Part 2 Full Length Interactive Mock Exam 1

A portfolio manager evaluates the risk of the following two-bond portfolio:

We assume that specific risk is negligible and that the volatility of changes in market yields is 50 basis points. Under these conditions, which is nearest to the volatility of the portfolio value? (note: variation on Jorion’s EOC question 11.8).^[1]

[1] Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd Edition (New York: McGraw Hill, 2006)

Among its financial positions, Zapex Financial Corporation has written a call, entered into an interest rate swap, and written a credit default swap. Among these (the following) four positions, which is the BEST example of wrong-way risk?

In December 2017, the Basel Committee (BCBS) made several revisions to the Basel III framework. This included revisions to both the standardized approach to credit risk (“Credit risk accounts for the bulk of most banks’ risk-taking activities and hence their regulatory capital requirements. The standardized approach is used by the majority of banks around the world, including in non-Basel Committee jurisdictions,” wrote the Committee)^[1] and the internal ratings-based (IRB) approaches to credit risk (“The financial crisis highlighted a number of shortcomings related to the use of internally modeled approaches for regulatory capital, including the IRB approaches to credit risk. These shortcomings include the excessive complexity of the IRB approaches, the lack of comparability in banks’ internally modeled IRB capital requirements and the lack of robustness in modelling certain asset classes,” wrote the Committee).[1]

In regard to these December 2017 revisions to credit risk approaches in Basel III, which of the following statements is TRUE?

[1] “High-level summary of Basel III reforms,” (Basel Committee on Banking Supervision Publication, December 2017)

An asset that is not very liquid is quoted bid $89.00, offer $96.00. Which is nearest to the proportional bid-offer spread?

The Investment Committee at your firm has a longstanding practice of weighing alpha, among other factors and criteria, in its evaluation of external managers. However, recently, a member voiced concern about the reliability of alpha in the context of certain strategies with known non-linear payoffs. For example, some of the firm’s external managers are effectively placing short volatility bets. The Committee wants to better evaluate manager alpha in light of these non-linear strategies. However, as they are highly influenced by Andrew Ang’s work, they do want their benchmarks to meet Ang’s^[1] criteria for an ideal benchmark: 1. Well defined, 2. Tradeable, 3. Replicable, and 4.Risk-adjusted. Which of the following solutions or approaches to this problem is the most viable?

[1] Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (NY: Oxford University Press, 2014)

Robert’s manager requests that he graph a five-year term structure of interest rates based on a binomial interest rate tree. The tree recombines with up- and down-jumps that are equal in magnitude (plus or minus X basis points) and likelihood (50%) such that the expected one-year rate on each of years two, three, four and five is today’s one-year spot rate. However, the interest rate assumptions in the tree’s nodes reflect an assumption of significant rate volatility. Further, a key input into the model is a risk premium which reflects an assumption that investors are risk averse. Which of the following is the most plausible predication about the produced graph of the term structure?

Consider a netting set with two derivative positions: an interest rate swap (IRS) with a marginal CVA of -1.450 and a cross-currency swap (CCS) with a marginal CVA of -1.550. If the first transaction is the cross-currency swap (CCS) and its incremental CVA is -2.100, then what is the incremental CVA of the IRS?

The central feature of Basel III’s first pillar is the regulatory capital (i.e., CET1, Tier 1, and total capital) requirements which require minimum fractions of risk-weighted assets (RWA). In addition to these minimums, as of early 2019 (when the buffers were fully phased in), Basel specifies three buffers: the capital conservation buffer (CCB), the G-SIB buffer, and the countercyclical buffer (CCyB). This is all very confusing, so you ask your colleague Mary to summarize these additional buffers and their motivations. She makes the following five points:

1. For all three, the additional buffer must be CET1
2. For all three, breach of the buffer requirements implies the bank’s ability to pay dividends will be restricted
3. The CCB requires an additional 2.5% of CET1 capital and is meant to ensure that banks have an additional layer of usable capital that can be drawn down when losses are incurred.
4. The additional G-SIB requirement includes five buckets {1.0%, 1.5%, 2.0%, 2.5%, or 3.5%} https://www.bis.org/fsi/fsisummaries/g-sib_framework.htm and is meant to reduce the likelihood and severity of the failure of a global systemically important financial institution
5. The CCyB requirement varies between zero and 2.5% and is meant to protect the banking sector from periods of excess aggregate credit growth that have often been associated with the build-up of system-wide risks

Is Mary correct in her summary?

