PRMIA 8010 Exam Practice Test Instant Access

Question 1

Which of the following describes rating transition matrices published by credit rating firms:

AExpected ex-ante frequencies of migration from one credit rating to another over a one year period

BProbabilities of default for each credit rating class

CProbabilities of ratings transition from one rating to another for a given set of issuers

DRealized frequencies of migration from one credit rating to another over a one year period

Answer : D

Transition matrices are used for building distributions of the value of credit portfolios, and are the realized frequencies of migration from one credit rating to another over a period, generally one year. Therefore Choice 'd' is the correct answer.

Since they represent an actually observed set of values, they are not probabilities nor are they forward looking ex-ante estimates, though they are often used as proxies for probabilities. Choice 'a' and Choice 'c' are not correct. They include more than information on just defaults, therefore Choice 'b' is not correct.

Question 2

For a back office function processing 15,000 transactions a day with an error rate of 10 basis points, what is the annual expected loss frequency (assume 250 days in a year)

A3750

B0.06

C37500

D375

Answer : A

An error rate of 10 basis points means the number of errors expected in a day will be 15 (recall that 100 basis points = 1%). Therefore the total number of errors expected in a year will be 15 x 250 = 3750. Choice 'a' is the correct answer.

Question 3

The definition of operational risk per Basel II includes which of the following:

1. Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events

2. Legal risk

3. Strategic risk

4. Reputational risk

A1, 2, 3 and 4

B2 and 3

C1 and 3

D1 and 2

Answer : D

Operational risk as defined in Basel II specifically excludes strategic and reputational risk. Therefore Choice 'd' is the correct answer.

Note that Basel II defines operational risk as follows:

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.

Question 4

A financial institution is considering shedding a business unit to reduce its economic capital requirements. Which of the following is an appropriate measure of the resulting reduction in capital requirements?

AIncremental capital for the business unit in consideration

BProportionate capital for the business unit in consideration

CPercentage of total gross income contributed by the business unit in question

DMarginal capital for the business unit in consideration

Answer : A

Incremental capital (or incremental VaR, depending upon the context), is a measure of the change in the capital (or VaR) requirements if a certain change is made to a portfolio. It uses the 'before' and 'after' approach, ie find out what the capital requirement or VaR will be without the change, and what it will be after the change. The difference is the incremental capital or incremental VaR. It helps measure the change in risk as a result of a particular action, eg a change in a position.

Marginal capital or VaR on the other hand is a method to break down the capital requirement or the VaR so that it can be assigned to individual positions within the portfolio. The total of marginal capital or marginal VaR for all the positions in a portfolio adds up to the total capital requirements or total VaR. Note that marginal VaR is also called component VaR.

Therefore incremental capital is the correct answer to this question. The other choices are incorrect. In the exam, the question may be phrased differently, so try to keep in mind the different between incremental and marginal capital, which can be a bit confusing given what these terms mean in plain English.

Question 5

An error by a third party service provider results in a loss to a client that the bank has to make up. Such as loss would be categorized per Basel II operational risk categories as:

AExecution delivery and process management

BOutsourcing loss

CBusiness disruption and process failure

DAbnormal loss

Answer : A

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

Question 6

For credit risk calculations, correlation between the asset values of two issuers is often proxied with:

ACredit migration matrices

BTransition probabilities

CEquity correlations

DDefault correlations

Answer : C

Asset returns are relevant for credit risk models where a default is related to the value of the assets of the firm falling below the default threshold. When assessing credit risk for portfolios with multiple credit assets, it becomes necessary to know the asset correlations of the different firms. Since this data is rarely available, it is very common to approximate asset correlations using equity prices. Equity correlations are used as proxies for asset correlation, therefore Choice 'c' is the correct answer.

Question 7

Loss from a lawsuit from an employee due to physical harm caused while at work is categorized per Basel II as:

AEmployment practices and workplace safety

BExecution delivery and process management

CUnsafe working environment

DDamage to physical assets

Answer : A

PRMIA 8010 Operational Risk Manager (ORM) Exam Practice Test