Pass the PRMIA PRM 8008 Questions and answers with ValidTests

The 'degree' of a node in a network measures the number of links to other nodes. For the financial network, each market participant can be thought of as a node. The 'degree distribution' can be thought of as the histogram of the number of links for each node.

The financial network has a degree distribution with rather long tails - and therefore Choice 'd' is the correct answer. The other choices are incorrect. Long tailed networks have the property that they are robust when affected by random disturbances, but susceptible to targeted attacks, for example on key hubs.

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

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

Transition matrices are used for building distributions of the value of credit portfolios, and are the realized frequencies of migration from one credit rating to another over a period, generally one year. Therefore Choice 'd' is the correct answer.

Since they represent an actually observed set of values, they are not probabilities nor are they forward looking ex-ante estimates, though they are often used as proxies for probabilities. Choice 'a' and Choice 'c' are not correct. They include more than information on just defaults, therefore Choice 'b' is not correct.

A situation where a firm has more liabilities than assets does not necessarily imply default, so long as the firm is able to pay its obligations when they come due. Therefore, short term debts have a greater bearing on a firm's default than longer term debt. However, this is not to say that merely having enough to pay off the short term debts (ie debts due within one year) is enough to avoid default. Over time, the long term debt will also be turning to short term debt, and it may not be possible for the firm to roll over its liabilities without lenders considering the long term debt. The KMV approach considers the entire short term debt and half of the long term debt as the critical value of assets below which default will be triggered. Therefore Choice 'c' is the correct answer.

The index option is affected by the spot value for the underlying index, as also the risk free interest rate, or the zero rate for the duration of the option. It is also affected by the volatility of the underlying. The 'strike price' is set and is fixed at the time the option is purchased, and therefore is not a risk factor.

Therefore other than IV, all other choices are valid risk factors that underlie an equity index option.

Other instruments may have other risk factors - for example, a long forex position will have the spot exchange rate as the only risk factor.

The square root of time rule cannot be applied here because the returns across the periods are not independent. (Recall that the square root of time rule requires returns to be iid, independent and identically distributed.) Here there is a 'autocorrelation' in play, which means one period's returns affect the returns of the other period.

This problem can be solved by combining the variance of the returns from the two consecutive periods in the same way as one would combine the variance of different assets that have a given correlation. In such cases we know that:

Variance (A + B) = Variance(A) + Variance(B) + 2*Correlation*StdDev(A)*StdDev(B).

The standard deviation can be calculated by taking the square root of the variance.

Therefore the combined volatility over the two months will be equal to =SQRT((5%^2) + (5%^2) + 2*0.3*5%*5%) = 8.062%. All other answers are incorrect.

Analytical or parametric approaches are not useful at all for liquidity at risk calculations because there are no neat distributions available to parameterize the large number of factors that affect the calculations of liquidity inflows and outflows. Historical simulations, Monte Carlo and scenario analysis (which can complement historical scenarios) are all valid choices

Risks such as abrupt changes to a firm's business model caused by legislation, or the introduction of capital controls in foreign countries where a firm in invested, geo-political risks etc are not modelable in the traditional sense. These risks cannot be modeled using VaR. Therefore statement I is correct.

VaR indeed does not consider liquidity risk, it is only concerned with the standard deviation of portfolio returns. Statement II is a valid criticism.

Statement III is not correct, as VaR can consider historical price movements.

Statement IV is correct, as VaR does not consider systemic risk or the risk of contagion.

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.

Refer to the detailed loss event type classification under Basel II (see Annex 9 of the accord). You should know the exact names of all loss event types, and examples of each.