Ultimate Guide to Prepare Free PRMIA 8008 Exam Questions & Answer
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NEW QUESTION 18
According to the implied capital model, operational risk capital is estimated as:
- A. Total capital less market risk capital less credit risk capital
- B. Operational risk capital held by similar firms, appropriately scaled
- C. Capital implied from known risk premiums and the firm's earnings
- D. Total capital based on the capital asset pricing model
Answer: A
Explanation:
Explanation
Operational risk capital estimated using the implied capital model is merely the capital that is not attributable to market or credit risk. Therefore Choice 'b' is the correct answer. All other responses are incorrect.
NEW QUESTION 19
Which of the following statements are true in relation to Monte Carlo based VaR calculations:
I. Monte Carlo VaR relies upon a full revalution of the portfolio for each simulation II. Monte Carlo VaR relies upon the delta or delta-gamma approximation for valuation III. Monte Carlo VaR can capture a wide range of distributional assumptions for asset returns IV. Monte Carlo VaR is less compute intensive than Historical VaR
- A. All of the above
- B. I, III and IV
- C. I and III
- D. II and IV
Answer: C
Explanation:
Explanation
Monte Carlo VaR computations generally include the following steps:
1. Generate multivariate normal random numbers, based upon the correlation matrix of the risk factors
2. Based upon these correlated random numbers, calculate the new level of the risk factor (eg, an index value, or interest rate)
3. Use the new level of the risk factor to revalue each of the underlying assets, and calculate the difference from the initial valuation of the portfolio. This is the portfolio P&L.
4. Use the portfolio P&L to estimate the desired percentile (eg, 99th percentile) to get and estimate of the VaR.
Monte Carlo based VaR calculations rely upon full portfolio revaluations, as opposed to delta/delta-gamma approximations. As a result, they are also computationally more intensive. Because they are not limited by the range of instruments and the properties they can cover, they can capture a wide range of distributional assumptions for asset returns. They also tend to provide more robust estimates for the tail, including portions of the tail that lie beyond the VaR cutoff.
Therefore I and III are true, and the other two are not.
NEW QUESTION 20
Which of the following are ordered correctly in the order of debt seniority in a bankruptcy situation?
I. Equity, Subordinate debt, Senior debt
II. Senior debt, Preferred stock, Equity
III. Secured debt, Accounts payable, Preferred stock
IV. Secured debt, DIP financing, Equity
- A. II, III and IV
- B. I and IV
- C. I
- D. II and III
Answer: D
Explanation:
Explanation
In a bankruptcy, equity ranks last. Preferred equity is one level above equity. Senior debt gets paid out first compared to junior debt, and secured debt is paid out first to the extent of the asset securing it (after which it counts as unsecured debt). Accounts payable and other short term liabilities are treated like unsecured creditors. Debtor-in-possession (DIP) financing ranks higher than any other asset as it is financing secured after the bankruptcy to continue the business.
Based on the above, statement I does not represent a correct ordering of seniority as equity is paid last.
Similarly, DIP financing receives higher priority than even secured debt, and therefore statement IV is incorrect. Therefore the only correct statements are II and III and Choice 'a' is the correct answer.
NEW QUESTION 21
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 distribution of the firms' asset returns
- B. The conditional transition matrix is the unconditional transition matrix adjusted for the state of the economy and other macro economic factors being modeled
- C. The conditional transition matrix is the transition matrix adjusted for the risk horizon being different from that of the transition matrix
- D. The conditional transition matrix is the unconditional transition matrix adjusted for probabilities of defaults
Answer: B
Explanation:
Explanation
Under the CreditPortfolio 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 22
Which of the following is true in relation to a Contingency Funding Plan (CFP)?
I. A CFP is like a disaster recovery plan to deal with a liquidity crisis II. A CFP should consider market stress conditions, but failures of payment systems are not relevant as they fall under the remit of operational risk III. Reputational damage may result if the market finds out that a firm has had to execute its CFP IV. Sources of emergency funding considered in the CFP should include the role of the central bank as the lender of last resort
- A. I, II and III
- B. IV
- C. I and III
- D. II and IV
Answer: C
Explanation:
Explanation
A CFP is indeed a disaster recovery plan to deal with a liquidity crisis. Therefore statement I is correct.
A CFP should consider market stress conditions, including wide scale failures of payment and settlement systems. Statement II is not correct.
It is true that reputational damage may result if a firm has to activate its CFP - therefore the plan should consider internal and external communications, the timing of information release and the groups within the firm who need to know about the implementation of the plan. Reputational damage can only make any existing liquidity problems worse. Statement III is correct.
Sources of emergency funding should not include funding from the central bank - unless as part of a regular lending facility. Its role as a lender of last resort can not be considered in a CFP. Statement IV is incorrect.
Therefore only statements I and III are correct.
