Free Practice Questions for GARP 2016-FRR Exam

This question appears to be similar to Question 295 but uses "external" instead of "exogenous."

Statement I: "Endogenous liquidity is the liquidity inherent in the bank's assets themselves." Correct.

Statement II: "External liquidity is the liquidity provided by the bank's liquidity structure to fund its assets and maturing liabilities." Correct.

Statement III: Incorrect for the same reasons as mentioned in Question 295.

Statement IV: Incorrect as endogenous liquidity is not the same as funding liquidity.

References

Based on the consistent use of definitions and explanations of endogenous and exogenous liquidity​​.

Preferred shares have specific characteristics that distinguish them from both common equity and debt:

Cross between Equity and Debt:Preferred shares have features of both equity and debt. They typically pay fixed dividends (similar to interest payments on debt) but do not have voting rights (similar to debt holders).

Subordination to Debt:In the event of liquidation, preferred shareholders are paid after debt holders but before common shareholders.

Perpetual or Long Maturities:Preferred shares can be perpetual, meaning they have no maturity date, or have long maturities, often exceeding those of typical corporate bonds.

Incorrect Statement - Residual Claim:The incorrect statement is that preferred shares represent the residual interest in the corporation after all other liabilities have been paid. In reality, this is the characteristic of common equity. Preferred shares have a higher claim on assets than common shares but are subordinate to all forms of debt.

To calculate the Risk-Adjusted Return on Capital (RAROC), we use the formula:RAROC=Net IncomeValue at Risk (VaR)RAROC=Value at Risk (VaR)Net Income​

Here, the net income from the transaction is the fees minus the financing costs:Net Income=$2,000,000−$600,000=$1,400,000Net Income=$2,000,000−$600,000=$1,400,000

The VaR is given as $8,000,000. So, the RAROC is:RAROC=$1,400,000$8,000,000=0.175 or 17.5%RAROC=$8,000,000$1,400,000​=0.175 or 17.5%

Cash yield curves are used to revalue loan and deposit positions in banks. The cash yield curve reflects the relationship between the yield on short-term cash instruments and their maturity. This curve is crucial for banks as it helps in determining the value of their loan and deposit portfolios, which are often sensitive to changes in short-term interest rates.

Position mapping is used in risk management to simplify the assessment of risks associated with various positions. The objectives of position mapping are:

For VaR (Value at Risk) calculations, it converts positions based on their deltas to underlying factor risks. This means mapping the positions to their underlying risk factors to make the complex position simpler to manage and evaluate.

Position mapping models risk factors affecting the value of a position as a combination of core risk factors used in the VaR calculations. This involves breaking down the complex risk factors into more manageable and fundamental risk components that can be easily analyzed.

By focusing on these two objectives, position mapping helps in both simplifying the risk assessment process and in ensuring that the primary risk factors are correctly identified and managed.

Comprehensive and Detailed In-Depth Explanation:

A daily decay factor (e.g., in EWMA models) weights recent data more heavily, but gradually reduces the influence of extreme returns over time, smoothing forecasts. Option B is correct—it mitigates the lasting impact of outliers. Option A is incorrect (recent volatility retains influence). Option C reverses the effect, and Option D is unrelated (decay doesn’t target low volatility). GARP’s FRR discusses this in VaR forecasting.

Exact Extract from Official Source:

GARP FRR Study Notes, Market Risk Section: "A decay factor in P&L forecasting, such as in EWMA, reduces the weight of extreme past returns over time, providing a balanced view of volatility."

BCBS, "Basel III: A Global Regulatory Framework," December 2010, para. 718: "Models using decay factors lessen the persistent effect of extreme events on risk estimates."

In this scenario, the trade was mistakenly accounted for as a sell order instead of a buy order. If the price of Eureka Corporation bonds goes up, this mistake would result in a larger loss than if the market remained stable. Conversely, if the market drops, the customer would benefit from the incorrect accounting. This example illustrates how market risk (the change in the price of the bonds) can magnify operational risk (the error in accounting for the trade incorrectly).

Comprehensive and Detailed In-Depth Explanation:

The loan-to-value (LTV) ratio represents the proportion of an asset’s value that is financed through a loan, expressed as a percentage. The haircut, in contrast, is the complement of the LTV—it represents the portion of the asset’s value that is not financed and serves as a buffer or margin of safety for the lender. Mathematically, the haircut is calculated as:

Haircut = 100% - LTV.

Given an LTV of 75%, the haircut is:

100% - 75% = 25%.

This concept is critical in Basel III’s collateral valuation and liquidity risk management rules, where haircuts are applied to adjust the value of collateral for risk purposes (e.g., in the Liquidity Coverage Ratio or repo transactions). The BCBS guidelines on collateral haircuts confirm this relationship, ensuring that the unfinanced portion protects against potential declines in asset value.

When a bank enters into long-term fixed-rate loans and interest rates rise, the bank faces higher costs for its deposits and debt if these are linked to floating rates or have shorter maturities. This creates a mismatch between the fixed income from the loans and the increased cost of funds, potentially squeezing the bank's margins.

Activities typically used to develop an operational risk framework include planning, training, and auditing. Marketing is not typically used to develop an operational risk framework, as it is more relevant to the promotion of products and services rather than the establishment of risk management processes and structures.