Learning outcomes: Describe how economic capital is derived.

Explain how the credit loss

distribution is modeled. Describe challenges to quantifying credit risk.

Questions:

507.1. Which best describes the relationship between economic capital and unexpected loss?

a. Economic capital is a multiple of unexpected loss

b. Economic capital is unrelated to unexpected loss
c. Economic capital is equal to (synonymous with) unexpected loss
d. Economic capital is unexpected loss plus credit value at risk (CVaR)

507.2. About the modeling of the credit loss distribution, Schroeck explains: "The crucial task in
estimating
economic capital is, therefore, the choice of the probability distribution ... One distribution often
recommended and suitable for this practical purpose is the beta distribution. This kind of
distribution is especially useful in modeling a random variable that varies between 0 and c (> 0).
And, in modeling credit events, losses can vary between 0 and 100%, so that c = 1. The beta
distribution is extremely flexible in the shapes of the distribution it can accommodate."

Which of the following is TRUE about the beta distribution?

a. The beta distribution is flexible because it has four (4) parameters, one for each moment,
allowing for precise calibration of tail (i.e., kurtosis)
b. In credit risk, the most convenient calibration of the beta distribution that is also sufficiently
realistic is to set the shape parameters, alpha and beta, equal to each other
c. As the beta distribution is characterized by the portfolio's expected loss, EL(P) and
unexpected loss, UL(P), the challenge is fitting the tail of the distribution which depends on the
ratio EL(P)/UL(P)
d. The chief drawback of the beta distribution is that--even when it is accurately fitted--it gives
us no way to determine the capital multiplier (CM), so the CM must be separately analyzed and,
realistically, this often requires a different distribution

507.3. Schroeck illustrates the "bottom up" approach to the quantification of economic capital
for credit risk. But he cautions "Despite the beauty and simplicity of the bottom-up (total) risk
measurement approach just described, there are a number of caveats that need to be addressed."
According to Schroeck, each of the following is a problem ("challenge") with the quantification
of credit risk EXCEPT which is not?

a. This approach assumes that credits are illiquid assets

b. This approach does not give us a way to aggregate economic capital across the major risk
types: credit, market and operational risk
c. In practice, to avoid undue complexity, these internal credit risk models tend to use only a
one-year estimation horizon rather than multi-period horizon
d. While this approach considers default correlation with the same credit risk type, it assumes
market and operational risk components are separated and are measured and managed in
different departments with the bank
Learning outcomes: Define and calculate expected loss (EL). Define and calculate unexpected
loss (UL). Calculate UL for a portfolio and the risk contribution of each asset.

Questions:

506.1. Consider the following four short-term loans held by a bank:

Which loan has the highest expected loss in dollar terms? (this question is a variation on FRM
Handbook Example 24.3)

a. Loan (a)
b. Loan (b)
c. Loan (c)
d. Loan (d)

506.2. A bank's credit exposure to a customer consists of the following:

Exposure amount (EA) is $50.0 million

Probability of default (PD) is 2.0%
Loss rate (LR; aka, loss given default) is 50.0%
Standard deviation of loss rate is 40.0%
The expected loss (EL) of this exposure is $500,000 = $50.0 million * 2.0% * 50%. Which is
nearest to the exposure's unexpected loss (UL)?

a. $2.48 million
b. $3.29 million
c. $4.50 million
d. $7.75 million

506.3. A bank has extended two loans to customers in the same industry. Both loans are have an
exposure amount (EA) of $50.0 million, default probability (PD) of 2.0%, loss rate (LR) of
50.0%, and standard deviation of loss rate of 60.0% such that each loan has an expected loss of
$500,000 and an unexpected loss of $5.5 million. In this way, the bank's credit portfolio
consists of these two credit assets; and the default correlation between the two loans is 28.0%.
Which is nearest to the risk contribution of each asset to the portfolio's unexpected loss?

a. $3.33 million
b. $4.40 million
c. $5.37 million
d. $5.50 million

Learning outcomes: Evaluate a banks economic capital relative to its level of credit risk.
Identify and describe important factors used to calculate economic capital for credit risk:
probability of default, exposure, and loss rate.

Questions:

505.1. According to Schroeck, economic capital is an estimate of the overall level of capital
necessary to guarantee the solvencyof the bank at some predetermined confidence level. Which
stakeholder tranche represents the "critical threshold" targeting by this confidence level?

a. Equity shareholders
b. Deposits and savings from insured customers
c. Senior uninsured debt
d. Junior uninsured debt

505.2. Which of the following is TRUE about expected credit loss?

a. Expected loss itself constitutes risk

b. Expected loss represents credit loss levels that do NOT fluctuate year to year
c. Expected loss is calculated from the bottom up (transaction by transaction) and reimbursed
through adequate loan pricing
d. Expected loss is the risk that arises due to the variation in loss levels and therefore justifies
the rationale for economic capital

505.3. Expected loss (EL) has three components: probability of default (PD), exposure amount
(EA), and loss rate (LR). With respect to these components of EL, each of the following is
true EXCEPT which is not accurate?

a. Exposure amount (EA) is the standard deviation of credit losses estimated at the end of the
horizon excluding outstanding interest payments
b. Probability of default (PD) is the probability that a borrower will default before the end of a
predetermined period of time (the estimation horizon typically chosen is one year)
c. Loss rate (LR) represents the ratio of actual losses incurred at the time of default (including all
costs associated with the collection and sale of collateral) to the exposure amount
d. Expected loss (EL) is equal to the product of: the probability of default up to time H
(horizon); the exposure amount at time H; and the loss rate experienced at time H; i.e., EL(H) =
PD(H)*EA(H)*LR(H)
AIMs: Explain the drawbacks to using a DV01-neutral hedge for a bond position. Describe a
regression hedge and explain how it improves on a standard DV01-neutral hedge. Calculate
the regression hedge adjustment factor, beta. Calculate the face value of an offsetting position
needed to carry out a regression hedge.

Questions:

321.1. A trader shorts $100.0 million of nominal US Treasury 3 5/8s bonds and, in a relative
trade, wants to hedge with a long in US Treasury Inflation Protected Securities (TIPS); the
relative trade will express a view on inflation as reflected in the spread between the rate of the
nominal bond and a TIPS. The yields and DV01s of each bond are shown below, in addition to
the output from a regression of nominal yield changes against real (TIPS) yield changes:

Which is nearest to the face amount of the long position in the 1 7/8s TIPS needed to carry out a
regression hedge?

a. $6.8 million face amount of TIPS

b. $68.83 million face amount of TIPS
c. $75.30 million face amount of TIPS
d. $105.68 million face amount of TIPS

321.2. A trader shorts $100.0 million of nominal US Treasury 3 5/8s bonds and, employing a
single-variable regression hedge, buys a face amount of 1 7/8s US TIPS. The bonds are show
below in addition to the results of a regression of the nominal against real yield:
Which is nearest to an estimate of the daily volatility of the P&L of the hedged portfolio?

a. $2,380
b. $43,760
c. $67,323
d. $212,000

321.3. A trader shorts $100.0 million of nominal US Treasury 3 5/8s bonds and hedges with a
purchase of a face amount of 1 7/8s US TIPS based on the regression results of a single-variable
hedge, which are shown here:

Each of the following are true about this regression hedge EXCEPT for which is false?
a. The regression model estimates a correlation between changes in the nominal and real yields
of about 82.5%
b. We can be 95% confident that the true value of beta is unity (1.0)
c. The daily volatility of the P&L of the hedged portfolio is about $88,000
d. The difference between a DV01-hedge and a regression hedge is about $17.14 million face
amount of the TIPS

Learning outcomes: Describe the rationale for the use of stress testing as a risk management
tool. Describe weaknesses identified and recommendations for improvement in: The use
of stress testing and integration in risk governance; Stress testing methodologies; Stress
testing scenarios; Stress testing handling of specific risks and products. Describe stress testing
principles for banks regarding the use of stress testing and integration in risk governance,
stress testing methodology and scenario selection, and principles for supervisors.

Questions:

504.1. According to the Principles for sound stress testing practices and supervision by BIS,
when is stress testing especially important?

a. When new regulations such as Basel III or Dodd-Frank are introduced and implemented
b. During periods of expansion or long periods of benign economic and financial conditions
c. During a corporate transaction such as a merger, especially if key executive roles are changing
d. Immediately after a market crisis because the standard models will be less useful when
systemic input assumptions are depressed

504.2. About stress testing methodologies, BIS writes, "Stress tests cover a range of
methodologies. Complexity can vary, ranging from simple sensitivity tests to complex stress
tests, which aim to assess the impact of a severe macroeconomic stress event on measures like
earnings and economic capital. Stress tests may be performed at varying degrees of aggregation,
from the level of an individual instrument up to the institutional level. Stress tests are
performed for different risk types including market, credit, operational and liquidity risk.
Notwithstanding this wide range of methodologies, the crisis has highlighted several
methodological weaknesses." According to BIS, which were the primary weaknesses of stress
testing methodologies during the crisis?

a. Most models relied on historical statistical relationship and insufficiently aggregated risks
across the firm, often due to infrastructure limitations
b. Too many scenarios were overly complex such that participants often did not understand the
output; and the output was not communicated in an easy-to-understand manner
c. Due to lack of general quantitative aptitude at the executive level, too often the subjective or
qualitative judgment of so-called experts was utilized instead of objective data
d. Scenarios tended to emphasize extremely severe market events, sometimes exaggerated
beyond all realism, and therefore ironically ignored more plausible but mundane scenarios
504.3. When developing a stress testing program, according to BIS, each of the following
elements or component is essentialEXCEPT which is not?

a. Reverse stress test

b. System-side interactions and feedback effects
c. Rigorously estimated ex ante probabilities of stress events based on statistical relationships
d. Imaginative and forward-looking scenarios informed by the judgment of experts across the
organization

Learning outcomes: Describe the various types of residential mortgage products. Calculate a
fixed rate mortgage payment, and its principal and interest components.

Questions:

500.1. Sally is meeting with her real estate agent in order to prepare her application for a
mortgage loan. The real estate agent makes the following four statements. Each of these
statements is true, or at plausible, EXCEPT which is clearly false?

a. The initial interest rate on a 3/1 hybrid adjustable rate mortgage (ARM) is less than the rate
on a 30-year fixed rate mortgage (FRM)
b. A conforming loan meets guidelines set by agencies such as Fannie Mae and Freddie Mac and
include limits on the loan size
c. A "jumbo" is a mortgage loan with an amount above the conforming (aka, agency) loan limit;
interest rates on a jumbo loan may be higher or even lower than (otherwise-equivalent)
conforming loans
d. In a low interest environment, an adjustable rate mortgage (ARM) is generally advised
because the borrower can always decide to refinance at a later date

500.2. Which is nearest to the principal component of the first monthly payment on a 30-year
fixed rate mortgage (FRM) with an original balance of $160,000 when the interest rate is
3.60%?

a. $39.00
b. $216.50
c. $420.00
d. $636.50

500.3. After five years (60 months), which is nearest to the outstanding scheduled principal
balance on a 30-year fixed rate mortgage (FRM) with an original balance of $140,000 and a
mortgage interest rate of 3.60%?

a. $152,300
b. $165,800
c. $179,700
d. $182,500
AIM: Define delta hedging for an option, forward, and futures contracts. Define and compute
delta for an option.

