# Financial Management Test

1. Consider a convertible bond that is trading at a conversion premium of 20 percent. If the value of the underlying stock rises by 25 percent, the value of the bond will: A.

**Financial Management Test**

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rise by less than 25%. B. rise by 25%. C. rise by more than 25%. D. remain unchanged. Correct answer: A The convertible bond implicitly gives bondholders a call option on the underlying stock. The delta of this option will vary between 0 (when the option is extremely out of the money) and 1 (when the option is extremely in the money).

In this case, the bond is trading at a conversion premium of 20% so the delta must be somewhere between zero and one, and hence the price of the convertible bond will rise by less than the price of the underlying stock. 2. If a cash flow of $10,000 in two years’ time has a PV of $8,455, the annual percentage rate, assuming continuous compounding is CLOSEST to: A. 8. 13%. B. 8. 39%. C. 8. 75%. D. 8. 95%. Correct answer: B Continuously compounded rate = ln(FV/PV)/N = ln(10000 / 8455) / 2 = 8. 39%. 3. The current values of a firm’s assets and liabilities are 200 million and 160 million respectively.

If the asset values are expected to grow by 40 million and liability values by 30 million within a year and if the annual standard deviation of these values is 50 million, the distance from default in the KMV model would be closest to: A. 0. 8 standard deviations. B. 1. 0 standard deviations. C. 1. 2 standard deviations. D. Cannot not be determined. Correct answer: B Distance from default = (Expected value of assets – Expected value of liabilities) / Standard deviation = (240 – 190)/50 = 1. 0. 4. What is the semiannual-pay bond equivalent yield on an annual-pay bond with a yield to maturity of 12. 51 percent? A. 12. 00%. B. 11. 49%.

C. 12. 51%. D. 12. 14%. Correct answer: D: The semiannual-pay bond equivalent yield of an annual-pay bond = 2 * [(1 + yield to maturity on the annual-pay bond)0. 5 -1] = 12. 14%. 5. You want to test at the 0. 05 level of significance that the mean price of luxury cars is greater than $80,000. A random sample of 50 cars has a mean price of $88,000. The population standard deviation is $15,000. What is the alternative hypothesis? A. The population mean is greater than or equal to $80,000. B. The population mean is less than $80,000. C. The population mean is not equal to $80,000. D. The population mean is greater than is $80,000.

Correct answer: D The alternate hypothesis is the statement which will be accepted if the null hypothesis is proven wrong. Therefore, we make whatever we are trying to test as the alternate hypothesis – in this case that the mean price of luxury cars is greater than $80,000, and the null hypothesis as the opposite (the mean price of luxury cars is less than or equal to $80,000). This problem is a common example of how statisticians establish hypotheses by proving that the opposite (i. e. the null hypothesis) is false. 6. Suppose that Gene owns a perpetuity, issued by an insurance company that pays $1,250 at the end of each year.

The insurance company now wishes to replace it with a decreasing perpetuity of $1,500 decreasing at 1% p. a. without any change in the payment dates. At what rate of interest (assuming a flat yield curve) would Gene be indifferent between the choices? A. 4%. B. 5%. C. 6%. D. 9%. Correct answer: B 1,250 / r = 1,500 / (r + 1%) or, 1,250 x (r + 1%) = 1,500 x r or, r = 12. 5 / (1,500 – 1,250) = 5%. 7. Which of the following is considered to be the responsibility of the legal risk manager? I. Inadequate documentation o f OTC derivatives transactions. II. The enforceability of netting agreements in bankruptcy.

III. Default on interest and principal payments. A. I only B. II only C. I and II only D. I, II, and III Answer : D Legal risk management is concerned with adequate documentation, public filings, compliance with regulatory entities, and some borrower impositions. The legal manager is also involved in deciding if default has occurred and, if so, assisting with the enforcement of netting agreements. 8. An analyst has constructed the following t-test for a portfolio of financial securities whose returns are normally distributed: Number of securities = 40.

H0: Mean return >= 18 percent. Significance level = 0. 1 What is the rejection point for this test? A. 1. 304. B. 1. 684. C. 2. 021. D. 2. 023. Correct answer: A This is a one-tailed test with 39 degrees of freedom and significance level of 0. 1. Looking up the Student’s t-distribution for df = 39 and p = 0. 1, we get the critical value of 1. 304. 9. Consider an A-rated institution that funds itself in the wholesale market at LIBOR + 90bps. Which of the following is the most attractive instrument for this firm to take exposure to an AAA-corporate issuer? A. Credit swap.

B. Floating rate note. C. Credit-linked note. D. Fixed coupon bond. Correct answer: A This firm has a fairly high funding cost. Funding itself at 90 bps over LIBOR and lending to AAA names at around LIBOR is a loss making strategy, which rules out the notes and the bond. The only way this firm can make money is by selling credit protection via a credit swap that does not require it to make a physical investment. 10. Which of the following statements about the Treynor ratio is correct? A. The Treynor ratio considers both systematic and unsystematic risk of a portfolio. B.

The Treynor ratio is equal to the excess return of a portfolio over the risk-free rate divided by the total risk of the portfolio. C. The Treynor ratio can be used to appraise the performance of well-diversified portfolios. D. The Treynor ratio is derived from portfolio theory since it assesses a portfolio’s excess return relative to its risk. Answer: C A is incorrect – Treynor ratio considers only systematic risk of a well-diversified portfolio B is incorrect – Treynor ratio denominator is beta of the portfolio C is correct – this statement is correct D is correct – Treynor ratio is derived from CAPM and not portfolio theory 11.

Which of the following is TRUE in relation to affirmative covenants? A. They prohibit the borrower from issuing new debt. B. They prohibit the borrower from paying dividends above a limit to shareholders. C. They require the borrower to take actions to service the debt and maintain collateral. D. They prohibit the borrower from paying dividends under certain circumstances to shareholders Correct answer: C Affirmative covenants are terms that require the borrower to take actions to service the debt and maintain collateral. 12. Suppose that you need to borrow $1 million for 24 months.

Two large US-based international banks with equal credit ratings offer deposit rates of 2%. To choose between the two banks, you would need all of the following except: A. day count basis. B. compounding basis. C. currency of deposit. D. balance sheets of the banks. Correct answer: D $1 million is a relatively small amount and the liquidity risk is not high in most markets. All other factors are crucial for the decision. 13. An analyst wants to test whether the variance of return from telecom stocks is higher than 0. 04. For this purpose, he obtains the following data from a sample of 51 telecom stocks.

