You are on page 1of 50

# 1. Consider a convertible bond that is trading at a conversion premium of 20 percent.

If the value of the underlying stock rises by 25 percent, the value of the bond will: A. rise by less than 25%. B. rise by 25%. C. rise by more than 25%. D. remain unchanged. Correct answer: A The convertible bond implicitly gives bondholders a call option on the underlying stock. The delta of this option will vary between 0 (when the option is extremely out of the money) and 1 (when the option is extremely in the money). In this case, the bond is trading at a conversion premium of 20% so the delta must be somewhere between zero and one, and hence the price of the convertible bond will rise by less than the price of the underlying stock. 2. If a cash flow of \$10,000 in two years' time has a PV of \$8,455, the annual percentage rate, assuming continuous compounding is CLOSEST to: A. 8.13%. B. 8.39%. C. 8.75%. D. 8.95%. Correct answer: B Continuously compounded rate = ln(FV/PV)/N = ln(10000 / 8455) / 2 = 8.39%. 3. The current values of a firm's assets and liabilities are 200 million and 160 million respectively. If the asset values are expected to grow by 40 million and liability values by 30 million within a year and if the annual standard deviation of these values is 50 million, the distance from default in the KMV model would be closest to: A. 0.8 standard deviations. B. 1.0 standard deviations. C. 1.2 standard deviations. D. Cannot not be determined. Correct answer: B Distance from default = (Expected value of assets - Expected value of liabilities) / Standard deviation = (240 - 190)/50 = 1.0. 4. What is the semiannual-pay bond equivalent yield on an annual-pay bond with a yield to maturity of 12.51 percent? A. 12.00%. B. 11.49%. C. 12.51%. D. 12.14%.

Correct answer: D: The semiannual-pay bond equivalent yield of an annual-pay bond = 2 * [(1 + yield to maturity on the annual-pay bond)0.5 -1] = 12.14%.

5. You want to test at the 0.05 level of significance that the mean price of luxury cars is greater than \$80,000. A random sample of 50 cars has a mean price of \$88,000. The population standard deviation is \$15,000. What is the alternative hypothesis? A. The population mean is greater than or equal to \$80,000. B. The population mean is less than \$80,000. C. The population mean is not equal to \$80,000. D. The population mean is greater than is \$80,000. Correct answer: D The alternate hypothesis is the statement which will be accepted if the null hypothesis is proven wrong. Therefore, we make whatever we are trying to test as the alternate hypothesis - in this case that the mean price of luxury cars is greater than \$80,000, and the null hypothesis as the opposite (the mean price of luxury cars is less than or equal to \$80,000). This problem is a common example of how statisticians establish hypotheses by proving that the opposite (i.e. the null hypothesis) is false. 6. Suppose that Gene owns a perpetuity, issued by an insurance company that pays \$1,250 at the end of each year. The insurance company now wishes to replace it with a decreasing perpetuity of \$1,500 decreasing at 1% p.a. without any change in the payment dates. At what rate of interest (assuming a flat yield curve) would Gene be indifferent between the choices? A. 4%. B. 5%. C. 6%. D. 9%. Correct answer: B 1,250 / r = 1,500 / (r + 1%) or, 1,250 x (r + 1%) = 1,500 x r or, r = 12.5 / (1,500 - 1,250) = 5%. 7. Which of the following is considered to be the responsibility of the legal risk manager? I. Inadequate documentation o f OTC derivatives transactions. II. The enforceability of netting agreements in bankruptcy. III. Default on interest and principal payments. A. I only B. II only C. I and II only D. I, II, and III

Answer : D Legal risk management is concerned with adequate documentation, public filings, compliance with regulatory entities, and some borrower impositions. The legal manager is also involved in deciding if default has occurred and, if so, assisting with the enforcement of netting agreements. 8. An analyst has constructed the following t-test for a portfolio of financial securities whose returns are normally distributed: Number of securities = 40. H0: Mean return >= 18 percent. Significance level = 0.1 What is the rejection point for this test? A. 1.304. B. 1.684. C. 2.021. D. 2.023. Correct answer: A This is a one-tailed test with 39 degrees of freedom and significance level of 0.1. Looking up the Student's t-distribution for df = 39 and p = 0.1, we get the critical value of 1.304. 9. Consider an A-rated institution that funds itself in the wholesale market at LIBOR + 90bps. Which of the following is the most attractive instrument for this firm to take exposure to an AAA-corporate issuer? A. Credit swap. B. Floating rate note. C. Credit-linked note. D. Fixed coupon bond. Correct answer: A This firm has a fairly high funding cost. Funding itself at 90 bps over LIBOR and lending to AAA names at around LIBOR is a loss making strategy, which rules out the notes and the bond. The only way this firm can make money is by selling credit protection via a credit swap that does not require it to make a physical investment. 10. Which of the following statements about the Treynor ratio is correct? A. The Treynor ratio considers both systematic and unsystematic risk of a portfolio. B. The Treynor ratio is equal to the excess return of a portfolio over the risk-free rate divided by the total risk of the portfolio. C. The Treynor ratio can be used to appraise the performance of well-diversified portfolios. D. The Treynor ratio is derived from portfolio theory since it assesses a portfolio's

excess return relative to its risk. Answer: C A is incorrect - Treynor ratio considers only systematic risk of a well-diversified portfolio B is incorrect - Treynor ratio denominator is beta of the portfolio C is correct - this statement is correct D is correct - Treynor ratio is derived from CAPM and not portfolio theory 11. Which of the following is TRUE in relation to affirmative covenants? A. They prohibit the borrower from issuing new debt. B. They prohibit the borrower from paying dividends above a limit to shareholders. C. They require the borrower to take actions to service the debt and maintain collateral. D.They prohibit the borrower from paying dividends under certain circumstances to shareholders Correct answer: C Affirmative covenants are terms that require the borrower to take actions to service the debt and maintain collateral. 12. Suppose that you need to borrow \$1 million for 24 months. Two large US-based international banks with equal credit ratings offer deposit rates of 2%. To choose between the two banks, you would need all of the following except: A. day count basis. B. compounding basis. C. currency of deposit. D. balance sheets of the banks. Correct answer: D \$1 million is a relatively small amount and the liquidity risk is not high in most markets. All other factors are crucial for the decision. 13. An analyst wants to test whether the variance of return from telecom stocks is higher than 0.04. For this purpose, he obtains the following data from a sample of 51 telecom stocks. Mean return from telecom stocks = 15% Standard deviation of return from telecom stocks = 24% Mean return from market = 12% Standard deviation of return from market = 13% Based on this information and a 0.05 significance level: A. we can say that the variance of telecom firms is lower than 0.04. B. we can say that the variance of telecom firms is higher than 0.04. C. we cannot say that the variance of telecom firms is lower than 0.04. D. none of the above. Correct answer: B Tests of the variance of a population require the chi-squared test. For this data, chi-squared = (n - 1) x Sample variance / Hypothesized variance = 50 x 0.24^2 / 0.04 =

72. Since the analyst wants to show that the variance is more than 0.04, this will be chosen as the alternative hypothesis and the null hypothesis will be that the variance is lower than or equal to 0.04. The critical value of the chi-squared statistic (for df=50 and p=0.05) is 67.505. Since the test statistic is higher than the critical statistic, we can reject the null hypothesis (variance <= 0.04), and accept the alternative hypothesis (variance > 0.04). 14. Which of the following internal controls does NOT effectively reduce operational risk? A. Separation of trading from accounting and data entry B. Automated reminders of payments required and contract expirations C. A multitude of users can modify trade tickets so that errors may be quickly corrected D. Reconciling results from different systems to ensure data integrity Answer: C Proper practice limits the amount of people who can change trade tickets and what information can be changed once a ticket is written. Double checking work, separating duties, and automatic reminders all help lower operational risk. 15. It would be prudent for a trader to direct accounting entries in the following situation: A. Never. B. when senior management of the firm and the Board of Directors are aware and have approved such on an exception basis. C. when audit controls are such that the entries are reviewed on a regular basis to ensure detection of irregularities. D. solely during such times as staffing turnover requires the trader to back-fill until additional personnel can be hired and trained. Answer: A In accordance with the separation of duties principle, it would never be appropriate for a trader to direct the accounting entries. 16. Which of the following statements concerning coupon rate structures is FALSE? A. Zero-coupon bonds have only one cash inflow at maturity. B. Accrual bonds, like zero-coupon bonds, always sell at a discount to face value. C. Accrual bonds have only one cash inflow at maturity. D. Step-up notes have coupon rates that increase over time at a pre-specified rate. correct answerB. Accrual bonds, unlike zero-coupon bonds, do not always sell at a discount to face value. The interest accrues forward and thus the bonds are likely to sell for more than face value. 17. Consider the following 3-year currency swap, which involves exchanging annual interest of 2.75% on 10 million US dollars for 3.75% on 15 million Canadian dollars. The CAD/USD spot rate is 1.52. The term structure is flat in both countries. Calculate

the value of the swap in USD if interest rates in Canada are 5% and in the United States are 4%. Assume continuous compounding. Round to the nearest dollar. A. \$152,000 B. \$145,693 C. \$131,967 D. \$127,818 Answer: C

## B fixed = ( PMT f .1 year e ( rt ) ) + ( PMT f .2 year e ( rt ) ) + [(notional +PMT f ,3 year ) e ( rt ) ]

Step 1.calculate value of USD-denominated bond:

BUSD = 275,000e 0.041 + 275,000e 0.042 + 10,275,000e 0.043 = USD9,631,182 275000 = 10000000 * 2.75%
Step 2.calculate value of CAD-denominated bond BCAD=565200e-0.05*1+565200e-0.05*2+15565200e-0.05*3=CAD14438805 565200=15000000*3.75% Step 3.calculate value of swap

## Vswap (USD) = BUSD ( So BCAD ) So = spot rate in USD per CAD

=9631182-14438805/1.52=USD131967 18. A 3-year, 8 percent semiannual coupon bond with \$100 par value currently yields 8.50 percent. What would be the price of the bond? A. \$95.49. B. \$99.24. C. \$98.70. D. \$119.50. Correct answer:C I/Y = 8.50/2 = 4.25; FV = 100; N = 3x2 = 6; PMT = 0.08/2 x 100 = 4; PV = -98.70. 19. Given that the dollar yen volatility is 12 percent and dollar peso volatility is 15 percent, and the correlation between dollar yen and dollar peso is 0.25, the best estimate of the yen peso volatility is: A. 16.7%. B. 19.2%. C. 21.4%. D. 23.1%.

