1 Flashcards
Which of the following statements are true ?
I. Risk governance structures distribute rights and responsibilities among stakeholders in the corporation
II. Cybernetics is the multidisciplinary study of cyber risk and control systems underlying information systems in an organization
III. Corporate governance is a subset of the larger subject of risk governance
IV. The Cadbury report was issued in the early 90s and was one of the early frameworks for corporate governance
(a) II and III (b) I and IV (c) I, II and IV (d) All of the above
The correct answer is choice ‘b’
Governance structures specify the policies, principles and procedures for making decisions about corporate direction. They distribute rights and responsibiliies among stakeholders that typically include executive management, employees, the board etc. Statement I is therefore correct.
“Cybernetics is a transdisciplinary approach for exploring regulatory systems, their structures, constraints, and possibilities. In the 21st century, the term is often used in a rather loose way to imply “control of any system using technology” (Wikipedia). Governance literature has been affected by cybernetics, which is not the same thing as information security or cyber security. Statement II is incorrect.
Corporate governance includes risk governance, and not the other way round. Therefore statement III is incorrect.
The Cadbury Report, titled Financial Aspects of Corporate Governance, was a report issued in the UK in December 1992 by “The Committee on the Financial Aspects of Corporate Governance”. The report is eponymous with the chair of the committee, and set out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures. Statement IV is therefore correct.
Which of the below are a way to classify risk governance structures:
(a) Committee based, regulation based and board mandated
(b) Top-down and Bottom-up
(c) Reactive, Preventative and Active
(d) Active and Passive
The correct answer is choice ‘c’
This is a tricky question in the sense no risk management professional can be expected to know the answer to this one unless they have read Chapter 2 of the PRMIA handbook. So this question appears purely for the sake of something you would need to know purely for the sake of the exam.
PRMIA’s handbook classifies governance sructures as reactive, preventative and active. Reactive structures involve monitoring signals after the event leading to corrective actions. Preventative structures are forward looking and anticipate issues before they arise. Active structures include considerations of operational efficiency and not just governance. All other answers are made up phrases and are incorrect.
In reality, corporations employ all structures together without worrying about the boundary between the three, and these distinctions do not exist except in textbooks.
Which of the following are a CRO's responsibilities: I. Statutory financial reporting II. Reporting to the audit committee III. Compliance with risk regulatory standards IV. Operational risk (a) III and IV (b) I and II (c) II and IV (d) All of the above
The correct answer is choice ‘a’
Statutory financial reporting is the responsibility of the Chief Financial Officer, not the Chief Risk Officer. The head of internal audit reports to the audit committee of the board, not the CRO. Therefore statements I and II are incorect.
The CRO is generally expected to drive risk and compliance with related regulatory standards. Market risk, credit risk and operational risk groups report into the CRO, so statements III and IV are correct.
Which of the following statements are correct?
I. A reliance upon conditional probabilities and a-priori views of probabilities is called the ‘frequentist’ view
II. Knightian uncertainty refers to things that might happen but for which probabilities cannot be evaluated
III. Risk mitigation and risk elimination are approaches to reacting to identified risks
IV. Confidence accounting is a reference to the accounting frauds that were seen in the past decade as a reflection of failed governance processes
(a) II and III
(b) I and IV
(c) II, III and IV
(d) All of the above
The correct answer is choice ‘a’
In statistics, which is relevant to risk management, a distinction is often drawn between ‘frequentists’ and ‘Bayesians’. Frequentists rely upon data to draw conclusions as to probabilities. Bayesians consider conditional probabilities, ie, take into account what things are already known, and inject sometimes subjective a-priori probabilities into the calculations. Statement I describes Bayesians, and not frequentists. In reality however, the difference is merely academic. Risk managers use whichever technique best applies to the given situation without making it about ideology.
The difference between ‘Knightian uncertainty’ and ‘Risk’ is similarly academic. Knightian uncertainty refers to risk that cannot be measured or calculated. ‘Risk’ on the other hand refers to things for which past data exists and calculations of exposure can be made. To give an example in the context of the financial world, the risk from a pandemic creating systemic failures from a failure of payment and settlement systems and the like is ‘Knightian uncertainty’, but the market risk from equity price movements can be modeled (albeit with limitations) and is calculable. Statement II is therefore correct.
Once a risk is identified, it can be mitigated, accepted, avoided or eliminated, or transferred by way of insurance. Therefore statement III is correct.
