Free PRMIA 8010 Practice Exam with Questions & Answers | Set: 7

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 tothe actuarial approach.

While conceptually VaR is a fairly straightforward concept, a number of decisions need to be made to select between the different choices available for the exact mechanism to be used for the calculations.

The Basel framework requires banks toestimate VaR at the 99% confidence level over a 10 day horizon. Yet this is a decision that needs to be explicitly made and documented. Therefore 'I' is a correct choice.

At various stages of the calculations, portfolio values need to be determined. The valuation can be done using a 'full valuation', where each position is explicitly valued; or the portfolio(s) can be reduced to a handful of risk factors, and risk sensitivities such as delta, gamma, convexity etc be used to value the portfolio. The decisionbetween the two approaches is generally based on computational efficiency, complexity of the portfolio, and the degree of exactness desired. 'II' therefore is one of the decisions that needs to be made.

The decision as to disclosing the VaR in financial filings comes after the VaR has been calculated, and is unrelated to the VaR calculation system a bank needs to set up. 'III' is therefore not a correct answer.

Though the Basel framework requires a 10-day VaR to be calculated, it also allows the calculation of the 1-day VaR and and scaling it to 10 days using the square root of time rule. The bank needs to decide whether it wishes to scale the VaR based on a 1-day VaR number, or compute VaR for a 10 day period to begin with. 'IV' therefore is a decision tobe made for setting up the VaR system.

The binomial, Poisson and the negative binomialdistributions can all be used to model the loss event frequency distribution. The omega distribution is not used for this purpose, therefore Choice 'a' is the correct answer.

Also note that the negative binomial distribution provides the best model fit because it has more parameters than the binomial or the Poisson. However, in practice the Poisson distribution is most often used due to reasons of practicality and the fact that the key model risk in such situations does not arise from the choice of an incorrect underlying distribution.

Offsetting trades with other counterparties will not reduce credit exposure to a given counterparty. All other choices represent means of reducing credit risk. Therefore Choice 'c' is the correct answer.

When modeling operational loss frequency distribution (which, for example, may be based upon a Poisson distribution) and a loss severity distribution (for example, based upon a lognormal distribution), it is assumed that the frequency of losses and the severity of the losses are completely independent and do not impact each other. Therefore Choice 'a' is correct, and the others are not validassumptions underlying the operational loss modeling.

Once each of these distributions has been built, a random number is drawn from each to determine a loss scenario. The process is repeated many times as part of a Monte Carlo simulation to get a the lossdistribution.

The capital adequacy ratio, also called the minimum capital requirement for credit risk per Basel II is 8% of riskweighted assets. The other choices are incorrect.

Error rates are generally modeled using thePoisson distribution. Recall that the Poisson distribution has only one parameter - λ - which is its mean and also its variance.

In the given case, the mean number of errors is 2,000,000 x 0.005% = 100. Since this is the variance as well, the standard deviation is √100 = 10. Therefore the range of outcomes within 2 standard deviations of the mean is 100 +/- (2*10) = 80 to 120 errors in a day.

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 atiny 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.

Economic capital is sub-additive, ie, because of the correlation being less than perfect between the risks of thedifferent business units, the total economic capital for the firm will be less than the sum of the EC for the individual business units. Therefore Choice 'b' is the correct answer.

In practice, correlations are difficult to estimate reliably, and banks often use estimates and corroborate their capital calculations with reference to a number of data points.

The point that this question is trying to emphasize is the independence of the risk management function. The risk function should be segregated from the risk taking functions as to maintain independence and objectivity.

Choice 'd', Choice 'c' and Choice 'a' run contrary to this requirement of independence, and are therefore not correct. The risk function should report directly to senior levels, for example directly to the audit committee, and not be a part of the risk taking functions.