2016-FRR GARP Financial Risk and Regulation (FRR) Series Free Practice Exam Questions (2025 Updated)

A matched book strategy involves matching every position with an offsetting position, effectively minimizing market risk. This strategy ensures that the bank's exposure to market fluctuations is neutralized, which is ideal for limiting risk exposure.

Commercial banking can be viewed as a fixed-income carry trade because banks typically engage in maturity transformation, where they borrow short-term and lend long-term.

Short-term floating-rate deposits:

Banks often attract deposits with short-term maturities and floating interest rates.

These deposits are generally considered stable and low-cost sources of funds.

Long-term fixed-rate loans:

Banks use these short-term deposits to fund long-term loans, such as mortgages or business loans, which typically have fixed interest rates.

This creates a mismatch between the interest rates and maturities of assets and liabilities.

Carry trade analogy:

The bank earns the spread between the interest it pays on short-term deposits and the interest it earns on long-term loans.

This process is similar to a carry trade, where profits are derived from the difference between borrowing costs and investment returns.

Thus, commercial banking inherently involves aspects of a carry trade through the practice of borrowing short-term to lend long-term.

References

Source: How Finance Works​

Current VaR: The bank has an existing VaR estimate of $100 million.

Standalone VaR for New Transaction: The standalone VaR of the new transaction is $5 million.

Correlation with Current Portfolio: The correlation of the new transaction with the current portfolio is 0.35.

Formula for Combined VaR:

New VaR=(Current VaR2)+(Standalone VaR2)+2×Correlation×Current VaR×Standalone VaR\text{New VaR} = \sqrt{(\text{Current VaR}^2) + (\text{Standalone VaR}^2) + 2 \times \text{Correlation} \times \text{Current VaR} \times \text{Standalone VaR}}New VaR=(Current VaR2)+(Standalone VaR2)+2×Correlation×Current VaR×Standalone VaR​

Plugging in the values:

New VaR=(1002)+(52)+2×0.35×100×5=10000+25+350=10375≈101.86\text{New VaR} = \sqrt{(100^2) + (5^2) + 2 \times 0.35 \times 100 \times 5} = \sqrt{10000 + 25 + 350} = \sqrt{10375} \approx 101.86New VaR=(1002)+(52)+2×0.35×100×5​=10000+25+350​=10375​≈101.86

References

Source: How Finance Works​

Comprehensive and Detailed In-Depth Explanation:

Loan loss reserves (LLR) are provisions for expected credit losses (ECL), but under traditional accounting (e.g., IAS 39), they were based on incurred losses (losses already evident), not forward-looking ECL as per IFRS 9 or CECL. Historically, LLR often exceeded ECL because banks conservatively reserved for incurred losses plus a buffer, reflecting a lag between expected and realized risk. Option C ("expected vs. incurred risk") captures this distinction. Option A (funded commitments) affects exposure, not reserves. Option B (forward-view period) applies to IFRS 9 ECL, not why reserves exceed ECL. Option D (write-down vs. financial loss) is unrelated to reserve levels. Basel II and GARP clarify this accounting vs. regulatory tension.

Exact Extract from Official Source:

BCBS, "Basel II: International Convergence of Capital Measurement and Capital Standards," June 2006, para. 43: "Provisions or loan loss reserves are established to cover expected credit losses, but under certain accounting standards, they reflect incurred losses, often leading to higher reserves than purely expected losses to account for uncertainty."

GARP FRR Study Notes, Credit Risk Section: "Loan loss reserves traditionally exceed expected credit losses due to the incurred loss model, which contrasts with the forward-looking expected loss approach introduced in newer standards like IFRS 9."

To hedge equity exposure without buying or selling shares of stock or rebalancing the portfolio, a risk manager can use derivatives. One effective method is:

Short Total Return Swap (TRS) Position:By entering into a short TRS, the risk manager agrees to pay the total return of the equity (including any dividends and capital gains) to the counterparty, effectively offsetting the exposure to the equity's performance. This allows the manager to hedge the risk without having to liquidate any holdings or reallocate the portfolio.

Avoiding Portfolio Rebalancing:This method avoids the transaction costs and potential market impact of rebalancing the portfolio through buying or selling actual shares.

Floating rate bonds have coupon payments that are tied to a floating interest rate or index, such as LIBOR. This means their coupon payments adjust periodically with changes in the underlying interest rates. Due to this mechanism, floating rate bonds typically have less price risk compared to fixed-rate bonds because their coupon payments reset in line with current market rates. Hence, floating rate bonds are generally not very sensitive to changes in interest rates since the adjustments in coupon payments help maintain their value. Therefore, the statement that floating rate bonds are very sensitive to changes in interest rates is incorrect.

Comprehensive and Detailed In-Depth Explanation:

PV01 (Present Value of a 1 basis point change) measures the change in a portfolio’s value for a 1 bp (0.01%) shift in interest rates, assuming a linear relationship. Its weakness is that it fails to capture non-linear effects (e.g., convexity) for large interest rate changes, where the actual value change deviates from the linear approximation. Option A is incorrect as PV01 ignores convexity, not overestimates it. Option C is false as PV01 is accurate for small changes. Option D is incorrect as PV01 is computationally simple. GARP’s FRR confirms this limitation in interest rate risk analysis.

Several bank events can stress the bank's liquidity position, including:

I.Maturing of Bank Debt:When a bank's debt matures, it must repay the principal amount. If the bank does not have sufficient liquid assets to meet this obligation, it can cause significant liquidity stress.