Questions:

6.1. What is, respectively, the delta of an at-the-money (ATM) six-month European call and put
option on a non-dividend-paying stock when the riskless rate is 4.0% per annum and the stock
price volatility is 28%?
a. 0.20 (ATM call) and -0.20 (ATM put)
b. 0.20 (ATM call) and -0.80 (ATM put)
c. 0.58 (ATM call) and -0.58 (ATM put)
d. 0.58 (ATM call) and -0.42 (ATM put)

6.2. A trader has a short position in 1,000 at-the-money (ATM) one-year put options when the
underlying stock price has a volatility of 20% per annum and the riskless rate is 4.0% per
annum. Which trade will make the position delta neutral?
a. Long 382 shares
b. Short 382 shares
c. Long 618 shares
d. Short 618 shares

6.3. The spot EUR/USD exchange rate is $1.30 (i.e., USD 1.30 per 1 EUR) with a volatility of
30% per annum. The USD riskless rate is 4% per annum and the EUR riskless rate is 3% per
annum. What is the delta of a one-year call option on the Euro with a strike price of EUR/USD
$1.36?
a. 0.4980
b. 0.5131
c. 0.5529
d. 0.6078

6.4. The spot price of oil is $80.00 per barrel with a volatility of 26% per annum. The riskfree
rate is 5.0% per annum. What is the delta of a one-year futures contract when the one-year
futures price is $90.00 per barrel?
a. 0.951
b. 1.000
c. 1.051
d. 1.118

6.5. The current price of the S&P 500 Index is 1200. The one-year futures price is 1262; i.e., +5%
continuously compounded. The volatility of the index is 18% per annum and the dividend yield
is 2.0% per annum. If the riskfree rate is 4.0% per annum, what is the detla of the the one-year
futures contract on the S&P 500 Index?
a. 0.9802
b. 1.0000
c. 1.0202
d. 1.0408

6.6. In sequence FROM LOWEST to highest value of option delta, what is the correct order of
the following four options: in-the-money (ITM) call option, out-of-the-money (OTM) call
option, in-the-money (ITM) put option, and out-of-the-money (OTM) put option?
a. OTM put, OTM call, ITM call, ITM put
b. OTM call, ITM call, ITM put, OTM put
c. ITM call, ITM put, OTM put, OTM call
d. ITM put, OTM put, OTM call, ITM call
Learning outcomes: Explain prepayment modeling and its four components: refinancing,
turnover, defaults, and curtailments. Describe the steps in valuing an MBS using Monte Carlo
Simulation. Define Option Adjusted Spread (OAS), and explain its challenges and its uses.

Questions:

503.1. According to Tuckman, "A prepayment model uses loan characteristics and the economic
environment (i.e., interest rates and sometimes housing prices) to predict prepayments. The
most common practice identifies four components of prepayments, namely, in order of
importance, refinancing, turnover, defaults, and curtailments. These components are typically
modeled separately and their parameters estimated or calibrated so as to approximate available
historical data." About these four components, each of the following is true EXCEPT which is
false?

a. Refinancing is often modeled with an incentive function for a pool or group of loans in a pool,
and then prepayments due to refinancing are defined as a nondecreasing function of that
incentive; an example of an incentive function is I = [WAC - R]*WALS*A-K
b. Turnover is primarily a function of interest rates and tends to be independent of seasonality
but highly responsive to the so-called media effect
c. Defaults are a source of prepayments in the sense that mortgage guarantors pay interest and
principal outstanding when a borrower defaults
d. Curtailments are partial prepayments by a particular borrower. These tend to be most
important when loans are older and balances are low

503.2. According to Tuckman, the valuation of a mortgage-backed security (MBS) is well-suited

to a Monte Carlo simulation because the model can incorporate each of the following
features EXCEPT which of these is difficult for the Monte Carlo simulation?

a. Path-dependent cash flows

b. Burnout and media effects
c. Measures of interest rate sensitivity
d. American- or Bermuda-style options

503.3. Tuckman writes that the "Option Adjust Spread (OAS) is the most popular measure of
relative value for MBS." In the context of a Monte Carlo valuation of a mortgage-backed security
(MBS), each of the following is true about the OASEXCEPT which is false?

a. If the assumption for interest rate volatility increases in the MBS Monte Carlo valuation
model, then the OAS should increase also
b. To the extent that the MBS Monte Carlo valuation model accounts correctly for scheduled
cash flows and prepayments, the OAS represents the deviation of a securitys market price from
its fair value
c. The practical challenge of using models and OAS to measure relative value is in determining
when OAS really does indicate relative value and when it indicates that the model is misspecified
d. Because the MBS Monte Carlo valuation model is supposed to account completely for the
effects of interest rates on cash flows and discounting, the OAS should be uncorrelated with
interest rate movements

Questions:

502.1. Consider an investor who wants to finance the purchase of a mortgage pool over a one
month period. One alternative is to sell an MBS repo, in which case the investor could sell the
pool today while simultaneously agreeing to repurchase it after a month. This trade has the
same economics as a secured loan: the investor effectively borrows cash today by posting the
pool as collateral, and, upon paying back the loan with interest after a month, retrieves the
collateral. An alternative is the "dollar roll." In the dollar roll, the buyer of the roll sells a TBA for
one settlement month (the "earlier month") and buys the same TBA for the following settlement
month (the "later month").

For example, the investor who just purchased a 30-year 4% FNMA pool might sell the FNMA
30-year 4% January TBA and buy the FNMA 30-year 4% February TBA. Delivering the pool just
purchased through the sale of the January TBA, which raises cash, and purchasing a pool
through the February TBA, which returns cash, is very close to the economics of a secured loan.

But there are two important differences between dollar roll and repo financing:

I. The buyer of the roll may not get back in the later month the same pool delivered in the earlier
month. The buyer of the roll delivers a particular pool, for example, in January but will have to
accept whatever eligible pool is delivered in the next February. By contrast, an MBS repo seller
is always returned the same pool that was originally posted as collateral.

II. The buyer of the roll does not receive any interest or principal payments from the pool over
the roll. For example, the buyer of the Jan/Feb roll, who delivers the pool in January, does not
receive the January payments of interest and principal. By contrast, a repo seller receives any
payments of interest and principal over the life of the repo. While the prices of TBA contracts
reflect the timing of payments, so that the buyer of a roll does not, in any sense, lose a month of
payments relative to a repo seller, the risks of the two transactions are different. The buyer of a
roll does not have any exposure to prepayments over the month being higher or lower than what
had been implied by TBA prices while the repo seller does.

Which of these two differences is (are) correct?

a. Neither are correct

b. I. is true but II. is incorrect
c. I. is incorrect but II. is true
d. Both are correct

502.2. Consider the scenario (a variation on Tuckman's example) illustrated below. Suppose
that the TBA prices of the Fannie Mae 6% for July 9 and August 9 settlements are $103.00 and
$102.60, respectively. The accrued interest to be added to each of these prices is 9 actual/360
days of a month's worth of a 6.0% coupon, i.e., 100 (9/30) 6.0%/12 or $0.150. Let the
expected total principal paydown, that is, scheduled principal plus prepayments, be 2.0% of
outstanding balance and let the appropriate short-term rate be 1.0%.

If an investor rolls a balance of $10.0 million, proceeds from selling the July TBA are $10.0
million (103.00 + 0.150)/100 or $10,315,000.00. Investing these proceeds to August 9 at 1.0%
earns interest of $10,315,000.00 (31/360) 1.0% or $8,882.36. Then, purchasing the August
TBA, which has experienced a 2.0% principal paydown, costs $10.0 million (1 - 2.0%)
(102.60 + 0.150)/100 or $10,069,500.00. The net proceeds from the roll, therefore, are
$10,315,000.00 + $8,882.36 - $10,069,500.00 or $254.382.36. If the investor does not roll, the
net proceeds are the coupon plus principal paydown: $10,000,000.00 (6.0%/12 + 2.0%) or
$250,000.00.

Given this scenario, which of the following is true?

a. The roll trades above carry (i.e., the value of the roll is positive) and this might be rationally
explained by delivery options of TBAs
b. The roll trades above carry (i.e., the value of the roll is positive) and this might be rationally
explained by the relatively low short-term interest rate
c. The roll trades below carry (i.e., the value of the roll is negative) and this might be rationally
explained by delivery options of TBAs
d. The roll trades at breakeven (i.e., the value of the roll is zero) and this is expected in efficient
markets

502.3. Which of the following is most likely to exhibit a dollar value of an 01 (DV01) that is
negative?
a. Principal-only (PO) at high yields
b. Interest-only (IO) strip at low yields
c. Interest only (IO) strip at high yields
d. Planned amortization class (PAC) bond at low yields

AIMs: Explain the objective for quantifying both expected and unexpected loss. Describe
factors contributing to expected and unexpected loss. Define, calculate and interpret the
unexpected loss of an asset. Explain the relationship between economic capital, expected loss
and unexpected loss.

Questions:

26.1. Of a total original commitment (COM) of $10.0 million, 20.0% is outstanding (OS) such
that $8.0 million is unused. The usage given default (UGD) assumption is 50.0% and the loss
given default (LGD) assumption is 40.0% where the standard deviation of the LGD is 30.0%. If
the probability of default (EDF) is 2.0%, what is the unexpected loss (UL) on the adjusted
exposure (AE)?

a. $48,000
b. $421,540
c. $573,495
d. $933,381

26.2. An exposure has a default probability (PD) of 4.0% and loss given default of 50.0%. The
standard deviation of the LGD is 25.0%. What is the ratio of the unexpected loss to the expected
loss, UL/EL?

a. 1.33
b. 3.72
c. 5.50
d. 9.64

26.3. In the assigned reading on unexpected loss (Ong Chapter 5), unexpected loss (UL) is given
as: UL = AE * SQRT[EDF*variance(LGD) + LGD^2*variance(EDF)]. Each of the following is
TRUE about this definition of unexpected loss (UL) EXCEPT:

a. It assumes independence (zero default correlation) between the default probability and loss
given default (LGD)
b. Economic capital will necessarily equal this value of this unexpected loss, as defined; i.e., EC
= UL
c. This unexpected loss (UL) is the standard deviation (volatility) of the unconditional value of
the asset at the horizon
d. Whereas expected loss (EL) increases as a linear function of EDF and LGD, unexpected loss
(UL) increases as a non-linear function of EDF and LGD
Learning outcomes: Define and describe the properties of the autoregressive moving
average (ARMA) process. Describe the application of AR and ARMA processes.

