bills
D USD 630,000 short position in growth stocks

41. Question A bank wants to reduce its operating expenses and considers hiring a third-party
service provider to offer additional loan origination and credit services to some of
the bank’s customers. The bank’s legal department has begun negotiating the terms
of a contract with the provider. Which of the following describes the most
appropriate set of due diligence actions for the bank to take before signing the
contract?

A The bank should audit the service provider’s operational processes and also give
the service provider the similar right to audit the bank’s processes.
B The bank should purchase insurance to cover potential losses resulting from the
provider’s services and should require that the provider deposit collateral with the
bank to mitigate performance risk.
C The bank should determine the compensation structure for the provider’s sales
representatives and ensure that it incentivizes their productivity through a high
proportion of variable compensation.
D The bank should define specific events that are considered a default under the
contract and give the provider an opportunity to resolve a default before terminating
the contract.

29
42. Question A bank buys a bond on its coupon payment date. Three months later, in order to
generate immediate liquidity, the bank decides to repo the bond. Details of the bond
and repo transaction are as follows:

Notional value (USD) 100,000

Coupon (semi-annual) 6%
Current bond price 97
Repo haircut 10%
Repo interest rate 4%

If the repo contract expires 6 months from now, what is the bank’s expected cash
outflow at the end of the repo transaction?

A USD 89,046
B USD 90,423
C USD 93,177
D USD 100,470

43. Question A risk analyst is studying a series of graphs plotting the empirical distribution of a
portfolio’s profit and loss quantiles against the quantiles of different specified
reference distributions. The analyst plans to use these QQ plots to gain insights into
the properties of the empirical distribution of the portfolio’s profits and losses. Which
of the following statements is correct regarding QQ plots?

A The tails of the empirical distribution are heavier than those of the reference
distribution if the QQ plot has a steeper slope at its tails.
B QQ plots are used to smooth the empirical distribution by removing outliers through
the use of quantiles.
C A distribution is considered a good reference distribution if data drawn from it
produces a QQ plot that is non-linear in the central mass of the distribution.
D The primary purpose of a QQ plot is to measure the skewness and kurtosis of the
empirical data.

30
44. Question A fixed-income portfolio manager is conducting a performance analysis on an
agency-MBS and the underlying pool of commercial mortgages. The manager
obtains the following information:

• The constant prepayment rate (CPR) of the commercial mortgages loan

pool: 14.38%
• Debt payments per year on the commercial mortgage loans: USD 730,000
• Net operating income per year of the commercial mortgage property: USD
1,825,000

The manager uses the following metrics as benchmarks for the commercial
mortgage sector analysis:

• Debt service coverage ratio (DSCR) of a benchmark obligor: 2.5

• Single monthly mortality (SMM) rate of a benchmark security: 0.85%

Which of the following statements is correct?

A The prepayments on the commercial mortgage measured by the CPR shows that
the reduction in yield on the MBS will likely be lower compared to that on a
benchmark security.
B The prepayments on the commercial mortgage measured by the CPR shows that
the reduction in yield on the MBS will likely be higher compared to that on a
benchmark security.
C The estimated DSCR of the commercial mortgage implies that the mortgage
borrower’s ability to repay the mortgage loan is stronger than that of a comparable
benchmark obligor.
D The estimated DSCR of the commercial mortgage implies that the mortgage
borrower’s ability to repay the mortgage loan is weaker than that of a comparable
benchmark obligor.

31
45. Question A manager from the structured credit risk desk at a bank is presenting to a group of
newly hired risk analysts on calculating cash flows in a securitization structure. The
manager illustrates the procedure with the existing collateral pool of loans and the
corresponding liabilities, all with a maturity of 5 years, using the following
information:

Initial number of loans in the collateral pool 100

Principal amount of each loan EUR 1,000,000
Total coupon interest to be paid annually on all junior
EUR 6,300,000
and senior bonds
Maximum annual amount flowing from the excess
EUR 1,500,000
spread into the overcollateralization account
Swap rate per year for all maturities 3.5%
Recovery rate in the event of a loan default 45%

The manager makes additional observations as follows:

• The loans in the collateral pool pay a fixed spread of 2.2% over the swap
curve.
• There were no defaults in year 1.
• The value of the overcollateralization account at the end of year 1 was
EUR 0.

What is the value of the overcollateralization account at the end of year 2 if there
are 8 defaults in year 2?

A EUR 600,000
B EUR 1,056,000
C EUR 2,544,000
D EUR 3,600,000

32
46. Question A quantitative analyst on the fixed-income desk of an investment bank is applying
the Vasicek model to estimate future short-term interest rates. The model is given
below:

dr = k * (ϴ - r) * dt + σ * dw

where dr is the change in the short-term interest rate, ϴ is the estimated long-run
value of the short-term interest rate, k is the mean reversion rate, r is the current
level of the short-term interest rate, σ is the annual basis-point volatility of the short-
term interest rate, dt is the time interval measured in years, and dw is a normally
distributed random variable with mean zero and standard deviation equal to the
square root of dt.

The analyst gathers the following information:

• Current short-term interest rate (r): 3.35%

• Long-run value of short-term interest rate (ϴ): 4.55%
• Mean reversion rate (k): 0.06
• Annual basis-point volatility (σ): 120 bps

The analyst then creates an interest rate tree, determines the expected short-term
interest rate after 8 years, and calculates how long it will take the short-term interest
rate to revert halfway to the long-run value. Which of the following statements would
be correct for the analyst to make?

A The expected short-term interest rate is 3.81% and the half-life is 11.6 years.
B The expected short-term interest rate is 3.81% and the half-life is 16.7 years.
C The expected short-term interest rate is 4.09% and the half-life is 11.6 years.
D The expected short-term interest rate is 4.09% and the half-life is 16.7 years.

33
47. Question A researcher at a national regulatory agency is examining the use of the
standardized ratings-based approach (SA) and the advanced internal ratings-based
(A-IRB) approach in determining credit risk capital. The researcher evaluates the
implications of applying these approaches on two different banks, Global Bank and
Resource Bank. Information about the credit exposures of the two banks is provided
below:

• Global Bank lends to large global corporations that have highly diverse
business lines by providing sizable long-dated unsecured credit facilities.
• Resource Bank lends to oil and gas producers in its region, most of which
have small-scale operations.

Which of the following is the most appropriate conclusion for the researcher to
reach?

A The A-IRB approach does not adjust for maturity, which means that A-IRB could
undercapitalize the long-dated exposures at Global Bank.
B The SA gives lower risk weights to unrated credits than to credits rated B+ or lower,
which may incentivize Resource Bank to lend to unrated companies with poor credit
quality.
C Model parameters used in the SA effectively capture the high default correlation that
is likely to exist between Resource Bank’s lending counterparties.
D The A-IRB approach would require Global Bank to model the exposure at default
while using a probability of default specified by the Basel committee.

34
48. Question A senior risk manager at Bank Gamma is presenting to a group of newly hired junior
risk analysts on calculating bilateral CVA (BCVA). To illustrate the calculations, the
manager assumes that Bank Gamma and Bank Phi are the only counterparties to
each other and provides the following information about Bank Gamma:

• The discounted expected positive exposure to Bank Phi is CNY 60 million

• The discounted expected negative exposure to Bank Phi is CNY 45 million

Additional information on the two banks is shown below:

Parameter Bank Gamma Bank Phi

Annual probability of default 2.5% 1.8%
Recovery rate 82% 92%

What is the BCVA from Bank Gamma’s perspective?

A CNY 84,240
B CNY 114,615
C CNY 198,855
D CNY 201,960

49. Question An analyst at a bank is asked to evaluate the efficacy of the VaR model that the
bank used over the last year. While evaluating the model, the analyst finds that the
bank experienced more VaR exceptions than were forecast by the bank’s VaR
model and examines both the reason this occurred and its potential impact on the
bank. Which of the following is correct regarding the analyst’s examination of the
situation?

A The confidence level of the backtest performed on the VaR model was set too low.
B The model is most likely overestimating the market risk faced by the bank.
C The risk-taking units of the bank will likely be allocated less capital than they should
be.
D The bank’s regulator will impose a financial penalty on the bank.

35
50. Question A risk analyst at a credit ratings agency is evaluating the economic capital for credit
risk of two competing regional banks, Bank ABC and Bank XYZ. The two banks
have the same credit asset exposure, duration of credit exposure, credit rating, and
expected loss. Assuming the average pairwise default correlation between credit
assets of Bank ABC is lower than that of Bank XYZ, and the two banks assess their
risk appetite at the same predetermined confidence level, which of the following
statements would be correct?

A If the confidence level for both banks is increased, the level of economic capital
needed for Bank ABC and for Bank XYZ will both increase.
B If the confidence level for both banks is decreased, the level of economic capital
needed will increase for Bank ABC but will decrease for Bank XYZ.
C If the confidence level for both banks is increased, the level of economic capital
needed will decrease for Bank ABC but will increase for Bank XYZ.
D If the confidence level for both banks is kept unchanged, the level of economic
capital needed for Bank ABC and for Bank XYZ will be equal.

36
51. Question An individual investor wants to invest USD 8 million in exchange-traded funds
(ETFs) or private equity funds (PEFs). The investor obtains the previous year’s
returns for several ETFs and calculates summary statistics such as volatility and
correlation based on these returns. The investor also reviews a database of
reported returns and volatilities for several PEFs and then selects two potential
investments in each asset class. Using the data from the sources described above,
the investor generates the following information for the four potential investments:

Annual
1-year
Asset volatility of
return
returns
Broad equity market index ETF (ETF1) 6.5% 11.4%
Growth stock ETF (ETF2) 8.3% 13.6%
Private equity fund 1 (PEF1) 7.4% 12.3%
Private equity fund 2 (PEF2) 10.2% 11.1%

Correlation of returns between ETF1 and ETF2 0.67

Correlation of returns between ETF1 and PEF1 0.25
Correlation of returns between PEF1 and PEF2 0.41

The manager evaluates this information while also considering the potential biases
and uncertainties in the reported data. Which of the following conclusions is most
appropriate for the investor to make?

A The correlation of returns between PEF1 and ETF1 is more accurate than the
correlation of returns between ETF1 and ETF2.
B The entire USD 8 million should be allocated to PEF2 because it is clearly the
superior investment from a return to risk perspective.
C The number of assets in PEFs are typically higher than the number of assets in
ETFs, which makes PEFs much less risky than ETFs over longer time horizons.
D Summary statistics computed using reported returns of PEFs can be biased
downward, which compromises the reliability of these risk measures.

37
52. Question The CRO of a regional mortgage lender has asked an enterprise risk manager to
develop a set of policies and procedures for the firm’s operational risk reporting. The
manager considers appropriate policies for the governance of the firm’s risk
reporting framework and also assesses how the firm should structure its risk reports
for different stakeholder groups and organizational functions. Which of the following
would be most appropriate for the manager to recommend?

A The firm should report a more detailed and extensive set of key risk indicators to the
board of directors than it does to business line managers to support the board’s
strategic risk review.
B The operational risk committee should be responsible for executing all necessary
changes to the firm’s risk exposures after risk reports are reviewed.
C The central operational risk function should be responsible for aggregating
information from each of the business units about operational risk exposures.
D The firm should emphasize forward-looking risk indicators and avoid the use of
backward-looking indicators in its risk reporting.

53. Question A risk analyst at a bank is estimating the VaR of an equally weighted, two-asset
portfolio as an exercise to demonstrate the impact of correlation on VaR. The
volatility of the daily returns of each asset in the portfolio is 2%, the value of the
portfolio is USD 20 million, and the 10-day 99% VaR of the portfolio is USD 2.33
million. If the correlation between the two assets doubles, which of the following is
closest to the new estimate of the 10-day 99% portfolio VaR?

A USD 1.16 million

B USD 2.55 million
C USD 4.66 million
D USD 5.43 million

38
54. Question A risk consultant is presenting on the evolution of macro-prudential stress testing
requirements established in response to the global financial crisis of 2007 – 2009.
The consultant compares features of the following three stress tests:

• The 2009 Supervisory Capital Assessment Program (SCAP) test

• The 2011 European Banking Association (EBA) test
• The 2012 Comprehensive Capital Analysis and Review (CCAR) test

Which of the following elements of these stress tests or their resulting impacts is
correct for the analyst to include in the presentation?

A Several Spanish banks failed the EBA stress test, and Spain imposed stricter
countrywide stress tests the following year that resulted in some banks raising
capital.
B The SCAP stress test scenario was less severe compared to later US stress tests
and did not result in any increased capital requirements for participating banks.
C The CCAR test required banks to evaluate both a base case and a stress scenario,
while the EBA test only included a stress scenario.
D The SCAP test only disclosed overall loss rates for retail and commercial
exposures, while the EBA test expanded disclosure to individual geographical
regions and asset classes.

55. Question A group of risk managers in a newly established asset management firm is assigned
to implement the risk management process that includes three fundamental
dimensions: risk planning, risk budgeting and risk monitoring. The managers start
by discussing the components of and the guidelines included in the risk plan. Which
of the following statements is correct?

A Qualitative scenario analyses can be incorporated into a risk plan to identify factors
that can cause aspects of the risk plan to fail.
B A risk plan can set volatility goals but cannot incorporate the effects of the
organization’s key dependencies on these goals.
C Extreme events should not be included in an organization’s risk plan but they should
be included in its strategic plan.
D A risk plan should include an estimate of return on equity found by using the return
on risk capital for each allocation taken independently.

39
56. Question An analyst working at a financial regulatory agency is studying the rationale for
including scenarios describing both normal and stressed market conditions while
performing credit evaluations for banks. The analyst compares two events, bank
failure and bank insolvency, and focuses on the implications of both their respective
credit analysis and the difference in impact between them. Which of the following
statements is correct?

A Both bank insolvency and bank failure are major concerns for the bank’s
counterparties even if the bank still has a source of liquidity under insolvency.
B For retail depositors, the expected loss on their deposits is the same whether the
bank fails or becomes insolvent.
C The rate of corporate failure during normal market conditions is the same for banks
and for nonfinancial corporations.
D As lender of last resort, a central bank provides capital to a bank in financial distress
for the same reason whether the bank is considered “too big to fail” or “too small to
fail.”

57. Question A quantitative risk analyst at a bank has been asked to incorporate market liquidity
into the bank’s VaR model. The analyst examines how changes in the level of
market liquidity impact the liquidity horizon and the bank’s credit risk exposure.
Which of the following statements describes the most likely impact of changes in
market liquidity?

A If market liquidity decreases, the liquidity horizon will shorten, and the credit risk
exposure will increase.
B If market liquidity decreases, the liquidity horizon will lengthen, and the credit risk
exposure will increase.
C If market liquidity increases, the liquidity horizon will shorten, and the credit risk
exposure will increase.
D If market liquidity increases, the liquidity horizon will lengthen, and the credit risk
exposure will decrease.

40
58. Question A senior risk analyst at VLT Bank (VLTB), a Singapore-based bank, is analyzing the
risks arising from a significant appreciation of the SGD against all other major world
currencies. VLTB has the following balance sheet structure:

▪ Assets:
• Germany government bonds denominated in EUR
• Singapore government bonds denominated in SGD
• Corporate bonds denominated in EUR
• Commercial loans denominated in SGD

▪ Liabilities:
• Long-term senior bonds denominated in EUR
• Long-term senior bonds denominated in SGD
• Retail deposits denominated in SGD
• Corporate term deposits denominated in SGD

The analyst considers other recent market developments, including a decline in

global equity prices, which resulted in many of VLTB’s larger retail depositors
experiencing margin calls and drawing down deposits to meet them. The analyst
notes that the bank took advantage of the demand for fixed-income securities and
issued additional long-term senior SGD bonds and the proceed was used to
purchase additional Germany government bonds. The overall impact of these
transactions on VLTB is that the bank’s net cash outflows during the month, its
overall net liabilities flow, and the required amount of stable funding, remain
unchanged. The following additional information is provided:

• The available stable funding (ASF) factor for retail deposits is 95%.
• The ASF factor for long-term senior SGD bonds is 100%.

The analyst also assesses the bank’s exposure to ConSol Corp, a publicly traded
Singapore manufacturer that is heavily dependent on locally produced raw materials
and generates its revenues primarily in EUR. VLTB is a major holder of ConSol
Corp’s EUR-denominated bonds and has taken a long CDS position on the bonds.
A German bank is the counterparty to that CDS contract.

In analyzing the impact of the reported developments in the currency, equity, and
bond markets on VLTB, which of the following is correct?

A VLTB’s CDS position will increase in value.

B VLTB’s net stable funding ratio will decrease.
C VLTB’s right-way risk with the German bank will increase.
D VLTB’s liquidity coverage ratio will decrease.

41
59. Question A manager at a financial institution is assessing the cash flow requirements of the
institution’s largest customers using the available funds gap (AFG) model. The
manager obtains the following current and projected inflows and outflows of funds:

Deposits received today USD 60 million

Approved new loan requests USD 57 million
Expected drawdown on corporate client's credit lines USD 16 million
Deposit inflows expected within the next week USD 12 million
10-year Treasury securities expected to be purchased this week USD 35 million
Other customer funds available today USD 45 million

Assuming all else is held constant, if the institution’s objective is to maintain an AFG
of zero, what is the maximum amount of unexpected customer withdrawals it can
meet within the next week?

A USD 0 million
B USD 3 million
C USD 9 million
D USD 15 million

42
60. Question A bank is planning to securitize car loans by creating an SPV. The bank would sell
the loans to an SPV through a “true sale” and the SPV would issue securities under
a “revolving securitization structure.” The project manager for this task is reviewing
characteristics of securitization transactions in general as well as specific features
that are commonly incorporated into revolving structures. Which of the following
statements is correct?

A The credit quality of the securitized car loan assets would be enhanced if the
principal value of securities issued is higher than the principal value of the assets.
B The SPV can allow the bank to access cheaper funding if the credit quality of the
securitized car loan assets is higher than the credit quality of the bank’s balance
sheet.
C Under a revolving structure, prepayment assumptions are not incorporated, which
typically results in principal amounts paid to investors through a series of coupons
over the lifetime of the security.
D Under a revolving structure, the bank transfers the car loan assets to the SPV and
the SPV can issue multiple securitizations, which are priced and traded based on
weighted-average life of the structure.

61. Question A risk analyst at an investment bank is examining how quantile estimators can be
incorporated into the bank’s risk measures. The analyst focuses on how estimators
are constructed and how their precision and usefulness are determined. Which of
the following statements about quantile estimators is correct?

A Each quantile in the loss distribution must have an equal weight when used to
create a coherent risk measure.
B The data and processes involved in estimating quantiles are different from those
used to estimate coherent risk measures.
C QQ plots are a useful tool to evaluate the precision of a quantile estimator.
D Both the halving error and the standard error of a quantile estimator decrease as the
number of quantiles used in the estimation process increases.

43
62. Question The head of the fixed-income department of a bank asks a risk analyst to review an
outstanding bond issued by Company GRN, a livestock producer. The bond
currently trades at a spread of 250 bps over the risk-free interest rate and has a
recovery rate of 75%. Senior management of the bank has expressed concern
about the slowdown in business activities in the livestock industry, which is
expected to last for the next 3 years. The analyst applies the constant hazard rate
process in estimating default probability and assumes that, under a stressed market
scenario, the bond would trade at a spread of 480 bps over the risk-free interest rate
curve, and its recovery rate would decrease to 40%. Assuming the stress scenario
prevails, what would be the correct estimate of the probability that Company GRN
would not default on its bond over the next 3 years?

A 69.8%
B 78.7%
C 86.6%
D 74.1%

63. Question A portfolio manager is constructing an equity portfolio that will include several
equities from multiple industries. The manager aims to achieve mean/variance
optimization and asks a group of analysts to perform alpha analysis and also to
estimate other portfolio inputs. As part of the alpha analysis, the analysts adjust
alphas based on the portfolio’s constraints and exclude very large positive and
negative alphas from their calculations. Additionally, the analysts plan to remove
biases or undesirable bets from the alphas. Which of the following procedures
should the analysts apply to execute this plan?

A Stratification
B Neutralization
C Scaling
D Trimming

44
64. Question The CRO at a bank wants to strengthen the bank’s capability to defend itself against
emerging cyber-threats. To help achieve this goal, the CRO is assessing the current
range of practices regarding the sharing of cybersecurity information between
different types of institutions, as well as the potential benefits from sharing
information. Which of the following statements would be most appropriate for the
CRO to make?

A The sharing of cybersecurity information among banks is less frequently observed

and generally considered to be less effective than other cyber-security information-
sharing practices.
B The scope and depth of information-sharing practices among banks may
significantly vary between financial markets, depending on the level of trust among
participating banks.
C Information-sharing among different national regulators has evolved significantly
over the past several years and is now a widespread practice at a large majority of
jurisdictions.
D Existing peer-sharing mechanisms among banks focus on the exchange of
information related to cyber-security incidents, but such information is generally not
shared from banks to regulators.

65. Question The board of directors at a large bank wants to improve the bank’s practices for
managing money laundering and financial terrorism (ML/FT) risk. The risk
committee of the bank meets to discuss ways to achieve this objective that conform
to best practices. Which of the following actions would be most appropriate for the
bank to recommend?

A Require the bank’s business units to screen potential employees as part of the first
line of defense in managing ML/FT risk.
B Establish a threshold transaction value and review all transactions above this
threshold for evidence of ML/FT.
C Exclude politically exposed persons (PEPs) from screening for ML/FT risk due to
their much lower ML/FT risk.
D Give the compliance and legal functions the primary responsibility for managing
ML/FT risk.

45
66. Question A risk analyst at an investment bank is evaluating the bank’s application of extreme
value theory (EVT) in managing financial risks. The analyst compares different
methods of estimating extreme value (EV) parameters for the bank’s operational
loss distribution and examines the mechanics of each method, as well as their
advantages and disadvantages. Which of the following statements regarding a
method used for estimating EV parameters is correct?

A The regression method uses an ordered sample of losses to obtain least squares
estimates of the EV parameters.
B The maximum-likelihood method uses the average of a random number of the most
extreme observations to estimate EV parameters.
C The main challenge associated with the moment-based method is choosing the
number of observations that minimizes the mean-squared-error loss function.
D A drawback of the semi-parametric estimation method is that the Hill estimator is
neither consistent nor asymptotically normal.

67. Question A treasurer at a regional bank is assessing the bank’s liquidity position. The
treasurer estimates that the following cash inflows and outflows will occur in the next
week:

Amount
Cash Flows (USD million)
Deposit withdrawals 50
Deposit inflows 80
Scheduled loan repayments 120
Acceptable loan requests 100
Borrowings from money market 80
Operating expenses 70
Stockholder dividend payments 40
Repayment of bank borrowings 60

Which of the following is the correct amount (in millions of USD), at the week’s end,
for the bank’s net liquidity position?

A USD -200
B USD -80
C USD -40
D USD 80

46
68. Question A newly established pension fund hires a risk consultant to help develop its risk
management framework and tools. During an initial meeting with the fund
managers, the consultant discusses the fundamental dimensions of the risk
management process and describes risk planning, risk budgeting, and risk
monitoring, as well as how each of these three dimensions should be structured.
Which of the following statements about the risk plan or the risk budget is correct?

A The risk budget should define acceptable levels of return on risk capital (RORC) for
each risk capital allocation.
B The risk budget should identify the firm’s critical dependencies regarding funding
and investment performance.
C The risk plan should state exactly how risk capital should be allocated among asset
classes.
D The risk plan should set volatility goals such as VaR or tracking error for relevant
time periods.

69. Question An analyst at a financial institution has been asked to assess the quality of
estimating credit VaR (CVaR) of a homogenous portfolio of firms (credits) using the
single-factor model, under which default correlation varies with the firm’s beta to the
market factor. The analyst examines the portfolio under the following assumptions:

• There are 1,000 firms (credits) in the portfolio.

• Each firm represents 0.1% of the portfolio.
• There is no idiosyncratic risk.
• Loss given default is the same for each firm in the portfolio.

Based on the information provided, which of the following observations, if made by

the analyst, would be correct regarding the application of the single-factor model
and its parameters?

A When the firm’s beta to the market factor is equal to 1, the loss rate of the credits is
either 0% or 100%.
B The distance to default of a firm will typically be low if the correlation to the market
factor is low, for a given probability of default.
C When the asset return correlation to the market factor is equal to zero, the loss rate
is typically higher than the probability of default of a firm in the portfolio.
D The asset return correlation to the market factor is measured by the square root of
beta.

47
70. Question A model validation team at a bank is backtesting the bank’s VaR model. In
preparation for the backtest, one of the team members expresses a concern that the
validation process could result in the team committing a Type I error or a Type II
error and discusses the characteristics of these errors with the team. Which of the
following is correct regarding Type I and Type II errors?

A The probability of committing a Type II error decreases when the sample size
increases and the level of significance is held constant.
B A backtest is considered statistically powerful if it minimizes the probability of
committing a Type II error regardless of the probability of committing a Type I error.
C A Type I error is committed when an incorrectly specified model is accepted.
D A Type II error is committed when a correctly specified model is rejected.

