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NEW QUESTION 121
Under the KMV Moody's approach to credit risk measurement, which of the following expressions describes the expected 'default point' value of assets at which the firm may be expected to default?
- A. Short term debt + Long term debt
- B. 2* Short term debt + Long term debt
- C. Short term debt + 0.5* Long term debt
- D. Long term debt + 0.5* Short term debt
Answer: C
Explanation:
Explanation
A situation where a firm has more liabilities than assets does not necessarily imply default, so long as the firm is able to pay its obligations when they come due. Therefore, short term debts have a greater bearing on a firm's default than longer term debt. However, this is not to say that merely having enough to pay off the short term debts (ie debts due within one year) is enough to avoid default. Over time, the long term debt will also be turning to short term debt, and it may not be possible for the firm to roll over its liabilities without lenders considering the long term debt. The KMV approach considers the entire short term debt and half of the long term debt as the critical value of assets below which default will be triggered. Therefore Choice 'c' is the correct answer.
NEW QUESTION 122
Which of the following event types is hacking damage classified under Basel II operational risk classifications?
- A. Information security
- B. Damage to physical assets
- C. Technology risk
- D. External fraud
Answer: D
Explanation:
Explanation
Choice 'b' is the correct answer. All other answers are incorrect.
Refer to the detailed loss event type classification under Basel II (see Annex 9 of the accord). You should know the exact names of all loss event types, and examples of each.
NEW QUESTION 123
A zero coupon corporate bond maturing in an year has a probability of default of 5% and yields 12%. The recovery rate is zero. What is the risk free rate?
- A. 6.40%
- B. 5.26%
- C. 7.00%
- D. 5.00%
Answer: A
Explanation:
Explanation
The probability of default would make the expected value of the future cash flows from both the corporate bond and the risk free bond identical. If p be the probability of default, the cash flows from the risky corporate bond would be
= (cash flows in the event of default x probability of default) + (cash flows without default x (1 - probability of default))
=> 5%*0 + (1 - 5%)*(1 + 12%) = (1 + Rf).
therefore Rf = 6.4%
(In reality investors would demand a 'credit risk premium' over and above the expected default loss rate. They are unlikely to be happy with just being compensated with exactly the expected default loss rate plus the risk-fre rate because the expected default loss rate itself is uncertain. They would demand some premium over and above what the default rate alone might mathematically imply above the risk free rate. In this question, this credit risk premium is ignored.)
NEW QUESTION 124
Which of the following statements are true:
I. A high score according to Altman's Z-Score methodology indicates a lower default risk II. A high score according to the Probit or Logit models indicates a higher default risk III. A high score according to Altman's Z-Score methodology indicates a higher default risk IV. A high score according to the Probit or Logit models indicates a lower default risk
- A. II and III
- B. I and IV
- C. I and II
- D. III and IV
Answer: C
Explanation:
Explanation
A high score under the probit and logit models indicates a higher default risk, while under Altman's methodology it indicates a lower default risk. Therefore Choice 'd' is the correct answer.
NEW QUESTION 125
Under the KMV Moody's approach to credit risk measurement, how is the distance to default converted to expected default frequencies?
- A. Using migration matrices
- B. Using a proprietary database based on historical information
- C. Using Monte Carlo simulations
- D. Using a normal distribution
Answer: B
Explanation:
Explanation
KMV Moody's uses a proprietary database to convert the distance to default to expected default probabilities.
NEW QUESTION 126
The estimate of historical VaR at 99% confidence based on a set of data with 100 observations will end up being:
- A. the extrapolated returns of the last 1.64 observations
- B. the weighted average of the top 2.33 observations
- C. the worst single observation in the data set
- D. None of the above
Answer: C
Explanation:
Explanation
The VaR in this case will be the top quintile of observations. In this case, since there are exactly 100 observations, this would mean the worst return would become the VaR. Therefore Choice 'b' is the correct answer. Choice 'a' and Choice 'c' make no sense. This highlights that at higher confidence levels, fewer and fewer observations impact the VaR if we are using historical simulation based VaR.
NEW QUESTION 127
If and are the expected rate of return and volatility of an asset whose prices are log-normally distributed, and a random drawing from a standard normal distribution, we can simulate the asset's returns using the expressions:
- A. - + .
- B. - .
- C. / .
- D. + .