Questions:

512.1. Each of the following is a motivating for an autoregressive moving average (ARMA)
process EXCEPT which is not?

a. AR processes observed subject to measurement error also turn out to be ARMA processes
b. When we need to violate or cannot achieve the stationarity condition, an ARMA(1,1) process
becomes necessary over MA(1) or AR(1) processes
c. If the random shock that drives an autoregressive process is itself a moving average process,
then it can be shown that we obtain an ARMA process
d. ARMA processes can arise from aggregation; for example, sums of AR processes, or sums of
AR and MA processes, can be shown to be ARMA processes

512.2. If both an AR(5) and ARMA(2,1) achieve the same approximation accuracy, why would we
prefer one over the other?

a. We would not have a preference

b. We would prefer the AR(5) because it uses more data
c. We would prefer the AR(5) due to its relative simplicity
d. We would prefer the ARMA(2,1) due to its fewer parameters

512.3. Each of the following is true about ARMA processes EXCEPT which is false?

a. As with autoregressions and moving averages, ARMA processes have a fixed unconditional
mean but a time-varying conditional mean
b. The demonstrated presence of common factors in an ARMA(3,1) validate its superiority over
an AR(2) model; a.k.a, ARMA(2,0)
c. ARMA models, by allowing for both moving average and autoregressive components, often
provide accurate approximations to the Wold representation that nevertheless have just a few
parameters; i.e., ARMA models are often both highly accurate and highly parsimonious
d. In contrast to pure moving average or pure autoregressive processes, however, neither the
autocorrelation nor partial autocorrelation functions of ARMA processes cut off at any
particular displacement. Instead, each damps gradually, with the precise pattern depending on
the process
Learning outcomes: Describe the properties of the first-order autoregressive (AR(1)) process,
and define and explain the Yule-Walker equation. Describe the properties of a general pth
order autoregressive (AR(p)) process

Questions:

511.1. Each of the following is true about a first-order autoregressive, AR(1), process with
parameter phi () EXCEPT which is false?
a. The processes are always invertible
b. The unconditional mean is zero and the conditional mean of y(t) is *y(t-1)
c. If phi () = 0.95, the AR(1) is far LESS persistent than an MA(1) with the same parameter
value
d. If phi() is greater than -1.0 and less than +1.0, the process is covariance stationary

511.2. What does the Yule-Walker equation do?

a. It is the equation that allows for a test designed to detect first-order serial correlation
b. It is the equation that transforms an autogressive, AR(p), process into white noise
c. It gives us the autocovariance and autocorrelation function of an autogressive, AR(p), process
d. It applies the AR(p) process to macroeconomic variables; e.g., it estimates employment as a
function of gross domestic product (GDP)

511.3. Assume the following AR(1) process: y(t) = 0.95*y(t-1) + (t). Which of the following is
TRUE about this AR(1) process?

a. The unconditional mean is 0.95

b. The unconditional variance is one (1)
c. The conditional variance is 0.90250 = 0.95^2
d. At displacement (tau) of three, = 3,the autocorrelation of this AR(1) process is about 0.857
~= 0.95^3
Learning outcomes: Describe the properties of the first-order moving average (MA(1))
process, and distinguish between autoregressive representation and moving average
representation. Describe the properties of a general finite-orderprocess of order q (MA(q))
process

Questions:

510.1. Assume the shock (aka, innovation), (t), in a time series is approximated by Gaussian
white noise. The lagged (yesterday's) realization was 0.0160 and the lagged shock was -0.280;
i.e., y(t-1) = 0.0160 and (t-1) = -0.280. Today's shock, (t), is 0.190. If the weight parameter
theta, , is equal to 0.60, which is nearest to the today's realization, y(t), under a first-order
moving average, MA(1), process?

a. -0.0027
b. 0.0018
c. 0.0220
d. 0.1140

510.2. About the first-order moving average, MA(1), process where ^2 is the variance of the
shock theta () is the weight, each of the following is true EXCEPT which is false?

a. The unconditional mean is zero

b. The unconditional variance is ^2*(1+^2)
c. At displacements of two or higher, the autocorrelation is zero
d. By definition, MA(1) cannot meet the requirements of covariance stationarity

510.3. In comparing the first-order moving average process, MA(1), to the general finite-order
process of order q, MA(q), which of the following is TRUE?

a. The MA(1) has the potential for longer memory than the MA(q)
b. Neither can be covariance stationary under any conditions due to the autocorrelation function
c. The MA(1) has the potential to deliver better approximations to the Wold representation than
the MA(q)
d. If a root condition is satisfied, both are invertible; i.e., the current value can be expressed in
terms of a current shock and lagged values of the series
Learning outcomes: Calculate the sample mean and sample autocorrelation, and describe
the Box-Pierce Q- statistic and the Ljung-Box Q-statistic. Describe sample partial
autocorrelation

Questions:

509.1. If a time series is reasonably approximated as white noise, then each of the following is
true EXCEPT which is not true of a white noise process?

a. Serial correlations (aka, autocorrelations) are zero

b. Observations in the time series are normally distributed
c. In a large sample, the distribution of the sample autocorrelations is approximately normal
with mean of zero
d. In a large sample, the distribution of the sample autocorrelations is approximately normal
with variance of 1/T

509.2. For a certain time series, you have produced a correlogram with an autocorrelation
function that includes twenty four monthly observations; m = degrees of freedom = 24. Your
calculated Box-Pierce Q-statistic is 19.50 and your calculated Ljung-Box Q-statistic is 27.90. You
want to determined if the series is
white noise. Which is your best conclusion (please note this requires a lookup)?

a. With 95.0% confidence, you accept the series as white noise (more accurately, you fail to
reject the null)
b. With 95.0% confidence, you accept the series as partial white noise (due to Box-Pierce) but
reject the null (due to Ljung-Box)
c. With 95.0% confidence, you reject both null hypotheses and conclude the series is not white
noise
d. With 95.0% confidence, you reject both null hypotheses but conclude the series is white noise
because the sum of the statistics is greater than the critical value

509.3. In regard to the Box-Pierce and Ljung-Box Q-statistics, each of the following is TRUE
except which is false?

a. The Box-Pierce Q-statistic is used to test whether the residuals in a time series are white noise
b. The Ljung-Box Q-statistic is used to test whether a time series exhibits a linear trend under
the null hypothesis of a unit root
c. The Box-Pierce Q-statistic is approximately distributed as a chi-squared random variable
under the null hypothesis that autocorrelations are jointly zero in a time series
d. Selection of the number of lags being tested (aka, maximum displacement, m) in the Ljung-
Box test is a balance between conducting a joint test (i.e., can't be too small) and quality of the
distribution approximations (i.e., can't be too large)
Learning outcomes: Describe Wolds theorem. Define a general linear process. Relate rational
distributed lags to Wolds theorem

Questions:

508.1. Wold's representation theorem points to an appropriate model for a covariance stationary
residual such that:

a. Any autoregressive process of (p) order can be expressed as a rational polynomial of lagged
errors
b. Any purely nondeterministic covariance-stationary process is a linear regression of y(t) on a
lagged conditional mean
c. Any purely nondeterministic covariance-stationary process is some linear combination of
lagged values of a white noise process
d. Any autoregressive moving average model, ARMA(p,q), can be shown as the sum of
autoregressive (AR) and moving average (MA) processes

508.2. Wolds theorem tells us that when formulating forecasting models for covariance
stationary time series we need only consider models according to the the general linear process.
General refers to the fact that any covariance stationary series can be captured by the process.
Linear reflects the fact that the Wold representation expresses the series as a linear function of
its innovations. Under the general linear process, each of the following is true EXCEPT which is
false?

a. Unconditional mean is constant

b. Unconditional variance is constant
c. Conditional mean moves over time in response to the information set
d. Conditional variance moves over time in response to the information set

508.3. In regard to rational distributed lag models, each of the following is true EXCEPT which
is false?

a. It is possible to approximate the Wold representation using a rational distributed lag

b. ARMA and ARIMA forecasting models are simply rational approximations to the Wold
representation
c. Rational distributed lags produce models that are parsimonious yet provide accurate
approximations to the Wold representation
d. ARMA(1,1) is not practical for two reasons: it cannot be covariance stationary; and its
unconditional mean is time-varying while its conditional mean is fixed
AIMs: Construct, perform, and interpret hypothesis tests and confidence intervals for: a single
coefficient in a multiple regression; and for multiple coefficients in a multiple regression.
Define and interpret the F-statistic.

Questions:

221.1. This question was sourced from Stock & Watson; the regression also applies to the next
question. Data were collected from a random sample of 220 home sales. Price is the regressand
(dependent variable) and denotes the selling price (in $1,000s). The regressors (independent
variables) are: BDR is number of bedrooms, Bath is number of bathrooms, HSize is size of house
in square feet, LSize is lot size (in square feet), Age is age of house (in years), and Poor is a
binary variable that is equal to one (1) if the condition of the house is reported as "poor." The
estimate regression, with included standard errors, is given by:

If a homeowner purchases 1,000 square feet from an adjacent lot (i.e., +1,000 to her lot size),
what is the 99% confidence interval for the change in value to her house?

a. +$76 to $324
b. +$275 to $1,512
c. +$763 to $3,236
d. +1,255 to $4,871

221.2. Assume the same multiple regression as above, and note the regression has six regressors.
The F-statistic for omitting BDR and Age from the regression is 3.31. The following four critical
value are provided to you from Table 4 in the Appendix: critical F(2 df, infinite) @ 5% = 3.00;
F(2 df, infinite) @ 1% = 4.61; F(6 df, infinite) @ 5% = 2.01; F(6 df, infinite) @ 1% = 2.64. Are the
coefficients BDR and Age statistically different from zero at, respectively, the 5% and 1% level?

a. No, they are not significant at either level

b. They are not significant at 5%, but they are significant at 1%
c. They are not significant at 1%, but they are significant at 5%
d. Yes, they are significant at both 5% and 1%

221.3. In regard to hypothesis tests in a multiple regression, each of the following is true
EXCEPT which of the following is false:
a. In the multiple regression model, the t-statistic for testing that the slope is significantly
different from zero is calculated by dividing the estimate by its standard error
b. To test the joint null hypothesis at 5% significance, we can use the t-statistic to test each
coefficient (one at a time) and, if any t-statistic exceeds 1.96, we can reject the joint null
c. When testing a joint hypothesis, we should use the F-statistic and reject at least one of the
hypothesis if the statistic exceeds the critical value
d. When the number of restrictions is one (q=1), the joint null hypothesis reduces to the null
hypothesis on a single regression coefficient, and the F-statistic is the square of the t-statistic;
e.g., the critical F(1, infinite) at 5% = 1.96^2

Learning outcomes: Define, white noise describe independent white noise and normal
(Gaussian) white noise. Explain the characteristics of the dynamic structure of white noise.
Explain how a lag operator works.

Questions:

507.1. In regard to white noise, each of the following statements is true EXCEPT which is false?

a. If a process is zero-mean white noise, then is must be Gaussian white noise

b. If a process is Gaussian (aka, normal) white noise, then it must be (zero-mean) white noise
c. If a process is Gaussian (aka, normal) white noise, then it must be independent white noise
d. If a process is stationary, has zero mean, has constant variance and it serially uncorrelated,
then the process is white noise

507.2. Your colleague Jeff makes the following four claims about white noise:

I. 1-step-ahead forecast errors from good models should never be white noise
II. Forecasting white noise is easy due to obvious patterns implied by its stringent conditions
III. Processes with rich dynamics can be built up by taking simple transformations of white
noise
IV. What happens to a white noise series at any time in the future is uncorrelated with anything
in the present or past

a. None are true

b. Only I. and II. are true
c. Only III. and IV. are true
d. All are true.