71. Question A risk manager at a bank is conducting an internal training program for newly hired
credit risk analysts. The manager gives an overview of credit risk models, compares
the bank’s internal credit rating models to the rating agencies’ models, and explains
the assumptions, structure, and performance measures of these models as applied
to counterparty default prediction. Assuming a stable market environment, which of
the following statements would the manager be correct to make?

A The Credit Risk Plus (CreditRisk+) model relies on the use of a company’s capital
structure and credit ratings to predict default of the company.
B Unlike the Merton model that produces default predictions based on asset and
liability values, the agencies’ rating models produce default predictions from a
substantially larger set of business factors.
C Unlike the agencies’ rating models, the KMV model is only used to compute the risk
of pure debt contracts and is not applicable to portfolios that include derivatives
contracts.
D A good rating model is expected to provide accurate borrower default predictions
without the need to be backtested.

48
72. Question The beneficiary of a trust who reaches adulthood and inherits assets that are mostly
liquid meets with an investment advisor to consult on various investment options.
During the meeting, the beneficiary expresses an interest in understanding the
different types of funds, especially hedge funds. Which of the following statements,
if made by the investment advisor, is correct?

A Market timing skills of indexed fund managers are more important than market
timing skills of hedge fund managers.
B Demands of institutional investors regarding the privacy of their investments have
caused hedge funds to become less transparent over time.
C Leveraging of investor capital and shorting securities are practices that are used
more extensively by hedge funds than by most conventional funds.
D Hedge funds must disclose their investment strategies to existing and prospective
clients but exchange-traded funds do not have to.

73. Question Quant Banking Corporation (QBCo) is a large financial institution based in Brazil.
QBCo’s core liquid assets include Brazil government bonds, cash, and foreign
sovereign bonds. In addition to receiving deposits, QBCo raises funds by issuing
secured short-term debt and unsecured long-term debt. The CRO of the bank is
analyzing the investment committee’s proposal to sell QBCo’s holdings of UK
government bonds and allocate the proceeds to extend new loans denominated in
BRL to corporations headquartered in Brazil. The new loans would be held to
maturity and fully collateralized by high quality foreign sovereign securities. The
CRO estimates that UK government bonds currently account for approximately 15%
of QBCo’s total assets. The estimated mark-to-market values and average value-
weighted durations of the bank’s assets and liabilities before implementation of the
proposal are given below:

Average value-
Market value weighted duration
Total assets BRL 60 billion 6 years
Total liabilities BRL 50 billion 6 years

Assuming no change to the average value-weighted duration of assets, no other

changes to QBCo's asset and liability structure, and all foreign exchange exposures
are fully hedged, which of the following will be correct if the bank implements the
new proposal?

A The credit quality of QBCo’s assets will not necessarily decrease from issuing new
loans to corporations headquartered in Brazil.
B QBCo should manage its leverage-adjusted duration gap by taking long positions in
government bond futures to address the risk of rising interest rates.
C The trading book VaR of QBCo will show significant increase.
D The liquidity coverage ratio of QBCo will show significant increase.

49
74. Question An analyst on the emerging markets fixed-income desk of an investment bank has
been asked to construct a term structure model of interest rates for one of the
countries the desk covers. After conducting initial research, the analyst assumes
that the 1-year spot rate for each of the next 3 years is expected to be 17.00% and
that the interest rate process can be represented by the following risk-neutral
interest rate tree:

Which of the following correctly describes the shape of the term structure that will
result from the given interest rate tree?

A Slightly downward sloping, since discounting the terminal cash flow over longer time
periods when interest rates exhibit volatility results in slightly lower spot rates.
B Flat, since the interest rate tree is based on the assumption that all expected 1-year
spot rates are equal.
C Slightly upward sloping, since there is an opportunity cost associated with long-term
interest rates.
D Steeply upward sloping, since investors will demand higher long-term interest rates
as compensation for interest rate volatility.

50
75. Question The CRO of Bank Alpha is reviewing a report from the US Federal Reserve on the
recent supervisory stress test performed on Bank Alpha. The report notes that while
Bank Alpha continues to build its capital levels and strengthen its ability to lend
during periods of stressed market conditions, the bank’s recent acquisition of a large
regional competitor and its growing exposure to digital assets make it vulnerable
under “severely adverse” scenarios. After discussing the stress test report, Bank
Alpha’s board of directors asks the CRO to critically review the bank’s risk
management practices. A summary of the CRO’s findings is given below:

• Item 1: Bank Alpha applies a counterparty’s marginal default probability and

the correlation of its own credit spread with the counterparty’s credit spread
as key inputs in stress testing counterparty credit risk.

• Item 2: Bank Alpha incorporates scenario analysis in its capital planning

process but only considers scenarios that lead to the quantification of risk.

• Item 3: Bank Alpha considers that contingency funding planning stress

scenarios are independent of its liquidity stress scenarios.

• Item 4: Bank Alpha complies with the regulatory requirement in sharing

information about cyber-security threats with peer banks to enable
regulators effectively monitor and mitigate systemic risk.

Which of the findings reported by the CRO in relation to Bank Alpha’s stress testing
and scenario analysis is aligned with best practices?

A Item 1
B Item 2
C Item 3
D Item 4

76. Question A credit analyst at an investment firm is estimating the 99% credit VaR of a 1-year
zero-coupon bond, the only debt issued by the firm. The analyst obtains relevant
data presented below:

• Face value of the firm’s 1-year zero-coupon bond: CNY 630 million
• The bond’s expected 1-year probability of default (PD): 6%
• The bond’s 1-year recovery rate: 90%

Assuming the variation of the future value of the bond is solely due to the possibility
of default, and the analyst’s estimate of the value of the bond in 1 year at the 99%
confidence level is CNY 567 million, what is the bond’s implied 1-year 99% credit
VaR?

A CNY 2.52 million

B CNY 3.40 million
C CNY 3.78 million
D CNY 6.30 million

51
77. Question A risk analyst at a bank is asked to prepare a report that tracks the relationship
between volatility and asset performance. The analyst assesses the performance of
various asset classes using empirical evidence over the last three decades and
compares returns on those asset classes with changes in market volatility. Which of
the following would be a correct statement for the analyst to include in the report?

A Currency strategies such as currency carry trades tend to perform poorly during
periods of high volatility.
B When volatility is rising, all assets are either positively or negatively affected, with
the exception of risk-free bonds.
C Whether the relationship between stock returns and volatility is positive or negative
depends on the phase of the business cycle.
D When volatility is rising, stock returns tend to increase but bond returns tend to
decrease.

78. Question A junior risk analyst at an investment bank is using a rating migration matrix to
calculate the default probability of a corporate bond issuer. The 1-year credit
migration matrix is presented below:

Rating in the next period

Current rating A B C Default
A 90% 8% 0% 2%
B 5% 76% 10% 9%
C 1% 14% 69% 16%

Which of the following statements is correct?

A A corporate bond that is currently rated A, and maintains the same rating up to the
end of year 1, has a 1.8% chance of default in year 2.
B A corporate bond that is currently rated B, and maintains the same rating up to the
end of year 1, has an 8.1% chance of default in year 2.
C A corporate bond that is currently rated B will default over a 2-year period with a
probability of 15.9%.
D A corporate bond that is currently rated C will default over a 2-year period with a
probability of 27.0%.

52
79. Question An analyst at a fixed-income investment company is evaluating different ways the
company uses to estimate the VaR of its corporate bond portfolios. The portfolios
consist of a large number of bonds with a wide range of maturities. The analyst
examines the possibility of using a mapping approach to simplify the estimation
process. Which of the following statements would the analyst be correct to make
regarding the approaches to mapping fixed-income portfolios?

A The VaR estimated using the principal mapping approach understates the true risk
of a portfolio since it ignores coupon payments and any risk associated with them.
B The VaR estimated using the duration mapping approach replaces the portfolio with
a zero-coupon bond whose maturity equals the duration of the portfolio.
C The VaR estimated using the principal mapping approach differs from the
undiversified VaR estimated using the duration mapping approach due to an
adjustment made for correlations.
D The VaR estimated using the cash-flow mapping approach is less accurate than the
VaR estimated using the duration mapping approach since it does not account for
the timing of cash flows.

80. Question A packaging materials manufacturer is considering a project that has an estimated
RAROC of 12%. Suppose that the risk-free rate is 4% per year, the expected
market rate of return is 10% per year, and the company's equity beta is 1.6. The
manufacturer uses the adjusted RAROC metric as the criterion to decide whether or
not to accept the project. Which of the following correctly describes the decision the
company should make and the rationale for making that decision?

A Reject the project because the adjusted RAROC is higher than the market expected
excess return.
B Accept the project because the adjusted RAROC is higher than the market
expected excess return.
C Reject the project because the adjusted RAROC is lower than the risk-free rate.
D Accept the project because the adjusted RAROC is lower than the risk-free rate.

53
 2024 FRM Part II Practice Exam #2 – Answer Key

1. B 21. C 41. D 61. D

2. A 22. B 42. B 62. B

3. C 23. A 43. A 63. B

4. D 24. D 44. B 64. B

5. A 25. C 45. C 65. A

6. C 26. C 46. A 66. A

7. A 27. B 47. B 67. C

8. B 28. B 48. B 68. D

9. B 29. C 49. C 69. A

10. B 30. D 50. A 70. A

11. B 31. A 51. D 71. B

12. B 32. B 52. C 72. C

13. D 33. A 53. B 73. A

14. A 34. B 54. A 74. A

15. C 35. B 55. A 75. A

16. B 36. C 56. A 76. A

17. B 37. A 57. B 77. A

18. B 38. D 58. B 78. A

19. C 39. C 59. D 79. B

20. B 40. B 60. B 80. C

54
1. Question A group of newly hired investment analysts at a large wealth management firm is
undergoing training on the company’s investment practices. Part of the training
focuses on hedge fund investments and addresses how the firm evaluates the risk
management processes and procedures of a hedge fund being considered for
investment. The analysts learn that the firm performs comprehensive due diligence
on the hedge fund’s investment environment, as well as on its operational
environment and business practices. Which of the following is correct about a hedge
fund investor’s due diligence on the operational environment of a hedge fund?

A An investor should assess the qualifications of the fund’s investment team members
but does not need to do the same for other fund personnel.
B An investor should investigate the fund’s compliance practices but does not need to
ensure that the fund has an in-house compliance function.
C An investor should review the fund documents but does not need to verify with the
fund’s law firm whether they are responsible for the content of these documents.
D An investor should ask if the fund uses third-party service providers but does not
need to inquire about the fund’s relationships with these service providers.

Correct B
Answer

Explanation B is correct. Compliance is one of the critical areas of investigation during due
diligence. Most firms today have either their own in-house compliance function or an
outsourced relationship with a compliance service provider.

A is incorrect. An assessment must be made whether the operations, accounting,

treasury, technology, compliance, and other personnel are truly qualified for the
positions they hold and the products the fund is trading.

C is incorrect. An investor needs to verify with the listed law firm in the fund
documents that they were responsible for the original content and for any updates.

D is incorrect. A due diligence process includes validation of a fund’s internal

procedures and its relationships or exposure to important service providers.

Section Risk Management and Investment Management

Learning Explain how due diligence can be performed on a hedge fund’s operational
Objective environment.

Reference Kevin R. Mirabile, Hedge Fund Investing: A Practical Approach to Understanding

Investor Motivation, Manager Profits, and Fund Performance, 2nd Edition (Hoboken,
NJ: Wiley Finance, 2016). Chapter 12. Performing Due Diligence on Specific
Managers and Funds

55
2. Question A risk manager in the stress testing group at a large bank is presenting at a
conference about best practices in stress testing operational risk. The manager
compares different types of stress testing approaches, including macroeconomic
stress testing, parameter stress testing, and reverse stress testing. The manager
then discusses the most suitable applications of each stress testing approach.
Which of the following statements is the most appropriate use of the
macroeconomic stress testing approach?

A Assessing potential changes in dependencies between different measurable and

immeasurable risks faced by the bank
B Stress testing the operational resilience of different important business services
provided by the bank
C Analyzing the impact of a three-standard-deviation increase in interest rates on the
modeled value of the bank’s bond portfolio
D Determining how severe a financial market crisis would need to be in order to result
in the bank’s insolvency

Correct A
Answer

Explanation A is correct. Macroeconomic stress testing is a holistic approach that aims to stress
both measurable and immeasurable risks and the dependencies between them.

B is incorrect. Reverse stress testing is more suitable for stress testing operational
resilience, since the event of an intolerable disruption can be used as the predefined
outcome and scenarios can then be identified that could result in this outcome.
More discussion about operational resilience and its goals is found in Chapters 1
and 4, including the focus on disruptions of important business services.

C is incorrect. This is an example of a parameter stress testing approach, which

uses a statistical change in a parameter (the interest rate) to assess the impact on a
modeled output.

D is incorrect. This describes reverse stress testing, which begins with the outcome
(insolvency) and assesses potential scenarios to result in that outcome.

Section Operational Risk and Resilience

Learning Describe elements of a stress-testing framework for financial institutions and explain
Objective best practices for stress testing.

Reference Global Association of Risk Professionals. Operational Risk and Resilience, New
York, NY: Pearson, 2022. Chapter 7. Integrated Risk Management

56
3. Question A market-maker on the foreign exchange (FX) desk at an investment bank has been
asked to provide a quote for an FX call option that expires in 7 months. The option
has a strike price (K) to spot price (S0) ratio of 1.075. The market-maker references
the following implied volatility surface when creating the quote:

Strike price to spot price ratio (K/S0)

Time to
expiration 0.90 0.95 1.00 1.05 1.10
1 month 9.25 8.55 8.05 8.70 9.45
3 months 9.10 8.70 8.30 8.75 9.15
6 months 9.45 9.05 8.70 9.10 9.45
1 year 9.65 9.50 9.35 9.55 9.75

What implied volatility should the market-maker use to create the quote?

A 9.18%
B 9.28%
C 9.34%
D 9.65%

Correct C
Answer

Explanation C is correct. There are two interpolations to be made to find the correct reference
implied volatility. One is time and the other is the K/S0 ratio.

To get 7-month reference implied volatilities with a K/S0 ratio of 1.075, interpolate
between 6-month and 1-year in the K/S ratios of 1.05 and 1.10.
We need to add one month’s worth of the difference between the 6-month and 1-
year volatilities to the 6-month volatility: 9.10 + 1/6*(9.55-9.10) = 9.175; 9.45 +
1/6*(9.75-9.45) = 9.5. Then average these two numbers since 1.075 is exactly
between 1.05 and 1.1. Thus, (9.175+9.5)/2=9.3375.

A is incorrect. This uses the volatilities at the 1.05 K/S0 ratio and only interpolates
time.

B is incorrect. This uses the volatilities at 6 months and only interpolates K/S0.

D is incorrect. This uses the volatilities at 12 month and only interpolates K/S 0.

Section Market Risk Measurement and Management

Learning Describe volatility term structures and volatility surfaces and how they may be used
Objective to price options.

Reference John C. Hull, Options, Futures, and Other Derivatives, 10th Edition (New York, NY:
Pearson, 2017). Chapter 20. Volatility Smiles

57
4. Question A midsize bank specializing in residential mortgages and credit cards is planning to
offer a new commercial loan product. The bank has an existing credit rating model
for its residential mortgage products which has performed well and has been
successfully backtested over several years, but the CRO considers whether the
bank should develop and implement a new model for the commercial loan product.
In addition, the CRO wants to ensure that the bank follows best practices for the
development, validation, and implementation of any models that it uses. Which of
the following actions should the CRO recommend that the bank take?

A Apply the strongly performing existing model to the new commercial loan product
given the model’s successful track record.
B Develop a new model for the commercial loan product and avoid the use of
qualitative or judgmental adjustments to the model’s quantitative output.
C Make the model development team responsible for validating all of the bank’s
models that are currently operational.
D Perform sensitivity analysis on all models used by the bank to identify market
conditions under which they might perform poorly.

Correct Answer D

Explanation D is correct. Sensitivity analysis and other checks for the robustness and stability of
a model should be repeated periodically. This analysis can help assess the model’s
performance given a wide range of market conditions and identify those conditions
(such as interest rate or financial market environments) in which the model might
not perform as effectively and therefore its use should be constrained under these
conditions.

A is incorrect. Even a fundamentally sound model producing accurate outputs

consistent with the design objective of the model may exhibit high model risk if it is
misapplied or misused. Applying a residential mortgage model to a commercial loan
product would be an example of misapplication.

B is incorrect. Best practices do not preclude the inclusion of qualitative or

judgmental aspects of models. In some cases, banks may take statistical output
from a model and modify it with judgmental or qualitative adjustments as part of
their model development process. While such practices may be appropriate, banks
should ensure that any such adjustments made as part of the development process
are conducted in an appropriate and systematic manner, and are well documented.

C is incorrect. Validation should be performed by parties who are independent of the

model development team to avoid conflicts of interest.

Section Operational Risk and Resilience

Learning Explain best practices for the development and implementation of models.
Objective
Describe elements of an effective model risk management process.

Reference “Supervisory Guidance on Model Risk Management,” Federal Deposit Insurance

Corporation, June 7, 2017

58
5. Question A portfolio manager at a US-based hedge fund has been searching for potential
return opportunities in the environment of declining global interest rates experienced
after the global financial crisis (GFC) of 2007-2009. The manager identifies the
existence of a positive cross-currency basis between two currencies and notes that
this positive basis has persisted since the GFC. What is the most appropriate
explanation for this persistence?

A The costs for arbitrageurs to finance their positions are increasingly reflected in the
basis.
B The costs of credit value adjustments have increased, as arbitrage positions
typically eliminate counterparty risks.
C Regulatory changes have permitted an increase in US banks’ speculative
proprietary trading activities.
D The addition of a liquidity risk cost to swap pricing is no longer required given the
decline in the overall level of interest rates in the global economy.

Correct A
Answer

Explanation A is correct. Post GFC, structural changes in how market participants price market,
credit, counterparty, and liquidity risks have tightened limits to arbitrage and
arbitrage now incurs a balance sheet cost which is persistent. The cost for all
arbitrage participants to finance offsetting positions, are now being reflected in the
FX swap basis.

B is incorrect. The pricing of credit value adjustments has now been incorporated
into the price and arbitrage positions do not always eliminate counterparty risks.

C is incorrect. Regulatory changes such as the Volcker rule have required US banks
to limit speculative proprietary trading activities. Additional regulations such as Basel
lll and US leverage ratios require market participants to hold capital in proportion to
their derivatives and other exposures.

D is incorrect. Liquidity risk costs need to be priced into transactions by market

participants. Although overall funding costs may have decreased this does not
mean that a charge is no longer required.

Section Liquidity and Treasury Risk Management

Learning Identify key factors that affect the cross-currency swap basis.
Objective

Reference Claudio Borio, Robert McCauley, Patrick McGuire, Vladyslav Sushko, 2016.
“Covered Interest Parity Lost: Understanding the Cross-Currency Basis,” BIS
Quarterly Review.

59
6. Question A credit risk analyst at a bank is using the Merton’s model to estimate the probability
of default (PD) of a non-dividend-paying company. The company’s debt consists of
only long-term zero-coupon bonds. The analyst gathers the following information:

Parameter Value
Value of the company's assets CAD 400 million
Face value of the company’s debt CAD 300 million
Expected rate of return of the value of company's assets 15%
Instantaneous volatility of the value of company's assets 25%
Annual interest rate 3%
Remaining time to maturity for the company’s debt 1 year

What is the PD of the company and a limitation of using the Merton model to predict
default of the company?

A The company’s PD is 3.03%, and a limitation of the Merton model is that it cannot
be applied to debt holdings maturing in more than 1 year.
B The company’s PD is 4.04, and a limitation of the Merton model is that it only
applies under the assumption that the value of the firm is normally distributed.
C The company’s PD is 5.20%, and a limitation of the Merton model is that it is costly,
especially for smaller firms, to continuously calibrate PD on historical series of
actual defaults.
D The company’s PD is 12.49%, and a limitation of the Merton model is that it is not
capable of continuously calibrating PD due to continually changing movements in
interest rates and market prices.

Correct C
Answer

Explanation C is correct. Using the Merton model, the PD is expressed as follows:

𝜎2
𝑙𝑛(𝐹) − 𝑙𝑛(𝑉) − 𝜇(𝑇 − 𝑡) + ( 2 ) (𝑇 − 𝑡)
𝑃𝐷 = 𝑁 ( ) = −1.626
𝜎√𝑇 − 𝑡

where;

V = CAD 400,000,000; F = CAD 300,000,000;  = 0.25; µ = 0.15; T- t = 1. Thus, the

company’s PD = N(-1.626) = 5.20% (Using Excel: PD = NORMSDIST(-1.626) =
0.051975).

The Merton model has several limitations. It is applicable to liquid, publicly traded
names only, and there is continuous need for calibration of the PD on historical
series of actual defaults as an analytical requirement, a maintenance requirement,
which is costly for smaller organizations. The Merton model also relies on the
continually changing movements in market prices, volatility, and interest rates.

A is incorrect. 3.03% is the result obtained by subtracting (instead of adding) the last

60
 term in the numerator. The Merton model can be applied to debt holding maturing in
more than 1 year.

B is incorrect. 4.04% is the result obtained by incorrectly adding the risk-free rate to
the asset return in the term in the numerator of the PD formula. Also, the statement
about a limitation of the Merton model that assumes the value of the firm is normally
distributed is incorrect. The Merton model assumes the firm value is lognormally
distributed.

D is incorrect. 12.49% is the result obtained by using the approximation formula to

compute DtD = ((lnV – lnF) / ) and deriving PD = N(-DtD). The Merton model
involves (and is capable of) continuous calibration to account for the continually
changing movements in market prices, volatility and interest rates, which is not a
limitation.

Section Credit Risk Measurement and Management

Learning Using the Merton model, calculate distance to default and default probability.
Objective

Reference John C. Hull, Risk Management and Financial Institutions (Sixth Edition, John Wiley
& Sons, 2023). Chapter 17. Estimating Default Probabilities.

61
7. Question A regulatory capital analyst at a large European bank is studying the liquidity
horizons specified for different risk factors in the Fundamental Review of the
Trading Book (FRTB). The analyst examines how these liquidity horizons are
included in and impact the bank’s calculations of capital requirements. Which of the
following statements is correct?

A Under the standardized approach, the liquidity horizons of risk factors are
incorporated into market risk capital calculations through the risk weights
determined by the Basel Committee.
B When a bank uses the historical simulation approach, the impact of 1-day changes
in risk factors are scaled to the liquidity horizon for the risk factor by multiplying by
the square root of time.
C The standardized approach incorporates the diversification benefits between risk
factors with different liquidity horizons through the risk weights set by the Basel
Committee.
D The historical simulation approach estimates a liquidity-adjusted ES by assuming a
10-day liquidity horizon for all risk factors, since their behavior will most likely be
highly correlated during volatile market conditions.

Correct A
Answer

Explanation A is correct. Liquidity horizons enter the standardized approach of the FRTB in the
risk weights set by the Basel Committee. Delta sensitivities are determined by the
bank.

B is incorrect. Under Basel I and II.5, one-day changes could be scaled to deduce
10-day changes but under FRTB actual past 10-day periods must be used in
historical simulation approach.

C is incorrect. The standardized approach assumes there are no diversification

benefits between risk factors in different risk classes.

D is incorrect. Under the historical simulation approach, the liquidity-adjusted ES

assigns risk factors to one of five liquidity horizons, and using the cascade approach
it is assumed that the behavior of each category of risk factors is independent of the
behavior of the other categories.

Section Market Risk Measurement and Management

Learning Compare the various liquidity horizons proposed by the FRTB for different asset
Objective classes and explain how a bank can calculate its expected shortfall using the
various horizons.

Reference John C. Hull, Risk Management and Financial Institutions 5th Edition (Hoboken, NJ:
John Wiley & Sons, 2018). Chapter 18. Fundamental Review of the Trading Book

62
8. Question An investor is comparing the performances of two portfolio managers who have
been allocated an equal amount of investment funds. The managers apply the same
strategy with the same constraints, and their portfolios are not diversified. The
investor gathers the following data about the two managers and the market index:

Market
Manager 1 Manager 2 index
Average return 32% 28% 22%
Beta with respect to market index 1.2 1.4 1.0
Standard deviation of returns 18% 14% 10%
Tracking error 8% 6% 0%

The risk-free rate of interest is 3%. Which of the following is an appropriate measure
to use and the correct conclusion to reach when comparing the performances of the
two managers?

A The Modigliani-squared measure, which shows that Manager 1 outperforms

Manager 2 by 2%
B The Modigliani-squared measure, which shows that Manager 2 outperforms
Manager 1 by 2%
C Treynor’s measure, which shows that Manager 1 outperforms Manager 2 by 6%
D Treynor’s measure, which shows that Manager 2 outperforms Manager 1 by 6%

Correct B
Answer

Explanation B is correct. When comparing the performances of portfolios that are not fully
diversified, the appropriate measure to use is Sharpe or M2; Sharpe to rank the
performance of the portfolios, M2 to calculate by how much one portfolio
outperforms/underperforms the market or the other portfolio. Treynor ratio is
appropriate to use when we are comparing many portfolios to form an overall
portfolio. Because the number of portfolios combined is high, nonsystematic risk is
largely diversified away and beta (rather than standard deviation) can be used to
measure risk. This is not the case here. The investor in the question is interested in
total risk.

