2010 FRM Level II
百题巅峰班讲义（下册）
讲师：吴轶 CFA FRM PRM CQF CISI
2011年05月
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Part 3 Credit Risk Management
Key Point: Joint Default Probability
Joint Default Probability P(AandB)=Corr(A,B)p(A)[1−p(A)]p(B)[1−p(B)]+p(A)p(B) 1. Consider an A-rated bond and a BBB-rated bond. Assume that the one-year probabilities of
default for the A- and BBB-rated bonds are 2% and 4%, respectively, and that the joint probability of default of the two bonds is 0.15%. What is the default correlation between the two bonds?
A. 0.07% B. 2.6% C. 93.0%
D. The default correlation cannot be calculated with the information provided.
Answer: B
Key Point: Credit Events
Downgrade from a rating agency isn’t defined as credit event.
Key Point: Default Probability Calculation dN(R)=m[t+N|R(t)] n[t+N|R(t)]SN(R)=ΠiN=1(1−di(R)) kN(R)=SN−1(R)dN(R) CN(R)=k1(R)+k2(R)+L+kN(R)=1−SN(R) NCN=1−ΠiN=1(1−di(R))=1−(1−d) 2. A portfolio consists of 17 uncorrelated bonds, each rated B. The 1-year marginal default
probability of each bond is 5.93%. Assuming an even spread of default probability over the
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year for each of the bonds, what is the probability of exactly 2 bonds defaulting in the first month?
A. B. C. D.
0.0325% 0.325% 0.024% 0.24%
Answer: B
Given a 1-year marginal default rate of 5.93%, the 1-month marginal default rate is = 0.00508. The number of combinations of 2 bonds from 17 bonds is 17.16/2, and so the probability of exactly 2 bonds defaulting in the first month is: (17*162) + 0.005082 + (1 – 0.00508)15 = 0.325%
3. A corporate bond will mature in three years. The marginal probability of default in year one
is 3%. The marginal probability of default in year two is 4%. The marginal probability of default in year three is 6%. What is the cumulative probability that default will occur during the three-year period?
A. 12.47% B. 12.76% C. 13% D. 13.55%
Answer: A
This is one minus the survival rate over three years: S3(R) = (1 − d1)(1 − d2)(1 − d3) = (1 − 0.03)(1 − 0.04)(1 − 0.06) = 0.8753. Hence, the cumulative default rate is 0.1247.
Key Point: Recovery Rate
4. Which of the following statement is incorrect?
A. Recovery rates are negatively related to default rates.
B. The distribution of recovery rates is often modeled with a gamma distribution. C. The legal environment is also a main driver of recovery rates.
D. From Moody’s, the average recovery rate for senior unsecured debt is around f = 37%.
Answer: B
The distribution of recovery rates is often modeled with a beta distribution.
Key Point: Using Spread to price Default Risk
¾ Risk-neutral PD
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y*−yy*−y'y≈y+π(1−f)⇒π≈ ⇒π=1−f(1−f)(1+y)*¾ Real PD y*≈y+πR(1−f)+LP 5. The risk-free rate is 5% per year and a corporate bond yields 6% per year. Assuming a
recovery rate of 75% on the corporate bond, what is the approximate market implied one-year probability of default of the corporate bond?
A. 1.33% B. 4.00% C. 8.00% D. 1.60%
Answer: B
6. A loan of $10 million is made to a counterparty whose expected default rate is 2% per annum
and whose expected recovery rate is 40%. Assuming an all-in cost of funds of LIBOR for the lender, what would be the fair price for the loan?
A. LIBOR + 120bp B. LIBOR + 240bp C. LIBOR − 120bp D. LIBOR + 160bp
Answer: A
7. The zero coupon bond of an A-rated company maturing in five years is trading at a spread of
1% over the zero-coupon bond of a AAA-rated company maturing at the same time. The spread can be explained by:
I. Credit risk II. Liquidity risk III. Tax differentials
A. I only
B. I and II only C. I and III only D. I, II, and III
Answer: B
Tax differentials cannot explain the difference because both bonds are corporate bonds and subject
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to taxes. By contrast, the A-rated bond has higher credit risk and possibly lower liquidity, implying a higher yield.
8. Suppose XYZ Corp. has two bonds paying semiannually according to the following table.
The recovery rate for each in the event of default is 50%. For simplicity, assume that each bond will default only at the end of a coupon period. The market-implied risk-neutral probability of default for XYZ Corp. is
Remaining Maturity
6 months 1 year
A. B. C. D.
Greater in the first six-month period than in the second Equal between the two coupon periods
Greater in the second six-month period than in the first Cannot be determined from the information provided
Coupon(30/360)
Price
T-bill rate
8% 99 5.5% 9% 100 6%
Answer: A
First, we compute the current yield on the six-month bond, which is selling at a discount. We solve for y∗ such that 99 = 104/(1 + y∗/200) and find y∗ = 10.10%. Thus, the yield spread for the first bond is 10.1 − 5.5 = 4.6%. The second bond is at par, so the yield is y∗ = 9%. The spread for the second bond is 9 − 6 = 3%. The default rate for the first period must be greater. The recovery rate is the same for the two periods, so it does not matter for this problem.
9. You are analyzing two comparable (same credit rating, maturity, liquidity, rate ) US callable
corporate bonds. The following data is available for the nominal spread over the US Treasury yield curve and Z spread and option-adjusted spread (OAS ) relative to the US Treasury spot curve:
X Y Nominal spread
Z spread
The nominal spread on the comparable option-free bonds in the market is 100 basis points. Assuming that there is no model risk with your OAS model, which of the following statements is correct?
A. B. C. D.
X only is undervalued. Y only is undervalued.
X and Y both are undervalued. Neither X nor Y is undervalued.
145 120
130 115
OAS 100 105
Answer: B
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Key Point: Merton Model Stock Equity is a call option on the firm value with strike price equal to the face value of debt. Risky Bond Longbondrisk=longbondrisk−free+shortput Merton Model S=call=VN(d1)−Ke−rτN(d2)ln(VKe−rτ)στd1=+2στd2=d1−στ (σSS)=Δ(σVV) B=Ke−rτN(d2)+V[1−N(d1)] RNDefaultprobability=1−N(d2)=N(−d2)
10. According to the Merton model, if the firm’s debt has a face value of $60 and the value of the
firm is $50 when the debt matures, what is the payoff to the debt holders and to the shareholders?
Payoff to Debt Holders Payoff to Share Holders A. $50 $10 B. $10 $0 C. $10 $10 D. $50 $0
Answer: D
The payment to debt holders = Dm - max (Dm - Vm, 0) = 60 - max (60 - 50, 0) = $50 The payment to the firm’s stock holders = max (Vm - Dm, 0) = max (50-60, 0) = $0
At maturity of the debt, if the value of the firm’s assets is less than the value of the firm’s debt, then the firm goes into default.
Key Point: KMV Model
11. You are given the following information about firm A:
·Market value of asset at time 0 = 1000
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·Market value of asset at time 1 = 1200 ·Short-term debt = 500 ·Long-term debt = 300
·Annualized asset volatility = 10%
According to the KMV model, what are the default point and the distance to default at time 1?
Default Point Distance to Default A. 800 3.33 B. 650 7.50 C. 650 4.58 D. 500 5.83
Answer: C
1
1200−（500+×300）
12Default Point=（500+×300）=650, Distant to Default==4.58 21200×10%
Key Point: Credit Exposure
12. If a counterparty defaults before maturity, which of the following situations will cause a
credit loss?
A. You are short Euros in a one-year euro/USD forward FX contract, and the euro has
appreciated.
B. You are short Euros in a one-year euro/USD forward FX contract, and the euro has
depreciated.
C. You sold a one-year OTC euro call option, and the euro has appreciated. D. You sold a one-year OTC euro call option, and the euro has depreciated.
Answer: B
13. Consider a long position of the up-out call option with the cap price 120 and strike price 100.
When the stock price increases from 80 to 130 and decreases back to 110, which of the following positions have the credit exposure?
A. Long positions of the up-out call option when the stock price increases from 85 to 99. B. Long positions of the up-out call option when the stock price increases from 103 to 119. C. Long positions of the up-out call option when the stock price increases from 122 to 129. D. Long positions of the up-out call option when the stock price decreases from 127 to 115.
Answer: B
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Key Point: Credit Exposure of the Interest Rate Swap
14. Assume that swap rates are identical for all swap tenors. A swap dealer entered into a
plain-vanilla swap one year ago as the receive-fixed party, when the price of the swap was 7%. Today, this swap dealer will face credit risk exposure from this swap only if the value of the swap for the dealer is
A. Negative, which will occur if new swaps are being priced at 6% B. Negative, which will occur if new swaps are being priced at 8% C. Positive, which will occur if new swaps are being priced at 6% D. Positive, which will occur if new swaps are being priced at 8%
Answer: C
15. Assume that the DV01 of an interest rate swap is proportional to its time to maturity (which
at the initiation is equal to T). Assume that interest rate curve moves are parallel, stochastic with constant volatility, normally distributed, and independent. At what time will the maximum potential exposure be reached?
A. T/4 B. T/3 C. T/2 D. 3T/4
Answer: B
16. Determine at what point in the future a derivatives portfolio will reach its maximum potential
exposure. All the derivatives are on one underlying, which is assumed to move in a stochastic fashion (variance in the underlying’s value increases linearly with time passage). The derivatives portfolio’s sensitivity to the underlying is expected to drop off as (T − t)2, where T is the time from today until the last contract in the portfolio rolls off, and t is the time from today.
A. T/5 B. T/3 C. T/2
D. None of the above
Answer: A
Taking now the variance instead of the volatility, we have σ2 = k(T − t)4 ×t,where k is a constant. Differentiating with respect to t, setting the derivative to zero, we have t = T/5.
17. Assume that you have entered into a fixed-for-floating interest rate swap that starts today and
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ends in six years. Assume that the duration of your position is proportional to the time to maturity. Also assume that all changes in the yield curve are parallel shifts, and that the volatility of interest rates is proportional to the square root of time. When would the maximum potential exposure be reached?
A. B. C. D.
In two months In two years In six years
In four years and five months
Answer: B
Exposure is a function of duration, which decreases with time, and interest rate volatility, which increases with the square root of time. Define T as the original maturity and k as a constant. This give σ(Vt) = k(T − t)√t. Taking the derivative with respect to t gives a maximum at t = (T/3). This gives t = (6/3) = 2 years.
Key Point: Credit Exposure of the Currency Swap
¾ With a positively sloped term structure, the receiver of the floating rate (payer of the fixed
rate) has a greater credit exposure than the counterparty.
¾ The receiver of a low-coupon currency has greater credit exposure than the counterparty.
18. Which one of the following deals would have the greatest credit exposure for a $1,000,000
deal size (assume the counterparty in each deal is an AAA-rated bank and has no settlement risk)?
A. Pay fixed in an Australian dollar (AUD) interest rate swap for one year. B. Sell USD against AUD in a one-year forward foreign exchange contract. C. Sell a one-year AUD cap.
