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NEW QUESTION # 10
The loss severity distribution for operational risk loss events is generally modeled by which of the following distributions:
I. the lognormal distribution
II. The gamma density function
III. Generalized hyperbolic distributions
IV. Lognormal mixtures
- A. I, II, III and IV
- B. II and III
- C. I, II and III
- D. I and III
Answer: A
Explanation:
Explanation
All of the distributions referred to in the question can be used to model the loss severity distribution for op risk.Therefore Choice 'c' is the correct answer.
NEW QUESTION # 11
Which of the following belong to the family of generalized extreme value distributions:
I. Frechet
II. Gumbel
III. Weibull
IV. Exponential
- A. II and III
- B. IV
- C. I, II and III
- D. All of the above
Answer: C
Explanation:
Explanation
Extreme value theory focuses on the extreme and rare events, and in the case of VaR calculations, it is focused on the right tail of the lossdistribution. In very simple and non-technical terms, EVT says the following:
1. Pull a number of large iid random samples from the population,
2. For each sample, find the maximum,
3. Then the distribution of these maximum values will follow a GeneralizedExtreme Value distribution.
(In some ways, it is parallel to the central limit theorem which says that the the mean of a large number of random samples pulled from any population follows a normal distribution, regardless of the distribution of the underlying population.) Generalized Extreme Value (GEV) distributions have three parameters: (shape parameter), (location parameter) and (scale parameter). Based upon the value of , a GEV distribution may either be a Frechet, Weibull or a Gumbel. These arethe only three types of extreme value distributions.
NEW QUESTION # 12
Which of the following is not an approach proposed by the Basel II framework to compute operational riskcapital?
- A. Advanced measurement approach
- B. Factor based approach
- C. Basic indicator approach
- D. Standardized approach
Answer: B
Explanation:
Explanation
Basel II proposes three approaches to compute operational risk capital - the basic indicator approach(BIA), the standardized approach (SIA) and the advanced measurement approach (AMA). There is no operational risk approach called the factor based approach.
NEW QUESTION # 13
Under the contingent claims approach to measuring credit risk, which of the following factors does NOT affect credit risk:
- A. Cash flows of the firm
- B. Volatility of the firm's asset values
- C. Maturity of the debt
- D. Leverage in the capital structure
Answer: A
Explanation:
Explanation
Under the contingent claims approach, credit risk is modeled as the value of a put option on the value of the firm's assets with a strike equal to the face value of the debt and maturity equal to the maturity of the obligation. The cost of credit risk is determined by the leverage ratio, the volatility of the firm's assets and the maturity of the debt. Cash flows are not a part of the equation. Therefore Choice 'a' is the correct answer.
NEW QUESTION # 14
If the cumulative default probabilities of default for years 1 and 2 for a portfolio of credit risky assets is 5% and 15% respectively, what is the marginal probability of default in year 2 alone?
- A. 10.00%
- B. 10.53%
- C. 11.76%
- D. 15.79%
Answer: B
Explanation:
Explanation
One way to think about this question is this: we are provided with two pieces of information: if the portfolio is worth $100 to start with, it will be worth $95 at the end of year 1 and $85 at the end of year 2. What it isasking for is the probability of default in year 2, for the debts that have survived year 1. This probability is $10/$95 =
10.53%. Choice 'b' is the correct answer.
Note that marginal probabilities of default are the probabilities for default for a given period, conditional on survival till the end of the previous period. Cumulative probabilities of default are probabilities of default by a point in time, regardless of when the default occurs. If the marginal probabilities of default for periods 1, 2... n are p1, p2...pn, then cumulative probability of default can be calculated as Cn = 1 - (1 - p1)(1-p2)...(1-pn). For this question, we can calculate the probability of default for year 2 as [1 - (1 - 5%)(1 - 10.53%)] = 15%.
NEW QUESTION # 15
Under the credit migration approach to assessing portfolio credit risk, which of the following are needed to generate adistribution of future portfolio values?
- A. The forward yield curve
- B. A specified risk horizon
- C. All of the above
- D. A rating migration matrix
Answer: C
Explanation:
Explanation
The credit migration approach to assessing portfolio credit risk involves obtaining a distribution of future portfolio values from the ratings migration matrix. First, the frequencies in the matrix are used as probabilities, and expected future values of the securities belonging to each rating category are calculated. These are then discounted to the present using the discount rate appropriate to the 'future' rating category. This gives us a forward distribution of the value of each security in the portfolio. These are then combined using the default correlations between the issuers. The default correlation between the issuers is often proxied using asset returns, and recognizing that default occurs when asset values fall below a certain threshold. A distribution for the future value of the portfolio is generated using simulation, and from thisdistribution the Credit VaR can be calculated.
