Free Practice Questions for PRMIA 8008 Exam

The default correlation between two obligors goes up if the joint probability of default between them increases. This is intuitive. Also consider the formula for the default correlation between two obligors

Default correlation = [P(1,2) - P1 * P2] / √P1*(1-P1)*P2*(1-P2); where P(1,2) is the joint probability of default between the two and P1 and P2 are their individual probabilities of default. Obviously, an increase in P(1,2) will cause the default correlation to increase.

Since the business units are uncorrelated, we can get the combined EC as equal to the square root of the sum of the squares of the individual EC estimates. Therefore Choice 'a' is the correct answer. [=SQRT(100^2+200^2+150^2)]

Exposure for derivative instruments can vary significantly over the lifetime of the instrument, depending upon how the market moves. The potential future exposure represents the extremes, not the most likely outcome. The expected exposure is the most suitable measure for pricing the credit risk. Over time, as multiple transactions are entered into, the expectation (or the mean) will be realized - though individual transactions may have more or less by way of exposure.

The notional amount may not be relevant, though for loans it may be the most important contributor to the expected exposure. Mark-to-market will represent the exposure at a given point in time, but cannot be predicted nor be used to price the credit risk.

Any good risk measure has the property that it is sub-additive, which means the whole is less than the sum of the parts. In the case of VaR, sub-additivity arises due to the diversification effect, or said differently, due to the correlation between different assets being less than one. Therefore Choice 'd' is the correct answer.

Super-additivity is just the opposite of sub-additivity, ie, the whole is greater than the sum of the parts. Good risk measures do not have super-additivity. Therefore Choice 'b' is incorrect.

Choice 'c' states the same thing as Choice 'b' in different words, and is incorrect. Choice 'a' is non-sensical and incorrect.

Survivorship bias is the tendency for failed companies, funds, investments and even entire markets (eg Russian stock market returns after the Communist revolution) to be excluded from performance studies because they no longer exist. Survivorship bias results in past results looking better than they actually were as data points relating to failures are not included.

A risk manager needs to be aware of survivorship bias when basing risk analysis on historical data and should question if failures (eg failed funds, delisted companies etc) have been included in the data he or she is relying upon.

The recovery rate, the default hazard rate (also called the average default intensity) and the spread on debt are linked by the equation Hazard Rate = Spread/(1 - Recovery Rate). Therefore, the recovery rate implicit in the given data is = 1 - 8%/10% = 20%.

The probability that the security would not default in the next 4 years is equal to the probability of survival at the end of the four years. In other words, =(1 - 3%)*(1 - 4%)*(1 - 4%)*(1 - 5%) = 84.93%. Choice 'd' is the correct answer.

The VaR of a fixed income instrument is given by Duration x Volatility of the interest rate x z-factor corresponding to the confidence level. Therefore as the volatility of the yield goes up, the value at risk for the instrument goes up.

At the same time, the value of the bond is given by the present value of its future cash flows using the current yield curve. This value is unaffected by the volatility of the underlying interest rates. Therefore a change in volatility of interest rates does not affect the value of the bond.

Therefore Choice 'd' represents the correct answer.

In December 2009 the BIS came out with a new consultative document on liquidity risk. Given the events of 2007 - 2009, it has been clear that a key characteristic of the financial crisis was the inaccurate and ineffective

management of liquidity risk

The paper two separate but complementary objectives in respect of liquidity risk management: The first objective relates to the short-term liquidity risk profile of institution, and the second objective is to promote resiliency over longer-term time horizons. The paper identifies the following two ratios - you should be aware of these - though I am not sure if these will show up in the PRMIA exam:

1. Liquidity Coverage Ratio addresses the ability of an institution to survive an acute liquidity risk stress scenario lasting one month. It is calculated as follows:

Liquidity Coverage Ratio = Stock of high quality liquid assets/Net cash outflows over a 30-day time period

2. Net Stable Funding Ratio has been developed to capture structural issues related to funding choices.

Net Stable Funding Ratio = Available amount of stable funding/Required amount of stable funding

Both ratios should be equal to or greater than 1. The statement contains detailed definitions of what is included or excluded from each of the terms used in the calculations for each of the ratios. In addition, the standard also describes the what the 'acute' scenario should include (things such as a 3 notch credit downgrade, reduction in retail deposits etc)

Therefore Choice 'b' is the correct answer. Book Value to Share Price and Earnings Per Share are accounting measures unrelated to liquidity.

Offsetting trades with other counterparties will not reduce credit exposure to a given counterparty. All other choices represent means of reducing credit risk. Therefore Choice 'c' is the correct answer.