507.3. Let B(L) be a lag operator polynomial of degree (m) that operates on y(t). Which best
characterizes y(t)?

a. B(L)y(t) --> y(t) = b(0)^m*y(t)

b. B(L)y(t) --> y(t) = b(0)*y(t-m)
c. B(L)y(t) --> y(t) = b(0)*y(t) + b(1)*y(t-1) + b(2)*y(t-2) + .... + b(m)*y(t-m)
d. B(L)y(t) --> y(t) = b(0)*y(t) + b(1)*y(t-1)^2 + b(2)*y(t-2)^3 + .... + b(m)*y(t-m)^(m+1)

Learning outcomes: Define covariance stationary, autocovariance function, autocorrelation

function, partial autocorrelation function and autoregression. Describe the requirements for a
series to be covariance stationary. Explain the implications of working with models that are
not covariance stationary

Questions:

506.1. In regard to covariance stationary stochastic processes each of the following statements is
true EXCEPT which is inaccurate?

a. In time series analysis, "cycles" refer to a general, all-encompassing notion of cyclicality: any
sort of dynamics with some persistence that is not captured by trends or seasonality
b. An upward trend corresponds to a steadily increasing mean, and seasonality corresponds to
means that vary with the season; both of which are violations of covariance stationarity
c. Due to the stringent requirements for covariance stationarity, and a practical inability to
transform non-stationary series, forecasting models avoid applying covariance stationarity in
practice
d. In a stationary process, distributions depend on displacement (i.e., the difference between
time subscripts) but do not depend on the time subscripts. A "strictly stationary" stochastic
process requires that the multivariate distribution function, including skew and kurtosis, be
stable and finite; but "weak stationarity" (aka, covariance stationarity) only requires means and
covariances to be stable and finite

506.2. Each of the following is a requirement for a series to be covariance stationary (aka, weak
stationarity, second-order stationarity) EXCEPT which is not a requirement?

a. The mean of the series is stable over time; E[y(t)] = (t)

b. The covariance structure of the series is stable over time; cov[y(t), y(t-)] = (t,)
c. The variance of the series (i.e., the autocovariance at displacement 0) is finite
d. The autocovariance depends on time (t), but does not depend on the displacement ()

506.3. What is the difference between autocorrelation and partial autocorrelation?

a. In the time series context, autocorrelation and partial autocorrelation are synonyms; i.e.,
there is no real difference, they are identical concepts
b. The partial autocorrelation is the correlation between y(t) and y(t-) multiplied by the
variance of y(0), an operation which standardizes the association across cycles
c. In the time series context, partial autocorrelation is the second moment of autocorrelation; if
autocorrelation is positive (negative), then partial autocorrelation must be positive (negative)
d. Autocorrelation is the typical correlation between y(t) and y(t-) while partial autocorrelation
measures the association between y(t) and y(t-) after controlling for the effects of y(t-1), ..., y(t-
+1)

Learning outcomes: Define copula, describe the key properties of copula and copula
correlation. Explain one tail dependence. Describe Gaussian copula, Student t-copula,
multivariate copula and one factor copula.

Questions:

504.1. In regard to copulas, each of the following is true EXCEPT which is false?

a. A copula is a way of defining the correlation between variables with known distributions.
b. Copulas cannot be used to define a correlation structure between more than two variables
c. The one-factor Gaussian copula model leads to very little tail dependence, which is a
limitation of the model
d. The Gaussian copula is just one copula that can be used to define a correlation structure
between marginal distributions; there are many other copulas leading to many other correlation
structures.

504.2. Consider the following three statements about tail dependence:

I. Tail dependence is the tendency for extreme values for two or more variables to occur together
II. The choice of the copula affects tail dependence
III. The tail dependence is higher in a bivariate Student t-distribution than in a bivariate normal
distribution.

Which of the above is (are) true?

a. None are true

b. Only I. is true
c. Only III. is true
d. All are true

504.3. Suppose that a bank has a total of $100.0 million of retail exposures of varying sizes with
each exposure being small in relation to the total exposure. The one-year probability of default
(PD) for each loan is 3.0% and the loss given default (LGD) for each loan is 60.0%. The copula
correlation parameter, rho(), is estimated as 0.250. Which is nearest to an estimate of the value
at risk with a one-year time horizon and a 99.9% confidence level? (note: this is a variation
on Hull's example 11.2)

a. $8.41 million
b. $12.57 million
c. $20.95 million
d. $36.72 million
Learning outcomes: Define mean squared error (MSE) and explain the implications of MSE in
model selection. Explain how to reduce the bias associated with MSE and similar measures.
Compare and evaluate model selection criteria, including s^2, the Akaike information
criterion (AIC), and the Schwarz information criterion (SIC). Explain the necessary conditions
for a model selection criterion to demonstrate consistency.

Questions:

505.1. Suppose a trend model over one hundred observations has eight parameters and its sum
of squared residuals is equal to 1,435; i.e., T = 100, k = 8, SSR (aka, residual sum of squares) =
1,435. Let's define "corrected MSE" as the mean squared error (MSE) that is penalized for
degrees of freedom used. Which are nearest, respectively, to (i) the mean squared error (MSE),
(ii) the corrected MSE, and (iii) the standard error of the regression, SER?

a. MSE = 13.29; corrected MSE = 14.35; SER = 3.95

b. MSE = 14.35; corrected MSE = 15.60; SER = 3.95
c. MSE = 14.35; corrected MSE = 26.43; SER = NA (not available with information given)
d. MSE = 179.38; corrected MSE = 14.35; SER = NA

505.2. Consider the following conditions for a model selection criteria to demonstrate
consistency:

I. When the true model (that is, the data-generating process, or DGP) is among the models
considered, the probability of selecting the true DGP approaches one as the sample size gets
large, and
II. When the true model is not among those considered, so that its impossible to select the true
data-generating process (DGP), the probability of selecting the best approximation to the true
DGP approaches one as the sample size gets large

Which of these conditions is (are) true?

a. Neither
b. I. only
c. II. only
d. Both

505.3. Consider the fitting of a polynomial trend model with (p) powers of time, T(t) = B(0) +
B(1)*TIME(t) + B(2)*TIME(t)^2 + B(p)*TIME(t)^p. Each of the following is
true EXCEPT which is not?

a. As we include higher powers of time, the sum of squared residuals cant rise, because the
estimated parameters are explicitly chosen to minimize the sum of squared residuals; therefore,
the more variables we include in a forecasting model, the lower the sum of squared residuals will
be, and therefore the lower MSE will be, and the higher R^2 will be
b. The mean squared error (MSE) is a biased estimator of out-of-sample 1-step-ahead prediction
error variance: the reduction in mean squared error (MSE) as higher powers of time are
included in the model occurs even if they are, in fact, of no use in forecasting the variable of
interest
c. While MSE and SIC are inconsistent, AIC is inconsistent
d. In-sample overfitting (aka, data mining) refers to the idea that including more variables in a
forecasting model wont necessarily improve its out-of-sample forecasting performance,
although it will improve the models fit on historical data.

Concept: These on-line quiz questions are not specifically linked to AIMs, but are instead based
on recent sample questions. The difficulty level is a notch, or two notches, easier than
bionicturtle.com's typical AIM-by-AIM question such that the intended difficulty level is nearer
to an actual exam question. As these represent "easier than our usual" practice questions, they
are well-suited to online simulation.

Questions:

414.1. A 30-year mortgage has an original balance of $160,000 and a fixed rate of 5.0% per
annum with typical monthly payments. Which of the following is nearest to the principal
reduced by the first month's mortgage payment?

a. Zero
b. $192.25
c. $666.67
d. $858.91

414.2. As Tuckman explains, "Mortgage borrowers have a prepayment option, that is, the option
to pay the lender the outstanding principal at any time and be freed of the obligation to make
further payments." In this way, prepayment risk is a defining characteristic of mortgages
and mortgage-backed securities (MBS). Each of the following is true about prepayment risk and
the prepayment option EXCEPT which is not?

a. The prepayment option implies negative convexity (in the price-rate relationship) at low
yields
b. The prepayment option does NOT imply negative duration at low yields
c. It is realistic for a prepayment model to assume the conditional prepayment rat (CPR) is a
decreasing function of rates; i.e., CPR increases as rates decrease
d. Due to the prepayment option, the duration of a mortgage-backed security (MBS) should be
calculated analytically with Macaulay duration; i.e., as the weighted average maturity of
mortgages in the pool where weights are present values of bond cash flows as a proportion of
bond price

414.3. According to Tuckman, "A prepayment model uses loan characteristics and the economic
environment (i.e., interest rates and sometimes housing prices) to predict prepayments. The
most common practice identifies four components of prepayments, namely, in order of
importance, refinancing, turnover, defaults, and curtailments. These components are typically
modeled separately and their parameters estimated or calibrated so as to approximate available
historical data." In regard to these four components of prepayment, each of the following is true
EXCEPT which is false?

a. Refinancing is often modeled with an incentive function, for example I = [WAC - R] WALS
A - K, that defines prepayments as a nondecreasing function of the incentive
b. Prepayments due to turnover are for the most part independent of interest rates, but there is
an interaction that cannot be ignored: borrowers are less likely to move if they currently enjoy a
below-market mortgage rate, a behavior known as the "lock-in effect"
c. Although defaults are never a source of prepayment since the principal is not recovered,
mortgage modifications, on the other hand, are a source of prepayment in most cases
d. Curtailments are partial prepayments by a particular borrower. These tend to be most
important when loans are older and balances are low. This driver of prepayments is modeled as
a function of loan age and can, with only a couple of years remaining to maturity, rise to a CPR
of about 5%.

AIMs: Define the Value-at-Risk (VaR) ... and explain the limitations of VaR. Define the
properties of a coherent risk measure and explain the meaning of each property: Explain why
VaR is not a coherent risk measure.

Questions:

29.1. A portfolio contains three independent bonds each with identical (i.i.d.) $100 par value,
3.0% probability of default (EDF) and loss given default (LGD) of 100%. What is, respectively,
the 95.0% confident and 99.0% confident portfolio value at risk (VaR)?

a. zero and zero at both 95% and 99%

b. $100 and $100 at both 95% and 99%
c. $200 @ 95% and $300 @ 99%
d. $285 @ 95% and $300 @ 99%

29.2. Your colleague reports a 95.0% one-day value-at-risk (VaR) of $1.4 million for a equities
portfolio. If we assume 250 trading days in a year, each of the following is a valid conclusion
EXCEPT which of the following is FALSE (cannot be concluded from the statement)?

a. If the VaR is accurate, we do expect the daily loss to exceed $1.4 million at least twelve (12)
days during the year
b. If the return distribution is normal, then we can assume the VaR is sub-additive
c. This is a parametric VaR and therefore cannot characterize a heavy-tailed distribution
d. If the returns are i.i.d. normal, we can scale to a 10-day VaR with $1.4*SQRT(10) = $4.3
million 95% 10-day VaR

29.3. Your colleague Stan collected the 99.0% daily value at risk (VaRs) for each of three
business units within his division: $10.0, $14.0 and $19.0 million. He aggregated them to arrive
at a divisional VaR of $43.0 million. However, he subsequently observes that the distributions
are non-normal (and non-elliptical) such that VaR in this context is not sub-additive.
a. No impact: lack of sub-additivity has no impact on the summation of VaR
b. Owing to diversification benefits, the true divisional VaR is less than $43.0 million
c. The true divisional VaR may be greater than $43.0 million
d. VaR's lack of sub-additivity is a minor, theoretical matter of little practical significance; if the
VaR lacked positive homogeneity, that would be of greater practical significance

Learning outcomes: Describe the procedure of generating samples from a bivariate normal
distribution. Describe properties of correlations between normally distributed variables when
using a one-factor model.