Thus, we need the migration matrix, the risk horizon from which the present values need to be calculated, and the forward yield curve or the discount curve for each rating category for the risk horizon. Thus,Choice 'd' is the correct answer.
NEW QUESTION # 16
The largest 10 lossesover a 250 day observation period are as follows. Calculate the expected shortfall at a
98% confidence level:
20m
19m
19m
17m
16m
13m
11m
10m
9m
9m
- A. 19.5
- B. 14.3
- C. 18.2
- D. 0
Answer: C
Explanation:
Explanation
For a dataset with 250 observations, the top 2% of the losses will be the top 5 observations. Expected shortfall is the average of the losses beyond the VaR threshold. Therefore the correct answer is (20 + 19 + 19 + 17 +
16)/5 = 18.2m .
Note that Expected Shortfall is also called conditional VaR (cVaR), Expected Tail Lossand Tail average.
NEW QUESTION # 17
The key difference between 'top down models' and 'bottom up models' foroperational risk assessment is:
- A. Top down approaches to operational risk are based upon an analysis of key risk drivers, while bottom up approaches consider causality in risk scenarios.
- B. Bottom up approaches to operational risk are based upon an analysis of key risk drivers, while top down approaches consider causality in risk scenarios.
- C. Top down approaches to operational risk calculate the implied operational risk using available data such as income volatility, capital etc; while bottom up approaches use causal factors, risk drivers and other factors to get an aggregated estimate of risk.
- D. Bottom up approaches to operational risk calculate the implied operational risk using available data such as income volatility, capital etc; while top down approaches use causal factors, risk drivers and other factors to get an aggregated estimate of risk.
Answer: C
Explanation:
Explanation
Top down approaches rely upon available data such as total capital, income volatility, peer group information etc and attempt to imply the capital attributable to operational risk. They do not consider firm specific scenarios or causal factors. Bottom up approaches on the other hand attempt to determine operational risk capital based upon an identification and quantification of firm specific risks. Bottom up approaches help determine a traditional loss distribution from which capital requirements can be determined at a given level of confidence.
Therefore Choice 'd' is the correct answer.
NEW QUESTION # 18
Which of the following statements is true:
I. Recovery rate assumptions can be easily made fairly accurately given past data available from credit rating agencies.
II. Recovery rate assumptions are difficult to make given the effect of the business cycle, nature of the industry and multiple other factors difficult to model.
III. The standard deviation of observed recovery rates is generally very high, making any estimate likely to differ significantly from realized recovery rates.
IV. Estimation errors for recovery rates are not a concern as they are not directionally biased and will cancel each other out over time.
- A. II and IV
- B. II and III
- C. I, II and IV
- D. III and IV
Answer: B
Explanation:
Explanation
Recovery rates vary a great deal from year to year, and are difficult to predict. Therefore statement III is true.
Similarly, any attempt to predict these is hamstrung by a high standard error, which can be as high as the historical mean itself. The error does not cancel itself out due to the effect of the business cycle making the error directionally biased. Thus statement IV is false.
Statement II is true as these are all factors that make forecasting recovery rates for any credit risk model ratherdifficult. Statement I is false because recovery rates are difficult to predict and assumptions are not easy to make.
NEW QUESTION # 19
Which of the following statements is true
I. If no loss data is available, good quality scenarios can be used to model operational risk II. Scenario data can be mixed with observed loss data for modeling severity and frequency estimates III. Severity estimates should not be created by fitting models to scenario generated loss data points alone IV. Scenario assessments should only be used as modifiers to ILD or ELD severity models.
- A. I
- B. I and II
- C. All statements are true
- D. III and IV
Answer: B
Explanation:
Explanation
There are multiple ways to incorporate scenario analysis for modeling operational risk capital - and the exact approach used depends upon thequantity of loss data available, and the quality of scenario assessments.
Generally:
- If there is no past loss data available, scenarios are the only practical means to model operational risk loss distributions. Both frequency and severity estimates can be modeled based on scenario data.
- If there is plenty of past data available, scenarios can be used as a modifier for estimates that are based solely on data (for example, consider the MAX of the loss estimates at the desired quantile as provided bythe data, and as indicated by scenarios)
- If high quality scenario data is available, and there is sufficient past data, one could mix scenario assessments with the loss data and fit the combined data set to create the loss distribution. Alternatively, both could be fitted with severity estimates and then the two severities could be parametrically combined.
In short, there is considerable flexibility in how scenarios can be used.
