Free GARP 2016-FRR Practice Exam with Questions & Answers | Set: 2

To convert annualized volatility to daily volatility, we can use the formula:????daily=????annual252σdaily​=252​σannual​​

Given the annualized standard deviation (volatility) of the portfolio returns is 30%, we calculate the daily volatility as follows:????daily=30%252≈30%15.87≈1.89%σdaily​=252​30%​≈15.8730%​≈1.89%

This value is closest to 1.0%, making option A the correct answer.

Cash yield curves are used to revalue loan and deposit positions in banks. The cash yield curve reflects the relationship between the yield on short-term cash instruments and their maturity. This curve is crucial for banks as it helps in determining the value of their loan and deposit portfolios, which are often sensitive to changes in short-term interest rates.

Minimizing credit risk in a bond portfolio involves selecting bonds with the highest credit quality. Investment-grade bonds are classified from AAA to BBB. Bonds rated AAA have the lowest default risk, which is a key factor in minimizing credit risk in a portfolio. When managing a bond portfolio composed of investment-grade bonds, adding bonds with the highest rating (AAA) will effectively minimize credit risk.

Interest Expense on Deposits:

Deposits = $100 million, interest rate = 3%

Interest expense = $100 million * 0.03 = $3 million

Interest Income from Loans:

Loan portfolio = $120 million, interest rate = 10%

Interest income = $120 million * 0.10 = $12 million

Net Interest Income Calculation:

Net interest income = Interest income - Interest expense = $12 million - $3 million = $9 million

References

Source: How Finance Works​

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.

The amount of Mega Bank's rate-sensitive liabilities includes the $150 million in deposits that reprice every month at LIBOR + 3%. These deposits are considered rate-sensitive liabilities because their interest rates are adjusted monthly based on LIBOR.

Comprehensive and Detailed In-Depth Explanation:

Operational risk under Basel II includes gains and losses from process failures (e.g., incorrect trade booking). This event, despite resulting in a profit, stems from an operational error, making it relevant for assessing control weaknesses and potential future losses. Option A is correct—excluding it underestimates operational risk exposure. Option B misclassifies it as market risk (the cause is operational). Option C is true but incomplete. Option D is wrong—Basel II includes near-misses and gains.

Exact Extract from Official Source:

BCBS, "Basel II: International Convergence of Capital Measurement and Capital Standards," June 2006, para. 673: "Operational risk data should include all relevant events, including those resulting in gains or near-misses, to provide a complete picture of risk exposure."

GARP FRR Study Notes, Operational Risk Section: "Events like trade errors, even if profitable, must be recorded in operational risk assessments to evaluate process reliability."

Modified duration is a key metric used to measure the sensitivity of a portfolio of assets and liabilities to changes in interest rates. It adjusts Macaulay duration to account for changes in yield, providing a moreaccurate reflection of the price sensitivity of a bond or a portfolio of bonds to interest rate changes. It is particularly useful for managing interest rate risk in a portfolio.

Correlation between two variables measures the degree to which the variables move in relation to each other. It indicates both the direction (positive or negative) and the strength (magnitude) of a relationship between the two variables. A correlation of 1 indicates a perfect positive relationship, while a correlation of -1 indicates a perfect negative relationship. A correlation of 0 means there is no linear relationship between the variables.

Comprehensive and Detailed In-Depth Explanation:

Implied volatility price risk arises from changes in the market’s expectation of future volatility, directly affecting the pricing of options via models like Black-Scholes, where implied volatility is a key input. Options prices are highly sensitive to volatility shifts, unlike:

Swaps:Sensitive to interest rate changes, not implied volatility.

Bonds:Affected by yield changes, not volatility.