PRM CERTIFICATION Exam 8010 Questions V8.02 PRM Certification Topics - Operational Risk Manager (ORM) Exam Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam 1.Which of the following statements are correct? I. A reliance upon conditional probabilities and a-priori views of probabilities is called the 'frequentist' view II. Knightian uncertainty refers to things that might happen but for which probabilities cannot be evaluated III. Risk mitigation and risk elimination are approaches to reacting to identified risks IV. Confidence accounting is a reference to the accounting frauds that were seen in the past decadeas a reflection of failed governance processes A. II, III and IV B. II and III C. I and IV D. All of the above Answer: B Explanation: In statistics, which is relevant to risk management, a distinction is often drawn between 'frequentists' and 'Bayesians’. Frequentists rely upon data to draw conclusions as to probabilities. Bayesians consider conditional probabilities, ie, take into account what things are already known, and inject sometimes subjective a-priori probabilities into the calculations. StatementI describes Bayesians, and not frequentists. In reality however, the difference is merely academic. Risk managers use whichever technique best applies to the given situation without making it about ideology. The difference between 'Knightian uncertainty ‘and 'Risk' is similarly academic. Knightian uncertainty refers to risk that cannot be measured or calculated. 'Risk' on the other hand refers to things for which past data exists and calculations of exposure can be made. To give an example in the contextof the financial world, the risk from a pandemic creating systemic failures from a failure of payment and settlement systems and the like is 'Knightian uncertainty', but the market risk from equity price movements can be modeled (albeit with limitations) and is calculable. Statement II is therefore correct. Once a risk is identified, it can be mitigated, accepted, avoided or eliminated, or transferred by way of insurance. Therefore statement III is correct. Confidence accounting is a conceptual idea that suggests that accounting statements make reference to ranges as opposed to point estimates in financial statements. For example, instead of saying that the pension obligation is $xx million, the company should say the pension obligation is in a range of $xxm - $yy m with a certain confidence level. Statement IV is therefore inaccurate. 2. Under the standardized approach to calculating operational risk capital under Basel II, negative regulatory capital charges for any of the business units: A. Should be ignored completely B. Should be offset against positive capital charges from other business units Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam C. Should be included after ignoring the negative sign D. Should be excluded from capital calculations Answer: B Explanation: According to Basel II, in any given year, negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit. Therefore Choice 'b' is the correct answer. 3. Credit exposure for derivatives is measured using A. Current replacement value B. Notional value of the derivative C. Forward looking exposure profile of the derivative D. Standard normal distribution Answer: C Explanation: Current replacement values are a very poor measure of the credit exposure from a derivative contract, because the future value of these instruments is unpredictable, ie is stochastic, and the range of values it can take increases the further ahead in the future we look. Therefore it is common for credit exposures for derivatives to be measured using forward looking exposure profiles, which are distributions of the expected value of the derivative at the time horizon for which credit risk is being measured. To be conservative, a high enough quintile of this distribution is taken as the 'loan equivalent value' of the derivative as the exposure. Choice 'c' is the correct answer. The notional value of derivative contracts generally tends to be quite high and unrelated to their economic value or the counterparty exposure. Therefore notional value is irrelevant. 4. Which of the following are valid approaches for extreme value analysis given a dataset: I. The Block Maxima approach II. Least squares approach III. Maximum likelihood approach IV. Peak-over-thresholds approach A. II and III B. I, III and IV C. I and IV D. All of the above Answer: C Explanation: For EVT, we use the block maxima or the peaks-over-threshold methods. Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam These provide us the data points that can be fitted to a GEVdistribution. Least squares and maximum likelihood are methods that are used for curve fitting, and they have a variety of applications across risk management. 5. Which of the following formulae describes Marginal VaR for a portfolio p, where V_i is the value of the i-th asset in the portfolio? (All other notation and symbols have their usual meaning.) A) B) C) D) All of the above A. Option A B. Option B C. Option C D. Option D Answer: D Explanation: Marginal VaR of a component of a portfolio is the change in the portfolio VaR from a $1 change in the value of the component. It helps a risk analyst who may be trying to identify the best way to influence VaR by changingthe components of the portfolio. Marginal VaR is also important for calculating component VaR (for VaR disaggregation), as component VaR is equal to the marginal VaR multiplied by the Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam value of the component in the portfolio. Marginal VaR is by definitionthe derivative of the portfolio value with respect to the component i. This is reflected in Choice 'a' above. Using the definitions and relationships between correlation, covariance, beta and volatility of the portfolio and/or the component, we can show that the other two choices are also equivalent to Choice 'a'. Therefore all the choices present are correct. 