FRM Part II Exam

Mock Questions with Answers - FRM Part II - Mock Exam #3

Offered by AnalystPrep

Last Updated: Apr 17, 2025

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Q.1 A bank is using bootstrap techniques to estimate the confidence intervals for its GARCH VaR
model. Which of the following is a significant challenge associated with this approach?

A. The potential for biased VaR estimates due to the resampling process.

B. The computational intensity of re-estimating the GARCH model for each bootstrap
sample

C. The difficulty in capturing the impact of extreme market events present in the
historical data.

D.The reliance on the assumption of normally distributed standardized residuals.

One of the primary challenges of using bootstrap techniques with GARCH models is the need to
re-estimate the model parameters for each bootstrap sample. This iterative process can be
computationally intensive, especially for large datasets or complex models, making it a
significant practical limitation of the approach.

A is incorrect. Bootstrapping is designed to reduce bias, not introduce it.

C is incorrect. The bootstrap uses the historical data, so it captures the extreme events that are
present within it. The problem is that it cannot create new extremes that are not present in the
historical data.

D is incorrect. One of the advantages of bootstrapping is that it does not require the
assumption of normally distributed standardized residuals. It is a non-parametric approach.

Things to Remember

Bootstrapping for GARCH VaR involves resampling standardized residuals and re-

estimating the GARCH model.

The accuracy of the bootstrapped confidence intervals depends on the accuracy of the

underlying GARCH model specification.

Section: Market Risk Measurement and Management

Chapter: Validating Bank Holding Companies’ Value-at-Risk Models for Market Risk

Learning Objective: Describe the challenges a financial institution could face when
calculating confidence intervals for VaR.

Q.2 Assume that an investor has bought $2 million in a bond from Issuer A. They are
now worried about Issuer A defaulting and have purchased a Credit Default Swap (CDS)
from Issuer B. The value of the CDS is mainly determined by the default probability of
the reference entity Issuer A. If the correlation between issuer A and B increases, what
will be the impact on the price of the CDS?

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 A. The price of the CDS will decrease because there is a greater chance of joint
default.

B. The price of the CDS will increase because there is a greater chance of joint
default.

C. There will be no impact on the price of the CDS because it is working as a

separate entity.

D.It may increase or decrease depending on the market and economic conditions
of the country.

The price of the CDS will decrease because there is a greater chance of joint default. An
increase in the correlation between the reference entity (Issuer A) and the CDS issuer
(Issuer B) implies a higher likelihood of both entities defaulting simultaneously. This
joint default risk reduces the present value of the CDS for the investor, leading to a
potential loss. The rationale behind this is that if the default probabilities of the
protection seller (Issuer B) and the reference entity (Issuer A) show co-movement (i.e.,
they increase together), the CDS is less likely to serve its intended purpose of
compensating the protection buyer (the investor) in the event of a default by the bond
issuer (Issuer A). This is because the protection seller (Issuer B) may also default and
fail to make the agreed-upon payment. Consequently, the protection seller will struggle
to convince the buyer to pay a higher premium for the CDS. The buyer will only accept a
lower premium to offset the risk of joint default, thereby causing the price of the CDS
to decrease.

Choice B is incorrect. While it's true that an increase in correlation between Entity A
and Entity B implies a greater chance of joint default, this would actually decrease the
price of the CDS, not increase it. This is because the increased correlation risk makes
the CDS less effective as a hedge against default by Entity A, thereby reducing its value
to the investor.

Choice C is incorrect. The statement that there will be no impact on the price of the
CDS because it is working as a separate entity is false. The price of a CDS does depend
on various factors including credit risk and correlation risk among others. In this case,
an increase in correlation between Entity A (the reference entity) and Entity B (the
provider of the CDS) would indeed affect the price of the CDS.

Choice D is incorrect. Although market and economic conditions can influence prices in
financial markets, they are not directly relevant to this specific question about how
changes in correlation between two entities affect the price of a Credit Default Swap
(CDS). In this context, an increase in correlation implies higher joint default risk which
decreases rather than increases or decreases depending on other factors.

Section: Market Risk Measurement and Management

Chapter: Correlation Basics: Definitions, Applications, and Terminology

Learning Objective: Estimate the impact of different correlations between assets in the
trading book on the VaR capital charge.

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Q.3 A $1m portfolio of credits is divided into 10 credit positions. Each credit position in
the portfolio has a default probability of 5% and a recovery rate of zero. Each credit
position is an obligation from the same obligor. What is the credit VaR at 99%
confidence for this portfolio?

A. $50,000

B. $950,000

C. $1 million

D.$0

Since, we have a common obligor in all credit positions, the default correlation is 1. As

such, the portfolio will act as if we have only one credit, not 10!

This in turn allows us to look at the portfolio as a binomially distributed variable with a
total loss probability of 5% or a zero loss probability of 95%. Therefore, with a recovery
rate of zero, the loss given default is $1m.

The expected loss is given as the total value of the portfolio times the probability of
default, i.e. (5% × 1,000,000) = $50,000.

By definition, credit VaR is the quantile of the credit loss less the expected loss.

Credit VaR = 1, 000, 000– 50 , 000 = 950 , 000

Section: Credit Risk Measurement and Management

Chapter: Portfolio Credit Risk

Learning Objective: Assess the impact of correlation on a credit portfolio and its Credit
VaR.

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Q.4 A bank based in Texas, USA, is considering outsourcing its human resource
activities from an HR agency. Its risk management team is considering all potential
risks that could arise from this arrangement, particularly compliance risks. Which of
the following would qualify as a compliance risk?

A. Advertising jobs without regard to existing labor laws.

B. Negative public opinion because of poor performance of outsourced activities.

C. Acceptance of fake academic documents.

D.Delays in service delivery.

Compliance risk is a type of operational risk that arises when an organization fails to
adhere to the laws, regulations, and standards that govern its operations. In the context
of this question, advertising jobs without regard to existing labor laws is a clear
violation of the law. This could potentially lead to legal repercussions, including
lawsuits and penalties, which could significantly impact the bank's reputation and
financial stability. Therefore, this scenario represents a compliance risk. The bank's
risk management team must ensure that the HR agency they are considering for
outsourcing is aware of and complies with all relevant labor laws to mitigate this risk.

Choice B is incorrect. Negative public opinion due to poor performance of outsourced

activities is a reputational risk, not a compliance risk. Compliance risks are associated
with the failure to comply with laws or regulations.

Choice C is incorrect. Acceptance of fake academic documents could be considered as

operational risk, specifically in the area of internal fraud or lack of proper controls and
procedures. It does not directly relate to compliance with laws or regulations.

Choice D is incorrect. Delays in service delivery can be classified as operational risk,

specifically under the category of business process disruptions. This does not fall under
compliance risk which pertains to legal and regulatory obligations.

Section: Operational Risk and Resilience

Chapter: Guidance on Managing Outsourcing Risk

Learning Objective: Explain how risks can arise through outsourcing activities to third-
party service providers and describe elements of an effective program to manage
outsourcing risk.

Q.5 A pension fund wants to allocate $300 million to a pool of active managers so as to
maximize the information ratio of the fund subject to an overall tracking error volatility
(TEV) of 4%. The table below provides more information:

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 TEV Information Ratio
Manager 1 8.0% 0.60
Manager 2 10.0% 0.40
Index 0.0% 0.00
Portfolio 6.0% 0.72

Assuming that the excess returns of the managers are independent of each other, the
optimal allocation for the index fund is equal to:

A. $40.50 million

B. $12.50 million

C. $60 million

D.$29.00 million

Optimal allocation for Manager 1 is calculated as:

I Ri (portfolio's tracking error)

Weight of portfolio(i) = ( )×
I Rp (manager's tracking error)
(6%) 0.60
= ×( ) = 62.5%
(8%) 0.72
Optimal allocation = $300 million × 62.5% = $187.5 million

Optimal allocation for Manager 2 is calculated as:

portfolio's tracking error

I Ri
Weight of portfolio(i) = ( )×( ))
I Rp (manager's tracking error
(6%) 0.40
= ×( ) = 33.3333%
(10%) 0.72
Optimal allocation= $300 million × 33.3333% = 1$100 million
The optimal allocation of Manager 1 and Manager 2 = $187.50 million + $100 million = $287.50 million
Total fund available = $300 million
Optimal allocation for the index fund = $300 million − $287.50 million = $12.50 million

Section: Risk Management and Investment Management

Chapter: Portfolio Performance Evaluation

Learning Objective: Describe and apply performance attribution procedures, including

the asset allocation decision, sector and security selection decision, and the aggregate
contribution.

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Q.6 Mark is an experienced portfolio manager with ABC Funds. His fund has a focus on
the US technology sector. Over the past five years, Mark's fund has consistently
outperformed the S&P 500. To evaluate the fund's performance, Mark has decided to
use alpha, benchmarks, and peer groups as inputs in the performance measurement
tools. Mark has conducted a linear regression analysis, regressing the excess returns of
his fund against the excess returns of the S&P 500. This has produced an alpha output
that is positive and statistically significant. Simultaneously, he conducted a similar
analysis against the excess returns of a group of technology-focused funds, his peer
group. Given this scenario, which of the following conclusions can Mark most reliably
make?

A. The positive alpha indicates superior management skills compared to the S&P
500.

B. The positive alpha against the S&P 500 is surefire proof of Mark's fund being
riskier than the market.

C. Mark can definitively separate the impact of his skill and leverage on the
excess returns of his fund.

D.The regression analysis against the peer group provides a less reliable
comparison due to potential survivorship bias and differences in fund sizes.

Regression analysis against a peer group suffers from potential survivorship bias as
poorly performing funds might have been dissolved, leaving only successful funds in the
comparison group. Additionally, differences in fund sizes could reduce comparability, as
larger funds may be able to leverage economies of scale and have a different risk/return
profile.

A is incorrect. A positive alpha against a single benchmark like the S&P 500 does not
confirm that the excess returns are due to management skills. A broader comparison
would be needed to draw such a conclusion.

B is incorrect. A positive alpha doesn't necessarily mean that the fund is riskier than
the market; it could also indicate superior management skills, or it could simply be due
to chance. Therefore, Mark cannot use the positive alpha as definitive proof of his fund
being riskier than the market.

C is incorrect. While regression analysis can provide some insights into the impact of a
manager's skill and leverage on returns, it cannot definitively separate the two. Other
factors, such as the specific risks the manager took, are also important and may not be
fully accounted for in the regression analysis.

Things to Remember

Linear regression analysis can be used to regress the excess returns of an

investment against the excess returns of a benchmark.

The regression analysis also allows for the comparison of the absolute amount

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 of excess returns compared to the benchmark.

Regressing the excess returns of a manager against the excess returns of the

manager's peer group has features similar to benchmark regression.

The peer group returns can, however, suffer from survivorship bias and

reduced comparability due to a wide range of funds under management

amongst the peers.

Section: Risk Management and Investment Management

Chapter: Alpha (and the Low-Risk Anomaly)

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

Q.7 A portfolio manager manages a portfolio for a large investment firm. The portfolio
tracks the XY Z index. The composition of the index and the portfolio performance is
given below:

Index Portfolio Return Index XYZ Return

Weights Weights
Infrastructures 0.20 10.00% 0.15 12.00%
Financial Services 0.15 15.00% 0.10 15.00%
Utilities 0.20 20.00% 0.25 22.00%
Energy 0.10 8.00% 0.05 5.00%
IT 0.20 18.00% 0.25 10.00%
Fixed income 0.15 15.00% 0.20 12.00%

Which of the following is closest to the excess return generated by the portfolio
manager?

A. 1.00%

B. 0.90%

C. 0.95%

D.0.80%

The return generated by the portfolio and the index is:

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 n
Rp = ∑ wi ri
i=1

Where

w i = component weights.

ri = component return.

Therefore,

R p = 0.2 × 10% + 0.15 × 15% + 0.20 × 20% + 0.10 × 8% + 0.20 × 18% + 0.15 × 15%
= 14.90%

And,

R Index = 0.15 × 12% + 0.10 × 15% + 0.25 × 22% + 0.05 × 5% + 0.25 × 10% + 0.20 × 12%
= 13.95%

∴ Excess Return = 14.90% − 13.95% = 0.95%

Section: Risk Management and Investment Management

Chapter: Portfolio Performance Evaluation

Learning Objective: Describe risk-adjusted performance measures, such as Sharpe’s

measure, Treynor’s measure, Jensen’s measure (Jensen’s alpha), and the information
ratio and identify the circumstances under which the use of each measure is most
relevant.

Q.8 A fund manager has recently started his own hedge fund. The fund’s investors
demand that the fund’s return must resemble that of a diversified hedge fund portfolio
and should adopt a highly active asset allocation strategy betting on a diverse range of
risk factors.

Which of the following is the most suitable hedge fund style for this manager?

A. Managed futures

B. Global macro

C. Merger arbitrage

D.Trend follower

Global macro fund managers are known for their dynamic trading strategies, which

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involve placing bets on a diverse range of risk factors. These risk factors can include
directional movements of exchange rates, interest rates, commodities, and stock
indices. The performance of a global macro manager is characterized by a highly active
portfolio of different hedge fund strategies. As a result, it mimics the return
characteristics of a diversified hedge fund portfolio. This makes the global macro style
the most suitable for the fund manager in question, as it aligns with the investors'
demands for a diversified hedge fund portfolio and a highly active asset allocation
strategy.

Choice A is incorrect. Managed futures funds primarily trade in commodity and

financial futures markets, and they typically follow a trend-following strategy. While
they can provide diversification benefits, they do not necessarily mirror the returns of a
diversified hedge fund portfolio as required by the investors.

Choice C is incorrect. Merger arbitrage involves betting on the completion of corporate

mergers and acquisitions. This style does not involve placing bets on a wide array of
risk factors, which contradicts with the investors' requirement for a highly active asset
allocation strategy.

Choice D is incorrect. Trend followers are typically systematic traders who use technical
analysis to identify market trends and make trading decisions accordingly. This style
may not be suitable for an active asset allocation strategy that places bets on various
risk factors as it mainly focuses on identifying and following market trends.

Things to Remember

Global macro hedge funds are known for their ability to generate returns in both
rising and falling markets.
This is due to their flexibility in taking both long and short positions in various asset
classes.
These funds often use leverage to amplify their returns.
However, this also increases the risk of the fund, making it a more volatile investment
option.
Global macro managers often have a deep understanding of macroeconomic trends
and events.
Due to their complex strategies and use of derivatives, global macro funds are often
less transparent than other types of hedge funds.
This can make it difficult for investors to fully understand the risks associated with
these funds.

Section: Risk Management and Investment Management

Chapter: Fund Management

Learning Objective: Describe various hedge fund strategies including long-short equity,
dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed
income arbitrage, emerging markets, global macro, and managed futures, and identify

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the risks faced by hedge funds.

Q.9 Pauline Nguyen, a financial analyst at Evergreen Investments, is evaluating trends

in the hedge fund industry. She observes a marked shift in the investor profile and a
surge in assets under management (AUM) over the past decade. Specifically, she notes
a shift from predominantly private wealth investors to institutional investors, and a
corresponding increase in AUM from $197 billion at the end of 1999 to $1.39 trillion by
the end of 2007. Given Pauline's observations, which of the following statements
correctly captures the factors contributing to the rising concentration of AUM in the
hedge fund industry?

A. The driving force is the promise of higher returns in hedge funds compared to
traditional equity markets, irrespective of the associated risk and higher fee
structures.

B. The shift in investor profile is due to the declining interest of private wealth
investors and the high risk associated with hedge funds.

C. Institutional investors are attracted by the possibility of consistent alpha

generation in hedge funds, which leads to an increase in AUM.

D.The pursuit of absolute performance and diversification beyond traditional

equity markets by institutional investors, despite concerns about alpha, has been
the catalyst for increasing AUM.

The surge in AUM in the hedge fund industry is largely attributed to the growing
participation of institutional investors like foundations, endowments, pension funds,
and insurance companies. Their quest for absolute performance and sources of return
beyond traditional equities, despite some concerns about the identification of alpha,
has fueled the increasing concentration of AUM. Along with this increased participation
has come greater demands for operational integrity and governance from hedge fund
managers.

A is incorrect because although hedge funds have historically outperformed traditional

equity markets, it's an oversimplification to attribute the growth in AUM solely to the
promise of higher returns. The needs of institutional investors are more nuanced and
include factors such as risk management, fee structures, and diversification benefits.

B is incorrect because the shift towards institutional investors is not mainly due to
declining interest from private wealth investors or perceived high risk in hedge funds.
Instead, it's about the benefits institutional investors perceive, including absolute
performance and diversification benefits.

C is incorrect because, while alpha generation could be a potential advantage of hedge

funds, there is skepticism regarding the consistent identification of alpha in hedge
funds. As such, it's not the primary driver for the increase in AUM.