Correct answer: A Here we use the expression that: (Vol_A/B)^2 = (Vol_A)^2 + (Vol_B)^2 - 2 x Correlation x (Vol_A) x (Vol_B). Therefore, yen/peso volatility = (0.12^2 + 0.15^2 - 2 x 0.25 x 0.12 x 0.15)^0.5 = 16.7%. 20. Suppose the daily returns of a portfolio and a benchmark portfolio it is replicating are as follows: Portfolio Return (bps) benchmark Portfolio Return(bps) Day 1 34 30 Day 2 -89 -87 Day 3 108 102 Day 4 70 70 What is the tracking error over the four day period? A. 3.16 bps B. 2 bps C. 10 bps D. 2.39 bps Answer: A A. Correct. Tracking error is the standard deviation of the difference between the return of the managed portfolio and the benchmark portfolio.

## tracking error = ep and

E [RP - RB] = (4 + (-2) + 6 + 0) / 4 = 2.00 E [(RP - RB)]2 = (16 + 4 + 36 + 0) / 4 = 14.00 So, TE = (14.00 - 4.00)1/2 = 3.16 bps. B. Incorrect. This solution incorrectly sets the tracking error equal to the average difference between the return of the managed portfolio and the benchmark portfolio. Tracking error is the standard deviation of the difference between the return of the managed portfolio and the benchmark portfolio. C. Incorrect. This solution incorrectly sets the tracking error equal to the variance of the difference between the return of the managed portfolio and the benchmark portfolio. Tracking error is the standard deviation of the difference between the return of the managed portfolio and the benchmark portfolio. D. Incorrect. This solution incorrectly sets the tracking error equal to the difference between the standard deviation of the return of the managed portfolio and the standard deviation of the return of the benchmark portfolio. Tracking error is the standard deviation of the difference between the return of the managed portfolio and the benchmark portfolio. 21. Which of the following statements are true with regard to a 3-year Bermuda put option? I. A lower bound on its price is the price of a 3-year European put option. II. A lower bound on its price is the price of a 3-year American put option.

III. It is likely to outperform both European and American put options as the price of the underlying rises. A. I only B. II only C. II and III D. III only Answer: A The Bermuda put option allows multiple opportunities to exercise. Therefore, its price must be higher than that of a European put option (which allows exercise only at maturity) but less than that of American put option (which allows exercise at any point before maturity). 22. Consider two portfolios: Portfolio I consists of 100 bonds, each rated AAA, all weighted equally; and Portfolio II consists of 20 bonds, each rated A, all weighted equally. The 1-year default probabilities of AAA and A bonds are 0.1% and 0.5% respectively in this country. Assume that the event of default on any bond is independent of default on others. Which one of the following statements is TRUE? A. The probability of observing no default in Portfolio I is lower than in Portfolio II. B. The probability of observing no default in Portfolio I is higher than in Portfolio II. C. The probability of observing no default in Portfolio I is roughly the same as Portfolio II. D. Insufficient information, we need to know the recovery rates. Correct answer: C Probability (no default in Portfolio I) = (1-0.1%)^100 =90.48%. Probability (no default in Portfolio II) = (1-0.5%)^20 =90.46%. Notes: 1 The question does not ask you to compute expected loss, so you do not need to know the recovery rates. 2 Even though both portfolios have the same probability of not defaulting, the loss in the event of a single default will be much lower in case of portfolio I than portfolio II. In this question, you are not concerned with it. Hence the answer is counter-intuitive. 23. Which of the following statements describe a property of bond convexity? Convexity: I. increases as yields increase. II. increases with the square of maturity. III. measures the rate of change in duration. IV. increases if the coupon on a bond is decreased. A. II and III only. B. I and III only. C. II and IV only. D. III and IV only. Correct answer A

Convexity is inversely related to yield and is directly related to the coupon rate on a bond. Convexity is the second derivative of price with respect to yield, which means that convexity measures the rate of change in duration. Convexity increases with the square of maturity. 24. To control risk-taking by traders, your bank links trader compensation with their compliance with imposed VaR limits on their trading book. Why should your bank be careful in tying compensation to the VaR of each trader? A. It encourages trader to select positions with high estimated risks, which leads to an underestimation of the VaR limits. B. It encourages trader to select positions with high estimated risks, which leads to an overestimation of the VaR limits. C. It encourages trader to select positions with low estimated risks, which leads to an underestimation of the VaR limits. D. It encourages trader to select positions with low estimated risks, which leads to an overestimation of the VaR limits. Correct answer: D D VaR limit VaR limit 25. An analyst wants to test whether the mean spending by tourists coming to a holiday resort is equal to or less than \$2,000 with a 1 percent level of significance. He finds that the average spending by 16 tourists is \$2,200 and the standard deviation of the population is \$400. The critical value of the Z statistic for this study is: A. 1.65. B. -1.96. C. 2.33. D. 2.58. Correct answer: C Since this is a one-tailed test with a 0.01 significance level the critical Z value is 2.33. 26. Bank Z, a medium-size bank, uses only operational loss data from internal records to model its loss distribution from operational risk events. The bank reviewed its records, and, after confirming that they were complete records of its historical losses and that its losses could be approximated by a uniform distribution, it decided against using external loss data to estimate its loss distribution. Based on that decision, which of the following statements is correct? A. The estimated loss distribution likely accurately represents Bank Zs real risk because the records are accurate and complete. B. The estimated loss distribution likely overtakes bank Zs real risk because many incidences in the past were likely one off.

C. The estimated loss distribution likely is the best estimate of Bank Zs real risk because there is no better loss data for the bank than its own. D. The estimated loss distribution likely understates Bank Zs real risk because the bank has not experienced a huge loss. Correct answer: D D Loss Distribution Uniform distribution 27. Your bank has chosen to use the advanced Internal Rating Based Approach under Basel II. The bank is contemplating a large securitization of low-quality loans that are currently on its balance sheet. You are concerned about whether the securitization will provide you with regulatory capital relief. Which one of the following approaches would be the most efficient in reducing the banks regulatory capital? A. The bank sets up an Special Purpose Vehicle (SPV) that issues securities. All proceeds from selling these securities are invested in a portfolio of equities. The SPV sells protection to the bank through a credit default swap on the loans in the banks portfolio. B. The bank sells the loans to an SPV and keeps an equity piece representing 8% of the value of the loans. C. The bank sells the loans to an SPV that issues securities. These securities issued are then sold to third-party investors. The bank indicates to some investors that if credit quality of the loans declines significantly, the bank will try to help the investors, but specifies that the bank is unwilling to provide a contractual guarantee. D. The bank forgoes the securitization and buys a credit default swap on the loans from an AAA-rated provider. Correct answer: C C A Bank set up a SPV B Bank 8% Equity Tranches SPV C Bank Loan True Sale D Bank CDSLoan CDS C Loan 28. A 12-year, 8 percent semiannual coupon bond with \$100 par value currently trades at \$78.75 and has an effective duration of 9.8 years and a convexity of 130.0. What is the price of the bond if the yield falls by 150 basis points?

A. \$67.17. B. \$86.47. C. \$91.48. D. \$95.43. Correct answer C Percentage price change = [(-) (effective duration)( y)]+[(1/2)(convexity)( y)2] = [(-)(9.80)(-0.015)]+[(0.5)(130)(-0.015)2] = 16.16 Estimated price = 78.75(1+0.1616) = \$91.48 29. Which of the below are methods to estimate parameters of operational loss distributions? I. Moments II. IV. A. B. C. D. Probability-weighted moments Econometric I and III I, II and III IV III and IV III. Maximum likelihood

Answer: B The parameters of loss distributions can be estimated by moments, probability-weighted moments, or with maximum likelihood techniques 30. Asset liquidity risk is most pronounced for A. A \$10 million position in distressed securities B. A \$10 million position in Treasury bonds C. A \$100 million position in distressed securities D. A \$100 million position in Treasury bonds Answer: C Asset liquidity risk is a function of the size of the position and the intrinsic liquidity of the instrument. Distressed securities trade much less than Treasury bonds, and so have more intrinsic liquidity. A \$100 million position is more illiquid than a \$10 million position in the same instrument. 31. You are given the following specification of the currency swap: notional principal \$10m euro 10.5m swap coupon 7.2% 6.8% current market yield 4.2% 3.6% There are two payments left in the swap (the first one in a year) and the current exchange rate is \$0.95/euro. Calculate the dollar value of the swap for the euro payer. A. - 16 299 \$.

B. - 17 344 \$. C. - 19 344 \$. D. - 21 283 \$. Correct answer: A The swap is equivalent to long position in dollar denominated bond and short position in euro denominated bond. (720,000 / 1.042 + 10,720,000 / 1.042^2) - ((714,000 / 1.036 + 11,214,000 / 1.036^2) x 0.95) = - 16,299. 32. How would you describe the typical price behavior of a low premium mortgage pass-through security? A. It is similar to a U.S. Treasury bond B. It is similar to a plain vanilla corporate bond C. When interest rates fall, its price increase would exceed that of a comparable duration U.S. Treasury. D. When interest rates fall, its price increase would lag that of a comparable duration U.S. Treasury. Answer: C Mortgage pass-through securities, unlike Treasuries or plain vanilla corporate bonds, have an embedded option allowing borrowers to repay the loan at any time. When rates fail, the effective duration of these securities decreases because borrowers will refinance mortgages at lower rates (putting the loans back to the investors); but when interest rates increase, borrowers will hold on to mortgages longer than they otherwise would, resulting in an increase in the effective duration of the loans. This is reflected in the price/yield relationship as negative convexity. 33. You are given the following information about a portfolio and are asked to make a recommendation about how to reallocate the portfolio to improve the risk/return tradeoff. Covariance Curren Margin Marginal Risk Expecte Standard of Marginal t al Return/ Contributio Asset d Portfolio and Return Weigh Risk Marginal risk n return Deviation Asset I t Returns Asset 1 7.10% Asset 2 8.00% Asset 3 6.70% Asset 4 6.90% Risk free 4.00% 17.00% 38.70 % 1.43% 2.44% 2.39% 1.41% 0.00% 3.10% 13.99% 4.00% 23.93% 2.70% 23.39% 2.90% 13.86% 22.17% 16.71% 11.55% 20.92% 5.41% 1.48% 1.29% 2.02%

