Pass the PRMIA PRM Certification 8008 Questions and answers with CertsForce

Choice 'b' is the correct answer. When two securities have a correlation of +1, they are effectively the same security. In such cases, the standard deviations of the two securities are additive, which means the VaRs can simply be added together to get the combined VaR. All the other choices are incorrect.

Choice 'c' in particular would have been correct if the securities were completely uncorrelated, ie if they had a correlation of zero.

Choice 'a' would have been correct if their correlation were -1.

KMV Moody's uses a proprietary database to convert the distance to default to expected default probabilities.

Collateral, limits to avoid credit exposure concentrations, termination rights based upon credit ratings, third party guarantees and credit derivatives are all tools or instruments that financial institutions use to manage their credit risk. A cumulative accuracy plot measures the accuracy of ratings, and is not a tool for managing credit risk. Therefore Choice 'b' represents the correct answer.

Choice 'b' is the correct answer. All other answers are incorrect.

Refer to the detailed loss event type classification under Basel II (see Annex 9 of the accord). You should know the exact names of all loss event types, and examples of each.

Concentration risk in a credit portfolio arises due to a high degree of correlation between the default probabilities of the issuers of securities in the portfolio. For example, the fortunes of the issuers in the same industry may be highly correlated, and an investor exposed to multiple such borrowers may face 'concentration risk'.

A low degree of correlation, or independence of individual defaults in the portfolio actually reduces or even eliminates concentration risk.

The fact that issuers are from the same country may not necessarily give rise to concentration risk - for example, a bank with all US based borrowers in different industries or with different retail exposure types may not face practically any concentration risk. What really matters is the default correlations between the borrowers, for example a lender exposed to cement producers across the globe may face a high degree of concentration risk.

This is an example of pipeline and warehousing risk. Generally there is a lag between acquiring assets and securitizing them due to the legal work to be done, the work to be done by the ratings agencies and in finding investors. During this period, the bank is exposed to the underlying assets purchased, and this is the 'pipeline and warehousing' risk as these assets are in the pipeline and warehoused for intended subsequent sale. Generally this period tends to be short. However, during the credit crisis this became a significant source of risk as many banks were left exposed to risk they had intended to get rid of, but could not do so as the market dried up. The other choices are all incorrect.

Note that pipeline and warehousing risk is also known as 'securitzation risk'. It means that funding from securitization cannot be relied upon as a matter of fact.

Statement I is true - component VaR for individual assets in the portfolio add up to the total VaR for the portfolio. This property makes component VaR extremely useful for risk disaggregation and allocation.

Stateent II is incorrect, the incremental VaRs for the positions in a portfolio do not add up to the portfolio VaR, in fact their sum would be greater.

Statement III is correct. Marginal VaR for an asset or position in the portfolio is by definition the change in the VaR as a result of a $1 change in that position. Incremental VaR is the change in the VaR for a portfolio from a new position added to the portfolio - and if that position is $1, it would be identical to the marginal VaR.

Statement IV is correct, VaR is sub-additive due to the diversification effect. Adding up the VaRs for all the positions in a portfolio will add up to more than the VaR for the portfolio as a whole (unless all the positions are 100% correlated, which effectively would mean they are all identical securities which means the portfolio has only one asset).

Statement V is in incorrect. As explained for Statement I above, component VaR adds up to the VaR for the portfolio.

According to Basel II, where marking-to-market is not possible, banks may mark-to-model, where this can be demonstrated to be prudent. Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. When marking to model, an extra degree of conservatism is appropriate. Supervisory authorities will consider the following in assessing whether a mark-to-model valuation is prudent:

• Senior management should be aware of the elements of the trading book which are subject to mark to model and should understand the materiality of the uncertainty this creates in the reporting of the risk/performance of the business.

• Market inputs should be sourced, to the extent possible, in line with market prices. The appropriateness of the market inputs for the particular position being valued should be reviewed regularly.

• Where available, generally accepted valuation methodologies for particular products should be used as far as possible.

• Where the model is developed by the institution itself, it should be based on appropriate assumptions, which have been assessed and challenged by suitably qualified parties independent of the development process. The model should be developed or approved independently of the front office. It should be independently tested. This includes validating the mathematics, the assumptions and the software implementation.

• There should be formal change control procedures in place and a secure copy of the model should be held and periodically used to check valuations.

• Risk management should be aware of the weaknesses of the models used and how best to reflect those in the valuation output.

• The model should be subject to periodic review to determine the accuracy of its performance (e.g. assessing continued appropriateness of the assumptions, analysis of P&L versus risk factors, comparison of actual close out values to model outputs).

• Valuation adjustments should be made as appropriate, for example, to cover the uncertainty of the model valuation.

The model should be created independent of the front office, and not by it. Therefore statement III does not represent an appropriate choice. Choice 'a' is the correct answer.

A default hazard rate is the rate of default in a continuous time setting. This question is asking for probability of survival at the end of 5 years. The formula to calculate the probability of survival at the end of t years where the default hazard rate is λ is e^(-λ *t) (or in Excel, =exp(-λ*t). Therefore the correct answer is Choice 'd'.

(It may be tempting to infer that if the probability of survival at the end of 1 year is 90% (1 - 10%), then the probability of survival in 5 years would be 90%^5. However this reasoning is not correct for the reason that the given rate is not the discrete rate of default, but the hazard rate which is nothing but the continuously compounded rate of default.)

This situation represents one of the paradoxes in estimating severity that one needs to be aware of - the improvement in controls reduces the weight of the body/middle of the distribution and moves it towards the tails (as the total probability under the curve must stay at 100%) and the distribution becomes more heavy tailed. As a result, the 99.9th percentile loss actually increases. instead of decreasing, creating a counterintuitive result. Therefore the correct answer is that the capital required will increase.

If scenario analysis produces such a result, the analyst must question if the 1 in 100 year loss severity is still accurate. If the new control has reduced the severity in the body of the distribution, the question as to why the more extreme losses have not changed should be raised.