Free Practice Questions for PRMIA 8008 Exam

Governance structures specify the policies, principles and procedures for making decisions about corporate direction. They distribute rights and responsibiliies among stakeholders that typically include executive management, employees, the board etc. Statement I is therefore correct.

"Cybernetics is a transdisciplinary approach for exploring regulatory systems, their structures, constraints, and possibilities. In the 21st century, the term is often used in a rather loose way to imply "control of any system using technology" (Wikipedia). Governance literature has been affected by cybernetics, which is not the same thing as information security or cyber security. Statement II is incorrect.

Corporate governance includes risk governance, and not the other way round. Therefore statement III is incorrect.

The Cadbury Report, titled Financial Aspects of Corporate Governance, was a report issued in the UK in December 1992 by "The Committee on the Financial Aspects of Corporate Governance". The report is eponymous with the chair of the committee, and set out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures. Statement IV is therefore correct.

The $10m cash flow due in 6 months is equivalent to a bond with a present value of 10m/(1.05)^0.5 =$9,759,000. Essentially, the question requires us to calculate the VaR of a bond.

The VaR of a fixed income instrument is given by Duration x Interest Rate x Volatility of the interest rate x z-factor corresponding to the confidence level.

In this case, since the question requires us to calculate the value "closest to" the correct answer, we can use an estimate for the modified duration of the bond as equal to 0.5 years/(1+r) = 0.5/1.05 = 0.47 years. The VaR would be given by 0.5 * 5% * 15% * 2.326 * sqrt(1/250) * 9,759,000 = $5,384 which is closest to $5,500. Therefore Choice 'a' is the correct answer. Note that we have to multiply by sqrt(1/250) as the given volatility is annual and the question is asking for daily VaR. All other answers are incorrect.

The correct answer is Choice 'd'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:

1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.

2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.

3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.

4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.

5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

Right after inception' is incorrect as the interest rate swap (IRS) would be valued at close to zero right after inception and the credit risk would be minimum. Choice 'a' (ie 10 years, at maturity) is incorrect as at maturity there would be no more cash flows to exchange, and the replacement value of the contract would again be close to zero.

Therefore the worst time for the counterparty to default is somewhere between inception and maturity - in fact the range of possible outcomes for the contract increases with the passage of time, and we should find the worst time to default to be a later date. However, towards maturity, the value of the contract starts to go towards zero again, and the maximum value is reached around 7 years. 2 years is too early for the maximum to be reached for the 10 year IRS, and therefore choice a is the correct answer.

The difference between the yields on corporate bonds and the risk free rate is called the corporate bond spread. Widening of the spread means that corporate bonds yield more, and their yield curve shifts upwards, driving down bond prices. The increase in the spread is a consequence of the market risk from holding these interest rate instruments, which is a part of market risk. If the reduction in the value of the portfolio were to be caused by a change in the credit rating of the bonds held, it would have been a loss arising due to credit risk. Counterparty risk and liquidity risk are not relevant for this question. Therefore Choice 'c' is the correct answer.

EVT, when used in the context of operational risk measurement, focuses on tail events and attempts to build a distribution of losses beyond what is covered by VaR. Statements I, II and II are correct. Statement IV describes conditional VaR (CVAR) and not EVT.

Choice 'c' is the correct answer.

When modeling operational loss frequency distribution (which, for example, may be based upon a Poisson distribution) and a loss severity distribution (for example, based upon a lognormal distribution), it is assumed that the frequency of losses and the severity of the losses are completely independent and do not impact each other. Therefore Choice 'a' is correct, and the others are not valid assumptions underlying the operational loss modeling.

Once each of these distributions has been built, a random number is drawn from each to determine a loss scenario. The process is repeated many times as part of a Monte Carlo simulation to get a the loss distribution.

The credit spread is equal to the default rate times the loss given default, or stated another way, default rate times (1 - recovery rate). It is not equal to the default rate times the recovery rate. Therefore statement I is not correct.

When ratings are upgraded by rating agencies, the spread contracts and not widen. Therefore statement II is not correct.

Both recovery rates and probabilities of default are related to the business cycle, and they move in opposite directions. Economic recessions witness an increase in the default rate and a decrease in the recovery rate, and economic expansions result in a decrease in the default rate and an increase in the recovery rates when default does happen. Therefore statement III is correct.

Bond spreads incorporate both the risk of default, but also considerations of liquidity in the case of corporate bonds. Hence statement IV is correct.

The state of the economy, credit quality of individual borrowers and concentration risk are all factors that affect the credit risk facing a lender. Mark to market accounting does not change the credit risk, or the underlying economic reality facing the institution. Therefore Choice 'b' is the correct answer.

Statement I is correct. Data is often divided into two sets - a 'training set' that is used to create and fine-tune the model while the 'control set' is used to prove that the model works on sample data. Back testing is then perfomed using actual data that becomes available over time, or may already be available as historical data.

Statement II is incorrect. A risk manager often spends a great deal of time in managing data, and ensuring that the data being used is accurate enough for the purpose it is being used for. A risk manager can expect to spend a good part of his or her team's time in cleansing data. While he or she can try to get the IT processes and systems to produce correct data in the first place so it requires minimal subsequent cleansing or validation, this task is likely to remain a key part of a risk manager's role for quite some time in the future given the challenges nearly all organizations face in managing risk data.

Statement III is correct. There was not enough granular data available on the underlying components of some of the derivative debt securities whose markets dried up during the crisis that began in 2007. This was because investors became increasingly unsure of what the value of these securities, such as CDOs was, leading to market seizure and firesale prices.

Statement IV is not correct. There is no easy solution to the lack of enough historical data, which is used to create as well as test models, and construct stress scenarios. Analytical approaches are not a good enough substitute for real market data. During the recent crisis, many instruments had rather short histories and there was not enough data available, and risk managers and portfolio managers relied upon analytical approaches to value and price them. Many of the assumptions that underpinned these approaches were untested in the real world and turned out to be incorrect.

Therefore Choice 'c' is the correct answer and the rest are incorrect.