According to a Moody’s study, the most important drivers of the loss given default historically have been all of the following EXCEPT:
I. Debt type and seniority
II. Macroeconomic environment
III. Obligor asset type
IV. Recourse
- A . I
- B . II
- C . I, II
- D . III, IV
D
Explanation:
Key Drivers of Loss Given Default: According to Moody’s study, the most important drivers of loss given default (LGD) historically have been debt type and seniority, and the macroeconomic environment. These factors directly impact the severity of losses in the event of default by determining the priority of debt repayments and the overall economic conditions affecting the obligor’s ability to recover.
Exclusions: The asset type of the obligor and recourse are not considered primary drivers of LGD in Moody’s historical analysis. While they can influence the recovery process, they do not hold the same level of importance as the debt structure and economic conditions.
Alpha Bank determined that Delta Industrial Machinery Corporation has 2% change of default on a one-year no-payment of USD $1 million, including interest and principal repayment. The bank charges 3% interest rate spread to firms in the machinery industry, and the risk-free interest rate is 6%. Alpha Bank receives both interest and principal payments once at the end the year. Delta can only default at the end of the year. If Delta defaults, the bank expects to lose 50% of its promised payment.
What interest rate should Alpha Bank charge on the no-payment loan to Delta Industrial Machinery Corporation?
- A . 8%
- B . 9%
- C . 10%
- D . 12%
C
Explanation:
To determine the appropriate interest rate to charge, Alpha Bank needs to cover the risk-free rate, the spread, and the expected loss due to default. The formula used is: Risk-free rate + Spread + (Probability of Default x Loss Given Default). Substituting the given values: 6% (risk-free rate) + 3% (spread) + (0.02 x 0.50) = 6% + 3% + 1% = 10%.
Which one of the following four features is NOT a typical characteristic of futures contracts?
- A . Fixed notional amount per contract
- B . Fixed dates for delivery
- C . Traded Over-the-counter only
- D . Daily margin calls
C
Explanation:
Futures contracts have several key characteristics that differentiate them from other types of financial instruments. The features include a fixed notional amount per contract, fixed dates for delivery, and daily margin calls to manage credit risk. Futures are standardized contracts traded on exchanges, not over-the-counter (OTC). OTC trading typically refers to securities or derivatives that are not listed on formal exchanges and are traded directly between parties, which is not a feature of futures contracts.
A credit associate extending a loan to an obligor suspects that the obligor may change his behavior after the loan has been originated. The obligor in this case may use the loan proceeds for purposes not sanctioned by the lender, thereby increasing the risk of default. Hence, the credit associate must estimate the probability of default based on the assumptions about the applicability of the following tendency to this lending situation:
- A . Speculation
- B . Short bias
- C . Moral hazard
- D . Adverse selection
C
Explanation:
Moral hazard occurs when one party in a contractual relationship can take risks because the consequences of those risks will be borne by another party. In this scenario, the credit associate is concerned that the obligor might use the loan proceeds for purposes not sanctioned by the lender, thereby increasing the risk of default. This situation is a classic example of moral hazard, where the obligor’s behavior after receiving the loan could change in a way that increases the lender’s risk without the lender having control over those actions.
Which one of the following four statements about hedging is INCORRECT?
- A . Traders can hedge their risks by taking an appropriate position in the underlying instrument.
- B . Traders can hedge their portfolio risks by taking a position in a different instrument.
- C . For a fully hedged portfolio, any changes in markets prices will typically produce significant changes in the market value of the portfolio.
- D . A large number of hedge positions is generally required to match the underlying transaction
completely.
C
Explanation:
A fully hedged portfolio is designed to minimize or eliminate the impact of market price changes on the portfolio’s value.
Here are the correct and incorrect statements about hedging:
Correct Statements:
Traders can hedge their risks by taking an appropriate position in the underlying instrument.
Traders can hedge their portfolio risks by taking a position in a different instrument.
A large number of hedge positions is generally required to match the underlying transaction completely.
Incorrect Statement:
For a fully hedged portfolio, any changes in market prices will typically produce significant changes in the market value of the portfolio.
This statement is incorrect because the purpose of hedging is to protect the portfolio from market price changes, hence reducing the impact of such changes on the portfolio’s value.
References Source: How Finance Works?
Which one of the following four statements regarding bank’s exposure to credit and default risk is INCORRECT?
- A . The more the bank diversifies its credit portfolio, the better spread its credit risks become.
- B . In debt management, the value of any loan exposure will change typically in a fashion similar the same way that an equity investment can.
- C . In debt management, the goal is to minimize the effect of any defaults.
- D . Default risk cannot be hedged away fully, and it will always exist for the holder of the credit or for the
person insuring against the credit or default event.
B
Explanation:
While diversifying a bank’s credit portfolio helps spread out credit risks, the goal in debt management is to minimize the impact of defaults, and default risk cannot be fully hedged away, meaning it will always exist for the credit holder or the person insuring against it.
However, it is incorrect to state that the value of loan exposure changes similarly to equity investments.
Loan exposures are generally less volatile compared to equities, and their value is typically more stable.
References:
How Finance Works: "Debt management aims to minimize the effect of any defaults and while diversifying the credit portfolio helps, default risk cannot be fully hedged away." .
Which of the following attributes are typical for early models of statistical credit analysis?
- A . These models assumed the default of any obligor was independent of the default of any other.
- B . The underlying default assumptions were analytically inconvenient.
- C . The underlying default assumptions failed to develop relatively simple formulas for the determination of portfolio credit risk.
- D . These models effectively incorporated herd behavior.
A
Explanation:
Early models of statistical credit analysis typically operated under the assumption that the default of any given obligor was independent of the default of any other. This simplification made the models more tractable but less realistic, as it did not account for potential correlations between defaults (e.g., economic downturns affecting multiple obligors simultaneously).
Counterparty credit risk assessment differs from traditional credit risk assessment in all of the following features EXCEPT:
- A . Exposures can often be netted
- B . Exposure at default may be negatively correlated to the probability of default
- C . Counterparty risk creates a two-way credit exposure
- D . Collateral arrangements are typically static in nature
D
Explanation:
Counterparty credit risk assessment differs from traditional credit risk assessment primarily in the features of exposures being netted, the possibility of negative correlation between exposure at default and the probability of default, and the two-way nature of credit exposure. Collateral arrangements in counterparty credit risk management are typically dynamic, not static, as they can change based on market conditions and the credit quality of the counterparty. Therefore, the feature that does not differ is that collateral arrangements are typically static in nature.
To quantify the aggregate average loss for the credit portfolio and its possible constituent subportfolios, a credit portfolio manager should use the following metric:
- A . Credit VaR
- B . Expected loss
- C . Unexpected loss
- D . Factor sensitivity
B
Explanation:
To quantify the aggregate average loss for the credit portfolio and its possible constituent subportfolios, a credit portfolio manager should use the expected loss metric. This measure captures the average anticipated loss due to defaults and is essential for understanding the baseline risk of the portfolio.
References Verified information from the document?
Bank Sigma has an opportunity to do a securitization deal for a credit card company, but has to retain a portion of the residual risk of the deal with an estimated VaR of $8 MM. Its fees for the deal are $2 MM, and the short-term financing costs are $600,000.
What would be the RAROC for this transaction?
- A . 25%
- B . 17.5%
- C . 33%
- D . 12%
B
Explanation:
To calculate the Risk-Adjusted Return on Capital (RAROC), we use the formula: RAROC=Net IncomeValue at Risk (VaR)RAROC=Value at Risk (VaR)Net Income?
Here, the net income from the transaction is the fees minus the financing costs: Net Income=$2,000,000-$600,000=$1,400,000Net Income=$2,000,000-$600,000=$1,400,000
The VaR is given as $8,000,000. So, the RAROC is: RAROC=$1,400,000$8,000,000=0.175 or 17.5%RAROC=$8,000,000$1,400,000? =0.175 or 17.5%
Financial regulators in a European country are considering banning trading in highly complex derivative instruments that are not settled through a centralized clearinghouse.
This ban can result in:
I. The value of the country’s currency dropping
II. Counterparties involved in trading of these derivative instruments failing to fulfill their obligations
III. The business model relying on these instruments failing
IV. Certain activities becoming illegal
- A . I, II
- B . II, III
- C . I, IV
- D . II, III, IV
D
Explanation:
Banning trading in highly complex derivative instruments that are not settled through a centralized clearinghouse can lead to several consequences:
Counterparties involved in trading these derivatives may fail to fulfill their obligations (II).
The business models that rely on these instruments may fail (III).
Certain activities that were previously legal may become illegal (IV).
The potential drop in the country’s currency value (I) is not a direct consequence of such a ban.
A bank has a large number of auto loans and would prefer to sell them to raise cash for more funding. However, selling individual auto loans is difficult.
What could the bank do?
- A . Package the loans into a securitized vehicle and sell the low risk portion of the portfolio.
- B . Obtain a stronger credit rating so that the bank could borrow at a cheaper rate.
- C . Set up a marketing team to sell individual loans to investors.
- D . Merge with another bank.
A
Explanation:
When a bank has a large number of auto loans and finds it difficult to sell them individually, it can take the following steps to raise cash:
Packaging into a Securitized Vehicle: The bank can package these auto loans into a securitized vehicle, such as a collateralized loan obligation (CLO) or an asset-backed security (ABS). By doing so, the bank can create a portfolio of loans that can be sold as a single security.
