Free PRMIA 8010 Practice Exam with Questions & Answers

Choice 'd' is the correct answer, as laid down in the Basel II document. The other choices are incorrect.

The correct answer is choice 'b'

Both statements are accurate. Basel IIrequires 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.

For a number of processes, including many in finance, while a distribution such as the normal distribution is a good approximation of the distribution near the modal value of the variable, thesame normal distribution may not be a good estimate of the tails. For this reason, the Pareto distribution is one of the distributions that is often used to model the tails of another distribution. Generally, if you have a set of observations, and you discard all observations below a threshold, you are left with what are called 'exceedances'. The threshold needs to be reasonably far out in the tail. If from each value of the exceedances you subtract the threshold value, the resulting dataset is estimated bythe generalized Pareto distribution.

The Pareto distribution has a 'shape parameter'. The average of two Pareto distributions with tail parameters ξ1 and ξ2 (ξ is a Greek character, pronounced as 'sai' (saa-eee)), is the weighted average of ξ1 and ξ2 with weights proportional to the number of observations in the datasets underlying the distributions.

Top down approaches do not consider event frequency and severity, on the otherhand they focus on high level available data such as total capital, income volatility, peer group information on risk capital etc. Bottom up approaches focus on severity and frequency distributions for events. Statement I is therefore not correct.

Top downapproaches do indeed rely upon high level aggregate data and tend to infer operational risk capital requirements from these. Bottom up approaches look at more detailed firm specific information. Statement II is correct.

Scenario analysis requires estimating losses from risk scenarios, and allows incorporating the judgment and views of managers in addition to any data that might be available from internal or external loss databases. Statement III is correct. Therefore Choice 'b' is the correct answer.

Statement I is correct. The financial system proved to be stable against small shocks and disturbances, or shocksof 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. Financialinnovation, 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.

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 migrationson 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. Thisapproach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

The probability that the security would not default in the next 4 years is equal to the probability of survival at the end of the four years. In other words, =(1 - 3%)*(1 - 4%)*(1 - 4%)*(1 - 5%) = 84.93%. Choice 'd' is the correct answer.

Statement I is true - capital adequacy indeed is a reference to the ability of the firm to stay a 'going concern'. (Going concern is an accounting term that means the ability of the firm to continue in business without the stress of liquidation.)

Statement II is not true because even though the stated objective of regulatory capital requirements is similar to the purposes for which economic capital is calculated, regulatory capital calculations are based upon a large number of ad-hoc estimates and parameters that are 'hard-coded' into regulation, while economic capital is generally calculated for internal purposes and uses an institution's own estimates and models. They are rarely identical.

Statement II is not true as the purpose of economic capital is to provide a buffer against unexpected losses. Expected losses are covered by the P&L (or credit reserves), and not capital.

Statement IV is incorrect as even though economic capital may be calculated at very high confidence levels, that is never 100% which would require running a 'risk-free' business, which would mean there are no profits either. The level of confidence is set at a level which is an acceptable balance between the interests of the equity providers and the debt holders.

Choice 'd' represents a risk that does not arise from its holdings of mortgages. Therefore Choice 'd' is the correct answer.

All the other risks identified are correct - the bank faces interest rate, default and prepayment risks on its mortgages.

Current replacement values are a very poor measure of the credit exposure from a derivative contract, because the future value of these instruments is unpredictable, ie is stochastic, and the range of values it can take increases the further ahead in the future we look. Therefore it is common for credit exposures for derivatives to be measured using forward looking exposure profiles, which are distributions of the expected value of the derivative at the time horizon for which credit risk is being measured. To be conservative, a high enough quintile of this distribution is taken as the 'loan equivalent value' of the derivative as the exposure.Choice 'c' is the correct answer.

The notional value of derivative contracts generally tends to be quite high and unrelated to their economic value or the counterparty exposure. Therefore notional value is irrelevant.