A portfolio holds 100,000 shares of a stock and this single position has a value of $3.0 million. The stock is quoted bid $29.00, offer $31.00. The stock’s daily volatility is 1.43% or 143 basis points. For purposes of value at risk (VaR), we will assume the stock’s arithmetic returns are normally distributed (aka, normal VaR) and the expected daily return rounds to zero (under these assumptions absolute VaR is identical to relative VaR).

Which is NEAREST to the position’s one-day 99.0% confident liquidity-adjusted value at risk (LVaR)?

Below are Andrew Ang’s actual regression results for the annual gross returns of the CalPERS pension fund against a passive portfolio of index funds in stocks and bonds. Please note the returns are gross returns, not excess returns; i.e., they are NOT net of the riskfree rate.

Which of the following statements about these regression results is TRUE?

Consider a $200.00 million portfolio that is equally allocated between two bonds: the first bond pays a 5.0% annual coupon and matures in five years; the second bond pays a 3.0% annual coupon and matures in three years. Both bonds are currently priced at par, so their market value is $100.00 million each. The spot rate term structure is depicted below: 1.20% at one year, 2.00% at two years, 3.04% at three years, 4.50% at four years and 5.20% at five years. Finally, the returns VaR (aka, risk) is based on a yield volatility of 100 basis points at all maturities and a confidence level of 99.0%. In this way, for example, the risk at one year is given by 1.0%*2.33*(1/1.0120) = 2.30%, and the risk at two years is given by 1.0%*2.33*(2/1.020) = 4.57%.

Please note that compound frequency is annual, following the annual coupon payment. Under the principal mapping approach, which is nearest to the portfolio value at risk (VaR)?

In regard to quantitative and qualitative credit analysis, each of the following is true, EXCEPT which is false?

Peter is studying for the Financial Risk Manager (FRM) exam and he thinks the historical evolution of the Basel regulations is confusing. In particular, he wants to better understand the difference between the original Basel I accord (aka, the 1988 Basel Accord that was implemented by 1992) and Basel II, which was finally published over ten years later in 2004. His colleague Mary explains that, in comparison to the original accord, Basel II contained four significant innovations. Specifically, in comparison to the original Basel I accord (which do include the 1995/1996 Amendments) that came before, Mary says that significant innovations in Basel II included the following:

1. In addition to credit risk and market risk, Basel II required capital for operational risk
2. Basel II eliminated risk weights and risk-weighted assets (RWA) and replaced them with direct calculation of risk charges
3. Basel II contained specific requirements for supervision related to capital and risk management (Pillar 2) and required public disclosures (Pillar 3)
4. To fine-tune the accord’s design, Basel II made repeated use of Quantitative Impact Studies (QIS) to which banks contributed data (i.e., feedback) that was analyzed by supervisors

Is Mary correct?

Assume the spot foreign exchange (FX) rate between the US dollar and the Japanese Yen is 110.00 which can be represented as USDJPY 110.00 or JPY 110.00 where USD is the base currency and JPY is the quote currency; aka, quote 110.00 yen per one dollar of the base or “per unit” currency. The USD interest rate is 2.50% and the JPY interest rate is 0.450%. The period is one year, and the compound frequency is annual. If the covered interest rate (CIP) arbitrage framework enforces a perfectly accurate one-year forward exchange rate, then what is the implied one-year “swap rate” which is here simply defined as the difference between the forward FX rate and the spot FX rate; put simply, what is the difference, F(USDJYP) – S(USDJPY), or F(USDJPY) – 110.00?

Below is the regression output of a portfolio’s excess returns against its benchmark’s excess return over the last three months (n = 60 trading days). Excess return is defined as return above the risk-free rate.

