FRM

Part II Exam

By AnalystPrep

Questions with Answers - Market Risk Measurement and

Management

Last Updated: Dec 19, 2020

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 Table of Contents

Estimating Market Risk Measures: An Introduction and

61 - 3
Overview
62 - Non-parametric Approaches 23
63 - Parametric Approaches (II): Extreme Value 42
64 - Backtesting VaR 64
65 - VaR Mapping 81
Messages from the Academic Literature on Risk Measurement
66 - 102
for the Trading Book
67 - Correlation Basics: Definitions, Applications, and Terminology 111
Empirical Properties of Correlation: How Do Correlations
68 - 133
Behave in the Real World?
69 - Financial Correlation Modeling—Bottom-Up Approaches 142
70 - Empirical Approaches to Risk Metrics and Hedging 149
71 - The Science of Term Structure Models 165
The Evolution of Short Rates and the Shape of the Term
72 - 181
Structure
73 - The Art of Term Structure Models: Drift 190
74 - The Art of Term Structure Models: Volatility and Distribution 214
75 - Volatility Smiles 231
76 - Fundamental Review of the Trading Book 244

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 Reading 61: Estimating Market Risk Measures: An Introduction and
Overview

Q.1471 During a job interview for the role of assistant financial risk manager, Jacob Lee was
asked to describe the advantages of geometric returns over arithmetic returns. He mentioned
the following point:

I. The geometric mean takes into account the compounding that occurs from period to period.
II. In the world of finance, the arithmetic mean is usually an appropriate method for calculating
multi-period average returns if the one-period returns are volative.

Which of the above-mentioned points is/are correct?

A. Only Point I is correct

B. Only Point II is correct

C. Both I and II are correct

D. Neither I nor II is correct

The correct answer is: A)

Point I is correct. The geometric mean differs from the arithmetic average, or arithmetic mean,
in how it's calculated because it takes into account the compounding that occurs from period to
period. Because of this, investors usually consider the geometric mean a more accurate measure
of returns than the arithmetic mean.

Point II is incorrect. For volatile numbers, the geometric average provides a far more accurate
measurement of the true return by taking into account period-over-period compounding. For
example, if your portfolio returns each year were 90%, 10%, 20%, 30%, and -90%, the arithmetic
average would be 12%. However, the geometric average annual return would be -20.08%, which
is a lot more accurate.

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Q.1472 If the arithmetic returns are 0.10, which of the following equations gives the
corresponding geometric returns?

A. Rt = ln(0.10)

B. Rt = ln(1.10)

C. Rt = ln(1.90)

D. Rt = ln(0.90)

The correct answer is: B)

If we have the arithmetic returns, rt, we can find the corresponding geometric returns from this
equation: Rt = ln (1+rt). In this case, Rt = ln (1+0.1).

Q.1473 Value at Risk (VaR) measures the level of financial risk over a predefined time period. Out
of the following, which method is not used to calculate VaR?

A. Historical Simulation (HS)

B. Parametric Approaches

C. Abnormally Distributed Profits/Losses

D. Normally Distributed Arithmetic Returns

The correct answer is: C)

When measuring VaR using profits/losses, the underlying assumption is that the values are
normally distributed.

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Q.1474 VaR is a quantile that demarcates the tail region and non-tail region. Which metric is
used to calculate the size of the tail?

A. Standard deviation

B. Confidence level

C. Number of observations

D. Variance

The correct answer is: B)

In theory, the VaR is the quantile that separates the tail region from the non-tail region, where
the size of the tail is determined by the confidence level. For example, suppose we have 1000
loss observations and are interested in the VaR at the 99% confidence level. This means we
would have a 1% tail, and 10 observations in the tail. The VaR would be the 11th highest loss
observation.

Q.1475 If Profit/Losses (P/L) are distributed normally with standard deviation 18 and mean 12,
then what is the value of the corresponding VaR using a 95% confidence interval?

A. 9.87

B. -17.61

C. 13.956

D. -13.956

The correct answer is: B)

If P/L over some period are normally distributed with mean 12 and standard deviation 18, then
the 95% VaR is

12 − 18z0.95 = 12 − 18 × 1.645 = −17.61

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Q.1476 If the natural log of X is distributed normally, then the random variable is:

A. Normally distributed

B. Lognormally distributed

C. Seminormally distributed

D. Equally distributed

The correct answer is: B)

A random X variable is said to be lognormally distributed if the natural log of X is normally

distributed.

Q.1477 Which of the following statements regarding the estimation of the expected shortfall (ES)
is false?

A. The ES can be estimated as an average-tail-VaR because it's actually the probability-

weighted average of tail losses

B. The ES can be estimated with the help of a 'closed-form' solution

C. A 'closed-form' solution is more preferable than the average-tail-VaR because the

formula and its application is widespread in all parametric distributions

D. The average-tail-VaR is more preferable method to estimate the Expected Shortfall

(ES) as it has higher applicability and is easier to implement

The correct answer is: C)

A 'closed-form' solution can be a useful way of estimating the ES, but ES formulas seem to be
known only for a limited number of parametric distributions. The 'average-tail-VaR' is
comparably easier to use and can be applied to most ESs encountered in practice.

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Q.1478 One of the easiest coherent risk measures is estimating expected short fall (ES). What
happens to the Expected Shortfall (ES) when the number of observations, n is increased?

A. The ES falls

B. The ES rises

C. The ES stays constant

D. The ES moves but not in a consistent manner

The correct answer is: B)

When calculating the ES for varying values of n, the results reveal that the ES rises as n
increases and gradually converges to the true value.

Q.1479 A generally coherent risk measure tends to involve increasingly sophisticated weighting
functions. Which of the following is a suitable replacement for the equal weights in the 'average
VaR' to estimate any risk measure?

A. Average weights

B. Exponential weights

C. Weights appropriate to risk exposure being estimated

D. None of the above.

The correct answer is: C)

When measuring risks, it is important to assign weights taking into account the specific risk
measure being estimated.

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Q.1480 The key to estimating coherent risk measures lies in the:

A. Ability to assign weights accurately

B. Ability to calculate exponential value accurately

C. Ability to estimate quantiles

D. Ability to approximate risk exposure

The correct answer is: C)

If quantiles are estimated appropriately, then the coherent risk measures can be easily
calculated by finding the average.

Q.1481 The precision of a risk measure estimate is evaluated by means of the corresponding
standard error(s). The quantile (VaR) standard error depends on which of the following?

A. f(q), sample size n and p

B. p, standard error s and variance of q

C. sample size n, p and square root of error

D. variance of q, sample size n and f(q)

The correct answer is: A)

According to Kendall and Stuart, the standard error falls as sample size n rises; it rises as
probabilities become extreme and more toward the tails; and it also depends on the probability
density function f(q).

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Q.1482 A portfolio has a beginning period value of $200. The arithmetic returns follow a normal
distribution with a mean of 5% and a standard deviation of 10%. Calculate VaR at both the 95%
and 99% confidence levels, respectively:

A. $23, $36.6

B. $43, $56.6

C. $1.65, $2.33

D. $23, $43

The correct answer is: A)

Using a parametric estimation approach,

VAR(α%) = (-μr + σr × Zα) × Pt - 1
Where:
μr = mean (arithmetic) return
σr = standard deviation of returns
Zα = normal distribution parameter
Pt - 1 = beginning period value

VAR(5%) = (-5% + 1.65 × 10%) × 200 = $23

VAR(1%) = (-5% + 2.33 × 10%) × 200 = $36.6

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Q.1483 In an exam, Tom Lee was asked to give three core issues regarding risk measures
commonly used in practice. Lee responded by saying that before embarking on risk
measurement, one must decide on:

I. The weighs to assign, and

II. The desired level of analysis

Which of the above-mentioned point(s) is/are incorrect regarding risk measures to use before
embarking to measure risk?

A. Only Point I is incorrect

B. Only Point II is incorrect

C. Both I and II are incorrect

D. Neither I nor II is incorrect

The correct answer is: A)

Before attempting to measure risks, one must establish the risk measure to use, e.g., the VaR,
ES, etc. Next, a decision must be made whether to estimate the risk at the individual level or the
portfolio level. In addition, one must select a suitable estimation method, such as parametric,
non-parametric, or even Monte Carlo estimation.

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Q.2628 You are assigned to calculate the monthly VaR for the stock of Apex Inc. You are provided
with the following data for the ten worst returns of the stock during the last 100 months:

-12%, -7%, -32%, -26%, -24%, -20%, -19%, -17%, -15%, -14%

Which of the following is closest to the monthly VaR for Apex using a confidence level of 95%?

A. -32%

B. -17%

C. -12%

D. -14.5%

The correct answer is: B)

The 95% VaR can be found by finding the value that separates the 5% worst values of the returns
distribution from the remaining distribution. This value will be the [(1-95%)100 + 1]th
observation, i.e., 6th observation after rearranging all the observations in ascending order.
[-32% -26% -24% -20% -19% -17% -14% -15% -12% -7%]
Thus, our observation of interest is -17%

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Q.2629 Jason Tyler has invested $100,000 in the shares of Kraken Corp. To calculate the market
risk of his portfolio, Tyler gathers the monthly returns for the security over the last 500 months.
The 10 worst returns during this period were:

-30%, -27%, -24%, -23%, -22%, -21%, -20%, -19%, -18%, -16%

What is the monthly VaR for Tyler’s investment using a confidence level of 99%?

A. $30,000

B. $16,000

C. $21,000

D. $27,000

The correct answer is: C)

In general, if there are n ordered observations, and a confidence level cl%, the cl% VaR is given
by the [(1 – cl%) n + 1]th highest observation. This is the observation that separates the tail from
the body of the distribution. For instance, if we have 1,000 observations and a confidence level of
95%, the 95% VaR is given by the (1 – 0.95)1,000 + 1 = 51st observation. There are 50
observations in the tail.

In this case, the look-back window has 500 observations, so the 99% VaR is given by the (1 –

0.99)500 + 1 = 6th worst observation. There are 5 observations in the tail.

Thus, monthly VaR = 21% * $100,000 = $21000

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Q.2630 Given a normally distributed profit and loss distribution with an annual mean of $500,000
and standard deviation of $50,000, calculate the VAR at a confidence level of 99%.

A. $598,000

B. $383,500

C. $616,500

D. $402,000

The correct answer is: B)

VaR = -μ + σ × z

For a confidence level of 99%, the Z value will be 2.33.

The VaR can be calculated as:

VaR = -500,000 + 2.33 (50,000)

VaR = -500,000 + 116,500
VaR = -383,500

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Q.2632 An analyst has gathered the following information about a portfolio which has normally
distributed geometric returns:

Mean 10%
Standard Deviation 40%
Portfolio 100 million

What is the 95% lognormal VAR for this portfolio?

A. $74.7 million

B. $35.3 million

C. $42.8 million

D. $113.4 million

The correct answer is: C)

Lognormal VaR = P(1-e(μ - σz))

= 100,000,000(1 - e(0.1 - 0.4(1.645)))
= 100,000,000 × (-0.4276)
= 42,764,737

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Q.2633 Jimmy Ray, a risk analyst at Alcoa Bank, has just performed a historical simulation for
estimating the VAR for the fixed income portfolio of the bank based on the returns for the last
500 trading days. The 10 worst one day returns generated in the simulation are:

-9,111, -8,669, -8,127, -7,098, -6,712, -6,698, -5,743, -5,189, -4,811, -4,775

Which of the following is the 99% one day expected shortfall for the portfolio?

A. 8.1452

B. 6.712

C. 9.111

D. 7,943

The correct answer is: D)

From a statistical point of view, the expected shortfall, also known as the conditional VaR (CVaR),
is a sort of mean excess
function, i.e. the average value of all the values exceeding a special threshold, the
VaR. CVAR indicates the potential
loss if the portfolio is “hit” beyond VAR:

ES = E[L|L is greater than VaR]

If there are n ordered observations, and a confidence level cl%, the cl% VaR is given by the [(1 –
cl%) n + 1]th highest observation. In this case, the 99% VaR is given by the (1 – 0.99)500 + 1 =
6th worst observation. There are 5 observations in the tail.

The 99% expected shortfall will be the average of the 5 worst returns (tail losses) which in this

case will be:

(-9,111 + -8,669 + -8,127 + -7,098+ 6.712)/5 = 7,493.4

Q.2636 Jacob Watson is a risk manager for a large bank. Presently, he is estimating the VaR for
the equities portfolio of the bank. He is considering estimating the VaR using both a normal
distribution assumption and a lognormal distribution assumption. He has gathered the following
information about the portfolio:

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 Value of the portfolio USD 1 million

Mean 15%

Volatility 25%

What would be the 1 year 99% VaR for the portfolio under the two assumptions?

A. Normal distribution: $495,000; Lognormal distribution: $460,000

B. Normal distribution: $460,000; Lognormal distribution: $495,000

C. Normal distribution: $432,500; Lognormal distribution: $351,000

D. Normal distribution: $499,000; Lognormal distribution: $432,500

The correct answer is: C)

Under normal distribution assumption:

VaR = μ - σ × z

For a confidence level of 99%, the Z value will be 2.33.

The VaR can be calculated as:

VaR = 0.15 - 2.33(0.25)

VaR = 43.25%

In dollar terms, this will be $432,500.

Under the lognormal distribution assumption:

Lognormal VaR = 1 - e(μ - σ × z)

= 1 – e(0.15 – 0.25(2.33))

= 35.1%

In dollar terms, this will be $351,000.

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Q.2815 If the geometric return Rt over some period of time is 8.62%, what is the arithmetic
return?

A. 0.0831

B. 0.0862

C. 0.0255

D. 0.0900

The correct answer is: D)

Recall that,

R t = ln(1 + rt )

⇒ rt = eRt − 1 = e0.0862 − 1 = 0.09002 ≈ 9%

Q.2816 If the geometric returns Rt is 0.013 over a specified period, then the arithmetic returns
must be:

A. 0.032562

B. 0.245861

C. 0.013085

D. 0.056894

The correct answer is: C)

geometric return = ln[1 + arithmetic return]

Let rt be the arithmetic return
0.013 = ln(1 + rt)

exp0.013 = 1 + rt

rt = exp0.013 - 1 = 0.013085

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Q.2817 Assuming that the P/L over a specified period is normally distributed and has a mean of
14.1 and a standard deviation of 28.2. What is the 95% VaR and the corresponding 99% VaR?

A. The 95% VaR is 32.289 and the 99% VaR is 51.4932

B. The 95% VaR is 36.495 and the 99% VaR is 51.556

C. The 95% VaR is 55.236 and the 99% VaR is 36.49551

D. The 95% VaR is 36.225 and the 99% VaR is 41.586

The correct answer is: A)

Recall that: αVaR = -µP/L + σP/Lzα ,

Therefore, the 95% VaR is: -14.1 + 28.2Z0.95 = -14.1 + 28.2 × 1.645 = 32.289

The 99% VaR is: -14.1 + 28.2Z0.99 = -14.1 + 28.2 × 2.326 = 51.4932

Q.2818 The arithmetic returns rt, over some period of time, are normally distributed with a mean
of 1.55 and a standard deviation 1.07. The portfolio is currently worth 1 unit. Calculate the 95%
VaR and the 99% VaR.

A. The 95% VaR is 2.3658 and the 99% VaR is 3.6588

B. The 95% VaR is 1.4542 and the 99% VaR is 0.0652

C. The 95% VaR is 0.6742 and the 99% VaR is 3.00896

D. The 95% VaR is 0.21015 and the 99% VaR is 0.93882

The correct answer is: D)

Recall, αVaR = - (µr – ðrzα)Pt-1,

Therefore, the 95% VaR is: -1.55 + 1.07 × 1.645 = 0.21015

The 99% VaR is: -1.55 + 1.07 × 2.326 = 0.93882

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Q.2819 Let’s assume that the geometric returns Rt, are normally distributed with mean 0.079
and standard deviation 0.312. Further, assume that the portfolio is currently worth 1 unit.
Calculate the 95% and 99% lognormal VaR.

A. The 95% VaR is 0.8951 and the 99% VaR is 0.2351

B. The 95% VaR is 0.88526 and the 99% VaR is 0.56898

C. The 95% VaR is 0.3522 and the 99% VaR is 0.4762

D. The 95% VaR is 0.8951 and the 99% VaR is 0.56898

The correct answer is: C)

From the lognormal derivation, αVaR = Pt-1 – P* = Pt-1(1 - exp[µR – σRZα]).

Applying the formula in the question we have:

95% VaR = 1 – exp(0.079 – 0.312 ×1.645) = 0.3522

99% VaR = 1 – exp(0.079 - 0.312 ×2.326) = 0.4762

Q.3006 If the arithmetic returns rt over some period of time are 0.09, what are the geometric
returns?

A. 0.0831

B. 0.08618

C. 0.02546

D. None of the above

The correct answer is: B)

Recall that, Rt = ln(1 + rt)

Therefore, ln(1 + 0.09) = ln(1.09) = 0.08618

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Q.3008 Assume the profit/loss distribution for XYZ is normally distributed with an annual mean
of $30 million and a standard deviation of $5 million. The 1% VaR is closest to:

A. 11.25 million

B. -30 million

C. -18.35 million

D. -18 million

The correct answer is: C)

The delta-normal VaR, given P/L data = -μP/L + σP/L × zα

At 99% confidence: VaR = -30 million + 2.33 × 5 million = -18.35 million.

Q.3011 Assume you are dealing with a stock "A" that displays a highly negatively skewed
distribution comprised of the past 260-days returns. Suppose you have P1 = A and P2 = -A,
meaning P1 is long stock A and P2 is short stock A. Which statement is most likely to be accurate
about a 99% VaR?

A. VaR (P1) > VaR (P2)

B. VaR (P1) < VaR (P2)

C. VaR (P1) = VaR (P2)

D. Cannot be concluded from the given information

The correct answer is: A)

Given that the return distribution of stock A is negatively skewed, the implication is that it
displays a long left tail, meaning large potential losses for a long position and conversely large
potential gains for a short position. Therefore, VaR (P1) will be expected to be higher. If the
distribution was symmetric, both P1 and P2 would have the same VaR.

Additional Explanation
A long left tail means there's a high probability of large potentially crashing losses on the asset.
If you are long the asset, then it means you are exposed to more risk; the asset price might fall
considerably, triggering a major loss. If you sell short (borrow and sell in the hope of
repurchasing the asset at a later date) your repurchase price is likely to be lower, which means
you will record a gain. Similarly, a short position in a call option on the asset will most likely
make a gain (keep the premium) because the asset will most likely fall in price, and the the long
position won't exercise their right to buy.

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Q.3036 What would be the 95% parametric VaR of a portfolio made of two independently
normally distributed stocks – A and B, with A⁓N(0.5,1) and B⁓N(3,15). Assume that P=(A+B)

A. 56×P

B. 4.87×P

C. 3.08×P

D. None of the above

The correct answer is: C)

Assuming (A+B), then P~N(3.5,16).

VaR (α%) = [−μr + σr × Zα ] P = [−3.5 + 4 × 1.645] P =3.08P

Note: The sum of two independent normally distributed random variables is normal, with its
mean being the sum of the two means, and its variance being the sum of the two variances

Where σr = √16 = 4

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 Reading 62: Non-parametric Approaches

Q.1484 In order to compile historical simulation data, one would need to assemble historical P/L
or return observations on the positions in the current portfolio. The series of historically
simulated P/L would form the basis of historically simulated VaR and ES. Which of the following
would be correct regarding the simulated series?

I. This series would not be same as the actual P/L earned on the portfolio.
II. It would show the P/L earned on the current portfolio.
III. This series would give an accurate measurement of the actual P/L.

A. Point I

B. Point II

C. Point III

D. None of the above

The correct answer is: A)

There would be a difference in actual P/L and historically simulated P/L because the portfolio
changes over time and is subjected to mapping approximations.

Q.1485 There are different benefits of parametric methods over nonparametric methods. An
FRM manager will consider non-parametric methods as the most natural choice for high-
dimension problems. Which of the following is NOT an advantage of nonparametric methods?

A. It is easy for non-parametric methods to accommodate high dimensions

B. In non-parametric methods, there is no difficulty in dealing with variance-covariance

matrices and curses of dimensionality

C. The non-parametric approaches can accommodate skewness, fat tails and other non-
normal features

D. The results from non-parametric methods are often hard to communicate

The correct answer is: D)

It is very easy for non-parametric methods to accommodate high dimensions; there are no
problems in dealing with variance-covariance matrices; and they also use data that is readily
available. In addition, results are easy to communicate.

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Q.1486 There are two bootstrapping approaches: parametric and non-parametric.

I. For a "non-parametric bootstrap", the exercise proceeds from a given data sample that’s
representative of the population. By re-sampling the data, you can reproduce the distribution of
your estimator, or just its mean, variance, etc.
II. In a "parametric bootstrap" you have an assumption on the underlying distribution of the
population up to some parameter. What you do is then estimate the parameter from the data, and
then sample from the assumed distribution with the estimated parameter.
III. In a "non-parametric bootstrap" we make assumptions about how the sample size will be
distributed and resample the parameter.

Which of the following statements correctly define each of these approaches?

A. Point I and III

B. Point I and II

C. Point II and III

D. None of the above

The correct answer is: B)

Nonparametric bootstraps make no assumptions about how your observations are distributed
and actually involve “re-sampling” your original sample. Parametric bootstraps resample a
known distribution function, whose parameters are estimated from your sample.

Further Explanation
In a nonparametric bootstrap, a sample of the same size as the data is take from the data with
replacement. Let's say you have an original sample comprised of 30 observations. By sampling
with replacement, you can create a new sample of size 30 by replicating some of the
observations in the original sample and omitting others.
Parametric bootstrapping, on the other hand assumes that the data comes from a known
distribution with unknown parameters. For example the data may come from a normal, Poisson,
negative binomial for counts, or some other continuous distribution. You then estimate the
parameters from the data that you have and then you use the estimated distributions to simulate
the samples.

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Q.1487 The non-parametric density estimation is based on the assumption that a basic historical
simulation does not get the best out of the information at hand. Which of the following examples
demonstrates this drawback?

A. If we have 100 P/L observations, the basic HS only permits us to estimate VaR at
discrete confidence levels, say, 95%

B. If we have 100 P/L observations, the VaR at the 95% confidence level is given by the
seventh-largest loss

C. If we have 100 P/L observations, the VaR at the 95% confidence level is given by the
fourth-largest loss.

D. None of the above.

The correct answer is: A)

Historical simulation does not allow us to estimate the VaR at non-discrete intervals. If we have
100 P/L observations, the VaR at 95% confidence level is given by the sixth-largest loss, but the
VaRs at 95.1%, 95.9%, and 95.5% confidence level cannot be obtained because there are no
corresponding loss observations.

Q.1488 Which of the following methods is NOT used to represent data under non-parametric
density estimation?

A. Histogram

B. Bar Chart

C. Naive Estimators

D. Kernels

The correct answer is: B)

Bar charts are not used for showcasing data as they do not justify the observations adequately.

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Q.1489 All of the following items are generally considered advantages of non-parametric
estimation methods except:

A. little or absolute lack of reliance on covariance matrices

B. Use of historical data

C. Ability to accommodate largely skewed data

D. Availability of data

The correct answer is: B)

Use of historical data is actually a disadvantage of non-parametric estimation methods because

the past is not necessarily an indication of the future. In particular, data gathered from a
relatively quiet (volatile) past period may lead to the development of models that underestimate
(overestimate)the current risk level.

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Q.1490 Estimating historical simulation ES or VaR does not have any theoretical problems;
however, it has a practical problem. Which one is it?

A. As the holding period decreases, the number of observations increases.

B. As the holding period increases, the number of observations decreases.

C. As the holding period decreases, the size of data decreases.

D. As the holding period increases, the size of the data decreases.

The correct answer is: B)

As the holding period rises, the number of observations rapidly falls, and we soon find that we
don't have enough data. Let's illustrate:
If we have 1000 observations of daily P/L, that corresponds to four years' worth of data at 250
trading days a year. What does this mean?
(I) We have 1000 P/L observations if we use a daily holding period.
(II) We have 200 observations if we use a weekly holding period with 5 days to a week because
each weekly P/L will be the sum of five daily P/Ls
(III) We have only 50 observations if we use a monthly holding period, again because each
monthly P/L will be the sum of 20 daily P/Ls

... and so on....and so on....

As such, it is clear that the number of effective observations rapidly falls as the holding period
rises, and the size of the data set imposes a major constraint on how large the holding period can
practically be.

C states that as the holding period decreases, the size of data decreases. That's correct, but it is
hardly a problem. That would actually be an advantage because we would have more data points
that are easier to gather.

