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NEW QUESTION 47
The cumulative probability of default for a security for 4 years is 11.47%. The marginal probability of default for the security for year 5 is 5% during year 5. What is the cumulative probability of default for the security for 5 years?
- A. None of the above
- B. 16.47%
- C. 15.90%
- D. 5.00%
Answer: C
Explanation:
Explanation
The cumulative probability of default for the security for the 5 years is [1 - (1 - probability of default upto year
4)*(1 - probability of default in year 5)]. An easier way to think about this is that the Probability of survival till year 5 = (Probability of survival till year 4 * Probability of survival during year 5). Using the relationship that probability of default = 1 - probability of survival, we can calculate the required probability in all cases.
In this case, the cumulative probability of default for the security for 5 years = 1 - (1 - 11.47%)*(1 - 5%) =
15.8695%, therefore Choice 'c' is the correct answer.
NEW QUESTION 48
The CDS quote for the bonds of Bank X is 200 bps. Assuming a recovery rate of 40%, calculate the default hazard rate priced in the CDS quote.
- A. 2.00%
- B. 3.33%
- C. 5.00%
- D. 0.80%
Answer: B
Explanation:
Explanation
Hazard rate x Loss given default = CDS quote. In other words, Hazard rate x (1 - recovery rate) = CDS quote.
We can therefore calculate the hazard rate for this problem as 200 bps/(1 - 40%) = 3.33%.
NEW QUESTION 49
For a FX forward contract, what would be the worst time for a counterparty to default (in terms of the maximum likely credit exposure)
- A. Right after inception
- B. Roughly three-quarters of the way towards maturity
- C. At maturity
- D. Indeterminate from the given information
Answer: C
Explanation:
Explanation
With the passage of time, the range of possible values the FX contract can take increases. Therefore the maximum value of the contract, which is when the credit risk would be maximum, would be at maturity. (Note that this is different than an interest rate swap whose value at maturity approaches zero.) Therefore Choice 'a' is the correct answer and the others are incorrect.
NEW QUESTION 50
A stock that follows the Weiner process has its future price determined by:
- A. its expected return alone
- B. its current price, expected return and standard deviation
- C. its expected return and standard deviation
- D. its standard deviation and past technical movements
Answer: B
Explanation:
Explanation
The change in the price of a security that follows a Weiner process is determined by its standard deviation and expected return. To get the price itself, we need to add this change in price to the current price. Therefore the future price in a Weiner process is determined by all three of current price, expected return and standard deviation.
NEW QUESTION 51
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. 100%
- B. 25%
- C. 0%
- D. 40%
Answer: B
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.
Default Correlation*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 52
Which of the following statements is true in relation to the Supervisory Capital Assessment Program (SCAP):
I. The SCAP is an annual exercise conducted by the Treasury Department to determine the health of key financial institutions in the US economy II. The SCAP was essentially a stress test where the stress scenarios were specified by the regulators III. Capital buffers calculated under the SCAP represented the amount of capital that the institutions covered by SCAP held in excess of Basel II requirements IV. The SCAP focused on both total Tier 1 capital as well as Tier 1 common capital
- A. I and III
- B. I, II and IV
- C. II and IV
- D. I and III
Answer: C
Explanation:
Explanation
In the February of 2009, the Federal Reserve (which is the US central bank system) and other US banking regulators embarked on a simultaneous assessment of the capital held by the 19 largest US bank holding companies. This was an unprecedented exercise of a kind never undertaken before, and was known as the Supervisory Capital Assessment Program (SCAP). The purpose of the exercise was to determine the amount of additional capital (called the 'capital buffer') each of the institutions covered would need to ensure that it would have sufficient capital if the economy weakened more than was then expected. The idea was that these financial institutions would then raise additional capital equal to their respective capital buffers by the fourth quarter of 2009.
Statement I is false on two counts: firstl the SCAP was conducted by the US central bank and other regulators, and not the 'Treasury Department' (the Treasury Department in the US is the equivalent of the Ministry of Finance in may other countries). Second, the SCAP was a one time exercise, and not annual.
Statement II is correct. The regulators prescribed rates of losses on credit assets of different kinds and other macro-economic assumptions, and asked the banks to determine the extent of losses they would need to bear (in addition to calculating them independently too). Therefore the SCAP was a stress test where the scenario was prescribed by the regulators.
