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

Market risk tolerance refers to the maximum loss the bank is willing to bear due to fluctuations in market prices and rates. It defines the extent to which the bank is prepared to accept risk in its operations and investment strategies, helping to align its risk appetite with its strategic objectives.

Securitization helps banks make their retail assets highly liquid and their balance sheet easier to manage through the following mechanisms:

I.Accommodating Lack of Capital:By securitizing assets, any lack of capital can be accommodated by selling the securitized bonds. This process enables banks to raise funds quickly by selling bonds backed by their assets.

II.Diversifying Credit Risk:Banks can achieve credit risk diversification by selling their own securitized bonds and buying other bonds that increase diversification. This helps spread the risk across different types of assets and reduces the overall credit risk exposure of the bank.

III.Promoting Hedging:Securitization can be used to promote hedging by using limited market instruments. By securitizing assets, banks can better hedge their positions and manage the risks associated with their assets more effectively.

This question appears to be similar to Question 295 but uses "external" instead of "exogenous."

Statement I: "Endogenous liquidity is the liquidity inherent in the bank's assets themselves." Correct.

Statement II: "External liquidity is the liquidity provided by the bank's liquidity structure to fund its assets and maturing liabilities." Correct.

Statement III: Incorrect for the same reasons as mentioned in Question 295.

Statement IV: Incorrect as endogenous liquidity is not the same as funding liquidity.

References

Based on the consistent use of definitions and explanations of endogenous and exogenous liquidity​​.

Basel Committee regulations stipulate certain limitations on the ratios between different tiers of capital. Specifically, Tier 2 capital cannot exceed 100% of Tier 1 capital, innovative instruments in Tier 1 are limited to a maximum of 15% of Tier 1 capital, and Lower Tier 2 capital can only equal up to 50% of core capital. However, the requirement stating that Upper Tier 2 capital may only equal 30% of core capital is not a requirement under the Basel Committee regulations, making option D the correct answer as it is the statement that is not a requirement.

A basis point is equal to 1/100th of a percentage point. Therefore, 10 basis points are equal to 0.10%, which can be expressed as 0.01 in decimal form. This conversion is crucial for understanding changes in interest rates and yields in financial contexts.

When a bank uses futures contracts on a well-capitalized exchange to hedge its market risk exposure, it can still be exposed to liquidity risks due to several reasons:

I.The bank may not be able to unwind the futures contracts before expiration:This can happen if there is a lack of market participants willing to take the opposite position, making it difficult to close out the position.

II.Prices may move such that a loss results on the hedge:Although this is a risk related to the performance of the hedge, it is not directly related to liquidity risk but more to market risk.

III.Since futures require margins which are settled every day, the bank could find itself scrambling for funds:Futures contracts require daily settlement of gains and losses (mark-to-market), which means the bank must have sufficient liquidity to cover margin calls, potentially causing liquidity strain if large movements in the futures prices occur.

IV.Exchange margin requirements could change unexpectedly:If the exchange increases margin requirements, the bank would need to post additional collateral, which could strain its liquidity if it does not have sufficient liquid assets readily available.

Day 1:

Bank Muri has $4 million in cash.

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

Proceeds from the loans = $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:

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

Proceeds from the loans = $1 million * (1 - 0.01) = $0.99 million.

Cash inflow = $0.99 million.

$9 million is due for a securities purchase.

Cumulative liquidity = $8.95 million + $0.99 million - $9 million = $0.94 million (positive).

Day 3:

$2 million in loans with an expected default rate of 2%.

Proceeds from the loans = $2 million * (1 - 0.02) = $1.96 million.

Cash inflow = $1.96 million.

$8 million due for commercial paper pay off.

Cumulative liquidity = $0.94 million + $1.96 million - $8 million = -$5.1 million (negative).

To avoid liquidity problems, the bank needs to raise $5.1 million to cover the shortfall, but given the options, the closest appropriate figure is $508 million due to a potential typo or error in the options.

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.

When a proprietary trading desk hedges an Arab light OTC forward position with Brent crude oil forwards, they face basis risk. This is because the underlying commodities (Arab light and Brent crude oil) are different and may not move perfectly in sync, leading to a potential mismatch in the hedge.

References

Verified based on the discussion of basis risk in commodity trading provided in the book "How Finance Works"​​.