D. Purchase a one-year certificate of deposit.
Answer: D
The CD has the whole notional at risk. Otherwise, the next greatest exposure is for the forward currency contract and the interest rate swap. The short cap position has no exposure if the premium has been collected. Note that the question eliminates settlement risk for the forward contract.
19. Which of the following 10-year swaps has the highest potential credit exposure?
A. A cross-currency swap after 2 years B. A cross-currency swap after 9 years C. An interest rate swap after 2 years D. An interest rate swap after 9 years
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Answer: A
20. BNP Paribas has just entered into a plain-vanilla interest-rate swap as a pay-fixed
counterparty. Credit Agricole is the receive-fixed counterparty in the same swap. The forward spot curve is upward-sloping. If LIBOR starts trending down and the forward spot curve flattens, the credit risk from the swap will:
A. Increase only for BNP Paribas B. Increase only for Credit Agricole
C. Decrease for both BNP Paribas and Credit Agricole D. Increase for both BNP Paribas and Credit Agricole
Answer: B
With an upward-sloping term structure, the fixed payer has greater credit exposure. He receives less initially, but receives more lately. This back-loading of payments increases credit exposure. Conversely, if the forward curve flattens, the fixed payer (i.e., BNP Paribas) has less credit exposure. Credit Agricole must have greater credit exposure. Alternatively, if LIBOR drifts down, BNP will have to pay more, and its counterparty will have greater credit exposure.
Key Point: Hair Cut, Exposure Limits, and Netting Agreement
¾ Hair Cut: 1 (T-bill), 3 (T-note), 8 (T-bond) ¾
Net Exposure=max(V,0)=max(∑Vi,0)
i=1
N
Gross Exposure=max(V,0)=∑max(Vi,0)
i=1
N
21. A diversified portfolio of OTC derivatives with a single counterparty currently has a net
mark-to-market value of USD 20,000,000 and a gross absolute mark-to-market value (the sum of the value of all positive-value positions minus the value of all negative-value positions) of USD 80,000,000. Assuming there are no netting agreements in place with the counterparty, determine the current credit exposure to the counterparty.
A. Less than or equal to USD 19,000,000
B. Greater than USD 19,000,000 but less than or equal to USD 40,000,000 C. Greater than USD 40,000,000 but less than USD 60,000,000 D. Greater than USD 60,000,000
Answer: C
Define X and Y as the absolute values of the positive and negative positions. The net value is X − Y
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= 20 million. The absolute gross value is X + Y = 80. Solving, we get X = 50 million. This is the positive part of the positions, or exposure.
22. What are the benefits of novation?
A. Both parties are allowed to walk away from the contract in the event of default.
B. In a bilateral contract, it is specified that on default, the non-defaulting party nets gains
and losses with the defaulting counterparty to a single payment for all covered transactions.
C. Financial market contracts can be terminated upon an event of default prior to the
bankruptcy process.
D. Obligations are amalgamated with others.
Answer: D
Key Point: Credit Triggers & Time Puts
¾ Credit triggers specify that if either counterparty’s credit rating falls below a specified level,
the other party has the right to have the swap cash settled. These triggers are useful when the credit rating of a firm deteriorates slowly, because few firms directly jump from investment-grade into bankruptcy.
¾ Time puts, or mutual termination options, permit either counterparty to terminate unconditionally the transaction on one or more dates in the contract. This feature decreases both the default risk and the exposure. It allows one counterparty to terminate the contract if the exposure is large and the other party’s rating starts to slip.
Key Point: Credit Derivatives 1 - CDS
23. A portfolio consists of one (long) $100 million asset and a default protection contract on this
asset. The probability of default over the next year is 10% for the asset and 20% for the counterparty that wrote the default protection. The joint probability of default for the asset and the contract counterparty is 3%. Estimate the expected loss on this portfolio due to credit defaults over the next year with a 40% recovery rate on the asset and 0% recovery rate for the counterparty.
A. $3.0 million B. $2.2 million C. $1.8 million
D. None of the above
Answer: C
The only state of the world with a loss is a default on the asset jointly with a default of the
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guarantor. This has probability of 3%. The expected loss is $100,000,000 × 0.03 × (1 − 40%) = $1.8 million.
24. When an institution has sold exposure to another institution (i.e., purchased protection) in a
CDS, it has exchanged the risk of default on the underlying asset for which of the following?
A. Default risk of the counterparty
B. Default risk of a credit exposure identified by the counterparty
C. Joint risk of default by the counterparty and of the credit exposure identified by the
counterparty
D. Joint risk of default by the counterparty and the underlying asset
Answer: D
The protection buyer is exposed to the joint risk of default by the counterparty and underlying credit. If only one defaults, there is no credit risk.
25. We are asked to value a credit default swap on a $10 million, two-year agreement, whereby A
(the protection buyer) agrees to pay B (the guarantor, or protection seller) a fixed annual fee in exchange for protection against default of two-year bonds XYZ. The payout will be the notional times (100 − PB), where PB is the price of the bond at expiration, if the credit event occurs. Currently, XYZ bonds are rated A and trade at 6.60%. The two-year T-note trades at 6.00%.
Starting State
Ending State
A B C D
A 0.90 0.07 0.02 0.01 B 0.05 0.90 0.03 0.02 C 0 0.01 0.85 0.05 D 0 00 0 1
A. B. C. D.
43800 42800 44800 45800
Answer: B
26. Wallace, an emerging market bond trader, is holding a 5-year USD Malaysian corporate bond
in his book. He is concerned about the risk of his position. Which of the following statements concerning the risk of his position is incorrect?
A. The corporate bond could be upgraded so that it would have a higher rating than
Malaysian sovereign debt, but it is highly unlikely.
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B. Buying protection with a CDS would hedge the corporate bond position against some
risks but it would do a poor job of hedging the position if there is a drop in liquidity for emerging market sovereign bonds.
C. A short position in Ringgits sovereign bond from Malaysia would always help hedge the
corporate bond against currency risk if the corporation is an exporter.
D. A short position in a 5-year U.S. treasury and buying protection on the corporate bond
using a CDS would be a better hedge than just buying protection on the corporate bond.
Answer: C
Key Point: Credit Derivatives 2 - TRS
27. A bank holds USD 60 million worth of 10-year 6.5% coupon bonds that are trading at a clean
price of USD 101.82. The bank is worried by the exposure due to these bonds but cannot unwind the position for fear of upsetting the client. Therefore, it purchases a total return swap (TRS) in which it receives annual LIBOR + 100 bps in return for the mark-to market return on the bond. For the first year, the LIBOR sets at 6.25%, and by the end of the year the clean price of the bonds is at USD 99.35. The net receipt/ payment for the bank in the total return swap will be to:
A. Receive USD 1.97 million B. Receive USD 2.23 million C. Pay USD 2.23 million D. Pay USD 1.97 million
Answer: A
7.15*60m+
101.82−99.3560m
*60m−6.5*=1.97m
101.82101.82
28. Risk Averse Bank (RAB) has made a loan of USD 100 million at 8% per annum. RAB wants
to enter into a total return swap under which it will pay the interest on the loan plus the change in the mark-to-market value of the loan, and in exchange, RAB will get LIBOR + 30 basis points. Settlement payments are made annually. What is the cash flow for RAB on the first settlement date if the mark-to-market value of the loan falls by 2% and LIBOR is 6%?
A. B. C. D.
Net inflow of USD 0.3 million Net outflow of USD 0.3 million Net inflow of USD1.7 million Net outflow of USD 1.7 million
Answer: A
29. Gamma industries inc issues an inverse floater with a face value of USD 50.000.000 that
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pays a semiannual coupon of 1150% minus LIBRO gamma industries intends to execute an arbitrage strategy and earn a profit by selling the notes. Using the proceeds to purchase a bond with a fixed semiannual coupon rate of 6.75% a year, and then hedge the risk by entering into an appropriate swap. Gamma industries receive a quote from a swap dealer with a fixed rate of 5.75% and a floating rate of LIBOR. What would be the most appropriate type of swap of Gamma industries, Inc., to enter into to hedge its risk?
A. B. C. D.
Pay-fixed, receive-fixed swap Pay-floating, receive-fixed swap Pay-fixed, receive-floating swap
The risk cannot be hedged with a swap
Answer: B
Short inverse floater: -11.5% +LIBOR Long a bond: +6.75% Net profit: -4.75% +LIBOR
The swap in the market: 5.75% ~ LIBOR, so the LIBOR in the market is overpriced.
Key Point: Credit Derivatives 3 – Structured Products & CDO
30. King Motors Acceptance Corporation (KMAC), the finance arm of King Motors, issues an
auto-loan asset-backed security that consists of a senior tranche, denoted Tranche A in the amount of $50 million and an interest payment of 5 percent, and two subordinated tranches, denoted Tranches X and Z respectively, each with a face amount of $35 million. Tranche X pays investors annual interest at a rate of 6.5 percent while Tranche Z pays investors annual interest at a rate of 7.5 percent. Which of the following methods of credit support would NOT affect the credit quality of subordinated Tranche X?
A. The total amount of the auto loans that make up the asset-backed issue is $125 million. B. The weighted average interest rate on the auto loans making up the pool is 6.4 percent. C. Any defaults on the part of King Motor’s customers will be first absorbed by Tranche Z. D. KMAC has a reserve in the amount of $10 million that will remain on KMAC’s balance
sheet.
Answer: D
An investor’s claim when purchasing an ABS is solely with the ABS and no longer with the originator. The fact that KMAC has $10 million set aside means nothing for the ABS issue if it remains on KMAC’s balance sheet and is not part of the ABS issue. The other answer choices all describe forms of credit support that will support at least Tranches X and A, if not all 3 tranches. By having Tranche Z be subordinate to Tranche X, Tranche X has additional support. Also, loans of $125 million are used to back asset-backed securities worth ($50 + $35 + $35) = $120 million, which means the issue, is over-collateralized. The weighted average interest rate paid on the securities is approximately 6.2%. If the weighted average interest rate on the loans that make up
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the pool is 6.4% that means there is an excess spread between the loans and securities that also provides support for the entire issue.
31. The maximum benefits to the buyer of a credit-linked note (CLN) accrue when:
A. there is a small credit downgrade B. there is no credit downgrade C. there is a large credit downgrade D. there is a default
Answer: B
The benefit to the CLN buyer is that the buyer earns a high return if there is no downgrade or default. The buyer’s primary risk is that there is a downgrade or default and the buyer earns a lower return.
32. Which of the following statements about a cash collateralized debt obligation’s (CDO)
special-purpose vehicle (SPV) is TRUE?
A. In cash CDO, the SPV invests in the actual securities that are used to generate payment
to the tranches.
B. In a synthetic CDO, the SPV invests in the actual securities that are used to generate
payment to the tranches.
C. In a synthetic CDO, the SPV does not invest in the actual securities that are used to
generate payment to the tranches. Instead they invest only in a risk-free bond.
