[Dec 15, 2021] Free PRM Certification 8008 Official Cert Guide PDF Download

PRMIA 8008 Official Cert Guide PDF

NEW QUESTION 205
For a back office function processing 15,000 transactions a day with an error rate of 10 basis points, what is the annual expected loss frequency (assume 250 days in a year)

• A. 0
• B. 1
• C. 0.06
• D. 2

Answer: B

Explanation:
Explanation
An error rate of 10 basis points means the number of errors expected in a day will be 15 (recall that 100 basis points = 1%). Therefore the total number of errors expected in a year will be 15 x 250 = 3750. Choice 'a' is the correct answer.

 

NEW QUESTION 206
Which of the following statements is true in relation to a normal mixture distribution:
I. The mixture will always have a kurtosis greater than a normal distribution with the same mean and variance II. A normal mixture density function is derived by summing two or more normal distributions III. VaR estimates for normal mixtures can be calculated using a closed form analytic formula

• A. I and II
• B. I and III
• C. II and III
• D. I, II and III

Answer: A

Explanation:
Explanation
Normal mixtures have higher peaks, and therefore higher kurtosis than a normal distribution with an equivalent mean and variance. Therefore statement I is correct.
The term 'normal mixture' literally means that - the distribution is derived by summing two or more normal distributions. Statement II is correct. One interesting thing to note about normal mixtures is that their mean and variances are just the weighted averages of the means and variances of their underlying component normal distributions. But their kurtosis is higher than that of either of the components. They are more peaked, and have fatter tails, a property that makes them useful in finance.
Unfortunately there is no analytical formula for calculating VaR based on normal mixtures. However, we can back solve for VaR (using Excel's Solver, for example), given we know the density functions for the underlying normal distributions. Statement III is not correct.

 

NEW QUESTION 207
When compared to a low severity high frequency risk, the operational risk capital requirement for a medium severity medium frequency risk is likely to be:

• A. Lower
• B. Unaffected by differences in frequency or severity
• C. Zero
• D. Higher

Answer: D

Explanation:
Explanation
High frequency and low severity risks, for example the risks of fraud losses for a credit card issuer, may have high expected losses, but low unexpected losses. In other words, we can generally expect these losses to stay within a small expected and known range. The capital requirement will be the worst case losses at a given confidence level less expected losses, and in such cases this can be expected to be low.
On the other hand, medium severity medium frequency risks, such as the risks of unexpected legal claims,
'fat-finger' trading errors, will have low expected losses but a high level of unexpected losses. Thus the capital requirement for such risks will be high.
It is also worthwhile mentioning high severity and low frequency risks - for example a rogue trader circumventing all controls and bringing the bank down, or a terrorist strike or natural disaster creating other losses - will probably have zero expected losses & high unexpected losses but only at very high levels of confidence. In other words, operational risk capital is unlikely to provide for such events and these would lie in the part of the tail that is not covered by most levels of confidence when calculating operational risk capital.
Note that risk capital is required for only unexpected losses as expected losses are to be borne by P&L reserves. Therefore the operational risk capital requirements for a low severity high frequency risk is likely to be low when compared to other risks that are lower frequency but higher severity.
Thus Choice 'c' is the correct answer.

 

NEW QUESTION 208
For a loan portfolio, expected losses are charged against:

• A. Credit reserves
• B. Regulatory capital
• C. Economic capital
• D. Economic credit capital

Answer: A

Explanation:
Explanation
Credit reserves are created in respect of expected losses, which are considered the cost of doing business.
Unexpected losses are borne by economic credit capital, which is a part of economic capital. Therefore Choice
'c' is the correct answer.

 

NEW QUESTION 209
Which of the following statements is true:
I. Expected credit losses are charged to the unit's P&L while unexpected losses hit risk capital reserves.
II. Credit portfolio loss distributions are symmetrical
III. For a bank holding $10m in face of a defaulted debt that it acquired for $2m, the bank's legal claim in the bankruptcy court will be $10m.
IV. The legal claim in bankruptcy court for an over the counter derivatives contract will be the notional value of the contract.

