[Sep-2022] The PRMIA 8010 Exam Test For Brief Preparation
Revolutionary Guide To Exam PRMIA Dumps
NEW QUESTION 44
What would be the consequences of a model of economic risk capital calculation that weighs all loans equallyregardless of the credit rating of the counterparty?
I. Create an incentive to lend to the riskiest borrowers
II. Create an incentive to lend to the safest borrowers
III. Overstate economic capital requirements
IV. Understate economic capitalrequirements
- A. I only
- B. I and IV
- C. III only
- D. II and III
Answer: B
Explanation:
Explanation
If capital calculations are done in a standard way regardless of risk (as reflected by credit ratings), then it creates a perverse incentive for the lenders' employees to lend to the riskiest borrowers that offer the highest expected returns as there is no incentive to 'save' on economic capital requirements that are equal for both safe and unsafe borrowers. Therefore statement I is correct.
Given that the portfolio of suchan institution is likely to then comprise poor quality borrowers, and economic capital would be based upon 'average' expected ratings, it is likely to carry lower economic capital given its exposures. Therefore any such economic risk capital model is likely to understate economic capital requirements. Therefore statement IV is correct.
Statements II and III are incorrect and Choice 'b' is the correct answer.
NEW QUESTION 45
Which of the following cannot be used as an internal credit rating model to assess an individual borrower:
- A. Probit model
- B. Distance to default model
- C. Altman's Z-score
- D. Logit model
Answer: B
Explanation:
Explanation
Altman's Z-score, the Probit and the Logit models can all be used to assess the credit rating of an individual borrower. There is no such model as the 'distance todefault model', and therefore Choice 'a' is the correct answer.
NEW QUESTION 46
Under the contingent claims approach to credit risk, risk increases when:
I. Volatility of the firm's assets increases
II. Risk free rate increases
III. Maturity of the debt increases
- A. I and II
- B. I and III
- C. I, II and III
- D. II and III
Answer: B
Explanation:
Explanation
Under the contingent claims approach, credit risk is evaluated as the value of the put on the firm's assets with a strike price equal to the face value of the debt and maturity equal to the maturity of the obligation. The Black Scholes model can then be used to value the put, and therefore an increase in volatility and the time to expiry (ie maturity) will increase the value of the debt. An increase in the risk free rate will actually reduce the value of the put, therefore statements I and III are correct and Choice 'b' is the correct answer.
NEW QUESTION 47
Which of the following are valid approaches for extreme value analysis given a dataset:
I. The Block Maxima approach
II. Least squares approach
III. Maximum likelihood approach
IV. Peak-over-thresholds approach
- A. All of the above
- B. I and IV
- C. I, III and IV
- D. II and III
Answer: B
Explanation:
Explanation
For EVT, we use the block maxima or the peaks-over-threshold methods. These provide us the data points that can be fitted to a GEVdistribution.
Least squares and maximum likelihood are methods that are used for curve fitting, and they have a variety of applications across risk management.
NEW QUESTION 48
There are three bonds in a diversified bond portfolio, whose default probabilities are independent of each other and equal to 1%, 2% and 3% respectively over a 1 year time horizon. Calculate the probability that exactly 1 of the three bonds will default.
- A. 5.8%
- B. .011%
- C. 0%
- D. 2%
Answer: A
Explanation:
Explanation
The probability that only one of thethree bonds will default is equal to the sum of the probabilities of the three scenarios where one bond defaults and the other two survive. This probability is given by 1%*(1 - 2%)*(1 -
3%) + (1 - 1%)*2%*(1 - 3%) + (1 - 1%)*(1 - 2%)*3% = 5.7818%. Choice 'c' is the correct answer.
NEW QUESTION 49
Which of the following statements are true:
I. The set of UoMs used for frequency and severity modeling should be identical II. UoMs can be grouped together into larger combined UoMs using judgment based on the knowledge of the business III. UoMs can be grouped together into combined UoMs using statistical techniques IV. One may use separate sets of UoMs for frequency and severity modeling
- A. All of the above
- B. I, II and III
- C. IV only
- D. II, III and IV
Answer: D
Explanation:
Explanation
One may use separate UoMs for frequency and severity modeling, for example, a combined UoM may be used for estimating thefrequency of cyber attacks in a scenario, while the severity may be modeled using a more granular line-of-business UoM. Therefore statement I is false, while statement IV is true.Statement II is correct, UoMs can be grouped together into larger units based on the facts relating to the business, controls and the business environment. Similarly, UoMs can be grouped together based on statistical clustering techniques using the 'distance' between the units of measure and combining UoMs that are closer to eachother.
