PRMIA 8008 - PRM Certification - Exam III: Risk Management Frameworks, Operational Risk, Credit Risk, Counterparty Risk, Market Risk, ALM, FTP - 2015 Edition

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).

In the case of mean reversion, the actual VaR would be lower than that estimated using the square root of time rule. This is because gains over a period would be followed by losses so that the price can revert to the mean. In such cases, the autocorrelation between subsequent periods is effectively negative. This means the combined VaR over the periods would be lower.

In the case of positive autocorrelation, the actual VaR would be higher than that estimated using the square root of time rule for exactly the opposite reason than that described for the mean-reverting case.

(Recall that Variance (A + B) = Variance(A) + Variance(B) + 2*Correlation*StdDev(A)*StdDev(B). In cases where correlation is zero, the variance can simply be added together (which is the case for iid observations). In cases where the correlation is negative, the combined variance (and therefore standard deviation and also VaR) will be lower; and where correlation is positive, the combined variance (and therefore standard deviation and also VaR) will be higher.)

Therefore statement II is correct, and so is statement III. Choice 'c' is the correct answer.

The beta distribution is commonly used to model recovery rates. It is a distribution for variables whose values lie between 0 & 1, and the parameters of the distribution can be estimated using the mean and standard deviation of the data. Therefore Choice 'a' is correct and the others are wrong.

Refer to the tutorial on distributions for an Excel model of the beta distribution.

In the Standardized Approach, banks’ activities are divided into eight business lines: corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Therefore Choice 'c' is the correct answer.

Credit reserves are created in respect of expected losses, which are considered the cost of doing business. Unexpected losses are borne by economic credit capital, which is a part of economic capital. Therefore Choice 'c' is the correct answer.

Parametric VaR relies upon reducing a portfolio's positions to risk factors, and estimating the first order changes in portfolio values from each of the risk factors. This is called the delta approximation approach. Risk factors include stock index values, or the PV01 for interest rate products, or volatility for options. This approach can be quite accurate and computationally efficient if the portfolio comprises products whose value behaves linearly to changes in risk factors. This includes long and short positions in equities, commodities and the like.

However, where non-linear products such as options are involved and large moves in the risk factors are anticipated, a delta approximation based valuation may not give accurate results, and the VaR may be misstated. Therefore in such situations parametric VaR is not advised (unless it is extended to include second and third level sensitivities which can bring its own share of problems).

Parametric VaR also assumes that the returns of risk factors are normally distributed - an assumption that is violated in times of market stress. So if it is known that the risk factor returns are not normally distributed, it is not advisable to use parametric VaR.

Strong management of collateral, both receivable and payable, is emerging as an area requiring significant investment by financial institutions and asset managers in IT infrastructures and business processes. A bank needs to make collateral calls daily, based upon the P&L of the previous day, and likewise receives collateral calls from its counterparties. Just like cash, a bank needs to make sure that it does not run out of collateral to post when a call is received. Interestingly, based upon the agreements between banks and their mutual understanding, only certain types of instruments often qualify as valid collateral - and in such cases even cash is not acceptable if the right type of bond or other agreed security is not available to post. The operational challenges of managing collateral increase manifold due to 'rehypothecation', ie when collateral received from one counterparty gets posted out as collateral where it is due. In such cases, the bank should have the mechanisms to receive the right assets back in a timely way in case rehypothecated assets are to be returned. The systems should be able to deal with delays, failures without impacting the ability of the bank to post collateral as needed. All of this requires major investments in IT and processes.

Statement I is not true as a bank is bound to post collateral to third parties when needed regardless of the failure of its counterparties to post collateral to it when owed. In the markets, failures by counterparties can and do happen, and a collateral management system needs to account for and keep a buffer for the fact that some collateral when due will not be received.

Statement II is not true as rehypothecation by counterparties of collateral posted increases the chances of the collateral not being received in time. The system should consider the need for liquidity to generate assets that can be posted as collateral when others have failed to return the collateral in a timely way.

Statement III is not correct as cash may not be acceptable to counterparties as collateral. From a practical point of view, they may not have the infrastructure to receive and account for cash as collateral. A Swiss bank, for example, may have an 'account' to receive US t-bills as collateral but may not even have a US dollar account to receive cash. Even if it did, the volumes of transactions going back and forth may make tracking and reconciliations impossible. Thus a bank should always make sure that it has the right type of collateral available to post.

Statement IV is incorrect as well, as treasury issued instruments are also subject to haircuts. Their value also fluctuates in response to changes in yields, and therefore they are subject to haircuts as well.

Thus none of the statements are correct and Choice 'd' is the correct answer.

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.

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.

Collateral, limits to avoid credit exposure concentrations, termination rights based upon credit ratings, third party guarantees and credit derivatives are all tools or instruments that financial institutions use to manage their credit risk. A cumulative accuracy plot measures the accuracy of ratings, and is not a tool for managing credit risk. Therefore Choice 'b' represents the correct answer.