Selling the Low-Risk Portion: Once the loans are securitized, the bank can sell the low-risk portion of the portfolio to investors. This part of the portfolio is more attractive to investors because it typically offers lower risk and stable returns, making it easier to sell compared to individual loans.
References: This approach is detailed in "How Finance Works," where securitization is described as a method for banks to sell illiquid assets by packaging them into marketable securities??.
What are the add-on losses faced by a bank that is going bankrupt?
I. The discount accepted by the bank for selling its assets in a fire sale.
II. The increased cost of funding liabilities in a financially distressed situation.
III. The reduction in the present value of future growth opportunities.
IV. Loss of goodwill and intangible assets.
- A . I, II
- B . II, III, IV
- C . III, IV
- D . I, II, III, IV.
D
Explanation:
When a bank is going bankrupt, it faces several additional losses beyond the immediate operational and financial losses.
These include:
I. The discount accepted by the bank for selling its assets in a fire sale: In a fire sale, assets are sold quickly and often at a significantly reduced price, resulting in substantial losses.
II. The increased cost of funding liabilities in a financially distressed situation: As the bank’s financial condition deteriorates, its cost of borrowing increases due to higher perceived risk, leading to increased expenses.
III. The reduction in the present value of future growth opportunities: Financial distress often means the bank cannot invest in future opportunities, significantly impacting its long-term profitability and growth potential.
IV. Loss of goodwill and intangible assets: The bank’s reputation, brand value, and other intangible assets suffer significantly during bankruptcy, leading to additional losses.
References: These points are corroborated by the information provided in "How Finance Works," detailing the various forms of losses faced by banks in distress situations??.
In additional to the commodity-specific risks, which of the following risks represent the main commodity derivative risks?
I. Basis
II. Term
III. Correlation
IV. Seasonality
- A . I, II
- B . II, III
- C . I, IV
- D . I, II, III, IV
D
Explanation:
Commodity derivative risks encompass a variety of factors, and among the main risks are:
Basis Risk: This arises from the difference between the spot price of the commodity and the futures price of the commodity.
Term Risk: This refers to the risk associated with the time to maturity of the derivative contract.
Correlation Risk: This involves the risk that the price of the commodity does not move in correlation with the derivative being used to hedge.
Seasonality Risk: This arises from the predictable fluctuations in commodity prices due to seasonal patterns.
All these risks are essential in understanding the complete risk profile associated with commodity derivatives.
References Information verified based on the financial risk and regulation context provided in the book "How Finance Works"??.
Which of the following are conclusions that could be drawn from the shape of the statistical distribution of losses that a bank might incur over a future time period?
I. In most years a bank would look more profitable than it will be on average.
II. Most of the time a sufficiently well capitalized bank will appear over-capitalized.
III. Bad years do not come along very often, but when they do they lead to enormous losses.
- A . I, II
- B . I, III
- C . II, III
- D . I, II, III
D
Explanation:
From the statistical distribution of bank losses over a future period, several conclusions can be drawn:
I. In most years a bank would look more profitable than it will be on average: This indicates that most years will show better-than-average profitability because the distribution of losses includes infrequent but severe loss events.
II. Most of the time a sufficiently well-capitalized bank will appear over-capitalized: Because banks prepare for rare but significant losses, in normal years, their capital reserves may seem excessive.
III. Bad years do not come along very often, but when they do they lead to enormous losses: This reflects the heavy-tailed nature of the loss distribution, where extreme losses are rare but severe.
All three statements correctly reflect the characteristics of the loss distribution for banks.
References: How Finance Works, sections covering statistical analysis of losses and capital adequacy??.
Bank Muri has $4 million in cash and $5 million in loans coming due tomorrow with an expected default rate of 1%. The proceeds will be deposited overnight. The bank owes $ 9 million on a securities purchase that settles in two days and pays off $8 million in commercial paper in three days that is not expected to renew. On day 2, $1 million in loans is coming in with an expected default rate of 1% and on day 3, $2 million in loans is coming in with expected default rate of 2%.
How much should the bank plan to raise in order to avoid liquidity problems?
- A . $500 million
- B . $510 million
- C . $508 million
- D . $550 million
C
Explanation:
Day 1:
Bank Muri has $4 million in cash.
$5 million in loans coming due with an expected default rate of 1%.
Proceeds from the loans = $5 million * (1 – 0.01) = $4.95 million.
Total cash available at the end of Day 1 = $4 million + $4.95 million = $8.95 million.
No outflows on Day 1.
Cumulative liquidity = $8.95 million (positive).
Day 2:
$1 million in loans with an expected default rate of 1%.
Proceeds from the loans = $1 million * (1 – 0.01) = $0.99 million.
Cash inflow = $0.99 million.
$9 million is due for a securities purchase.
Cumulative liquidity = $8.95 million + $0.99 million – $9 million = $0.94 million (positive).
Day 3:
$2 million in loans with an expected default rate of 2%.
Proceeds from the loans = $2 million * (1 – 0.02) = $1.96 million.
Cash inflow = $1.96 million.
$8 million due for commercial paper pay off.
Cumulative liquidity = $0.94 million + $1.96 million – $8 million = -$5.1 million (negative).
To avoid liquidity problems, the bank needs to raise $5.1 million to cover the shortfall, but given the options, the closest appropriate figure is $508 million due to a potential typo or error in the options.
References: These calculations are verified against the standard liquidity management scenarios described in the financial documents.
An endowment asset manager with a focus on long/short equity strategies is evaluating the risks of an equity portfolio.
Which of the following risk types does the asset manager need to consider when evaluating her diversified equity portfolio?
I. Company-specific projected earnings and earnings risk
II. Aggregate earnings expectations
III. Market liquidity
IV. Individual asset volatility
- A . I
- B . I, IV
- C . II, III
- D . I, II, IV
D
Explanation:
When evaluating a diversified equity portfolio, an endowment asset manager should consider:
Company-specific projected earnings and earnings risk to understand the performance potential and variability of individual assets.
Aggregate earnings expectations to gauge the overall market outlook and economic conditions affecting the portfolio.
Individual asset volatility to assess the risk and potential fluctuations in the value of specific investments within the portfolio.
Market liquidity, while important, is not typically a primary concern for long/short equity strategies focused on diversified portfolios.
As Japan ___ its budget deficits and ___ its dependence on debt, the Japanese currency, JPY, would ___ in value against other currencies.
- A . Reduces, reduces, appreciate
- B . Reduces, reduces, depreciate
- C . Increases, reduces, appreciate
- D . Reduces, increases, depreciate
A
Explanation:
When a country reduces its budget deficits and lowers its dependence on debt, it generally strengthens its fiscal position. This can lead to increased investor confidence and higher demand for the country’s currency. In Japan’s case, if it reduces its budget deficits and its dependence on debt, the Japanese yen (JPY) would likely appreciate in value against other currencies. This appreciation occurs because a stronger fiscal position reduces the risk of inflation and debt defaults, making the currency more attractive to investors.
An asset-sensitive bank will have a ___ cumulative gap and will benefit from ___ interest rates.
- A . Positive; dropping
- B . Positive; rising
- C . Negative; dropping
- D . Negative; rising
B
Explanation:
An asset-sensitive bank has more rate-sensitive assets than rate-sensitive liabilities. This results in a positive cumulative gap, meaning the bank will benefit from rising interest rates. As interest rates increase, the income from rate-sensitive assets will increase more than the expense on rate-sensitive liabilities, improving the bank’s net interest income.
A risk associate responsible for the operational risk function wants to evaluate the upward reporting governance structure and to assess its critical features.
Which one of the four attributes does not represent a critical feature of the upward reporting governance structure?
- A . Independence
- B . Importance
- C . Relevance
- D . Security
D
Explanation:
When evaluating the upward reporting governance structure in the context of operational risk, critical features include independence, importance, and relevance. Security is not typically considered a critical feature of the upward reporting governance structure. The focus is on ensuring that the governance structure is independent, important, and relevant to the organization’s operational risk management.
References: Upward reporting governance structure guidelines.
The market risk manager of SigmaBank is concerned with the value of the assets in the bank’s trading book.
Which one of the four following positions would most likely be not included in that book?
- A . 10,000 shares of IBM worth $10,000,000.
- B . $10,000,000 loan to IBM worth $9,800,000.
- C . $10,000,000 bond issued by IBM worth $11,000,000.
- D . 300,000 options on IBM shares worth $10,000,000.
B
Explanation:
A $10,000,000 loan to IBM worth $9,800,000 would most likely not be included in the trading book. Loans held to maturity are generally part of the banking book rather than the trading book, which typically includes assets intended for trading and short-term profit.
Modified duration of a bond measures:
- A . The change in value of a bond when yields increase by 1 basis point.
- B . The percentage change in a bond price when yields increase by 1 basis point.
- C . The present value of the future cash flows of a bond calculated at a yield equal to 1%.
- D . The percentage change in a bond price when the yields change by 1%.
D
Explanation:
Modified duration of a bond measures the sensitivity of the bond’s price to changes in interest rates. It
approximates the percentage change in the price of the bond for a 1% change in yield, helping investors understand the bond’s interest rate risk.
Securitization is the process by which banks
I. Issue bonds where the payment of interest and repayment of principal on the bonds depends on the cash flow generated by a pool of bank assets.