• A. I, II and IV
• B. I and III
• C. II and IV
• D. III and IV

Answer: B

Explanation:
Explanation
Statement I is true as expected losses are the 'cost of doing business' and charged against the P&L of the unit holding the exposure. When evaluating the business unit, expected losses are taken into account. Unexpected losses however require risk capital reserves to be maintained against them.
Statement II is not true. Credit portfolio loss distributions are not symmetrical, in fact they are highly skewed and have heavy tails.
Statement III is true. The notional, or the face value of a defaulted debt is the basis for a claim in bankruptcy court, and not the market value.
Statement IV is false. In the case of over the counter instruments, the replacement value of the contract represents the amount of the claim, and not the notional amount (which can be very high!).

 

NEW QUESTION 210
Which of the following statements are true:
I. Liquidity risks during time of crisis may be exacerbated by large collateral calls continuing over a period of time.
II. Stress tests are always separately modeled from VaR computations which cannot deal with stress scenarios of the kind considered in stress tests.
III. A maximum loss scenario considers the maximum possible loss given a 'plausibility constraint' that is based upon the joint probability of such a loss happening

• A. I and II
• B. II and III
• C. I and III
• D. I, II and III

Answer: C

Explanation:
Explanation
If VaR is calculated based upon historical simulations, and these simulations are designed as to include all stress scenarios of interest, then VaR and stress tests can be a part of an integrated risk measurement system.
Therefore it is not correct to say that stress tests are always separately modeled from VaR and II is false. I and III are true, and therefore Choice 'd' is the correct answer.

 

NEW QUESTION 211
An investor enters into a 5-year total return swap with Bank A, with the investor paying a fixed rate of 6% annually on a notional value of $100m to the bank and receiving the returns of the S&P500 index with an identical notional value. The swap is reset monthly, ie the payments are exchanged monthly. On Jan 1 of the fourth year, after settling the last month's payments, the bank enters bankruptcy. What is the legal claim that the hedge fund has against the bank in the bankruptcy court?

• A. $6m
• B. $0, as all payments on the swap are current
• C. The replacement value of the swap
• D. $100m

Answer: C

Explanation:
Explanation
According to ISDA standard definitions, the legal claim for OTC derivatives is the current replacement value of the contract. Therefore Choice 'c' is the correct answer. None of the other choices are correct.

 

NEW QUESTION 212
Which of the following is the most accurate description of EPE (Expected Positive Exposure):

• A. The maximum average credit exposure over a period of time
• B. The average of the distribution of positive exposures at a specified future date
• C. Weighted average of the future positive expected exposure across a time horizon.
• D. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date

Answer: C

Explanation:
Explanation
When a derivative transaction is entered into, its value generally is close to zero. Over time, as the value of the underlying changes, the transaction acquires a positive or negative value. It is not possible to predict the future value of the transaction in advance, however distributional assumptions can be made and potential exposure can be measured in multiple ways. Of all the possible future exposures, it is generally positive exposures that are relevant to credit risk because that is the only situation where the bank may lose money from a default of the counterparty.
The maximum (generally a quantile eg, the 97.5th quantile) exposure possible over the time of the transaction is the 'Potential Future Exposure', or PFE.
The average of the distribution of positive exposures at a specified date before the longest trade in the portfolio is called 'Expected Exposure', or EE.
The expected positive exposure calculated as the weighted average of the future positive Expected Exposure across a time horize is called the EPE, or the 'Expected Positive Exposure'.
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date - is the 'fair value', as defined under FAS 157.
Therefore the corect answer is that EPE is the weighted average of the future positive expected exposure across a time horizon.

 

NEW QUESTION 213
When doing stress tests based on historical scenarios, if no appropriate historical scenarios exist for a security, it is most INAPPROPRIATE to:

• A. Estimate a shock factor based on other instruments that might be considered as proxies for such a security
• B. Leave the position unshocked
• C. Estimate a shock factor based upon extrapolation
• D. Estimate a shock factor based upon interpolation

Answer: B

Explanation:
Explanation
Where a historical shock factor does not exist for a security, for example because the security is new or was only thinly traded earlier, or because a particular emerging market was immature at the time of the historical scenario being considered, it is inappropriate to leave the position unshocked. By and large, the general rule to be followed when carrying out stress testing is to leave no position unshocked. Therefore Choice 'b' is the correct answer.
Choice 'd', Choice 'a' and Choice 'c' all represent valid approaches to estimating a shock factor in such cases.

 

NEW QUESTION 214
Which of the following will be a loss not covered by operational risk as defined under Basel II?

