Free and Premium PRMIA 8008 Dumps Questions Answers

VaR is specified by just two parameters - the holding period, and the confidence level. We speak of, for example, a 10-day VaR at the 95% confidence level. No other parameters are required. Therefore Choice 'd' is the correct answer and the others are incorrect.

When a default occurs, the proportion of the exposure represented by the recovery rate is recovered. For example, if the recovery rate is 40% for a loan, the actual loss in the event of a default would be $60 for a $100 loan. In other words, the loss given default = 1 - recovery rate. Hence Choice 'd' is the correct answer. All other choices are incorrect.

For a dataset with 250 observations, the top 2% of the losses will be the top 5 observations. Expected shortfall is the average of the losses beyond the VaR threshold. Therefore the correct answer is (20 + 19 + 19 + 17 + 16)/5 = 18.2m .

Note that Expected Shortfall is also called conditional VaR (cVaR), Expected Tail Loss and Tail average.

The credit spread is equal to the default rate times the loss given default, or stated another way, default rate times (1 - recovery rate). It is not equal to the default rate times the recovery rate. Therefore statement I is not correct.

When ratings are upgraded by rating agencies, the spread contracts and not widen. Therefore statement II is not correct.

Both recovery rates and probabilities of default are related to the business cycle, and they move in opposite directions. Economic recessions witness an increase in the default rate and a decrease in the recovery rate, and economic expansions result in a decrease in the default rate and an increase in the recovery rates when default does happen. Therefore statement III is correct.

Bond spreads incorporate both the risk of default, but also considerations of liquidity in the case of corporate bonds. Hence statement IV is correct.

Normal mixtures address fat or heavy tails, not volatility clustering. Therefore statement I is not correct.

Statement II is not correct. Where VaR is calculated at low levels of confidence, VaR based on normal mixtures may be lower than that under a normal assumption. This is no different than for other fat tailed distributions.

Statement III is correct. In situations where multiple market scenarios can unfold with a given probability, and each scenario is normal, we can express the result with a normal mixture where the underlying normal distributions have the probabilities of the different scenarios.

Choice 'b' is the correct answer. All other answers are incorrect.

Refer to the detailed loss event type classification under Basel II (see Annex 9 of the accord). You should know the exact names of all loss event types, and examples of each.

Delta is non-linear with respect to prices for a number of securities such as bonds, options and other derivatives. It changes with changes in prices, and any hedge initially undertaken becomes quickly mismatched. Therefore delta hedges need to be managed quite actively and kept up-to-date. Therefore I is true.Primary risks comprise most of the risk in a position, and therefore portfolio managers are right to focus on them over secondary risks. Therefore II is true.The greater the hedge rebalance frequency, the lower is the hedge mismatch at any point in time, and therefore residual risks would be lower. However, rebalancing hedges requires rebalance trades to be done, and these involve transaction costs. Generally, a reasonable balance needs to be struck between the frequency of rebalances (a lower frequency increases residual risk, but this residual risk is not directionally biased) and the costs of rebalancing. III is correct.Vega risk is the risk arising due to changes in prices due to changes in volatility.  Options carry vega risk. Therefore any hedges against vega risks can only be obtained using other options positions.  (Vega risk may also be hedged using other volatility based products, eg an OTC volatility swap, or a VIX futures type product.)

Stress tests can cover known events, but since the future is unknown, and new events may be entirely different from what has happened in the past, they provide no assurance that an institution's worst case losses would be covered. Hence II is false.

Stress testing is required to be performed as part of Basel II, and therefore III is false.

Historical events do not have sharply defined start and end dates. Often, even after a crises ends, its after effects may continue to affect the markets for a long time. In such cases, it may be difficult to define the start and end of the crises. In many cases, the crises may persist for months or even years, making it difficult for the risk manager to identify a time period that covers the essence of the crises, and yet is focused enough to constitute a plausible scenario. Therefore IV is false too. Only I is true, and the correct answer is Choice 'b'.

If annual variance is 0.0256, then annual volatility (ie standard deviation) is √0.0256. Therefore the daily volatility will be √0.0256/√250 = 1.01%. The other choices are not correct.