Mean return from telecom stocks = 15% Standard deviation of return from telecom stocks = 24% Mean return from market = 12% Standard deviation of return from market = 13% Based on this information and a 0. 05 significance level: A. we can say that the variance of telecom firms is lower than 0. 04. B. we can say that the variance of telecom firms is higher than 0. 04. C. we cannot say that the variance of telecom firms is lower than 0. 04. D. none of the above. Correct answer: B Tests of the variance of a population require the chi-squared test. For this data, chi-squared = (n – 1) x Sample variance / Hypothesized variance = 50 x 0. 4^2 / 0. 04 = 72. Since the analyst wants to show that the variance is more than 0. 04, this will be chosen as the alternative hypothesis and the null hypothesis will be that the variance is lower than or equal to 0. 04. The critical value of the chi-squared statistic (for df=50 and p=0. 05) is 67. 505. Since the test statistic is higher than the critical statistic, we can reject the null hypothesis (variance <= 0. 04), and accept the alternative hypothesis (variance > 0. 04). 14. Which of the following internal controls does NOT effectively reduce operational risk? A.

Separation of trading from accounting and data entry B. Automated reminders of payments required and contract expirations C. A multitude of users can modify trade tickets so that errors may be quickly corrected D. Reconciling results from different systems to ensure data integrity Answer: C Proper practice limits the amount of people who can change trade tickets and what information can be changed once a ticket is written. Double checking work, separating duties, and automatic reminders all help lower operational risk. 15. It would be prudent for a trader to direct accounting entries in the following situation: A.

Never. B. when senior management of the firm and the Board of Directors are aware and have approved such on an exception basis. C. when audit controls are such that the entries are reviewed on a regular basis to ensure detection of irregularities. D. solely during such times as staffing turnover requires the trader to back-fill until additional personnel can be hired and trained. Answer: A In accordance with the separation of duties principle, it would never be appropriate for a trader to direct the accounting entries. 16. Which of the following statements concerning coupon rate structures is FALSE?

A. Zero-coupon bonds have only one cash inflow at maturity. B. Accrual bonds, like zero-coupon bonds, always sell at a discount to face value. C. Accrual bonds have only one cash inflow at maturity. D. Step-up notes have coupon rates that increase over time at a pre-specified rate. correct answer:B. Accrual bonds, unlike zero-coupon bonds, do not always sell at a discount to face value. The interest accrues forward and thus the bonds are likely to sell for more than face value. 17. Consider the following 3-year currency swap, which involves exchanging annual interest of 2. 5% on 10 million US dollars for 3. 75% on 15 million Canadian dollars. The CAD/USD spot rate is 1. 52. The term structure is flat in both countries. Calculate the value of the swap in USD if interest rates in Canada are 5% and in the United States are 4%. Assume continuous compounding. Round to the nearest dollar. A. $152,000 B. $145,693 C. $131,967 D. $127,818 Answer: C Vswap (USD) = BUSD ? ( So ? BGBP ) ( So = spot rate in USD per GBP) B fixed = ( PMT f . 1 year ? e ? ( r? t ) ) + ( PMT f . 2 year ? e ? ( r? t ) ) + [(notional +PMT f ,3 year ) ? e ? ( r? t ) ] Step 1. alculate value of USD-denominated bond: BUSD = 275,000e ? 0. 04? 1 + 275,000e ? 0. 04? 2 + 10,275,000e ? 0. 04? 3 = USD9,631,182 275000 = 10000000 * 2. 75% Step 2. calculate value of CAD-denominated bond BCAD=565200e-0. 05*1+565200e-0. 05*2+15565200e-0. 05*3=CAD14438805 565200=15000000*3. 75% Step 3. calculate value of swap Vswap (USD) = BUSD ? ( So ? BCAD ) ( So = spot rate in USD per CAD) =9631182-14438805/1. 52=USD131967 18. A 3-year, 8 percent semiannual coupon bond with $100 par value currently yields 8. 50 percent. What would be the price of the bond? A. $95. 49. B. $99. 24. C. $98. 0. D. $119. 50. Correct answer:C I/Y = 8. 50/2 = 4. 25; FV = 100; N = 3×2 = 6; PMT = 0. 08/2 x 100 = 4; PV = -98. 70. 19. Given that the dollar yen volatility is 12 percent and dollar peso volatility is 15 percent, and the correlation between dollar yen and dollar peso is 0. 25, the best estimate of the yen peso volatility is: A. 16. 7%. B. 19. 2%. C. 21. 4%. D. 23. 1%. Correct answer: A Here we use the expression that: (Vol_A/B)^2 = (Vol_A)^2 + (Vol_B)^2 – 2 x Correlation x (Vol_A) x (Vol_B). Therefore, yen/peso volatility = (0. 12^2 + 0. 15^2 – 2 x 0. 25 x 0. 12 x 0. 15)^0. 5 = 16. 7%. 20.

Suppose the daily returns of a portfolio and a benchmark portfolio it is replicating are as follows: Portfolio Return (bps) benchmark Portfolio Return(bps) Day 1 34 30 Day 2 -89 -87 Day 3 108 102 Day 4 70 70 What is the tracking error over the four day period? A. 3. 16 bps B. 2 bps C. 10 bps D. 2. 39 bps Answer: A A. Correct. Tracking error is the standard deviation of the difference between the return of the managed portfolio and the benchmark portfolio. tracking error = ? ep and E [RP – RB] = (4 + (-2) + 6 + 0) / 4 = 2. 00 E [(RP – RB)]2 = (16 + 4 + 36 + 0) / 4 = 14. 00 So, TE = (14. 00 – 4. 00)1/2 = 3. 6 bps. B. Incorrect. This solution incorrectly sets the tracking error equal to the average difference between the return of the managed portfolio and the benchmark portfolio. Tracking error is the standard deviation of the difference between the return of the managed portfolio and the benchmark portfolio. C. Incorrect. This solution incorrectly sets the tracking error equal to the variance of the difference between the return of the managed portfolio and the benchmark portfolio. Tracking error is the standard deviation of the difference between the return of the managed portfolio and the benchmark portfolio.

D. Incorrect. This solution incorrectly sets the tracking error equal to the difference between the standard deviation of the return of the managed portfolio and the standard deviation of the return of the benchmark portfolio. Tracking error is the standard deviation of the difference between the return of the managed portfolio and the benchmark portfolio. 21. Which of the following statements are true with regard to a 3-year Bermuda put option? I. A lower bound on its price is the price of a 3-year European put option. II. A lower bound on its price is the price of a 3-year American put option. III.

It is likely to outperform both European and American put options as the price of the underlying rises. A. I only B. II only C. II and III D. III only Answer: A The Bermuda put option allows multiple opportunities to exercise. Therefore, its price must be higher than that of a European put option (which allows exercise only at maturity) but less than that of American put option (which allows exercise at any point before maturity). 22. Consider two portfolios: Portfolio I consists of 100 bonds, each rated AAA, all weighted equally; and Portfolio II consists of 20 bonds, each rated A, all weighted equally.

The 1-year default probabilities of AAA and A bonds are 0. 1% and 0. 5% respectively in this country. Assume that the event of default on any bond is independent of default on others. Which one of the following statements is TRUE? A. The probability of observing no default in Portfolio I is lower than in Portfolio II. B. The probability of observing no default in Portfolio I is higher than in Portfolio II. C. The probability of observing no default in Portfolio I is roughly the same as Portfolio II. D. Insufficient information, we need to know the recovery rates.

