Free PRMIA 8005 Practice Exam with Questions & Answers | Set: 10

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.

The duration matched hedge is the best hedge for the bond manager. Matched durations in the bond portfolio and the hedge positions will ensure that any decline in the bond portfolio due to interestrate changes is matched by a rise in the futures position. Hedging dollar-to-dollar will not work unless the bonds and the futures contracts are identical in duration terms. For example, if the duration of the portfolio is 7 years, and each futures contract has a duration of 3.5 years, then selling $1m in value will only cover half the risk. Choice 'b' is the right answer.

An option on a futures contract is like any other option contract, and only the option premium is due upfront. If the option is exercised, then the futures contract comes into existence and futures margins become due in the normal way. Therefore Choice 'b' is the correct answer.

The OTC market for foreign exchange is indeed much larger than the exchange traded futures market for FX. Therefore statement I is correct.

Delivery-versus-payment (DVP) arrangements make sure that title to a security passes only whenpayment has been made, and these arrangements, usually implemented through national clearing agencies such as the DTC in the US, help avoid the risk of counterparty defaults.

Electronic Clearing Networks (ECNs) offer cheaper trading costs than exchanges, in fact that is their primary attraction. Exchanges offer other advantages, but lower trading costs is not one of them.

ISDA master agreements provide templates that a large number of OTC market participants use to standardize their OTC trading activities. Therefore statement IV is correct.

Since $100 is convertible into two shares, the price upon conversion per share is $50, which is the same as the current share price. Therefore there is no premium, and Choice 'c' is the correct answer.

Contingent premium options are options where no premiums are due upfront, and are due only at expiry and only if the option finishes in the money. (If this sounds too good to be true, remember that at expiry it is possible that the premiums due exceed the payoffs from the option. So there is no free lunch.) For this reason they are also called pay-later options.

They are simple combinations of a vanilla option and the 'right' number of cash-or-nothing options. The buyer of a contingent premium option has effectively purchased a vanilla option and sold enough number of cash-or-nothing options so that the net premium due at inception is zero.

Therefore statement I, II and III are correct and Choice 'b' is the correct answer.

Some risk experts have suggested the use of extreme value theory to model tail risk or extreme events for operational risk. The generalized Pareto model or the Peaks-over-Threshold (POT) model are often used to model extreme value distributions, and therefore Choice 'a' is the correct answer.