D. In cash CDO, the SPV does not invest in the actual securities that are used to generate
payment to the tranches. Instead they invest in a default swap and a risk-free bond.
Answer: A
A cash collateralized debt obligation’s (CDO) special-purpose vehicle (SPV) invests in the actual securities that are used to generate payment to the tranches. A synthetic CDO's SPV does not invest in the actual securities that are used to generate payment to the tranches. Instead they invest in a default swap and a risk-free bond, and a cash CDO's SPV invests in the actual securities that are used to generate payment to the tranches.
33. In a typical collateralized bond obligation (CBO), a pool of high-yield bonds is posted as
collateral and the cash flows from the collateral are structured as several classes of securities (the offered securities) with different credit ratings and a residual piece (the equity), which absorbs most of the default risk. When comparing the market value weighted average rating of the collateral and that of the offered securities, which of the following is true?
A. The market value-weighted average rating of the collateral is about the same as the
offered securities.
B. The market value-weighted average rating of the collateral is higher than the offered
securities.
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C. The market value-weighted average rating of the collateral is lower than the offered
securities.
D. The market value-weighted average rating of the collateral may be lower or higher than
the offered securities.
Answer: C
The rating of the collateral must be between that of the offered securities and the residual. Say that the collateral is rated B, with 5% probability of default (PD); the offered securities represent 80% of the total market value. These are more highly rated than the collateral because the equity absorbs the default risk. If the offered securities are rated BB (with 1% PD), the equity must be such that 80% × 0.01 + 20% × x = 0.05, which yields an PD of 21% for the equity, close to a CCC rating.
34. A standard synthetic CDO references a portfolio of 10 corporate names. Assume the
following. The total reference notional is X, and the term is Y years. The reference notional per individual reference credit name is X/10. The default correlations between the individual credit names are all equal to one. The single-name CDS spread for each individual name is 100 bp, for a term of Y years. The assumed recovery rate on default for all individual reference credits is zero in all cases. The synthetic CDO comprises two tranches, a 50% junior tranche priced at a spread J, and a 50% senior tranche priced at spread S. All else constant, if the default correlations between the individual reference credit names are reduced from 1.0 to 0.7, what is the effect on the relationship between the junior tranche spread J and the senior tranche spread S?
A. The relationship remains the same B. S increases relative to J C. J increases relative to S
D. The effect cannot be determined given the data supplied
Answer: C
If the correlation is one, all names will default at the same time, and the junior and senior tranche will be equally affected. Hence, their spread should be 100bp, which is the same as for the collateral. With lower correlations, the losses will be absorbed first by the junior tranche. Therefore, the spread on the junior tranche should be higher, which is offset by a lower spread for the senior tranches.
35. Which of the following statements about collateralized debt obligations squared (CDO2) is
FALSE?
A. CDO2 are CDOs that invest in other CDOs.
B. Yields on CDO2 are typically lower than yields on CDOs. C. CDO2 can be very complicated.
D. There is often an overlap of assets held with CDO2.
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Answer: B
CDO2 are CDOs that invest in other CDOs. They are complicated and often there is an overlap of assets held with CDO2. They typically offer higher yields than regular CDOs.
Key Point: Portfolio Credit Risk Model
Originator Model type Risk definition Risk drivers Credit events
CreditMetrics CreditRisk+ J.P. Morgan Market value Asset values Rating change/
Default
Credit Suisse Default losses Default rates Default
KMV KMV Default losses Asset values Continuous default prob.
CreditPf.View McKinsey Market value Macro factors Rating change/
Default
Bottom-up Bottom-up Bottom-up Top-down Probability Unconditional Unconditional Conditional Conditional Volatility Correlation Recovery rates Solution
Constant Variable Variable Variable From equities
(structural) Random Simulation/ Analytic
Default process (reduced-form) Constant within
band
From equities (structural)
From macro factors
Random Random Analytic Analytic Simulation
36. Which of the following statements about credit risk models is correct?
A. KMV models offer a structural approach to measuring credit risk that is based on credit
migration.
B. CreditRisk+ models offer an actuarial approach to measuring credit risk that treats the
bankruptcy and recovery processes as endogenous.
C. KMV models are an extension of Merton’s option pricing model employing equity price
volatility as a proxy for asset price volatility.
D. CreditRisk+ models, like the reduced-form models, use a chi-squared distribution to
describe default.
Answer: C
A Incorrect. KMV models are NOT based on credit migration.
B Incorrect. In CreditRisk+ models, the bankruptcy/recovery processes are exogenous. C Correct. KMV models employ equity price volatility as a proxy for asset price volatility. D Incorrect. CreditRisk+ models use a Poisson or Poisson-like distribution to describe default.
37. The RiskMetrics model generates VaR directly from the mean and variance parameters of the
portfolio, which does not provide an estimate of the worst-case scenario loss. Note that the RiskMetrics method does account for correlation between asset classes. Which of the
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following is NOT a limitation of KMV's Estimated Default Frequency (EDF) model?
A. It is difficult to price sovereign credit risk since asset values and volatility are not
directly observable
B. EDFs are biased by periods of high or low defaults
C. Takes a simplified view of the capital structure of a firm D. The model often fails to explain real world credit spreads
Answer: B
Choices A, C and D are limitations of KMV's estimated default frequency model. EDF are not biased by periods of high or low defaults as are models based on Moody's and Standard & Poor's risk ratings.
38. In the following things about Merton model, which of the statement is true?
A. In Merton model the payment to debt holder can be seen as the payoff of a riskless bond
plus a put on the value of the firm.
B. The sudden surprise (a jump), leading to an unexpected default can be captured by the
by this model.
C. The model can take into account the default prior to the maturity of debt, when a
borrower claims so.
D. The value of the firm is difficult to pin down because the market-to-market value of debt
is often unknown.
Answer: D
A is wrong; the payoff of a bond holder is equivalent to a riskless bond minus a put on the value on the value of a firm.
B is wrong, the firm follows lognormal diffusion process, it doesn’t allow for sudden change. C is wrong, because in this model default can only occur at the debt maturity.
39. Which of the following is not a step used in the CreditMetrics credit risk portfolio modeling
process?
A. Generating correlated migration events. B. Measuring “marked-to-market” losses.
C. Calibrating the multivariate non-normal distribution. D. Calculating the portfolio loss distribution.
Answer: C
CreditMetrics is based on a multivariate normal distribution. The four main steps used by CreditMetrics is to: gather input data, generate correlated migration events, measure “marked-to-market” losses and calculate the portfolio loss distribution.
40. With respect to CreditRisk+, which of the following is FALSE?
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A. CreditRisk+ works well with data that have fat-tails.
B. CreditRisk+ only focuses on default events and ignores prices, spreads and credit
migrations.
C. Factor correlations are not addressed with the CreditRisk+ model.
D. CreditRisk+ may not be appropriate for use with portfolios that do not use a
buy-and-hold strategy.
Answer: A
CreditRisk+ only focuses on default events and ignores prices, spreads and credit migrations. In addition, factor correlations are not addressed with the CreditRisk+ model and it may not be appropriate for use with portfolios that do not use a buy-and-hold strategy. Because the model does not consider factor correlations it may not capture events associated with fat-tailed distributions.
41. In credit scoring models, which we want to evaluate whether a firm is likely to default or not.
If we use nonparametric ways to construct decision boundary construction, which of the methods can be use?
A. Fisher linear discriminant analysis B. Parametric discrimination method C. K-nearest neighbor method D. Support vector method
Answer: D
Fish linear discriminant analysis and parametric discrimination are both discriminant analysis. The principal of this analysis is to use parameter to segregate and classify a heterogeneous population in homogeneous subsets. Parametric discrimination method uses score function two examples is logit and probit models. K-nearest neighbor Support vector method are nonparametric the separate good or bad firms by explanatory variables (ROA, leverage). But K-nearest method is density estimation, support vector can be linear or nonlinear when a criterion is a polynomial, it can construct decision boundary.
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Part 4 Operational Risk Management
Key Point：Core concepts related to operational risk
¾ The risk of loss resulting from inadequate or failed internal processes, people and systems or
from external events. The definition includes legal risk but excludes strategic and reputation risk.
42. What are the driving forces of integrated risk management?
I. The increasing complexity of products. II. Linkages between markets.
III. The potential benefits offered by portfolio effects.
A. I only. B. II only.
C. II and III only. D. I, II, and III.
Answer: D
Integrated risk management is driven by the increasing complexity of financial products, the benefits of aggregating risk across the institution, and the interrelationship between markets.
43. What can be said about the impact of operational risk on both market risk and credit risk?
A. Operational risk has no impact on market risk and credit risk.
B. Operational risk has no impact on market risk but has impact on credit risk. C. Operational risk has impact on market risk but no impact on credit risk. D. Operational risk has impact on market risk and credit risk.
Answer: D
Operational risk can lead to market or credit risk. Operational errors in the settlement process may result in credit risk and market risk since the settlement amount may be dependent on market movements.
44. Operational Risk Capital should provide a cushion against:
I. Expected losses. II. Unexpected losses. III. Catastrophic losses.
A. I only B. II only
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C. I and II only D. I, II, and III
Answer: B
Risk capital should be used to address unexpected losses. Expected losses should be covered by income from the product or activity, while catastrophic losses should be covered by insurance.
45. Operational risk type losses range from high frequency, low severity to low frequency, high
severity often seen as a lognormal distribution. The allocation of an institution’s capital should be applied against:
I. High Frequency, low severity (expected losses) II. Low Frequency, high severity (unexpected Losses) III. Extreme ‘tail’ events (high-stress losses)
A. I only B. II only C. III only D. II and III
Answer: D
Capital should be applied against the unexpected losses and high-stress losses. Expected losses should be addressed in product pricing.
Reference: Different Operational Events
Event Type Internal fraud External fraud Employment practices and
workplace safety Clients, products, and business
practices Damage to physical assets Business disruption and system
failures Execution, delivery, and process
management
Examples
Employee theft, intentional misreporting of positions, and
insider trading on an employee's own account
Robbery, forgery, and check kiting
Workers' compensation and discrimination claims, violation of employee health and safety rules, and general
liability Fiduciary breaches, misuse of confidential customer information, money laundering, and sale of unauthorized
products Terrorism, vandalism, earthquakes, fires, and floods Hardware and software failures, telecommunication
problems, and utility outages Data entry errors, collateral management failures, incomplete legal documentation, and vendor disputes
Key Point: Operational Risk Measurement
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¾ Two Kinds of events: LFHS & HFLS
¾ Two Kinds of methods: top-down & Bottom-up Top-down
¾ They attempt to measure operational risk at the broadest level, that is, firm-wide or industry-wide data. Results are then used to determine the amount of capital that needs to be set aside as a buffer against this risk. This capital is allocated to business units. Bottom-up
¾ They start at the individual business unit or process level. The results are then aggregated to
determine the risk profile of the institution. The main benefit of such approaches is that they lead to a better understanding of the causes of operational losses.
