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

Question 10

Which of the following best describes the concept of marginal VaR of an asset in a portfolio:

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Marginal VaR is the value of the expected losses on occasions where the VaR estimate is exceeded.
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Marginal VaR is the contribution of the asset to portfolio VaR in a way that the sum of such calculations for all the assets in the portfolio adds up to the portfolio VaR.
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Marginal VaR is the change in the VaR estimate for the portfolio as a result of including the asset in the portfolio.
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Marginal VaR describes the change in total VaR resulting from a $1 change in the value of the asset in question.

Question 11

Which of the following statements is the most appropriate description of feedback effects:

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The amplification of smaller initial shocks to one risk factor creating larger subsequent shocks through system-wide interactions between other risks, creating self-perpetuating downward stresses in the markets
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The lack of a comprehensive view of risk across credit, market and liquidity risks leading to an underestimation of correlations that tend to spike up in the event of a crisis C. The spread of contagion from the bankruptcy of one participant leading to a similar outcome for other market participants
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The revision of stress testing scenarios based upon management, business unit and regulatory feedback on the plausibility or otherwise of stress scenarios.

Reference / correct answer:

The amplification of smaller initial shocks to one risk factor creating larger subsequent shocks through system-wide interactions between other risks, creating self-perpetuating downward stresses in the markets

: Choice 'a' (The amplification of smaller initial shocks to one risk factor creating larger subsequent shocks through system-wide interactions between other risks, creating self-perpetuating downward stresses in the markets) is the most comprehensive description of 'feedback effects', as described in the BCBS document on stress testing. Choice 'c' is one manifestation of feedback effects, but does not describe the entire effect. Choice 'b' is not a description of 'feedback effects', but one of the various weaknesses in stress testing that was seen during the crisis. Choice 'd' is plain nonsensical. The BCBS paper provides a good and succinct description of feedback effect: how mortgage default shocks led to a deterioration of market prices of CDOs, followed by a drying up of the liquidity in these markets. This led to banks having to hold on to assets they intended to securitize (securitization and warehousing risk), and given the absence of transparency on who was exposed to what, banks refusing to lend to each other and a drying up of the wholesale funding market as well. All of this was additionally accompanied by a general flight to quality, households withdrawing money from money market funds creating a crisis in that market as well. At each stage, the initial shock was amplified and fed back into the system through interactions that had not been imagined by any market participant or regulator, leave alone risk managers.

Question 12

Which of the following statements is true in relation to collateral management?

I. A collateral management system need not consider the failure by counterparties to returncollateral when due

II. The extent to which counterparties may have rehypothecated collateral is not aconsideration for a collateral management system

III. Cash is an acceptable substitute for any type of collateral required to be posted

IV. Haircuts do not apply to treasury issued instruments posted as collateral

Select an option, then click Submit answer.

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I, II and III
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I, II, III and IV
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II and III
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None of the statements is true
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A collateral management system need not consider the failure by counterparties to returncollateral when due

II. The extent to which counterparties may have rehypothecated collateral is not aconsideration for a collateral management system

III. Cash is an acceptable substitute for any type of collateral required to be posted

IV. Haircuts do not apply to treasury issued instruments posted as collateral

Reference / correct answer:

None of the statements is true

:

Strong management of collateral, both receivable and payable, is emerging as an area requiring significant investment by financial institutions and asset managers in IT infrastructures and business processes. A bank needs to make collateral calls daily, based upon the P&L of the previous day, and likewise receives collateral calls from its counterparties. Just like cash, a bank needs to make sure that it does not run out of collateral to post when a call is received. Interestingly, based upon the agreements between banks and their mutual understanding, only certain types of instruments often qualify as valid collateral - and in such cases even cash is not acceptable if the right type of bond or other agreed security is not available to post. The operational challenges of managing collateral increase manifold due to 'rehypothecation', ie when collateral received from one counterparty gets posted out as collateral where it is due. In such cases, the bank should have the mechanisms to receive the right assets back in a timely way in case rehypothecated assets are to be returned. The systems should be able to deal with delays, failures without impacting the ability of the bank to post collateral as needed. All of this requires major investments in IT and processes.

Statement I is not true as a bank is bound to post collateral to third parties when needed regardless of the failure of its counterparties to post collateral to it when owed. In the markets, failures by counterparties can and do happen, and a collateral management system needs to account for and keep a buffer for the fact that some collateral when due will not be received.

Statement II is not true as rehypothecation by counterparties of collateral posted increases the chances of the collateral not being received in time. The system should consider the need for liquidity to generate assets that can be posted as collateral when others have failed to return the collateral in a timely way.

Statement III is not correct as cash may not be acceptable to counterparties as collateral. From a practical point of view, they may not have the infrastructure to receive and account for cash as collateral. A Swiss bank, for example, may have an 'account' to receive US tbills as collateral but may not even have a US dollar account to receive cash. Even if it did, the volumes of transactions going back and forth may make tracking and reconciliations impossible. Thus a bank should always make sure that it has the right type of collateral available to post.

Statement IV is incorrect as well, as treasury issued instruments are also subject to haircuts. Their value also fluctuates in response to changes in yields, and therefore they are subject to haircuts as well.

Thus none of the statements are correct and Choice 'd' is the correct answer.

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