Questions:

503.1. Let (U) be a random normal with mean of 5.0 and standard deviation of 3.0, and let (V)
be a random normal with mean of 10.0 and standard deviation of 6.0; i.e., U ~ N(5.0, 3.0^2)
and V ~ N(10.0, 6.0^2). We want to generate samples from a bivariate normal distribution
where the correlation parameter (rho) is 0.70. If the univariate standard normal random draws
are z(1) = -0.880 and z(2) = +0.630, such that z(1) informs (U), which are nearest to the
corresponding bivariate samples?

a. $2.36 and $9.00

b. $3.11 and $3.97
c. $4.37 and $15.02
d. $8.87 and $19.32

503.2. Sometimes the correlations between normally distributed variables are defined using a
factor model. Suppose that U(1), U(2), ... U(N) have standard normal distributions. In a one-
factor model, each U(i) has a component dependent on a common factor, (F), and a component
that is uncorrelated with the other variables. Each of the following statements is true about the
one-factor model EXCEPT which is false?

a. A one-factor model imposes some structure on the correlations and has the advantage that the
resulting covariance matrix is always positive-semidefinite
b. If we do not assume factor model, the number of correlations to estimate for (N) variables is
N*(N-1)/2; for example, if N = 20, 435 = 30*29/2 correlation pair estimates are required
c. If we do assume a one-factor model, the minimum number of parameter estimates is only
(2*N), an systematic value plus a non-systematic value for each variable; for example, if N = 20,
then 40 = 2*20 estimates are required at a minimum
d. An example of a one-factor model from the world of investments is the capital asset pricing
model where the return on a stock has a component dependent on the return from the market
and an idiosyncratic (non-systematic) component that is independent of the return on other
stocks

503.3. In a one-factor model, each U(i) has a component dependent on a common factor, F, and
a component that is uncorrelated with the other variables. Formally, U(i) = a(i)*F + sqrt[1 -
a(i)^2]*Z(i), where (F) and Z(i) have standard normal distributions and a(i) is a constant
between -1.0 and +1.0. The Z(i) are uncorrelated with each other and uncorrelated with (F).
Consider two variables, U(1) and U(2) as follows:

U(1) = a(1)*F + sqrt[1 - a(1)^2]*Z(1) = 0.650*F + sqrt[1 - 0.650^2]*Z(1)

U(2) = a(2)*F + sqrt[1 - a(2)^2]*Z(2) = 0.480*F + sqrt[1 - 0.480^2]*Z(2)
Which is nearest to the coefficient of correlation between U(1) and U(2)?

a. 0.0973
b. 0.1498
c. 0.2028
d. 0.3120
Learning outcomes: Apply Bayes theorem to scenarios with more than two possible outcomes.

Questions:

501.1. As a risk analyst, you are asked to look at Whitetech Corporation, which has issued both
equity and bonds. The bonds can either be downgraded, be upgraded, or have no change in
rating. The stock can either perform above the market, with unconditional probability of 60.0%,
or below the market with unconditional probability of 40.0%. If the equity performs above the
market, there is a 20.0% probability of a bond upgrade; P[U|A] = 20.0%. If the equity performs
below the market, there is only a 10.0% probability of a bond upgrade; P[U|B] = 10.0%.

If the bond was upgraded, what is the probability that the equity finished the period below the
benchmark; i.e., Prob [B|U] ?

a. 4.0%
b. 10.0%
c. 25.0%
d. 50.0%

501.2. As a risk analyst, you are asked to analyze the bonds of Ganztrax Corporation in the
context of economic cycles. The economic cycle can be in one of three states: recession, flat or
growth. The corresponding unconditional probabilities are P[R] = 25.0%, P[F] = 35.0%, and
P[G] = 40.0%. If the economy is in a growth cycle, then the bond can be either upgraded,
downgraded, or unchanged; the corresponding conditional probabilities are P[U|G] = 35.0%,
P[N|G] = 60.0% and P[D|G] = 5.0%.
If the bond was downgraded, which is nearest to the probability that the economy is in a growth
cycle; i.e., Prob[G|D] ?

a. 2.0%
b. 9.5%
c. 13.0%
d. 15.4%

501.3. Your firm is testing a new quantitative strategy. The analyst who developed the strategy
claims that there is a 60.0% probability that the strategy will generate positive returns on any
given day. After 30 trading days the strategy has generated a profit 21 times, which is fully
70.0%. Assume that there are only two possible states of the world: Either the analyst is correct,
or there the strategy is equally likely to gain or lose money on any given day. Your prior
assumption was that these two states of the world were equally likely. Which is nearest to the
probability that the analyst is right and the actual probability of positive returns for the strategy
is 60%? (Please note: this question is not exam-realistic because it requires
spreadsheet/software to retrieve binomial probabilities. Source: variation on Miller 6-4).

a. 60.0%
b. 74.3%
c. 86.1%
d. 90.5%
Learning Outcomes: Distinguish between expected loss and unexpected loss, and provide
examples of each. Interpret the relationship between risk and reward. Describe and
differentiate between the key classes of risks, explain how each type of risk can arise, and
assess the potential impact of each type of risk on an organization.

Questions:

502.1. Crouhy writes that "understanding [the difference between expected loss and unexpected
loss] is the key to understanding modern risk management concepts such as economic capital
attribution and risk-adjusted pricing." Which of the following statements is TRUE about
unexpected loss (UL)?

a. Unexpected loss levels tend to be higher for a consumer credit card portfolio than a corporate
loan portfolio
b. In a credit portfolio, higher default correlation implies lower portfolio unexpected losses
c. Unexpected loss (UL) it typically priced into the products or services offered to customers,
while expected loss is the denominator of risk-adjusted return on capital (RAROC)
d. Market risk value at risk (MVaR) can be expressed as either relative MVaR or absolute MVaR
but it is "relative MVaR" that matches (better captures) unexpected losses (UL)

502.2. Crouhy's risk typology is consistent with Jorion's. This typology includes the three major
financial risks (market, credit and operational risk) and includes liquidity risk as a key financial
risk. Non-financial risks are either business or non-business risks. Non-business risks include
reputation and political risks; business risks include strategy and technological innovation. For
FRM purposes, however, the domain is financial risks, primarily: market risk, liquidity risk,
credit risk, and operational risk. According to this risk typology, each of the following is true but
which statement is false?

a. Basis risk is a context-specific form of market risk

b. There are four major types of market risk: interest rate risk, equity price risk, foreign
exchange risk, and commodity price risk; interest rate risk parses into trading risk and the
special case of gap risk (gap risk relates to the risk that arises in the balance sheet of an
institution as a result of the different sensitivities of assets and liabilities to changes of interest
rates).
c. Credit risk can be decomposed into four main types: default risk, bankruptcy risk, downgrade
(credit deterioration) risk, and settlement risk.
d. Because legal and regulatory risk are classified as business risks rather than financial risks,
many of the large losses from derivatives trading case studies (debacles) over the last decade are
technically business risk failures not financial risk failures

502.3. According to Crouhy, at least among the given choices, which of the following is probably
the most important current and future challenge to the wider risk management profession as it
seeks to improve the efficacy of the risk manager's job?

a. In the extended wake of the financial crisis and ensuing confidence loss in many quantitative
approaches, restore the reputation of financial engineering by building better mathematical
measures of risk
b. Build a wider risk culture and promote risk literacy in which key staff members understand
how they can affect the risk profile of the organization; i.e., "put down deeper risk management
roots in each organization."
c. Improve the ability of firms to predict the expected future value (i.e., the expected mean) of
financial variables with better accuracy; e.g., "dispersions won't matter if we can't find a more
accurate crystal ball for forecasting"
d. Promote the continual "upgrading" from naive, simple metrics (e.g., notional limits) toward
more sophisticated methods which are almost universally more robust and automatically
comparable

Learning outcome: Describe Bayes theorem and apply this theorem in the calculation of
conditional probabilities. Compare the Bayesian approach to the frequentist approach.
Questions:

500.1. According to Miller, each of the following is true about Bayes' theorem and Bayesian
analysis EXCEPT which is false?

a. Bayes' theorem is often described as a procedure for updating beliefs about the world when
presented with new information
b. Bayes' theorem updates a prior probability with evidence (aka, likelihood) to generate a
posterior probability
c. Risk management, performance analysis and stress testing are areas where we often have very
little data, and where the data tends to be noisy, such the frequentist approach is superior to the
Bayesian approach
d. Although the theorem itself is simple, Bayes' Theorem can be applied to a wide range of
problems (e.g., it is used in everything from spam filters to machine translation and to the
software that controls self-driving cars) and its application can often be quite complex

500.2. You have a portfolio of bonds, each with a 1.0% probability of default. An analyst
develops a model for forecasting bond defaults, but the model is only 70.0% accurate. In other
words, of the bonds that actually default, the model identifies only 70.0% of them; likewise, of
the bonds that do not default, the model correctly predicts that 70% will not default. Given that
the model predicts that a bond will default, what is the probability that it actually defaults?
(note: this is a variation on Miller's question 6-2).

a. 1.00%
b. 1.43%
c. 2.30%
d. 7.00%

500.3. You have a model that classifies Federal Reserve statements as either bullish or bearish.
When the Fed makes a bullish announcement, you expect the market to be up 80.0% of the
time. The market has 60.0% probability of being up, and a 40.0% probability of being flat or
down (the only two states are up, or not up). The Fed makes bullish announcements 60.0% of
the time. What is the probability that the Fed made a bearish announcement, given that the
market was up? (note: this is a variation on Miller's question 6-7)

a. 20.0%
b. 40.0%
c. 60.0%
d. 80.0%

Learning outcomes: Identify the data architecture and IT infrastructure features that can
contribute to effective risk data aggregation and risk reporting practices. Describe
characteristics of a strong risk data aggregation capability and demonstrate how these
characteristics interact with one another. Describe characteristics of effective risk reporting
practices.
Questions:

512.1. About risk data aggregation capabilities, the Committee says "[35.] Banks should develop
and maintain strong risk data aggregation capabilities to ensure that risk management reports
reflect the risks in a reliable way (ie meeting data aggregation expectations is necessary to meet
reporting expectations). Compliance with these Principles should not be at the expense of each
other. These risk data aggregation capabilities should meet all Principles below ..." Which are
the four principles?

a. Governance; and Data architecture & IT infrastructure

b. Accuracy and integrity; Completeness; Timeliness; Adaptability
c. Comprehensiveness; Clarity and usefulness; Frequency
d. Comprehensiveness; Clarity and usefulness; Distribution

512.2. About risk reporting practices, the Committee says "[51.] Accurate, complete and timely
data is a foundation for effective risk management. However, data alone does not guarantee that
the board and senior management will receive appropriate information to make effective
decisions about risk. To manage risk effectively, the right information needs to be presented to
the right people at the right time. Risk reports based on risk data should be accurate, clear and
complete. They should contain the correct content and be presented to the appropriate decision-
makers in a time that allows for an appropriate response. To effectively achieve their objectives,
risk reports should comply with the following principles. Compliance with these principles
should not be at the expense of each other ...".

Each of the following EXCEPT which is not a risk reporting principle?

a. Accuracy
b. Comprehensiveness
c. Clarity and usefulness
d. Manual workarounds

512.3. Consider the following set of definitions used in "Principles for effective risk data
aggregation and risk reporting:"

Distribution: Ensuring that the adequate people or groups receive appropriate risk
reports.
Frequency: The rate at which risk reports are produced over time.
Integrity: Freedom of risk data from unauthorized alteration and unauthorized
manipulation that compromise its accuracy, completeness and reliability.
Risk tolerance/appetite: The level and type of risk a firm is able and willing to assume in
its exposures and business activities, given its business and obligations to stakeholders;
it is generally expressed through both quantitative and qualitative means.
Risk Data aggregation: Defining, gathering, and processing risk data according to the
banks risk reporting requirements to enable the bank to measure its performance
against its risk tolerance/appetite; this includes sorting, merging or breaking down sets
of data.
 Timeliness: Availability of aggregated risk data within such a time frame as to enable a
bank to produce risk reports at an established frequency.
Validation: The process of comparing items or outcomes and explaining the differences.
The process by which the correctness (or not) of inputs, processing, and outputs is identified
and quantified. Each is stated accurately, EXCEPT which is incorrect?

a. Integrity
b. Risk tolerance
c. Timeliness
d. Validation

Learning outcomes: Explain the potential benefits of having effective risk data
aggregation and reporting. Describe keygovernance principles related to risk data
aggregation and risk reporting practices.

