All 8010 Test Inside PRMIA Questions

All the factors listed above contributed to systemic failure. Liquidity risk was not on the radar of regulators, and was a second priority for risk managers, and most of the focus was oncapital adequacy as liquidity was thought to be an unlikely problem. Liquidity, regardless of capital adequacy, was the primary cause of failure of a number of institutions during the crisis.

Similarly, stress tests proved to be much milder than the shocks that were actually experienced, and the strategy of 'originate and distribute' implied that the mortgage and other debt originators had no interest in any due diligence as they intended to package and sell the debt to other investors.

Therefore Choice 'd' is the correct answer.

According to a paper by the BCBS, here is an excellent summary of what happened. Based on this, Choice 'c' is the correct answer.

"At the outset of the crisis, mortgage default shocks played a part in the deterioration of marketprices of collateralised debt obligations (CDOs). Simultaneously, these shocks revealed deficiencies in the models used to manage and price these products. The complexity and resulting lack of transparency led to uncertainty about the value of the underlying investment. Market participants then drastically scaled down their activity in the origination and distribution markets and liquidity disappeared. The standstill in the securitisation markets forced banks to warehouse loans that were intended to be soldin the secondary markets. Given a lack of transparency of the ultimate ownership of troubled investments, funding liquidity concerns were triggered within the banking sector as banks refused to provide sufficient funds to each other. This in turn led to the hoarding of liquidity, exacerbating further the funding pressures within the banking sector. The initial difficulties in subprime mortgages also fed through to a broader range of market instruments since the drying up of market and funding liquidity forced market participants to liquidate those positions which they could trade in order to scale back risk. An increase in risk aversion also led to a general flight to quality, an example of which was the high withdrawals by households from money market funds."

The risk analyst is using the block maxima approach. The data points that result will then be used to fit a GEV distribution.

Expected shortfall refers to the expected losses beyond a specified threshold. The peaks-over-threshold approach is an alternative approach to the block maxima approach, and involves considering exceedances above a threshold. Fourier transformation is not relevant in this context, and is a non-sensical option.

The easiest way to answer this question is to ignore the joint probability of default as thatis irrelevant to expected losses. The joint probability of default impacts the volatility of the losses, but not the expected amount. One way to think about it is to think of asset portfolios, where diversification reduces risk (ie standard deviation) butthe expected returns are nothing but the average of the expected returns in the portfolio. Just as the expected returns of the portfolio are not affected by the volatility or correlations (these affect standard deviation), in the same way the joint probability of default does not affect the expected losses. Therefore the expected losses for this portfolio are simply $1m x 10% + $1m x 15% = $250,000.

This can also be seen from the lens of a joint probability distribution as follows:

There are four possibilities for this portfolio:

- Only loan A defaults: loss of $1m: 9% probability

- Only loan B defaults: loss of $1m: 14% probability

- Both loan A and B default: loss of $2m: 1% probability

- Neither A nor B default: loss of $0m: 76% probability

Therefore the expected losses on the portfolio are ($1m x 9%) + ($1m x 14%) + ($2m x 1%) + ($0m x 76%) = $250,000.

(Notes: How is the above table calculated? The totals (10%, 90%, 15% and 85%) are filled in first. The top left cell (both A & B default) is given as 1%. We can now calculate the rest of the cells as the totals are known.)