Key output from the regression includes:

• The sample size is 60 trading days
• With respect to the portfolio, its average excess return is 3.29% (in excess of the riskfree rate) with volatility of 3.67%
• With respect to the benchmark, its average excess return is 0.98% (in excess of the riskfree rate) with volatility of 1.99%
• The average difference in return between the portfolio and the benchmark, avg(P-M), is 2.31%; this is also called the active return
• The regression intercept is 0.0180 and the regression slope is 1.5231 (as displayed on plot)
• The tracking error (standard error of the regression) is 2.10%

Which of the following is nearest to the information ratio (IR) if we measure the IR as residual return per unit of residual risk?

Which of the following is TRUE about VaR mapping?

A firm has an asset value (V) of $110.00 million with asset volatility of 30.0% per annum. Its only debt is a zero-coupon bond with face value of $80.0 million that matures in five years. The riskfree rate is 4.0%. In Stulz’s notation, V=110, σ(V)= 0.30, F=80.0, T=5.0 and r=0.04. The Black-Scholes Merton (BSM) price of a put option,p , on the firm’s assets with strike price equal to the face value of the bond is $6.95 million; i.e., p(V=110, F=80, sigma=0.30, T=5, r=0.04) = $6.95 million. Which is nearest to the current value of the firm’s debt?

The diagram below plots the exposures of three counterparties (A, B, and C). There are two types of exposures: standard transactions can be cleared centrally and are represented below by the BLUE dashed lines; nonstandard transactions cannot be cleared centrally and are represented by SOLID black lines. For example, between counterparties A and B, the standard transactions (dashed blue line) are worth +40 to A (and -40 to B). while the nonstandard transactions (solid black line) are worth +120 to B (and -120 to A).

We can observe that WITHOUT central clearing, as shown in the diagram, netting implies an average exposure of 50.0%. This is because bilateral netting (without the CCP) allows non-standard transactions to be netted with standard transactions. Consequently, the average exposure equals (0 + 120 + 30) / 3 = 50.0 where counterparty A will net to an exposure of zero, counterparty B will net to a netted exposure of (120.0 – 40.0) + (30.0 + 10.0) = 120.0, and counterparty C will net to an exposure of (80.0 – 50.0) + 0 = 30.0.

What is the average exposure (both including and excluding exposure to the CCP) if we introduce central clearing but only the standard transactions are centrally cleared?

Liquidity Early Warning Indicators (EWI) can be compared to an automobile’s dashboard signal system where the appearance of a red light points our attention to something that may become a problem if not addressed. Each of the following is a credible red indicator (aka, red flag) in a Liquidity Early Warning Indicator (aka, Liquidity EWI) dashboard EXCEPT which is not a red (red flag) liquidity indicator?

Andrew Ang explains that a large literature has tried to estimate the return-volatility trade-off as represented by Ang’s formula 7.1 below, where gamma, γ, is the risk aversion of the average investor and σ(m)^2 is the variance of the market return:^[1]

About the relationship between returns (or earned premiums) and volatility, which of the following statements is TRUE?

[1] Equation 7.1 – Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (NY: Oxford University Press, 2014)

Barbara is a Risk Analyst at a financial services firm, and she is simulating the backtest of proposed value at risk (VaR) model for her firm. She is revising the simulation because the previous version was submitted to the Risk Committee of the Board and the following feedback came back: they asked to reduce the probability of a Type II error in the backtest. The previous version assumed a 97.5% value at risk (VaR) model and the backtest assumed a two-tailed confidence level of 95.0%. The sample size was two years of daily profit and loss (P/L); i.e., 500 trading days. Which of the following adjustments is the MOST EFFECTIVE way to REDUCE the Type II error rate, per the Board’s preference?

Retail exposures include the following: credit cards, installment loans (e.g., personal finance, educational loans, auto loans, leasing), revolving credits (e.g., overdrafts, home equity lines of credit), and residential mortgages. Each of the following tends to be a stronger feature of retail credit risk rather than corporate credit risk EXCEPT which is more typical of corporate credit risk?

A person named Jack Ryan has applied to open a new account at Quadstreet International Bank. The bank has a modern, well-established, and compliant customer acceptance policy. Immediately the bank is able to determine two facts: Jack is a high-risk customer, but he previously had an account at another large bank. Further, Quadstreet does conduct business with Jack’s previous bank and considers it to be reputable. With respect to money laundering and terrorism financing (ML/FT), which of the following statements is TRUE about Jack Ryan’s application?