Which of the following statements are correct in relation to the financial system just prior to the current financial crisis:
I. The system was robust against small random shocks, but not against large scale disturbances to key hubs in the network
II. Financial innovation helped reduce the complexity of the financial network
III. Knightian uncertainty refers to risk that can be quantified and measured
IV. Feedback effects under stress accentuated liquidity problems
(a) I, II and IV
(b) III and IV
(c) I and IV
(d) II and III
The correct answer is choice ‘c’
Which of the following statements is true:
I. Basel II requires banks to conduct stress testing in respect of their credit exposures in addition to stress testing for market risk exposures
II. Basel II requires pooled probabilities of default (and not individual PDs for each exposure) to be used for credit risk capital calculations
(a) I & II
(b) I
(c) II
(d) Neither statement is true
The correct answer is choice ‘a’
Both statements are accurate. Basel II requires pooled probabilities of default to be applied to risk buckets that contain similar exposures. Also, stress testing is mandatory for both market and credit risk.
Which of the following is a measure of the level of capital that an institution needs to hold in order to maintain a desired credit rating?
(a) Economic capital
(b) Book value
(c) Regulatory capital
(d) Shareholders
’
equity
The correct answer is choice ‘a’
Economic capital is a measure of the level of capital needed to maintain a desired credit rating. Regulatory capital is the amount of capital required to be held by regulation, and this may be quite different from economic capital. Book value is an accounting measure reflecting the assets minus liabilities as measured per accounting rules, this is often expressed per share. Shareholders’ equity is a narrow term which is the amount of capital attributable to the shareholders and includes paid up capital and reserves but not long term debt or other non-equity funding.
Which of the following statements are true:
I. Capital adequacy implies the ability of a firm to remain a going concern
II. Regulatory capital and economic capital are identical as they target the same objectives
III. The role of economic capital is to provide a buffer against expected losses
IV. Conservative estimates of economic capital are based upon a confidence level of 100%
(a) I
(b) I, III and IV
(c) III
(d) I and III
The correct answer is choice ‘a’
Statement I is true - capital adequacy indeed is a reference to the ability of the firm to stay a ‘going concern’. (Going concern is an accounting term that means the ability of the firm to continue in business without the stress of liquidation.)
Statement II is not true because even though the stated objective of regulatory capital requirements is similar to the purposes for which economic capital is calculated, regulatory capital calculations are based upon a large number of ad-hoc estimates and parameters that are ‘hard-coded’ into regulation, while economic capital is generally calculated for internal purposes and uses an institution’s own estimates and models. They are rarely identical.
Statement II is not true as the purpose of economic capital is to provide a buffer against unexpected losses. Expected losses are covered by the P&L (or credit reserves), and not capital.
Statement IV is incorrect as even though economic capital may be calculated at very high confidence levels, that is never 100% which would require running a ‘risk-free’ business, which would mean there are no profits either. The level of confidence is set at a level which is an acceptable balance between the interests of the equity providers and the debt holders.
When combining separate bottom up estimates of market, credit and operational risk measures, a most conservative economic capital estimate results from which of the following assumptions:
(a) Assuming that market, credit and operational risk estimates are perfectly negatively correlated
(b) Assuming that market, credit and operational risk estimates are perfectly positively correlated
(c) Assuming that the resulting distributions have a correlation between 0 and 1
(d) Assuming that market, credit and operational risk estimates are uncorrelated
The correct answer is choice ‘b’
If the risks are considered perfectly positively correlated, ie assumed to have a correlation equal to 1, the standard deviations can simply be added together. This gives the most conservative estimate of combined risk for capital calculation purposes. In practice, this is the assumption used most often.
If risks are uncorrelated, ie correlation is assumed to be zero, variances can be added or the standard deviation is the root of the sum of the squares of the individual standard deviations. This obviously gives a number lower than that given when correlation is assumed to be +1.
Similarly, assumptions of negative correlation, or any correlation other than +1 will give a standard deviation number that is smaller and therefore less conservative. Choice ‘b’ is the correct answer.
The Options Theoretic approach to calculating economic capital considers the value of capital as being equivalent to a call option with a strike price equal to:
(a) The market value of the debt
(b) The value of the assets
(c) The value of the firm
(d) The notional value of the debt
The correct answer is choice ‘d’
The Options Theoretic approach to calculating economic capital is a top-down approach that considers the value of capital as being equivalent to a call option with a strike price equal to the notional value of the debt - ie, the shareholders have a call option on the assets of the firm which they can acquire by paying the debt holders a value equal to their notional claim (ie the face value of the debt). Therefore Choice ‘d’ is the correct answer and the other choices are incorrect.
