Financial Risk and Regulation Changed 2016-FRR Questions

Risk Adjusted Return on Capital (RAROC) is the ratio of profitability to the risk of a trading portfolio or bank business unit. This measure helps in assessing how much return is generated per unit of risk, allowing banks to compare the performance of different business units and investment opportunities on a risk-adjusted basis.

A bank customer can use either a plain vanilla option or an option contract with volumetric flexibility to reduce market risk and basis risk. Market risk involves the risk of changes in market prices, and basis risk involves the risk that the derivative's price does not move perfectly with the underlying asset. Operational risk, on the other hand, involves risks related to internal processes, systems, or external events, which are not typically managed through financial derivatives like options.

References

Verified from the discussion on managing market and basis risks with options in the book "How Finance Works"​​.

Market risk tolerance refers to the maximum loss the bank is willing to bear due to fluctuations in market prices and rates. It defines the extent to which the bank is prepared to accept risk in its operations and investment strategies, helping to align its risk appetite with its strategic objectives.

When a bank looks to issue new capital to increase its Tier 1 capital levels, the following instrument is most likely considered:

Convertible Preferred Shares: These shares can be converted into common stock. They are considered part of Tier 1 capital because they have characteristics of equity, such as absorbing losses while the bank remains a going concern.

Long-term and callable debt, short-term callable debt, and short-term debt convertible to non-cumulative preferred shares do not typically qualify as Tier 1 capital because they do not provide the same level of loss absorption as equity instruments.