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Q.1491 The theory of order statistics gives us a complete function of VaR (or ES) distribution and
it’s a very easy-to-compute-and-apply approach. Which of the following statements is
INCORRECT regarding estimates of the standard normal VaR based on the conventional
formula?

A. As n increases, the estimated VaR median tends to converge to conventional estimate.

B. The confidence interval is wide as n gets larger and narrow for low values of n.

C. The confidence interval shows a gap between 5 and 95 percentiles.

D. The confidence interval is wider for extreme VaR confidence levels.

The correct answer is: B)

Recall that that with n observations, we take the VaR as equal to the negative of the rth lowest
observation,
where

r = n(1 − α) + 1

Also, note that estimates of the lower and upper percentiles of the VaR distribution function give
the estimates of the bounds of our VaR confidence interval. Thus, the confidence interval is quite
wide for low values of n, but narrows as n gets larger.

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Q.1492 Which on of the following statements is most likely correct? A bootstrapping exercise:

A. resampling from our existing data set without replacement

B. assumes that the distribution of returns will remain the same in the past and in the
future

C. assumes that the distribution of returns in future will be markedly different from past
distributions

D. results in a VaR estimate that is a sum of sample VaRs after repeated sampling

The correct answer is: B)

Bootstrapping presents a simple but powerful improvement over basic Historical Simulation is to
estimate VaR and ES. Crucially, it assumes that the distribution of returns will remain the same
in the past and in the future, justifying the use of historical returns to forecast the VaR.
A bootstrap procedure involves resampling from our existing data set with replacement. A
sample is drawn from the data set, its VaR recorded, and the data “returned.” This procedure is
repeated over and over. The final VaR estimate from the full data set is taken to be the average
of all sample VaRs. In fact, bootstrapped VaR estimates are often more accurate than a ‘raw’
sample estimates.

Q.1493 The closed-form confidence intervals have limited applicability as we do not have
expressions for standard errors. Which of the following parameters will pose similar problems?

A. Medians

B. Tail probabilities

C. Correlations

D. All of the above

The correct answer is: D)

To estimate confidence intervals for all the parameters above, traditional closed-form approaches
would require us to make the use of statistical theory, but the theory itself is of limited use.

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Q.1494 In layman’s term, there is a huge problem with volatility as a measurement of risk, at
least for the returns of financial securities. The problem is that excess returns are seen as risky.
This is why in the 80s, J.P. Morgan came with a measurement of risk that only considered
downside risk, the Value at Risk (VaR). One of the methods used to measure the VaR is
bootstrapping. Which of the below statements is an advantage of bootstrapping?

I. Bootstrapping allows us to estimate confidence intervals of any parameter.

II. The underlying assumptions behind bootstrapping are less demanding.

A. Both Point I and II

B. None of the above

C. Point I

D. Point II

The correct answer is: A)

Both I and II are advantages of bootstrapping. Bootstrapping allows us to estimate confidence

intervals of any parameter and the underlying assumptions behind bootstrapping are less
demanding.

Q.1495 Even though bootstrapping has numerous advantages, the bootstrap estimates are
associated with a little bias or error. Which of the following presents an error of bootstrapping?

A. Un-sampling variability

B. Re-sampling variability

C. Dual-sampling variability

D. Bootstrapping variability

The correct answer is: B)

There are two types of errors in bootstrapping estimates: sampling variability (we have a sample
of size n drawn from our population, rather than the whole population itself); and re-sampling
variability (we take only B bootstrap re-samples rather than an infinite number).

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Q.1496 One of the drawback of the historical simulation approach is that the discreteness of the
data rules out estimation of VaRs between data points. For example, if there were 100 historical
observations, estimation of the VaR is a straightforward process at the 95% or the 96%
confidence levels, but it is impossible to incorporate a confidence level of, say 95.5%. Which of
the following methods can solve this problem?

A. Applying Brute Force

B. Bootstrapping

C. non-parametric density estimation

D. Use of a large number of re-samples

The correct answer is: C)

Simple HS only allows VaR estimate at discrete confidence levels. Non-parametric density
estimation treats data as if they were drawings from some unspecified or unknown empirical
distribution function. The existing data points can be used to “smooth” the data points, paving
the way for VaR calculation at all confidence levels.

Q.1497 Which of the following is NOT a step from the three-step model developed by Andrews
and Buchinsky to determine B (the number of bootstrap resamples)?

A. Assuming a value "x" and plugging it into the relevant equation to get a preliminary
value of B

B. Simulating B0 re-samples

C. Taking an infinite number of bootstrap re-samples

D. Making an estimate of the sample kurtosis

The correct answer is: C)

We cannot take an infinite number of re-samples; only a finite (desired) number is used.

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Q.2631 An analyst performing a historical simulation to measure the VaR of a portfolio uses a
volatility-weighted approach. One month ago, the actual return of the asset was 5% and its daily
volatility estimate was 2%. If the current daily volatility is 1.5%, calculate the volatility-adjusted
return.

A. 0.03

B. 0.0167

C. 0.0375

D. 0.0667

The correct answer is: C)

σT ,i 0.015
r∗t,i = ( ) rt, i = ( ) 0.05 = 0.0375
σt, i 0.020

Q.2635 Which of these statements about non-parametric approaches for estimating VAR is not
true?

A. Non-recurrent extreme losses can dominate and skew non-parametric estimates

B. If there is a lot of volatility in the period chosen, the VAR and expected shortfall
estimates will be too high

C. Unlike parametric approaches, non-parametric approaches can easily accommodate

non-normal features like fat tails and skewness

D. Data for these methods can be very difficult to obtain and needs frequent adjustments

The correct answer is: D)

Non-parametric approaches are easy and intuitive to use and do not require any assumptions for
probability distributions or variance-covariance matrices. They rely primarily on historical data
to estimate VAR. Data for these approaches is easy to obtain and does not require adjustment.
Since these approaches rely on historical data only, estimates can be skewed by periods of high
volatility or by non-recurrent extreme losses.

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Q.2820 The mean return from a dataset has been pre-calculated and is given as 0.04. The
standard deviation has also been given as 0.32. With 90% confidence, what will be our
percentage maximum loss? Assume that from our dataset, Z = -1.28 and N(Z) = 0.10 since you
are to locate the value at the 10th percentile.

A. 36.96%

B. 11.27%

C. 11.32%

D. 36.72%

The correct answer is: A)

Recall that Z = (X − µ)/σ

From the data, we are given that: µ = 0.04, σ = 0.32, and Z = -1.28

Therefore: -1.28 = (X−0.04)/(0.32) ⇒ X = -1.28(0.32) + 0.04 = -0.3696

X = -0.3696 = 36.96% loss

This means that we are 90% confident that the maximum loss will not exceed 36.96%.

Q.2821 Which of the following is NOT an advantage of non-parametric methods?

A. When combined with add-ons, non-parametric methods are capable of refinement and
potential improvement

B. Non-parametric methods can accommodate any type of position including derivative

positions

C. Non-parametric methods are not subject to the phenomenon of ghost effect or shadow
effects

D. Non-parametric methods can accommodate fat tails, skewness and other abnormal
features to parametric approaches

The correct answer is: C)

Most (if not all) non-parametric methods are subject (to a greater or lesser extent) to the
phenomenon of ghost or shadow effects. This is actually a disadvantage.

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Q.2822 There are 30 observations in a dataset. The worst 10 return observations (in %) are listed
below:

[-20, -18, -18, -17, -15, -14, -12, -10, -7, -3]

What is the VaR at the 90% confidence?

A. 17%

B. 18%

C. 16%

D. 15%

The correct answer is: A)

The VaR at 90% cl is given by the [(1-0.90)30 + 1] = 4th worst observation

VaR = 17%

Q.3007 You are a VaR analyst on a trading floor and one of the traders has complained to you
about the historical VaR of one of his stock: he argues that over the past 3 trading days, the end–
of-trading stock price has been flat and as a result, no movement is expected from his VaR. You
noted however that though the stock price has remained flat, interest rates have moved. In these
circumstances, is the trader right?

A. Yes, the trader is right: as long as the stock price didn't move, the risk remains
unchanged

B. No, the trader is wrong: even if the stock price did not move, then the risk of that
stock should change

C. Yes, the trader is right: price is the only determinant of daily VaR

D. None of the above: further analysis is required

The correct answer is: D)

Further analysis is required: the historical VaR is based on a set of moving 260 days return. As a
result one of your previous day worst scenarios might move out of your 260 days window. The
result of this will be that though your stock price may remain flat, your tail of worst return might
change, resulting in a VaR variation.

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Q.3010 You have been hired on a popular trading floor and one of the traders comes over and
asks about the impact of price changes on her VaR - made of a single long position in stock KKJL.
Yesterday's closing price was USD 100.

You are using a 95% confidence historical VaR based on a 260 days moving window of historical
data. In this time period, the 16 worst 1-day returns from for KKJL as of yesterday were as
follows (in %): -9.5, -8, -7.6, -7.4, - 7.2, -7.18, -7.1, -6.9, -6.57, -6.56, -6.45, -6.4, -6.25, -6.05, -5.99,
-5.85.

Suppose that the stock price decreased by 10% between yesterday and today.

What will be the 95% confidence VaR in absolute terms?

A. USD 6.25

B. USD 5.625

C. USD 6.625

D. Cannot be concluded from the given information

The correct answer is: B)

In general, if there are n ordered observations, and a confidence level cl%, the cl% VaR is given
by the [(1 – cl%) n + 1]th highest observation. This is the observation that separates the tail from
the body of the distribution. Given 260 observations, we are therefore interested in the [(1 -
0.95)260 + 1]th = 14th worst observation
Before the latest 10% loss, the ordered losses are as follows:
[-9.5, -8, -7.6, -7.4, - 7.2, -7.18, -7.1, -6.9, -6.57, -6.56, -6.45, -6.4, -6.25, -6.05, -5.99, -5.85]

The 14th worst observation is -6.05. However, given that the stock decreased by 10% between
yesterday and today, the arrangement changes; -10% will now be the worst return that the stock
experienced over the last 260 business days. The 16 worst returns shall now be:[-10, -9.5, -8,
-7.6, -7.4, - 7.2, -7.18, -7.1, -6.9, -6.57, -6.56, -6.45, -6.4, -6.25, -6.05, -5.99]

The VaR at 95% will be based on the 14th worst return, which is now -6.25%

VaR = 90 × 6.25% = 5.625

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Q.3012 Under age-weighted historical simulation,

A. more recent observations are weighted more and distant observations weighted less

B. all observations are weighted equally

C. the decay parameter takes a value of 1

D. the historical window of observations must not exceed 250 days

The correct answer is: A)

The age-weighted historical simulation method makes an adjustment to the equal-weighted

assumption used in historical simulation; More weight is attached to recent observations. Distant
observations that are less likely to recur have less weight.
The decay parameter takes a value between 0 and 1, with values close to 1 indicating slow decay
The size of the historical window is not limited.

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Q.3035 Paul is using the age-weighted historical simulation approach to estimate the VaR of a
stock portfolio, with a historical sample size of 100 days and a decay factor of 0.96. Over the
recent past, the portfolio has registered the following returns:

Return Periods Ago(Days)

−3.2% 109
−3.3% 75
−2.3% 66
−1.3% 22
−3.0% 45

Determine the weight on the return earned 45 days ago

A. 0.05

B. 0.0025

C. 0.0065

D. 0.006751

The correct answer is: D)

Under age-weighted (aka Hybrid) historical simulation, the weight, wi, given to an observation i
days old is given by:

λ i−1 (1−λ)
wi = (1−λ n)
So,
0.96 45−1 (1−0.96)
w 45 = = 0.006751
(1−0.96100 )

Note: Any return falling outside the historical window would have a weight of zero, for instance,
the observation made 109 days ago.

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Q.3037 You have been hired on the trading floor and one of the traders comes over and asks
about the impact of a price change on her VaR made of a long position in stock A, whose value
stood at 100 as of yesterday.

Assume you are using a 95% confidence historical VaR (based on 260 days moving window of
historical data). Further, assume that the 16 worst 1-day returns of stock as of yesterday were as
follows:

-9.5, -8, -7.6, -7.4, - 7.2, -7.18, -7.1, -6.9, -6.57, -6.56, -6.45, -6.4, -6.25 -6.05, -5.99,-5.85.

Assume the price of the stock increased by 10% between yesterday and today. What will the
value of today's 95% VaR (in absolute value)?

A. $6.25

B. $6.655

C. $10

D. Cannot conclude

The correct answer is: B)

Today's stock price is $100 × (1 + 10%) = $110

The 95% VaR is given by the 14th worst return, i.e., -6.05%,

N/B: Using 260 days moving window of historical data, the 95% VaR will be r=260(1-95%) +1 =
14th observation

The new 95% VaR will be $110 - $110 × (1 - 6.05/100) = -$6.655

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Q.3039 Let's assume you are requested to calculate the historical VaR of the below portfolio with

P = A + B with A = 10 and B = 100.

Assume also a correlation of 0.2 between the past 300 historical returns of stocks A and B.

The table below displays the five worst returns of each stock by date.

Stock A Stock B
Return Date Rank Return % Return Date Rank Return %
Day 1 1 −7.50 Day 1 1 −9.00
Day 2 2 −7.00 Day 2 2 −8.50
Day 3 3 −6.50 Day 3 3 −8.00
Day 4 4 −6.40 Day 4 4 −7.90
Day 5 5 −6.25 Day 5 5 −7.80

Based on the above the 99% historical VaR of P in absolute value will be:

A. $7.11

B. $1.74

C. $6.92

D. $8.54

The correct answer is: D)

The VaR at 99% confidence is given by the 4th worst observation:

[(1-0.99)300 + 1]th = 4th observation.

The fourth worst observations in both portfolios are recorded on the fourth day, i.e.,-6.40 nd -7.9
in A and B, respectively.

Thus, VaR = 6.4/100 × 10 + 7.9/100 × 100 = $8.54

Note that the correlation factor is irrelevant here given that the distribution of the returns was

already provided. Also, the VaR in the solution is given as a positive, but remember that a

negative is implied.

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 Reading 63: Parametric Approaches (II): Extreme Value

Q.2175 Extreme events have a very low probability of occurrence but are nonetheless taken very
seriously in the financial world. Which of the following best explains why?

A. Extreme events tend to recur at rather regular time intervals

B. Extreme events rarely have warning signs and thus markets cannot prepare for them
in any way

C. Extreme events are normally very costly and can create a “ripple” effect on the global
market

D. No models have been developed to accurately predict and estimate the effects of
extreme events in qualitative terms

The correct answer is: C)

Although extreme events have extremely low associated probabilities, they are normally high-
impact, heavy-loss events. They rarely occur, but when they do, their impact is so dramatic and
can lead to failure of key market players and loss in value of key market products with a huge
subscription base. In some cases, extreme events can trigger off a financial crisis.

Q.2176 It’s normally very difficult and problematic to model extreme events mainly because of:

A. A lack of models that can estimate the effects of certain extreme but possible events

B. A lack of qualified personnel to oversee the modeling process

C. A lack of credible, reliable input data

D. The fact that extreme event modeling requires a considerable investment of time and
expertise

The correct answer is: C)

There are very few historical observations on which to base our estimates. A model is only as
good as the input data. Due to a lack of credible historical data on extreme events (some of
which have never occurred but can still occur), practitioners formulate assumptions.
Unfortunately, some of the assumptions are normally out of sync with the reality, meaning the
resulting estimates are also not reliable. For example, an incorrect assumption regarding the
distribution of a certain phenomenon might correctly model central observations but fail to come
up with reliable estimates of extreme observations.

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Q.2177 Extreme events can best be modeled through the application of:

A. The central limit theorem

B. The standard normal distribution

C. Extreme-value theorems

D. The exponential distribution

The correct answer is: C)

Central tendency statistics are best governed by central limit theorems, but extreme tendency
statistics can only be governed, appropriately enough, by extreme-value theorems such as the
widely applied Fisher-Tippett theorem.

Q.2178 The following is the probability distribution function of the generalized extreme value
distribution:

1
⎧
⎪ −
⎪ exp [−(1 + ξ(X−μ) ) ξ ] ,
⎪ ξ≠0
σ
H ξ,μ, α =⎨
⎪
⎩ exp [−exp (− (X−μ) )] ,
⎪
⎪ ξ=0
σ

ξ(X−μ)
Where X satisfies the condition 1 + σ > 0
What is represented by μ,α, and ξ respectively?

A. The location parameter, the scale parameter, and the shape parameter

B. The scale parameter, the location parameter, and the shape parameter

C. The mean, the variance, and the shape parameter

D. The mean, the shape parameter, and the location parameter

The correct answer is: A)

The GEV distribution has 3 parameters: μ represents the location parameter of the limiting
distribution, α represents the scale parameter, and ξ represents the shape parameter (it gives an
indication of the heaviness of the tail of the limiting distribution).

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Q.2179 The following is the probability distribution function of the generalized extreme value
distribution:

1
⎧
⎪ −
⎪ exp [−(1 + ξ(X−μ) ) ξ ] ,
⎪ ξ≠0
σ
H ξ,μ, α =⎨
⎪
⎪
⎩ exp [−exp (−
⎪ (X−μ)
)] , ξ=0
σ

ξ(X−μ)
Where X satisfies the condition 1 + >0
σ
If ξ > 0, the GEV becomes the:

A. Frechet distribution

B. Pareto distribution

C. Gumbel distribution

D. Weibull distribution

The correct answer is: A)

If ξ > 0, the GEV becomes the Frechet distribution and applies when the cumulative distribution
of X obeys a power function as is therefore heavy.

Q.2180 If ξ < 0, the GEV becomes the Weibull distribution, but this distribution is rarely used to
model financial returns mainly because:

A. Its cumulative distribution has heavier than normal tails and very few empirical
financial returns are heavy-tailed

B. Its cumulative distribution has lighter than normal tails and very few empirical
financial returns are light-tailed

C. It’s asymmetric

D. It’s symmetric

The correct answer is: B)

If ξ < 0, the GEV becomes the Weibull distribution, corresponding to the case where F(x) has
lighter than normal tails. This is precisely why the Weibull distribution is not used to model most
empirical financial returns since only a few of them have light tails.

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Q.2181 For the standardized Gumbel distribution, the 10% quantile is equal to:

A. -0.5

B. 0.8340

C. -0.3445

D. -0.8340

The correct answer is: D)

When ξ = 0, X = μ – σ ln[ – ln(p) ]

Now, μ = 0,and σ = 1 (As a result of standardization)
Hence, the 10% quartile = – ln[–ln(0.1)]= –0.8340

Q.2182 For the standardized Frechet distribution with ξ=0.3, the 5% quantile is equal to:

A. -0.9000

B. -0.8340

C. -0.4567

D. -0.9349

The correct answer is: D)

When ξ > 0,X = μ – (σ/ξ) [1 – (– ln(p)) –ξ ]

Therefore, the 5% quantile = –(1/0.3) [1 – (–ln(0.05) )-0.3] = –0.9349

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Q.2956 Suppose that we are informed that in a U.S. stock market, the location parameter of the
limiting distribution, μ, is 2, the scale parameter, σ, is 0.6, and the tail index, ξ, is 0.4. Apply
these parameters in the Fréchet VaR formula to calculate the estimated 95% VaR and 99.5% VaR,
respectively. Assume n =100.

A. 95% VaR: 1.340; 99.5% VaR: 1.657

B. 95% VaR: 1.657; 99.5% VaR: 1.119

C. 95% VaR: 1.28; 99.5% VaR: 2.477

D. 95% VaR: 1.657; 99.5% VaR: 1.876

The correct answer is: C)

Recall that, for ξ > 0:

σn
V aR = μ n − [1 − (−nln(α))−n ξ]
ξn

Therefore,
For 95% VaR:

0.6
V aR = 2 − [1 − (−100 × ln(0.95))−0.4] = 1.28
0.4

For 99.5% VaR:

0.6
V aR = 2 − [1 − (−100 × ln(0.995))−0.4] = 2.477
0.4

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Q.2957 Assuming that we are given the following parameters based on the empirical values from
/
contracts on futures clearing companies; β = 0.7, ξ = 0.12, u = 3%, Nu = 5%. Compute the VaR
n

and the Expected Shortfall at 99.5%, respectively.

A. VaR: 1.674; Expected Shortfall: 2.453

B. VaR: 4.856; Expected Shortfall: 5.905

C. VaR: 1.453; Expected Shortfall: 2.420

D. VaR: 1.667; Expected Shortfall: 2.554

The correct answer is: B)

Recall that:

−ξ
β n
tex tV aR = u + {[ (1 − α)[] − 1}
ξ Nu

And

V aR β − ξu
ES = +
1− ξ 1 −ξ

Therefore:

−0.12
0.7 1
textV aR = 3 + {[ (1 − 0.995)[] − 1} = 4.856
0.12i 0.05

4.856 0.7 − 0.12 × 3

ES = + = 5.905
1 − 0.12 1 − 0.12

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Q.3993 To retrieve the value at risk (VaR) for the U.S stock market under the generalized
extreme-value (GEV) distribution, a risk analyst uses the following equation which characterizes
a heavy-tailed Fr´echet distribution.

σn
VaR α = μ n − [1 − (−nln (α))−ξn ]
ξn

The analyst uses the following somewhat "realistic" parameters:

Location, μ = 3.0%

Scale, σ = 0.70%

Tail index, ξ = 0.30%

If the sample size, n = 100, then which is nearest to the implied 99.90% VaR?

A. 2.3651%

B. 2.547%

C. 3.521%

D. 5.3216%

The correct answer is: D)

σn
VaRα = μ n − [1 − (−nln (α))−ξn ]
ξn

At α = 0.999 ,

0.7
VaR0.999 = 3 − [1 − (−100ln (0.999))−0.3] = 5.3216%
0.3

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Q.3994 In FRM parlance, an extreme value is one that has a low probability of occurrence but
potentially disastrous (catastrophic) effects. The main challenge posed by extreme values is that:

A. They do not conform to any of the established loss distributions

B. They can only be fully characterized by multiple loss distributions

C. They are too big such that the resulting loss estimates are infinitely large

D. There are only a few observations from which a credible, reliable analytical model can
be built

The correct answer is: D)

The main challenge posed by extreme values is that there are only a few observations from which
a credible, reliable analytical model can be built. In fact, there are some extreme values that
have never occurred but that does not necessarily imply there’s no chance of occurrence in the
future. Trying to model such events can be quite an uphill task.

Q.3995 Simon is trying to fit a distribution to the extreme loss tail of a historical financial return
dataset. He does not have a good fit for the parent distribution, and has therefore not settled on
an appropriate extreme value theory (EVT) approach. He decides to conduct a hypothesis test
and concludes that the tail index is insignificant. In this scenario, which of the following
distributions should he use?

A. Gumbel

B. Fr´echet

C. Normal

D. None of the above

The correct answer is: A)

One practical consideration the risk managers and researchers face is whether to assume either
ξ > 0 or ξ = 0 , and apply the respective Fr´echet or Gumbel distributions. One of the solutions
involves conducting a hypothesis test with the null hypothesis as:

H0 : ξ = 0

If there’s insufficient evidence to reject the null hypothesis (implying the tail index ξ is
insignificant), then then the Gumbel distribution should be used. If the tail index is significant
(greater than zero), the Fr´echet distribution is most appropriate.

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Q.3996 Vanessa is trying to fit a distribution to the extreme loss tail of a historical financial
return dataset. After studying the data and consulting with end users, she has established the
following:

I. The loss data somewhat cluster; that is, losses are not strictly i.i.d.
II. The end users do prefer that the extreme loss tail distribution itself exhibit right-skew;
aka, positive skew
III. The distribution F (x) is actually unknown; i.e., it could be anything
IV. The parent distribution is non-normal

Which of the established issues, in theory, effectively DISQUALIFIES the generalized extreme-
value (GEV) distribution as a candidate for application?

A. I only

B. II and IV

C. III only

D. None of these issues disqualify the GEV distribution

The correct answer is: A)

For the generalized extreme value distribution to be used, the data set must be comprised of
independent, identically distributed random values. The parent distribution need not be normal.
Preference for a positively skewed distribution is in line with GEV’s two most common
distributions - the Fr´echet and Gumbel distributions.

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Q.3997 Which of the following statements about Extreme Value Theory (EVT) and its application
to value at risk are true?

I. EVT extends the Central Limit Theorem to the distribution of the tails of independent,
identically distributed random variables drawn from an unknown distribution.
II. For empirical stock market data, the shape parameter in EVT is positive implying tails
that disappear more slowly than a normal distribution.
III. EVT can help avoid a shortcoming of the historical simulation method which may have
difficulty calculating VaR reliably due to a lack of data in the tails.