Economic capital under the Earnings Volatility approach is calculated as:
(a) Earnings under the worst case scenario at a given confidence level/Required rate of return for the firm
(b) [Expected earnings less Earnings under the worst case scenario at a given confidence level]/Required rate of return for the firm
(c) Expected earnings/Required rate of return for the firm
(d) Expected earnings/Specific risk premium for the firm
The correct answer is choice ‘b’
The Earnings Volatility approach to calculating economic capital is a top down approach that considers economic capital as being the capital required to make for the worst case fall in earnings, and calculates EC as equal to the worst case decrease in earnings capitalized at the rate of return expected of the firm. The worst case decrease in earnings, or the earnings-at-risk can only be stated at a given confidence level, and is equal to the Expected Earnings less Earnings under the worst case scenario.
Which of the following is not one of the ‘three pillars’ specified in the Basel accord:
(a) Minimum capital requirements
(b) National regulation
(c) Supervisory review
(d) Market discipline
The correct answer is choice ‘b’
The three pillars are minimum capital requirements, supervisory review and market discipline. National regulation is not a pillar described under the accord. Choice ‘b’ is the correct answer.
According to the Basel framework, shareholders’ equity and reserves are considered a part of:
(a) Tier 1 capital
(b) Tier 2 capital
(c) Tier 3 capital
(d) All of the above
The correct answer is choice ‘a’
According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves.
Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt.
Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority.
According to the Basel framework, reserves resulting from the upward revaluation of assets are considered a part of:
(a) Tier 2 capital
(b) Tier 1 capital
(c) Tier 3 capital
(d) All of the above
The correct answer is choice ‘a’
According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves.
Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt.
Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority.
According to the Basel II framework, subordinated term debt that was originally issued 4 years ago with a maturity of 6 years is considered a part of:
(a) Tier 3 capital
(b) Tier 1 capital
(c) Tier 2 capital
(d) None of the above
The correct answer is choice ‘c’
According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves.
Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt issued originally for 5 years or longer.
Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority. This only includes short term subordinated debt originally issued for 2 or more years.
Which of the following is NOT an approach used to allocate economic capital to underlying business units:
(a) Fixed ratio economic capital contributions
(b) Incremental economic capital contributions
(c) Stand alone economic capital contributions
(d) Marginal economic capital contributions
The correct answer is choice ‘a’
Other than Choice ‘a’, all others represent valid approaches to allocate economic capital to underlying business units. There is no such thing as ‘fixed ratio economic capital contribution’
The sum of the stand alone economic capital of all the business units of a bank is:
(a) unrelated to the economic capital for the firm as a whole
(b) less than the economic capital for the firm as a whole
(c) equal to the economic capital for the firm as a whole
(d) more than the economic capital for the firm as a whole
The correct answer is choice ‘d’
Economic capital is sub-additive, ie, because of the correlation being less than perfect between the risks of the different business units, the total economic capital for the firm will be less than the sum of the EC for the individual business units. Therefore Choice ‘d’ is the correct answer.
In practice, correlations are difficult to estimate reliably, and banks often use estimates and corroborate their capital calculations with reference to a number of data points.
The standalone economic capital estimates for the three uncorrelated business units of a bank are $100, $200 and $150 respectively. What is the combined economic capital for the bank?
(a) 72500
(b) 450
(c) 269
(d) 21
The correct answer is choice ‘c’
Since the business units are uncorrelated, we can get the combined EC as equal to the square root of the sum of the squares of the individual EC estimates. Therefore Choice ‘c’ is the correct answer. [=SQRT(100^2+200^2+150^2)]
The standalone economic capital estimates for the three business units of a bank are $100, $200 and $150 respectively. What is the combined economic capital for the bank, assuming the risks of the three business units are perfectly correlated?
(a) 21
(b) 269
(c) 72500
(d) 450
The correct answer is choice ‘d’
Since the business units are perfectly correlated, we can get the combined EC as equal to the sum of the individual EC estimates. Therefore Choice ‘d’ is the correct answer.
A key problem with return on equity as a measure of comparative performance is:
(a) that return on equity measures do not account for interest and taxes
(b) that return on equity are not adjusted for cash flows being different from accounting earnings
(c) that return on equity is not adjusted for risk
(d) that return on equity ignores the effect of leverage on returns to shareholders
The correct answer is choice ‘c’
The major problem with using return on equity as a measure of performance is that return on equity is not adjusted for risk. Therefore, a riskier investment will always come out ahead when compared to a less risky investment when using return on equity as a performance metric.