If a corporation’s marginal tax rate is 30.0% and it purchases an A-rated municipal bond that offers a 4.20% gross yield (aka, yield to maturity), what is the tax-equivalent yield (TEY)?

Which is TRUE about the endogenous component of liquidity risk?

Bertha the risk analyst has sorted portfolio returns for the last ninety days (K = 90 days) and the worst seven are displayed below. She wants to calculate the age-weighted historical simulation (HS) value at risk (VaR) with 95.0% confidence. Her selected exponential rate of decay, λ – 0.940; e.g., the worst daily loss of -5.0% occurred 40 days ago which is weighted λ^(n-1)*(1-λ)/(1 – λ^K) = 0.940^(40-1)*(1-0.940)/(1-0.940^90) = 0.54%.

There are three ways to retrieve the 95.0% age-weighted historical simulation, but in this case two of them return approximately the same answer. Which of the following pairs is nearest to the 95.0% confident age-weighted historical simulation?

Crouhy describes each of the following as a trend in retail banking EXCEPT which is not?

Peter is a risk analyst who seeks to validate his bank’s default probability (PD) estimates. His bank’s large historical sample includes several years of PD estimates and the actual (aka, observed) default rates. As De Laurentis writes, “validating calibration means analyzing differences between forecasted PDs and realized default rates.”^[1] In regard to possible credit rating validation methodologies, each of the following statements is true EXCEPT which is false?

[1] Giacomo De Laurentis, Renato Maino, Luca Molteni, Developing, Validating and Using Internal Ratings (Hoboken, NJ: John Wiley & Sons, 2010).

Over the next 24 hours, Greenlux State Bank estimates that the following cash inflows and outflows (all figures in millions) will occur:

What is the bank’s projected net liquidity position?

In introducing multifactor models, Andrew Ang explains that “to capture the composite bad times over multiple factors, the new asset pricing approach uses the notion of a pricing kernel. This is also called a stochastic discount factor (SDF). We denote the SDF as (m).” This allows him to write the risk premium of an asset as a function of β(i,m) and the price of risk, λ(m), as follows:^[1]

About the relationship and its implications, each of the following statements is true EXCEPT which is false? Reminder hint: the β(i,m) here is not exactly the same CAPM’s traditional beta exposure to the market risk premium, this is a generalized, different beta.

[1] Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (NY: Oxford University Press, 2014)

Betty is trying to decide between basic historical simulation (HS) and bootstrap historic simulation (BOOTSTRAP). In making her choice, which of the following statements is TRUE?

If the nominal value of the credit-sensitive assets in the collateral pool are exactly equal to the nominal value of issued securities, then which of the following is equal to zero?

According to the FDIC, model risk management starts with robust model development, implementation, and use (aka, the first element. The second element is a sound validation process. The third element is governance). Which of the following is a TRUE statement about this first element (development, implementation, and use) of model risk management?

Suppose that Acme Bank reports interest-sensitive assets (ISA) of $490.0 million and interest-sensitive liabilities (ISL) of $610.0 million. Recall that the relative interest-sensitive gap (aka, Relative IS GAP) is equal to the Dollar IS GAP divided (aka, scaled) by the size of the bank (where IS assets is a valid measure of size). Respectively, what is the bank’s relative IS GAP; its interest-sensitivity ratio (ISR); and the impact of rising interest rates on its net interest margin (NIM)?

In regard to the hedge fund’s operational environment, Mirable^[1] advises each of the following as true for investors during due diligence, EXCEPT however which is not true?

[1] Kevin R. Mirabile, Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance 2nd Edition (Hoboken, NJ: Wiley Finance, 2016)

Sally is a Risk Analyst who wants to estimate the 95.0% expected shortfall (ES) but finds it much easier to retrieve the extreme quantiles of the distribution, which are shown below:

Based on these quantiles, which of the following is the BEST estimate of the 95.0% expected shortfall (ES)?

The exhibit below (displayed in a format similar to De Laurentis’ Table 3.7)^[1] shows the Altman’s Z-score calculation for a hypothetical company:

Assume a stress test that downwardly shocks three of the variables as follows:

• Sales decline of 10%
• EBITDA decline of 10%
• Equity market value decline of 20%

No other accounts are affected. Which of the following is nearest to the outcome for the updated Altman’s Z-score?

