Exam

Question 1

Three aims of RM:

Answer 1

• Identify, assess and prioritize risks
• Minimize, monitor and control the probability of unfortunate events
• Maximize business opportunities

Question 2

Risk

Answer 2

probability that an actual return on an investment will be lower than the exp. return

Question 3

Efficient Frontier

Answer 3

represents the set of all the portfolios that maximize the expected return for a given volatility, thus dominating all other portfolios

Question 4

CAPM

Answer 4

can be calculated by Systematic Risk (beta * Rm) (not diversified) and Idiosyncratic Risk (e) (diversified) with alpha as extra return and beta obtained by OLS

Question 5

Difference Exchange Traded & OTC

Answer 5

standard contracts versus computer/telephone network

Question 6

Difference Forward and Future contract

Answer 6

OTC and Exchange respectively

Question 7

Net Interest Income

Answer 7

excess of interest received over interest paid

Question 8

Net Interest Margin

Answer 8

The ratio between Net Interest Income and income producing assets

Question 9

Duration

Answer 9

weighted average of the times in which payments are made, where the weights are given by the proportions of the bond’s total present value at different times (can be negative by going short on a bond)

Question 10

Coherency

Answer 10

• Monotonicity  allows for an ordering of risks. If Z1 < Z2 then f(Z1) < f(Z2)
• Sub-additivity  Incentives to diversification. f(Z1 + Z2) ≤ f(Z1) + f(Z2)
• Positive Homogeneity  proportional to risk. f(aZ) = af(Z)
• Translation Invariance  neutral risk w.r.t. liquidity. f(Z + b) = f(Z)

Question 11

Coherency Variance and Std Dev

Answer 11

Variance not coherent because of positive homogeneity and sub-additivity. Std. Dev. always

Question 12

Value at Risk

Answer 12

VaR is the loss value for which the probability of observing a larger loss, given the available information is equal to 1 minus alpha

Question 13

Expected Shortfall

Answer 13

average value of all the values exceeding the threshold (VaR)

Question 14

Credit Risk

Answer 14

the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms

• Default Risk (EAD * LGD)
• Migration Risk (downgrade risk related to deterioration in the counterparty’s creditworthiness)
• Spread Risk (rise in the spreads required by the market from borrowers)
• Recovery Risk (recovery rate actually recorded after liquidation of counterparty’s assets will be smaller than original estimates.

Question 15

3 approaches to Credit Risk (Basel II-III)

Answer 15

1. Standardized Approach (risk weights provided by regulator)
2. Foundation Internal Rating Based (can compute PD of their counterparty’s)
3. Advanced Internal Rating Based (free to calculate all risk parameters)

Question 16

LGD

Answer 16

Loss rate experienced on a credit exposure if the counterparty defaults

Question 17

Basel Framework

Answer 17

1. Minimum Capital Requirements (Credit Risk, Market Risk, Operational Risk)
2. Supervisory Review Process
3. Market Discipline

Question 18

Moody’s KMV

Answer 18

IMPORTANT is the Distance to Default. Overcomes weaknesses of Merton:

1. Gaussianity
2. Default may only happen in T

Question 19

Market Risk

Answer 19

the risk of losses in on-and off-balance sheet positions arising from movements in market prices (VaR and ES)

• Historical-simulation Approach
• Model-building Approach

Question 20

Operational risk

Answer 20

risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Includes legal risk, excludes strategic and reputational risk. Four sources:

1. Process Risk
2. People Risk
3. System Risk
4. External Risk

Question 21

3 approaches to asses operational risk under Basel II-III

Answer 21

1. Basic Indicator
2. Standardized Approach
3. Advanced Measurement Approach

Question 22

Difference Basel:

Answer 22

• Basel 1, no model of default correlation
• Basel 2 has the three pillars and the three approaches to Credit Risk
• Basel 2 has the three approaches to Operational Risk
• Basel 2.5 has three changes
  o Calculation of Stressed VaR
  o New incremental risk charge
  o Comprehensive risk measure for instruments dependent on credit correlation
• Basel 3 states that a bank’s total capital consists of:
  o Tier 1 equity capital
  o Additional Tier 1 capital
  o Tier 2 capital