Return on equity does not ignore the effect of leverage (though return on assets does) because it considers the income attributable to equity, including income from leveraged investments.
Return on equity is generally measured after interest and taxes at the company wide level, though at business unit level it may use earnings before interest and taxes. However this does not create a problem so long as all performance being covered is calculated in the same way.
Cash flows being different from accounting earnings can create liquidity issues, but this does not affect the effectiveness of ROE as a measure of performance.
As opposed to traditional accounting based measures, risk adjusted performance measures use which of the following approaches to measure performance:
(a) adjust returns based on the level of risk undertaken to earn that return
(b) adjust both return and the capital employed to account for the risk undertaken
(c) adjust capital employed to reflect the risk undertaken
(d) Any or all of the above
The correct answer is choice ‘d’
Performance measurement at a very basic level involves comparing the return earned to the capital invested to earn that return. Risk adjusted performance measures (RAPMs) come in various varieties - and the key difference between RAPMs and traditional measures such as return on equity, return on assets etc is that RAPMs account for the risk undertaken. They may do so by either adjusting the return, or the capital, or both. They are classified as RAROCs (risk adjusted return on capital), RORACs (return on risk adjusted capital) and RARORACs (risk adjusted return on risk adjusted capital).
For a group of assets known to be positively correlated, what is the impact on economic capital calculations if we assume the assets to be independent (or uncorrelated)?
(a)
Economic capital estimates remain the same
(b)
The impact on economic capital cannot be determined in the absence of volatility information
(c)
Estimates of economic capital go down
(d)
Estimates of economic capital go up
The correct answer is choice ‘c’
By assuming the assets to be independent, we are reducing the correlation from a positive number to zero. Reducing asset correlations reduces the combined standard deviation of the assets, and therefore reduces economic capital. Therefore Choice ‘c’ is the correct answer.
Note that this question could also be phrased in terms of the impact on VaR estimates, and the answer would still be the same. Both VaR and economic capital are a multiple of standard deviation, and if standard deviation goes down, both VaR and economic capital estimates will reduce.
A financial institution is considering shedding a business unit to reduce its economic capital requirements. Which of the following is an appropriate measure of the resulting reduction in capital requirements?
(a) Marginal capital for the business unit in consideration
(b) Percentage of total gross income contributed by the business unit in question
(c) Proportionate capital for the business unit in consideration
(d) Incremental capital for the business unit in consideration
The correct answer is choice ‘d’
Incremental capital (or incremental VaR, depending upon the context), is a measure of the change in the capital (or VaR) requirements if a certain change is made to a portfolio. It uses the ‘before’ and ‘after’ approach, ie find out what the capital requirement or VaR will be without the change, and what it will be after the change. The difference is the incremental capital or incremental VaR. It helps measure the change in risk as a result of a particular action, eg a change in a position.
Marginal capital or VaR on the other hand is a method to break down the capital requirement or the VaR so that it can be assigned to individual positions within the portfolio. The total of marginal capital or marginal VaR for all the positions in a portfolio adds up to the total capital requirements or total VaR. Note that marginal VaR is also called component VaR.
Therefore incremental capital is the correct answer to this question. The other choices are incorrect. In the exam, the question may be phrased differently, so try to keep in mind the different between incremental and marginal capital, which can be a bit confusing given what these terms mean in plain English.
Which of the following best describes economic capital?
(a) Economic capital is a form of provision for market risk losses should adverse conditions arise
(b) Economic capital is the amount of regulatory capital that minimizes the cost of capital for firm
(c) Economic capital reflects the amount of capital required to maintain a firm
’
s target credit rating
(d) Economic capital is the amount of regulatory capital mandated for financial institutions in the OECD countries
The correct answer is choice ‘c’
Economic capital is often calculated with a view to maintaining the credit ratings for a firm. It is the capital available to absorb unexpected losses, and credit ratings are also based upon a certain probability of default. Economic capital is often calculated at a level equal to the confidence required for the desired credit rating. For example, if the probability of default for a AA rating is 0.02%, and the firm desires to hold an AA rating, then economic capital maintained at a confidence level of 99.98% would allow for such a rating. In this case, economic capital set at a 99.8% level can be thought of as the level of losses that would not be exceeded with a 99.8% probability, and would help get the firm its desired credit ratin