PRMIA 8010 Exam Questions Instant Access - No Installation Required

Question 1

The key difference between 'top down models' and 'bottom up models' for operational risk assessment is:

ATop down approaches to operational risk are based upon an analysis of key risk drivers, while bottom up approaches consider causality in risk scenarios.

BBottom up approaches to operational risk are based upon an analysis of key risk drivers, while top down approaches consider causality in risk scenarios.

CBottom up approaches to operational risk calculate the implied operational risk using available data such as income volatility, capital etc; while top down approaches use causal factors, risk drivers and other factors to get an aggregated estimate of risk.

DTop down approaches to operational risk calculate the implied operational risk using available data such as income volatility, capital etc; while bottom up approaches use causal factors, risk drivers and other factors to get an aggregated estimate of risk.

Answer : D

Top down approaches rely upon available data such as total capital, income volatility, peer group information etc and attempt to imply the capital attributable to operational risk. They do not consider firm specific scenarios or causal factors. Bottom up approaches on the other hand attempt to determine operational risk capital based upon an identification and quantification of firm specific risks. Bottom up approaches help determine a traditional loss distribution from which capital requirements can be determined at a given level of confidence.

Therefore Choice 'd' is the correct answer.

Question 2

The Options Theoretic approach to calculating economic capital considers the value of capital as being equivalent to a call option with a strike price equal to:

AThe notional value of the debt

BThe market value of the debt

CThe value of the firm

DThe value of the assets

Answer : A

The Options Theoretic approach to calculating economic capital is a top-down approach that considers the value of capital as being equivalent to a call option with a strike price equal to the notional value of the debt - ie, the shareholders have a call option on the assets of the firm which they can acquire by paying the debt holders a value equal to their notional claim (ie the face value of the debt). Therefore Choice 'a' is the correct answer and the other choices are incorrect.

Question 3

What would be the consequences of a model of economic risk capital calculation that weighs all loans equally regardless of the credit rating of the counterparty?

1. Create an incentive to lend to the riskiest borrowers

2. Create an incentive to lend to the safest borrowers

3. Overstate economic capital requirements

4. Understate economic capital requirements

A3 only

B1 and 4

C2 and 3

D1 only

Answer : B

If capital calculations are done in a standard way regardless of risk (as reflected by credit ratings), then it creates a perverse incentive for the lenders' employees to lend to the riskiest borrowers that offer the highest expected returns as there is no incentive to 'save' on economic capital requirements that are equal for both safe and unsafe borrowers. Therefore statement I is correct.

Given that the portfolio of such an institution is likely to then comprise poor quality borrowers, and economic capital would be based upon 'average' expected ratings, it is likely to carry lower economic capital given its exposures. Therefore any such economic risk capital model is likely to understate economic capital requirements. Therefore statement IV is correct.

Statements II and III are incorrect and Choice 'b' is the correct answer.

Question 4

Changes in which of the following do not affect the expected default frequencies (EDF) under the KMV Moody's approach to credit risk?

AChanges in the debt level

BChanges in the risk free rate

CChanges in asset volatility

DChanges in the firm's market capitalization

Answer : B

EDFs are derived from the distance to default. The distance to default is the number of standard deviations that expected asset values are away from the default point, which itself is defined as short term debt plus half of the long term debt. Therefore debt levels affect the EDF. Similarly, asset values are estimated using equity prices. Therefore market capitalization affects EDF calculations. Asset volatilities are the standard deviation that form a place in the denominator in the distance to default calculations. Therefore asset volatility affects EDF too. The risk free rate is not directly factored in any of these calculations (except of course, one could argue that the level of interest rates may impact equity values or the discounted values of future cash flows, but that is a second order effect). Therefore Choice 'b' is the correct answer.

Question 5

If the loss given default is denoted by L, and the recovery rate by R, then which of the following represents the relationship between loss given default and the recovery rate?

AL = 1 + R

BR = 1 + L

CR = 1 / L

DR = 1 - L

Answer : D

When a default occurs, the proportion of the exposure represented by the recovery rate is recovered. For example, if the recovery rate is 40% for a loan, the actual loss in the event of a default would be $60 for a $100 loan. In other words, the loss given default = 1 - recovery rate. Hence Choice 'd' is the correct answer. All other choices are incorrect.

Question 6

Which of the following statements is true:

1. Confidence levels for economic capital calculations are driven by desired credit ratings

2. Loss distributions for operational risk are affected more by the severity distribution than the frequency distribution

3. The Advanced Measurement Approach (AMA) referred to in the Basel II standard is a type of a Loss Distribution Approach (LDA)

4. The loss distribution for operational risk under the LDA (Loss Distribution Approach) is estimated by separately estimating the frequency and severity distributions.

A1 and 2

B1, 3 and 4

C1, 2 and 4

D4 and 4

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.

Question 7

A key problem with return on equity as a measure of comparative performance is:

Athat return on equity is not adjusted for risk

Bthat return on equity are not adjusted for cash flows being different from accounting earnings

Cthat return on equity measures do not account for interest and taxes

Dthat return on equity ignores the effect of leverage on returns to shareholders

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.

PRMIA Operational Risk Manager (ORM) 8010 Exam Questions