Pass the GARP Financial Risk and Regulation 2016-FRR Questions and answers with CertsForce

Comprehensive and Detailed In-Depth Explanation:

Risk models (e.g., VaR, stress testing) rely on historical data to estimate potential future outcomes, but they cannot predict the future with certainty due to inherent uncertainties and changing conditions. Option C correctly states that such models "estimate possible future market behavior," acknowledging their probabilistic nature. Option A and B are incorrect—models don’t inherently assume better or worse markets; they extrapolate based on data. Option D is false—historical data-based models are not guaranteed to be accurate, as past patterns may not repeat. This aligns with Basel’s emphasis on model limitations and the need for stress testing to complement historical estimates.

Exact Extract from Official Source:

BCBS, "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems," December 2010, para. 718(xi): "Models relying on historical data provide estimates of possible future outcomes but do not predict future market behavior with certainty, necessitating the use of stress scenarios to capture tail risks."

GARP FRR Study Notes, Quantitative Analysis Section: "Risk models using historical data, such as VaR, offer probabilistic estimates of future market behavior, not definitive predictions, due to the limitations of assuming stationarity in financial markets."

Derivatives have several advantages over cash instruments in hedging transactions. These include:

Lower Credit Risk:

Derivatives, especially exchange-traded ones, often have lower credit risk because the clearinghouse guarantees the performance of the contract.

Lower Funding Requirements:

Derivatives typically require lower upfront capital than buying or selling the underlying cash instruments directly. This is due to the leverage they offer, where only a margin is required instead of the full value of the position.

Lower Dealing Costs:

Trading derivatives can be cheaper in terms of transaction costs compared to trading the underlying cash instruments. This is especially true for large positions or frequent trading.

Lower Capital Charges:

Regulatory capital requirements for derivatives can be lower compared to cash instruments because derivatives can be used to hedge and reduce overall portfolio risk, thereby reducing capital charges under regulatory frameworks.

References

Source: How Finance Works​

The forward price of a commodity like oil is typically determined by the expected future spot price and adjusted for the risk premium associated with the market.

Storage costs are often considered separately and are not typically included in the forward pricing relationship in the simple form as given in option A.

Therefore, the most straightforward and likely answer based on common financial theory is the expected future oil price adjusted by the market risk premium.

Comprehensive and Detailed In-Depth Explanation:

The Basel I Accord, introduced in 1988 by the BCBS, focused primarily on credit risk, establishing a standardized framework for capital requirements to cover potential losses from borrowers’ defaults. It introduced risk-weighted assets (RWA) with specific weights (e.g., 0% for OECD government bonds, 100% for corporate loans) and required banks to hold a minimum capital ratio of 8% against credit risk exposures. Market risk was not addressed until the 1996 Amendment to Basel I, operational risk was introduced in Basel II (2004), and liquidity risk became a focus in Basel III (2010). Thus, Basel I’s original scope was limited to credit risk.

The modified duration of a bond can be estimated using the following formula:Modified Duration=Δ????/????Δ????Modified Duration=ΔyΔP/P​whereΔ????ΔPis the change in the bond's price,????Pis the initial price, andΔ????Δyis the change in yield.

Given:

Initial price (P) = $87,000

New price after yield change (P') = $84,500

Change in price (ΔP) = $87,000 - $84,500 = $2,500

Change in yield (Δy) = 5.7% - 4.7% = 1% = 0.01

Modified Duration =2,500/87,0000.01=0.0287350.01=2.8735≈2.880.012,500/87,000​=0.010.028735​=2.8735≈2.88

Identify the strategies for achieving leverage in long positions:

I. Securities may be purchased with borrowed funds using a bank loan from the broker.

This is a common method known as margin trading, where an investor borrows money from a broker to purchase securities.

II. Securities may be borrowed on margin by taking a loan from a broker.

This is another form of margin trading where the securities themselves are used as collateral for the loan.

III. Securities may be purchased and used in a repo transaction to generate cash for further security purchases.

In a repurchase agreement (repo), securities are sold with an agreement to buy them back at a later date, providing immediate liquidity for further investments.

IV. The bank may enter into a derivative transaction, such as a total return swap, that requires little to no collateral but mimics the performance of a long or short position in the underlying instrument.

Derivatives like total return swaps allow for exposure to the performance of an asset without owning it, often with minimal collateral requirements.

Explanation:

All the listed strategies (I, II, III, IV) are valid methods for a bank to achieve leverage in long positions. They involve different mechanisms of borrowing funds or utilizing existing assets to increase the potential return on investment.

Collateralized mortgage obligations (CMOs) are a type of asset-backed security that pools together mortgages and then issues tranches with different maturities and levels of risk. They do not have CDOs as their underlying collateral; instead, they are backed by mortgage loans. Therefore, the statement that CMOs have pools of CDOs as underlying collateral is incorrect.

The modified duration of a bond portfolio is calculated as the value-weighted average of the modified durations of the component bonds. This approach accounts for the proportion of the total portfolio value that each bond represents, providing a more accurate measure of the portfolio's sensitivity to changes in interest rates.

The TED spread is calculated as the difference between the interest rates on interbank loans and short-term U.S. government debt (T-bills). Specifically, the TED spread = LIBOR - Treasury bill rate. In this case, the 3-month LIBOR rate is 2.5% and the yield on the 3-month U.S. Treasury bill is 0.5%. Thus, the TED spread is 2.5% - 0.5% = 2.0%.

Comprehensive and Detailed In-Depth Explanation:

Operational risk under Basel II includes gains and losses from process failures (e.g., incorrect trade booking). This event, despite resulting in a profit, stems from an operational error, making it relevant for assessing control weaknesses and potential future losses. Option A is correct—excluding it underestimates operational risk exposure. Option B misclassifies it as market risk (the cause is operational). Option C is true but incomplete. Option D is wrong—Basel II includes near-misses and gains.

Exact Extract from Official Source:

BCBS, "Basel II: International Convergence of Capital Measurement and Capital Standards," June 2006, para. 673: "Operational risk data should include all relevant events, including those resulting in gains or near-misses, to provide a complete picture of risk exposure."

GARP FRR Study Notes, Operational Risk Section: "Events like trade errors, even if profitable, must be recorded in operational risk assessments to evaluate process reliability."