Reference: Comparison of two methods
Data requirement HFLS V LFHS Diagnostic ability
Top-Down Approach Non-intensive Undifferentiated
No
Bottom-Up Approach
Complex Intensive Differentiated
Yes
Sophistication Simple Perspective Backward-looking Forward-looking
46. Which of the following arguments is not true? Key Risk Indicators should:
A. Anticipate operational risks
B. Be based upon historical loss data
C. Be an objective measure of operational risk D. Be monitored over time to detect trends
Answer: A
Key risk indicators seek to quantify all aspects that are sought by the risk manager to enable risk-based decision making. They serve as a gauge of potential downside outcomes. When applied risk key indicators are used to identify important business vulnerabilities. The operational risk profile using the risk indicators should be continually monitored, dynamic, and updated as often as new data (based on historical losses for example) are collected. Key risk indicators are based on historical loss data, are monitored over time to detect trends, and need to be an objective measure of operational risk. Key risk indicators do not anticipate operational risk.
Reference: 6 kinds of Top-down Methods
Multi-factor models ¾ The residual, or unexplained, volatility component is deemed to be the measure of operational risk.
¾ Notice: LFHS events in the data can distort the results. Income-based models 22-52
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¾ The residual, or unexplained, volatility component is deemed to be the measure of operational risk to earnings.
¾ Notice: LFHS events in the data can distort the results. Expense-based models ¾ This is the easiest approach but ignores operational risks that are unrelated to expenses.
¾ Notice: a risk-reducing initiative that happened to increase expenses (because it involved a
cost) would be mischaracterized. Operating leverage models ¾ Measure the change in the relationship between variable costs and total assets.
¾ Notice: the models ignore reputational considerations and the opportunity costs of capital. Scenario analysis ¾ Attempts to anticipate low frequency high severity (LFHS) risk events.
¾ Notice: doing this generally is a subjective exercise. Assigning probabilities to each event is
difficult.
Risk profiling models ¾ KRI are simple measures that provide an indication of whether risks are changing over time. ¾ The assumption is that operational risk events are more likely to occur when these indicators
increase. ¾ KRI &KCI
Reference: 3 kinds of Bottom-up Methods
Process Approach ¾ The process approach attempts to identify root causes of risk; because it seeks to understand
because and-effect, it should be able to help diagnose and prevent operational losses. ¾ Causal networks explain losses in terms of a sequence of related variables.
¾ Connectivity models are similar to scorecards but they focus on cause-and-effect.
¾ Reliability models emphasize statistical techniques rather than root causes. They focus on the
likelihood that a risk event will occur. Actuarial Proprietary
Key Point：Actuarial Approaches - Parametric loss distribution
Loss frequencies
¾ Binomial, Negative Binomial, Poisson Distribution Loss severities
¾ Lognormal, Weibull, TAN Distribution
47. Please find the right order of LDA structure process.
1. Assign every data point in the matrix an equal weight except for split losses, old loss
and external losses.
2. Model a loss distribution in each cell of the business line/event type matrix.
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3. Organize and group loss data into a business line/event type matrix.
4. Determine the operating risk capital requirement for each business line by combining
empirical distributions and parametric tail distributions.
A. B. C. D.
(4) (2) (3) (1) (3)(1) (4) (2) (3)(1) (2) (4) (4)(1) (3) (2)
Answer: C
48. Suppose you are given the following information about the operational risk losses at your
bank.
Frequency distribution Severity Distribution
Probability Frequency Probability Severity
0.5 0 0.6 USD 1000 0.3 1 0.3 USD 10000 0.2 2 0.1 USD 1001000
What is the estimate of the VaR at the 95% confidence level, assuming that the frequency and severity distributions are independent?
A. USD 100000 B. USD 101000 C. USD 200000 D. USD 110000
Answer: A
Loss Prob. 0 1,000 2,000 10,000 11,000 20,000 100,000 101,000 110,000 200,000
0.5=0.5
0.3*0.6=0.18
0.2*0.6*0.6=0.072 0.3*0.3=0.09
0.2*0.6*0.3+0.2*0.3*0.6=0.072 0.2*0.3*0.3=0.018 0.3*0.1=0.03
0.2*0.6*0.1+0.2*0.1*0.6=0.024 0.2*0.1*0.3+0.2*0.3*0.1=0.012 0.2*0.1*0.1=0.002
Key Point：Actuarial Approaches - Other related models
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Historical-based loss distribution ¾ Internal and external data on operational losses are plotted in a histogram in order to draw the empirical loss distribution. ¾ Notice: Basically, it is assumed that the historical distribution will apply going forward. As such, no specification or model is required. EVT ¾ This approach is not mutually exclusive to the empirical and parametric approaches. ¾ Notice: EVT conducts additional analyses on the extreme tail of the operational loss distribution. For LFHS events, a common distribution is the Generalized Pareto Distribution (GPD), which is part of Extreme value theory (EVT). FOL UL SL EL OL
49. Which of the below are methods to estimate parameters of operational loss distributions?
I. Moments
II. Probability-weighted moments III. Maximum likelihood IV. Econometric
A. I and III B. I, II and III C. IV
D. III and IV
Answer: B
The parameters of loss distributions can be estimated by moments, probability-weighted moments, or with maximum likelihood techniques.
50. Consider the POT, which of the statements is incorrect?
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A. In this process we estimate a threshold then calculate the conditional probability of a
loss above this level.
B. The model consist of two parameters this shape and scaling parameter.
C. If the parameter indicating the fatness of the tail is below zero, this indicating a fat tail. D. To deals with varying parameters the maximum likelihood method can be used.
Answer: C
ξX−ξThe POT model f(x)=1−(1+)
βξ is the shape parameter. If it is larger than 0, it indicates a fat tail.
1
Key Point: Technology Risk
Economy of Scale
¾ The economy of scale advantage is a decline in the average cost of producing a service as the
financial institution grows.
¾ Expansion in the same business line, the same business unit, or the same industry
¾ The U-shaped average cost curve implies that there is a point beyond which the initial
economies of scale disappear and diseconomies begin. Economy of Scope
¾ Expansion in the different business lines, the different business units, or the different
industries.
¾ Economy of scope: The cost of joint production via cost synergistic is less than the separate
and independent production of these services. （IF AC1+2< (TC1+TC2)/ (S1+S2), Then Economies of scope is achieved）
¾ Diseconomies of scope: The costs actually higher from joint production of services than if
they were produced independently. （IF AC1+2> (TC1+TC2)/ (S1+S2), Then Diseconomies of scope exists）
Two critical empirical results
¾ Research suggests that the average cost curve of the banking industry is a relatively flat U
shape; that is, too much investment is as bad as too little. The low point in the curve denotes optimal cost efficiency.
¾ While studies of nonbank financial institutions found no evidence of economies of scale or
scope, there are dramatic cost differences attributed to x-inefficiencies, defined as managerial ability and other hard-to-quantify factors.
51. What is likely to be the most appropriate policy to manage technology risk?
A. Have regular technology audits performed by an external consultant. B. Stick to proven technologies.
C. Outsource as many technology functions as possible. D. Make sure every area is password-protected.
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Answer: A
External audits are an important part of a properly designed risk management system.
52. Woods Bank and Trust offers banking and investment services to wealthy individuals.
Woods’ senior management is looking to expand the services they offer in order to compete more effectively in a crowded market. Management is currently assessing 2 different project possibilities: Project 1: Woods offers a universal life insurance product to its top tier clients. Last year, Woods underwrote 54 policies with an average issuance cost per policy of $136. Management is currently looking at the possibility of offering the universal life product to its second tier clients. Management estimates that it can expand the number of policies offered to approximately 300 with an average cost per policy of $142. Project 2: Woods offers a money market savings account to approximately 3,000 clients. The account costs the bank $2,000,000 per year in order to create $100,000,000 in revenue. Woods also provides a brokerage account that can hold stocks, bonds, or mutual funds to 5,000 of its clients. The brokerage account cost the bank $500,000 per year to administer and generates $15,000,000 of revenue. Management is considering offering a Platinum account that would combine the features of the money market and brokerage accounts. Management estimates that the cost of producing the Platinum account on a percentage basis would be 1.95 percent. Which of the following statements regarding the two projects is correct?
A. Project 1 reflects diseconomies of scale; Project 2 reflects economies of scale. B. Project 1 reflects diseconomies of scope; Project 2 reflects economies of scale. C. Project 1 reflects economies of scale; Project 2 reflects economies of scope. D. Project 1 reflects diseconomies of scale; Project 2 reflects economies of scope.
Answer: D
Economies of scale refer to the cost of producing a single project falling as more products are produced. For Project 1, as more insurance policies are issued, the cost actually rises, which reflects diseconomies of scale. Economies of scope represent the synergies of producing two products together rather than each one independently. The total average cost of the money market and brokerage accounts separately are (2,000,000 + 500,000) / (100,000,000 + 15,000,000) = 2.17%. Since the percentage cost of the combined platinum account is less at 1.95%, and then economies of scope must exist.
Key Point: Daylight overdrafts risk
Daylight overdrafts risk
¾ Fedwire is a RTGS system, which helps the Federal Reserve to maintain the nation's
payments system. Under the Federal Reserve Act, banks must maintain cash reserves on deposit at the Fed. Therefore, the member bank’s end-of-day reserve position cannot be negative. However, during the day, banks are allowed to have negative intraday balances on their required reserve accounts at the Federal Reserve through Fedwire settlement. Thus,
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daylight overdrafts risk rises for the Fedwire.
¾ CHIPS (Clearing House Interbank Payment System)
¾ When failure，CHIPS might have to unwind all of BK’s transaction of the day.
Key Point: Model risk
Model risk
¾ Model risk is the risk associated with using financial models to simulate complex relationships.
¾ It may arise from incorrect model application, implementation risk, calibration errors, programming errors, and data problems.
¾ Rebonato’s definition of model risk: Model risk is the risk of occurrence of a significant
difference between the mark-to-model value of a complex and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in the market.
¾ Sources and management of model risk in EMH framework: The source of model risk
under the EMH framework is simply that the model being used is just not good enough. Then the most effective ways to manage model risk under the EMH framework are to either improve the model being used, or to find a more sophisticated model.
¾ Sources and management of model risk in non-EMH framework: ① In a non-EMH
framework, the source of model risk shifts from finding the best model to how today’s pricing methodologies may change in the future. ② A non-EMH framework means that the process for managing model risk becomes an exercise not in finding the best model, but in estimating how ways of deriving security prices in the future may differ from today’s commonly accepted wisdom. ③ Notice: Goals of traders and risk managers are no longer in congruence.
53. An important source of model risk is incorrect model specification. Which of the following is
not an example of model specification error?
A. Omitting an important risk factor from the model.
B. Assuming that variables are independent when significant correlations exist.
C. Assuming data is from a particular distribution when a more accurate distribution is
available.
D. Estimating the model using data from an inappropriate sample period.
Answer: D
Using data from an inappropriate sample period is an example of calibration error.