[1] Giacomo De Laurentis, Renato Maino, and Luca Molteni, Developing, Validating and Using Internal Ratings (West Sussex, United Kingdom: John Wiley & Sons, 2010).

Betty and Peter are discussing the proper definition of “risk culture.” In particular, they are interested in the relationship between corporate culture and risk culture. Betty and Peter each have a different perspective, as summarized this way:

1. Betty argues that risk culture (RC) refers to the firm’s basic assumptions: RC is the set of values and beliefs about risk shared by the firm’s employees​
2. Peter argues that risk culture (RC) refers to norms and behavior: RC is how individuals discuss, behave, decide, and act with respect to the firm’s risks​

According to Carretta and Schwizer, who has the better definition of risk culture?

Venkat explains that “all risk management frameworks start with a governance structure that defines the roles and responsibilities of various bank employees and committees in overseeing risk-related activities,”^[1] and effective governance includes the oversight of intraday liquidity risk. In regard to the governance structure of intraday liquidity risk management which of the following statements is TRUE?

[1] Shyam Venkat, Stephen Baird, Liquidity Risk Management (Hoboken, NJ: John Wiley & Sons, 2016)

You receive a general solicitation from a hedge fund, which is now possible under the 2012 JOBS Act. The fund advertises its style as a long/short equity manager. However, you are skeptical of each of the solicitation’s claims. In fact, each of the following claims from the long/short equity manager is dubious or unlikely EXCEPT which is the MOST PLAUSIBLE or MOST LIKELY?

A hedge fund’s daily P/L for the last 300 trading days is plotted below in a histogram where the bin width is $0.20. Additionally, the worst 20 daily losses are sorted explicitly below the histogram:

Which is nearest to the 99.0% expected shortfall (ES)?

The following plots the exposure profile for a given netting set:

Each of the lines in this chart is a function of the expected exposure (EE) which is plotted with green circular markers. The solid dark green line is a non-decreasing EE. The light blue horizontal line is the time-weighted average of the expected exposure; the red horizontal line is the time-weighted average of the non-decreasing EE. Each of the following statements is true about this exposure profile EXCEPT which is false?

Culture is famously difficult to define. The Financial Risk Manager (FRM) says that risk culture “can be thought of as the set of goals, values, beliefs, procedures, customs, and conventions that influence how staff create, identify, manage, and think about risk within an enterprise, including implicit and explicit beliefs.” By comparison, the G30’s simplified framework (see image below) asserts that bank culture is one of the key inputs that determines the bank’s outcomes.

Specifically, the G30 defines culture as “the mechanism that delivers the values and behaviors that shape conduct and contributes to creating trust in banks and a positive reputation for banks among key stakeholders, both internal and external.”^[1]

Which of the following statements about culture is TRUE?

[1] “Banking Conduct and Culture: A Permanent Mindset Change,” G30 Working Group, 2018.

Geofinancial Bank currently has the following (very) simplified balance sheet:

Further, the maturities of these accounts are as follows:

• Assets: The bonds ($30.0 million) expire in one year. In regard to the loans ($70.0), $40.0 million expire in five (5) years, $10.0 million expire in seven (7) years, and $20.0 million expire in ten (10) years.
• Liabilities: In regard to the deposits ($20.0 million), $10.0 million expire in one (1) year, and $20.0 million expire in two (2) years. In regard to the bonds ($50.0 million), $10.0 million expire in five (5) years, $30.0 million expire in seven (7) years, and $10.0 million expire in beyond ten (>10) years.
• Equity ($20.0 million) is presumed to expire in ten (10) years

Consider the following possible term structures of expected cash flows:

Which term structure of expected cash flows is accurate for Geofinancial Bank?

Both value at risk (VaR) and tracking error (TE) are considered risk measures. Which of the following statements is TRUE about the relationship and/or contrast between VaR and tracking error (TE)?

A mutual fund’s daily returns for the last 300 trading days is plotted on this histogram. Additionally, the worst 20 daily returns are sorted explicitly below the histogram:

Under the basic historical simulation approach, which of the following is the BEST one-day 99.0% value at risk (VaR)?