6. Which of the following should be included when calculating the Gross Income indicator used to calculate operational risk capital under the basic indicator and standardized approaches under Basel II? A. Insurance income B. Operating expenses C. Fees paid to outsourcing service proviers D. Net non-interest income Answer: D Explanation: Gross income is defined by Basel II (see para 650 of the Basel standard) as net interest income plus netnon-interest income. It is intended that this measure should: (i) be gross of any provisions (e.g. for unpaid interest); (ii) be gross of operating expenses, including fees paid to outsourcing service providers; (iii) exclude realised profits/losses from the sale of securities in the banking book; and (iv) exclude extraordinary or irregular items as well as income derived from insurance. What this means is that gross income is calculated without deducting any provisions or operating expenses from net interest plus non-interest income; and does not include any realised profits or losses from the sale of securities in the banking book, and also does not include any extraordinary or irregular item or insurance income. Therefore operating expenses are to be notto be deducted for the purposes of calculating gross income, and neither are any provisions. Profits and losses from the sale of banking book securities are not considered part of gross income, and so isn't any income from insurance or extraordinary items. Of the listed choices, only net non-interest income needs to be included for gross income calculations, and the others are to be excluded. Therefore Choice 'd' is the correct answer. Try to remember the components of gross income from the definition above because in the exam the question may be phrased differently. 7. A loan portfolio's full notional value is $100, and its value in a worst case scenario at the 99% level of confidence is $65. Expected losses on the portfolio are estimated at 10% . What is the level of economic capital required to cushion unexpected losses? A. 25 B. 65 Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam C. 10 D. 35 Answer: A Explanation: Expected value = $90 ($100 - 10%) Value at 99% confidence level = $65 Therefore economic capital required at this level of confidence = $90 - $65 = $25. Choice 'a' is the correct answer, the other choices are not. (We can also look at it this way as explained in section III.B.6.2.2 of the handbook: Economic capital is designed to absorb unexpected losses, which areequal to total losses at a given confidence level minus expected losses. (Expected losses are to be covered by credit reserves). Total losses are $100-$65=$35, and expected losses are 10%*$100=$10, therefore economic capital should be $35-$10=$25.) 8. Which of the following can be used to reduce credit exposures to a counterparty: I. Netting arrangements II. Collateral requirements III. Offsetting trades with other counterparties IV. Credit default swaps A. I and II B. I, II, III and IV C. I, II and IV D. III and IV Answer: C Explanation: Offsetting trades with other counterparties will not reduce credit exposure to a given counterparty. All other choices represent means of reducing credit risk. Therefore Choice 'c' is the correct answer. 9. Which of the following is NOT an approach used to allocate economic capital to underlying business units: A. Stand alone economic capital contributions B. Marginal economic capital contributions C. Fixed ratio economic capital contributions D. Incremental economic capital contributions Answer: C Explanation: Other than Choice 'c', all others represent valid approaches to allocate economic capital to underlying business units. There is no such thing as 'fixed ratioeconomic capital contribution' Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam 10. For a given notional amount, which of the following carries the greatest counterparty exposure (assuming the same counterparty credit rating for each): A. A futures contract on an equity index B. A one year certificate of deposit C. A one year forward foreign exchange contract D. A one year interest rate swap Answer: B Explanation: The exposure at default is the greatest for the certificate of deposit as the entire notional amount is exposed to the risk of default. The other choices represent derivatives for which the current replacement value, which would be far less than notional, would be the credit exposure. Said another way - if the counterparty were to default, the entire money in the CD would be at risk, whereas for the derivative contracts it would only be the replacement value that would be at risk. 11. Identify the correct sequence of events as it unfolded in the credit crisis beginning 2007: I. Mortgage defaults increased II. Collapse in prices of unrelated assets as banks tried to create liquidity III. Banks refused to lend or transact with each other IV. Asset prices for CDOs collapsed A. III, IV, I and II B. I, III, IV and II C. I, IV, III and II D. IV, I, II and III Answer: C Explanation: According to a paper by the BCBS, here is an excellent summary of what happened. Based on this, Choice 'c' is the correct answer. "At