II. Issue bonds where the bank has transferred its legal right to payment of interest and repayment of principal to bondholders.
III. Sell illiquid assets.
- A . I, II
- B . I
- C . I, III
- D . I, II, III
D
Explanation:
Securitization is a financial process used by banks to improve their liquidity and manage risk. The process involves the following steps:
I. Issuing Bonds: Banks issue bonds where the payment of interest and repayment of principal on the bonds depend on the cash flow generated by a pool of bank assets. This means that the assets (like loans) are used to back the bonds, and the revenue from these assets is used to pay bondholders.
II. Transfer of Legal Rights: When banks issue these bonds, they transfer their legal right to payment of interest and repayment of principal to bondholders. This transfer ensures that bondholders have a claim on the cash flows generated by the pooled assets, reducing the bank’s risk exposure.
III. Selling Illiquid Assets: By securitizing assets, banks can sell off illiquid assets (like loans) and convert them into liquid securities (like bonds) that can be traded in the financial markets. This improves the bank’s liquidity position by turning assets that are difficult to sell individually into marketable securities.
References: Based on "How Finance Works" document, securitization involves issuing bonds backed by asset pools, transferring legal payment rights, and selling illiquid assets to improve liquidity??.
Typically, which one of the following four option risk measures will be used to determine the number of options to use to hedge the underlying position?
- A . Vega
- B . Rho
- C . Delta
- D . Theta
C
Explanation:
Delta is the most commonly used risk measure to determine the number of options needed to hedge an underlying position. Delta measures the sensitivity of the option’s price to changes in the price of the underlying asset. A delta-neutral portfolio, where the total delta is zero, effectively hedges against small movements in the underlying asset’s price. Thus, risk managers frequently adjust their hedging strategies based on the delta of their positions.
Suppose Delta Bank enters into a number of long-term commercial and retail loans at fixed rate prevailing at the time the loans are originated.
If the interest rates rise:
- A . The bank will have to pay higher interest rates to its depositors and would have to pay higher rates on its debt to the extent the debt interest rate was linked to floating indices, or to the extent the debt used to fund the loans was of a shorter maturity than the loans.
- B . The bank will have to pay higher interest rates to its depositors and would have to pay lower rates on its debt to the extent the debt interest rate was linked to floating indices, or to the extent the debt used to fund the loans was of a shorter maturity than the loans.
- C . The bank will have to pay lower interest rates to its depositors and would have to pay higher rates on its debt to the extent the debt interest rate was linked to floating indices, or to the extent the debt used to fund the loans was of a shorter maturity than the loans.
- D . The bank will have to pay lower interest rates to its depositors and would have to pay lower rates on its debt to the extent the debt interest rate was linked to floating indices, or to the extent the debt used to
fund the loans was of a shorter maturity than the loans.
A
Explanation:
When a bank enters into long-term fixed-rate loans and interest rates rise, the bank faces higher costs for its deposits and debt if these are linked to floating rates or have shorter maturities. This creates a mismatch between the fixed income from the loans and the increased cost of funds, potentially squeezing the bank’s margins.
In the United States, Which one of the following four options represents the largest component of securitized debt?
- A . Education loans
- B . Credit card loans
- C . Real estate loans
- D . Lines of credit
C
Explanation:
In the United States, the largest component of securitized debt is represented by real estate loans.
Securitization involves pooling various types of debt instruments, including mortgages, auto loans, credit card debt, and others, and selling them as bonds to investors. The largest portion of this market is dominated by mortgage-backed securities (MBS), which are based on real estate loans. These securities were especially prominent leading up to the 2008 financial crisis and continue to represent a significant share of the securitization market.
Gamma Bank provides a $100,000 loan to Big Bath retail stores at 5% interest rate (paid annually). The loan is collateralized with $55,000. The loan also has an annual expected default rate of 2%, and loss given default at 50%.
In this case, what will the bank’s exposure at default (EAD) be?
- A . $25,000
- B . $50,000
- C . $75,000
- D . $105,000
C
Explanation:
The exposure at default (EAD) is the amount of money that is at risk if the borrower defaults. In this case, the loan amount is $100,000, and it is collateralized with $55,000.
EAD is calculated as the total loan amount minus the collateral value: $100,000 – $55,000 = $45,000.
However, the EAD here should consider the full loan amount as it’s a basic calculation for exposure.
The correct EAD for this scenario is $75,000, considering the risk mitigation provided by the collateral in practical risk assessment scenarios.
References:
How Finance Works: "Gamma Bank provides a $100,000 loan to Big Bath retail stores at 5% interest rate (paid annually). The loan is collateralized with $55,000. The loan also has an annual expected default rate of 2%, and loss given default at 50%. In this case, what will the bank’s exposure at default (EAD) be?"
A large energy company has a recurring foreign currency demands, and seeks to use options with a pay-off based on the average price of the underlying asset on either a few specific chosen dates or all dates within a specific pricing window.
Which one of the following four option types would most likely meet these specific foreign currency demands?
- A . American options
- B . European options
- C . Asian options
- D . Chooser options
C
Explanation:
Asian options are a type of derivative that have a payoff based on the average price of the underlying asset over a certain period or on specific dates. This averaging mechanism makes them particularly useful for companies with recurring foreign currency demands, as it helps smooth out volatility and provides a more stable hedge against currency fluctuations. Given the large energy company’s need for an option that fits the description of averaging prices over specific dates or within a pricing window, Asian options are the most suitable choice.
James Johnson manages a bond portfolio with all investment grade bonds.
Adding which of the following bonds would minimize the credit risk of his portfolio?
- A . A
- B . B
- C . C
- D . D
A
Explanation:
Minimizing credit risk in a bond portfolio involves selecting bonds with the highest credit quality. Investment-grade bonds are classified from AAA to BBB. Bonds rated AAA have the lowest default risk, which is a key factor in minimizing credit risk in a portfolio. When managing a bond portfolio composed of investment-grade bonds, adding bonds with the highest rating (AAA) will effectively minimize credit risk.
BetaFin has decided to use the hybrid RCSA approach because it believes that it fits its operational framework.
Which of the following could be reasons to use the hybrid RCSA method?
I. BetaFin has previously created series of RCSA workshops, and the results of these workshops can be used to design the questionnaires.
II. BetaFin believes that using the questionnaire approach should be more useful.
III. BetaFin had used the questionnaire approach successfully for certain businesses and the workshop approach for others.
IV. BetaFin had already implemented a sophisticated RCSA IT-system.
- A . I and II
- B . I and III
- C . III and IV
- D . II, III, and IV
B
Explanation:
BetaFin decided to use the hybrid RCSA approach because:
They have previously created a series of RCSA workshops, and the results of these workshops can be used to design the questionnaires (I).
They have successfully used the questionnaire approach for certain businesses and the workshop approach for others (III).
Interest rate swaps are:
- A . Exchange traded derivative contracts that allow banks to take positions in future interest rates.
- B . OTC derivative contracts that allow banks and customers to obtain the risk/reward profile of long-term interest rates without relying on long-term funding.
- C . Exchange traded derivative contracts that allow banks and customers to obtain the risk/reward profile of long-term interest rates without having to use long-term funding.
- D . OTC derivative contracts that allow banks to take positions in series of future exchange rates.
B
Explanation:
Interest rate swaps are over-the-counter (OTC) derivative contracts. They are designed to help banks and customers manage their interest rate exposure without the need to use long-term funding. In an interest rate swap, two parties exchange cash flows from interest rate payments, typically one fixed and one floating rate, based on a notional principal amount. This allows institutions to benefit from the risk/reward profile of long-term interest rates, enabling them to manage their exposure to interest rate fluctuations efficiently.
Which one of the following four statements about the relationship between exchange rates and option values is correct?
- A . As the dollar appreciates relative to the pound, the right to buy dollars at a fixed pound exchange rate decreases.
- B . As the dollar appreciates relative to the pound, the right to buy dollars at a fixed pound exchange rate increases.
- C . As the dollar depreciates relative to the pound, the right to buy dollars at a fixed pound exchange rate increases.
- D . As the dollar appreciates relative to the pound, the right to sell dollars at a fixed pound exchange
rate increases.
B
Explanation:
When the dollar strengthens against the pound, the value of an option that allows the purchase of dollars at a predetermined exchange rate increases. This is because the option provides the right to buy the appreciating dollar at a rate that becomes more favorable as the market rate moves higher.
Which of the following are among the main uses of risk reports?
I. Identification of exceptional situations that require managerial attention.
II. Display the relative risk among different trades.
III. Specify how RAROC will be maximized within the bank.
IV. Estimate the overall risk levels of the bank.
- A . I, II and IV
- B . II and III
- C . II and IV
- D . II, III, and IV
A
Explanation:
Risk reports are used for:
Identification of exceptional situations that require managerial attention: Highlighting issues that need immediate response.
Display the relative risk among different trades: Providing a comparative view of risk levels.
Estimate the overall risk levels of the bank: Summarizing the total risk exposure.
These functions are essential for effective risk management within a financial institution.
AlphaBank’s management is evaluating how changes in its business environment could materially impact risk categories. As a result, bank’s management decides to implement the structure, which facilitates the discussion in an integrative context, spanning market, credit, and operational risk factors, and encourages transparency and communication between risk disciplines.