Things to Remember

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 Hedge fund industry growth was significant from 1999 to 2007, attracting not

just private wealth but also institutional investors.

The appeal for institutional investors was driven by superior performance

compared to traditional equity indices like the S&P 500, albeit in a higher fee

environment.

The standard deviation of returns for these hedge funds was also lower than

the S&P 500, indicating lower volatility and thus potentially better risk-

adjusted returns.

As institutional investment in hedge funds grew, the demand for operational

integrity and governance within these funds increased.

Section: Risk Management and Investment Management

Chapter: Hedge Funds

Learning Objective: Explain the impact of institutional investors on the hedge

fund industry and assess reasons for the growing concentration of assets under
management (AUM) in the industry.

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Q.10 Jimmy Ray, a risk analyst at Alcoa Bank, has just performed a historical simulation
for estimating the VAR for the fixed-income portfolio of the bank based on the returns
for the last 500 trading days. The 10 worst one-day returns generated in the simulation
are:
-9,111, -8,669, -8,127, -7,098, -6,712, -6,698, -5,743, -5,189, -4,811, -4,775

Which of the following is the 99% one day expected shortfall for the portfolio?

A. 8,145

B. 6,712

C. 9,111

D.7,943

From a statistical point of view, the expected shortfall, also known as the conditional
VaR (CVaR), is a sort of mean excess function, i.e., the average value of all the values
exceeding a special threshold, the VaR. CVAR indicates the potential loss if the portfolio
is “hit” beyond VAR:

If there are n ordered observations, and a confidence level cl%, the cl% VaR is given by
the [(1 – cl%) n + 1]th highest observation. In this case, the 99% VaR is given by the (1 –
0.99)500 + 1 = 6th worst observation.

The 99% expected shortfall will be the average of the 5 worst returns (tail losses) which
in this case will be:

(−9 , 111 + −8, 669 + −8 , 127 + −7, 098 + −6 , 712)

= 7, 943.4
5

Section: Market Risk Measurement and Management

Chapter: Estimating Market Risk Measures: An Introduction and Overview

Learning Objective: Estimate the expected shortfall given profit and loss (P&L) or
return data.

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Q.11 A model gives an annual VaR value of $9.5 million for a portfolio at a 99%
confidence interval. A one-year backtest conducted at the 95% confidence level reveals
that losses exceeded $9.5 million on 12 occasions. The model is accepted as accurate.
Assuming 224 days in a year, which of these statements is most likely true?

A. A Type I error has occurred.

B. A Type II error has occurred.

C. Both Type I and Type II errors have occurred.

D.The model has been accepted correctly.

A Type II error, also known as a false negative, occurs when a false null hypothesis is
not rejected. In this context, the null hypothesis is that the model is accurate. Despite
the backtest results showing that the losses exceeded the VaR estimate on more
occasions than would be expected at the 95% confidence level, the model was still
accepted as accurate. This is a clear indication of a Type II error. The calculation of the
z-value further confirms this. The z-value is calculated as (12 - 0.01*224) /
sqrt(0.01*0.99*224), which equals 6.55. This value is significantly greater than the
critical value of 1.96 at the 95% confidence level, indicating that the null hypothesis
should be rejected. However, in this case, the null hypothesis was not rejected, leading
to a Type II error.

Choice A is incorrect. A Type I error, also known as a false positive, occurs when we
reject a true null hypothesis. In this case, the null hypothesis would be that the model
is accurate. However, given that the model has been deemed accurate despite 12
instances of losses exceeding the VaR estimate, we have not rejected this hypothesis.
Therefore, a Type I error has not occurred.

Choice C is incorrect. Both Type I and Type II errors occurring simultaneously would
imply that we have both incorrectly rejected a true null hypothesis (Type I error) and
failed to reject a false null hypothesis (Type II error). Given our scenario where only one
type of error could have occurred - either accepting an inaccurate model or rejecting an
accurate one - it's impossible for both types of errors to occur at once.

Choice D is incorrect. The statement "The model has been accepted correctly" implies
that there were no errors in accepting the accuracy of the model. However, with 12
instances where losses exceeded VaR estimates out of 224 trading days at 95%
confidence level indicates potential issues with the accuracy of this model which
suggests it may not have been accepted correctly.

Section: Market Risk Measurement and Management

Chapter: Backtesting VaR

Learning Objective: Identify and describe Type I and Type II errors in the context of a
backtesting process

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Q.12 An ABS based on credit card receivables has the following composition:

Current receivables $25 , 200 , 000

Receivables over 30 days past due $8, 250, 000
Receivables over 60 days past due $2, 750, 000
Receivables over 90 days past due $1, 300, 000

Calculate the delinquency ratio of the ABS.

A. 2.93%

B. 3.47%

C. 5.16%

D.7.33%

The delinquency ratio is the ratio of the receivables that are over 90 days past due to
the total receivables pool.

Total receivables pool = Current receivables + Receivables over 30 days past due
+ Receivables over 60 days past due + Receivables over 90 days past due

From the given information,

1, 300, 000 1, 300, 000

Delinquency ratio = = = 3.47%
25, 200, 000 + 8, 250, 000 + 2, 750, 000 + 1, 300,
(37,
000500, 000)

Section: Credit Risk Measurement and Management

Chapter: An Introduction to Securitisation

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

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Q.13 A portfolio manager focused on buying stocks that have gone up in recent months
and shorting stocks with the lowest returns during the same period is most likely
pursuing which of these investment strategies?

A. Value investing

B. Growth investing

C. Momentum investing

D.Income investing

Momentum investing is a strategy that aims to capitalize on the continuance of existing

trends in the market. The basic idea is that once a trend is established, it is more likely
to continue in that direction than to move against the trend. Thus, if a stock has been
increasing in value over the last few months, a momentum investor would expect this
trend to continue and would invest accordingly. Similarly, if a stock has been
performing poorly, a momentum investor would expect this trend to continue and would
short sell the stock. This strategy relies heavily on technical analysis and requires a
high level of market monitoring and quick response to market trends.

Choice A is incorrect. Value investing involves buying securities that appear

underpriced by some form of fundamental analysis. This strategy does not involve
focusing on stocks with an upward trend or shorting those with the lowest returns,
which is more characteristic of momentum investing.

Choice B is incorrect. Growth investing involves investing in companies that are

expected to grow at an above-average rate compared to other companies. While this
may sometimes involve buying stocks on an upward trend, it does not typically involve
shorting stocks with low returns.

Choice D is incorrect. Income investing focuses on generating a steady income from

investments through dividends or interest payments rather than capital appreciation.
This strategy would not typically involve concentrating on stocks with recent upward
trends or shorting those with the lowest returns.

Section: Risk Management and Investment Management

Chapter: Factors

Learning Objective: Compare value and momentum investment strategies, including

their return and risk profiles

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Q.14 A hedge fund's Chief Risk Officer (CRO) has tasked the risk management team
with developing a term-structure model to fit interest rates for the fund's options
pricing practices. The team is considering two models: a Ho-Lee model and a Cox-
Ingersoll-Ross (CIR) model. Which of the following statements correctly describes a
characteristic of these models?

A. In the Ho-Lee model, the interest rate process includes a constant drift term.

B. In the Ho-Lee model, the drift term is adjusted to ensure the interest rate
reverts to a long-run mean.

C. In the CIR model, the volatility of the short-term interest rate is presumed to
decline exponentially to a constant long-run level.

D.In the CIR model, the volatility of the short-term interest rate is proportional
to the square root of the rate.

The Cox-Ingersoll-Ross (CIR) model is designed to reflect the realistic behavior of

interest rates by capturing their tendency to revert to a long-run mean and ensuring
that volatility increases with higher interest rates. In this model, the rate of volatility
increases with the square root of the interest rate, meaning that even small changes in
low rates can have significant impacts on volatility, which is important for accurately
pricing options.

A is incorrect. The Ho-Lee model uses a time-dependent drift term rather than a
constant one. This flexibility allows the model to fit the current term structure of
interest rates more accurately by adjusting the drift over time.

B is incorrect. The Ho-Lee model does not include mean-reversion. Instead, it is

focused on matching the observed term structure by adjusting the drift term over time,
without any mechanism for the rates to revert to a long-run mean.

C is incorrect. The volatility of the short-term rate is assumed to be proportional to the

square root of the short-rate in the CIR model.

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Q.15 Which of the following is the main driver behind the Know Your Customer (KYC)
programs outlined in the Basel Committee's papers on customer due diligence for
banks?

A. Protecting the integrity of the banking systems.

B. The Financial Action Task Force's (FATF) recommendations.

C. Protecting the integrity of the capital markets.

D.Customer protection.

The main driver behind the Know Your Customer (KYC) programs, as outlined in the
Basel Committee's papers on customer due diligence for banks, is to protect the
integrity of the banking systems. The primary motivation for these KYC programs is to
prevent financial crimes such as money laundering, terrorist financing, and other
activities that can jeopardize the banking system's integrity. KYC programs assist banks
in identifying and verifying their customers' identities, assessing the risks associated
with their activities, and monitoring their transactions for suspicious activity. This
helps in maintaining the integrity of the banking systems by ensuring that the banks
are not used as a medium for illegal activities.

Choice B is incorrect. While the Financial Action Task Force's (FATF) recommendations
do play a significant role in shaping global financial regulations, they are not the
primary driver for implementing KYC programs as per the Basel Committee's
guidelines. The main aim of these programs is to protect the integrity of banking
systems rather than adhering to FATF recommendations.

Choice C is incorrect. Protecting the integrity of capital markets, although important, is

not the primary reason for implementing KYC programs according to Basel
Committee's guidelines. These programs are primarily designed to safeguard banking
systems from various financial crimes and not specifically targeted towards capital
markets.

Choice D is incorrect. Customer protection, while an essential aspect of any banking

operation, isn't the primary factor driving KYC implementation as per Basel
Committee's guidelines. The main objective here is protecting banking system integrity
rather than individual customer protection.

Section: Operational Risk and Resilience

Chapter: Sound Management of Risks related to Money Laundering and Financing of

Terrorism

Learning Objective: Explain best practices recommended by the Basel committee for
the assessment, management, mitigation, and monitoring of money laundering and
financing of terrorism (ML/FT) risks.

Q.16 Goodwill Bank’s balance sheet contains the following items. The available stable

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funding (ASF) and required stable funding (RSF) factors for each category of funding
capital are also provided:

ASF factor
Retail Deposits 35 90%
Wholesale Deposits 50 50%
Tier 2 Capital 5 100%
Tier 1 Capital 10 100%
RSF Factor
Cash 7 0%
Mortgages 38 65%
Treasury Bonds 6.5 5%
Small Business Loans 54 85%
Fixed Assets 12 100%

Which of the following is closest to the net stable funding ratio?

A. 84.9%

B. 86.2%

C. 83.1%

D.88.0%

Recall that:

Amount of stable funding

N SF R =
Required Amount of stable Funding

Amount of stable funding = 35 × 0.9 + 50 × 0.5 + 5 × 1 + 10 × 1 = 71.5

And:

RSF = 7 × 0 + 38 × 0.65 + 6.5 × 0.05 + 54 × 0.85 + 12 × 1 = 82.925

Therefore:

71.500
NSF R = = 0.862 = 86.2%
82.925

Section: Operational Risk and Resilience

Chapter: Solvency, Liquidity, and Other Regulation After the Global Financial Crisis

Learning Objective: Describe and calculate ratios intended to improve the management

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of liquidity risk, including the required leverage ratio, the liquidity coverage ratio, and
the net stable funding ratio.

Q.17 Anthony James has a portfolio with only a single position of $700 million invested
in shares of Grinold Bank. The manager is considering adding a $300 million position
in Shares of Fujarah Bank or Yamama Bank to the portfolio. The current volatility of
Grinold is 12%. In addition, the shares of Fujarah Bank have a return volatility of 9%
and a correlation with Grinold equal to 0.8, while the shares of Yamama Bank have a
return volatility of 12% and a correlation with Grinold equal to zero.
Which of the two proposed additions will keep Anthony's risk budget at an optimal level
at the 99% confidence level and what will be the portfolio's VAR?

A. Fujarah added; Varp: $195.72 million

B. Yamama added; Varp: $212.94 million

C. Fujarah added; Varp: $248.92 million

D.Yamama added; Varp: $414.54 million

The current VaR Grinold s = 2.33∗0.12∗ 700 = 195.72

Standard deviation of Grinold + Fujara = √((0.7)2 (0.12)2 + (0.3)2 (0.09)2 + (2) (0.7) (0.3) (0.12) (0.09

= √0.0114138 = 0.1068 or 10.68%

V aRGrinold+Fujarah = 2.33∗0.1068∗1000 = $248.92 million

Now

Standard deviationGrinold+Yamama = √((0.7)2 (0.12)2 + (0.3)2 (0.12)2 + (2) (0.7) (0.3) (0.12) (0.12) (0))

= √0.008352 = 0.09139 or 9.14%

V aRGrinold+Yamama = 2.33∗0.09139 ∗1000 = $212.94 million

Yamama should be added because V aR Grinold+Yamama is less than V aRGrinold+Fujarah

Section: Risk Management and Investment Management

Chapter: VaR and Risk Budgeting in Investment Management

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

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Q.18 Richard Burns is a risk analyst at Platinum Investment Trust, a large asset
management company managing portfolios of multiple high-net-worth clients, most of
whom are in the search of long-term superior returns above market returns. Currently,
he is assisting his portfolio manager in evaluating a two-asset portfolio that consists of
stock in the aviation industry, namely Venus Airline and Mars Airline. The risk and
return data on the stocks and the portfolio are shown below:

Asset Position Return Standard Beta

Value (million) Deviation (%)
Venus 450 16 1.5
Mars 250 11 0.9
Portfolio 700 14 1.3

Based on this information, the portfolio's estimated diversified VaR benefit at the 95%
confidence level is closest to:

A. $166.7 million

B. $164.2 million

C. $2.5 million

D.$161.7 million

VaR of a portfolio = α×portfolio standard deviation×portfolio value = 1.65×0.14×700

= $161.7 million
V aRVenus = 1.65×0.16×450 = 118.8 million
V aRMars = 1.65×0.11×250 = 45.4 million

The portfolio diversified VaR benifit = Sum of individual VaR of assets in the portfolio less Portfolio VaR
= (118.8 + 45.4) − 161.7 = 164.2 − 161.7 = 2.5 million

Section: Risk Management and Investment Management

Chapter: Portfolio Risk: Analytical Methods

Learning Objective: Define, calculate, and distinguish between the following portfolio
VaR measures: diversified and undiversified portfolio VaR, individual VaR, incremental
VaR, marginal VaR, and component VaR.

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Q.19 David Parker is a portfolio manager at Krempton Investment, an asset
management company managing the investments of high-net-worth individuals. For the
firm, David purchased 500 shares of Yamacha Petroleum for $60 per share on January
1st 2016 and another 500 shares at $75 on January 1st, 2017. The stock paid a dividend
of $5 per share on December 31st 2016 and another $5 per share on December 31st
2017. Also, on December 31st 2017, David sold all of his shares for $90 each. Given this
information, the time-weighted rate of return on the investment is closest to:

A. 29.94%

B. 33.33%

C. 26.66%

D.68.88%

The time-weighted rate of return (TWRR) calculation is as follows:

January 1st, 2016 to December 31st, 2016:

Initial Investment = 500 shares × $60/share = $30,000

Ending Value = 500 shares × ($75/share + $5/share) = $40,000

Ending Value−Initial Investment $40,000−$30,000
Sub-period Return for 2016 = = = 0.333 or 3.33%
Initial Investment $30,000

January 1st, 2017 to December 31st, 2017:

Additional Investment = 500 shares × $75/share = $37,500

Initial Investment for 2017 = $37,500 (from 2016) + $37,500 (new investment) =
$75,000

Ending Value = 1000 shares × ($90/share + $5/share) = $95,000

Ending Value−Initial Investment $95,000−$75,000
Sub-period Return for 2017 = = = 0.2667 or 26.67%
Initial Investment $75,000

The TWRR:

TWRR = [(1 + return2016) ⋅ (1 + return2017 )]1/n − 1

So, TWRR = [(1 + 0.333) ⋅ (1 + 0.2667)]1/2 − 1 = 0.2994 , or approximately 29. 94%

Section: Risk Management and Investment Management

Chapter: Portfolio Performance Evaluation

Learning Objective: Differentiate between the time-weighted and dollar-weighted

returns of a portfolio and describe their appropriate uses.