II.Repurchase Agreements (Repos):These are short-term borrowing agreements where the bank sells securities with an agreement to repurchase them at a higher price. If the market conditions change or the counterparty demands early repayment, it can put pressure on the bank's liquidity.

III.Futures Margins:Banks engaging in futures contracts must maintain margin accounts. If the market moves unfavorably, the bank might need to post additional margin, causing a liquidity crunch.

Interest rates can vary based on the term of the debt instrument. Generally, short-term interest rates are more sensitive to changes in monetary policy and economic conditions, leading to higher variability compared to long-term interest rates. This is because short-term rates are directly influenced by central bank policies, such as changes in the federal funds rate, which can lead to frequent fluctuations. Long-term rates, on the other hand, are influenced more by long-term economic expectations and inflation forecasts, which tend to be more stable over time.

Comprehensive and Detailed In-Depth Explanation:

Basel I (1988) focused on credit risk with a simple risk-weighting system (e.g., 0% for OECD government bonds, 100% for corporates) but did not account for:

B:The maturity of exposures, as risk weights were static and not adjusted for tenor (a limitation addressed in Basel II’s IRB approach).

A:It explicitly set capital requirements for OECD bonds (0%), so this is considered.

C:It linked credit risk to capital via risk-weighted assets (RWA), so this is addressed.

Value-at-Risk (VaR) can be calculated using either parametric or non-parametric methods. Parametric methods, such as the variance-covariance approach, typically assume that returns follow a normal distribution. This assumption simplifies the calculations but may not always accurately reflect the true distribution of returns, especially in the presence of skewness and kurtosis.

On the other hand, non-parametric methods, such as historical simulation or Monte Carlo simulation, do not make any assumptions about the distribution of returns. Instead, they rely on actual historical return data or simulated data to estimate the VaR, allowing for more flexibility and potentially more accurate risk assessments in cases where the return distributions deviate significantly from normality.

To achieve a strategic goal that facilitates discussion in an integrative context spanning market, credit, and operational risk factors, and encourages transparency and communication between risk disciplines, AlphaBank's management should choose the enterprise risk management (ERM) approach. ERM integrates all types of risks and promotes a comprehensive risk management culture within the organization.

The historical simulation method does not assume a normal distribution of asset returns. Instead, it uses actual historical returns to simulate future returns, thereby addressing the problem of incorrect assumptions about the normal distribution of asset returns. This approach can better capture the empirical distribution of returns, including skewness and kurtosis.

DeltaBank should consider counterparty risk on both long and short OTC option positions. OTC options do not go through a centralized exchange, making them subject to counterparty risk. Exchange-traded options have significantly lower counterparty risk because the exchange acts as the counterparty to all trades.

Comprehensive and Detailed In-Depth Explanation:

Short-selling (selling borrowed securities expecting a price drop) entails:

I:Extreme losses if prices rise unexpectedly (unlimited upside risk).

II:Borrow risk if shares become unavailable or costly to borrow.

III:Market behavior risk from coordinated actions (e.g., short squeezes).

An asset-sensitive bank has more rate-sensitive assets than rate-sensitive liabilities. This results in a positive cumulative gap, meaning the bank will benefit from rising interest rates. As interest rates increase, the income from rate-sensitive assets will increase more than the expense on rate-sensitive liabilities, improving the bank's net interest income.

When a bank has loans in the "pipeline," it means these loans are in the process of origination but have not yet been originated. During this period, the bank is exposed to both interest rate risk and credit risk.

Interest Rate Risk:This risk arises because changes in interest rates can affect the bank's profitability on these loans. If interest rates change unfavorably between the time the loan terms are set and the time the loan is actually issued, the bank might end up earning less than expected. This is particularly relevant in a volatile interest rate environment.

Credit Risk:Even though the loans are not yet originated, the bank assesses the creditworthiness of the potential borrowers during the pipeline stage. If the financial condition of a borrower deteriorates before the loan is finalized, the bank faces the risk of having to deal with a higher probability of default.

These risks are inherent to the loan origination process and are present even before the loan is officially on the bank's books.

Comprehensive and Detailed In-Depth Explanation:

Securitization involves pooling illiquid assets (e.g., mortgages, loans) and converting them into tradable securities sold to investors, thereby transferring risk and improving balance sheet liquidity. Option C is correct as it describes selling illiquid assets (e.g., loans) via securitization. Option A is vague (“exogenous liquidity” isn’t a standard term), Option B is incorrect (securitization enhances, not reduces, liquidity), and Option D is wrong (liquid assets like cash aren’t typically securitized). GARP’s FRR confirms this process.

To establish a leveraged position using exchange-traded options, a trader would benefit from attributes that increase exposure while minimizing initial cash outlay.

Higher degrees of exposure at less cash cost: Options provide significant leverage because they allow traders to control large positions with a relatively small amount of capital. This leverage is achieved through the options' pricing mechanism, where the premium paid is significantly less than the actual value of the underlying asset.

Unlimited losses for long option positions: This is not an advantage for establishing a leveraged position. In fact, long option positions have limited losses, confined to the premium paid.

Option positions have the same credit risks as a margined long forward: This is incorrect. Options have different risk profiles compared to margined long forwards, primarily because options confer the right but not the obligation to execute the contract.

Option positions have the same cash risks as a margined short futures purchase: This is incorrect. Options and futures have different risk and margin requirements, and they do not expose traders to the same cash risks.

Thus, the most advantageous attribute for a trader using exchange-traded options to establish a leveraged position is the higher degrees of exposure at less cash cost.

References

Source: How Finance Works​