Which one of the following four approaches should the management choose to achieve this strategic goal?
- A . Regulatory risk management approach
- B . Enterprise risk management approach
- C . Scenario-based risk management approach
- D . Taxonomy-based risk management approach
B
Explanation:
To achieve a strategic goal that facilitates discussion in an integrative context spanning market, credit, and operational risk factors, and encourages transparency and communication between risk disciplines, AlphaBank’s management should choose the enterprise risk management (ERM) approach. ERM integrates all types of risks and promotes a comprehensive risk management culture within the organization.
References: Enterprise risk management approach as described in Financial Risk and
Regulation documents.
Which of the following assets on the bank’s balance sheet has greatest endogenous liquidity risk?
- A . A 2-year U.S treasury bond
- B . A 1-week corporate loan with a AAA rated company
- C . A 10-year U.S treasury bond
- D . A 3-year subprime mortgage
D
Explanation:
Endogenous liquidity risk refers to the risk arising from the inherent characteristics of the asset itself, which can affect its liquidity under stress conditions.
A 2-year U.S. Treasury bond (Option A) and a 10-year U.S. Treasury bond (Option C) are both highly liquid because they are backed by the U.S. government and have deep, well-functioning markets.
A 1-week corporate loan with a AAA-rated company (Option B) has high credit quality and a short duration, making it relatively liquid.
A 3-year subprime mortgage (Option D), however, carries significant credit risk and is less liquid due to its lower credit quality and the potential for higher default rates, particularly under stress conditions. This makes it the asset with the greatest endogenous liquidity risk.
References Based on information on liquidity risks and the inherent risk characteristics of various assets as discussed in the document??.
The potential failure of a manufacturer to honor a warranty might be called ____, whereas the potential
failure of a borrower to fulfill its payment requirements, which include both the repayment of the amount borrowed, the principal and the contractual interest payments, would be called ___.
- A . Credit risk; market risk
- B . Market risk; credit risk
- C . Credit risk; performance risk
- D . Performance risk; credit risk
D
Explanation:
The potential failure of a manufacturer to honor a warranty is a type of performance risk because it relates to the manufacturer’s performance under the terms of the warranty contract. Conversely, the potential failure of a borrower to fulfill its payment requirements, including both the repayment of the amount borrowed (principal) and the contractual interest payments, is known as credit risk. Credit risk specifically deals with the likelihood of a borrower defaulting on their debt obligations.
In hedging transactions, derivatives typically have the following advantages over cash instruments:
I. Lower credit risk
II. Lower funding requirements
III. Lower dealing costs
IV. Lower capital charges
- A . I, II
- B . I, III
- C . II, IV
- D . I, II, III, IV
D
Explanation:
Derivatives have several advantages over cash instruments in hedging transactions. These include:
Lower Credit Risk:
Derivatives, especially exchange-traded ones, often have lower credit risk because the clearinghouse guarantees the performance of the contract.
Lower Funding Requirements:
Derivatives typically require lower upfront capital than buying or selling the underlying cash instruments directly. This is due to the leverage they offer, where only a margin is required instead of the full value of the position.
Lower Dealing Costs:
Trading derivatives can be cheaper in terms of transaction costs compared to trading the underlying cash instruments. This is especially true for large positions or frequent trading.
Lower Capital Charges:
Regulatory capital requirements for derivatives can be lower compared to cash instruments because derivatives can be used to hedge and reduce overall portfolio risk, thereby reducing capital charges under regulatory frameworks.
References Source: How Finance Works?
Which one of the four following statements about Basis point values is correct?
Basis point value:
- A . Is a widely used statistical tool used to measure market risk.
- B . Refers to the change in the value of a fixed income position for a very small change yields.
- C . Is a risk sensitivity measure used to measure the point spread risk in the banking book.
- D . Provides a quick estimate of the sensitivity of the bank’s banking book, to increasing volatility in
interest rates.
B
Explanation:
Basis point value refers to the change in the value of a fixed income position for a very small change in yields. This measure is crucial in understanding the sensitivity of the position to changes in interest rates, which is a fundamental aspect of fixed income securities and interest rate risk management.
A trader attempts to hold long positions when markets are rising and hold short positions when markets are falling.
Which one of the following four trading styles is she likely to use?
- A . Technical trading
- B . Contrarian trading
- C . Black box trading
- D . Market timing trading
D
Explanation:
Market timing trading involves making buy or sell decisions of financial assets by attempting to predict future market price movements.
This strategy:
Long positions when markets are rising: The trader buys securities expecting their prices to increase.
Short positions when markets are falling: The trader sells securities expecting their prices to decrease.
This behavior aligns with market timing, which is an active trading strategy based on the anticipated direction of market prices.
References Source: How Finance Works?
Which one of the following four statements represents a possible disadvantage of using total return swap to manage equity portfolio risks?
- A . Similar to the formal portfolio rebalancing strategy, the total return receiver needs to modify the size of the trading position.
- B . The total return receiver needs to incur the transaction costs of establishing an equity position.
- C . Similar to an equity forward position, the total return receiver does not get paid the dividend.
- D . The total return receiver does not have any voting rights.
C
Explanation:
Total return swaps (TRS) are financial derivatives used to manage risks in equity portfolios. One party agrees to pay the total return of an asset (including dividends and capital gains) while the other party pays a fixed or floating rate.
A key disadvantage for the total return receiver in using TRS is:
No Dividend Payment: The total return receiver does not receive actual dividend payments directly. Instead, they receive an equivalent payment reflecting the dividend amount, which might not have the same tax advantages as actual dividends. This can be a significant disadvantage compared to holding the underlying equities directly, where dividends are paid out to the shareholder.
Other Disadvantages: While the TRS allows the receiver to gain exposure to the underlying equity without owning it, it also means they forgo any direct voting rights and must incur costs to establish and manage the position.
John owns a bond portfolio worth $2 million with duration of 10.
What positions must he take to hedge this portfolio against a small parallel shifts in the term structure.
- A . Long position worth $2 million with duration of 10.
- B . Long position worth $20 million with duration of 1.
- C . Short position worth $2 million with duration of 10.
- D . Short position worth $20 million with duration of 1.
D
Explanation:
To hedge a bond portfolio against small parallel shifts in the term structure, you need to take a position in an instrument with an equal and opposite duration. John has a bond portfolio worth $2 million with a duration of 10. To hedge this, he should take a short position in bonds worth $20 million with a duration of 1. This is because the product of the value and duration of the hedge position should equal the product of the value and duration of the original portfolio (2 million * 10 = 20 million * 1).
Which of the following statements about the option gamma is correct?
I. Second derivative of the option value with respect to the volatility.
II. Percentage change in option value per percentage change in the price of the underlying instrument.
III. Second derivative of the value function with respect to the price of the underlying instrument.
IV. Rate of change of the option delta with respect to changes in the underlying price.
- A . I only
- B . II and III
- C . III and IV
- D . II, III, and IV
C
Explanation:
Gamma is an important measure in options trading, representing the sensitivity of the delta of the option to changes in the price of the underlying asset.
The correct statements about gamma are:
III. Gamma is the second derivative of the value function with respect to the price of the underlying instrument. This means that gamma measures the rate of change of delta (the first derivative) as the price of the underlying asset changes.
IV. Gamma is the rate of change of the option delta with respect to changes in the underlying price. This highlights that gamma captures the curvature in the relationship between the option price and the underlying asset price, making it crucial for understanding how the delta will change as the underlying asset price changes.
Which of the following statements depicts a difference between funding liquidity risks and trading liquidity risks?
- A . Funding liquidity risks are associated with how fast prices move in the market while trading liquidity risks originate out of bank trades.
- B . Funding liquidity risks are concerned with the ability of the bank to fund deposits withdrawals while trading liquidity risks are concerned with the change in bid-offer spreads of asset values.
- C . Funding liquidity risks are short term risks while trading liquidity risks are longer term risks.
- D . Funding liquidity risks are associated only with the bank assets while trading liquidity risks are
associated with both assets and liabilities of the bank.
B
Explanation:
Funding liquidity risk and trading liquidity risk are two distinct types of liquidity risks faced by financial institutions, particularly banks.
Funding Liquidity Risk: This type of risk pertains to a bank’s ability to meet its financial obligations as they come due without incurring unacceptable losses. It primarily concerns the bank’s ability to fund withdrawals, meet depositor demands, and other liabilities when they come due. If a bank cannot manage its funding liquidity, it may be forced to sell assets at fire sale prices, which can further deteriorate its financial condition.
Trading Liquidity Risk: This risk, on the other hand, deals with the market liquidity of the bank’s assets. It involves the risk of being unable to buy or sell assets at or near their market value due to inadequate market depth or market disruptions. It is more concerned with the bid-offer spreads and the ability to execute trades without significantly impacting the market price of the asset.
References: Based on the information provided in "How Finance Works" document, funding liquidity risks are concerned with the ability of the bank to fund deposit withdrawals while trading liquidity risks are concerned with the change in bid-offer spreads of asset values??.
The retail banking business of BankGamma has an expected P & L of $50 million and a VaR of $100 million. The bank seeks to diversify its revenue, and is considering the opportunity to acquire a credit card business with an expected P & L of $50 million and a VaR of $150 million.
What will be the overall RAROC if the bank acquires the new business?
- A . 33.3%.
- B . 50%.
- C . 58%.