Statement III is false. Capital buffer under the SCAP referred to the additional capital the banks would need to have certain ratios of capital, and not 'excess' capital.
Statement IV is correct. The SCAP envisaged two capital targets: a Tier 1 capital ratio in excess of 6% at the end of 2010; and a Tier 1 common capital ratio in excess of 4%. Therefore both the total Tier 1 capital and Tier 1 common capital were targeted.
Therefore Choice 'c' is the correct answer.
NEW QUESTION 53
If the returns of an asset display a strong tendency for mean reversion, what is the relationship between annualized volatility calculated based on daily versus weekly volatilities (using the square root of time rule)?
- A. Either daily or weekly volatility will be greater, depending upon how the week went
- B. Daily volatility will be greater than weekly volatility
- C. Daily and weekly volatilities will be the same
- D. Weekly volatility will be greater than daily volatility
Answer: B
Explanation:
Explanation
If returns display mean reversion, then clearly daily volatilities will be greater than weekly volatility, both annualized using the square root of time rule. Mean reversion would imply that the deviation from the mean will be lower over a longer time period than a shorter time period, and therefore annualized volatility based on daily volatility will be greater.
NEW QUESTION 54
The Altman credit risk score considers:
- A. A historical database of the firms that have defaulted
- B. A historical database of the firms that have survived
- C. A combination of accounting measures and market values
- D. A quadratic approximation of the credit risk based on underlying risk factors
Answer: C
Explanation:
Explanation
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.
NEW QUESTION 55
Which of the following is not a possible early warning indicator in relation to the health of a counterparty?
- A. Credit rating downgrade
- B. Negative publicity
- C. A decline in the counterparty's corporate debt yield
- D. Falling stock price
Answer: C
Explanation:
Explanation
Negative publicity, a downgrade in the credit rating, a falling stock price are all pointers to potential credit problems, and the counterparty credit monitoring group of a bank should be using these as possible early indicators of an upcoming credit health problem. A decline in the yield of the debt issued by a counterparty means its spread is declining and the health of the credit is actually improving. Therefore a decline in the counterparty's corporate debt yield cannot be used as an indicator of potential credit problems.
Choice 'c' is therefore the correct answer.
NEW QUESTION 56
Which of the following statements is true in respect of a non financial manufacturing firm?
I. Market risk is not relevant to the manufacturing firm as it does not take proprietary positions II. The firm faces market risks as an externality which it must bear and has no control over III. Market risks can make a comparative assessment of profitability over time difficult IV. Market risks for a manufacturing firm are not directionally biased and do not increase the overall risk of the firm as they net to zero over a long term time horizon
- A. IV only
- B. I and II
- C. III only
- D. III and IV
Answer: C
Explanation:
Explanation
A non-financial firm such as a manufacturing company faces market risks similar to those faced by financial firms, except perhaps for not being exposed to risks from the equity markets. Non financial firms commonly face interest rate risks in respect of their debts, commodity price risks in respect of their inputs and products, and foreign currency risks in respect of their overseas operations. It is therefore not correct to say that the manufacturing firm does not face market risk because it does not take proprietary positions. While decisions on positions may not be actively taken, positions in foreign exchange (eg, through overseas debtors owing foreign currency, or liabilities in foreign currencies to overseas suppliers), commodities (through exposure to the need for raw material and inventory of finished goods) and interest rates (through debt financed, whether at fixed or floating rates) exist and create market risk much in the same way as they would for a proprietary position. Therefore statement I is incorrect.
While the firm faces market risks as an externality (as do financial firms for that matter, though often they seek such exposure to profit from their view on which way the externality will express itself), it is incorrect to say that these risks must be borne. They can be measured and hedged. Therefore statement II is incorrect.
The results of a manufacturing firm will include gains and losses arising from exposure to market risk, and will cloud the true profitability of the business. A firm with significant unhedged overseas sales may show vastly different results across time periods due to the FX gains and losses, making comparative assessment of profitability difficult. Therefore statement III is correct.
Market risks for a manufacturing firm may be directionally biased in terms of exposure, ie there may be a consistent 'long' position in a particular commodity that the firm produces, and a consistent 'short' position in the commodities consumed. In the same way, directional biases may exist in FX or interest rate exposures too.