As part of a reverse stress test, a firm has to identify and assess the scenarios most likely to cause it to fail, or in other words using the language used by the FSA in the UK, for its current business plan to become unviable. A firm's business plan should be considered to become unviable at the point that crystallizing risks cause the market to lose confidence it it, with the consequence that counterparties and other stakeholders are unwilling to transact with it or provide capital to the firm and, where releant, that existing counterparties may seek to terminate their contracts. Recent experience suggests that this point is reached well before a firm's regulatory capital is exhausted.

Large known losses, or negative EBITDA (earnings before interest , tax, depreciation and amortization) may be indicators or contribute to the loss of confidence, but do not of themselves make the current business plan unviable. Therefore Choice 'd' is the correct answer.

If the marginal probability of default of two securities A and B is P(A) and P(B), then the probability of both of them defaulting together is affected by the default correlation between them. Marginal probability of default means the probability of default of each security on a standalone basis, ie, the probability of default of one security without considering the other security.

The relationship that expresses the probability of joint default of the two is given by the following expression:

It is easy to see that in a situation where the Default Correlation of A & B = 0, ie, the defaults are independent, the combined probability of default is P(A)*P(B), exactly what we would intuitively expect. Also in the other extreme case where the default correlation is equal to 1 and P(A) = P(B) = p, ie the securities behave in an identical way, the expression resolves to just p, which is what we would expect.

From the above relationship, it is clear that the probability of joint default of A and B is the greatest when default correlation between the two is equal to 1, ie the securities behave in an identical way. Therefore Choice 'a' is the correct answer.

The difference between the yields on corporate bonds and the risk free rate is called the corporate bond spread. Widening of the spread means that corporate bonds yield more, and their yield curve shifts upwards, driving down bond prices. The increase in the spread is a consequence of the market risk from holding these interest rate instruments, which is a part of market risk. If the reduction in the value of the portfolio were to be caused by a change in the credit rating of the bonds held, it would have been a loss arising due to credit risk. Counterparty risk and liquidity risk are not relevant for this question. Therefore Choice 'c' is the correct answer.

A computation of Altman's Z-score considers the following ratios:

- Working capital to total assets

- Retained earnings to total assets

- EBIT to total assets

- Market cap to debt

- Sales to total assets

Nearly all the numbers above are accounting measures derived straight from the balance sheet or the income statement. Market capitalization is a market driven number. Therefore Choice 'c' is the correct answer as the Altman credit risk score considers both accounting and market based measures.

Altman's score, though computationally straightforward and intuitively easy to understand, was introduced in the late sixties and has been very accurate in predicting corporate bankruptcies, which is why it continues to be used extensively.

When two bonds that appear identical in every respect trade at different prices, the difference is often due to differences in liquidity between the two bonds (the less liquid bond will be cheaper and yield higher), and also due to the fact that ratings from the major rating agencies do not generally react to day to day changes in the market. The market's perception of the differences in the two credits will cause a divergence in the prices. This has been an extremely visible phenomenon during the credit crisis of 2007-2009, where fixed income security prices have changed sharply for many securities without any changes in external credit ratings.

Bonds carrying 'different market risk' is meaningless, and so is the difference in convexity (because the calculated convexity would be identical for similar bonds).

Therefore Choice 'c' is the correct answer.

The point that this question is trying to emphasize is the independence of the risk management function. The risk function should be segregated from the risk taking functions as to maintain independence and objectivity.

Choice 'd', Choice 'c' and Choice 'a' run contrary to this requirement of independence, and are therefore not correct. The risk function should report directly to senior levels, for example directly to the audit committee, and not be a part of the risk taking functions.

When VaR is based on an assumption of normality with a static mean and volatility, it means anything that violates these assumptions will introduce model error. Volatility clustering implies a non-static volatility. Heavy tails imply non-normality of the shape of the distribution. Autocorrelation of squared returns implies that returns are not independent and identically distributed. Therefore all of these introduce model error. Choice 'd' is therefore the correct answer.

According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves.

Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt issued originally for 5 years or longer.

Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority. This only includes short term subordinated debt originally issued for 2 or more years.

An interesting thing to note is the difference between 'subordinated term debt' under Tier 2 and the 'short term subordinated debt' under Tier 3. The distinction is based upon the years to maturity at the time the debt was issued. The remaining time to maturity is not relevant. For the subordinated term debt included under Tier 2, the amount that can be counted towards capital is reduced by 20% for every year when the debt is due within 5 years. This takes care of the time to maturity problem for Tier 2 subordinated debt. For Tier 3 short term subordinated debt, this is not an issue because debt will only qualify for Tier 3 if it has a lock-in clause stipulating that the debt is not required to be repaid if the effect of such repayment is to take the bank below minimum capital requirements.

It is the cross-default clauses in debt agreements that generally provide that a default on one obligation is considered a credit event applying to all debts of the obligor, and therefore we are able to deal with credit risk at the borrower level, and not at the level of the individual security. It also helps avoid situations where borrowers can selectively default on some obligations while continuing to service others. Therefore Choice 'a' is the correct answer. The other choices are incorrect.

Choice 'd' is correct because VaR is sub-additive in cases where correlation is less than one.

Specific VaR refers to the risk in the portfolio from security selection, ie the risk from holding the specific equities in the portfolio, while systematic risk refers to the market risk. Definitionally, specific risk and systematic risk are uncorrelated, ie their correlation is zero. Since their correlation is zero, combining them will produce a VaR number lower than their stand alone aggregate. Total risk includes both specific risk and systematic risk, and can be calculated taking into account the specific and systematic VaRs and their correlation.

All other answers are therefore incorrect.

Basel II requires financial institutions to compare their ex-ante VaR estimates to actual realized P&L. Therefore Choice 'd' is the correct answer. A bank may use hypothetical P&L based upon constant positions to validate its model, but that is not required for Basel II.

The minimum variance hedge ratio answers the question of how much of the hedge to buy to hedge a given position. It minimizes the combined volatility of the primary and the hedge position. The minimum variance hedge ratio is given by the expression [ σ(x) / σ(y) ] * ρ(x,y)]. Effectively, this is the same as the beta of the primary position with respect to the hedge.

In this case, the hedge ratio is = 10%/9% * 0.9 = 1

Choice 'b', Choice 'c' and Choice 'a' correctly describe a bilateral close out netting as recommended by the ISDA. However Choice 'd' is not correct as it suggests individual settlement of transactions without netting which is the whole point of bilateral close out netting.

Suppose during a historical event interest rates rose from 2% to 2.25%. This can be understood as a change of either 25 basis points, or a change of 12.5%. When applied to the current portfolio when interest rates are 0.50%, we may model this 'shock' as either a rise to 0.75%, or 0.5625% (ie a rise of 12.5% over existing levels). The former is called an absolute shock, and the latter a relative shock.

I is true as relative shocks can never change the sign of a risk factor. Yet interest rate changes are modeled as absolute changes as relative shocks can get artificially amplified or attenuated if the current level of interest rates is too different from those that existed during the crisis being modeled. Therefore II is true. III and IV are false as volatility is modeled as a relative shock and spreads are modeled as absolute shocks.

A default hazard rate is the rate of default in a continuous time setting. This question is asking for probability of survival at the end of 5 years. The formula to calculate the probability of survival at the end of t years where the default hazard rate is λ is e^(-λ *t) (or in Excel, =exp(-λ*t). Therefore the correct answer is Choice 'd'.

(It may be tempting to infer that if the probability of survival at the end of 1 year is 90% (1 - 10%), then the probability of survival in 5 years would be 90%^5. However this reasoning is not correct for the reason that the given rate is not the discrete rate of default, but the hazard rate which is nothing but the continuously compounded rate of default.)