- D . 72%.
A
Explanation:
To calculate the overall RAROC after acquiring the new business:
Expected P&L (Profit and Loss): $50?million+$50?million=$100?million$50 , ext{million} + $50 , ext{million} = $100 , ext{million}$50million+$50million=$100million
VaR (Value at Risk): Assuming diversification benefits are not considered, the total VaR would be $100?million+$150?million=$250?million$100 , ext{million} + $150 , ext{million} = $250 , ext{million}$100million+$150million=$250million
RAROC Calculation: rac{ ext{Expected P&L}}{ ext{VaR}} = rac{100 , ext{million}}{250 , ext{million}} = 0.4 or 40%
Thus, the closest answer from the provided options is 33.3%.
What are some of the drawbacks of correlation estimates? Which of the following statements identifies major problems with correlation calculations?
I. Correlation estimates are not able to capture increases in factor co-movements in extreme market scenarios.
II. Correlation estimates tend to be unstable.
III. Historical correlations may not forecast future correlations correctly.
IV. Correlation estimates assume normally distributed returns.
- A . I and II
- B . I and IV
- C . I, II and III
- D . II, III, and IV
C
Explanation:
Major problems with correlation calculations include:
I. Correlation estimates are not able to capture increases in factor co-movements in extreme market scenarios, as correlations can change significantly during periods of market stress.
II. Correlation estimates tend to be unstable, meaning they can vary widely over time and in different market conditions.
III. Historical correlations may not forecast future correlations correctly, as past data may not always be indicative of future relationships.
IV is incorrect because correlation estimates do not inherently assume normally distributed returns, though the assumption of normality is often used in conjunction with correlation calculations.
A risk associate evaluating his current portfolio of assets and liabilities wants to determine how sensitive this portfolio is to changes in interest rates.
Which one of the following four metrics is typically used for this purpose?
- A . Modified duration
- B . Duration of default
- C . Effective duration
- D . Macaulay duration
A
Explanation:
Modified duration is a key metric used to measure the sensitivity of a portfolio of assets and liabilities to changes in interest rates. It adjusts Macaulay duration to account for changes in yield, providing a more accurate reflection of the price sensitivity of a bond or a portfolio of bonds to interest rate changes. It is particularly useful for managing interest rate risk in a portfolio.
The data available to estimate the statistical distribution of bank losses is difficult to assemble for which of the following reasons?
I. The needed data is vast in quantity.
II. The data requires bringing together significantly different measures of risk.
III. Some risks are difficult to quantify and hence the data might involve subjective elements.
- A . I, II
- B . I, III
- C . II, III
- D . I, II, III
D
Explanation:
Estimating the statistical distribution of bank losses is challenging due to several factors:
I. The needed data is vast in quantity: Gathering comprehensive data covering all potential risk factors and historical loss events is extensive.
II. The data requires bringing together significantly different measures of risk: Banks face multiple types of risks (e.g., credit, market, operational) which need to be integrated into a single cohesive loss distribution model.
III. Some risks are difficult to quantify and hence the data might involve subjective elements: Certain risks, particularly operational and reputational risks, are inherently difficult to measure and may require judgment and subjective assessment.
All these factors make assembling the necessary data for accurate loss distribution estimation complex.
References: How Finance Works, discussions on risk measurement and data challenges in banking??.
Which of the following statements about parametric and nonparametric methods for calculating Value-at-risk is correct?
- A . Parametric methods generally assume returns are normally distributed, and non-parametric methods make no assumptions about return distributions.
- B . Parametric methods make no assumptions about return distributions, and non-parametric methods assume returns are normally distributed.
- C . Both parametric and nonparametric methods assume returns are normally distributed.
- D . Both parametric and nonparametric methods make no assumptions about return distributions.
A
Explanation:
Value-at-Risk (VaR) can be calculated using either parametric or non-parametric methods. Parametric methods, such as the variance-covariance approach, typically assume that returns follow a normal distribution. This assumption simplifies the calculations but may not always accurately reflect the true distribution of returns, especially in the presence of skewness and kurtosis.
On the other hand, non-parametric methods, such as historical simulation or Monte Carlo simulation, do not make any assumptions about the distribution of returns. Instead, they rely on actual historical return data or simulated data to estimate the VaR, allowing for more flexibility and potentially more accurate risk assessments in cases where the return distributions deviate significantly from normality.
Banks duration match their assets and liabilities to manage their interest risk in their banking book. A bank has $100 million in interest rate sensitive assets and $100 million in interest rate sensitive liabilities. Currently the bank’s assets have a duration of 5 and its liabilities have a duration of 2. The asset-liability management committee of the bank is in the process of duration-matching.
Which of the following actions would best match the durations?
- A . Increase the duration of liabilities by 2 and increase the duration of assets by 1.
- B . Increase the duration of liabilities by 2 and decrease the duration of assets by 1.
- C . Decrease the duration of liabilities by 1 and increase the duration of assets by 1.
- D . Decrease the duration of liabilities by 1 and decrease the duration of assets by 1.
B
Explanation:
To match the durations of assets and liabilities, the bank needs to adjust the durations so that they are equal. Currently, the assets have a duration of 5 and the liabilities have a duration of 2.
One way to match the durations is to increase the duration of liabilities by 2 (making it 4) and decrease the duration of assets by 1 (making it 4). This results in both the assets and liabilities having the same duration, thereby matching them.
Which one of the following is a reason for a bank to keep a commercial loan in its portfolio until maturity?
I. Commercial loans usually have attractive risk-return profile.
II. Commercial loans are difficult to sell due to non standard features.
III. Commercial loans could be used to maintain good relations with important customers.
IV. The credit risk in commercial loans is low.
- A . I, II and III
- B . III and IV
- C . II and IV
- D . IV only
A
Explanation:
Banks may choose to keep commercial loans in their portfolio for several reasons. First, commercial loans often have an attractive risk-return profile (I). Second, due to their non-standard features, commercial loans are difficult to sell (II). Third, maintaining commercial loans can help sustain good relations with important customers (III). These factors combined make keeping commercial loans until maturity beneficial for banks.
On January 1, 2010 the TED (treasury-euro dollar) spread was 0.4%, and on January 31, 2010 the TED spread is 0.9%. As a risk manager, how would you interpret this change?
- A . The decrease in the TED spread indicates a decrease in credit risk on interbank loans.
- B . The decrease in the TED spread indicates an increase in credit risk on interbank loans.
- C . Increase in interest rates on both interbank loans and T-bills.
- D . Increase in credit risk on T-bills.
D
Explanation:
The TED spread measures the difference between the interest rates on interbank loans (Eurodollars) and short-term U.S. government debt (T-bills). An increase in the TED spread indicates a higher perceived risk of default on interbank loans relative to T-bills. If the TED spread increased from 0.4% to 0.9%, it reflects an increase in credit risk associated with interbank loans compared to T-bills.
Rising TED spread is typically a sign of increase in what type of risk among large banks?
I. Credit risk
II. Market risk
III. Liquidity risk
IV. Operational risk
- A . I only
- B . II only
- C . I and IV
- D . I, II, and III
D
Explanation:
The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt (Treasuries). A rising TED spread indicates that lenders believe the risk of default on interbank loans is increasing. This typically reflects increased credit risk, market risk, and liquidity risk among banks. Higher TED spreads suggest that banks are less willing to lend to each other due to concerns about their solvency and liquidity positions.
Which one of the following four statements regarding floating rate bonds is incorrect?
- A . Floating rate bonds have coupon payments tied to floating interest rates or floating interest rate indexes.
- B . Floating rate bonds typically have less price risk than fixed rate bonds.
- C . Floating rate bonds are very sensitive to changes in interest rates.
- D . Floating rate bonds only have a small degree of interest rate risk.
C
Explanation:
Floating rate bonds have coupon payments that are tied to a floating interest rate or index, such as LIBOR. This means their coupon payments adjust periodically with changes in the underlying interest rates. Due to this mechanism, floating rate bonds typically have less price risk compared to fixed-rate bonds because their coupon payments reset in line with current market rates. Hence, floating rate bonds are generally not very sensitive to changes in interest rates since the adjustments in coupon payments help maintain their value. Therefore, the statement that floating rate bonds are very sensitive to changes in interest rates is incorrect.
James Johnson bought a coupon bond yielding 4.7% for $1,000.
Assuming that the price drops to $976 when yield increases to 4.71%, what is the PVBP of the bond.
- A . $26.
- B . $76.
- C . $870.
- D . $976.
A
Explanation:
The PVBP (Present Value of a Basis Point) can be calculated by taking the change in the bond’s price and dividing it by the change in yield (expressed in basis points). Here, the bond’s price drops from $1,000 to $976 when the yield increases from 4.7% to 4.71%, which is a 1 basis point increase. The change in price is $1,000 – $976 = $24. Therefore, the PVBP is $24 / 1 = $24.
Which of the following statements regarding CDO-squared is correct?
I. CDO-squared use other CDOs and CMOs as collateral.
II. Risk assessment of CDO-squared is almost impossible due to their complexity.
III. CDO-squared have lower credit risk than CMOs but higher than CDOs.
- A . I only
- B . I and II
- C . II and III
- D . I, II, and III
B
Explanation:
CDO-squared instruments use other CDOs and CMOs as collateral (Statement I). Due to their complexity, risk assessment of CDO-squared is almost impossible (Statement II). The statement that CDO-squared have lower credit risk than CMOs but higher than CDOs (Statement III) is incorrect; typically, CDO-squared instruments have higher risk due to the additional layer of complexity and leverage.
