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

According to a paper by the BCBS, here is an excellent summary of what happened. Based on this, Choice 'c' is the correct answer.

"At the outset of the crisis, mortgage default shocks played a part in the deterioration of market prices of collateralised debt obligations (CDOs). Simultaneously, these shocks revealed deficiencies in the models used to manage and price these products. The complexity and resulting lack of transparency led to uncertainty about the value of the underlying investment. Market participants then drastically scaled down their activity in the origination and distribution markets and liquidity disappeared. The standstill in the securitisation markets forced banks to warehouse loans that were intended to be sold in the secondary markets. Given a lack of transparency of the ultimate ownership of troubled investments, funding liquidity concerns were triggered within the banking sector as banks refused to provide sufficient funds to each other. This in turn led to the hoarding of liquidity, exacerbating further the funding pressures within the banking sector. The initial difficulties in subprime mortgages also fed through to a broader range of market instruments since the drying up of market and funding liquidity forced market participants to liquidate those positions which they could trade in order to scale back risk. An increase in risk aversion also led to a general flight to quality, an example of which was the high withdrawals by households from money market funds."

Basel II proposes three approaches to compute operational risk capital - the basic indicator approach (BIA), the standardized approach (SIA) and the advanced measurement approach (AMA). There is no operational risk approach called the factor based approach.

This is a trick question, no great science to it. Remember that the 'present value of a basis point' refers to PV01, which is the same as BPV (basis point value) referred to in the PRMIA handbook. In other textbooks, the same term is also variously called 'DV01' (dollar value of a basis point). Remember these other terms too.

PV01, or the present value of a basis point, is the change in the value of a bond (or other fixed income security) from a 1 basis point change in the yield. PV01 is calculated as (Price * Modified Duration/10,000).

Therefore Choice 'a' is the correct answer.

When the economy is expanding, firms are less likely to default. Therefore the conditional probability of default, given an economic expansion, is likely to be lower than the unconditional probability of default. Therefore Choice 'a' is the correct answer and the other statements are incorrect.

The correct answer is Choice 'b'. 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).

The first order approximation of the VaR of an option position is nothing but the VaR of the underlying multiplied by the option's delta. This is intuitive because the delta is the sensitivity of the option price to changes in the prices of the underlying, and in this case since the delta is 0.3 and the underlying's VaR is $100, the VaR of the options position is 0.3 x $100 = $30. Therefore Choice 'c' is the correct answer.

(Note that the second order approximation of the VaR of an options position considers the option gamma too, and VaR reduces if gamma increases.)

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.

It is important to note the difference between sensitivity analysis and stress testing. Sensitivity analysis applies to measuring the effect of changes on the outputs of a model by varying the inputs - generally one input at a time.

In scenario analysis, a number of variables may be changed at the same time to see the impact on the dependent variable. For example, a bank may measure the changes in the value of its mortgage portfolio by varying its assumptions on prepayment expectations, interest rates and other factors, using its modeling software or application. The changes in the inputs may or may not relate to integrated real world situations that may arise. Sensitivity analysis is purely a quantitative exercise, much like calculating the delta of a portfolio.

A stress test may include shocks or large changes to input parameters but it does so as part of a larger stress testing programme that generally considers the interaction of risk factors, past scenarios etc. At its simplest, a stress test may be no different from a sensitivity analysis exercise, but that is generally not what is considered a stress test at large financial institutions.

A stress test may consider multiple scenarios, for example one scenario may include the events witnessed during the Asian crisis, another may include the events of the recent credit crisis. Simulation generally refers to a Monte Carlo or historical simulation, and is often a more limited exercise.

The exercise described in the question is the closest to a scenario analysis, therefore Choice 'c' is the correct answer.

It is important to note that all of the choices referred to in this question are related to each other, and the boundaries between them tend to be fuzzy. At what point does a complex sensitivity analysis start resembling a scenario, or a stress test can always be debatable, but such a debate would be more about the symantics than be of any practical use.

All of the listed reports (or information) would be useful to a risk manager analyzing liquidity risk. Therefore Choice 'c' is the correct answer. Additionally, reports on assets brought on margin (that may result in collateral or margin calls), trading exposures to different counterparties, reports on financial health, share price and credit ratings of key counterparties will also be useful.

Generally, the probability of default is an input into determining the price of a security. However, if we know the market price of a security, we can back out the probability of default that the market is factoring into pricing that security. Market implied default probabilities are the probabilities of default priced into security prices, and can be determined from both bond prices and CDS spreads. Credit ratings issued by a credit agency do not give us 'market implied default probabilities', and neither does an internal scoring model like Altman's as these do not consider actual market prices in any way.

Therefore Choice 'b' is the correct answer and the others are not.