In December 2009 the BIS came out with a new consultative document on liquidity risk. Given the events of 2007 - 2009, it has been clear that a key characteristic of the financial crisis was the inaccurate and ineffective

management of liquidity risk

The paper two separate but complementary objectives in respect of liquidity risk management: The first objective relates to the short-term liquidity risk profile of institution, and the second objective is to promote resiliency over longer-term time horizons. The paper identifies the following two ratios - you should be aware of these - though I am not sure if these will show up in the PRMIA exam:

1. Liquidity Coverage Ratio addresses the ability of an institution to survive an acute liquidity risk stress scenario lasting one month. It is calculated as follows:

Liquidity Coverage Ratio = Stock of high quality liquid assets/Net cash outflows over a 30-day time period

2. Net Stable Funding Ratio has been developed to capture structural issues related to funding choices.

Net Stable Funding Ratio = Available amount of stable funding/Required amount of stable funding

Both ratios should be equal to or greater than 1. The statement contains detailed definitions of what is included or excluded from each of the terms used in the calculations for each of the ratios. In addition, the standard also describes the what the 'acute' scenario should include (things such as a 3 notch credit downgrade, reduction in retail deposits etc)

Therefore Choice 'b' is the correct answer. Book Value to Share Price and Earnings Per Share are accounting measures unrelated to liquidity.

The index option is affected by the spot value for the underlying index, as also the risk free interest rate, or the zero rate for the duration of the option. It is also affected by the volatility of the underlying. The 'strike price' is set and is fixed at the time the option is purchased, and therefore is not a risk factor.

Therefore other than IV, all other choices are valid risk factors that underlie an equity index option.

Other instruments may have other risk factors - for example, a long forex position will have the spot exchange rate as the only risk factor.

The recovery rate, the default hazard rate (also called the average default intensity) and the spread on debt are linked by the equation Hazard Rate = Spread/(1 - Recovery Rate). Therefore, the recovery rate implicit in the given data is = 1 - 8%/10% = 20%.

Choice 'c' is the correct answer. The Markov property is the assumption that there is no ratings momentum, and that transition probabilities are dependent only upon where the rating currently is and where it is going to. Where it has come from, or what the past changes in ratings have been, have no effect on the transition probabilities. ('Herstatt risk' refers to settlement risk, and is irrelevant.)

The CDS rate is approximated by the [Loss given default x Default hazard rate]. Thus Choice 'b' is the correct answer.

Note that this is also equal to the credit spread on the reference bond over the risk free rate. Therefore credit spreads and CDS rates are generally the same. Also, 'loss given default' is nothing but (1 - Recovery rate). This can be substituted in the formula for the credit spread to get an alternative expression that directly refers to the recovery rate. Therefore all other choices are incorrect.

Bank B's exposure is measured by the price it paid for the bonds, which in this case is $7m ($10m x 70/100). Hence Choice 'c' represents the correct answer.

(Note that the question is asking for 'exposure' and not the legal claim in the event of default. The legal claim in the event of default would be the full notional of $10m. )

The initial issue price and issue size are irrelevant.

The probability of default would make the future cash flows from both the bonds identical. If p be the probability of default, the cash flows from the risky corporate bond would be

= (cash flows in the event of default x probability of default) + (cash flows without default x (1 - probability of default))

=> p*0 + (1 - p)*(1 + 8.5%) = (1 - p)*1.085.

The cash flows from the treasury bond would be 1.04. These two should be equal, ie,

1.04 = (1- p)*1.085, implying p = 4.15%.

(Note: The above is a simplification intended for the exam. In reality investors would demand a 'credit risk premium' for the corporate bond over and above the expected default loss rate. They are unlikely to be happy with just being compensated with exactly the expected default loss rate plus the risk-fre rate because the expected default loss rate itself is uncertain. They would demand some premium over and above what the default rate alone might mathematically imply above the risk free rate. In this question, this credit risk premium is ignored.)

When we do a Monte Carlo simulation, the statistic we obtain (eg, the expected price) is an estimate of the real variable. The difference between the real value (which would be what we would get if we had access to the entire population) and that estimated by the Monte Carlo simulation is measured by the 'standard error', which is the standard deviation of the difference between the 'real' value and the simulated value (ie, the 'error').

