PRMIA Operational Risk Manager (ORM) 8010 Exam Practice Test

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Total 241 questions
Question 1

Company A issues bonds with a face value of $100m, sold at $98. Bank B holds $10m in face of these bonds acquired at a price of $70. Company A then defaults, and the recovery rate is expected to be 30%. What is Bank B's loss?



Answer : B

The bank paid $7m for the bonds, and expected recovery is $3m (30% x $10m face). Therefore Bank B's loss is $4m ($7m - $3m). Choice 'b' is the correct answer. All other answers are incorrect.


Question 2

When modeling severity of operational risk losses using extreme value theory (EVT), practitioners often use which of the following distributions to model loss severity:

1. The 'Peaks-over-threshold' (POT) model

2. Generalized Pareto distributions

3. Lognormal mixtures

4. Generalized hyperbolic distributions



Answer : D

The peaks-over-threshold model is used when losses over a given threshold are recorded, as is often the case when using data based on external public sources where only large loss events tend to find a place. The generalized Pareto distribution is also used when attempting to model loss severity using EVT. Lognormal mixtures and generalized hyperbolic distributions are not used as extreme value distributions.

Choice 'd' is the correct answer.


Question 3

If X represents a matrix with ratings transition probabilities for one year, the transition probabilities for 3 years are given by the matrix:



Answer : B

Assuming time invariance and the Markov property, it is easy to calculate the transition matrix for any time period as P^n, where P is the given transition matrix for one period and n the number of time periods that we need to compute the new transition matrix for. Thus Choice 'b' is the correct answer.


Question 4

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



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 5

Which of the following are a CRO's responsibilities:

1. Statutory financial reporting

2. Reporting to the audit committee

3. Compliance with risk regulatory standards

4. Operational risk



Answer : C

Statutory financial reporting is the responsibility of the Chief Financial Officer, not the Chief Risk Officer. The head of internal audit reports to the audit committee of the board, not the CRO. Therefore statements I and II are incorect.

The CRO is generally expected to drive risk and compliance with related regulatory standards. Market risk, credit risk and operational risk groups report into the CRO, so statements III and IV are correct.


Question 6

The standalone economic capital estimates for the three business units of a bank are $100, $200 and $150 respectively. What is the combined economic capital for the bank, assuming the risks of the three business units are perfectly correlated?



Answer : A

Since the business units are perfectly correlated, we can get the combined EC as equal to the sum of the individual EC estimates. Therefore Choice 'a' is the correct answer.


Question 7

For a corporate bond, which of the following statements is true:

1. The credit spread is equal to the default rate times the recovery rate

2. The spread widens when the ratings of the corporate experience an upgrade

3. Both recovery rates and probabilities of default are related to the business cycle and move in opposite directions to each other

4. Corporate bond spreads are affected by both the risk of default and the liquidity of the particular issue



Answer : B

The credit spread is equal to the default rate times the loss given default, or stated another way, default rate times (1 - recovery rate). It is not equal to the default rate times the recovery rate. Therefore statement I is not correct.

When ratings are upgraded by rating agencies, the spread contracts and not widen. Therefore statement II is not correct.

Both recovery rates and probabilities of default are related to the business cycle, and they move in opposite directions. Economic recessions witness an increase in the default rate and a decrease in the recovery rate, and economic expansions result in a decrease in the default rate and an increase in the recovery rates when default does happen. Therefore statement III is correct.

Bond spreads incorporate both the risk of default, but also considerations of liquidity in the case of corporate bonds. Hence statement IV is correct.


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Total 241 questions