FRM L2 Mock Exam (1) Questions
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1-20 FRM Part 2 Mock Exam One 1.
Which of the following statements is correct regarding the pricing of fixed-income securities? I.
The more frequent the time steps used for projected fixed-income security values, the more accurate the pricing. II.
The Black-Scholes-Merton model is preferred for the pricing of fixed-income securities because of its continuous time assumption. A.
I only. B.
II only. C.
Both I and II. D.
Neither I nor II. 2.
Which of the following market participants are most likely to provide liquidity for new financial securities? A.
Government. B.
Investment banks. C.
Risk averse investors. D.
Speculators 3.
What is the primary purpose of a leveraged recapitalization of a private equity fund portfolio company? A.
Fund cash dividend to private equity owner. B.
Restructure firm’s financial position by decreasing debt. C.
Provide growth capital to finance an acquisition or enter a new market. D.
Position target firm for additional asset sales and cost cutting. 4.
A cash-or-nothing call (also known as a digital call) pays a fixed amount to the buyer if the asset finishes above the strike price. Assume that at the end of a 1-year investment horizon, the stock is equal to $50, the fixed payment amount is equal to $45, and N(d
1
) and N(d
2
) from the Black-Scholes-Merton model are equal to 0.9767 and 0.9732, respectively. The value of this cash-or-nothing call when the risk-free rate equals 3% is closest to: A.
$5. B.
$42. C.
$44. D.
$47. 5.
Melvin Brown manages a long portfolio of debt and equity investments for an insurance company and has been trying to implement a new risk management program based on estimating and reporting the daily value at risk (VaR) for each manager’s portfolio. Brown is writing a report to gain support for his proposal. If Brown determines that daily VaR (10%) for his portfolio is equal to $20,000, which of the following statements should he include in his report?
2-20 A.
Computationally, delta-normal VaR is more complex than standard deviation but easier to interpret from a risk management perspective. B.
VaR was developed specifically for the purpose of measuring the economic capital required to protect bank portfolios against losses. C.
The risk of losing more than $20,000 in Brown’s portfolio value in any given week is 10%. D.
Portfolio diversification is not fully accounted for using the VaR methodology 6.
In managing model risk, risk managers should do all of the following except: A.
Try to eliminate model risk. B.
Avoid adding complexity to a model unless there is a strong need. C.
Backtest and stress test models. D.
Check the sensitivity of a model’s performance to changes in key assumptions. 7.
How many of the following statements regarding risk budgeting are correct? I.
Tracking error is defined as the standard deviation of the difference between the returns on a portfolio and the benchmark portfolio. II.
Using only information ratios allows risk of entire (firm) portfolios to be budgeted (allocated) across various portfolios managed by separate managers. III.
The optimal weights of the allocations to various fund managers (of a firm) do not necessarily have to sum to one. IV.
The benchmark portfolio cannot be assigned any weight under the optimal allocation scheme across active fund managers of a firm. A.
One. B.
Two. C.
Three. D.
Four. 8.
The Basel Committee requires that four data elements be used to calculate a bank’s operational risk capital charge. Which of the following is not one of the four elements? A.
External data. B.
Scenario analysis. C.
Internal loss data. D.
Regression analysis and other statistical tools. 9.
According to the Merton model, if the firm’s debt has a face value of $60 and the value of the firm is $50 when the debt matures, what are the payoffs to the debtholders and to the shareholders? Payoff to debtholders
Payoff to shareholders
A.
$50 $0 B.
$50 $10 C.
$10 $0 D.
$10 $10
3-20 10.
Historical data on hedge fund performance was difficult to obtain prior to the early 1990s. In early 1994, hedge fund databases were developed so that participants could better obtain and analyze hedge fund performance. Which of the following statements best describes hedge fund performance during the 2001—2010 time period? A.
All three hedge fund indices slightly underperformed equities but with a smaller standard deviation range compared to equities. B.
All three hedge fund indices substantially outperformed equities; however, their range of standard deviation was nearly double that of equities. C.
Hedge fund performance suffered following the Long-Term Capital Management (LTCM) hedge fund collapse. D.
All three hedge fund indices substantially outperformed equities, accompanied by less than half the standard deviation of equities. 11.
A firm uses VaR to estimate the probability of losses. However, management is concerned that the estimation process gives equal weight to all observations. Therefore, alternative approaches are considered. ‘Which of the following statements accurately describes an alternative weighted historic simulation approach? I.
Individual observations can be weighted based on volatility by substituting historical returns with volatility-adjusted returns. II.
Historical returns can be revised using correlation-adjusted returns. A.
I only. B.
II only. C.
Both I and II. D.
Neither I nor II. 12.
Consider the following scenarios regarding parties analyzing the potential use of collateralized debt obligations (CDOs).
Half-Pass Investments structures a deal to add value by repackaging bonds into tranches. Half-Pass plans to capture for equity investors the spread between relatively high yielding assets and lower yielding liabilities.
Piaffe First Bank recently acquired Pirouette Financial. Adding Pirouette’s portfolio of loans will result in Piaffe’s not being in compliance with internal asset composition targets because its concentration of subprime loans will be too high.
Canter Consulting has been asked to advise a U.S. commercial bank on ways to reduce the risk-based capital requirement for the commercial loan portfolio. Currently, the bank must reserve 100% capital against the loan balances.
Renvers Holdings plans to put together a CDO that it believes can generate a profit from the spread between the return on the collateral and the funding costs. Which of the choices below most accurately reflects the motivations for the parties in the above scenarios? Arbitrage-driven CDO Balance-sheet-driven CDO
A.
Piaffe and Canter Half-Pass and Renvers B.
Piaffe and Renvers Half-Pass and Canter C.
Half-Pass and Renvers Piaffe and Canter
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4-20 D.
Half-Pass and Canter Piaffe and Renvers 13.