As we increase the number of draws in a Monte Carlo simulation, the closer our estimate will be to the true value of the variable we are trying to estimate. But increasing the sample size does not reduce the error in a linear way, ie doubling the sample size does not halve the error, but reduces it by the inverse of the square root of the sample size. So if we have a sample size of 1000, going up to a sample size of 100,000 will reduce the standard error by a factor of 10 (and not 100), ie, SQRT(1/100) = 1/10. In other words, standard error is proportional to 1/√N, where N is the sample size.

Therefore Choice 'c' is correct and the others are incorrect.

According to ISDA, a credit event is an event linked to the deteriorating credit worthiness of an underlying reference entity in a credit derivative. The occurrence of a credit event usually triggers full or partial termination of the transaction and a payment from protection seller to protection buyer. Credit events include

- bankruptcy,

- failure to pay,

- restructuring,

- obligation acceleration,

- obligation default and

- repudiation/moratorium.

A rating downgrade is not a credit event.

When a operational loss frequency distribution (which, for example, may be based upon a Poisson distribution) and a loss severity distribution (for example, based upon a lognormal distribution), it is assumed that the frequency of losses and the severity of the losses are completely independent and do not impact each other. Therefore statement II is correct, and the others are not valid assumptions underlying the operational loss distribution.

The distance to default is the number of standard deviations that expected asset values are away from the default point. The expression in Choice 'd' represents distance to default. Choice 'd' is the correct answer. The other choices are incorrect.

Statement I is not correct as VaR does not set an upper limit on losses. In this case, the bank expects the losses to exceed $253m 5% of the times, and the VaR number does not indicate any theoretical maximum amount of losses.Statement II is incorrect as there is a 95% (and not 5%) probability that the bank's losses will not exceed $253mStatement III is correct and describes VaR.Statement IV is incorrect, as regulatory capital is a more complex computation for which VaR is only one of the various input.Therefore Choice 'b' is the correct answer.

The 10-day VaR is = $25m x SQRT(10) = $79.06m. Choice 'b' is the correct answer.

Since the business units are perfectly correlated, we can get the combined EC as equal to the sum of the individual EC estimates. Therefore Choice 'a' is the correct answer.

GARCH is a mean reverting model of volatility, with a steady state mean that the model reverts to in the absence of market shocks. EWMA is not mean reverting and volatility under EWMA stays constant in the absence of shocks. Therefore statement I is correct.

Both EWMA and GARCH models are designed to address volatility clustering, which explains much of the non-normality of returns. When returns are standardized to the volatility calculations under either of these methods, the returns appear far closer to the normal distribution than non-standardized returns. (If it were not to, then there would have been no point in using these techniques.) Statement II is correct.

Steady state variance under GARCH is defined as ω / (1 - α - β), where α and β are the two parameters (called the reaction and persistence coefficient respectively). Clearly, it is affected by more than just the persistence coefficient, therefore statement III is not correct.

Sub-additivity is a very desired property in risk measures. It implies the sum of the parts is greater than the whole. In the case of risk measures, the whole is smaller than the sum of the parts due to diversification. Statement IV is true.

Therefore the correct answer is Choice 'c'

Under the contingent claims approach, a firm will default on its debt when the value of its assets fall to less than the face value of the debt. Debt holders can protect themselves against such an event by buying a put on the assets of the firm, where the strike price is equal to the value of the debt. In other words, Risky Debt + Put on the firm's assets = Risk free debt. This is because if the value of the assets is greater than the value of the debt, they will be paid in full. If the value of the assets is lower than the value of the debt, they will exercise the put and be paid in full.

Therefore the value of the put on the firm's assets with a strike equal to the value of the debt represents the cost of eliminating credit risk. Choice 'b' is the correct answer.

Note that it is improbable that a put on the firm's assets is available in real life to debt holders. However, the same effect can be synthetically achieved by using the shares of the firm as a proxy for its assets, and shorting an appropriate number of shares. Such a synthetic put will require frequent readjustments.

Stress testing is used for all the listed purposes. Therefore Choice 'a' is the correct answer.