the outset of the crisis, mortgage default shocks played a part in the deterioration of marketprices of collateralised debt obligations (CDOs). Simultaneously, these shocks revealed deficiencies in the models used to manage and price these products. The complexity and resulting lack of transparency led to uncertainty about the value of the underlying investment. Market participants then drastically scaled down their activity in the origination and distribution markets and liquidity disappeared. The standstill in the securitisation markets forced banks to warehouse loans that were intended to be soldin the secondary markets. Given a lack of transparency of the ultimate ownership of troubled investments, funding liquidity concerns were triggered within the banking sector as banks refused to provide sufficient funds to each other. This in turn led to the hoarding of liquidity, exacerbating further the funding pressures Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam within the banking sector. The initial difficulties in subprime mortgages also fed through to a broader range of market instruments since the drying up of market and funding liquidity forced market participants to liquidate those positions which they could trade in order to scale back risk. An increase in risk aversion also led to a general flight to quality, an example of which was the high withdrawals by households from money market funds." 12. Which of the following belong in a credit risk report? A. Exposures by country B. Exposures by industry C. Largest exposures by counterparty D. All of the above Answer: D Explanation: All the listed variables are relevant to management monitoring the credit risk profile of an institution, therefore Choice 'd' is the correct answer. 13. Which of the following statements are true: I. A transition matrix is the probability of a security migrating from one rating class to another during its lifetime. II. Marginal default probabilities refer to probabilities of default in a particular period, given survival atthe beginning of that period. III. Marginal default probabilities will always be greater than the corresponding cumulative default probability. IV. Loss given default is generally greater when recovery rates are low. A. I and III B. I, III and IV C. II and IV D. I and IV Answer: C Explanation: Statement I is incorrect. A transition matrix expresses the probabilities of moving to a given set of ratings at the end of a period (usually one year) conditional upon a given rating at the beginning of the period. It does not make a reference to an individual security and certainly not to the probability of migrating to other ratings during its entire lifetime. Statement II is correct. Marginal default probabilities are the probability of default in a given year, conditional upon survival at the beginning of that year. Statement III is incorrect. Cumulative probabilities of default will always be greater than the marginal probabilities of default - except in year 1 when they will be equal. Statement IV is correct. LGD= 1 - Recovery Rate, therefore a low recovery rate Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam implies higher LGD. 14. The VaR of a portfolio at the 99% confidence level is $250,000 when mean return is assumed to be zero. If the assumption of zero returns is changed to an assumption of returns of $10,000, what is the revised VaR? A. 260000 B. 240000 C. 273260 D. 226740 Answer: B Explanation: The exact formula for VaR is = -(Z + ), where Z is the z-multiple for the desired confidence level, and is the mean return. Now Z is always a negative number, or at least will certainly be provided the desired confidence level is greater than 50%, and is often assumed to be zero because generally for the short time periods for which market risk VaR is calculated, its value is very close to zero. Therefore in practice the formula for VaR just becomes -Z, andsince Z is always negative, we normally just multiply the Z factor without the negative sign with the standard deviation to get the VaR. For this question, there are two ways to get the answer. If we use the formula, we know that -Z= 250,000 (as =0), and therefore -Z - = 250,000 - 10,000 = $240,000. The other, easier way to think about this is that if the mean changes, then the distribution's shape stays exactly the same, and the entire distribution shifts to the right by $10,000 as the mean moves upby $10,000. Therefore the VaR cutoff, which was previously at - 250,000 on the graph also moves up by 10k to -240,000, and therefore $240,000 is the correct answer. The other choices are intended to confuse by multiplying the z-factor for the 99% confidence level with 10,000 etc. 15. Which of the following need to be assumed to convert a transition probability matrix for a given time period to the transition probability matrix for another length of time: I. Time invariance II. Markov property III. Normal distribution IV. Zero skewness A. I, II and IV B. III and IV C. I and II D. II and III Answer: C Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam Explanation: Time invariance refers to all timeintervals being similar and identical, regardless of the effects of business cycles or other external events. The Markov property is the assumption that there is no ratings momentum, and that transition probabilities are dependent only upon where the rating currently is and where it is going to. Where it has come from, or what the past changes in ratings have been, have no effect on the transition probabilities. Rating agencies generally provide transition probability matrices for a given period of time, say a year. The risk analyst may need to convert these into matrices for say 6 months, 2 years or whatever time horizon he or she is interested in. Simplifying assumptions that allow him to do so using simple matrix multiplication include these two assumptions - time invariance and the Markov property. Thus Choice 'c' is the correct answer. The other choices (normal distribution and zero skewness) are non-sensical in this context. 