NEW QUESTION 23
Which of the following statements is true:
I. Basel II requires banks to conduct stress testing in respect of their credit exposures in addition to stress testing for market risk exposures II. Basel II requires pooled probabilities of default (and not individual PDs for each exposure) to be used for credit risk capital calculations
- A. Neither statement is true
- B. II
- C. I
- D. I & II
Answer: D
Explanation:
Explanation
The correct answer is choice 'b'
Both statements are accurate. Basel II requires pooled probabilities of default to be applied to risk buckets that contain similar exposures. Also, stress testing is mandatory for both market and credit risk.
NEW QUESTION 24
Under the contingent claims approach to measuring credit risk, which of the following factors does NOT affect credit risk:
- A. Cash flows of the firm
- B. Leverage in the capital structure
- C. Volatility of the firm's asset values
- D. Maturity of the debt
Answer: A
Explanation:
Explanation
Under the contingent claims approach, credit risk is modeled as the value of a put option on the value of the firm's assets with a strike equal to the face value of the debt and maturity equal to the maturity of the obligation. The cost of credit risk is determined by the leverage ratio, the volatility of the firm's assets and the maturity of the debt. Cash flows are not a part of the equation. Therefore Choice 'a' is the correct answer.
NEW QUESTION 25
Which of the following is the most important problem to solve for fitting a severity distribution for operational risk capital:
- A. The risk functional's minimization should lead to a good estimate of the 0.999 quantile
- B. Determine plausible scenarios to fill the data gaps in the internal and external loss data
- C. The fit obtained should reduce the combination of the fitting and approximation errors to a minimum
- D. Empirical loss data needs to be extended to the ranges below the reporting threshold and above large value losses
Answer: A
Explanation:
Explanation
Ultimately, the objective of the operational risk severity estimation exercise is to calculate the 99.9th percentile loss over a one year horizon; and everything else we do with data, collecting loss information, modeling, curve fitting etc revolves around this objective. If we cannot estimate the 99.9th percentile loss accurately, then not much else matters. Therefore Choice 'a' is the correct answer.
Minimizing the combination of fitting and approximation errors is one of the things we do with a view to better estimating the operational loss distribution. Likewise, empirical loss data generally is range bound because corporations do not require employees to log losses less than an threshold, and high value losses are generally rare. This problem is addressed by extrapolating both large and small losses, something that impacts the performance of our model. Likewise, one of the objectives of scenario analysis is to fill data gaps by generating plausible scenarios. Yet while all these are real issues to address, the primary problem we are trying to solve is estimating the 0.999th quantile.
NEW QUESTION 26
Which of the following are valid approaches to leveraging external loss data for modeling operational risks:
I. Both internal and external losses can be fitted with distributions, and a weighted average approach using these distributions is relied upon for capital calculations.
II. External loss data is used to inform scenario modeling.
III. External loss data is combined with internal loss data points, and distributions fitted to the combined data set.
IV. External loss data is used to replace internal loss data points to create a higher quality data set to fit distributions.
- A. All of the above
- B. I, II and III
- C. I and III
- D. II and IV
Answer: B
Explanation:
Explanation
Internal loss data is generally the highest quality as it is relevant, and is 'real' as it has occurred to the organization. External loss data suffers from a significant limitation that the risk profiles of the banks to which the data relates is generally not known due to anonymization, and may likely may not be applicable to the bank performing the calculations. Therefore, replacing external loss data with external loss data is not a good idea. Statement IV is therefore incorrect.
All other approach described are valid approaches for the risk analyst to consider and implement. Therefore statements I, II and III are correct and IV is not.
NEW QUESTION 27
For a corporate issuer, which of the following can be used to calculate market implied default probabilities?
I. CDS spreads
II. Bond prices
III. Credit rating issued by S&P
IV. Altman's scoring model
- A. I, II and III
- B. I and II
- C. II and III
- D. III and IV
Answer: B
Explanation:
Explanation
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.
NEW QUESTION 28
Which of the following statements are correct in relation to the financial system just prior to the current financial crisis:
I. The system was robust against small random shocks, but not against large scale disturbances to key hubs in the network II. Financial innovation helped reduce the complexity of the financial network III. Knightian uncertainty refers to risk that can be quantified and measured IV. Feedback effects under stress accentuated liquidity problems
- A. I, II and IV
- B. I and IV
- C. II and III
- D. III and IV
Answer: B
Explanation:
Explanation
Statement I is correct. The financial system proved to be stable against small shocks and disturbances, or shocks of a particular type (eg, the dotcom crash, the wars in the Persian Gulf); but rather fragile against other types of shocks, including disturbances to key market participants caused by a worsening of mortgage defaults.Statement II is incorrect. Financial innovation, in particular the slicing and dicing of 'risk' through securitization, significantly increased interrelationships, dependence on the same risk factors, and the complexity of the system as a whole.Statement III is incorrect. A distinction is sometimes made between risk that is knowable, measureable, and quantifiable through parameters; and uncertainty, where the parameters are not known at all. The latter is called 'Knightian uncertainty' after the name of the scholar who came up with the distinction between the two.Statement IV is correct. Feedback effects had the greatest impact on liquidity which was tended to be hoarded, and on asset prices that tumbled as market participants tried to sell assets to become more liquid.Thus, choice is a the correct answer.