Statement I is therefore correct, and so is statement II as both indicate valid uses of scenarios.
Statement III is not correct because it may be okay to create severity estimates based on scenario data alone.
Statement IV is not correct because while using scenarios as modifiers to other means of estimation is acceptable, that isnot the only use of scenarios.
NEW QUESTION # 20
An operational loss severity distribution is estimated using 4 data points from a scenario. The management institutes additional controls to reduce the severity of the loss if the risk is realized, and as a result the estimated losses from a 1-in-10-year losses are halved. The 1-in-100 loss estimate however remains the same.
What would be the impact on the 99.9th percentile capital required for this risk as a result of the improvement in controls?
- A. The capital required will stay the same
- B. The capital required will decrease
- C. Can't say based on the information provided
- D. The capital required will increase
Answer: D
Explanation:
Explanation
This situation represents one of the paradoxes in estimating severity that one needs to be aware of - the improvement in controls reduces the weight of the body/middle of the distribution and moves it towards the tails (as the total probability under the curve must stay at 100%) and the distribution becomes more heavy tailed. As a result, the 99.9th percentile loss actually increases. instead of decreasing, creating a counterintuitive result. Therefore the correct answer is that the capital required will increase.
If scenario analysis produces such a result, the analyst must question if the 1 in 100 year loss severity is still accurate. If the new control has reduced the severity in the body of the distribution, the question as to why the more extreme losses have not changed should be raised.
NEW QUESTION # 21
Which of the following is not true about the ISDA master agreement (ISDA MA):
- A. All transactions under the ISDA MA are considered separate obligations
- B. The ISDA MA describes events of default, and termination events
- C. The CSA (Credit Support Annex) is one of the parts of the ISDA MA
- D. The ISDA MA describes the close out process
Answer: A
Explanation:
Explanation
The ISDA MA provides a template that can be used by market participants to document derivativetransactions.
It has a core section that applies always, and various schedules that can be agreed to by the parties. The ISDA MA considerably facilitates closing transactions once the ISDA MA has been has been negotiated, without requiring a renegotiationeach time.
A key feature of the ISDA MA is that it binds all transactions into a single net obligation. The ISDA Master
2002 states that "All transactions are entered into in reliance on the fact that this Master Agreement and all Confirmations form a single agreement between the parties ... and the parties would not otherwise enter into any Transactions." Therefore transactions under the ISDA MA are not considered separate obligations.
The ISDA MA does indeed define close out processes, default and termination events, and the CSA is one of the parts of the MA that describes the collateral related agreement.
NEW QUESTION # 22
Which of the following is closest to the description of a 'risk functional'?
- A. A risk functional is the distribution thatmodels the severity of a risk
- B. A risk functional is a model distribution that is an approximation of the true loss distribution of a risk
- C. Risk functional refers to the Kolmogorov-Smirnov distance
- D. A risk functional assigns a penalty value for the difference between a model distribution and a risk's severity distribution
Answer: D
Explanation:
Explanation
For operational risk modeling, both frequency and severity distributions need to be modeled. Modeling severity involves finding an analyticaldistribution, such as log-normal or other that approximates the distribution best represented by known data - whether from the internal loss database, the external loss database or scenario data. A 'risk functional' is a measure of the deviation of the model distribution from the risk's actual severity distribution. It assigns a penalty value for the deviation, using a statistical measure, such as the KS distance (Kolmogorov-Smirnov distance).
The problem of finding the right distribution then becomes the problem of optimizing the risk functional. For example, if F is the model distribution, and G is the actual, or empirical severity distribution, and we are using the KS test, then the Risk Functional R is defined as follows:
Note that supx stands for 'supremum', which is a more technical way of saying 'maximum'. In other words, we are calculating the maximum absolute KS distance between the two distributions. (Note that the KS distance is the max of the distance between identical percentiles of the two distributions using the CDFs of the two.) Once the risk functional is identified, we can minimize it to determine the best fitting distribution for severity.
NEW QUESTION # 23
Which of the following is the most accurate description of EPE (Expected Positive Exposure):
- A. The average of the distribution of positive exposures at a specified future date
- B. Weighted average of thefuture positive expected exposure across a time horizon.
- C. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date
- D. The maximum average credit exposure over a period of time
Answer: B
Explanation:
Explanation
When a derivative transaction is entered into, its value generally is close to zero. Over time, as the value of the underlying changes, the transaction acquires a positive or negative value. It is not possible to predict the future value of the transaction in advance, however distributional assumptions can be made and potential exposure can be measured in multiple ways. Of all the possible future exposures, it is generally positive exposures that are relevant to credit risk because that is the only situation where the bank may lose money from a default of the counterparty.
