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

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.

Option delta (Δ) is a measure used in finance to indicate the sensitivity of an option's price to the price of the underlying asset. Specifically, it represents the rate of change of the option's value with respect to changes in the price of the underlying instrument. It is a fundamental concept in options trading and risk management.

Comprehensive and Detailed In-Depth Explanation:

Operational risk under Basel II includes gains and losses from process failures (e.g., incorrect trade booking). This event, despite resulting in a profit, stems from an operational error, making it relevant for assessing control weaknesses and potential future losses. Option A is correct—excluding it underestimates operational risk exposure. Option B misclassifies it as market risk (the cause is operational). Option C is true but incomplete. Option D is wrong—Basel II includes near-misses and gains.

Exact Extract from Official Source:

BCBS, "Basel II: International Convergence of Capital Measurement and Capital Standards," June 2006, para. 673: "Operational risk data should include all relevant events, including those resulting in gains or near-misses, to provide a complete picture of risk exposure."

GARP FRR Study Notes, Operational Risk Section: "Events like trade errors, even if profitable, must be recorded in operational risk assessments to evaluate process reliability."

The TED spread is calculated as the difference between the interest rates on interbank loans and short-term U.S. government debt (T-bills). Specifically, the TED spread = LIBOR - Treasury bill rate. In this case, the 3-month LIBOR rate is 2.5% and the yield on the 3-month U.S. Treasury bill is 0.5%. Thus, the TED spread is 2.5% - 0.5% = 2.0%.

Present Value of a Basis Point (PVBP) measures the change in the value of a bond when the yield changes by one basis point (0.01%). This measure helps quantify the interest rate risk of a bond by indicating how much its price will fluctuate with small changes in yield.

Comprehensive and Detailed In-Depth Explanation:

The Basel I Accord, introduced in 1988 by the BCBS, focused primarily on credit risk, establishing a standardized framework for capital requirements to cover potential losses from borrowers’ defaults. It introduced risk-weighted assets (RWA) with specific weights (e.g., 0% for OECD government bonds, 100% for corporate loans) and required banks to hold a minimum capital ratio of 8% against credit risk exposures. Market risk was not addressed until the 1996 Amendment to Basel I, operational risk was introduced in Basel II (2004), and liquidity risk became a focus in Basel III (2010). Thus, Basel I’s original scope was limited to credit risk.

Value-at-Risk (VaR) is a statistical measure used to assess the risk of loss on a specific portfolio of financial assets. It estimates the maximum potential loss with a given confidence level over a defined period.

Maximum Likely Loss: VaR calculates the worst expected loss under normal market conditions at a specific confidence level.

Time Period: VaR is assessed over a specified time horizon, such as a day, week, or month.

Confidence Level: VaR is defined at a certain confidence level, typically 95% or 99%. This means there is a 95% (or 99%) probability that the loss will not exceed the VaR estimate.

For instance, a daily VaR of $1 million at a 99% confidence level implies that there is only a 1% chance that the portfolio will lose more than $1 million in a day.

References

How Finance Works.pdf, p. 201 ​

To determine the risk premium, we first calculate the credit spread. The yield difference between the corporate bond and the government bond gives the credit spread: Corporate bond yield = 6% Government bond yield = 2%

Credit spread = Corporate bond yield - Government bond yield Credit spread = 6% - 2% = 4%.

Next, we account for the expected loss. The expected loss is the probability of default times the loss given default: Probability of default = 2.5% Loss given default = 60%

Expected loss = 0.025 * 0.60 = 0.015 or 1.5%.

Risk premium = Credit spread - Expected loss Risk premium = 4% - 1.5% = 2.5%.

Therefore, the risk premium included in the credit spread is 2.5%.

A fully hedged portfolio is designed to minimize or eliminate the impact of market price changes on the portfolio’s value. Here are the correct and incorrect statements about hedging:

Correct Statements:

Traders can hedge their risks by taking an appropriate position in the underlying instrument.

Traders can hedge their portfolio risks by taking a position in a different instrument.

A large number of hedge positions is generally required to match the underlying transaction completely.

Incorrect Statement:

For a fully hedged portfolio, any changes in market prices will typically produce significant changes in the market value of the portfolio.

This statement is incorrect because the purpose of hedging is to protect the portfolio from market price changes, hence reducing the impact of such changes on the portfolio's value.

References

Source: How Finance Works​

Comprehensive and Detailed In-Depth Explanation:

Short-selling (selling borrowed securities expecting a price drop) entails:

I:Extreme losses if prices rise unexpectedly (unlimited upside risk).

II:Borrow risk if shares become unavailable or costly to borrow.

III:Market behavior risk from coordinated actions (e.g., short squeezes).