2015.

11 FRM 二级 mock 题

1． An analyst has determined that the 2-year CDS on an industrial firm has a continuously
compounded spread of 350 bps over the LIBOR curve. Assuming a 30% recovery rate in the
event of default, the estimated risk-neutral hazard rate is closest to:

A. 0.035
B. 0.050
C. 0.117
D. 0.300

2. An analyst determines that Company A has a very weak financial condition. Using a contingent
claims model, what should the analyst expect to happen if Company A’s firm value volatility
increases?

A. Senior debt value decreases and subordinated debt value remains the same.
B. Senior debt value decreases and subordinated debt value increases.
C. Senior debt value increases and subordinated debt value decreases.
D. Senior debt value decreases and subordinated debt value decreases.

3. A bank’s risk management group is reviewing several balance sheet modeling assumptions the
bank has made in constructing its stress test scenarios. Which of the following assumptions
made in a stress test scenarios would be the least conservation, and therefore, the most
inappropriate?

A. The bank assumes that returns for several different asset classes, such as real estate and
equities, become more positively correlated.
B. The bank assumes that depositors will sell risky assets held at other firms and increase
deposits at the bank.
C. The bank assumes an increased liquidity discount on bond holdings it sells during the
horizon period.
D. The bank assumes that its operating margin decreases over the stress test horizon period.

4. A bank’s risk manager is analyzing Societe Generale’s operational loss event that became public
in 2008 in order to apply the lessons learned from this event to the bank’s operational risk
management framework. Which of the following is a proper application of lessons learned as a
result of this event?

A. Banks should monitor trader’s personal bank accounts in order to detect unauthorized
trading patterns.
 B. Large expected trading gains can be assumed to be legitimate, but unexpected losses should
be investigated.
C. Traders should have extensive bank-office experience to better understand a bank’s control
processes.
D. Internal controls should be applied from a firm-wide- perspective, and limit breaches should
always be investigated.

5. A team leader is reviewing a report written by a risk analyst who backtested a 1-day 99% VaR
model at the 95% confidence level. Which statement found in the report is correct?

A. The ratio of the number of exception to the sample size should converge to 1% as the
sample size increases, assuming the VaR model is accurate.
B. Backtesting requires the assumption of normally distributed returns to calculate a test
statistic.
C. It is difficult to backtest VaR models with a confidence level less than 95% because the
number of exceptions is often too low to determine if the model is measuring risk correctly.
D. If there are too many exceptions, the model is overestimating risk and this can cause an
inefficient allocation of capital among risk-taking units.

6. A firm has been using a simple RAROC approach to make its capital decisions. A risk consultant
advises the firm that the second generation RAROC approach, the adjusted RAROC approach
(RAROC), would provide a more effective way to allocate economic capital. What is one way an
ARAROC model improves economic capital allocation decisions?

A. ARAROC applies the same hurdle rate across different business divisions.
B. ARAROC maximizes firm value instead of shareholder value.
C. ARAROC reduces the cost of debt by adjusting for tax obligations.
D. ARAROC varies the cost of equity capital based on the risk of the project.

7. The recent credit crisis has had a significant impact on derivative markets and how transactions
are conducted in them. Which of the following changes in over-counter derivative trading would
most likely directly increase an institution’s liquidity risk?

A. New regulatory requirements limiting rehypothecation of collateral.

B. The establishment of swap execution facilities and organized trading facilities.
C. The development of central trade repositories.
D. Increased use of netting to settle transactions.

8. In 2005, some asset managers had significant losses when a relative value trade, which was
modeled using a copula function, behaved in unexpected ways. In the trade, the investor went
 long credit risk by selling protection on the equity tranche of a synthetic CDO and at the same
time went short credit risk on the mezzanine tranche. To help avoid similar losses in the future, a
fund manager is studying the way this trade was modeled. Which of the following statements
most accurately describes a copula model shortcoming that contributed to the losses?

A. The copula model failed to recognize that the mezzanine tranche showed negative convexity,
which would magnify the default sensitivity.
B. The copula model used a distribution that did not fit the actual data; it should have based the
distribution on historical simulation.
C. The copula model ignored correlation, which caused the hedge to bread down as the two
tranches began to move in similar way during turbulent markets.
D. The copula model assumed a fixed correlation between the two tranches, and when
correlation fell sharply, the short position did not decrease as much as expected.

9. A risk manager is evaluating a simple two-asset portfolio. The manager assumes that the asset
returns are normally distributed with a correlation of 0.3. Current holdings and estimated
volatilities are shown in the following table:
Asset Position Volatility of Annual
Returns
X USD 1,600,000 27.00%
Y USD 800,000 20.00%
Portfolio USD 2,400,000 20.99%
If the portfolio manager sells USD 800,000 worth of X and buys USD 800,000 worth of Y, how
much will the annual 99% VaR of the portfolio decrease by?

A. USD 111,276
B. USD 157,135
C. USD 372,800
D. USD 503,280

10. The risk management team of a financial institution backtested its 95% daily VaR model using
end-of-day values from the past 250 trading days. For sample sizes over 100, a normal
distribution is assumed and model fit is assessed using a two-tailed test at the 95% confidence
level. If the exceedance rate was determined to be 8.4%, which of the following is correct?

A. Management does not reject the model because the test statistic is less than the critical
value.
B. Management does not reject the model because the test statistic is greater than the critical
value.
C. Management rejects the model because the test statistic is less than the critical value.
D. Management rejects the model because the test statistic is greater than the critical value.
11. A European call and a European put have the same strike price, the same underlying asset, the
same maturity date, and current prices of USD 7 and USD 3, respectively. The present value of
the strike price is USD 20. Under the Black-Scholes-Merton framework, if the annual dividend
yield is 0%, and the current underlying security price decreases to USD 18, then:

A. Both the delta of the call and the delta of the put increase.
B. Both the delta of the call and the delta of the put decrease.
C. The delta of the call increases and the delta of the put decreases.
D. The delta of the call decreases and the delta of the put increases.

12. A newly hired risk consultant is analyzing the historical progression of the Basel regulations to
gain a greater understanding of the market conditions that Basel has attempted to address. As
part of the analysis, the consultant reviews the three pillars that are part of Basel II. Which of the
following statements is correct with respect to the three pillars?

A. Pillar I requires that banks hold capital equal to a minimum of 6% of risk-weighted assets.
B. Pillar II recommends that supervisors supply appropriate models to banks to use in their
operational risk capital calculations.
C. Pillar II requires that banks increase their capital buffer during times of market stress.
D. Pillar III recommends that banks expand their public disclosure of their capital assets.