Correct answer: C Probability (no default in Portfolio I) = (1-0. 1%)^100 =90. 48%. Probability (no default in Portfolio II) = (1-0. 5%)^20 =90. 46%. Notes: 1 The question does not ask you to compute expected loss, so you do not need to know the recovery rates. 2 Even though both portfolios have the same probability of not defaulting, the loss in the event of a single default will be much lower in case of portfolio I than portfolio II. In this question, you are not concerned with it. Hence the answer is counter-intuitive. 23. Which of the following statements describe a property of bond convexity?

Convexity: I. increases as yields increase. II. increases with the square of maturity. III. measures the rate of change in duration. IV. increases if the coupon on a bond is decreased. A. II and III only. B. I and III only. C. II and IV only. D. III and IV only. Correct answer :A Convexity is inversely related to yield and is directly related to the coupon rate on a bond. Convexity is the second derivative of price with respect to yield, which means that convexity measures the rate of change in duration. Convexity increases with the square of maturity. 24.

To control risk-taking by traders, your bank links trader compensation with their compliance with imposed VaR limits on their trading book. Why should your bank be careful in tying compensation to the VaR of each trader? A. It encourages trader to select positions with high estimated risks, which leads to an underestimation of the VaR limits. B. It encourages trader to select positions with high estimated risks, which leads to an overestimation of the VaR limits. C. It encourages trader to select positions with low estimated risks, which leads to an underestimation of the VaR limits. D.

It encourages trader to select positions with low estimated risks, which leads to an overestimation of the VaR limits. Correct answer: D D ?? ,????????? ,???????????????????? ?? ,??????????????????????????????? ?,?????????????? VaR limit,?? VaR limit ????? 25. An analyst wants to test whether the mean spending by tourists coming to a holiday resort is equal to or less than $2,000 with a 1 percent level of significance. He finds that the average spending by 16 tourists is $2,200 and the standard deviation of the population is $400. The critical value of the Z statistic for this study is: A. 1. 65. B. -1. 6. C. 2. 33. D. 2. 58. Correct answer: C Since this is a one-tailed test with a 0. 01 significance level the critical Z value is 2. 33. 26. Bank Z, a medium-size bank, uses only operational loss data from internal records to model its loss distribution from operational risk events. The bank reviewed its records, and, after confirming that they were complete records of its historical losses and that its losses could be approximated by a uniform distribution, it decided against using external loss data to estimate its loss distribution. Based on that decision, which of the following statements is correct?

A. The estimated loss distribution likely accurately represents Bank Z’s real risk because the records are accurate and complete. B. The estimated loss distribution likely overtakes bank Z’s real risk because many incidences in the past were likely “one off. ” C. The estimated loss distribution likely is the best estimate of Bank Z’s real risk because there is no better loss data for the bank than its own. D. The estimated loss distribution likely understates Bank Z’s real risk because the bank has not experienced a huge loss. Correct answer: D D ?????? Loss Distribution ?????

Uniform distribution,?????? ????????? ,???????? ,??????????????? ?,?????????????? ,?????? ,?????????? ?????????? 27. Your bank has chosen to use the advanced Internal Rating Based Approach under Basel II. The bank is contemplating a large securitization of low-quality loans that are currently on its balance sheet. You are concerned about whether the securitization will provide you with regulatory capital relief. Which one of the following approaches would be the most efficient in reducing the bank’s regulatory capital? A. The bank sets up an Special Purpose Vehicle (SPV) that issues securities.

All proceeds from selling these securities are invested in a portfolio of equities. The SPV sells protection to the bank through a credit default swap on the loans in the bank’s portfolio. B. The bank sells the loans to an SPV and keeps an equity piece representing 8% of the value of the loans. C. The bank sells the loans to an SPV that issues securities. These securities issued are then sold to third-party investors. The bank indicates to some investors that if credit quality of the loans declines significantly, the bank will try to help the investors, but specifies that the bank is unwilling to provide a contractual guarantee. D.

The bank forgoes the securitization and buys a credit default swap on the loans from an AAA-rated provider. Correct answer: C C A ? Bank set up a SPV ??????? ,????? ,?????????? ?? B ? Bank ??? 8%? Equity Tranches,? SPV ???????? ,???? ???????? C ? Bank ???? Loan ???? ,??? True Sale,??????? ,?? ?????? ,?????????????? D ? Bank ?????? ,????? CDS,Loan ???????????? ??? CDS ??????????? ,?????? C ?????? Loan ? ??? 28. A 12-year, 8 percent semiannual coupon bond with $100 par value currently trades at $78. 75 and has an effective duration of 9. 8 years and a convexity of 130. 0. What is the price of the bond if the yield falls by 150 basis points?

A. $67. 17. B. $86. 47. C. $91. 48. D. $95. 43. Correct answer :C Percentage price change = [(-) (effective duration)( ? y)]+[(1/2)(convexity)( ? y)2] = [(-)(9. 80)(-0. 015)]+[(0. 5)(130)(-0. 015)2] = 16. 16 Estimated price = 78. 75(1+0. 1616) = $91. 48 29. Which of the below are methods to estimate parameters of operational loss distributions? I. Moments II. IV. A. B. C. D. Probability-weighted moments Econometric I and III I, II and III IV III and IV III. Maximum likelihood Answer: B The parameters of loss distributions can be estimated by moments, probability-weighted moments, or with maximum likelihood techniques 30.

Asset liquidity risk is most pronounced for A. A $10 million position in distressed securities B. A $10 million position in Treasury bonds C. A $100 million position in distressed securities D. A $100 million position in Treasury bonds Answer: C Asset liquidity risk is a function of the size of the position and the intrinsic liquidity of the instrument. Distressed securities trade much less than Treasury bonds, and so have more intrinsic liquidity. A $100 million position is more illiquid than a $10 million position in the same instrument. 31.

You are given the following specification of the currency swap: notional principal $10m euro 10. 5m swap coupon 7. 2% 6. 8% current market yield 4. 2% 3. 6% There are two payments left in the swap (the first one in a year) and the current exchange rate is $0. 95/euro. Calculate the dollar value of the swap for the euro payer. A. – 16 299 $. B. – 17 344 $. C. – 19 344 $. D. – 21 283 $. Correct answer: A The swap is equivalent to long position in dollar denominated bond and short position in euro denominated bond. (720,000 / 1. 042 + 10,720,000 / 1. 042^2) – ((714,000 / 1. 036 + 11,214,000 / 1. 36^2) x 0. 95) = – 16,299. 32. How would you describe the typical price behavior of a low premium mortgage pass-through security? A. It is similar to a U. S. Treasury bond B. It is similar to a plain vanilla corporate bond C. When interest rates fall, its price increase would exceed that of a comparable duration U. S. Treasury. D. When interest rates fall, its price increase would lag that of a comparable duration U. S. Treasury. Answer: C Mortgage pass-through securities, unlike Treasuries or plain vanilla corporate bonds, have an embedded option allowing borrowers to repay the loan at any time.

