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

To calculate the Risk-Adjusted Return on Capital (RAROC), we use the formula:RAROC=Net IncomeValue at Risk (VaR)RAROC=Value at Risk (VaR)Net Income​

Here, the net income from the transaction is the fees minus the financing costs:Net Income=$2,000,000−$600,000=$1,400,000Net Income=$2,000,000−$600,000=$1,400,000

The VaR is given as $8,000,000. So, the RAROC is:RAROC=$1,400,000$8,000,000=0.175 or 17.5%RAROC=$8,000,000$1,400,000​=0.175 or 17.5%

Floating rate bonds typically have a short duration because their interest payments reset periodically, aligning closely with current interest rates. This frequent resetting makes them lesssensitive to changes in interest rates compared to fixed-rate bonds, which have a long duration and are more sensitive to interest rate fluctuations.

This statement is incorrect because it is generally observed that longer-term contracts can be less volatile due to the smoothing effect over time, whereas short-term contracts can be more sensitive to immediate market conditions and supply-demand imbalances.

References

Verified with information on the volatility of term contracts in commodity derivatives discussed in the book "How Finance Works"​​.

Comprehensive and Detailed In-Depth Explanation:

Spread risk refers to the risk of a change in an instrument’s price due to fluctuations in its credit spread (the yield premium over a risk-free rate), without a change in its credit rating. This is a market risk factor, often affecting bonds or CDS, driven by market perceptions rather than rating agency actions. Option B relates to collateral risk, Option C to credit rating risk, and Option D to modeling discrepancies—none define spread risk. GARP’s FRR and Basel III market risk rules support this definition.

Economic capital models, while useful, have the following disadvantages:

Model Risk: These models may not accurately capture the complexities of financial systems, leading to significant model risk.

Estimation Errors: Potential errors in risk estimation can lead to either underestimation or overestimation of required capital.

Regulatory Differences: These models may not align with regulatory capital requirements, causing discrepancies.

Complexity: The complexity of these models makes them difficult to understand and manage.

References

Source: How Finance Works​

A very strong positive linear relationship between the returns on two assets means that their correlation is close to 1, which is 100%. This indicates that the returns on the two assets move almost perfectly in tandem with each other.

Collecting internal operational risk event and loss information serves several purposes:

Assessing the risk of specific areas of concern (I).

Evaluating risk events and outcomes (II).

Collecting data for capital modeling (III). Getting insight into risk events in other firms in the industry (IV) typically involves external data collection rather than internal event collection.

TIdentify the regulation:

Regulation T of the Federal Reserve Bank governs the amount of credit that brokers and dealers can extend to investors for the purchase of securities.

Borrowing limit:

Regulation T allows investors to borrow up to 50% of the value of the securities from their brokers.

Explanation:

This regulation is in place to limit the amount of leverage investors can use when buying securities, aiming to reduce the risk of significant market volatility and potential defaults.

By selling off the lower risk portions of the portfolio credit risk, Delta Bank can increase its cash efficiency. This process generates cash which can be reinvested or used for other purposes, effectively improving the return on equity (ROE).

The overall risk exposure of the bank is reduced as the lower risk assets are sold off, leaving a more concentrated higher-risk portfolio, which still needs to be managed effectively.

ThetaBank's default risk assessment involves calculating the joint probability of default for the two mortgage companies and comparing it to the independent risk model.

Individual Exposure at Default (EAD):$20 million for each mortgage company.

Loss Given Default (LGD):100%

Probability of Default (PD):10% for each mortgage company.

Joint Probability of Default:5%

For independent risks, the joint probability of default for two independent events is the product of their individual probabilities:

\text{Joint Probability (Independent)} = PD_1 \times PD_2 = 0.10 \times 0.10 = 0.01 \text{ (or 1%)}

Given that ThetaBank predicts the joint probability at 5%, the independent model would have underestimated the actual probability by:

5%−1%=4%5%−1%=4%

Therefore, the underestimated probability is:

4%−2%=2%4%−2%=2%

References

Verified information from the document ​