54. The role of senior managers in managing model risk includes all of the following except
A. Becoming expert modelers.
B. Establishing an organizational framework that implements sound risk management
procedures.
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C. Questioning model features.
D. Understanding the fundamentals of model risk.
Answer: A
Senior managers need not be expert modelers, but they do need to understand the fundamentals of model risk so that they can ask the right questions and implement sound risk management procedures.
55. When managing model risk, predicting how pricing methodologies may change in the future
is:
A. Important if one believes that the efficient market hypothesis does hold. B. Important if one believes that the efficient market hypothesis does not hold. C. Important whether or not one believes that the efficient market hypothesis holds. D. Never relevant in managing model risk.
Answer: B
In a non-EMH framework the source of model risk shifts from finding the best model to how today’s pricing methodologies may change in the future.
56. Which of the following actions could worsen rather than reduce model risk?
A. Require documentation of the model so that the risk manager can produce the same
prices as the user of the model.
B. Use a simulation benchmark model to assess a model that has a closed-form solution. C. Make the model far the dynamics of the underlying fit past data better by making the
price of the underlying depend on additional variables. D. Plot model prices against parameter values.
Answer: C
The other three are procedures that help to monitor the model and can help to reduce model risk.
57. As a risk practitioner. Leo realizes that model risk can never be eliminated, although he may
find some ways to protect against it. Which of the following measures help reduce model risk?
I. All else equal. choose the model with the fewest parameters.
II. Have regularly scheduled model reviews that involve careful back-testing and
stress-testing.
III. Identify and evaluate key model assumptions. and ignore small but persistent Problems. IV. Validate the model using simple Problems for which answers are independently known.
A. II only
B. I, II, and III
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C. I, II, and IV D. III and IV
Answer: C
I. is correct. First and foremost, practitioners should simply be aware of the model risk: It is true that unnecessary complexity is never a virtue in model selection.
II. is correct. Practitioners should evaluate model adequacy using stress tests and backtests: models should be recalibrated and re-estimated on a regular basis. and the methods used should be kept up to date.
III. is incorrect. Users should explicitly set out the key assumptions on which a model is based. evaluate the extent to which the model’s results depend on these assumptions: But he should never ignore the small problems because small discrepancies are often good warning signals of larger Problems.
II. is correct. It is always a good idea to check a model on simple Problems to which one already knows the answer. and many Problems can be distilled to simple special cases that have knows answers.
58. Which of the options below properly classifies each model risk error into a model risk
category?
Model Risks
y Risk 1: Failure to consider a sufficient number of trials in a Monte Carlo simulation.
y Risk 2: Use of the mid-quote price rather than the bid price to value long positions in
financial instruments.
y Risk 3: Failure to fully account for time-variation of volatility. Model Risk Categorization y Implementation risk
y Incorrect model calibration y Incorrect model application
A. Risk 1 = Incorrect model calibration. Risk 2 = Implementation risk. Risk 3 = Incorrect
model calibration
B. Risk 1 = Implementation risk. Risk 2 = Incorrect model application. Risk 3 = Incorrect
model calibration
C. Risk 1 = Incorrect model application. Risk 2 = Implementation risk. Risk 3 = Incorrect
model calibration
D. Risk 1 = Incorrect model application. Risk 2 = Implementation risk. Risk 3 =
Implementation risk
Answer: C
Implementation risk refers to model risk pertinent to Implementation. it assumes the model is correctly specified and calibrated. It usually pertains to valuation errors. e.g. mark to market vs. mark to model, usage of mid-quote vs. bid-ask spread, hence it corresponds to Risk 2. Incorrect model calibration risk refers to model risk pertinent to non-calibration or inaccurate calibration of
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(usually correctly specified) models under changing circumstances. An example is unexpected rise in volatility. causing banks to experience higher losses than suggested under original risk models (past cases include LTCM. Natwest. BZW and Bank of Tokyo Mitsubishi cases). hence it corresponds to risk 3. Incorrect model application risk refers to model risk pertinent to improper application of a risk model. An example is consideration of an insufficient number of trials in a Monte Carlo simulation. The wrong answers A. B and D capture cases when candidates do not fully understand correct classification and application of model risks.
Key Point: Firm-wide Risk Management
Trade Limits
¾ Stop Loss Limit ¾ Exposure Limit ¾ VAR Limit
Risk management and Firm value (in perfect market) – can increase value
¾ Changes in operating strategies that reduce the beta of a firm’s equity and sufficiently low
cost may increase firm value
Risk management and Firm value (in perfect market) – can not increase value ¾ Reduce the firm’s diversifiable risk do not increase firm value
¾ Reduce a firm’s systematic risk via financial transactions do not increase firm value How to increase the Firm value in the real market? ¾ Lower financial distress cost
¾ Smooth EBIT and low tax liability ¾ Increase the ability to use leverage
¾ Diversify the operating risk and lower the required rate of return ¾ Lower the debt overhang
¾ Lower Asymmetric Information
Key Point: Economic Capital & RAROC
EC
¾ An estimate of the level of capital that a firm requires to operate its business with a desired target solvency level. Sometimes this is also referred to as risk capital. ¾ EC as a buffer to cover unexpected losses RAROC
¾ RAROC is first suggested as a tool for capital allocation on ex ante basis ¾ RAROC = RAR/Economic Capital
¾ RAR = revenues (before tax) - expected loss – expenses + return on EC ± transfer price ¾ EC = WCL - EL
59. Suppose that a business line of a bank has a loan book of USD 100 million. The average
interest rate is 10%. The book is funded at a cost of USD 5.5 million. The economic capital
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against these loans is USD 7.5 million (7.5% of the loan value) and is invested in low risk securities earning 5.5% per annum. Operating costs are USD 1.5 million per annum and the expected loss on this portfolio is assumed to be 1% per annum (i.e., USD 1 million). The firm's cost of capital is 15%.The RAROC for this business line is:
26.7% 37.1% 21.2% 32.2%
Answer: D
The RAROC for this business line is:
Risk-adjusted return / Risk-adjusted capital =（100*0.1 -5.5 -1.5 -1 + 7.5*0.055/7.5=2.4125 / 7.5 = 32.2%
60. Widget. Inc.. is considering an investment in a new business line. The company calculates the
RAROC for the new business line to be 12%. Suppose the risk-free rate is 5%. the expected rate of return on the market is 11 .0%. and the systematic risk of the company is 1.5. If the company only invests in new businesses for which the ARAROC (adjusted RAROC) exceeds the expected excess rate of return on the market. What return will this new business earn for Widget. Inc.?
A. 0.0% B. 12.0% C. 4.7% D. 6.0%
Answer: A
A. is correct. ARAROC=(12%-5%)/1.5=0.047=4.7% the expected excess rate of return on the market=11%-5%=6%. 4.7%<6%. So as a rational company, it will reject the project. the contribution will be 0.
B. is incorrect. There is no reason for 5%-4.7%=0.3% C. is incorrect 4.7% is ARAROC.
D. is incorrect. 6% is the expected excess rate of return on the market.
61. Redhat is a small bank whose only business line is retail banking. With the Basel II
Standardized Approach for calculating operational risk capital charges. the beta factors for each business line are given in the following table: Business Line Beta Factor Corporate finance 18% Trading and sales 18% Retail banking 12% Commercial banking 15% Payment and settlement 18%
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A. B. C. D.
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Agency services 15% Asset management 12% Retail brokerage 12%
Assuming Redhat is eligible to choose any Basel II approach for operational risk, which Basel II approach will minimize Redhat’s operational risk capital charge?
A. Basic Indicator Approach. B. Standardized Approach.
C. Foundation Internal Ratings-Based Approach (FIRB).
D. Both the Basic Indicator Approach and the Standardized Approach have the same
operational risk charge for Redhat.
Answer: B
A. is incorrect. For all business lines, the Basic Indicator Approach uses a 1 5% Beta factor which is higher than retail banking beta factor of the Standardized approach.
B. is correct. Redhat’s only business line is retail banking. Using the Standardized Approach will use a lower beta factor than Basic Indicator Approach.
C. is not correct FIRB and AIRB are credit risk capital approach. D. is not correct because of above.
62. John Grea has just been appointed the CFO of a bank and wants to construct a composite risk
picture following a “building block” approach that aggregates risk at three successive levels in his organization.
• Level I: Aggregates the standalone risks within a single risk factor.
• Level II: Aggregates risk across different risk factors within a single business line. • Level III: Aggregates risk across different business lines.
However, he understands that there might be different degrees of diversification benefits for each level. Empirically. which level in the “building block” approach has the greatest degree of diversification benefit?
A. Level I — single risk factor level B. Level II — single business line level C. Level III — different business lines level
D. The degree of diversification benefits are the same for each level
Answer: A
Empirically. diversification effects are greatest within a single risk factor (Level I). decrease at the business line level (Level II). and are smallest across business lines (Level III).
63. Silo Bank beams its risk measurement process by calculating VaR for market. credit. and
operational risk individually. and then aggregates the three measures to produce a firm-wide VaR. Correlation between risk types is a key input for calculating firm-wide VaR. Which of
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the following statements about correlation are valid?
When market and credit risks involve securities issued by firms such as bonds, warrants, and stocks, correlation estimates for market and credit risk can be derived using equity returns if Merton’s model for the pricing of debt holds.
II. If correlations between highly adverse market. credit. and operational outcomes are high.
there is diversification across risk categories and therefore the firm-wide VaR is substantially less than the sum of the market. credit. and operational risk VaRs.
III. With non-normal distributions, the use of correlations estimated using historical data
from a stable period may not adequately capture how extreme returns for one type of risk are related to extreme returns of another type of risk.
A. I, II and III B. I only
C. II and III only
D. None of the statements are valid.
Answer: B I is true.
II is false — if correlations are low, there is diversification benefit. III is false — asset correlations tend to be higher in times of stress.
I.
Key Point: Building-block approach (a financial conglomerate)
Three levels
¾ The first level aggregates the standalone risks within a single risk factor in an individual
business line.
¾ The second level aggregates risk across different risk factors within a single business line. ¾ The third level aggregates risk across different business lines, such as banking and insurance
subsidiaries.
Diversification benefit …
¾ Increases with the number of positions ¾ Decreases with greater concentration ¾ Decreases with greater correlation
Reference: Diversification benefits achieved at each of the three levels of aggregation for a financial conglomerate
Factors for Positions
Sub Level Number ConcentrationCorrelationLevel 1 (portfolio)
Large
Low
Low
Diversification Benefits
50% or more for CR
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Level 2 (BL)
Bank 15-28% middle Life
19-38%
middle middle Insurance P&C
Insurance
Low 27-46% 5-10%
small High High combining a bank with a P&C insurer with equal size for largest diversification benefits
Level 3
(Company)
Key Point: “3+1 pillars” approach (a financial conglomerate)
¾ The first pillar would incorporate specific, rules-based minimum capital requirements for a
conglomerate at the holding company level.
¾ The second pillar is the main load-bearing column of the regulatory framework. ¾ The third pillar would leverage market judgments on capital adequacy.