13. A corporate pension plan’ stock/bond asset mix recently shifted from its benchmark target
weights due to strong equity performance, but has remained within tolerance limits. The plan’s
benchmark is a blend of the S&P 500 Index and the Barclay’s Aggregate Bond Index. Data for
the plan’s managed portfolios and benchmark are given below:

Managed Actual Actual Managed

Portfolio Portfolio Return Portfolio
Component Weight Return
Equity 0.70 7.0% 4.90%
Bonds 0.30 2.0% 0.60%
Total 1.00 5.50%
Benchmark Index Benchmar Return Benchmark
Portfolio k on Portfolio
Component Weight Index Return
Equity S&P 500 0.60 6.0% 3.60%
Bonds Barclay’s 0.40 1.5% 0.60%
bond
Total 1.00 4.20%

The contribution from asset allocation and the contribution from security selection to the plan’s
 performance are most appropriately attributed as:

A. Asset allocation=0.45%; selection=0.85%

B. Asset allocation=0.50%; selection=0.80%
C. Asset allocation=0.80%; selection=0.50%
D. Asset allocation=0.85%; selection=0.45%

QUESTIONS 14 AND 15 REFER TO THE FOLLOWING INFORMATION

As part of its regulatory review, a central bank examination team is assessing the economic capital
framework of a large bank. One of the examiners’ concerns is the quality of the bank’s exposure
management. In the past, the examination team has been concerned about the bank’s collateralization
program that appeared to significantly reduce many credit exposures but failed to mitigate losses
when actual defaults occurred. Among some of the measures the team will review is how the bank
models the correlations among credit, market, and operational risks.

14. In order to identify potential sources of model risk, the examination team is reviewing
assumptions used in the bank’s economic capital models to determine if they are appropriate. If
used, which of the following assumptions would be appropriate?

A. Return correlations between financial asset classes tend to decrease during crisis
situations.
B. The operational risk distribution has a large number of small losses and very high kurtosis.
C. Under normal market conditions, market risk and operational risk are typically highly
correlated.
D. CDS protection against default risk becomes more effective during broad financial
downturns.

15. The bank holds a wide variety of derivative exposures with various counterparties, some of
which have posted collateral. In describing guidelines for evaluating the bank’s counterparty
credit risk, which of the following statements is correct?

A. Operational risks related to counterparty exposure are generally easy to quantify and
integrate into an economic capital model.
B. Wrong-way risk arises when the probability of default and loss given default increase at the
same time that the exposure to the counterparty is falling.
C. VaR models are generally preferred to simulations in assessing longer-term uncollateralized
exposures.
D. In modeling exposure, a longer forecasting period should be used for non-margined
counterparties compared to counterparties that have posted margin.
16. The CRO for a large, fully-invested, diversified fund has just estimated the portfolio VaR and
found that it significantly exceeds the fund’s policy limit due to changes in composition and
volatility of the fund’s asset mix. Assuming that the primary objective is to reduce the fund’s
level of risk, which of the following measures would be the most useful as a first step in
evaluating alternatives to reduce the fund’s portfolio VaR?

A. Component VaR
B. Incremental VaR
C. Individual VaR
D. Marginal VaR

17. A bank holds a portfolio of 1,000 CDS on a variety of underlying instruments. Each of the
underlying has a 1-year default probability of 2% and a notional value of USD 1,000. All the
positions are short credit protection. The credit risk team has estimated that there is a 5%
probability that at least 28 of these 1,000 CDS will trigger due to their underlying defaulting.
Assuming a recovery rate of 0% for each of the underlying instruments, what is the 1-year 95%
Credit VaR of this portfolio?

A. USD 7,000
B. USD 8,000
C. USD 9,000
D. USD 10,000

18. The CRO of a bank is reviewing the bank’s internal control environment to ensure its controls
reflect best practices as recommended by the Basel Committee. Which of the following
statements best describes a sound practice for having a strong internal control environment?

A. Ensure that dual control and segregation of duties are in place throughout the organization.
Encourage use of risk transfer tools, such as insurance, to replace internal operational
controls and risk management programs.
B. Maintain business continuity by discouraging vacations for key employees and traders that
exceed 1 week at a time.
C. Eliminate the use of third-party services providers by bringing the outsourced processes
in-house.

QUESTIONS 19 THROUGH 21 REFER TO THE FOLLOWING INFORMATION

Investment firm XYZ operates two euro-denominated open-ended mutual funds. One fund is a
balanced equity fund that is designed to replicate the performance of a 50%/50% blend of the FTSE
Euro Index and the Composite Index of Delta, a small eurozone country. The other fund invests in a
variety of European fixed-income instruments, including corporate and sovereign debt of Delta.
Delta’s financial markets have been strained in 2015; trading on the country’s stock exchange was
halted for approximately 5 weeks during the third quarter of 2015. Concerns about corporate defaults
and even sovereign default have risen markedly. This is reflected in the rising yields on Delta
government debt. Relevant data are shown in the charts below:

To estimate risk and correlation measures, XYZ uses the log of daily returns and a 30-trading-day
lookback window. To estimate the risk of sovereign default, XYZ relies on in-house country risk
analysis that uses a model based on the Merton model framework to estimate corporate default
probabilities. XYZ has followed these practices through all market conditions, including those
periods when observed market prices did not change due to trading stoppages.

19. The CRO of XYZ is preparing a report intended to explain some of the events of the year to date,
their impact on the funds, and expectations for going forward. Using only the information
presented, which of the following statements is correct?

A. During the period that trading was halted, XYZ’s estimated VaR of its Delta Index holdings
decreased to 0.
B. During the period that trading was halted, XYZ’s estimated correlation between its FTSE
Index and Delta Index holdings increased steadily.
C. In the days immediately following the resumption of trading, XYZ’s estimated correlation
between its FTSE Index and Delta Index holdings decreased sharply.
D. In the days immediately following the resumption of trading, XYZ’s estimated VaR of its
Delta Index holdings was at its highest level so far for the year.

20. XYZ has purchased credit protection via standard CDS on Delta corporate debt from Bank ABC
(ABC). ABC does a lot of business in Delta and is the main provider of credit commitments to
several of the corporations in Delta that XYZ has purchased credit protection on. One of ABC’s
 board members, concerned with the increasing default risk of Delta creditors, has been
pressuring ABC management to restrict further credit line drawdowns to all of its Delta
corporate clients to the extent possible. If ABC management did cancel further credit line
drawdowns to its Delta corporate clients, which of the following should XYZ be most concerned
about?

A. XYZ will have to make higher payments on its existing Delta CDS contracts with ABC.
B. To replace ABC as a source of additional funding, corporations in Delta will issue stock.
C. The CDS will increase XYZ’s right-way risk with corporations in Delta.
D. XYZ’s wrong-way risk with ABC will increase.