## 40.60% 6.20% 44.80% 5.50% 21.40% 0.00% 14.60 % 35.00 %

Which of the following the recommendations will improve the risk/return tradeoff of the portfolio? A. Increase the allocations to assets 1 and 3 and decrease the allocations to assets 2 and 4. B. Increase the allocations to assets 1 and 2 and decrease the allocations to assets 3 and 4. C. Increase the allocations to assets 2 and 3 and decrease the allocations to assets 1 and 4. D. Increase the allocations to assets 1 and 4 and decrease the allocations to assets 2 and 3. Answer: D A. Incorrect. Asset 3 should be decreased since it has the lowest marginal return-to-marginal risk ratio. B. Incorrect. Asset 4 should be increased since it has the highest marginal return-to-marginal risk ratio. C. Incorrect. Asset 4 should be increased since it has the highest marginal return-to-marginal risk ratio. D. Correct. A portfolio optimizing the risk-reward tradeoff has the property that the ratio of the marginal return to marginal risk of each asset is equal. Therefore, this option is the only recommendation that will move the ratios in the right direction. 34. Calculate the estimated default frequency (EDF) for a KMV credit risk model using the data given below (all figures in millions). Assets Liabilities Market value 195 185 Book value 180 165 Standard deviation 25 15 of returns A. 11.5%. B. 27.4%. C. 34.5%. D. 57.9%. Correct answer: A The distance between the current value of the assets and the book value of the liabilities = 195- 165 = 30. Using the standard deviations in the return on assets this distance = 30 / 25 = 1.2 standard deviations. Thus the probability of default = cumulative probability of standard normal distribution below -1.2, i.e. 11.5%. 35. Suppose the payoff from a merger arbitrage operation is \$5 million if successful, -\$20 million if not. The probability of success is 83%. The expected payoff on the operation is A. \$5 million B. \$0.75 million C. \$0 since markets are efficient D. Symmetrically distributed Answer: B

The expected payoff is the sum of probabilities times the payoff in each state of the world, or 83% \$5 + 17% (-\$20) = \$4.15 - \$3.40 = \$0.75. Note that the distribution is highly asymmetric, with a small probability of a large loss. 36. Your firm does market direction neutral arbitrage in the spread between US Treasuries and Argentina bonds. Your trader plans to buy default swaps on Argentina. Then he wants to increase the size of position to \$1,500 million. As a risk manager, apart from basis risk, your main concern will be that: A. US yields would fly up too soon. B. liquidity in US Treasuries will dry up. C. liquidity in Argentina bonds will dry up. D. CDS writer may go bankrupt, leaving you uncovered. Correct answer: C Liquidity risk is the most prominent form of risk when emerging markets securities are involved. 37. The VaR of a portfolio at a 95% confidence level is 15.2. If the confidence level is raised to 99% (assuming a one-tailed normal distribution) the new value of VaR will be closest to: A. 10.8. B. 15.2. C. 18.1. D. 21.5. Correct answer: D 95% confidence level requires a volatility multiple (alpha) of 1.65 while 99% confidence level requires a multiple of 2.33. Since VaR is directly proportional to this multiple, the 99% confidence level VaR = 15.2 x 2.33 / 1.65 = 21.5 38. A particular operational risk event is estimated to occur once in 200 years for an institution. The loss for this type of event is expected to be between HKD 25 million and HKD 100 million with equal probability of loss in that range (and zero probability outside that range). Based on this information, determine the fair price of insurance to protect the institution against a loss of over HKD 80 million for this particular operational risk. A. HKD 133,333 B. HKD 90,000 C. HKD 120,000 D. HKD 106,667 Answer: C The range of losses is HKD 25 million to HKD 100 million, with equal probability. The probability of a loss being greater than HKD 80 million is (100 - 80)/(100 - 25) or 20/75. If the loss is over HKD 80, the expected loss (being equally probable) would be HKD 90

million:

## 100 million+80 million 20 1 Expected value of loss = = HKD120,000 2 75 200

39. In august 2006, the hedge fund Amaranth had large calendar spread positions in natural gas. According to historical VaR models, such spread positions would have had limited risk. In light of the dramatic losses to the funds, which led to Amaranths collapse in September 2006, its risk management policies came under scrutiny. Keeping the funds policies, trading, and position limits unchanged, which of the following risk management policies could have better captured the extent of the risks that sank Amaranth? i. Using Riskmetrics-type VaR instead of a historical VaR to estimate its risk exposures. ii. Adding counterparty risk to its risk measurement. iii. implementing stress tests to quantify possible losses if it had to liquidate large positions. iv. Including operational VaR to its risk measurement. A ii, iii, and iv only B i, ii, iii, and iv C i and iii only D None of the changes would have helped Answer: C C Amaranth 40. Assume Satya Bank, having a capital of USD 500 million, wants to limit its losses in the energy sector to 6% and in the construction sector to 4.5% of its capital. The LGD rates for the energy and construction sectors are, respectively, 45% and 70%. If Satya Bank wants to strictly adhere to its concentration limit policy, the maximum permitted loan amount to the energy and construction sectors will be: Energy Construction A. USD 66.7 million USD 32.1 million B. USD 13.5 million USD 15.8 million C. USD 37.5 million USD77.8 million D. USD 30.0 million USD 22.5 million Answer: A A. Correct. Concentration Limit = Capital x (loss limit on capital / loss rate of the sector) Concentration Limit for Energy = USD 500 million x (0.06 / 0.45) = USD 66,666,667 Concentration Limit for Constr. = USD 500 million x (0.045 / 0.70) = USD 32,142,857 B. Incorrect. It uses incorrect variables and/or formula to calculate concentration limits. C. Incorrect. It uses incorrect variables and/or formula to calculate concentration limits. D. Incorrect. It uses incorrect variables and/or formula to calculate concentration limits.

41. Credit risk is NOT an increasing function of: A. level of debt. B. risk-free interest rate. C. time to maturity of debt. D. standard deviation of asset returns. Correct answer: B In the context of the analytical model, credit risk is a decreasing function of risk-free interest rate 42. Prepayment models are complex and rely upon a number of different methods to circumvent the problem of prepayment path dependency. Which of the following is often used to avoid the problems associated with prepayment path dependency? A. Error-correction model tree design. B. Monte Carlo simulation. C. Cox-Ingersoll-Ross tree design. D. Bernard and Schwartz simulation. Correct answer:B Monte Carlo simulation techniques have been used to deal with problems associated with prepayment path dependency. 43. Assume that the short-term interest rate in London is 4 percent and that the short-term interest rate in the US is 2 percent. If the current exchange rate between the euro and dollar is 1=US\$1.2217, using the continuous time futures pricing model, what is the price of a three-month futures contract? A. \$1.2207. B. \$1.2156. C. \$1.2144. D. \$1.2235. Correct answer: B. The formula is: 1.2217e(0.02-0.04)(0.25) = \$1.2156. 44. When an investor is obligated to buy the underlying asset in a futures position, it is a: A. basis trade. B. short-futures position. C. hedged-futures position. D. long-futures position. Correct answer:D When an investor is obligated to buy the underlying asset in a futures position, it is a long futures position.

45. Portfolio manager returns 10% with a volatility of 20%. The benchmark returns 8% with risk of 14%. The correlation between the two is 0.98. The risk-free rate is 3%. Which of the following statements is correct? A. The portfolio has higher SR than the benchmark B. The portfolio has negative IR C. The IR is 0.35 D. The IR is 0.29 Answer: D The Sharpe ratios of the portfolio and benchmark are (10% - 3%)/20% = 0.35, and (8% 3%)/14% = 0.36, respectively. So, the SR of the portfolio is lower than that of the benchmark. Answer a) is incorrect. The TEV is the square root of

## 0.00472 = 6.87% . So the IR of the

portfolio is (10% - 8%)/6.87% = 0.29. This is positive, so answer B) is incorrect. Answer C) is the SR of the portfolio, not the IR, so it is incorrect. 46. In commodity trading, the exchange removes any daily losses from a trader account and s adds any gains to the traders account. This process is known as: A. initial margin. B. maintenance margin. C. variation margin. D. marking to market. Correct answer:D. To safeguard the clearinghouse, commodity exchanges require traders to settle their accounts on a daily basis. Marking to market is when any loss for the day is deducted from the traders account, and any gains are added to the account. 47. A portfolio manager is constructing a portfolio of stocks and corporate bonds. The portfolio manager has estimated that stocks and corporate bond returns have daily standard deviations of 1.8 percent and 1.1 percent, respectively, and estimates a correlation coefficient of returns of 0.43. If the portfolio manager plans to allocate 35 percent of the portfolio to corporate bonds and the rest to stocks, what is the daily portfolio VAR (2.5 percent) on a percentage basis? A. 2.71%. B. 3.05%. C. 2.57%. D. 2.27%. Correct answer : A First, calculate the daily percentage VAR for stocks and corporate bonds: Stocks: VAR(2.5%)Percentage Basis = z2.5% ? = 1.96(0.018) = 0.0353 = 3.53% Bonds: VAR(2.5%)Percentage Basis = z2.5% ? = 1.96(0.011) = 0.0216 = 2.16%

Next calculate the portfolio VAR using weights of 35% for bonds and 65% for stocks: [0.652(0.03532) + 0.352(0.02162) + 2(0.35)(0.65)(0.0353)(0.0216)(0.43)]0.5 = 0.0271 = 2.71% 48. A corn grower is concerned that the price he can get from the field in mid-September will be less than he has forecasted. To protect himself from price declines, the farmer has decided to hedge. The best available futures contract he can find is for August delivery. Which of the following is the appropriate direction of his position and the source of basis risk that may impact the farmer? A. Short futures; correlation. B. Long futures; correlation. C. Short futures; rollover. D. Long futures; rollover. Correct answer : C The farmer needs to be short the futures contracts. The source of basis risk for this farmer arises from the fact that his contract and harvest dates do not perfectly match. As a result, he will be exposed to basis risk due to a necessary rollover in his position. 49. Two banks enter into a 1-year plain vanilla interest-rate swap with the following terms: Notional principal is \$500,000,000. The fixed component of the swap is 7%, which is the current market rate. The floating component of the swap is LIBOR + 200bps. If the current risk-free rate is 4 percent, the value for this swap at inception is closest to: A. \$0. B. \$500,000,000. C. \$8,750,000. D. \$35,000,000. Correct answer:A The initial value of a swap is always zero. As interest rates move and payments take place, the value of the swap will change for both parties. 50. What is the value of the European call option given below using the Black-Scholes model? Spot rate = 120 Strike price = 125 Risk- free rate = 8% Time to expiration = 0.5 years N(d1) = 0.554 N(d2) = 0.498 A. 1.69. B. 4.23. C. 6.67. D. 11.83. Correct answer: C Using the Black-Scholes model, the value of a call option = Spot price x N(d1) - Strike