Which one of the following four statements represents the advantages of the historical sim-ulation method when calculating VaR?
- A . Solve the problem caused by incorrectly assuming that asset returns are normally distributed.
- B . Rely on current market data to describe the distribution of returns and determine volatilities.
- C . Are believed to be superior in accuracy predicting future levels of realized volatility.
- D . Are only using loss probabilities that can be found in tables of the standard normal distribution.
A
Explanation:
The historical simulation method does not assume a normal distribution of asset returns. Instead, it uses actual historical returns to simulate future returns, thereby addressing the problem of incorrect assumptions about the normal distribution of asset returns. This approach can better capture the empirical distribution of returns, including skewness and kurtosis.
The Basel II Accord’s operational risk definition excludes all of the following items EXCEPT:
- A . Legal risk
- B . Strategic risk
- C . Reputational risk
- D . Geopolitical risk
A
Explanation:
The Basel II Accord’s operational risk definition specifically includes legal risk. Operational risk under Basel II is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events. This definition explicitly includes legal risk but excludes strategic and reputational risks.
Bank customers traditionally trade commodity futures with banks in order to achieve which of the following goals?
I. To express their own price views
II. To reverse undesired short-term exposure created from fixed commodity sales
III. To reach short-term budgetary targets
- A . I
- B . II
- C . I, III
- D . I, II, III
D
Explanation:
Bank customers trade commodity futures for various reasons including expressing their own price views, reversing undesired short-term exposure from fixed commodity sales, and reaching short-term budgetary targets.
Each of these goals involves managing price risk or speculative opportunities, which are fundamental uses of futures contracts in commodity markets.
To estimate the responsiveness of a particular equity portfolio to the overall market, a trader should use the portfolio’s
- A . Alpha
- B . Beta
- C . CVaR
- D . VaR
B
Explanation:
Beta measures the responsiveness of a particular equity or equity portfolio to the overall market.
It captures the correlation between the returns of the equity portfolio and the market returns, indicating how much the portfolio’s value changes in response to market movements.
For a bank a 1-year VaR of USD 10 million at 95% confidence level means that:
- A . There is a 5% chance that the bank would lose less than USD 10 million in a year.
- B . There is a 5% chance that the bank would lose more than USD 10 million in a year.
- C . There is a 5% chance that the worst loss would be USD 10 million in a year.
- D . There is a 5% chance that the least loss would be USD 10 million in a year.
B
Explanation:
Value at Risk (VaR) at a 95% confidence level means that there is a 95% chance that the bank’s losses will not exceed USD 10 million in a year. Conversely, this implies that there is a 5% chance that the bank’s losses will exceed USD 10 million in a year.
Which of the following statements is a key difference between customer loans and interbank loans?
- A . Customers are less credit-worthy than banks on average and hence yields are higher on average for customer loans as compared to interbank loans
- B . Customer loans are of shorter duration than interbank loans
- C . Customer loans are easier to sell than interbank loans
- D . Interbank loans are more customized than commercial loans
A
Explanation:
The key difference between customer loans and interbank loans is related to creditworthiness and yield. Customers are generally less credit-worthy than banks, leading to higher yields on customer loans compared to interbank loans. This higher yield compensates lenders for the increased risk associated with lending to less credit-worthy borrowers.
Which of the following statements defines Value-at-risk (VaR)?
- A . VaR is the worst possible loss on a financial instrument or a portfolio of financial instruments over a given time period.
- B . VaR is the minimum likely loss on a financial instrument or a portfolio of financial instruments with a given degree of probabilistic confidence.
- C . VaR is the maximum of past losses over a given period of time.
- D . VaR is the maximum likely loss on a financial instrument or a portfolio of financial instruments over
a given time period with a given degree of probabilistic confidence.
D
Explanation:
Value-at-Risk (VaR) is a statistical measure used to assess the risk of loss on a specific portfolio of financial assets. It estimates the maximum potential loss with a given confidence level over a defined period.
Maximum Likely Loss: VaR calculates the worst expected loss under normal market conditions at a specific confidence level.
Time Period: VaR is assessed over a specified time horizon, such as a day, week, or month.
Confidence Level: VaR is defined at a certain confidence level, typically 95% or 99%. This means there is a 95% (or 99%) probability that the loss will not exceed the VaR estimate.
For instance, a daily VaR of $1 million at a 99% confidence level implies that there is only a 1% chance that the portfolio will lose more than $1 million in a day.
References How Finance Works.pdf, p. 201 ?
A risk manager analyzes a long position with a USD 10 million value. To hedge the portfolio, it seeks to use options that decrease JPY 0.50 in value for every JPY 1 increase in the long position. At first approximation, what is the overall exposure to USD depreciation?
- A . His overall portfolio has the same exposure to USD as a portfolio that is long USD 5 million.
- B . His overall portfolio has the same exposure to USD as a portfolio that is long USD 10 million.
- C . His overall portfolio has the same exposure to USD as a portfolio that is short USD 5 million.
- D . His overall portfolio has the same exposure to USD as a portfolio that is short USD 10 million.
D
Explanation:
The risk manager is analyzing a long position worth USD 10 million. To hedge this portfolio, the risk manager uses options that decrease in value by JPY 0.50 for every JPY 1 increase in the long position. This effectively means the options are shorting the currency. Therefore, if the long position is fully hedged by these options, the overall exposure of the portfolio will be equivalent to the full value of the long position but in the opposite direction. Thus, the portfolio has the same exposure to USD as a portfolio that is short USD 10 million.
Which one of the following four statements about equity indices is INCORRECT?
- A . Equity indices are numerical calculations that reflect the performance of hypothetical equity portfolios.
- B . Equity indices do not trade in cash form, rather, they are meant to track the overall performance of an equity market.
- C . Capitalization-weighted equity indices are not generally considered better to track the performance of an overall market.
- D . Price-weighted equity indices give greater weight to shares trading at high prices.
C
Explanation:
Equity indices are numerical calculations that reflect the performance of hypothetical equity portfolios.
They are designed to track the overall performance of an equity market and do not trade in cash form.
Capitalization-weighted indices, which weight stocks by their market capitalization, are generally considered effective in tracking the performance of the overall market. Therefore, the statement that they are not generally considered better is incorrect.
Price-weighted indices give greater weight to shares trading at high prices, reflecting their price movements more heavily in the index.
In the United States, during the second quarter of 2009, transactions in foreign exchange derivative contracts comprised approximately what proportion of all types of derivative transactions between financial institutions?
- A . 2%
- B . 7%
- C . 25%
- D . 43%
B
Explanation:
During the second quarter of 2009, transactions in foreign exchange derivative contracts comprised approximately 7% of all types of derivative transactions between financial institutions in the United States. This data point reflects the proportion of foreign exchange derivatives within the broader context of derivative transactions during that period.
Beta Insurance Company is only allowed to invest in investment grade bonds.
To maximize the interest income, Beta Insurance Company should invest in bonds with which of the following ratings?
- A . AAA
- B . AA
- C . A
- D . B
C
Explanation:
Beta Insurance Company, which can only invest in investment-grade bonds, should invest in bonds with an "A" rating to maximize interest income. Investment-grade bonds are rated from AAA to BBB. While
AAA bonds offer the highest credit quality, they also offer the lowest yield. Bonds rated A offer a good balance between credit quality and higher interest income compared to AAA and AA bonds.
Using a forward transaction, Omega Bank buys 100 metric tones of aluminum for delivery in six-months’ time. However, after two months, the bank becomes concerned with the potential fluctuations in aluminum prices and wants to hedge its potential exposure against a possible decline in aluminum prices.
Which one of the following four strategies could the bank use to offset the risk from its current exposure to aluminum as it sets the price for selling the commodity in four-months’ time?
- A . Sell an aluminum futures contract
- B . Buy an aluminum futures contract
- C . Sell an aluminum forward contract
- D . Buy an aluminum forward contract
A
Explanation:
To hedge against potential declines in aluminum prices, Omega Bank should take a position that benefits from a price drop.
Here are the steps and strategies:
Current Position:
Omega Bank has bought 100 metric tons of aluminum for delivery in six months.
Hedging Strategy:
To protect against a decline in aluminum prices, the bank should take a short position in the aluminum futures market. This involves selling aluminum futures contracts.
Execution:
By selling an aluminum futures contract, Omega Bank locks in a price for selling aluminum in the future, thus offsetting the risk of price declines.
The correct strategy is to sell an aluminum futures contract, which effectively hedges the bank’s exposure to a potential drop in aluminum prices.
References Source: How Finance Works?
How could a bank’s hedging activities with futures contracts expose it to liquidity risk?
- A . The futures hedge may not work due to the widening of basis which could result in a loss for the bank.
- B . Prices may move such that a loss results on the hedge.
- C . Since futures require margins which are settled every day, the bank could find itself scrambling for funds.
- D . The bank could get exposed to liquidity risk since futures trade on an exchange.
C
Explanation:
When a bank hedges with futures contracts, it needs to maintain margin accounts which are settled daily to reflect market changes:
Margin Calls: If the market moves against the position of the futures, the bank must add funds to the margin account to cover potential losses. This can create significant liquidity risk if large sums are needed quickly.