Answer: D
Explanation:
Explanation
A standard model for representing asset returns in finance is the Geometric Brownian Motion process, and returns according to this model can be estimated by the expression given in Choice 'b'. Note that prices according to this model are log-normally distributed, and returns are normally distributed.
NEW QUESTION 128
Which of the following is not one of the 'three pillars' specified in the Basel accord:
- A. Market discipline
- B. Minimum capital requirements
- C. National regulation
- D. Supervisory review
Answer: C
Explanation:
Explanation
The three pillars are minimum capital requirements, supervisory review and market discipline. National regulation is not a pillar described under the accord. Choice 'c' is the correct answer.
NEW QUESTION 129
What percentage of average annual gross income is to be held as capital for operational risk under the basic indicator approach specified under Basel II?
- A. 0.15
- B. 0.12
- C. 0.08
- D. 0.125
Answer: A
Explanation:
Explanation
Banks using the basic indicator approach must hold 15% of the average annual gross income for the past three years, excluding any year that had a negative gross income. Therefore Choice 'd' is the correct answer.
NEW QUESTION 130
If two bonds with identical credit ratings, coupon and maturity but from different issuers trade at different spreads to treasury rates, which of the following is a possible explanation:
I. The bonds differ in liquidity
II. Events have happened that have changed investor perceptions but these are not yet reflected in the ratings III. The bonds carry different market risk IV. The bonds differ in their convexity
- A. II and IV
- B. I and II
- C. I, II and IV
- D. III and IV
Answer: B
Explanation:
Explanation
When two bonds that appear identical in every respect trade at different prices, the difference is often due to differences in liquidity between the two bonds (the less liquid bond will be cheaper and yield higher), and also due to the fact that ratings from the major rating agencies do not generally react to day to day changes in the market. The market's perception of the differences in the two credits will cause a divergence in the prices. This has been an extremely visible phenomenon during the credit crisis of 2007-2009, where fixed income security prices have changed sharply for many securities without any changes in external credit ratings.
Bonds carrying 'different market risk' is meaningless, and so is the difference in convexity (because the calculated convexity would be identical for similar bonds).
Therefore Choice 'c' is the correct answer.
NEW QUESTION 131
The CDS rate on a defaultable bond is approximated by which of the following expressions:
- A. Hazard rate / (1 - Recovery rate)
- B. Hazard rate x Recovery rate
- C. Loss given default x Default hazard rate
- D. Credit spread x Loss given default
Answer: C
Explanation:
Explanation
The CDS rate is approximated by the [Loss given default x Default hazard rate]. Thus Choice 'b' is the correct answer.
Note that this is also equal to the credit spread on the reference bond over the risk free rate. Therefore credit spreads and CDS rates are generally the same. Also, 'loss given default' is nothing but (1 - Recovery rate). This can be substituted in the formula for the credit spread to get an alternative expression that directly refers to the recovery rate. Therefore all other choices are incorrect.
NEW QUESTION 132
Which of the following statements are true:
I. Stress tests should consider simultaneous pressures in funding and asset markets, and the impact of a reduction in liquidity II. Judging the effectiveness of risk mitigation techniques is not a part of stress testing III. A reverse stress test is useful for discovering hidden vulnerabilities and inconsistencies in hedging strategies IV. Reputational risk, which is explicitly excluded from the definition of operational risk under Basel II, should still be considered as part of stress tests.
- A. II and IV
- B. All of the above
- C. I and III
- D. I, III and IV
Answer: D
Explanation:
Explanation
All the statements in this question are directly based on the principles for effective stress testing as laid down in the BCBS document on stress testing issued in May 2009. Statement 1 is correct and is an almost verbatim reproduction of principle 10 as laid down in that document. Statement II is incorrect as it is contrary to principle 11 laid down in the same document. Statement III is correct as discovering hidden vulnerabilities and inconsistencies in hedging strategies is one of the objectives of reverse stress tests. Similarly, even though reputational risk is not really covered under any risk category under Basel II (as it is not a part of either market, credit or operational risk), principle 14 of this paper requires the mitigation of spill-over effects on market confidence of reputational risk when thinking about stress tests.
Thus statements I, III and IV are correct and statement II is incorrect.
NEW QUESTION 133
For a corporate issuer, which of the following can be used to calculate market implied default probabilities?
