PRMIA 8010 Exam Practice Test Instant Access

Question 1

If two bonds with identical credit ratings, coupon and maturity but from different issuers trade at different spreads to treasury rates, which of the following is a possible

1. The bonds differ in liquidity

2. Events have happened that have changed investor perceptions but these are not yet reflected in the ratings

3. The bonds carry different market risk

4. The bonds differ in their convexity

A1, 2 and 4

B2 and 4

C1 and 2

D3 and 4

Answer : C

When two bonds that appear identical in every respect trade at different prices, the difference is often due to differences in liquidity between the two bonds (the less liquid bond will be cheaper and yield higher), and also due to the fact that ratings from the major rating agencies do not generally react to day to day changes in the market. The market's perception of the differences in the two credits will cause a divergence in the prices. This has been an extremely visible phenomenon during the credit crisis of 2007-2009, where fixed income security prices have changed sharply for many securities without any changes in external credit ratings.

Bonds carrying 'different market risk' is meaningless, and so is the difference in convexity (because the calculated convexity would be identical for similar bonds).

Therefore Choice 'c' is the correct answer.

Question 2

When compared to a high severity low frequency risk, the operational risk capital requirement for a low severity high frequency risk is likely to be:

AHigher

BZero

CLower

DUnaffected by differences in frequency or severity

Answer : C

High frequency and low severity risks, for example the risks of fraud losses for a credit card issuer, may have high expected losses, but low unexpected losses. In other words, we can generally expect these losses to stay within a small expected and known range. The capital requirement will be the worst case losses at a given confidence level less expected losses, and in such cases this can be expected to be low.

On the other hand, medium severity medium frequency risks, such as the risks of unexpected legal claims, 'fat-finger' trading errors, will have low expected losses but a high level of unexpected losses. Thus the capital requirement for such risks will be high.

It is also worthwhile mentioning high severity and low frequency risks - for example a rogue trader circumventing all controls and bringing the bank down, or a terrorist strike or natural disaster creating other losses - will probably have zero expected losses & high unexpected losses but only at very high levels of confidence. In other words, operational risk capital is unlikely to provide for such events and these would lie in the part of the tail that is not covered by most levels of confidence when calculating operational risk capital.

Note that risk capital is required for only unexpected losses as expected losses are to be borne by P&L reserves. Therefore the operational risk capital requirements for a low severity high frequency risk is likely to be low when compared to other risks that are lower frequency but higher severity.

Thus Choice 'c' is the correct answer.

Question 3

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 4

Conditional default probabilities modeled under CreditPortfolio view use a:

APower function

BAltman's z-score

CProbit function

DLogit function

Answer : D

Conditional default probabilities are modeled as a logit function under CreditPortfolio view. That ensures the resulting probabilities are 'well behaved', ie take a value between 0 and 1. The probability may be expressed as = 1/ (1 + exp(I)), where I is a country specific index taking various macro economic factors into account.

Question 5

Which of the following statements are true:

1. The set of UoMs used for frequency and severity modeling should be identical

2. UoMs can be grouped together into larger combined UoMs using judgment based on the knowledge of the business

3. UoMs can be grouped together into combined UoMs using statistical techniques

4. One may use separate sets of UoMs for frequency and severity modeling

A1, 2 and 3

B4 only

C2, 3 and 4

DAll of the above

Answer : C

One may use separate UoMs for frequency and severity modeling, for example, a combined UoM may be used for estimating the frequency of cyber attacks in a scenario, while the severity may be modeled using a more granular line-of-business UoM. Therefore statement I is false, while statement IV is true. Statement II is correct, UoMs can be grouped together into larger units based on the facts relating to the business, controls and the business environment. Similarly, UoMs can be grouped together based on statistical clustering techniques using the 'distance' between the units of measure and combining UoMs that are closer to each other. In addition, it is also possible to combine both business knowledge and statistical algorithms to combine UoMs.

Question 6

A risk management function is best organized as:

Aintegrated with the risk taking functions as risk management should be a pervasive activity carried out at all levels of the organization.

Breport independently of the risk taking functions

Creporting directly to the traders, as to be closest to the point at which risks are being taken

Da part of the trading desks and other risk taking teams

Answer : B

The point that this question is trying to emphasize is the independence of the risk management function. The risk function should be segregated from the risk taking functions as to maintain independence and objectivity.

Choice 'd', Choice 'c' and Choice 'a' run contrary to this requirement of independence, and are therefore not correct. The risk function should report directly to senior levels, for example directly to the audit committee, and not be a part of the risk taking functions.

Question 7

The loss severity distribution for operational risk loss events is generally modeled by which of the following distributions:

1. the lognormal distribution

2. The gamma density function

3. Generalized hyperbolic distributions

4. Lognormal mixtures

A2 and 3

B1, 2 and 3

C1, 2, 3 and 4

D1 and 3

Answer : C

All of the distributions referred to in the question can be used to model the loss severity distribution for op risk. Therefore Choice 'c' is the correct answer.

PRMIA Operational Risk Manager (ORM) 8010 Exam Practice Test