Market
Manager 1 Manager 2 Index
Sharpe 1.61 1.79 1.90
% of P in adjusted P 0.56 0.71 1.00
% of T-bills in adjusted P 0.44 0.29 0.00
Adjusted P return 0.19 0.21 0.22
M2 -0.03 -0.01 0.00
Treynor's measure 0.24 0.18 0.19

A, C, and D are incorrect.

63
Section Risk Management and Investment Management

Learning Describe the uses for the Modigliani-squared and Treynor’s measure in comparing
Objective two portfolios and the graphical representation of these measures.

Reference Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 12th Edition (New York,
NY: McGraw-Hill, 2020). Chapter 24. Portfolio Performance Evaluation

64
9. Question A senior risk consultant is discussing different types of operational risk with a group
of managers at Bank JKY. During the discussion, the consultant describes the
seven Basel event categories for the classification of operational losses and
provides examples of losses in each of the categories. Which of the following
describes an operational loss that Bank JKY should classify in the Execution,
Delivery, and Process Management loss category?

A A client files a lawsuit against Bank JKY for a breach of fiduciary responsibility in the
client’s investment account, and Bank JKY pays a monetary settlement to the client.
B The data capture system of Bank JKY fails to capture correct market prices, causing
OTC derivative trades to occur at incorrect prices and resulting in significant losses.
C A rogue trader makes a series of unauthorized derivative trades, which are
liquidated by Bank JKY for a sizable loss after the trades are discovered.
D A corporate client of Bank JKY suffers a major financial loss from a cyber-attack and
is therefore unable to make payments on its debt to Bank JKY, which triggers a
default.

Correct B
Answer

Explanation B is correct. This loss was caused by an error in transaction capture, which is
classified as an operational loss in the Execution, Delivery and Process
Management category.

A is incorrect. This is an operational risk in the Clients, Products and Business

Practices classification related to disputes over performance of advisory activities.

C is incorrect. This is a loss in the Internal Fraud category.

D is incorrect. This is an example of a credit risk loss for Bank JKY, even though it
resulted from an operational risk event at the counterparty. Also, monetary loss due
to a cyber-attack should be classified by the client in the External Fraud category.

Section Operational Risk and Resilience

Learning Describe the seven Basel II event risk categories and identify examples of
Objective operational risk events in each category.

Describe and apply an operational risk taxonomy and give examples of different
taxonomies of operational risks.

Reference Global Association of Risk Professionals, Operational Risk and Resilience (New
York, NY: Pearson, 2022). Chapter 1 – Introduction to Operational Risk and
Resilience

Global Association of Risk Professionals, Operational Risk and Resilience (New

York, NY: Pearson, 2022). Chapter 3 – Risk Identification

65
10. Question A fast-growing UK-based FinTech firm offers savings accounts, cryptocurrency
accounts, domestic bill payment services, and services that allow customers to
make payments in different currencies. A senior operations manager at the firm is
developing a plan to comply with new UK regulatory requirements for operational
resilience. Which of the following steps should the manager recommend that the
firm take to best comply with the regulatory expectations in this area?

A Develop an impact tolerance for each of the internal processes performed by the
firm.
B Identify important business services and map the dependencies between these
services.
C Calculate the 1-year 99.9% VaR for operational risk for each of the firm’s business
divisions and use this result to reserve additional capital for each division.
D Create an operational resilience team that is led by the IT department, with its other
members coming from the operational risk management, legal, and compliance
functions.

Correct B
Answer

Explanation B is correct. One of the steps in developing an operational resilience framework is to

identify the firm’s important business services, which for this firm would likely include
the bill payment services and the international currency payment services. These
important business services should all be customer-facing services. Once the
important business services are identified, the firm must next map the dependencies
between the services to identify potential vulnerabilities or areas where a disruption
in one important business service can affect others.

A is incorrect. An impact tolerance should be developed for important business

services. There are many internal processes that are not customer-facing (such as
payroll, human resources, and office supplies procurement) so regulators do not
require impact tolerances to be developed for these.

C is incorrect. Regulatory expectations for operational resilience do not include the

provision of additional capital. Also, current Basel regulatory guidelines for
operational risk no longer include an approach that requires the calculation of a
99.9% VaR, this approach (the Advanced Measurement Approach) was phased out.

D is incorrect. Operational resilience should be a multi-disciplinary approach. The

resilience team is usually coordinated by the operational risk management function
and includes representatives from functions such as business continuity
management, human resources, third-party risk management, IT, infrastructure, and
operations. Legal and compliance functions, while important, do not have as much
of the relevant operational or process-related expertise that is important in a
resilience context.

Section Operational Risk and Resilience

Learning Describe and explain the steps to ensure a strong level of operational resilience,
Objective and to test the operational resilience of important business services.

66
 Reference Global Association of Risk Professionals, Operational Risk and Resilience (New
York, NY: Pearson, 2022). Chapter 4 – Risk Measurement and Assessment

11. Question A consultant is reviewing the disclosures hedge funds are required to file with the
US Security and Exchange Commission. The consultant highlights how investors
can use these disclosures to identify and manage fraud risk. Which of the following
statements is correct?

A Disclosures of past regulatory or legal violations are not effective in predicting fraud
because circumstances almost always change.
B There is not enough evidence to conclude that investors of hedge funds are
compensated for fraud risk by receiving higher returns.
C Regulatory and legal prohibitions prevent fraud, and insufficient requirements on
disclosure of violations cause fraud.
D Regulatory and legal violation disclosures benefit only a small fraction of investors
who have access to high-cost contemporaneous data.

Correct B
Answer

Explanation B is correct. There’s no evidence that supports that investors are compensated for
fraud risk through higher returns or lower fees.

A is incorrect. Disclosures regarding past regulatory or legal violations are effective

in predicting fraud.

C is incorrect. Although certain characteristics, such as conflicts of interest, can

predict fraud, we cannot infer that conflicts of interest cause fraud, or that their
prohibition would deter fraud.

D is incorrect. In the past, SEC didn’t provide access to historical data

(contemporaneous data has always been available) but this is not the case
anymore. Up until 2007, the investing public’s ability to develop and use predictive
models based on Form ADV data was potentially limited because the SEC did not
provide access to historical data. As a result, the realized benefits of disclosure
during that time frame may have been lower. The results of the study given in the
reading suggest that improving public access to comprehensive historical
disclosures could increase the benefits these disclosures were meant to provide.

Section Risk Management and Investment Management

Learning Explain the use and efficacy of information disclosures made by investment
Objective advisors in predicting fraud.

Reference Stephen G. Dimmock and William C. Gerken: Predicting Fraud by Investment

Managers (2012)

67
12. Question An analyst on the fixed-income desk at Bank PNMS has been asked to complete
the construction of a zero-coupon bond price tree that was started by another team
member. The analyst is given an interest rate tree of semi-annual spot interest rates
quoted on an annualized basis, and the partially completed price tree, both with
semi-annual time steps, as shown below (time t in years and price P in USD):

When completing the price tree, which of the following is a correct estimate of price
P(1,1)?

A USD 954.15
B USD 954.81
C USD 956.25
D USD 956.92

Correct B
Answer

Explanation B is correct. For a full example see page 160.

The analyst first needs to solve for q using the following system of equations:

Equation 1: (0.72*P1,1 + 0.28*P1,0) / (1 + 0.042/2) = 937.489

Equation 2: (975.13q + 979.43(1-q)) / (1 + 0.0465/2) = P1,1
Equation 3: (979.43q + 983.77(1-q)) / (1 + 0.0375/2) = P1,0

Substituting equations 2 and 3 into equation 1 allows for q to be solved for, yielding
a result of q=0.563.

Then to find P1,1, the value of q can be substituted back into equation 2.
(975.13*0.563 + 979.43*(1-0.563)) / (1 + .0465/2) =
(548.998 + 428.011) / (1.02325) = 954.81
P. 158-160

A is incorrect. The probabilities of up and down moves given in the rate tree are

68
 incorrectly used as values for q and 1-q.
(975.13*0.72 + 979.43*(1-0.72)) / (1 + .0465/2) =
(702.094 + 274.24) / (1.02325) = 954.15

C is incorrect. The probabilities of up and down moves given in the rate tree are
incorrectly used as values for q and 1-q AND the interest rate at the initial node is
incorrectly used as the discount rate.
(975.13*0.72 + 979.43*(1-0.72)) / (1 + .042/2) =
(702.094 + 274.24) / (1.021) = 956.25

D is incorrect. The interest rate at the initial node is incorrectly used as the discount
rate.
(975.13*0.563 + 979.43*(1-0.563)) / (1 + .042/2) =
(548.998 + 428.011) / (1.021) = 956.91

Section Market Risk Measurement and Management

Learning Explain how the principles of arbitrage pricing of derivatives on fixed-income

Objective securities can be extended over multiple periods.

Reference Bruce Tuckman and Angel Serrat, Fixed Income Securities: Tools for Today’s
Markets, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011). Excerpt of Chapter
7. The Science of Term Structure Models

69
13. Question An external auditor is reviewing the modeling processes used by a US-based bank
to model operational losses as part of the bank’s capital planning process. Using
guidelines set by the Federal Reserve with respect to capital planning, which of the
following processes or assumptions would the auditor find most appropriate?

A Assuming a high positive correlation between operational loss severity and equity
index movements during normal market conditions
B Using a net charge-off model to predict shorter-term credit losses and a roll-rate
model to predict losses over a longer time horizon
C Modeling operational losses by projecting an annual loss estimate and then evenly
distributing the losses across the four quarters of the year
D Incorporating forward-looking factors and idiosyncratic risk exposures into stressed
operational loss estimates

Correct D
Answer

Explanation D is correct. Banks with stronger practices will incorporate forward-looking and
idiosyncratic factors into their stress scenarios.

A is incorrect. Operational risks typically have a low correlation with other market
risk variables so assuming a zero correlation is conservative and an acceptable
practice (see p. 276). “Most BHCs were not able to find meaningful correlation
between macroeconomic variables and operational-risk loss severity”. Banks can
provide correlation estimates between OpRisk and market risk variables with a
proper defense, but assuming that op risk and market risk variables are strongly
correlated is a cause for concern.

B is incorrect: This is a weak practice: Fed Capital Planning: ”In general, it is a

weaker practice to combine two different models, as it can introduce unexpected
jumps in estimated losses over the planning horizon”. The paper also detailed some
difficulties with roll rate models, which estimate the rate at which loans that are
current or delinquent in a given quarter roll into delinquent or default status in the
next period. By not using the roll-rate model to model the near-term quarters, this
could lead to poor predictive power farther out.

C is incorrect. This is a weak practice as it ignores potential seasonal patterns.

Rather, a preferred method would be to provide a careful estimate of the expected
quarterly path of losses as well as net revenues and capital projections.

Section Operational Risk and Resilience

Learning Describe practices that can result in a strong and effective capital adequacy process
Objective for a BHC in the following areas: Estimating losses, revenues, and expenses,
including qualitative and qualitative methodologies

Reference “Capital Planning at Large Bank Holding Companies: Supervisory Expectations and
Range of Current Practice,” Board of Governors of the Federal Reserve System,
August 2013

70
14. Question An operational risk manager at a large retail bank is asked to review the framework
for the bank’s risk mitigation controls. As part of this review, the manager classifies
the risk controls as preventive, detective, corrective, or directive. Which of the
following should the manager classify as a directive control?

A An employee training program that explains the policies and procedures for
reviewing new account applications
B A notification to a credit card customer about a potentially fraudulent transaction on
that customer’s account
C An implementation of an antivirus software update across all of the bank’s IT
systems
D A dual-factor authentication protocol that is used to control access to critical
business systems

Correct A
Answer

Explanation A is correct. Internal training programs are examples of directive controls. Directive
controls describe all the policies, procedures, and rules to help execute a process
as well as mitigate the risk of that process.

B is incorrect. This is a detective control.

C is incorrect. This could be either a preventive control, if the update was

implemented in the absence of any cyber risk incident, or a corrective control if it
was performed in response to an incident.

D is incorrect. This is an example of an access control, which is a preventive control.

Section Operational Risk and Resilience

Learning Compare different types of internal controls and provide examples of each type of
Objective internal control.

Reference Global Association of Risk Professionals, Operational Risk and Resilience (New
York, NY: Pearson, 2022). Chapter 5 – Risk Mitigation

71
15. Question An analyst at a commercial bank is evaluating how the bank applies historical
simulation (HS) to estimate VaR and ES. The analyst focuses on the approaches
used for weighting past return observations, including the age-weighted, volatility-
weighted, correlation-weighted, and filtered HS approaches. Which of the following
statements is correct regarding the given weighting approach?

A The age-weighted approach typically specifies that observations that occurred after
the cutoff date are given an equal weight while observations that occurred before
the cutoff date are given a weight of zero.
B The volatility-weighted approach adjusts historical returns in the sample by
increasing them if the historical volatility forecast was higher than the current
volatility forecast, and decreasing them if the historical volatility forecast was lower
than the current volatility forecast.
C The correlation-weighted approach uses matrix multiplication to adjust historical
portfolio returns so that these returns reflect current volatilities and current
correlations.
D The filtered HS approach allows the historical returns data to be trimmed or
customized based on day of the week, magnitude of return, or any other
characteristic of the data.

Correct Answer C

Explanation C is correct. The correlation-weighted approach is similar to the volatility-weighted

approach in that both approaches adjust past returns that occurred under a different
correlation or volatility regime to reflect the current correlation or volatility. In the
correlation-weighted approach this is accomplished through matrix multiplication
since correlations are represented with a matrix.

A is incorrect. This is a description of an equal-weighted approach, not an age-

weighted approach.

B is incorrect. The volatility-weighted approach does adjust historical returns but

does so in a manner that decreases the historical return if the historical volatility
forecast was higher than the current volatility forecast, and increases the historical
return if the historical volatility forecast was lower than the current volatility forecast.
The volatility adjusted returns are given by the following formula: r*t,I = (σT,i / σt,i) rt,I
Where σT,I is the current volatility forecast, σt,I is the historical volatility forecast, rt,I
is the historical return, and r*t,I is the adjusted historical return.

D is incorrect. The filtered HS approach is not a simple filter but is a form of semi-
parametric bootstrap model that adjusts returns within a conditional volatility
framework.

Section Market Risk Measurement and Management

Learning Compare and contrast the age-weighted, the volatility-weighted, the correlation-
Objective weighted, and the filtered historical simulation approaches.

Reference Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, UK: John Wiley &
Sons, 2005). Chapter 4. Non-Parametric Approaches [MR-2]

72
16. Question A portfolio manager is revising an equity portfolio with the goal of attaining the
optimal portfolio on the portfolio’s efficient frontier. The manager believes this goal
can be achieved by replacing a stock in the portfolio with a new stock that is not part
of the existing portfolio and keeping the portfolio value constant. The manager
considers the following alternative actions:

• Action 1: Sell the stock with the highest marginal VaR and purchase an
equivalent value of a new stock that would have the lowest marginal VaR in
the portfolio.
• Action 2: Sell a particular stock and purchase an equivalent value of a new
stock, which would cause the ratio of expected excess returns to portfolio
beta for all stocks in the portfolio to be equal.
• Action 3: Sell a particular stock and purchase an equivalent value of a new
stock, which would cause the portfolio betas of all stocks in the portfolio to
be equal.
• Action 4: Sell a particular stock and purchase an equivalent value of a new
stock, which would significantly decrease the portfolio standard deviation
without changing the average excess portfolio return.

Which of the actions above would create an optimal portfolio?

A Action 1
B Action 2
C Action 3
D Action 4

Correct B
Answer

Explanation B is correct. The optimal portfolio is on the efficient frontier. It is the one that
maximizes the slope of the tangent from the origin. At this point, the ratio of
expected excess returns to portfolio beta (or marginal VaR) for all stocks in the
portfolio is equal.

A is incorrect. This action would only minimize the risk of the portfolio.

C is incorrect. This action would only minimize the risk of the portfolio.

D is incorrect. This action doesn’t necessarily create an optimal portfolio.

Section Risk Management and Investment Management

Learning Explain the risk-minimizing position and the risk and return-optimizing position of a
Objective portfolio.

Reference Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk,
3rd Edition (New York, NY: McGraw-Hill, 2007). Chapter 7. Portfolio Risk: Analytical
Methods

73
17. Question A regional commercial bank is considering a loan with the following parameters that
would be fully funded by deposits:

• Loan amount: CNY 3.8 billion

• Average annual interest rate paid on deposits: 0.6%
• Annual interest rate received on loan: 4.1%
• Expected loss: 3.0% of face value of loan
• Annual operating costs: 0.3% of face value of loan
• Economic capital required to support the loan: 15.0%
• Average pre-tax return on economic capital: 2.0%
• Effective tax rate: 38%
• Other transfer costs: CNY 0

What is the after-tax RAROC for this loan?

A 0.31%
B 2.07%
C 3.33%
D 10.07%

Correct B
Answer

Explanation B is correct. The risk-adjusted after-tax return on capital (RAROC) is computed by:

𝐴𝑓𝑡𝑒𝑟𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑖𝑠𝑘 − 𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

𝑅𝐴𝑅𝑂𝐶 =
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

𝐸𝑅 + 𝑅𝑂𝐸𝐶 − 𝐼𝐶 − 𝑂𝐶 − 𝐸𝐿 − 𝑇𝑎𝑥𝑒𝑠 ± 𝑇𝑟𝑎𝑛𝑠𝑓𝑒𝑟𝑠

=
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

where,

Economic capital = CNY 3,800,000,000 x 0.15 = CNY 570,000,000,

ER = expected revenue = CNY 3,800,000,000 x 0.041 = CNY 155,800,000,

ROEC = pre-tax return on invested economic capital =

= Economic capital x 0.02 = CNY 570,000,000 x 0.02 = CNY 11,400,000,

IC = interest expense = CNY 3,800,000,000 x 0.006 = CNY 22,800,000,

OC = Operating Cost = CNY 3,800,000,000 x 0.003 = CNY 11,400,000,

EL = expected loss = CNY 3,800,000,000 x 0.03 = CNY 114,000,000,

Taxes = (Revenue + Income – Interest – Operating Cost – Loss)*(Tax rate)

= (155,800,000 + 11,400,000 – 22,800,000 – 11,400,000 – 114,000,000)*(0.38)
= (CNY 19,000,000)*(0.38) = CNY 7,220,000.

Therefore, numerator = 155,800,000 + 11,400,000 – 22,800,000 – 11,400,000 –

74
 114,000,000 – 7,220,000 = CNY 11,780,000.

Thus,

11,780,000
𝑅𝐴𝑅𝑂𝐶 = = 0.0207 = 2.07%
570,000,000

A is incorrect. 0.31% is the result obtained when the denominator is incorrectly

taken to be CNY 3.8 billion instead of being 15% of the loan amount.

C is incorrect. 3.33% is the result obtained when taxes are ignored.

D is incorrect. 10.07% is the result obtained when IC is added instead of subtracting

in the numerator.

Section Operational Risk and Resilience

Learning Michel Crouhy, Dan Galai and Robert Mark, The Essentials of Risk Management,
Objective 2nd Edition (New York, NY: McGraw-Hill, 2014). Chapter 17 - Risk Capital
Attribution and Risk-Adjusted Performance Measurement.

Reference Compute and interpret the RAROC for a project, loan, or loan portfolio and use
RAROC to compare business unit performance.

75
18. Question The head of the structured securities desk at an investment bank directs all
derivatives traders on the desk to use trade compressions on all eligible trades to
reduce counterparty risk. One of the analysts decides to use trade compression on
a portfolio of single-name CDS contracts with the same maturity and transacted with
two counterparties, as presented in the table below, to estimate the investment
bank’s compressed notional value:

Reference Notional Bank’s Coupon

Counterparty credit (EUR million) position (bps)
Digital Long
NUMU Inc. 9 180
Corporation protection
Digital WKL Long
6 150
Corporation Company protection
WKL Short
NUMU Inc. 7 150
Company protection

What is the notional value of the investment bank’s net contract on compressed
trades only?

A EUR 1 million
B EUR 2 million
C EUR 8 million
D EUR 15 million

Correct B
Answer

Explanation B is correct. In the trade compression, only contracts on the same reference credit
can be compressed, and so the bank’s long position with Digital Corporation on
WKL Company as reference credit is not considered.

Therefore,

Net contract notional value = Long 9,000,000 + Short 7,000,000 = Long 2,000,000

A is incorrect. Long EUR 1 million is the result of netting the trades with the same
coupon and incorrectly stating it as a net long instead of a net short position.

C is incorrect. Long EUR 8 million is the result of netting all the trades.

D is incorrect. Long EUR 15 million is the result of summing the positions with the
same counterparty.

Section Credit Risk Measurement and Management

Learning Describe the mechanics of termination provisions and trade compressions and
Objective explain their advantages and disadvantages.

76
Reference Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral,
and Capital, 4th Edition (West Sussex, UK: John Wiley & Sons, 2020). Chapter 6.
Netting, Close-out and Related Aspects

77
19. Question An option pricing analyst at an investment bank has been asked to write a report
examining the relationship between option prices and implied volatility curves. The
analyst notes that the implied volatility curves of different underlying assets often
have different shapes and explains the reasons why this occurs. Which of the
following statements can correctly be included in the report?

A The implied volatility smile commonly seen in equity options is due to the higher
probability of a greater than three standard deviation price change than would be
expected if prices are lognormally distributed.
B The implied volatility smile commonly seen in foreign exchange rate options is due
to the higher probability of a price change of between one and two standard
deviations from the mean than would be expected if prices are lognormally
distributed.
C Demand for option protection against steep drops in equity prices leads to higher
prices in out-of-the-money puts relative to out-of-the-money calls, which creates a
downward-sloping implied volatility skew in these options.
D Demand for option protection against the impact of unexpected central bank
announcements on foreign exchange rates leads to higher prices, and higher
implied volatilities, for at-the-money options relative to out-of-the-money options.

Correct C
Answer

Explanation C is correct. Demand for protective puts will increase the price of these puts, which
will increase their implied volatilities, which creates a downward sloping volatility
skew.

A is incorrect. The volatility smile commonly seen in equity options is downward

sloping with higher implied volatility in lower strike prices and lower implied volatility
in higher strike prices. This implies a greater probability of seeing a price in the left
hand tail and a lower probability of seeing a price in the right hand tail than in the
lognormal distribution.

B is incorrect. The volatility smile commonly seen in foreign exchange rate options
implies a greater probability of the future rate being either <1 standard deviation
or >2 standard deviations away from the mean, and a lower probability of the future
rate being between 1 and 2 standard deviations away from the mean.

D is incorrect. Since the central bank announcements are unexpected the volatility
curve will not be shaped with higher implied volatilities at-the-money than out-of-the-
money. Protection will most likely be bought using out-of-the-money options which
will create a volatility smile, rather than a frown.

Section Market Risk Measurement and Management

Learning Describe the volatility smile for equity options and foreign currency options and
Objective provide possible explanations for its shape.

Compare the shape of the volatility smile (or skew) to the shape of the implied
distribution of the underlying asset price and to the pricing of options on the
underlying asset.

78
Reference John C. Hull, Options, Futures, and Other Derivatives, 10th Edition (New York, NY:
Pearson, 2017). Chapter 20. Volatility Smiles

79
20. Question An investment fund uses risk budgeting as part of its risk management process.
Risk is calculated and monitored using delta-normal VaR at the 99% confidence
level. The fund’s total principal of EUR 100 million is invested across four asset
classes comprised of European stocks, non-European stocks, European bonds, and
non-European bonds. The total volatility profile of the fund is maintained at 5%.
Information on the four asset classes is given below:

Average Correlation
Asset classes Weight return Volatility 1 2 3 4
European
1 40% 12.99% 9.25% 1.00 -0.05 -0.07 -0.03
stocks
Non-
2 European 12% 10.82% 11.91% -0.05 1.00 0.02 -0.01
stocks
European
3 22% 5.10% 5.76% -0.07 0.02 1.00 0.02
bonds
Non-
4 European 26% 10.53% 11.94% -0.03 -0.01 0.02 1.00
bonds

What is the sum of the risk budgets that should be allocated to the four asset
classes?

A EUR 11.64 million

B EUR 22.12 million
C EUR 38.86 million
D EUR 100.0 million

Correct B
Answer

Explanation B is correct:

Principal by Risk budget

Volatility of asset class (VaRi)
Weight returns (C = Ax100) (BxCx2.33) Sum of risk
Asset (given) (given) (in EUR (in EUR budgets of
class (A) (B) millions) millions) asset classes
1 40% 9.25% 40 8.62
2 12% 11.91% 12 3.33
3 22% 5.76% 22 2.96
4 26% 11.94% 26 7.21 22.12
11.64 < 22.12
due to
Fund 100% 10.00% 100.00 22.12 diversification

A is incorrect. EUR 11.64 million is the VaR of the fund:

100 x 5% x 2.33 = 11.64

80
 C is incorrect. EUR 38.86 million is found when volatilities are multiplied by EUR
100 million and added together.

D is incorrect. EUR 100 million is the principal amount.

Section Risk Management and Investment Management

Learning Describe the risk budgeting process and calculate risk budgets across asset classes
Objective and active managers.