When rates fail, the effective duration of these securities decreases because borrowers will refinance mortgages at lower rates (putting the loans back to the investors); but when interest rates increase, borrowers will hold on to mortgages longer than they otherwise would, resulting in an increase in the effective duration of the loans. This is reflected in the price/yield relationship as negative convexity. 33. You are given the following information about a portfolio and are asked to make a recommendation about how to reallocate the portfolio to improve the risk/return tradeoff.

Covariance Curren Margin Marginal Risk Expecte Standard of Marginal t al Return/ Contributio Asset d Portfolio and Return Weigh Risk Marginal risk n return Deviation Asset I t Returns Asset 1 7. 10% Asset 2 8. 00% Asset 3 6. 70% Asset 4 6. 90% Risk free 4. 00% 17. 00% 38. 70 % 1. 43% 2. 44% 2. 39% 1. 41% 0. 00% 3. 10% 13. 99% 4. 00% 23. 93% 2. 70% 23. 39% 2. 90% 13. 86% 22. 17% 16. 71% 11. 55% 20. 92% 5. 41% 1. 48% 1. 29% 2. 02% 40. 60% 6. 20% 44. 80% 5. 50% 21. 40% 0. 00% 14. 60 % 35. 00 % Which of the following the recommendations will improve the risk/return tradeoff of the portfolio? A.

Increase the allocations to assets 1 and 3 and decrease the allocations to assets 2 and 4. B. Increase the allocations to assets 1 and 2 and decrease the allocations to assets 3 and 4. C. Increase the allocations to assets 2 and 3 and decrease the allocations to assets 1 and 4. D. Increase the allocations to assets 1 and 4 and decrease the allocations to assets 2 and 3. Answer: D A. Incorrect. Asset 3 should be decreased since it has the lowest marginal return-to-marginal risk ratio. B. Incorrect. Asset 4 should be increased since it has the highest marginal return-to-marginal risk ratio. C. Incorrect.

Asset 4 should be increased since it has the highest marginal return-to-marginal risk ratio. D. Correct. A portfolio optimizing the risk-reward tradeoff has the property that the ratio of the marginal return to marginal risk of each asset is equal. Therefore, this option is the only recommendation that will move the ratios in the right direction. 34. Calculate the estimated default frequency (EDF) for a KMV credit risk model using the data given below (all figures in millions). Assets Liabilities Market value 195 185 Book value 180 165 Standard deviation 25 15 of returns A. 11. 5%. B. 27. 4%. C. 34. 5%.

D. 57. 9%. Correct answer: A The distance between the current value of the assets and the book value of the liabilities = 195- 165 = 30. Using the standard deviations in the return on assets this distance = 30 / 25 = 1. 2 standard deviations. Thus the probability of default = cumulative probability of standard normal distribution below -1. 2, i. e. 11. 5%. 35. Suppose the payoff from a merger arbitrage operation is $5 million if successful, -$20 million if not. The probability of success is 83%. The expected payoff on the operation is A. $5 million B. $0. 75 million C. $0 since markets are efficient D.

Symmetrically distributed Answer: B The expected payoff is the sum of probabilities times the payoff in each state of the world, or 83% ? $5 + 17% ? (-$20) = $4. 15 – $3. 40 = $0. 75. Note that the distribution is highly asymmetric, with a small probability of a large loss. 36. Your firm does market direction neutral arbitrage in the spread between US Treasuries and Argentina bonds. Your trader plans to buy default swaps on Argentina. Then he wants to increase the size of position to $1,500 million. As a risk manager, apart from basis risk, your main concern will be that: A. US yields would fly up too soon. B. iquidity in US Treasuries will dry up. C. liquidity in Argentina bonds will dry up. D. CDS writer may go bankrupt, leaving you uncovered. Correct answer: C Liquidity risk is the most prominent form of risk when emerging markets securities are involved. 37. The VaR of a portfolio at a 95% confidence level is 15. 2. If the confidence level is raised to 99% (assuming a one-tailed normal distribution) the new value of VaR will be closest to: A. 10. 8. B. 15. 2. C. 18. 1. D. 21. 5. Correct answer: D 95% confidence level requires a volatility multiple (alpha) of 1. 65 while 99% confidence level requires a multiple of 2. 3. Since VaR is directly proportional to this multiple, the 99% confidence level VaR = 15. 2 x 2. 33 / 1. 65 = 21. 5 38. A particular operational risk event is estimated to occur once in 200 years for an institution. The loss for this type of event is expected to be between HKD 25 million and HKD 100 million with equal probability of loss in that range (and zero probability outside that range). Based on this information, determine the fair price of insurance to protect the institution against a loss of over HKD 80 million for this particular operational risk. A. HKD 133,333 B. HKD 90,000 C.

HKD 120,000 D. HKD 106,667 Answer: C The range of losses is HKD 25 million to HKD 100 million, with equal probability. The probability of a loss being greater than HKD 80 million is (100 – 80)/(100 – 25) or 20/75. If the loss is over HKD 80, the expected loss (being equally probable) would be HKD 90 million: ? 100 million+80 million ? ? 20 ? ? 1 ? Expected value of loss = ? ?? ?? ? = HKD120,000 2 ? ? ? 75 ? ? 200 ? 39. In august 2006, the hedge fund Amaranth had large calendar spread positions in natural gas. According to historical VaR models, such spread positions would have had limited risk.

In light of the dramatic losses to the funds, which led to Amaranth’s collapse in September 2006, its risk management policies came under scrutiny. Keeping the fund’s policies, trading, and position limits unchanged, which of the following risk management policies could have better captured the extent of the risks that sank Amaranth? i. Using Riskmetrics-type VaR instead of a historical VaR to estimate its risk exposures. ii. Adding counterparty risk to its risk measurement. iii. implementing stress tests to quantify possible losses if it had to liquidate large positions. iv. Including operational VaR to its risk measurement.

A ii, iii, and iv only B i, ii, iii, and iv C i and iii only D None of the changes would have helped Answer: C C Amaranth ???? 40. Assume Satya Bank, having a capital of USD 500 million, wants to limit its losses in the energy sector to 6% and in the construction sector to 4. 5% of its capital. The LGD rates for the energy and construction sectors are, respectively, 45% and 70%. If Satya Bank wants to strictly adhere to its concentration limit policy, the maximum permitted loan amount to the energy and construction sectors will be: Energy Construction A. USD 66. 7 million USD 32. 1 million B. USD 13. 5 million USD 15. million C. USD 37. 5 million USD77. 8 million D. USD 30. 0 million USD 22. 5 million Answer: A A. Correct. Concentration Limit = Capital x (loss limit on capital / loss rate of the sector) Concentration Limit for Energy = USD 500 million x (0. 06 / 0. 45) = USD 66,666,667 Concentration Limit for Constr. = USD 500 million x (0. 045 / 0. 70) = USD 32,142,857 B. Incorrect. It uses incorrect variables and/or formula to calculate concentration limits. C. Incorrect. It uses incorrect variables and/or formula to calculate concentration limits. D. Incorrect. It uses incorrect variables and/or formula to calculate concentration limits. 1. Credit risk is NOT an increasing function of: A. level of debt. B. risk-free interest rate. C. time to maturity of debt. D. standard deviation of asset returns. Correct answer: B In the context of the analytical model, credit risk is a decreasing function of risk-free interest rate 42. Prepayment models are complex and rely upon a number of different methods to circumvent the problem of prepayment path dependency. Which of the following is often used to avoid the problems associated with prepayment path dependency? A. Error-correction model tree design. B. Monte Carlo simulation. C. Cox-Ingersoll-Ross tree design.