Risk aggregation is one of the challenging areas within the economic capital implementation framework. Risk aggregation involves indentifying the individual risk types and making certain choices in aggregating those risk types. Classification by risk types (market, credit, operational, and business) may be approximate and prone to error. For example, the definitions of risk types may differ across banks or within a given bank, which complicates the aggregation process. Most banks begin by aggregating risk into silos by risk-type across the entire bank. Other banks prefer using business unit silos, while others combine both approaches. ‘Which of the following statements regarding risk aggregation is correct? A.
Combining two portfolios, for risk aggregation across different portfolios or business units of a bank, will result in lower risk per investment unit in the combined portfolio versus the weighted average of the two separate portfolios. B.
A simple summation method of risk aggregation adds together individual capital components, differentiates between risk types, and produces unequal weighting. C.
A variance-covariance matrix risk aggregation method summarizes the interdependencies across risk types and provides a flexible framework for recognizing diversification benefits. D.
A full modeling/simulation method of risk aggregation combines marginal probability distributions into a joint probability distribution through copula functions. 14.
Grayson Ballentine, an analyst with Platinum Consultants, is analyzing the economic effects of buying stock with borrowed funds for a high net worth individual client. Assume that the client has $200 cash invested (i.e., no borrowed funds) and then uses the cash to purchase stock. The client then decides to use 50% borrowed funds to purchase stock on margin. After the margin transaction, the total assets on the full economic balance sheet and the leverage ratio are closest to: Total Assets
Leverage Ratio
A.
$200 1.0 B.
$300 1.5 C.
$300 2.0 D.
$400 2.0 15.
Which of the following statements did JPMorgan Chase disclose to the Office of the Comptroller of the
Currency (OCC) regarding the Synthetic Credit Portfolio (SCP)? A.
The extremely large losses incurred by the SCP in January, February, and March 2012. B.
The SCP was growing rapidly and had a net notional value of $51 billion by the end of 2011. C.
A change in the value at risk (VaR) model in January 2012 and that the new model cut the banks risk in half. D.
That the SCP was actively traded, not traded for the long term as originally envisioned by the bank in the SCP origination document. 16.
As a result of the new Basel standards, every bank must now calculate explicit capital charges to cover operational risk using one of three approaches: the basic indicator approach
5-20 (BIA), the standardized approach (SA), and the advanced measurement approach (AMA). How many of the following statements are true with respect to these operational risk approaches? I.
In practice the AMA is the most stringent approach for operational risk. II.
The most popular method to satisfy the AMA is the loss distribution approach. III.
The AMA allows a bank to build its own operational risk model and measurement system comparable to market risk standards. IV.
BIA is widely used in insurance and actuarial science. A.
One. B.
Two. C.
Three. D.
Four. 17.
A market risk manager uses historical information on 1,000 days of profit/loss information to calculate a daily VaR at the 99
th
percentile, of USD 8 million. Loss observations beyond the 99the percentile are then used to estimate the conditional VaR. If the losses beyond the VaR level, in millions, are USD 9, USD 10, USD 11, USD 13, USD 15, USD 18, USD 21, USD 24, and USD 32, then what is the conditional VaR? A.
USD 9 million B.
USD 32 million C.
USD 15 million D.
USD 17 million 18.
As a hedge fund manager enrolled in a continuing education course, you are required to review the “Trust and Delegation” study by Brown, Goetzrnann, Liang, and Schwarz (2010) as one of your assignments. You are particularly interested in their separation between problem and non-problem hedge funds and the characteristics of each. Based on univariate tests, which of the following characteristics is less likely to occur with problem funds? A.
More likely to switch data vendors. B.
Longer lock-up and redemption periods than non-problem funds. C.
Generally smaller than non-problem funds. D.
Generally have poorer operational controls than non-problem funds. 19.
Under the contingent claim approach to the firm’s capital structure, which of the following statements is true? Assume the amount of senior debt, subordinated debt, and equity is represented as F, U, and S, respectively. A.
The value of subordinated debt is less than the value of senior debt. B.
Subordinated debt can be represented by a long call with exercise price of F and short call with exercise price of U. C.
Subordinated debt behaves more like equity in distress and more like debt when the firm is not in distress. D.
The value of subordinated debt is always greater than the value of equity. 20.
Which of the following statements comparing VaR with expected shortfall is true?
6-20 A.
Expected shortfall is sub-additive while VaR is not. B.
Both VaR and expected shortfall measure the amount of capital an investor can expect to lose over a given time period and are, therefore, interchangeable as risk measures. C.
Both VaR and expected shortfall depend on the assumption of a normal distribution of returns. D.
VaR can vary according to the confidence level selected, but expected shortfall will not. 21.
Monte Carlo simulations are commonly used to estimate interest rate paths in dynamic valuation approaches for mortgage-backed securities (MBSs). Which of the following statements is a critical assumption of the Monte Carlo simulation techniques for these types of models? I.
The spread between the refinancing rate and the 1-month interest rates is allowed to vary for each of the simulated paths. II.
Prepayment models incorporate refinancing rates to generate cash flows. A.
I only. B.
II only. C.
Both I and II. D.
Neither I nor II. 22.
Compare the capital requirements of Bank A and Bank B based on the following equal-sized portfolios. Bank A Bank B 25% OECD sovereign debt 50% OECD sovereign debt 75% non-OECD sovereign debt 50% non-OECD sovereign debt The credit risk capital requirement of Bank A will be greater than the credit risk capital requirement of Bank B under the: A.
Standardized approach of Basel 1. B.
Standardized approach of Basel II. C.
IRB foundation approach of Basel II. D.
Advanced measurement approach of Basel II. 23.
Two major differences between credit value at risk (credit VaR) and market risk VaR are that credit VaR: A.
Compares two future values and is typically defined using lower confidence levels than market risk VaR. B.
Compares two future values and is typically defined using higher confidence levels than market risk VaR. C.