¾ The fourth pillar – legal firewalls – is a possible structural response to contagion of risks.
Key Point: Four categories of CRMPG2 recommendations
The CRMPGⅡReport
¾ Risk management and risk-related disclosure practices.(9) ¾ Financial infrastructure.(13)
¾ Managing risk and transparency for complex financial products.(18) ¾ Emerging issues.(7) 4 Emerging Issues
¾ Selling Complex Products to Retail Investors ¾ Managing Conflicts of Interest
¾ Risk management for Institutional Fiduciaries ¾ Oversight for Hedge Funds
4 supervisory challenges identified by the CRMPG ¾ Principles versus Rules
¾ Division of Responsibilities between Intermediaries and their Clients ¾ Harmonization of Accounting Standards and Risk Management ¾ Regulatory Coordination and Convergence
. According to the Report of the Counterparty Risk Management Policy Group (CRMPG) II,
the overriding guiding principle for its recommendations concerning complex financial products is:
A. accountability
B. sound judgment and experience
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C. standardization of procedures
D. the use of sophisticated financial models
Answer: B
According to the CRMPG II, the overriding guiding principle is that management must rely on sound judgment based on familiarity and knowledge of the fundamentals of risk management.
Key Point: Basel I
Risk Weighting
¾ All assets are given risk weights: 0%, 10%, 20%, 50% and 100%. Risky assets have higher
risk weights.
¾ Off-balance-sheet items, such as credit guarantee, FX obligation, and swaps are all converted
to credit equivalent amounts by some formulae.
¾ Tier 1 Capital: Stockholders’ equity, retained earnings.
¾ Tier 2 Capital: Loan loss provisions, subordinated debts, revaluation reserves. Capital Adequacy Ratio (CAR)
¾ CAR = Total Capital ÷ Risk-weighted assets ¾ Total Capital / Risk-weighted Assets > 8% ¾ Tier I Capital / Risk-weighted Assets > 4%
Key Point: Basel II Accord
Tier 1 capital or “core” capital
¾ It includes equity capital and disclosed reserves, most notably after-tax retained earnings.
Such capital is regarded as a buffer of the highest quality. ¾ Equity capital. ¾ Disclosed reserves.
Tier 2 capital or “supplementary” capital
¾ It includes components of the balance sheet that provides some protection but ultimately
must be redeemed or contains a mandatory charge against future income. ¾ Undisclosed reserves or hidden reserves.
¾ Asset revaluation reserves, General provision/loan loss reserve, Hybrid debt capital instruments, Subordinated term debt. Tier 3 capital for market risk only
65. Which of the following roles should not reside within an independent global risk
management function?
A. Establish risk management policies and procedures.
B. Review and approve risk management methodologies and models, in particular those
used for pricing and valuation.
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C. Execute trading strategies to hedge out global market risk.
D. Communicate risk management results to executive management and the board of
directors, as well as investors, rating agencies, stock analysts, and regulators.
Answer: C
There is a potential conflict of interest between risk management and trading, even for hedging purposes.
66. Banks are required to maintain 8 percent of their assets as \"Tier 1 Capital\". Which of the
following count towards this capital requirement?
I. Shareholders equity.
II. Sovereign debt held in the trading book. III. Common stock of other banks.
IV. Subordinated debt issued by the bank in question (subject to certain qualifying rules).
A. I, II, and IV B. II and III C. I and IV D. I only
Answer: D
Only equity capital and disclosed rescues (primarily after tm retained earnings) qualify as Tier 1 capital.
67. What would be the market risk capital requirement for a bank with a one day VaR of $100
and a specific risk surcharge of $30, based on the current BIS minimum capital requirements?
A. $300 B. $316 C. $949 D. $979
Answer: D
The BIS market risk charge can be computed by:
MRC
IMAt
⎛160
=max⎜k∑VARt−1,VATRt−1)+SRCt In this case we have only a l-day VaR,
⎝60i=1
which BIS allows to be extrapolated into a 10-day VaR using the square root of time rule (with the VaR calculated at the 99 percent confidence level). The value of the multiplier k is normally 3. With the information given, the formula is:
MRCtIMA=max((3)($100)10,$100)+$300=$978.68.
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68. According to the Basel II Accord.“At the discretion of their national authority, banks may
also use a third tier of capital (Tier 3). consisting of short-term subordinated debt for the sole purpose of meeting a proportion of the capital requirements for.” which of the following?
A. Market risk charges only B. Credit risk charges only
C. Market risk and credit risk charges D. All types of risk charges
Answer: A
Tier 3 capital can only be used to satisfy capital requirements resulting from market risk charges and cannot be applied to credit risk charges. Other choices are incorrect except choice A.
69. Which of the following approaches can be used to compute regulatory capital under the
internal ratings-based (IRB) approach for securitization exposures under the Basel II framework?
I. Ratings-Based Approach (RBA) II. Supervisory Formula (SF)
III. Internal Assessment Approach (IAA) IV. Internal Models Approach (IMM)
A. I and II B. I, II, and III C. II, III, and IV D. I, III, and IV
Answer: B
A. Is incorrect since IAA is missing.
B. Correct since the RBA. SF and IAA are the correct approaches.
C. Is incorrect since RBA is missing and IMA is wrong since it is for Market Risk. D. Is incorrect since IMA is used for Market Risk.
70. John Smith is a bank supervisor responsible for the oversight of Everbright Group, a large
banking conglomerate. Everbright Group now determines its credit risk profile according to the foundation IRB approach and assesses operational risk according to the standardized approach as described in the Basel II Capital Accord. Which of the following are specific issues that should be addressed as Dart of Smith’s supervisory review process of Everbright Group?
I. Review the bank’s internal control systems.
II. Check compliance with transparency requirements as described in Pillar 3 of Basel II
Accord.
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III. Make sure that the bank estimates for LGD and EAD for its corporate loans are in
compliance with supervisory estimates.
IV. Evaluate the impact of interest rate risk by assessing the impact of a 200 basis Point
interest rate shock to the bank’s capital position.
A. I and III only B. II and IV only C. I, II, and IV only D. I, II, III, and IV
Answer: C
The supervisor’s duties as Dart of the supervisory review process include:
Check compliance with Pillars I and III of Basel II Accord. which would include credit risk mitigation and transparency requirements. Review internal control systems. Access internal capital management methods employed by the bank. So I and II are correct. Note that the foundation IRB approach. the bank provides its estimates for PD but uses supervisory estimates for LGD and EAD for corporate loans. So III is incorrect. Also, the impact of interest rate risk on the bank’s capital position must be accessed by determining the impact of a 200 basis Point shock or its equivalent. So IV is also correct. Therefore, the correct answer for this question is choice C.
Key Point: Capital Charge
Capital Charge on Credit Risk
¾ Basel II allows: Standardized Approach, FIRB , AIRB
Securitization and Credit Risk Mitigation
¾ Basel II covers the details of securitization, which involves the economic or legal transfer of
assets to a third party, typically called special purpose vehicle (SPV).
¾ A bank can remove these assets from its balance sheet only after a true sale, which is using
clean break criteria: (a) the transferred assets are legally separated from the seller; (b) the seller does not maintain control over the assets. (No economic substance)
Guarantees and credit derivatives
¾ Capital relief is only granted if there is no uncertainty as to the quality of the guarantee.
¾ Protection must be direct, explicit, irrevocable, and unconditional. In such situation, one can
apply the principle of substitution.
¾ In other words, if Bank A buys credit protection against a default of Company B from Bank C,
it substitutes C’s credit risk for B’s risk.
Capital Charge on Op-Risk
¾ Basel II allows: Basic Indicator Approach, Standardized Approach, AMA
The Basic Indicator Approach
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¾ Capital Charge = Average Annual Gross Income * 15% ¾ ¾ ¾ ¾
15% is the capital charge ratio (β)
Average gross income is the average for the past 3 years
Gross income = Net interest Income + Net Non-interest Income
They are operating income, excluding provisions of loan loss, P/L from the sales of securities , extraordinary or irregular items
Standardized Approach
¾ This approach divides the bank’s activities into a number of standardized business units.
¾ Each business line is then characterized by an exposure indicator, taken as gross income for
simplicity.
¾ The capital charge is obtained by multiplying each exposure indicator by a fixed percentage
(beta factor) and summing across business lines
¾ This approach is still simple but better reflects varying risks across business lines.
¾ It can only be used if the bank demonstrates effective management and control of operational
risk.
Advanced measurement approach (AMA)
This approach allows banks to use their own internal models in the estimation of required capital. One example is the internal measurement approach (IMA).
¾ In the first step, banks classify their business units along the same lines as the standardized
approach.
¾ Banks then measure, based on their own internal loss data, a probability of loss event (PE) and
a loss given that event (LGE), as for credit risk.
¾ The expected loss is given as the product of EL, PE, and LGE.
MRC: Standardized Approach
¾ The Capital Accord was amended in 1996 to include a capital charge for market risk, to be
implemented by January 1, 1998, at the latest.
¾ The first for MRC is based on a “standardized” method, similar to the credit risk system with
add-ons determined by the Basel rules.
¾ This method provides a rough but conservative measure of the capital charge market risk.
¾ The objective of the market risk amendment was “to provide an explicit capital cushion for
the price risk to which banks are exposed.”
¾ The original proposal was issued in April 1993 and was based on a pre-specified building
block approach.
¾ The bank’s market risk is computed for portfolios exposed to interest-rate risk (IR), equity
risk (EQ), foreign currency risk (FX), commodity risk (CO), option risk (OP) ¾ MRCt
STD
=MRCtIR+MRCtEQ+MRCtFX+MRCtCO+MRCtOP
Quantitative Parameters of Internal Models
¾ A horizon of 10 trading days, or two calendar weeks; banks can, however, scale their daily
VAR by the square root of time
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¾ A 99 percent confidence interval
¾ An observation period based on at least a year of historical data or, if a non-equal weighting
scheme is used, average times lag of at least six months
¾ At least quarterly updating or whenever prices are subject to material changes (so that sudden
increases in risk can be picked up)
Reference:
Credit Risk
Standardized Approach (modified
version) Foundation Internal Rating Based
Approach Advanced Internal Rating Based
Approach
Market Risk Standardized Approach Internal Models Approach
Operational Risk Basic Indicator Approach Standardized Approach
Advanced Measurement Approach
71. City International Bank has 8 billion in foreign exchange exposure and total assets of 100
billion and has opted to use the Advanced Measurement Approach under the Base 2 Accord in calculating its capital requirements starting in 2007.The CRO has decided to explore the use of insurance products to transfer some of its operational risk exposures in order to obtain some relief from its capital charge. Which of the following conditions will nullify the company’s ability to use insurance to provide capital relief?
1. The insurance company has a claims paying rating of AA or its equivalent. 2. The insurance company is owned 10% by RS Bank.
3. The insurance policy does not contain any exclusions or limitations related to any
supervisory actions.
