Free Practice Questions for GARP 2016-FRR Exam

Economic capital is a risk measure used by banks to determine the amount of capital they need to hold to remain solvent and cover potential losses:

Internal Risk Estimates: Unlike regulatory capital, which is determined by external regulatory requirements, economic capital is based on the bank's own risk assessment models and internal estimates of potential losses.

Risk Types: It considers a range of risks including credit risk, market risk, operational risk, and other financial risks that the bank might face.

Purpose: The goal is to ensure the bank has enough capital to absorb unexpected losses and to maintain confidence among depositors and investors.

Therefore, economic capital is a measure of the potential losses based on the bank's internal risk estimates.

Mathematical valuation and risk assessment models can be misleading or inaccurate for several reasons:

Missing factors in models: Important variables or conditions might be overlooked.

Bad or wrong data: Incorrect or poor-quality data input can lead to faulty outcomes.

Misinterpretation of results: Users might not correctly understand or use the results.

Errors in the derivation of the model: Mistakes in the mathematical formulation or assumptions can lead to errors.

All these factors contribute to the potential inaccuracy or misleading nature of such models.

Interest rates can vary based on the term of the debt instrument. Generally, short-term interest rates are more sensitive to changes in monetary policy and economic conditions, leading to higher variability compared to long-term interest rates. This is because short-term rates are directly influenced by central bank policies, such as changes in the federal funds rate, which can lead to frequent fluctuations. Long-term rates, on the other hand, are influenced more by long-term economic expectations and inflation forecasts, which tend to be more stable over time.

Comprehensive and Detailed In-Depth Explanation:

Herd behavior in the context of financial risk refers to the phenomenon where multiple obligors (borrowers or counterparties) default simultaneously or in a clustered manner, often due to correlated economic or market conditions. This term is widely used in credit risk modeling and operational risk analysis to describe synchronized default events driven by systemic factors, such as economic downturns or industry-specific shocks. The Basel II framework, under the Internal Ratings-Based (IRB) approach, implicitly accounts for such behavior through correlation assumptions in default probabilities (PD). Herd behavior contrasts with divergent behavior (unrelated defaults), default bias (systematic error in default estimation), and speculative bias (bias in speculative investment decisions), making "herd behavior" the correct term. GARP’s FRR materials emphasize this concept in discussions of systemic risk and portfolio credit risk.

Market risk typically involves risks that affect the entire market or market segment. These include:

Unexpected changes in the term structure of interest rates:

This affects the prices of bonds and other interest-rate-sensitive securities.

The JPY depreciating against the USD:

This is an example of foreign exchange risk, which is a type of market risk.

Changes in the oil price due to the discovery of new oil fields:

This affects commodities markets and can have broader economic implications.

Increased default rate on commercial mortgages due to higher interest rates:

This is more of a credit risk than market risk. It specifically relates to the creditworthiness of borrowers rather than the overall market movements.

Thus, the increased default rate on commercial mortgages due to higher interest rates is not a typical source of market risk.

References

Source: How Finance Works​​

To calculate the financial impact of this transaction for Alpha Bank, follow these steps:

Customer Transaction:

Alpha Bank sells BRL 100 million at a quoted rate of 101 to the customer.

The customer pays in AUD: BRL100,000,000101=AUD990,099.0099\frac{BRL 100,000,000}{101} = AUD 990,099.0099101BRL100,000,000​=AUD990,099.0099.

Market Transaction:

Alpha Bank buys BRL 100 million at the market rate of 100.

The cost in AUD is: BRL100,000,000100=AUD1,000,000\frac{BRL 100,000,000}{100} = AUD 1,000,000100BRL100,000,000​=AUD1,000,000.

Profit Calculation:

Alpha Bank's profit = Amount received from customer - Cost in the market

Profit = AUD1,010,000−AUD1,000,000=AUD10,000AUD 1,010,000 - AUD 1,000,000 = AUD 10,000AUD1,010,000−AUD1,000,000=AUD10,000.

Thus, Alpha Bank makes a profit of AUD 10,000 from this transaction.

References

Source: How Finance Works​

Risk and Control Self-Assessments (RCSA) distinguish themselves from other types of assessments because they include both a risk assessment and a control assessment. This combined approach allows for a comprehensive view of both the potential risks and the effectiveness of the controls in place to mitigate those risks.

Comprehensive and Detailed In-Depth Explanation:

Pillar 2 of Basel II (Supervisory Review Process) focuses on ensuring banks have adequate processes to identify, measure, and manage all material risks (beyond just market, credit, and operational risks covered in Pillar 1), including interest rate risk in the banking book, concentration risk, and others. It requires banks to maintain capital above the Pillar 1 minimum if warranted by their risk profile, as assessed by supervisors. Option D describes Pillar 1, not Pillar 2. Option B aligns with Pillar 3 (disclosure), and Option A (reputational risk) is not a specific Pillar 2 focus.

Operational risk events are categorized based on the nature of the incident.

Alfred Fall's injury due to falling on the marble floors of the bank and subsequent personal injury claim aligns with incidents related to workplace safety.

Option A:Business Disruption and System Failures - Incorrect, as this category relates to disruptions in business operations, not physical injuries.

Option B:Employment Practices and Workplace Safety - Correct. This category includes incidents related to safety within the workplace.

Option C:Not qualifying as an operational risk event is incorrect, as it clearly involves a risk incident.

Option D:Legal Risk is more about legal exposures due to contractual breaches or legal actions unrelated to workplace safety.

Market manipulation refers to deliberate actions taken to deceive or mislead investors by affecting the supply, demand, or price of securities. Here are the activities considered:

Market gap: This refers to the difference between the closing price of one trading session and the opening price of the next session. It is not inherently a form of market manipulation.

Crowded trades: These occur when a large number of market participants take the same position in a security. While this can influence prices, it is not a deliberate act of manipulation.

Short squeeze: This occurs when a heavily shorted stock suddenly increases in price, forcing short sellers to buy back shares to cover their positions, further driving up the price. This can be orchestrated to create rapid price increases, qualifying as market manipulation.

Stop-loss order: This is an order placed with a broker to buy or sell once the stock reaches a certain price. It is a risk management tool and not a form of manipulation.

Therefore, a short squeeze is an example of market manipulation.

References

Source: How Finance Works​