Julia the analyst is analyzing the credit risk of a contract to which her firm is considering entering into as a party. If true, which feature of her work (among the choices below) most likely signifies or indicates that this is a case of counterparty credit risk rather than (traditional) lending risk or some other type of risk?

The Basel regulatory framework has undergone several major renovations but started in the late 1980s when the Basel Committee on Banking Supervision^[1] published the first Basel accord, which is now called Basel I; this original Basel I was implemented in 1992. According to Carey (GARP Chapter 19), which BEST summarizes the motivation(s) of the original Basel?

[1] BCBS at https://www.bis.org/bcbs/

Which of the following types of liquidity is available in the form of the institution’s liquidity asset buffer (LAB) and represents liquidity available to meet general financial obligations under a stress scenario?

According to Rosengarten and Peter Zangari (Litterman), “In response to this heightened level of risk consciousness, many organizations and asset managers have formed independent risk management units (RMUs) that oversee the risk exposures of portfolios and ensure that such exposures are authorized and in line with risk budgets.”^[1]

Which of the following is the LEAST LIKELY to be an objective of a risk management unit (RMU)?

[1] Robert Litterman and the Quantitative Resources Group, Modern Investment Management: An Equilibrium Approach (Hoboken, NJ: John Wiley & Sons, 2003)

Peter the risk manager conducts a backtest of his company’s 97.0% value at risk (VaR) model over a one-year horizon that includes 250 days. He observes only one exception; i.e., for the year the loss exceeded the VaR only once. If his backtest requires a one-tailed confidence level of 99.0%, should he conclude the model is correctly calibrated (note: because there are two “yes” and two “no” choices, please select the best answer)?

Freecone Financial LLC entered into an interest rate swap some time ago where it agreed to make semi-annual fixed payments at a rate of 3.0% per annum, in exchange for receiving floating payments on a notional amount of $50.0 million. The floating rate is the six-month secured overnight financing rate (SOFR) and this is also the discount rate used to value the swap. The swap has a remaining life of 1.25 years. The SOFR rate applicable to the exchange in three months was determined three months ago: it was 2.40%. Just as with a LIBOR-based swap, the floating rate is observed at the beginning of each six-month period but paid at the end of the period. Currently, the SOFR term structure is flat at 2.60% per annum with continuous compounding. With respect to its position in this swap, which of the following is nearest to Freecone Financial’s current exposure?

In finance, a standard model of the behavior over time of an asset price or risk factor is the geometric Brownian motion (or diffusion model) This model is also the basis for the Black-Scholes option pricing model, and is generally a point of departure for analysis of asset return behavior. In this standard model, returns are normally distributed. However, it is well understood that actual returns do not necessarily comport to the standard model. In fact, real-world asset returns tend to exhibit each of the following EXCEPT for which is not generally true about real-world asset returns?

The staff at Umbrella Street Bank, which is a commercial bank (it could also be a savings institution or credit union), produces several liquidity risk reports on a daily, weekly, monthly, and quarterly basis. Among these liquidity risk reports is a deposit tracker report. Among the following metrics, which is MOST LIKELY to appear in their deposit tracker report?

Your wealthy Aunt Betty has capital to invest and is trying to choose between a hedge fund and a mutual fund. According to Fung and Hsieh, which of the following is the best argument in favor of a hedge fund investment rather than a mutual fund investment?

About the Gaussian copula utilized for financial applications, Meissner says each is true EXCEPT which is not?

The figure below illustrates the general role of the credit value adjustment (CVA) desk at Heroic Multifunction Bank (aka, the bank). Assume the trader is a market maker. The uncollateralized trade with the customer (on the left) is hedged with a collateralized trade (on the right):

Assume the uncollateralized transaction (with the client) has a positive mark-to-market (MTM) value such that, by definition, the collateralized hedge position, therefore, has a negative MTM value. If the market moves such that, with respect to the position with the client, the position’s positive MTM value INCREASES and becomes even more positive, then which of the following implications is most likely to be TRUE?

