8008 PRMIA PRM Certification - Exam III: Risk Management Frameworks, Operational Risk, Credit Risk, Counterparty Risk, Market Risk, ALM, FTP - 2015 Edition Free Practice Exam Questions (2025 Updated)

Explanation

If the risks are considered perfectly positively correlated, ie assumed to have a correlation equal to 1, the standard deviations can simply be added together. This gives the most conservative estimate of combined risk for capital calculation purposes. In practice, this is the assumption used most often.

If risks are uncorrelated, ie correlation is assumed to be zero, variances can be added or the standard deviation is the root of the sum of the squares of the individual standard deviations. This obviously gives a number lower than that given when correlation is assumed to be +1.

Similarly, assumptions of negative correlation, or any correlation other than +1 will give a standard deviation number that is smaller and therefore less conservative. Choice 'b' is the correct answer.

The minimum multiplication factor specified under Basel II is 3. Therefore the correct answer is Choice 'a'. The exact requirements are laid down below.

Each bank must meet, on a daily basis, a capital requirement expressed as the higher of (i) its previous day’s value-at-risk number measured according to the parameters specified in this section and (ii) an average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by a multiplication factor.

The multiplication factor will be set by individual supervisory authorities on the basis of their assessment of the quality of the bank’s risk management system, subject to an absolute minimum of 3. Banks will be required to add to this factor a “plus” directly related to the ex-post performance of the model, thereby introducing a built in positive incentive to maintain the predictive quality of the model. The plus will range from 0 to 1 based on the outcome of so-called “backtesting.”

VaR is specified by just two parameters - the holding period, and the confidence level. We speak of, for example, a 10-day VaR at the 95% confidence level. No other parameters are required. Therefore Choice 'd' is the correct answer and the others are incorrect.

The state of the economy, credit quality of individual borrowers and concentration risk are all factors that affect the credit risk facing a lender. Mark to market accounting does not change the credit risk, or the underlying economic reality facing the institution. Therefore Choice 'b' is the correct answer.

Assuming time invariance and the Markov property, it is easy to calculate the transition matrix for any time period as P^n, where P is the given transition matrix for one period and n the number of time periods that we need to compute the new transition matrix for. Thus Choice 'b' is the correct answer.

The second order approximation of the VaR of an options position is given by [Option delta x Underlying's VaR - Option gamma/2 x (Underlying's VaR)^2]. Therefore, a higher gamma reduces VaR and a lower gamma increases VaR. Hence Choice 'b' is the correct answer.

In statistics, which is relevant to risk management, a distinction is often drawn between 'frequentists' and 'Bayesians'. Frequentists rely upon data to draw conclusions as to probabilities. Bayesians consider conditional probabilities, ie, take into account what things are already known, and inject sometimes subjective a-priori probabilities into the calculations. Statement I describes Bayesians, and not frequentists. In reality however, the difference is merely academic. Risk managers use whichever technique best applies to the given situation without making it about ideology.

The difference between 'Knightian uncertainty' and 'Risk' is similarly academic. Knightian uncertainty refers to risk that cannot be measured or calculated. 'Risk' on the other hand refers to things for which past data exists and calculations of exposure can be made. To give an example in the context of the financial world, the risk from a pandemic creating systemic failures from a failure of payment and settlement systems and the like is 'Knightian uncertainty', but the market risk from equity price movements can be modeled (albeit with limitations) and is calculable. Statement II is therefore correct.

Once a risk is identified, it can be mitigated, accepted, avoided or eliminated, or transferred by way of insurance. Therefore statement III is correct.

Confidence accounting is a conceptual idea that suggests that accounting statements make reference to ranges as opposed to point estimates in financial statements. For example, instead of saying that the pension obligation is $xx million, the company should say the pension obligation is in a range of $xx m - $yy m with a certain confidence level. Statement IV is therefore inaccurate.

Counterparty risk was difficult to gauge as it was impossible to know who the counterparty's counterparties were - this is true as the chain of financial transactions became excessively long with no central transparency of who owed who what. Bank A's credit depended upon the health of its counterparties, whose health in turn depended upon other counterparties. Thus Choice 'd' is a correct statement.

In an attempt to diversify, banks became more like each other - chasing yield, they piled into securitized products, and chasing diversification, they piled into different types of securitized products. The system as a whole became susceptible to small shocks in the assets underlying this vast edifice of structured products. Therefore Choice 'a' represents a correct statement.

Choice 'c' does not represent a correct statement. Central banks had little data on the interconnections between institutions. They were aware of the large volumes of OTC transactions, but had no data to figure out who was connected to who, and who had what kind of exposures.

Choice 'b' represents a correct statement. Most transactions, other than exchange cleared futures trades (which were a tiny fraction of all trades) were cleared on a bilateral basis. The existence of central counterparties (CCPs) could have limited the impact of the crisis significantly as market participants would not have lost trust in each other, and the 'collateral damage' that was witnessed from a fall in housing prices, and thereby mortgage assets, would have been more contained.

The correct answer is Choice 'd'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:

1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.

2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.

3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.

4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.