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Q.20 A financial institution has a trading portfolio with the following characteristics:

Previous day's VaR (VaRt-1): $1,200,000 (10-day time horizon, 99% confidence

level)

Average VaR over the past 60 days (VaRavg): $1,400,000 (10-day time horizon,

99% confidence level)

Previous day's Stressed VaR (SVaRt-1): $2,200,000 (10-day time horizon, 99%

confidence level)

Average Stressed VaR over the past 60 days (SVaRavg): $2,000,000 (10-day

time horizon, 99% confidence level)

Multiplicative factor for VaR (mr): 3

Stressed VaR multiplicative factor (ms): 3

Calculate the total market risk capital charge based on the Basel 2.5 framework.

A. $10,200,000

B. $9,200,000

C. $5,000,000

D.$4,987,000

To calculate the total market risk capital charge, we must use the given formula:

Total capital charge = max(VaRt-1, mr × VaRavg) + max(SVaRt-1, ms × SVaRavg)

First, we need to calculate the maximum of VaRt-1 and mr × VaRavg:

max(VaRt-1, mr × VaRavg) = max($1 , 200, 000, 3 × $1, 400, 000) = max($1 , 200, 000, $4, 200, 000) =

Next, we need to calculate the maximum of SVaRt-1 and ms × SVaRavg:

max(SVaRt-1, ms × SVaRavg) = max($2 , 200, 000, 3 × $2, 000, 000) = max($2 , 200 , 000, $6, 000, 000

Now, we can calculate the total capital charge:

Total capital charge = $4,200,000 + $6,000,000 = $10,200,000

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Section: Operational Risk and Resilience

Chapter: Solvency, Liquidity, and Other Regulation After the Global Financial Crisis

Learning Objective: Describe and calculate the stressed VaR introduced in Basel 2.5
and calculate the market risk capital charge.

Q.21 Jinshi&Houshi Corporation is a large commercial bank operating in mainland

China. It has adopted the Basel I framework and must maintain at least 8% capital to
risk-weighted assets. The bank makes use of the following add-on factors for
derivatives:

Add-On Factors as a Percent of Principal for Derivatives

Remaining Interest Exchange Equity Precious Other
Maturity Rate Rate and Metals Commodities
(yr) Gold Except Gold
<1 0.0 1.0 6.0 7.0 10.0
1 to 5 0.5 5.0 8.0 7.0 12.0
>5 1.5 7.5 10.0 8.0 15.0

The bank made the following transactions during a one-year period:

(a) A seven-year interest rate swap with a notional principal of $400 million and a
current market value of -$3 million.

(b) A three-year interest rate swap with a notional principal of $170 million and a
current value of $7 million.

(c) A four-month derivative on a commodity with a principal of $80 million that is

currently worth $4 million.

Using this information, what is the capital requirment for the bank under Basel I if the
counterparty is a corporation (the risk weight for corporations is 0.5, assuming no
netting?

A. $1.034 million

B. $2.068 million

C. $0.517 million

D.$1.535 million

Capital required must be 8% of risk-weighted assets.

To calculate the risk-weighted assets for an off-balance sheet item, we must first
establish the item's credit equivalent amount (CEA). The credit equivalent amount is

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then multiplied by the risk weight for the counterparty to calculate risk-weighted
assets.

For interest rates swaps and other over-the-counter (OTC) derivatives, the credit
equivalent amount is calculated as:

CEA = max(V , 0) + a × L

where:

V = current value of the derivative to the bank

a = add-on factor

L = principal amount

Following are CEAs for each transaction:

CEA(a) = 0 + 1.5% × $400m = $6 million

CEA(b) = 7 + 0.5% × $170m = $7.85 million

CEA(c) = 4 + 10% × $80m = $12 million

The bank is transacting with a corporation and as per Basel guidelines (as pointed out
in the question) the risk weight for corporations is 0.5.

Thus,

Risk weighted assets = 0.5[6 + 7.85 + 12] = $12.925 million

Capital required = 0.08 × 12.925 = $1.034 million

Section: Operational Risk and Resilience

Chapter: Capital Regulation Before the Global Financial Crisis (

Learning Objective: Explain the calculation of risk-weighted assets and the capital
requirement per the original Basel I guidelines..

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Q.22 A security issued by the United States federal government which matures in one
year following the date of issue is most likely a:

A. Treasury note

B. Treasury bond

C. Treasury bill

D.Structured note

A Treasury bill, often referred to as a T-bill, is a short-term debt obligation backed by

the U.S. government with a maturity of less than one year. T-bills are sold in
denominations of $1,000 up to a maximum purchase of $5 million and commonly have
maturities of one month (4 weeks), three months (13 weeks), or six months (26 weeks).
However, they can also have a maturity of one year. They are issued through a
competitive bidding process at a discount from par, which means that rather than
paying fixed interest payments like traditional bonds, the appreciation of the bond
provides the return to the holder.

Choice A is incorrect. Treasury notes are medium-term securities issued by the U.S.
federal government with maturities ranging from 2 to 10 years, not one year.

Choice B is incorrect. Treasury bonds are long-term securities issued by the U.S. federal
government with maturities that typically exceed 10 years, far longer than the one-year
maturity period described in the question.

Choice D is incorrect. Structured notes are complex financial instruments that combine
a bond with a derivative component and their maturity periods can vary widely, but they
are not typically issued directly by the U.S. federal government.

Section: Liquidity and Treasury Risk Management

Chapter: The Investment Function in Financial-Services Management

Learning Objective: Compare various money market and capital market instruments
and discuss their advantages and disadvantages.

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Q.23 According to U.S. regulations, specific foreign banking organizations should
conduct liquidity stress tests for intermediate holding companies and branches. Which
of the following choices is the most valid reason for this regulation?

A. To prevent foreign banks operating in the country from been over-reliant on

offshore funding.

B. Intermediate holding companies and branches share a common currency,

hence no currency conversion.

C. Intermediate companies and branches are more likely to face liquidity

challenges during stress periods

D.It is just a way of monitoring the liquidity levels for the intermediate holding
companies.

The primary reason for the U.S. regulations requiring foreign banking organizations to
conduct liquidity stress tests for their intermediate holding companies and branches is
to prevent these entities from becoming overly reliant on offshore funding. Over-
reliance on offshore funding can pose significant risks to the financial stability of these
entities and, by extension, the broader financial system. Offshore funding sources may
be more volatile and less reliable, particularly in times of financial stress. By requiring
liquidity stress tests, regulators can ensure that these entities have sufficient liquidity
buffers to withstand potential disruptions in their offshore funding sources.

Choice B is incorrect. While it's true that intermediate holding companies and branches
may share a common currency, this is not the reason for requiring liquidity stress tests.
The main concern is to ensure that foreign banks operating in the U.S. are not overly
reliant on offshore funding, which could pose a risk to financial stability.

Choice C is incorrect. Although intermediate companies and branches might be more

susceptible to liquidity challenges during stress periods, this does not fully explain why
these entities specifically are required to conduct liquidity stress tests. The key issue
being addressed by this regulation is the potential over-reliance of foreign banks on
offshore funding.

Choice D is incorrect. While monitoring liquidity levels for intermediate holding

companies forms part of the rationale behind these regulations, it does not capture the
full scope of concerns being addressed by requiring foreign banking organizations to
conduct liquidity stress tests for their U.S.-based operations.

Section: Liquidity and Treasury Risk Management

Chapter: Liquidity Stress Testing

Learning Objective: Differentiate between various types of liquidity, including funding,

operational, strategic, contingent, and restricted liquidity.

Q.24 Considering the costs associated with clearing trades, which of the following

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statements accurately reflects the cost dynamics of central clearing when compared to
bilateral clearing?

A. Bilateral clearing involves direct negotiation of costs and may result in

variable margin requirements, leading to potentially inconsistent cost
structures.

B. Central clearing consistently has higher cost structures due to the

standardization of margin requirements, regardless of the market conditions.

C. CCPs eliminate the costs associated with trade clearing by pooling risk, thus
removing the necessity for individual default funds or margins from members.

D.In bilateral clearing, the higher predictability of costs is due to standardized

practices that lead to uniform pricing models across all trades.

In bilateral clearing, costs are subject to negotiations and agreements between the
trading parties, which can lead to variable margin requirements. This lack of
standardization may result in inconsistent pricing structures and cost dynamics
between different trades.

B is incorrect. While central clearing involves standardization, it does not necessarily

mean that costs are higher in all cases. The standardized margin requirements are
based on market conditions, which can lead to reduced variability but not always to a
higher cost structure.

C is incorrect. CCPs do not eliminate the costs of trade clearing. They manage risk by
pooling it across multiple members, and costs are typically absorbed through
standardized margins and default funds that are mutualized among all clearing
members.

D is incorrect. Bilateral clearing does not typically feature predictability in costs due to
less standardized practices. Rather, bilateral clearing can lead to varied pricing models
that accommodate the unique trade requirements and creditworthiness of
counterparties.

Things to Remember

In bilateral clearing, cost considerations are more variable as they depend on

the negotiations between the parties involved in the trade.

Standardized practices in central clearing can lead to more predictable and

consistent cost structures, particularly with margin requirements.

Bilateral and central clearing differ in how they manage and distribute the

costs related to counterparty risk and defaults.

Section: Credit Risk Measurement and Management

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Chapter: Central Clearing

Learning Objective: Compare bilateral and central clearing.

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Q.25 Walter runs a business in the United States. He wants to purchase some materials
for his warehouse from France. Walter decides to purchase the warehouse on a
mortgage that needs him to make the payments in euros. However, since his company is
in the United States, the main currency he will receive when conducting business is
dollars. Thus, he is required to have the U.S dollars converted to Euros so that he can
make payments to his mortgage in France. Unfortunately, the dollar’s value is
weakening against the euro. This means that Walter will have to pay expensively for the
mortgage payments. What should Walter do so that he does not end up paying a
mortgage that keeps getting more expensive?

A. He should adopt a cross-currency swap.

B. He should adopt a carry trade

C. He should avoid entering any swaps

D.He should wait until when the foreign exchange market has stabilized

A cross-currency swap is a financial derivative that allows two parties to exchange

interest payments and principal in different currencies. The main purpose of a cross-
currency swap is to hedge against foreign exchange risk. In Walter's case, he can use a
cross-currency swap to borrow dollars and convert them into Euros at a fixed rate. This
means that Walter will take out a loan and make interest payments in dollars, his home
currency, instead of in Euros. This strategy will protect him from the weakening dollar
against the euro, and he will not have to worry about his mortgage payments becoming
more expensive. Cross-currency swaps are commonly used in international finance and
are a valuable tool for businesses that have income in one currency and liabilities in
another.

Choice B is incorrect. A carry trade involves borrowing in a low-interest-rate currency

and investing in a high-interest-rate currency. This strategy is not suitable for Walter's
situation because it does not address his need to hedge against the risk of the dollar
weakening against the euro.

Choice C is incorrect. Avoiding entering any swaps would mean that Walter continues to
bear the foreign exchange risk, which could lead to further increases in his mortgage
payments if the dollar continues to weaken against the euro.

Choice D is incorrect. Waiting until when the foreign exchange market has stabilized
does not provide any immediate solution for Walter's predicament. Moreover, there is
no guarantee that waiting will result in favorable conditions as currency markets can be
unpredictable.

Section: Liquidity and Treasury Risk Management

Chapter: Covered Interest Parity Lost: Understanding the Cross-Currency Basis

Learning Objective: Differentiate between the mechanics of foreign exchange (FX)

swaps and cross-currency swaps.

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Q.26 A risk manager of a large bank wishes to incorporate the bootstrap historical
simulation approach to estimate the market risk that a bank is exposed to by
calculating the bank's VaR. What is the main reason for using historical returns to
forecast VaR in the bootstrap historical simulation approach?

A. The distribution of returns is expected to change over time.

B. The distribution of returns will remain the same in the past and in the future.

C. The historical returns are always normally distributed.

D.The historical returns have no impact on future returns.

The bootstrap historical simulation approach operates on the assumption that the
distribution of returns will remain consistent over time. This means that the
distribution observed in the past will be the same as that in the future. This assumption
forms the basis for using historical returns to forecast VaR. The approach essentially
uses the past as a mirror to reflect potential future outcomes. By doing so, it provides a
way to estimate the market risk a bank might be exposed to, based on the historical
performance of the market. This approach is particularly useful in situations where the
market is stable and the distribution of returns is expected to remain relatively
unchanged.

Choice A is incorrect. The bootstrap historical simulation approach does not assume
that the distribution of returns will change over time. Instead, it assumes that the
distribution of returns will remain the same in the past and in the future.

Choice C is incorrect. The bootstrap historical simulation approach does not require
that historical returns are always normally distributed. In fact, one of its advantages is
its ability to handle non-normal distributions.

Choice D is incorrect. This statement contradicts with the basic premise of using
historical data for forecasting purposes in risk management, including VaR estimation
through bootstrap historical simulation approach.

Section: Market Risk Measurement and Management

Chapter: Non-parametric Approaches

Learning Objective: Apply the bootstrap historical simulation approach to estimate

coherent risk measures.

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Q.27 Which of the following statements best describes the purpose of Root Cause
Analysis?

A. To identify an immediate cause of a significant operational risk event.

B. To compare the results of multiple investigations and identify patterns

leading to operational risk events.

C. To evaluate the impact of a near miss or incident on operational performance.

D.To support or challenge the initiatives proposed by the second line of defense.

Root Cause Analysis is designed to investigate incidents or near misses that led or
could have led to operational impacts above the materiality threshold. It is more
valuable to compare the results of previous investigations and look for links and
commonalities in the causes and failures leading to significant operational risk events,
in order to identify patterns within an organization that can help create action plans
across it. A key purpose of RCA is thus not only identifying an immediate cause, but
also recognizing underlying trends that can lead to greater understanding and
preventative measures.

A is incorrect. Though this statement is partially true, it does not encompass all
elements of root cause analysis. Identifying immediate causes is just one part;
recognizing underlying trends in order to formulate preventive action plans is another.

C is incorrect. While RCA certainly includes evaluation, its main purpose is not solely
limited to assessment; rather, it involves systematic investigation into why an incident
has happened in order to build greater understanding and develop preventative
measures.

D is incorrect. The statement does not accurately reflect RCA’s true purpose. Root
cause analysis involves assessing incidents and near misses in order to recognize
underlying trends which can then be used for preventative measures, as opposed to
supporting or challenging particular initiatives.

Section: Operational Risk and Resilience

Chapter: Risk Measurement and Assessment

Learning Objective: Explain operational risk-assessment processes and tools, including

risk control self-assessments (RCSAs), likelihood assessment scales, and heatmaps.

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Q.28 During a job interview for the assistant financial risk manager role, the
interviewers asked Jacob Lee to describe the advantages of geometric returns over
arithmetic returns. Which of the following is an advantage of geometric returns over
arithmetic returns?

A. Geometric returns are easier to calculate.

B. Geometric returns account for compounding effects.

C. Geometric returns are less volatile.

D. Geometric returns provide a better measure of central tendency.

Geometric returns account for the compounding effects of investment returns, which is
a significant advantage over arithmetic returns. Compounding is a process where the
returns of an investment are reinvested, and these reinvested returns also earn returns.
This process results in exponential growth over time. Geometric returns accurately
reflect this growth, providing a more precise measure of investment performance. This
is particularly important in financial risk management, where accurate measures of
investment performance are crucial for making informed decisions and managing risk
effectively.

Choice A is incorrect. Geometric returns are not necessarily easier to calculate than
arithmetic returns. Both require a certain level of mathematical understanding and
computational skills, but neither is inherently simpler or more complex.

Choice C is incorrect. The volatility of geometric returns is not inherently less than that
of arithmetic returns. Volatility depends on the underlying asset or investment, not the
method used to calculate returns.

Choice D is incorrect. While it's true that both geometric and arithmetic returns can
provide measures of central tendency, it's not accurate to say that one provides a better
measure than the other in all cases. The choice between using geometric or arithmetic
return often depends on the specific circumstances and requirements of the analysis
being performed.

Section: Market Risk Measurement and Management

Chapter: Estimating Market Risk Measures: An Introduction and Overview

Learning Objective: Estimate risk measures by estimating quantiles.

Q.29 Daniel Kevin, a portfolio manager, is estimating returns on a stock i. He has

decided to use the Fama-French model for segregating asset returns. The prevailing
risk-free rate is 2.5%. Kevin has gathered the following information:

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 Variable Value Variable Value
βi,MKT 1.10 Return of winner stocks 15%
βi,SMB 1.3 Return of loser stocks 7%
βi,HML 0.9 Return of high BV stocks 13%
βi,UMD 1.2 Return of low BV stocks 5.5%
βi,WML 1.2 Return of small-cap stocks 11%
Expected return on the market 7.5% Return of large-cap stocks 4.4%

Calculate the expected return of the underlying stock considering the momentum
effect.

A. 0.1373

B. 0.3043

C. 0.3293

D.0.3568

The Fama-French is extended to cater for the momentum effect as follows:

E (R i) = R f + βi,MKT E (R m − Rf ) + βi,SMB E (SMB) + βi,HMLE (HML) + βi,WML E(WML)

The additional component, that is, βi,WML E (WML), captures the impact of momentum.