price x exp(-Risk-free rate x Time to expiration) x N(d2) = 120 x 0.554 - 125 x exp(0.08 x 0.5) x 0.498 = 6.671. 51. Which statement about option valuation is least accurate? A. The value of an option is its time value plus its intrinsic value. B. Prior to maturity, out-of-the-money options have no value. C. The buyer of a call option contract can never lose more than the initial premium. D. If the stock price is lower than the strike price at expiration, a put option is worth the difference between the stock price and the strike price. Correct answer: B While out-of-the-money options have no intrinsic value, they still have time value prior to maturity. The remaining statements are true. 52. Balance sheet liquidity refers to the ability to: A. meet debt covenants. B. raise debt without moving the market. C. meet financial obligations as they arise. D. merge with or acquire other firms at short notice. Correct answer: C Balance sheet liquidity refers to the ability to meet cash needs with the available cash, marketable securities and exiting credit lines, i.e. the ability to avoid running out of cash. 53. Which of the following best explains put-call parity? A. No arbitrage requires that using any three of the four instruments (stock, call, put, bond) the fourth can be synthetically replicated. B. A stock can be replicated using any call option, put option and bond. C. A stock can be replicated using any at the money call and put options and a bond. D. No arbitrage requires that only the underlying stock can be synthetically replicated using at the money call and put options and a zero coupon bond with a face value equal to the strike price of the options. Correct answer: A A portfolio of the three instruments will have the identical profit and loss pattern as the fourth instrument and therefore the same value by no arbitrage. So the fourth security can be synthetically replicated using the remaining three. 54. A portfolio has a mean value of \$100 million and a daily standard deviation of \$19 million. Assuming that the portfolio values are normally distributed, the lowest value that the portfolio will fall to over the next five days and within 95% probability is: A. -\$31.7 million. B. \$1.2 million.

C. \$30.1 million. D. \$57.5 million. Correct answer: C Given that the daily standard deviation is \$19 million, the standard deviation over 5 days = \$19 million x (5/1)^0.5 = \$42.49 million. Given that the returns are normally distributed, we know that 95% of the outcomes will be above 1.645 standard deviations below the mean, i.e. above \$30.1 million. 55. You are considering an investment in one of three different bonds. Your investment guidelines require that any bond you invest in carry an investment grade rating from at least two recognized bond rating agencies. Which, if any, of the bonds listed below would meet your investment guidelines? A. Bond A carries an S&P rating of BB and a Moodys rating of Baa. B. Bond B carries an S&P rating of BBB and a Moodys rating of Ba. C. Bond C carries an S&P rating of BBB and a Moodys rating of Baa. D. None of the above. Correct answer: c Explain: The lowest investment-grade ratings are BBB and Baa. 56. A security sells for \$40. A 3-month call with a strike of \$42 has a premium of \$2.49. The risk-free rate is 3 percent. What is the value of the put according to put-call parity? A. \$1.89. B. \$4.18. C. \$3.45. D. \$6.03. Correct answer:B p = c + X S = 2.49 + 42 e 0.03 0.25 40 = \$4.18 57. Which of the following statements regarding the Black-Scholes-Merton option-pricing model is TRUE? A. As the number of periods in the binomial options-pricing model is increased toward infinity, it converges to the Black-Scholes-Merton option-pricing model. B. The Black-Scholes-Merton option-pricing model is the discrete time equivalent of the binomial option-pricing model. C. The Black-Scholes-Merton model is superior to the binomial option-pricing model in its ability to price options on assets with periodic cash flows. D. As the periods in the binomial option-pricing model are lengthened, it converges to the Black-Scholes-Merton option-pricing model. Correct answer: A

As the option period is divided into more/shorter periods in the binomial option-pricing model, we approach the limiting case of continuous time and the binomial model results converge to those of the continuous-time Black-Scholes-Merton option pricing model. 58. If we use four of the inputs into the Black-Scholes-Merton option-pricing model and solve for the asset price volatility that will make the model price equal to the market price of the option, we have found the: A. implied volatility. B. historical volatility. C. market volatility. D. option volatility. Correct answer:A The question describes the process for finding the expected volatility implied by the market price of the option. 59. A stock that is currently trading at \$50 and can either move to \$55 or \$45 over the next 6-month period. The continuously compounded risk-free rate is 2.25 percent. What is the risk-neutral probability of an up movement? A. 0.6655. B. 0.6565. C. 0.5566. D. 0.5656. Correct answer:C: The risk-neutral probability, p, can be calculated as . In this case, r = 0.0225, u = 1.1, d = 0.9, which makes p equal to [e[0.0225*(6/12)] - 0.9] / [1.1 - 0.9] = .5566 60. Given the following ratings transition matrix, calculate the two-period cumulative probability of default for a B credit.

## A. 2.0% B. 2.5% C. 4.0% D. 4.5% Correct answer: d

Explain: Scenario one: B can go into default the first year, with probability of 0.02. Scenario two: B could go to A then D, with probability of 0.03 0.00 = 0. Scenario three: B could go to B then D, with probability of 0.90 0.02 = 0.018. Scenario four: B could go to C then D, with probability of 0.05 0.14 = 0.007. The total is 0.045.

61. BBB-rated firms have default probability of 0.2% over a period of one year. Based on this information the default probability over the next quarter will be CLOSEST to: A. 0.05%. B. 0.45%. C. 0.50%. D. 1.50%. Correct answer: A Assuming a constant marginal default probability, Default probability over a quarter = 1 - (1 Default probability over a year)^(1/4) = 1 - (1 - 0.2%)^0.25 = 0.05%. However, the marginal rate of default for high credits tends to rise with the time horizon. So, the default probability for the immediate quarter is likely to be lower than the average of 0.0005. 62. A CBO (collateralized bond obligation) consists of several tranches of notes from a repackaging of corporate bonds, ranging from equity to super senior. Which of the following is generally true of these structures? A. The total yield of all the CBO tranches is slightly less than the underlying repackaged bonds to allow the issuer to recover fees/costs/ profits. B. The super senior tranche has expected loss rate higher than the junior tranche. C. The super senior tranche is typically rated below AAA and sold to bond investors. D. The equity tranche does not absorb the first losses of the structure. Correct Answer: a Explain: In the absence of transaction costs or fees, the yield on the underlying portfolio should be equal to the weighted average of the yields on the different tranches. With costs, however, the CBO yield will be slightly less. Otherwise, the senior tranche is typically rated AAA, has the lowest loss rate of all tranches, and absorbs the last loss on the structure.

63. What is the most significant difference to consider when assessing the creditworthiness of a country rather than a company? A. The countrys willingness and its ability to pay must be analyzed. B. Financial data on a country is often available only with long lags. C. It is more costly to do due diligence on a country rather than on a company.

D. A country is often unwilling to disclose sensitive financial information. Correct answer: a Explain: Countries cannot be forced into bankruptcy. There is no enforcement mechanism for payment to creditors such as for private companies. Recent history has shown that a country can simply decide to renege on its debt. So, willingness to pay is a major factor in assessing the creditworthiness of a country.

64. Assume a bank wants to limit its losses in a particular sector to 5% of its capital and that the loss rate for this sector is 50%. The concentration limit for this particular borrower is closest to: A. 8.33% B. 2.50% C. 10.00% D. 25.00% Answer: C 5%/50%=10% 65. Which of the following is not a commonly used method for generating a recovery rate function? A. Nonparametric kernel estimation. B. Cubic SPLINE estimation. C. Assume the recovery rate follows a beta distribution. D. Estimate conditional densities with generalized method of moments. Answer: B Explanation: Cubic SPLINE estimation would make little sense here. 66. Your analysis shows that if a risky bond defaults, we can expect to recover 2,102.02 per 10,000 of face value, after a period of five years from the scheduled maturity date of the bond? The yield curve for risk-free debt is flat at 1.00%. What is the LGD ratio for this debt? A. 20.00%. B. 21.02%. C. 22.09%. D. None of the above. Correct answer: A We need to find the present value recovery at the time of Scheduled Maturity. Hence, LGD = (2,102.02 / 1.01^5) / 10,000 = 20.00%

67. An investor owns a stock and believes that the stocks price will remain relatively unchanged for the short term but is bullish in the long term. Which of the following strategies will be the best for this investor? A. A protective put. B. An at-the-money strip. C. A covered call. D. An at-the money strap. Correct answer:C A covered call strategy is used to generate cash on a stock position that is not expected to increase in value over the life of the option. 68. A credit manager discovers that the defaults by sub-investment grade clients of his bank follow a Poisson distribution, with an average number of defaults in the year equal to 7. What is the probability that there will be 6 defaults over the next year? A. 12.1%. B. 12.8%. C. 13.5%. D. 14.9%. Correct answer: D Probability of three defaults = [7^6 x exp(-7)] / fact(6) = [117649 x 0.000912] / 720 = 14.9%. 69. All of the following are assumptions of the Capital Asset Pricing Model EXCEPT: A. Each investor seeks to maximize the expected utility of wealth at the end of that investors horizon. B. Investors can borrow and lend at the same risk-free rate. C. Investors have the same expectations concerning returns. D. The time horizons of investors are normally distributed. Answer: D The CAPM assumes that investors all have the same horizon (as well as expectations). This means that the distribution of the horizons is not normal because normality implies a bell-shaped curve distribution, which would have a positive variance and, hence, dispersion. 70. The estimated default frequency in KMV model are calculated using: I. bond spreads. II. asset volatilities. III. balance sheet items IV. Monte Carlo simulation. A. I and II. B. I and IV.

C. II and III. D. III and IV. Correct answer: C The estimated default frequency in KMV model is calculated using balance sheet items and the standard deviation of the assets. 71. A major acquisition has just been announced, targeting company B. The bid from Company A is an exchange offer with a ratio of 2. Just after the announcement, the prices of A and B are \$50 and \$90, respectively. A hedge fund takes a long position in company B hedged with A's stock. After the acquisition goes through, the prices move to \$120 and \$60. For each share of B, the gain is A. \$30 B. \$20 C. \$10 D. \$0 since the acquisition is successful Answer: C This position is long one share of company B offset by a short position in two shares of company A. The payoff is (\$120-\$90)-2(\$60-\$50)=\$30-\$20=\$10. 72. If the mean P/E of 30 stocks in a certain industrial sector is 18 and the sample standard deviation is 3.5, standard error of the mean is CLOSEST to: A. 0.12. B. 0.34. C. 0.64. D. 1.56. Correct answer: C Standard error of the mean = s / n^0.5 = 3.5 / 30^0.5 = 0.64. 73. Which of the following methods can be used to measure corporate "Cash-Flow at Risk"? I. Delta Normal. II. Historical Simulation. III. Monte Carlo Simulation. A. I and II. B. I and III. C. II and III. D. I, II and III. Correct answer: D All these methods can be alternatively used to measure corporate Cash-Flow at Risk 74. Which of the following statements regarding the beta distribution used in the modeling of recovery functions is FALSE?

