PRMIA Operational Risk Manager (ORM) 8010 Exam Questions

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 : D

All the listed variables are relevant to management monitoring the credit risk profile of an institution, therefore Choice 'd' is the correct answer.

Answer : B

According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves.

Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt.

Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority.

Answer : C

The probabilities of default of the two bonds are independent (as indicated by a zero default correlation). The various possible states of the portfolio are as follows:

First bond defaults, and the second does not: Probability * Loss = 0.03*0.92 * $50m = $1.38m

Second bond defaults, and the first does not: Probability * Loss = 0.97*0.08 * $50m = $3.88m

Both bonds default: Probability * Loss = 0.03*0.08 * $100m = $0.24m

Thus total expected loss on this portfolio = $5.5m. Since recovery rates are not provided, those should be assumed to be zero.

There is an easier way to solve this as well: default correlation does not affect expected losses, but their volatility. You can calculate the expected losses of the two bonds and add them up, ie, $50m*0.03 + $50m *0.08 = $5.5m

Answer : A

The binomial, Poisson and the negative binomial distributions can all be used to model the loss event frequency distribution. The omega distribution is not used for this purpose, therefore Choice 'a' is the correct answer.

Also note that the negative binomial distribution provides the best model fit because it has more parameters than the binomial or the Poisson. However, in practice the Poisson distribution is most often used due to reasons of practicality and the fact that the key model risk in such situations does not arise from the choice of an incorrect underlying distribution.

Answer : D

Statement I is true - capital adequacy indeed is a reference to the ability of the firm to stay a 'going concern'. (Going concern is an accounting term that means the ability of the firm to continue in business without the stress of liquidation.)

Statement II is not true because even though the stated objective of regulatory capital requirements is similar to the purposes for which economic capital is calculated, regulatory capital calculations are based upon a large number of ad-hoc estimates and parameters that are 'hard-coded' into regulation, while economic capital is generally calculated for internal purposes and uses an institution's own estimates and models. They are rarely identical.

Statement II is not true as the purpose of economic capital is to provide a buffer against unexpected losses. Expected losses are covered by the P&L (or credit reserves), and not capital.

Statement IV is incorrect as even though economic capital may be calculated at very high confidence levels, that is never 100% which would require running a 'risk-free' business, which would mean there are no profits either. The level of confidence is set at a level which is an acceptable balance between the interests of the equity providers and the debt holders.

Answer : B

The bank will not be able to recover the principal advanced on this loan if both the home buyer defaults, and the house value falls to less than $1m, ie the price moves adversely by more than $500k, which is $-500k/$150k = -3.33. (Note that 150k is the 1 year volatility in dollars, ie $1.5m * 10%).

The probability of both these things happening together is just the product of the two probabilities, one of which we know to be 5%. The other is also certainly a small number, and intuitively it is clear that the probability of both the things happening together will be less than 1%.

For a more precise answer, we can calculate the probability of the house price falling by 3.33 standard deviations by calculating the area under the standard normal curve to the left of -3.33. This indeed is a very small number (actually equal to NORMSINV(-3.33)=0.00043), which when multiplied by the probability of default of the home buyer at 5% is certainly going to be less than 1%. Therefore Choice 'b' is the correct answer.