ßi,W M L is the factor load of the asset with market momentum, and E(WML) is the
expected return of winner minus loser stocks in market momentum.

E(SMB) stands for the expected returns of small stocks minus big stocks.

E(HML) stands for the expected returns of a portfolio of high book-to-market stocks
minus a portfolio of low book to market stocks.

E(R i ) = 2.5% + 1.1 (7.5% − 2.5%) + 1.3 (11% − 4.4%) + 0.9 (13% − 5.5%) + 1.2 (15% − 7%)
= 2.5% + 5.5% + 8.58% + 6.75% + 9.6%
= 32.93%

Section: Risk Management and Investment Management

Chapter: Factors

Learning Objective: Compare value and momentum investment strategies, including

their return and risk profiles

Q.30 James Wit is a portfolio manager at ABC Investment Ltd. His goal is to create a

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new pool of investments comprising of different assets. Wit begins the investment
process by adding two assets A and B into a new portfolio. Assume that the
idiosyncratic components of the assets are uncorrelated and that the assets have a
volatility of 6% and 10%, respectively. The amount invested in asset A is $2.5 million,
while that invested in B is $1 million. Additionally, the asset betas are 0.97 and 1.075
respectively. Calculate the percentage contribution of the component VaRs of both
assets to the portfolio VaR at the 95% confidence level.

28.7%
A. [ ]
71.3%

86.2%
B. [ ]
13.8%

81.6%
C. [ ]
18.6%

69.3%
D.[ ]
30.7%

The following approaches can be used to calculate the percentage contribution to VaR
of component:

Approach 1: “The simplest”

Percentage contribution of Asset A,

i A7 = w A βA
2.5
wA = = 0.7143
(2.5 + 1)
βA = 0.97

Thus

iA = 0.7143 × 0.97 = 69.3%

Percentage contribution of Asset B,

iB = w B βB
1
wB = = 0.2857 And,
(2.5 + 1)
βB = 1.075

Thus

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 iB = 0.2857 × 1.075 = 30.71
69.3%
⟺( )
30.7%

Approach 2:

We first compute the portfolio VaR:

The variance of the portfolio dollar return is computed as:

0.062 0 2.5 0.062 × 2.5 + 0 × 1 = 0.009

∑x = [ ] [ ] = [ ]
0 0.102 1 0 × 2.5 + 0.102 × 1 = 0.010

The portfolio variance in dollar terms will then be:

σp2 W 2 = x′ (∑ x) = [2.5 1 ] [0.009 0.010 ] = 2.5 × 0.009 + 1 × 0.010 = 0.0325

The dollar volatility is therefore

√0.0325 = $0.1803 million

Thus,

V aRP = 1.65 × $0.1803 = $0.2975

Next, we calculate the marginal VaR as:

V aRβi
V aR i =
W
0.2975 × 0.97
V aR A = = 0.08245
3.5
0.2975 × 1.075
V aR B = = 0.0914
3.5

Component VaR,

CV aRi = V aRi × x i
CV aRA = 0.08245 × 2.5 = 0.2061
CV aRB = 0.0914 × 1 = 0.0914

Thus,

C V aR 0.2061
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 C V aRA 0.2061
= ≈ 69.3%
V aR 0.2975
C V aRB 0.0914
= ≈ 30.7%
V aR 0.2975

Section: Risk Management and Investment Management

Chapter: Portfolio Risk: Analytical Methods

Learning Objective: Define, calculate, and distinguish between the following portfolio
VaR measures: diversified and undiversified portfolio VaR, individual VaR, incremental
VaR, marginal VaR, and component VaR.

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Q.31 In the Bernie Madoff fraud case study, which of the following actions was a
significant red flag that contributed to the ultimate discovery of the Ponzi scheme?

A. High-frequency trading activity.

B. Madoff's refusal to provide detailed portfolio information.

C. An unusually high volume of international investments.

D.Frequent changes in the company's legal counsel.

Madoff's refusal to provide detailed portfolio information was a significant red flag in
the case. This lack of transparency made it difficult for investors and regulators to
scrutinize his operations and assess the true nature of his business. By withholding this
crucial information, Madoff was able to perpetuate his Ponzi scheme for a longer
period. This behavior is a common characteristic of fraudulent schemes, as the
perpetrators often try to avoid scrutiny and maintain control over information to
prevent the discovery of their illicit activities.

Choice A is incorrect. High-frequency trading activity, while it can be a sign of potential

market manipulation or other illicit activities, is not inherently indicative of a Ponzi
scheme. In the case of Madoff's scandal, high-frequency trading was not a significant
red flag that led to the uncovering of his fraudulent scheme.

Choice C is incorrect. An unusually high volume of international investments does not

necessarily signal fraudulent activity. While it may raise questions about risk
management and diversification strategies, it does not directly point towards a Ponzi
scheme like the one orchestrated by Madoff.

Choice D is incorrect. Frequent changes in a company's legal counsel could indicate

various issues within an organization but it doesn't necessarily suggest financial fraud
or specifically a Ponzi scheme. In Madoff's case, this was not one of the key factors that
exposed his fraudulent activities.

Section: Risk Management and Investment Management

Chapter: Finding Bernie Madoff: Predicting Fraud by Investment Managers

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

Q.32 GlobalBank, a large multinational bank, experiences a significant cyber attack

that disrupts its real-time electronic payment system. This disruption leads to
widespread delays in processing transactions across the globe. GlobalBank is
interconnected with various financial institutions through digital platforms used for
transactions and trade settlements. In this scenario, what is a direct systemic risk
resulting from the cyber attack on GlobalBank?

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 A. Reduced consumer confidence in digital banking, leading to an increased
preference for cash transactions.

B. A rapid increase in short-selling of stocks of financial institutions

interconnected with GlobalBank.

C. Other financial institutions facing disruptions in their transaction processing

due to their interconnectivity with GlobalBank.

D.Stricter regulatory measures imposed on electronic payment systems across

the financial sector.

The cyber attack on GlobalBank's electronic payment systems highlights the systemic
risk inherent in the interconnectedness of modern financial institutions. As GlobalBank
plays a crucial role in the financial market, the disruption in its payment systems can
have cascading effects on other institutions that rely on these systems for their
transactions and settlements. This scenario exemplifies how an incident in one
institution can propagate to others, leading to broader disruptions in the financial
system.

A is incorrect because while reduced consumer confidence in digital banking is a

plausible consequence of the cyber attack, it does not directly lead to systemic financial
risk. It is more of a behavioral response from the public rather than an operational
disruption in the financial system.

B is incorrect because the rapid increase in short-selling of stocks is more of a market

reaction to the cyber attack and not a direct systemic risk. This action reflects investor
sentiment and market dynamics, rather than an operational risk within the financial
system itself.

D is incorrect because while stricter regulatory measures may be a long-term response

to such an incident, they do not constitute a direct systemic risk resulting from the
cyber attack. Regulatory changes are preventative and reformative measures, not
immediate systemic consequences of the cyber incident.

Things to Remember

Systemic risk refers to the risk of a breakdown or failure of an entire system or

market, rather than individual parts or components.

Cyber risk is the potential for loss or harm related to technical infrastructure,

information systems, or data breaches.

Section: Current Issues in Financial Markets

Chapter: Digital Resilience and Financial Stability. The Quest for Policy Tools in The
Financial Sector

Learning Objective: Assess the interactions between cyber and ICT risks and financial
risks and explain how cyber and ICT risk events at financial institutions can lead to

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systemic financial risk.

Q.33 Despite having undergone extensive resolution planning in the years leading up to
the crisis, the resolution of Credit Suisse presented certain challenges. Which of the
following was identified as a weakness in the resolution framework exposed by this
case?

A. Difficulty in restoring market trust post-intervention.

B. Lack of pre-planning for potential bank failures.

C. Insufficient public liquidity backstop mechanisms.

D.Absence of cross-border cooperation protocols.

Correct Answer: A.

The resolution framework assumed that planned mechanisms like bail-ins and
recapitalization would be sufficient to manage crises. However, the Credit Suisse case
revealed that such tools might fail to quickly restore market confidence in a high-
pressure situation, prompting the need for an extraordinary solution like the UBS
acquisition.

B is incorrect. Credit Suisse had engaged in extensive resolution planning and was in
compliance with Swiss and international regulatory frameworks. The issue was not the
lack of planning but the effectiveness of the response in addressing a crisis of
confidence.

C is incorrect. The Swiss National Bank provided substantial liquidity to Credit Suisse
during the crisis. The challenge was not about liquidity support but about maintaining
trust and preventing client withdrawals and counterparty concerns.

D is incorrect. Cross-border cooperation protocols are well-established for globally

significant banks like Credit Suisse, and no major issues regarding international
coordination were reported during this event.

Section: Current Issues in Financial Markets

Chapter: 2023 Bank Failures, Preliminary lessons learnt for resolution

Learning Objective: Identify and describe the strengths and weaknesses of the
resolution framework as demonstrated by Credit Suisse case and the US bank failures
of 2023.

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Q.34 As a risk manager at a financial institution, you are reviewing a recent security
incident. The details of the incident are as follows: The bank had recently outsourced
its customer data analysis to a specialized analytics company. This arrangement was
intended to leverage the company's advanced data processing capabilities to gain better
customer insights. However, it was discovered that due to inadequate security protocols
at the analytics company, there was unauthorized access to the bank's customer data.
This breach led to the exposure of sensitive personal and financial information. Based
on this incident, what type of risk does this situation most closely represent?

A. Operational risk

B. Third-party risk

C. Compliance risk

D.Cyber risk

The incident involves a service outsourced to an external company, and the security
breach occurred outside the bank's direct control due to the external company's
inadequate security measures.

A is incorrect because the issue did not originate from the bank's internal processes or
systems but rather from an external service provider.

C is incorrect because, although there may be compliance implications, the primary

concern in this scenario is the risk associated with outsourcing services to an external
provider.

D is incorrect as the focus of the incident is not on a direct cyber attack on the bank's
systems but on a breach that occurred due to vulnerabilities at an external service
provider.

Section: Current Issues in Financial Markets

Chapter: Digital Resilience and Financial Stability. The Quest for Policy Tools in The
Financial Sector

Learning Objective: Describe characteristics of cyber risks and

information/communication technology (ICT) risks faced by financial institutions.

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Q.35 Mr. Rihan, a risk specialist at Bank ABC, is presenting to the board of directors on
the Basel regulatory expectations for the governance of an operational risk
management Framework. What is the purpose of supervisory risk management in the
ORM framework of banks in this context?

A. To create a paper trail of compliance activities.

B. To set model documentation standards, data quality expectations, and

versioning criteria.

C. To develop robust governance policies and processes and manage material

risks per the firm's risk appetite.

D.To oversee all the activities of banks.

Supervisory risk management in the ORM framework of banks is a comprehensive

process that involves several key steps. These include assessing the risk profile in a
forward-looking manner, developing robust governance policies and processes,
identifying and managing all material risks in line with the firm's risk appetite, and
ensuring an effective control environment. The goal of these activities is to establish a
robust risk management framework that can effectively manage the bank's operational
risks. This is not merely about creating a paper trail of compliance activities, but rather
about creating a sound and effective risk management system that can protect the bank
from potential losses and ensure its long-term sustainability.

Choice A is incorrect. While creating a paper trail of compliance activities is part of the
supervisory risk management's role, it does not fully define their role within the ORM
framework. The supervisory risk management's role extends beyond just documenting
compliance activities; it also includes developing robust governance policies and
managing material risks in line with the firm's risk appetite.

Choice B is incorrect. Setting model documentation standards, data quality

expectations, and versioning criteria is the role of model risk management.

Choice D is incorrect. Overseeing all activities of banks goes beyond the scope of
supervisory risk management within an ORM framework. While they do have oversight
responsibilities, these are specifically related to operational risks and associated
governance policies rather than all bank activities.

Section: Operational Risk and Resilience

Chapter: Cyber-resilience: Range of practices

Learning Objective: Describe current practices by banks and supervisors in the

governance of a cyber-risk management framework, including roles and
responsibilities.

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Q.36 Which of the following is most likely a role and responsibility of the second line of
defense for the overall risk management of a firm under risk governance?

A. Making decisions for managing risks.

B. Establishing risk management methods, and measurement methods.

C. Overseeing the risk management activities of the third line of defense.

D.Reports independently to the board of directors.

The second line of defense in a firm's risk governance structure is primarily responsible
for establishing risk management methods, tools, models, and measurement methods.
This line of defense plays a crucial role in training the first line of defense, raising risk
awareness, developing risk management policies, and ensuring effective risk
management. The second line of defense acts as a bridge between the first line of
defense, which is directly involved in managing risks, and the third line of defense,
which oversees the risk management activities. Therefore, the second line of defense is
instrumental in establishing the methods and measurements that are used to manage
risks within the firm.

Choice A is incorrect. The second line of defense does not make decisions for managing
risks. This responsibility typically lies with the first line of defense, which includes
business units and operational management who directly manage risks.

Choice C is incorrect. The third line of defense, not the second, is responsible for
overseeing the first and the second lines of defense.

Choice D is incorrect. While it's true that some elements within a firm's second line of
defense may report to the board (such as compliance or risk management), this isn't
their primary role or responsibility within a firm's risk governance structure. Their
main function involves establishing and monitoring risk management methods and
measurement methods.

Section: Operational Risk and Resilience

Chapter: Risk Governance

Learning Objective: Describe the “three lines of defense” model for operational risk
governance and compare roles and responsibilities for each line of defense.

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Q.37 A risk management team at a multinational bank is conducting an exceedance-
based backtest on its VaR model to ensure its effectiveness. The team aims to reflect
the model's key properties through a PIT-based backtest. Which attributes of PITs are
essential for validating that exceedance-based properties are maintained?

A. Skewness and Heavy Tails

B. Uniform Distribution and Independence

C. Periodicity and Cyclicality

D.Concentration and Clustering

Uniform Distribution and Independence in PITs are essential for reflecting an accurate
VaR model. These properties ensure that each PIT value represents an equally probable
outcome, and independence confirms no serial dependency over time, matching the
exceedance-based backtest accuracy criteria.

A is incorrect. Skewness and heavy tails suggest bias or incomplete capturing of risk
scenarios.

C is incorrect. Periodicity and cyclicality indicate potential model inadequacies, not

desirable for VaR validation.

D is incorrect. Concentration and clustering in PITs imply systemic issues with model
predictions.

Things to Remember:

Uniformity in PITs ensures that the model's exceedance rate matches expected

values across all quantiles.

Independence of PITs validates the model's stability across time, essential for

credible risk assessment.

Clear distribution patterns are indicative of accurate and reliable risk

prediction methodologies.

Section: Market Risk Measurement and Management

Chapter: Beyond Exceedance-Based Backtesting of Value-at-Risk Models

Learning Objective: Identify the properties of an exceedance-based backtest that

indicate a VaR model is accurate, and describe how these properties are reflected in a
PIT-based backtest.

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Q.38 According to a risk manager, a corporation's hazard rate is 0.09 per year. Given
that the company survived the first year, what is the probability that it will default
before the end of the second year, assuming a constant hazard rate model?

A. 9.14%

B. 8.61%

C. 8.27%

D.7.87%

Given the hazard rate λ = 0.09 per year, the unconditional probabilities of default can be
calculated as:

Unconditional one year PD = 1 − e−λ×1 = 1 − e−0.09

Unconditional two year PD = 1 − e−λ ×2 = 1 − e−0.18

The probability that the company will survive the first year and then default before the
end of the second year is given by:

Unconditional two year PD − Unconditional one year PD

Conditional PD =
One year survival PD
−0.18
(1 − e ) − (1 − e−0.09 ) e−0.09 − e−0.18
= =
1 − (1 − e−0.09 ) e−0.09
= 1 − e−0.09 = 1 − 0.9139312 ≈ 0.0860688

So, the probability that the company will survive the first year and then default before
the end of the second year, assuming a constant hazard rate model, is approximately
0.0860688 or 8.60688%.

Section: Credit Risk Measurement and Management

Chapter: Credit Scoring and Retail Credit Risk Management

Learning Objective: Discuss the key variables in a mortgage credit assessment and
describe the use of cutoff scores, default rates, and loss rates in a credit scoring model.

Q.39 In a deep dive session on the implications of Central Counterparties (CCPs) in the
OTC derivatives market, a nuanced debate arises about the unintended consequences of
CCPs' roles. One particularly complex issue is the concept of moral hazard associated
with the use of CCPs. Which of the following statements best captures the moral hazard
problem that can arise in the context of CCPs?

A. CCPs, by providing a guarantee on transactions, may inadvertently encourage

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 market participants to engage in riskier trading practices, underestimating the
systemic risk due to perceived security.