21. Several issues have become significant concerns for XYZ’s CRO, including: the reaction of
investors in the blended equity fund to events in the market, the risk profile of the fixed-income
fund, and certain estimation procedures and reporting policies. Given the information presented,
which of the following is correct?

A. During the period that trading in Delta equities was halted, an increase in net redemptions
form the blended fund would have caused XYZ’s estimated volatility of the blended fund to
decrease.
B. Between January 2015 and the end of the second quarter of 2015, the duration of a 3-year
Delta sovereign bond increased.
C. At the end of the second quarter of 2015, the hazard rate associated with 30-year Delta
sovereign debt was significantly higher than the hazard rate on 3-year Delta sovereign debt.
D. One advantage to using the Merton model approach to estimating corporate default
probabilities in situations like that experienced in 2015 is that it does not assume that
equities are continuously traded.

22. The treasurer of a bank has recommended to the board of directors that the bank securitize its
portfolio of automobile loans. The most appropriate argument the treasurer could make in
support of this recommendation is that the securitization will:

A. Increase the bank’s total assets and total liabilities.

B. Increase the bank’s financial leverage and return on equity.
C. Remove the assets from the bank’s balance sheet.
D. Improve the underwriting standards for originating automobile loans.

23. A bank has a short position in a 39 forward rate agreement (FRA), using US Treasuries as the
reference security. All else being equal, which of the following changes will most likely increase
the VaR of this position?

A. The correlation between the 3-month and 9-month US Treasury bills increases.
B. The correlation between the 3-month and 9-month US Treasury bills decreases.
 C. The liquidity for 3-month US Treasury bills increases.
D. The VaR for 9-month US Treasury bills decreases.

24. An investment advisor is evaluating potential sources of business model risk for a portfolio of
hedge funds as part of the advisor’s due diligence process. Which of the following observations
would signal the highest potential business model risk in a hedge fund?

A. The fund relies on incentive fees to fund its operating costs.

B. The fund exhibits return volatility that is more than one standard deviation greater than the
benchmark’s return volatility.
C. The head trader has agreed not to privately hold any positions that are also held by the
hedge fund.
D. The hedge fund invests exclusively in other hedge funds.

25. A large not-for-profit organization is creating a pension plan for its employees. Two analysts,
hired to advise the firm, are debating whether the pension plan should invest a substantial
portion of its assets in emerging markets. Analyst A believes that emerging markets will provide
strong returns over the next 3 years. Analyst B agrees with this forecast, but argues for a smaller
allocation towards emerging markets as this sector could experience large losses under certain
scenarios. Analyst B’s argument is primarily concerned with:

A. Active management risk.

B. Sponsor risk.
C. Policy-mix risk.
D. Funding risk.

26. A bank measures its risk using a 1-day 95% VaR model, and the bank’s VaR backtesting report
for this model shows 12 breaches over the past 250 trading days. However, six of these breaches
occurred immediately after a breach on the previous day. A likely explanation for this is that the
bank’s VaR model:

A. Fails to capture loss amounts beyond the VaR confidence level.

B. Fails to capture serial dependence in the daily returns.
C. Assumes the distribution of daily returns is normal.
D. Uses geometric returns rather than arithmetic returns.

27. Three months ago, a pension fund entered into a long 1-year forward contract with a major
investment bank to purchase an asset. At that time, the underlying asset was priced at USD 86.0
million and the forward price was USD 89.734 million, assuming continuous compounding. The
current market price of the asset is USD 88.0 million. The risk-free rate of interest has remained
 stable at 4.25% per share and is not expected to change during the entire contract period. What is
the current credit risk exposure on the forward contract and who bears the potential credit risk?

A. USD -0.786 million; the investment bank bears the potential credit risk
B. USD -0.786 million; the pension fund bears the potential credit risk
C. USD 1.081 million; the investment bank bears the potential credit risk
D. USD 1.081 million; the pension fund bears the potential credit risk

28. CDOs are subject to moral hazard in that the originating situation could potentially sell high-risk
loans to the CDO. This moral hazard problem can most likely be reduced by:

A. Requiring the originator to geographically diversify the underlying loans sold to the CDO.
B. Structuring the CDO as an arbitrage CDO.
C. Requiring the originator to from a special purpose vehicle to purchase the loans that fund
the CDO.
D. Requiring the originator to retain a sizable equity stake in the CDO.

29. A risk analyst is estimating the 95% VaR of a portfolio consisting of two stocks, A and B, and
gathers the information shown in the table below:

Stock Current Individual Marginal VaR Beta

Position VaR
(USD) (USD)
A 2,000,000 263,177 0.068 1.3
B 3,000,000 444,110 0.080 0.9
Total 5,000,000
Which of the following is closest to the difference between the undiversified VaR and diversified
VaR of this portfolio?

A. USD 314,487
B. USD 331,287
C. USD 353,550
D. USD 376,000

30. A risk manager has been asked to report on the firm’s model risk exposure. Which of the
following statements about model risk would the risk manager find most appropriate in
preparing this report?

A. Model risk can typically be reduced through the use of copulas to estimate statistical
dependence.
B. An effective way to reduce model risk is to exclude transaction costs from the modeling
 process.
C. A model should never be used if it incorporates assumptions that are known to be invalid.
D. Estimating confidence intervals can give estimates of parameter risk, a type of model risk.

31. Risk analysts at a bank are applying the peaks-over-threshold approach to model tail losses of
their credit risk distribution. This approach implies the fitting of a generalized Pareto (GP)
distribution. An important decision in using this approach is the selection of an appropriate
threshold. In choosing the threshold, which of the following statements is correct?

A. It must be low enough so that the GP distribution has a reasonable fit, but high enough so
that sufficient observations above the threshold are obtainable.
B. It must be high enough so that the GP distribution has a reasonable fit, but low enough so
that sufficient observations above the threshold are obtainable.
C. It must be low enough so that the GP distribution has a reasonable fit, and low enough so
that sufficient observations above the threshold are obtainable.
D. It must be high enough so that the GP distribution has a reasonable fit, and high enough so
that sufficient observations above the threshold are obtainable.

32. Requiring more derivatives to be cleared through a central counterparty (CCP) runs the risk of
creating CCPs that become “too-big-to-fail”, a problem seen with the largest banks during the
credit crisis. Which of the following can most likely reduce the possibility of a CCP failure?
A. Reducing liquidity constraints by limiting the margin requirements of CCP members
B. Limiting the number of members clearing through the CCP
C. Diversifying the CCP’s business lines beyond clearing derivatives transactions
D. Requiring that other CCP members unwind all or part of the opposite side of a defaulted
position cleared by the CCP

QUESTIONS 33 THROUGH 36 REFER TO THE FOLLOWING INFORMATION

In a surprise move, the People’s Bank of China cut its daily currency reference rate against the USD,
resulting in a large devaluation of the CNY versus the USD. The CRO of CMM Bank (CMM) is
evaluating the impact of this and other events on the bank’s position.

