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Get Prepared for Your 8010 Exam With Actual 242 Questions
NEW QUESTION # 18
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. III and IV
- B. I
- C. All statements are true
- D. I and II
Answer: D
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 # 19
Which of the following are valid criticisms of value at risk:
I. There are many risks that a VaR framework cannot model
II. VaR does not considerliquidity risk
III. VaR does not account for historical market movements
IV. VaR does not consider the risk of contagion
- A. I, II and IV
- B. I and III
- C. All of the above
- D. II and IV
Answer: A
Explanation:
Explanation
Risks such as abrupt changes to a firm's businessmodel caused by legislation, or the introduction of capital controls in foreign countries where a firm in invested, geo-political risks etc are not modelable in the traditional sense. These risks cannot be modeled using VaR. Therefore statement I is correct.
VaR indeed does not consider liquidity risk, it is only concerned with the standard deviation of portfolio returns. Statement II is a valid criticism.
Statement III is not correct, as VaR can consider historical price movements.
Statement IV is correct,as VaR does not consider systemic risk or the risk of contagion.
NEW QUESTION # 20
In respect of operational risk capital calculations, the Basel II accord recommends a confidence leveland time horizon of:
- A. 99.9% confidence level over a 10 day time horizon
- B. 99.9% confidence level over a 1 year time horizon
- C. 99% confidence level over a 1 year time horizon
- D. 99% confidence level over a 10 year time horizon
Answer: B
Explanation:
Explanation
Choice 'd' represents the Basel II requirement, all other choices are incorrect.
NEW QUESTION # 21
Which of the following cannot be used as an internal credit rating model to assess an individual borrower:
- A. Probit model
- B. Distance to default model
- C. Altman's Z-score
- D. Logit model
Answer: B
Explanation:
Explanation
Altman's Z-score, the Probit and the Logit models can all be used to assess the credit rating of an individual borrower. There is no such model as the 'distance todefault model', and therefore Choice 'a' is the correct answer.
NEW QUESTION # 22
What would be the correct order of steps to addressing data quality problems in an organization?
- A. Articulate goals, do a 'strategy-fit' analysis and plan for action
- B. Design the future state, perform a gap analysis, analyze the current state and implement the future state
- C. Assess the current state, design the future state, determine gaps and the actions required to be implemented to eliminate the gaps
- D. Call in external consultants
Answer: C
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 # 23
If the full notional value of a debt portfolio is $100m, its expected value in a year is $85m, and the worst value of the portfolio in one year's time at 99% confidence level is $60m, then what is the credit VaR?
- A. $60m
- B. $40m
- C. $15m
- D. $25m
Answer: D
Explanation:
Explanation
Credit VaR is the difference between the expected value of the portfolio and the value of the portfolio at the given confidence level. Therefore the credit VaR is $85m - $ 60m = $25m. Choice 'b' is the correctanswer.
Note that economic capital and credit VaR are identical at a risk horizon of one year. Therefore if the question asks for economic capital, the answer would be the same.
[Again, an alternative way to look at this is to consider the explanation given in III.B.6.2.2: Credit Var = Q(L)
- EL where Q(L) is the total loss at a given confidence interval, and EL is the expected loss. In this case Q(L) -
$100-$60 = $40, and EL = $100-$85=$15. Therefore Credit VaR = $40-$15=$25.]
NEW QUESTION # 24
Identify the correct sequence of events as it unfolded in the credit crisis beginning 2007:
I. Mortgage defaults increased
II. Collapse in prices of unrelated assets as banks tried to create liquidity III. Banks refused to lend or transact with each other IV. Asset prices for CDOs collapsed
- A. III, IV, I and II
- B. IV, I, II and III
- C. I, III, IV and II
- D. I, IV, III and II
Answer: D
Explanation:
Explanation
According to a paper by the BCBS, here is an excellent summary of what happened. Based on this, Choice 'c' is the correct answer.