B. CCPs, through their stringent margin requirements, deter participants from

entering into derivative transactions, thereby excessively limiting market
liquidity and trade volumes.

C. CCPs, by offering advisory services on risk management and investment

strategies, may lead to an over-reliance on CCP judgments, diminishing the
participants' responsibility in risk assessment.

D.CCPs, by simplifying the legal framework for derivatives, may inadvertently

increase legal risk due to participants' overconfidence in CCPs' ability to manage
complex cross-border transactions.

Moral hazard in the context of CCPs primarily arises when these institutions, by
providing guarantees on transactions, inadvertently encourage market participants to
engage in riskier trading practices. This occurs because the perceived security offered
by CCPs might lead participants to underestimate the systemic risk, believing that the
CCP will absorb any potential losses. This false sense of security can result in higher
risk-taking, potentially destabilizing the market if many participants engage in such
behavior simultaneously. While CCPs are meant to mitigate counterparty risk and
enhance market stability, the moral hazard problem highlights the need for cautious
risk management and awareness of the potential for riskier behavior induced by the
presence of a CCP.

B is incorrect because while stringent margin requirements are a feature of CCPs, they
are not associated with moral hazard. These requirements are meant to mitigate risk,
not to deter market participation or to inadvertently encourage riskier behavior.

C is incorrect because CCPs do not typically offer advisory services on risk management
and investment strategies. Their primary role is managing counterparty risk through
clearing and settlement services, not advising market participants.

D is incorrect because while legal risk is a consideration in derivatives markets,

simplifying the legal framework is not typically seen as a source of moral hazard
associated with CCPs. The moral hazard issue is more directly related to the guarantees
on transactions and the potential for encouraging riskier trading behavior.

Things to Remember

Moral hazard in the context of CCPs refers to the potential for these

institutions to encourage riskier behavior among market participants due to

the perceived security provided by the CCP's guarantees.

CCPs play a vital role in mitigating counterparty risk, but it's important for

market participants and regulators to remain vigilant about the potential for

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 moral hazard and its implications for market stability.

Section: Credit Risk Measurement and Management

Chapter: Central Clearing

Learning Objective: Compare initial margin and default fund requirements for clearing
members in relation to loss coverage, cost of clearing, and moral hazard.

Q.40 Synthetic data is used to enhance AI models, especially in sensitive sectors like
finance. What is a key advantage of using synthetic data?

A. Perfect replication of real data statistics.

B. Elimination of bias replication risk.

C. Mitigation of privacy concerns.

D.Lower generation cost than real data collection.

Synthetic data is artificially generated and does not contain personal or sensitive
information tied to real individuals or entities. This makes it an effective tool for
mitigating privacy concerns, especially in sensitive sectors like finance, where handling
customer data often involves strict compliance with data protection regulations (e.g.,
GDPR, CCPA).

A is incorrect: Synthetic data mimics, not perfectly replicates, statistics.

B is incorrect: Biases in real data can be replicated in synthetic data.

D is incorrect: High-quality synthetic data generation can be complex and costly.

Section: Current Issues in Financial Markets

Chapter: Generative Artificial Intelligence in Finance: Risk Considerations

Learning Objective: Examine the use of synthetic data to enhance AI models and the
potential risks associated with synthetic data generation and application.

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Q.41 A key trade-off for central banks considering AI adoption involves choosing
between "off-the-shelf" (external) and in-house (internal) models. What is a primary
disadvantage of using external AI models?

A. Higher development costs and longer implementation times.

B. Reduced transparency and potential vendor lock-in.

C. Limited access to large datasets for model training.

D.Difficulty in attracting and retaining specialized AI talent.

Correct Answer: B

External "off-the-shelf" AI models are often proprietary, meaning central banks may
have limited visibility into how these models function (lack of transparency) and may be
reliant on the vendor for updates, maintenance, or modifications (vendor lock-in). This
can hinder the institution's ability to fully understand and trust the model's outputs,
which is particularly concerning in critical areas like monetary policy and financial
regulation.

A is incorrect: These are disadvantages of internal model development.

C is incorrect: External models often benefit from the large datasets held by the
providers.

D is incorrect: This challenge pertains to in-house models, as off-the-shelf solutions do

not require the institution to have extensive AI expertise.

Section: Current Issues in Financial Markets

Chapter: Artificial intelligence and the economy: implications for central banks

Learning Objective: Explain the macroeconomic impact of AI, including implications for
firms’ productive capacity and investment, labor productivity, household consumption,
economic output, inflation, and fiscal sustainability.

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Q.42 The methods used by banks in emerging markets and advanced economies impact
their vulnerabilities to interest rate changes. What vulnerability are EME banks
particularly exposed to due to their approach to interest rate risk management?

A. Counterparty risks from extensive derivatives portfolios.

B. Maturity mismatches due to long-duration fixed assets.

C. Valuation losses from securities as interest rates fluctuate.

D.High operational costs due to frequent restructuring of loans.

Correct Answer: B.

EME banks are particularly vulnerable to valuation losses from securities as interest
rates fluctuate because their management strategies often lack extensive derivative use
for hedging. While they frequently adjust short-term loans and deposits, this approach
may not fully mitigate risks associated with longer-duration securities, which are
sensitive to interest rate changes. Without effective hedging strategies, such securities
can suffer significant valuation changes, affecting the bank’s balance sheet and overall
financial stability. EME banks face greater exposure to rate-induced valuation volatility
compared to banks in advanced economies, which more frequently employ sophisticated
hedging strategies to manage these risks.

Choice A is incorrect. Counterparty risks are more associated with extensive derivatives
usage, common in advanced economies.

Choice B is incorrect. EME banks strive to minimize maturity mismatches through

flexible asset structures.

Choice D is incorrect. Operational costs from restructuring are more about transaction
efficiency, not directly tied to interest rate risk alone.

Things to Remember

EME banks' strategies might not fully mitigate valuation risks from rate

changes.

Securities holdings with longer durations increase sensitivity to rate shifts.

Hedging limitations could expose them to significant unrealized losses.

Section: Current Issues in Financial Markets

Chapter: Interest Rate Risk Management by EME Banks

Learning Objective: Compare the methods banks in emerging market economies (EME)
and banks in advanced economies have historically used to manage their interest rate
risk and how these methods affected their vulnerability to changes in interest rates.

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Q.43 The past year has seen significant disinflation globally, driven by various factors.
Which factor contributed most significantly to disinflation in advanced economies
during this period?

A. Increased government spending on infrastructure projects.

B. Increased supply, particularly in critical sectors like manufacturing and

energy.

C. Reduction in labor force participation due to demographic shifts.

D.Rampant consumer spending leading to demand-pull inflation.

Correct Answer: B.

Increased supply, especially in critical sectors such as manufacturing and energy,

contributed significantly to disinflation in advanced economies. The expansion of
supply capabilities helped alleviate inflationary pressures, allowing prices to stabilize
and decrease across various regions.

Choice A is incorrect. While government spending can influence economic activities, it

generally does not directly lead to disinflation.

Choice C is incorrect. A reduction in labor force participation typically increases

inflationary pressures, not reduces them.

Choice D is incorrect. Consumer spending tends to drive up demand and prices,

counteracting disinflation.

Things to Remember

Disinflation largely results from increased supply and improved market

efficiencies.

Sector-specific supply growth helps alleviate broad inflationary trends.

Expanded supply enables markets to balance demand effectively, contributing

to disinflation

Section: Current Issues in Financial Markets

Chapter: Laying a robust macro-financial foundation for the future

Learning Objective: Identify and describe key factors that played a role in the process of
disinflation around the world over the past year.

Q.44 An institutional investor is constructing a portfolio with a specific mandate to

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generate consistent income while managing downside risk. Considering the
characteristics of private credit and private equity, which allocation strategy best aligns
with this mandate?

A. A higher allocation to private equity due to its potential for higher capital
appreciation.

B. A balanced allocation between private credit and private equity to maximize

diversification.

C. A higher allocation to private credit due to its focus on income generation and
lower volatility.

D.A strategic allocation to private equity focused on established, cash-flow

generating businesses within defensive sectors.

Correct Answer: C.

Private credit aligns well with a mandate to generate consistent income while managing
downside risk because:

Income generation: Private credit investments, such as loans and debt

instruments, typically provide regular interest payments, delivering steady

cash flows to investors.

Lower volatility: Compared to private equity, private credit tends to have lower

volatility because it focuses on debt, which is higher in the capital structure

and less sensitive to equity market fluctuations.

Downside Protection: Debt investments often include covenants and collateral

that reduce the risk of loss compared to equity investments.

A is incorrect: Private equity prioritizes capital appreciation over income and carries
higher volatility.

B is incorrect: While diversification is generally beneficial, a mandate focused on

income and risk management suggests a greater emphasis on private credit.

D is incorrect. While this strategy may provide some income, private equity still carries
higher risk and less consistent cash flows compared to private credit.

Section: Current Issues in Financial Markets

Chapter: The Rise and Risks of Private Credit

Learning Objective: Describe characteristics of private credit, including its typical

investors and borrowers, and compare private credit to other types of loans and fixed-

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income instruments.

Q.45 In a commercial bank, the credit committee is revisiting its approach towards
high-risk credit portfolios. The committee is focusing on aligning its strategies with
best practices in credit risk management. Which of the following tasks is most likely to
be undertaken by the credit committee as part of its defined roles according to the
organization's credit guidelines?

A. Directly engaging in the recovery process of defaulted loans.

B. Implementing new software systems for credit risk analysis.

C. Revising and updating the bank's credit risk management policies.

D.Conducting hands-on training sessions for new credit analysts.

Revising and updating the bank's credit risk management policies is a critical function
of the credit committee in a commercial bank, especially when focusing on high-risk
credit portfolios. The committee plays a vital role in formulating, reviewing, and
updating policies that govern credit risk management. This includes setting credit
limits, defining risk appetites, and developing guidelines for managing different types
of credit exposures. By doing so, they ensure that the bank’s credit risk practices are
up-to-date, effective, and aligned with industry standards and regulatory requirements.

A is incorrect because the direct recovery process of defaulted loans is typically handled
by specialized recovery teams or departments, not the credit committee.

B is incorrect as implementing new software systems for credit risk analysis is usually
the responsibility of the bank's IT department, in collaboration with risk management
teams, rather than the credit committee itself.

D is incorrect because conducting hands-on training sessions for new credit analysts is
generally not a function of the credit committee. Training is usually overseen by the
human resources department or specialized training teams.

Things to Remember

Policy revision by the credit committee is crucial for adapting to changing

market conditions, regulatory landscapes, and emerging risks in the credit

environment.

The committee's role in policy development includes considering the impact of

new policies on the bank’s overall risk profile and operational efficiency.

Regular updates to credit policies ensure that the bank maintains a robust risk

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 management framework that can effectively identify, assess, and mitigate

credit risks.

Section: Credit Risk Measurement and Management

Chapter: Governance

Learning Objective: Describe the roles of the credit committee in an organization.

Q.46 In light of recent economic uncertainties, a regional bank is reassessing its

approach to managing credit risk associated with high-risk borrowers and problematic
loans. The bank has identified a need for more effective handling of accounts that have
exceeded credit limits, become delinquent, or entered default. Which policy revision
would best enhance the bank's ability to manage these high-risk situations?

A. Outsourcing the management of all high-risk accounts to external consultants

for immediate action.

B. Introducing a dynamic credit limit system that automatically adjusts based on

the borrower's repayment behavior.

C. Establishing a specialized internal team dedicated to the workout of

delinquent or defaulted accounts with structured and independent oversight.

D.Implementing a policy of immediate legal action against all borrowers whose

accounts become delinquent.

Establishing a specialized internal team dedicated to the workout of delinquent or

defaulted accounts, with structured and independent oversight, would significantly
enhance the bank's ability to manage high-risk situations. This policy would ensure a
focused and expert approach to dealing with problematic loans, providing the necessary
resources and expertise to evaluate and address each case effectively. Structured and
independent oversight ensures that the workout process is consistent, fair, and aligned
with the bank’s broader credit risk management objectives.

A is incorrect because outsourcing the management of high-risk accounts to external

consultants might not provide the same level of understanding and commitment to the
bank’s specific policies and client relationships as an internal team would.

B is incorrect because while a dynamic credit limit system can be part of the solution, it
does not address the need for direct management and workout of accounts that have
already become problematic.

D is incorrect because taking immediate legal action against all delinquent borrowers
can be unnecessarily aggressive and might not always be in the best interest of the
bank, especially in terms of maintaining customer relationships and reputation.

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Things to Remember

Effective management of high-risk accounts requires a dedicated approach

with specialized resources and expertise.

Structured and independent oversight in the workout process ensures

consistency, fairness, and alignment with the bank's risk management goals.

Maintaining a balance between firm action and preserving customer

relationships is crucial in handling delinquent or defaulted accounts.

Section: Credit Risk Measurement and Management

Chapter: Credit Risk Management

Learning Objective: Describe the scope and allocation processes of a bank’s credit
facility and explain bank-specific policies and actions to reduce credit risk.

Q.47 A community bank has recently restructured several loans due to borrowers'
financial difficulties. The bank's management is now considering the appropriate
accounting treatment for these restructured loans. According to sound financial
accounting practices, how should the bank reflect these restructured loans in its
financial statements?

A. Keep the recorded investment of restructured loans unchanged to maintain

consistency in the loan portfolio.

B. Increase the recorded investment of restructured loans to cover potential

future losses.

C. Measure the restructured loan by reducing its recorded investment to net

realizable value, charging the reduction to the income statement.

D.Record the reduction in loan value as a deferred charge, to be recognized in

future financial periods.

Measuring the restructured loan by reducing its recorded investment to the net
realizable value and charging the reduction to the income statement is the appropriate
accounting treatment. This approach ensures that the financial statements accurately
reflect the current economic value of the restructured loans. The reduction in the
loan's recorded investment should be recognized as an expense in the income
statement for the period in which the loan is restructured, accurately representing the
financial impact of the restructuring and maintaining the integrity of the bank’s
financial reporting.

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A is incorrect because keeping the recorded investment of restructured loans
unchanged does not reflect the modifications made to the loan terms. This can lead to
inaccuracies in the bank's financial statements and does not provide a true picture of
the loan's current value.

B is incorrect because increasing the recorded investment of restructured loans does

not align with the financial reality of the restructuring. Typically, restructured loans
involve concessions that reduce their value, not increase it.

D is incorrect because recording the reduction in loan value as a deferred charge does
not accurately reflect the immediate financial impact of the restructuring. The
reduction should be recognized as an expense in the period the restructuring occurs.

Things to Remember

Accurate accounting treatment of restructured loans is crucial for providing a

realistic view of the bank's financial health.

Restructured loans should be measured at their net realizable value to reflect

the actual economic value post-restructuring.

The reduction in a loan’s recorded investment due to restructuring should be

recognized in the income statement in the period of restructuring.

Section: Credit Risk Measurement and Management

Chapter: Credit Risk Management

Learning Objective: Describe a workout procedure for loss assets and compare the
following two

Q.48 In comparing credit scoring and credit rating systems, an analyst must consider
not just their output but also the purpose and usage of these tools. When assessing the
credit quality of potential borrowers, which of the following statements best
distinguishes the typical application and audience for credit scoring and credit rating
systems?

A. Credit scoring systems are designed for public use and facilitate investors'
assessments of credit risk using ordinal grades, while credit rating systems
provide numerical scores for internal decision-making by financial institutions.

B. Credit scoring systems are crafted for internal decision-making by financial

institutions using historical data and numerical scores, whereas credit rating
agencies use publicly disseminated qualitative scales for investor guidance.

C. Credit scoring and credit rating systems both employ numerical values and

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 ordinal grades interchangeably, serving both public and internal institutional
purposes.

D.Both credit scoring and credit rating systems are exclusively used for public
dissemination, offering guidance through a combination of automated models
and expert judgmental assessments.

Credit scoring systems are primarily used internally by financial institutions and
corporate clients. They utilize a numeric score derived from automated models using
historical data and facilitate internal decision-making, loan pricing, and credit portfolio
management. Credit rating systems, on the other hand, are developed by credit rating
agencies for public dissemination. They employ qualitative ordinal risk grades that
combine model analysis with judgmental assessments to guide investors and other
stakeholders in assessing credit risk.

A is incorrect because credit scoring systems are not typically designed for public use,
nor do they employ ordinal grades. It is the credit rating systems that are intended for
public dissemination and to provide qualitative risk assessments.

C is incorrect because it inaccurately suggests that credit scoring and rating systems
employ both numerical values and ordinal grades for both public and internal uses.
Credit scoring predominantly uses numerical scores for internal use, while credit rating
systems use qualitative scales for public guidance.