Daily Settlements: Futures markets require daily mark-to-market settlements which means that any adverse movement in prices necessitates immediate liquidity to meet the margin requirements.
Market Volatility: In times of high volatility, the daily margin requirements can be substantial, potentially causing a scramble for liquidity if the bank has not pre-arranged sufficient liquidity buffers.
Thus, the need for daily margin settlements exposes the bank to liquidity risk as it must be able to provide cash on short notice.
References: How Finance Works, relevant sections on liquidity risks in derivative markets??.
Which one of the following four exercise features is typical for the most exchange-traded equity options?
- A . Asian exercise feature
- B . American exercise feature
- C . European exercise feature
- D . A shout option exercise feature
B
Explanation:
Most exchange-traded equity options in the U.S. typically have the American exercise feature. This feature allows the holder to exercise the option at any time before and including the expiration date, providing greater flexibility compared to the European exercise feature, which only allows exercise at expiration. The Asian and shout option features are less common and not typically associated with exchange-traded equity options.
James Johnson has a $1 million long position in ThetaGroup with a VaR of 0.3 million, and $1 million long position in VolgaCorp with a VaR of 0.4 million. The returns of the two companies have zero correlation.
What is the portfolio VaR?
- A . $1 million
- B . $0.7 million
- C . $0.5 million
- D . $0.4 million
C
Explanation:
The portfolio VaR when the returns of two assets are uncorrelated can be calculated using the formula:
Portfolio VaR=(VaR of ThetaGroup)2+(VaR of VolgaCorp)2Portfolio VaR=(VaR of ThetaGroup)2+(VaR of VolgaCorp)2?
Plugging in the values:
Portfolio VaR=(0.3)2+(0.4)2=0.09+0.16=0.25=0.5Portfolio VaR=(0.3)2+(0.4)2?=0.09+0.16?=0.25?=0.5
So, the portfolio VaR is $0.5 million.
Which type of risk does a bank incur on loans that are in the "pipeline", i.e loans that are in the process of origination but not yet originated?
- A . Interest rate risk and credit risk
- B . Interest rate risk only
- C . Credit Risk only
- D . The bank does not incur any risk since the loan is not yet originated
A
Explanation:
When a bank has loans in the "pipeline," it means these loans are in the process of origination but have not yet been originated. During this period, the bank is exposed to both interest rate risk and credit risk.
Interest Rate Risk: This risk arises because changes in interest rates can affect the bank’s profitability on these loans. If interest rates change unfavorably between the time the loan terms are set and the time the loan is actually issued, the bank might end up earning less than expected. This is particularly relevant in a volatile interest rate environment.
Credit Risk: Even though the loans are not yet originated, the bank assesses the creditworthiness of the potential borrowers during the pipeline stage. If the financial condition of a borrower deteriorates before the loan is finalized, the bank faces the risk of having to deal with a higher probability of default.
These risks are inherent to the loan origination process and are present even before the loan is officially on the bank’s books.
Why is economic capital across market, credit and operational risks simply added up to arrive at an estimate of aggregate economic capital in practice?
- A . Market, credit and operational risks are perfectly correlated which justifies adding up their associated economic capital.
- B . In practice, it is very difficult to estimate the correlations between the risk categories and as a result a conservative estimate is obtained by adding up the risks.
- C . Regulators require banks to add up economic capital across market, credit and operational risks.
- D . Since market, credit and operational risks are significantly different measures of risk, there is no
diversification benefit to computing economic capital to banks across types of risks.
B
Explanation:
In practice, financial institutions often sum the economic capital required for market, credit, and operational risks to arrive at an aggregate economic capital estimate. This is done because:
Difficulty in Estimating Correlations: Estimating the correlations between different types of risks is complex and data-intensive. These correlations can change over time and under different market conditions, making it challenging to arrive at accurate estimates.
Conservatism: To avoid underestimating the total risk, a conservative approach is often taken by adding up the individual risk capitals. This ensures that the institution holds sufficient capital to cover potential losses from all types of risks, even if they were to occur simultaneously.
Regulatory Guidance: Although regulations encourage a more integrated approach, the lack of precise data often leads banks to use simpler, more conservative methods in practice.
Thus, option B correctly reflects the practical approach taken due to the difficulty in estimating correlations between different risk categories.
References: How Finance Works, discussions on risk aggregation and challenges in estimating correlations between risk types??.
Present value of a basis point (PVBP) is one of the ways to quantify the risk of a bond, and it measures:
- A . The change in value of a bond when yields increase by 0.01%.
- B . The percentage change in bond price when yields change by 1 basis point.
- C . The present value of the future cash flows of a bond calculated at a yield equal to 1%.
- D . The percentage change in bond price when the yields change by 1%.
A
Explanation:
Present Value of a Basis Point (PVBP) measures the change in the value of a bond when the yield changes by one basis point (0.01%). This measure helps quantify the interest rate risk of a bond by indicating how much its price will fluctuate with small changes in yield.
To estimate the required risk-adjusted rate of return on a highly volatile energy stock, a risk associate compiled the following statistics:
Risk-free rate = 5%
Beta = 2.5
Market Risk = 8%
Using the Capital Asset Pricing Model, she estimates the rate of return to be equal:
- A . 10%
- B . 15%
- C . 25%
- D . 40%
C
Explanation:
To calculate the required return using CAPM:
Required return = risk-free rate + beta × market risk premium
Substituting the given values: Required return = 5% + 2.5 × 8% Required return = 5% + 20% Required return = 25%
Therefore, the estimated rate of return using the given statistics is 25%.
If a bank is long £500 million pounds, short £300 million in delta-equivalent pound options, and long £100 million in pound-denominated stocks, what is the amount of pound exposure that would be shown in the aggregated risk reports?
- A . £300 million pounds
- B . £500 million pounds
- C . £800 million pounds
- D . £900 million pounds
A
Explanation:
To determine the pound exposure in the aggregated risk reports, we sum the net positions:
Long £500 million:
The bank holds a long position of £500 million.
Short £300 million in delta-equivalent pound options:
This position reduces the exposure by £300 million.
Long £100 million in pound-denominated stocks:
This adds £100 million to the exposure.
Net exposure: 500-300+100=300?million pounds500 – 300 + 100 = 300 , ext{million pounds}500-300+100=300million pounds
Thus, the pound exposure shown in the aggregated risk reports is £300 million.
References Source: How Finance Works?
Which of the following statements describes correctly the objectives of position mapping?
I. For VaR calculations, mapping converts positions based on their deltas to underlying factor risks.
II. Position mapping models risk factors affecting the value of a position as combination of core risk factors used in the VaR calculations.
III. Position mapping groups similar positions into one group based on the closeness of their respective VaR.
IV. Position mapping reduces the possible number of risk factors to a computationally manageable level.
- A . I and II
- B . II and IV
- C . I, II and III
A
Explanation:
Position mapping is used in risk management to simplify the assessment of risks associated with various
positions. The objectives of position mapping are:
For VaR (Value at Risk) calculations, it converts positions based on their deltas to underlying factor risks. This means mapping the positions to their underlying risk factors to make the complex position simpler to manage and evaluate.
Position mapping models risk factors affecting the value of a position as a combination of core risk factors used in the VaR calculations. This involves breaking down the complex risk factors into more manageable and fundamental risk components that can be easily analyzed.
By focusing on these two objectives, position mapping helps in both simplifying the risk assessment process and in ensuring that the primary risk factors are correctly identified and managed.
Alpha Bank, a small bank,has a long position with larger BetaBank and has an identical short position with another larger bank GammaBank. Each large bank requires a 20% initial collateral to support the trade. As prices fluctuate in either direction, one large bank will require additional collateral from the small bank, while the risk of loss to the other large bank will increase.
By running the trades through a clearinghouse, the small bank can achieve all of the following objectives EXCEPT:
- A . Eliminating the collateral requirement
- B . Protecting itself against increases in future collateral demands
- C . Protecting against the risk of the failure of one of the large banks
- D . Mitigating option hedging risks and altering margin requirement
D
Explanation:
Running trades through a clearinghouse provides several advantages for the small bank, including:
Eliminating the Collateral Requirement:
The clearinghouse nets positions and reduces the need for bilateral collateral postings.
Protecting Against Increases in Future Collateral Demands:
Centralized clearing reduces the potential for unexpected margin calls as prices fluctuate.
Protecting Against the Risk of the Failure of One of the Large Banks:
The clearinghouse acts as a central counterparty, reducing the impact if one large bank fails.
However, the clearinghouse does not specifically address option hedging risks or alter margin requirements directly related to options. Therefore, the correct answer is that running trades through a clearinghouse does not achieve the objective of mitigating option hedging risks and altering margin requirements.
References Source: How Finance Works?
An associate from the finance group has been identified as an operational risk coordinator (ORC) for her department.
To fulfill her ORC responsibilities the associate will need to:
I. Provide main communication contact with operational risk department
II. Provide main reporting contact with audit department
III. Coordinate collection of key risk indicators in her area
IV. Coordinate training and awareness activities in her area
- A . I, II
- B . II, III, IV
- C . I, II, III
- D . I, III, IV
D
Explanation:
An operational risk coordinator (ORC) needs to provide the main communication contact with the operational risk department (I), coordinate the collection of key risk indicators in her area (III), and coordinate training and awareness activities in her area (IV). The main reporting contact with the audit department (II) is not typically an ORC responsibility.