"At the outset of the crisis, mortgage default shocks played a part in the deterioration of marketprices of collateralised debt obligations (CDOs). Simultaneously, these shocks revealed deficiencies in the models used to manage and price these products. The complexity and resulting lack of transparency led to uncertainty about the value of the underlying investment. Market participants then drastically scaled down their activity in the origination and distribution markets and liquidity disappeared. The standstill in the securitisation markets forced banks to warehouse loans that were intended to be soldin the secondary markets. Given a lack of transparency of the ultimate ownership of troubled investments, funding liquidity concerns were triggered within the banking sector as banks refused to provide sufficient funds to each other. This in turn led to the hoarding of liquidity, exacerbating further the funding pressures within the banking sector. The initial difficulties in subprime mortgages also fed through to a broader range of market instruments since the drying up of market and funding liquidity forced market participants to liquidate those positions which they could trade in order to scale back risk. An increase in risk aversion also led to a general flight to quality, an example of which was the high withdrawals by households from money market funds."
NEW QUESTION # 25
If A and B be two debt securities, which of the following is true?
- A. The probability of simultaneous default of A and B is greatest when their default correlation is negative
- B. The probability of simultaneous default of A and B is greatest when their default correlation is 0
- C. The probability of simultaneous default of Aand B is not dependent upon their default correlations, but on their marginal probabilities of default
- D. The probability of simultaneous default of A and B is greatest when their default correlation is +1
Answer: D
Explanation:
Explanation
If the marginal probability of default of two securities A and B is P(A) and P(B), then the probability of both of them defaulting together is affected by the default correlation between them. Marginal probability of default means the probability of default of each security on a standalone basis, ie, the probability of default of one security without considering the other security.
The relationship that expresses the probability of joint default of the two is given by the following expression:
It is easy to see that in a situation where the Default Correlation of A & B = 0, ie, the defaults are independent, the combined probability of default is P(A)*P(B), exactly what we would intuitively expect. Also in the other extreme case where the default correlation is equal to 1 and P(A) = P(B) = p, ie the securities behave in an identical way, the expression resolves to just p, which is what we would expect.
From the above relationship, it is clear that the probability of joint default of A and B is the greatest when default correlation between the two is equal to 1, ie the securities behave in an identical way. Therefore Choice
'a' is the correct answer.
NEW QUESTION # 26
If X represents a matrix with ratings transition probabilities for one year, the transition probabilities for 3 years are given by the matrix:
- A. P x P x P
- B. P ^ (-3)
- C. 3 [P ^ (-1)]
- D. 3 [P]
Answer: A
Explanation:
Explanation
Assuming timeinvariance and the Markov property, it is easy to calculate the transition matrix for any time period as P^n, where P is the given transition matrix for one period and n the number of time periods that we need to compute the new transition matrix for. ThusChoice 'b' is the correct answer.
NEW QUESTION # 27
Which of the following does not affect the credit risk facing a lender institution?
- A. The state of the economy
- B. The applicability or otherwise of mark tomarket accounting to the institution
- C. Credit ratings of individual borrowers
- D. The degree of geographical or sectoral concentration in the loan book
Answer: B
Explanation:
Explanation
The state of the economy, credit quality of individual borrowers and concentration risk are all factors that affect the credit risk facing a lender. Mark to market accounting does not change the credit risk, or the underlying economic reality facing the institution. Therefore Choice 'b' is the correct answer.
NEW QUESTION # 28
Which of the following decisions need to be made as part of laying down a system for calculating VaR:
I. The confidence level and horizon
II. Whether portfolio valuation is based upon a delta-gamma approximation or a full revaluation III. Whether the VaR is to be disclosed in the quarterly financial statements IV. Whether a 10 day VaR will be calculated based on 10-day return periods, or for 1-day and scaled to 10 days
- A. I, II and IV
- B. I and III
- C. All of the above
- D. II and IV
Answer: A
Explanation:
Explanation
While conceptually VaR is a fairly straightforward concept, a number of decisions need to be made to select between the different choices available for the exact mechanism to be used for the calculations.