D is incorrect because not both systems are used for public dissemination. Credit
scoring is an internal tool, whereas credit rating is what provides public guidance.

Things to Remember

Credit scoring systems usually generate a numerical value to measure the

creditworthiness of a borrower, serving as an internal tool for financial

institutions and corporate clients.

Credit rating systems assign ordinal risk grades to debt issuers and their

instruments, primarily used by investors and other market participants for

public risk evaluation

Section: Credit Risk Measurement and Management

Chapter: Credit Scoring and Rating

Learning Objective: Describe the process for developing credit risk scoring and rating
models

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Q.49 Long-term economic repercussions of a sovereign default can span beyond
immediate financial markets. How might sovereign defaults affect bilateral trade
between the defaulting country and its trading partners?

A. Sovereign defaults generally lead to a strengthening of bilateral trade due to

renegotiated terms and improved competitiveness.

B. Bilateral trade typically remains unaffected by sovereign defaults as trade

agreements are insulated from sovereign credit events.

C. Trade retaliation and inhibitions on investment activities can lead to a

significant reduction in bilateral trade following a default.

D.Defaults result in increased bilateral trade as international partners offer

more favorable trade terms to support economic recovery.

Sovereign defaults can have a detrimental impact on bilateral trade. Studies indicate
that there could be around an 8% reduction in bilateral trade following a default, with
the effects persisting for years. Such a reduction is attributed to trade retaliation
measures and reduced foreign investment activities that may accompany the perceived
increase in country risk.

A is incorrect. The aftermath of a sovereign default typically challenges, rather than

strengthens, bilateral trade relations.

B is incorrect. Bilateral trade can be affected by changes in the perception of risk and
trust which can be influenced by sovereign defaults.

D is incorrect. Rather than offering more favorable terms, trading partners may impose
harsher terms or reduce trade due to increased risk perception.

Things to Remember

The impact of sovereign defaults on bilateral trade underscores the

interconnected nature of international economic relationships.

The reduction in trade can exacerbate the economic challenges faced by the

defaulting country, affecting their export-led industries and overall recovery.

Policy measures and diplomatic engagement may be necessary to mitigate the

adverse effects on trade due to sovereign defaults.

Section: Credit Risk Measurement and Management

Chapter: Country Risk: Determinants, Measures, and Implications

Learning Objective: Explain the consequences of a country’s default.

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Q.50 While performing a risk analysis on a corporate bond portfolio, a financial analyst
calculates the expected loss for each bond. To better assess the bank's resilience to
credit risk, the analyst must now estimate the unexpected losses. The bonds have
varying probabilities of default and loss given defaults, with associated volatilities. Why
can't the analyst simply aggregate the unexpected losses of individual bonds to
estimate the total unexpected loss for the portfolio?

A. Because the unexpected loss is calculated using the average of the expected
losses, and the aggregation of the averages does not give the unexpected loss.

B. Because the aggregation of individual unexpected losses assumes perfect

correlation among the bonds, which is rarely the case in practice.

C. Because the bond portfolio is subject to market risk, which needs to be

calculated separately from the credit risk of individual bonds.

D.Because the unexpected loss calculation requires the inclusion of recovery

rates, which have not been accounted for individually for each bond.

The unexpected loss of a portfolio cannot simply be the sum of the individual
unexpected losses unless there is a perfect correlation between the bonds. Since default
events are often not perfectly correlated, portfolio unexpected loss must take into
account the correlations amongst the individual bonds, affecting their collective risk
profile.

A is incorrect. Unexpected loss is not calculated as an average of expected losses but as

a measure of variability or volatility around the expected loss.

C is incorrect. While market risk is a consideration for bond portfolios, this does not
preclude the calculation of unexpected losses on the credit risk of individual bonds,
which is what is being assessed.

D is incorrect. Recovery rates influence the loss given default, but the question of their
inclusion does not address why individual unexpected losses cannot be aggregated to
estimate total portfolio unexpected loss.

Things to Remember

When calculating the unexpected loss for a portfolio, it's essential to consider

the correlation between the default probabilities of the individual assets.

Diversification effects imply that the total portfolio risk is generally less than

the sum of the individual asset risks when they are not perfectly correlated.

An accurate estimation of portfolio unexpected loss allows banks to

appropriately allocate economic capital to cover potential extreme credit

losses.

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Section: Credit Risk Measurement and Management

Chapter: Capital Structure in Banks

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

Q.51 Consider the following data for a particular fund for the year 2017:

Portfolio Market
Average return 32% 25%
Beta 1.15 1
Standard deviation 40% 30%
Tracking error σ(e) 16% 0%
T-Bill rate 6%

Determine the Sharpe ratio of the portfolio and the market, respectively.

A. 0.65 and 0.63

B. 0.60 and 0.65

C. 0.68 and 0.66

D.0.72 and 0.69

(R p − Rf )
Sharpe ratio =
σp
(32% − 6%)
Sharpe ratio of portfolio = = 0.65
(40%)
(25% − 6%)
Sharpe ratio of market = = 0.63
(30%)

Section: Risk Management and Investment Management

Chapter: Portfolio Performance Evaluation

Learning Objective: Describe risk-adjusted performance measures, such as Sharpe’s

measure, Treynor’s measure, Jensen’s measure (Jensen’s alpha), and the information
ratio and identify the circumstances under which the use of each measure is most
relevant.

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Q.52 Suppose that we are informed that in a U.S. stock market, denominated in %
terms, the location parameter of the limiting distribution, μ, is 2%, the scale parameter,
σ, is 0.6, and the tail index, ξ , is 0.4. Apply these parameters in the Fréchet VaR formula
to calculate the estimated 95% VaR and 99.5% VaR, respectively. Assume n = 100 .

A. 95% VaR: 1.340; 99.5% VaR: 1.657

B. 95% VaR: 1.657; 99.5% VaR: 1.119

C. 95% VaR: 1.28; 99.5% VaR: 2.477

D.95% VaR: 1.657; 99.5% VaR: 1.876

Recall that, for ξ > 0 :

σn
V aR = μn − [1 − (−nln(α))−ξn ]
ξn

Therefore,

For 95% VaR:

0.6
V aR = 2 − [1 − (−100 × ln(0.95))−0.4] = 1.28
0.4

For 99.5% VaR:

0.6
V aR = 2 − [1 − (−100 × ln(0.995))−0.4] = 2.477
0.4

Section: Market Risk Measurement and Management

Chapter: Parametric Approaches (II): Extreme Value

Learning Objective: Describe extreme value theory (EVT) and its use in risk
management.

Q.53 While carrying out backtesting of a leading bank's VaR model, you have made the
following findings: the bank is currently calculating the 1-day VaR at a confidence level
of 99%. However, based on your findings you suggest changing the confidence level
from 99% to 95%. Which of the following statements would justify your stance?

A. While conducting backtesting with a 95% confidence interval, the probability

of committing a Type 1 error is small as compared to the probability of Type 1
error when backtesting with 95% and 99% VaR models.

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 B. The accuracy of the VaR model and the basis of accepting/rejecting the model
have a greater reliability at a 95% confidence level VaR as compared to at a 99%
confidence level.

C. While conducting backtesting with a 95% confidence interval, the probability

of rejecting the VaR models at a 95% confidence level is equal to that at a 99%
confidence level.

D.There are fewer chances of a 95% VaR model being rejected based on
backtesting as compared to a 99% VaR model.

The accuracy of the VaR model and the basis of accepting/rejecting the model have a
greater reliability at a 95% confidence level VaR as compared to at a 99% confidence
level. This is because a lower VaR confidence level creates a larger rejection region,
allowing for more exceptions. This, in turn, enhances the reliability of the test. The
reliability of a test is crucial in risk management as it determines the effectiveness of
the model in predicting potential losses. A model with high reliability is more likely to
accurately predict potential losses, thereby enabling the bank to take appropriate
measures to mitigate these risks. Therefore, a 95% confidence level VaR model would
be more reliable and accurate in predicting potential losses compared to a 99%
confidence level VaR model.

Choice A is incorrect. The statement is not accurate because the probability of

committing a Type 1 error (rejecting a true null hypothesis) does not depend on the
confidence level used in backtesting. Rather, it depends on the significance level
chosen for the test.

Choice C is incorrect. This statement is also inaccurate as the probability of rejecting

VaR models at different confidence levels would not be equal. The rejection or
acceptance of a model during backtesting depends on how well it predicts losses, which
can vary significantly between different confidence levels.

Choice D is incorrect. While it's true that there may be fewer chances of rejecting a 95%
VaR model compared to a 99% VaR model due to its wider range, this doesn't
necessarily support shifting from one to another as it doesn't consider other factors
such as risk tolerance and regulatory requirements.

Things to Remember

Backtesting is a process used to assess the accuracy of a VaR model by

comparing the predicted losses with the actual losses observed over time.

Type 1 error in hypothesis testing refers to rejecting a true null hypothesis,

while Type 2 error refers to accepting a false null hypothesis.

Significance level in hypothesis testing is the probability of committing a Type

1 error, typically denoted by alpha.

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Section: Market Risk Measurement and Management

Chapter: Backtesting VaR

Learning Objective: Describe backtesting and exceptions and explain the importance of
backtesting VaR models.

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Q.54 A financial risk analyst is evaluating a VaR model by examining the Probability
Integral Transform (PIT) distribution shape. Why is the shape of the PIT distribution
crucial in assessing model quality, and what characteristic best indicates a well-
calibrated model?

A. A heavy-tailed distribution, indicating extreme event capture.

B. A bimodal distribution, indicating inconsistent risk segmentation.

C. A clustered distribution, displaying conservative risk estimates.

D.A uniform distribution, signifying consistent predictive accuracy.

A uniform distribution of PITs indicates a well-calibrated VaR model, showing that all
possible outcomes are equally probable and the model's predictions align with observed
data. This uniformity ensures the model accurately represents risks across the entire
distribution, enhancing its reliability. It also confirms the absence of systematic biases,
supporting consistent performance in various market conditions.

A is incorrect. A heavy-tailed distribution might suggest model deficiencies in regular

risk prediction, not an ideal calibration.

B is incorrect. Bimodal distributions could indicate bifurcated risk assumptions,

complicating consistency in prediction.

C is incorrect. Clustering in distributions typically points to misaligned estimates,

reflecting overly cautious projections.

Things to Remember:

Uniform PIT distributions confirm model predictions align with observed

probabilities across various scenarios.

Randomness and lack of clustering in PIT distributions verify the absence of

systematic biases.

Calibration correctness hinges on ensuring uniform distribution throughout

the [0,1] interval.

Section: Market Risk Measurement and Management

Chapter: Beyond Exceedance-Based Backtesting of Value-at-Risk Models

Learning Objective: Describe how the shape of the distribution of PITs can be used as
an indicator of the quality of a VaR model.

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Q.55 According to academic literature, “time-varying volatility in financial risk factors
is important to the VaR.” When the true underlying risk factors exhibit time-varying
volatility, the use of historically simulated VaR without incorporating time-varying
volatility can:

A. Reduce pro-cyclicality

B. Under-estimate risk

C. Increase instability

D.Over-estimate risk

The Value at Risk (VaR) is a statistical technique used to measure and quantify the level
of financial risk within a firm or investment portfolio over a specific time frame. This
metric is most commonly used by investment and commercial banks to determine the
extent and occurrence rate of potential losses in their institutional portfolios. VaR
calculations can be applied to specific positions or portfolios as a whole or to measure
firm-wide risk exposure. When the true underlying risk factors exhibit time-varying
volatility, and this is not incorporated into the VaR calculation through historical
simulation, the risk can be dangerously underestimated. This underestimation occurs
because the historical simulation VaR method assumes that the past is a good predictor
of the future. However, when volatility is time-varying, this assumption does not hold,
leading to an underestimation of risk. This underestimation can lead to insufficient
capital allocation for risk management and potential financial losses.

Choice A is incorrect. The use of historically simulated VaR without incorporating time-
varying volatility does not reduce pro-cyclicality. In fact, it may increase pro-cyclicality
as the model would be less responsive to changes in market conditions and risk factors
over time.

Choice C is incorrect. While it's true that ignoring time-varying volatility can lead to
inaccurate risk estimates, this doesn't necessarily translate into increased instability.
Instability refers to a system's propensity for sudden and drastic changes, which isn't
directly related to the concept of VaR or its estimation methods.

Choice D is incorrect. Ignoring time-varying volatility in historically simulated VaR

would more likely lead to an underestimation of risk rather than an overestimation.
This is because historical simulation assumes that past patterns will continue into the
future, which may not be accurate if there are significant fluctuations in volatility over
time.

Things to Remember

Time-varying volatility refers to the fluctuations in volatility over time.

Historically simulated VaR uses historical data to estimate potential future

losses.

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 Underestimating risk could lead to insufficient capital allocation for potential

losses.

The pro-cyclicality in finance refers to the idea that during periods of

economic growth, risks are often underestimated, leading to excessive lending

and investing.

Section: Market Risk Measurement and Management

Chapter: Messages from the academic literature on risk measurement for the trading
book, Basel Committee on Banking Supervision

Learning Objective: Explain the following lessons on VaR implementation: time horizon
over which VaR is estimated, the recognition of time-varying volatility in VaR risk
factors, and VaR backtesting.

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Q.56 An investment analyst is tasked with calculating the hedge ratio (β) for a bond
portfolio using bond futures. The following data is provided:

The correlation between the returns of the bond portfolio and the bond

futures: ρ(Yh , Y p ) = 0.6

The standard deviation of the bond portfolio returns: σ(Y p ) = 0.08

The standard deviation of the bond futures returns: σ(Y h ) = 0.05

What is the hedge ratio (β) required to minimize the bond portfolio's exposure to
interest rate risk?

A. 1.92

B. 1.50

C. 1.20

D.0.96

The hedge ratio (β) is calculated using the formula:

Cov(Y h , Yp )
β=
Var(Y h )

First, calculate Cov(Y h , Y p ) using the formula:

Cov(Yh , Y p ) = ρ(Y h , Yp ) ⋅ σ(Yh ) ⋅ σ(Yp )

Substituting the given values:

Cov(Y h , Yp ) = 0.6 ⋅ 0.05 ⋅ 0.08 = 0.0024

Now substitute into the hedge ratio formula:

0.0024
β= = 0.96
0.0025

Section: Market Risk Measurement and Management

Chapter: Regression Hedging and Principal Component Analysis

Learning Objective: Calculate the regression hedge adjustment factor, beta.

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Q.57 Which of the following approaches should banks use to compute capital with
respect to assets held under a securitization business model?

A. Internal models approach

B. Standardized approach

C. Advanced measurement approach

D.Revised internal models approach

The Basel Committee on Banking Supervision, through the Fundamental Review of the
Trading Book (FRTB), requires banks to use the standardized approach for
securitizations. This decision was made because the Committee found that the use of
internal models by banks resulted in too much variation in the capital charges
calculated by different banks for the same portfolio. The standardized approach,
therefore, provides a more uniform method of calculating capital charges for
securitized assets. It is designed to be less risk-sensitive than the internal models
approach and is simpler to implement. The standardized approach also reduces the
potential for regulatory arbitrage, where banks might choose a particular approach
simply because it results in lower capital charges.

Choice A is incorrect. The Internal Models Approach (IMA) is not recommended by the
Basel Committee for computing capital with respect to securitized assets. This
approach is typically used for market risk and not specifically designed for
securitization business models.

Choice C is incorrect. The Advanced Measurement Approach (AMA) also does not apply
to the computation of capital for securitized assets. AMA is generally used in the
context of operational risk, which involves risks resulting from inadequate or failed
internal processes, people, and systems or from external events.

Choice D is incorrect. The Revised Internal Models Approach (RIMA) isn't suggested by
the Basel Committee either. RIMA, like IMA, focuses on market risk and doesn't cater
specifically to securitization business models.

Things to Remember

Securitization involves pooling financial assets together and issuing securities

backed by these assets.

Capital requirements for securitized assets are important for ensuring banks

have enough capital to cover potential losses.

The standardized approach provides a more uniform method of calculating

capital charges for securitized assets compared to internal models.

Regulatory arbitrage refers to the practice of taking advantage of the

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 differences in regulations to reduce capital requirements.

Operational risk, which is addressed by the Advanced Measurement Approach

(AMA), involves risks related to internal processes, people, systems, and

external events.

Section: Market Risk Measurement and Management

Chapter: Volatility Smiles

Learning Objective: Describe the changes to the Basel framework for calculating
market risk capital under the Fundamental Review of the Trading Book (FRTB) and the
motivations for these changes.

Q.58 A portfolio manager at an investment firm is designing a bespoke hedging strategy

for a client who has specific exposure to foreign currency risk. The client's exposure is
tied to unique cash flow timelines and amounts, which do not align with standard
contract sizes or maturities available in the market. The manager opts for an over-the-
counter (OTC) derivative to mitigate this currency risk. What is the primary benefit of
using an OTC derivative in this scenario?

