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Question 1

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 2

Which of the following is true in relation to the application of Extreme Value Theory when applied to operational risk measurement?

1. EVT focuses on extreme losses that are generally not covered by standard distribution assumptions

2. EVT considers the distribution of losses in the tails

3. The Peaks-over-thresholds (POT) and the generalized Pareto distributions are used to model extreme value distributions

4. EVT is concerned with average losses beyond a given level of confidence

A1 and 4

B2 and 3

C1, 2 and 3

D1, 2 and 4

Answer : C

EVT, when used in the context of operational risk measurement, focuses on tail events and attempts to build a distribution of losses beyond what is covered by VaR. Statements I, II and II are correct. Statement IV describes conditional VaR (CVAR) and not EVT.

Choice 'c' is the correct answer.

Question 3

The sum of the stand alone economic capital of all the business units of a bank is:

Aless than the economic capital for the firm as a whole

Bmore than the economic capital for the firm as a whole

Cequal to the economic capital for the firm as a whole

Dunrelated to the economic capital for the firm as a whole

Answer : B

Economic capital is sub-additive, ie, because of the correlation being less than perfect between the risks of the different business units, the total economic capital for the firm will be less than the sum of the EC for the individual business units. Therefore Choice 'b' is the correct answer.

In practice, correlations are difficult to estimate reliably, and banks often use estimates and corroborate their capital calculations with reference to a number of data points.

Question 4

Loss provisioning is intended to cover:

AUnexpected losses

BLosses in excess of unexpected losses

CBoth expected and unexpected losses

DExpected losses

Answer : D

Loss provisioning is intended to cover expected losses. Economic capital is expected to cover unexpected losses. No capital or provisions are set aside for losses in excess of unexpected losses, which will ultimately be borne by equity.

Choice 'd' is the correct answer.

Question 5

Which of the following statements is true:

ABoth total expected losses and total unexpected losses are less than the sum of expected and unexpected losses on underlying exposures respectively

BTotal expected losses are equal to the sum of individual underlying exposures while total unexpected losses are greater than the sum of unexpected losses on underlying exposures

CTotal expected losses are equal to the sum of expected losses in the individual underlying exposures while total unexpected losses are less than the sum of unexpected losses on underlying exposures

DTotal expected losses are greater than the sum of individual underlying exposures while total unexpected losses are less than the sum of unexpected losses on underlying exposures

Answer : C

Total expected losses which are average and anticipated are equal to the sum of expected losses in the underlying exposures. Total unexpected losses, which are the excess of worst case losses at a certain confidence level over the expected losses, benefit from the diversification effect and are lower than the sum of unexpected losses of the underlying exposures. Therefore Choice 'c' is the correct answer. The other choices are incorrect.

Question 6

In respect of operational risk capital calculations, the Basel II accord recommends a confidence level and time horizon of:

A99.9% confidence level over a 10 day time horizon

B99% confidence level over a 10 year time horizon

C99% confidence level over a 1 year time horizon

D99.9% confidence level over a 1 year time horizon

Answer : D

Choice 'd' represents the Basel II requirement, all other choices are incorrect.

Question 7

A loan portfolio's full notional value is $100, and its value in a worst case scenario at the 99% level of confidence is $65. Expected losses on the portfolio are estimated at 10%. What is the level of economic capital required to cushion unexpected losses?

A25

B65

C10

D35

Answer : A

Expected value = $90 ($100 - 10%)

Value at 99% confidence level = $65

Therefore economic capital required at this level of confidence = $90 - $65 = $25.

Choice 'a' is the correct answer, the other choices are not.

(We can also look at it this way as explained in section III.B.6.2.2 of the handbook: Economic capital is designed to absorb unexpected losses, which are equal to total losses at a given confidence level minus expected losses. (Expected losses are to be covered by credit reserves). Total losses are $100-$65=$35, and expected losses are 10%*$100=$10, therefore economic capital should be $35-$10=$25.)

PRMIA Operational Risk Manager (ORM) 8010 Exam Questions