Compares a future value with a current value and is typically defined using lower confidence levels than market risk VaR. D.
Compares a future value with a current value and is typically defined using higher confidence levels than market risk VaR. 24.
In a private equity transaction, what is the term for an investment in preferred stock or subordinated debt?
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7-20 A.
Growth capital B.
Bridge financing C.
Senior term debt D.
Mezzanine capital 25.
A firm’s financial planning department reports that a project’s proposed risk- adjusted return on capital (RAROC) is 13%, the risk-free rate is 3%, the market return is 11%, and the firm’s equity beta is 1.3. Use adjusted risk-adjusted return on capital (ARAROC) to determine whether or not the project should be accepted. This firm should: A.
Reject the project because its expected ARAROC is higher than the market’s excess return. B.
Accept the project because its expected ARAROC is higher than the market’s excess return. C.
Accept the project because its expected ARAROC is lower than the market’s excess return. D.
Reject the project because its expected ARAROC is lower than the market’s excess return. 26.
Using Model 1, assume the current short-term interest rate is 5%, annual volatility is 80bps, and d
ω
, a normally distributed random variable with mean 0 and standard deviation dt
, has an expected value of zero. After one month, the realization of d
ω
is -0.5. What is the change in the spot rate and the new spot rate? Change in Spot
New Spot Rate
A.
0.40% 5.40% B.
-0.40% 4.60% C.
0.80% 5.80% D.
-0.80% 4.20% 27.
Harrison Michaels, FRM, an analyst at Hudson Risk Analytics, is discussing the default sensitivities of equity, mezzanine, and senior tranches and makes the following statements. Which of the following statements is (are) most likely correct? I.
Default sensitivities are largest close to the attachment point between tranches. II.
Default sensitivities are computed by shocking the credit default swap (CDS) default curve. A.
I only. B.
II only C.
Both I and II. D.
Neither I nor II 28.
An analyst is using the delta-normal method to determine the VaR of a fixed- income portfolio. The portfolio contains a long position in 1-year bonds with a $1 million face value and a 6% coupon that is paid semiannually. The interest rates on 6- and 12-month maturity zero-coupon bonds are 2% and 2.5%, respectively. Mapping the long position to standard
8-20 positions in the 6- and 12-month zeros, respectively, provides which of the following mapped positions? 6-month CF
12-month CF
A.
$29,700 $1,004,725 B.
$30,000 $1,030,000 C.
$29,500 $975,610 D.
$30,300 $1,035,000 29.
Which of the following examples least likely describes one of the main channels through which sovereign risk can be transmitted to the financial sector? A.
A loss of market confidence in sovereign debt triggers fiscal consolidation. B.
An increase in sovereign risk reduces available collateral, leading to reduced funding capacity by banks. C.
Sovereign distress raises the cost of bank funding, crowding out private sector debt. D.
A troubled, systemically important euro-area bank is bailed out by its sovereign. 30.
Vega is the sensitivity of an option’s price to changes in volatility. Increases in an underlying instrument’s volatility will usual increase the value of options since increases in volatility produce a greater probability that an option will find its way into the money. Of the four options listed below, which investment has the potential to produce a negative Vega measure? A.
Shout option. B.
Call option. C.
Put option. D.
Barrier option. 31.
Jorgens, Inc., (Jorgens) frequently enters into derivatives trades with its counterparties. Which of the following termination events would Jorgens most likely find beneficial if it wanted to maintain the ability to terminate a trade at pre-specified future dates? A.
Walkaway clause. B.
Break clause. C.
Additional termination event. D.
Close-out. 32.
Suppose an investor expects that the 1-year rate will remain at 5% for the first year for a 2-year zero-coupon bond. In addition, the investor estimates a 50% probability that 1-year spot rates will be 6% in one year and a 50% probability that 1-year spot rates will be 4% in one year. Which of the following inequalities most accurately reflects the convexity effect for this 2-year bond using Jensen’s inequality formula? A.
$0.95247 > $0.95238. B.
$0.91584 > $0.91575. C.
$0.90711 > $0.90703. D.
$0.89856 > $0.89847. 33.
A portfolio includes a position of $1 million invested in DEF shares. The price volatility of
9-20 the shares over one week is 0.5%. The bid-ask spread is a constant 0.6%. What is the 1-week liquidity adjusted VaR (LVaR) for this position at the 95% confidence level? A.
$1,000. B.
$5,250. C.
$8,000. D.
$11,250. 34.
You propose to compute the expected shortfall (ES) of a position by employing extreme value theory (EVT) to characterize the loss tail with either a GPD (POT approach) or GEV (block maxima approach) distribution. Your colleague Fred objects with the following criticisms: I.
EVT is incompatible with expected shortfall (ES), you need to choose one approach or the other. II.
We are “stuck with” GEV or GPD due to small samples. As the sample size increases, the central limit theorem (CLM) justifies a normal distribution for the extreme loss tail. If our sample is sufficiently large, we should assume a normal distribution. III.
To fit either distribution (GDP or GEV), we need to specify both a scale and a tail parameter, but there are no known methods for estimating these parameters with historical data. IV.
EVT estimates are uncertain and attach with relatively wide confidence intervals due to their (mostly) asymptotic nature and paucity of data. Which of Fred’s criticisms is valid? A.
None are valid B.
Only II and III C.
Only IV D.
All are valid 35.
A trader needs to have a very quick idea of the BCVA (bilateral credit value adjustment) on a swap. The EPE (expected positive exposure) for a trade of this type is 7.0% whilst the ENE (expected negative exposure) is 4.0%. The credit spread of the counterparty is considered to be around 300 basis points per annum and the credit spread of the trader’s own institution is 200 basis points per annum. Which is nearest to an estimate of the BCVA? A.
2 bps B.
9 bps C.
13 bps D.
17 bps 36.