A. I only

B. II only

C. II and III only

D. All the above statements are correct.

The correct answer is: C)

I is incorrect. Extreme value theory is not governed by the central limit theorem because it deals
with the tail region of the relevant distribution.

II is correct. The shape parameter in EVT for empirical stock market data is typically between

0.2 and 0.4, implying that the tails disappear more slowly than a normal distribution.

III is correct. Due to its reliance on historical data which may lack sufficient extreme values (i.e.,

extreme events), VaR calculation using the historical simulation method can be difficult; EVT can

help avoid this shortcoming.

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Q.3998 The returns of a portfolio of stocks quoted in the S&P 500 share index over the last year
follow a distribution that is approximately normal. A trainee analyst removes some of the very
best performing stocks and produces reports based on the altered portfolio of returns. Which of
the following statements about the returns of the altered portfolio is/are correct?

I. The distribution of returns of the altered portfolio is likely to be negatively skewed

II. The distribution of returns of the altered portfolio is likely to be positively skewed
III. The mean return is likely to be lower compared to the original portfolio.
IV. The median return is likely to be higher compared to the original portfolio

A. II, III, and IV

B. I and II

C. II and III

D. I and III

The correct answer is: D)

The distribution of returns is likely to be negatively skewed, since the extreme values on the
extreme right side of the distribution have been removed, therefore

I is correct

II is incorrect

Removing some of the highest values will decrease the mean and median, so III is correct and IV

is incorrect.

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Q.3999 Which of the following statements about Extreme Value Theory (EVT) and its application
to value at risk is incorrect?

A. Unlike conventional approaches for estimating VAR, EVT considers only the tail
behavior of the distribution

B. Unlike conventional approaches for estimating VAR that assume that the distribution
of returns follows a unique distribution for the entire range of values, EVT allows the
returns to follow an unknown distribution.

C. EVT establishes the optimal point beyond which all values belong to the tail and then
separately models the distribution of tail events.

D. By segregating the tail of the distribution, EVT effectively ignores extreme events and
losses

The correct answer is: D)

A is correct. EVT uses only information in the tail.

B is correct. Conventional approaches such as delta-normal VAR and the historical method

assume a fixed probability density function (p.d.f.) for the entire distribution. This could have the

effect of understating the extent of fat tails.

C is correct. EVT attempts to establish a cutoff point for the tail, and then estimates the

parameters of the tail distribution.

D is incorrect. EVT does not ignore extreme events (as long as they are in the sample). Rather,

emphasis is put on such events.

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Q.4000 For the standardized Gumbel, determine the 5% quantile, 95% quantile and the 99%
quantile, respectively.

A. -1.0972; 2.9702; 4.6001

B. -2.0845; 0.0052; 0.0041

C. 4.5614; 3.8542; 2.7823

D. -1.0965; 0.0052; -2.0485

The correct answer is: A)

First recall that for the standardized Gumbel, μ = 0, σ = 1

x = μ − σln [−ln (p)]

The 5% quantile is : 0 − (1) ln [−ln (0.05)] = −1.0972

The 95%quantile is : 0 − (1) ln [−ln (0.95)] = 2.9702

The 99% quantile is : 0 − (1) ln [−ln (0.99)] = 4.6001

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Q.4001 In reality, natural and financial disasters are often related, and risk managers endeavor
to have some awareness of multivariate extreme risks. In this regard, why do risk managers limit
themselves to the study of a small number of financial variables at a time?

A. A lack of sufficient data

B. The curse of dimensionality

C. Multivariate extremes are sufficiently rare that we need not worry about them

D. The study of multivariate extremes is costly and time consuming.

The correct answer is: B)

Analysts study multivariate extreme events through EV copulas that have been developed over
time. In theory, a single copulas can have as many dimensions as the random variables of
interest, but there’s a curse of dimensionality in the sense that as the number of random
variables considered increases, the probability of a multivariate extreme event decreases.

For example, let’s start with the simple case where there are only two independent variables and

assume that univariate extreme events are those that occur only once for every 100

observations. In these circumstances, we should expect to see one multivariate extreme event

(both variables taking extreme values) only one time in 1002; that’s one time in 10,000

observations. If we work with three independent variables, we should expect to see a

multivariate extreme event one time in 1003; that’s one time in 1,000,000 observations. This

clearly shows that as the dimensionality rises, multivariate extreme events become rarer. That

implies we have a smaller pool of multivariate extreme events to work with, and more

parameters to estimate. As such, analysts are forced to work with a small number of variables at

a time.

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Q.4002 In financial risk management, the clustering of high-severity risks is referred to as:

A. Multivariate risk analysis

B. Tail dependence

C. Univariate extreme value theory

D. Dimensional analysis

The correct answer is: B)

Tail dependence refers to clustering of extreme events. Loosely speaking, tail dependence
describes the limiting proportion that one variable exceeds a certain threshold given that the
other variable has already exceeded that threshold. In financial risk management, the clustering
of high-severity risks can have a devastating effect on the financial health of firms and this
makes it an important part of risk analysis.

Q.4003 In practice, risk analysts prefer the Peaks-over-threshold (POT) approach over the
generalized extreme value approach because the POT approach:

A. Is less time consuming

B. Is more efficient in the use of data

C. Does not require the analyst to choose a threshold

D. All of the above

The correct answer is: B)

In practice, risk analysts prefer the POT approach over the GEV approach because the former is

more efficient in the use of data. In other words, the GEV approach involves some loss of useful

data relative to the POT approach, because some blocks might have more than one extreme in

them. In addition, the POT approach is better adapted to the risk measurement of tail losses

because it focuses on the distribution of exceedances over a threshold.

However, the POT approach comes with the problem of choosing a threshold, a situation that

does not arise with the GEV approach.

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Q.4004 To retrieve the value at risk (VaR) for the U.S stock market under the generalized
extreme-value (GEV) distribution, a risk analyst uses the following somewhat "realistic"
parameters:

Location, μ = 4.0%

Scale, σ = 0.80%

Tail index, ξ = 0.5%

If the sample size, n = 100, then which is nearest to the implied 99.90% VaR?

A. 0.0225

B. 0.05852

C. 0.04123

D. 0.02512

The correct answer is: B)

Applying the Fr´echet distribution (since ξ > 0 ), the VaR at α level of confidence is given by:

σn
VaRα = μ n − [1 − (−nln (α))−ξn ]
ξn

At σ = 0.999,

0.008
VaR0.999 = 0.04 − [1 − (−100ln (0.999))−0.005 ] = 0.05852
0.005

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Q.4005 Assume the following observed parameter values:

β = 0.60

ξ = 0.30

μ = 1%

Nμ
n
= 5%

Compute the VaR at 99% confidence and the corresponding expected shortfall.

A. VaR = 2.25% ; ES = 3.5%

B. VaR = 2.2548% ; ES = 0.5252%

C. VaR = 2.2413% ; ES = 3.6304%

D. VaR = 1.5825% ; ES = 2.2385%

The correct answer is: C)

−ξ
β n
VaR = μ + [[ (1 − confidence level)] − 1]
ξ Nμ
−0.30
0.6 1
VaR0.99 = 1 + [[ (1 − 0.99)] − 1] = 2.2413%
0.3 0.05
VaR β − ξμ
ES = +
1− ξ 1 −ξ
2.2413 0.6 − 0.3 × 1
ES = + = 3.6304%
1 − 0.3 1 − 0.3

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Q.4006 Dyer and Blair Investment bank has an active position in commodity futures and is using
the peaks-over-threshold (POT) approach (EVT) to estimate value at risk (VaR) and expected
shortfall (ES) in accordance with extreme value theory. After careful consideration, the firm's
risk managers have settled on a threshold level of 5.00% to evaluate excess losses. This choice of
the threshold is informed by the realization that 3.0% of the observations are in excess of this
threshold value. As displayed below, empirical analysis suggests the two other distributional
parameters: scale, β = 0.70; and shape (aka, tail index), ξ = 0.25.

Parameter Value
Loss threshold, u 5.00%
No. of observations, N 700
No. of observations that exceed threshold, N(u) 21
N(u)/N 3.00%
Scale, β 0.70%
Shape, aka, tail, ξ 0.25%

Determine the VaR at the 99% confidence level.

A. 0.02225

B. 0.04125

C. 0.05885

D. 0.03

The correct answer is: C)

−ξ
β n
VaR = μ + [[ (1 − confidence level)] − 1]
ξ Nμ
−0.25
0.7 1
VaR0.99 = 5 + [[ (1 − 0.99)] − 1] = 5.885%
0.25 0.03

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Q.4007 Kelvin Streetman is evaluating the extreme risks associated with active contracts on a
futures clearing house. He intends to use the peaks-over-threshold (POT) approach (EVT) to
estimate value at risk (VaR) and expected shortfall (ES) in accordance with extreme value theory.
Kelvin has set parameters at some empirically plausible values denominated in % terms as
displayed below:

Parameter Value
Loss threshold, u 5.00%
No. of observations, N 700
No. of observations that exceed threshold, N(u) 21
N(u)/N 3.00%
Scale, β 0.70%
Shape, aka, tail, ξ 0.25%

At the 99.0% confidence level, the position's VaR under the POT approach is 5.885%. Which is
nearest to the corresponding 99.0% expected shortfall (ES)?

A. 0.075426

B. 0.071133

C. 0.01885

D. 0.0225

The correct answer is: B)

VaR β − ξμ
ES = +
1 −ξ 1− ξ
5.885 0.7 − 0.25 × 5
ES = + = 7.1133%
1 − 0.25 1 − 0.25

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Q.4008 Extreme value theory (EVT) is a branch of applied statistics developed to address study
and predict the probabilities of extreme outcomes. Which of the following statements about EVT
and its applications is incorrect?

A. The peaks-over-threshold approach provides the natural way to model exceedances

over a high threshold; which then determines the number of observed exceedances;
the threshold must be sufficiently high to apply the theory, but sufficiently low so that the
number of observed exceedances is a reliable estimate.

B. EVT estimates are subject to considerable model risk, and EVT results are often very
sensitive to the precise assumptions made.

C. Because observed data in the tails of distribution is limited, EV estimates can be very
sensitive to small sample effects and other biases

D. EVT asserts that distributions justified by the central limit theorem can be used for
extreme value estimation.

The correct answer is: D)

EVT differs from "central tendency" statistics where we seek to dissect probabilities of relatively
more common events, making use of the central limit theorem. Extreme value theory is not
governed by the central limit theorem because it deals with the tail region of the relevant
distribution.

EVT is subject to estimation risk, so B and C are correct.

Q.4009 According to the Fisher-Tippett theorem, as the sample size n gets large, the distribution
of extremes converges to:

A. a uniform distribution

B. a normal distribution

C. a generalized extreme value distribution

D. a generalized Pareto distribution

The correct answer is: C)

The Fisher-Tippett theorem says that as the sample size n gets large, the distribution of
extremes, denoted M , converges to a generalized extreme value (GEV) distribution.

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Q.4010 As the threshold level, u, gets large, the Gnedenko–Pickands–Balkema–DeHaan (GPBdH)
theorem states that the distribution above-threshold observations converges to:

A. a normal distribution

B. a generalized extreme value distribution

C. a generalized Pareto distribution

D. a uniform distribution

The correct answer is: C)

The second theorem of EVT is the Pickands-Balkema-de Haan theorem. It states that given a {X1,
..., Xn} sequence of i.i.d. variables, the conditional distribution Fu(y) = P(Xi - u < y|Xi > u) of each
random variable Xi of the sequence converges toward a generalized Pareto distribution for large
u.

Q.4011 In setting the threshold in the POT approach, which of the following statements is most
accurate? Setting the threshold relatively low makes the model:

A. more applicable but decreases the number of observations in the modeling procedure.

B. less applicable and decreases the number of observations in the modeling procedure

C. more applicable but increases the number of observations in the modeling procedure.

D. less applicable but increases the number of observations in the modeling procedure.

The correct answer is: D)

The GPD is considered the natural model for excess losses since all distributions of excess losses
converge to the GDP. To apply the GPD, however, we need to choose a reasonable threshold u,
which determines the number of observations, Nμ , in excess of the threshold value. But the
process involves a trade-off. On the one hand, we have to come up with a threshold that is
sufficiently high for the GPBdH theorem to apply reasonably closely. On the other, we have to be
careful not to settle on a value that’s too high such that it leaves us with an insufficient number
of excess-threshold observations that lead to unreliable estimates.

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Q.4012 The peaks-over-threshold approach generally requires:

A. fewer estimated parameters than the GEV approach and shares one parameter with
the GEV.

B. fewer estimated parameters than the GEV approach and does not share any
parameters with the GEV approach

C. more estimated parameters than the GEV approach and shares one parameter with
the GEV.

D. more estimated parameters than the GEV approach and does not share any
parameters with the GEV approach.

The correct answer is: A)

The GEV has three parameters: location parameter μ , scale parameter σ , and shape (tail index)
parameter ξ

peaks-over-threshold approach, POT( has only two parameters:

A positive scale parameter, β

A shape/tail index parameter, ξ that can be positive, zero, or negative. However, we

limit our interest to positive or zero values. (This parameter is the same tail index

encountered under GEV theory.

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 Reading 64: Backtesting VaR

Q.1498 Value-at-risk (VaR) models are used for predicting risks; therefore, there must be a
proper process of validation which checks the adequacy of a model. There are various tools and
models to check validation such as oversight, independent review, stress testing, and
backtesting. Which of the following statements are CORRECT about backtesting?

I. Backtesting is a statistical framework which provides verification that actual and projected
losses are in line
II. Backtesting compares the history of VaR forecasts to actual (realized) returns
III. Backtesting involves conducting reality checks which make up useful information for
investment decisions

A. Both I and II

B. Both II and III

C. Both I and III

D. All of the above

The correct answer is: A)

Statements I & II are correct. I. Backtesting is a statistical framework which provides

verification that actual and projected losses are in line. As such, backtesting compares the
history of VaR forecasts to actual (realized) returns.brbr

Statement III is incorrect. The reality checks provided by backtesting help risk managers in

checking their VaR forecasts but do not facilitate in investment decision-making.

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Q.1499 While conducting backtesting of VaR as an FRM manager, an accurate model is one
where:

A. The frequency of confidence levels is greater than the number of exceptions

B. The frequency of confidence levels is lower than the number of exceptions

C. The frequency of confidence levels is equal to the number of exceptions

D. None of the above

The correct answer is: C)

In accurate models, the frequency of confidence levels must show the number of exceptions that
we made in the VaR model.

Q.1500 The theory of order statistics gives us a complete function of VaR (or ES) distribution and
it’s a very easy-to-compute-and-apply approach. Critics of VaR models contend that:

A. VaR models are based on static portfolios

B. The market prices used in VaR models do not depict volatility

C. VaR models are based on the assumption that managers rebalance the portfolios t-day
period

D. VaR models are based on the assumption that portfolios are actively managed

The correct answer is: A)

VaR is a static measure of risk. By definition, VaR gives a particular characteristic of the
underlying probability distribution.

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Q.1501 While carrying out backtesting of a leading bank’s VaR model, you have made the
following findings: the bank is currently calculating the 1-day VaR at a confidence level of 99%.
However, based on your findings you suggest changing the confidence level from 99% to 95%.
Which of the following statements would justify your stance?

A. While conducting backtesting with a 90% confidence interval, the probability of

committing a Type 1 error is small as compared to the probability of Type 1 error when
backtesting with 95% and 99% VaR models.

B. The accuracy of the VaR model and the basis of accepting/rejecting the model have a
greater reliability at a 95% confidence level VaR as compared to at a 99% confidence
level.

C. While conducting backtesting with a 95% confidence interval, the probability of

rejecting the VaR models is higher at a 95% confidence level than at a 99% confidence
level.

D. There are fewer chances of a 95% VaR model being rejected based on backtesting as
compared to a 99% VaR model.

The correct answer is: B)

Using a lower VaR confidence level makes a bigger rejection region, giving room for more
exceptions. This also makes the test more reliable.

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Q.1502 Matthew Hopkins is invited to interview for a position as a financial risk manager. After
completing an initial set of questions, the interviewer asks for the interpretation of the following
case: a $20 million 15-day VAR figure having a confidence level of 95%. Which of the following
represents the CORRECT interpretation?

A. There is a 5 percent chance that there will be a gain of greater than $20 million in a
time period of 15 days

B. The corresponding VAR of the following day is $20 million, with a confidence interval
of 95%

C. The amount of minimum loss spread over the next 15 days is at least $20 million with
a confidence of 95%

D. The amount of loss spread over the next 15 days is expected to be less than $20
million in 95 percent of case scenarios

The correct answer is: D)

A 95% confidence level means that in 95% of the time, we expect losses not to exceed the stated
VaR amount. ($20 million in this case). Put differently, there's a 5% chance that over the next 15
days, there will be a loss exceeding $20 million.

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Q.1503 The notion of backtesting generally includes the comparison of profits and losses on a
daily basis. The 1996 Market Risk Amendment sheds light on the framework of backtesting.
Which of the following metrics are considered critical for such a process?

I. The number of outliers

II. The size of the outliers
III. The risk measure to use

A. I and II

B. II and III

C. II only

D. None of the above

The correct answer is: A)

The number and size of the outliers are significant measures. The number of outliers is the
number of times when the realized loss exceeds the VaR value. Size refers to the extent to which
outliers have been grouped. That is, whether in time, they have become independent.

However, the model allows banks to use proprietary in-house models for measuring market risks.
Banks using proprietary models must compute VaR daily, using 99th percentile, one-tailed
confidence interval with a time horizon of ten trading days using a historical observation period
of at least one year.

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Q.1504 A detailed analysis of backtesting reveals that there are two major areas where
backtesting applies: in the calculation of the Value at Risk (VaR) and in the calculation of EPE1
profiles. Considering this, the Basel Committee has stated very clear rules as to how to perform
the VaR backtest, along with factors distinguishing good and bad models. Which of the following
statements about the Basel Committee guidelines are CORRECT?

I. The Basel rules for backtesting are directly derived from the failure rate test.
II. As per Basel Committee, 5 exceptions are acceptable and fall under the green zone.
III. When exceptions fall in the red zone and become greater than or equal to 10, an automatic
penalty is generated.

A. I and II

B. II and III

C. I and III

D. All of them

The correct answer is: C)

Point number II mentions that 5 exceptions are acceptable, which is incorrect. Only 4 exceptions
are acceptable, and any number greater than this can result in a penalty.

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Q.1505 It is a well-known fact that backtesting requires the application of quantitative, most
often statistical methods, for the purpose of determining whether a model for the assessment of
risk is adequate or not. Which of the following categories form part of the Basel Committee
guidelines regarding exceptions?

I. Model accuracy could be improved

II. Basic integrity of the model
III. Bad Luck and Intraday trading

A. I and II

B. II and III

C. I and III

D. All of them

The correct answer is: D)

All three options (A, B and C) show 4 categories used by the Basel Committee when assessing
the degree of penalty to be imposed on a party.

Q.1506 Designing a verification test is actually a situation where there is a tradeoff between
Type I error and Type II error. As an FRM student, complete the decision errors in the following
table. (Answer choices are in order of i, ii, iii, iv.)

Model
Decision Correctl Incorrect
Accept i ii
Reject iii iv

A. Ok, Type 1 error, Ok, Type 2 error

B. Ok, Type 2 error, Type 1 error, Ok

C. Type 1 error, Ok, Type 2 error, Ok

D. Ok, Ok, Type 1 error, Type 2 error

The correct answer is: B)

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For the purpose of backtesting, users need to balance type 1 errors against type 2 errors. The
preferred choice should have a low Type 1 error.

Recall that in statistics, here's how we interpret type 1 and type 2 errors:

Type 1 error - rejection of the null hypothesis when it is in fact true

Type 2 error - failure to reject the null hypothesis when it is in fact false

For purposes of backtesting, we follow the same logic so that:

type 1 error = rejection of a "correct" model, and

type 2 error= failure to reject an incorrect model

"Ok" simply means that the right decision is made, i.e., a correct model is accepted or an
incorrect model is rejected.

Q.1507 The Basel Committee is based on the assumption that regulators operate under diverse
constraints. The Basel rules are derived from the failure rate test, in which an analyst has to first
select the rate of the Type 1 error and then try to pick a test with a low Type 1 error. Based on
this knowledge, which of the following categories involves deviation due to risk NOT being
measured precisely?

A. Model accuracy could be improved

B. Basic integrity of the model

C. Bad luck

D. Intraday trading

The correct answer is: A)

Under category A above, the deviation occurs because the model does not measure risk with
enough precision (e.g., has too few maturity buckets). This implies a bank’s systems are poor at
capturing the risks of the various positions taken. For instance, correlations may have been
mispecified.

This is a very serious flaw which calls for an increase in the scaling factor penalty that should
apply an immediate corrective action.

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Q.1508 The underlying crux behind backtesting is that faulty models and bad luck must be
separated, or there must be a balance between Type I and Type II errors. However, backtesting
has certain limitations. Which of the following is NOT a limitation of backtesting?

A. Inability to model strategies affecting historic prices

B. Potential curve fitting which means past successful strategies do not work in future

C. Requirement of past conditions with adequate details

D. Reducing volatility

The correct answer is: D)

Reducing volatility is an advantage of backtesting and not a limitation.

Q.1509 Generally, the backtesting model focuses on unconditional coverage as it does not
account for time variations or conditioning in data. As a result, exceptions can bunch closely or
cluster in time. Which of the following backtesting outcomes does NOT raise a red flag?

I. At 95% confidence level, 12 exceptions occur on an annual basis and are spread evenly.
II. At 95% confidence level, 12 exceptions occur on an annual basis and 9 of these occurred over
last 3 weeks.
III. At 95% confidence level, 12 exceptions occur on an annual basis - one exception per month.

A. I and II

B. II and III

C. I and III

D. All of them

The correct answer is: C)

If 9 out of 12 exceptions occurred over the last 3 weeks, this means there is increased volatility
in the market which is not captured by VaR. This situation requires attention and raises a red
flag.

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Q.2637 Jason Black, a risk analyst at a large multinational bank, is backtesting the VaR model of
the bank. The model being tested is a daily, 98% VaR model. If the backtest is conducted for one
year at a 95% confidence level, what is the acceptable number of daily losses that will lead Black
to conclude that the model is calibrated correctly?

A. 6

B. 9

C. 12

D. 5

The correct answer is: B)

Since the test is being conducted at a 95% level, the cutoff value for the test will be 1.96. To test
whether the model is accurate, the following hypothesis is tested:

(x − pT )
> z = 1.96
√ [p(1 − p)T ]
x − 0.02 × 252
= 1.96
√0.02 × 0.98 × 252
⇒ x = 9.4

The acceptable number of exceptions allowed for Black to conclude that the model is correctly
calibrated is 9.

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Q.2638 A model gives a VaR value of $9.5 million for a portfolio at a 99% confidence interval. A
one-year backtest conducted at the 90% confidence level reveals that losses exceeded $9.5
million on 12 occasions. The model is accepted as accurate. Assuming 224 days in a year, which
of these statements is most likely true?

A. A Type I error has occurred

B. A Type II error has occurred

C. Both Type I and Type II errors have occurred

D. The model has been accepted correctly

The correct answer is: B)

To test whether the model is accurate, the following hypothesis is tested:

(x − pT )
> z = 1.65
√ [p(1 − p)T ]
12 − 0.01 × 224
= 1.65
√0.01 × 0.99 × 224
⇒ x = 6.55

The z value calculated is 6.55, which is greater than 1.65. Thus, the hypotheses that the model is
correctly calibrated can be rejected. Accepting an inaccurate model is a type II error. Therefore,
it can be said that the model is not accurate. Accepting an inaccurate model is a Type II error.

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Q.2640 Willy Jones and Craig Atherton are two junior risk analysts. They have recently been
assigned to perform a 1-year backtest of a 1 day 98% VaR model, assuming 225 days in the year.

During the next few days, they exchange a number of emails regarding the assignment:

Email 1 - Jones forecasts the number of expected exceptions for the model to be 4.5.

Email 2 - Atherton replies that according to the Basel Committee’s prescribed penalty zones, the
yellow zone starts at six exceptions and attracts a multiplier of four.

Email 3 - Jones states a type II error occurs when an accurate model is rejected.

The contents of which of the emails is/are not true?

A. Emails 1 and 2

B. Emails 2 and 3

C. Emails 1 and 3

D. All three emails

The correct answer is: B)

Both statements 2 and 3 are incorrect.

The number of forecasted exceptions are (1 - 0.98) × 225 = 4.5

According to the Basel Committee, the yellow zone is between 5 and 9 exceptions and attracts a
multiplier between 3.4 and 3.85.

