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

Collateralized debt obligations (CDOs) typically have loans or bonds as underlying collateral (Statement I). There is also a correlation among defaults in the CDO collateral, which should be considered in their valuation due to the complexity of these instruments (Statement III). Therefore, the correct statements are I and III.

Most exchange-traded equity options in the U.S. typically have the American exercise feature. This feature allows the holder to exercise the option at any time before and including the expiration date, providing greater flexibility compared to the European exercise feature, which only allows exercise at expiration. The Asian and shout option features are less common and not typically associated with exchange-traded equity options.

The basic Net Interest Income (NII) model assumes that assets and liabilities do not necessarily have the same interest rate sensitivities. Interest rate changes affect assets and liabilities differently, which is why managing the gap between rate-sensitive assets and liabilities is crucial for banks.

The Basel II Accord's operational risk definition specifically includes legal risk. Operational risk under Basel II is defined as the risk of loss resulting from inadequate or failed internal processes, people, andsystems, or from external events. This definition explicitly includes legal risk but excludes strategic and reputational risks.

Skewness measures the asymmetry of the return distribution. A negative skewness value, such as -1.5, indicates that the left tail (negative returns) of the distribution is longer or fatter than the right tail (positive returns). This suggests that there is a higher relative probability of observing negative returns compared to what would be expected under a normal distribution, which is symmetric. In this case, the negative skewness implies a higher chance of experiencing extreme negative returns, making option A the correct interpretation.

Regulatory capital is the minimum amount of capital that a bank is required to hold by financial regulators. These rules are imposed by outside authorities such as central banks or financial supervisory bodies to ensure the stability and solvency of financial institutions. This differs from economic capital, which is determined internally by the bank to cover its own estimated risk exposures.

Comprehensive and Detailed In-Depth Explanation:

The Comprehensive Risk Measure (CRM) under Basel III is a specific capital charge designed to address the risks associated with complex, correlation-dependent trading portfolios. According to the Basel III framework, the CRM applies to correlation trading portfolios, which typically involve instruments such as credit default swaps (CDS), collateralized debt obligations (CDOs), and other structured credit products where the risk arises from the correlation between underlying assets rather than just individual credit exposures. This measure was introduced to capture the additional risks (e.g., basis risk, correlation risk) not adequately covered by the standard Value-at-Risk (VaR) or Stressed VaR models. The Basel Committee on Banking Supervision (BCBS) document "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems" (December 2010, revised June 2011) explicitly states that the CRM is an incremental charge for the correlation trading portfolio, requiring banks to hold additional capital for these positions. Options trading, swaps trading, and covariance trading are not specifically targeted by the CRM under Basel III.

Banning trading in highly complex derivative instruments that are not settled through a centralized clearinghouse can lead to several consequences:

Counterparties involved in trading these derivatives may fail to fulfill their obligations (II).

The business models that rely on these instruments may fail (III).

Certain activities that were previously legal may become illegal (IV).

The potential drop in the country's currency value (I) is not a direct consequence of such a ban.

Comprehensive and Detailed In-Depth Explanation:

Stress testing evaluates a credit portfolio’s resilience under adverse scenarios (e.g., economic downturns), quantifying impacts on defaults, losses, and capital adequacy. Option D is correct—Basel II’s Pillar 2 mandates stress testing for unexpected outcomes. Option A (common situations) describes standard modeling, not stress testing. Option B (probabilistic expectations) aligns with VaR, not stress testing’s focus on extremes. Option C (optimizing migration) is unrelated to stress testing’s purpose.

Exact Extract from Official Source:

BCBS, "Basel II: International Convergence of Capital Measurement and Capital Standards," June 2006, para. 434: "Stress testing is a critical tool for credit risk assessment, enabling banks to quantify the impact of adverse and unexpected scenarios on their credit portfolios and capital levels."

GARP FRR Study Notes, Credit Risk Section: "Stress testing assesses the effect of severe, unexpected events on credit losses and capital, distinguishing it from routine risk modeling."

The key difference between customer loans and interbank loans is related to creditworthiness and yield. Customers are generally less credit-worthy than banks, leading to higher yields on customer loans compared to interbank loans. This higher yield compensates lenders for the increased risk associated with lending to less credit-worthy borrowers.