A. B. C. D.

The beta distribution does not fit bimodal recovery functions well. The beta distribution only requires two inputs for calibration. The beta distribution is a nonparametric distribution. The beta distribution can be skewed, symmetric, or convex.

Answer: C The beta distribution is a parametric distribution. The beta distribution does not fit bimodal recovery functions well, and only requires two inputs for calibration. In addition, it can be skewed, symmetric, or convex. 75. Hedge fund managers following a convertible arbitrage strategy are said to be: A. long gamma and short vega B. short gamma and short vega C. long gamma and long vega D. short gamma and long vega Answer: C Convertible arbitrage managers hedge their equity exposure by shorting stocks using the delta hedge ratio. Because they are exposed to changes in the hedge ratio, they are said to be long gamma. They are also exposed to changes in the price volatility of the stock underlying the option embedded in the convertible security, so they are said to be long vega. 76. Suppose that the yield on 1-year Treasury zero is 2% and the constant, cumulative probability of default on AAA bonds is 1%. If the recovery rate in the case of default is zero, what is the continuous compounded yield on AAA 1-year zero? A. 2.98%. B. 3.00%. C. 3.01%. D. 3.03%. Correct answer: D AAA 1-year zero rate = (1 + default-free rate) / (1 - probability of default) = (1 + 2%) / (1 1%) - 1 = 3.03%. 77. The 1-year US dollar interest rate is 3% and the 1-year Canadian dollar interest rate is 4.5%. The current USD/CAD spot exchange rate is 1.5000. Calculate the 1-year forward rate. A. 1.5225 B. 1.5218 C. 1.5207 D. 1.5199 Answer: B

In order to get the answer reported in GARPs answer key, you have to assume annual compounding, even though the question doesnt specifically state that:

F = 1.500
answer

## F = 1.500 e 0.0450.03 = 1.5227 . Our advice is to be prepared for this type of

ambiguity on the FRM exam. 78. Which of the following statements regarding economic capital are true? i. Economic capital is designed to provide a cushion against unexpected losses at a specified confidence level over a set time horizon. ii. Since regulatory capital models and economic capital models have different objectives, economic capital models cannot help regulators in setting regulatory capital requirements. iii. Firms whose capital exceeds their required regulatory capital are firms that employ their capital inefficiently, and their shareholders would benefit if they used all of their excess capital to repurchase shares or increase dividends. iv. Economics capital can be used to validate a firms regulatory capital requirement against its own assessment of the risks it is running. A i, ii, and iii only B iii and iv only C i and iv only D i, iii, and iv only Correct answer: C iii regulatory capital 79. The weighted average rating of the collateral pool used to structure collateralized bond obligations: A. is same as that of the securities issued. B. is lower than that of the securities issued. C. is higher than that of the securities issued. D. may be higher or lower than that of the securities issued depending on the number of tranches. Correct answer: B An issuer (SPV) needs to provide for a significantly higher collateral than the securities issued. This excess collateral (or the equity tranche) absorbs a significant amount of the credit risk of the pool of bond obligations and leaves the securities offered to investors with lesser risk and hence a higher rating. 80. A hedge fund with \$100 million in equity is long \$200 million in some stocks and short \$150 million in other stocks. The gross leverage and net leverage are, respectively,

A. B. C. D.

2.0 and 0.5 2.0 and 1.5 3.5 and 0.5 3.5 and 1.5

Answer: C The gross leverage is (200 + 150)/100 = 3.5. The net leverage is (200 - 150)/100 = 0.5. 81. Which of the following is a type of credit derivative? I. A put option on a corporate bond II. A total return swap on a loan portfolio III. A note that pays an enhanced yield in the case of a bond downgrade IV. A put option on an off-the-run Treasury bond A. I, II, and III B. II and III only C. II only D. All of the above Correct Answer: a Explain: Part I, II, and III are correct. An option on a T-bond has no credit component.

82. Wallace, an emerging market bond trader, is holding a 5-year USD Malaysian corporate bond in his book. He is concerned about the risk of his position. Which of the following statements concerning the risk of his position is incorrect? A. The corporate bond could be upgraded so that it would have a higher rating than Malaysian sovereign debt, but it is highly unlikely. B. Buying protection with a CDS would hedge the corporate bond position against some risks but it would do a poor job of hedging the position if there is a drop in liquidity for emerging market sovereign bonds. C. A short position in Ringgits sovereign bond from Malaysia would always help hedge the corporate bond against currency risk if the corporation is an exporter. D. A short position in a 5-year U.S. treasury and buying protection on the corporate bond using a CDS would be a better hedge than just buying protection on the corporate bond. Answer: A Sovereign debt is typically rated higher than corporate debt in the same country. 83. Consider a swap contract that has just been initiated with a term to maturity of 10 years. If the DV01 of the swap is proportional to its term to maturity and the movement of the term structure of interest rates is stochastic, parallel, normally distributed with a constant

volatility, the potential exposure of the swap will peak after: A. 2.5 years. B. 3.3 years. C. 5.6 years. D. 6.7 years. Correct answer: B If the DV01 is proportional to its term to maturity, the potential exposure peaks after one third of the initial life of the contract. 84. If an investor holds a five-year IBM bond, it will give him a return very close to the return of the following position: A. A five-year IBM credit default swap on which he pays fixed and receives a payment in the event of default B. A five-year IBM credit default swap on which he receives fixed and makes a payment in the event of default C. A five-year U.S. Treasury bond plus a five-year IBM credit default swap on which he pays fixed and receives a payment in the event of default D. A five-year U.S. Treasury bond plus a five-year IBM credit default swap on which he receives fixed and makes a payment in the event of default Correct Answer: d Explain: A long corporate bond position is equivalent to a long Treasury bond position plus a short CDS.

85. The National Stock Exchange of India introduced bond futures trading in 2003. In the past, interest rate volatility in India had been very high, especially during international currency crises. However, this volatility is currently low. Which of the following positions would you agree the most? A. While determining initial margin at 99% 1-day VAR, the interest rate volatility of the past crises needs to be ignored as the regime has clearly shifted. B. While determining initial margin at 99% 1-day VAR, the interest rate volatility of the past crises needs to be accounted if these events have occurred in the recent past and could recur. C. We need to have an additional factor measuring (and possibly predicting) pressure on currency. The decision to include or exclude high volatility samples can then be made on a real-time basis. D. None of the above. Correct answer: C An unduly low margin would bankrupt the clearing house, while an unduly high margin

would kill trading interest. The best compromise would be statement C, where the clearing house can change the measurement of VAR. 86. When choosing a hedging approach, you expect operational risks to be higher for: A. a product traded on an organized exchange. B. dynamic replication using an exchange-traded product. C. an OTC product. D. static replication using an exchange-traded product. Answer: B Operational risks tend to be higher for dynamic replication using an exchange-traded product, because the need for rebalancing increases the chance of mishaps in implementing the strategy. 87. Which of the following in NOT an issue in the active risk management of a credit book? A. Serial correlations. B. Limited number of issuers. C. Illiquidity of the underlying. D. Need to maintain client relationship. Correct answer: B The credit market has enough issuers. The problem lies in the illiquidity of the papers, possible serial correlations in credit events and the need to accommodate clients. 88. A department store chain has a B1 rating from Moodys and a B+ rating from S&P. Its balance sheet reflects a large number of receivables from shoppers who use the chains private label credit card. The firm has decided to raise much needed funds for renovation by securitizing these receivables. Which of the following scenarios is the most likely outcome? A. The bond issued in the securitization will be B1/B+ rated because the department store chain is rated B1/B+. B. The asset-backed security (ABS)will have a senior tranche that is rated investment grade and whose face value is lower than the value of the receivables that were on the firms balance sheet. C. The asset-backed security (ABS)will be over collateralized with the receivables that had been on the firms balance sheet and are now a liability of the special purpose entity (SPE). D. The securitization will result in a bond with two tranches: one that is senior and receives a Ba3/BB-rating and another that is junior and receives a B2/B. Answer: B A. Incorrect. Because ABS bonds are rated with respect to the risk of the underlying assets (in this credit card receivables) not the risk of the originator of the assets.

B.

Correct. A large fraction of ABSs are structured with senior and sub tranches. The senior is usually AAA because it has the full backing of all the assets in the pool that the SPE owns, while the sub tranche only gets paid back if the senior tranche is paid in full. To ensure that the default risk is lower, the senior tranche is smaller than the pool of receivables backing the bond. C. Incorrect. Because if over collateralization is used the collateral is an asset of the SPE not a liability D. Incorrect. Because it is usually the case that at least one of the tranches is investment-grade.

89. For a financial institution, model risk would not exist if: A. accurate prices for financial instruments were observable at all times. B. assets were traded infrequently. C. all financial assets were simple in design. D. all financial assets were complex. Answer: A Model risk is a result of incorrect estimates of market prices. If accurate prices were always observable, there would be no need to estimate market prices and no need to manage model risk. Infrequent trading exacerbates model risk, because it makes asset values difficult to determine based on recent transactions. Model risk exists for both simple and complex instruments when assets are infrequently traded. 90. Which of the following statements about the role of the model risk manager is most correct? The role of the model risk manager is: A. less likely to include the reverse engineering of prices if the risk manager does not believe in the efficient market hypothesis. B. more likely to include the reverse engineering of prices if the risk manager does believe in the efficient market hypothesis. C. more likely to include the reverse engineering of prices if the risk manager does not believe in the efficient market hypothesis. D. never likely to include the reverse engineering of prices regardless of the risk managers beliefs regarding the efficient market hypothesis. Answer: C The reverse engineering of prices is the process of finding the set of pricing methodologies that best accounts for observed market prices. This process is important in a non-efficient market setting, where an important objective in the model risk management process is to identify the model currently used to arrive at observed market prices that may differ from true fundamental value. This differs from an efficient market setting where the objective is to identify the model that produces the true fundamental value. 91. The difference between a Monte Carlo simulation and a historical simulation is that a

historical simulation uses randomly selected variables from past distributions, while a Monte Carlo simulation: A. uses randomly selected variables from future distributions. B. uses variables based on roulette odds. C. uses a computer to generate random variables. D. projects variables based on a priori principles. Correct answer: C. A Monte Carlo simulation uses a computer to generate random variables from specified distributions. 92. Which of the common methods of computing value at risk relies on the assumption of normality? A. Historical. B. Variance/covariance. C. Monte Carlo simulation. D. Rounding estimation. Correct answer:B The variance/covariance method relies on the assumption of normality. 93. The mean age of the 80 employees in a company is 35 and the standard deviation is 15. Assuming that the ages are normally distributed and using 95 percent confidence, we can say that the employees within the firm fall between: A. 20.0 and 50.0 years. B. 31.7 and 38.3 years. C. 33.8 and 36.2 years. D. 34.6 and 35.4 years. Correct answer: B The range of the 95 percent confidence interval = mean 1.96 x standard deviation / Number of employees^0.5 = 35 1.96 x 15 / 80^0.5 = 35 3.3 = between 31.7 and 38.3 94. Which of the following are examples of model risk? I. A VaR model that has been prepared by an external contractor. II. A mark-to-market model that cannot be understood by risk managers. III. A VaR model that does not allow for the adjustment of market correlations. IV. A mark-to-market model that relies on volatility figures prepared by the trader being monitored. A. I and III. B. II and IV.