Rejecting an accurate model is classified as a type I error. A type II error occurs when an
inaccurate model is accepted.

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Q.2641 What is the number of exceptions that are forecasted during the backtesting of a VaR
model that is constructed using a 95% confidence interval over a 1000-day period?

A. 100

B. 10

C. 25

D. 50

The correct answer is: D)

The number of exceptions is equal to 1 - confidence level or 1 - 0.95 = 5%. Multiplying this by
the number of days used will give us the exact number of exceptions:

5% × 1000 = 50

Q.2642 According to the Basel Committee rules for the backtesting of VaR, which of the following
statements in relation to the number of exceptions and the corresponding capital multiplier is
NOT accurate?

A. If the number of exceptions is between 5 and 9, the bank will fall in the yellow zone.

B. If the number of exceptions is between 5 and 9, a capital multiplier of 3 will be

applied.

C. If the number of exceptions exceeds 10, a capital multiplier of 4 will be applied.

D. Banks in the red zone will be charged the highest penalty.

The correct answer is: B)

The Basel Committee has defined penalty zones based on the number of exceptions, which are as
follows:

Zone Number of Exceptions Muliplicative Factor

Green 0 to 4 3.0
Yellow 5 3.4
6 3.5
7 3.65
8 3.75
9 3.85
Red 10+ 4.0

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Q.2643 The Basel Committee has defined four major reasons for exceptions found during
backtesting. These include all of the following, except:

A. Model not calibrated to market conditions

B. Model lacks basic integrity

C. Intraday trading

D. Bad luck

The correct answer is: A)

According to the Basel Committee rules for backtesting of VaR, four different categories have
been defined for reasons of exceptions. These include the need for improvement in model
accuracy, lack of integrity of the model, exceptions caused by intraday trading activity and lastly
bad luck or cases where market conditions varied significantly from the norm.

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Q.2824 The management of a financial institution reports that on a particular year, the daily
revenue fell short of the downside 95% VaR band on 24 occasions (days), or more than 5% of the
time. Ten of these 24 occurrences fell within the May to July period. Assuming 252 days in the
year, test if this was a faulty model or bad luck using the binomial distribution.

A. 8.32; it is a faulty model

B. 2.16; it is bad luck

C. 1.01; it is bad luck

D. 3.3; it is a faulty model

The correct answer is: D)

Considering the equation:

(x − pT)
Z= ≈ N (0, 1)
√p(1 − p)T

we have x = 24, p = 5%, T = 252.

Applying these values in the equation, we get:

(24 − 0.05 × 252)

Z=
√0.05(1 − 0.05) × 252
Z = 3.3

Which is larger than the cut off value of 1.96.

Therefore, we reject the hypothesis that the VaR model is unbiased. It is not likely that this was
bad luck at the 95% confidence level.

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 Reading 65: VaR Mapping

Q.1511 Risk measurement is widely practiced in the financial sector to establish the risk
characteristics of trading instruments and portfolios. This is done via several methods some of
which can be time-consuming and complex because it is literally impractical to measure all risk
factors individually. Hence, the VaR method is used through the process of mapping to:

A. Simplify a portfolio by mapping positions on selected risk factors

B. Simplify a portfolio by mapping positions on all risk factors which can have a minor or
major impact on the performance of an instrument

C. Simplify portfolio by mapping positions on only five risk factors

D. Simplify portfolio by mapping positions on all abnormal risk factors which can impact
the performance of an instrument

The correct answer is: A)

Whichever value-at-risk (VaR) method is used, the risk measurement process needs to simplify
the portfolio by mapping the positions on the selected risk factors. It would be too complex and
time-consuming to model all positions individually as risk factors.

Q.1512 Mapping is a useful process and also an instructive one because it provides useful
judgments about risk drivers of derivatives. Financial institutions cannot always use historical
prices to develop a risk profile for the instrument. In addition, they cannot develop risk profiles
of options on the basis of historic values. Therefore, mapping gives us a way to handle these
practical problems when:

A. Characteristics of instrument do not change over time

B. Characteristics of instrument change over time

C. A large number of factors needs to be measured separately for each position

D. The characteristics of the instrument are only exposed to a single major risk factor

The correct answer is: B)

Mapping is the only solution when the characteristics of the instrument change over time. The
risk profile of bonds, for instance, changes as they age. The bonds must be mapped on yields that
best represent their current profiles. Similarly, the risk profile of options changes very quickly.
Options must be mapped on their primary risk factors. Mapping provides a way to tackle these
practical problems.

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Q.1513 As we know, mapping is the simple process of analyzing the market instruments on
primitive risk factors. Considering this concept, let’s take a single instrument that has a market
value of Vm. It is allocated to specific risk exposures namely X1, X2, and X3. Suppose not all of
the current market value Vm is allocated to these risk factors. What does that imply with regard
to the remaining value?

A. The remainder value is not exposed to any risk

B. The remainder value is allocated to cash which is not a risk factor

C. The remainder value is allocated to a separate set of risk factors

D. The remainder value’s risk exposure is very difficult to measure

The correct answer is: D)

If not fully allocated to the risk factors, it must mean that the remainder value’s risk exposure is
very difficult to measure as it is not possible to find all risk factors in the real-world

Q.1514 In the process of mapping, finance experts first need to choose the most effective set of
primitive risk factors against which the market instrument will be positioned to measure risk.
This choice of factors must be balanced between time devotion and accurate risk measurement.
In short, the choice of primitive risk factors should reflect:

A. The easiest way to get better results in the least amount of time

B. The trade-off between models with a large number of factors and less complex models

C. The trade-off between better quality of approximation and faster processing

D. The trade-off between specific risks with significant effects and those with
insignificant effects

The correct answer is: C)

The choice should reflect the trade-off between better quality approximation and faster
processing. More factors lead to tighter risk measurement but also require more time devoted to
the modeling process and risk computation.

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Q.1515 Once we have selected the risk factors, then, the next step is to map the portfolio or
instrument positions against these risk factors which can be achieved through any of the three
approaches of mapping, depending on the best suitable approach. In choosing the mapping
approach, which important factor should be kept in mind?

A. Mapping should only preserve the market value of the instrument

B. Mapping should preserve the par value as well as the market risk of the position

C. Mapping should preserve the market value as well as the interest rate risk of the
position

D. Mapping should preserve the market value as well as the market risk of the position

The correct answer is: D)

The essence of mapping is to identify risk factors that "explain" the current values of the
portfolio positions. By preserving the market value, you enforce the assumption that the total
value of the position is attributable to the risk factors identified. By preserving the market risk,
you enforce the assumption that the risk factors identified are a true representative of total
market risk.

Q.1516 Considering an example of a two-bond portfolio, we calculated the portfolio returns and
the risks associated with those portfolios using the mapping technique. Then, we found some
specific values, say, 2.80 VaR for duration mapping and 2.67 VaR for cash flow mapping. This
notable difference in these values is due to the fact that:

A. Risk measures are not perfectly linear with maturity and correlations are below unity

B. Risk measures are perfectly linear with maturity and correlations are below unity

C. Risk measures are perfectly linear with maturity and correlations are above unity

D. Risk measures are not perfectly linear with maturity and correlations are equal to
unity

The correct answer is: A)

The difference is due to two factors. First, risk measures are not perfectly linear with maturity.
Secondly, correlations are below unity, which reduces risk even further.

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Q.1517 Benchmarking is the process of evaluating a portfolio’s risk against some standard or
ideal portfolio risk that is considered as the benchmark. Therefore, the VaR of the deviation of
portfolio A relative to the benchmark is

Tracking Error VaR = α√(x – x0)’ Σ(x – x0)

After we performed the necessary calculations for portfolio A, we found the tracking error VaR of
portfolio A which is 0.63 million.

What does this tracking error VaR value imply?

A. The maximum deviation between the index and portfolio A is at most 0.63 million
under normal market conditions

B. The minimum deviation between the index and portfolio A is at most 0.63 million
under normal market conditions

C. The maximum deviation between the index and portfolio A is at most 0.63 million
under abnormal market conditions

D. The minimum deviation between the index and portfolio A is at most 0.63 million
under abnormal market conditions

The correct answer is: A)

The tracking error VaR (TE-VaR) is the maximum deviation between the index and the portfolio
under normal market conditions.

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Q.1518 The stress testing approach of assessing risk exposure represents the link between
calculating VaR through matrix multiplication and movement in underlying prices. This test gives
more direct and appropriate results. Keeping this in mind, which of the following is true about
stress testing as described above?

A. Stress testing is used to evaluate the potential impact on portfolio values of unlikely
events or movements in a set of financial variables

B. Stress testing is a risk management tool that compares predicted results to observed
actual results (historical data)

C. Both A and B options are true

D. None of the above are true

The correct answer is: A)

Stress testing is an approach which computes VaR through matrix multiplication and through
movements in underlying prices. Computing VaR through matrix multiplication is much more
direct and more appropriate because it cuts across different sectors of the yield curve.

Q.1519 Forward contracts are the simplest types of derivatives and their risk can easily be
calculated through basic building blocks forming those contracts. But before buying forward
contracts, an investor needs to make a decision between two alternatives which are economically
equivalent. The usual options available to the investor are to:

A. Buy X units of any asset at price P and sell them at a higher price to potentially earn
profits or enter into a forward contract to buy one unit of the asset in one period

B. Buy X units of any asset at price P and hold them for one period or enter into a
forward contract to buy one unit of the asset in two periods

C. Buy X units of any asset at price P and hold them for one period or enter into a
forward contract to buy one unit of the asset in one period

D. Buy X units of any asset at price P and sell them at a higher price to potentially earn
profits or enter into a forward contract to buy one unit of the asset in one period at the
lowest price possible

The correct answer is: C)

Investors have two alternatives that are economically equivalent: (1) Buy X units of the asset at
the prevailing market prices and hold them for one period, or (2) enter into a forward contract to
buy one unit of the asset in one period.

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Q.1520 One of the methods of cash flow mapping involves decomposing bond risk into the risk of
each of the bond's cash flows. This describes:

A. Principal mapping

B. Duration mapping

C. Cash flow mapping

D. Present value mapping

The correct answer is: C)

Under cash flow mapping, the risk of the bond is decomposed into the risk of each of the bonds'
cash flows. The present value of cash flows is mapped onto the risk factors for zeros of the same
maturity.
Under principal mapping, we only consider the risk of the repayment of the principal amount.
Under duration mapping, the risk of the bond is mapped to a zero-coupon bond of the same
duration.
"Present value mapping" is nonexistent.

Q.1521 Financial institutions determine the market values of forward contracts on the basis of
some underlying pricing factors. These factors can include market interest rate, risk and
correlation, etc. Such factors can affect the price on the basis of their volatility and VaR
percentage. What does positive correlation between two factors - A and B - indicate?

A. It indicates that when factor A goes up in value, the value of factor B is likely to
depreciate

B. It indicates that when factor A goes down in value, the value of factor B is likely to
appreciate

C. It indicates that when factor A goes up in value, the value of factor B does remains
unaffected

D. It indicates that when factor A goes up in value, the value of factor B is likely to
appreciate

The correct answer is: D)

A positive correlation means the prices of two assets move in the same direction. For example, a
correlation of 0.13 between the EURO spot and bill positions indicates that when the EUR goes
up in value against the dollar, the value of a 1-year EURO investment is likely to appreciate.

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Q.1522 To determine the value of forward contracts, we decompose the forward contract into its
main building blocks which will impose the net effect on the risk and price of the forward
contract. This methodology can also be used for long-term currency swaps which are typically
identical to portfolios of forward contracts. Keeping this scenario in mind, which of the following
statements is true?

A. A 5-year contract to pay dollars and receive Euros is equivalent to a series of 5

forward contracts to exchange a set amount of dollars

B. A 5-year contract to pay dollars and receive Euros is equivalent to a series of any
number of forward contracts to exchange a set amount of dollars

C. A 5-year contract to pay dollars and receive Euros is equivalent to a forward contract
to exchange a set amount of dollars

D. A 5-year contract to pay dollars and receive Euros is not equivalent to a series of 5
forward contracts to exchange a set amount of dollars

The correct answer is: A)

A swap contract is equivalent to a portfolio of forward contracts with identical delivery prices
and different maturities. Consequently, swap contracts are similar to forwards in that (1) at any
date, swap contracts can have positive, negative, or no value, and (2) at initiation, the fixed
amount paid is chosen so that the swap contract is costless. The unique fixed amount which
zeros out the value of a swap contract is called the swap price.

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Q.1523 The valuation of commodity forward contracts is much more complex compared to that of
financial assets such as currencies or stock indices because these commodity-based contracts do
not have well-defined income flows and most of the time do not make monetary payments.
Rather, items are consumed giving an implied benefit called convenience yield, which
represents:

A. The quantifiable disadvantage to owning the commodity rather than buying the futures
contract

B. The quantifiable advantage to owning the commodity rather than buying the futures
contract

C. The addition of the risk-free rate and the storage cost

D. The cost of storage cost from holding the commodity

The correct answer is: B)

The flow of benefits net of storage cost is loosely called convenience yield to represent the
benefits from holding the cash product. In other words, the convenience yield is an implied
return on holding inventories. It is an adjustment to the cost of carry in the non-arbitrage pricing
formula for forward prices in markets with trading constraints.

Mathematically, it can be written as:

S0e(r + λ - c)
Where S0 is the spot price;
r is the risk-free rate of return;
λ is the storage cost; and
c is the convenience yield.

We can see from this that the convenience yield lowers the price of the contract because it is the
quantifiable advantage to owning the commodity rather than buying the futures contract. For
example, I have wheat in case I need it to eat, rather than simply having a wheat futures
contract.

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Q.1524 A forward rate agreement is a type of forward contracts that allows the contracting
parties to make transactions in a locked interest rate at some future date. The buyer in this
contract locks in the borrowing rate and the seller locks in the lending rate at some future date.

Which statement is true about such a contract if the spot rate is higher than the forward rate at
the time of the transaction?

A. The buyer will be worse off and will receive payments at a lower rate and the seller
will also be worse off by lending at a lower rate

B. The buyer will be worse off and will receive payments at a lower rate while the seller
will benefit by lending at a lower rate

C. The buyer will benefit and will receive payments at a lower rate while the seller will be
worse off by lending at a lower rate

D. Both the buyer and the seller will be in the same position with no effect in benefits and
losses

The correct answer is: C)

Forward rate agreements (FRAs) are forward contracts that allow users to lock in an interest
rate at some future date. The buyer of an FRA locks in a borrowing rate and the seller locks in a
lending rate. In other words, the "long" receives payments if the spot rate is above the forward
rate.

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Q.1525 The forward rate can be defined as the implied rate that makes the return on a T2 period
investment and a T1 period investment equal. That is:

(1+R2T2) = (1+R1T1) [1+F1,2(T2 -T 1)]

It means that if you sold a 5*10 FRA on $50 million, this transaction is equal to borrowing $50
million into 5-month Bills and investing the proceeds into 10-month Bills.

Which of the following formulas is supporting the above statement?

A. Long 6*12FRA = Short 6-month Bills + Long 12-month Bills

B. Long 6*12FRA = Short 12-month Bills - Long 6-month Bills

C. Long 6*12FRA = Long 12-month Bills + Short 6-month Bills

D. Long 6*12FRA = Long 6-month Bills + Short 12-month Bills

The correct answer is: D)

Long 6*12FRA = Long 6-month Bill + short 12-month bill

Q.1526 Interest rate swaps are the most commonly used derivatives because of their less volatile
risk positions. An interest rate swap is an agreement between two parties to exchange interest
rate flows on the basis of fixed to floating rates and vice versa. They can be broken down into
two legs: a fixed leg and floating leg. The fixed leg can be the price on a:

A. Floating-rate note and the floating leg can be equivalent to a coupon-paying bond

B. Coupon-paying bond and the floating leg can be equivalent to a floating-rate note

C. Zero-coupon bond and the floating leg can be equivalent to a floating-paying bond

D. Floating-paying bond and the floating leg can be equivalent to a zero-coupon bond.

The correct answer is: B)

Swaps can be decomposed into two legs, a fixed leg and a floating leg. The fixed leg can be
priced as a coupon-paying bond and the floating leg is equivalent to a floating-rate note (FRN).

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Q.1527 Risk measurement is difficult for non-linear derivatives or options because of non-
linearity. To simplify the process, the Black-Scholes model is used.

What is the assumption of this model other than perfect capital markets?

A. Underlying spot prices follow a continuous geometric Brownian motion with constant
volatility

B. Underlying spot rates follow a continuous algebraic Brownian motion with constant
volatility

C. Underlying spot prices follow a stationary geometric Brownian motion with constant
volatility

D. There is no other assumption of this model except for perfect capital markets

The correct answer is: A)

The BS model assumes, in addition to perfect capital markets, that the underlying spot price
follows a continuous geometric Brownian motion with constant volatility.

Q.1528 Consider the Black-Scholes (BS) model for European options. Suppose we drew a graph
showing the relationship between delta (the first partial derivative of a nonlinear option) and
spot prices of options with differing maturities. What would be the relationship observed for
long-term and short-term options?

I. The relationship becomes more nonlinear for short-term options than long-term options
II. The relationship becomes more linear for short-term options than long-term options
III. Linear approximations may be acceptable for options with long maturities when the risk
horizon is short

A. I and III only

B. II and IIII only

C. II only

D. III only

The correct answer is: A)

Delta increases with the underlying spot price and the relationship becomes more nonlinear for
short-term options. Secondly, linear approximations may be acceptable for options with long
maturities when the risk horizon is short.

Further explanation:

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As stated in the chapter:

"The figure shows that delta is not a constant, which may make linear methods inappropriate for

measuring the risk of options. Delta increases with the underlying spot price. The relationship

becomes more nonlinear for short-term options, for example, with an option maturity of 10 days.

Linear methods approximate delta by a constant value over the risk horizon. The quality of this

approximation depends on parameter values."

...

"Thus linear approximations may be acceptable for options with long maturities when the risk

horizon is short."

Further explanation:

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The delta for short-term options changes faster than the delta of long-term options because as

the time to expiration decreases, it means that any change in the underlying's price is unlikely to

evaporate fast enough, and will therefore most likely persist up until the maturity date and

impact the decision whether or not to exercise the option. If the change is likely to persist, then

the option price (and hence delta) will also change faster and actually exhibit more of a "jump", a

non-linear change.

In fact, as the time remaining to expiration grows shorter, the time value of the option

evaporates and correspondingly, the delta of in-the-money (ITM) options increases faster relative

to longer-term ITM options. Similarly, the delta of out-of-the-money (OTM) options decreases

faster relative to that of longer-dated OTM options.

Q.1529 Risk measurement should always be a prioritized endeavor for financial institutions. In
this regard, financial instruments need to be mapped on a set of primitive risk factors. The art of
risk management lies in the ability to choose an appropriate set of risk factors. Keeping this in
mind, which of the following statements is/are true?

I. A large number of risk factors should be incorporated to avoid any future loses
II. Only a few risk factors should be selected to save time and make decisions in a timely fashion
III. There should be proper allocation of primitive risk factors to avoid slow and wasteful
measurements
IV. There should be a proper set of general market and specific risk factors depending on the
position of the instrument

A. I and IV

B. III and IV

C. IV only

D. I and III

The correct answer is: B)

Too many risk factors would be unnecessary, slow, and wasteful. Too few risk factors, in contrast,
could create blind spots in the risk measurement system.

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Q.1530 In practice, we have to keep the number of risk factors small during mapping. These risk
factors include both general market risks and specific market risks for the entire portfolio. Thus
the portfolio return is calculated including variance through the following equation on:

n
V (R P ) = (B2p )V (Rm ) + ∑ (Wi2 )(σgi )
i=1

This decomposition shows that:

A. With less general market risk factors, there will be less specific risk factors for fixed
amount of total risk, (V)(Rp)

B. With more general market risk factors, there will be more specific risk factors for fixed
amount of total risk, (V)(Rp)

C. There will be equal general market and specific risk factors for a fixed amount of total
risk, (V)(Rp)

D. With more general market risk factors there will be less specific risk factors for fixed
amount of total risk, (V)(Rp)

The correct answer is: D)

This decomposition shows that with more detail on the primitive or general-market risk factors,
there will be less specific risk for a fixed amount of total risk V (Rp).

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Q.2644 Adding more general risk factors to a VaR model will most likely:

A. Increase the size of specific risks

B. Decrease the size of specific risks

C. Have no effect on the size of specific risks

D. None of the above. While adding more factors to a model will affect the size of specific
risk it is not possible to determine the exact nature of the change without considering
what factors are added.

The correct answer is: B)

The number of general risk factors used in a VaR model will affect the size of the specific or
residual risk. For instance, a model that only considers the duration of the portfolio will have a
larger residual/specific risk as compared to a model that considers both duration and credit risk.
Risk can be better defined by adding more risk factors. Adding general risk factors to the model
will help define the risk more accurately and will reduce the specific or residual risk.

Q.2645 All of the following are VAR mapping systems for fixed-income securities, except:

A. Principal mapping

B. Duration mapping

C. Cash flow mapping

D. Interest mapping

The correct answer is: D)

There are three different VaR mapping approaches. These include principal mapping, duration
mapping, and cash-flow mapping.

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Q.2825 Determine the forward rate for a 1-year forward contract to exchange US dollars for
Euros. It is estimated that the Euro spot is $1.3988. The 1-year EURO T-bill is quoted at 2.28%
while the 1-year USD T-bill is quoted at 3.33%.

A. 1.41 USD/EURO

B. 1.31 USD/EURO

C. 1.22 USD/EURO

D. 1.5 USD/EURO

The correct answer is: A)

(1 + AFd × rd )
F Xf wd = F Xsp ot × [ ]
(1 + AFf × rf )

Where:

F Xf wd = fair forward rate (units of domestic currency / unit of foreign currency)

F Xs pot = spot FX rate (units of domestic currency / unit of foreign currency)

rd = domestic annual interest rate

rf = foreign annual interest rate

AFd = domestic accrual factor (days of accrued interest / days in a year)

AFf = foreign accrual factor

Thus,

(1 + 360/360 × 0.033)
F Xf wd = 1.3988 × [ ] = 1.41U SD/EURO
(1 + 360/360 × 0.0228)

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Q.2826 A bank has a cash flow decomposition with a duration of 5 years. Given that the VaR of
the index at the 95% confidence level is $2.080 million, with a tracking error of $1.09 million,
calculate the variance improvement relative to the original index.

A. 23.5%

B. 33.6%

C. 72.5%

D. 95.1%

The correct answer is: C)

Recall that the variance improvement is given by:

1 − ((Tracking Error)/(Absolute risk index))2

= 1 − (1.09/2.08)2

= 0.725

= 72.5%

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Q.2827 The following table gives VaR percentages at the 95% confidence level for a bond with
matuities ranging from one year to 5 years:

Maturity VaR
1 0.4777
2 0.9961
3 1.4264
4 1.9618
5 2.4120

A bond portfolio consists of a $100 million bond maturing in one year and a $100 million bond
maturing in three years. Determine the VaR of this bond portfolio using the principal VaR
mapping method

A. $1.2235m

B. $1.7765m

C. $1.9922m

D. $1.5m

The correct answer is: C)

The VaR percentage is 0.9961 for a two-year zero-coupon bond [(1 + 3) / 2 = 2].
Principal mapping VaR = VaR percentage × market value of the average life of the bond
Principal mapping VaR = 0.9961% × $200m = $1.9922m

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Q.2828 Calculate the current forward rate if you are given that the spot price of 1 unit of the
underlying cash asset is 1.22, with a domestic free rate of 0.037 and τ = 1. The income flow rate
y is 1.92%. (Assume continuous compounding.)

A. 1.24

B. 0.78

C. 1.32

D. 1.50

The correct answer is: A)

Remember that the current forward rate is given by the equation:

Ft = Ste−ytert

We know that, St = 1.22, r = 0.037, y = 0.0192 and τ = 1.

Applying the formula:

Ft = 1.22e−0.0192×1 × e0.037×1 = 1.24

The forward rate to but one unit of the underlying cash asset is 1.24

Q.3015 Which of the following components is NOT a relevant factor while calculating the total
VaR of a USD corporate bond for a US investor?

A. The USD swap interest rate

B. The bond sector's credit spreads

C. The maturity of the bond

D. FX rates

The correct answer is: D)

For a US investor, FOREX rates are not relevant for VaR calculation if the bond in question is
denominated in USD. All the other 3 factors are necessary inputs.

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Q.3016 Which of the following inputs is NOT required in order to calculate the 99% Monte Carlo
1-day VaR of a portfolio made of two stocks A and B, assuming both stocks have normally
distributed returns?