D. Bernard and Schwartz simulation. Correct answer:B Monte Carlo simulation techniques have been used to deal with problems associated with prepayment path dependency. 43. Assume that the short-term interest rate in London is 4 percent and that the short-term interest rate in the US is 2 percent. If the current exchange rate between the euro and dollar is 1=US$1. 2217, using the continuous time futures pricing model, what is the price of a three-month futures contract? A. $1. 2207. B. $1. 2156. C. $1. 2144. D. $1. 2235. Correct answer: B. The formula is: 1. 2217e(0. 02-0. 04)(0. 25) = $1. 2156. 44.

When an investor is obligated to buy the underlying asset in a futures position, it is a: A. basis trade. B. short-futures position. C. hedged-futures position. D. long-futures position. Correct answer:D When an investor is obligated to buy the underlying asset in a futures position, it is a long futures position. 45. Portfolio manager returns 10% with a volatility of 20%. The benchmark returns 8% with risk of 14%. The correlation between the two is 0. 98. The risk-free rate is 3%. Which of the following statements is correct? A. The portfolio has higher SR than the benchmark B. The portfolio has negative IR C. The IR is 0. 35 D. The IR is 0. 9 Answer: D The Sharpe ratios of the portfolio and benchmark are (10% – 3%)/20% = 0. 35, and (8% 3%)/14% = 0. 36, respectively. So, the SR of the portfolio is lower than that of the benchmark. Answer a) is incorrect. The TEV is the square root of 20% 2 + 14% 2 + 2 ? 0. 98 ? 20% ? 14% , which is 0. 00472 = 6. 87% . So the IR of the portfolio is (10% – 8%)/6. 87% = 0. 29. This is positive, so answer B) is incorrect. Answer C) is the SR of the portfolio, not the IR, so it is incorrect. 46. In commodity trading, the exchange removes any daily losses from a trader’ account and s adds any gains to the trader’s account. This process is known as: A. nitial margin. B. maintenance margin. C. variation margin. D. marking to market. Correct answer:D. To safeguard the clearinghouse, commodity exchanges require traders to settle their accounts on a daily basis. Marking to market is when any loss for the day is deducted from the trader’s account, and any gains are added to the account. 47. A portfolio manager is constructing a portfolio of stocks and corporate bonds. The portfolio manager has estimated that stocks and corporate bond returns have daily standard deviations of 1. 8 percent and 1. 1 percent, respectively, and estimates a correlation coefficient of returns of 0. 3. If the portfolio manager plans to allocate 35 percent of the portfolio to corporate bonds and the rest to stocks, what is the daily portfolio VAR (2. 5 percent) on a percentage basis? A. 2. 71%. B. 3. 05%. C. 2. 57%. D. 2. 27%. Correct answer : A First, calculate the daily percentage VAR for stocks and corporate bonds: Stocks: VAR(2. 5%)Percentage Basis = z2. 5% ? ? = 1. 96(0. 018) = 0. 0353 = 3. 53% Bonds: VAR(2. 5%)Percentage Basis = z2. 5% ? ? = 1. 96(0. 011) = 0. 0216 = 2. 16% Next calculate the portfolio VAR using weights of 35% for bonds and 65% for stocks: [0. 652(0. 03532) + 0. 352(0. 02162) + 2(0. 35)(0. 65)(0. 353)(0. 0216)(0. 43)]0. 5 = 0. 0271 = 2. 71% 48. A corn grower is concerned that the price he can get from the field in mid-September will be less than he has forecasted. To protect himself from price declines, the farmer has decided to hedge. The best available futures contract he can find is for August delivery. Which of the following is the appropriate direction of his position and the source of basis risk that may impact the farmer? A. Short futures; correlation. B. Long futures; correlation. C. Short futures; rollover. D. Long futures; rollover. Correct answer : C The farmer needs to be short the futures contracts.

The source of basis risk for this farmer arises from the fact that his contract and harvest dates do not perfectly match. As a result, he will be exposed to basis risk due to a necessary rollover in his position. 49. Two banks enter into a 1-year plain vanilla interest-rate swap with the following terms: *Notional principal is $500,000,000. *The fixed component of the swap is 7%, which is the current market rate. *The floating component of the swap is LIBOR + 200bps. If the current risk-free rate is 4 percent, the value for this swap at inception is closest to: A. $0. B. $500,000,000. C. $8,750,000. D. $35,000,000.

Correct answer:A The initial value of a swap is always zero. As interest rates move and payments take place, the value of the swap will change for both parties. 50. What is the value of the European call option given below using the Black-Scholes model? Spot rate = 120 Strike price = 125 Risk- free rate = 8% Time to expiration = 0. 5 years N(d1) = 0. 554 N(d2) = 0. 498 A. 1. 69. B. 4. 23. C. 6. 67. D. 11. 83. Correct answer: C Using the Black-Scholes model, the value of a call option = Spot price x N(d1) – Strike price x exp(-Risk-free rate x Time to expiration) x N(d2) = 120 x 0. 554 – 125 x exp(0. 08 x 0. 5) x 0. 498 = 6. 671. 51.

Which statement about option valuation is least accurate? A. The value of an option is its time value plus its intrinsic value. B. Prior to maturity, out-of-the-money options have no value. C. The buyer of a call option contract can never lose more than the initial premium. D. If the stock price is lower than the strike price at expiration, a put option is worth the difference between the stock price and the strike price. Correct answer: B While out-of-the-money options have no intrinsic value, they still have time value prior to maturity. The remaining statements are true. 52. Balance sheet liquidity refers to the ability to: A. eet debt covenants. B. raise debt without moving the market. C. meet financial obligations as they arise. D. merge with or acquire other firms at short notice. Correct answer: C Balance sheet liquidity refers to the ability to meet cash needs with the available cash, marketable securities and exiting credit lines, i. e. the ability to avoid running out of cash. 53. Which of the following best explains put-call parity? A. No arbitrage requires that using any three of the four instruments (stock, call, put, bond) the fourth can be synthetically replicated. B. A stock can be replicated using any call option, put option and bond. C.