CMM is an international bank with outstanding long-term debt denominated in USD and deposits
denominated in CNY. A significant portion of CMM’s lending portfolio is also denominated in CNY
and consists largely of loan and lines of credit to Chinese manufacturers who are heavily dependent
on imported raw materials. Other loans to non-Chinese firms with exposure to China are
denominated in USD. The bank’s portfolio investments include CNY-denominated Chinese Treasury
securities and other sovereign debt.

A portion of CMM’s retail customer base had invested on margin in the Chinese equity markets.
Over the past few months, local stock markets experienced declines in share prices. Many of CMM’s
large retail depositors experienced margin calls and had begun to draw down demand deposits to
meet them. Offsetting these outflows, however, were increases in the 3-month, 6-month and 9-month
term deposit balances at CMM of several large corporate customers. The result is that CMM’s
overall net deposit flow has been approximately CNY 0.

As a result of credit developments elsewhere in the world, several of CMM’s sovereign debt holdings
have been downgraded, some from AA to A and some from A to BBB. As a result, bid/ask spreads
have widened on many of the sovereign bonds held and traded by CMM. Despite these developments,
CMM’s sovereign debt portfolio remains exclusively investment grade with a weighted average
rating of A+.

33. CMM’s CRO is concerned about the bank’s liquidity position and is reviewing the impact of
recent events on its net stable funding ratio (NSFR). Ignoring any changes in the market value of
CMM’s sovereign debt holdings, the NSFR will:

A. Not be impacted by the sovereign credit rating changes because the overall sovereign debt
portfolio remains investment grade.
B. Be reduced due to the sovereign credit rating changes but this effect can be offset by selling
A-rated sovereign debt and investing the proceeds in gold.
C. Not be impacted by the change in demand deposits because the bank’s overall deposit level
is unchanged.
D. Be reduced due to the change in demand deposits but this effect can be offset by issuing
common stock.

34. Before the devaluation, CMM’s trading desk had established a short call options position on the
CNY-USD exchange rate that was made delta-neutral through a spot USD transaction. The
position is no longer delta-neutral and the desk would like to take steps to make it delta-neutral
again. The bank is concerned about whether this would involve buying or selling USD and the
impact this might have on liquidity. A trader suggests that, once it is made delta-neutral, the
short call options position will be an effective hedge of the bank’s long CNY exposure against
further CNY devaluations and the bank should consider increasing the size of the position
accordingly. In considering this situation, what should the CRO conclude?

A. The bank would have to buy USD to make the position delta-neutral, but the delta-neutral
short call options position is not an effective hedge against further devaluations.
B. The bank would have to sell USD to make the position delta-neutral, but the delta-neutral
short call options position is not an effective hedge against further devaluations.
C. The bank would have to buy USD to make the position delta-neutral, and the delta-neutral
short call options position is an effective hedge against further devaluations.
D. The bank would have to sell USD to make the position delta-neutral, and the delta-neutral
short call options position is an effective hedge against further devaluations.

35. The risk management group has noticed that the liquidity-adjusted VaR that is being reported by
 the sovereign debt trading desk in Hong Kong is lower than that reported by the sovereign debt
trading desk in Singapore, even on identical bond holdings. Which of the following best explains
this difference in liquidity –adjusted VaR?

A. The Hong Kong desk uses the constant spread approach and the Singapore desk uses the
exogenous spread approach.
B. The Hong Kong desk uses the exogenous spread approach and the Singapore desk uses the
constant spread approach.
C. Both desks use the endogenous price approach but the Hong Kong desk uses a higher value
for the price elasticity of demand assumption.
D. Both desks use the endogenous price approach but the Hong Kong desk uses a higher value
for the transaction cost assumption.

36. CMM has CNY-denominated loans outstanding to TVR, a manufacturing firm that generates its
revenue in CNY. To hedge some of its risk, CMM has bought CDS protection on TVR from a
bank located in the same country as TVR, Bank EP. If the default probability of TVR and the
default correlation between TVR and Bank EP suddenly increase, the value of the CDS:

A. Increases and CMM has wrong-way risk with Bank EP.

B. Decreases and CMM has wrong-way risk with Bank EP.
C. Increases and CMM has right-way risk with Bank EP.
D. Decreases and CMM has right-way risk with Bank EP.

37. A large dealer bank is reviewing the risk of its derivative trading. The group conducting the
review is preparing a report for the bank’s management committee describing risk characteristics
associated with derivatives and derivative trading. Which of these statements is most appropriate
to include?

A. Entering into derivative contracts will reduce operational risk for the bank.
B. Derivative counterparties can use a netting agreement to lower both their exposure and
collateral requirements.
C. Exchange-traded derivative contracts can be structured to serve individual derivative
counterparties’ specific needs.
D. Derivatives will generally have less liquidity risk than the underlying assets on which they
are based.

38. A pension fund has USD 100 million in assets and USD 80 million in liabilities. If the
annualized rate of return on the fund’s assets is 10% and the fund’s cost of liabilities is 8%, what
is the fund’s surplus return?

A. 2.0%
 B. 2.8%
C. 3.2%
D. 3.6%

39. As cyber-attacks against financial institutions have become more prevalent, the need to
strengthen corporate governance within institutions with respect to cyber security has increased
in importance. Which of the following practices is the most appropriate for an institution in
order to improve its corporate governance as it relates to cyber security?

A. The general counsel should identify possible stakeholders requiring feedback after a
cyber-attack.
B. The information technology department should focus primarily on providing ad hoc security
updates.
C. Security reports should be proactively sent across the organization, including to all levels of
management and the board of directors.
D. Senior management should have the largest representation in the institution’s cyber security
structure.

40. Senior management at a bank is planning to implement a risk appetite framework (RAF) and is
reviewing best practices for implementation of an RAF. Which statement best reflects an
appropriate practice in the effective implementation of an RAF?
Business line managers should determine the risk appetite for their individual business lines,
which are then combined to form the RAF.

A. The CRO should take full ownership of the RAF and be responsible for developing and
approving changes to the RAF.
B. An RAF requires the bank to establish a large number of risk limits to quantify its risk
tolerance range.
C. An RAF should help to guide the bank’s strategic planning process and improve its ability to
make strategic decisions.
D. An RAF should help to guide the bank’s strategic planning process and improve its ability
to make strategic decisions.