A. The correlation of the returns between A and B

B. The credit rating of entities A and B

C. The spot values of stocks A and B

D. Normally distributed random numbers

The correct answer is: B)

Credit ratings are irrelevant for a market risk VaR calculation of both stocks.

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Q.3040 Mapping refers to the process of replacing the current values of a portfolio with risk
factor exposures. More generally, it is the process of replacing each instrument by its exposures
on selected risk factors. Mapping is important because:

A. it helps us to cut down on the dimensionality of covariance matrices and correlations

B. it helps avoid rank correlation problems

C. it greatly reduces the time needed to carry out risk assessment and related
calculations

D. All of the above

The correct answer is: D)

Mapping helps us to cut down on the dimensionality of covariance matrices and correlations.
Given a portfolio comprising of n instruments, we would need to gather data on n volatilities and
n(n-1)/2 correlations, resulting in a labyrinth of pieces of information. As n increases, so does the
amount of information we have to collect and process. It is important to keep the dimensionality
of our covariance matrix at a manageable level to avoid computational problems.

Mapping helps avoid rank correlation problems By handling a large number of risk factors that
are closely correlated (or even perfectly correlated in extreme cases), we might run into rank
problems with the covariance matrix and end up producing pathological estimates that might
lead to erroneous conclusions. To avoid such problems, it is important that we select an
appropriate set of risk factors that are not closely related.

Mapping greatly reduces the time needed to carry out risk assessment and related calculations.
By reducing a portfolio comprised of a large number of different positions to a consolidated set
of risk-equivalent positions in basic risk factors, it is possible to conduct calculations at a faster
speed. The only downside to such a move is that precision is lost.

Q.3041 If portfolio assets are perfectly correlated, portfolio VaR will equal:

A. Component VaR

B. Marginal VaR

C. Diversified VaR

D. Undiversified VaR

The correct answer is: D)

If we assume perfect correlation among assets, VaR would be equal to undiversified VaR

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 Reading 66: Messages from the Academic Literature on Risk
Measurement for the Trading Book

Q.1531 One of the fundamental issues when using VaR for regulatory capital is the horizon over
which VaR is calculated. Scaling up the short-horizon VaR to the desired time period using the
square-root-of-time may compromise the accuracy of VaR because:

A. The tail risk is likely to be overestimated

B. The downward bias tends to decrease as we increase the time horizon

C. The tail risk is likely to be underestimated

D. The upward bias tends to decrease as we increase the time horizon

The correct answer is: C)

The tail risk is likely to be underestimated when the results are scaled up using the square-root-
of-time. As a result, even if the square-root-of-time rule has widespread applications in the Basel
Accords, it fails to address the objective of the Accords.

Q.1532 The intra-horizon VaR is a risk measure that combines VaR over the regulatory horizon
with P&L fluctuations over the short term. Taking intra-horizon risk into account generates risk
measures consistently higher than standard VaR, up to multiples of VaR, and:

A. The divergence is larger for derivative exposures

B. The minimum cumulative loss exerts a distinct effect on the capital of a financial
institution

C. The divergence is smaller for derivative exposures

D. The information is carried on low-frequency P&L

The correct answer is: A)

Bakshi and Panayotov (2010) found that taking intra-horizon risk into account generates risk
measures consistently higher than standard VaR, and the divergence is larger for derivative
exposures.

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Q.1533 According to academic literature, “time-varying volatility in financial risk factors is
important to the VaR.” When the true underlying risk factors exhibit time-varying volatility, the
use of historically simulated VaR without incorporating time-varying volatility can:

A. Reduce pro-cyclicality

B. Under-estimate risk

C. Increase instability

D. Over-estimate risk

The correct answer is: B)

Option B is the correct answer because Risk Metrics Technical document showed theoretically
that using historical simulation VaR without incorporating time-varying volatility can
dangerously under-estimate risk.

Q.1534 Multivariate GARCH models such as the BEKK model of Engle and Kroner (1995) or the
DCC model of Engle (2002) can be used to estimate:

I. Time-varying volatilities
II. Correlations
III. Large numbers of positions

A. I and II

B. II and III

C. I, II and III

D. None of the above

The correct answer is: C)

Multivariate GARCH models can be used to estimate time-varying volatilities as well as

correlations. In addition, some recent advances in literature allow us to estimate a multivariate
GARCH-type model when there is a large number of risk factors.

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Q.1535 The amalgamation of VaR models and market liquidity requires a distinction between
exogenous and endogenous liquidity. Which of the following descriptions is correct?

A. The endogenous component of liquidity risk corresponds to the average transaction

costs set by the market for standard transaction sizes

B. The exogenous liquidity risk corresponds to the normal variation of bid/ask spreads
across instruments

C. The endogenous risk of collective portfolio adjustments is easier to include in a VaR

computation

D. The exogenous component corresponds to the impact on prices of the liquidation of a

position in a relatively tighter market

The correct answer is: B)

Exogenous liquidity risk can be, from a theoretical point of view, easily integrated into a VaR
framework. It corresponds to the normal variation of bid/ask spreads across instruments.

Liquidity risk can be divided into an endogenous liquidity component and an exogenous liquidity
component. Exogenous liquidity escapes from the control of the trader and finds its origin in the
characteristics of markets. The key element of its determination is associated with precise
modeling of the spread’s behavior. By opposition, the endogenous liquidity component is specific
to the characteristics of the position and will, therefore, vary across markets.

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Q.1536 Expected shortfall is the most well-known risk measure following the VaR. It is
conceptually intuitive, has firm theoretical backgrounds and is now preferred to VaR. Which of
the following statements about the expected shortfall is/are correct?

I. The expected shortfall does not account for the severity of loss the confidence threshold
II. The expected shortfall is always sub-additive and coherent
III. The expected shortfall mitigates the impact that the particular choice of a single confidence
level may have on risk management decisions

A. I and II

B. II and III

C. I and III

D. None of the above

The correct answer is: B)

The expected shortfall does account for the severity of losses beyond the confidence threshold,
while always being subadditive and coherent, and mitigating the impact that the particular
choice of a single confidence level may have on risk management decisions.

Q.1537 In order to estimate the range and magnitude of the differences between
compartmentalized and unified risk measures, you are required to obtain a simple ratio of these
two measures. After performing relevant calculations, you come to the conclusion that ratio
values greater than one indicate:

A. Risk compounding, and values less than one indicate risk diversification

B. Risk augmentation, and values less than one indicate risk reduction

C. Risk diversification, and values less than one indicate risk reduction

D. Risk augmentation, and values less than one indicate risk compounding

The correct answer is: A)

Ratio values greater than one indicates risk compounding and values less than one indicate risk
diversification.

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Q.1538 The examination of variable rate loans, in which the interaction between market and
credit risk can be analyzed, is performed by modeling the dependence of credit risk factors on
the interest rate environment. These factors include:

I. Loans' default probabilities

II. The exposure at default
III. Loss-given-default

A. I and II

B. II and III

C. I and III

D. I, II and III

The correct answer is: D)

Credit risk factors include loans' default probabilities (PD), exposure at default (EAD), and loss-
given-default (LGD).

Q.1539 Consider yourself as an intermediary who actively runs a VaR-based risk management
system. You start with a balance sheet consisting of risk-free debt and equity. This is followed by
an asset boom, which leads to an expansion in the values of securities. Without any balance sheet
adjustment, this leads to:

A. A reduction in liability

B. An expansion in capital

C. An expansion in equity

D. A reduction in expenses

The correct answer is: C)

An asset boom leads to an expansion in the values of securities. Since debt was risk-free to begin
with, without any balance sheet adjustment, this leads to a pure expansion in equity.
Further Explanation
Value at risk - which is the equity capital the firm must hold to be solvent - is tied to a bank’s
level of economic capital. Most entities work with a target ratio of VaR to economic capital, and
therefore a VaR constraint on leveraged investors can be established. If there happens to be an
economic boom, it will relax the VaR constraint because the equity will now be worth more. This
will pave the way for financial institution to take on more risk and further increase debt

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Q.2647 Which of these is not a disadvantage of VaR?

A. VaR does not consider the worst case losses that lie beyond the VaR confidence level

B. VaR is not subadditive

C. The VaR of different types of assets cannot be compared

D. VaR gets difficult to calculate as the size of the portfolio and the number of assets in
the portfolio increases

The correct answer is: C)

VaR is a simple and easy to understand and calculate metric for market risk. However, VaR is
calculated for a certain confidence level, and losses beyond that threshold are not considered.
Another disadvantage of the method is that the VaR measure is not subadditive. As the number of
assets in a portfolio increases, it gets more difficult to calculate VaR as the number of
correlations between the assets in the portfolio increase.

Q.2829 Let a balance sheet for an institution be given such that the liabilities side is 759 in debts
and 104 equity shares. Calculate the total leverage.

A. 15.9

B. 21.5

C. 11.6

D. 8.3

The correct answer is: D)

Recall that leverage is the total assets to equity ratio. This is given by the expression

L = Assets/Equity

But from the accounting equation: Assets = Total Equities + Total Liabilities

⇒ Assets = 759 + 104 = 863

⇒ L = 863/104 = 8.3

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Q.2830 What type of liquidity risk is most troublesome for complex trading positions?

A. Endogenous

B. Spectral

C. Exogenous

D. Market-specific

The correct answer is: A)

Endogenous liquidity is the adjustment for the price effect associated with the liquidation of
specific positions. It is especially relevant in complex high-stress market conditions.

Q.2831 Find the weight of an observation 13 days ago if the total number of days in the historical
window is 300 with a 0.8 control rate of memory decay.

A. 0.013

B. 2.2050

C. 0.0205

D. 0.2250

The correct answer is: A)

The weight of observation i-days ago is given by:

λ i−1 (1 − λ)
w(i) =
1 − λn

Where n is the number of days in the historical window and θ is the control rate of the memory
decay,

Therefore:

0.812 (1 − 0.8)
W (12) = = 0.01374
1 − 0.8300

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Q.2832 Branch Bank has the proportion of capital to be held per total VaR as 2.9 while the future
value of its assets is $56 million. Calculate the leverage for Branch Bank if the Value at Risk is
$1.6 million.

A. 13.5

B. 22.1

C. 12.07

D. 15.6

The correct answer is: C)

We were given that Leverage:

A 1 A
L= =( )×( )
K λ V aR

Where A is the future value of assets, and λ is the proportion of capital to be held per total VaR.
Thus:

1 56
⇒L=( ×( )) = 12.07
2.9 1.6

Q.2833 Considering arbitrary portfolios A and B, and their combined portfolio C, which of the
following relationships holds for VARs of A, B, and C ?

A. VaRA + VaRB = VaRC

B. VaRA + VaRB ≤ VaRC

C. VaRA + VaRB ≥ VaRC

D. None of the above

The correct answer is: D)

This is the correct answer given the “always” requirement and the fact that VAR is not always
sub-additive. Otherwise, (b) is not a bad answer, but additional distributional assumptions are
required.

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Q.3014 In many banks, aggregate risk is defined using a rollup or risk aggregation model;
capital, as well as capital allocation, is based on the aggregate risk model. Which of the following
is least likely correct regarding risk aggregation?

A. The top-down risk aggregation model assumes that a bank’s portfolio can be cleanly
subdivided according to market, and operational risk measures only

B. The bottom-up risk aggregation model attempts to account for interactions among
various risk factors

C. In the bottom-up aggregation model, the sub-risk levels are aggregated bottom-up
using a joint model of risk

D. None of the above (All options are correct)

The correct answer is: A)

A is incorrect. In the top-down aggregation, risk is measured on the sub-risk level, and risks
considered are market risk, credit risk and operational risk.
B and C are both correct. In the bottom-up aggregation model, the sub-risk levels are aggregated
bottom-up using a joint model of risk and correlations between the different sub-risks that drive
risk factors

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 Reading 67: Correlation Basics: Definitions, Applications, and
Terminology

Q.1540 Financial correlation is the process of measuring the relationship between two or more
financial assets over time. It measures the extent to which two financial variables move with
respect to each other. The original copula approach for collateralized debt obligation is a type of
static financial correlation that measures the default correlation of all assets in the CDO for a
certain time period. Here, the “certain time period” for a CDO is usually equal to:

A. The reinvestment period of the collateralized debt obligation

B. The maturity of the collateralized debt obligation

C. The time up to which the assets of the collateralized debt obligation defaults

D. The time up to which any single asset of the collateralized debt obligation defaults

The correct answer is: B)

The “certain time period” refers to the time to maturity of a CDO.

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Q.1541 Assume that an investor has bought $2 million in a bond from Issuer A. They are now
worried about Issuer A defaulting and have purchased a Credit Default Swap (CDS) from Issuer
B. The value of the CDS is mainly determined by the default probability of the reference entity
Issuer A. If the correlation between issuer A and B increases, what will be the impact on the
price of the CDS?

A. The price of the CDS will decrease because there is a greater chance of joint default.

B. The price of the CDS will increase because there is a greater chance of joint default.

C. There will be no impact on the price of the CDS because it is working as a separate
entity.

D. It may increase or decrease depending on the market and economic conditions of the
country.

The correct answer is: A)

An increasing p means a higher probability of the reference asset and the counterparty
defaulting together. If the correlation between Issuer A and the CDS issuer increases, the
present value of the CDS for the investor will decrease and he will suffer a loss.

Further explanation:

If the default correlation between the CDS and the reference entity is positive, what this implies
is that the default probabilities of the protection seller (PS) and the reference entity (bond
issuer) tend to show co-movement; if the PD of the issuer increases, the PD of the PS also
increases. What does that mean? The CDS is unlikely to serve its purpose of compensating the
protection buyer in the event of default on the part of the bond issuer because there's a good
chance the protection seller will not be in a position to make the agreed-upon payment.

Therefore, if the default correlation is positive, the protection seller will have a hard time
convincing the buyer to pay a higher premium. The buyer will only accept a lower premium to
offset the risk of joint default.

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Q.1542 Suppose a correlation swap buyer pays a fixed correlation rate of 0.28 with a notional
value of $10 million for one year for a portfolio of three assets. The following are the realized
pairwise correlations of the daily log returns at maturity for the three assets:

ρ2,1 = 0.7

ρ3,1 = 0.2

ρ3,2 = 0.03

Assuming that for all pairs, i > j, the payoff for the correlation swap buyer is equal to:

A. $0.28 millin

B. $0.31 million

C. $0.3 million

D. $0.25 million

The correct answer is: C)

The payoff for the correlation swap buyer is given by:

Payoff = Notional Amount × (ρre alized − ρfixed )

Where:

2
ρreali ze d = ∑ ρi j
− n i>j .
n2
2
= 2 ∑ ρi. j
3 − 3 i>j
= 0.7 + 0.2 + 0.03 = 0.31

Thus,

Payoff = 10 , 000, 000(0.31 − 0.28) = $ 300, 000 = 0.3 milliom

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Q.1544 Nowadays in financial markets, investors are hedging their risk of portfolios by keenly
studying correlation and attempting to financially gain from those correlation changes.
Correlation trading is basically trading those assets whose prices are based on the movement of
one or more assets in time. In these correlation assets, the strike price - the price determined at
the start of the option - is commonly used. What does this strike price indicate?

A. The price at which the underlying asset can be bought in the case of a call, and the
price at which the underlying asset can be sold in the case of a put

B. The price at which the underlying asset can be bought at the time the option is created

C. The price at which the underlying asset can be bought in the case of a put, and the
price at which the underlying asset can be sold in the case of a call

D. The right, but not the obligation, to buy or sell a stock at an agreed-upon price within
a certain period of time

The correct answer is: A)

The strike price refers to the price at which the underlying asset can be bought in the case of a
call, and the price at which the underlying asset can be sold in the case of a put. The strike price
is agreed upon at the start of the option.

"The right, but not the obligation, to buy or sell a stock at an agreed-upon price within a certain
period of time" is the definition of an option, not the strike price.

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Q.1545 When buying multi-asset options, investors must take into account any correlation
between the assets. In fact, the higher the correlation of two assets in an option, the higher the
price of that option. What does a negative correlation between the assets of the option indicate?

I. If one asset’s value decreases, on average, the other asset’s price appreciates.
II. If one asset’s value decreases, on average, the other asset’s price also decreases
III. If one asset’s value increases, on average, the other asset’s price appreciates.
IV. One of the two assets is likely to appreciate which will result in a high payoff, compensating
the other asset’s loss.

A. I only

B. I and III

C. I and IV

D. IV only

The correct answer is: C)

A negative correlation means prices move in different directions. If the price of one asset
decreases, on average, the price of the other one increases. Therefore, one of the two assets is
likely to result in a high payoff.

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Q.1546 A quanto option is another correlation option that authorizes a domestic investor to
interchange his potential option payoff (which is in foreign currency) back into its domestic
currency at a fixed exchange rate. This option helps the investor get protected against currency
risk. From a risk management standpoint, the financial institutions which are selling these
correlation options do not have information about two things. These are:

A. The foreign currency amount to be converted into the domestic currency, and
secondly, the exchange rate at option maturity at which the foreign currency payoff will
be converted into the domestic currency.

B. The domestic currency amount to be converted into the foreign currency, and
secondly, the exchange rate at option maturity at which the domestic currency payoff will
be converted into the foreign currency.

C. The foreign currency that’s correlated with the domestic currency, and secondly, the
impact of the correlation on the buying and selling of quanto options.

D. The domestic currency amount to be converted into the foreign currency, and
secondly, the impact of the correlation on the buying and selling of quanto options.

The correct answer is: A)

The financial institutions that sell quanto calls do not know two things:

1. How deep in the money the call will be, i.e., which Yen amount has to be converted into
Dollars.
2. The exchange rate at option maturity at which the stochastic Yen payoff will be converted into
Dollars.

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Q.1547 A correlation swap is a type of financial variable in which the correlation between assets
can be traded. In a correlation swap, a fixed known correlation is traded against the unknown
correlation that will actually occur. This type of correlation swap protects the investor from a
stock market decline. The payment of a correlation swap for the correlation fixed rate payer at
maturity is:

A. N(pfixed – prealised)

B. μ(prealised – pfixed)

C. N(prealised – pfixed)

D. Nμ(prealised – pfixed)

The correct answer is: C)

The payoff of a correlation swap for the correlation fixed rate payer at maturity is N(prealised –
pfixed).

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Q.1548 After the global crisis, financial institutions have become more risk-averse to avoid any
possible losses. For this reason, financial risk management has become a vital part of the
financial sector and VaR is one of the tools of financial risk management used to measure the
market risk of the portfolio. VaR measures the expected maximum loss of a portfolio with respect
to a certain probability for a time t. The equation for VaR is:

VaRp = σp α √x

What do σp and α represent here?

A. σp is the volatility of the portfolio P, which includes the correlation between the assets
in the portfolio, while α is the abscise value of a standard normal distribution

B. σp is the abscise value of a standard normal distribution, while α is the volatility of the
portfolio, which includes the correlation between the assets in the portfolio

C. σp is the volatility of the portfolio P, which does not indicate anything about the
correlation between the assets in the portfolio, while α is the covariance matrix of the
returns of the assets

D. σp is the volatility of the portfolio P, which includes the correlation between the assets
in the portfolio, while α is the covariance matrix of the returns of the assets

The correct answer is: A)

α is the abscise value of a standard normal distribution corresponding to a certain confidence

level and σp is the volatility of the portfolio P, which includes the correlation between the assets
in the portfolio.

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Q.1549 We have calculated the value of VaR for a two-asset portfolio to analyze the impact of
correlations between the two assets. After going through all calculations of variance with the
given data, we reached a value of VaR. The VaR value for a 10-day two-asset portfolio with a
correlation coefficient of 0.7 on a 99% confidence interval is $1.786 million. What does this value
imply?

A. Only once in a hundred 10-day period will this VaR amount ($1.7486 million) be
exceeded

B. We are 99% confident that we can lose more than $1.786 million of our two asset
portfolio in the next 10 days

C. We are 99% confident that we will not lose less than $1.786 million of our two asset
portfolio in the next year

D. Only once every 10,000 days will this VaR amount ($1.7486 million) be exceeded

The correct answer is: A)

On average, only once in a hundred 10-day period (so once every 1,000 days) will this VaR
amount ($1.7486 million) be exceeded.

Q.1550 Suppose we drew a graph showing the correlation between two assets, and found it to be
negative. It would mean that:

A. If the market value of one asset decreases, the other asset, on average, also decreases,
hence reducing the overall risk.

B. If the market value of one asset decreases, the other asset, on average, increases,
hence reducing the overall risk.

C. If one asset’s value decreases, the other asset’s value, on average, increases, hence
increasing the overall risk.

D. If one asset increases, the other asset, on average, increases, hence reducing the
overall risk.

The correct answer is: B)

The lower the correlation, the lower the risk, as measured by the VaR. Preferably, the correlation
is negative. In this case, if one asset decreases, the other asset, on average, increases, hence
reducing the overall risk.

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Q.1551 The global financial crisis of 2007-2009 was caused by a number of reasons which may
include high levels of debt, low interest rates, high-level speculation, and mortgage-backed
securities. It was the first correlation-related crisis marked by correlations among bonds and
CDOs and this led to the fall of many hedge funds.

Which statement is true regarding the cause of losses in CDOs?

A. The losses occurred mainly from a lack of understanding of the correlation properties
of financial markets and hedge funds

B. The losses occurred mainly because of the correlation properties of the CDOs
themselves

C. The losses occurred mainly because of a lack of understanding of the correlation

properties of the tranches in the CDOs, not the CDOs themselves

D. The losses occurred because of an economic and financial downfall which eventually
led to the fall of the CDO market

The correct answer is: C)

It is important to point out that the losses resulted from a lack of understanding of the
correlation properties of the tranches in the CDOs. The CDOs themselves can hardly be blamed
or be called toxic for their correlation properties.

Q.1552 Other reasons for the financial crisis included residential mortgages, giving loans at
lower interest rates, and also the collapse of the subprime mortgage market. All these led to
heavy selling and buying of CDOs and Credit Default Swaps (CDSs).

CDSs are used to protect against the default of the underlying asset. What is the purpose of the
insurance contract underlying a Credit Default Swap?

A. To divide/spread the risk to a large audience and, as a result, reduce the individual
risk of any asset

B. To speculate on the market movement in CDOs

C. To reduce the individual risk of any asset by selling a large number of CDSs/

D. To trade a large number of securities at once to hedge against risk

The correct answer is: A)

It is the principle of an insurance contract to spread the risk to a wider audience and, therefore,
reduce the individual risk.

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Q.1553 After the global financial crisis of 2007-2009, the financial regulators decided to
implement some rules and regulations for the stability of the financial markets and the banking
sector. For this purpose, the Basel Accords were introduced to deal with the deficiencies of the
banking system. In essence, the purpose of the Basel Accords was:

A. To offer motivations to the banking sector to improve their risk measurement and
management systems

B. To offer motivations to investors to increase their investments in the banking sector

C. To contribute to a higher level of trading in the banking system

D. To invite risk managers and regulators to take part in the wellbeing of the financial
sector

The correct answer is: A)

The objective of the Basel Accords was to "provide incentives for banks to enhance their risk
measurement and management systems" and "to contribute to a higher level of safety and
soundness in the banking system."

Q.1554 Correlation risk is an important part of market risk which is typically measured with the
help of Value at Risk concepts. Market risk indirectly integrates the correlation risk. Market risk
is also measured using the expected shortfall, characterized as tail risk. Keeping this in mind,
what is the purpose of the expected shortfall?

A. To measure market risk for risky events, typically for the worst 0.1%, 1%, or 5% of
past scenarios.

B. It measures market risk for extreme events, typically for the worst 0.01%, 0.1%, or 1%
of possible future scenarios.

C. It measures market risk for extreme events, typically for the worst 0.1 %, 1%, or 5% of
possible future scenarios.

D. It measures market risk for risky events, typically for the worst 0.01%, 0.1%, or 1% of
past scenarios.

The correct answer is: C)

Market risk is also quantified with expected shortfall (ES), also termed conditional VaR or tail
risk. Expected shortfall measures market risk for extreme events, typically for the worst 0.1%,
1%, or 5% of possible future scenarios. Extreme events are those, despite having a very low
probability of occurrence, cause huge losses when they do occur.

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Q.1555 The higher the default correlation between assets, the higher the probability that the
investors will lose all of their investments if a single asset’s price declines. However, lenders can
lower the default risk by diversifying their portfolio. What is the best policy for lending
companies to avoid risk and default?