C. D.

## II, III and IV. I, II, III and IV.

Correct answer: C The fact that VaR model that has been prepared by an external contractor does not by itself lead to model risk. Rather the risk arises if the risk manager does not understand the model, or the results of the model are derived using assumptions given by the trader being monitored, or if some of the assumptions regarding market parameters are hard-coded into the model. 95. A bank can service 1,000 loans for an average cost of \$362 per year, per loan. If the bank can service 5,000 loans for an average cost of \$298 per year, per loan, the servicing is said to have: A. economies of scope B. economies of scale C. synergy of service D. diseconomies of scope Answer: B Economies of scale refers to the cost of producing a single project falling as more products are produced. 96. Which of the following statements are TRUE? I. The credit exposure on derivatives contracts can be thought of as an option written with the strike price of zero. II. The option on a portfolio is never more valuable than a portfolio of individual options. III. The option on a portfolio is always more valuable than portfolio of individual options. A. I and II. B. I and III. C. II and III. D. I, II and III. Correct answer: A The option on a portfolio can, at most, be equal in valuable to the portfolio of individual options, when the correlation between the assets is a perfect 1.00%. Thus, the option on portfolio is never more valuable than a portfolio of individual options. 97. In the netting arrangement, which of the following contracts would NOT be netted with other contracts? A. Short positions in options. B. Short positions in forwards. C. Short positions in currency swaps.

D. Short positions in interest rate swaps. Correct answer: A Short positions in options are obligations, ab initio([](=from the beginning) adv. ), hence there is no netting 98. A bank has an opening reserve account balance of \$42 million. During the morning, the bank sends customer wires totaling \$59 million. In the afternoon, it receives \$50 million from the sale of securities, and the closing reserve account balance is \$33 million. This is an example of: A. a daylight overdraft B. a reserve overdraft C. borrowed reserves D. lending of fed funds Answer: A The Fed allows banks to fund negative intra-day balances. While providing liquidity to the transaction settlement process, it poses a systemic risk as the Fed guarantees every wire that is sent through the system. 99. An analyst observes that the closing price of a stock during a week as \$55, \$43, \$58, \$64, \$69. On the corresponding days the S&P 500 closed at 1,150, 1,100, 1,200, 1,160, 1,190. Based on this data, the covariance of the stock with the market is CLOSEST to: A. 45 B. 108 C. 252 D. 315 Correct answer: C Step 1. Calculate the mean stock price = (55 + 43 + 58 + 64 + 69) / 5 = 57.8. Step 2. Calculate the mean S&P level = (1,150 + 1,100 + 1,200 + 1,160 + 1,190) / 5 = 1,160. Step 3. The covariance between the stock and S&P = [(55 - 57.8)(1150 - 1160) + (43 57.8) (1100 - 1160) + (58 - 57.8)(1200 - 1160) + (64 - 57.8)(1160 - 1160) + (69 57.8)(1190 1160)] / 5 = 252. 100. Which of the following strategies can contribute to minimizing operational risk? I. Individual responsible for committing to transaction should perform clearance and accounting functions. II. To value current positions, price information should be obtained from external sources. III. Compensation scheme for trader should be directly linked to calendar revenues. IV. Trade tickets need to be confirmed with the counterparty. A. I and II B. II and IV

C. III and IV D. I, II, and III Answer: B II and IV are both correct. I is incorrect because it violates the separation of duties principle. III is incorrect because it ignores the amount of risk assumed by the trader and may encourage taking risks that may not become evident during the calendar period. 101. Portfolio A has total assets of \$14 million and an expected return of 12.50 percent. Historical VAR of the portfolio at 5 percent probability level is \$2,400,000. What is the portfolios standard deviation? A. 12.50%. B. 17.97%. C. 14.65%. D. 15.75%. Correct answer:B VAR = Portfolio Value [E(R)-z ]-br> -2,400,000 = 14,000,000[0.125 -(1.65)(X)]-br> -2,400,000 = 1,750,000-23,100,000(X) X = 17.97%. Note that VAR value is always negative. 102. In the approaches for weight data points in LDA model which one is incorrect A. Split loss is the loss affects more than one business line, each business line needs to be weighted. B. Scale bias is caused by the possibility that larger firms could have large loss. C. Data capture bias is caused by the fact that banks do not collect data below a given threshold. D. To deal with data capture bias, the analysis can increase the probabilities of smaller losses and decrease the possibility of larger losses. Answer:C Data capture bias is caused by a correlation between the probability of a loss been reported and the size of the loss. 103. Which of the following reasons does not help explain the problems of LTCM in August and September 1998: A. A spike in correlations B. An increase in stock index volatilities C. A drop in liquidity D. An increase in interest rates on on-the-run Treasuries

Answer: D Increased volatility and higher correlations led to substantial losses in LTCMs highly-leveraged portfolio. A significant drop in market liquidity forced LTCM to liquidate these highly-leveraged positions at substantial discounts. An increase in the spread between U.S. treasury rates and Russian government rates resulted in significant losses. 104. The Peyton Formika Fund is a global macro asset allocation hedge fund designed to provide low correlations with U.S. assets. Dominic James is a fund of hedge funds manager that is analyzing the Peyton Formika Fund for signs of style drift. James makes note of the following findings about the fund: I. The R2 of the fund versus the global macro peer group has changed from 0.72 to 0.78 over the past 12 months. II. Due to outstanding returns, assets in the fund have increased from \$70 million to \$430 million over the past 12 months. III. The fund made a major shift in allocation by moving 40 percent of its holdings from Eastern European equities to Asian equities. IV. After a recent trip to India, the fund manager gained confidence in his existing Indian equity holdings and levered his existing 5% weighting in India only by a 10 to 1 ratio. Which of James findings are indicators that the Peyton Formika Fund is at risk for style drift? A. II and IV only B. I and II only C. II and III only D. I, III and IV only

Answer A Hedge fund style drift occurs when there are changes in the risk factor exposures of the fund or changes in the overall risk of the fund, notably through leverage. Using leverage only for his Indian equity position would definitely be an indicator of style drift. Even though the initial position is small, a 10 to 1 leverage ratio would significantly change the risk of the fund. Excessive cash inflows which may be more money than the manager can sustain is also a potential indicator of style drift. The change in allocation from Eastern European equities to Asian equities is within the objectives of a global allocation fund, so that would not indicate style drift. Also, style drift would be a concern with a decrease, not an increase in the R-squared measure against the peer group. 105. James Henry is preparing a presentation on the calculation of VAR for his supervisor.

Henry is having trouble however, determining which return calculation will maintain the distribution assumptions of a 1-day VAR when converting to a multiple-day VAR. Which of the following types of return calculations should Henry select in order to estimate VAR? A. Continuously compounded return. B. Absolute return. C. Geometric mean return. D. Simple return. Correct answer: A The continuously compounded return is the most appropriate return calculation to use in estimating VAR. Using continuously compounded returns, a 1-day VAR can be extended to a multiple-day VAR using the square root rule without violating the assumptions underlying the 1-day VAR calculation. 106. Which of the following portfolios would have suffered the greatest drop in value as a result of the Russian debt crisis in 1998? A. Long-short market neutral US equity fund B. Long 5-year on the run US treasury C. A money market account plus a pay fixed USD swap D. Duration-matched portfolio, long US Low-grade corporate bonds, short US treasuries Answer: D The Russian Crisis is an example of an environment in which there would be fight to quality. A flight-to-quality is a flow of funds from riskier to safer investments in times of uncertainty. In this environment we would expect the demand for safer assets, and hence their prices, to increase. Thus, the price of US treasuries will increase. The demand of riskier assets, and hence their price would decline. We would see the prices of US corporates decline relative to US treasuries. Of the four choices, choice D contains two asset classes which differ on the basis of risk. This duration matched portfolio would suffer the greatest drop ff value because the price of US low-grade corporate would decline and the price of US treasuries would increase. 107. A portfolio contains two perfectly negatively correlated investments with volatilities of 5 percent and 7 percent. The proportion of these two securities that would lead to the lowest risk are: A. 58% and 42%. B. 42% and 58%. C. 34% and 66%. D. 66% and 34%. Correct answer: A

Since the investments are perfectly negatively correlated the volatility of the portfolio = (w1 x v1 - w2 x v2). This can be reduced to zero by adjusting the amounts invested in the inverse of the ratios of the volatilities (i.e. w1/w2 = v2/v1). 108. Which of the following cases of losses was not the result of unauthorized or rogue trading? A. Long-Term Capital Management B. Allied Irish Bank C. Sumitomo D. Daiwa Answer: A A. LTCM was an example of strategies that were deliberately undertaken and approved but that didnt pay off. LTCM was subject to operational risks like model risk, but the trades that led to the losses were not unauthorized. B. Allied Irish Bank involved a rogue trader making fx trades. C. Sumitomos rogue trading in copper killed it. D. Daiwa had a fixed income rogue doing unauthorized trades. 109. An analyst is studying a stock that is currently trading at \$35. The analyst estimates that there is 33 percent probability that the stock will trade at \$50 after one year, a 20 percent probability that the stock will trade at \$42, and a 47 percent chance that the stock will trade at \$20. What is the implied volatility of this stock price? A. 13%. B. 24%. C. 31%. D. 39%. Correct answer: D Step 1. The returns for the three scenarios given are: 42.857% [= (50 - 35)/35], 20% [= (42 35) / 35], and -42.857% [= (20 - 35) / 35] Step 2. Calculate expected price = 33% x 42.857% + 20% x 20% + 47% x -42.857% = -2%. Step 3. Calculate Variance = 33% x (-2% - 42.857%)^2 + 20% x (-2% - 20%)^2 + 47% x (2% + 42.857%)^2 = 0.154538 Step 4. Calculate volatility/standard deviation = 0.154538^0.5 = 39.31%. 110. Risk management activities can reduce the probability that a firm will experience a debt overhang in the future. The costs that are usually associated with debt overhang include: I. excessive hedging by managers. II. a reduction in risk at bondholders expense. III. giving shareholders an incentive to take on negative NPV projects. IV. excessive managerial focus on bondholders interests at shareholders expense. A. I, II, and IV B. I and III only

