Pass the GARP Financial Risk and Regulation 2016-FRR Questions and answers with ValidTests

Risk measures such as the present value of a basis point (I), Macaulay's duration (III), and modified duration (IV) are based on the underlying assumption that interest rates across all maturities change by exactly the same amount. These measures rely on the concept of a parallel shift in the yield curve, where all interest rates move together in a uniform manner. Yield volatility (II), on the other hand, is not predicated on this assumption as it measures the variability in yields over time and does not assume uniform changes across all maturities.

Estimating the statistical distribution of bank losses is challenging due to several factors:

I. The needed data is vast in quantity: Gathering comprehensive data covering all potential risk factors and historical loss events is extensive.

II. The data requires bringing together significantly different measures of risk: Banks face multiple types of risks (e.g., credit, market, operational) which need to be integrated into a single cohesive loss distribution model.

III. Some risks are difficult to quantify and hence the data might involve subjective elements: Certain risks, particularly operational and reputational risks, are inherently difficult to measure and may require judgment and subjective assessment.

All these factors make assembling the necessary data for accurate loss distribution estimation complex.

An asset-sensitive bank has more rate-sensitive assets than rate-sensitive liabilities. This results in a positive cumulative gap, meaning the bank will benefit from rising interest rates. As interest rates increase, the income from rate-sensitive assets will increase more than the expense on rate-sensitive liabilities, improving the bank's net interest income.

Comprehensive and Detailed In-Depth Explanation:

Core deposits are stable, low-cost funds (e.g., savings, checking accounts) that depositors tend to leave with the bank over time, despite contractual flexibility to withdraw them. This stability is due to customer behavior and inertia, making them a reliable funding source under Basel III’s Net Stable Funding Ratio (NSFR). Credible deposits (A) and permanent deposits (C) are not standard terms, andtangible equity (D) is a capital measure, not a deposit type.

James is managing a loans portfolio and must evaluate which loans to keep or sell. The most likely loan to be sold is one made to a highly risky borrower, even if it is fully collateralized by the customer's deposits. This is because, despite the collateral, the high risk associated with the borrower could lead to potential problems and higher costs for the bank in the future. Selling this loan transfers the risk to another bank and frees up resources for potentially more profitable and less risky loans.

To hedge a bond portfolio against small parallel shifts in the term structure, you need to take a position in an instrument with an equal and opposite duration. John has a bond portfolio worth $2 million with a duration of 10. To hedge this, he should take a short position in bonds worth $20 million with a duration of 1. This is because the product of the value and duration of the hedge position should equal the product of the value and duration of the original portfolio (2 million * 10 = 20 million * 1).

To perform foreign exchange matched position trading, Alpha Bank should match the customer's transaction to eliminate currency risk. Here’s the breakdown:

Customer transaction: The customer buys AUD 1,010,000 at a rate of 101 for BRL 100 million.

Market transaction: To cover this, Alpha Bank should buy BRL at the market rate of 100, paying AUD 1,000,000 (BRL 100 million / 100 = AUD 1,000,000).

This ensures that the bank is not exposed to fluctuations in the BRL/AUD exchange rate.

References

Source: How Finance Works​

To calculate the required return using CAPM: Required return = risk-free rate + beta × market risk premium

Substituting the given values: Required return = 5% + 2.5 × 8% Required return = 5% + 20% Required return = 25%

Therefore, the estimated rate of return using the given statistics is 25%.

In practice, financial institutions often sum the economic capital required for market, credit, and operational risks to arrive at an aggregate economic capital estimate. This is done because:

Difficulty in Estimating Correlations: Estimating the correlations between different types of risks is complex and data-intensive. These correlations can change over time and under different market conditions, making it challenging to arrive at accurate estimates.

Conservatism: To avoid underestimating the total risk, a conservative approach is often taken by adding up the individual risk capitals. This ensures that the institution holds sufficient capital to cover potential losses from all types of risks, even if they were to occur simultaneously.

Regulatory Guidance: Although regulations encourage a more integrated approach, the lack of precise data often leads banks to use simpler, more conservative methods in practice.

Thus, option B correctly reflects the practical approach taken due to the difficulty in estimating correlations between different risk categories.

Preferred shares have specific characteristics that distinguish them from both common equity and debt:

Cross between Equity and Debt:Preferred shares have features of both equity and debt. They typically pay fixed dividends (similar to interest payments on debt) but do not have voting rights (similar to debt holders).

Subordination to Debt:In the event of liquidation, preferred shareholders are paid after debt holders but before common shareholders.

Perpetual or Long Maturities:Preferred shares can be perpetual, meaning they have no maturity date, or have long maturities, often exceeding those of typical corporate bonds.

Incorrect Statement - Residual Claim:The incorrect statement is that preferred shares represent the residual interest in the corporation after all other liabilities have been paid. In reality, this is the characteristic of common equity. Preferred shares have a higher claim on assets than common shares but are subordinate to all forms of debt.