A. Intersector default correlations are typically higher than intrasector default

correlations so the lending companies are recommended to create a sector-diversified
loan portfolio to decrease default correlation risk

B. Intersector default correlations are typically lower than intrasector default

correlations so the lending companies are recommended to create a sector-diversified
loan portfolio to decrease default correlation risk

C. Intrasector default correlations are typically higher than intersector default

correlations so the lending companies are recommended to specialize in a single-sector
loan portfolio to avoid default correlation risk

D. Intersector default correlations are typically higher than intrasector default

correlations so the lending companies are recommended to specialize in a single-sector
loan portfolio to decrease default correlation risk

The correct answer is: B)

Since the intrasector default correlations are higher than intersector default correlations, a
lender is advised to have a sector-diversified loan portfolio to reduce default correlation risk.

Q.1556 Systemic risk refers to the risks that affect financial markets as a whole. Which of the
following statements gives the correct relationship between systemic risk and correlation risk?

A. Systemic risk and correlation risk are partially dependent

B. Systemic risk and correlation risk are highly independent

C. Systemic risk and correlation risk are independent of each other

D. Systemic risk and correlation risk are highly dependent

The correct answer is: D)

Systemic risk and correlation risk are highly dependent. Since a systemic decline in stocks
involves almost the entire stock market, correlations between stocks increase sharply as a result
of any systemic decline.

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Q.1557 Concentration risk is a financial loss due to financial exposure. This risk can be
quantified with the help of the concentration ratio. What will be the rule of thumb for the
creditor regarding the concentration ratio?

A. The lower the value of the concentration ratio, the higher the diversification, and the
lower the default risk of the creditor

B. The higher the value of the concentration ratio, the higher the diversification, and the
lower the default risk of the creditor

C. The lower the concentration ratio, the lower the diversification, and the higher the
default risk of the creditor

D. The higher the value of the concentration ratio, the higher the diversification, and the
higher the default risk of the creditor

The correct answer is: A)

The lower the concentration ratio, the more diversified is the default risk of the creditor,
assuming the default correlation between the counterparties is smaller than 1.

Q.1558 Suppose that MLA Commercial Bank has lent Rs.10,000 to a single company, named X.
Therefore, MLA Commercial Bank’s concentration ratio is 1. In addition, suppose company X has
a default probability P(x) of 10%. The expected loss from company X is Rs.10,000 x 0.1 =
Rs.1,000. Now, if MLA Commercial Bank lent the same amount of Rs.10,000 among three
different companies, assuming a default risk of 10% each, what will be the concentration ratio
for the bank?

A. 0.5

B. 1

C. 0.3

D. 0.333

The correct answer is: D)

Concentration risk is the risk of financial loss due to a concentrated exposure to a particular
group of counterparties.
With a single borrower, concentration = 1. With three, the concentration ratio would be reduced
to 1/3

Note:
Similarly, the concentration ratio for a creditor with 100 loans of equal size to different entities is
0.01 (= 1/100).

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Q.1559 Correlations and correlation risks form an important part of risk management because
different values of correlation result in different amounts of risk for any portfolio. Higher
correlations can lead to unexpected losses if not properly managed. Therefore, correlation
trading means:

A. Traders should trade assets or implement trading strategies based on correlations

between assets

B. Traders should not trade assets or implement trading strategies on the basis of market
and economic conditions and how they related to single assets

C. Traders should trade assets or implement trading strategies on the basis of market
and economic conditions and how they related to single assets

D. Traders should trade assets or implement trading strategies based solely on

uncorrelated assets

The correct answer is: A)

Correlation trading means that traders trade assets or execute trading strategies whose value is
at least in part determined by similar movements of two or more assets.

Q.1579 The following are limitations of the Pearson correlation approach, EXCEPT:

A. The Pearson correlation approach is typically not invariant to transformations. After

transformation of data, the information value of the Pearson correlation coefficient is
limited.

B. The Pearson correlation approach only measures linear relationships and most
financial relationships are nonlinear

C. A zero correlation derived by the Pearson approach does not necessarily mean
independence. Therefore, the outcome of the Pearson correlation approach can be
misleading.

D. The variances of the sets, say, X and Y, have to be infinite but finite for distributions
with strong kurtosis

The correct answer is: D)

The variances of the sets X and Y have to be finite. However, for distributions with strong
kurtosis, for example, the Student's t distribution with v ≤ 2, the variance is infinite.

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Q.2634 A portfolio manager is considering adding one of two stocks to his existing portfolio. He
has gathered the following data to make his decision:

Expected Return Annual Standard Deviation Value Correlation with Portfolio

Existing Portfolio 7% 20% $ 500
Stock 1 5% 15% $ 100 0.5
Stock 2 8% 25% $ 100 0.3

The manager will only add a stock to the portfolio if the VAR of the resultant portfolio does not
exceed a daily VAR limit of $15 at a 99% confidence level. Given the information above, what
should the manager do?

A. Add Stock 1

B. Add Stock 2

C. Add either, if only VAR limit is the consideration, as the VAR of the resultant portfolio
will be the same in both cases

D. Add neither, as the VAR exceeds the VAR limit of $15 in both cases

The correct answer is: D)

Compute the variance of the portfolio:

(500 × 0.2)2 + (100 × 0.15)2 + 2(0.5)(500 × 0.2)(100 × 0.15) = 11 , 725

VaR will be:

√11 , 725 × 2.33

= 15.96
√250

Now compute the variance of the portfolio if Stock 2 is added:

(500 × 0.2)2 + (100 × 0.25)2 + 2(0.3)(500 × 0.2)(100 × 0.25) = 12 , 125

VaR will be:

√12 , 125 × 2.33

= 16.33
√250

The daily VAR of both resultant portfolios exceeds the limit of $15, so the manager should invest
in neither stock.
Additional explanation: Please note that the information given relates to a full year, particularly

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with regard to volatility. However, the question requires us to compute the daily VaR. As such, we
must make use of the following relationship:

VaR(T days) = 1-day VaR × √T

Thus,

annual VaR
1-day VaR =
√T

We usually assume that there are 250 trading days in a year.

Q.2639 For a portfolio having long positions in two assets, which value of correlation between
the assets will yield the highest value for VaR?

A. 1

B. 0.5

C. -0.5

D. 0

The correct answer is: A)

For a portfolio of two assets, if the assets are perfectly correlated, the value of VaR will be
maximized.

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Q.2646 The VaR of a portfolio is said to be undiversified when the assets in the portfolio are:

A. Positively correlated

B. Perfectly correlated

C. Negatively correlated

D. Not correlated

The correct answer is: B)

If the assets in a portfolio are perfectly correlated, then portfolio VaR is the sum of the individual
VaRs of the assets in the portfolio. In such a situation, the portfolio VaR is also known as
undiversified VaR.

Q.2648 A portfolio consists of two assets X and Y. If $10 million is invested in the two assets in
the ratio 6:4 and the volatility of the two assets is 5% and 10% respectively, what will be the
value of the portfolio VaR at a 99% confidence level if the assets are (i) perfectly correlated and
(ii) uncorrelated?

A. Perfectly correlated: 1.16 million; Uncorrelated: 1.63 million

B. Perfectly correlated: 1.63 million; Uncorrelated: 1.16 million

C. Perfectly correlated: 1.35 million; Uncorrelated: 1.16 million

D. Perfectly correlated: 1.63 million; Uncorrelated: 1.35 million

The correct answer is: B)

Calculate the individual VaR of the two assets:

VaR X = P × (σz) = 0.6(10) × (0.05)(2.33) = 0.70 million

VaR Y = P × (σz) = 0.4(10) × (0.10)(2.33) = 0.93 million

When the assets are perfectly correlated, the portfolio VaR is simply the sum of the VaRs of the
two assets.

Portfolio VaR when perfectly correlated = 0.7 + 0.93 = 1.63 million

When the assets are uncorrelated, the portfolio VaR = √(VaRx2 + VaRy2)

Portfolio VaR when uncorrelated = √(0.72 + 0.932) = 1.16 million

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Q.2649 A portfolio is composed of two assets – A and B. An analyst has gathered the following
information about the portfolio:

Asset Value Return Standard Deviation

A 3 million 5% 3%
B 7 million 7% 5%

What will be the 1-day VaR for this portfolio at a 99% confidence level if the correlation
coefficient between asset A and asset B is 0.4?

A. 0.92 million

B. 0.85 million

C. 1.02 million

D. 0.36 million

The correct answer is: A)

The covariances for the portfolio will be:

CovarianceAA = ρAAσAσA = 1 * 0.03 * 0.03 = 0.0009

Covariance AB = ρABσAσB = 0.4 * 0.03 * 0.05 = 0.0006

Covariance BA = ρBAσBσA = 0.4 * 0.05 * 0.03 = 0.0006

Covariance BB = ρBBσBσB = 1 * 0.05 * 0.05 = 0.0025

The standard deviation for the portfolio can be calculated by multiplying the covariance matrix
with the amount of investment:

=(3 * 0.0009 + 7 * 0.0006 * 3 * 0.0006 + 7 * 0.0025)

= (0.0069 0.0193)

(βh C) βγ=(3 * 0.0069+ 7 * 0.0193) = 0.1558

i.e.
σP = √(βh C) βγ = √0.1558 = 0.3947
Note: 0.3947 is the portfolio standard deviation in dollar terms,
VaRP = σP∝ √x

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= $0.3947m * 2.33 √1

= 0.92 million
Note: When using the variance-covariance approach to calculate the VaR, the portfolio standard
deviation obtained is in dollar terms, not a percentage. In other words, variance-covariance VaR
uses dollar volatility (unlike parametric VaR which uses percentage volatility).

Q.2650 Calculate the payoff for the buyer of a correlation swap with three assets, a fixed rate of
30%, the notional amount of $2 million, and maturity of 1 year. The pairwise correlations of the
log-returns of the three assets are given in the table below:

Sj =1 Sj =2 Sj =3
Si =1 1 0.9 0.3
Si =2 0.9 1 0
Si =3 0.3 0 1

A. $300,000

B. -$200,000

C. $200,000

D. -$300,000

The correct answer is: C)

Calculate ρ realized.

2
ρre alized = ∑ ρi,j
n2 − n
2
= 2 (0.9 + 0 + 0.3)
3 −3
= 0.4

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Q.2651 A bank has issued loans to two companies– A and B. The probabilities of default of A and
B are 5% and 10%, respectively.What is the joint probability of default for the two companies if
their default correlation is 0.6?

A. 3.92%

B. 5.78%

C. 4.42%

D. 7.04%

The correct answer is: C)

PD = ρ (AB)√PD(A)(1−PD(A)) × PD(B)(1−PD(B)) + PD(A) PD(B)

Joint probability of default = 0.6 √0.05 (1−0.05) × 0.10 (1−0.10) + 0.05 × 0.10

Joint probability of default = 0.6√0.004275 + 0.0050

Joint probability of default = 4.42%

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Q.2652 A bank has given companies A and B loans of $2 million each. Company A has a
probability of default of 5% while that of B is 15%. Calculate the expected loss of the bank under
a worst-case scenario if the default correlation is 0.5 and loss given default is 90%.

A. $167,040

B. $209,576

C. $172,312

D. $307,153

The correct answer is: A)

PD = ρ (AB) √PD(A) (1−PD(A)) × PD(B)(1−PD(B)) + PD(A) PD(B)

Joint probability of default = 0.5√0.05 (1−0.05) × 0.15 (1−0.15) + 0.05 × 0.15

Joint probability of default = 0.5√0.006056 + 0.0075

Joint probability of default = 4.64%

Expected loss = PD x LGD x EAD

Expected loss = 4.64% x 90% x 4,000,000

Expected loss = $ 167,040

Q.2653 What will be the most likely effect of a decreasing concentration ratio on the joint
probability of default?

A. It will increase

B. It is not possible to determine

C. It will decrease

D. The concentration ratio does not affect the joint probability of default

The correct answer is: C)

The concentration ratio will decrease (increase) as a bank issues more (less) loans. Unless the
default correlation between the loans is equal to 1, the decrease in concentration ratio will result
in a lower joint probability of default.

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Q.2834 Calculate the payoff of a correlation swap if the number of assets is 3 and the realized
pairwise correlations of the log returns at maturity level are given as 0.24, 0.26, 0.36. You are
also given that the notional amount is $12 million at a 18% fixed rate with 1 year to maturity.

A. $0.29 million

B. $1.28 million

C. $0.24 million

D. $5.04 million

The correct answer is: B)

The realized correlation is calculated as:

2
ρrealized = ( ) ∑ ρi,j
n 2 − n i>j

Therefore,

2
ρreal ized = ( ) (0.24 + 0.26 + 0.36) = 0.28667
2
3 −3

Then:

N (ρreal ized − ρfi xed ) = 0.28667 − 0.18 = 0.10667

The payoff of the correlation fixed rate payer at maturity is

$12million × 0.10667 = $1.28million .

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 Reading 68: Empirical Properties of Correlation: How Do Correlations
Behave in the Real World?

Q.1560 Which of the following statements is/are INCORRECT about equity correlation?

I. Equity correlations fluctuate during expansionary and recessionary periods but in normal
economic periods, equity correlations do not fluctuate.
II. Economic stages only consider equity correlation volatility, not equity correlation levels.
III. Traders don’t need to consider higher equity correlation levels and higher equity correlation
volatility when making decisions.

A. I and II

B. I and III

C. II and III

D. I, II and III

The correct answer is: D)

All of the above statements about correlation are incorrect. Both equity correlation levels and
equity correlation volatility fluctuate in all the economic stages whether they are expansionary,
recessionary or normal. Moreover, traders and risk managers should take into consideration
higher correlation levels and higher correlation volatility that markets exhibit during times of
economic distress.

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Q.1561 The equity correlation data of a particular country during different economic stages
showed that, in an expansionary economic stage, the correlation volatility was 74.54%. In normal
economic periods, the correlation volatility was 87.66%. In a recessionary economic stage, the
correlation volatility was 89.12%. Based on this information, we can conclude that:

A. Correlation volatility is lower in recessions and normal economic periods but higher in
expansionary periods

B. Correlation volatility is higher in recessionary and normal economic periods but lower
in expansionary periods

C. Correlation volatility is higher in a recession but lower in normal and expansionary

periods

D. Correlation volatility is lower in a recession but higher in normal and expansionary

periods

The correct answer is: B)

Equity correlation volatility is at it's lowest in an expansionary period and higher in normal and
recessionary economic periods.

Q.1562 An investor is willing to make an investment of $100 in a fixed-coupon bond. At maturity,

this bond will revert to exactly the par value of $100. This type of bond gives an example of:

A. Autocorrelation

B. Mean reversion

C. Correlation volatility

D. Correlation levels

The correct answer is: B)

Fixed-coupon bonds, when they do not default, exhibit strong mean reversion: A bond is typically
issued at par, for example at $100. If the bond does not default, at maturity it will revert to
exactly that price of $100, which is typically close to its long-term mean.

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Q.1563 An investor is concerned about the figures of the mean reversion and autocorrelation of a
particular set of data. After analyzing the data, it is found that the mean reversion is 72.96%.
Which of the following is closest to the autocorrelation for the data?

A. 0.8171

B. 0.8935

C. 0.8296

D. 0.2704

The correct answer is: D)

Autocorrelation is the opposite property of mean reversion: the stronger the mean reversion, the
lower the autocorrelation.
The sum of the mean reversion rate and the one-period autocorrelation rate will always equal
one (= 72.96% + 27.04%)

Q.1564 Which of the following statements is/are NOT true about the properties of Bonds
Correlation:

I. Bonds correlation properties are similar to equity correlation properties but, in a recessionary
economic stage, the correlation levels and correlation volatility of bonds are generally lower.
II. Bonds correlation properties are similar to equity correlation properties, but mean reversion
is not present in bonds correlation.

A. I only

B. II only

C. All of the above

D. None of the above

The correct answer is: C)

Both statements I and II are not true about bonds correlation because, in bad economic times,
bonds correlation levels and correlation volatility are higher and bonds correlation exhibits mean
reversion.

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Q.1565 The economy of a country is experiencing a positive growth rate but, in the past, the
economy of the country faced recessionary stages several times. An investor is willing to make
an investment but he is not sure that the economy will remain in the expansionary stage in the
near future. How can future recessions be predicted in the country?

A. By using equity correlation, mean reversion and autocorrelation

B. By using future inflation rates

C. By the occurrence of a downturn in equity correlation volatility

D. By analyzing growth rates

The correct answer is: C)

Before every recession, a downturn in correlation volatility occurs. Therefore, it is likley that
equity correlation volatility is an indicator of a future recession.

Q.1566 Bonds and their default probabilities also have correlation distributions just like equity.
Which of the following best describes the default probability correlation distribution and
correlation distribution for bonds?

A. Both the default probability correlation distribution and the correlation distribution
can be best modeled using the Johnson SB distribution.

B. The default probability correlation distribution shows a normal shape and can be best
modeled using the generalized extreme value distribution, whereas the correlation
distribution can be best modeled using the Johnson SB distribution.

C. The default probability correlation distribution can be best modeled using the Johnson
SB distribution, whereas the correlation distribution can be best modeled using the
generalized extreme value distribution.

D. Both the default probability correlation distribution and the correlation distribution
can be best modeled using the generalized extreme value distribution.

The correct answer is: C)

The default probability correlation distribution is similar to the equity correlation distribution
and can be replicated best using the Johnson SB distribution. However, the bond correlation
distribution shows a more normal shape and can be best modeled using the generalized extreme
value distribution. It is to note that the bond correlation distribution can also quite well be
replicated using the normal distribution.

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Q.1567 According to the correlation volatility study of a particular country, it was found that the
correlation volatility for bonds was 68.38% and the correlation level was 44.12%. For default
probabilities correlation, volatility was 85.22% and the correlation level was 30.34%. If the
equity correlation volatility was 74.31%, then which of the following statements is correct about
correlation volatility?

A. Correlation volatility for bonds is higher and slightly lower for default probabilities as
compared to equity correlation volatility

B. Bonds, equity and default probabilities have the same correlation volatility

C. Correlation volatility for bonds is lower and slightly higher for default probabilities as
compared to equity correlation volatility

D. Both bonds and default probabilities have lower correlation volatility as compared to
equity correlation volatility

The correct answer is: C)

Correlation volatility for bonds is lower (68.38%) and slightly higher for default probabilities
(85.22%) as compared to equity correlation volatility (74.31%).

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Q.2654 Given the following data about a variable S:

St-1 = 40

St = 60

Mean reversion rate = 0.5

Calculate the long-run mean value for the variable.

A. 80

B. 60

C. 100

D. 75

The correct answer is: A)

St – St-1= a (µ - St-1)

60 – 40= 0.5 (µ -40)

20 = 0.5µ - 20

µ = 80

Q.2655 Which of these distributions best fits an equity correlation distribution?

A. Chi squared

B. Generalized extreme value

C. Pareto

D. Johnson SB

The correct answer is: D)

The Johnson SB is the best-fit distribution for equity correlation distributions.

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Q.2835 A correlation data has a long term mean of 52.6%. The averaged correlation was again
observed as 31.26% in April 2011 for the 30 x 30 Dow correlation matrices. Given that the
average mean reversion was 82.1% from the regression function for 40 years, what is the
expected correlation one month later?

A. 23.56%

B. 32.21%

C. 48.78%

D. 38.23%

The correct answer is: C)

Using equation: St − St−1 = aµs − aSt−1

Then: St = a(µs − st−1) + St−1

Where a = 82.1%, µs = 52.6%, St−1 = 31.26%

Therefore, St = 0.821(0.526 – 0.3126) + 0.3126 = 0.4878 = 48.78%

The mean reversion rate of 82.1% increases correlation of 31.26% in April 2011 to an expected
correlation of 48.78% in May 2011.

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Q.2836 Using the Vasicek 1977 process, quantify the degree of mean reversion assuming that the
price of a stock at a previous point in time is $12 and the long-term mean is $16 with a mean
reversion rate of $3 given that the change in time Δt is 2.

A. $24

B. $36

C. $27

D. $26.56

The correct answer is: A)

From the Vasicek process, we have that:

St − St−1 = a(µs − St−1)Δt + σs ε√Δt

Where a = 3, St−1=12, µs = 16.

Since we are only interested in the mean reversion, we ignore the σs ε√Δt, part of the equation.

Therefore:

St − St−1 = a(µs − St−1)Δt

⇒ St − St−1 = 3(16 − 12) × 2 = 24

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Q.2837 The Dow correlation matrices for a given data set today have an average correlation of
0.1645 with a long-term mean of 0.1972. Compute the expected correlation for exactly one year
from today if the average mean reversion is 0.7512.

A. 20.00%

B. 52.12%

C. 51.22%

D. 18.91%

The correct answer is: D)

Using equation: St − St−1= aµs − aSt−1

Then: St = a(µs − st−1) + St−1

Where a = 0.7512, µs = 0.1972, St−1 = 0.1645

Therefore, St = 0.7512(0.1972 − 0.1645) + 0.1645 = 0.1891

= 18.91%

Q.2838 Which of the following is the most appropriate definition of autocorrelation?

A. The tendency of a variable to be pulled back to its original mean

B. The degree to which a variable is correlated to its past values

C. The apparent relationship between the variables

D. The relationship between two variables keeping all other variables constant

The correct answer is: B)

A variable is usually correlated to its past values up to a certain degree. This degree of
correlation is called autocorrelation.

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 Reading 69: Financial Correlation Modeling—Bottom-Up Approaches

Q.1588 Copula functions, when described clearly, split down into multiple univariate
distributions. For instance:

C[G1(U1), ……. , Gn(Un)] = Fn[F1-1(G1(U1)), …., Fn-1(Gn(Un)); PF

In this illustration, Fi-1 describes:

A. the correlation structure of Fn

B. the inverse of Fi

C. the joint cumulative distribution function

D. the marginal distribution.

The correct answer is: B)

In general, suppose Gi (ui ) ∈ [0 , 1] is a univariate, uniform distribution with u i = u1 , … u n and i ∈ N

(i is an element of set N). Then, we define a copula function as follows:

C[G1 (u 1 ), … , Gn (un )] = Fn [F−1

1
(G1(u 1 )),… , F−1
n (Gn (u n )); ρF ]

where:

Gi (ui ) are the marginal distributions that have no well-known properties

Fn is the joint cumulative distribution function

F−1
i
is the inverse of Fi

ρF is the correlation structure of Fn

Put in words, the above equation reads:

Given the marginal distributions G1 (u1 ) to Gn (u n ), there exists a copula function that allows the

mapping of the marginal distributions G1 (u1 ) to Gn (u n ) via F−1 and the joining of the (abscise

values) F−1
i
(Gi (ui )) to a single, n-variate function Fn [F−1
1
(G1 (u 1 )), … , F−1
n (Gn (u n ))] that has a

correlation structure of ρF .

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Q.1589 Because of appropriate and well-suited properties of the Gaussian copula, it is among the
most widely used copulas in finance.

When applying the n-variate case, which of the following statements is correct if Gx(Ux) is
uniform?

A. The N-1 (Gx(Ux)) are univariate normal, and Mn is standard multivariate normal

B. The N-1 (Gx(Ux)) are multivariate normal, and Mn is univariate normal

C. The N-1 (Gx(Ux)) are standard normal, and Mn is standard multivariate normal

D. The N-1 (Gx(Ux)) are standard normal and Mn is standard normal

The correct answer is: C)

If the Gx(Ux)) is uniform, then the N-1 (Gx(Ux)) is standard normal and Mn is standard
multivariate normal. For proof, see Copula Method in Finance by Cherubini et. al., 2004.

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Q.1590 The following equation gives the Gaussian default time copula:

CGD[Qi (t), ... , Qn(t)] = Mn[N-1(Q1(t)), ... , N-1(Qn(t)); pm]

It reveals that the term N-1 maps the cumulative default probabilities Q of asset i for time t, Qi (t)
to the univariate standard normal distribution, percentile to percentile. Keeping this in mind,
which of the following statements is correct?

A. The 5th percentile of Qi (t) is plotted to the 5th percentile of the standard normal
distribution

B. The 4th percentile of Qi (t) is plotted to the 5th percentile of the standard normal
distribution

C. The 5th percentile of Qi (t) is plotted to the 3rd percentile of the standard normal
distribution

D. The 5th percentile of Qi (t) is plotted to the 10th percentile of the standard normal
distribution

The correct answer is: A)

The term N-1 maps the cumulative default probabilities Q of asset i for time t, Qi(t), to the

univariate standard normal distribution. So the 5th percentile of Qi(t) is mapped to the 5th

percentile of the standard normal distribution, the 10th percentile of Qi(t) is mapped to the 10th
percentile of the standard normal distribution, and so forth.

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Q.1591 Let’s assume we have only two assets - A and B. Suppose we feed our data to the
Gaussian default time copula function. How many correlation coefficients would we find?