C. I only D. III only Answer: D Debt overhang provides shareholders with an incentive to take on risky, negative NPV projects, because debtholders bear the cost if the project fails while shareholders benefit from low probability outcomes associated with high cash flows. The other major cost of debt overhang is that it may lead to underinvestment, because positive NPV projects that do not provide cash flow sufficient to repay the debt may be bypassed. 111. Which of the following statements best defines VAR(5%) on a percentage basis? VAR(5%) is the: A. maximum percentage loss that is expected to occur 5% of the time. B. percentage loss in value that will only be exceeded or equaled on 5 out of 100 days. C. probability that a loss will exceed 5% of the portfolio value. D. maximum dollar loss that is expected to occur 95% of the time. Correct answer:B VAR(5%) on a percentage basis is defined as the percentage loss in value that is expected to be equaled or exceeded only 5% of the time (5 days out of 100). VAR itself is not a probability. It is a statement of loss in either percentage or dollar terms for a given probability. Note that maximum dollar loss would have been correct if the question asked for the definition of VAR(5%) on a dollar basis. 112. Which of the following statements is not correct? A. The more firm hedges its financial exposures, the less equity it requires to support its business. B. In order to maximize value, a firm must hedge its financial exposure irrespective of its capital structure. C. The use of risk management to reduce financial exposures effectively increases a firms debt capacity. D. Decisions to hedge financial exposures should be made jointly with the companys capital structure decisions. Answer: B Hedging is not a mandatory, i.e. hedging could help some firms to increase shareholder value, while for other firms, leaving exposures unhedged or selectively hedged while maintaining more equity may be the value-maximizing strategy. Therefore, consideration of capital structure plays a vital role in hedging decisions. 113. Consider the following statements and identify which ones are true: I. Severity assessment involves the determination of the probability of loss should a failure occur in a given operational risk category II. External dependency risk is a widely recognized operational risk component

III. IV. A. B. C. D.

Forecasting changes in asset and liability duration is one way to manage strategic operational risk Corporate restructuring is one of the transitory conditions that are particularly risky for organizations I, II and IV II and IV I, II, and III I, III and IV

Answer: B I is incorrect. Severity assessment involves the determination of the extent of the loss, not the probability. Probability is measured by the net likelihood assessment. II is a correct. The three components identified are operational failure risk, operational strategic risk and external dependency risk. III is incorrect. Duration management is not part of strategic operational risk. IV is correct. Corporate restructuring is one of the transitory conditions that are particularly risky for organizations. 114. You are an analyst at Bank Alpha. You were given the task to determine whether under Basel II your bank can use the simplified approach to report options exposure instead of the intermediate approach. Which of the following criteria would your bank have to satisfy in order for it to use the simplified approach? A. The bank writes options, but its options trading is insignificant in relation to its overall business activities. B. The bank purchases and writes options and has significant option trading. C. The bank solely purchases options, and its options trading is insignificant in relation to its overall business activities. D. The bank purchases and writes options, but its option trading is insignificant. C 115. Bank B lends \$10 million to Company C for six months and receives \$12 million worth of US Treasuries as collateral. The 6-month default probability of the Company C is 2 percent and the 6-month 99% VaR on the Treasuries is \$2 million. Assuming that the performance of Company C is not affected by interest rates, the probability of Bank B not recovering the full principal of the loan is most will be closest to: A. 0.002%. B. 0.02%. C. 0.2%. D. 2%.

Correct answer: B Bank B will not recover the full principal of the loan only if the Company C defaults and the value of the collateral falls by \$2 million (the probability of which is 1%). Since the performance of Company C does not depend on interest rates, the events of default by Company C and the extreme fall in the value of Treasures (more than \$2 million) will be independent. Therefore, the joint probability of both occurring together will be 2% x 1% = 0.02%. 116. Consider a portfolio of five equally-weighted bonds. Each bond has default probability of 5% per annum and the defaults are independent of each other. What is the probability that this portfolio will see its first default by the end of second year? Assume the same default probabilities for first and second years for the surviving bonds. A. 17.50%. B. 22.62%. C. 40.13%. D. Insufficient Information. Correct answer: C The probability that this portfolio will see its first default by the end of second year = P[first default in year 1] + P[first default in year 2] = P[first default in year 1] + P[no default in first year] x P[at least one default in second year] = (1 - 0.95^5) + 0.95^5 x (1 - 0.95^5) = 40.13%. 117. Which of the following is NOT one of the three traits common to past major financial shocks? A. Reliance on overly complex pricing models. B. A lack of market liquidity. C. A sharp decline in asset prices due to a triggering event. D. Leverage concerns. Answer: A The three common traits associated with past major financial shocks are: a triggering event leads to a sharp decline in asset prices. liquidity pressures. leverage concerns. 118. Two NY-based banks entered into a credit derivative contract to compensate the actual credit loss suffered by one party in consideration of annual fee paid by it to the second party. In this situation, which of the following is correct? A. As per UK law, this is a wager and so the contract is void. B. As per the State of NY Insurance Department, this is an insurance contract. C. As per the State of NY Insurance Department, this is not an insurance contract, but a financial derivative. D. None of the above.

Correct answer: B Since this contract seeks to compensate the actual loss, this is an insurance contract, as payment is contingent on BOTH the credit event happening AND the party suffering loss. In credit derivative, the payment is contingent ONLY on credit event happening. 119. In an attempt to provide guidance on an additional steps to be taken by the private sector to promote the efficiency ,effectiveness and stability of the global financial system .The counterparty risk management policy Group II (GRMPG II) published a report in July 2005 containing recommendations and guiding principles. According to the GRMPG II report, which of the following statements relating to Emerging Issue is incorrect ? A. GRMPG II recommends that fiduciaries taking on risks associated with complex products should have the ability to aggregate risk across their entire pool of assets in order to understand portfolio-level implications. B. GRMPG II recommends that hedge funds. on a voluntary basis, adopt the relevant recommendations and guiding principles contained in their (GRMPG II) report. C. As a guiding principle in selling structured products to retail investors ,financial intermediaries should consider whether disclosure appropriately conveys the fact that secondary market value ,at maturity, will be less than the issue price. D. As a guiding principlesenior management should conduct periodic reviews of the financial intermediarys internal controls for the sale of complex products retail investors. Answer: C A. Is incorrect. Because the statement is correct according to CRMPG II report. This basically comes from the New Prudent Man Rule as opposed to the traditional Fiduciary Rule. B. Is incorrect. Because the statement is correct according to CRMPG II report. This recommendation is an effort to promote the efficiency, effectiveness and stability of the global financial system. C. Is correct. Per CRMPG II report, disclosure should relate to the secondary market value at or near issuance (not at maturity). D. Is incorrect. Because the statement is correct according to CRMPG II report. This is the essence of Sarbanes-Oxley requirement. 120. Which of the following statements describe an appropriate step in the structured Monte Carlo (SMC) approach for measuring risk? I. The first step simulates thousands of valuation outcomes for the underlying assets. II. The first step assumes some properties of the underlying assets return distribution such as normality. III. The second step measures the VAR for the portfolio of derivatives based on the simulated outcomes. A. I only. B. I, II, and III.

C. II only. D. I and III. Correct answer:B Steps in using the SMC approach include: Step 1: Simulate thousands of valuation outcomes for the underlying assets based on the assumption of normality. Step 2: The VAR for the portfolio of derivatives is then calculated from the simulated outcomes. 121. A trader buys one wheat contract (underlying = 5,000 bushels) at a price of \$1.89 per bushel. The initial margin on the contract is \$4,800 and the maintenance margin is \$3,200. At what price will the trader receive a maintenance margin call? A. \$1.25. B. \$1.57. C. \$2.21. D. \$2.53. Correct answer: B The trader would have to post a margin of \$4,800 at the outset and would receive a margin call if the value of this margin fell to \$3,200. Thus the margin call would come when the contract lost \$1,600 (= \$4,800 - \$3,200) of is value. This translates in to a price level = Current price Dollar loss/Underlying quantity = \$1.89 - \$1,600 / 5,000 = \$1.57. 122. Consider a 5-year interest rate swap with notional of \$500 million. Over a horizon of one year, the returns are normally distributed and the volatility in the market value of the swap is \$40 million. To compute expected default loss, you need to know: I. the expected default rate of the counterparty. II. the expected recovery rate, given the default. III. the history of rating changes of the counterparty, with analysis of the balance sheet to find out leverage ratio. A. I and II. B. I and III. C. II and III. D. I, II and III. Correct answer: A The expected default loss = expected exposure x 0.5 x default probability x (1 recovery rate). 123. In the peaks-over-threshold to estimate parametric tails in distributions which of the statements is incorrect. A In this process we estimate a threshold then calculate the conditional probability of

B C tail. D

a loss above this level. The model consist of two parameter this shape and scaling parameter. If the parameter indicating the fatness of the tail is below zero, this indicating a fat To deals with varying parameters the maximum likelihood method can be used.

Answer: C

## X The POT model is f ( x) = 1 (1 + ) , of which is the shape parameter. If it is

1

larger than 0, it indicates a fat tail. 124. In the is description about the subexponential distribution which one is incorrect. A. Subexpoential distribution includes Weibull, Negative binomial, and Parto distribution. B. Parto distribution decays more slowly than exponential distribution prior to the tail. C. The sum of n independent distributed severities will tend to be large due to the severity a single large loss event. D. The equation lim

## P ( X 1 + ... + X n > X ) = 1 is satisfied. P(max( X 1... X n ) > X )

Answer: A Subexpoential distribution does not include negative binomial distribution. 125. Which of the following is not an accurate statement regarding the purchase of insurance by banks for covering operational risk-related losses? A Insurance for operational risk events can be very expensive. B Insurance companies do not have any comparative advantage in bearing or measuring operational risk and thus make poor risk management partners for banks. C The presence of moral hazard in insurance leads to numerous contracting terms that restrict and condition the insurance and that make the insurance less valuable for banks. D Policy limits often limit insurance coverage to levels well below the catastrophic levels for which banks actually need protection. Answer: B B 126. Which of the following risks is not included in the Basel II definition of operational risk?

