8008 PRM Certification - Exam III: Risk Management Frameworks, Operational Risk, Credit Risk, Counterparty Risk, Market Risk, ALM, FTP - 2015 Edition - Practice Questions

Question 1

Which of the following credit risk models focuses on default alone and ignores credit migration when assessing credit risk?

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CreditPortfolio View
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The contingent claims approach
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The CreditMetrics approach
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The actuarial approach

Question 2

The 99% 10-day VaR for a bank is $200mm. The average VaR for the past 60 days is $250mm, and the bank specific regulatory multiplier is 3. What is the bank's basic VaR based market risk capital charge?

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$250mm
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$200mm
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$750mm
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$600mm

Reference / correct answer:

$750mm

:

The current Basel rules for the basic VaR based charge for market risk capital set market risk capital requirements as the maximum of the following two amounts:

1. 99%/10-day VaR,

2. Regulatory Multiplier x Average 99%/10-day VaR of the past 60 days

The 'regulatory multiplier' is a number between 3 and 4 (inclusive) calculated based on the number of 1% VaR exceedances in the previous 250 days, as determined by backtesting.

- If the number of exceedances is <= 4, then the regulatory multiplier is 3.

- If the number of exceedances is between 5 and 9, then the multiplier = 3 + 0.2*(N-4),where N is the number of exceedances.

- If the number of exceedances is >=10, then the multiplier is 4.

So you can see that in most normal situations the risk capital requirement will be dictated by the multiplier and the prior 60-day average VaR, because the product of these two will almost often be greater than the current 99% VaR.

The correct answer therefore is = max(200mm, 3*250mm) = $750mm.

Interestingly, also note that a 99% VaR should statistically be exceeded 1%*250 days = 2.5 times, which means if the bank's VaR model is performing as it should, it will still need to use a reg multiplier of 3.

Question 3

Which of the following statements is true in respect of a non financial manufacturing firm?

I. Market risk is not relevant to the manufacturing firm as it does not take proprietarypositions

II. The firm faces market risks as an externality which it must bear and has no control over

III. Market risks can make a comparative assessment of profitability over time difficult

IV. Market risks for a manufacturing firm are not directionally biased and do not increasethe overall risk of the firm as they net to zero over a long term time horizon

Select an option, then click Submit answer.

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III only
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IV only
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I and II
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III and IV
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Market risk is not relevant to the manufacturing firm as it does not take proprietarypositions

II. The firm faces market risks as an externality which it must bear and has no control over

III. Market risks can make a comparative assessment of profitability over time difficult

IV. Market risks for a manufacturing firm are not directionally biased and do not increasethe overall risk of the firm as they net to zero over a long term time horizon

Reference / correct answer:

III only

:

A non-financial firm such as a manufacturing company faces market risks similar to those faced by financial firms, except perhaps for not being exposed to risks from the equity markets. Non financial firms commonly face interest rate risks in respect of their debts, commodity price risks in respect of their inputs and products, and foreign currency risks in respect of their overseas operations. It is therefore not correct to say that the manufacturing firm does not face market risk because it does not take proprietary positions. While decisions on positions may not be actively taken, positions in foreign exchange (eg, through overseas debtors owing foreign currency, or liabilities in foreign currencies to overseas suppliers), commodities (through exposure to the need for raw material and inventory of finished goods) and interest rates (through debt financed, whether at fixed or floating rates) exist and create market risk much in the same way as they would for a proprietary position. Therefore statement I is incorrect.

While the firm faces market risks as an externality (as do financial firms for that matter, though often they seek such exposure to profit from their view on which way the externality will express itself), it is incorrect to say that these risks must be borne. They can be measured and hedged. Therefore statement II is incorrect.

The results of a manufacturing firm will include gains and losses arising from exposure to market risk, and will cloud the true profitability of the business. A firm with significant unhedged overseas sales may show vastly different results across time periods due to the FX gains and losses, making comparative assessment of profitability difficult. Therefore statement III is correct.

Market risks for a manufacturing firm may be directionally biased in terms of exposure, ie there may be a consistent 'long' position in a particular commodity that the firm produces, and a consistent 'short' position in the commodities consumed. In the same way, directional biases may exist in FX or interest rate exposures too. Regardless of the bias, the existence of market risk exposures increase the volatility of the income stream and make the firm more risky, even though the long term expected returns from such exposures is zero (ie, returns may be zero but standard deviation is not). Therefore statement IV is not correct as market risks form non financial firms do increase the overall risk of the firm.

8008 – PRM Certification - Exam III: Risk Management Frameworks, Operational Risk, Credit Risk, Counterparty Risk, Market Risk, ALM, FTP - 2015 Edition