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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.