A. Legal Risk. B. Reputation Risk. C. Process Failure Risk. D. Systems Failure Risk. Answer: B Reputation risk Strategy Risk Operational risk 127. Your bank is implementing the advanced Internal Rating Based Approach of Basel II for credit risk, and the Advanced Measurement Approach for operational risk. The bank uses the model approach for market risk. The Chief Risk Officer (CRO) wants to estimate the banks total risk by adding up the regulatory capital for market risk, credit risk, and operational risk. The CRO asks you to identify the problems with using this approach to estimate the banks total risk. Which of the following statements about this approach is incorrect? A It assumes market, credit, and operational risks have zero correlation. B It uses a 10-day horizon for market risk. C It ignores strategic risks. D It ignores the interest risk associated with the banks loans. Correct answer: D A CRO B Basel 10 99% C D 3 128. Every year Business Week reports the performance of a group of existing equity mutual funds, selected for their popularity. Taking the average performance of this group of funds will create A. Survivorship bias only B. Selection bias only C. Both survivorship and selection bias D. Instant-history bias only Answer: C The publication lists existing funds, so it must be subject to survivorship bias, because dead funds are not considered. In addition, there is selection bias because the publication focuses on just the popular funds, which are large and likely to have done well. Answers a) and b) are incomplete. Answer d) is also incomplete.

129. Firm A has 40 derivatives contract outstanding with Firm B. The net mark-to-market value of these contracts is \$50 million and gross mark-to-market value (sum of absolute values) is \$90 million. The current credit exposure of Firm A to Firm B will be: A. \$70 million. B. \$90 million. C. \$120 million. D. \$140 million. Correct answer: A Say that the sum of the positive MTM values is X and the sum of the negative MTM values is Y. Then X + Y = \$50 million and X - Y = \$90 million. Solving these equations we get X = \$70 million. 130. Which of the following statements about the Sortino ratio are valid?

I. The Sortino ratio is more appropriate for asymmetrical return distributions. II. The Sortino ratio compares the portfolio return to the return of a benchmark
portfolio.

III. The Sortino ratio allows one to evaluate portfolios obtained through an
optimization algorithm that uses variance as a risk metric.

IV. The Sortino ratio is defined on the same principles as the Sharpe ratio, but the
Sortino ratio replaces the risk free rate with the minimum acceptable return and the standard deviation of returns with the standard deviation of returns below the minimum acceptable return. II and III I, III and IV I and III I and IV

A. B. C. D.

Answer: D A. Incorrect. II The information ratio, not the Sortino ratio, compares the portfolio return to the return of a benchmark portfolio. III The Sortino ratio allows one to evaluate portfolios obtained through an optimization algorithm that uses semi-variance, not variance, as a risk metric. B. Incorrect. III The Sortino ratio allows one to evaluate portfolios obtained through an optimization algorithm that uses semi-variance, not variance, as a risk metric. C. Incorrect. III The Sortino ratio allows one to evaluate portfolios obtained through an optimization algorithm that uses semi-variance, not variance, as a risk metric. D. Correct. I Since the Sortino ratio uses the notion of semi-variance, it is more appropriate for asymmetric return distributions than any metric that uses standard deviation (such as the Sharpe ratio). IV The Sortino ratio is similar to the Sharpe ratio, except the risk free rate is replaced with the minimum acceptable return in the numerator and the standard deviation of the returns is replaced with the standard

deviation of the returns below the minimum acceptable return in the denominator. II The information ratio, not the Sortino ratio, compares the portfolio return to the return of a benchmark portfolio. III The Sortino ratio allows one to evaluate portfolios obtained through an optimization algorithm that uses semi-variance, not variance, as a risk metric. 131. Suppose a portfolio consists of a USD 1 million investment in Euros and a USD 4 million investment in Mexican Pesos. Additional information is given below: Portfolio beta of Euro = 0.90 Portfolio beta of Peso = 1.30 Diversified Portfolio VaR = USD 324,700 Based on the given information, the marginal VaR and the component VaR of the Euro position are closest to: Marginal VaR Component VaR A. USD 0.058 USD 58,446 B. USD 0.292 USD 292,230 C. USD 0.084 USD 337,688 D. USD 0.106 USD 422,110 Answer: A A. Correct. Marginal VaR of Euro = (USD 324,700 / USD 5,000,000)0.90 = USD 0.058 Component VaR of Euro = USD 324,700 0.90 (1,000,000 / 5,000,000) = USD 58,446 B. Incorrect. Because of the use of incorrect variable and/or incorrect formula. C. Incorrect. Because of the use of incorrect variable and/or incorrect formula. D. Incorrect. Because of the use of incorrect variable and/or incorrect formula. 132. Which of the following models for interest rates would allow for mean reversion? A. dr = a dt + s dz B. dr = a dt b dt + s dz C. dr = a (b r ) dt + s dz D. dr = a (r b) dt + s dz

Correct answer: C

## dr = a (b r ) dt + s dz , is the only model given above that allows for the

interest rate r to mean revert to a level b. 133. Which of the following is an example of liquidity risk? A. A financial institution does not have the cash to meet its capital withdrawals. B. The bid-ask spread for an actively traded asset is close to zero.

C. The daily trading volume for a stock is significantly higher than the daily trading volume for the average stock. D. A firm issues new bonds upon the maturity of an older bond issue. Correct answer:A Liquidity risk (funding related) refers to the risk that a financial institution will be unable to raise the cash necessary to roll over its debt, fulfill cash requirements of counterparties, or meet capital withdrawals. Note that a wide bid-ask spread would indicate high liquidity risk (trading-related), while a bid-ask spread close to zero indicates little liquidity risk. Also, high trading volume would tend to indicate lower liquidity risk (trading-related). 134. A bank enters into a 5-year swap with a client to pay a fixed annual coupon of 7% in return or semi-annual LIBOR. Two years later the client defaults, at which point the 3-year swap rate is 6%. The loss incurred by the bank as a percentage of the notional amount due to this default will be CLOSEST to: A. 0.0%. B. 2.6%. C. 3.0%. D. 4.1%. Correct answer: A At the point of default, the bank is paying a rate of 7% when the prevailing market rate is 6%. Therefore, the bank owes the client rather than the other way around. Due to the ISDA agreement, the bank will probably have to pay the net value of the swap (after expenses) with the client's creditor, but will not bear any loss. 135. According to the Report of the Counterparty Risk Management Policy Group (CRMPG) II, the overriding guiding principle for its recommendations concerning complex financial products is: A. accountability B. sound judgment and experience C. standardization of procedures D. the use of sophisticated financial models Answer: B According to the CRMPG II, the overriding guiding principle is that management must rely on sound judgment based on familiarity and knowledge of the fundamentals of risk management. 136. For a portfolio with a large number of relatively small positions, the component VAR of a given position would probably be closest to: A. the positions marginal VAR divided by the value invested in the position. B. the positions marginal VAR multiplied by the beta of the position with the overall portfolio.

C. the positions marginal VAR divided by the beta of the position with the overall portfolio. D. the positions marginal VAR multiplied by the value invested in the position. Correct answer:D In a large portfolio with many positions, the approximation is simply the marginal VAR multiplied by the dollar weight in position ,where is the value of the portfolio, is the weight in the portfolio. 137. You need to update a daily volatility forecast using the RiskMetricsTM exponential method with a decay factor of 0.97. Yesterday's forecast of standard deviation was 1%. Given that you just observed a return of 2%, what will be the new forecast of standard deviation? A. 1.030% B. 1.044% C. 1.970% D. 1.977% Answer: B The formula for the weighted average forecast for the time t variance using the RiskMetricsTM approach is: ht = ht 1 + (1 )( rt 1 ) , where r is the return for time t-1, ht 1 and
2

ht are forecast variances at time t-1 and t respectively, and is an exponential deny factor.
Using the information provided, the updated forecast for standard deviation is:

(h t ) 2 =
1

[(0.97)(0.01)

+ (1 0.97 )(0.02)

1 2 2

= 1.044%.

138. Metallgesellschaft Refining and Marketing offered customers long-term contracts with fixed prices for petroleum contracts. Their strategy to hedge this exposure: A. did not account for funding risk created by a mismatch between the timing of the hedge cash flows and the contract cash flows. B. failed because of improper internal controls. C. was based on fraudulent reporting. D. suffered from poor diversification. Answer: A Metallgesellschaft implemented a stack-and-roll hedge strategy, which uses short-term futures contracts to hedge long-term risk exposure. The stack-and-roll hedge strategy proved ineffective due to interim funding cash outflows created by margin calls, a shift in the market from backwardation to contango, and other factors. No offsetting interim cash inflows were available on their long-term customer contracts, creating a liquidity

crisis that was exacerbated by their size of their futures positions in relation to the liquidity of the market. Central themes were not diversification, fraud, or operational controls. 139. Given a one-year and a three-year zero coupon bond price of 95.18 and 83.75 respectively, what should be the price of a two year zero coupon bond using linear interpolation on zero rates (semiannual compounding)? A. 95.18 B. 89.47 C. 89.72 D. 83.75 Answer: C Step 1. compute semiannual zero rates for the 1- and 3-year bonds. 1-year bond: FV = I00; N = 2; PMT =0, PV =-95.18 CPT 3-year bond: FV = I00; N = 6; PMT =0, PV =-83.75 CPT Step 2. use linear interpolation on zero rates for 2- year bond (6%-5.%)/2=0.5%zero rates for 2- year bonds=5%+0.5%=5.5% Step3. compute 2-year bond price FV = I00; N =4; PMT =0, I/Y =2.755.5/2CPT PV =-89.72 I/Y =2.5008*2=5.0%. I/Y =3*2=6%

140. Lawsuits about derivatives to major corporations are most likely to involve which of the following issues? A. The type of derivative. B. Broker size C. Breach of fiduciary duty. D. Enforceability of contract Answer: D Most lawsuits involving derivatives are the result of the enforceability of the provisions of the derivatives contract. Master netting agreements have been used effectively to reduce the occurrence of contract disputes, reducing both legal and credit risk. These contracts contain carefully-formulated, standardized language that minimizes the chances of mistakes or misunderstandings.