PRMIA Operational Risk Manager (ORM) 8010 Exam Questions

Answer : D

The key to pricing loans is to make sure that the prices cover expected losses. The correct measure of expected losses is the mean, and not the median. To the extent the median is different from the mean, the loans would be over or underpriced.

The loss curve for credit defaults is a distribution skewed to the right. Therefore its mode is less than its median which is less than its mean. Since the median is less than the mean, the bank is pricing in fewer losses than the mean, which means over the long run it is underestimating risk and underpricing its loans. Therefore Choice 'd' is the correct answer.

If on the other hand for some reason the bank were overpricing risk, its loans would be more expensive than its competitors and it would lose market share. In this case however, this does not apply. Loan pricing decisions are driven by the rate of defaults, and not the other way round, therefore any pricing decisions will not reduce the rate of default.

Answer : D

Banks using the basic indicator approach must hold 15% of the average annual gross income for the past three years, excluding any year that had a negative gross income. Therefore Choice 'd' is the correct answer.

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.

Answer : D

Units of Measure for operational risk are homogenous groupings of risks to allow sensible modeling decisions to be made. For example, some risks may be fat-tailed, for example the risk of regulatory fines. Other risks may have finite tails - for example damage to physical assets risk (DPA) may be limited to the value of the asset in the question.

Additionally, risk reporting may need to be done at the line of business, legal entity or regional basis, and in order to be able to do, so the right level of granularity needs to be captured in the risk modeling exercise. The level of granularity applied is called the 'unit of measurement' (UoM), and it is okay to adopt all of the choices listed above as the dimensions that describe the unit of measure.

Note that it is entirely possible, even likely, to use legal entity, risk type, region, business and other dimensions simultaneously, though doing so is likely to result in an extremely large number of UoM combinations. That can be addressed by then subsequently grouping the more granular UoMs into larger UoMs, which may ultimately be used for frequency and severity estimation.

Answer : C

Statement I is correct. Economic capital is the capital available to absorb unexpected losses, and credit ratings are also based upon a certain probability of default. Economic capital is often calculated at a level equal to the confidence required for the desired credit rating. For example, if the probability of default for a AA rating is 0.02%, then economic capital maintained at a 99.98% would allow for such a rating. Economic capital set at a 99.8% level can be thought of as the level of losses that would not be exceeded with a 99.8% probability.

Loss distributions are the product of the severity and frequency distributions, each of which are estimated separately. The total loss distribution is affected far more by the severity distribution than by the frequency distribution, therefore statement II is correct.

The Loss Distribution Approach (LDA) is one of the ways in which the requirements of the AMA can be satisfied, and not the other way round. Therefore statement III is incorrect.

Statement IV is correct as the total loss distribution is estimated using separate estimates of loss frequency and distributions.

Answer : A

The major problem with using return on equity as a measure of performance is that return on equity is not adjusted for risk. Therefore, a riskier investment will always come out ahead when compared to a less risky investment when using return on equity as a performance metric.

Return on equity does not ignore the effect of leverage (though return on assets does) because it considers the income attributable to equity, including income from leveraged investments.

Return on equity is generally measured after interest and taxes at the company wide level, though at business unit level it may use earnings before interest and taxes. However this does not create a problem so long as all performance being covered is calculated in the same way.

Cash flows being different from accounting earnings can create liquidity issues, but this does not affect the effectiveness of ROE as a measure of performance.

Answer : A

This is a tricky question in the sense no risk management professional can be expected to know the answer to this one unless they have read Chapter 2 of the PRMIA handbook. So this question appears purely for the sake of something you would need to know purely for the sake of the exam.

PRMIA's handbook classifies governance sructures as reactive, preventative and active. Reactive structures involve monitoring signals after the event leading to corrective actions. Preventative structures are forward looking and anticipate issues before they arise. Active structures include considerations of operational efficiency and not just governance. All other answers are made up phrases and are incorrect.

In reality, corporations employ all structures together without worrying about the boundary between the three, and these distinctions do not exist except in textbooks.