The maximum (generally aquantile eg, the 97.5th quantile) exposure possible over the time of the transaction is the 'Potential Future Exposure', or PFE.
The average of the distribution of positive exposures at a specified date before the longest trade in the portfolio is called'Expected Exposure', or EE.
The expected positive exposure calculated as the weighted average of the future positive Expected Exposure across a time horize is called the EPE, or the 'Expected Positive Exposure'.
The price that would be received to sell anasset or paid to transfer a liability in an orderly transaction between market participants at the measurement date - is the 'fair value', as defined under FAS 157.
Therefore the corect answer is that EPE is the weighted average of the future positive expected exposure across a time horizon.
NEW QUESTION # 24
What would be the correct order of steps to addressing data quality problems in an organization?
- A. Assess the current state, design the future state, determine gaps and the actions required to be implemented to eliminate the gaps
- B. Call in external consultants
- C. Design the future state, perform a gap analysis, analyze the current state and implement the future state
- D. Articulate goals, do a 'strategy-fit' analysis and plan for action
Answer: A
Explanation:
Explanation
The correct answer is choice 'a'
The correct order of steps to addressing data quality problems in an organization would include:
1. Assesing the current state
2. Designing the future state, and
3. Planning and implementation which would include identifying the gaps between the current and the desired future state, and implementation to address the gaps.
Therefore Choice 'a' is the correct answer.
Choice 'c' is incorrect because a gap analysis cannot be performed without understanding the 'as-is' (which results from understanding the current state).
Choice 'b' is non-sensical, and Choice 'd' is a flippant option (though often used in real life situations by management as an easy (and ineffective) way to escape accountability for difficult problems)
NEW QUESTION # 25
A bank extends a loan of $1m to a home buyer to buy a house currently worth $1.5m, with the house serving as the collateral. The volatility of returns (assumed normally distributed) on house prices in that neighborhood is assessed at 10% annually. The expected probability of default of the home buyer is 5%.
What is the probability that the bank will recover less than the principal advanced on this loan; assuming the probability of the home buyer's default is independent of the value of the house?
- A. Less than 1%
- B. 0
- C. More than 1%
- D. More than 5%
Answer: A
Explanation:
Explanation
The bank will not be able to recover the principal advanced on this loan if both the home buyer defaults, and the house value falls to less than $1m, ie the price moves adversely by more than$500k, which is
$-500k/$150k = -3.33. (Note that 150k is the 1 year volatility in dollars, ie $1.5m * 10%).
The probability of both these things happening together is just the product of the two probabilities, one of which we know to be 5%. The other is also certainly a small number, and intuitively it is clear that the probability of both the things happening together will be less than 1%.
For a more precise answer, we can calculate the probability of the house price falling by 3.33 standard deviations bycalculating the area under the standard normal curve to the left of -3.33. This indeed is a very small number (actually equal to NORMSINV(-3.33)=0.00043), which when multiplied by the probability of default of the home buyer at 5% is certainly going to be less than 1%. Therefore Choice 'b' is the correct answer.
NEW QUESTION # 26
For creditrisk calculations, correlation between the asset values of two issuers is often proxied with:
- A. Equity correlations
- B. Transition probabilities
- C. Credit migration matrices
- D. Default correlations
Answer: A
Explanation:
Explanation
Asset returns are relevant for credit risk models where a default is related to the value of the assets of the firm falling below the default threshold. When assessing credit risk for portfolios with multiple credit assets, it becomes necessary to know the asset correlations of the different firms. Since this data is rarely available, it is very common to approximate asset correlations using equity prices. Equity correlations are used as proxies for asset correlation, therefore Choice 'c' is the correct answer.
NEW QUESTION # 27
Which of the following is true for the actuarial approach to credit risk modeling (CreditRisk+):
- A. The approach is based upon historical rating transition matrices
- B. The approach considers only default risk, and ignores the risk to portfolio value from credit downgrades
- C. Default correlations between obligors are accounted for using a multivariate normal model
- D. The number ofdefaults is modeled using a binomial distribution where the number of defaults are considered discrete events
Answer: B
Explanation:
Explanation
The actuarial model considers defaults to follow a Poisson distribution with a given mean per period, and these are binary in nature, ie a default happens or it does not happen. The model does not consider the loss of value from credit downgrades, and focuses only on defaults. The model also does not consider default correlations between obligors. Therefore Choice 'c' is the correct answer.
The other choices are not true statements that would apply tothe actuarial approach.