Regardless of the bias, the existence of market risk exposures increase the volatility of the income stream and make the firm more risky, even though the long term expected returns from such exposures is zero (ie, returns may be zero but standard deviation is not). Therefore statement IV is not correct as market risks form non financial firms do increase the overall risk of the firm.
NEW QUESTION 57
Which of the following is true for the actuarial approach to credit risk modeling (CreditRisk+):
- A. The approach is based upon historical rating transition matrices
- B. The approach considers only default risk, and ignores the risk to portfolio value from credit downgrades
- C. Default correlations between obligors are accounted for using a multivariate normal model
- D. The number of defaults is modeled using a binomial distribution where the number of defaults are considered discrete events
Answer: B
Explanation:
Explanation
The actuarial model considers defaults to follow a Poisson distribution with a given mean per period, and these are binary in nature, ie a default happens or it does not happen. The model does not consider the loss of value from credit downgrades, and focuses only on defaults. The model also does not consider default correlations between obligors. Therefore Choice 'c' is the correct answer.
The other choices are not true statements that would apply to the actuarial approach.
NEW QUESTION 58
An investor enters into a 5-year total return swap with Bank A, with the investor paying a fixed rate of 6% annually on a notional value of $100m to the bank and receiving the returns of the S&P500 index with an identical notional value. The swap is reset monthly, ie the payments are exchanged monthly. On Jan 1 of the fourth year, after settling the last month's payments, the bank enters bankruptcy. What is the legal claim that the hedge fund has against the bank in the bankruptcy court?
- A. $0, as all payments on the swap are current
- B. $100m
- C. $6m
- D. The replacement value of the swap
Answer: D
Explanation:
Explanation
According to ISDA standard definitions, the legal claim for OTC derivatives is the current replacement value of the contract. Therefore Choice 'c' is the correct answer. None of the other choices are correct.
NEW QUESTION 59
Which of the following statements is NOT true in relation to the recent financial crisis of 2007-08?
- A. Counterparty risk was difficult to gauge as it was impossible to know who the counterparty's counterparties were
- B. 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
- C. Central banks had data on the interconnections between institutions, but poor understanding and analysis meant this data was never analyzed
- D. The existence of central counterparties could have limited the damage caused by the financial crisis
Answer: C
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 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.
NEW QUESTION 60
When compared to a low severity high frequency risk, the operational risk capital requirement for a medium severity medium frequency risk is likely to be:
- A. Higher
- B. Unaffected by differences in frequency or severity
- C. Lower
- D. Zero
Answer: A
Explanation:
Explanation
High frequency and low severity risks, for example the risks of fraud losses for a credit card issuer, may have high expected losses, but low unexpected losses. In other words, we can generally expect these losses to stay within a small expected and known range. The capital requirement will be the worst case losses at a given confidence level less expected losses, and in such cases this can be expected to be low.
On the other hand, medium severity medium frequency risks, such as the risks of unexpected legal claims,
'fat-finger' trading errors, will have low expected losses but a high level of unexpected losses. Thus the capital requirement for such risks will be high.
It is also worthwhile mentioning high severity and low frequency risks - for example a rogue trader circumventing all controls and bringing the bank down, or a terrorist strike or natural disaster creating other losses - will probably have zero expected losses & high unexpected losses but only at very high levels of confidence. In other words, operational risk capital is unlikely to provide for such events and these would lie in the part of the tail that is not covered by most levels of confidence when calculating operational risk capital.
Note that risk capital is required for only unexpected losses as expected losses are to be borne by P&L reserves. Therefore the operational risk capital requirements for a low severity high frequency risk is likely to be low when compared to other risks that are lower frequency but higher severity.
Thus Choice 'c' is the correct answer.
NEW QUESTION 61
Which of the following is the best description of the spread premium puzzle:
- A. The spread premium puzzle refers to observed default rates being much less than implied default rates, leading to lower credit bonds being relatively cheap when compared to their actual default probabilities
- B. The spread premium puzzle refers to AAA corporate bonds being priced at almost the same prices as equivalent treasury bonds without offering the same liquidity or guarantee as treasury bonds
- C. The spread premium puzzle refers to dollar denominated non-US sovereign bonds being priced a at significant discount to other similar USD denominated assets
- D. The spread premium puzzle refers to the moral hazard implicit in the monoline insurance market
Answer: A
Explanation:
Explanation
Choice 'a' is the correct answer. The other choices represent non-sensical statements.
