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

An FX swap transaction involves exchanging principal and interest payments in different currencies, typically combining a spot transaction with a forward contract. However, contrary to statement C, FX swaps are generally used to hedge against exchange rate risk rather than generating more of it. Thus, the incorrect statement is that FX swaps generate more exchange rate risk than simple forward transactions.

Market-linked credit risk drivers often face specific disadvantages:

Need to supply a large number of input parameters to the model:Complex models require numerous data inputs, which can be challenging to obtain and maintain.

Slow computation speed due to higher simulation complexity:The complexity of these models can lead to slower computation times, making them less efficient for real-time analysis.

Non-linear nature of models and the need to estimate unknown variables are also relevant but are not as primary disadvantages as the first two mentioned.

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The expected loss (EL) on a credit instrument is calculated by multiplying the probability of default (PD), the loss given default (LGD), and the exposure at default (EAD). This formula captures the risk of default and the potential loss severity.

Other options (B, C, D) incorrectly represent the relationship between these components.

When an asset manager for a large mutual fund engages in forward exchange transactions traded in a clearinghouse system, the primary risks that arise are exchange rate risk and credit risk. Exchange rate risk is inherent in any foreign exchange transaction due to potential fluctuations in the currency's value over time. Credit risk is also significant as it involves the possibility that the counterparty may default on their contractual obligations.

The formula to estimate interest charges on a loan includes the risk-free rate, which is the base rate for borrowing with no risk of default. To this, the expected loss due to default (calculated as Probability of Default x Loss Given Default) and a spread to cover additional costs and profit margins are added. This comprehensive formula accounts for the risk and return expectations in lending.

An American call option allows the holder to purchase the underlying asset at any time before the option's expiration. This is in contrast to a European call option, which can only be exercised at the expiry date. The ability to exercise at any time gives the American option greater flexibility and potential value.

Counterparty credit risk refers to the risk that the counterparty to a financial contract will default before the final settlement of the contract's cash flows, resulting in a financial loss. This is correctly stated in option A.

The exposure at default (EAD) is indeed variable due to fluctuations in the underlying valuations, such as swaps, as mentioned in option B.

The EAD can be negatively correlated with the probability of default (PD) because as the credit quality of a counterparty deteriorates, their exposure may also decline, correctly stated in option C.

However, dynamic collateral provisions are typically designed to reduce counterparty risk by adjusting collateral requirements based on changes in exposure and credit quality, not to increase it. Therefore, option D is incorrect.

Asian options are path-dependent options, which means their payoff depends on the average price of the underlying asset over a certain period, rather than just the price at maturity. This characteristic makes them path-dependent because the path taken by the asset's price during the life of the option affects the payoff, unlike path-independent options which only depend on the final price at maturity.

In the United States, foreign exchange derivative transactions typically occur between a few large internationally active banks. These banks are major players in the foreign exchange markets and often act as intermediaries, providing liquidity and managing risks for themselves and their clients. The concentration of these transactions among a few large banks leads to a concentration of risks within these institutions.

The formula to estimate a partial change in an option's price based on the change in the underlying asset's price is primarily dependent on the option's Delta. Delta represents the sensitivity of the option's price to changes in the price of the underlying asset. Therefore, the most straightforward and widely used formula to estimate this partial change is:

Partial change in option price=Δ×Change in underlying pricePartial change in option price=Δ×Change in underlying price

This formula directly utilizes Delta to measure the immediate rate of change in the option's price relative to a small change in the underlying asset's price. The other options involving Gamma are more complex and not typically used for simple partial changes.