NEW QUESTION # 28
CreditRisk+, the actuarial model for calculating portfolio credit risk, is based upon:
- A. the exponential distribution
- B. the Poisson distribution
- C. the log-normal distribution
- D. the normal distribution
Answer: B
NEW QUESTION # 29
There are three bonds in a diversified bond portfolio, whose default probabilities are independent of each other and equal to 1%, 2% and 3% respectively over a 1 year time horizon. Calculate the probability that exactly 1 of the three bonds will default.
- A. .011%
- B. 5.8%
- C. 0%
- D. 2%
Answer: B
Explanation:
Explanation
The probability that only one of thethree bonds will default is equal to the sum of the probabilities of the three scenarios where one bond defaults and the other two survive. This probability is given by 1%*(1 - 2%)*(1 -
3%) + (1 - 1%)*2%*(1 - 3%) + (1 - 1%)*(1 - 2%)*3% = 5.7818%. Choice 'c' is the correct answer.
NEW QUESTION # 30
A loan portfolio's full notional value is $100, and its value in a worst case scenario at the 99% level of confidence is $65. Expected losses on the portfolio are estimated at 10%. What is the level of economic capital required to cushion unexpected losses?
- A. 0
- B. 1
- C. 2
- D. 3
Answer: B
Explanation:
Explanation
Expected value = $90 ($100 - 10%)
Value at 99% confidence level = $65
Therefore economic capital required at this level of confidence = $90 - $65 = $25.
Choice 'a' is the correct answer, the other choices are not.
(We can also look at it this way as explained in section III.B.6.2.2 of the handbook: Economic capital is designed to absorb unexpected losses, which areequal to total losses at a given confidence level minus expected losses. (Expected losses are to be covered by credit reserves). Total losses are $100-$65=$35, and expected losses are 10%*$100=$10, therefore economic capital should be $35-$10=$25.)
NEW QUESTION # 31
For a bank using the advanced measurement approach to measuring operational risk, which of the following brings the greatest 'model risk' to its estimates:
- A. Choice of an incorrect distribution for loss event frequencies
- B. Choice of incorrect parameters for loss severity distributions
- C. Aggregation risk, from selecting an incorrect value of estimated correlations between different operational risk estimates
- D. Insufficient number of simulations when building the loss distribution
Answer: C
Explanation:
Explanation
The greatest model risk when calculating operational risk capital comes fromincorrect assumptions about correlations between different operational risks for which standalone risk calculations have been made.
Generally, the correlation can be expected to be positive, and would therefore vary between 0 and 1. These two values determine the 'bounds' between which the total operational risk capital would lie, and these bounds are generally quite far apart. Therefore the total value of the operational risk capital is very sensitive to the value chosen for the correlation, and this is the source of the biggest model risk under the AMA.
NEW QUESTION # 32
According to the Basel II framework, subordinated term debt that was originally issued 4 years ago with amaturity of 6 years is considered a part of:
- A. Tier 3 capital
- B. Tier 2 capital
- C. None of the above
- D. Tier 1 capital
Answer: B
Explanation:
Explanation
According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves.
Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt issued originally for 5 years or longer.
Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority. This only includes short term subordinated debt originally issued for 2 or more years.
An interesting thing to note is the difference between 'subordinated term debt' under Tier 2 and the 'short term subordinated debt' under Tier 3. The distinction is based upon the years to maturity at the time the debt was issued. The remaining time to maturity is not relevant. For the subordinated term debt included under Tier 2, the amount that can be counted towards capital is reduced by 20% for every year when the debt is due within 5 years. This takes care of the time to maturity problem for Tier 2subordinated debt. For Tier 3 short term subordinated debt, this is not an issue because debt will only qualify for Tier 3 if it has a lock-in clause stipulating that the debt is not required to be repaid if the effect of such repayment is to take the bank below minimum capital requirements.
NEW QUESTION # 33
Under the contingent claims approach to credit risk, risk increases when:
I. Volatility of the firm's assets increases
II. Risk free rate increases
III. Maturity of the debt increases
- A. I and II
- B. II and III
- C. I, II and III
- D. I and III
Answer: D
Explanation:
Explanation
Under the contingent claims approach, credit risk is evaluated as the value of the put on the firm's assets with a strike price equal to the face value of the debt and maturity equal to the maturity of the obligation. The Black Scholes model can then be used to value the put, and therefore an increase in volatility and the time to expiry (ie maturity) will increase the value of the debt. An increase in the risk free rate will actually reduce the value of the put, therefore statements I and III are correct and Choice 'b' is the correct answer.
NEW QUESTION # 34
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