Reference Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk,
3rd Edition (New York, NY: McGraw-Hill, 2007). Chapter 17. VaR and Risk
Budgeting in Investment Management

81
21. Question A wealth management firm has JPY 86 billion in assets under management. The
portfolio manager computes the daily VaR at various confidence levels as follows:

Confidence Level VaR (JPY)

95.0% 397,463,000
95.5% 401,682,500
96.0% 406,224,500
96.5% 418,453,000
97.0% 428,934,000
97.5% 439,415,500
98.0% 451,993,000
98.5% 468,763,000
99.0% 490,773,000
99.5% 524,663,000

What is the closest estimate of the daily ES at the 97.5% confidence level?

A JPY 398 million

B JPY 400 million
C JPY 484 million
D JPY 497 million

Correct C
Answer

Explanation C is correct. An estimate of the expected shortfall (ES) can be obtained by taking
the average of the VaRs for the various confidence levels that are greater than
97.5%. Therefore,
ES = (451,993,000+468,763,000+490,773,000+524,663,000)/4 = JPY 484,048,000

Section Market Risk Measurement and Management

Learning Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, UK: John Wiley &
Objective Sons, 2005). Chapter 3 - Estimating Market Risk Measures: An Introduction and
Overview

Reference Estimate the expected shortfall given profit and loss (P/L) or return data.

82
22. Question The treasurer of a regional bank is concerned that the bank may not be properly
compensated for the services it provides to its depositors and asks a manager to
assess a price for these services. The manager applies cost-plus pricing for all
depository services and uses the following data for pricing the automated teller
machine (ATM) service:

• Operating expense per ATM visit: USD 0.25

• Estimated overhead cost allocated per ATM visit: USD 0.35
• Profit required per ATM visit: USD 0.05
• The bank’s target return on capital: 15%

What is the correct amount for the bank to charge per ATM visit according to the
cost-plus pricing model?

A USD 0.30
B USD 0.65
C USD 0.70
D USD 0.74

Correct Answer B

Explanation B is correct. Based on a cost-plus pricing formula, the price to be charged per ATM
visit is USD 0.65 = 0.25 + 0.35 + 0.05

A is incorrect. This includes only the operating expense per ATM visit and profit per
ATM visit. It neglects to add in the estimated overhead per ATM visit.

0.25 + 0.05 = 0.30

C is incorrect. This includes an additional return on bank capital fee to the estimated
overhead per ATM visit (0.15 x 0.35), which is already captured through the
required profit per ATM visit.

0.65 + 0.0525 = 0.7025

D is incorrect. This includes an additional return on bank capital fee to the estimated
overhead per ATM visit and to the operating expense fee per ATM visit (0.15 x (0.35
+ 0.25)), which is already captured through the required profit per ATM visit.

0.65 + .09 = 0.74

Section Liquidity and Treasury Risk Management

Learning Compare the different methods used to determine the pricing of deposits and
Objective calculate the price of a deposit account using cost-plus, marginal cost, and
conditional pricing formulas.

Reference Peter Rose, Sylvia Hudgins, Bank Management & Financial Services, 9th Edition
(New York, NY: McGraw-Hill, 2013). Chapter 12. Managing and Pricing Deposit
Services

83
23. Question The treasurer of a US bank is concerned about potential future interest rate
increases by the Federal Reserve (FED) and their impact on the bank’s net worth.
After reviewing the bank’s stress testing framework, the treasurer asks a manager to
consider including an additional scenario in which the FED increases interest rates
by 200 bps and to perform duration analysis on the scenario. The manager gathers
information on the bank’s balance sheet and the duration of each asset and liability
item as provided below:

Amount Duration
(USD million) (years)
Assets
Cash 400 0
Federal funds loans 400 1.0
Government securities and mortgages 600 5.0
Loans and leases 1100 3.0
Total assets 2500
Liabilities
Interest-bearing deposits (marketable) 1000 0.5
Other borrowings 1200 4.0
Total liabilities 2200

Assuming the current level of interest rates is 2%, which of the following is a correct
statement for the manager to make regarding this stress scenario?

A A 200-bps increase in interest rates will cause the bank’s net worth to decrease by
USD 27.4 million.
B A 200-bps increase in interest rates will cause the bank’s net worth to decrease by
USD 52.4 million.
C Compared to the bank’s other balance sheet items, interest-bearing deposits will
experience the smallest change in value given a 200-bps increase in interest rates.
D In this scenario, utilizing USD 200 million of cash to first pay off USD 200 million of
other borrowings in response to a 200-bps increase in interest rates will cause the
value of the bank’s net worth to increase.

Correct A
Answer

Explanation A is correct.
The duration of the bank’s assets and liabilities are as follows:
D Assets: (400 x 0 + 400 x 1 + 600 x 5 + 1100 x 3)/2500 = 2.68
D Liabilities: (1000 x 0.5 + 1200 x 4)/2200 = 2.41
And the effect of a 200 bps increase in interest rates on the bank’s net worth can be
calculated as follows:
-(2.68 x 0.02 x 2500)/1.02 – (-2.41 x 0.02 x 2200)/1.02 = -131.37 + 103.96 = -27.41

B is incorrect.
It omits cash from the asset’s duration calculation.
The duration of the bank’s assets and liabilities are calculated as follows:
D Assets: (400 x 1 + 600 x 5 + 1100 x 3)/2100 = 3.19
D Liabilities: (1000 x 0.5 + 1200 x 4)/2200 = 2.41
And the effect of a 200 bps increase in interest rates on the bank’s net worth is

84
 calculated as follows:
-(3.19 x 0.02 x 2500)/1.02 – ( -2.41 x 0.02 x 2200)/1.02 = -156.37 + 103.96 = -52.41

C is incorrect. Cash will have the lowest percentage change in value as cash has a
duration of zero and is unaffected by changes in interest rates.

D is incorrect. This will decrease the bank’s net worth as indicated below:
The present asset duration of the bank is 2.68 (see calculation for A).
If the scenario in D is applied, the asset duration becomes (400 x 1 + 600 x 5 +
1100 x 3) / (2500 – 200) = 2.913

If the scenario in D is applied, the liability duration becomes (1000 x 0.5 + 1000 x 4)
/ (2200 – 200) = 2.25

And the effect of a 200 bps increase in interest rates on the bank’s net worth can be
calculated as follows:
-(2.913 x 0.02 x 2300) / 1.02 – (-2.25 x 0.02 x 2000) / 1.02 = -131.37 + 88.24 = -
43.14

Section Liquidity and Treasury Risk Management

Learning Describe duration gap management and apply this strategy to protect a bank’s net
Objective worth.

Reference Peter Rose, Sylvia Hudgins, Bank Management & Financial Services, 9th Edition
(New York, NY: McGraw-Hill, 2013). Chapter 7. Risk Management for Changing
Interest Rates: Asset-Liability Management and Duration Techniques

85
24. Question A treasurer at a US-based bank is reviewing the bank’s balance sheet and wants to
evaluate the sensitivity of the bank’s net worth to a potential change in interest
rates. The treasurer asks a manager to apply duration analysis to assess the impact
of a 100-bps change in interest rates on the bank’s net worth. Which of the following
is a correct statement for the manager to make?

A The percentage change in the value of an asset or liability resulting from a 100-bps
change in interest rates is directly proportional to its duration but is unaffected by
the corresponding percentage change in interest rates.
B Using USD 100 million of cash to pay a cash dividend will not affect the overall
asset duration of the bank.
C A prepayable mortgage loan has a higher duration than an identical non-prepayable
loan and is typically more sensitive to overall interest rate changes.
D The sensitivity of assets and liabilities to changes in interest rates is greater when
the coupon is lower, the duration is higher, or the overall level of interest rates is
lower.

Correct D
Answer

Explanation D is correct. Asset and liability values are more sensitive to interest changes for
those instruments with lower coupons, higher durations, and lower interest rates.

A is incorrect. The percentage change in the value of an asset or liability resulting

from a 100 bp change in interest rates is directly proportional to its duration and is
also dependent on the corresponding percentage change in interest rates.

B is incorrect. Utilizing USD 100 million of cash to pay the bank’s cash dividend
payment will affect the overall asset duration of the bank as the overall level of
assets decrease due to the cash dividend payment.

C is incorrect. A prepayable mortgage has a lower duration than an identical non-

prepayable investment and is typically less sensitive to overall interest rate
changes.

Section Liquidity and Treasury Risk Management

Learning Describe duration gap management and apply this strategy to protect a bank’s net
Objective worth.

Reference Peter Rose, Sylvia Hudgins, Bank Management & Financial Services, 9th Edition
(New York, NY: McGraw-Hill, 2013). Chapter 7. Risk Management for Changing
Interest Rates: Asset-Liability Management and Duration Techniques

86
25. Question The chief investment officer (CIO) of a large university endowment fund is
considering adding some illiquid assets to improve the performance of the
university’s investment portfolio. The CIO asks an investment manager to prepare a
report discussing the characteristics of illiquid asset returns. The manager reviews
the dynamics of illiquid assets and the determinants of their returns. Which of the
following is a correct statement for the manager to include in the report?

A Survivorship bias overstates reported returns of illiquid assets by reporting only the
returns of those funds that have achieved a return above a required threshold.
B Reporting bias overstates reported returns of illiquid assets because only the
returns of those funds that continue to remain in business over a given time period
are considered.
C Survivorship bias and reporting bias can theoretically be eliminated by including the
returns of the entire population of funds.
D Infrequent trading, although considered a bias, can still generate sufficient data for
accurate beta and correlation estimates.

Correct C
Answer

Explanation C is correct. Survivorship and reporting biases can be theoretically eliminated by

including the entire population of funds.

A is incorrect. Reporting bias enhances illiquid asset reported returns by reporting

the returns only of those funds which have achieved a sufficiently attractive return.

B is incorrect. Survivorship bias enhances illiquid asset reported returns by reporting

the returns only of those funds that continue to remain in business over a set period.

D is incorrect. Infrequent trading/sampling although considered a bias will provide

estimations for beta, correlation and volatility which are too low.

Section Liquidity and Treasury Risk Management

Learning Assess the impact of biases on reported returns for illiquid assets.
Objective

Reference Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (New
York, NY: Oxford University Press, 2014). Chapter 13. Illiquid Assets

87
26. Question A treasurer of a bank is assessing the different methods of pricing liquidity and is
concerned about the potential impact of applying each method. The treasurer asks
an analyst to review and evaluate the various approaches to liquidity transfer pricing
and to prepare a report with recommendations. Which of the following statements
would be correct for the analyst to include in the report?

A A zero-cost of funds approach tends to result in the bank holding long-term highly
illiquid assets funded by long-term stable liabilities.
B An average cost of funds approach tends to result in the greatest maturity
transformation for a bank’s balance sheet.
C A matched-maturity marginal cost of funds approach converts the bank’s fixed-rate
borrowing cost to a floating-rate borrowing cost.
D Both an average cost of funds approach and a zero-cost of funds approach
appropriately align the maturity of the bank’s lending and borrowing activities when
management compensation is based on net income.

Correct C
Answer

Explanation C is correct. A matched-maturity marginal cost of funds liquidity pricing policy

converts the bank’s fixed rate borrowing cost to floating and equals the spread
above a reference rate.

A is incorrect. A zero-cost liquidity pricing policy will tend to result in the bank
holding long-term highly illiquid assets matched by short-term liabilities.

B is incorrect. A zero-cost of funds liquidity pricing policy will tend to result in the
greatest maturity transformation for a bank’s balance sheet.

D is incorrect. Neither a zero-cost of funds approach nor an average cost of funds

approach will appropriately align the maturity of the bank’s lending and borrowing
activities when renumeration is based on net income. A significant maturity
mismatch between assets and liabilities can be structured by management in order
to increase net income

Section Liquidity and Treasury Risk Management

Learning Compare the various approaches to liquidity transfer pricing (zero cost, average
Objective cost, and matched maturity marginal cost).

Reference Joel Grant, 2011. “Liquidity Transfer Pricing: A Guide to Better Practice,” Occasional
Paper, Financial Stability Board, Bank for International Settlements.

88
27. Question A chief investment officer (CIO) of a large university endowment fund is considering
whether to add illiquid assets to the university’s investment portfolio. Before making
a decision, the CIO asks an investment analyst to review illiquidity risk premiums
across and within asset categories and to prepare a report with findings. Which of
the following statements is correct for the analyst to include in the report?

A Corporate bonds that trade less frequently or have larger bid-ask spreads have
lower returns than more liquid corporate bonds.
B Expected returns of illiquid assets can be overstated due to measurement biases.
C US Treasury instruments are the only assets that do not exhibit illiquidity risk
premium.
D Hedge funds that do not place restrictions on withdrawals exhibit higher returns.

Correct B
Answer

Explanation B is correct. Expected returns of illiquid assets can be overstated due to

measurement biases such as infrequent trading, survivorship, and reporting biases.

A is incorrect. Corporate bonds that trade less frequently or have larger bid–ask
spreads have higher returns.

C is incorrect. US Treasuries do exhibit illiquidity risk premiums between on-the-run

and off-the-run bonds.

D is incorrect. Hedge funds which do place restrictions on investor withdrawals have

shown higher returns.

Section Liquidity and Treasury Risk Management

Learning Compare illiquidity risk premiums across and within asset categories.
Objective

Reference Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (New
York, NY: Oxford University Press, 2014). Chapter 13. Illiquid Assets

89
28. Question A national regulator is developing a set of indicators to serve as warning signs that
the liquidity of the stock market could be decreasing. The regulator is particularly
concerned about the potential for a “liquidity black hole” to develop which could
destabilize the stock market. Which of the following observations would be of
greatest concern to the regulator as a signal of a potential liquidity black hole
occurring?

A A majority of large investors increasingly follow a trend-following trading strategy

B Brokerage firms purchase call options as a hedge against the sale of a large
number of put options to institutional investors.
C Portfolio managers sell stocks that have increased in value and reached their price
target.
D Bid-ask spreads for less liquid stocks become narrower.

Correct B
Answer

Explanation A is correct. This is an example of positive feedback trading, where investors trade
in the direction of the market.

B is incorrect. These two trades would not contribute to creating a black hole since
the delta neutral hedge for a sale of put options is a sale of stock while the
brokerage firm’s additional purchase of call options would require the brokerage
firm’s counterparty to purchase shares for their own delta neutral hedge.

C is incorrect. Selling stocks after they appreciate would not destabilize the market,
and the use of limit orders would not be further destabilizing because they will only
trigger if the limit is reached.

D is incorrect. Narrowing spreads indicate greater liquidity.

Section Liquidity and Treasury Risk Management

Learning Explain liquidity balck holes and identify the causes of positive feedback trading.
Objective

Reference John C. Hull, Risk Management and Financial Institutions, 5th Edition (Hoboken,
NJ: John Wiley & Sons, 2018), Chapter 24. Liquidity Risk

90
29. Question A manager at an asset management firm requests that an analyst calculate the cost
of liquidation of one of the fund’s stock positions. The position consists of 100,000
shares of company ABC and the stock has a current bid price of USD 53.5 and an
offer price of USD 54.5. The mean and standard deviation for the stock’s
proportional bid-offer spread is 0.0185 and 0.0250 respectively. The analyst
calculates the cost of liquidation for this entire stock position under a stressed
market scenario based on a 99% confidence level. What is the correct cost of
liquidation for this stock position?

A USD 49,950
B USD 99,900
C USD 206,955
D USD 413,910

Correct C
Answer

Explanation C is correct.
Liquidation in a stressed market = 0.5 x (54 x 100,000) x (0.0185 + 2.326 x 0.025) =
206,955

A is incorrect.
Liquidation in a normal market = 0.0185 x (54 x 100,000) x 0.5 = 49,950

B is incorrect.
Liquidation in a normal market by making the mistake of not including 0.5 in the
equation = 99,900

D is incorrect.
Liquidation in a stressed market by making the mistake of not including 0.5 in the
equation = 413,910

Section Liquidity and Treasury Risk Management and Measurement

Learning Explain and calculate liquidity trading risk via cost of liquidation and liquidity-
Objective adjusted VaR (LVaR).

Reference John C. Hull, Risk Management and Financial Institutions, 5th Edition (Hoboken,
NJ: John Wiley & Sons, 2018). Chapter 24. Liquidity Risk

91
30. Question An enterprise risk consultant is presenting about the management of risk associated
with third-party vendor relationships at a financial conference. To emphasize the
importance of understanding this risk and to illustrate lessons learned, the
consultant describes several past examples of large losses and data breaches
incurred by different financial institutions due to deficient or fraudulent third-party
vendor practices. One example provided is the large loss incurred by Capital One, a
US-based bank holding company, that resulted from its relationship with a third-
party vendor. Which of the following best describes the circumstances that led to the
loss in this case?

A The vendor provided an inaccurate loan pricing model to Capital One, which
incurred far greater default losses than expected.
B A bill payment system provided by the vendor failed for an extended period of time,
resulting in many Capital One customers canceling their accounts and causing
severe reputational impact.
C The vendor’s sales manager established extremely high incentives for its
representatives to sell Capital One products, resulting in regulatory fines for selling
inappropriate products to consumers.
D A former staff member of the vendor hacked into a database of Capital One’s
personal customer information that was stored on the vendor’s cloud services
platform and stole much of this information.

Correct D
Answer

Explanation D is correct. The Capital One loss was caused by a data breach in which a former
cloud-services vendor employee exploited a weakness in a misconfigured web
application firewall to gain access to the files stored in an Amazon Web Services
(AWS) database. As a result, tens of thousands of customer Social Security
numbers and account numbers were stolen, and Capital One was fined USD 80
million dollars for “failure to establish effective risk assessment processes prior to
migrating significant information technology operations to the public cloud
environment”.

A, B, and C are incorrect. These did not contribute to the loss.

Section Operational Risk and Resilience

Learning Describe the lessons learned from the case study involving a data breach caused
Objective by a third-party vendor employee.

Reference Global Association of Risk Professionals, Operational Risk and Resilience (New
York, NY: Pearson, 2022). Chapter 13. Case Study: Third-party Risk Management
[ORR-13]

92
31. Question A portfolio manager at a pension fund is presenting on investment strategies during
a training for newly-hired portfolio analysts. The manager discusses low volatility
strategies, illustrates historical performance measures of firms that apply these
strategies, and draws attention to the benchmarks used. Which of the following
statements about low volatility strategies would be correct for the manager to make
during the presentation?

A The strategies tend to have significant alphas relative to standard market

capitalization benchmarks.
B The strategies tend to have negative alphas relative to dynamic factors such as
value or momentum.
C The strategies tend to generate high alphas over the risk-free rate but negligible
alphas over any other benchmark.
D The strategies tend to generate low alphas if the benchmark used is adjusted for
risk and high alphas otherwise.

Correct A
Answer

Explanation A is correct. Low-risk strategies appear to have significant alpha relative to standard
market capitalization benchmarks and sophisticated factor benchmarks that control
for risk using dynamic value and momentum factors.

B is incorrect. See explanation for A.

C is incorrect. See explanation for A.

D is incorrect. We can’t say that. Alpha is very much dependent on the benchmark
used as well as whether or not that benchmark is adjusted for risk.

Section Risk Management and Investment Management

Learning Explain the impact of benchmark choice on alpha and describe characteristics of an
Objective effective benchmark to measure alpha.

Reference Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (New
York, NY: Oxford University Press, 2014). Chapter 10. Alpha (and the Low-Risk
Anomaly)

93
32. Question A financial analyst is calculating the weighted average life (WAL) of the loans in an
MBS pool. The initial notional value outstanding of the MBS pool is USD 50 million.
The payment schedule and the assumed pool factor for the MBS are provided in the
table below:

Coupon Principal payment

payment date Dates Actual days Pool factor (USD million)
November
0 66 1.00 --
21, 2023
January
1 181 0.76 12
26, 2024
July
2 184 0.54 11
26,2024
January
3 183 0.38 8
26, 2025
July 25,
4 182 0.26 6
2025
January
5 183 0.18 4
24, 2026
July 25,
6 -- -- 9
2026

Assuming coupon payments are made semi-annually and there are 365 days in a
year, what is the WAL of the MBS pool?

A 1.06 years
B 1.24 years
C 2.12 years
D 2.68 years

Correct B
Answer

Explanation B is correct. WAL is computed by:

𝑛

𝑊𝐴𝐿 = ∑ 𝑡 ∗ (𝑃𝑜𝑜𝑙 𝐹𝑎𝑐𝑡𝑜𝑟)𝑠

𝑠=1
Where:

t = (Actual Days) / 365

s = Coupon payment date
Pool Factor at date s is given.

Therefore, WAL is computed as presented in the table below:

94
 Coupon Actual PF = Pool t = (Actual
payment date days factor days)/365 t*PF
0 66 1.00 0.1808 0.1808
1 181 0.76 0.4959 0.3769
2 184 0.54 0.5041 0.2722
3 183 0.38 0.5014 0.1905
4 182 0.26 0.4986 0.1296
5 183 0.18 0.5014 0.0902
6 -- -- - -
Sum = WAL (in years) 1.2403

A is incorrect. 1.06 years is the result obtained if the pool factor of time 0 is ignored.

C is incorrect. 2.12 years the sum of the pool factor for every payment date after
time 0.

D is incorrect. 2.68 years is the sum of (actual days)/365.

Section Credit Risk Measurement and Management

Learning Define and calculate the delinquency ratio, default ratio, monthly payment rate
Objective (MPR), debt service coverage ratio (DSCR), the weighted average coupon (WAC),
the weighted average maturity (WAM), and the weighted average life (WAL) for
relevant securitized structures.

Reference Moorad Choudhry, Structured Credit Products: Credit Derivatives & Synthetic
Securitisation, 2nd Edition (New York, NY: John Wiley & Sons, 2010). Chapter 12.
An Introduction to Securitisation.

95
33. Question A risk analyst at an investment bank has been asked to evaluate the bank’s risk
measurement process. The bank currently uses VaR as its primary risk measure,
but the analyst believes ES may be a better measure during periods of market
turmoil. When comparing VaR and ES, which of the following statements is correct?

A When estimating ES and VaR at the same confidence level, ES will always be
greater than VaR.
B If a VaR model backtest at a specified confidence level accepts the model, then the
corresponding ES model will also be accepted.
C While VaR ensures that the estimate of portfolio risk is less than or equal to the sum
of the risks of that portfolio’s positions, ES does not.
D While ES is more difficult to estimate than VaR, it is easier to backtest than VaR.

Correct A
Answer

Explanation A is correct. Expected shortfall is always greater than or equal to VaR for a given
confidence level α, since α measures the minimum loss in case the worst α
probability event happens and ES accounts for the severity of expected losses
beyond VaR.

B is incorrect. The VaR backtest acceptance does not guarantee the correctness of
the ES calculation.

C is incorrect. VaR is not subadditive. ES is subadditive.

D is incorrect. Backtesting ES is more complicated because while VaR backtesting

deals with the number of VaR violations, ES backtesting also deals with the
magnitude of such violations.

Section Market Risk Measurement and Management

Learning Compare VaR, expected shortfall and other relevant risk measures.
Objective

Reference "Messages from the Academic Literature on Risk Measurement for the Trading
Book", Basel Committee on Banking Supervision, Working Paper No. 19, January
2011

96
34. Question The CRO of a regional bank wants to ensure that the modeling assumptions used in
the bank’s economic capital models are sound. The CRO asks a member of the
validation team to review the bank’s process of assessing the interest rate risk in its
banking book and to validate the assumptions used in its interest rate models.
Which of the following assumptions would be most appropriate for the bank to
make?

A The bank changes the interest rate it offers to depositors by the full amount of any
change in market interest rates.
B The bank models its retail non-maturity deposits as floating-rate, putable bonds.
C The bank assumes that its residential mortgages exhibit positive convexity as
interest rates decrease.
D The bank models its interest rate risk in the banking book independently from its
credit risk.

Correct B
Answer

Explanation B is correct. There are two embedded options in non-maturity deposits. The first is
the bank’s option to change the interest rate and to determine what interest rate to
charge its depositors. The second is the depositors’ option to put the deposits back
to the institution by withdrawing them. Given these characteristics, non-maturity
deposits can be viewed as floating rate, putable bonds.

A is incorrect. In addition, while banking institutions may change the offered deposit
rates when market interest rates change, they do so with a lagged response, and by
less than the full amount of the change in market rates.

C is incorrect. Mortgages will have negative convexity as their value increases less
than an option-free bond because of the prepayment option.

D is incorrect. Interest rate risk and credit risk can interact, especially in stress
situations, so the bank should incorporate a rule that links credit spread to changes
in macroeconomic variables and interest rates.

Section Operational Risk and Resilience

Learning Within the economic capital implementation framework, describe the challenges that
Objective appear in: Defining and calculating risk measures; Risk aggregation; Validation of
models; Dependency modeling in credit risk; Evaluating counterparty credit risk;
Assessing interest rate risk in the banking book

Reference “Range of practices and issues in economic capital frameworks,” (Basel Committee
on Banking Supervision Publication, March 2009)

97
35. Question The CRO of a large bank has asked a group of risk managers to prepare a plan to
implement the revisions to the Basel III guidelines finalized in December 2017. The
bank expects to qualify as a global systemically important bank (G-SIB) by the time
the revisions are implemented. Which of the following actions is most appropriate
for the bank to take to comply with the revised Basel lll guidelines?