NEW QUESTION 62
When compared to a high severity low frequency risk, the operational risk capital requirement for a low severity high frequency risk is likely to be:
- A. Lower
- B. Higher
- C. Unaffected by differences in frequency or severity
- D. Zero
Answer: A
Explanation:
Explanation
High frequency and low severity risks, for example the risks of fraud losses for a credit card issuer, may have high expected losses, but low unexpected losses. In other words, we can generally expect these losses to stay within a small expected and known range. The capital requirement will be the worst case losses at a given confidence level less expected losses, and in such cases this can be expected to be low.
On the other hand, medium severity medium frequency risks, such as the risks of unexpected legal claims,
'fat-finger' trading errors, will have low expected losses but a high level of unexpected losses. Thus the capital requirement for such risks will be high.
It is also worthwhile mentioning high severity and low frequency risks - for example a rogue trader circumventing all controls and bringing the bank down, or a terrorist strike or natural disaster creating other losses - will probably have zero expected losses & high unexpected losses but only at very high levels of confidence. In other words, operational risk capital is unlikely to provide for such events and these would lie in the part of the tail that is not covered by most levels of confidence when calculating operational risk capital.
Note that risk capital is required for only unexpected losses as expected losses are to be borne by P&L reserves. Therefore the operational risk capital requirements for a low severity high frequency risk is likely to be low when compared to other risks that are lower frequency but higher severity.
Thus Choice 'c' is the correct answer.
NEW QUESTION 63
An equity manager holds a portfolio valued at $10m which has a beta of 1.1. He believes the market may see a dip in the coming weeks and wishes to eliminate his market exposure temporarily. Market index futures are available and the current futures notional on these is $50,000 per contract. Which of the following represents the best strategy for the manager to hedge his risk according to his views?
- A. Liquidate his portfolio as soon as possible
- B. Sell 220 futures contracts
- C. Sell 200 futures contracts
- D. Buy 220 futures contracts
Answer: B
Explanation:
Explanation
The number of futures contracts to sell are equal to $10m x 1.1/$50,000 = 220. Liquidating his portfolio would reduce the beta to zero, but would also get rid of the bets he wants to play on. Therefore Choice 'c' is the correct answer.
(Note that futures and spot prices generally move together allowing futures positions to be used for hedging the risk against movement in spot prices. However there is a basis risk between spot and futures, therefore the a perfect hedge is never possible with futures. If interest rates move a great deal, spot and futures prices may diverge. Of course, this risk is generally quite low but may become amplified with large leveraged portfolios.
Just something to be aware of.)
NEW QUESTION 64
Which of the following represent the parameters that define a VaR estimate?
- A. confidence level and the underlying stochastic process
- B. confidence level and the holding period
- C. trading position and distribution assumption
- D. confidence level, the holding period and expected volatility
Answer: B
Explanation:
Explanation
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.
NEW QUESTION 65
Which of the following losses can be attributed to credit risk:
I. Losses in a bond's value from a credit downgrade
II. Losses in a bond's value from an increase in bond yields
III. Losses arising from a bond issuer's default
IV. Losses from an increase in corporate bond spreads
- A. II and IV
- B. I, III and IV
- C. I and II
- D. I and III
Answer: D
Explanation:
Explanation
Losses due to credit risk include the loss of value from credit migration and default events (which can be considered a migration to the 'default' category). Therefore Choice 'd' is the correct answer. Changes in spreads or interest rates are examples of market risk events.
[Discussion: It may be argued that losses from spreads changing could be categorized as credit risk and not market risk. The distinction between credit and market risk is never really watertight.
The reason I have called it market risk in this question is because spreads can change due to two reasons: first, due to the individual issuer going down in their credit rating (whether issued or perceived, as we have witnessed in Europe sovereign debt), and second due to the spread for the overall category changing due to macro fundamentals with nothing changing for the individual issuer. For example the spread between municipal bonds and treasuries may be small during boom times and may expand during recessions - regardless of how the individual issuer has been doing. Clearly, the first case is credit risk and the second is probably market risk.
A change in overall corporate bond spreads is something I would consider akin to a rate change - which is why I have called it as not a part of credit risk. But an alternative perspective may not be incorrect either.]
NEW QUESTION 66
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