A. One correlation coefficient

B. One correlation matrix Pm

C. Multivariate correlation coefficients

D. Two correlation matrices

The correct answer is: A)

Strictly speaking, only the bivariate Gaussian copula is a one-parameter copula, the parameter
being the copula correlation coefficient. A multivariate Gaussian copula may incorporate a
correlation matrix, containing various correlation coefficients.

Q.1592 Suppose we wish to analyze two companies, A and B, using the Gaussian default time
copula. After plotting the cumulative probabilities percentile to percentile to a standard normal
distribution, which of the equations below would we end up with?

A. Mi[N-1 (QA)(t), N-1(Qi(t)); ρ]

B. M2[N-1 (QA)(t), N-1(QB(t)); ρ]

C. M5[N-1 (Q1)(t), N-1(QB(t)); ρ]

D. M2[N-1 (Q1)(t), N-1(Qi(t)); ρ]

The correct answer is: B)

We have only n = 2 companies A and B in our example. Therefore, the Gaussian default time
copula equation reduces to the form in choice B above. In addition, note that we would have only
one correlation coefficient (ρ), not a correlation matrix.

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Q.1593 To find the default time of an asset which is correlated to the default times of other
assets using the Gaussian default time copula, we would first need to:

A. Derive the sample of normal standard distributions

B. Derive the sample of the correlation matrix

C. Derive the sample of Mn(.) from the multivariate copula

D. Derive any of the components listed above

The correct answer is: C)

To derive the default time t of asset i, Ti, which is correlated to the default times of all other
assets i = 1...n, we would first derive a sample Mn(.) from a multivariate copula, in the Gaussian
case, Mn(.) ∈ [0, 1].

Q.1594 When deriving the default time copula of an asset which is correlated to the default times
of other assets using the Gaussian default time copula, what is taken as the input from the n-
variate standard normal distribution Mn?

A. The N-variate matrix

B. The average matrix

C. The default time of assets

D. The correlation matrix

The correct answer is: D)

When estimating the default time of asset i, Ti, we include the default correlation with the other
assets in the portfolio. The default correlation matrix is an input of the n-variate standard normal
distribution Mn.

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Q.1595 When flexible copula functions were introduced in the field of finance, they became very
popular immediately. But after some time they drastically lost their importance due to which of
the following unfavorable events/causes?

A. They found out not be helpful in solving complex problems

B. They are tough to apply to all statistical problems

C. They fell into disgrace when the global financial crisis hit in 2007

D. They found out not be helpful in the banking sector

The correct answer is: C)

When flexible copula functions were introduced to finance in 2000, they were enthusiastically
embraced. Investors believed that they could rely on the copulas to establish correlations among
multiple assets. However, copulas fell into disgrace when the global financial crisis hit in 2007, in
which correlations played a major part in the now infamous (disastrous) outcome.

Q.1596 Copula functions are introduced to simplify statistical problems. They enable the joining
of multiple univariate distributions to a single univariate distribution. Which statement truly
supports the above expression of facts?

A. They transform an n-dimensional function into a unit-dimensional function

B. They transform a one-dimensional function into an n-dimensional function

C. They transform a one-dimensional function into a matrix

D. They transform a matrix into an n-dimensional function

The correct answer is: A)

A copula function transforms an n-dimensional function on the interval [0, 1] into a unit-
dimensional one:

C: [0,1]n → [0,1]

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Q.1597 To derive the default time of a large number of assets during a simulation, the correlated
default time of multiple assets, the sample of Mn(.), is found through which of the following?

A. The copula decomposition

B. The normal decomposition

C. The cumulative decomposition

D. The Cholesky decomposition

The correct answer is: D)

To derive the default time T of asset i, Ti , which is correlated to the default times of all other
assets i = 1, ... , n, we first derive a sample Mn(.) from a multivariate copula via the Cholesky
decomposition.

Q.2656 A Gaussian copula maps the marginal distribution of each variable to which of the
following distributions?

A. Lognormal distribution

B. Poisson distribution

C. Standard normal distribution

D. Binomial distribution

The correct answer is: C)

A Gaussian copula maps the marginal distribution of each variable to the standard normal
distribution.

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 Reading 70: Empirical Approaches to Risk Metrics and Hedging

Q.1598 In any financial investment, you will find embedded financial risks. There are different
methods to minimize such risks which are possible if you are able to locate and assess them.
Some of them include the use of hedging and risk metrics. Which of the following statements
stands TRUE regarding the aforementioned methods?

I. Risk metrics and hedging are mechanisms to provide a quantitative measure of the hidden
financial risks associated with a financial investment.
II. Risk metrics and hedging are mechanisms to provide a quantitative measure of only the
idiosyncratic financial risks associated with a financial investment.
III. Hedging and risk metrics reflect the interdependency of the rates and terms associated with
a financial investment.

A. Both I and II

B. Both II and III

C. Both I and III

D. None of the above

The correct answer is: C)

Hedging and risk metrics try to rein in all risks, particularly systematic ones that cannot be
eliminated via diversification. Multifactor metrics and hedges are implicit assumptions about
how the rates of different term structures change relative to one another.

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Q.1599 Inflation has an impact on the rate of returns associated with different financial
instruments provided and traded in the market. Which of the following statements is FALSE
regarding TIPS (Treasury Inflation Protected Securities)?

I. TIPS provide a relatively low rate of return to investors.

II. TIPS compensates for inflation by providing an inflation risk premium.
III. TIPS are traded at relatively high yields or low prices because their cash-flows aren’t
inflation-protected.

A. Both I and II

B. Both II and III

C. Both I and III

D. None of the above

The correct answer is: B)

TIPS make real or inflation-adjusted payments by regularly indexing their principal amount
outstanding for inflation. Real earnings are earnings that have taken into account the ‘eroded’
purchasing power of money via inflation.

Q.1600 The nominal rate, a significant term in Finance, is often seen as the stated/advertised
interest rate on a loan, excluding charges, fees and/or interest compounding. What is the
CORRECT definition of the nominal rate?

A. The nominal rate is the real rate plus the inflation rate

B. The nominal rate is the real rate minus the inflation rate

C. The nominal rate is the real rate plus the interest rate

D. The nominal rate is the real rate minus the interest rate

The correct answer is: A)

The nominal rate is applied to those securities which are inflation-protected. To offset the loss in
the purchasing power of money, an inflation risk premium is incorporated into the nominal rate.

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Q.1601 A 20-year semiannual coupon bond has a DV01 of 0.18125. An investor wishes to hedge
his position in this bond with another 10-year semiannual coupon bond whose DV01 is equal to
0.11369. Calculate the hedge ratio:

A. 1.85

B. 1.59

C. 1.2

D. 1.5

The correct answer is: B)

A hedge ratio determines the amount of par of the hedge position that needs to be bought or sold
for every $1 par value of the original position. The goal of hedging is to lock in the value of a
position even in the face of small changes in yield. The hedge ratio is given by:

DV01 of initial position

HR =
DV01 of hedging tool

0.18125
HR = = 1.59
0.11369

Interpretation: For every $100 par value of the 20-year bond, short $159 of par of the 10-year
bond.

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Q.1602 Which of the following statements stands TRUE about the following equation of the
Least-Squares Regression Analysis?

ΔtN = α + β ΔytR + εt

I. Changes in the real-bond-yield are represented by ΔtN and changes in the nominal-yield are

represented by ΔytR.
II. Changes in the nominal-yield are the independent variable creating changes in the real-bond-
yield, which is the dependent variable.
III. The slope and intercept for the formula are to be assumed as the investor’s best guess.
IV. The error term shows the real-bond-yield’s change from the model’s predicted change on any
specified day.

A. Both I and II

B. Both II and III

C. All of the above

D. None of the above

The correct answer is: D)

ΔtN and ΔytR represent the changes in the yields of the nominal and real bonds respectively, and
changes in the real yield and the independent variable are used to predict changes in the
nominal yield and the dependent variable. The intercept and the slope need to be estimated from
the data whereas the error term is the deviation of the nominal yield change on a particular day
from the change predicted by the model.

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Q.1603 The following table represents the regression analysis of changes in the yield of the
Treasury Bond on changes in the yield of the TIPS (Treasury Inflation-Protected Securities) by
means of the following equation:

ΔtN = α + β ΔytR + εt

No. of Observations 229

R-Squared 56.3%

Standard Error 3.82

Regression Coefficients Value Std. Error

Constant 0.0503 0.2529

Change in Real Yield 1.0189 0.0595

Which of the following statement gives an INCORRECT interpretation of the table above?

A. The change in real yield of 1.0189 means that if the real yield increases by 1.0189
basis points, the nominal yield decreases by 1.0189 bps over the sample period

B. The regression constant term is more or less equal to zero, meaning that the yield
doesn’t trend upwards or downwards when the comparable yield isn’t changing

C. α and β as are normally distributed under the assumption of least squares and
sufficiency of data

D. The table shows R-squared (56.3%) representing the variance of nominal yield’s
changes that can be studied

The correct answer is: A)

The change in real yield reported in the table is 1.0189, which says that, over the sample period,
the nominal yield increases by 1.0189 basis points.

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Q.1604 Hedging is an investment strategy used to minimize the risk of adverse asset price
movements. The hedge is normally carried out by taking an offsetting position in a related
financial instrument. When hedging two securities, one with the real rate of return and the other
with the nominal rate of return, it should be understood that:

A. The risk of the two securities can be measured accurately by DV01 alone

B. The risk of the two securities cannot be measured accurately by DV01 alone

C. The risk of the two securities can be measured accurately by PV01 alone

D. None of the above

The correct answer is: B)

The risk of the two securities cannot be measured accurately by DV01 alone, in part because the
regression-based and DV01 hedges are certainly not always close in magnitude, even in other
cases of hedging TIPS versus nominal.

Q.1605 A regression framework is a statistical mechanism in the scope of finance, used widely to
determine the strengths/weaknesses of a relationship between two variables (one dependent and
the other independent). When used for hedging purposes, it provides many advantages.
However, the downside is that:

A. It is able to give an estimation of the hedged portfolio’s volatility

B. A comparison can be made by the trader of the volatility with expected gain for his
verdict on the attractiveness of the risk-return structure

C. The average change in the nominal yield for a given change in the real yield can be
estimated by the trader and he can then make adjustments to the DV01 hedge
accordingly

D. No complete control can be made on the dispersion of the change in the nominal yield
in relation to the change in the real yield

The correct answer is: D)

With respect to improving the DV01 hedge, all the work is done based on an estimation rather
than on actual figures and there is not much the trader can do about the dispersion of the
change in the nominal yield for a given change in the real yield.

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Q.1606 The hedge coefficient makes regression-based hedging difficult because, with the
passage of time, the regression coefficient estimated at one point in time tends to change. It can
be handled by:

I. Estimating the coefficient over different time spans

II. Using available recent data since the more up-to-date the data is, the better will be the result.
III. Assuming the coefficient is always equal to 1.

A. Both I and II

B. Both I and III

C. All of the above

D. None of the above

The correct answer is: A)

Although chances are that the results achieved may vary greatly without assuming any one value
for the coefficient, blindly assuming a β of one (as in DV01 hedging) is generally not a superior
approach.

Q.1607 Eric Rich, a trader, is making a relative value trade by selling a U.S. Treasury bond and
correspondingly purchasing U.S. Treasury TIPS. Guided by the current spread between the two
securities, Eric decides to short $100 million of the nominal bond and simultaneously purchases
76.2 million of TIPS. Soon afterward, Eric's position is disrupted by a change in the yield on TIPS
in relation to nominal bonds. After running a regression, he determines that the nominal yield
has changed by 1.03540 basis points per basis point in the real yield. By how much should Eric
adjust the hedge?

A. $2 million

B. $2.7 million

C. $79 million

D. $1.0354 million

The correct answer is: B)

The trader would need to adjust the hedge as follows: $76.2 million x 1.0354 = $78.9 million
Thus, the trader needs to purchase additional TIPS worth $2.7 million.

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Q.1608 The Principal Component Analysis is a practical framework utilized in the scope of Risk
Analysis and Management in Finance, enabling traders to better estimate risk and return on
their securities. It’s particularly useful because:

A. The sum of the variances of the first two PCs is usually quite close to the sum of
variances of all the rates

B. The sum of the variances of the first three PCs is usually quite close to the sum of
variances of all the rates

C. The sum of the variances of the last three PCs is usually quite close to the sum of
variances of all the rates

D. None of the above

The correct answer is: B)

PC Analysis provides the empirical structure on which basis one can simply describe the
structure and volatility of each of only three PCs.

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Q.1609 Which of the following statements is FALSE regarding the Principal Component (PC)
Analysis:

I. The PC Analysis provides a mechanism of empirical regularity for regression analysis.

II. The sum of the PCs’ variances equals the sum of the individual rates’ variances capturing the
volatility of the set’s interest rates.
III. The sum of the variances of the first two PCs is usually quite close to the sum of variances of
all the rates.

A. I only

B. I and II

C. III only

D. None of the above

The correct answer is: C)

Statement III is false. PCs of rates provide empirical regularity: the sum of the variances of the
first three PCs is usually quite close to the sum of variances of all the rates. Hence, rather than
describing movements in the term structure by describing the variance of each rate and all pairs
of correlation, one can simply describe the structure and volatility of each of only three PCs.

Statements I and II are correct. The PC Analysis provides a mechanism of empirical regularity
for regression analysis. The sum of the PCs’ variances equals the sum of the individual rates’
variances capturing the volatility of the set’s interest rates.

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Q.1610 Principal Component (PC) Analysis is unique in scope and helps investors to achieve
maximum gain from trading of securities. Which of the following is correct with regard to PCs?

A. The PCs are uncorrelated with each other while individual interest rates are highly
correlated

B. The PCs are correlated with each other while individual interest rates are highly
uncorrelated

C. The PCs are poorly correlated with each other while individual interest rates are
highly correlated

D. The PCs are poorly uncorrelated with each other while individual interest rates are
highly uncorrelated

The correct answer is: A)

While changes in individual rates are, of course, highly correlated with each other, the PCs are
constructed so that they are uncorrelated.

Q.1611 Which of the following statements is true regarding principal components (PCs)?

A. Each PC is chosen to have the maximum possible variance given all earlier PCs

B. Each PC is chosen to have the maximum possible variance given all later PCs

C. Each PC is chosen to have the minimum possible variance given all earlier PCs

D. Each PC is chosen to have the minimum possible variance given all later PCs

The correct answer is: A)

The first PC explains the largest fraction of the sum of the variances of the rates, the second PC
explains the next largest fraction, etc.

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Q.1612 The financial markets comprise of different financial rates and the common classification
is in terms of time-frame, namely short-term and long-term financial rates. Which of the
following statements is TRUE regarding short-term and long-term rates associated with the
financial markets?

A. Long-term rates are more volatile than short-term rates

B. Short-term rates are more volatile than long-term rates

C. Both long-term and short-term rates are equally volatile

D. None of the above

The correct answer is: B)

Changes in short-term rates are determined by current economic conditions, which are relatively
volatile, while longer-term rates are determined mostly by expectations of future economic
conditions, which are relatively less volatile.

Q.1614 What makes the Principal Component Analysis (PCA) highly practical and doable in the
scope of hedging and risk metrics?

A. The PCA is very useful in the construction of empirically-based hedges for large
portfolios

B. The PCA is very useful in the construction of empirically-based hedges for small
portfolios

C. The PCA is very useful in the construction of theoretically-based hedges for large
portfolios

D. The PCA is very useful in the construction of theoretically based-hedges for small
portfolios

The correct answer is: A)

It is impractical to perform and assess individual regressions for every security in a large
portfolio. In modern times, investors have large portfolios and through The PCA, they can
manage/hedge risks quite seamlessly.

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Q.1615 The butterfly trade is defined as a neutral strategy as it is a limited risk and limited profit
option. To hedge against market risks, butterfly traders can:

A. Short the wings and buy the security of intermediate maturity

B. Buy the wings and short the security of intermediate maturity

C. Implement either A or B as outlined above

D. None of the given practices can be implemented

The correct answer is: C)

Both practices outlined in choices A and B above provide a neutralized strategy in terms of
financial gain and this is the crux of a butterfly trade.

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Q.2846 Alvin Johnson is a trader and plans to short $230 million of the (nominal) 46⁄7s of 17th

February 2020 and purchase some amount of the TIPS 25⁄7 s of 17th January 2020 against that.

The yields and DVO1s of a TIPS and a nominal US Treasury as of 30th April 2015 are provided as
follows:

Bond Yield% DVO1

Tips 25⁄7 s of 17th January 2020 1.096 0.092

46⁄7 s of 17th February 2020 3.461 0.056

Compute the TIPS face amount that should be purchased for the trade to be hedged against the
interest rate levels.

A. $200 million

B. $275 million

C. $160 million

D. $140 million

The correct answer is: D)

This can be achieved by making the trade DVO1-neutral.

Johnson has to buy the FR face amount of the TIPS such that:

FR × 0.092/100 = $230 million × (0.056/100)

⇒ FR = $230 million × (0.056/0.092)

= $140 million

Q.2847 A trader believes that the 5-year swap rate is far too high relative to the 2- and the 10-
year swap rates. She decides to receive in the 5-year and pay in the 10-year. The tables below
give the par swap rates and the DVO1s of the swaps of the relevant terms. Compute the 5-year
hedging ratio of the DVO1, by the 2- and the 10-year swap.

Par swap rates and DVO1s:

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 Term Rate% DVO1

2 1.064 0.0286

5 2.535 0.0547

10 3.187 0.0931

Principal components of the USD swap curve:

Term Level Slope Short Rate PC Vol

2 5.27 -3.18 0.68 6.48

5 6.76 -1.64 -0.48 7.13

10 6.46 0.17 -0.45 6.27

Compute the 5-year hedging ratio of the DVO1, by the 2- and the 10-year swap.

A. 55.3% and 66.5%

B. 54.3% and 65.7%

C. 54.8% and 60.0%

D. 52.8% and 66.5%

The correct answer is: C)

The equation that neutralizes the overall portfolio exposure to the level PC is:

0.0286 0.0931 0.0547

-F 2 × 5.27 − F10 × 6.46 − 100 × × 6.76 = 0 .......equation 1
100 100 100

Similarly, the equation that neutralizes the overall exposure to the slope PC is:

0.0286 0.0931 0.0547

-F 2 × (−3.18) − F10 × (0.17) − 100 × × (−1.64) = 0 ......equation 2
100 100 100

Solving for F2 and F10 simultaneously, we get -104.767 and -35.227 consecutively (These values
are calculated below)

In terms of the risk weights:

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(104.767 × (0.0286/100))/0.0547= 54.8%

And (35.227 × (0.0931/100))/0.0547= 60.0%

----------------------------------------
Solving simultaneous equations:
The two equations resulring from equations 1 and 2, respectively, are:
-0.150722F2 - 0.601426F10 = 36.9772 ....................equation 2
and
0.090948F2 - 0.015827F10 = -8.9708 ....................equation 3

From equation 3,

0.090948F2 = -8.9708 + 0.015827F10

Thus, F2 = -98.636584 + 0.174023F10

Substituting this in equation 2,

-0.150722[-98.636584 + 0.174023F10] - 0.601426F10 = 36.9772

14.866708 - 0.026229F10 - 0.601426F10= 36.9772

F10 = -35.227

Finally, F2 = -98.636584 + 0.174023F10 = -98.636584 + 0.174023(-35.227) = -104.767

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Q.2848 A trader plans to short $175 million of the 32⁄7s of 20th February 2019 and purchase

some amount of the TIPS 23⁄7 s of 20th January 2019 against that. Assume that the nominal yield
in the data changes by 1.036 basis points per basis-point change in the real yield. The yields and
DVO1s of a TIPS and a nominal US Treasury as of 30th April 2015 are provided as follows:

Bond DVO1

23⁄7 s of 20th January 2019 0.087

32⁄7s of 20th February 2019 0.066

Compute the TIPS face amount that should be purchased for the trade to be hedged against the
interest rate levels.

A. $137.5 million

B. $126.2 million

C. $160.4 million

D. $140.0 million

The correct answer is: A)

This can be achieved by making the trade DVO1-neutral.

The trader has to buy the FR face amount of the TIPS such that:

FR × (0.087/100) = $175 million × (0.066/100) × 1.036

FR = $175mm × (0.066/0.087) × 1.036

= $137.5 million

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Q.2849 What is the role of regression analysis in bonds?

A. It is used to explain the value at risk of amounts invested in bonds

B. It explains the changes in the yield of one bond relative to the changes in yields of a
small number of other bonds

C. It is used for empirical description of the term structure of bonds

D. All the above

The correct answer is: B)

Regression analysis in bonds tries to explain the changes in the yield of one bond relative to
changes in the yields of a small number of other bonds.

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 Reading 71: The Science of Term Structure Models

Q.1616 The market rate of a bond is considered to be equivalent to the price of that bond having
the same maturity. Securities with assumed prices are called underlying securities to distinguish
them from the:

A. Proprietarily rights priced by arbitrage arguments

B. Contingent claims priced by arbitrage arguments

C. Contingent rights priced by arbitrage arguments

D. Proprietarily claims priced by arbitrage arguments

The correct answer is: B)

Securities with assumed prices are called underlying securities to distinguish them from the
contingent claims priced by arbitrage arguments.

Q.1617 Refer to the following binomial tree:

p = 12 ; 5.50%

5%
↗
↘
p = 12 ; 4.50%

The six-month rate is 5% today, which will be called date 0. On the next date six months from
now, which will be called date 1, there are two possible outcomes.

The 5.50% state is called the:

A. Higher state

B. Upper extreme state

C. Up-state

D. Maximum state

The correct answer is: C)

In the figure above, the 5.50% state will be called the up-state while the 4.50% state will be
called the down-state.

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Q.1618 Refer to the following binomial tree:

p = 12 ; 5.50%

5%
↗
↘
p = 12 ; 4.50%

The six-month rate is 5% today, which will be called date 0. On the next date six months from
now, which will be called date 1, there are two possible outcomes.
Given the current term structure of spot rates, trees for the prices of six-month and one-year
zero-coupon bonds can be computed. The price tree for $666 face value of the six-month zero
will approximately be:

A. 635

B. 650

C. 675

D. 680

The correct answer is: B)

$ 666
= $649.75
0.05
(1 + 2

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Q.1619 Refer to the following binomial tree:

p = 12 ; 5.50%

5%
↗
↘
p = 12 ; 4.50%

The six-month rate is 5% today, which will be called date 0. On the next date six months from
now, which will be called date 1, there are two possible outcomes, where the risk-neutral
probability of an increase or decrease in the 6-month spot rate is 10%.
Considering the above data, suppose you wanted to find the price of a call option, maturing in 6
months, of a $1,000 face value of a then six-month zero at $972. The right to buy the zero at
$972 would be worth:

A. $6

B. $976

C. $3.53

D. $978

The correct answer is: C)

If the price of the six-month rate turns out to be 5%, the price of a six-month zero is:
1000/[1 +0.055/2] = $973.23
Hence, the right to buy the zero at $972 is worth $1.23 ( = 973.23 - 972)
If the six-month rate turns out to be 4.50%, the price of a six-month zero is $978(= 1000/[1 +
0.045/2]
Hence, the right to buy the zero at $972 is worth $978 - $972 = $6.
Total worth = [1/2 * $1.23 + 1/2 * $6] = $3.62

Which when discounted is :

3.62(1 + (5

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Q.1620 We can price a security by means of arbitrage pricing and this is done by first searching
and valuing a portfolio which is a replica of the original one. In comparison, the derivative
context is complicated as its cash flows are dependent on the rates, and the portfolio replica is
required to duplicate the derivative security for any possible:

A. Inflation rate scenario

B. Call option scenario

C. Interest rate scenario

D. Sell option scenario

The correct answer is: C)

In the case of derivatives, cash flows depend on the levels of rates, and the replicating portfolio
must replicate the derivative security for any possible interest rate scenario.

Q.1621 An analyst wants to determine the value of a call option, maturing in six months, to
purchase $1,000 face value of a then six-month zero at $975. To do so, he constructs a
replicating portfolio of six-month and one-ear zeros. The following spot rates apply:

Six-month spot rate = 5.0%

One-year spot rate = 5.30%
Six months from now (date 1), the six-month rate will be either 6.0% (the up state) or 4.0% (the
down state). Both outcomes are equally likely to occur. Determine the value of the call option.