A. Access to a wide range of standardized contract sizes and maturities.

B. Availability of highly liquid secondary markets for the derivative.

C. Ability to customize the contract to match the unique hedging needs of the
client.

D.Reduction of legal and operational risks associated with the derivative

contract

Choosing an over-the-counter (OTC) derivative in this scenario provides the primary

benefit of customizability. OTC derivatives are less standardized and are typically
traded bilaterally, allowing for a high degree of customization in contract terms. This
flexibility is crucial for the portfolio manager to tailor the derivative contract
specifically to the client's unique foreign currency exposure, including matching cash
flow timelines and amounts. Unlike standardized contracts found in exchange-traded
derivatives, OTC derivatives can be structured to meet specific needs that are not
catered for by standard market offerings, thereby providing a more effective hedging
solution in this case.

A is incorrect because OTC derivatives are known for their lack of standardization in
contract sizes and maturities. Instead, they allow for tailored contract specifications,
which is a key requirement in this scenario.

B is incorrect because OTC derivatives typically do not have highly liquid secondary

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markets. Their customized nature often means that they are less liquid compared to
standardized, exchange-traded derivatives.

D is incorrect because the use of OTC derivatives generally involves higher legal and
operational risks, due to their customized nature and the need for bilateral negotiation
and documentation.

Things to Remember

OTC derivatives provide the flexibility to customize contract terms such as

notional amounts, maturity dates, and underlying assets, making them suitable

for specific risk management needs.

In the context of currency risk, OTC derivatives can be tailored to match the

exact exposure, including the amount and timing of foreign currency cash

flows.

While offering customization, OTC derivatives require careful consideration of

counterparty risk and may involve complex legal and operational

arrangements.

Section: Credit Risk Measurement and Management

Chapter: Central Clearing

Learning Objective: Describe central clearing of OTC derivatives and discuss the roles,
mandate, advantages, and disadvantages of the central counterparty (CCP).

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Q.59 Five years ago, American Banking Group approved a loan to Hazard Corp. with a
total commitment of USD 120 million. Today, the outstanding balance of the loan is
USD 80 million. The credit risk department provided the following details with regard
to the riskiness of the loan:

The standard deviation of the probability of default and the loss rate are 4

percent and 15 percent, respectively

The probability of default over the next year is 1%

The loss rate if the customer defaults is 25 percent

What is the unexpected loss for this loan today?

A. USD 2.163 million

B. USD 1.206 million

C. USD 0.769 million

D.USD 1.442 million

2 + LR2 × σ 2
Unexpected loss = Exposure amount × √ PD × σLR PD

= USD 80 million × √ 0.01 × (0.15)2 + 0.25 2 × 0.04 2

= USD 1.442 million

Section: Credit Risk Measurement and Management

Chapter: Capital Structure in Banks

Learning Objective: Define and calculate unexpected loss (UL).

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Q.60 Fusion Bank is applying a bottom-up approach to quantify its credit risk in order
to derive economic capital. What challenge is Fusion Bank likely to face with this
approach, particularly when it involves credit assets viewed as illiquid?

A. The approach may lead to an underestimation of credit losses due to an

insufficient focus on portfolio diversification

B. The methodology often requires estimation of losses over a period longer than
one year, although the models are typically designed for one-year estimates

C. The approach might require additional resources as it separates credit risk

from market and operational risks, each managed independently

D.Illiquidity of assets implies that expected losses can be hedged, nullifying the
need to calculate economic capital for those assets

Fusion Bank is applying a bottom-up approach, which measures credit losses by their
contribution to the credit portfolio without factoring in the correlation amongst risk
factors. A significant challenge with this approach is the need for additional resources
as this methodology classifies different types of risks separately and does not account
for the effects of risk diversification across the different types of risks that the bank
faces.

A is incorrect. The bottom-up approach may not necessarily underestimate credit

losses; the concern is more about the segregation of risk types and the need for
additional resources.

B is incorrect. Although it is ideal to estimate credit risk over a longer period, the
bottom-up approach typically uses credit risk models that estimate expected and
unexpected losses over a one-year horizon.

D is incorrect. Illiquidity of assets makes it difficult to hedge expected losses, and thus,
there is still a need to calculate economic capital for illiquid credit assets.

Things to Remember

The bottom-up approach looks at individual assets in isolation and usually

requires managing credit, market, and operational risks independently.

A potential downside of the bottom-up approach is the increasing complexity

and resource requirements due to managing different risk types separately.

Section: Credit Risk Measurement and Management

Chapter: Capital Structure in Banks

Learning Objective: Describe challenges to quantifying credit risk.

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Q.61 An investment analyst is assessing the credit risk of three different companies
using the Black-Scholes Option Pricing Model. The analyst calculates the Distance to
Default (DD) for each company based on various financial data. The analyst aims to
rank the companies from the most likely to the least likely to default based on their DD
values. The following table provides the necessary data for each company:

Company Market Value Face Value Volatility of Expected Asset Time to Debt
of Assets (A) of Debt (L) Assets (uA) Return (µ) Maturity (T)
Company X $ 800, 000 $ 500, 000 25% 7% 3 years
Company Y $ 1 , 000, 000 $ 600, 000 20% 5% 4 years
Company Z $ 900, 000 $ 400, 000 30% 6% 2 years

Based on the Black-Scholes model, how should the analyst rank these companies from
the most likely to the least likely to default?

A. Company X, Company Y, Company Z

B. Company Z, Company Y, Company X

C. Company Y, Company Z, Company X

D.Company Z, Company X, Company Y

Calculating DD for each company:

Company X:

800 000 0.25 2

ln( 500,,000) + (0.07 − ) × 3 ln(1.6) + (0.07 − 0.03125) × 30.4700 + 0.11625 0.58625
2
DDX = = = = ≈ 1.35
0.25 × √3 0.25 × 1.732 0.4330 0.4330

Company Y:

1 000 000
, , 0.20 2
ln( 600 ) + (0.05 − ) × 4 ln(1.6667) + (0.05 − 0.02) × 40.5108 + 0.12 0.6308
,000 2
DDY = = = = ≈ 1.577
0.20 × √4 0.20 × 2 0.40 0.40

Company Z:

900 000 0.30 2

ln( 400,,000) + (0.06 − 2
) × 2 ln(2.25) + (0.06 − 0.045) × 20.8109 + 0.03 0.84039
DDZ = = = = ≈ 1.98
0.30 × √2 0.30 × 1.414 0.4242 0.4242

The company with the lowest DD has the highest likelihood of default. After calculating
DD for each company, we find that Company X has the lowest DD, followed by Company
Y, and then Company Z with the highest DD. Thus, the ranking from most likely to least
likely to default is Company X, Company Y, Company Z.

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Things to Remember

Distance to Default (DD) is a key metric in credit risk analysis, indicating how

many standard deviations a firm's asset value is above the default threshold.

The calculation of DD includes not just the volatility of the assets (uA) but also

the expected asset return (µ), which replaces the risk-free rate in the

traditional Black-Scholes model.

When ranking companies based on their likelihood of default using DD, lower

DD values indicate a higher likelihood of default.

Section: Credit Risk Measurement and Management

Chapter: Introduction to Credit Risk Modeling and Assessment

Learning Objective: Apply the Merton model to calculate default probability and the
distance to default and describe the limitations of using the Merton model.

Q.62 A financial analyst is evaluating a firm using the KMV model to estimate the firm's
probability of default. The analyst has calculated the firm's distance to default and now
needs to determine the probability of default. Which of the following best describes how
the KMV model maps distance to default to probability of default?

A. By applying a standard normal distribution to the distance to default

B. By using a Poisson distribution based on the firm's past default history.

C. By deriving an empirical distribution of default frequencies from historical

data.

D.Through a constant default probability.

The KMV model, unlike traditional methods that might use a normal distribution,
utilizes historical data to create an empirical distribution of default frequencies. This
approach allows the KMV model to map the calculated distance to default to the
probability of default more accurately. By considering historical default rates, the
model can provide a nuanced and realistic estimate of a firm's default risk.

A is incorrect because the KMV model does not primarily use a standard normal
distribution to map distance to default to probability of default. Instead, it relies on an
empirical distribution derived from historical data.

B is incorrect because while the Poisson distribution is used in some credit risk models,
the KMV model specifically uses historical data to derive an empirical distribution of

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default frequencies for this purpose.

D is incorrect because the KMV model does not assume a constant default probability;
it varies based on the calculated distance to default and empirical data.

Things to Remember

The KMV model is an advanced credit risk tool that uses market data to assess

a firm's credit risk, particularly focusing on the likelihood of default.

In the KMV model, the firm's equity is viewed as a call option on its assets,

with the default point usually set at the level of short-term debt and half of the

long-term debt.

This model is particularly useful in estimating default risk for firms with

publicly traded equity, as it requires market data to assess equity value and

volatility.

Section: Credit Risk Measurement and Management

Chapter: Introduction to Credit Risk Modeling and Assessment

Learning Objective: Apply the Merton model to calculate default probability and the
distance to default and describe the limitations of using the Merton model.

Q.63 Understanding the value of debt is crucial for both financial management and
strategic planning. Debt financing involves borrowing funds that must be repaid over
time with interest. For a firm financed partly by debt and partly by equity, the value of
debt:

A. increases if the volatility of the firm increases.

B. increases if the face amount of debt falls.

C. falls if its time to maturity lengthens.

D.increases if the interest rate increases.

If the time to repay the debt is extended, the present value of the debt typically falls.
This is because money due in the future is worth less today due to the time value of
money. The longer the wait for repayment, the less valuable those future payments are
today.

A is incorrect. If a firm becomes more volatile (i.e., its earnings or business risk
fluctuate a lot), the risk of default (failure to repay the debt) increases. This makes the

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debt less attractive and less valuable because there’s a higher chance the firm won’t be
able to repay it. So, rising volatility decreases the value of the debt.

B is incorrect. If the face value (principal) of the debt decreases, the overall value of
the debt also decreases. This is because the company now owes less money, making the
debt worth less.

D is incorrect. When interest rates go up, the value of debt generally decreases. This
happens because higher interest rates reduce the present value of future payments that
the firm must make on the debt. Think of it this way: future cash flows from the debt
become less valuable because you could now earn a higher return elsewhere (due to
higher interest rates)

Things to Remember

Debt and equity are two main sources of financing for a firm.

Debt holders have a higher priority claim on the firm's assets in case of

bankruptcy compared to equity holders.

The value of debt is influenced by factors such as interest rates, time to

maturity, and the firm's volatility.

Debt can be issued in the form of bonds, loans, or other debt instruments.

Debt financing typically involves regular interest payments and repayment of

the principal amount at maturity.

Section: Credit Risk Measurement and Management

Chapter: Estimating Default Probabilities

Learning Objective: Using the Merton model, calculate the value of a firm’s debt and
equity, the volatility of firm value, and the volatility of firm equity.

Q.64 Jane Thomas is a credit manager at ABC Bank. She is assessing the risk of default
for four banks that her bank regularly lends to. She has obtained the following
information on the two banks.

Bank A Bank B Bank C Bank D

Annual volatility of assets value 9% 11% 10% 7%
Face value of debt $80 million $120 million $90 million $60 million
Market value of assets $150 million $230 million $150 million $100 million

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Which of the four banks is most likely to default, assuming that a zero-coupon bond
maturing in 1 year is the only liability for each company and has a 1-year horizon?

A. Bank A

B. Bank B

C. Bank C

D.Bank D

The higher the distance to default, the least likely to default.

The distance to default is given by:

σ2
a
InVa − I nF + (μ − ) ( t)
2
D tD =
σa √t

Where:

F = debt face value

Va = firm asset value

μ= expected return in the “risky world”

t= time remaining to maturity

σa = volatility of the asset

This formula can be simplified to:

I nVa − InF
D tD ≅
σa

Bank A

I nVa − InF I n( 150)

80
DtDBank A = = = 6.98
σa 0.09

Banks B

I nVa − InF I n( 230)

120
DtDBank B = = = 5.91
σa 0.11

Bank C

I n( 150)
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 I nV a − I nF I n( 150)
90
DtDBank C = = = 5.11
σa 0.10

Bank D

I nV a − I nF I n( 100 )
60
DtDBank D = = = 7.30
σa 0.07

Therefore, Bank D is the most likely to default.

Section: Credit Risk Measurement and Management

Chapter: Estimating Default Probabilities

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

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Q.65 Suppose a financial institution holds a portfolio of commercial loans totaling $120
million. The average probability of default for these loans over a year is calculated to be
2%. Additionally, the average recovery rate in case of default is estimated at 40%. The
correlation parameter for the copula model is assessed to be 0.25. What is the
regulatory capital requirement at 99.9% confidence level?

A. 43.2

B. 20.05

C. 18.61

D.33.42

We first determine the 99.9% worst-case default rate, V (X, T ):

N −1 (P (T )) + √ρN −1(X)
v(x , ρ) = N ( )
√1 − ρ
N −1 (0.02) + √0.25N −1 (0.999)
⇒ V (0.999 , 0.25) = N ( )
√1 − 0.25
−2.0537 + √0.25 3.0902
=N( )
√ 1 − 0.25
= N (−0.5873) = 0.2785

Therefore, the regulatory capital requirement at the 99.9% confidence level is

$120 million × (1 − 0.40) × (0.2785 − 0.02) ≈ $18.61 million

Section: Credit Risk Measurement and Management

Chapter: Credit Value at Risk

Learning Objective: Describe the application of the Vasicek model to estimate capital
requirements under the Basel II internal-ratings-based (IRB) approach

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Q.66 Raul Gaucho Trading is a trading firm from Brazil that needs to have a very quick
idea on a swap’s Bilateral Credit Value Adjustment (BCVA). The firm discovered that the
expected positive exposure (EPE) for a trade of this type is 13.6% with an expected
negative exposure of -0.09. The counterparty credit spread is found to be around 267
bps and the credit spread of the trader’s own institution is 191 basis points per annum.
Which of the following is nearest to an estimate of the BCVA?

A. -32.268 bps

B. -19.122 bps

C. -21.338 bps

D.-53.502 bps

Recall that BCVA, which is an obvious extension of DVA, is calculated by using the
following formula:

BC V A = −EPE × Spreadc − (ENE × Spreadp )

From the question, we have: EP E = 0.136 , Spreadc = 267, EN E = 0.09, and Spreadp = 191

Therefore:

BCV A = −0.136 × 267 bps − (−0.09 × 191 bps) = −19.122 bps

Section: Credit Risk Measurement and Management

Chapter: CVA

Learning Objective: Calculate DVA, BCVA, and BCVA as a spread.

Q.67 A trading desk engages in a diverse range of trades. As part of its risk
management policies, every trade position the desk takes must have a netting
agreement, and at the moment is has 9 equity trade positions with an average
correlation of 0.35. The chief trader feels there is room for even more diversification
benefits if the desk manages to revise the existing agreement. She has presented 4
potential trade combinations to the team for consideration, as illustrated below:

Trade Combination Number of positions Average Correlation

K 4 0.25
Y 7 −0.08
E 10 −0.11
W 5 0.55

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Which of the above trade combinations would increase the trading desk is expected
netting benefit the most from the current level? Assume that all of the potential trade
positions are normally distributed.

A. Trade combination K

B. Trade combination Y

C. Trade combination E

D.Trade combination w

We assess the expected netting benefit by computing the netting factor. The lower the
netting factor, the higher the netting benefit.

√n + n(n − 1)ρ̄
Netting Factor =
n

where n represents the number of exposures and ρ̄ is the average correlation.

The current trades have a netting factor of 65% as calculated below:

√9 + 9(9 − 1) × 0.35
Netting Factor = = 65%
9

When there are 10 positions with an average correlation of -0.11, the netting factor is
3.16%, and that is when there is the biggest reduction in the netting factor (most
increase in the expected netting benefit).

√10 + 10(10 − 1) × (−0.11)

Netting Factor = = 3.16%
10

A is incorrect. Trade combination K results in a higher netting factor compared to the

current trades and would, therefore, cause a deterioration of the current trades.

√4 + 4(4 − 1) × 0.25
Netting Factor = = 66.14%
4

B is incorrect. Although trade combination Y does improve the netting benefit, the
improvement is not as much as for trade combination E.

√7 + 7(7 − 1) × (−0.08)
Netting Factor = = 27.26%
7

D is also incorrect. Combination W results in a bigger netting factor compared to the

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current trades and would, therefore, have a lower netting benefit. In fact, Y would be
the worst combination of the four possible choices.

√5 + 5(5 − 1)0.55
Netting Factor = = 80%
5

Section: Credit Risk Measurement and Management

Chapter: Netting, Close-out and Related Aspects

Learning Objective: Summarize netting and close-out procedures (including

multilateral netting), explain their advantages and disadvantages, and describe how
they fit into the framework of the ISDA master agreement.