16. Which of the following contributed to the systemic failure during the credit crisis that began in 2007? A. Stress tests that did not stress enough B. Moral hazard from the strategy of 'originate and distribute' C. Inadequate attentionpaid to liquidity risk D. All of the above Answer: D Explanation: All the factors listed above contributed to systemic failure. Liquidity risk was not on the radar of regulators, and was a second priority for risk managers, and most of the focus was oncapital adequacy as liquidity was thought to be an unlikely problem. Liquidity, regardless of capital adequacy, was the primary cause of failure of a number of institutions during the crisis. Similarly, stress tests proved to be much milder than the shocks that were actually experienced, and the strategy of 'originate and distribute' implied that the mortgage and other debt originators had no interest in any due diligence as they intended to package and sell the debt to other investors. Therefore Choice 'd' is the correct answer. 17. If the full notional value of a debt portfolio is $100m, its expected value in a year is $85m, and the worst value of the portfolio in one year's time at 99% confidence level is $60m, then what is the credit VaR? A. $40m B. $25m C. $60m D. $15m Answer: B Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam Explanation: Credit VaR is the difference between the expected value of the portfolio and the value of the portfolio at the given confidence level. Therefore the credit VaR is $85m - $ 60m = $25m. Choice 'b' is the correct answer. Note that economic capital and credit VaR are identical at a risk horizon of one year. Therefore if the question asks for economic capital, the answer would be the same. [Again, an alternative way to look at this is to consider the explanation given in III.B.6.2.2:Credit Var = Q(L) - EL where Q(L) is the total loss at a given confidence interval, and EL is the expected loss. In this case Q(L) - $100-$60 = $40, and EL = $100-$85=$15. Therefore Credit VaR = $40-$15=$25.] 18. According to the Basel II framework, subordinated term debt that was originally issued 4 years ago with amaturity of 6 years is considered a part of: A. Tier 2 capital B. Tier 1 capital C. Tier 3 capital D. None of the above Answer: A Explanation: According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves. Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt issued originally for 5 years or longer. Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority. This only includes short term subordinated debt originally issued for 2 or more years. An interesting thing to note is the difference between 'subordinated term debt' under Tier 2 and the 'short term subordinated debt' under Tier 3. The distinction is based upon the years to maturity at the time the debt was issued. The remaining time to maturity is not relevant. For the subordinated term debt included under Tier 2, the amount that can be counted towards capital is reduced by 20% for every year when the debt is due within 5 years. This takes care of the time to maturity problem for Tier 2subordinated debt. For Tier 3 short term subordinated debt, this is not an issue because debt will only qualify for Tier 3 if it has a lock-in clause stipulating that the debt is not required to be repaid if the effect of such repayment is to take the bank below minimum capital requirements. 19. According to the implied capital model, operational risk capital is estimated as: A. Operational risk capital held by similar firms, appropriately scaled B. Total capital less market risk capital less credit risk capital Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam C. Capitalimplied from known risk premiums and the firm's earnings D. Total capital based on the capital asset pricing model Answer: B Explanation: Operational risk capital estimated using the implied capital model is merely the capital that is not attributable to market or credit risk. Therefore Choice 'b' is the correct answer. All other responses are incorrect. 20. Which of the following are a CRO's responsibilities: I. Statutory financial reporting II. Reporting to the audit committee III. Compliance with risk regulatory standards IV. Operational risk A. I and II B. II and IV C. III and IV D. All of the above Answer: C Explanation: Statutory financial reporting is the responsibility of the Chief Financial Officer, not the Chief Risk Officer. The head of internal audit reports to theaudit committee of the board, not the CRO. Therefore statements I and II are incorect. The CRO is generally expected to drive risk and compliance with related regulatory standards. Market risk, credit risk and operational risk groups report into the CRO, so statements III and IV are correct. 