In addition, it is also possible to combine both business knowledge and statistical algorithms to combine UoMs.
NEW QUESTION 50
If X represents a matrix with ratings transition probabilities for one year, the transition probabilities for 3 years are given by the matrix:
- A. P ^ (-3)
- B. 3 [P ^ (-1)]
- C. 3 [P]
- D. P x P x P
Answer: D
Explanation:
Explanation
Assuming timeinvariance 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. ThusChoice 'b' is the correct answer.
NEW QUESTION 51
For creditrisk calculations, correlation between the asset values of two issuers is often proxied with:
- A. Transition probabilities
- B. Credit migration matrices
- C. Default correlations
- D. Equity correlations
Answer: D
Explanation:
Explanation
Asset returns are relevant for credit risk models where a default is related to the value of the assets of the firm falling below the default threshold. When assessing credit risk for portfolios with multiple credit assets, it becomes necessary to know the asset correlations of the different firms. Since this data is rarely available, it is very common to approximate asset correlations using equity prices. Equity correlations are used as proxies for asset correlation, therefore Choice 'c' is the correct answer.
NEW QUESTION 52
The VaR of a portfolio at the 99% confidence level is $250,000 when mean return is assumed to be zero. If the assumption of zero returns is changed to an assumption of returns of $10,000, what is the revised VaR?
- A. 0
- B. 1
- C. 2
- D. 3
Answer: A
Explanation:
Explanation
The exact formula for VaR is = -(Z + ), where Z is the z-multiple for the desired confidence level, and is the mean return. Now Z is always a negative number, or at least will certainly be provided the desired confidence level is greater than 50%, and 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 -Z, andsince 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 -Z= 250,000 (as
=0), and therefore -Z - = 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 upby $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.
NEW QUESTION 53
According to the Basel framework, reserves resulting from the upward revaluation of assets are considered a part of:
- A. All of the above
- B. Tier 1 capital
- C. Tier 3 capital
- D. Tier 2 capital
Answer: D
Explanation:
Explanation
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.
Tier 3 capital, or shortterm subordinated debt, is intended only to cover market risk but only at the discretion of their national authority.
NEW QUESTION 54
An operational loss severity distribution is estimated using 4 data points from a scenario. The management institutes additional controls to reduce the severity of the loss if the risk is realized, and as a result the estimated losses from a 1-in-10-year losses are halved. The 1-in-100 loss estimate however remains the same.
What would be the impact on the 99.9th percentile capital required for this risk as a result of the improvement in controls?
- A. The capital required will increase
- B. Can't say based on the information provided
- C. The capital required will stay the same
- D. The capital required will decrease
Answer: A
Explanation:
Explanation
This situation represents one of the paradoxes in estimating severity that one needs to be aware of - the improvement in controls reduces the weight of the body/middle of the distribution and moves it towards the tails (as the total probability under the curve must stay at 100%) and the distribution becomes more heavy tailed. As a result, the 99.9th percentile loss actually increases. instead of decreasing, creating a counterintuitive result. Therefore the correct answer is that the capital required will increase.
If scenario analysis produces such a result, the analyst must question if the 1 in 100 year loss severity is still accurate. If the new control has reduced the severity in the body of the distribution, the question as to why the more extreme losses have not changed should be raised.
NEW QUESTION 55
Calculate the 1-year 99% credit VaR of a portfolio of two bonds, each with a value of $1m, and the probability of default of 1% each over the next year. Assume the recovery rate to be zero, and the defaults of the two bonds to be uncorrelated to each other.
- A. 0
- B. 1
- C. 2
- D. 3
Answer: A
Explanation:
Explanation
This question requires the calculation of the credit VaR of the bonds - note that in the real exam the question may not refer to 'credit' VaR, but that canbe inferred from the context, ie because the probability of default is provided, it can only be asking for the credit VaR. (Note the difference from the market risk VaR which is driven by interest rate changes affecting the value of the bonds - there are other questions addressing that calculation).