I. CDS spreads
II. Bond prices
III. Credit rating issued by S&P
IV. Altman's scoring model
- A. II and III
- B. I and II
- C. I, II and III
- D. III and IV
Answer: B
Explanation:
Explanation
Generally, the probability of default is an input into determining the price of a security. However, if we know the market price of a security, we can back out the probability of default that the market is factoring into pricing that security. Market implied default probabilities are the probabilities of default priced into security prices, and can be determined from both bond prices and CDS spreads. Credit ratings issued by a credit agency do not give us 'market implied default probabilities', and neither does an internal scoring model like Altman's as these do not consider actual market prices in any way.
Therefore Choice 'b' is the correct answer and the others are not.
NEW QUESTION 134
The VaR of a portfolio at the 99% confidence level is $250,000 when mean return is assumed to be zero. If the assumption of zero returns is changed to an assumption of returns of $10,000, what is the revised VaR?
- A. 0
- B. 1
- C. 2
- D. 3
Answer: B
Explanation:
Explanation
The exact formula for VaR is = -(Z + ), where Z is the z-multiple for the desired confidence level, and is the mean return. Now Z is always a negative number, or at least will certainly be provided the desired confidence level is greater than 50%, and is often assumed to be zero because generally for the short time periods for which market risk VaR is calculated, its value is very close to zero.
Therefore in practice the formula for VaR just becomes -Z, and since Z is always negative, we normally just multiply the Z factor without the negative sign with the standard deviation to get the VaR.
For this question, there are two ways to get the answer. If we use the formula, we know that -Z= 250,000 (as
=0), and therefore -Z - = 250,000 - 10,000 = $240,000.
The other, easier way to think about this is that if the mean changes, then the distribution's shape stays exactly the same, and the entire distribution shifts to the right by $10,000 as the mean moves up by $10,000. Therefore the VaR cutoff, which was previously at -250,000 on the graph also moves up by 10k to -240,000, and therefore $240,000 is the correct answer.
The other choices are intended to confuse by multiplying the z-factor for the 99% confidence level with
10,000 etc.
NEW QUESTION 135
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. 5.8%
- B. .011%
- C. 2%
- D. 0%
Answer: A
Explanation:
Explanation
The probability that only one of the three 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 136
When compared to a medium severity medium frequency risk, the operational risk capital requirement for a high severity very low frequency risk is likely to be:
- A. Higher
- B. Unaffected by differences in frequency or severity
- C. Lower
- D. Zero
Answer: D
Explanation:
Explanation
High frequency and low severity risks, for example the risks of fraud losses for a credit card issuer, may have high expected losses, but low unexpected losses. In other words, we can generally expect these losses to stay within a small expected and known range. The capital requirement will be the worst case losses at a given confidence level less expected losses, and in such cases this can be expected to be low.
On the other hand, medium severity medium frequency risks, such as the risks of unexpected legal claims,
'fat-finger' trading errors, will have low expected losses but a high level of unexpected losses. Thus the capital requirement for such risks will be high.
It is also worthwhile mentioning high severity and low frequency risks - for example a rogue trader circumventing all controls and bringing the bank down, or a terrorist strike or natural disaster creating other losses - will probably have zero expected losses & high unexpected losses but only at very high levels of confidence. In other words, operational risk capital is unlikely to provide for such events and these would lie in the part of the tail that is not covered by most levels of confidence when calculating operational risk capital.
Note that risk capital is required for only unexpected losses as expected losses are to be borne by P&L reserves. Therefore the operational risk capital requirements for a low severity high frequency risk is likely to be low when compared to other risks that are lower frequency but higher severity.
Thus Choice 'c' is the correct answer.
NEW QUESTION 137
If the duration of a bond yielding 10% is 6 years, the volatility of the underlying interest rates 5% per annum, what is the 10-day VaR at 99% confidence of a bond position comprising just this bond with a value of $10m?
Assume there are 250 days in a year.
- A. 0
- B. 1
- C. 2
- D. 3
Answer: A
NEW QUESTION 138
Which of the following is not a credit event under ISDA definitions?
- A. Rating downgrade
- B. Restructuring
- C. Obligation accelerations
- D. Failure to pay
Answer: A
Explanation:
Explanation
According to ISDA, a credit event is an event linked to the deteriorating credit worthiness of an underlying reference entity in a credit derivative. The occurrence of a credit event usually triggers full or partial termination of the transaction and a payment from protection seller to protection buyer. Credit events include
- bankruptcy,
- failure to pay,
- restructuring,
- obligation acceleration,
- obligation default and
- repudiation/moratorium.