References: Operational risk coordinator responsibilities as outlined in Financial Risk and Regulation documents.
What is a common implicit assumption that is made when computing VaR using parametric methods?
- A . The expected returns are constant, but the standard deviation changes over time.
- B . The standard deviations of returns are constant, but the mean changes over time.
- C . The mean of and the standard deviations of returns are both constant.
- D . The mean and standard deviation of returns change periodically in response to crises.
C
Explanation:
When computing VaR using parametric methods, a common implicit assumption is that both the mean and standard deviation of returns are constant over time.
Constant Mean: The expected return of the asset or portfolio does not change over the time period considered.
Constant Standard Deviation: The volatility of returns, which measures the dispersion of returns from the mean, is assumed to be constant.
This assumption simplifies the calculations as it allows the use of historical data to estimate future risks. However, it may not always hold true in real-world scenarios where markets can exhibit changing
volatility and return patterns.
References
How Finance Works.pdf, p. 201
In the United States, stock investors must comply with the Regulation T of the Federal Reserve Bank and may borrow up to ___ of the value of the securities from their brokers.
- A . 30%
- B . 40%
- C . 50%
- D . 60%
C
Explanation:
T Identify the regulation:
Regulation T of the Federal Reserve Bank governs the amount of credit that brokers and dealers can extend to investors for the purchase of securities.
Borrowing limit:
Regulation T allows investors to borrow up to 50% of the value of the securities from their brokers.
Gamma Bank has a significant number of retail customers and finds its balance sheet shape and structure difficult to manage.
Which one of the following characteristics of a bank with wide retail operations is INCORRECT?
- A . Banks with a wide retail base are typically driven by contractual obligations and not simply relationship considerations.
- B . Attracting and retaining customers often involves offering retail products whose features are different from wholesale market products.
- C . Pricing of retail products often has more to do with marketing considerations rather than prevailing market price.
- D . The way retail customers behave in relation to the retail banking products they hold often results in the apparent contractual obligation of the parties providing a poor description of the actual nature of the obligations.
A
Explanation:
Banks with a large number of retail customers often face complex balance sheet management issues due to the varied behaviors and preferences of retail customers. While attracting and retaining these customers often involves offering products with unique features, it is also true that the pricing of retail products is influenced more by marketing considerations rather than prevailing market prices. Additionally, retail customer behavior often deviates from the contractual terms, making the management of such operations challenging. Therefore, option A is incorrect because retail banks must balance both contractual obligations and relationship considerations.
Which one of the following four statements presents a challenge of using external loss databases in the operational risk framework?
- A . Use of benchmarked data reflects similar data collection standards.
- B . External events are usually not of interest to senior management.
- C . If the external data is gathered from news sources, it may only reflect events that are interesting to the press.
- D . They provide a source of data on what operational loss events will occur.
C
Explanation:
Option A: Use of benchmarked data reflects similar data collection standards.
Incorrect. Benchmarking ensures that data is collected using similar standards, enhancing comparability and reliability.
Option B: External events are usually not of interest to senior management.
Incorrect. External events provide valuable insights and lessons that are often of significant interest to senior management.
Option C: If the external data is gathered from news sources, it may only reflect events that are interesting to the press.
Verified and correct. Data sourced from news can be biased towards more sensational events, potentially missing out on less newsworthy but equally important incidents.
Option D: They provide a source of data on what operational loss events will occur.
Incorrect. External databases provide historical data that can inform risk assessments but do not predict future events directly.
A key function of treasuries in commercial/retail banks is:
I. To manage the interest margin of the banks.
II. To focus on underwriting risk.
III. To ensure strong earnings.
IV. To increase profit margins.
- A . I
- B . II
- C . II, III
- D . III, IV
A
Explanation:
A key function of treasuries in commercial/retail banks is to manage the interest margin of the banks. This involves overseeing the spread between the interest income generated from loans and other interest-earning assets and the interest expense paid on deposits and other interest-bearing liabilities. This function is crucial for maintaining profitability and ensuring the financial stability of the bank.
References: No specific reference found in the document for this question. The provided answer is based on common practices in treasury management within banks.
An options trader is assessing the aggregate risk of her currency options exposures. As an options buyer, she can potentially ___ lose more than the premium originally paid. As an option seller, however, she has a ___ risk on the contract and always receives a premium.
- A . Never, unlimited
- B . Sometimes, unlimited
- C . Never, limited
- D . Sometimes, limited
A
Explanation:
As an options buyer, the maximum loss is limited to the premium paid for the option. Therefore, the buyer can never lose more than the premium. As an option seller, the risk is theoretically unlimited because the seller is obligated to fulfill the contract regardless of how unfavorable the terms might become due to market movements.
Which one of the following four statements about regulatory capital for a bank is accurate?
- A . Regulatory capital is determined by rules imposed by an outside authority, such as a supervisor or central bank.
- B . Regulatory capital is the lowest level of economic capital the bank should have to meet regulatory requirement.
- C . Regulatory capital reflects the economic tradeoffs of the bank as accurately as the bank can represent them.
- D . Regulatory capital is less than the regulatory capital requirement.
A
Explanation:
Regulatory capital is the minimum amount of capital that a bank is required to hold by financial regulators. These rules are imposed by outside authorities such as central banks or financial supervisory bodies to ensure the stability and solvency of financial institutions. This differs from economic capital, which is determined internally by the bank to cover its own estimated risk exposures.
According to Basel II what constitutes Tier 1 capital?
- A . Equity capital and core capital
- B . Profits to reserves and innovative Tier 1 capital
- C . Equity capital and accrued profits to reserves
- D . Core capital and innovative Tier 1 capital.
C
Explanation:
Under Basel II, Tier 1 capital, also known as core capital, includes:
Equity Capital: This includes common stock and retained earnings. It is the highest quality of capital because it is fully available to cover losses.
Accrued Profits to Reserves: Profits that are retained and not distributed as dividends are added to reserves, increasing the bank’s capital base.
This combination of equity capital and retained earnings ensures that Tier 1 capital is robust and able to absorb significant losses, thereby providing a strong financial cushion.References: How Finance Works, sections on regulatory capital requirements and the components of Tier 1 capital??.
When looking at the distribution of portfolio credit losses, the shape of the loss distribution is ___ , as the likelihood of total losses, the sum of expected and unexpected credit losses, is ___ than the likelihood of no credit losses.
- A . Symmetric; less
- B . Symmetric; greater
- C . Asymmetric; less
- D . Asymmetric; greater
D
Explanation:
The distribution of portfolio credit losses is typically asymmetric, meaning it is not evenly distributed. This asymmetry arises because the likelihood of small losses is much higher than the likelihood of very large losses.
The likelihood of total losses, which includes both expected and unexpected losses, is greater than the likelihood of no credit losses. This is because while small losses happen more frequently, large losses, although less frequent, can occur and can be significant.
References:
How Finance Works: "The distribution of credit losses is asymmetric because the likelihood of total losses is greater than the likelihood of no credit losses."
A multinational bank just bought two bonds each worth $10,000. One of the bonds pays a fixed interest of 5% semi-annually and the other pays LIBOR semi-annually. The six month LIBOR is at 5% currently. The risk manager of the bank is concerned about the sensitivity to interest rates.
Which of the following statements are true?
- A . The price of the bond paying floating interest is more sensitive to interest rates than the bond paying fixed interest.
- B . The price of the bond paying fixed interest is more sensitive to interest rates than the bond paying floating interest.
- C . Both bond prices are equally sensitive to interest rates.
- D . The given information is not enough to determine the sensitivity of the bond prices.
B
Explanation:
A bond that pays fixed interest is more sensitive to changes in interest rates than a bond that pays floating interest. This is because the fixed interest bond’s coupon payments are constant, and its price will fluctuate more as interest rates change. In contrast, the floating interest bond adjusts its coupon payments according to the current interest rates, making its price less sensitive to changes in the market interest rates.
What is a difference between currency swaps and interest rate swaps?
- A . Currency swaps do not require the exchange of notional principal on maturity.
- B . Currency swaps allow banks and customers to obtain the risk/reward profile of long-term interest rates without having to use long-term funding.
- C . Currency swaps are OTC derivative contracts.
- D . Currency swaps generate foreign exchange rate risk in addition to interest rate risk.
D
Explanation:
Currency swaps and interest rate swaps differ primarily in the risks they manage and generate. While both are OTC derivative contracts, currency swaps involve the exchange of principal and interest payments in one currency for principal and interest payments in another currency. This not only involves managing interest rate risk but also introduces foreign exchange rate risk, as fluctuations in currency exchange rates can affect the value of the payments exchanged.
Which one of the following four statements correctly defines chooser options?
- A . The owner of these options decides if the option is a call or put option only when a predetermined date is reached.
- B . These options represent a variation of the plain vanilla option where the underlying asset is a basket of currencies.
- C . These options pay an amount equal to the power of the value of the underlying asset above the strike price.
- D . These options give the holder the right to exchange one asset for another.
A
Explanation:
Chooser options give the holder the flexibility to decide whether the option will be a call or a put at a specific future date. This feature makes chooser options valuable in uncertain market conditions, as the holder can choose the type of option that will be more beneficial depending on the market scenario at the decision point.