When a derivative transaction is entered into, its value generally is close to zero. Over time, as the value of the underlying changes, the transaction acquires a positive or negative value. It is not possible to predict the future value of the transaction in advance, however distributional assumptions can be made and potential exposure can be measured in multiple ways. Of all the possible future exposures, it is generally positive exposures that are relevant to credit risk because that is the only situation where the bank may lose money from a default of the counterparty.

The maximum (generally a quantile eg, the 97.5th quantile) exposure possible over the time of the transaction is the 'Potential Future Exposure', or PFE.

The average of the distribution of positive exposures at a specified date before the longest trade in the portfolio is called 'Expected Exposure', or EE.

The expected positive exposure calculated as the weighted average of the future positive Expected Exposure across a time horize is called the EPE, or the 'Expected Positive Exposure'.

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date - is the 'fair value', as defined under FAS 157.

Therefore the corect answer is that EPE is the weighted average of the future positive expected exposure across a time horizon.

The actuarial or CreditRisk+ model considers default as an 'end of game' event modeled by a Poisson distribution. The annual number of defaults is a stochastic variable with a mean of μ and standard deviation equal to √μ.

The probability of n defaults is given by (μ^n e^-μ) /n!, and therefore in this case is equal to (=2^4 * exp(-2))/FACT(4)) = 0.0902.

Note that CreditRisk+ is the same methodology as the actuarial approach, and requires using the Poisson distribution.

In the univariate Gaussian model, each risk factor is modeled separately independent of the others, and the dependence between the risk factors is captured by the covariance matrix (or its equivalent combination of the correlation matrix and the variance matrix). Risk factors could include interest rates of different tenors, different equity market levels etc.

While this is a simple enough model, it has a number of limitations.

First, it fails to fit to the empirical distributions of risk factors, notably their fat tails and skewness. Second, a single covariance matrix is insufficient to describe the fine codependence structure among risk factors as non-linear dependencies or tail correlations are not captured. Third, determining the covariance matrix becomes an extremely difficult task as the number of risk factors increases. The number of covariances increases by the square of the number of variables.

But an inability to capture linear relationships between the factors is not one of the limitations of the univariate Gaussian approach - in fact it is able to do that quite nicely with covariances.

A way to address these limitations is to consider joint distributions of the risk factors that capture the dynamic relationships between the risk factors, and that correlation is not a static number across an entire range of outcomes, but the risk factors can behave differently with each other at different intersection points.

Survivorship bias is the tendency for failed companies, funds, investments and even entire markets (eg Russian stock market returns after the Communist revolution) to be excluded from performance studies because they no longer exist. Survivorship bias results in past results looking better than they actually were as data points relating to failures are not included.

A risk manager needs to be aware of survivorship bias when basing risk analysis on historical data and should question if failures (eg failed funds, delisted companies etc) have been included in the data he or she is relying upon.

A situation where a firm has more liabilities than assets does not necessarily imply default, so long as the firm is able to pay its obligations when they come due. Therefore, short term debts have a greater bearing on a firm's default than longer term debt. However, this is not to say that merely having enough to pay off the short term debts (ie debts due within one year) is enough to avoid default. Over time, the long term debt will also be turning to short term debt, and it may not be possible for the firm to roll over its liabilities without lenders considering the long term debt. The KMV approach considers the entire short term debt and half of the long term debt as the critical value of assets below which default will be triggered. Therefore Choice 'c' is the correct answer.

The correct answer is Choice 'b'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:

1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.

2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.

3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.

4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.

5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

For operational risk modeling, both frequency and severity distributions need to be modeled. Modeling severity involves finding an analytical distribution, such as log-normal or other that approximates the distribution best represented by known data - whether from the internal loss database, the external loss database or scenario data. A 'risk functional' is a measure of the deviation of the model distribution from the risk's actual severity distribution. It assigns a penalty value for the deviation, using a statistical measure, such as the KS distance (Kolmogorov-Smirnov distance).