Questions:

511.1. Among the Basel Committee's Principles for effective risk data aggregation and risk
reporting, Principle 2 is "Data architecture and IT infrastructure: A bank should design, build
and maintain data architecture and IT infrastructure which fully supports its risk data
aggregation capabilities and risk reporting practices not only in normal times but also during
times of stress or crisis, while still meeting the other Principles." The principle includes
paragraph 33, where two terms have been replaced with "[keyword #1]" and "[keyword #2]":

"A bank should establish integrated data [keyword #1 here] and architecture across the banking
group, which includes information on the characteristics of the data--i.e., [keyword#2 inserts
here]--as well as use of single identifiers and/or unified naming conventions for data including
legal entities, counterparties, customers and accounts." The first keyword, [keyword #1], refers
to the categorization or classifications of data; for example, market risk and credit risk are
categories of risk. The second keyword, [keyword #2], refers to information about the data."

Which terms correctly replace, respectively, [keyword #1] and [keyword #2]?

a. aggregation and principles

b. capabilities and architecture
c. taxonomies and metadata
d. timelines and accuracy

511.2. Among the Basel Committee's Principles for effective risk data aggregation and risk
reporting, Principle 5 is "Timeliness: A bank should be able to generate aggregate and up-to-
date risk data in a timely manner while also meeting the principles relating to accuracy and
integrity, completeness and adaptability.

The precise timing will depend upon the nature and potential volatility of the risk being
measured as well as its criticality to the overall risk profile of the bank. The precise timing will
also depend on the bank-specific frequency requirements for risk management reporting, under
both normal and stress/crisis situations, set based on the characteristics and overall risk profile
of the bank. 45. The Basel Committee acknowledges that different types of data will be required
at different speeds, depending on the type of risk, and that certain risk data may be needed
faster in a stress/crisis situation. Banks need to build their risk systems to be capable of
producing aggregated risk data rapidly during times of stress/crisis for all critical risks"

Critical risks include each of the following EXCEPT which is not a critical risk?

a. credit exposure to a large corporate borrower

b. Trading exposures
c. Liquidity risk indicators
d. Legal settlement probabilities

511.3. Consider the following set of definitions used in "Principles for effective risk data
aggregation and risk reporting:"

Accuracy: Closeness of agreement between indications or measured quantity values

obtained by replicating measurements on the same or similar objects under specified
conditions.
Adaptability: The ability of risk data aggregation capabilities to change (or be changed)
in response to changed circumstances (internal or external).
Approximation: A result that is not necessarily exact, but acceptable for its given
purpose.
Clarity: The ability of risk reporting to be easily understood and free from indistinctness
or ambiguity.
Completeness: Availability of relevant risk data aggregated across all firm's constituent
units (eg legal entities, business lines, jurisdictions, etc)
Comprehensiveness: Extent to which risk reports include or deal with all risks relevant to
the firm.
Manual workarounds: Employing human-based processes and tools to transfer,
manipulate or alter data used to be aggregated or reported.
Each is stated accurately, EXCEPT which is incorrect?

a. Accuracy
b. Approximation
c. Clarity
d. Comprehensiveness
Learning outcomes: Explain the roles of incentives and regulatory arbitrage in the outcome of
the crisis. Apply the key lessons learned by risk managers to the scenarios provided.

Questions:

510.1. Agency costs is a term used to describe the costs in a situation where the interests of two
parties are not perfectly aligned. In the events leading up to the Global Financial Crisis (CFC;
aka, credit crisis), which of the following was a source of agency cost?

a. Home appraisers seeking loan-to-value ratios

b. Rating agencies paid by issuers
c. Annual (end-of-year) bonuses
d. All of the above

510.2. According to Hull , many factors contributed to the crisis that started in 2007. One of the
problems was so-called regulatory arbitrage. Which of the following enabled regulatory
arbitrage?

a. Capital requirements were different for the banking book than for the trading book
b. BBB-rated corporate bonds had different credit quality characteristics than BBB-rated
tranches of asset-backed securities (ABS)
c. Mortgage loan servicing regulations differed by state
d. An employee's annual bonus was legally due to the employee even if the financial institution's
investment in ABS CDO instruments failed over the long run

510.3. The Global Financial Crisis was clearly multivariate in cause and effect. Consequently,
there are many lessons to draw from the crisis. According to Hull, each of the following is a
lesson except which is inaccurate?

a. Correlations always increase in stressed markets

b. Recovery rates decline with default rates increase
c. Investors should not rely on ratings
d. Traders should be paid salaries but not bonuses
Learning outcomes: Evaluate some advantages and disadvantages of hedging risk exposures.
Explain how a company can determine whether to hedge specific risk factors, including the
role of the board of directors and the process of mapping risks. Apply appropriate methods to
hedge operational and financial risks, including pricing, foreign currency and interest rate
risk. Assess the impact of risk management instruments.

Questions:

503.1. You are the Chief Risk Officer (CRO) at a non-financial company and the board of
directors has asked you to make a recommendation with respect to hedging one of the firm's key
exposures. The board wants you to make a recommendation of either "in favor" or "against" the
implementation of a hedge against the exposure. Your staff prepared the following arguments,
three in favor and three against:

Three Arguments AGAINST hedging an exposure at a non-financial firm

1. Our investors own diversified portfolios such that in theory our firm's specific risks are
effectively costless to them
2. If markets are perfect, hedging is a theoretically a zero-sum game
3. Practical (non-theoretical) objections include that risk management requires specialized
skills; and can incur high compliance costs
Arguments IN FAVOR of hedging an exposure at a non-financial firm

1. Financial distress incurs a high fixed costs, which is a salient market imperfection
2. Risk management gives management better economic control over the firm's natural
economic performance
3. Hedging has the potential to reduce the firm's cost of capital, reduce its cash flow
volatility, and enhance its ability to grow
Which of these arguments is valid, or at least plausible?

a. None of the arguments are valid

b. Each set of arguments contains one mistake (or fallacy) and two valid arguments
c. Each set of arguments contains two mistakes (or fallacies) and one valid argument
d. All of the arguments are valid in both sets

503.2. Crouhy refers to the difference between hedging activities related to firm's operations and
hedging related to the balance sheet. When it comes to hedges, as risk-reducing positions, which
of the following best summarizes his advice to managers?

a. If markets are perfect and the capital asset pricing model (CAPM) assumptions are true, then
hedging and risk reduction are theoretically useless in all cases, including both operations and
financial positions
b. Even if markets are imperfect and CAPM assumptions are false, hedging and risk reduction in
theory cannot add value
c. Firms should risk-manage (e.g., hedge) their operations and, if markets are imperfect, maybe
should hedge their assets and liabilities (so long as they disclose their hedging policy)
d. Firms should always hedge their balance sheets, even if markets are perfect, but they probably
should not hedge their operations (and they should avoid disclosure in order to protect
confidential information that might be revealed by, for example, forward transactions).

503.3. In order to put risk management into practice, Crouhy outlines high-level steps in the
following order:

1. Risk appetite: Determine the firm's risk appetite which should include the firm's risk and
return objectives
2. Mapping: After the objectives have been set, map the relevant risks and estimate their
current and future magnitudes
3. Instrument selection: After mapping the risks, identify instruments that can be used to
risk-manage the exposures (Some of the instruments can be devised internally; i.e.,
natural hedges)
4. Strategy: Construct and implement a strategy
5. Evaluation: Periodically evaluate the performance of the risk management system
Each of the following is a true statement about some aspect of this process EXCEPT which is
false?

a. When developing the firm's risk appetite, it is rarely feasible to define an objective in terms of
a single, simple formula; rather, the objective should be broken down into clear rules that can be
implemented in line with major policy choices such as risk constituents (e.g., shareholders or
debtors), time horizon, and accounting versus economic profits
b. When mapping the firm's risks, it is important to differentiate between risks that can be
insured against, risks that can be hedged, and risks that are noninsurable and nonhedgeable.
This classification is important because the next step is to look for instruments that might help
to minimize the risk exposure of the firm.
c. When implementing a strategy, because FAS 133 and IFRS 9 allow for hedge accounting for
any derivative instrument regardless of the economic relationship between the derivative and
the hedged item, firm's should prefer mark-to-mark (MtM) derivatives over-the-counter (OTC)
derivatives
d. When implementing a strategy, a key tactical decision is whether to employ static or dynamic
hedges. A static strategy is relatively easy to implement and monitor. Dynamic strategies involve
an ongoing series of trades that are used to calibrate the combined exposure and the derivative
position; this dynamic strategy calls for much greater managerial effort in implementing and
monitoring the positions, and may incur higher transaction costs.

Learning outcomes: Analyze various factors that contributed to the Credit Crisis of 2007 and
examine the relationships between these factors. Describe the mechanics of asset-backed
securities (ABS) and ABS collateralized debt obligations (ABS CDOs) and explain their role in
the 2007 credit crisis.

Questions:

509.1. It is a consensus that not one but several factors contributed to the Credit Crisis of 2007.
According to John Hull, each of the following is a key contributing factor EXCEPT which does
he not cite as a key factor?

a. There was a relaxation of the criteria used for mortgage lending; in many cases, mortgage
originators used lax lending standards
b. The widespread reliance on market value-at-risk (MVaR) as the key risk metric at major
banks enabled a chain of downgrades and promulgated a procyclical contagion
c. Rating agencies moved from their traditional business of rating bonds (where they had a great
deal of experience) to rating structured products (which were relatively new and for which there
were relatively little historical data)
d. Products were developed to enable mortgage originators to profitably transfer credit risk to
investors, but the products bought by investors were complex and in many instances investors
and rating agencies had inaccurate or incomplete information about the quality of the
underlying assets

509.2. Hull writes "A natural starting point for a discussion of the credit crisis of 2007 is the
U.S. housing market. [The chart below] shows the S&P/Case-Shiller composite-10 index for
house prices in the United States between January 1987 and July 2011. This tracks house prices
for ten major metropolitan areas in the United States. In about the year 2000, house prices
started to rise much faster than they had in the previous decade. The very low level of interest
rates between 2002 and 2005 was an important contributory factor, but the bubble in house
prices was largely fueled by mortgage lending practices."
An economic bubble has both a boom and a bust. According to Hull, each of the following is true
about the US home price bubble EXCEPT which is not?

a. Since the 1990s, the U.S. government had been promoting home ownership. Some concerned
state legislators did want to curtail perceived, predatory lending practices, but the courts
decided that national standards should prevail (contributing to price boom)
b. Adjustable rate mortgages (ARMs) with low teaser rates increased in popularity, but some
borrowers with teaser rates found that they could no longer afford their mortgages when the
teaser rates ended. This led to foreclosures and an increase in the supply of houses for sale
(contributing to boom and exacerbating bust)
c. Because in the US mortgage loans are full recourse, while most mortgage loans outside the US
are non-recourse, lenders effectively held an American-style put option which they often
exercised, even as borrows would have preferred to keep their homes. The practice put upward
pressure on house prices (contributing to price boom)
d. As foreclosures increased, the losses on mortgages also increased. Losses were high because
houses in foreclosure were often surrounded by other houses that were also for sale. They were
sometimes in poor condition. In addition, banks faced legal and other fees. In normal market
conditions, a lender can expect to recover 75% of the amount owing in a foreclosure. In 2008
and 2009, recovery rates as low as 25% were experienced in some areas (exacerbating price
bust)

509.3. About collateralized debt obligations (aka, ABS CDO as CDOs are a type of asset-backed
security) Hull writes, "Finding investors to buy the senior AAA-rated tranches created from
subprime mortgages was not difficult. Equity tranches were typically retained by the originator
of the mortgages or sold to a hedge fund. Finding investors for the mezzanine tranches was more
difficult." Which of the following statements is TRUE about asset-backed securities (ABS)
and/or ABS collateralized debt obligations (ABS CDOs)?
a. As default correlation decreases, the senior tranche of an ABS becomes more risky because it
is more likely to suffer losses
b. Compared to a bond with a BBB rating, the mezzanine tranche of a CDO with a BBB rating
has an identical, or at least highly similar, probability distribution
c. The senior tranche of the ABS CDO was rated AAA and, at the time of the crises, AAA-rated
tranches were much thicker--e.g., often 90% or more of the principal of the underlying mortgage
portfolios--than the mezzanine and equity tranches
d. In the ABS CDO, a "waterfall" occurs when investors became reluctant to take any credit risk
and instead prefer to buy Treasury instruments and similarly safe investments. This "cascades"
into a sharp widening of credit spreads (i.e., the extra return required for taking credit risks)

Learning outcomes: Describe current best practices for the implementation and
communication of RAFs. Explain the relationship between the RAF and the strategic and
capital planning processes. Assess the role of stress testing within an RAF as well as
challenges in firm-wide risk aggregation.

