PRM Certification Changed 8008 Questions

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.