Credit VaR = Expected Value - Worst case portfolio value at the selected percentile (ie the confidence level) Thus if we know the distribution of the portfolio value in the future, we can find out the value at the required percentile (in this case 99%), and the VaR will be the difference between this value and the expected value of the portfolio.
An important piece of information provided is that the defaults are independent, ie they are not correlated. This means joint probabilities of default or survival can be easily found by multiplying the relevant probabilities.
The following outcomes are possible:
1. Both bonds default: Probability = 1% * 1% = 0.01%. Portfolio value = $0 (because both bonds have defaulted& there is zero recovery)
2. One bond defaults and the other survives: Probability = 2 * 1% * 99% = 1.98%. Portfolio value = $1m (because one bond survives with a value of $1m and the defaulted bond has a value of $0). (Note that because there are two waysin which this can happen, ie bond 1 defaults, bond 2 survives; and bond 1 survives, bond 2 defaults, we need to multiply the probability by 2).
3. Both bonds survive: Probability = 99% * 99% = 98.01%. Portfolio value = $2m.
Expected value is therefore $1.98m (which is equal to 2 * $1m * (1 - 1%), or alternatively can also be obtained by multiplying the probabilities in the above three outcomes with the value associated with each).
The future distribution of the value of the portfolio can be constructed from the three outcomes outlined above:
a. Upto the 98.01th percentile the value of the portfolio is $2m, and the VaR is zero (being greater than the expected value, so there is nothing to lose) b. From the 98.01th percentile to the 99.99th percentile (98.01+the next 1.98%), the value of the portfolio is
$1m. VaR in this range is $0.98m (=$1.98m - $1m)
c. From the 99.99th to the 100th percentile the value of the portfolio is $0, and the VaR is $1.98m.
Since the question is asking for VaR at the 99% confidencelevel, it lies in the range in 'b' above, and therefore the VaR is $0.98m.
Therefore Choice 'c' is the correct answer and the rest are incorrect.
NEW QUESTION 56
Which of the following statements are true:
I. Credit VaR often assumes a one year time horizon, as opposed to a shorter time horizon for market risk as credit activities generally span alonger time period.
II. Credit losses in the banking book should be assessed on the basis of mark-to-market mode as opposed to the default-only mode.
III. The confidence level used in the calculation of credit capital is high when the objective is tomaintain a high credit rating for the institution.
IV. Credit capital calculations for securities with liquid markets and held for proprietary positions should be based on marking positions to market.
- A. I and II
- B. I and III
- C. I, III and IV
- D. II and III
Answer: C
Explanation:
Explanation
Statement I is correct as credit VaR calculations often use a one year time horizon. This is primarily because the cycle in respect of credit related activities, such as loan loss reviews, accounting cycles for borrowers etc last a year.
Statement II is false. There are two ways in which loss assessments in respect of credit risk can be made:
default mode, where losses are considered only in respect of default, and no losses are recognized in respect of the deterioration of the creditworthiness of the borrower (which is often expressed through a credit rating transition matrix); and the mark-to-market mode, where losses due to both defaults and credit quality are considered. The default mode is used for the loan book where the institution has lentmoneys and generally intends to hold the loan on its books till maturity. The mark to market mode is used for traded securities which are not held to maturity, or are held only for trading.
Statement III is correct. The confidence interval, or the quintile of losses used for maintaining credit ratings tends to be very high as the possibility of the institution's default needs to be remote.
Statement IV is correct too, for the reasons explained earlier.
NEW QUESTION 57
According to the Basel framework, shareholders' equity and reserves are considered a part of:
- A. Tier 1 capital
- B. All of the above
- C. Tier 2 capital
- D. Tier 3 capital
Answer: A
Explanation:
Explanation
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.
Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority.
NEW QUESTION 58
Under the CreditPortfolio View approach to credit risk modeling, which of the following best describes the conditional transition matrix:
- A. The conditional transition matrix is the transition matrix adjusted for the risk horizon being different from that of the transition matrix
- B. The conditional transition matrix is the transition matrix adjusted for the distribution of the firms' asset returns
- C. The conditional transition matrix is the unconditional transition matrix adjusted for probabilities of defaults
- D. The conditional transition matrix is the unconditional transition matrix adjusted for the state of the economy and other macro economic factors being modeled
Answer: D
Explanation:
Explanation
Under theCreditPortfolio View approach, the credit rating transition matrix is adjusted for the state of the economy in a way as to increase the probability of defaults when the economy is not doing well, and vice versa. Therefore Choice 'a' is the correct answer.The other choices represent nonsensical options.