A stock can be replicated using any at the money call and put options and a bond. D. No arbitrage requires that only the underlying stock can be synthetically replicated using at the money call and put options and a zero coupon bond with a face value equal to the strike price of the options. Correct answer: A A portfolio of the three instruments will have the identical profit and loss pattern as the fourth instrument and therefore the same value by no arbitrage. So the fourth security can be synthetically replicated using the remaining three. 54. A portfolio has a mean value of $100 million and a daily standard deviation of $19 million.

Assuming that the portfolio values are normally distributed, the lowest value that the portfolio will fall to over the next five days and within 95% probability is: A. -$31. 7 million. B. $1. 2 million. C. $30. 1 million. D. $57. 5 million. Correct answer: C Given that the daily standard deviation is $19 million, the standard deviation over 5 days = $19 million x (5/1)^0. 5 = $42. 49 million. Given that the returns are normally distributed, we know that 95% of the outcomes will be above 1. 645 standard deviations below the mean, i. e. above $30. 1 million. 55. You are considering an investment in one of three different bonds.

Your investment guidelines require that any bond you invest in carry an investment grade rating from at least two recognized bond rating agencies. Which, if any, of the bonds listed below would meet your investment guidelines? A. Bond A carries an S&P rating of BB and a Moody’s rating of Baa. B. Bond B carries an S&P rating of BBB and a Moody’s rating of Ba. C. Bond C carries an S&P rating of BBB and a Moody’s rating of Baa. D. None of the above. Correct answer: c Explain: The lowest investment-grade ratings are BBB and Baa. 56. A security sells for $40. A 3-month call with a strike of $42 has a premium of $2. 9. The risk-free rate is 3 percent. What is the value of the put according to put-call parity? A. $1. 89. B. $4. 18. C. $3. 45. D. $6. 03. Correct answer:B p = c + X – S = 2. 49 + 42 e –0. 03 ? 0. 25 – 40 = $4. 18 57. Which of the following statements regarding the Black-Scholes-Merton option-pricing model is TRUE? A. As the number of periods in the binomial options-pricing model is increased toward infinity, it converges to the Black-Scholes-Merton option-pricing model. B. The Black-Scholes-Merton option-pricing model is the discrete time equivalent of the binomial option-pricing model.

C. The Black-Scholes-Merton model is superior to the binomial option-pricing model in its ability to price options on assets with periodic cash flows. D. As the periods in the binomial option-pricing model are lengthened, it converges to the Black-Scholes-Merton option-pricing model. Correct answer: A As the option period is divided into more/shorter periods in the binomial option-pricing model, we approach the limiting case of continuous time and the binomial model results converge to those of the continuous-time Black-Scholes-Merton option pricing model. 58.

If we use four of the inputs into the Black-Scholes-Merton option-pricing model and solve for the asset price volatility that will make the model price equal to the market price of the option, we have found the: A. implied volatility. B. historical volatility. C. market volatility. D. option volatility. Correct answer:A The question describes the process for finding the expected volatility implied by the market price of the option. 59. A stock that is currently trading at $50 and can either move to $55 or $45 over the next 6-month period. The continuously compounded risk-free rate is 2. 25 percent.

What is the risk-neutral probability of an up movement? A. 0. 6655. B. 0. 6565. C. 0. 5566. D. 0. 5656. Correct answer:C: The risk-neutral probability, p, can be calculated as . In this case, r = 0. 0225, u = 1. 1, d = 0. 9, which makes p equal to [e[0. 0225*(6/12)] – 0. 9] / [1. 1 – 0. 9] = . 5566 60. Given the following ratings transition matrix, calculate the two-period cumulative probability of default for a B credit. A. 2. 0% B. 2. 5% C. 4. 0% D. 4. 5% Correct answer: d Explain: Scenario one: B can go into default the first year, with probability of 0. 02. Scenario two: B could go to A then D, with probability of 0. 3 ? 0. 00 = 0. Scenario three: B could go to B then D, with probability of 0. 90 ? 0. 02 = 0. 018. Scenario four: B could go to C then D, with probability of 0. 05 ? 0. 14 = 0. 007. The total is 0. 045. 61. BBB-rated firms have default probability of 0. 2% over a period of one year. Based on this information the default probability over the next quarter will be CLOSEST to: A. 0. 05%. B. 0. 45%. C. 0. 50%. D. 1. 50%. Correct answer: A Assuming a constant marginal default probability, Default probability over a quarter = 1 – (1 Default probability over a year)^(1/4) = 1 – (1 – 0. %)^0. 25 = 0. 05%. However, the marginal rate of default for high credits tends to rise with the time horizon. So, the default probability for the immediate quarter is likely to be lower than the average of 0. 0005. 62. A CBO (collateralized bond obligation) consists of several tranches of notes from a repackaging of corporate bonds, ranging from equity to super senior. Which of the following is generally true of these structures? A. The total yield of all the CBO tranches is slightly less than the underlying repackaged bonds to allow the issuer to recover fees/costs/ profits. B.

The super senior tranche has expected loss rate higher than the junior tranche. C. The super senior tranche is typically rated below AAA and sold to bond investors. D. The equity tranche does not absorb the first losses of the structure. Correct Answer: a Explain: In the absence of transaction costs or fees, the yield on the underlying portfolio should be equal to the weighted average of the yields on the different tranches. With costs, however, the CBO yield will be slightly less. Otherwise, the senior tranche is typically rated AAA, has the lowest loss rate of all tranches, and absorbs the last loss on the structure. 3. What is the most significant difference to consider when assessing the creditworthiness of a country rather than a company? A. The country’s willingness and its ability to pay must be analyzed. B. Financial data on a country is often available only with long lags. C. It is more costly to do due diligence on a country rather than on a company. D. A country is often unwilling to disclose sensitive financial information. Correct answer: a Explain: Countries cannot be forced into bankruptcy. There is no enforcement mechanism for payment to creditors such as for private companies.

Recent history has shown that a country can simply decide to renege on its debt. So, willingness to pay is a major factor in assessing the creditworthiness of a country. 64. Assume a bank wants to limit its losses in a particular sector to 5% of its capital and that the loss rate for this sector is 50%. The concentration limit for this particular borrower is closest to: A. 8. 33% B. 2. 50% C. 10. 00% D. 25. 00% Answer: C 5%/50%=10% 65. Which of the following is not a commonly used method for generating a recovery rate function? A. Nonparametric kernel estimation.

B. Cubic SPLINE estimation. C. Assume the recovery rate follows a beta distribution. D. Estimate conditional densities with generalized method of moments. Answer: B Explanation: Cubic SPLINE estimation would make little sense here. 66. Your analysis shows that if a risky bond defaults, we can expect to recover 2,102. 02 per 10,000 of face value, after a period of five years from the scheduled maturity date of the bond? The yield curve for risk-free debt is flat at 1. 00%. What is the LGD ratio for this debt? A. 20. 00%. B. 21. 02%. C. 22. 09%. D. None of the above.