A Introduce an internally created model to determine the bank’s operational risk

capital.
B Assign different credit risk weights for residential mortgages based on each
mortgage’s loan-to-value ratio.
C Apply the advanced internal rating-based approach for certain types of credit
exposures, such as exposures to banks and large corporations.
D Decrease the bank’s target level of its countercyclical buffer and its Basel III Tier 1
leverage ratio.

Correct B
Answer

Explanation B is correct. One of the key changes in the December 2017 Basel reforms was the
introduction of a set of variable risk weights for residential mortgages which varied
base on the risk of the mortgage. This risk is reflected mainly in the loan-to-value
(LTV) ratio with higher LTV mortgages receiving higher risk weights. This replaces
an old flat rate system.

A is incorrect. The Basel reforms replaced the advanced measurement approach for
operational risk, which required the use of internal models, with a standardized
approach to be used by all banks. The new standardized approach does not allow
internal modeling.

C is incorrect. The new reforms eliminated the use of the IRB approach for these
asset classes.

D is incorrect. The 2017 reforms introduced a leverage ratio buffer that requires G-
SIBs to have a higher minimum Tier 1 leverage ratio. Therefore, if anything, the
target Tier 1 leverage ratio should increase. Also, the countercyclical buffer
requirements were not changed as part of this reform.

Section Operational Risk and Resilience

Learning Summarize the December 2017 revisions to the Basel III framework in the following
Objective areas:
- The standardized approach to credit risk
- The internal ratings-based (IRB) approaches for credit risk
- The CVA risk framework
- The operational risk framework
- The leverage ratio framework

Reference “High-level summary of Basel III reforms,” (Basel Committee on Banking

Supervision Publication, December 2017)

98
36. Question An analyst on a fixed-income desk of a large investment company is studying term
structure models that incorporate measures of volatility into the interest rate
process. The analyst focuses on the Cox-Ingersoll-Ross (CIR) model and its
treatment of volatility of the short-term interest rate. Which of the following
statements is correct regarding the yield volatility and basis-point volatility in the CIR
model?

A Periods of extremely low short-term interest rates are accompanied by high basis-
point volatility, which increases the possibility of negative interest rates in the CIR
model.
B In the CIR model, basis-point volatility is specified as a decreasing function of the
mean reversion factor.
C In the CIR model, yield volatility is specified as being constant while basis-point
volatility is allowed to vary.
D Basis-point volatility and yield volatility are used interchangeably to measure the
same volatility in the CIR model.

Correct C
Answer

Explanation C is correct. In the CIR model, basis-point volatility is a function of the yield volatility,
which is assumed to be constant and the square root of the short rate. Therefore, by
assumption yield volatility is constant and basis-point volatility varies.

A is incorrect. CIR states that when short-term interest rates are very low, basis-
point volatility will also be very low, which decreases the possibility of negative
interest rates. This possibility can be removed entirely if a positive drift factor that is
larger than the impact of volatility is included in the model.

B is incorrect. In CIR, basis-point volatility is specified as an increasing function of

the short rate.

D is incorrect. Basis-point volatility and yield volatility are measured in different

units, but they do not measure the same volatility in the CIR model.

Section Market Risk Measurement and Management

Learning Calculate the short-term rate change and describe the basis-point volatility using the
Objective CIR and lognormal models.

Reference Bruce Tuckman and Angel Serrat, Fixed Income Securities: Tools for Today’s
Markets, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011). Chapter 10. The Art
of Term Structure Models: Volatility and Distribution

99
37. Question A credit analyst at a bank is asked to estimate the credit VaR (CVaR) for three loans
in the bank's credit portfolio. The analyst assembles the following loan information:

Maturity Exposure Loss given

Loan (years) (SGD) default S&P rating
S 2 55,000,000 0.8 BBB
T 3 36,000,000 0.9 BB-
U 4 50,000,000 0.7 A

In addition, the annual probability of default (PD) based on loan rating and maturity
is provided in the table below:

Loan maturity (years) 2 3 4

PD (investment grade) 1.5% 2.5% 3.5%
PD (non-investment grade) 5.0% 12.0% 18.0%

Assuming the 95th percentile of the unrecovered credit loss for the three loans are
the same, which of the following is correct about the comparison of the 95% CVaR
of the loans?

A CVaR of Loan S > CVaR of Loan U > CVaR of Loan T

B CVaR of Loan T > CVaR of Loan U > CVaR of Loan S
C CVaR of Loan T > CVaR of Loan S > CVaR of Loan U
D CVaR of Loan U > CVaR of Loan S > CVaR of Loan T

Correct A
Answer

Explanation A is correct. Since the 95th percentile of the unrecovered credit loss of the three
loans are the same and the 95% CVaR is derived as follows:

95% CVaR = 95th percentile of the unrecovered credit loss – Expected Loss

Therefore, we only need to consider the expected loss.

The LGD and EAD are provided directly in the first table. The PD component is
obtained from the information in the second table. The PD for each loan is:

Loan S = Investment grade, 2-year maturity: PD = 1.5%

Loan T = Non-investment grade, 3-year maturity: PD = 12.0%
Loan U = Investment grade, 4-year maturity: PD = 3.5%

The expected loss (EL) calculations are:

Loan S: EL = 0.015 * 0.80 * SGD 55,000,000 = SGD 660,000

Loan T: EL = 0.12 * 0.90 * SGD 36,000,000 = SGD 3,888,000
Loan U: EL = 0.035 * 0.70 * SGD 50,000,000 = SGD 1,225,000

100
 Given that the 95th percentile loss (extreme loss) of the loans are the same, and
since CVaR = 95th percentile loss – EL, we can conclude that:

CVaR of Loan S > CVaR of Loan U > CVaR of Loan T

Section Credit Risk Measurement and Management

Learning Define and calculate expected loss (EL)

Objective Define and calculate Credit VaR

Reference Allan Malz, Financial Risk Management: Models, History, and Institutions,
(Hoboken, NJ: John Wiley & Sons, 2011). Chapter 8. Portfolio Credit Risk

Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions

(New York, NY: John Wiley & Sons, 2002). Chapter 5. Capital Structure in Banks
(pages 170-186 only)

101
38. Question A credit risk manager at a bank is estimating the unexpected loss (UL) of the bank’s
portfolio of loans and the UL contributions of the individual loans to the overall
portfolio UL. The portfolio consists of a large number of loans and the manager
assumes that the loans have approximately the same characteristics and size, with
a constant pairwise default correlation of 0.32. Assuming the UL of each loan is
USD 10,500, what is the approximate UL contribution of each loan to the portfolio
UL?

A USD 0
B USD 1,075
C USD 3,360
D USD 5,940

Correct D
Answer

Explanation D is correct. Using Equation (3.15), for a large number of loans, the unexpected loss
contribution of each loan (ULCi) to the portfolio (ULp) is derived as follows:

ULCi = ULi * sqrt()

where:

ULi = USD 10,500

 = 0.32

Therefore, ULCi = ULi * sqrt() = 10,500*sqrt(0.32) = USD 5,939.70

A is incorrect. ULC of each credit asset is not zero, as explained in D above.

B is incorrect. USD 1,075 is the result obtained if the formula incorrectly includes the
square of the default correlation instead of the square root.

C is incorrect. USD 3,360 ignores the application of the square root of the default
correlation in the formula.

Section Credit Risk Measurement and Management

Learning Calculate UL for a credit asset portfolio and the UL contribution of each asset under
Objective various scenarios of portfolio composition, asset characteristics and size.

Reference Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions
(New York, NY: John Wiley & Sons, 2002). Chapter 5. Capital Structure in Banks
(pages 170-186 only)

102
39. Question A derivatives trader at an investment bank is considering how to hedge a relatively
illiquid 7-year USD interest-rate swap the bank just entered into as the fixed-rate
payer. The trader recognizes that any profit resulting from the bid-ask spread may
be lost if the trade is hedged with another illiquid 7-year swap and considers using
the more liquid 5-year and 10-year USD interest-rate swaps as a hedge. To
evaluate this possible hedge, the trader runs a two-variable regression model using
changes in the 5-year and 10-year swap rates to explain changes in the 7-year
swap rate. The regression model, regression results, and information about the
swaps are given below:

Δyt7 = α + β5Δyt5 + β10Δyt10 + εt

Number of observations 1255

R-squared 98.1%
Standard error 0.12
Regression coefficients Value Standard error
Constant (α) 0.0012 0.0030
Change in 5-year swap rate (β5) 0.2471 0.0025
Change in 10-year swap rate (β 10) 0.6536 0.0027

Swap tenor Swap fixed rate DV01

5-year 2.591% 0.061
7-year 2.492% 0.084
10-year 2.475% 0.115

What are the correct notional amounts of 5-year and 10-year swaps needed to
hedge a USD 100 million notional amount of 7-year swaps?

A USD 23.76 million of 5-year swaps, and USD 65.81 million of 10-year swaps
B USD 24.71 million of 5-year swaps, and USD 65.36 million of 10-year swaps
C USD 34.03 million of 5-year swaps, and USD 47.74 million of 10-year swaps
D USD 68.85 million of 5-year swaps, and USD 36.52 million of 10-year swaps

Correct C
Answer

Explanation C is correct.
To determine the notional amount of the 5-year and 10-year swaps required to
hedge USD 100 million notional of a 7-year swap it must be understood that the
P&L of the position is given by:
-F7*(DV017/100)*Δyt7 – F5*(DV015/100)*Δyt5 – F10*(DV0110/100)*Δyt10
In a perfect hedge, this P&L would equal zero.

Substituting the predicted change in the 7-year swap rate from the regression
equation into the P&L equation given above, and retaining only the terms related to
the changes in the 5-year and 10-year swap rates gives the following equation for
the P&L:
[-F7*(DV017/100)*β5 – F5*(DV015/100)]*Δyt5 +
[-F7*(DV017/100)*β10 – F10*(DV0110/100)]*Δyt10

103
 Now set the terms inside the brackets equal to zero so the P&L is not dependent on
changes in the 5-year and 10-year swap rates. This leaves:
F5 = -F7 * (DV017/DV015) * β5
F10 = -F7 * (DV017/DV0110) * β10

Now, using the information derived from the regression and the DV01s, the notional
amounts of the 5-year and 10-year swaps can be calculated.

F5 = -100 * (0.084/0.061) * 0.2471 = -34.03, USD 34.03 million as the fixed-rate

receiver

F10 = -100 * (0.084/0.115) * 0.6536 = -47.74, USD 47.74 million as fixed-rate

receiver

A is incorrect. The ratio of fixed rates is used instead of the ratio of DV01s in the
formula.

F5 = -100 * (0.02492/0.02591) * 0.2471 = -23.76, USD 23.76 million as the fixed-rate

receiver

F10 = -100 * (0.02492/0.02475) * 0.6536 = -65.81, USD 65.81 million as fixed-rate

receiver

B is incorrect. This answer choice simply multiplies the Betas and the initial notional
amount.

D is incorrect. This answer choice uses the ratio of DV01s but not the betas, then
divides by 2 since the position is a butterfly.

F5 = -100 * (0.084/0.061) / 2 = -68.85, USD 68.85 million as the fixed-rate receiver

F10 = -100 * (0.084/0.115) / 2 = -36.52, USD 36.52 million as the fixed-rate receiver

Section Market Risk Measurement and Management

Learning Calculate the face value of multiple offsetting swap positions needed to carry out a
Objective two-variable regression hedge.

Reference Bruce Tuckman and Angel Serrat, Fixed Income Securities: Tools for Today’s
Markets, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011). Chapter 6. Empirical
Approaches to Risk Metrics and Hedging

104
40. Question An individual investor reviews historical data on the performance of several
investment funds and decides to create a USD 1 million portfolio that mimics the
strategy of Fund CRN, which has consistently generated high alphas. The investor
gathers Fund CRN’s monthly returns over the last 10 years and regresses Fund
CRN’s monthly excess returns over the risk-free rate against the Fama-French
model’s three factors as well as a momentum factor. The investor obtains the
following statistically significant estimates:

Coefficient T-statistic
Alpha 0.08 2.10
MKT loading 0.55 6.72
SMB loading -0.63 4.35
HML loading 0.36 3.20
UMD loading -0.07 2.77
Adj R2 0.56

Which of the following positions is a component of the mimicking portfolio?

A USD 7,000 long position in stocks showing positive momentum

B USD 360,000 long position in value stocks
C USD 450,000 short position in T-bills
D USD 630,000 short position in growth stocks

Correct B
Answer

Explanation B is correct.

The mimicking portfolio should consist of (in percentages):

(1 - 0.55) = 45% in T-bills
+ 55% in the market portfolio
- 63% in small caps + 63% in large caps
+ 36% in value stocks – 36% in growth stocks
- 7% in past winning stocks + 7% in past losing stocks

The 36% long position in value stocks translates to USD 360,000 for a portfolio of
USD 1 million.

Section Risk Management and Investment Management

Learning Apply a factor regression to construct a benchmark with multiple factors, measure a
Objective portfolio’s sensitivity to those factors, and measure alpha against that benchmark.

Reference Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (New
York, NY: Oxford University Press, 2014). Chapter 10. Alpha (and the Low-Risk
Anomaly)

105
41. Question A bank wants to reduce its operating expenses and considers hiring a third-party
service provider to offer additional loan origination and credit services to some of
the bank’s customers. The bank’s legal department has begun negotiating the terms
of a contract with the provider. Which of the following describes the most
appropriate set of due diligence actions for the bank to take before signing the
contract?

A The bank should audit the service provider’s operational processes and also give
the service provider the similar right to audit the bank’s processes.
B The bank should purchase insurance to cover potential losses resulting from the
provider’s services and should require that the provider deposit collateral with the
bank to mitigate performance risk.
C The bank should determine the compensation structure for the provider’s sales
representatives and ensure that it incentivizes their productivity through a high
proportion of variable compensation.
D The bank should define specific events that are considered a default under the
contract and give the provider an opportunity to resolve a default before terminating
the contract.

Correct D
Answer

Explanation D is correct. The agreement should define specific events that constitute a default,
and the bank should give the provider an opportunity to cure the default if one of
these events occur instead of immediately terminating the contract.

A is incorrect. While the bank should audit the provider’s processes, the bank
shouldn’t give the provider the right to audit its own processes.

B is incorrect. Neither of these actions are required to comply with best practices,
although the bank should assess the adequacy of the provider’s insurance policy.

C is incorrect. The provider should develop its own incentive compensation

structure, and the bank should review it. The bank should ensure that sales reps do
not receive an incentive compensation structure which would encourage the bank or
its customers to take too much risk, and a high proportion of variable compensation
would be problematic in this respect.

Section Operational Risk and Resilience

Learning Describe topics and provisions that should be addressed in a contract with a third-
Objective party service provider.

Reference “Guidance on Managing Outsourcing Risk,” Board of Governors of the Federal

Reserve System, December 2013

106
42. Question A bank buys a bond on its coupon payment date. Three months later, in order to
generate immediate liquidity, the bank decides to repo the bond. Details of the bond
and repo transaction are as follows:

Notional value (USD) 100,000

Coupon (semi-annual) 6%
Current bond price 97
Repo haircut 10%
Repo interest rate 4%

If the repo contract expires 6 months from now, what is the bank’s expected cash
outflow at the end of the repo transaction?

A USD 89,046
B USD 90,423
C USD 93,177
D USD 100,470

Correct B
Answer

Explanation B is correct. Cash inflow at beginning of repo: (100,000)*(97%+6%*0.25)*(1-10%) =

88,650; Cash outflow at end of repo: 88,650*(1+4%*0.5)=90,423

A is incorrect. Left out the accrued interest of 6%*0.25 in the correct equation for
cash inflow.

C is incorrect. Used 1 instead of 97% for price in the correct equation for cash
inflow.

D is incorrect. eft out haircut of 10% in the correct equation for cash inflow.

Section Liquidity and Treasury Risk

Learning Describe the mechanics of repurchase agreements (repos) and calculate the
Objective settlement for a repo transaction.

Reference Bruce Tuckman and Angel Serrat, Fixed Income Securities: Tools for Today’s
Markets, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011). Chapter 12 -
Repurchase Agreements and Financing

107
43. Question A risk analyst is studying a series of graphs plotting the empirical distribution of a
portfolio’s profit and loss quantiles against the quantiles of different specified
reference distributions. The analyst plans to use these QQ plots to gain insights into
the properties of the empirical distribution of the portfolio’s profits and losses. Which
of the following statements is correct regarding QQ plots?

A The tails of the empirical distribution are heavier than those of the reference
distribution if the QQ plot has a steeper slope at its tails.
B QQ plots are used to smooth the empirical distribution by removing outliers through
the use of quantiles.
C A distribution is considered a good reference distribution if data drawn from it
produces a QQ plot that is non-linear in the central mass of the distribution.
D The primary purpose of a QQ plot is to measure the skewness and kurtosis of the
empirical data.

Correct A
Answer

Explanation A is correct. If the empirical distribution has heavier tails than the reference
distribution, the QQ plot will have steeper slopes at its tails. Conversely, if the
empirical distribution has lighter tails than the reference distribution, the QQ plot will
have flatter slopes at its tails.

B is incorrect. Outliers are easily identified on QQ plots due to the nature of the
plotting, and this is one of the ways QQ plots are useful.

C is incorrect. Reference distributions that produce non-linear QQ plots can be

dismissed from consideration as a good representative of the empirical data since
data drawn from the reference distribution should produce a linear QQ plot.

D is incorrect. The primary purpose of a QQ plot is to determine the proper

reference distribution. One can see if there is skewness and kurtosis although it
cannot be measured with a QQ plot.

Section Market Risk Measurement and Management

Learning Interpret quantile-quantile (QQ) plots to Identify the characteristics of a distribution.

Objective

Reference Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, UK: John Wiley &
Sons, 2005). Chapter 3. Estimating Market Risk Measures: An Introduction and
Overview

108
44. Question A fixed-income portfolio manager is conducting a performance analysis on an
agency-MBS and the underlying pool of commercial mortgages. The manager
obtains the following information:

• The constant prepayment rate (CPR) of the commercial mortgages loan

pool: 14.38%
• Debt payments per year on the commercial mortgage loans: USD 730,000
• Net operating income per year of the commercial mortgage property: USD
1,825,000

The manager uses the following metrics as benchmarks for the commercial
mortgage sector analysis:

• Debt service coverage ratio (DSCR) of a benchmark obligor: 2.5

• Single monthly mortality (SMM) rate of a benchmark security: 0.85%

Which of the following statements is correct?

A The prepayments on the commercial mortgage measured by the CPR shows that
the reduction in yield on the MBS will likely be lower compared to that on a
benchmark security.
B The prepayments on the commercial mortgage measured by the CPR shows that
the reduction in yield on the MBS will likely be higher compared to that on a
benchmark security.
C The estimated DSCR of the commercial mortgage implies that the mortgage
borrower’s ability to repay the mortgage loan is stronger than that of a comparable
benchmark obligor.
D The estimated DSCR of the commercial mortgage implies that the mortgage
borrower’s ability to repay the mortgage loan is weaker than that of a comparable
benchmark obligor.

Correct B
Answer

Explanation B is correct.

• CPR of the MBS = 14.38% (given)

• On the other hand, the benchmark security’s SMM is 0.85%, which gives CPR =
1 – (1 – SMM)12 = 9.74%. Since the mortgage’s CPR of 14.38% is higher than
the benchmark CPR of 9.74%, the faster prepayment, for a given price, would
reduce the yield on the MBS much more than the reduction of yield on a
benchmark MBS.

• DSCR = Net operating income/Debt payments (service) = 1,825,000/730,000 =

2.5. The mortgage borrower’s DSCR is the same as the benchmark DSCR.
Thus, the mortgage borrower’s ability to repay the loan is not any weaker or
stronger than that of a comparable benchmark obligor, based on the DSCR.

Thus, A, C and D are incorrect.

Section Credit Risk Measurement and Management

109
Learning Define and calculate the delinquency ratio, default ratio, monthly payment rate
Objective (MPR), debt service coverage ratio (DSCR), the weighted average coupon (WAC),
the weighted average maturity (WAM), and the weighted average life (WAL) for
relevant securitized structures.

Explain the prepayment forecasting methodologies and calculate the constant

prepayment rate (CPR) and the Public Securities Association (PSA) rate.

Reference Moorad Choudhry, Structured Credit Products: Credit Derivatives & Synthetic
Securitisation, 2nd Edition (New York, NY: John Wiley & Sons, 2010). Chapter 12.
An Introduction to Securitisation.

110
45. Question A manager from the structured credit risk desk at a bank is presenting to a group of
newly hired risk analysts on calculating cash flows in a securitization structure. The
manager illustrates the procedure with the existing collateral pool of loans and the
corresponding liabilities, all with a maturity of 5 years, using the following
information:

Initial number of loans in the collateral pool 100

Principal amount of each loan EUR 1,000,000
Total coupon interest to be paid annually on all junior
EUR 6,300,000
and senior bonds
Maximum annual amount flowing from the excess
EUR 1,500,000
spread into the overcollateralization account
Swap rate per year for all maturities 3.5%
Recovery rate in the event of a loan default 45%

The manager makes additional observations as follows:

• The loans in the collateral pool pay a fixed spread of 2.2% over the swap
curve.
• There were no defaults in year 1.
• The value of the overcollateralization account at the end of year 1 was
EUR 0.

What is the value of the overcollateralization account at the end of year 2 if there
are 8 defaults in year 2?

A EUR 600,000
B EUR 1,056,000
C EUR 2,544,000
D EUR 3,600,000

Correct C
Answer

Explanation C is correct: The value of the overcollateralization account (OC) at end of year 2
(OC2) includes the compounded year-1 value of the OC (OC1), the recovered
principal amount at the end of year 2 (R2) and is computed as follows:

OC2 = (1 + swap rate)*OC1 + R2.

Since there is no default in year 1, consider

Min[(0.035 + 0.022)*100*1,000,000 - 6,300,000; 1,500,000] = -600,000

As that is negative, the overcollateralization account is entirely depleted at the end

of year 1.

For year 2,

First:

111
 Excess spread at the end of year 2 = L – B

where,

L = interest from surviving loans = (0.035 + 0.022) *(100 – 8) * 1,000,000

= EUR 5,244,000

B = bond coupon interest due to both junior and senior bonds

= USD 6,300,000 (given)

Therefore, excess spread = 5,244,000 – 6,300,000 = EUR -1,056,000 (negative).

Second:

Recovery principal amount in year 2 = R2 = 0.45 * 8 * 1,000,000 = EUR 3,600,000,

which would flow into the overcollateralization account (OC).

Therefore, since the OC had a net EUR 0 at the beginning of year 2, then the
interest shortfall (calculated in the first step above, as negative) should be paid from
the OC account, leaving the OC with a net amount = 3,600,000 – 1,056,000 = EUR
2,544,000. (See discussions on page 166-167, [CR-8]).

A is incorrect. = EUR 600,000 is the result obtained by ignoring the number of

defaults in year 2 and using an incorrect formula: B – L = 6,300,000 – (0.035 +
0.022) *100*1,000,000 = EUR 600,000

B is incorrect. EUR 1,056,000 is the excess spread as derived in C above.

D is incorrect. EUR 3,600,000 is the recovered principal in year 2 as derived above.

Section Credit Risk Measurement and Management

Learning Compute and evaluate one or two iterations of interim cashflows in a three-tiered
Objective securitization structure.

Reference Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken,
NJ: John Wiley & Sons, 2011). Chapter 9. Structured Credit Risk

112
46. Question A quantitative analyst on the fixed-income desk of an investment bank is applying
the Vasicek model to estimate future short-term interest rates. The model is given
below:

dr = k * (ϴ - r) * dt + σ * dw

where dr is the change in the short-term interest rate, ϴ is the estimated long-run
value of the short-term interest rate, k is the mean reversion rate, r is the current
level of the short-term interest rate, σ is the annual basis-point volatility of the short-
term interest rate, dt is the time interval measured in years, and dw is a normally
distributed random variable with mean zero and standard deviation equal to the
square root of dt.

The analyst gathers the following information:

• Current short-term interest rate (r): 3.35%

• Long-run value of short-term interest rate (ϴ): 4.55%
• Mean reversion rate (k): 0.06
• Annual basis-point volatility (σ): 120 bps

The analyst then creates an interest rate tree, determines the expected short-term
interest rate after 8 years, and calculates how long it will take the short-term interest
rate to revert halfway to the long-run value. Which of the following statements would
be correct for the analyst to make?

A The expected short-term interest rate is 3.81% and the half-life is 11.6 years.
B The expected short-term interest rate is 3.81% and the half-life is 16.7 years.
C The expected short-term interest rate is 4.09% and the half-life is 11.6 years.
D The expected short-term interest rate is 4.09% and the half-life is 16.7 years.

Correct A
Answer

Explanation A is correct. The equation for determining the expected short-term interest rate after
some number of years (T) when the interest rate process follows a Vasicek model is
given as follows (equation 13.23 in the Market Risk book):

r0*e-kT + ϴ*(1 - e-kT)

Using the information provided, the expected short-term interest rate after 8 years
is:
0.0335 * e-0.06*8 + 0.0455 * (1 - e-0.06*8) = 0.0335 * 0.6188 + 0.0455 * 0.3812 =
0.0381, 3.81%.