The problem of finding the right distribution then becomes the problem of optimizing the risk functional. For example, if F is the model distribution, and G is the actual, or empirical severity distribution, and we are using the KS test, then the Risk Functional R is defined as follows:

Note that supx stands for 'supremum', which is a more technical way of saying 'maximum'. In other words, we are calculating the maximum absolute KS distance between the two distributions. (Note that the KS distance is the max of the distance between identical percentiles of the two distributions using the CDFs of the two.)

Once the risk functional is identified, we can minimize it to determine the best fitting distribution for severity.

Analytical or parametric approaches are not useful at all for liquidity at risk calculations because there are no neat distributions available to parameterize the large number of factors that affect the calculations of liquidity inflows and outflows. Historical simulations, Monte Carlo and scenario analysis (which can complement historical scenarios) are all valid choices

It is not generally sufficient to ensure the adequacy of liquidity across a group - ie it is not appropriate to just add up the sources and needs for liquidity across multiple entities in a group. This is because there can be restrictions on transferring liquidity between entities, particularly when the entities are located across borders. In cases where transfers of liquidity are permitted, there may be settlement delays in transferring funds from one entity to another. Therefore both statements I and II are incorrect.

Wholesale funding sources refers to the temporary interbank funding sources that need to be rolled over on very short intervals, often as short as overnight. These are not stable sources for long term funding. Statement III is therefore false.

Statement IV is correct as funding diversification refers to diversification of both funding sources and the duration for which the amounts are borrowed, ie tenor diversity.

Statement IV is the only correct statement and therefore Choice 'a' is the correct answer.

Incremental VaR is the change in portfolio VaR resulting from a change in a single position. This is accurately described by VaR_(p+a) - VaR_p. The other answers are incorrect, and describe other concepts.

It is important to know and understand the ideas behind MVaR (marginal VaR), CVaR (component VaR) and iVaR (incremental VaR), and the differences between them.

Explantion:

Changing leverage does not affect the Sharpe ratio or the Information ratio. However, leverage magnifies both risk and return. Therefore Choice 'b' is the correct answer.Recall that Sharpe ratio is the ratio of the excess returns (over the risk free rate) of an investment to its standard deviation, and the information ratio is the ratio of the 'alpha' returns to the standard deviation of such returns.

Historical Simulation VaR is conceptually very straightforward: actual prices as seen during the observation period (1 year, 2 years, or other) become the 'scenarios' forming the basis of the valuation of the portfolio. For each scenario, full revaluation is performed, and a P&L data set becomes available from which the desired loss quantile can be extracted.

Historical simulation is based upon actually seen prices over a selected historical period, therefore no distributional assumptions are required. The data is what the data is, and is the distribution. Statement I is therefore not correct.

It uses full revaluation for each historical scenario, therefore statement II is correct.

Since the prices are taken from actual historical observations, a correlation matrix is not required at all. Statement III is therefore incorrect (it would be true for Monte Carlo and parametric Var).

Historical simulation VaR suffers from the limitation that if enough representative data points are no available during the historical observation period from which the scenarios are drawn, the results would be inaccurate. This is likely to be the case for new products. Therefore Statement IV is incorrect.

The exact formula for VaR is = -(Zα σ + μ), where Z α is the z-multiple for the desired confidence level, and μ is the mean return. Now Zα is always a negative number, or at least will certainly be provided the desired confidence level is greater than 50%, and μ is often assumed to be zero because generally for the short time periods for which market risk VaR is calculated, its value is very close to zero.

Therefore in practice the formula for VaR just becomes -Zασ, and since Z is always negative, we normally just multiply the Z factor without the negative sign with the standard deviation to get the VaR.

For this question, there are two ways to get the answer. If we use the formula, we know that -Zασ= 250,000 (as μ=0), and therefore -Zασ - μ = 250,000 - 10,000 = $240,000.

The other, easier way to think about this is that if the mean changes, then the distribution's shape stays exactly the same, and the entire distribution shifts to the right by $10,000 as the mean moves up by $10,000. Therefore the VaR cutoff, which was previously at -250,000 on the graph also moves up by 10k to -240,000, and therefore $240,000 is the correct answer.

The other choices are intended to confuse by multiplying the z-factor for the 99% confidence level with 10,000 etc.