Correct answer: A We need to find the present value recovery at the time of Scheduled Maturity. Hence, LGD = (2,102. 02 / 1. 01^5) / 10,000 = 20. 00% 67. An investor owns a stock and believes that the stock’s price will remain relatively unchanged for the short term but is bullish in the long term. Which of the following strategies will be the best for this investor? A. A protective put. B. An at-the-money strip. C. A covered call. D. An at-the money strap. Correct answer:C A covered call strategy is used to generate cash on a stock position that is not expected to increase in value over the life of the option. 8. A credit manager discovers that the defaults by sub-investment grade clients of his bank follow a Poisson distribution, with an average number of defaults in the year equal to 7. What is the probability that there will be 6 defaults over the next year? A. 12. 1%. B. 12. 8%. C. 13. 5%. D. 14. 9%. Correct answer: D Probability of three defaults = [7^6 x exp(-7)] / fact(6) = [117649 x 0. 000912] / 720 = 14. 9%. 69. All of the following are assumptions of the Capital Asset Pricing Model EXCEPT: A. Each investor seeks to maximize the expected utility of wealth at the end of that investor’s horizon.

B. Investors can borrow and lend at the same risk-free rate. C. Investors have the same expectations concerning returns. D. The time horizons of investors are normally distributed. Answer: D The CAPM assumes that investors all have the same horizon (as well as expectations). This means that the distribution of the horizons is not normal because normality implies a bell-shaped curve distribution, which would have a positive variance and, hence, dispersion. 70. The estimated default frequency in KMV model are calculated using: I. bond spreads. II. asset volatilities. III. balance sheet items IV.

Monte Carlo simulation. A. I and II. B. I and IV. C. II and III. D. III and IV. Correct answer: C The estimated default frequency in KMV model is calculated using balance sheet items and the standard deviation of the assets. 71. A major acquisition has just been announced, targeting company B. The bid from Company A is an exchange offer with a ratio of 2. Just after the announcement, the prices of A and B are $50 and $90, respectively. A hedge fund takes a long position in company B hedged with A’s stock. After the acquisition goes through, the prices move to $120 and $60. For each share of B, the gain is A. 30 B. $20 C. $10 D. $0 since the acquisition is successful Answer: C This position is long one share of company B offset by a short position in two shares of company A. The payoff is ($120-$90)-2($60-$50)=$30-$20=$10. 72. If the mean P/E of 30 stocks in a certain industrial sector is 18 and the sample standard deviation is 3. 5, standard error of the mean is CLOSEST to: A. 0. 12. B. 0. 34. C. 0. 64. D. 1. 56. Correct answer: C Standard error of the mean = s / n^0. 5 = 3. 5 / 30^0. 5 = 0. 64. 73. Which of the following methods can be used to measure corporate “Cash-Flow at Risk”? I. Delta Normal.

II. Historical Simulation. III. Monte Carlo Simulation. A. I and II. B. I and III. C. II and III. D. I, II and III. Correct answer: D All these methods can be alternatively used to measure corporate Cash-Flow at Risk 74. Which of the following statements regarding the beta distribution used in the modeling of recovery functions is FALSE? A. B. C. D. The beta distribution does not fit bimodal recovery functions well. The beta distribution only requires two inputs for calibration. The beta distribution is a nonparametric distribution. The beta distribution can be skewed, symmetric, or convex.

Answer: C The beta distribution is a parametric distribution. The beta distribution does not fit bimodal recovery functions well, and only requires two inputs for calibration. In addition, it can be skewed, symmetric, or convex. 75. Hedge fund managers following a convertible arbitrage strategy are said to be: A. long gamma and short vega B. short gamma and short vega C. long gamma and long vega D. short gamma and long vega Answer: C Convertible arbitrage managers hedge their equity exposure by shorting stocks using the delta hedge ratio. Because they are exposed to changes in the hedge ratio, they are said to be long gamma.

They are also exposed to changes in the price volatility of the stock underlying the option embedded in the convertible security, so they are said to be long vega. 76. Suppose that the yield on 1-year Treasury zero is 2% and the constant, cumulative probability of default on AAA bonds is 1%. If the recovery rate in the case of default is zero, what is the continuous compounded yield on AAA 1-year zero? A. 2. 98%. B. 3. 00%. C. 3. 01%. D. 3. 03%. Correct answer: D AAA 1-year zero rate = (1 + default-free rate) / (1 – probability of default) = (1 + 2%) / (1 1%) – 1 = 3. 03%. 77. The 1-year US dollar interest rate is 3% and he 1-year Canadian dollar interest rate is 4. 5%. The current USD/CAD spot exchange rate is 1. 5000. Calculate the 1-year forward rate. A. 1. 5225 B. 1. 5218 C. 1. 5207 D. 1. 5199 Answer: B In order to get the answer reported in GARP’s answer key, you have to assume annual compounding, even though the question doesn’t specifically state that: F = 1. 500 ? answer 1. 045 = 1. 5218 . If you use continuous compounding, you’ll get an 1. 03 which is actually closer to choice “a”: F = 1. 500 ? e 0. 045? 0. 03 = 1. 5227 . Our advice is to be prepared for this type of ambiguity on the FRM exam. 78.

Which of the following statements regarding economic capital are true? i. Economic capital is designed to provide a cushion against unexpected losses at a specified confidence level over a set time horizon. ii. Since regulatory capital models and economic capital models have different objectives, economic capital models cannot help regulators in setting regulatory capital requirements. iii. Firms whose capital exceeds their required regulatory capital are firms that employ their capital inefficiently, and their shareholders would benefit if they used all of their excess capital to repurchase shares or increase dividends. v. Economics capital can be used to validate a firm’s regulatory capital requirement against its own assessment of the risks it is running. A i, ii, and iii only B iii and iv only C i and iv only D i, iii, and iv only Correct answer: C iii ?? ,???? regulatory capital ??????? 79. The weighted average rating of the collateral pool used to structure collateralized bond obligations: A. is same as that of the securities issued. B. is lower than that of the securities issued. C. is higher than that of the securities issued. D. may be higher or lower than that of the securities issued depending on the number of tranches.

Correct answer: B An issuer (SPV) needs to provide for a significantly higher collateral than the securities issued. This excess collateral (or the equity tranche) absorbs a significant amount of the credit risk of the pool of bond obligations and leaves the securities offered to investors with lesser risk and hence a higher rating. 80. A hedge fund with $100 million in equity is long $200 million in some stocks and short $150 million in other stocks. The gross leverage and net leverage are, respectively, A. B. C. D. 2. 0 and 0. 5 2. 0 and 1. 5 3. 5 and 0. 3. 5 and 1. 5 Answer: C The gross leverage is (200 + 150)/100 = 3. 5. The net leverage is (200 – 150)/100 = 0. 5. 81. Which of the following is a type of credit derivative? I. A put option on a corporate bond II. A total return swap on a loan portfolio III. A note that pays an enhanced yield in the case of a bond downgrade IV. A put option on an off-the-run Treasury bond A. I, II, and III B. II and III only C. II only D. All of the above Correct Answer: a Explain: Part I, II, and III are correct. An option on a T-bond has no credit component. 82.