NEW QUESTION 59
A bank expects the error rate in transaction data entry for a particular business process to be 0.005%. What is the range of expected errors in a day within +/- 2 standard deviations if there are 2,000,000 such transactions each day?
- A. 90 to 110 errors in a day
- B. 60 to 80 errors in a day
- C. 0 to 200 errors in a day
- D. 80 to 120 errors in a day
Answer: D
Explanation:
Explanation
Error rates are generally modeled using thePoisson distribution. Recall that the Poisson distribution has only one parameter - - which is its mean and also its variance.
In the given case, the mean number of errors is 2,000,000 x 0.005% = 100. Since this is the variance as well, the standard deviation is 100 = 10. Therefore the range of outcomes within 2 standard deviations of the mean is 100 +/- (2*10) = 80 to 120 errors in a day.
NEW QUESTION 60
For a corporate bond, which of the following statements is true:
I. The credit spread is equal to the default rate times the recovery rate II. The spread widens when the ratings of the corporate experience an upgrade III. Both recovery rates and probabilities of default are related to the business cycle and move in oppositedirections to each other IV. Corporate bond spreads are affected by both the risk of default and the liquidity of the particular issue
- A. III and IV
- B. I, II and IV
- C. IV only
- D. III only
Answer: A
Explanation:
Explanation
The credit spread is equal to thedefault rate times the loss given default, or stated another way, default rate times (1 - recovery rate). It is not equal to the default rate times the recovery rate. Therefore statement I is not correct.
When ratings are upgraded by rating agencies, the spread contracts and not widen. Therefore statement II is not correct.
Both recovery rates and probabilities of default are related to the business cycle, and they move in opposite directions. Economic recessions witness an increase in the default rate anda decrease in the recovery rate, and economic expansions result in a decrease in the default rate and an increase in the recovery rates when default does happen. Therefore statement III is correct.
Bond spreads incorporate both the risk of default, but also considerations of liquidity in the case of corporate bonds. Hence statement IV is correct.
NEW QUESTION 61
Once the frequency and severity distributions for loss events have been determined, which of the following is an accurate description of the process to determine a full loss distribution for operational risk?
- A. A firm wide operational risk distribution is generated by adding together the frequency and severity distributions
- B. A firm wide operational risk distribution is generated using Monte Carlo simulations
- C. A firm wide operational risk distribution is set to be equal to the product of the frequency and severity distributions
- D. The frequency distribution alone forms the basis for the loss distribution for operational risk
Answer: B
Explanation:
Explanation
Once the frequency distribution has been determined (for example, using the binomial, Poisson or the negative binomial distributions) and the severity distribution has also been determined (for example, using the lognormal, gamma or other functions), the loss distribution can be produced by a Monte Carlo simulation using successive drawings from each of these two distributions. It is assumed that the severity and frequency are independent of each other. The resulting distribution gives a distribution showing the losses for operational risk, from whichthere Op Risk VaR can be determined using the appropriate percentile.Therefore Choice 'b' is the correct answer.
NEW QUESTION 62
An assumption regarding the absence of ratings momentum is referred to as:
- A. Time invariance
- B. Markov property
- C. Ratings stability
- D. Herstatt risk
Answer: B
Explanation:
Explanation
Choice 'c' is the correct answer. The Markov property is the assumption that there is no ratings momentum, and that transition probabilities are dependent only upon where the rating currently is and where it is going to.
Where it has come from, or what the past changes in ratings have been, have no effect on the transition probabilities. ('Herstatt risk' refers to settlement risk, and is irrelevant.)
NEW QUESTION 63
There are two bonds in a portfolio, each with a market value of $50m. The probability of default of the two bonds are 0.03 and 0.08 respectively, over a one year horizon. If the probability of the two bonds defaulting simultaneously is 1.4%, what is the default correlation between the two?
- A. 25%
- B. 100%
- C. 0%
- D. 40%
Answer: A
Explanation:
Explanation
Probability of the joint default of both A and B =
We know all the numbers except default correlation, and we can solve for it.
DefaultCorrelation*SQRT(0.03*(1 - 0.03)*0.08*(1 - 0.08)) + 0.03*0.08 = 0.014.