The half-life of the short-term interest rate is given as being equal to ln(2)/k (see
equation 13.25 in Market Risk book). Therefore, the half-life in this example is
ln(2)/0.06 = 11.55 years.

B is incorrect. The half-life is incorrectly calculated as being 1/k, or 1/0.06, 16.7

years.

113
 C is incorrect. The expected short-term interest rate is incorrectly estimated by
switching the position of e-kT and 1 - e-kT, which then yields 4.09%.

D is incorrect. Both errors made in B and C are made in this answer choice.

Section Market Risk Measurement and Management

Learning Calculate the Vasicek Model rate change, standard deviation of the rate change,
Objective expected rate in T years, and half-life.

Reference Bruce Tuckman and Angel Serrat, Fixed Income Securities: Tools for Today’s
Markets, 3rd Edition (Hoboken, NJ: John Wiley and Sons, 2011), Chapter 9. The Art
of Term Structure Models: Drift

114
47. Question A researcher at a national regulatory agency is examining the use of the
standardized ratings-based approach (SA) and the advanced internal ratings-
based (A-IRB) approach in determining credit risk capital. The researcher
evaluates the implications of applying these approaches on two different banks,
Global Bank and Resource Bank. Information about the credit exposures of the
two banks is provided below:

• Global Bank lends to large global corporations that have highly diverse
business lines by providing sizable long-dated unsecured credit facilities.
• Resource Bank lends to oil and gas producers in its region, most of which
have small-scale operations.

Which of the following is the most appropriate conclusion for the researcher to
reach?

A The A-IRB approach does not adjust for maturity, which means that A-IRB could
undercapitalize the long-dated exposures at Global Bank.
B The SA gives lower risk weights to unrated credits than to credits rated B+ or
lower, which may incentivize Resource Bank to lend to unrated companies with
poor credit quality.
C Model parameters used in the SA effectively capture the high default correlation
that is likely to exist between Resource Bank’s lending counterparties.
D The A-IRB approach would require Global Bank to model the exposure at default
while using a probability of default specified by the Basel committee.

Correct B
Answer

Explanation B is correct (p. 331). The SA provides a 100% risk weight for unrated credits and
150% risk weight for B+ or lower, resulting in potential adverse selection and
moral hazard risks.

A is incorrect. (p. 332) The A-IRB approach has an explicit adjustment for
maturity. SA has some adjustments relating to short-dated exposures.

C is incorrect. (pp. 331-332) SA is not a modeled approach and therefore does

not have correlation parameters. The Foundation IRB incorporates a correlation
parameter chosen by the Basel committee, but not the SA. Even if high
correlations exist, it is not possible to know if they are captured in a non-modeled
approach.

D is incorrect. (p. 331.) Under the A-IRB, the bank specifies the probability of
default (PD), loss given default, and exposure at default. Even under the
Foundation IRB, the bank still specifies the PD.

Section Operational Risk and Resilience

Learning Compare the standardized internal ratings-based (IRB) approach, the foundation
Objective IRB approach, and the advanced IRB approach for the calculation of credit risk
capital under Basel II.

115
Reference Mark Carey, “Capital Regulation Before the Global Financial Crisis,” GARP Risk
Institute, April 2019. [ORR-21]

116
48. Question A senior risk manager at Bank Gamma is presenting to a group of newly hired junior
risk analysts on calculating bilateral CVA (BCVA). To illustrate the calculations, the
manager assumes that Bank Gamma and Bank Phi are the only counterparties to
each other and provides the following information about Bank Gamma:

• The discounted expected positive exposure to Bank Phi is CNY 60 million

• The discounted expected negative exposure to Bank Phi is CNY 45 million

Additional information on the two banks is shown below:

Parameter Bank Gamma Bank Phi

Annual probability of default 2.5% 1.8%
Recovery rate 82% 92%

What is the BCVA from Bank Gamma’s perspective?

A CNY 84,240
B CNY 114,615
C CNY 198,855
D CNY 201,960

Correct B
Answer

Explanation B is correct. Let p denote Bank Gamma as the party (as the party making the
calculation), and c denote Bank Phi as counterparty. Also, note that the BCVA =
CVA + DVA

So,

CVAp = – LGDc * EPEp * PDc * (1 – PDp)

= – (0.08 * 60,000,000 * 0.018 * 0.975) = CNY -84,240
DVAp = – LGDp * ENEc * PDp * (1 – PDc)
= – (0.18 * -45,000,000 * 0.025 * 0.982) = CNY 198,855

Therefore,

BCVA = CVA + DVA = CNY -84,240 + CNY 198,855 = CNY 114,615

A is incorrect. CNY 84,240 is the CVA of Bank Gamma and the negative sign is
ignored.

C is incorrect. CNY 198,855 is the DVA of Bank Gamma.

D is incorrect. CNY 201,960 is the result obtained when the expected exposures in
the CVA and the DVA formulas are switched and ignored the sign of BCVA.

Section Credit Risk Measurement and Management

Learning Calculate DVA, BCVA, and BCVA as a spread.

Objective

117
Reference Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral,
and Capital, 4th Edition (West Sussex, UK: John Wiley & Sons, 2020). Chapter 17.
CVA

118
49. Question An analyst at a bank is asked to evaluate the efficacy of the VaR model that the
bank used over the last year. While evaluating the model, the analyst finds that the
bank experienced more VaR exceptions than were forecast by the bank’s VaR
model and examines both the reason this occurred and its potential impact on the
bank. Which of the following is correct regarding the analyst’s examination of the
situation?

A The confidence level of the backtest performed on the VaR model was set too low.
B The model is most likely overestimating the market risk faced by the bank.
C The risk-taking units of the bank will likely be allocated less capital than they should
be.
D The bank’s regulator will impose a financial penalty on the bank.

Correct C
Answer

Explanation C is correct. A model that produces too many exceptions may cause too little capital
to be allocated to risk-taking units.

A is incorrect. Observing too many or too few exceptions is not a related to the
confidence level of the model.

B is incorrect. A model that produces too many exceptions is underestimating the

market risk the bank faces.

D is incorrect. The bank’s VaR model may see too many exceptions due to a poorly
designed model, deliberately underestimating risk, or bad luck. The regulator may
impose penalties to prevent the first two reasons, but the regulator may not impose
penalties if the exceedances are the result of bad luck, or intraday trading.

Section Market Risk Measurement and Management

Learning Describe backtesting and exceptions and explain the importance of backtesting VaR
Objective models.

Reference Philippe Jorion, Value at Risk: The New Benchmark for Managing Financial Risk,
3rd Edition (New York, NY: McGraw-Hill, 2007). Chapter 6. Backtesting VaR

119
50. Question A risk analyst at a credit ratings agency is evaluating the economic capital for credit
risk of two competing regional banks, Bank ABC and Bank XYZ. The two banks
have the same credit asset exposure, duration of credit exposure, credit rating, and
expected loss. Assuming the average pairwise default correlation between credit
assets of Bank ABC is lower than that of Bank XYZ, and the two banks assess their
risk appetite at the same predetermined confidence level, which of the following
statements would be correct?

A If the confidence level for both banks is increased, the level of economic capital
needed for Bank ABC and for Bank XYZ will both increase.
B If the confidence level for both banks is decreased, the level of economic capital
needed will increase for Bank ABC but will decrease for Bank XYZ.
C If the confidence level for both banks is increased, the level of economic capital
needed will decrease for Bank ABC but will increase for Bank XYZ.
D If the confidence level for both banks is kept unchanged, the level of economic
capital needed for Bank ABC and for Bank XYZ will be equal.

Correct A
Answer

Explanation A is correct. If the confidence level is raised, economic capital needed would be
higher since a higher capital multiplier is applied to the UL.

B is incorrect. A lower confidence level implies a lower credit rating target (and a
lower capital multiplier), and hence lower capital level is needed to cover credit
assets, for both banks.

C is incorrect. See explanation in B.

D is incorrect. Given the same exposures and EL, and since asset correlation
(hence, the volatility of UL) for Bank XYZ credit assets is higher, economic capital
needed for Bank XYZ will be higher than that for Bank ABC even if the confidence
level is unchanged (i.e., the capital multiplier is unchanged).

Section Credit Risk Measurement and Management

Learning Describe how economic capital is derived.

Objective

Reference Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions
(New York, NY: John Wiley & Sons, 2002). Chapter 5. Capital Structure in Banks
(pages 170-186 only)

120
51. Question An individual investor wants to invest USD 8 million in exchange-traded funds
(ETFs) or private equity funds (PEFs). The investor obtains the previous year’s
returns for several ETFs and calculates summary statistics such as volatility and
correlation based on these returns. The investor also reviews a database of
reported returns and volatilities for several PEFs and then selects two potential
investments in each asset class. Using the data from the sources described above,
the investor generates the following information for the four potential investments:

Annual
1-year
Asset volatility
return
of returns
Broad equity market index ETF (ETF1) 6.5% 11.4%
Growth stock ETF (ETF2) 8.3% 13.6%
Private equity fund 1 (PEF1) 7.4% 12.3%
Private equity fund 2 (PEF2) 10.2% 11.1%

Correlation of returns between ETF1 and ETF2 0.67

Correlation of returns between ETF1 and PEF1 0.25
Correlation of returns between PEF1 and PEF2 0.41

The manager evaluates this information while also considering the potential biases
and uncertainties in the reported data. Which of the following conclusions is most
appropriate for the investor to make?

A The correlation of returns between PEF1 and ETF1 is more accurate than the
correlation of returns between ETF1 and ETF2.
B The entire USD 8 million should be allocated to PEF2 because it is clearly the
superior investment from a return to risk perspective.
C The number of assets in PEFs are typically higher than the number of assets in
ETFs, which makes PEFs much less risky than ETFs over longer time horizons.
D Summary statistics computed using reported returns of PEFs can be biased
downward, which compromises the reliability of these risk measures.

Correct D
Answer

Explanation D is correct. Because private equity funds trade infrequently, their risk measures—
such as volatilities, correlations, and betas—can be too low when computed using
reported returns. See p. 386 in LTR and p.86 in IM

A is incorrect. Correlations regarding PEF1 are not reliable (See explanation for D).
The correlation between the two ETFs is more reliable.

B is incorrect. Because the volatility of PEF2 is likely understated, it is not clear that
PEF2 truly has the best return to risk profile out of the four investments. Even if it
did in fact have the best return/risk profile, it is inappropriate to conclude that the
investor should allocate all these funds to that one investment. The investor should
consider other factors, such as potential diversification benefits from holding a
mixture of the four investments as well as diversification benefits with other
investments and asset classes that the investor may own. There is not enough
information given to make this conclusion.

121
 C is incorrect. The number of assets alone cannot be a determinant of the risk level
of a portfolio. Also, ETFs often hold a very large number of assets, while PEFs can
be more concentrated.

Section Risk Management and Investment Management

Learning Explain the impact of correlation on portfolio risk.

Objective Describe the risk management challenges associated with investments in hedge
funds.

Assess the impact of biases on reported returns for illiquid assets.

Reference Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk,
3rd Edition (New York, NY: McGraw-Hill, 2007).
Chapter 7. Portfolio Risk: Analytical Methods
Chapter 17. VaR and Risk Budgeting in Investment Management

Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (New

York, NY: Oxford University Press, 2014). Chapter 13. Illiquid Assets

122
52. Question The CRO of a regional mortgage lender has asked an enterprise risk manager to
develop a set of policies and procedures for the firm’s operational risk reporting. The
manager considers appropriate policies for the governance of the firm’s risk
reporting framework and also assesses how the firm should structure its risk reports
for different stakeholder groups and organizational functions. Which of the following
would be most appropriate for the manager to recommend?

A The firm should report a more detailed and extensive set of key risk indicators to the
board of directors than it does to business line managers to support the board’s
strategic risk review.
B The operational risk committee should be responsible for executing all necessary
changes to the firm’s risk exposures after risk reports are reviewed.
C The central operational risk function should be responsible for aggregating
information from each of the business units about operational risk exposures.
D The firm should emphasize forward-looking risk indicators and avoid the use of
backward-looking indicators in its risk reporting.

Correct C
Answer

Explanation C is correct. The central operational risk function should be responsible for
collecting information about specific operational risk exposures from the business
units and aggregating this information into a firm-wide risk report.

A is incorrect. Reports to the board of directors should contain a less extensive set
and concentrate on those metrics that provide an overview of the firm’s key risk
exposures and are necessary for decision-making. Business line managers and
other first-line risk managers should monitor a much more extensive set of
indicators to detect potential adverse trends across a wide variety of metrics that
might require action or escalation.

B is incorrect. The firm’s executive committee should have this responsibility.

D is incorrect. Reporting operational risks using a forward-looking perspective is

often done, especially in firms with a more mature operational risk management
function. However, risk reporting does not have to be exclusively forward looking
and many firms still use a largely backward-looking approach. Examples of a
valuable backward-looking approach is performing trend or volatility analysis on the
firm’s operational losses in different categories over time.

Section Operational Risk and Resilience

Learning Identify roles and responsibilities of different organizational committees, and explain
Objective how risk reports should be developed for each committee or business function.

Describe components of operational risk reports and explain best practices in

operational risk reporting.

Reference Global Association of Risk Professionals, Operational Risk and Resilience (New
York, NY: Pearson, 2022). Chapter 6 – Risk Reporting

123
53. Question A risk analyst at a bank is estimating the VaR of an equally weighted, two-asset
portfolio as an exercise to demonstrate the impact of correlation on VaR. The
volatility of the daily returns of each asset in the portfolio is 2%, the value of the
portfolio is USD 20 million, and the 10-day 99% VaR of the portfolio is USD 2.33
million. If the correlation between the two assets doubles, which of the following is
closest to the new estimate of the 10-day 99% portfolio VaR?

A USD 1.16 million

B USD 2.55 million
C USD 4.66 million
D USD 5.43 million

Correct B
Answer

Explanation B is correct.

Since the portfolio is equally weighted the variance of the daily portfolio return is
given by:

σ2 = w12 σ12 + w22 σ22 + 2w 1w2σ1σ2ρ12

σ2 = 0.52(0.02)2 + 0.52(0.02)2 + 2*0.5*0.5*0.02*0.02*ρ12

σ2 = 0.0001 + 0.0001 + 0.0002*ρ12 = 0.0002*(1+ ρ12)

Since the initial 10-day VaR is known, we can work backward to solve for the initial
correlation. The 1-day VaR is estimated using the equation:

zα * σp * Vp , where Vp is the value of the portfolio

And this is then scaled by √10 to estimate the 10-day VaR. So working backward,

USD 2,330,000 = √10 * 2.326 * USD 20,000,000 * σp ,

Where σp = √0.0002 ∗ (1 + ρ12 ) = 0.01414*√(1 + ρ12 )

So, USD 2,330,000 = √10 * 2.326 * USD 20,000,000 * 0.01414* √(1 + ρ12 )

USD 2,330,000 = USD 2,080,123 *√(1 + ρ12 )

1.1201 = √(1 + ρ12 )

1.2547 = 1+ ρ12

ρ12 = 0.2547

Now, if the correlation doubles, the new correlation is 2 * 0.2547 = 0.51

So the new variance of the portfolio is:

σ2 = w12 σ12 + w22 σ22 + 2w 1w2σ1σ2ρ12

σ2 = 0.52(0.02)2 + 0.52(0.02)2 + 2*0.5*0.5*0.02*0.02*0.51

124
 σ2 = 0.0001 + 0.0001 + 0.0001

To estimate the VaR of the portfolio we need the daily standard deviation of the
portfolio, which is found by taking the square root of the variance of the portfolio:

σp = √0.0003 = 0.01732 = 1.73%

The 1-day VaR of the portfolio is estimated with the equation:

zα * σp * Vp , where V p is the value of the portfolio

So the 1-day VaR is 2.326 * 0.0173 * USD 20,000,000 = USD 805,750

To estimate the 10-day VaR, the 1-day VaR must be scaled by square root of time,

USD 805,750 * √10 = USD 2,548,005

Section Market Risk Measurement and Management

Learning Estimate the impact of different correlations between assets in the trading book on
Objective the VaR capital charge.

Reference Gunter Meissner, Correlation Risk Modeling and Management, 2 nd edition, Risk
books, 2019, Chapter 1. Correlation Basics: Definitions, Applications, and
Terminology

125
54. Question A risk consultant is presenting on the evolution of macro-prudential stress testing
requirements established in response to the global financial crisis of 2007 – 2009.
The consultant compares features of the following three stress tests:

• The 2009 Supervisory Capital Assessment Program (SCAP) test

• The 2011 European Banking Association (EBA) test
• The 2012 Comprehensive Capital Analysis and Review (CCAR) test

Which of the following elements of these stress tests or their resulting impacts is
correct for the analyst to include in the presentation?

A Several Spanish banks failed the EBA stress test, and Spain imposed stricter
countrywide stress tests the following year that resulted in some banks raising
capital.
B The SCAP stress test scenario was less severe compared to later US stress tests
and did not result in any increased capital requirements for participating banks.
C The CCAR test required banks to evaluate both a base case and a stress scenario,
while the EBA test only included a stress scenario.
D The SCAP test only disclosed overall loss rates for retail and commercial
exposures, while the EBA test expanded disclosure to individual geographical
regions and asset classes.

Correct A
Answer

Explanation A is correct. Five Spanish banks did not pass the EBA stress tests, which resulted in
another series of stress tests in Spain that led to increased capital requirements at
11 Spanish banks.

B is incorrect. The SCAP was developed due to significant uncertainty about the
strength of US banks coming out of the crisis, and 10 of the banks were required to
raise a total of US 75 billion in capital.

C is incorrect. CCAR required only a stress scenario, while EBA included both a
base case and a stress scenario. This is still incorrect today as EBA still requires a
baseline scenario (CCAR does too now.)

D is incorrect. The SCAP test released loss rates by asset class including first lien
mortgages, credit cards, and commercial real estate. This increased the disclosure
dramatically over earlier US stress tests.

Section Operational Risk and Resilience

Learning Describe the evolution of the stress testing process and compare the methodologies
Objective of historical European Banking Association (EBA), Comprehensive Capital Analysis
and Review (CCAR), and Supervisory Capital Assessment Program (SCAP) stress
tests.

Reference “Stress Testing Banks,” Til Schuermann, International Journal of Forecasting 30, no.
3, (2014):717–728

126
55. Question A group of risk managers in a newly established asset management firm is assigned
to implement the risk management process that includes three fundamental
dimensions: risk planning, risk budgeting and risk monitoring. The managers start
by discussing the components of and the guidelines included in the risk plan. Which
of the following statements is correct?

A Qualitative scenario analyses can be incorporated into a risk plan to identify factors
that can cause aspects of the risk plan to fail.
B A risk plan can set volatility goals but cannot incorporate the effects of the
organization’s key dependencies on these goals.
C Extreme events should not be included in an organization’s risk plan but they should
be included in its strategic plan.
D A risk plan should include an estimate of return on equity found by using the return
on risk capital for each allocation taken independently.

Correct A
Answer

Explanation A is correct. Scenario analyses can be incorporated into a risk plan to explore
factors that can cause aspects of the risk plan to fail. These scenario analyses can
be quantitative as well as qualitative.

B is incorrect. A risk plan should identify the key dependencies and incorporate the
effects of their possible breakdowns on set return and volatility estimates.

C is incorrect. A company’s risk plan should include low probability, severe events
as well as planned strategic responses to those events.

D is incorrect. Yes, a risk plan should set an expected value for return on equity,
which should be found by considering the correlations among each activity’s defined
minimum acceptable RORC level.

Section Risk Management and Investment Management

Learning Describe risk planning, including its objectives, effects, and the participants in its
Objective development.

Reference Robert Litterman and the Quantitative Resources Group, Modern Investment
Management: An Equilibrium Approach (Hoboken, NJ: John Wiley & Sons, 2003)
Chapter 17. Risk Monitoring and Performance Measurement

127
56. Question An analyst working at a financial regulatory agency is studying the rationale for
including scenarios describing both normal and stressed market conditions while
performing credit evaluations for banks. The analyst compares two events, bank
failure and bank insolvency, and focuses on the implications of both their respective
credit analysis and the difference in impact between them. Which of the following
statements is correct?

A Both bank insolvency and bank failure are major concerns for the bank’s
counterparties even if the bank still has a source of liquidity under insolvency.
B For retail depositors, the expected loss on their deposits is the same whether the
bank fails or becomes insolvent.
C The rate of corporate failure during normal market conditions is the same for banks
and for nonfinancial corporations.
D As lender of last resort, a central bank provides capital to a bank in financial distress
for the same reason whether the bank is considered “too big to fail” or “too small to
fail.”

Correct A
Answer

Explanation A is correct. Despite having access to liquidity (e.g., central bank as “lender of last
resort”), a bank under insolvency is of concern to counterparties and other
stakeholders (e.g., investors) because the bank’s credit quality (rating) declines,
access to some (but not all) sources of funding is lost, the pricing of its risk is
changed, and the allocation of bank capital is changed.

B is incorrect. The extent of deposit insurance varies from country to country. In

most cases, the insurance may not cover deposits in whole and the expected loss
under bank failure would not be the same as the expected loss under bank
insolvency, which is still a going concern.

C is incorrect. Bank failures are rare during normal times compared to nonbank firm
failures. Weaker banks tend to be merged into other stronger banks.

D is incorrect. With “too big to fail,” the central banks provide capital support to
avoid systemic risk of contagion and the possibility of adverse country-wide financial
instability. However, with “too small to fail,” central banks arrange somewhat quiet
absorption for small banks in trouble because it is cheaper and more expedient, and
also because it would be embarrassing to let the small banks fail.

Section Credit Risk Measurement and Management

Learning Explain the distinctions between insolvency, default, and bankruptcy.

Objective

Reference Sylvain Bouteille and Diane Coogan-Pushner, The Handbook of Credit Risk
Management: Originating, Assessing, and Managing Credit Exposures (2nd Edition,
Hoboken, NJ: John Wiley & Sons, 2022). Chapter 1. Fundamentals of Credit Risk.

128
57. Question A quantitative risk analyst at a bank has been asked to incorporate market liquidity
into the bank’s VaR model. The analyst examines how changes in the level of
market liquidity impact the liquidity horizon and the bank’s credit risk exposure.
Which of the following statements describes the most likely impact of changes in
market liquidity?

A If market liquidity decreases, the liquidity horizon will shorten, and the credit risk
exposure will increase.
B If market liquidity decreases, the liquidity horizon will lengthen, and the credit risk
exposure will increase.
C If market liquidity increases, the liquidity horizon will shorten, and the credit risk
exposure will increase.
D If market liquidity increases, the liquidity horizon will lengthen, and the credit risk
exposure will decrease.

Correct B
Answer

Explanation B is correct. If market liquidity decreases, the liquidity horizon (the time it takes to
liquidate a position) will increase, and therefore, the credit risk faced by the bank will
typically increase due to the longer amount of time the bank will be forced to hold at
least some portion of the position.

A is incorrect. This answer choice incorrectly states the impact of market liquidity on
the liquidity horizon. If market liquidity decreases, the liquidity horizon (the time it
takes to liquidate a position) will not decrease but will increase, and therefore, the
credit risk faced by the bank will typically increase.

C is incorrect. This answer choice incorrectly states the impact of liquidity horizon on
the credit risk exposure. If market liquidity increases, the liquidity horizon (the time it
takes to liquidate a position) will decrease, and therefore, the credit risk faced by the
bank will typically decrease, not increase, due to the shorter amount of time the
bank will be forced to hold at least some portion of the position.

D is incorrect. This answer choice incorrectly states the impact of market liquidity on
the liquidity horizon. If market liquidity increases, the liquidity horizon (the time it
takes to liquidate a position) will decrease, not increase, and therefore, the credit
risk faced by the bank will typically decrease due to the shorter amount of time the
bank will be forced to hold at least some portion of the position.

Section Market Risk Measurement and Management

Learning Describe exogenous and endogenous liquidity risk and explain how they might be
Objective integrated into VaR models.

Reference “Messages from the academic literature on risk measurement for the trading book,”
Basel Committee on Banking Supervision, Working Paper, No. 19, Jan. 2011

129
58. Question A senior risk analyst at VLT Bank (VLTB), a Singapore-based bank, is analyzing the
risks arising from a significant appreciation of the SGD against all other major world
currencies. VLTB has the following balance sheet structure:

▪ Assets:
• Germany government bonds denominated in EUR
• Singapore government bonds denominated in SGD
• Corporate bonds denominated in EUR
• Commercial loans denominated in SGD

▪ Liabilities:
• Long-term senior bonds denominated in EUR
• Long-term senior bonds denominated in SGD
• Retail deposits denominated in SGD
• Corporate term deposits denominated in SGD

The analyst considers other recent market developments, including a decline in

global equity prices, which resulted in many of VLTB’s larger retail depositors
experiencing margin calls and drawing down deposits to meet them. The analyst
notes that the bank took advantage of the demand for fixed-income securities and
issued additional long-term senior SGD bonds and the proceed was used to
purchase additional Germany government bonds. The overall impact of these
transactions on VLTB is that the bank’s net cash outflows during the month, its
overall net liabilities flow, and the required amount of stable funding, remain
unchanged. The following additional information is provided:

• The available stable funding (ASF) factor for retail deposits is 95%.
• The ASF factor for long-term senior SGD bonds is 100%.