Questions:

508.1. What is a risk posture?

a. A set of measurable indicators of compliance with risk management norms that can form a
robust basis for promotion and remuneration
b. An public statement for external stakeholders (e.g., shareholders) that translates the risk
appetite framework into non-technical language
c. A qualitative expression of whether the business unit intends to take more, less, or
approximately the same amount of risk over the next planning period
d. The consensus orientation the firm takes with respect to its regulatory supervisor; for
example, will the firm be highly cooperative or will it only meet legal requirements

508.2. The Institute of International Finance says about firm-wide risk aggregation, "One of the
significant challenges that firms will eventually face as they proceed along the risk appetite
journey is the issue of risk appetite aggregationthat being, once individual businesses have set
their own risk appetite boundaries, how does an organization decide whether, in aggregate,
these boundaries fit within the fims overall risk appetite? or, conversely, if key quantitative
aspects of the groups overall risk appetite have been determined, how can the risk appetite of
individual businesses be set in such a way as to ensure alignment with the overall risk appetite
in aggregate?" Which of the following statements is true about firm-wide risk aggregation?

a. Aggregation is a mature art and science with converging practices and relatively uniform
regulatory role models
b. Aggregation of risk appetite should be done on both a normal course and stressed basis
c. Only quantifiable risks should be included in the aggregation process in order to ensure an
objective outcome
d. The advantages of economic capital measures for aggregation include: easily linked to specific
macroeconomic scenarios; naturally captures the liquidity dimension of risk; and is highly
intuitive such that senior managers immediately engage with it

508.3. According to the Institute of international Finance, each of the following is a

responsibility of either senior management or risk management EXCEPT which is inaccurate?

a. Senior management must set the tone and lead the discussion regarding risk appetite
b. Risk management staff must take ownership, and drive the development, of line-of-business
risk appetites and profiles because these are primarily a means of setting limits and constraining
business
c. Risk management must provide clarity of concept and definition and support in
understanding the implications of the risk appetite statements and metrics as they develop
d. Risk management must provide the appropriate infrastructure and controls to support the
ongoing maintenance of the RAF
Learning outcomes: Relate the use of risk appetite frameworks (RAF) to the management of
risk in a firm. Define risk culture and assess the relationship between a firms risk appetite and
its risk culture. Describe and evaluate key challenges to the implementation of RAFs.

Questions:

507.1. Which is the best definition of a firm's risk appetite?

a. The existing levels of risk being run by a firm

b. The maximum amount of risk a firm is technically able to assume given its capital base
c. The amount and type of risk that a company is able and willing to accept in pursuit of its
business objectives
d. The norms and traditions of behavior of individuals and of groups within an organization that
determine the way in which they identify, understand, discuss, and act on the risks the
organization confronts and the risks it takes

507.2. Which of the following is true about the firm's risk appetite framework (RAF)?

a. A risk appetite framework (RAF), if supported by a strong risk culture, should be able to
substitute for systems, controls and limits
b. The risk appetite framework should be developed in a top-down style, at the board, and
should produce a discrete set of mechanisms
c. Aspirational statements relating to zero tolerance of certain types of risk are essential as
mosts risks can be completely avoided
d. The risk appetite framework is an iterative learn-by-doing process which requires significant
time and resources and yields a diversity of of approaches among firms

507.3. If we want to evaluate a firm in order to determine whether they have a robust risk
appetite framework (RAF) and whether the firm has a strong risk culture, according to the
Institute of International Finance, which of the following is LEAST indicative or LEAST relevant
to the evaluation?
a. Simple and uniform set of indicators which can be monitored on a single screen (dashboard
view)
b. Inextricable link to strategy development and business plans
c. Clarity of ownership and responsibility of risk
d. Regular dialog (communication) about risk appetite and evolving risk profiles
Learning outcomes: Describe enterprise risk management (ERM) and compare and contrast
differing definitions of ERM. Compare the benefits and costs of ERM and describe the
motivations for a firm to adopt an ERM initiative. Describe the role and responsibilities of a
chief risk officer (CRO) and assess how the CRO should interact with other senior
management. Distinguish between components of an ERM program.

Questions:

506.1. James Lam considers different, valid definitions for enterprise risk management (ERM)
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and the
International Organization of Standardization (ISO) but settles on his own definition: "Risk is a
variable that can cause deviation from an expected outcome. ERM is a comprehensive and
integrated framework for managing key risks in order to achieve business
objectives, minimize unexpected earnings volatility, and maximize firm value."
He claims that ERM offer the potential to confer three major benefits: increased organizational
effectiveness , better risk reporting, and improved business performance. However, to achieve
successful ERM is not easy.

According to Lam, there are requirements, or prerequisites, to the achievement of successful

ERM. Each of the following is a prerequisite to successful ERM EXCEPT which is not?

a. The integration of internal and external communications (including investor and public
relations) that support a successful ERM launch date; the timing of the switch to ERM should be
coordinated on a specific date as this avoids a long project with overruns and encourages
accountability
b. The integration of risk transfer strategies which takes a portfolio view of all types of risk
within a company and rationalizes the use of derivatives, insurance, and alternative risk transfer
products to hedge only the residual risk deemed undesirable by management.
c. An integrated risk organization which probably implies a centralized risk management unit
(RMU) reporting to the Chief Executive Officer (CEO) and a Chief Risk Officer (CRO) who is
responsible for overseeing all aspects of risk within the organization
d. The integration of risk management into the business processes of a company which enables a
shift from defensive or control-oriented approaches to managing downside risk (or earnings
volatility) in favor of risk as "an offensive weapon for management"

506.2. The role of Chief Risk Officer (CRO) is clearly gaining in prominence. According to James
Lam, the CRO is responsible for:

Providing the overall leadership, vision, and direction for enterprise risk management;
Establishing an integrated risk management framework for all aspects of risks across the
organization;
Developing risk management policies, including the quantification of the firm's risk
appetite through specific risk limits;
 Implementing a set of risk indicators and reports, including losses and incidents, key risk
exposures, and early warning indicators;
Allocating economic capital to business activities based on risk, and optimizing the
company's risk portfolio through business activities and risk transfer strategies;
Communicating the company's risk profile to key stakeholders such as the board of
directors, regulators, stock analysts, rating agencies, and business partners; and
Developing the analytical, systems, and data management
Given these responsibilities, Lam says an ideal CRO would have superb skills in five areas
("While it is unlikely that any single individual would possess all of these skills, it is important
that these competencies exist either in the CRO or elsewhere within his or her organization.").
Those five skills are:

Leadership skills to hire and retain talented risk professionals and establish the overall
vision for ERM
Evangelical skills to convert skeptics into believers, particularly when it comes to
overcoming natural resistance from the business units.
Stewardship to safeguard the company's financial and reputational assets
Technical skills in big data analytics which requires some background in programming
code preferably with R and/or python
Consulting skills in educating the board and senior management, as well as helping
business units implement risk management at the enterprise level
However, which of the above skills is inaccurately specified (defined)?

a. Leadership
b. Evangelical
c. Stewardship
d. Technical

506.3. According to James Lam, a successful enterprise risk management (ERM) program can
be broken down into seven key components:
In particular, he says it is important that "expected losses and the cost of risk capital should be
included in the pricing of a product or the required return of an investment project. In business
development, risk acceptance criteria should be established to ensure that risk management
issues are considered in new product and market opportunities. Transaction and business
review processes should be developed to ensure the appropriate due diligence. Efficient and
transparent review processes will allow managers to develop a better understanding of those
risks that they can accept independently and those that require corporate approval or
management." To which component does this key activity--i.e., pricing of risk at its inception--
primarily refer?

a. Corporate Governance
b. Line Management
c. Portfolio Management
d. Risk Transfer

Learning outcomes: Distinguish the different mechanisms for transmitting risk

governance throughout an organization. Illustrate the interdependence of functional units
within a firm as it relates to risk management. Assess the role and responsibilities of a firms
audit committee.

Questions:

505.1. A key but new (recent) mechanism for risk governance is the risk advisory director.
Which of the following best summarizes the function of a risk advisor director?

a. To ensure the accuracy of the banks financial and regulatory reporting, and the bank's
compliance with minimum or best-practice standards in other key activities; e.g., regulatory,
legal, compliance, and risk management activities
b. To improve the overall efficiency and effectiveness of the senior risk committees and the audit
committee, as well as the independence and quality of risk oversight by the main board
c. To be responsible for independently reviewing the identification, measurement, monitoring,
and controlling of credit, market, and liquidity risks, including the adequacy of policy guidelines
and systems
d. To design and implement the incentive pay and compensation schemes for executives and
staff

505.2. Each of the following is true about the re-empowered role of the Chief Risk Officer (CRO)
EXCEPT which is false?

a. The CRO should report to line business management, but should be independent of both the
CEO and the board's risk committee
b. The CRO must evaluate all new financial products to verify that the expected return is
consistent with the risks undertaken
c. CROs should not just be after-the-fact risk managers but also risk strategists
d. The CRO they should play a significant role in determining the risks that the bank assumes as
well as helping to manage those risks.

505.3. Crouhy writes, "To achieve best-practice corporate governance, a corporation must be
able to tie its board-approved risk appetite and risk tolerances to particular business strategies.
This means, in turn, that an appropriate set of limits and authorities must be developed for each
portfolio of business and for each type of risk (within each portfolio of business), as well as for
the entire portfolio." According to Crouhy, which of the following statements is true about limits
and limit standard policies?

a. Limits are effective for market risk but they cannot be applied to credit risk
b. Limits should be calibrated such that in the normal markets exposures average about 100% of
the limit
c. Two different types of limits--e.g., Type A (Tier 1) and Type B (Tier 2)--should be avoided
because this encourages "cherry picking" the more accommodating limit
d. Limits should be expressed in normal markets (e.g., VaR) but they should also be expressed in
worst-case scenarios, probably by scenario analysis and/or stress testing
Learning outcomes: Compare and contrast best practices in corporate governance with those
of risk management. Assess the role and responsibilities of the board of directors in risk
governance. Evaluate the relationship between a firms risk appetite and its business strategy.

Questions:

504.1. According to Crouhy , "Following a series of failures and near-failures of large financial
institutions between 2007 and 2009, boards professed ignorance of the risks that had been
assumed in the pursuit of profit--and sometimes senior management offered the same excuse.
In particular, the risk management function at many firms failed to attract the attention of
senior management, or the boards, to the risk accumulated in structured financial products. One
reason may have been a process of marginalization of the role of risk management in financial
institutions during the boom years in the run-up to the crisis." Following the crisis, a debate
therefore ensued about the role of corporate governance. About the key areas of debate, which of
the following is the LEAST plausible?

a. Because banks have a uniquely complicated set of stakeholders, the usual solution of
empowering shareholders (equity owners) may not be the complete governance solution
b. As the boards at all of the large failures during the crises lacked both banking expertise and
expert insiders, there is a an obvious and high correlation between board composition (i.e.,
independence, banking expertise) and bank failure
c. Regulators have pushed banks to set out a formal board-approved risk appetite. This risk
appetite can be translated into an enterprise-wise set of risk limits, but definition and
translation of "risk appetite" remains a work-in-progress
d. One of the key levers of the board in determining bank behavior on risk is control over
compensation schemes. Some banks have begun to institute reforms such as making bonuses a
smaller part of the compensation page, including bonus clawbacks and deferred payments to
capture longer-term risks.