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. 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: A Sovereign debt is typically rated higher than corporate debt in the same country. 83. Consider a swap contract that has just been initiated with a term to maturity of 10 years. If the DV01 of the swap is proportional to its term to aturity and the movement of the term structure of interest rates is stochastic, parallel, normally distributed with a constant volatility, the potential exposure of the swap will peak after: A. 2. 5 years. B. 3. 3 years. C. 5. 6 years. D. 6. 7 years. Correct answer: B If the DV01 is proportional to its term to maturity, the potential exposure peaks after one third of the initial life of the contract. 84. If an investor holds a five-year IBM bond, it will give him a return very close to the return of the following position: A. A five-year IBM credit default swap on which he pays fixed and receives a payment in the event of default B.

A five-year IBM credit default swap on which he receives fixed and makes a payment in the event of default C. A five-year U. S. Treasury bond plus a five-year IBM credit default swap on which he pays fixed and receives a payment in the event of default D. A five-year U. S. Treasury bond plus a five-year IBM credit default swap on which he receives fixed and makes a payment in the event of default Correct Answer: d Explain: A long corporate bond position is equivalent to a long Treasury bond position plus a short CDS. 85. The National Stock Exchange of India introduced bond futures trading in 2003.

In the past, interest rate volatility in India had been very high, especially during international currency crises. However, this volatility is currently low. Which of the following positions would you agree the most? A. While determining initial margin at 99% 1-day VAR, the interest rate volatility of the past crises needs to be ignored as the regime has clearly shifted. B. While determining initial margin at 99% 1-day VAR, the interest rate volatility of the past crises needs to be accounted if these events have occurred in the recent past and could recur. C.

We need to have an additional factor measuring (and possibly predicting) pressure on currency. The decision to include or exclude high volatility samples can then be made on a real-time basis. D. None of the above. Correct answer: C An unduly low margin would bankrupt the clearing house, while an unduly high margin would kill trading interest. The best compromise would be statement C, where the clearing house can change the measurement of VAR. 86. When choosing a hedging approach, you expect operational risks to be higher for: A. a product traded on an organized exchange. B. ynamic replication using an exchange-traded product. C. an OTC product. D. static replication using an exchange-traded product. Answer: B Operational risks tend to be higher for dynamic replication using an exchange-traded product, because the need for rebalancing increases the chance of mishaps in implementing the strategy. 87. Which of the following in NOT an issue in the active risk management of a credit book? A. Serial correlations. B. Limited number of issuers. C. Illiquidity of the underlying. D. Need to maintain client relationship. Correct answer: B The credit market has enough issuers.

The problem lies in the illiquidity of the papers, possible serial correlations in credit events and the need to accommodate clients. 88. A department store chain has a B1 rating from Moody’s and a B+ rating from S. Its balance sheet reflects a large number of receivables from shoppers who use the chain’s private label credit card. The firm has decided to raise much needed funds for renovation by securitizing these receivables. Which of the following scenarios is the most likely outcome? A. The bond issued in the securitization will be B1/B+ rated because the department store chain is rated B1/B+.

B. The asset-backed security (ABS)will have a senior tranche that is rated investment grade and whose face value is lower than the value of the receivables that were on the firm’s balance sheet. C. The asset-backed security (ABS)will be over collateralized with the receivables that had been on the firm’s balance sheet and are now a liability of the special purpose entity (SPE). D. The securitization will result in a bond with two tranches: one that is senior and receives a Ba3/BB-rating and another that is junior and receives a B2/B. Answer: B A.

Incorrect. Because ABS bonds are rated with respect to the risk of the underlying assets (in this credit card receivables) not the risk of the originator of the assets. B. Correct. A large fraction of ABSs are structured with senior and sub tranches. The senior is usually AAA because it has the full backing of all the assets in the pool that the SPE owns, while the sub tranche only gets paid back if the senior tranche is paid in full. To ensure that the default risk is lower, the senior tranche is smaller than the pool of receivables backing the bond.

C. Incorrect. Because if over collateralization is used the collateral is an asset of the SPE not a liability D. Incorrect. Because it is usually the case that at least one of the tranches is investment-grade. 89. For a financial institution, model risk would not exist if: A. accurate prices for financial instruments were observable at all times. B. assets were traded infrequently. C. all financial assets were simple in design. D. all financial assets were complex. Answer: A Model risk is a result of incorrect estimates of market prices.

If accurate prices were always observable, there would be no need to estimate market prices and no need to manage model risk. Infrequent trading exacerbates model risk, because it makes asset values difficult to determine based on recent transactions. Model risk exists for both simple and complex instruments when assets are infrequently traded. 90. Which of the following statements about the role of the model risk manager is most correct? The role of the model risk manager is: A. less likely to include the reverse engineering of prices if the risk manager does not believe in the efficient market hypothesis.

B. more likely to include the reverse engineering of prices if the risk manager does believe in the efficient market hypothesis. C. more likely to include the reverse engineering of prices if the risk manager does not believe in the efficient market hypothesis. D. never likely to include the reverse engineering of prices regardless of the risk manager’s beliefs regarding the efficient market hypothesis. Answer: C The reverse engineering of prices is the process of finding the set of pricing methodologies that best accounts for observed market prices.

This process is important in a non-efficient market setting, where an important objective in the model risk management process is to identify the model currently used to arrive at observed market prices that may differ from true fundamental value. This differs from an efficient market setting where the objective is to identify the model that produces the true fundamental value. 91. The difference between a Monte Carlo simulation and a historical simulation is that a historical simulation uses randomly selected variables from past distributions, while a Monte Carlo simulation: A. uses randomly selected variables from future distributions.

B. uses variables based on roulette odds. C. uses a computer to generate random variables. D. projects variables based on a priori principles. Correct answer: C. A Monte Carlo simulation uses a computer to generate random variables from specified distributions. 92. Which of the common methods of computing value at risk relies on the assumption of normality? A. Historical. B. Variance/covariance. C. Monte Carlo simulation. D. Rounding estimation. Correct answer:B The variance/covariance method relies on the assumption of normality. 93. The mean age of the 80 employees in a company is 35 and the standard deviation is 15.

Assuming that the ages are normally distributed and using 95 percent confidence, we can say that the employees within the firm fall between: A. 20. 0 and 50. 0 years. B. 31. 7 and 38. 3 years. C. 33. 8 and 36. 2 years. D. 34. 6 and 35. 4 years. Correct answer: B The range of the 95 percent confidence interval = mean ?? 1. 96 x standard deviation / Number of employees^0. 5 = 35 ?? 1. 96 x 15 / 80^0. 5 = 35 ?? 3. 3 = between 31. 7 and 38. 3 94. Which of the following are examples of model risk? I. A VaR model that has been prepared by an external contractor. II. A mark-to-market model that cannot be understood by risk managers.

III. A VaR model that does not allow for the adjustment of market correlations. IV. A mark-to-market model that relies on volatility figures prepared by the trader being monitored. A. I and III. B. II and IV. C. D.