5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

A bank's stress testing programme in relation to firm wide stress tests should document the type, frequency and the purpose of the programme, as well as methodologies for defining scenarios and the remedial actions envisaged. Choice 'b' is therefore a necessary attribute of a robust stress testing programme.

The programme should be supported by a robust systems infrastructure that allows the execution of periodic as well as ad-hoc stress tests at the right level (business unit, as well as firm-wide) at the right level of detail or granularity. Choice 'c' also therefore is a valid choice.

A related element is data quality - without which no stress tests can be be credible.

Therefore all the choices listed are correct and Choice 'd' is the correct answer.

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.

A high score under the probit and logit models indicates a higher default risk, while under Altman's methodology it indicates a lower default risk. Therefore Choice 'd' is the correct answer.

The correct answer is Choice 'c'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:

1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.

2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.

3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.

4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.

5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

The correct answer is choice 'd'

For settlement of interbank payments, there are broadly two kinds of systems: RTGS (Real Time Gross Systems) and Deferred Net Systems (DNS). RTGS process payments in real time, settlement by settlement, and each transaction is settled by the a clearing institution (mostly the central bank) on a gross basis without regard for other settlements affecting the counterparty. DNS systems, on the other hand, allow for debiting or crediting the accounts of counterparties at periodic intervals after netting all payments paid or received since the last settlement. The exact timing of the payments does not matter so long as a bank has sufficient funding on a net basis at settlement time. Implicit in the DNS system is the extension of credit and liquidity by the central bank to the participating banks as it is possible for a bank to issue payment instructions even without having funds so long as they can arrange for such funds prior to settlement at the end of the day. In RTGS, a bank needs to have funds to make a payment at any point, and cannot make a payment against moneys expected to be received later intra-day. RTGS systems therefore need more liquidity on the part of the participants, and consume far more liquidity than DNS arrangements. Of course, the 'liquidity' of the DNS arrangement has a cost - which is that someone is taking up settlement risk, and invariably it is the central bank. If a bank under DNS fails to settle, its transactions have to be 'unwound', ie all payments made by it have to be rolled back. This can cause other banks to trip, causing further unwinding transactions. RTGS systems do not carry this risk. Therefore statement I is not correct as RTGS consume more liquidity than DNS arrangements.

Statement II is correct. US Fedwire or European TARGET are RTGS while CHIPS is a DNS based payment system.

Statement III is not correct. Current Basel requirements do not require any disclosure in respect of liquidity risk management. A consultative paper was issued by BIS in Dec 2009 for comments from members, but it is far from final. The BIS is still reacting to the liquidity issues that arose during the 2007-09 credit crisis.

Statement IV is not correct as a CFP is like a disaster recovery plan for liquidity, ie it helps a bank plan for and think about what steps would be taken to deal with a liquidity disaster situation. It does not provide any access to central bank financing.

The exact formula for VaR is = -(Zα σ + μ), where Z α is the z-multiple for the desired confidence level, and μ is the mean return. Now Zα is always a negative number, or at least will certainly be provided the desired confidence level is greater than 50%, and μ is often assumed to be zero because generally for the short time periods for which market risk VaR is calculated, its value is very close to zero.

Therefore in practice the formula for VaR just becomes -Zασ, and since Z is always negative, we normally just multiply the Z factor without the negative sign with the standard deviation to get the VaR.

For this question, there are two ways to get the answer. If we use the formula, we know that -Zασ= 250,000 (as μ=0), and therefore -Zασ - μ = 250,000 - 10,000 = $240,000.

The other, easier way to think about this is that if the mean changes, then the distribution's shape stays exactly the same, and the entire distribution shifts to the right by $10,000 as the mean moves up by $10,000. Therefore the VaR cutoff, which was previously at -250,000 on the graph also moves up by 10k to -240,000, and therefore $240,000 is the correct answer.

The other choices are intended to confuse by multiplying the z-factor for the 99% confidence level with 10,000 etc.

The three pillars under Basel II are minimum capital requirements, supervisory review process and market discipline. Therefore statement I is false. The other two statements are accurate. Therefore Choice 'd' is the correct answer.

Generally, the probability of default is an input into determining the price of a security. However, if we know the market price of a security, we can back out the probability of default that the market is factoring into pricing that security. Market implied default probabilities are the probabilities of default priced into security prices, and can be determined from both bond prices and CDS spreads. Credit ratings issued by a credit agency do not give us 'market implied default probabilities', and neither does an internal scoring model like Altman's as these do not consider actual market prices in any way.

Therefore Choice 'b' is the correct answer and the others are not.

The Earnings Volatility approach to calculating economic capital is a top down approach that considers economic capital as being the capital required to make for the worst case fall in earnings, and calculates EC as equal to the worst case decrease in earnings capitalized at the rate of return expected of the firm. The worst case decrease in earnings, or the earnings-at-risk can only be stated at a given confidence level, and is equal to the Expected Earnings less Earnings under the worst case scenario.

Collateral, limits to avoid credit exposure concentrations, termination rights based upon credit ratings, third party guarantees and credit derivatives are all tools or instruments that financial institutions use to manage their credit risk. A cumulative accuracy plot measures the accuracy of ratings, and is not a tool for managing credit risk. Therefore Choice 'b' represents the correct answer.