The Basel framework requires banks toestimate VaR at the 99% confidence level over a 10 day horizon. Yet this is a decision that needs to be explicitly made and documented. Therefore 'I' is a correct choice.
At various stages of the calculations, portfolio values need to be determined. The valuation can be done using a 'full valuation', where each position is explicitly valued; or the portfolio(s) can be reduced to a handful of risk factors, and risk sensitivities such as delta, gamma, convexity etc be used to value the portfolio. The decisionbetween the two approaches is generally based on computational efficiency, complexity of the portfolio, and the degree of exactness desired. 'II' therefore is one of the decisions that needs to be made.
The decision as to disclosing the VaR in financial filings comes after the VaR has been calculated, and is unrelated to the VaR calculation system a bank needs to set up. 'III' is therefore not a correct answer.
Though the Basel framework requires a 10-day VaR to be calculated, it also allows the calculation of the 1-day VaR and and scaling it to 10 days using the square root of time rule. The bank needs to decide whether it wishes to scale the VaR based on a 1-day VaR number, or compute VaR for a 10 day period to begin with. 'IV' therefore is a decision tobe made for setting up the VaR system.
NEW QUESTION # 29
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. Unaffected by differences in frequency or severity
- B. Zero
- C. Lower
- D. Higher
Answer: B
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 below.
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 suchrisks 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 ofconfidence 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 # 30
The Options Theoretic approach to calculating economic capital considers the value of capital as being equivalent to a call option with a strike price equal to:
- A. The notional value ofthe debt
- B. The value of the firm
- C. The value of the assets
- D. The market value of the debt
Answer: A
Explanation:
Explanation
The Options Theoretic approach to calculating economic capital is a top-down approach that considers the value of capital as being equivalent to a calloption with a strike price equal to the notional value of the debt - ie, the shareholders have a call option on the assets of the firm which they can acquire by paying the debt holders a value equal to their notional claim (ie the face value of the debt).Therefore Choice 'a' is the correct answer and the other choices are incorrect.
NEW QUESTION # 31
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 2 capital
- B. Tier 3 capital
- C. Tier 1 capital
- D. None of the above
Answer: A
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 # 32
When considering a request for a loan from a retail customer, which of the following factors is relevant for a bank to consider:
- A. All of the above
- B. The credit worthiness of the retail customer
- C. The other retail loans inits portfolio
- D. The contribution this new loan would bring to total portfolio risk
Answer: A
Explanation:
Explanation
The credit worthiness of the retail customer is certainly a factor for thebank to consider as it will need to price the loan to cover the expectation of default. At the same time, it will need to look at other loans in its portfolio as to avoid unacceptable concentration risk. A corollary of the same theme is that the bank willneed to take a portfolio view of the loan request and consider its contribution to total portfolio risk. Therefore all the choices are appropriate considerations for the bank and Choice 'd' is the correct answer.
NEW QUESTION # 33
Which of the following is not a limitation of the univariate Gaussian model to capture the codependence structure between risk factros used for VaR calculations?
- A. The univariate Gaussian model fails to fit to the empirical distributions of risk factors, notably their fat tails and skewness.
- B. A single covariance matrix is insufficient to describe the fine codependence structure among risk factors as non-linear dependencies or tail correlations are not captured.
- C. Determining the covariance matrix becomes an extremely difficult task as the number of risk factors increases.
- D. It cannot capture linear relationships between risk factors.
Answer: D
Explanation:
Explanation
In the univariate Gaussian model, each risk factor is modeled separately independent of the others, and the dependence between the risk factors is captured by the covariance matrix (or its equivalent combination of the correlation matrix and the variance matrix). Risk factors could include interest rates of different tenors, different equity market levels etc.
While this is a simple enough model, it has a number of limitations.