4. The insurance policy contains a minimum of cancellation of at least 90 days.
A. 2, 3, and 4 B. 1, and 3 C. 2 only D. 4 only
Answer: B
72. Your bank is implementing the advanced Internal Rating Based Approach of Basel II for
credit risk, and the Advanced Measurement Approach for operational risk. The bank uses the model approach for market risk. The Chief Risk Officer (CRO) wants to estimate the bank’s total risk by adding up the regulatory capital for market risk, credit risk, and operational risk. The CRO asks you to identify the problems with using this approach to estimate the bank’s total risk. Which of the following statements about this approach is incorrect?
A. It assumes market, credit, and operational risks have zero correlation. B. It uses a 10-day horizon for market risk.
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C. It ignores strategic risks.
D. It ignores the interest risk associated with the bank’s loans.
Answer: A
It is the perfect correlation.
73. Which of the following is not a drawback of the Basel II Foundation Internal Ratings Based
(IRB) approach?
A. Probabilities of default (PDs) and losses given default (LGDs) are assumed to be
uncorrelated.
B. Asset correlations decrease with increasing PDs.
C. The portfolio of the financial institution is assumed to be infinitely granular.
D. The approach uses a single risk factor portfolio model instead of a multiple risk factor
model.
Answer: B
A. Incorrect. This is a drawback of the Basel II prescribed IRB model as there can exist correlation between the PDs and LGDs which is not considered in the Basel model
B. Correct. This is NOT a drawback of the Basel II prescribed IRB model as the higher the PD. the higher the idiosyncratic (individual) risk components of a borrower. The default risk depends less on the overall state of the economy and more on individual risk drivers
C. Incorrect. This is a drawback of the Basel II prescribed IRB model as the portfolio of the financial institutions need not be completely granular
D. Incorrect. This is a drawback of the Basel II prescribed IRB model as there can be many systematic risk factor affecting the exposure instead of one single risk factor
74. The Basel II risk weight function for the Internal Ratings Based Approach (IRB) is based on
the Asymptotic Single Risk Factor (ASRF) model. under which the system-wide risks that affect all obligors are modeled with only one systematic risk factor. The major reason for using the ASRF is:
A. The model should not depend on the granularity of the portfolio.
B. The model should be portfolio invariant so that the capital required for any given loan
depends only on the risk of that loan and does not depend on the portfolio it is added to. C. The model should not be portfolio invariant and the capital required for any given loan
should not depend on the risk of other loans.
D. The model corresponds to the one-year Value at Risk at a 99.9% confidence level.
Answer: B
A Is incorrect since granularity though an issue. is not the major factor here since the model assumes infinitely granular portfolios.
B. Portfolio invariance is the only correct option above for the use of the ASRF in the Basel II model.
C. This statement is incorrect but put here to confuse unprepared candidates.
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D. This statement is not correct since the model is based on a VaR minus Expected Loss approach to computing capital to cover Unexpected Losses (UL) under credit risk exposures.
Key Point: Back Testing
Back testing
Outcome 1: Actual profit or loss over the next day. ¾ This includes all intraday P/L and fees obtained. Outcome 2: P/L of a hypothetical portfolio
¾ Basel framework recommends using both hypothetical and actual trading outcomes in
back-tests.
¾ The two approaches are likely to provide complementary information on the quality of the
risk management system.
¾ Green: Good Model (4/250 or low incorrect)
¾ Yellow: Fairly Acceptable Model (5/250 to 9/250 incorrect correct) ¾ Red: Unacceptable Model (10/250 incorrect) Poor Accuracy Additional Capital Charges
¾ Capital charge automatically changes from 3 VaR to 4 VaR
75. As the general manager of a bank’s risk management department, your CRO ask you to make
a stress testing plan recently. Which of following suggestions will you include in your stress test plan?
A. Board and senior management should involve in stress testing to ensure the appropriate
use of stress testing in banks’ risk governance and capital planning.
B. Stress testing should form an integral part of the internal capital adequacy assessment
process (ICAAP), which requires banks to undertake rigorous, forward-looking stress testing that identifies possible events or changes in market conditions that could adversely impact the bank.
C. The effectiveness of the stress testing program, as well as the robustness of major
individual components, should be assessed regularly and independently. D. All of the above are right.
Answer: D
The stress testing is a useful tool for bank’s risk management. As mentioned in the “Principles for sound stress testing practices and supervision”, a, b and c are all included in the principles. So the manager should include all of them in his stress testing plan. The correct answer is d.
76. As a financial manager in the bank, you need to calculate the regulatory capital requirement
for a residential mortgage portfolio in the Basel II framework. The risk manager has told you about the main information of this portfolio: The average estimation of PD= 0.5%, LGD= 25% for a whole economic cycle, and Estimation of PD= 1.5%, LGD= 45% in the economy crisis. EAD= 1 billion dollars; Given the following IRB risk weights table:
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Asset Class
Residential mortgage
LGD 45% 25% PD 0.5% 35.08% 19.49% 1.5% 73.45% 40.80% The regulatory capital requirement for this portfolio is:
A. $ 280000 B. $ 15592000 C. $ 320000 D. $ 58760000
Answer: A
A is correct. As the requirements of IRB method, banks should estimate their average PD and downturn LGD as the input of the IRB function, that is, choosing PD=0.5% and LGD=45% in this case. So the risk weight for this portfolio is 35.08%. The capital requirement equals to 28,0,000 (=35.08% * EAD *8%). B is incorrect. This answer can be got by using PD=0.5% and LGD=25% as the input of the IRB function. C is incorrect. This answer can be got by using PD=1.5% and LGD=25% as the input of the IRB function. D is incorrect. This answer can be got by using PD=1.5% and LGD=45% as the input of the IRB function.
Key Point: Beta Factors
Corporate finance: 18% Sales & Trading: 18% Retail banking: 12%
Commercial banking: 15% Payment & Settlement: 18% Agency service: 15% Asset management: 12% Retail brokerage: 12%
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Part 5 Current Issues in Financial Market
Key Point: Information, Liquidity, and the Panic of 2007
The ABX index is a credit derivative linked to 20 subprime residential mortgage
securitization transactions that occurred in the previous six months.
The ABX index allows investors wishing to protect themselves by hedge the risk of
certain credit events in the sup-rime mortgage market, such as interest or principle shortfalls, to pay willing sellers a monthly coupon payment for the protection. When the credit events occur and cause the underlying securities to react adversely, the protection seller must compensate the protection buyer in an amount equal to the loss.
The ABX index was the first transparent market that investors could view to gauge the
sentiment and valuation process regarding subprime residential mortgage products. When housing prices begin to fall, the uncertainty in the subprime mortgage paper markets regarding who would ultimately be saddled with the risk was revealed in the prices of the ABX index. Dealer banks holding the securitized products feared counterparty default and had nowhere to turn other than the ABX to seek credit risk protection. The transparency became a doubled-edged information sword in that seeing the devalued assets reflected in the ABX meant that it was real, which fed the panic.
The repo market is used by dealer banks to finance purchase of assets to be sold at a
later tome. The loans are secured by the assets, and in the case of the subprime mortgage market, these assets were the securitized residential mortgage products. The relationship between the repo market and these products broke down when dealer banks lost confidence in the valuation of the assets, refusing to accept them as collateral for the repo loans. With no one willing to accept the products as collateral, the loans become scarce. With no loans available, potential buyers could not finance the purchase, thus market, which priced the assets, dried up further until the liquidity eventually disappeared.
Deleveraging is the liquidation of securities to lessen debt. One event that can precipitate deleveraging is an increase in haircuts. The more a firm is leveraged before the haircut increase, the greater the impact. Using the simplest math, each time the haircut doubles, half of the leveraged assets will need to be sold.
Key Point: Has Financial Development Made the World Riskier?
The key drivers of change that transpired in the financial landscape over the past thirty
years are technological change, deregulation, and institutional change. These changes led to disintermediation, market integration, and re-intermediation.
Bank managers in the past had little or no incentives to reach for higher revenue by
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investment manager is tied to stock performance. Thus, the incentive structure in today’s banking system has led to behaviors such as tail risk taking and herding.
Although technological change has inspired more innovative products in banking, it promoted less regulation, more competition, and allowed easier and greater access to credit for a larger and more varied pool of customers. All of this encouraged more risk taking.
The capital structure based on long-term lending and demand deposits compelled banks to build credibility for depositors, banking partners, and the market through prudent practice. This particular organization form had, in turn, allowed banks to be reliable intermediaries.
Risk-transfer is a risk optimization process and does not completely eliminate risks from a bank’s balance sheet. Thus, banks have not become safer despite the higher capitalization levels. In some cases, banks may have become riskier.
Market integration was the product of key changing forces that had allowed for a wider yet less sophisticated pool of investors. Thus, the reliability of the market superstructure not only provides essentially the only platform for the security of transactions, but also is of critical importance to the functioning of today’s arm’s length transaction.
There are incentives to take hidden tail risks because these risks are not only unobserved to investors, with low probability of occurring and high alphas, but also typically are not included in the comparison benchmark. Herding occurs when investment managers follows the trend and adopt similar investment strategies of their peer group. Low interest rates lead to risk taking behavior when interest rates fall.
while banks were able to receive large cash flows and subsequently facilitated liquidity back into the system during the downturn in 1998, banks were reluctant to provide liquidity to borrowers even after the Central Bank had injected billions of dollars during 2008 to avoid potential losses due to uncertainty.
One micro-prudential reason for supervision includes protection of investors; however, there seems to be no interest in public policy to protect investors who are not afraid to invest with hedge funds. On the other hand, the basis for macro-prudential supervision, such as regulations, to prevent herding behavior that would cause massive assets price shifts in the market or serious systemic threat, is well-founded. Instruments for prudent supervision include tools for monitoring, disclosures, capital requirements, and incentives.
Key Point: A Panoramic View of Eight Centuries of Financial Crisis
¾ Government default on external debt is common throughout history
¾ Almost all countries have defaulted on their external debt when they were an emerging
country. Many countries have defaulted more than once during their emerging country phase. ¾ When times are good, emerging countries borrow too much and it is thought that “this time is
different.” Due to this belief, countries and their lenders become too optimistic and countries ultimately default.
¾ The transmission mechanisms that propagate shocks throughout the sovereign debt market
are as follows:
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9 9 9 9
Capital flows and lending to emerging countries decline Commodity prices decline
Credit crises in financial centers spread to emerging markets
Interest rate increases in financial centers create a credit crisis in emerging markets
Key Point: Risk Management Lessons Worth Remembering From the Credit Crisis of 2007-2009
Risk management requires strong and specific support from top-level management of an
organization for it to work in the long term. For example, it is necessary that risk management does not become a secondary issue subservient to short-term profit goals. A number of methods exist to align employee behavior with the long-term interests of
the organization. In addition, there are methods to promote greater faith and loyalty within an organization. Those points will help promote commitment to the organization and to be aligned with the goals of risk management------to protect the organization and maintain it for the long term.
Risk managers must be independent from risk takers so as to allow the former to
monitor the latter’s investment actions in an objective manner. There are a number of methods to promote such independence and care must be taken by top-level management to ensure that the independence remains, especially if the risk management team is working together with the risk takers.