21. Which of the following statements are true: I. Top down approaches help focus management attention on the frequency and severity of loss events, while bottom up approaches do not. II. Top down approaches rely upon high level data while bottom up approaches need firm specific risk data to estimate risk. III. Scenario analysis can help capture both qualitative and quantitative dimensions of operational risk. A. III only B. II and III C. I only D. II only Answer: B Explanation: Top down approaches do not consider event frequency and severity, on the otherhand they focus on high level available data such as total capital, income Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam volatility, peer group information on risk capital etc. Bottom up approaches focus on severity and frequency distributions for events. Statement I is therefore not correct. Top down approaches do indeed rely upon high level aggregate data and tend to infer operational risk capital requirements from these. Bottom up approaches look at more detailed firm specific information. Statement II is correct. Scenario analysis requires estimating losses from risk scenarios, and allows incorporating the judgment and views of managers in addition to any data that might be available from internal or external loss databases. Statement III is correct. Therefore Choice 'b' is the correct answer. 22. When compared to a medium severity medium frequency risk, the operational risk capital requirement for a high severity very low frequency risk is likely to be: A. Higher B. Lower C. Zero D. Unaffected by differences in frequency or severity Answer: C Explanation: High frequency and low severity risks, for example the risks of fraud losses for a credit card issuer, may have high expected losses, but low unexpected losses. In other words, we can generally expect these losses to stay within a small expected and known range. The capital requirement will be the worst case losses at a given confidence level less expected losses, and in such cases this can be expected to below. On the other hand, medium severity medium frequency risks, such as the risks of unexpected legal claims, 'fat-finger' trading errors, will have low expected losses but a high level of unexpected losses. Thus the capital requirement for suchrisks will be high. It is also worthwhile mentioning high severity and low frequency risks - for example a rogue trader circumventing all controls and bringing the bank down, or a terrorist strike or natural disaster creating other losses - will probably have zero expected losses & high unexpected losses but only at very high levels of confidence. In other words, operational risk capital is unlikely to provide for such events and these would lie in the part of the tail that is not covered by most levels of confidence when calculating operational risk capital. Note that risk capital is required for only unexpected losses as expected losses are to be borne by P&L reserves. Therefore the operational risk capital requirements for a low severity high frequency risk is likely to be low when compared to other risks that are lower frequency but higher severity. Thus Choice 'c' is the correct answer. Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam 23. The sum of the stand alone economic capital of all the business units of a bank is: A. less than the economic capital for the firm as a whole B. more than the economic capital for the firm as a whole C. equalto the economic capital for the firm as a whole D. unrelated to the economic capital for the firm as a whole Answer: B Explanation: Economic capital is sub-additive, ie, because of the correlation being less than perfect between the risks of the different business units, the total economic capital for the firm will be less than the sum of the EC for the individual business units. Therefore Choice 'b' is the correct answer. In practice, correlations are difficult to estimate reliably, and banks often use estimates and corroborate their capital calculations with reference to a number of data points. 24. Which of the following is not a permitted approach under Basel II for calculating operational riskcapital A. the internal measurement approach B. the basic indicator approach C. the standardized approach D. the advanced measurement approach Answer: A Explanation: The Basel II framework allows the use of the basic indicator approach, the standardized approach and the advanced measurement approaches for operational risk. There is no approach called the 'internal measurement approach' permitted for operational risk. Choice 'a' is therefore the correct answer. 25. Which of the following statements are true? I. Risk governance structures distribute rights and responsibilities among stakeholders in the corporation II. Cybernetics is the multidisciplinary study of cyber risk and control systems underlying information systems in an organization III. Corporate governance is a subset of the larger subject of risk governance IV. The Cadbury report was issued in the early 90s and was one of the early frameworks for corporate governance A. I, II and IV B. I and IV C. II and III D. All of the above Answer: B Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam Explanation: Governance structures specify the policies, principles and procedures for making decisions about corporate direction. They distribute rights and responsibiliies among stakeholders that typically include executive management, employees, the board etc. Statement I is therefore correct. "Cybernetics is a transdisciplinary approach for exploring regulatory systems, their structures, constraints, and possibilities. In the 21st century, the term is often used in a rather loose way to imply "controlof any system using technology" (Wikipedia). Governance literature has been affected by cybernetics, which is not the same thing as information security or cyber security. Statement II is incorrect. Corporate governance includes risk governance, and not the other way round. Therefore statement III is incorrect. The Cadbury Report, titled Financial Aspects of Corporate Governance, was a report issued in the UK in December 1992 by "The Committee on the Financial Aspects of Corporate Governance". The report is eponymous with the chair of the committee, and set out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures. Statement IV is therefore correct. 