• A. Fat finger losses
• B. Systems failure
• C. Strategic planning
• D. Earthquakes

Answer: C

Explanation:
Explanation
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.
Therefore any losses from poor strategic planning will not be a part of operational risk. Choice 'd' is the correct answer.
Note that floods, earthquakes and the like are covered under the definition of operational risk as losses arising from loss or damage to physical assets from natural disaster or other events.

 

NEW QUESTION 215
Which of the following is not true about the ISDA master agreement (ISDA MA):

• A. The ISDA MA describes the close out process
• B. The ISDA MA describes events of default, and termination events
• C. All transactions under the ISDA MA are considered separate obligations
• D. The CSA (Credit Support Annex) is one of the parts of the ISDA MA

Answer: C

Explanation:
Explanation
The ISDA MA provides a template that can be used by market participants to document derivative transactions. It has a core section that applies always, and various schedules that can be agreed to by the parties. The ISDA MA considerably facilitates closing transactions once the ISDA MA has been has been negotiated, without requiring a renegotiation each time.
A key feature of the ISDA MA is that it binds all transactions into a single net obligation. The ISDA Master
2002 states that "All transactions are entered into in reliance on the fact that this Master Agreement and all Confirmations form a single agreement between the parties ... and the parties would not otherwise enter into any Transactions." Therefore transactions under the ISDA MA are not considered separate obligations.
The ISDA MA does indeed define close out processes, default and termination events, and the CSA is one of the parts of the MA that describes the collateral related agreement.

 

NEW QUESTION 216
Which of the following formulae describes CVA (Credit Valuation Adjustment)? All acronyms have their usual meanings (LGD=Loss Given Default, ENE=Expected Negative Exposure, EE=Expected Exposure, PD=Probability of Default, EPE=Expected Positive Exposure, PFE=Potential Future Exposure)

• A. LGD * EPE * PD
• B. LGD * ENE * PD
• C. LGD * EE * PD
• D. LGD * PFE * PD

Answer: A

Explanation:
Explanation
The correct definition of CVA is LGD * EPE * PD. All other answers are incorrect.
CVA reflects the adjustment for counterparty default on derivative and other trading book transactions. This reflects the credit charge, that neeeds to be reduced from the expected value of the transaction to determine its true value. It is calculated as a product of the loss given default, the probability of default and the average weighted exposure of future EPEs across the time horizon for the transaction.
The future exposures need to be discounted to the present, and occasionally the equations for CVA will state that explicitly. Similarly, in some more advanced dynamic models the correlation between EPE and PD is also accounted for. The conceptual ideal though remains the same: CVA=LGD*EPE*PD.

 

NEW QUESTION 217
The probability of default of a security over a 1 year period is 3%. What is the probability that it would have defaulted within 6 months?

• A. 98.49%
• B. 17.32%
• C. 1.51%
• D. 3.00%

Answer: C

Explanation:
Explanation
The question is asking for the probability of default over a 6 month period when the probability of annual default is known. If we let the 6 month probability of defaut be 'd', then the probability of survival at the end of
1 year would be (1 - d)^2. This we know is equal to 1 - 3% = 0.97. Therefore we can calculate 'd' to be equal to 1.51%. Choice 'c' is the correct answer, the others are incorrect.
Note that an exam question may ask for probability of the security having survived after 6 months, in which case the answer might be 1 - 1.51%. Also note that such questions will always require you to use the probability of survival (1 - probability of default) for doing the calculations. That is because the probabilities of survival can be multiplied over periods of time, but not probabilities of default as the first default in any period is the 'game-over' event after which neither survival nor defaults mean anything. Therefore you generally always have to get the probability of survival till a point in time, and use that for any other calculations.

 

NEW QUESTION 218
Under the standardized approach to calculating operational risk capital, how many business lines are a bank's activities divided into per Basel II?

• A. 0
• B. 1
• C. 2
• D. 3

Answer: A

Explanation:
Explanation
In the Standardized Approach, banks' activities are divided into eight business lines: corporate finance, trading
& sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Therefore Choice 'c' is the correct answer.