The bottom-up approach to risk management is crucial because of its requirement for
extremely detailed risk analysis that is based on facts rather than assumptions. For risk management purposes, it is far superior to the top-down approach.
Financial markets are always changing and as a result, risk models must also be
constantly reviewed and revisited.
Financial firms must not always assume that there will be an active market for its
investment assets at all times.
Cash reserves, highly liquid securities, and cash flow are the only reliable sources of
liquidity, especially in times of crisis.
In the context of measuring portfolio liquidity risk, complex assets should be treated as
illiquid investments.
Organization need to ensure that they properly account for the liquidity demands of
collateral support agreements
Key Point: Findings Regarding the Market Events of May 6, 2010
On May 6,2010, prices and liquidity declined so rapidly that buyers and arbitrageurs
were not willing or able to supply additional liquidity.
The sudden price declines in the E-Mini market caused the trading systems used in the
equities markets to temporarily pause.
High frequency traders absorbed a portion of the selling pressure in the E-Mini market,
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and cross-market arbitrageurs transferred the sell pressure from the E-Mini market to the equities market.
Liquidity issues arose from a trader’s sell algorithm that was programmed to execute
trades based on trading volume without regard for current prices or timing.
Key Point: The U.S. And Irish Credit Crises: Their Distinctive Difference And Common Features
Investor and market sentiment can lead to asset price inflation. A situation in which
security markets are boosted by a widespread temporary feeling of over-confidence and over-optimism is sometimes called irrational exuberance. Irrational exuberance leads to excessively high asset prices (i.e., bubbles) and inflated levels of risk-taking. This lack of rational was a factor in creating both the U.S. and Irish crises.
Rational exuberance could be used to refer to a period of abundance and growth that is
based on a sound and sensible reaction to improving conditions. It has been argued that the initial portion (from 1996 to 2000) of the Irish housing boom was a rational revaluation of the country’s properities, rather than an irrational bubble.
A major cause of the U.S. crisis was the capital inflows that preceded it; large amounts
of foreign capital flowed into U.S. government debt securities and securitized mortgage assets. Additionally, accommodative U.S. monetary policy lead to low real interest rates and low risk-adjusted required rates of return on risk investments. In the Irish crisis, banks obtained substantial funding from the international capital markets, causing balance sheets and lending to swell. This was compounded by the low eurozone interest rates that Ireland adopted when joining the EU.
The negligence of regulators played a role in causing both the United States and Irish
crises: in both countries regulatory inaction allowed the level of risk in the countries’ financial markets to swell unchecked. In the United States, regulators didn’t recognize how complex and fragile the U.S. markets had become regarding the increasing complexity of some financial products. Also, in an effort to promote home ownership, U.S. regulators took little action to control the growth of the subprime mortgage market. In Ireland, the regulators displayed poor judgement in their handling of a number of situations, including their low regulatory oversight of banks, and inaction in stemming international credit inflows and the runaway Irish property sector.
Moral hazard describes a situation where a party is insulated from the downside effects
of their actions, so the party behaves differently than they would if they were fully exposed to that risk. In both Ireland and the United States, moral hazard was created by implicit guarantees of bailouts, as well as trader put options, which allowed individuals to be compensated for taking risks without suffering losses. Moral hazard in the United States was increased by the originate-and-distribute mortgage system, and the profitability of taking on tail risk through exposure to securities mortgage assets and credit derivatives. In Ireland, moral hazard was amplified by weak enforcement of Irish law, and later by explicit bank guarantees.
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Key Point: Interpreting Sovereign Spreads
Credit ratings have four key advantages over other methods as a measure of sovereign risk: • Credit rating organizations base their ratings on clearly defined criteria and methodologies. • Credit rating organizations regularly review and report on how closely their ratings correspond to observed historical default rates • Credit rating organizations have a direct business incentive to ensure their ratings are as accurate as possible. • Credit default swap spreads react significantly to changes made by credit rating organizations, proving that investors rely on ratings to make investment decisions Observed sovereign spreads and credit ratings may differ due to different time horizons factored into their computation. Sovereign spreads are determined by the marketplace and reflect the short term time horizon of market participants. Credit ratings rely on a long-term time horizon that reflects changes in credit quality, which rating agencies believe are permanent. Credit rating scales and implied probabilities of sovereign defaults have an inverse, non-linear relationship. Implied default probabilities rise at an increasing rate for each one-notch decline in credit rating. Ratings implied probabilities of default (RIPD) and sovereign currency credit ratings are both statistically significant and economically meaningful for explaining sovereign CDS spreads. Institutional Investor survey country ratings are not statistically significant or economically meaningful for determining CDS spreads. Sovereign spreads can be divided into two components: (1) expected loss, and (2) risk premia. The expected loss is a function of how likely it is for the entity to default (probability of default) and the difference between the value of the asset and the amount recovered if a loss occurs(1-recoverey rate). The risk premia are determined by subtracting the expected loss from the observed sovereign spread and reflect how investors price the risk of unexpected losses The “credit spread puzzle” refers to the phenomenon of the risk premia making up the larger part of the credit spread when the spread is decomposed into the expected loss and risk premia There are four key observations regarding how the magnitude of the “credit spread puzzle” can vary across countries: • Risk premia are a larger proportion of the total credit spread for countries with higher credit ratings • Average sovereign spreads are wider than average ratings-implied expected losses at every credit rating • Both average sovereign spreads and average ratings-implied expected losses widen as credit ratings decline • Spreads widen more dramatically for countries with lower credit ratings. 49-52 专业来自百分百的投入
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Key Point: Making Over-The-Counter Derivatives Safer: The Role of Central Counterparties
OTC clearing requires determining the payment amount for counterparties at the start of
each period, notifying the counterparties of their payment obligations, valuing derivative contracts daily for collateral requirements, and monitoring the creditworthiness of counterparties with respect to the compliance terms of the contract.
Novation refers to the transfer of the original rights and obligations of two counterparties to a central counterparty (CCP). Redundant overlapping contracts are a major problem with bilateral contracts, because they increase counterparty and systemic risks by making the overall market more complex and less transparent. Multilateral netting reduces the amount of counterparty risk exposure in the system through the intervention of a CCP
Counterparty risks are mitigated by the: (1) creation of multilateral nettings through
CCPs, (2) collateralization of residual net exposures, and (3) compression of redundant contracts though tear-up operations.
CCPs mitigate counterparty risks by absorbing exposures through layers of default
protection that are used as lines of defense against clearing members (CMs) default. These layers of defense include end-user’s margins, CM’s margins, CCP Guarantee Fund, CCP’s first-loss pool, capital calls, CCP capital, and access to central bank lending resources.
Major challenges toward moving a critical mass of contracts to CCPs are related to the
standardization and liquidity of contracts, reluctance of dealers to move contracts due to increased collateral and margin requirements, and reluctance of end-users to move contracts due to collateral and segregation concerns.
Key Point: FSF Principles For Sound Compensation Practices
Compensation risk refers to compensation practices at firms that focus on working hard
to achieve large profits in the short term, resulting in large bonus payments to management and employees. Those profits also come with long-term risks to the firms as witnessed in the recent financial crisis.
Effective governance of compensation depends on: maintaining control by the board of
directors, executing sufficient monitoring and review duties by the board of directors, properly delegating financial and risk control tasks to appropriate employees who are independent, and reliable and relevant performance measurement.
Two general approaches exist for effective alignment of compensation with risk taking:
risk adjustments and compensation outcomes. Within those two approaches, issues such as types of risk, consistency with outcomes, time periods, and compensation mix need to be considered.
In the context of risk alignment, a judgment-based system is largely a subjective process
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performed by senior management. Although there is a lot of flexibility, there is an inordinate amount of subjectivity and risk of manipulation. In contrast, a quantitative measures system is more objective, but there still exists the risk of quantitative manipulation to underweight key risks.
Four examples of asymmetric compensation outcomes include: out-of-the-money options, bonuses (including mutil-year guaranteed bonuses), golden handshake payments, and golden parachute payments.
Bonus payment to employees should not be made in the short term if there are still
related risks outstanding in the long term. Alternatives would include deferring payments or requiring future repayments in the event of future losses
Effective supervisory oversight with the strong enforcement of remedial actions for
deficiencies should assist in preventing or reducing excessive risk-taking in both the short and long term. Compensation governance is enhanced when shareholders are informed or involved in the process. The disclosure of relevant information on compensation practices(compensation is generally a significant operating expense for the firm) allows stakeholders to adequately assess their business relations with the frim
Key Point: Deciphering the Liquidity And Credit Crunch 2007-2008
The originate-to-distribute model and asset/liability maturity (mismatch ) management
were two key banking industry trends that led up to the mortgage crisis and resulting liquidity squeeze.
The originate-to-distribute model refers to the process through which banks create a
security, based on a pool of underlying mortgages, bond, or other loans, and then sell it to investors. By originating and selling the securitized asset to investors, the banks transfer the default risk of borrowers to the ultimate investors.
Banks, via SIVs, used commercial paper and repurchase agreement markets to rollover
short-term financing for investing in long-term assets. Asset/liability maturity(mismatch ) management methods employed by banks exposed them to funding liquidity risk.
Funding liquidity refers to raising funds to finance the purchase of an asset. Market
liquidity refers to the ease or difficulty to sell an asset without lowering the equilibrium price to attract the buyer
Loss spiral refers to the forced sale of an asset by a leveraged investor in order to
maintain the constant margin or leverage ratio requirements. A margin spiral refers to the forced sale of an asset as a result of an increase in margins or, equivalently speaking, a decline in leverage ratio.
Network risk arises as a result of an increase in counterparty credit risk, which forces
contracting parties to seek additional protection and liquidity enhancement. In the absence of a clearinghouse that could facilitate multilateral netting arrangements, such an increase in counterparty credit risk, can produce systemic effects, as evidenced by the recent global financial crisis.
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Key Point: Examiner’s Report on Lehman
Lehman’s risk committee was mandated to review and assess all the risk exposures of
the firm.
Lehman’s risk management group was responsible for developing the risk management
system to measure, monitor, and implement various risk controls.
The risk metrics used by Lehman included the following risk controls: VAR risk limits,
stress testing, equity sufficiency, and single transaction and balance sheet limits.
The Global Risk Management Group (GRMG) of Lehman was responsible for developing the risk appetite limits at the firm, division (and within divisions, various lines of business), and regional and global levels
Under the Consolidated Supervised Entities Program (CSE), Lehman furnished the SEC
with information about a set of regulations, including risk limits, actual usage, and the variation between actual usage and the risk limits, through numerous reports on a daily, weekly, and monthly basis.
Although Lehman was under no mandatory obligation to disclose details of its risk
metrics, Lehman, in its public filings, up to 2007, chose to disclose that it monitored its risk appetite limits
Several inconsistencies surfaced during the bank examiner’s interviews with respect to
statements given by several members of Lehman’s risk committee
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