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

Comprehensive and Detailed In-Depth Explanation:

Basel I (1988) defined Tier 1 capital as the core capital to absorb losses, primarily comprising common stock (equity) and disclosed reserves (retained earnings). Option A is correct. Subordinated debt (B) is Tier 2 capital, undisclosed reserves (C) were allowed in Tier 2 under certain conditions but not Tier 1, and short-term capital (D) isn’t a Basel I category. Tier 1’s focus on equity ensures loss absorption capacity, a principle retained in later frameworks.

Exact Extract from Official Source:

BCBS, "International Convergence of Capital Measurement and Capital Standards" (Basel I), July 1988, para. 14: "Tier 1 capital consists predominantly of common stock and disclosed reserves (retained earnings), representing the highest quality capital available to cover losses."

GARP FRR Study Notes, Regulatory Framework Section: "Under Basel I, Tier 1 capital is limited to common equity and disclosed reserves, excluding subordinated debt and undisclosed reserves, which fall under Tier 2."

When a bank is going bankrupt, it faces several additional losses beyond the immediate operational and financial losses. These include:

I.The discount accepted by the bank for selling its assets in a fire sale:In a fire sale, assets are sold quickly and often at a significantly reduced price, resulting in substantial losses.

II.The increased cost of funding liabilities in a financially distressed situation:As the bank's financial condition deteriorates, its cost of borrowing increases due to higher perceived risk, leading to increased expenses.

III.The reduction in the present value of future growth opportunities:Financial distress often means the bank cannot invest in future opportunities, significantly impacting its long-term profitability and growth potential.

IV.Loss of goodwill and intangible assets:The bank's reputation, brand value, and other intangible assets suffer significantly during bankruptcy, leading to additional losses.

Under Basel II, Tier 2 capital, also known as supplementary capital, includes:

Subordinated Debt: This type of debt ranks below other debts with respect to claims on assets or earnings. It is considered Tier 2 capital because it can absorb losses in the event of a winding-up of the bank.

Other Instruments: This category can also include hybrid instruments, undisclosed reserves, revaluation reserves, and general provisions/general loan-loss reserves.

These components enhance the bank's ability to absorb losses beyond the protection provided by Tier 1 capital.

Comprehensive and Detailed In-Depth Explanation:

Crowded trades occur when many market participants adopt the same trading strategy, leading to concentrated positions in a specific asset (e.g., selling physical gold). This increases systemic risk, as a sudden reversal or liquidity crunch can amplify losses. GARP’s FRR materials discuss crowded trades in the context of market risk and systemic vulnerabilities, noting their potential to destabilize markets. Basis trades involve exploiting price differences between related instruments, disappearance trades and break trades are not standard terms in this context, making "crowded trades" the correct answer.

Value at Risk (VaR) is a statistical measure used to assess the risk of loss on a specific portfolio of financial assets. In this case, Bank G has a 1-year VaR of USD 20 million at 99% confidence level, while Bank H has a 1-year VaR of USD 10 million at the same confidence level. The VaR figure indicates the maximum potential loss over a given period (1 year) at a certain confidence level (99%). Therefore, Bank G is taking twice the risk of Bank H as the VaR is double that of Bank H.

I. The static model gives a liquidity estimate only after the bank faces the liquidity problem:

This statement is true because the static liquidity ladder model does not predict future liquidity needs, it only assesses current liquidity status.

II. The static model can only make projections over a few days:

This statement is true as static models are typically used for short-term liquidity assessment.

III. The static model does not incorporate uncertainty in the analysis:

This statement is true because the static model does not consider the variability or uncertainty in future cash flows or obligations.

Therefore, all the statements I, II, and III are correct about the shortfalls of the static liquidity ladder model.

For American options, exercising an in-the-money call option before the ex-dividend date can be beneficial if the option is deep in the money and the dividend is significant. This is because the holder would receive the dividend payment, which can make early exercise profitable.

To calculate the 12-month futures price for Unico Delta stock, we use the formula for pricing equity futures, considering the current stock price, dividend yield, and the risk-free rate (LIBOR in this case):

????=????×????(????−????)????F=S×e(r−d)t

Where:

????Fis the futures price

????Sis the current stock price ($20)

????ris the risk-free rate (3% or 0.03)

????dis the dividend yield (5% or 0.05)

????tis the time to maturity (1 year)

Plugging in the values:

????=20×????(0.03−0.05)×1F=20×e(0.03−0.05)×1????=20×????−0.02F=20×e−0.02????≈20×0.9802F≈20×0.9802????≈20.04F≈20.04

Therefore, the 12-month futures contract will trade at approximately $20.04.

References

How Finance Works.pdf, p. 206 ​

Standard operational risk definitions typically include human errors (I), process failure (II), and systems failure (III). Unexpected events (IV) are generally considered in broader risk categories but are not standard elements of operational risk definitions.

Under Basel II, Tier 1 capital, also known as core capital, includes:

Equity Capital: This includes common stock and retained earnings. It is the highest quality of capital because it is fully available to cover losses.

Accrued Profits to Reserves: Profits that are retained and not distributed as dividends are added to reserves, increasing the bank's capital base.

This combination of equity capital and retained earnings ensures that Tier 1 capital is robust and able to absorb significant losses, thereby providing a strong financial cushion.