GARP 2016-FRR - Financial Risk and Regulation (FRR) Series

Comprehensive and Detailed In-Depth Explanation:

Mark-to-market (MtM) involves valuing positions at current market prices daily, primarily for the trading book (e.g., securities, derivatives). Option C—obtaining and verifying market prices for trading book instruments—is the core MtM activity under Basel III’s market risk rules. Option A applies to the banking book (not typically MtM), Option B describes settlement, and Option D is a profitability analysis, not MtM.

Exact Extract from Official Source:

BCBS, "Basel III: A Global Regulatory Framework," December 2010, para. 688: "Mark-to-market requires banks to obtain current market prices and verify them daily for all trading book positions to reflect fair value."

GARP FRR Study Notes, Market Risk Section: "The MtM process entails collecting and validating market prices for trading book instruments to determine their current value."

Treasury Functions:

Management of Assets and Liabilities: Treasury functions include managing the bank's balance sheet, which involves optimizing the mix of assets and liabilities.

Management of Liquidity: Ensuring the bank has sufficient liquidity to meet its obligations.

Management of Capital: Overseeing the capital adequacy to meet regulatory requirements and support the bank's operations and growth.

Performance Estimates:

Estimating and managing the bank’s performance involves various departments, not typically the treasury function. Performance estimates would be more related to financial planning and analysis functions.

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.

Market timing trading involves making buy or sell decisions of financial assets by attempting to predict future market price movements. This strategy:

Long positions when markets are rising: The trader buys securities expecting their prices to increase.

Short positions when markets are falling: The trader sells securities expecting their prices to decrease.

This behavior aligns with market timing, which is an active trading strategy based on the anticipated direction of market prices.

References

Source: How Finance Works​

Comprehensive and Detailed In-Depth Explanation:

Securitization transforms illiquid retail assets (e.g., mortgages) into tradable securities, enhancing liquidity and balance sheet flexibility:

I:Selling securitized bonds raises capital, reducing reliance on deposits and freeing up the balance sheet (correct).

II:Selling these bonds and buying others diversifies credit risk, improving portfolio management (correct).

III:The value of securitization depends on the underlying assets’ credit quality, not the bank’s rating, making this statement incorrect.

Formula for modified duration change:

Change in modified duration = Convexity * Change in yield

Given:

Initial modified duration = 10

Convexity = 0.5

Change in yield = 1%

Calculation:

Change in modified duration = 0.5 * 1% = 0.5

Since the yield increases, the modified duration decreases by 0.5.

ReferencesCalculation based on standard formulas for duration and convexity.

Net Interest Income Calculation:

As previously calculated, the net interest income is $9 million per year.

Present Value of Perpetuity Formula:

Present Value (PV) = Net Interest Income / Discount Rate

PV = $9 million / 0.05 = $180 million

Correction:

The net interest income was stated as $9 million earlier, but here, let's verify this calculation:

Interest income from $120 million at 10% = $12 million

Interest expense on $100 million at 3% = $3 million

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

Correct Present Value Calculation:

PV = $9 million / 0.05 = $180 million

Final Verification:

The previous net interest income used is correct and the final PV calculation should stand corrected as per the perpetual formula:

PV = $9 million / 0.05 = $180 million, confirming the right choice should be $180 million.

References

Source: How Finance Works​

Consortium databases in the context of operational risk management:

Gather loss data from multiple firms to provide a comprehensive view of industry-wide risk events.

Contain anonymous information to protect the identities of the contributing firms while still providing valuable risk data. They do not gather information from news articles, use data only from the top 5% of the industry, or specifically map risk categories with causes.

Day 1:

Bank Milo has $4 million in cash.

$5 million in loans coming due with an expected default rate of 1%.

The proceeds from the loans will be $5 million * (1 - 0.01) = $4.95 million.

Total cash available at the end of Day 1 = $4 million + $4.95 million = $8.95 million.

No outflows on Day 1.

Cumulative liquidity = $8.95 million (positive).

Day 2:

No cash inflow.

$9 million is due for a securities purchase.

Cumulative liquidity = $8.95 million - $9 million = -$0.05 million (negative).

Day 3:

No cash inflow.

$8 million due for commercial paper pay off.

Cumulative liquidity = -$0.05 million - $8 million = -$8.05 million (negative).

Therefore, Bank Milo faces negative cumulative liquidity on Days 2 and 3.

DeltaBank should consider counterparty risk on both long and short OTC option positions. OTC options do not go through a centralized exchange, making them subject to counterparty risk. Exchange-traded options have significantly lower counterparty risk because the exchange acts as the counterparty to all trades.