A bank is using the VaR and stressed VaR (SVaR) market risk framework according to the Basel 2.5 guidelines. The bank’s internal models for market risk have generated the following risk measures for the current trading book positions (VaR and SVaR are in USD millions):

The supervisor has set both multiplication factors, m and m(S), to 3.0. What is the correct capital requirement for general market risk for the bank under Basel 2.5? (note: this question inspired by Question 42 of GARP’s 2020 Part 2 Practice Exam).

Which of the following provides the BEST explicit link(s) between a bank’s contingency funding plan (CFP) and its liquidity stress testing framework?

Andrew Ang develops an analogy, writing “factors are to assets what nutrients are to food.”67 His theory of factor risk premiums includes each of the following three ideas EXCEPT which is not in the theory?

You ask a junior staffer to review the evidence on equity correlations using as the data set the daily closing prices of the 30 stocks in the Dow Jones Industrial Average (Dow) from January 1972 to October 2012. He reports back the following four summary findings:

I. Equity correlation levels are lowest during economic expansions (growth) and highest during recessions

II. Equity correlation volatility is generally high; i.e., above 70.0% during each of growth/normal/recessionary periods

III. There is a general, positive association between correlation level and correlation volatility

IV. Equity correlations exhibit high, strong mean reversion and, therefore, low (positive) autocorrelation

Which is (are) correct?

Acme Financial has a position in five derivative contracts with its counterparty. The current mark-to-market values of the positions are the following: +12, -9, +20, -6, and +8. The five positions are all included in a single netting set. Let’s define the “netting benefit” as the reduction in current exposure due to netting; that is, the difference between the total current exposure with netting and the current exposure “as if” netting did not apply. What is the netting benefit in this set?

Assume a bank’s $2.0 billion corporate loan portfolio offers a return of 6.0% per annum. The expected loss on the portfolio is estimated to be 1.5% per annum; i.e., $30 million. The portfolio is funded by $2.0 billion in retail deposits with a transfer-priced interest rate charge of 2.00%. The bank (the lender) has a direct operating cost of $16.0 million per annum and an effective tax rate of 25.0%. Risk analysis of the unexpected losses associated with the portfolio tell us we need to set aside economic capital of $200.0 million against the portfolio; i.e., 10.0% of the loan amount. The bank’s economic capital must be invested in risk-free securities and, unfortunately in the regime of ultra low interest rates, the risk-free rate on government securities is only 1.0%.

Although the loan portfolio’s risk-adjusted return on capital (RAROC) is positive and seemingly high, the bank wants to adjust the traditional RAROC calculation to obtain a RAROC measures that takes into account the systemic riskiness of the expected returns. If the risk-free rate is 1.0% (as above), and the expected rate of return on the market portfolio is 8.0% such that the equity risk premium is 7.0%, and the beta of the firm’s equity is 1.60, which of the following is the correct adjusted RAROC and is the project advisable?

In order to identify the presence of illiquidity risk premium(s), Andrew Ang71 references data presented by Antti Ilmanen in his well-regarded book Expected Returns (An Investor’s Guide to Harvesting Market Rewards). This data is displayed below as a scatterplot where the y-axis is the long-run average return of the asset class and the x-asset is an index of illiquidity. A higher index (i.e., to the right) implies less liquidity. For example, the venture capital as an asset class is assigned to the least liquid (most illiquid) asset class but it also plots the highest long-run average return.

In regard to the illiquidity risk premium, which of the following statements is TRUE?

You have been tasked to perform due diligence on a hedge fund. According to Mirable^[1], each of the following is a desirable–or even necessary–characteristic of the fund or critical activity in the due diligence process EXCEPT which is not desirable or necessary?

[1] Kevin R. Mirabile, Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance (Hoboken, NJ: Wiley Finance, 2013)

Meissner^[1] makes some important points about the terminology surrounding “correlation.” Which of the following is true?

[1] Gunter Meissner,  Correlation Risk Modeling and Management, (New York: Wiley, 2014)

The graph below represents a trilateral scenario between three different counterparties (called A, B, and C) with position sizes in a certain fungible (aka, interchangeable) product. The values represent notional sizes and the direction represents exposures:

In this ring, the current total notional is 370. If trade compression can be achieved, which of the following is an efficient solution?

Silverfind Financial International is planning to conduct a risk control self-assessment (RCSA) for each of its business units. Which of the following is MOST LIKELY to be a feature or element of the firm’s RCSA?