A constant maturity Treasury (CMT) swap pays ($1,000,000/2)
×
(Y
CMT
—8%) every six months. There is an 80% probability of an increase in the 6-month spot rate and a 70% probability of an increase in the 1-year spot rate. The rate change in all cases is 0.50% per period and the initial Y
CMT
is 8%. What is the value of this CMT swap? A.
$1,838. B.
$3,608. C.
$3,747.
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10-20 D.
$3,897. 37.
Which of the following statements is correct regarding enterprise risk management (ERM)? I.
Risk management should minimize the “underinvestment problem” that a firm potentially faces. II.
The assessment of the risk of each project is based on the project’s contribution to the firm’s total risk. A.
I only. B.
II only. C.
Both I and II. D.
Neither I nor II. 38.
One thing that is important to asset pricing is the distinction between risk and uncertainty. Regarding non-normality and asset pricing, which of the following statements is correct? A.
Risk arises when the distribution of future data is unknown (or cannot be calculated). B.
Uncertainty arises when the distribution is known (or can be calculated). C.
Much of financial research in the past 50 years has ignored uncertainty and focused solely on risk. D.
Under uncertainty, there is not a range of asset prices but a single asset price. 39.
Burton Puchee, FRM, is structuring a convertible arbitrage trade for a client on the stock Flathead Industries. Puchee is outlining a strategy of purchasing the convertible, which he considers undervalued, while shorting Flathead’s stock simultaneously. In determining the number of shares to sell short, which of the following should be considered? A.
Conversion price and gamma. B.
Delta-neutral exposure and conversion ratio. C.
Short interest and stock dividend. D.
Conversion ratio and delta. 40.
Which of the following statements is not true regarding a credit default swap (CDS) ? A.
The purchaser of a CDS seeks credit protection. B.
The protection seller is short the credit risk and pays the premium. C.
Physical settlement provides the CDS buyer the par value of the reference obligation. D.
A CDS has the same payoffs as a credit default put with installment payments. 41.
Jeremy Jackson is a portfolio manager who is summarizing the risks associated with mortgages and mortgage-backed securities in a quarterly report. Which of the following statements in his report is correct? A.
There is little risk associated with declining interest rates on a pool of residential mortgages because default risk is much less likely in this environment. B.
The percentage of the pool that is paying on time in relation to those who are delaying payments is known as the severity measure. C.
The PSA prepayment benchmark assumes that the monthly prepayment rate for a mortgage pool decreases as it ages.
11-20 D.
Delinquency is one important credit risk measure for a pool of mortgages. 42.
The single-factor model is used to examine the impact of varying default correlations based on a credit position’s beta. Each individual firm or credit, i, has a beta correlation,
i
, with the market, m. Which of the following statements most accurately describes the implication of using a specific value m
for the market parameter in the single-factor model? A.
The conditional probability of default will be greater than the unconditional probability of default when
i
is equal to zero. B.
The unconditional standard deviation is less than the conditional standard deviation. C.
Individual idiosyncratic shocks,
i
, are positively correlated to other firms’ shocks. D.
Individual asset returns, a
i
, are dependent from other firm’s shocks and returns. 43.
Small Bank is attempting to transition to the new Basel III standards. Specifically, they are wondering if their liquidity and funding ratios meet the updated requirements as specified by the Basel Committee. Given the following information, what is the bank’s net stable funding ratio?
High-quality liquid assets $300
Marketable securities $125
Required amount of stable funding $250
Cash inflows over the next 30 days $214
Net cash outflows over the next 30 days $285
Long-Term economic capital $500
Available amount of stable funding $255 A.
89%. B.
98%. C.
102%. D.
196%. 44.
Shawn Owens is giving a presentation on time-varying volatility and how it results from volatility fluctuations over time. Specifically, he is discussing the effect of time-varying volatility on the accuracy of value at risk (VaR) measures. What effect does time-varying volatility have on accurate VaR measures? A.
The effects of time-varying volatility on accurate VaR measures decrease as time horizon lengthens. B.
The effects of time-varying volatility on accurate VaR measures decrease as time horizon shortens. C.
The effects of time-varying volatility on accurate VaR measures increase as time horizon lengthens. D.
Accurate VaR measures are not affected by time horizon. 45.
The stress testing of banks in the period leading up to the banking crisis in Iceland: A.
Was conducted by the Financial Supervisory Authority (FME) yearly.
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12-20 B.
Was not transparent, as the results were not made public. C.
Was endorsed and approved by the International Monetary Fund (IMF) D.
Focused on individual banks as the stress scenarios were not applied across the banking sector. 46.
In a portfolio consisting of three currency positions, the relationship between the component VaR of each position and the individual VaR of each position is likely to be which of the following? A.
The component VaR is likely to be less than the individual VaR. B.
The component VaR is likely to be greater than the individual VaR. C.
The component and individual VaR are the same for currency positions. D.
There is no predictable relationship between the component VaR and the individual VaR. 47.
If a pool of mortgage loans begins the month with a balance of$10,500,000, has a scheduled principal payment of $54,800, and ends the month with a balance of $9,800,000, what is the CPR for this month? A.
6.177%. B.
42.240%. C.
53.472%. D.
66.670%. 48.
Danny Zelibor is a quantitative analyst who is partly responsible for evaluating counterparty credit risk at Prime Bank. In transacting with counterparties with which the bank has other/existing credit exposures, which of the following additional probability of default (PD) and loss given default (LGD) calculations does Danny need to perform? A.
PD for the counterparty and facility. B.
LGD for just the counterparty. C.
PD and LGD for the counterparty and facility. D.
LGD for just the facility. 49.
The rate parameter in the exponential distribution measures the rate at which it takes an event to occur. In the context of waiting for a company to default, the rate parameter is known as the hazard rate and indicates the rate at which default will arrive. Which of the following statements about hazard rates (i.e., default intensity) is correct assuming a constant default intensity of 0.2? A.