Solving, we get default correlation = 25%
NEW QUESTION 64
Which of the following statements are true:
I. Heavy tailed parametricdistributions are a good choice for severity modeling in operational risk.
II. Heavy tailed body-tail distributions are a good choice for severity modeling in operational risk.
III. Log-likelihood is a means to estimate parameters for a distribution.
IV. Body-tail distributions allow modeling small losses differently from large ones.
- A. I and IV
- B. II, III and IV
- C. All of the above
- D. II and III
Answer: C
Explanation:
Explanation
When modeling for operational risk, we are generally concerned with tail losses - this isbecause the horizon for operational risk is 1 year at the 99.9th percentile. Since the 99.9th percentile is in the tail region, we would like to ensure that the tails are modeled as accurately as possible. Operational risk distributions are modeled usingheavy tailed distributions.
Heavy tailed parametric distributions such as log-normal, pareto and others are therefore a good choice for modeling risk severity, therefore statement I is correct.
Body-tail distributions are combinations of parametric distributions, with different types of distributions being used to model the body and the tail - this provides flexibility because small and medium losses upto a threshold can be modeled using one distribution, and losses beyond the threshold can be modeled usinga different distribution that is a better estimate of the tail. Statement II is therefore correct.
A log-likelihood function simplifies the optimization of a regular likelihood function. We generally maximize (or minimize the risk functional) a likelihoodfunction with a view to estimating the parameters of the underlying distribution. If the likelihood function is complex, it may sometimes make it mathematically easier to optimize the log of the function - as that changes exponents and multiplications toadditions, while behaving in the same way as the underlying function. Therefore statement III is correct, log-likelihood is a means to estimate parameters for a distribution.
Statement IV is correct as body-tail distributions allow modeling different partsof the distribution differently from each other.
NEW QUESTION 65
Which of the following statements is NOT true in relation to the recent financial crisis of 2007-08?
- A. Counterparty risk was difficult togauge as it was impossible to know who the counterparty's counterparties were
- B. Central banks had data on the interconnections between institutions, but poor understanding and analysis meant this data was never analyzed
- C. An intention to diversify from their core activities led all market participants to the same activities, which though appearing diversified at the bank's level, created a concentration risk at the systemic level
- D. The existence of central counterparties could have limited the damage caused by the financial crisis
Answer: B
Explanation:
Explanation
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 atiny 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.
NEW QUESTION 66
Which of the following contributed to the systemic failure during the credit crisis that began in 2007?
- A. Moral hazard from the strategy of 'originate and distribute'
- B. Inadequate attentionpaid to liquidity risk
- C. All of the above
- D. Stress tests that did not stress enough
Answer: C
Explanation:
Explanation
All the factors listed above contributed to systemic failure. Liquidity risk was not on the radar of regulators, and was a second priority for risk managers, and most of the focus was oncapital adequacy as liquidity was thought to be an unlikely problem. Liquidity, regardless of capital adequacy, was the primary cause of failure of a number of institutions during the crisis.
Similarly, stress tests proved to be much milder than the shocks that were actually experienced, and the strategy of 'originate and distribute' implied that the mortgage and other debt originators had no interest in any due diligence as they intended to package and sell the debt to other investors.
Therefore Choice 'd' is the correct answer.
NEW QUESTION 67
The loss severity distribution for operational risk loss events is generally modeled by which of the following distributions:
I. the lognormal distribution
II. The gamma density function
III. Generalized hyperbolic distributions
IV. Lognormal mixtures
- A. I, II and III
- B. I and III
- C. I, II, III and IV
- D. II and III
Answer: C
Explanation:
Explanation
All of the distributions referred to in the question can be used to model the loss severity distribution for op risk.Therefore Choice 'c' is the correct answer.
NEW QUESTION 68
For a back office function processing 15,000 transactions a day with an error rate of 10 basis points, what is the annual expected loss frequency (assume 250 days in a year)
- A. 0.06
- B. 0
- C. 1
- D. 2
Answer: B
Explanation:
Explanation
An error rate of 10 basis points means the number of errors expected in a day will be 15 (recall that 100 basis points = 1%). Therefore the total number of errors expected in a year will be 15 x250 = 3750. Choice 'a' is the correct answer.
NEW QUESTION 69
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