41. An endowment fund has received a donation of USD 800 million. The fund’s CIO has decided to
invest the USD 800 million in a portfolio that contains two actively managed portfolios, both
benchmarked to the same index. Currently, the CIO is trying to decide how to allocate the USD
800 million to these two portfolios within the overall portfolio so as to maximize the resulting
information ratio, subject to an overall 3% tracking error volatility target. Relevant statistics for
the two portfolios, the current overall portfolio, and the benchmark index are given in the
following table:
 Tracking Error Volatility Information Ratio
Portfolio 1 5.0% 0.50
Portfolio 2 5.0% 0.65
Overall Portfolio 3.0% 0.75
Benchmark Index 0.0% 0.00

Assuming the active returns of the two portfolios are independent and normally distributed and
that the fund’s risk budget is USD 55,920,000 at the 99% confidence level, the risk budget
allocation to Portfolio 1 is closest to:

A. USD 22,368,000
B. USD 27,960,000
C. USD 37,280,000
D. USD 46,600,000

42. A manager of a mutual fund that has significant credit exposure to Europe and Asia wants to
change the assumptions in the fund’s risk model. If the assumed default correlation between
bonds issued in Europe and bonds issued in Asia is increased and all other parameters remain
constant, which of the following is correct?

A. The expected loss of the fund will increase.

B. The unexpected loss of the fund will increase.
C. The expected loss of the fund will decrease.
D. The unexpected loss of the fund will decrease.

43. A risk analyst is assessing a foreign currency investment portfolio to determine the best
approach to direct small cash inflows to and outflows from the portfolio. The analysts has the
following risk report:

Current Individual β Component Percent

Position VaR VaR Contributi
(USD) on
CAD 5,000,000 495,000 0.6511 373,627 32.56%
EUR 2,000,000 363,000 1.2246 281,091 24.49%
JPY 3,000,000 594,000 1.4317 492,932 42.95%
Total 10,000,000
The analyst first simulates a hypothetical USD 10,000 inflow into the fund and then a
hypothetical USD 10,000 outflow from the fund. Assuming that minimizing portfolio VaR is the
only consideration, which currency should be purchased with the incremental inflow and sold
with the incremental outflow?
 A. CAD for inflows, EUR for outflows
B. CAD for inflows, JPY for outflows
C. EUR for inflows, CAD for outflows
D. EUR for inflows, JPY for outflows

44. A risk management unit (RMU) of an asset management firm conducts a performance evaluation
of the firm’s portfolio managers. The RMU regresses excess returns of the portfolios against
excess returns of the benchmarks relevant to the portfolios over observation periods the RMU
deems appropriate. For one portfolio manager, the regression output indicates that the intercept
is positive but not statistically significant and the slope coefficient is greater than one and
statistically significant. What is the most appropriate conclusion that can be reached from this
data regarding that portfolio manager?

A. The manager is skilled at generating excess returns, and the portfolio does not use leverage.
B. The manager is skilled at generating excess returns, and the portfolio is highly leveraged.
C. It is unclear whether the manager is skilled at generating excess returns, but the portfolio has
more systematic risk than its benchmark.
D. It is unclear whether the manager is skilled at generating excess returns, but the portfolio has
less systematic risk than its benchmark.

45. A portfolio manager is concerned about potential credit losses on a USD 250 million senior
secured bond. The current annual probability of default is 2.5%, up from 2.0% last year. In the
event of a default, the average recovery rate for senior secured bonds is 65%. What is the bond’s
current annual expected loss?

A. USD 1,750,000
B. USD 2,187,500
C. USD 4,062,500
D. USD 6,250,000

46. A financial institution has a two-way collateral support annex with a counterparty covering a
portfolio valued at USD 3,200,000. The margining terms of the collateralized portfolio include a
threshold of USD 1,500,000; a minimum transfer amount of USD 250,000; and a margin period
of risk of 12 days. Which of the following is correct regarding the impact of collateral on the
counterparty risk of the portfolio?

A. Collateral has a large impact at the beginning but little impact at the end of the exposure
profile.
B. A shorter margin period of risk lowers the impact of collateral on counterparty risk.
C. Whenever there is a minimum transfer amount, collateral impact on counterparty risk is
minimal.
 D. A higher threshold value reduces the impact of collateral on counterparty risk.
47. A risk analyst at a reinsurance company is asked to develop a risk model for catastrophic events.
The firm provides various reinsurance contracts to many insurance companies, each of which
covers different catastrophic events. To estimate the risk related to claims on multiple contracts
occurring together, the analyst is considering using multivariate extreme value theory (MEVT).
Which of the following is a correct statement regarding the application of MEVT in this
situation?

A. Proper correlation estimates are sufficient in modeling the dependence structure between
extreme events.
B. Because the events covered by the firm are typically independent of each other, correlation
estimates are not relevant in applying MEVT.
C. A major advantage of MEVT is that it can effectively model as many different catastrophic
events as desired.
D. The firm may not have enough data to model as the occurrence of each type of catastrophic
event is rare and multiple catastrophic events occurring together is even rarer.

48. An analyst for a money market mutual fund is monitoring credit markets. The fund is heavily
invested in commercial paper. Recently, there have been signs of deterioration in corporate credit
quality, and the short-term commercial paper-to-bill spread has widened. Fund investor
redemption requests are increasing significantly. In this situation, which of these statements is
most likely to describe a cause of concern for the operations manager?

A. The fund may need to sell commercial paper at a loss in order to meet the redemption
requests.
B. Regulators might require the fund to raise more capital if its net asset value falls below par.
C. Investors may face the fund to purchase CDS protection on corporate issuers at very high
rates.
D. The fund may be unable to reflect the lower credit quality in its net asset value, since it uses
the amortized cost method of accounting.

49. An investor wants to understand an investment fund’s loss potential. The fund regularly reports a
VaR figure, but the investor would like to estimate potential losses in cases where the VaR
threshold is exceeded. To respond to the investor, the fund manager calculates ES. The days with
the biggest losses over the past year, along with the returns for those days, are described in the
table below:

Date Day’s Return

January 24 -2.3%
February 3 -2.4%
April 10 -1.6%
July 31 -2.0%
 September 25 -1.1%
October 7 -0.8%
October 9 -2.1%
October 13 -1.8%
December 10 -2.3%
December 12 -1.3%
Based
on the information in the table and assuming 250 trading days in a year, what is the best
approximation for the fund’s ES using historical simulation, with 98% confidence?

A. 1.66%
B. 1.80%
C. 2.00%
D. 2.22%

50. High frequency trading is characterized by rapid placement and execution of orders in response
to information flows. The reduction of latency in executing a trade is deemed critical for both
“price takers” and “price makers”. Which of the following statements provides a justification for
reducing latency?