The cumulative default probability after 3 periods = e
-(0.2)3
B.
The conditional default probability after 1 period = 2%. C.
The unconditional default probability is memoryless. D.
The default probability in the second period = 14.9% 50.
A portfolio consists of two positions. One position has a VaR equal to $50, and the other has a VaR equal to $80 million. If the returns of the two positions are not correlated, the VaR of the portfolio would be closest to:
13-20 A.
$61.10 million. B.
$70.00 million. C.
$130.00 million. D.
$94.34 million. 51.
Which of the following statements on credit enhancement on securitized assets for the purposes of mitigating credit risk and liquidation risk is false? A.
Internal and external enhancements can be used for both credit and liquidity risk. B.
Liquidity reserves for liquidity risk are similar to a cash collateral account for credit risk. C.
Credit enhancements guarantee performance; liquidity enhancements are not responsible for shortfalls. D.
Asset swaps for liquidity enhancements adjust the notional principal upward to account for defaults. 52.
Griffin Riehl is a risk manager at Bluegrass Bank and Trust, a small, independent commercial bank in Kentucky. Riehl has recently read the Basel Committee on Banking Supervision’s recommendations for sound operational risk management and would like to put several controls in place. He would like to start with the three lines of defense suggested by the committee. Which of the following is not one of the three common “lines of defense” suggested by the Basel Committee for operational risk governance? A.
Business line management. B.
Board of directors and senior management risk training programs. C.
Creating an independent operational risk management function in the bank. D.
Conducting independent reviews of operational risks and risk management operations. 53.
The regulatory response to past financial crises has resulted in increased risk management and regulation, as well as the number of regulators. In which of the following banking regulations were banks first encouraged to use technology to increase their abilities to measure and self-calibrate risks? A.
Basel I. B.
Solvency It. C.
Dodd-Frank Act. D.
Basel Market Risk Amendment. 54.
Using the Vasicek model, assume a current short-term rate of 6.2% and an annual volatility of the interest rate process of 2.5%. Also assume that the long-run mean-reverting level is 13.2% with a speed of adjustment of 0.4. Within a binomial interest rate tree, what are the upper and lower node rates after the first month? Upper node
Lower node
A.
6.67% 5.71% B.
6.67% 6.24% C.
7.16% 6.24% D.
7.16% 5.71%
14-20 55.
Ki Dean, FRM, is a consultant for U.S.-based McGreggor Bank. Dean attended a meeting where a Senior Vice President made the following statements about the Basel II Accord. I.
By switching from the standardized approach to the foundation IRB approach, our risk weightings for a majority of the bank’s assets are lower, which could reduce our capital requirements by as much as 15% next year. II.
Under the IRB advanced approach, we generate all the estimates used in the models. III.
Pillar 2 concerns external monitoring and supervisory review. How many of the statements are correct? A.
None. B.
One. C.
Two. D.
Three. 56.
A 2-year credit default swap (CDS) specifying physical delivery defaults at the end of two years. If the reference asset is a $200 million, 8.0% ABC corporate bond, and the CDS spread is 125 basis points, the buyer of the CDS will: A.
Receive payments of 800 basis points for the next two years. B.
Receive a payment of $167.5 million. C.
Deliver the bond and receive a payment of $200 million. D.
Continue to receive payments of 675 basis points for the next two years. 57.
Nonlinearities in hedge fund returns are extremely common. Based on the following fund return equation and your knowledge of “phase-locking” behavior, which of the following statements regarding “phase-locking” behavior is (are) least likely correct?
it
i
i
t
t
t
it
R
M
I Z
I.
t
Z
dominates the expected return when
t
I
1
and the volatility of t
Z
is much larger than the volatility of the market factor. II.
During the recent credit crisis, assets that normally had a negative correlation (close to -1) began to move in a manner similar to positive correlation (close to + 1). A.
I only. B.
II only. C.
Both I and II. D.
Neither I nor II. 58.
Model risk is the risk associated with trying to capture an observed phenomenon using a financial model. Models, by their very construction, are flawed instruments and cannot possibly capture the full scope of factors necessary to explain the dynamic relationships we observe. It is better to ask oneself what is wrong with the model rather than glossing over potential errors in construction. Important sources of model risk include incorrect model specifications, incorrect model application, implementation risk, incorrect calibration, programming errors, and data problems. Which of the following statements is correct regarding sources of model risk? A.
An example of incorrect model application would be if a model assumes a binomial distribution, whereas a normal distribution represents a more accurate underlying
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15-20 stochastic process. B.
Multiple users of the capital asset pricing model (CAPM) may incorporate different measures of beta. This is an example of incorrect model specification. C.
Use of outdated model input parameters measured with error or based upon inappropriate sample periods is an example of incorrect model application. D.
Using the standard bond valuation model to value mortgage-backed securities is an example of incorrect model application. 59.
Jason Connor, FRM, is a hedge fund manager who is explaining implied volatility for currency options to junior analysts. Which of the following statements best completes his explanation? If the implied volatilities are greater for away-from-the-money actual currency options than they are for at-the- money currency options, then currency traders must believe that: A.
There is a greater chance of extreme price movements than predicted by a lognormal distribution. B.
Arbitrage opportunities clearly exist. C.
The implied volatility of currency options is expected to increase in the near future. D.
There are no arbitrage opportunities unless the implied volatility versus strike price represents a skewness that is referred to as a smirk rather than a smile. 60.
Assume three counterparties (A, B and C) are entered into bilateral derivative trades with the following net current replacement values: replacement value for A with respect to B = $10 million (i.e., if closed out immediately, B would owe $10 million to A); replacement value for B with respect to C = $10 million; replacement value for C with respect to A =$10 million. If these positions were immediately novated to central counterparty with multilateral netting, which of the following is implied? A.