26. The generalized Pareto distribution, when used in the context of operational risk, is used to model: A. Tail events B. Average losses C. Unexpected losses D. Expected losses Answer: A Explanation: Some risk experts have suggested the use of extreme value theory to model tail risk or extreme events for operational risk. The generalized Pareto model or the Peaks- over-Threshold (POT) model are often used to model extreme value distributions, and therefore Choice 'a' is the correct answer. 27. A bank expects the error rate in transaction data entry for a particular business process to be 0.005% . What is the range of expected errors in a day within +/- 2 standard deviations if there are 2,000,000 such transactions each day? A. 80 to 120 errors in a day B. 60 to 80 errors in a day C. 0 to 200 errors in a day D. 90 to 110 errors in a day Answer: A Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam Explanation: Error rates are generally modeled using thePoisson distribution. Recall that the Poisson distribution has only one parameter - - which is its mean and also its variance. In the given case, the mean number of errors is 2,000,000 x 0.005% = 100. Since this is the variance as well, the standard deviation is 100 = 10. Therefore the range of outcomes within 2 standard deviations of the mean is 100 +/- (2*10) = 80 to 120 errors in a day. 28. Which loss event type is the failure to timely deliver collateral classified as under the Basel II framework? A. Clients, products and business practices B. External fraud C. Information security D. Execution, Delivery & Process Management Answer: D Explanation: 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. 29. An error by a third party service provider results in a loss to a client that the bank has to make up. Such as loss would be categorized per Basel IIoperational risk categories as: A. Execution delivery and process management B. Outsourcing loss C. Business disruption and process failure D. Abnormal loss Answer: A Explanation: Choice 'a' is the correct answer. 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. 30. Which of the following is not one of the 'three pillars' specified in the Basel accord: A. Market discipline B. Supervisory review C. National regulation D. Minimum capital requirements Answer: C Explanation: Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam The three pillars are minimum capital requirements, supervisory review and market discipline. National regulation is not a pillar described under the accord. Choice 'c' is the correct answer. 31. If F be the face value of a firm's debt, V the value of its assets and E the market value of equity, then according to the option pricing approach a default on debt occurs when: A. F > V B. V < E C. F < V D. F - E < V Answer: A Explanation: According to the option pricing approach developed by Merton, the shareholders of a firm have a put on the assets of the firm where the strike price is equal to the face value of the firm's debt. This is just a more complicated way of saying that the debt holders are entitled to all the assets of the firm if these assets are insufficient to pay off the debts, and because of limited liability of the shareholders of a corporation this part payment will fully extinguish the debt. A firm will default on its debt if the value of the assets falls below the face value of the debt. Therefore Choice 'a' is the correct answer. All other choices are incorrect. (There are two ways to consider this sort of optionality, and I have mentioned only one for this question: 32. The equity holders can sell the assets of the firm to the debt holders at a price equal to the face value of the debt, ie a put. (ie they can extinguish their liability to the debt holders in full by handing them the assets of the firm, effectively selling them the assets at the value of the debt) 33. The equity holders have a long position in a call option where they can keep the assets of the firm by paying a price equal to the face value of the debt (ie, they can pay off the debt holders and keep the assets) For this question, perspective 1 applies but you should be aware of the second one too as a question may reference that view point.) 34. Which of the following is the best description of the spread premium puzzle: A. The spread premium puzzle refers to observed default rates being much less than implied default rates, leading to lower credit bonds being relatively cheap when compared to their actual default probabilities B. The spread premium puzzle refers to dollar denominated non-US sovereign bonds Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam being priced a at significant discount to other similar USD denominated assets C. The spread premium puzzle refers to AAA corporate bonds being priced at almost the same prices as equivalent treasury bonds without offering the same liquidity or guarantee as treasury bonds D. The spread premium puzzle refers to the moral hazard implicit in the monoline insurance market Answer: A Explanation: Choice 'a' is the correct answer. The other choices represent non-sensical statements. 