NEW QUESTION 29
Which of the following credit risk models includes a consideration of macro economic variables such as unemployment, balance of payments etc to assess credit risk?
- A. CreditPortfolio View
- B. The CreditMetrics approach
- C. The actuarial approach
- D. KMV's EDF based approach
Answer: A
Explanation:
Explanation
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).
NEW QUESTION 30
If a borrower has a default probability of 12% over one year, what is the probability of default over a month?
- A. 1.00%
- B. 1.06%
- C. 12.00%
- D. 2.00%
Answer: B
Explanation:
Explanation
Let the probability of default over a month be p. Therefore the probability of survival at the end of 12 months would be (1 - p)^12. Since the one year probability of default is 12%, we know that the probability of survival is 88%. Putting (1 - p)^12 = 88% and solving for p, we get p = 1.06%. Therefore Choice 'd' is the correct answer.
NEW QUESTION 31
What percentage of average annual gross income is to be held as capital for operational risk under the basic indicator approach specified under Basel II?
- A. 0.12
- B. 0.125
- C. 0.08
- D. 0.15
Answer: D
Explanation:
Explanation
Banks using the basic indicator approach must hold 15% of the average annual gross income for the past three years, excluding any year that had a negative gross income. Therefore Choice 'd' is the correct answer.
NEW QUESTION 32
What does a middle office do for a trading desk?
- A. Risk analysis
- B. Reconciliations
- C. Transaction data entry
- D. Operations
Answer: A
Explanation:
Explanation
The 'middle office' is a term used for the risk management function, therefore Choice 'd' is the correct answers.
The other functions describe what the 'back office' does (IT, accounting). The 'front office' includes the traders.
NEW QUESTION 33
If E denotes the expected value of a loan portfolio at the end on one year and U the value of the portfolio in the worst case scenario at the 99% confidence level, which of the following expressions correctly describes economic capital required in respect of credit risk?
- A. U/E
- B. E - U
- C. E
- D. U
Answer: B
Explanation:
Explanation
Economic capital in respect of credit risk is intended to absorb unexpected losses. Unexpected losses are the losses above and beyond expected losses and up to the level of confidence that economic capital is being calculated for. The capital required to cover unexpected losses in this case is E - U, and therefore Choice 'a' is the correct answer.
This question does raise an important point - are expected losses a part of economic capital, or are they not?
Different text books say different things, and sometimes they say both the things. I have tried to take an approach that uses what I read in the PRMIA handbook.
This
writeup - http://www.riskprep.com/all-tutorials/37-exam-3/111-credit-var-an-intuitive-understanding - may help clarify things further.
NEW QUESTION 34
For a given mean, which distribution would you prefer for frequency modeling where operational risk events are considered dependent, or in other words are seen as clustering together (as opposed to being independent)?
- A. Poisson
- B. Negative binomial
- C. Gamma
- D. Binomial
Answer: B
Explanation:
Explanation
An interesting property that distinguishes the three most used distributions for modeling event frequency is that for a given mean, their variances differ. The ratio of variance to mean (the variance-mean ratio, calculated as variance/mean) can then be used to decide the kind of distribution to use. Both the variance and the mean can be estimated from available data points from the internal or external loss databases, or the scenario exercise.
The variance-mean ratio reflects how dispersed a distribution is. (In the PRMIA handbook, the variance to mean ratio has been described as the "Q-Factor".) The Poisson distribution has its mean equal to its variance, and therefore the variance to mean ratio is 1. For the negative binomial distribution, this ratio is always greater than 1, which means there is greater dispersion compared to the mean - or more intervals with low counts as well as more intervals with high counts. For the binomial distribution, the variance to mean ratio is less than one, which means it is less dispersed than the Poisson distribution with values closer to the mean.
In a situation where operational risk events are seen as clustering together, or dependent, the variance will be higher and it would be more appropriate to use the negative binomial distribution.
NEW QUESTION 35
A zero coupon corporate bond maturing in an year has a probability of default of 5% and yields 12%. The recovery rate is zero. What is the risk free rate?
- A. 5.00%
- B. 7.00%
- C. 6.40%
- D. 5.26%
Answer: C
Explanation:
Explanation
The probability of default would make the expected value of the future cash flows from both the corporate bond and the risk free bond identical. If p be the probability of default, the cash flows from the risky corporate bond would be
= (cash flows in the event of default x probability of default) + (cash flows without default x (1 - probability of default))
=> 5%*0 + (1 - 5%)*(1 + 12%) = (1 + Rf).
therefore Rf = 6.4%
(In reality investors would demand a 'credit risk premium' over and above the expected default loss rate. They are unlikely to be happy with just being compensated with exactly the expected default loss rate plus the risk-fre rate because the expected default loss rate itself is uncertain. They would demand some premium over and above what the default rate alone might mathematically imply above the risk free rate. In this question, this credit risk premium is ignored.)
NEW QUESTION 36
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