504.2. Crouhy writes, "The board may be challenged by the complexity of the risk management
process, but the principles at a strategic level are quite simple. There are only four basic choices
in risk management." Each of the following of one of his four basic choices EXCEPT which is
not?

a. Avoid risk by choosing not to undertake some activities.

b. Transfer risk to third parties through insurance, hedging, and outsourcing.
c. Mitigate (reduce) risk; e.g., mitigate operational risk through preventive and detective control
measures.
d. Reclassify (redefine) risk; e.g., exclude liquidity risk from the definition of financial risk,
prioritize accounting performance

504.3. Among the choices, which question probably serves as the best gauge of whether a
company takes its risk process seriously?

a. What is the quality and quantity of slogans published because communication is the key?
b. Does the board have a separate Audit committee and is the Audit chairperson a Certified
FRM?
c. How is human capital employed; e.g., career paths for risk managers, reporting structure,
compensation?
d. Does the board undertake risk management on a day-to-day basis?
Learning Objectives: Explain the concept of risk and compare risk management with risk
taking. Describe the risk management process and identify problems and challenges which
can arise in the risk management process. Evaluate and apply tools and procedures used to
measure and manage risk, including quantitative measures, qualitative assessment, and
enterprise risk management.

Questions:
501.1. You are having lunch with a client who suddenly asks you, "I noticed that you studied risk.
To me, risk is when bad stuff can happen. Can you tell me, what is your definition of risk?" As far
as the financial risk manager (FRM) is concerned--at least among the following potential
responses to your client's question--which of the following definitions of risk is best?

a. Risk is the source or cause of a financial loss or cost

b. Risk is a condition that increases the probability of a loss
c. Risk is the size of a loss or cost: if a cost is greater, then its risk is greater
d. Risk is the variability of adverse outcomes that are unexpected

501.2. According to Crouhy, Galia and Mark, which of the following is TRUE about the 2007 to
2009 global financial crisis (GFC) and its implication on risk management?

a. Soft factors--e.g., corporate governance structures and risk cultures--did NOT cause the GFC;
instead, the GFC was effectively caused by hard factors and, in particular, technical deficiencies
in risk measurement
b. Since the GFC, risk managers have--to at least some degree--shifted away from historical-
statistical treatments of risk and toward scenario analysis and stress testing
c. Contrary to the popular mainstream narrative, financial engineering and derivatives helped
mitigate losses during the GFC due to their innate ability to disperse risk; for example, "without
credit derivatives, financial risk would have been far more concentrated and the consequences of
the crisis would have almost certainly been worse."
d. Although risk management was narrowly responsible for minor failures leading up to (and
during) the GFC, these failures were small exceptions to the general rule that risk management
has consistently and successfully prevented market disruptions and accounting scandals for over
three decades

501.3. According to Crouhy et al, each of the following statements about the numerical
measurement of risk is true EXCEPT which is false?

a. Merely judgmental rankings of risk (e.g., Risk Rating 3 versus Risk Rating 2) can help us
make more rational in-class comparative decisions
b. If we can put an absolute cost or price on a risk, then we can make rational economic
decisions about risks; at this point, risk management decisions become fungible with other
management decisions
c. The best numerical measure of risk during abnormal markets, over longer periods, or for
illiquid portfolios is value at risk (VaR)
d. All risk measures depend on a robust control environment; for example, in many rogue-
trading case studies (debacles) traders found some way of circumventing trading controls and
suppressing risk measures
AIM: Calculate the mean and variance of sums of random variables.

Questions:

202.1. A high growth stock has a daily return volatility of 1.60%. The returns are positively
autocorrelated such that the correlation between consecutive daily returns is +0.30. What is the
two-day volatility of the stock?
a. 1.800%
b. 2.263%
c. 2.580%
d. 3.200%

202.2. A three-bond portfolio contains three par $100 junk bonds with respective default
probabilities of 4%, 8% and 12%. Each bond either defaults or repays in full (three Bernoulli
variables). The bonds are independent; their default correlation is zero. What is, respectively,
the mean value of the three-bond portfolio and the standard deviation of the portfolio's value?
a. mean $276.00 and StdDev $46.65
b. mean $276.00 and StdDev $139.94
c. mean $276.00 and StdDev $2,176.45
d. mean $313.00 and StdDev $94.25

202.3. Assume two random variables X and Y. The variance of Y = 49 and the correlation
between X and Y is 0.50. If the variance[2X - 4Y] = 652, which is a solution for the standard
deviation of X?
a. 2.0
b. 3.0
c. 6.0
d. 9.0

202.4 A risky bond has a (Bernoulli) probability of default (PD) of 7.0% with loss given default
(LGD) of 60.0%. The LGD has a standard deviation of 40.0%. The correlation between LGD and
PD is 0.50. What is the bond's expected loss, E[L] = E[PD * LGD]?
a. 3.1%
b. 4.2%
c. 7.5%
d. 9.3%

202.5. Portfolio (P) is equally-weighted in two positions: a 50% position in StableCo (S) plus a
50% position in GrowthCo (G). Volatility of (S) is 9.0% and volatility of (G) is 19.0%. Correlation
between (S) and (G) is 0.20. The beta of GrowthCo (G) with respect to the portfolio--denoted
Beta (G, P)--is given by the covariance(G,P)/variance(P) where P = 0.5*G + 0.5*S. What is
beta(G, P)?
a. 0.45
b. 0.88
c. 1.39
d. 1.55

202.6. Two extremely risky bonds have unconditional probabilities of default (Bernoulli PDs) of
10% and 20%. Their default correlation is 0.35. What is the probability that both bonds default?
a. 2.0%
b. 4.6%
c. 6.2%
d. 9.7%
AIMs: Define and calculate a conditional probability, and distinguish between conditional and
unconditional probabilities. Describe Bayes Theorem and apply this theorem in the
calculation of conditional probabilities.

Questions:

302.1. There is a prior (unconditional) probability of 20.0% that the Fed will initiate
Quantitative Easing 4 (QE 4). If the Fed announces QE 4, then Macro Hedge Fund will
outperform the market with a 70% probability. If the Fed does not announce QE 4, there is only
a 40% probability that Macro will outperform (and a 60% that Acme will under-perform; like
the Fed's announcement, there are only two outcomes). If we observe that Macro outperforms
the market, which is nearest to the posterior probability that the Fed announced QE 4?

a. 20.0%
b. 27.9%
c. 30.4%
d. 41.6%

302.2. The following probability matrix displays the joint probabilities with respect to two
bonds, an investment grade bond and a speculative (junk) bond:

For example, the joint probability that both bonds default is 0.060%; the joint probability that
both survive is 96.030%. Consider two posterior probabilities:

I. If we have already observed that the junk bond has defaulted, what is the (posterior)
probability that the investment-grade bond defaulted; i.e., Prob [i default | j default]
II. If we have already observed that the investment-grade bond has defaulted, what is the
(posterior) probability that the junk bond defaulted; i.e., Prob [j default | i default]

What are these probabilities, respectively?

a. Prob[i default | j default] = 0.06% and Prob[j default | i default] = 2.79%

b. Prob[i default | j default] = 1.98% and Prob[j default | i default] = 6.00%
c. Prob[i default | j default] = 3.27% and Prob[j default | i default] = 4.25%
d. Can't answer, we need unconditional (marginal) probabilities

302.3. Next year the economy will experience one of three states: a downturn, stable state, or
growth. The following probability matrix displays joint probabilities of a bond default and the
economic state:
For example, the joint probability that the economy is stable and the bond defaults is 1.0%; the
unconditional probability that the economy will be stable is 50.0% = 49.0% + 1.0%. If we
observe that the bond has defaulted, what is the (posterior) probability that the economy
experienced a downturn?

a. 0.60%
b. 19.40%
c. 26.33%
d. 31.58%
AIM: Perform and interpret hypothesis tests for the difference between two means.

Questions:

212.1. We want to decide whether the average arithmetic return of Fund A is better than the
average return of Fund B: the null hypothesis is that the true average difference is zero. For both
fund, our sample is 60 months. Over this sample, the average return of Fund A was 2.0% with a
standard deviation of 3.0%; the average return of Fund B was only 1.0% with standard deviation
of 2.0%. With 95% confidence, do we reject the null hypothesis (i.e., fail to accept) and decide
that the average return of Fund A was truly better?

a. No, the t-statistic is only 0.465

b. No, the t-statistic is only 1.465
c. Yes, the t-statistic is 2.148
d. Yes, the t-statistic is 5.359

212.2. The average hourly earnings among a sample of 1,500 men is $22.00 with a sample
standard deviation of $9.00. The average hourly earnings among a sample of 1,000 women is
$20.00 with a sample standard deviation of $6.00. What is the 95% confidence interval for the
(two-sided) difference in average earnings between men and women?

a. $0.04 to $3.96
b. $1.41 to $2.59
c. $1.70 to $2.30
d. $1.83 to $2.17

212.3. A credit rating agency wants to compare the difference in default rates between structured
notes in two speculative rating categories: SF B versus SF CCC. The default rate among a sample
of 1,800 SF B-rated obligors was 5.0%, compared to the default rate among a sample of 1,000 SF
CCC-rated obligors was 8.0%. Default is characterized by a Bernoulli random variable. What is
the 95% confidence interval for the difference in default rates?
a. 2.97% to 3.04%
b. 2.11% to 3.89%
c. 1.75% to 4.25%
d. 1.04% to 4.96%
Questions:

415.1. A bond with a 1.5 year maturity has a coupon rate of 12.0% and pays the coupon semi-
annually. The spot rate curve is very steep: 1.0% at 0.5 years, 2.0% at 1.0 years and 3.0% at 1.5
years. Because the spot rates are per annum with continuous compounding, the bond's price is
$6.00*exp(-0.01*0.5) + $6.00*exp(-0.02*1.0) + $106*exp(-0.04*1.5) = $113.19. Under a
scenario assumption of realized forwards--i.e., "[realized forwards] is to assume that forward
rates equal expectations of future rates and that, as time passes, these forward rates are
realized" says Tuckman--which is nearest to the bond price in six months?

a. $99.97
b. $107.75
c. $112.25
d. $118.00

415.2. A bond with a 1.5 year maturity has a coupon rate of 4.0% and the coupon pays semi-
annually. The forward rate curve is very steep and high: 2.0% at six months, 4.0% at 1.0 years
and 7.0% at 1.5 years, all rates per annum with semi-annual compounding. The bond price is
therefore $99.5833 with a yield (yield-to-maturity) of 4.290%. Under a scenario assumption of
an unchanged term structure (in contrast to "realized forwards"), which is nearest to the
expected yield (YTM) of the bond six months in the future?

a. 2.99%
b. 4.00%
c. 4.29%
d. 7.00%

415.3. Consider a bond with a maturity of (T) years when the spot rate curve is upward-sloping.
In six months, when the bond's maturity is (T-0.5 years) which of the following is necessarily
TRUE about the bond's price?
a. Its expected price (in six months) will be lower than the current price
b. Its expected price (in six months) will be higher than the current price
c. Its expected price will be lower under an unchanged term structure scenario than under a
realized forward scenario
d. Its expected price will be lower under a realized forward scenario than under an unchanged
term structure scenario