A. Price takers are at risk after they receive confirmation of orders being filled.
B. Price makers are at risk until they receive confirmation that money transfers have been
completed on settlements.
C. Price takers are at risk that the market moves after their orders have been filled.
D. Price makers are at risk that prices of orders they have placed will remain longer than
justified by current information.

QUESTION 51 THROUGH 54 REFER TO THE FOLLOWING INFORMATION

The CRO of a bank is concerned about the potential impact of a rising US federal funds rate on other
fixed-income instruments. To estimate the relationship between changes in the monthly average
federal funds rate and changes in the monthly average 6-month LIBOR, the CRO runs a regression
of monthly changes in 6-month LIBOR on changes in the federal funds rate and obtains the
following results:
Further, the CRO estimates that for federal funds rate increases up to 100 bps, the impact on US
Treasury note yields can be approximated with the formula TY( M)=0.9 Mx FF , where TY is the
change in the yield on a US Treasury note with maturity M (in years) and FF is the change in the
federal funds rate.

51. The CRO is evaluating the potential impact of federal funds rate increases on the credit value
adjustment (CVA) applied to positions in the bank’s derivatives portfolio. The bank uses
monthly average 6-month LIBOR, currently at 46 bps, to compute the discount factor used in
determining the appropriate CVA. Using the results of the regression analysis, what would be the
expected impact of a 25 bp increase in the average monthly federal funds rate on the CVA
associated with a USD 100 million expected exposure assuming a 6% probability of default, a
40% recovery rate, and defaults occurring in 1 year?

A. A decrease of USD 8,947

B. A decrease of USD 7,129
C. An increase of USD 7,129
D. An increase of USD 8,947

52. The bank currently uses OIS as the discount rate for valuing certain LIBOR-based forward rate
agreements (FRAs). One of the bank’s traders, with long positions in 6-month and 1-year FRAs,
has been pressuring middle-office staff to switch from OIS to LIBOR discounting. The trader
argues that making this switch will better match the cash flows from the swap with the discount
rate used to value the FRAs. If the bank switches from OIS to LIBOR discounting, which of the
following will likely result?

A. A decrease in the counterparty credit risk of the FRA positions

B. A decrease in the operational risk related to the bank’s calculation of the discount rate
C. An increase in the discounted value of the trader’s FRA positions
D. An increase in the correlation between banking sector credit quality and the discount rate.

53. The CRO is aware that the choice of the VaR mapping approach can affect how changing
interest rates impact the estimated VaR of fixed-income portfolios. As part of a presentation to
senior management on this issue, the CRO uses as an illustration a simple portfolio consisting of
a 1-year 0.5% annual-pay par bond and a 5-year 1.5% annual-pay par bond. Relevant data
related to this portfolio are given in the following table:

Term (Years) Cash Flows (USD) Current spot Zero-coupon

1-Year 5-Year rate (%) Bond VaR
(%)
1 1,005 15 0.50 0.5
2 15 0.65 1.0
 3 15 0.75 1.5
4 15 1.00 2.0
5 1,015 1.52 2.5

Assuming an increase in the federal funds rate and no change in the risk or correlation structure
of zero-coupon bonds, which of the following is correct?

A. Using principal mapping, VaR will decrease.

B. Using duration mapping, VaR will decrease.
C. Using cash-flow mapping, diversified VaR will not change.
D. Using cash-flow mapping, undiversified VaR will increase.

54. The CEO has asked for an analysis of the impact of either raising or not raising demand deposit
rates in response to increase in short-term rates offered by competitors. All else being equal,
which of the following should the analysis include?

A. If the bank does not raise demand deposit rates, its liquidity coverage ratio would decrease.
B. If the bank does not raise demand deposit rates, its liquidity coverage ratio would not
change.
C. If the bank raises demand deposit rates, the RAROC on existing loans would increase.
D. If the bank raises demand deposit rates, the RAROC on existing loans would not change.

55. A semiconductor manufacturing company has, on date t=0, issued a 2-year floating-rate note on
which it pays LIBOR+250 bps semiannually. Also on date t=0, the company immediately enters
into a swap agreement with a bank, agreeing to pay the bank an annual fixed rate of 5% and to
receive LIBOR on the USD 105 million notional. Payment dates (t) are illustrated in the timeline
below:

The credit risk exposure, for either the bank or the semiconductor manufacturer, is most likely to
be greatest closer to:

A. Date t=0
B. Date t=2
C. Date t=3
D. Date t=4

56. A 2-year 5.0% LIBOR-for-fixed swap with a notional value of USD 1,000 is trading at par. The
1-year OIS rate is 4.0% while the 2-year OIS rate is 4.5%. Assuming annual payments and
 compounding, what is the value of the LIBOR-for-fixed swap’s floating-rate leg using OIS
discounting?

A. USD 963.81
B. USD 1,000.00
C. USD 1,009.60
D. USD 1,100.00

57. A company owns several commercial buildings. Recently, a severe storm and flooding
completely destroyed one of the buildings and the equipment inside. In order to conform to
Basel guidelines, the correct gross loss amount the company should report is most likely:

A. The construction cost of the building and the original cost of the equipment plus any
insurance premiums paid.
B. The most recently published book value of the building and equipment.
C. The current replacement cost of the building and all destroyed equipment.
D. The most recently published book value of the building and equipment minus any expected
compensation from insurance.

58. Assuming the same counterparty and notional principal, which type of credit derivative creates
the least counterparty credit exposure for the protection buyer?

A. Total return swap

B. Credit-linked note
C. Senior basket credit default swap
D. Insufficient information to determine

59. A credit analyst is reviewing the debt of GHX, a large supplier of automotive equipment. The
analyst is concerned about a downturn in the automotive industry, which is expected to last for
the next 3 years. The analyst examines historical default rates for the industry and estimates that,
in a worst-case scenario, GHX could have a constant 7% probability of default per year. Using
the worst-case scenario and assuming the independence of annual defaults, the probability that
GHX will default during the next 3 years is closet to:

A. 7%
B. 20%
C. 21%
D. 80%
60. In 2009, the Basel Committee announced revisions to the capital requirements for market risk to
better capture the potential impact of market movements on a bank’s portfolio during times of
market stress. A bank measured the following 10-day VaR metrics at the 99% confidence level:
● Latest available VaR: EUR 180 million
● Average VaR over the previous 60 days: EUR 50 million

● Latest available stressed VaR: EUR 260 million

● Average stressed VaR over the previous 60 days: EUR 110 million
If the multiplication factor for both VaR and stressed VaR is set to 3, how much greater is the
bank’s capital requirement for market risk under the revised Basel standards than under the
original Basel guidelines?

