Free Practice Questions for GARP 2016-FRR Exam

Floating rate bonds have coupon payments that are tied to a floating interest rate or index, such as LIBOR. This means their coupon payments adjust periodically with changes in the underlying interest rates. Due to this mechanism, floating rate bonds typically have less price risk compared to fixed-rate bonds because their coupon payments reset in line with current market rates. Hence, floating rate bonds are generally not very sensitive to changes in interest rates since the adjustments in coupon payments help maintain their value. Therefore, the statement that floating rate bonds are very sensitive to changes in interest rates is incorrect.

Comprehensive and Detailed In-Depth Explanation:

Operational risk under Basel II includes gains and losses from process failures (e.g., incorrect trade booking). This event, despite resulting in a profit, stems from an operational error, making it relevant for assessing control weaknesses and potential future losses. Option A is correct—excluding it underestimates operational risk exposure. Option B misclassifies it as market risk (the cause is operational). Option C is true but incomplete. Option D is wrong—Basel II includes near-misses and gains.

Exact Extract from Official Source:

BCBS, "Basel II: International Convergence of Capital Measurement and Capital Standards," June 2006, para. 673: "Operational risk data should include all relevant events, including those resulting in gains or near-misses, to provide a complete picture of risk exposure."

GARP FRR Study Notes, Operational Risk Section: "Events like trade errors, even if profitable, must be recorded in operational risk assessments to evaluate process reliability."

Interest Expense on Deposits:

Deposits = $100 million, interest rate = 3%

Interest expense = $100 million * 0.03 = $3 million

Interest Income from Loans:

Loan portfolio = $120 million, interest rate = 10%

Interest income = $120 million * 0.10 = $12 million

Net Interest Income Calculation:

Net interest income = Interest income - Interest expense = $12 million - $3 million = $9 million

References

Source: How Finance Works​

Comprehensive and Detailed In-Depth Explanation:

Implied volatility price risk arises from changes in the market’s expectation of future volatility, directly affecting the pricing of options via models like Black-Scholes, where implied volatility is a key input. Options prices are highly sensitive to volatility shifts, unlike:

Swaps:Sensitive to interest rate changes, not implied volatility.

Bonds:Affected by yield changes, not volatility.

When a trader inadvertently books a trade with incorrect information and a subsequent market move results in a gain for the bank, the event should be included in the operational loss event data program because:

Indication of Control Failure (II):The gain indicates that a control failed or a process is flawed. Even if the outcome was a gain, the underlying issue was a mistake, pointing to a weakness in the bank's operational controls that needs to be addressed.

Recording the Event as a Loss (III):Although the event resulted in a gain, it should be included in the operational loss event data program and recorded as a loss. The principle behind this is to ensure that all operational risk events are tracked, irrespective of their financial outcome, to provide a complete picture of operational risk exposures and to improve risk management practices.

Including such events helps in identifying and correcting process flaws to prevent future incidents that could result in actual losses.

References

How Finance Works.pdf, Index section​

Comprehensive and Detailed In-Depth Explanation:

An Asian option (or average rate option) has a payoff based on the average price of the underlying asset over a specified period, rather than its spot price at expiry. For a commodity Asian option, the underlying contract is the average of daily prices (e.g., throughout the month), smoothing out volatility. Option B (volumetric amounts) relates to quantity, not price. Option C describes a vanilla option, and Option D resembles a forward contract. GARP’s FRR confirms this in derivatives pricing.

Exact Extract from Official Source:

GARP FRR Study Notes, Market Risk Section: "Asian options derive their value from the average price of the underlying asset over a period, such as daily commodity prices over a month, reducing the impact of price spikes."

BCBS, "Basel III: A Global Regulatory Framework," December 2010, para. 689: "Exotic options, such as Asian options, base their payoffs on average prices rather than spot prices at maturity."

Risk and control self-assessments (RCSA) have several advantages:

They provide insight into risks that exist in a firm but may not have occurred before (II).

They allow each department to take ownership of its own risks and controls (IV). However, RCSA may not always provide very accurate scoring of risks and controls due to its subjective nature (I), and while it can produce biased operational risk reporting, the primary advantage is the transparency it offers, not the bias (III).

The market risk management function within a bank encompasses several key roles:

Establish a comprehensive market risk policy framework: This ensures that there are clear guidelines and procedures for managing market risk.

Define, approve, and monitor risk limits: This involves setting boundaries on the levels of risk that can be taken and continuously overseeing them.

Perform stress tests and other qualitative risk assessments: These are conducted to evaluate the bank's resilience to extreme market conditions and to identify potential vulnerabilities.

These activities are crucial for maintaining the bank's overall market risk exposure within acceptable levels.

Property I: The range of possible losses above the average loss is much greater than those below the average loss:

Statistical distributions of potential losses, especially in financial contexts, often exhibit a right-skewed pattern where extreme losses are more probable than extreme gains. This skewness results in a greater range of possible losses above the average loss.

Property II: The loss that is most likely to occur is below the average loss:

In skewed distributions, the mode (most likely value) is often different from the mean. For losses, the most likely (mode) value is typically below the average loss because the average is pulled up by the tail of extreme losses.

Property III: The loss that is most likely to occur is above the average loss:

This statement is incorrect for the typical skewed distribution described in financial risk contexts. The mode is below the mean due to the influence of extreme losses.

References

Source: How Finance Works​

A carry trade typically involves borrowing in a currency with low-interest rates and investing in a currency with high-interest rates to profit from the difference in interest rates.

Identify the currencies:

Low-interest currency: Typically, these are currencies of countries with low-interest rates, such as Japan (JPY) or Switzerland (CHF).

High-interest currency: These are currencies of countries with high-interest rates, such as emerging market currencies or certain developed countries during specific periods.

Mechanics of carry trade:

The bank borrows in a low-interest currency.

The bank then converts these funds into a high-interest currency.

The funds are deposited or invested in high-yield instruments denominated in the high-interest currency.

The profit arises from the differential between the interest paid on the borrowed currency and the interest earned on the invested currency.

This strategy benefits from interest rate differentials and can yield significant profits if exchange rates remain stable or move favorably.

References

Source: How Finance Works​