Pass the PRMIA PRM 8008 Questions and answers with ValidTests

If the daily standard deviation is 2%, the 10-day standard deviation will be 2%* √10 = 0.063245. The value of Z at the 95% confidence level is 1.64485. Therefore the VaR value is 1.64485 * 0.063245 = 10.4%. The other choices are incorrect.

Any good risk measure has the property that it is sub-additive, which means the whole is less than the sum of the parts. In the case of VaR, sub-additivity arises due to the diversification effect, or said differently, due to the correlation between different assets being less than one. Therefore Choice 'd' is the correct answer.

Super-additivity is just the opposite of sub-additivity, ie, the whole is greater than the sum of the parts. Good risk measures do not have super-additivity. Therefore Choice 'b' is incorrect.

Choice 'c' states the same thing as Choice 'b' in different words, and is incorrect. Choice 'a' is non-sensical and incorrect.

All product pricing should reflect the cost of maintaining the liquidity required to support a product. This is regardless of the accounting treatment for the product, ie irrespective of whether the product is on or off balance sheet. Therefore statement I is incorrect.

The time horizon to consider for liquidity risk management is determined taking into account a number of factors, which include both the speed at which new sources of liquidity can be generated and any applicable regulatory requirements. Statement II is correct.

Managing collateral, both collateral received and collateral posted with counterparties, is an important aspect of liquidity risk management as liquidity problems often manifest themselves in the form of margin calls requiring collateral to be posted. Statement III is therefore correct.

The maturity period of the different sources of capital funding for a bank, for example equity capital, preferred shares, long term debt etc quite clearly has a significant impact on liquidity needs. Stable sources of funds such as equity or preferred capital, or debt that is not maturing shortly help the liquidity position. Statement IV is therefore correct.

Choice 'b' is the correct answer.

Incremental capital (or incremental VaR, depending upon the context), is a measure of the change in the capital (or VaR) requirements if a certain change is made to a portfolio. It uses the 'before' and 'after' approach, ie find out what the capital requirement or VaR will be without the change, and what it will be after the change. The difference is the incremental capital or incremental VaR. It helps measure the change in risk as a result of a particular action, eg a change in a position.

Marginal capital or VaR on the other hand is a method to break down the capital requirement or the VaR so that it can be assigned to individual positions within the portfolio. The total of marginal capital or marginal VaR for all the positions in a portfolio adds up to the total capital requirements or total VaR. Note that marginal VaR is also called component VaR.

Therefore incremental capital is the correct answer to this question. The other choices are incorrect. In the exam, the question may be phrased differently, so try to keep in mind the different between incremental and marginal capital, which can be a bit confusing given what these terms mean in plain English.

A computation of Altman's Z-score considers the following ratios:

- Working capital to total assets

- Retained earnings to total assets

- EBIT to total assets

- Market cap to debt

- Sales to total assets

It does not consider Net Income to total assets, therefore Choice 'c' is the correct answer. This makes sense as net income is after interest and taxes, both of which are not relevant for considering the cash flows for debt servicing.

Bank B's exposure is measured by the price it paid for the bonds, which in this case is $7m ($10m x 70/100). Hence Choice 'c' represents the correct answer.

(Note that the question is asking for 'exposure' and not the legal claim in the event of default. The legal claim in the event of default would be the full notional of $10m. )

The initial issue price and issue size are irrelevant.

Right after inception' is incorrect as the interest rate swap (IRS) would be valued at close to zero right after inception and the credit risk would be minimum. Choice 'a' (ie 10 years, at maturity) is incorrect as at maturity there would be no more cash flows to exchange, and the replacement value of the contract would again be close to zero.

Therefore the worst time for the counterparty to default is somewhere between inception and maturity - in fact the range of possible outcomes for the contract increases with the passage of time, and we should find the worst time to default to be a later date. However, towards maturity, the value of the contract starts to go towards zero again, and the maximum value is reached around 7 years. 2 years is too early for the maximum to be reached for the 10 year IRS, and therefore choice a is the correct answer.

Netting is the ability to set just the net balances when amounts are both owed and due. Netting can take many forms. Payment netting is netting between counterparties that owe moneys to each other in the same currency under the same transaction (or master agreement). Closeout netting is when parties settle a net amount for the value of all outstanding transactions upon the occurrence of an event of default such as bankruptcy. Multiateral netting involves a third party that sets off exposures across counterparties that owe moneys to each other.

Closeout netting under the ISDA master agreement enables a party to terminate transactions early if an Event of Default or Termination Event occurs in respect of the other party. It involves the calculation and netting of the termination values of all transactions to produce a single amount payable between the parties. Closeout netting is therefore the correct answer.

With the passage of time, the range of possible values the FX contract can take increases. Therefore the maximum value of the contract, which is when the credit risk would be maximum, would be at maturity. (Note that this is different than an interest rate swap whose value at maturity approaches zero.) Therefore Choice 'a' is the correct answer and the others are incorrect.

Statement I is correct as credit VaR calculations often use a one year time horizon. This is primarily because the cycle in respect of credit related activities, such as loan loss reviews, accounting cycles for borrowers etc last a year.

Statement II is false. There are two ways in which loss assessments in respect of credit risk can be made: default mode, where losses are considered only in respect of default, and no losses are recognized in respect of the deterioration of the creditworthiness of the borrower (which is often expressed through a credit rating transition matrix); and the mark-to-market mode, where losses due to both defaults and credit quality are considered. The default mode is used for the loan book where the institution has lent moneys and generally intends to hold the loan on its books till maturity. The mark to market mode is used for traded securities which are not held to maturity, or are held only for trading.

Statement III is correct. The confidence interval, or the quintile of losses used for maintaining credit ratings tends to be very high as the possibility of the institution's default needs to be remote.

Statement IV is correct too, for the reasons explained earlier.