The analyst also assesses the bank’s exposure to ConSol Corp, a publicly traded
Singapore manufacturer that is heavily dependent on locally produced raw materials
and generates its revenues primarily in EUR. VLTB is a major holder of ConSol
Corp’s EUR-denominated bonds and has taken a long CDS position on the bonds.
A German bank is the counterparty to that CDS contract.

In analyzing the impact of the reported developments in the currency, equity, and
bond markets on VLTB, which of the following is correct?

A VLTB’s CDS position will increase in value.

B VLTB’s net stable funding ratio will decrease.
C VLTB’s right-way risk with the German bank will increase.
D VLTB’s liquidity coverage ratio will decrease.

Correct B
Answer

Explanation A is correct. ConSol Corp’s currency risk has increased (due to appreciation of SGD
against major currencies, ConSol Corp is reliant on EUR revenue), has EUR debt
payments due, which most likely increases ConSol Corp’s CDS spread. Thus, the
value of the CDS from the perspective of ConSol Corp will increase.

130
 B is incorrect. The shift in the demand deposit base from retail deposits (with
available stable funding (ASF) factor of 95%) to long-term senior bonds (with ASF
factor of 100%) would lead to a higher available amount of stable funding
(numerator of the net stable funding ratio (NSFR) formula) than before, thereby
increasing the NSFR. The denominator (the required amount of stable funding) is
reported to be unchanged.

C is incorrect. VLTB has a wrong-way risk (not right-way risk) with the German bank
since VLTB’s CDS exposure is increasing (due to ConSol Corp’s condition) as the
credit quality of German bank is most likely decreasing (weaker EUR against SGD,
and declining equity prices).

D is incorrect. The LCR, defined as HQLA/net CF in 30-day period, will increase

since the denominator is unchanged (given) and the numerator increases since
additional sovereign securities (Germany government bonds) with no haircuts
(compared to lost deposits, with haircuts) have been added.

Section Credit Risk Measurement and Management

Learning Describe credit derivatives including credit default swap (CDS), total return swap,
Objective and collateralized debt obligation (CDO).

Identify examples of wrong-way risk and examples of right-way risk.

Describe and calculate ratios intended to improve the management of liquidity risk,
including the required leverage ratio, the liquidity coverage ratio and the net stable
funding ratio.

Reference John C. Hull, Options, Futures, and Other Derivatives (11th Edition, Pearson, 2022).
Chapter 25. Credit Derivatives.

Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral,
and Capital, 4th Edition (West Sussex, UK: John Wiley & Sons, 2020). Chapter 17.
CVA.

Mark Carey, “Solvency, Liquidity and Other Regulation After the Global Financial
Crisis,” GARP Risk Institute, April 2019.

131
59. Question A manager at a financial institution is assessing the cash flow requirements of the
institution’s largest customers using the available funds gap (AFG) model. The
manager obtains the following current and projected inflows and outflows of funds:

Deposits received today USD 60 million

Approved new loan requests USD 57 million
Expected drawdown on corporate client's credit lines USD 16 million
Deposit inflows expected within the next week USD 12 million
10-year Treasury securities expected to be purchased this week USD 35 million
Other customer funds available today USD 45 million

Assuming all else is held constant, if the institution’s objective is to maintain an AFG
of zero, what is the maximum amount of unexpected customer withdrawals it can
meet within the next week?

A USD 0 million
B USD 3 million
C USD 9 million
D USD 15 million

Correct D
Answer

Explanation
C is correct. Available funds gap (AFG) is calculated as follows:

AFG = (Current and projected loans and investments)

– (Current and projected deposit inflows and other funds available)
= (57 + 16 + 35) – (60 + 12 + 45) = 108 – 117 = USD -9 million.

Therefore, the institution can fund loans and investments with the current and
projected inflows and have USD 9 million left that can meet unexpected customer
withdrawal.

A is incorrect. The AGP is not zero, as shown in B above.

B is incorrect. USD 3 million ignores projected deposit funds of USD 12 million.

D is incorrect. USD 15 million is the difference between the deposit funds and other
customer funds.

Section Liquidity and Treasury Risk

Learning Describe and calculate the available funds gap.

Objective

132
Reference Peter Rose, Sylvia Hudgins, Bank Management & Financial Services, 9th Edition
(New York, NY: McGraw-Hill, 2013)

133
60. Question A bank is planning to securitize car loans by creating an SPV. The bank would sell
the loans to an SPV through a “true sale” and the SPV would issue securities under
a “revolving securitization structure.” The project manager for this task is reviewing
characteristics of securitization transactions in general as well as specific features
that are commonly incorporated into revolving structures. Which of the following
statements is correct?

A The credit quality of the securitized car loan assets would be enhanced if the
principal value of securities issued is higher than the principal value of the assets.
B The SPV can allow the bank to access cheaper funding if the credit quality of the
securitized car loan assets is higher than the credit quality of the bank’s balance
sheet.
C Under a revolving structure, prepayment assumptions are not incorporated, which
typically results in principal amounts paid to investors through a series of coupons
over the lifetime of the security.
D Under a revolving structure, the bank transfers the car loan assets to the SPV and
the SPV can issue multiple securitizations, which are priced and traded based on
weighted-average life of the structure.

Correct Answer B

Explanation B is correct. One of the benefits of securitization for financial institutions is to obtain
cheaper funding: the weighted average cost of the securitization may be lower than
the cost of the bank’s current debt. This is often the case if the credit quality of the
securitized assets is higher than the credit quality of the bank’s balance sheet as a
whole.

A is incorrect. The statement incorrectly describes overcollateralization, which is an

enhancement made to the assets that raises their credit quality. Specifically, the
credit quality of the securitized car loan assets would be raised during the credit
rating process if the principal value of notes issued is lower (not higher) than the
principal value of the assets.

C is incorrect. The statement describes an amortizing (pass-through) SPV structure

and not a revolving SPV structure, which can provide principal payments in equal
installments or as lump sum payments at maturity. However, it incorrectly states that
pre-payment assumptions are not incorporated.

D is incorrect. The first part of the statement describes the master trust SPV
structure, not the revolving structure, and the reference to weighted-average life
(WAL) describes the amortization structure.

Section Credit Risk Measurement and Management

Learning Define securitization, describe the securitization process, and explain the role of
Objective participants in the process.

Reference Moorad Choudhry, Structured Credit Products: Credit Derivatives & Synthetic
Securitisation, 2nd Edition (New York, NY: John Wiley & Sons, 2010). Chapter 12.
An Introduction to Securitisation

134
61. Question A risk analyst at an investment bank is examining how quantile estimators can be
incorporated into the bank’s risk measures. The analyst focuses on how estimators
are constructed and how their precision and usefulness are determined. Which of
the following statements about quantile estimators is correct?

A Each quantile in the loss distribution must have an equal weight when used to
create a coherent risk measure.
B The data and processes involved in estimating quantiles are different from those
used to estimate coherent risk measures.
C QQ plots are a useful tool to evaluate the precision of a quantile estimator.
D Both the halving error and the standard error of a quantile estimator decrease as the
number of quantiles used in the estimation process increases.

Correct D
Answer

Explanation D is correct. The halving error and the standard error of a quantile estimator will
both decrease as the number of slices, n, or quantiles, used in the process of
estimating the risk measure increases.

A is incorrect. Coherent risk measures can be created using sophisticated weighting

functions and do not need to be equally weighted.

B is incorrect. The building blocks of quantile estimation are essentially the same
needed to estimate coherent risk measures.

C is incorrect. QQ plots are a useful diagnostic tool when considering what kind of
distribution might fit the profit and loss data. QQ plots are not used to analyze or
evaluate quantile estimators.

Section Market Risk Measurement and Management

Learning Estimate risk measures by estimating quantiles.

Objective

Reference Kevin Dowd, Measuring Market Risk, 2 nd edition, West Sussex, UK, John Wiley and
Sons, 2005. Chapter 3. Estimating Market Risk Measures: An Introduction and
Overview

135
62. Question The head of the fixed-income department of a bank asks a risk analyst to review an
outstanding bond issued by Company GRN, a livestock producer. The bond
currently trades at a spread of 250 bps over the risk-free interest rate and has a
recovery rate of 75%. Senior management of the bank has expressed concern
about the slowdown in business activities in the livestock industry, which is
expected to last for the next 3 years. The analyst applies the constant hazard rate
process in estimating default probability and assumes that, under a stressed market
scenario, the bond would trade at a spread of 480 bps over the risk-free interest rate
curve, and its recovery rate would decrease to 40%. Assuming the stress scenario
prevails, what would be the correct estimate of the probability that Company GRN
would not default on its bond over the next 3 years?

A 69.8%
B 78.7%
C 86.6%
D 74.1%

Correct B
Answer

Explanation B is correct. First, calculate the hazard rate under stressed condition (See page
138, [CR-6]):
480
𝑠𝑝𝑟𝑒𝑎𝑑 (10000)
= = = 0.08
1 − 𝑅𝑅 1 − 0.4

Using the constant hazard rate process, the probability of surviving up to end of
year 3 (t = 3) = exp(-t) = exp(-0.08*3) = 0.7866 = 78.66%.

A is incorrect. 69.77% is the result obtained by incorrectly using the recovery rate
and not the LGD in the hazard rate formula.

C is incorrect. 86.59% is the result obtained by incorrectly taking the hazard rate per
year to be equal to 4.8% (ignoring the recovery rate). Thus, probability of surviving
up to end of year 3 = exp(-t) = exp(-0.048*3) = 0.8659 = 86.59%.

D is incorrect. 89.14% is the result obtained by incorrectly using the original spread
(250 bps) and recovery rate of 75% to calculate the hazard rate per year = 250 /
(10,000/0.25) = 0.10, which provides probability of surviving up to end of year 3 =
exp(-t) = exp(-0.10*3) = 0.7401 = 74.1%.

Section Credit Risk Measurement and Management

Learning Define the hazard rate and use it to define probability functions for default time and
Objective to calculate conditional and unconditional default probabilities.

136
Reference John C. Hull, Risk Management and Financial Institutions (Sixth Edition, John Wiley
& Sons, 2023). Chapter 17. Estimating Default Probabilities.

137
63. Question A portfolio manager is constructing an equity portfolio that will include several
equities from multiple industries. The manager aims to achieve mean/variance
optimization and asks a group of analysts to perform alpha analysis and also to
estimate other portfolio inputs. As part of the alpha analysis, the analysts adjust
alphas based on the portfolio’s constraints and exclude very large positive and
negative alphas from their calculations. Additionally, the analysts plan to remove
biases or undesirable bets from the alphas. Which of the following procedures
should the analysts apply to execute this plan?

A Stratification
B Neutralization
C Scaling
D Trimming

Correct B
Answer

Explanation B is correct. We can remove biases or undesirable bets from our alphas by
neutralization. Benchmark neutralization means that the benchmark has 0 alpha. If
our initial alphas imply an alpha for the benchmark, the neutralization process
recenters the alphas to remove the benchmark alpha. We may also want to make
the alphas cash-neutral; i.e., the alphas will not lead to any active cash position. It is
possible to make the alphas both cash- and benchmark-neutral. We can also
neutralize the alphas against the risk factors. The neutralized alphas will include
only information on the factors the manager can forecast, along with specific asset
information. Once neutralized, the alphas of the risk factors will be 0. For example, a
manager can ensure that her portfolios contain no active bets on industries or on a
size factor.

A is incorrect. Stratification is not an alpha refinement method; it is a portfolio

construction method.

C is incorrect. Alphas must have already been scaled when the constraints were
incorporated into the calculations.

D is incorrect. Analysts already applied trimming by excluding very large positive

and negative alphas from calculations.

Section Risk Management and Investment Management

Learning Describe neutralization and the different approaches used for refining alphas to be
Objective neutral.

Reference Richard Grinold and Ronald Kahn, Active Portfolio Management: A Quantitative
Approach for Producing Superior Returns and Controlling Risk, 2nd Edition (New
York, NY: McGraw-Hill, 2000). Chapter 14. Portfolio Construction

138
64. Question The CRO at a bank wants to strengthen the bank’s capability to defend itself against
emerging cyber-threats. To help achieve this goal, the CRO is assessing the current
range of practices regarding the sharing of cybersecurity information between
different types of institutions, as well as the potential benefits from sharing
information. Which of the following statements would be most appropriate for the
CRO to make?

A The sharing of cybersecurity information among banks is less frequently observed

and generally considered to be less effective than other cyber-security information-
sharing practices.
B The scope and depth of information-sharing practices among banks may
significantly vary between financial markets, depending on the level of trust among
participating banks.
C Information-sharing among different national regulators has evolved significantly
over the past several years and is now a widespread practice at a large majority of
jurisdictions.
D Existing peer-sharing mechanisms among banks focus on the exchange of
information related to cyber-security incidents, but such information is generally not
shared from banks to regulators.

Correct B
Answer

Explanation B is correct. Sharing of information and collaboration among banks depends on the
financial industry’s culture and level of trust among participants. Experience shows
that a two-level information-sharing structure through which information would be
first shared on the interpersonal level with a closer group and then be exchanged at
the company level with a broader group of banks helps build trust into the system.

A is incorrect. Sharing of information among banks is one of the most widely

observed practices across jurisdictions and a relatively wider range of information,
such as knowledge about cyber threats / cyber intelligence is typically shared
among banks.

C is incorrect. Sharing amongst regulators is one of the least observed practices

and a majority of jurisdictions do not currently allow it.

D is incorrect. Banks typically do not share information about cyber-incidents with

each other, but they do share this information with regulators at times when required
by regulatory reporting practices.

Section Operational Risk and Resilience

Learning Explain and assess current practices for the sharing of cybersecurity information
Objective between different types of institutions.

Reference “Cyber-Resilience: Range of Practices”, Basel Committee on Banking Supervision,

December 2018

139
65. Question The board of directors at a large bank wants to improve the bank’s practices for
managing money laundering and financial terrorism (ML/FT) risk. The risk
committee of the bank meets to discuss ways to achieve this objective that conform
to best practices. Which of the following actions would be most appropriate for the
bank to recommend?

A Require the bank’s business units to screen potential employees as part of the first
line of defense in managing ML/FT risk.
B Establish a threshold transaction value and review all transactions above this
threshold for evidence of ML/FT.
C Exclude politically exposed persons (PEPs) from screening for ML/FT risk due to
their much lower ML/FT risk.
D Give the compliance and legal functions the primary responsibility for managing
ML/FT risk.

Correct A
Answer

Explanation A is correct. As part of the first line of defense, business units must identify, assess,
and control ML/FT risks, have written policies and procedures as well as employee
training for managing ML/FT risk, and screen potential employees.

B is incorrect. Monitoring for ML/FT risk should cover all accounts and transactions.

C is incorrect. Politically exposed persons (PEP) pose higher ML/FT risk given the
possibility that some wealth may have been obtained through corruption.

D is incorrect. A chief ML/FT officer should be appointed to lead the bank’s

management of ML/FT risk, and ideally ML/FT risk should be managed using a
three lines of defense approach involving multiple business functions.

Section Operational Risk and Resilience

Learning Explain best practices recommended for the assessment, management, mitigation
Objective and monitoring of money laundering and financial terrorism (ML/FT) risks.

Reference Mark Carey “Management of Risks Associated with Money Laundering and
Financing of Terrorism,” GARP Risk Institute, February 2019.

140
66. Question A risk analyst at an investment bank is evaluating the bank’s application of extreme
value theory (EVT) in managing financial risks. The analyst compares different
methods of estimating extreme value (EV) parameters for the bank’s operational
loss distribution and examines the mechanics of each method, as well as their
advantages and disadvantages. Which of the following statements regarding a
method used for estimating EV parameters is correct?

A The regression method uses an ordered sample of losses to obtain least squares
estimates of the EV parameters.
B The maximum-likelihood method uses the average of a random number of the most
extreme observations to estimate EV parameters.
C The main challenge associated with the moment-based method is choosing the
number of observations that minimizes the mean-squared-error loss function.
D A drawback of the semi-parametric estimation method is that the Hill estimator is
neither consistent nor asymptotically normal.

Correct A
Answer

Explanation A is correct. The regression method is the easiest method to apply, and the
recovery of least squares estimates of the EV parameters from a regression is
straightforward. The first step in applying the regression method is to order the
sample of extreme values from lowest to highest.

B is incorrect. The use of an arbitrary (not random) number would correctly describe
the Hill estimator, which is used in semi-parametric estimation method. However,
this would still be an incorrect answer to this specific question.

C is incorrect. The main challenge with the semi-parametric method (not the
moment-based method) is choosing the number of observations to include in the
tail, as the parameter estimates can be sensitive to this number.

D is incorrect. The most popular semi-parametric estimation method is the Hill

estimator, which is known to be consistent and asymptotically normal.

Section Market Risk Measurement and Management

Learning Describe extreme value theory (EVT) and its use in risk management.
Objective

Reference Kevin Dowd, Measuring Market Risk, 2 nd edition, West Sussex, UK, John Wiley and
Sons, 2005. Excerpt of Chapter 7. Measuring Market Risk

141
67. Question A treasurer at a regional bank is assessing the bank’s liquidity position. The
treasurer estimates that the following cash inflows and outflows will occur in the next
week:

Amount
Cash Flows (USD million)
Deposit withdrawals 50
Deposit inflows 80
Scheduled loan repayments 120
Acceptable loan requests 100
Borrowings from money market 80
Operating expenses 70
Stockholder dividend payments 40
Repayment of bank borrowings 60

Which of the following is the correct amount (in millions of USD), at the week’s end,
for the bank’s net liquidity position?

A USD -200
B USD -80
C USD -40
D USD 80

Correct C
Answer

Explanation C is correct. -50+80+120-100+80-70-40-60 = -40

A is incorrect. Flips the sign for borrowings from money market.

B is incorrect. Flips the sign for scheduled loan repayments and acceptable loan
requests.

D is incorrect. Flips the sign for repayment of bank borrowings.

Section Liquidity and Treasury Risk

Learning Calculate a bank’s net liquidity position and explain factors that affect the supply
Objective and demand of liquidity at a bank.

Reference Peter Rose, Sylvia Hudgins, Bank Management & Financial Services, 9th Edition
(New York, NY: McGraw- Hill, 2013). Chapter 11 - Liquidity and Reserves
Management: Strategies and Policies

142
68. Question A newly established pension fund hires a risk consultant to help develop its risk
management framework and tools. During an initial meeting with the fund
managers, the consultant discusses the fundamental dimensions of the risk
management process and describes risk planning, risk budgeting, and risk
monitoring, as well as how each of these three dimensions should be structured.
Which of the following statements about the risk plan or the risk budget is correct?

A The risk budget should define acceptable levels of return on risk capital (RORC) for
each risk capital allocation.
B The risk budget should identify the firm’s critical dependencies regarding funding
and investment performance.
C The risk plan should state exactly how risk capital should be allocated among asset
classes.
D The risk plan should set volatility goals such as VaR or tracking error for relevant
time periods.

Correct D
Answer

Explanation D is correct. The risk plan should set expected return and volatility goals (e.g. VaR
or tracking error) for relevant time periods.

A is incorrect. The risk plan should define acceptable levels of return on risk capitals
(RORCs) for each risk capital allocation.

B is incorrect. The risk plan should identify critical dependencies that exist inside
and outside the organization.

C is incorrect. The risk budget expresses exactly how risk capital should be
allocated among asset classes and active managers.

Section Risk Management and Investment Management

Learning Describe the three fundamental dimensions behind risk management, and their
Objective relation to VaR and tracking error.

Reference Robert Litterman and the Quantitative Resources Group, Modern Investment
Management: An Equilibrium Approach (Hoboken, NJ: John Wiley & Sons, 2003).
Chapter 17. Risk Monitoring and Performance Measurement

143
69. Question An analyst at a financial institution has been asked to assess the quality of
estimating credit VaR (CVaR) of a homogenous portfolio of firms (credits) using the
single-factor model, under which default correlation varies with the firm’s beta to the
market factor. The analyst examines the portfolio under the following assumptions:

• There are 1,000 firms (credits) in the portfolio.

• Each firm represents 0.1% of the portfolio.
• There is no idiosyncratic risk.
• Loss given default is the same for each firm in the portfolio.

Based on the information provided, which of the following observations, if made by

the analyst, would be correct regarding the application of the single-factor model
and its parameters?

A When the firm’s beta to the market factor is equal to 1, the loss rate of the credits is
either 0% or 100%.
B The distance to default of a firm will typically be low if the correlation to the market
factor is low, for a given probability of default.
C When the asset return correlation to the market factor is equal to zero, the loss rate
is typically higher than the probability of default of a firm in the portfolio.
D The asset return correlation to the market factor is measured by the square root of
beta.

Correct A
Answer

Explanation A is correct. Under perfect correlation (beta equal to 1), there are two possibilities:
either all the credits default (loss rate equals to 100%), or none of the credits
defaults (loss rate equals to 0%).

B is incorrect. The reading explains that correlation to the market factor determines
how spread out the defaults are over the range of the market factor such that, if the
correlation to the market factor is low (high), then for any probability of default, the
number of defaults will be low (high) and the distance to default of credit assets will
typically be high (low).

C is incorrect. Given no idiosyncratic risk and a default correlation of zero, the loss
rate is likely very close to the probability of default.

D is incorrect. The pairwise asset return correlation is measured by the square of

beta.

Section Credit Risk Measurement and Management

Learning Describe the use of a single factor model to measure portfolio credit risk, including
Objective the impact of correlation.

Reference Allan Malz, Financial Risk Management: Models, History, and Institutions,
(Hoboken, NJ: John Wiley & Sons, 2011). Chapter 8. Portfolio Credit Risk.

144
70. Question A model validation team at a bank is backtesting the bank’s VaR model. In
preparation for the backtest, one of the team members expresses a concern that the
validation process could result in the team committing a Type I error or a Type II
error and discusses the characteristics of these errors with the team. Which of the
following is correct regarding Type I and Type II errors?

A The probability of committing a Type II error decreases when the sample size
increases and the level of significance is held constant.
B A backtest is considered statistically powerful if it minimizes the probability of
committing a Type II error regardless of the probability of committing a Type I error.
C A Type I error is committed when an incorrectly specified model is accepted.
D A Type II error is committed when a correctly specified model is rejected.

Correct A
Answer

Explanation A is correct. As the sample size increases, the confidence region of the failure rate
(expressed as N/T) for a correctly specified model will shrink, and an incorrectly
specified model should be able to be rejected more easily.

B is incorrect. A test with a low type I error rate and a low type II error rate is said to
be powerful. The power of a test relates to the error rates of both type I and type II
errors.

C is incorrect. A type I error is rejecting a correctly specified model.

D is incorrect. A type II error is not rejecting an incorrectly specified model.

Section Market Risk Measurement and Management

Learning Define and identify Type I and Type II errors.

Objective

Reference Philippe Jorion, Value at Risk: The New Benchmark for Managing Financial Risk,
3rd Edition (New York, NY: McGraw-Hill, 2007). Chapter 6. Backtesting VaR

145
71. Question A risk manager at a bank is conducting an internal training program for newly hired
credit risk analysts. The manager gives an overview of credit risk models, compares
the bank’s internal credit rating models to the rating agencies’ models, and explains
the assumptions, structure, and performance measures of these models as applied
to counterparty default prediction. Assuming a stable market environment, which of
the following statements would the manager be correct to make?

A The Credit Risk Plus (CreditRisk+) model relies on the use of a company’s capital
structure and credit ratings to predict default of the company.
B Unlike the Merton model that produces default predictions based on asset and
liability values, the agencies’ rating models produce default predictions from a
substantially larger set of business factors.
C Unlike the agencies’ rating models, the KMV model is only used to compute the risk
of pure debt contracts and is not applicable to portfolios that include derivatives
contracts.
D A good rating model is expected to provide accurate borrower default predictions
without the need to be backtested.

Correct B
Answer

Explanation B is correct. The agencies’ rating models also consider the country of incorporation
and/or of operations (so called ‘sovereign’ risk), the industry profile and the
competitive environment, the business sector and many more. The statement is
correct as presented.

A is incorrect. The Credit Risk Plus (CreditRisk+) model does not use the company’s
capital structure (unlike the KMV model) and credit ratings (unlike the CreditMetrics
model) to predict default. It focuses on default events.

C is incorrect. KMV models can be used to compute the risk of portfolios that
include other payoffs besides pure debt contracts. For example, swap contracts,
convertible debt, etc.

D is incorrect. Desirable features of rating systems include measurability and

verifiability, which means they have to give correct expectations in terms of default
probabilities, adequately and continuously back tested.

Section Credit Risk Measurement and Management

Learning Apply the Merton model to calculate default probability and the distance to default
Objective and describe the limitations of using the Merton model.

Discuss measures of sovereign default risk and describe components of a

sovereign rating.

Describe rating agencies’ assignment methodologies for issue and issuer ratings,
and identify the main criticisms of the credit rating agencies’ ratings.