Q.68 In the realm of financial regulation, banks are required to conduct thorough
customer due diligence (CDD) to prevent money laundering and other illicit activities.
This process involves verifying the identity of customers and assessing their risk
profiles. Given the complexities and resource demands of this task, banks sometimes
seek external assistance. Under what circumstances may a bank rely on a third party for
customer due diligence (CDD)?

A. When the third party has an established business relationship with the
customer.

B. When the third party is a bank or financial institution, regardless of the

nature of the relationship with the customer.

C. When the third party is subject to different levels of supervision and

regulation than the bank, but is able to demonstrate a strict AML/CFT program.

D.When the bank conducts periodic checks to ensure the third party's CDD
process is more comprehensive than its own.

A bank may rely on a third party for customer due diligence (CDD) when the third party
has an established business relationship with the customer. This is because the third
party, having an established relationship, would have a better understanding of the
customer's financial behavior and risk profile. The bank can leverage this
understanding to conduct a more effective CDD. However, the bank must establish a
written document acknowledging the reliance on the other party's CDD processes. This
is to ensure that the bank has a clear understanding of the third party's CDD processes
and can hold them accountable for any lapses in the CDD.

Choice B is incorrect. While it might seem logical for a bank to rely on another
financial institution for CDD, the nature of the relationship with the customer is
crucial. Simply being a bank or financial institution does not automatically qualify a
third party to conduct CDD on behalf of another bank.

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Choice C is incorrect. The level of supervision and regulation that a third party is
subject to, even if different from that of the bank, does not necessarily make them
suitable for conducting CDD. They must also have an established business relationship
with the customer and be able to demonstrate strict adherence to AML/CFT programs.

Choice D is incorrect. Conducting periodic checks on the third party's CDD process
does not justify relying on them for this task unless they have an established business
relationship with the customer. The comprehensiveness of their process alone cannot
be used as a criterion for selection.

Things to Remember

Customer Due Diligence (CDD) is a critical process for banks to assess the risk

associated with their customers and prevent money laundering and terrorist

financing.

Third-party reliance for CDD can help banks leverage existing relationships

and expertise to enhance their risk assessment processes.

It is important for banks to have clear written agreements with third parties

outlining the responsibilities and expectations regarding CDD processes.

Section: Operational Risk and Resilience

Chapter: Guidance on Managing Outsourcing Risk

Learning Objective: Describe topics and provisions that should be addressed in a

contract with a third-party service provider

Q.69 Different countries may have different laws against money laundering and
terrorism financing. On 20 May 2015, the European Parliament and Council issued a
directive to prevent the use of the financial system for money laundering or terrorist
financing. According to the European Union, which of the following activities are
considered money laundering?

A. Knowingly converting or transferring property derived from criminal activity

in order to disguise the illicit origin of the property.

B. The provision or collection of funds to be used, partly or in full, to facilitate

any offense considered by the authorities as a terrorism act

C. Any intentional violation of the law or of internal policies perpetrated by the

firm's employees

D.Getting the money out to use while evading taxes and law enforcement

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 through activities such as fake payments to employees, fake loans, or dividends
to accomplices

The European Parliament and Council's directive defines money laundering as the
process of making illegally-gained proceeds appear legal. This is typically achieved
through three steps: placement, layering, and integration. Placement refers to the
process of introducing the illicit money into the financial system. Layering is the
process of creating complex networks of transactions to obscure the money's origin.
Finally, integration involves merging the laundered money back into the legitimate
economy. Choice A accurately describes the process of converting or transferring
property derived from criminal activity for the purpose of disguising its illicit origin or
assisting someone involved in such activity to evade legal consequences. This activity
falls under the definition of money laundering as per the directive.

Choice B is incorrect. While the provision or collection of funds to facilitate any offense
considered as a terrorism act is indeed a serious crime, it falls under the category of
terrorism financing rather than money laundering according to the directive issued by
the European Parliament and Council.

Choice C is incorrect. Intentional violation of law or internal policies perpetrated by a

firm's employees may constitute fraud or misconduct, but it does not necessarily equate
to money laundering unless it involves activities such as conversion or transfer of
property derived from criminal activity with an intent to disguise its illicit origin.

Choice D is incorrect. Evading taxes and law enforcement through activities such as
fake payments to employees, fake loans, or dividends to accomplices can be part of tax
evasion schemes and fraudulent practices. However, these actions do not meet the
specific definition of money laundering within the European Union unless they involve
knowingly converting or transferring property derived from criminal activity for
disguising its illicit origin.

Things to Remember

Money laundering is a criminal activity that involves making illegally obtained

money appear as if it were obtained through legal means.

The process of money laundering typically involves three main stages:

placement, layering, and integration.

Placement is the initial stage where the illicit funds are introduced into the

financial system.

Layering involves creating complex networks of transactions to obscure the

origin of the money.

Integration is the final stage where the laundered money is reintroduced into

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 the legitimate economy.

Terrorism financing is the act of providing or collecting funds to be used in

whole or in part to facilitate terrorist activities.

Money laundering and terrorism financing are distinct but related financial

crimes with different objectives.

Section: Operational Risk and Resilience

Chapter: Financial Crime and Fraud

Learning Objective: Describe elements of a control framework to manage financial

fraud risk and money laundering risk.

Q.70 Which regulations resulted in the formation of the Consumer Financial Protection
Bureau (CFPB) as an independent financial regulator to regulate consumer finance
markets?

A. The Markets in Financial Instruments Directive (MIFID)

B. Dodd-Frank Act

C. The Financial Industry Regulatory Authority (FINRA)

D.The Volcker Rule

The Investor Protection Act, Dodd-Frank is the regulation that led to the establishment
of the Consumer Financial Protection Bureau (CFPB). The Dodd-Frank Wall Street
Reform and Consumer Protection Act, commonly referred to as Dodd-Frank, was signed
into law in 2010 in response to the 2008 financial crisis. One of its key provisions was
the creation of the CFPB, an independent agency tasked with protecting consumers in
the financial sector. The CFPB's mandate includes enforcing consumer protection laws,
conducting financial education, researching consumer behavior, and monitoring
financial markets for risks to consumers.

Choice A is incorrect. The Markets in Financial Instruments Directive (MiFID) is a

European Union law that provides harmonized regulation for investment services across
the 31 member states of the European Economic Area. It does not have any direct
relation to the establishment of CFPB in the United States.

Choice C is incorrect. The Financial Industry Regulatory Authority (FINRA) is a private,

self-regulatory organization in the United States, which was created to regulate
member brokerage firms and exchange markets. It was not responsible for creating
CFPB.

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Choice D is incorrect. The Volcker Rule refers to § 619[1] part of the Doddâ​​Frank Wall
Street Reform and Consumer Protection Act, originally proposed by American
economist and former United States Federal Reserve Chairman Paul Volcker to restrict
United States banks from making certain kinds of speculative investments that do not
benefit their customers. While it's part of Dodd-Frank act, it's not directly related to
formation of CFPB.

Things to Remember

The Consumer Financial Protection Bureau (CFPB) is an independent agency

of the United States government responsible for consumer protection in the

financial sector.

The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted

in 2010 to address the causes of the 2008 financial crisis and to promote

financial stability.

CFPB's responsibilities include enforcing consumer protection laws,

supervising financial institutions, and educating consumers about financial

products and services.

The Markets in Financial Instruments Directive (MiFID) is a European Union

regulation aimed at harmonizing financial markets and investor protection

across the EU.

The Financial Industry Regulatory Authority (FINRA) is a self-regulatory

organization that oversees brokerage firms and exchange markets in the

United States.

The Volcker Rule, part of the Dodd-Frank Act, restricts banks from engaging in

certain types of speculative trading activities.

Section: Operational Risk and Resilience

Chapter: Guidance on Managing Outsourcing Risk

Learning Objective: Describe elements of a control framework to manage financial

fraud risk and money laundering risk.

Q.71 A risk manager at a bank is presenting to the board of directors about model risk

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management. He starts his presentation by defining a model. Which one of the
following is the correct definition of a model in the context of risk management in the
modern day today?

A. A tool used for forecasting based on complex statistical techniques

B. A tool used for forecasting based on qualitative techniques

C. A tool that applies quantitative approaches to forecast results

D.A tool used for forecasting based on both quantitative and qualitative methods

A model, in the context of risk management, is indeed a tool used for forecasting based
on quantitative methods. The Federal Reserve defines a model as a quantitative
method, system, or approach that applies statistical, economic, financial, or
mathematical theories, techniques, and assumptions to process input data into
quantitative estimates. This definition also encompasses quantitative approaches whose
inputs are partially or wholly qualitative or based on expert judgment, as long as the
outputs are quantitative in nature.

Choice A is incorrect. The definition of a model does not really focus on its complexity.

Choice B and D are incorrect. The definition of a model only focuses on quantitative
methods, but the input may be either quantitative or qualitative as long as the output is
quantitative.

Things to Remember

Models in risk management are used to quantify and manage risks by

providing estimates and forecasts based on historical data and assumptions.

Model risk management involves the identification, assessment, and mitigation

of risks associated with the use of models in decision-making processes.

Models can be used for various purposes in risk management, such as credit

risk modeling, market risk modeling, operational risk modeling, and stress

testing.

Model validation is an important process in model risk management that

involves assessing the accuracy, reliability, and relevance of models used in

risk management.

Regulatory bodies, such as the Federal Reserve, provide guidelines and

requirements for model risk management to ensure the soundness and

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 effectiveness of risk management practices in financial institutions.

Section: Operational Risk and Resilience

Chapter: Model Risk and Model Validation

Learning: Define a model and describe different ways that financial institutions can
become exposed to model risk.

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Q.72 Suppose that the liquidity division in QPR bank has bought 25 million shares of
one company and 35 million ounces of a commodity. Assume that the shares are bid
$90.8, offer $92.4, and the commodity is bid $24, offer $ 26.2. Calculate its liquidation
cost in a normal market.

A. $45.67million

B. $58.49 million

C. $23.56million

D.$32.08million

The mid-market value of the position of the shares is equivalent to:

25 × 91.6 = $2, 290 million

Note that the mid-market price is halfway between the offer price and the bid price.

The mid-market of the position in the commodity is:

25.1 × 35 = $878.5 million

The proportional bid-offer spread for the position of the shares is:

Offer price-Bid price

s=
Mid-market price
(92.4 − 90.8)
= = $0.017467
91.6

Similarly, the proportional bid-offer spread for the commodity;

(26.2 − 24)
= $0.087649
25.1

Hence the cost of liquidation in a normal market is;

(0.5 × 0.017467 × 2, 290) + (0.5 × 0.087649 × 878.5) = $58.49 million

Section: Liquidity and Treasury Risk Management

Chapter: Liquidity Risk

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

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Q.73 Bob Woolmer is a fund manager at Fortune Investment. He is analyzing shares of
Bell Aviation which currently have a bid price of $32.45 and an ask price of $32.90. The
sample standard deviation of this bid-ask spread is 0.004. Given this information,
determine the 99 percent confidence interval on the transactions cost, in dollars per
unit of the asset, and the 99% spread risk factor for a transaction involving Bell
Aviation.

A. Transactions Cost: $0.759; Spread Risk Factor: 0.0232

B. Transactions Cost: $0.759; Spread Risk Factor: 0.0139

C. Transactions Cost: $0.378; Spread Risk Factor: 0.0116

D.Transactions Cost: $0.379; Spread Risk Factor: 0.0139

Ask price − Bid priceAsk price − Bid price

S=2 =
Ask price + Bid price Mid Price

S is an estimate of the expected or typical bid-ask spread,and P is the asset's mid-price.

¯¯¯¯
Under zero-mean normality, the hypothesis is that S = S .

1 ¯¯¯¯
± ¯P¯¯¯ (S + 2.33σS)
2
1
Expected transactions cost = P × [S + 2.33 (0.004)]
2

($32.90 + 32.45)
Midprice P = = $32.68
2

($32.90 − 32.45)
Expected bid-ask spread (S ) = = 0.0138
$32.68

1
Expected transactions cost = $32.68 × [0.0138 + 2.33 (0.004)] = $0.378
2

¯¯¯¯
Where P is an estimate of the next day asset mid-price,and since P = P , the 99 percent
risk factor is referred to as:

1 ¯¯¯¯
(S + 2.33σS )
2
1
99% spread risk factor = [0.0138 + 2.33 (0.004)] = 0.01156
2

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Section: Liquidity and Treasury Risk Management

Chapter: Liquidity and Leverage

Learning Objective: Calculate the expected transactions cost and the spread risk factor
for a transaction and calculate the liquidity adjustment to VaR for a position to be
liquidated over a number of trading days.

pl

Q.74 You are given the assets, liabilities, and their respective expiry terms of a financial
institution XYZ, as shown in the table below. Given that the assets bear no default risk,
no liquidity options are embedded within the deposit, and both the assets and the
liabilities have been ordered according to their maturity, disregarding which kind of
contract they are. Study the table for building a TSECF for the institution.

Expiry Notional Interest Notional Interest

Positive Positive Negative Negative
Cashflows Cashflows Cashflows Cashflows
1 20 6 0 −4
2 0 5 −10 −4
3 0 5 0 −3
4 0 5 0 −2
5 50 5 0 −3
6 0 2 0 −3
7 0 2 −70 −3
8 0 2 0 0
9 0 2 0 0
10 30 2 0 0
> 10 0 − −20 0

What is TSECCF for the assets and liabilities with 6 years expiry term?

A. 70

B. 22

C. 18

D.69

In generating the TSECCF we calculate the TSECF for the first year and then cumulate
the amounts until the 6th year following TSECCF as follows:

TSECCF(t0 , t6 ) = {CF(t0 , t0 , t1 ), CF(t0 , t0 , t2 ), . . . , CF(t0 , t0 , t6 )}

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The cumulated amounts are as in the below:

Assets and Liabilities Classified According to Maturity

Expiry Notional Interest on Notional on Interest on TSECCF

Positive Positive Negative Negative
Cashflows Cashflows Cashflows Cashflows
1 20 6 0 −4 22
2 0 5 −10 −4 13
3 0 5 0 −3 15
4 0 5 0 −2 18
5 50 5 0 −3 70
6 0 2 0 −3 69
7 0 2 −70 −3 −2
8 0 2 0 0 0
9 0 2 0 0 2
10 30 2 0 0 34
> 10 0 − −20 0 14

Section: Liquidity and Treasury Risk Management

Chapter: Monitoring Liquidity

Learning Objective: Interpret the term structure of expected cash flows and cumulative
cash flows.

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Q.75 A global investment firm is reassessing its approach to evaluating sovereign debt
risks following recent economic turbulence in several emerging markets. The firm's
risk management team has traditionally relied heavily on sovereign ratings provided by
major credit rating agencies. During a strategy meeting, the chief risk officer raises
concerns about the limitations of these ratings. Which of the following statements most
accurately captures a significant shortcoming of sovereign rating systems employed by
rating agencies?

A. The ratings tend to be excessively volatile, leading to frequent and

unnecessary market disruptions.

B. Sovereign ratings typically lag behind market indicators and fail to provide
timely warnings of impending crises.

C. Rating agencies consistently overestimate the creditworthiness of developed

economies while underestimating emerging markets.

D.The methodologies used are too transparent, allowing governments to

manipulate economic data to achieve better ratings.

Sovereign ratings typically lag behind market indicators and fail to provide timely
warnings of impending crises. This is a significant shortcoming of the sovereign rating
systems employed by rating agencies. Rating agencies often struggle to update their
assessments quickly enough to reflect rapidly changing economic and political
conditions, resulting in ratings that may not accurately represent the current risk
profile of a sovereign entity.

A is incorrect because sovereign ratings are generally criticized for being too stable
rather than excessively volatile. Rating agencies tend to favor rating stability to avoid
causing unnecessary market disruptions, which can lead to delayed downgrades or
upgrades. This stability bias is actually part of the problem that contributes to ratings
lagging behind market indicators.

C is incorrect as there is no consistent evidence that rating agencies systematically

overestimate developed economies while underestimating emerging markets. While
biases can exist, they are not typically this systematic or predictable. Rating agencies
strive to apply consistent methodologies across all sovereign entities, regardless of
their development status.

D is incorrect because the lack of transparency in rating methodologies is often cited as

a criticism, not excess transparency. While rating agencies have made efforts to
increase transparency in recent years, their exact methodologies and the weights
assigned to various factors are not fully disclosed. This makes it difficult for
governments to manipulate data specifically to achieve better ratings.

Section: Credit Risk Measurement and Management

Chapter: Sovereign Default Risk

Learning Objective: Describe the shortcomings of the sovereign rating systems of rating
agencies

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