35. Which of the following situations are not suitable for applying parametric VaR: I. Where the portfolio's valuation is linearly dependent upon risk factors II. Where the portfolio consists of non-linear products such as options and large moves are involved III. Where the returns of risk factors are known to be not normally distributed A. I and II B. II and III C. I and III D. All of the above Answer: B Explanation: Parametric VaR relies upon reducing a portfolio's positions to risk factors, and estimating the first order changes in portfolio values from each of the risk factors. This is called the delta approximation approach. Riskfactors include stock index values, or the PV01 for interest rate products, or volatility for options. This approach can be quite accurate and computationally efficient if the portfolio comprises products whose value behaves linearly to changes in risk factors. This includes long and short positions in equities, commodities and the like. However, where non-linear products such as options are involved and large moves in the risk factors are anticipated, a delta approximation based valuation may not give accurate results, and the VaR may be misstated. Therefore in such situations parametric VaR is not advised (unless it is extended to include second and third level sensitivities which can bring its own share of problems). Parametric VaR also assumes that the returns of risk factors are normally distributed - an assumption that is violated in times of market stress. So if it is known that the risk factor returns are not normally distributed, it is not advisable to use parametric VaR. 36. A corporate bond maturing in 1 year yields 8.5% per year,while a similar treasury bond yields 4% . What is the probability of default for the corporate bond assuming the recovery rate is Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam zero? A. 4.15% B. 4.50% C. 8.50% D. Cannot be determined from the given information Answer: A Explanation: The probability of default would make the future cash flows from both the bonds identical. If p be the probability of default, the cash flows from the risky corporate bond would be = (cash flows in the event of default x probability of default) + (cash flows without default x (1 - probability of default)) => p*0 + (1 - p)*(1 + 8.5%) = (1 - p)*1.085. The cash flows from the treasury bond would be 1.04. These two should be equal, ie, 1.04 = (1-p)*1.085, implying p = 4.15%. (Note: The above is a simplification intended for the exam. In reality investors would demand a 'credit risk premium' for the corporate bond over and above the expected default loss rate. They are unlikely to be happy with just being compensated with exactly the expected default loss rate plus the risk-fre rate because the expected default loss rate itself is uncertain. They would demand some premium over and above what the default rate alone might mathematically imply above the risk free rate. In this question, this credit risk premium is ignored.) 37. As the persistence parameter under EWMA is lowered, which of the following would be true: A. The model will react slower to market shocks B. The model will react faster to market shocks C. High variance from the recent past will persist for longer D. The model will give lower weight to recent returns Answer: B Explanation: The persistence parameter, , is the coefficient of the prior day's variance in EWMA calculations. A higher value of the persistence parameter tends to 'persist' the prior value of variance for longer. Consider an extreme example - if the persistence parameter is equal to 1, the variance under EWMA will never change in response to returns. 1 - is the coefficient of recent market returns. As is lowered, 1 - increases,giving a greater weight to recent market returns or shocks. Therefore, as is lowered, the model will react faster to market shocks and give higher weights to recent returns, and at the same time reduce the weight on prior variance which will tend to persist for a shorter period. Real 8010 Exam Questions [2022] To Pass PRMIA 8010 Exam 38. What is the risk horizon period used for credit risk as generally used for economic capital calculations and as required by regulation? A. 1-day B. 1 year C. 10 years D. 10 days Answer: B Explanation: The credit risk horizon for credit VaR is generally one year. Therefore Choice 'b' is the correct answer. 39. A key problem with return on equity as a measure of comparative performance is: A. that return on equity is not adjusted for risk B. that return on equity are not adjusted for cash flows being different from accounting earnings C. that return on equity measures do not account for interest and taxes D. that return on equity ignores the effect of leverage on returns to shareholders Answer: A Explanation: The major problem with using return onequity as a measure of performance is that return on equity is not adjusted for risk. Therefore, a riskier investment will always come out ahead when compared to a less risky investment when using return on equity as a performance metric. Return on equitydoes not ignore the effect of leverage (though return on assets does) because it considers the income attributable to equity, including income from leveraged investments. Return on equity is generally measured after interest and taxes at the company wide level, though at business unit level it may use earnings before interest and taxes. However this does not create a problem so long as all performance being covered is