 

NEW QUESTION 219
A portfolio's 1-day VaR at the 99% confidence level is $250m. What is the annual volatility of the portfolio?
(assuming 250 days in the year)

• A. $2,410.3m
• B. $3,952.8m
• C. $1,699.4m
• D. $107.5m

Answer: C

Explanation:
Explanation
This is easy to calculate as follows: At the 99% confidence level, the VaR=2.326 * Std Deviation (remember the z values at the 95% and 99% levels, the PRMIA exam may not give you these values). Thus the 1-day standard deviation is $250m/2.326, and the 250-day standard deviation is 250 * ($250m/2.326) = $1,699.4m.
Remember: if you know the VaR, you know the standard deviation. Once you know the standard deviation for any period of time, you can convert it into standard deviation for another period using the square root of time rule. You can also calculate the VaR at a different confidence level too.

 

NEW QUESTION 220
The Options Theoretic approach to calculating economic capital considers the value of capital as being equivalent to a call option with a strike price equal to:

• A. The value of the assets
• B. The market value of the debt
• C. The notional value of the debt
• D. The value of the firm

Answer: C

Explanation:
Explanation
The Options Theoretic approach to calculating economic capital is a top-down approach that considers the value of capital as being equivalent to a call option with a strike price equal to the notional value of the debt - ie, the shareholders have a call option on the assets of the firm which they can acquire by paying the debt holders a value equal to their notional claim (ie the face value of the debt). Therefore Choice 'a' is the correct answer and the other choices are incorrect.

 

NEW QUESTION 221
There are three bonds in a diversified bond portfolio, whose default probabilities are independent of each other and equal to 1%, 2% and 3% respectively over a 1 year time horizon. Calculate the probability that none of the three bonds will default.

• A. 0.0006%
• B. 2%
• C. 94%
• D. 0.11%

Answer: C

Explanation:
Explanation
The probability that only none of the three bonds will default is equal to the probability of all surviving. Since default correlation is zero, we can simply multiply the probabilities of survival. Therefore the correct answer is
94% = (1 - 1%) * (1 - 2%) * (1 - 3%)

 

NEW QUESTION 222
Which of the following credit risk models includes a consideration of macro economic variables such as unemployment, balance of payments etc to assess credit risk?

• A. The actuarial approach
• B. KMV's EDF based approach
• C. The CreditMetrics approach
• D. CreditPortfolio View

Answer: D

Explanation:
Explanation
The correct answer is Choice 'd'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:
1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.
2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.
3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.
4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.
5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

 

NEW QUESTION 223
For an equity portfolio valued at V whose beta is , the value at risk at a 99% level of confidence is represented by which of the following expressions? Assume represents the market volatility.

• A. 2.326 x V x /
• B. 1.64 x x V x
• C. 2.326 x x V x
• D. 1.64 x V x /

Answer: C

Explanation:
Explanation
For the PRM exam, it is important to remember the z-multiples for both 99% and 95% confidence levels (these are 2.33 and 1.64 respectively).
The value at risk for an equity portfolio is its standard deviation multiplied by the appropriate z factor for the given confidence level. If we knew the standard deviation, VaR would be easy to calculate. The standard deviation can be derived using a correlation matrix for all the stocks in the portfolio, which is not a trivial task.
So we simplify the calculation using the CAPM and essentially say that the standard deviation of the portfolio is equal to the beta of the portfolio multiplied by the standard deviation of the market.
Therefore VaR in this case is equal to Beta x Mkt Std Dev x Value x z-factor, and therefore Choice 'a' is the correct answer.

 

NEW QUESTION 224
Which of the following are measures of liquidity risk
I. Liquidity Coverage Ratio
II. Net Stable Funding Ratio
III. Book Value to Share Price
IV. Earnings Per Share

• A. I and IV
• B. I and II
• C. II and III
• D. III and IV

Answer: B

Explanation:
Explanation
In December 2009 the BIS came out with a new consultative document on liquidity risk. Given the events of
2007 - 2009, it has been clear that a key characteristic of the financial crisis was the inaccurate and ineffective management of liquidity risk The paper two separate but complementary objectives in respect of liquidity risk management: The first objective relates to the short-term liquidity risk profile of institution, and the second objective is to promote resiliency over longer-term time horizons. The paper identifies the following two ratios - you should be aware of these - though I am not sure if these will show up in the PRMIA exam:
1. Liquidity Coverage Ratio addresses the ability of an institution to survive an acute liquidity risk stress scenario lasting one month. It is calculated as follows:
Liquidity Coverage Ratio = Stock of high quality liquid assets/Net cash outflows over a 30-day time period
2. Net Stable Funding Ratio has been developed to capture structural issues related to funding choices.
Net Stable Funding Ratio = Available amount of stable funding/Required amount of stable funding Both ratios should be equal to or greater than 1. The statement contains detailed definitions of what is included or excluded from each of the terms used in the calculations for each of the ratios. In addition, the standard also describes the what the 'acute' scenario should include (things such as a 3 notch credit downgrade, reduction in retail deposits etc) Therefore Choice 'b' is the correct answer. Book Value to Share Price and Earnings Per Share are accounting measures unrelated to liquidity.