According to Rose and Hudgins, the factors affecting the choice of non-deposit funding sources include the following: the relative costs of each funding source; the risk of each funding source, including the dependability and volatility; the length of time for which funds will be needed; the size of the financial institution needing the funds; and regulations on the use of other sources of funds. In regard to the various sources of non-deposit funding, which of the following statements is TRUE?

We can add a momentum factor to the Fama-French so that it becomes a four-factor model. This momentum factor is denoted by WML (i.e., past winners minus past losers) or UMD (i.e., stocks that have gone up minus stocks that have gone down). At least with respect to the historical window analyzed, which is the long period from January 1965 to December 2011, which of the following statements is TRUE about the momentum factor?

Commercial bank (C) has lent to company (A) and company (B). Both (A) and (B) have a 9.0% default probability. If their pairwise default correlation is 0.280, which is nearest to the joint probability of default (we can use the referenced binomial correlation measure of Lucas 1995, but it is available to us with application of FRM Part 1 concepts)?

Two counterparties (A and B, illustrated below) have between them a set of OTC derivative transactions.

Associated with the positions, these counterparties also entered into a bilateral collateral agreement prior to initiation of the underlying transactions. Each of the following is true EXCEPT which is false?

At initiation of a repurchase agreement (repo), Counterparty A sells a security to Counterparty B for settlement on June 1st, 2015 at an invoice price of USD 180.0 million. At the same time, Counterparty A agrees to repurchase the security three months later, for settlement on September 1st, 2015, at a purchase price equal to the original invoice price plus interest at a repo rate of 0.90%.

Using the actual/360 convention of most money market instruments, which is nearest to the repurchase price?

What is the primary (valid) reason that banks need proper liquidity transfer pricing (LTP)?

Ang says “The $64,000 question with multifactor pricing kernel models is: how do you define bad times?”77 With respect to the multifactor model, among the following choices which is the BEST definition of “bad times?”

The table below illustrates a volatility surface (an exaggeration variation on Hull’s Table 19.2).^[1] The main body of the table shows implied volatilities calculated from the Black-Scholes-Merton (BSM) model. One dimension of the table is maturity; the other dimension is strike divided by asset price, K/[S(0)]. Implied volatilities are (hypothetically) calculated from traded options; for example, there exists a traded market price for a one-year at-the-money (ATM) option price such that its implied volatility is 22.10%:

Currently, the asset price, S(0), is $30.00. In order to value an out-of-the-money (OTM) call option with a strike price of $33.00 and a maturity of 4.0 years, a trader wants to obtain an implied volatility in order to use the BSM option pricing model. Which is nearest to the implied volatility estimate?

[1] Hull, Options, Futures, and Other Derivatives, PrenticeHallPub; 8th edition (2011)

Consider two counterparties who are about to enter into bilateral framework under an ISDA Master Agreement. They are currently negotiating the credit support annex (CSA) which will govern the terms of collateral posting. Each of the following is true EXCEPT which is inaccurate?

At the time of the Bear Stern’s demise in March 2008, Paul Friedman was a Senior Managing Director at the firm with responsibility for its fixed income repo desk. About the repo market’s role in the collapse of Bear Sterns, he said in testimony before the Financial Crisis Inquiry Commission, “During the week of March 10, 2008, Bear Stearns suffered from a run on the bank that resulted, in my view, from an unwarranted loss of confidence in the firm by certain of its customers, lenders, and counterparties. In part, this loss of confidence was prompted by market rumors, which I believe were unsubstantiated and untrue, about Bear Stearns’ liquidity position. Nevertheless, the loss of confidence had three related consequences.”

Each of the following was one of his cited three consequences EXCEPT which was not?

According to Patrick McGuire, which of the following best summarizes the proximate cause of the US dollar shortage during the global financial crisis (GFC)?

Janice is preparing to conduct factor regressions in order to discover the factor loadings in her firm’s equity portfolio. She will begin by regressing three explanatory (aka, independent) variables: the market factor (MKT) plus two additional factors. Each of the following pairs of factors are good candidates for these additional factors EXCEPT which of the following pair is NOT a good candidate?