Counterparty exposures among A, B and C are each eliminated to zero; but each will have a $10 million exposure to the central counterparty. B.
Counterparty exposures among A, B and C are each eliminated to zero; and each will have zero exposure to the central counterparty. C.
Counterparty exposures among A, B and C are, in total, reduced from $30 million to $10 million; and the central counterparty assumes $20 million in exposure. D.
The total exposure is not reduced from $30 million; it is effectively transferred to the central counterparty. 61.
An analyst is backtesting a daily holding period VaR model using a 97.5% confidence level over a 255-day period and is using a 3.84 test statistic. The following table shows the calculated values of a log-likelihood ratio (LR) at a 97.5% confidence level. Number of Exceptions 1 2 3 4 5 6 7 8 9 10 11 12 7.16 4.19 2.27 1.04 0.33 0.02 0.06 0.39 0.98 1.81 2.84 4.06 Based on the above information, which of the following statements accurately describes the VaR model that is being backtested? A.
If the number of exceptions is more than 3, we would not reject the model.
16-20 B.
If the number of exceptions is more than 2 and less than 12, we may commit a Type II error. C.
If the number of exceptions is less than 2, we would accept the hypothesis that the model is correct. D.
If the number of exceptions is less than 2, we may commit a Type II error. 62.
In order to improve the management of solvency risk, a bank should: A.
Focus on solvency stress testing and not the liquidity stress testing. B.
Focus on liquidity stress testing and not the solvency stress testing. C.
Focus more on balance sheet items and ignore the off-balance sheet items. D.
Focus on unusual or unexpected risk scenarios. 63.
A portfolio manager estimates the VaRs for the two positions in his portfolio as follows: VaR
1
= $4.8 million and VaR
2
= $2.6 million. What is the VaR for the portfolio if the returns of the two securities are uncorrelated, and what is the VaR for the portfolio if the returns of the two securities are perfectly correlated? A.
For zero correlation, VaR is $5.46 million, and for perfect correlation, VaR is $7.40 million. B.
For zero correlation, VaR is $4.46 million, and for perfect correlation, VaR is $6.40 million. C.
For zero correlation, VaR is $7.46 million, and for perfect correlation, VaR is $3.40 million. D.
For zero correlation, VaR is $5.46 million, and for perfect correlation, VaR is $9.40 million. 64.
Using the Merton model, calculate the current value of a firm’s equity and debt given that the current value of the firm is $100 million, the principal amount due in five years on the zero-coupon bond is $100 million, the annual interest rate is 10%, and the volatility of the firm is 20%. A.
$100 million in debt and $0 in equity. B.
$60.65 million in debt and $39.35 million in equity. C.
$58.38 million in debt and $41.62 million in equity. D.
$32.59 million in debt and $67.41 million in equity. 65.
Which of the following statements is incorrectly associated with the construction of a synthetic option using dynamic replication? A.
Operational risks are higher compared to static replication. B.
Transactions costs are higher compared to static replication. C.
Less capital is required, compared to an exchange traded option. D.
Confidentiality is greater, compared to an exchange traded option. 66.
Angelique Uttaro is reviewing a proposal for a collateralized debt obligation (CDO) from Pilot Investors. The CDO will be collateralized by a pool of emerging Market bonds. The report offers two alternatives: a simple cash CDO and a synthetic CDO. The report contains
17-20 the following statements: I.
In the synthetic CDO, the junior bondholders receive income from the high- quality debt securities in the portfolio and pay the insurance premium on a credit default swap. II.
Disadvantages of a cash CDO include a longer ramp-up period and the need to fund the senior section. Regarding the above statements, which one is correct? A.
I only. B.
II only. C.
Both I and II. D.
Neither I nor II. 67.
A bank located in an OECD member country uses the standardized approach to estimate total risk weighted credit risk exposure. An external credit rating agency assigns the following weights to the bank’s risk exposures. Risk Exposure Weight $50 million 150% $10 million No rating $20 million 5% $30 million 10% $5 million 50% According to the Basel II Accord, a bank should maintain a minimum capital amount of: A.
$5.24 million. B.
$7.32 million. C.
$23.2 million. D.
$12.2 million. 68.
Asu Walia is a senior analyst working for a sell side company preparing research reports on the mining sector. Walia noted that one of the companies he follows recently increased risk to the firm’s assets, which he expects will benefit equity holders to the detriment of debt holders. Which of the following concepts best describes the scenario in Walia’s analysis? A.
Coordination failures. B.
Adverse selection. C.
Risk shifting. D.
Principal-agent problem. 69.
A binomial interest rate tree indicates a 6-month spot rate of 3.5%, and the price of the bond is 97.25 if rates decline and 95.875 if rates increase. The risk- neutral probability of an interest rate increase is 0.60. You hold a put option on the bond. The put has an exercise price of 97.00 and expiration of six months. The option value is closest to: A.
0.10. B.
0.43. C.
0.66. D.
0.76.
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18-20 70.
During the recent credit crisis, subprime mortgages received pressure from upward movements in interest rates, along with the impossibility for most of these borrowers to refinance. As a result, many subprime borrowers allowed their reduced value homes to be taken over by the lender. All of the following statements describe the effect subprime actions had on mortgage-backed security portfolios except: A.
Repayment issues in lower tranches impacted confidence in higher tranches. B.
There was a fire sale of securitized debt. C.
Panic among MBS investors led to a flight to safer assets. D.
The defaults in the lower tranches were high but did not affect senior tranche investors. 71.
Given the information below, what is the liquidity-adjusted VaR at the 95% confidence level? Current stock price $200 Stock price standard deviation 3.0% Bid-ask spread mean 1.0% Bid-ask spread standard deviation 0.5% Spread confidence parameter 1.96 A.
$11.73. B.
$11.88. C.
$13.59. D.
$13.74. 72.