 

NEW QUESTION 225
If the full notional value of a debt portfolio is $100m, its expected value in a year is $85m, and the worst value of the portfolio in one year's time at 99% confidence level is $60m, then what is the credit VaR?

• A. $15m
• B. $60m
• C. $40m
• D. $25m

Answer: D

Explanation:
Explanation
Credit VaR is the difference between the expected value of the portfolio and the value of the portfolio at the given confidence level. Therefore the credit VaR is $85m - $ 60m = $25m. Choice 'b' is the correct answer.
Note that economic capital and credit VaR are identical at a risk horizon of one year. Therefore if the question asks for economic capital, the answer would be the same.
[Again, an alternative way to look at this is to consider the explanation given in III.B.6.2.2: Credit Var = Q(L)
- EL where Q(L) is the total loss at a given confidence interval, and EL is the expected loss. In this case Q(L) -
$100-$60 = $40, and EL = $100-$85=$15. Therefore Credit VaR = $40-$15=$25.]

 

NEW QUESTION 226
Which of the following statements is true?

• A. Under times of liquidity stress, both prepayments of loans extended and expected withdrawals from on-demand deposits will decrease
• B. For an issuer of life insurance policies, longevity risk can lead to reserves falling short of payments due
• C. Deterioration in the balance sheets of key counterparties is a concern for a liquidity manager even though it may not immediately affect a firm
• D. Only the drawn portions of credit facilities extended to clients by a bank count towards its liquidity exposure

Answer: C

Explanation:
Explanation
Deterioration in the balance sheets of key counterparties is a concern for a liquidity manager even though it may not immediately affect a firm, and this is true because counterparty failures may lead to liquidity shortfalls for an institution for no fault of its own. It is important for a liquidity risk manager to watch the health of key counterparties where exposure is concentrated and take timely steps to reduce it should the health deteriorate.
Under times of liquidity stress, prepayments of loans extended will decline while withdrawals of demand deposits are likely to increase. Both will not decrease, and therefore Choice 'b' is incorrect.
A bank is exposed to the undrawn portions of a line of credit extended to a borrower as the borrower, with superior information on its own finances, is likely to draw upon undrawn lines of credit thereby increasing the bank's exposure. Therefore Choice 'a' is incorrect. Generally, a portion of the undrawn part is counted towards a liquidity outflow.
Longevity risk is the risk facing sellers of annuities that their clients will outlive their assumptions on their length of life, while mortality risk is the downside risk for an insurer that clients will die sooner than expected causing the reserves to fall short of what is needed. Therefore Choice 'd' is not correct as the opposite is true.

 

NEW QUESTION 227
Which of the following credit risk models relies upon the analysis of credit rating migrations to assess credit risk?

• A. The actuarial approach
• B. KMV's EDF based approach
• C. The CreditMetrics approach
• D. The contingent claims approach

Answer: C

Explanation:
Explanation
The correct answer is Choice 'b'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:
1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.
2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.
3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.
4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.
5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

 

NEW QUESTION 228
The estimate of historical VaR at 99% confidence based on a set of data with 100 observations will end up being:

• A. the worst single observation in the data set
• B. the weighted average of the top 2.33 observations
• C. None of the above
• D. the extrapolated returns of the last 1.64 observations

Answer: A

Explanation:
Explanation
The VaR in this case will be the top quintile of observations. In this case, since there are exactly 100 observations, this would mean the worst return would become the VaR. Therefore Choice 'b' is the correct answer. Choice 'a' and Choice 'c' make no sense. This highlights that at higher confidence levels, fewer and fewer observations impact the VaR if we are using historical simulation based VaR.

 

NEW QUESTION 229
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