Compare and contrast different approaches to credit risk modeling, such as those
related to the Merton model, Credit Risk Plus (CreditRisk+), CreditMetrics, and the

146
 Moody’s-KMV model.

Reference Aswath Damodaran, Country Risk: Determinants, Measures, and Implications – The
2022 Edition (2022).

Michalis Doumpos, Christos Lemonakis, Dimitrios Niklis, and Constantin

Zopounidis, Analytical Techniques in the Assessment of Credit Risk: An Overview of
Methodologies and Applications (Springer, 2019). Chapter 1. Introduction to Credit
Risk Modeling and Assessment.

Michalis Doumpos, Christos Lemonakis, Dimitrios Niklis, and Constantin

Zopounidis, Analytical Techniques in the Assessment of Credit Risk: An Overview of
Methodologies and Applications (Springer, 2019). Chapter 2. Credit Scoring and
Rating.

147
72. Question The beneficiary of a trust who reaches adulthood and inherits assets that are mostly
liquid meets with an investment advisor to consult on various investment options.
During the meeting, the beneficiary expresses an interest in understanding the
different types of funds, especially hedge funds. Which of the following statements,
if made by the investment advisor, is correct?

A Market timing skills of indexed fund managers are more important than market
timing skills of hedge fund managers.
B Demands of institutional investors regarding the privacy of their investments have
caused hedge funds to become less transparent over time.
C Leveraging of investor capital and shorting securities are practices that are used
more extensively by hedge funds than by most conventional funds.
D Hedge funds must disclose their investment strategies to existing and prospective
clients, but exchange-traded funds do not have to.

Correct C
Answer

Explanation C is correct. It is the practice of shorting and the leveraging of investors’ capital that
distinguishes hedge funds from conventional long-bias funds.

A is incorrect. An indexed fund is managed to have holdings that mimic a

benchmark index and it has well-defined performance targets. A hedge fund, on the
other hand, can hold substantial short positions in a range of asset categories and
apply complex strategies. Therefore, hedge fund portfolio returns are highly
dependent on the relevant managers’ market timing skills.

B is incorrect. The opacity of hedge fund vehicles persisted for over half a century
until the arrival of institutional investors in the new millennium. It was wealthy
individual investors of early hedge fund vehicles who demanded their investment in
the vehicle be kept private.

D is incorrect. Mutual funds and ETFs must disclose their investment strategies.
Hedge funds generally follow proprietary strategies that they see as fundamental to
their competitiveness and/or value proposition. They give prospective clients some
information to explain their value proposition, but do not disclose everything.
Furthermore, they are not obligated to stick to one strategy.

Section Risk Management and Investment Management

Learning Describe the characteristics of hedge funds and the hedge fund industry and
Objective compare hedge funds with mutual funds.

Reference G. Constantinides, M. Harris and R. Stulz, eds., Handbook of the Economics of

Finance, Volume 2B (Oxford, UK: Elsevier, 2013). Chapter 17. Hedge Funds

148
73. Question Quant Banking Corporation (QBCo) is a large financial institution based in Brazil.
QBCo’s core liquid assets include Brazil government bonds, cash, and foreign
sovereign bonds. In addition to receiving deposits, QBCo raises funds by issuing
secured short-term debt and unsecured long-term debt. The CRO of the bank is
analyzing the investment committee’s proposal to sell QBCo’s holdings of UK
government bonds and allocate the proceeds to extend new loans denominated in
BRL to corporations headquartered in Brazil. The new loans would be held to
maturity and fully collateralized by high quality foreign sovereign securities. The
CRO estimates that UK government bonds currently account for approximately 15%
of QBCo’s total assets. The estimated mark-to-market values and average value-
weighted durations of the bank’s assets and liabilities before implementation of the
proposal are given below:

Average value-
Market value weighted duration
Total assets BRL 60 billion 6 years
Total liabilities BRL 50 billion 6 years

Assuming no change to the average value-weighted duration of assets, no other

changes to QBCo's asset and liability structure, and all foreign exchange exposures
are fully hedged, which of the following will be correct if the bank implements the
new proposal?

A The credit quality of QBCo’s assets will not necessarily decrease from issuing new
loans to corporations headquartered in Brazil.
B QBCo should manage its leverage-adjusted duration gap by taking long positions in
government bond futures to address the risk of rising interest rates.
C The trading book VaR of QBCo will show significant increase.
D The liquidity coverage ratio of QBCo will show significant increase.

Correct A
Answer

Explanation A is correct. The new corporate loans are collateralized by investment-grade

sovereign securities. To a large extent, while sovereigns still bear some risk, they
are reasonably liquid, low default risk, and are good risk mitigants. Thus, the bank’s
credit quality does not necessarily decrease with the issuing of new credits to local
corporates. In addition, assuming the sovereign bonds used as collateral come from
a number of countries, there may also be a diversification effect that will reduce
QBCo’s credit risk.

B is incorrect. QBCo currently has a positive leverage-adjusted duration gap [(DA –

(DL)*(L/A)] = + 1.0 > 0] (asset duration greater than leverage-adjusted liability
duration), which poses a significant interest rate risk to the bank if interest rates rise.
In that situation the bank’s net worth will decline as assets will lose more value than
the decrease in liabilities. To hedge the risk, the bank can shorten the duration of the
assets by taking a short (not long) position in futures contracts (or options, or
swaps).

C is incorrect. There is insufficient information to determine with certainty that the

trading book’s VaR after the transaction will increase. We know that portfolio value
will decrease (UK government bonds sold, and the proceeds are moved to the

149
 banking book), which may lower trading book portfolio VaR. But we don’t know if the
change in interest rates will not impact portfolio volatility. A rise in portfolio volatility
would increase VaR. Thus, the net effect is unknown.

D is incorrect. The liquidity coverage ratio (LCR) is computed as:

𝐻𝑖𝑔ℎ 𝑞𝑢𝑎𝑙𝑖𝑡𝑦 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

𝐿𝐶𝑅 = >1
𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 𝑖𝑛 𝑎 30 𝑑𝑎𝑦 𝑝𝑒𝑟𝑖𝑜𝑑

In this case, while there is no change in the “Net cash outflows in a 30-day period”
(denominator), there is definitely a decrease in the numerator, the “High quality
liquid assets (HQLA)”. Since sovereign securities (UK government bonds), with zero
risk-weight and no haircuts, are being replaced with corporate bonds with 50%
haircuts, the HQLA will decrease. Thus, LCR will decrease.

Section Credit Risk Measurement and Management

Liquidity and Treasury Risk Measurement and Management

Operational Risk and Resilience

Risk Management and Investment Management

Learning Describe the scope and allocation processes of a bank’s credit facility and explain
Objective bank-specific policies and actions to reduce credit risk.

Explain the components of credit risk management capacity and outline key
questions that the board of directors of a bank should ask.

Describe duration gap management and apply this strategy to protect a bank’s net
worth.

Describe and calculate ratios intended to improve the management of liquidity risk,
including the required leverage ratio, the liquidity coverage ratio, and the net stable
funding ratio.

Define, calculate and distinguish between the following portfolio VaR measures:
individual VaR, incremental VaR, marginal VaR, component VaR, undiversified
portfolio VaR and diversified portfolio VaR.

Reference Hennie van Greuning and Sonja Brajovic Bratanovic, Analyzing Banking Risk
(Fourth Edition, World Bank Group, 2020). Chapter 7. Credit Risk Management.

Peter Rose, Sylvia Hudgins, Bank Management & Financial Services, 9th Edition
(New York, NY: McGraw-Hill, 2013). Chapter 7. Risk Management for Changing
Interest Rates: Asset-Liability Management and Duration Techniques.

Mark Carey, “Solvency, Liquidity and Other Regulation After the Global Financial
Crisis,” GARP Risk Institute, April 2019.

Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk,
3rd Edition (New York, NY: McGraw-Hill, 2007). Chapter 7. Portfolio Risk: Analytical
Methods.

150
74. Question An analyst on the emerging markets fixed-income desk of an investment bank has
been asked to construct a term structure model of interest rates for one of the
countries the desk covers. After conducting initial research, the analyst assumes
that the 1-year spot rate for each of the next 3 years is expected to be 17.00% and
that the interest rate process can be represented by the following risk-neutral
interest rate tree:

Which of the following correctly describes the shape of the term structure that will
result from the given interest rate tree?

A Slightly downward sloping, since discounting the terminal cash flow over longer time
periods when interest rates exhibit volatility results in slightly lower spot rates.
B Flat, since the interest rate tree is based on the assumption that all expected 1-year
spot rates are equal.
C Slightly upward sloping, since there is an opportunity cost associated with long-term
interest rates.
D Steeply upward sloping, since investors will demand higher long-term interest rates
as compensation for interest rate volatility.

Correct A
Answer

Explanation A is correct. The shape of the term structure will be slightly downward sloping due to
the effect of discounting the terminal cash flow by the high and highly volatile
interest rates in the tree given above. This can be seen from the calculations of the
2- and 3-year spot rates below:

Price of 2-year zero = 1/(1 + 2-year spot rate)^2

Price of 3-year zero = 1/(1 + 3-year spot rate)^3

The interest rate tree is used to derive the price trees, which are then used in the
above formulas.

2-year price tree:

151
 So, 0.73073 = 1/(1+R2)^2 , (1+R2)^2 = 1/0.73073, 1+ R2 = 1.16983, R2=0.16983

3-year price tree:

So, 0.62510 = 1/(1+R3)^3 , (1+R3)^3 = 1/0.62510, 1+ R3 = 1.16953, R3=0.16953

Since the 2-year spot rate is 16.983% and the 3-year spot rate is 16.953% the term
structure is downward sloping.

P 169-170

B is incorrect. Even though all 1-year spot rates are assumed to be the same the
term structure is not flat, as shown in the calculations for A.

C and D are incorrect. As shown in the calculations the term structure will be
downward sloping, not upward sloping.

Section Market Risk Measurement and Management

Learning Apply a risk-neutral interest rate tree to assess the effect of volatility on the shape of
Objective the term structure.

152
Reference Bruce Tuckman and Angel Serrat, Fixed Income Securities: Tools for Today’s
Markets, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011). Chapter 8. The
Evolution of Short Rates and the Shape of the Term Structure

153
75. Question The CRO of Bank Alpha is reviewing a report from the US Federal Reserve on the
recent supervisory stress test performed on Bank Alpha. The report notes that while
Bank Alpha continues to build its capital levels and strengthen its ability to lend
during periods of stressed market conditions, the bank’s recent acquisition of a large
regional competitor and its growing exposure to digital assets make it vulnerable
under “severely adverse” scenarios. After discussing the stress test report, Bank
Alpha’s board of directors asks the CRO to critically review the bank’s risk
management practices. A summary of the CRO’s findings is given below:

• Item 1: Bank Alpha applies a counterparty’s marginal default probability and

the correlation of its own credit spread with the counterparty’s credit spread
as key inputs in stress testing counterparty credit risk.

• Item 2: Bank Alpha incorporates scenario analysis in its capital planning

process but only considers scenarios that lead to the quantification of risk.

• Item 3: Bank Alpha considers that contingency funding planning stress

scenarios are independent of its liquidity stress scenarios.

• Item 4: Bank Alpha complies with the regulatory requirement in sharing

information about cyber-security threats with peer banks to enable
regulators effectively monitor and mitigate systemic risk.

Which of the findings reported by the CRO in relation to Bank Alpha’s stress testing
and scenario analysis is aligned with best practices?

A Item 1
B Item 2
C Item 3
D Item 4

Correct A
Answer

Explanation A is correct. When stress testing counterparty credit risk, Bank Alpha should not
only consider that its counterparty will default, but also that the bank itself could
default to its counterparty. Thus, Bank Alpha should take the counterparty’s
marginal default probability as a significant input, but also should consider the
correlation of its own credit spread with the counterparty’s credit spread. (See pages
304-305 [CR-14]).

B is incorrect. Stress testing within the risk appetite framework should help the bank
incorporate the implications of all the risks, qualitative and quantitative, on both the
bank’s risk appetite and implications on its capital levels. (See ORR reading,
Chapter 7; also, see discussions in Foundations of Risk Management (FRM Part I)
reading, pages 47-52).

C is incorrect. The bank’s contingency funding planning (CFP) stress scenarios and
liquidity stress scenarios should be aligned. Liquidity stress test scenarios address
both systemic risks and institution-specific liquidity and funding liquidity risks over
short-term and prolonged stress periods.

154
 D is incorrect. Sharing information about cyber-security threat is not a regulatory
requirement, it is a recommendation, however. Regulators in most jurisdictions are
not directly involved in bank-to-bank information-sharing but do play a role in
facilitating the establishment of voluntary sharing mechanisms of cyber-vulnerability,
threat and incident information, and in some cases indicators of compromise.” (See
pages 145-148 [ORR-8]).

Section Credit Risk Measurement and Management

Operational Risk and Resilience

Liquidity and Treasury Risk Measurement and Management

Learning Describe a stress test that can be performed on CVA. [CR–16]

Objective
Describe the role of risk governance, risk appetite, and risk culture in the context of
an enterprise risk management (ERM) framework. [ORR-7]

Discuss the relationship between contingency funding plan and liquidity stress
testing. [LTR–11]

Explain and assess current practices for the sharing of cybersecurity information
between different types of institutions. [ORR-8]

Reference Stress Testing: Approaches, Methods, and Applications, Edited by Akhtar Siddique
and Iftekhar Hasan (London, UK: Risk Books, 2013). Chapter 4. The Evolution of
Stress Testing Counterparty Exposures

GARP (2022). Integrated Risk Management. Chapter 7.

Shyam Venkat, Stephen Baird, Liquidity Risk Management (Hoboken, NJ: John
Wiley & Sons, 2016). Chapter 7. Contingency Funding Planning

“Cyber-resilience: Range of practices,” (Basel Committee on Banking Supervision

Publication, December 2018). Chapter 8

155
76. Question A credit analyst at an investment firm is estimating the 99% credit VaR of a 1-year
zero-coupon bond, the only debt issued by the firm. The analyst obtains relevant
data presented below:

• Face value of the firm’s 1-year zero-coupon bond: CNY 630 million
• The bond’s expected 1-year probability of default (PD): 6%
• The bond’s 1-year recovery rate: 90%

Assuming the variation of the future value of the bond is solely due to the possibility
of default, and the analyst’s estimate of the value of the bond in 1 year at the 99%
confidence level is CNY 567 million, what is the bond’s implied 1-year 99% credit
VaR?

A CNY 2.52 million

B CNY 3.40 million
C CNY 3.78 million
D CNY 6.30 million

Correct Answer A

Explanation A is correct.

The 99% CVaR = 99th percentile of the unrecovered credit loss – Expected Loss

where,

• 99th percentile of the unrecovered credit loss = (630 – 567)*(1 – 0.9) million
= CNY 6.3 million

• Expected Loss = PD x LGD x EAD = 0.06* (1 – 0.9) * 630 = CNY 3.78 million

Therefore,

CVaR at 99% confidence level = 6.30 – 3.78 = CNY 2.52 million.

B is incorrect. CNY 3.402 million is the result of subtracting CNY 3.78*0.1 million
from (CNY 630m*0.06*0.1).

C is incorrect. CNY 3.78 million is the EL.

D is incorrect. CNY 6.3 million is the incorrect result of ignoring the EL.

Section Credit Risk Measurement and Management

Learning Define and calculate Credit VaR.

Objective

Reference Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken,
NJ: John Wiley & Sons, 2011). Chapter 8. Portfolio Credit Risk (Sections 8.1, 8.2,
8.3 only)

156
77. Question A risk analyst at a bank is asked to prepare a report that tracks the relationship
between volatility and asset performance. The analyst assesses the performance of
various asset classes using empirical evidence over the last three decades and
compares returns on those asset classes with changes in market volatility. Which of
the following would be a correct statement for the analyst to include in the report?

A Currency strategies such as currency carry trades tend to perform poorly during
periods of high volatility.
B When volatility is rising, all assets are either positively or negatively affected, with
the exception of risk-free bonds.
C Whether the relationship between stock returns and volatility is positive or negative
depends on the phase of the business cycle.
D When volatility is rising, stock returns tend to increase but bond returns tend to
decrease.

Correct A
Answer

Explanation A is correct. Currency strategies fare especially poorly in times of high volatility.

B is incorrect. Risk-free bonds tend to perform well during periods of high volatility.

C is incorrect. The relationship is negative for stocks and it doesn’t change sign as
the economy switches from one phase to another.

D is incorrect. Stock returns also tend to decrease during periods of rising volatility.

Section Risk Management and Investment Management

Learning Explain how different macroeconomic risk factors, including economic growth,
Objective inflation, and volatility, affect asset returns and risk premiums.

Reference Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (New
York, NY: Oxford University Press, 2014). Chapter 7. Factors

157
78. Question A junior risk analyst at an investment bank is using a rating migration matrix to
calculate the default probability of a corporate bond issuer. The 1-year credit
migration matrix is presented below:

Rating in the next period

Current rating A B C Default
A 90% 8% 0% 2%
B 5% 76% 10% 9%
C 1% 14% 69% 16%

Which of the following statements is correct?

A A corporate bond that is currently rated A, and maintains the same rating up to the
end of year 1, has a 1.8% chance of default in year 2.
B A corporate bond that is currently rated B, and maintains the same rating up to the
end of year 1, has an 8.1% chance of default in year 2.
C A corporate bond that is currently rated B will default over a 2-year period with a
probability of 15.9%.
D A corporate bond that is currently rated C will default over a 2-year period with a
probability of 27.0%.

Correct A
Answer

Explanation A is correct. In year 2, there is a 1.80% chance of default if the bond was rated A at
end of first year and was rated A at beginning of first year (= 90%*2% = 1.80%).

B is incorrect. In year 2, there is a 6.84% chance of default if the bond was rated B
(6.84% = 76%*9%) and not 8.1% (= 0.90 * 0.09 = 0.081).

C is incorrect. The probability of default of a bond currently rated B over a 2-year

period is 17.54% (not 15.94%, which ignores the 1.6%). There are four situations
which should be assessed (calculated) (and not the first three which give a
probability of 15.94%):

Current B: first year > Default; second year > Default = 9%*100% = 9.00%
Current B: first year > A; second year >Default = 5%*2% = 0.10%
Current B: first year > B; second year > Default = 76%*9% = 6.84%
Current B: first year > C; second year > Default = 10%*16% = 1.60%
Therefore, the total probability is: 9.0% + 0.10% + 6.84% + 1.6% = 17.54%.

D is incorrect. For an issuer currently rated C: After year 1 there is a 16% chance of
default and 69% chance of still being C-rated; and 1% chance of being A-rated; and
a 14% chance of being B-rated.

In year 2, there is a 0.02% chance of default if it was rated A (1%*2% = 0.02%); and
a 1.26% chance of default if it was rated B (1.26% = 14%*9%); and 11.04% if it was
rated C (= 69%*16% = 11.04%).

For a bond currently rate C, there are also FOUR situations which should be
calculated:

158
 Current C: first year > Default; second year > Default = 16%*100% = 16.00%
Current C: first year > A; second year >Default = 1%*2% = 0.02%
Current C: first year > B; second year > Default = 14%*9% = 1.26%
Current C: first year > C; second year > Default = 69%*16% = 11.04%
Therefore, the total probability is: 16.00% + 0.02% + 1.26% + 11.04% = 28.32%
(and not 27.0%).

Section Credit Risk Measurement and Management

Operational Risk and Resilience

Learning Describe the relationship between borrower rating and probability of default.
Objective

Reference John C. Hull, Risk Management and Financial Institutions (Sixth Edition, John Wiley
& Sons, 2023). Chapter 17. Estimating Default Probabilities.

159
79. Question An analyst at a fixed-income investment company is evaluating different ways the
company uses to estimate the VaR of its corporate bond portfolios. The portfolios
consist of a large number of bonds with a wide range of maturities. The analyst
examines the possibility of using a mapping approach to simplify the estimation
process. Which of the following statements would the analyst be correct to make
regarding the approaches to mapping fixed-income portfolios?

A The VaR estimated using the principal mapping approach understates the true risk
of a portfolio since it ignores coupon payments and any risk associated with them.
B The VaR estimated using the duration mapping approach replaces the portfolio with
a zero-coupon bond whose maturity equals the duration of the portfolio.
C The VaR estimated using the principal mapping approach differs from the
undiversified VaR estimated using the duration mapping approach due to an
adjustment made for correlations.
D The VaR estimated using the cash-flow mapping approach is less accurate than the
VaR estimated using the duration mapping approach since it does not account for
the timing of cash flows.

Correct B
Answer

Explanation B is correct. The process used in the duration mapping approach is to replace the
portfolio of fixed-income investments with a single zero-coupon with a maturity
equal to the duration of the portfolio.

A is incorrect. Principal mapping overstates the true risk of the portfolio because it
ignores coupon payments. Taking these payments into account decreases the
duration of the portfolio, which decreases portfolio VaR. Therefore, principal
mapping overstates the risk of the portfolio.

C is incorrect. Undiversified VaR and the inclusion of correlations are associated

with the cash-flow mapping approach rather than the duration mapping approach.
There is a difference between the VaR estimated using the principal mapping
approach and the diversified VaR estimated using the duration mapping approach
due to the intervening cash flows. The principal mapping approach ignores
intervening cash flows while they are implicitly accounted for in the duration
mapping approach.

D is incorrect. The VaR estimated using the cash-flow mapping approach is more
accurate than the VaR estimated using the duration mapping approach since the
cash-flow approach incorporates correlations into the estimation process.

Section Market Risk Measurement and Management

Learning Differentiate among the three methods of mapping portfolios of fixed income
Objective securities.

Reference Philippe Jorion, Value at Risk: The New Benchmark for Managing Financial Risk,
3rd Edition (New York, NY: McGraw-Hill, 2007). Chapter 11. VaR Mapping

160
80. Question A packaging materials manufacturer is considering a project that has an estimated
RAROC of 12%. Suppose that the risk-free rate is 4% per year, the expected
market rate of return is 10% per year, and the company's equity beta is 1.6. The
manufacturer uses the adjusted RAROC metric as the criterion to decide whether or
not to accept the project. Which of the following correctly describes the decision the
company should make and the rationale for making that decision?

A Reject the project because the adjusted RAROC is higher than the market expected
excess return.
B Accept the project because the adjusted RAROC is higher than the market
expected excess return.
C Reject the project because the adjusted RAROC is lower than the risk-free rate.
D Accept the project because the adjusted RAROC is lower than the risk-free rate.

Correct C
Answer

Explanation C is correct.

Consider the adjusted RAROC for the risk of returns:

Adjusted RAROC = RAROC - βE*(Rm – Rf),

where:
βE = Beta of the equity of the firm
Rm = Expected market rate of return
Rf = Risk-free rate of interest
βE*(Rm – Rf) = Risk premium of the project.

Adjusted RAROC is simply “RAROC adjusted for the systematic riskiness of the
returns.”

Adjusted RAROC can be used in evaluating the project in the following way: if the
project’s “RAROC less the project’s risk premium” is greater than the risk-free rate,
then the firm’s shareholders are compensated for the non-diversifiable systematic
risk they bear when investing in the activity, assuming the investors hold a well-
diversified portfolio (i.e., the project adds value). That is, if the project’s adjusted
RAROC exceeds the risk-free rate, it should be accepted by the firm. Otherwise, if it
is less than the risk-free rate, the project should be rejected.

Given RAROC = 12%, βE = 1.6, Rm = 10% and Rf = 4%, one can compute Adjusted
RAROC as 0.12-1.6*(0.10- 0.04) = 0.024 = 2.4%, which is less that Rf = 4%. Thus,
the project is rejected.

Section Operational Risk and Resilience

Learning Compute the adjusted RAROC for a project to determine its viability.
Objective

161
Reference Michel Crouhy, Dan Galai and Robert Mark, The Essentials of Risk Management,
2nd Edition (New York: McGraw-Hill, 2014). Chapter 17 - Risk Capital Attribution
and Risk-Adjusted Performance Measurement

162
 HEADQUARTERS
111 Town Square Place
14th Floor
Jersey City, New Jersey
garp.org 07310 USA
+1 (201) 719.7210

ABOUT GARP | The Global Association of Risk Professionals is a non-

partisan, not-for-profit membership organization focused on elevating the
LONDON
practice of risk management. GARP offers the leading global certification
17 Devonshire Square
for risk managers in the Financial Risk Manager (FRM®), as well as the
4th Floor
Sustainability and Climate Risk (SCR®) Certificate and ongoing educational
London, EC2M 4SQ UK
opportunities through Continuing Professional Development. Through the
+44 (0) 20 7397.9630
GARP Benchmarking Initiative (GBI)® and GARP Risk Institute (GRI), GARP
sponsors research in risk management and promotes collaboration among
practitioners, academics, and regulators.
HONG KONG
The Center
Founded in 1996 and governed by a Board of Trustees, GARP is
99 Queen’s Road Central
headquartered in Jersey City, N.J., with offices in London and Hong Kong.
Office No. 5510
55th Floor
For more information, visit garp.org or follow GARP on LinkedIn, Facebook,
Central, Hong Kong SAR,
and X (formerly Twitter).
China
+852 3168.1532
© 2023 Global Association of Risk Professionals. All rights reserved. (11.23)