A. EUR 260 million

B. EUR 330 million
C. EUR 360 million
D. EUR 430 million

61. A portfolio manager for a long-only diversified equity fund thinks that stock PQR has the
potential to significantly outperform the expected returns of the fund’s current portfolio on a
risk-adjusted basis. The manager is considering a pro-rata sale of 7% of the portfolio’s current
holdings and using the proceeds to establish a long position in stock PQR.
A risk manager assigned to review this proposed transaction has conducted a principal
components analysis on the fund’s current portfolio and has determined that there are 10
principal components which account for 90% of the variance in the portfolio’s returns. The
manager estimates that PQR has an expected variance approximately equal to that of the current
portfolio, but the 10 principal components only account for 70% of the variance in PQR’s
returns. Furthermore, the residual error is orthogonal to the error for the existing portfolio.
If the proposed transactions are completed, which of the following will be correct?

A. The diversified VaR of the portfolio will not change.

B. The expected RAROC of the portfolio will decrease.
C. The ex-post Sharpe ratio of the portfolio will increase.
D. The marginal VaR of the transaction will be negative.

62. An analyst seeks to confirm the reported value of a trading desk’s derivatives portfolio with a
given counterparty. In order to properly reflect the credit risk of this counterparty defaulting on
its transactions, which of the following adjustments is most appropriate?

A. A funding value adjustment using the OIS rate for the collateralized transactions.
B. A debit value adjustment for the uncollateralized transactions.
C. A credit value adjustment for the entire portfolio.
D. No adjustment is needed as this risk is reflected in the no-default value of the derivatives
 traded.

63. A trainee was assigned a rotation to various desks on a trading floor. While on the equity options
desk, the trainee became familiar with the use of the Black-Scholes-Merton (BSM) model for
pricing options. Upon moving to the fixed-income options desk, the trainee was surprised to find
that the BSM model was rarely used; the experienced traders seemed to prefer other ways of
constructing replicating portfolios to be used in pricing. What explanation best describes a
drawback in using the BSM model to price options on fixed-income securities?

A. The assumption of a constant short-term interest rate is inconsistent with the stochastic
movement of a bond price.
B. The volatility of a bond’s price movements tends to increase as the bond approaches
maturity while stock price volatility tends to decline with time.
C. It is not possible to calculate risk-neutral probabilities for interest rate movements across the
entire term structure of interest rates.
D. The BSM model assumes interest rate drift, which is not appropriate for short-dated options
on fixed-income instruments.

64. In recent years, regulators have focused more attention on pre- and post-trade risk controls for
high frequency trading. Which of the following is a characteristic of the best practice pre-trade
risk controls used by exchanges?

A. Exchanges should use the same pre-trade risk controls that trading firms with direct market
access use.
B. Exchanges should not allow market makers to set their own pre-trade limits.
C. Exchanges should not conduct pre-trade risk control until orders reach the exchange
matching engine.
D. Exchanges should set limits on the maximum order size that can be placed in the market.

65. A risk analyst at a bank has been asked to suggest distributions to be used in modeling the
frequency and severity of operational loss distributions. Which of the following combinations
would be most appropriate to use in modeling the frequency and severity of operational loss
distributions?

A. Loss frequency is modeled by a Student’s t-distribution, and loss severity is modeled by a

Weibull distribution.
B. Loss frequency is modeled by a Poisson distribution, and loss severity is modeled by a
lognormal distribution.
C. Loss frequency is modeled by a generalized Pareto distribution, and loss severity is modeled
by a chi-squared distribution.
D. Loss frequency is modeled by a negative binomial distribution, and loss severity is modeled
 by a normal distribution.

66. A bank is evaluating proposed derivative exposures to new counterparties. The bank currently
has no exposure to these firms and all of the proposed trades are within the bank’s limits on
notional exposure to new counterparties. However, the CRO has recently suggested that no new
exposures to new customers, of the type and size proposed, should incur a CVA charge of more
than USD 4 million. Based on the information in the table below, which of the proposed
derivative positions would cause a violation of the CVA-based restriction?

Positio Loss Given Probability of Expected Discount

n Default Default Exposure Factor
(USD millions)
A 60% 6% 100 0.95
B 65% 4% 120 0.95
C 70% 4% 110 0.95
D 75% 6% 95 0.95

A. Position A
B. Position B
C. Position C
D. Position D

67. an asset manager has a portfolio currently worth GBP 15 million. The portfolio's annualized
geometric return is normally distributed with a mean of 6% and a standard deviation of 15%.
assuming 250 trading days in a year, and that the current portfolio value is GBP 15 million.
which of the following is closest to the portfolio's 1-day 99% VaR?

A. GBP 229,431
B. GBP 230,488
C. GBP 324,405
D. GBP 327,965

68. A bank has hired a risk consultant to help implement best practices in estimating potential losses
over a stress test horizon period. Which of the following practices would represent the most
effective approach for the consultant to recommend?

A. Combining the results of net charge-off models and roll-rate loss models to predict retail
credit losses
B. Using a weighted-average approach to model loss given default for a portfolio of credit
exposures
C. Smoothing historical default rates to generate a ratings transition matrix
 D. Assuming increased drawdowns of credit lines prior to default

69. The use of copula functions increased prior to the financial crisis, due in part to their
applicability to certain statistical problems. Which of the following statements is correct?

A. A copula function provides the probability-weighted expected tail loss.

B. A copula function can be used to describe the relationship between the returns of assets in a
portfolio.
C. A copula function measures the VaR of the target portfolio and the benchmark VaR.
D. A copula function evaluates historical returns over time by spotting style drift easily.
70. A manager of a diversified portfolio is using a mapping approach to model the exposure to major
risk factors of derivatives held in the portfolio. In mapping each derivative to an appropriate set
of financial instruments, which of the following statements regarding the mapping process is
correct?

A. A long 36 forward rate agreement can be replicated with a short 3-month T-bill and a long
6-month T-bill.
B. A long-term currency swap that pays USD and receives JPY is equivalent to a series of long
JPY spot, long JPY bill, and short USD T-bill positions.
C. Mapping commodity forwards is less complex than mapping financial assets.
D. Principal mapping considers the timing of principal and interest payments within the
portfolio.

71. A CIO responsible for several large, diversified, mutual funds is concerned that some of the
funds may have previously unidentified biases in their alphas and has asked the CRO to prepare
a presentation on alpha neutralization for the portfolio managers. Regarding the alpha
neutralization process, which of the following statements is correct?