Advanced Pharmaceuticals is considering an investment in a very risky drug therapy treatment. If the investment is successful, Advanced Pharmaceuticals can earn substantial profits. On the other hand, if the therapy treatments create long-term side-effects, the firm will be subject to expensive litigation. How should Advanced Pharmaceuticals structure its investment to minimize its cost of capital? A.
Ring-fence the investment so a special purpose entity (SPE) can issue debt at lower costs. B.
Ring-fence the investment into a SPE so the parent company can increase transparency. C.
Securitize the investment due to its predictable cash flows. D.
Sell the investment in a true sale, increasing adverse selection. 73.
Value at risk (VaR) determines the maximum value we can lose for a given confidence level. For this reason, Kenneth Fulton is concerned that the VaR is not providing the magnitude of the actual loss. He has prepared the following table based on the assumption that returns are normally distributed and a corresponding n = 5. What is the expected shortfall using the information in the following table? Confidence level VaR Difference 95% 1.6392 96% 1.7507 0.1115 97% 1.8808 0.1301 98% 2.0537 0.1729 99% 2.3263 0.2726 A.
0.687.
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19-20 B.
1.930. C.
2.003. D.
2.054. 74.
In general, a long-short equity strategy does not stay market-neutral but invests on both the long and short sides of the market. Which of the following statements is false regarding the long-short equity strategy? I.
This strategy helps balance the market by providing desirability to the losing stocks and increasing inventory of the winners. II.
The extra trading due to the long-short strategy tends to increase market volatility. A.
I only. B.
II only. C.
Both I and II. D.
Neither I nor II. 75.
The RAROC is 15%, the risk-free rate is 3%, the market return is 16%, and the equity beta is 1.50. What is the adjusted RAROC (ARAROC), and should the project be accepted? A.
The ARAROC is 8.0%, and the project should be rejected. B.
The ARAROC is 8.0%, and the project should be accepted. C.
The ARAROC is 12.0%, and the project should be rejected. D.
The ARAROC is 12.0%, and the project should be accepted. 76.
Calculate the market risk capital requirement for a bank with an average VaR over the previous 60 days of $250 and a specific risk surcharge of $75, based on the current BIS minimum capital requirements. A.
$835. B.
$866. C.
$2,372. D.
$2,447. 77.
Fenn Tomnick is a risk analyst at one of the major equity research firms specializing in Eurozone banks. In a recent review of the European financial crisis, Tomnick indicated that in times of distress of systematically important financial institutions, sovereign governments are often compelled to provide financial support to the struggling institution. Which of the following statements best describes Tomnicks example? A.
The example describes one of the channels through which sovereign risk is transmitted to the financial sector. B.
The example describes one of the channels through which financial sector risk is transmitted to sovereigns. C.
The example describes a key way in which financial institutions are vulnerable to exposure to private sector debt. D.
The example provides an illustration of the interconnectedness of the global financial system.
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20-20 78.
Which is true about the difference between a balance sheet and arbitrage CDO? A.
An arbitrage CDO is a cash flow CDO but a balance sheet CDO is a market value CDO. B.
An arbitrage CDO is more likely to employ a collateral manager. C.
A balance sheet CDO is more likely to be actively managed. D.
The arbitrage CDO is more likely to be motivated by regulatory arbitrage. 79.
Which of the following subprime characteristics provide direct protection for senior tranches? A.
Subordination, excess spread, and shifting interest. B.
Subordination, prepayments, and shifting interest. C.
Overcollateralization, excess spread, and timing of losses. D.
Overcollateralization, excess spread, and prepayments. 80.
Gilbert Granston has been analyzing bid-ask spreads on over-the-counter equities for the last several years in his job as an equity analyst. He notes that with the exception of the 2007—2008 financial crisis, spreads have generally narrowed over his period of study. If Granston is correct, this is an indication that: A.
Liquidity has improved over the period. B.
The market has become more resilient over the period. C.
The depth of the market has improved over the period. D.
Credit risk has fallen over the period.
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Related Documents
Related Questions
1. Suppose there are three complex securities and three different states as follows:
Security So S₁(1) S₁ (2) S₁ (3)
1.2
3
0
0
1.8 4
2
0
1.2 2
1
1
2
10
4
A
B
C
D
(a) Find the arbitrage-free price of asset D.
(b) What is the risk-free return compatible with these asset prices?
arrow_forward
Assignment One
The curvature of the bond price yield curve has been explained to be caused by three basictheories or hypotheses, namelya) Liquidity preference theoryb) Market segmentation hypothesisc) Expectation hypothesisExplain each of the above and how they influence the price-yield curve.
arrow_forward
Question 1 Fill the parts in the above table that are shaded in yellow. You will notice that there are nineline items.
Question 2Using the data generated in the previous question (Question 1);a) Plot the Security Market Line (SML) b) Superimpose the CAPM’s required return on the SML c) Indicate which investments will plot on, above and below the SML? d) If an investment’s expected return (mean return) does not plot on the SML, what doesit show? Identify undervalued/overvalued investments from the graph
arrow_forward
Question 1Fill the parts in the above table that are shaded in yellow. You will notice that there are nineline items.
Question 2 Using the data generated in the previous question (Question 1)a) Plot the Security Market Line b) Superimpose the CAPM’s required return on the SML c) Indicate which investments will plot on, above and below the SML?d) If an investment’s expected return (mean return) does not plot on the SML, what doesit show? Identify undervalued/overvalued investments from the graph
arrow_forward
Please answer both
QUESTION 7
According to the capital asset pricing model (CAPM), fairly priced securities should have
A. A non-zero alpha.
в.A fair return based on the level of systematic risk.
C. A fair return based on the level of unsystematic risk.
D.A beta of 1.
QUESTION 8
Diversification can increase fair return.
True
False
arrow_forward
Question: There are three securities in the market. The following chart shows their possible payoffs: &n...