A rating downgrade is not a credit event.
NEW QUESTION 139
When compared to a low severity high frequency risk, the operational risk capital requirement for a medium severity medium frequency risk is likely to be:
- A. Higher
- B. Unaffected by differences in frequency or severity
- C. Lower
- D. Zero
Answer: A
Explanation:
Explanation
High frequency and low severity risks, for example the risks of fraud losses for a credit card issuer, may have high expected losses, but low unexpected losses. In other words, we can generally expect these losses to stay within a small expected and known range. The capital requirement will be the worst case losses at a given confidence level less expected losses, and in such cases this can be expected to be low.
On the other hand, medium severity medium frequency risks, such as the risks of unexpected legal claims,
'fat-finger' trading errors, will have low expected losses but a high level of unexpected losses. Thus the capital requirement for such risks will be high.
It is also worthwhile mentioning high severity and low frequency risks - for example a rogue trader circumventing all controls and bringing the bank down, or a terrorist strike or natural disaster creating other losses - will probably have zero expected losses & high unexpected losses but only at very high levels of confidence. In other words, operational risk capital is unlikely to provide for such events and these would lie in the part of the tail that is not covered by most levels of confidence when calculating operational risk capital.
Note that risk capital is required for only unexpected losses as expected losses are to be borne by P&L reserves. Therefore the operational risk capital requirements for a low severity high frequency risk is likely to be low when compared to other risks that are lower frequency but higher severity.
Thus Choice 'c' is the correct answer.
NEW QUESTION 140
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 rather difficult. Statement I is false because recovery rates are difficult to predict and assumptions are not easy to make.
NEW QUESTION 141
Which of the following correctly describes survivorship bias:
- A. Survivorship bias refers to prudent and conservative risk management
- B. Survivorship bias is the positive tail risk that ensures survival over the long run
- C. Survivorship bias is the negative skew in returns data resulting from credits that have survived despite a high probability of default
- D. Survivorship bias is the tendency for failed companies, markets or investments to be excluded from performance data.
Answer: D
Explanation:
Explanation
Survivorship bias is the tendency for failed companies, funds, investments and even entire markets (eg Russian stock market returns after the Communist revolution) to be excluded from performance studies because they no longer exist. Survivorship bias results in past results looking better than they actually were as data points relating to failures are not included.
A risk manager needs to be aware of survivorship bias when basing risk analysis on historical data and should question if failures (eg failed funds, delisted companies etc) have been included in the data he or she is relying upon.
NEW QUESTION 142
Which of the following is not an event of default covered in the ISDA Master Agreement?
I. failure to pay or deliver
II. credit support default
III. merger without assumption
IV. Bankruptcy
- A. II and III
- B. All are considered events of default
- C. IV
- D. I
Answer: D
Explanation:
Explanation
Note that events of default under the ISDA MA are caused by one of the parties that is considered 'at fault'. In contrast, "termination events" are events for which no one is at fault, for example changes in legislation, illegality etc that still justify termination of the transactions under the contract.
The ISDA MA describes the following 8 types of events of default:
1. failure of pay or deliver
2. breach of agreement
credit support default
4. misrepresentation
5. default under specified transaction
6. cross default
7. bankruptcy
8. merger without assumption
All of the options presented in the question are events of default.
NEW QUESTION 143
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. 10.53%
- B. 15.79%
- C. 11.76%
- D. 10.00%
Answer: A
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 is asking 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 144
An investor enters into a 5-year total return swap with Bank A, with the investor paying a fixed rate of 6% annually on a notional value of $100m to the bank and receiving the returns of the S&P500 index with an identical notional value. The swap is reset monthly, ie the payments are exchanged monthly. On Jan 1 of the fourth year, after settling the last month's payments, the bank enters bankruptcy. What is the legal claim that the hedge fund has against the bank in the bankruptcy court?
- A. $0, as all payments on the swap are current
- B. $100m
- C. $6m
- D. The replacement value of the swap
Answer: D
Explanation:
Explanation
According to ISDA standard definitions, the legal claim for OTC derivatives is the current replacement value of the contract. Therefore Choice 'c' is the correct answer. None of the other choices are correct.
NEW QUESTION 145
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