A. In a benchmark-neutral alpha, the optimal portfolio has an alpha of one.

B. It is not possible to make the alphas both cash-neutral and benchmark-neutral in a portfolio.
C. When risk factors affecting a position are hard to forecast, the manager should neutralize
alphas against the risk factors.
D. When the benchmark portfolio has an alpha of zero, the benchmark return is 0%.

72. The validation team at an asset management firm is preparing to backtest the firm’s portfolio
VaR model. A risk analyst has suggested backtesting with hypothetical returns as well as actual
returns. Hypothetical portfolio returns would be constructed using a combination of fixed
positions in securities and actual returns on securities. The most appropriate explanation for
using hypothetical as well as actual returns in backtesting VaR is to account:

A. For the volatility of trading returns.

 B. For the static nature of the portfolio in VaR calculation.
C. More accurately for a longer time horizon.
D. For intraday trading.

73. A collateralized loan obligation (CLO) has 100 identical loans, each priced and selling at its par
value of USD 1,000,000. The loans are floating-rate obligations that pay a fixed spread of 4.0%
over 1-month LIBOR. The CLO pays LIBOR+0.5% to the USD 75 million senior tranche, and
LIBOR+6.0% to the USD 10 million mezzanine tranche, and has an overcollateralization
account with an annual maximum of USD 1,800,000. During the first year, LIBOR is constant at
4.0%.
Two loans default with a 0% recovery rate before making their first interest payment. There are
no other defaults. Which of the cash flow patterns outlined below would result after the first
year?

Payments (USD)
Option Senior Mezzanine Equity Overcollateralizat
Tranche Tranche Tranche ion
Account
A 1,665,000 1,000,000 3,375,000 1,800,000
B 3,375,000 1,000,000 3,465,000 0
C 3,375,000 1,825,000 0 1,800,000
D 3,375,000 1,000,000 1,665,000 1,800,000

A. Option A
B. Option B
C. Option C
D. Option D

74. An analyst is evaluating the impact of convexity on the price of a 2-year zero-coupon bond. The
current 1-year and 2-year spot rates are both 5%. Market investors forecast the 1-year spot rate 1
year from now to have a 50% chance of being 4% and a 50% chance of being 6%. If applying
Jensen’s inequality, what is the correct estimate of the convexity effect?

A. -1.82bps
B. -0.86bps
C. 0.86 bps
D. 1.82bps

QUESTIONS 75 AND 76 REFER TO THE FOLLOWING INFORMATION

Alpha is a small investment management firm that specializes in trading Asian sovereign debt. Alpha
funds its positions by engaging in overnight repurchase agreements (repos) with several firms, but
primarily with Beta. Over the weekend, Alpha was informed by Beta that its repo line had been
frozen. Alpha learned that Beta had been defrauded by Gamma, another repo borrower, who had
provided false documentation of non-existent securities. Alpha feared a run by its investors as news
of the fraud spread.

75. Of the following, the biggest impact of the use of a central clearinghouse to handle the
transactions executed between Alpha, Beta, and Gamma would likely have been a reduction in:

A. Beta’s funding liquidity risk.

B. Gamma’s default risk.
C. Alpha’s lending risk.
D. Beta’s operational risk.

76. If a clearinghouse had been used to handle transactions between Alpha, Beta, and Gamma,
obligations owed between Beta and Gamma could have been netted once the fraudulent
documentation was discovered. Which of the following is the most appropriate type of netting to
use in this situation and what would be a likely additional impact from using this netting?

A. Payment netting would be used, which would reduce Beta’s counterparty risk, but this risk
would be transferred to other creditors outside the clearinghouse.
B. Payment netting would be used, which would reduce Gamma’s counterparty risk, but Beta’s
counterparty risk would be increased.
C. Closeout netting would be used, which would reduce Beta’s counterparty risk, but this risk
would be transferred to other creditors outside the clearinghouse.
D. Closeout netting would be used, which would reduce Gamma’s counterparty risk, but Beta’s
counterparty risk would be increased.

77. A firm’s risk management staff obtained a 1-day 95% VaR estimate using historical simulation
and a 100-day lookback period. The risk management staff also performed a bootstrapped
historical simulation using 1,000 resamples with replacement from the same 100-day lookback
sample. Which of the following is correct regarding these approaches?

A. The bootstrapped VaR estimate will generally be less than the historical VaR estimate.
B. The VaR estimates will be the same as both approaches use the same underlying market
data.
C. The bootstrapped VaR estimate will generally be greater than the historical VaR estimate
because of the resampling.
D. Neither the bootstrapped VaR estimate nor the historical VaR estimate assume a normal
distribution.
78. A liquidity risk manager at a bank is analyzing the liquidity cost of a USD 3 million corporate
bond position held by the bond trading desk. The position is small relative to the bond’s average
daily trading volume, so trades made by the desk do not impact the market price. The desk has
the following information about the position:
VaR (in USD) 175,000
Current spread 2.5%
Mean spread over a 30-day period 1.0%
The manager is concerned that the distribution of spreads for this bond may have excess kurtosis
and therefore assigns a value of 3 for the spread parameter, k. If the volatility of the spread is
0.3%, what is the correct approach that the bank should use to calculate its liquidity cost and the
correct liquidity-adjusted VaR (LVaR)?

A. Endogenous spread approach; LVaR=USD 176,700

B. Exogenous spread approach; LVaR=USD 203,500
C. Exogenous spread approach; LVaR=USD 226,000
D. Endogenous spread approach; LVaR=USD 250,000

79. Credit analysts are stress testing a proposed EUR 650 million loan in a portfolio to shocks in
various operational and market variables. The loan would be fully funded by deposits paying an
average annual interest rate of 2.0% and analysts have correctly calculated the RAROC to be
14.0% using the following base-case set of estimates:

Expected annual revenue: EUR 40 million

Expected loss EUR 6 million
Unexpected loss: EUR 20 million
Economic capital required: EUR 80 million
Annual operating expenses to maintain the EUR 13 million
loan
Expected rate of return on economic capital: 4.0%
The bank has an internal RAROC target of 9.5% for all the loans in its portfolio. With all other
variables held constant, which of the following shocks would cause the RAROC to fall below
the target?

A. Annual operating expenses increase by 30%.

B. The expected loss increase by 50%.
C. The interest rate paid on deposits rises to 2.5%.
D. The loan now requires EUR 100 million of economic capital.

80. The CRO of an investment bank is proposing that the board of directors authorize entering into
netting agreements with counterparties as part of the bank’s risk control.
If the netting factor is the ratio of net to gross exposure, which of the following graphs best
illustrates the relationship between the number of netted positions and the benefits of
diversification (1-netting factor), assuming that all future values follow a multivariate normal
distribution with a constant average correlation?

A. Graph 1
B. Graph 2
C. Graph 3
D. Graph 4