Edit question
There are three securities in the market. The following chart shows their possible payoffs:
State
Probabilityof Outcome
Return on Security 1
Return on Security 2
Return on Security 3
1
.14
.199
.199
.049
2
.36
.149
.099
.099
3
.36
.099
.149
.149
4
.14
.049
.049
.199
a-1.
What is the expected return of each security? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Answer 12.40%
a-2.
What is the standard deviation of each security? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Answer 4.50%
b-1.
What are the covariances between the pairs of securities? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and round your…
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Question: accounting
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QUESTION 2
The security market line (SML) is
a. the line that represents the expected return-beta relationship.
b.
also called the capital allocation line.
C.
the line that is tangent to the efficient frontier of all risky assets.
d. the line that represents the expected return-standard deviation relationship.
e. the line that describes the expected return-beta relationship for well-diversified portfolios only.
arrow_forward
Question 2
The following is the information for securities of ABC plc and XYZ plc:
XYZ plc
26
40
1.25
Particulars
Expected return
Standard deviation
Beta
ABC plc
25
42
0.85
The correlation coefficient between the returns of the two securities is 0.70 and
standard deviation of the market return is 20%.
Required
(a) As a new graduate accountant, CPA(T), determine if it is better to invest in
securities of ABC plc or XYZ plc
(b) If the proportional of investment in ABC plc is 40% and that in XYZ plc is 60%
determine the expected rate of return and portfolio standard deviation
(c) Determine the risk free rate
arrow_forward
Suppose you observe the following situation:
Security
Pete Corporation
Repete Company
Beta
1.70
1.39
a. Expected return on market
b. Risk-free rate
Expected
Return
.180
.153
a. Assume these securities are correctly priced. Based on the CAPM, what is the
expected return on the market? (Do not round intermediate calculations and enter
your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b. What is the risk-free rate? (Do not round intermediate calculations and enter your
answer as a percent rounded to 2 decimal places, e.g., 32.16.)
%
%
arrow_forward
Solve this practice problem
arrow_forward
QUESTION 15
Which of the following statements about Markovitz's portfolio theory is not correct?
O A. Portfolio theory ignores unsystematic risk
B. Portfolio theory can accommodate investors with different attitudes to risk
O. Portfolio theory accommodates the existence of risk free assets
OD. Portfolio theory preceded Sharpe's capital asset pricing model
O E. Portfolio theory is more appropriate for large institutional investors rather than for private investors
arrow_forward
Suppose you observe the following situation:
Security Beta Expected Return
Pete Corp. 1.50 0.160
Repete Co. 1.19 0.133
Assume these securities are correctly priced. Based
on the CAPM, what is the expected return on the
market? (Do not round intermediate calculations.
Round the final answers to 2 decimal places.)
Expected Return on Market
Pete Corp. %
Repete Co. %
What is the risk-free rate? (Do not round
intermediate calculations. Round the final answer to
3 decimal places.)
Risk-free rate
arrow_forward
QUESTION 6
Which of the following measures or concepts are deliberately used by modern portfolio theory?
I.
beta
II.
inter industry diversification
III.
efficient frontier
IV.
correlation
II and III only
I and IV only
I, III and IV only
I, II, III and IV
arrow_forward
QUESTION 8
In the present value bond valuation model, risk is generally incorporated into the
O timing of cash flows (assuming more risky cash flows are received early).
O discount rate or required return.
O cash flows (making some smaller if they are more risky).
O maturity amount.
arrow_forward
Which of the statements about the Arbitrage Pricing Theory MUST BE TRUE. I. There is only one systematic risk, the market risk. II. The market risk factor must be one of many systematic risk factors. III. Individual assets may have a positive or negative alpha A. I only B. II only C. III only D. None of the above
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24
From the viewpoint of the investor, which of the following securities provides the least risk?
Group of answer choices
Debentures
Mortgage bond
Subordinated debenture
Income bond
arrow_forward
13. Securities with less predictable
prices and have longer maturity time is
considered as____. A. cash equivalents
B. long-term investments C.
inventories D. short-term investments
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Question 2
(a) Evaluate the following statement: "Two stocks should be viewed as equally risky
because they have the same standard deviation."
(b) Suppose that the relevant equilibrium model is the CAPM with unlimited borrowing
and lending at a riskless rate of interest. Assuming, you discovered a security that
was located below the security market line.
(i) What would you conclude about the pricing of this particular security?
(ii)
Describe any changes you would expect to occur in its price.
(c) Suppose that the relevant equilibrium model is CAPM with unlimited borrowing and
lending at a riskless rate of interest. Compute the missing values (a*, b*, c*, d*,
e*) in the following table, showing all intermediate steps.
Expected Standard
Residual
Variance
Asset
Return
Deviation Beta
A
0.1
a*
0
B
b*
2
0.49
C
d*
1
0
D
e*
0
0.36
0.08
0.12
c*
0.05
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- 1. Suppose there are three complex securities and three different states as follows: Security So S₁(1) S₁ (2) S₁ (3) 1.2 3 0 0 1.8 4 2 0 1.2 2 1 1 2 10 4 A B C D (a) Find the arbitrage-free price of asset D. (b) What is the risk-free return compatible with these asset prices?arrow_forwardAssignment One The curvature of the bond price yield curve has been explained to be caused by three basictheories or hypotheses, namelya) Liquidity preference theoryb) Market segmentation hypothesisc) Expectation hypothesisExplain each of the above and how they influence the price-yield curve.arrow_forwardQuestion 1 Fill the parts in the above table that are shaded in yellow. You will notice that there are nineline items. Question 2Using the data generated in the previous question (Question 1);a) Plot the Security Market Line (SML) b) Superimpose the CAPM’s required return on the SML c) Indicate which investments will plot on, above and below the SML? d) If an investment’s expected return (mean return) does not plot on the SML, what doesit show? Identify undervalued/overvalued investments from the grapharrow_forward
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