First, it fails to fit to the empirical distributions of risk factors, notably their fat tails and skewness. Second, a single covariance matrix is insufficient to describe the fine codependence structure among risk factors as non-linear dependencies or tailcorrelations are not captured. Third, determining the covariance matrix becomes an extremely difficult task as the number of risk factors increases. The number of covariances increases by the square of the number of variables.
But an inability to capture linear relationships between the factors is not one of the limitations of the univariate Gaussian approach - in fact it is able to do that quite nicely with covariances.
A way to address these limitations is to consider joint distributions of the risk factors that capture the dynamic relationships between the risk factors, and that correlation is not a static number across an entire range of outcomes, but the risk factors can behave differently with each other at different intersection points.
NEW QUESTION # 34
The probability of default of a security over a 1 year period is 3%. What is the probability that it would have defaulted within 6 months?
- A. 98.49%
- B. 1.51%
- C. 3.00%
- D. 17.32%
Answer: B
Explanation:
Explanation
The question is asking for the probability of default over a 6 month period when the probability of annual default is known. If we let the 6 month probability of defaut be 'd', then the probability of survival at the end of
1 year would be (1 - d)^2. This we know is equal to 1 - 3% = 0.97. Therefore we can calculate 'd' to be equal to 1.51%. Choice 'c' is the correct answer, the others are incorrect.
Note that an exam question may ask for probability of the security having survived after 6 months, in which case the answer might be 1 - 1.51%. Also note that such questions will always require you to use the probability of survival (1 - probability of default) for doing the calculations. That isbecause the probabilities of survival can be multiplied over periods of time, but not probabilities of default as the first default in any period is the 'game-over' event after which neither survival nor defaults mean anything. Therefore you generally always have to get the probability of survival till a point in time, and use that for any other calculations.
NEW QUESTION # 35
If the marginal probabilities of default for a corporate bond for years 1, 2 and 3 are 2%, 3% and 4% respectively, what is the cumulative probability of default at the end of year 3?
- A. 91.26%
- B. 9.00%
- C. 8.74%
- D. 9.58%
Answer: C
Explanation:
Explanation
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 3 as =1 - (1-2%)*(1-3%)*(1-4%) = 8.74%
NEW QUESTION # 36
If EV be the expected value of a firm's assets in a year, and DP be the 'default point' per the KMV approach to credit risk, and be the standard deviation of future asset returns, then the distance-to-default is given by:
A)
B)
C)
D)
- A. Option A
- B. Option C
- C. Option D
- D. Option B
Answer: C
Explanation:
Explanation
The distance to default is the number of standard deviations that expected asset values are away from the default point. The expression in Choice 'd' represents distance to default. Choice 'd' is the correct answer. The other choices are incorrect.
NEW QUESTION # 37
Which of the following risks and reasons justify the use of scenario analysis in operational riskmodeling:
I. Risks for which no internal loss data is available
II. Risks that are foreseeable but have no precedent, internally or externally III. Risks for which objective assessments can be made by experts IV. Risks that are known to exist, but for which no reliable external or internal losses can be analyzed
V. Reducing the complexity of having to fit statistical models to internal and external loss data VI. Managing the capital estimation process as to produce estimates in line with management's desired capital buffers.
- A. I, II, III and IV
- B. V
- C. I, II and III
- D. All of the above
Answer: A
Explanation:
Explanation
All the reasons and risks presented above are valid reasons for using scenario analysis, except V and VI - ie, the need to reduce the complexity of calculations is not a valid reason for using scenario analysis. Similarly, making operational risk capital estimates match management's desired capital allocation targets is also not a valid reason. Capital calculations are intended to provide adequate capital for managing the risk from operations, regardless of what management may desire them to be.
NEW QUESTION # 38
Which loss event type is the failure to timely deliver collateral classified as under the Basel II framework?
- A. Information security
- B. External fraud
- C. Clients, products and business practices
- D. Execution, Delivery & Process Management
Answer: D
Explanation:
Explanation
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 # 39
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