A. $2

B. $5

C. $0.5

D. $1.02

The correct answer is: D)

If the six-month rate on date 1 turns out to be 6.0% (the up state), the price of the then six-month
zero will be:
1000
1 =
970.87
(1+ 0.06)
2
In this case, the right to buy the zero at $975 will be worth zero (There’s no point exercising the
option).
If the six-month rate on date 1 turns out to be 4.0% (down state), the price of the then six-month
zero will be:
1000
1 =
980.4
(1+ 0.04)
2

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In this case, the right to buy the zero at $975 (call option strike) will be worth $5.4.
To price the option by arbitrage, the analyst must construct a replicating portfolio today (date 0)
of underlying securities, namely six-month and one-year zero-coupon bonds, that will be worth
$0 in the up state on date 1 and $5 in the down state.
Let the face value of the six-month zero in the replicating portfolio be F0.5, and,
the face value of the 1-year zero in the replicating portfolio be F1 These values must satisfy the
following equations:
1
F0.5 + F1 ≡ F0.5 + 0.9709F1 = $0.....in the up state
0.06 1
(1+ )
2
1
F0.5 + 1
F1 ≡ F0.5 + 0.9804F1 = $5.4.....in the down state
(1+0.04)
2
Solving these equations:
−0.9709F1 = 5.4 − 0.9804F1
F1 = 568.42
F0.5 = 5.4 − 0.9804 × 568.42 = −551.88
Thus, on date 0, the option can be replicated by buying about $568.42 face value of one-year
zeros and simultaneously shorting about $551.88 face amount of six-month zeros. By the law of
one price,
price of call option = price of the replicating portfolio
1 1
= F +
1 0.5
F
2 1
(1+0.05) (1+ 0.053)
2 2

= −538.41 + 539.43 = $1.02

Q.1622 You have been provided an interest rate tree to price the value of a one-year zero-coupon
bond and a call option on this bond. If the probability of an up-move increases suddenly, the
current value of a one-year zero should:

A. Decline and the value of the call option should decline as well.

B. Increase and the value of the call option should increase as well.

C. Increase and the value of the call option should decrease.

D. Decrease and the value of the call option should remain unchanged.

The correct answer is: A)

The sudden increase in the probability of an “up-move” would translate into a higher likelihood
that interest rates will rise. As interest rates increase, bond prices decrease, and the value of call
options to purchase bonds must also fall. We can say that the price of an option is indirectly
dependent on the probabilities all the way through the price of the 1-year zero.

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Q.1624 The risk penalty implicit in the call option price is inherited from the risk penalty of the
one-year zero, that is, from the premise that the price of the one-year zero is:

A. Greater than its expected discounted value

B. Less than its expected discounted value

C. Equal to its expected discounted value

D. Not related to its expected discounted value

The correct answer is: B)

The risk penalty implicit in the call option price is inherited from the premise that the price of
the one-year zero is less than its expected discounted value.

Q.1625 It is a requirement of arbitrage pricing that the replica portfolio’s value must match the
option value in both ups and downs. One of the extraordinary aspects of this is that the
probabilities of moving down and up are:

A. Never encountered while calculating the arbitrage price

B. Always encountered while calculating the arbitrage price

C. Sometime encountered while calculating the arbitrage price

D. Partially encountered while calculating the arbitrage price

The correct answer is: A)

Probabilities of up and down moves never enter into the calculation of the arbitrage price.

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Q.1626 The Black-Scholes-Merton model is not appropriate to value derivatives on fixed-income
securities because:

A. It assumes there is no upper limit to the price of the underlying asset

B. It assumes bond price volatility is constant

C. It assumes the risk-free rate is constant

D. All of the above

The correct answer is: D)

The BSM model has several shortcomings which make it an inappropriate tool for valuing
derivatives on fixed-income securities:
(I) It assumes there is no upper limit to the price of the underlying asset. However, bond prices
actually have a maximum value.
(II) It assumes bond price volatility is constant. However, since bonds are redeemed at par,
volatility decreases as maturity approaches.
(III) It assumes the risk-free rate is constant. In reality, changes in short-term rates do occur,
causing rates along the yield curve and bond prices to change.

Q.1627 An option, like a derivative, depends on the probabilities only through current bond
prices. If the probability of an up move suddenly increases, the current value of a one-year zero
would decline. If the replicating portfolio comprises of long one-year zeros, the value of the
option would:

A. Increase

B. Decline

C. Remain unchanged

D. Cannot say due to insufficient information

The correct answer is: B)

If the current value of a one-year zero declines and the replicating portfolio is of long one-year
zeros, the value of the option would decline as well.

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Q.1628 Risk-neutral pricing is a technique that modifies an assumed interest rate process so that
any contingent claim can be priced without having to construct and price its replicating portfolio.
It is an extremely efficient way to price many contingent claims under the same assumed rate
process because:

A. The original interest rate process has to be modified once or more than once, and this
modification only requires pricing the contingent claim(s) by arbitrage

B. The original interest rate process has to be modified only once, and this modification
only requires pricing the contingent claim(s) by arbitrage

C. The original interest rate process does not need to be modified, and there is no need to
price the contingent claim(s) by arbitrage

D. None of the above

The correct answer is: B)

In risk-neutral pricing, the original interest rate process has to be modified once, and this
modification only requires pricing a single contingent claim by arbitrage.

Q.1629 The price of a derivative in the real economy may be computed as the discounted value
under the risk-neutral probabilities. Which of the following statement about the price of an
option is correct?

A. The arbitrage price of the option equals its expected discounted value under the risk-
neutral probabilities

B. The price of a security that is priced by arbitrage depends on investors' risk

preferences

C. Investors in the imaginary economy penalize securities for risk and do not price
securities by expected discounted value

D. The price of an option does not necessarily need to be the same in the real and
imaginary economies

The correct answer is: A)

The arbitrage price of the option equals its expected discounted value under the risk-neutral
probabilities.

Q.1630 While performing arbitrage pricing in a multi-period setting, recombining trees are

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considered to be economically reasonable. Consider the following tree diagrams and choose the
correct option:

I.

6.00%

5.50%
↗
↘
5.00%
↗ 5.00%
↘
4.50%
↗
↘
4.00%

II.

6.00%

5.50%
↗
↘
5.00%
↗ 4.95%
↘
4.50%
↗
↘
4.05%

A. (I) is a recombining tree while (II) is a no recombining tree

B. (I) is a non-recombining tree while (II) is a recombining tree

C. Both (I) and (II) are recombining trees

D. Both (I) and (II) are non-recombining trees

The correct answer is: C)

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A tree in which the up-down and down-up-states have the same value is called a recombining
tree, whereas when an up move followed by a down move does not give the same rate as a down
move followed by an up move, the tree is said to be non-recombining.

Q.1631 You are asked to price a particular derivative security having a $200 million face value of
a stylized constant-maturity treasury swap struck at 5%. It is a one-year CMT swap on the six-
month yield. 50 bps increments/decrements are anticipated. On date 2, the state 2, 1, and 0
payoffs will be:

A. $1 million, -$1 million and $0 respectively

B. -$1 million, $0 and $1 million respectively

C. -$1 million, $1 million and $0 respectively

D. $1 million, $0 and -$1 million respectively

The correct answer is: D)

Payoff = $200 million * [(ycmt - 5%)/2]

Substituting 6%, 5% and 4% as YCMT in will result in $1 million, $0 and -$1 million respectively.

Q.1632 An option-adjusted spread is a widely-used measure of the relative value of a security,

that is, of its market price relative to its model value. In addition, an option-adjusted spread can
be elaborated as spread which makes a security’s market price ______ the price of its
corresponding model when discounted values are computed at risk-neutral rates plus that
spread.

A. equal to

B. greater than

C. lesser than

D. None of the above

The correct answer is: A)

An OAS is defined as the spread such that the market price of a security equals its model price
when the discounted value is computed at a risk-neutral rate plus that spread.

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Q.1633 The return of a security or its profit and loss (P&L) may be divided into a component due
to the passage of time, a component due to changes in the factor, and a component due to the
change in the option-adjusted spread (OAS). On the other hand, if securities are non-priced in
accordance with the model (securities have an OAS greater/lesser than zero), their relevant cash
flows are discounted at:

A. The short-term rate

B. The long-term rate

C. The short-term rate plus the OAS

D. The short-term rate minus the OAS

The correct answer is: C)

Cash flows for securities that are not priced according to the model are discounted at the short-
term rate plus the OAS.

Q.1634 Usually, the time that elapses between dates of the tree is six months. However, we might
choose time steps smaller than six months because:

I. Decreasing the time step to a day, week, month or quarter assures that cash flows are
adequately close to pertinent data
II. Smaller steps result in a more realistic distribution of interest rates

A. I only

B. II only

C. All of the above

D. None of the above

The correct answer is: C)

In practice, we might choose time steps smaller than six months to bring cash flows closer to
data and attain a more realistic distribution of interest rates.

Q.2660 A constant maturity treasury (CMT) swap of face value $1 million is struck at 6%. The
swap pays 1,000,000 ((yCMT − 6%)/2) where yCMT is a semiannually compounded yield, of a
predetermined maturity, on the payment date. Given the following binomial tree, calculate the
value of the swap.

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 A. $678.22

B. $458.74

C. $798.12

D. $689.89

The correct answer is: B)

The swap pays off when the interest rate exceeds 6%.
For the two scenarios that can occur in the first 6 months the payoff of the swap will be:
Payoff if rate increases to 6.5% = 1,000,000 ((6.5% − 6%)/2) = $2,500
Payoff if rate decreases to 5.5% = 1,000,000 ((5.5% − 6%)/2) = - $2,500

For the three scenarios that can occur after one year the payoff of the swap will be:
Payoff if rate increases to 7% = 1,000,000 ((7% − 6%)/2)= $5,000
Payoff if rate remains at 6% = 1,000,000 ((6% − 6%)/2)= $0
Payoff if rate decreases to 5% = 1,000,000 ((5% − 6%)/2)= - $5,000

Payoff if rate remains at 6% = 1,000,000 ((6% − 6%)/2)= $0

Payoff if rate decreases to 5% = 1,000,000 ((5% − 6%)/2)= - $5,000

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The possible prices in six months are given by the expected discounted value of the 1-year
payoffs under the risk-neutral probabilities, plus the 6-month payoffs ($2,500 and —$2,500).
Hence, the 6-month values for the top and bottom node are as follows:
The value of the upper node will be (5,000 × 0.7 + 0 × 0 .3)/(1 + 0.065/2) + 2,500 = 5,889.83
The value of the lower node will be (0 * 0.7 - 5,000 * 0 .3)/(1 + 0.055/2) - 2,500 = -3,959.85

The current price can then be calculated by multiplying the values calculated at 6 months by
their risk neutral probabilities and discounting them at the current rate:
Value = (5,889.83 * 0.45 + (-3,959.85 × 0 .55))/(1 + 0.06/2) = $458.74

Q.2662 Which of the following is the term used to describe the process of valuing a bond using a
binomial interest rate tree?

A. Bootstrapping

B. Backward induction

C. Backtesting

D. Bootstrap historical simulation

The correct answer is: B)

The process of valuing a bond using a binomial interest rate tree is known as backward
induction.

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Q.2850 All of the following statements are true about callable bonds as screened against
noncallable bonds, EXCEPT:

A. At low yields, reinvestment risk falls

B. Capital gains are capped as the yield falls

C. They have less price volatility

D. They have negative convexity

The correct answer is: A)

Callable bonds have the following characteristics:

(I)When yields fall reinvestment risk increases
(II)They have less price volatility
(III)They have negative convexity
(IV)Capital gains are capped as yields fall

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Q.2851 A $7 million face value of a stylized constant-maturity treasury (CMT) swap is struck at
7%. It is a one-year CMT swap on the six-month yield in 0.5% increments. Calculate the possible
payoffs of the CMT swap after 6 months and one year.

A. 6 months: $17,500 and -$17,500; One year: $35,000, 0 and -$35,000

B. 6 months: $35,000 and -$35,000; One year: $70,000, 0 and -$70,000

C. 6 months: $8,750 and -$8,750; One year: $17,000, 0 and -$17,000

D. None of the above

The correct answer is: A)

The CMT swap pays:

yCMT − 7%
$7,000,000
2

In 6 months, the state 1 and 0 payoffs are, respectively:

7.5%−7%
$7,000,000 = $17,500
2

6.5%−7%
$7,000,000 = −$17,500
2

In one year, the state 2, 1 and 0 payoffs are:

8%−7%
$7,000,000 = $35,000
2

7%−7%
$7,000,000 = $0
2

6%−7%
$7,000,000 = −$35,000
2

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Q.2852 Which of the following statements are correct about the option-adjusted spread and the
Z-spread for option embedded bonds?

I. For a callable bond, the OAS is less than the Z-spread

II. For a putable bond, the OAS is greater than the Z-spread.

A. I only

B. II only

C. Both I and II

D. None of the above

The correct answer is: C)

With zero volatility, the Z-spread minus the OAS is equal to the option cost in percentage for a
callable bond greater than zero. For a putable bond, the OAS is greater than the Z-spread.

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 Reading 72: The Evolution of Short Rates and the Shape of the Term
Structure

Q.1635 We can derive a risk-neutral process on the basis of the assumptions related to interest
rates and a term structure that is based on market price movements. As risk analysts, we can use
it for pricing fixed-income securities with the means of arbitrage. Which of the following
components of a term structure are directly determined by assumptions?

I. The level of the term structure

II. The shape of the term structure
III. The duration of the term structure

A. I and II

B. II and III

C. I and III

D. I, II and III

The correct answer is: A)

Assumptions about the interest rate process and the risk premium determine the level and shape
of the term structure.

Q.1636 You are asked to start with assumptions about the interest rate process and about the
risk premium demanded by the market for bearing interest rate risk and then derive the risk-
neutral process. This approach results in:

A. An arbitrage-free model

B. An equilibrium model

C. The matching of the initial term structure

D. The pricing of all fixed-income securities by arbitrage

The correct answer is: B)

Models of this sort do not necessarily match the initial term structure and are called equilibrium
models.

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Q.1637 One of the financial engineering models used in market analysis is known as the
arbitrage-free model. This model basically allocates prices to instruments such as derivatives in a
manner that makes it extremely difficult to create arbitrage opportunities. In the case of an
arbitrage-free model, an understanding of the relationships between the model assumptions and
the shape of the term structure is important to:

A. Make reasonable assumptions about the interest rate process and the risk premium

B. Comprehend the assumptions implied by the market through the observed term
structure

C. Calculate the marginal productivity of capital

D. Compare propensity to save and expected inflation

The correct answer is: B)

In the case of arbitrage-free models, an understanding of the relationships between the model
assumptions and the shape of the term structure reveals the assumptions implied by the market
through the observed term structure.

Q.1638 The 2-year spot rate, S2 is 9%, and the 1-year spot rate, S1 is 4%. What is the 1-year
forward rate?

A. 0.05

B. 0.048

C. 0.1024

D. 0.1424

The correct answer is: D)

Let the 1-year forward rate be y 1. Therefore:

(1 + s2 )2 = (1 + s1 )(1 + y1 )

(1.09)2
⇒ y1 = [ ] − 1 = 0.1424
1.04

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Q.1639 As finance professionals, we know the definition of the term structure of interest rates as
“the relationship among bond yields or interest rates and different maturities or terms.” The
forecasts are useful in describing the shape and level of the term structure over ______ horizons
and the level of rates at ______ horizons. This carries significant implications when selecting term
structure models.

A. medium-term; short-term

B. long-term; short-term

C. long-term; medium-term

D. short-term; long-term

The correct answer is: D)

Forecasts are useful in describing the shape and level of the term structure over short-term
horizons and the level of rates in the long term.

Q.1640 Convexity can make duration negative, since there are some securities, like few
mortgage-backed securities, that exhibit negative convexity. Assume that, other factors kept
constant, the value of convexity of the curve increases with maturity of its pricing function. The
securities with greater convexity perform better when:

A. Yields remain constant

B. Yields change a little

C. Yields change a lot

D. None of the above

The correct answer is: C)

Securities with greater convexity perform better when yields change a lot and perform worse
when yields do not change by much.

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Q.1641 Convexity is the rate at which the duration changes along the price-yield curve. In the
case of no interest rate volatility, the yields are completely determined by forecasts. But when
volatility is taken into account, the yields are affected by the value of convexity. The value of
convexity increases with:

I. Volatility
II. Maturity
III. Yield

A. I only

B. I and II

C. I and III

D. I, II and III

The correct answer is: B)

The value of convexity increases with volatility and maturity.

However, convexity typically decreases with an increase in yield. The higher the interest rate (or
yield), the lower the convexity — or market risk — of a bond. This reduction of risk occurs
because market rates would have to increase greatly to surpass the coupon on the bond,
meaning there is less risk to the investor.

Q.1642 Assume that the maturity of a pricing function affects the convexity of the curve. A bond
with greater convexity is less affected by interest rates than a bond with less convexity. Also,
bonds with greater convexity will have a higher price than bonds with a lower convexity,
regardless of whether interest rates rise or fall. Therefore, which of the following securities
perform worse when yields do not change by much?

A. 1-year T-bill; convexity = 0.0265

B. 5-year T-note; convexity = 0.5863

C. 10-year T-note; convexity = 1.5986

D. 10-year corporate bond; convexity = 1.3256

The correct answer is: C)

Securities with greater convexity perform better when yields change a lot and perform worse
when yields do not change by much.

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Q.1643 Under the assumption of risk-neutrality, the prices of subsequent-year zeroes may be
calculated using the rate tree shown below (p = 1/2).

0.844595

0.769067
↗
↘
0.751184
↗ 0.905797
↘
0.889587%
↗
↘
0.976563%

The expected return of the three-year zero over the next year is:

A. 0.062

B. 0.104

C. 0.128

D. 0.142

The correct answer is: B)

The three-year zero over next year =

[0.5(0.769067 + 0.889587) – 0.751184] / 0.751184 = 10.4%

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Q.1644 The convexity in a financial model refers to non-linearities. For very short terms and
realistic levels of volatility, the value of convexity is quite small. It has been proved that
convexity:

A. Increases bond yields in theory and in practice

B. Decreases bond yields in theory and in practice

C. Increases bond yields in theory but not in practice

D. Decreases bond yields in theory but not in practice

The correct answer is: B)

From market analysis, it has been found that convexity does, in fact, lower bond yields in
practice.

Q.1645 In one year, if the interest rate is 14%, then the price of a one-year zero will be 1/1.14 or
.877193. If the rate is 6%, then the price will be 1/1.06 or 0 .943396. Which of the following is
closest to the expected return of the two-year zero priced at 0.826035?

A. 0.095

B. 0.1

C. 0.102

D. 0.105

The correct answer is: C)

Expected Return = [0.5(0.877193 + 0.943396) – 0.826035] / 0.826035 = 0.1020 = 10.20%

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Q.1646 The Capital Asset Pricing Model can be considered as the foundation of all financial
domains in this subject area but it also has prime relevance for practical decision-making.
According to the model, assets whose returns are positively correlated with aggregate
consumption or wealth will earn:

A. A return equivalent to the rate of the GDP

B. A risk premium

C. The risk-free rate of return

D. A return equivalent to the rate of inflation

The correct answer is: B)

The asset pricing theory (e.g., CAPM) informs us that assets whose returns are positively
correlated with aggregate wealth or consumption will earn a risk premium.

Q.1647 You acquire an asset that is negatively correlated with the economy. When investments
are negatively correlated we can use them in risk management for diversifying, or mitigating, the
risk exposures relevant to the portfolio. The holdings which exist in that asset allow you to
reduce your exposure to the economy. Therefore, that asset is said to have:

A. Zero risk premium

B. Positive risk premium

C. Negative risk premium

D. None of the above

The correct answer is: C)

If an asset is negatively correlated with the economy, investors would expect a return that’s
below the risk-free rate of return, that is, a negative risk premium.

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Q.1648 The bonds with interest rate risk earn a risk premium. The interest rates rise when
inflation and expected inflation rise. It is said that:

A. High inflation is correlated with good economic times

B. Uncertain inflation is correlated with good economic times

C. Measurable inflation is correlated with good economic times

D. Low inflation is correlated with good economic times

The correct answer is: A)

Interest rates rise when inflation and expected inflation rises and that high inflation is indicative
of good economic times. Growth in the economy results in more income being created, the
spending increase, consumption increases, and this trigger prices and inflation to rise.

Q.1649 While exploring the “relationship among bond yields or interest rates and different
maturities or term,” we can use also the term ‘yield curve’ to denote the term structure of
interest rates. On average, over the past 75 years, the term structure of interest rates has sloped
upward. A term structure that, on average, slopes upward can only be explained by:

A. A positive risk premium

B. Assumptions about convexity

C. Expectations of interest rate

D. A negative risk premium

The correct answer is: A)

Only a positive risk premium can explain a term structure that, on average, slopes upward.

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Q.2853 Investors value the current one-year interest rate at 11.316%. However, they also
forecast that for the following year, the one-year interest rate will be 13.457% and 15.658% for
the year that follows next. Calculate the two- and three-year spot rates, ρ(2) and ρ(3),
respectively.

A. 11.3% and 13.5%

B. 15.3% and 16.1%

C. 12.8% and 13.5%

D. 12.4% and 13.5%

The correct answer is: D)

The two-year spot rate ρ(2) is such that:

1 1
= =
(1.11316)(1.13457) (1 + p(2))2
1
⇒ = (1.11316)(1.13457)
(1 + p(2))2
= p(2) = 0.124 = 12.4%

The three-year spot rate is such that:

1
p(3) =
(1.11316)(1.13457)(1.15658)

p(3) = 0.135 = 13.5%

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 Reading 73: The Art of Term Structure Models: Drift

Q.1650 We can determine the Continuously Compounded Interest Rate via the following simple
model when no drifting is considered and rates are normally distributed:

dr = σdw

In this equation, what do dr and dw indicate?

A. dr denotes the change in the time with the small change in interest rate measured
annually; dw indicates a normally distributed random variable

B. dr indicates the change in the rate over a small time interval, dt, measured in years;
dw indicates a normally distributed random variable with a mean of zero

C. dr indicates a normally distributed random variable with a mean of one ; dw denotes

the change in the rate over a small time interval, dt, measured in years

D. dr denotes the change in the time with the small change in interest rate measured
annually; dw indicates a partially normal distributed random variable with a mean of one

The correct answer is: B)

dr indicates the change in the rate over a small time interval, dt, measured in years; dw indicates
a normally distributed random variable with a mean of zero.

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Q.1651 Suppose the current short-term interest rate is 7.18%, in a time interval of 3 months per
year (or 3/12 per year), with a volatility of 118 basis points per year. After a period of three
months, the random variable dw has a value of 0.18. What are the change in the short-term
interest rate and the short-term rate after 3 months?

A. 0.2124% is the change in the short-term rate; 7.3924% is the short-term rate after 3
months

B. 7.3924% is the change in the short-term rate; 0.2124% is the short-term rate after 3
months

C. 1.2924 % is the change in the short-term rate; 8.4724% is the short-term rate after 3
months

D. 8.4724% is the change in the short-term rate; 1.2924 % is the short-term rate after 3
months

The correct answer is: A)

Using the formula for simple short-term rates, dr = σdw.

dr = 118/100 * 0.18 = 0.2124%

0.2124% is the change in the short-term rate; 7.3924% is the short-term rate after 3 months
(7.18 + 0.2124).

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Q.1652 Term structure models in which the terminal distribution of interest rates has a normal
distribution are commonly known as Gaussian or normal models. The limitation of these models
is that the short-term rate can become negative. Which of the following statements is true?

A. Negative short-term interest rate are very attractive for lenders because lenders will
have zero lending risk

B. Individuals will never lend money at negative rates; they would rather hold it and earn
a zero rate

C. Individuals will lend money at negative rates to help the borrowers in tough situations
and boost the economy

D. Negative short-term rates can neither affect borrowers nor lenders because, in the
long-term, the rates become positive

The correct answer is: B)

A negative short-term rate does not make much economical sense because people would never
lend money at a negative rate when they can at least hold cash and earn a zero rate instead.

Note the term "individuals" in the question. Some central banks or governments might lend a
negative rates in some special circumstances.

Q.1653 A popular method of overcoming the problem of negative interest rates is to construct
interest rate trees with the desired distribution and fix all negative rates to zero. When using this
method, rates in the original tree are considered as:

A. Volatile market rates while the adjusted interest rates in the tree are called the
interest expected rates of interest

B. Volatile market rates of interest while the adjusted interest rates in the tree are called
the shadow rates of interest

C. Short-term rate of interest while adjusted interest rates in the tree are called the
shadow rates of interest

D. Shadow rates of interest while the adjusted interest rates in the tree are called the
observed rates of interest

The correct answer is: D)

Rates in the original tree are called the shadow rates of interest while the rates in the adjusted
tree could be called the observed rates of interest. When the observed rate hits zero, it would
“stay put” until the shadow rate crosses back to a positive rate.

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Q.1654 The simplest model of term structuring is Model 1. This model’s term structure is
downward sloping, because it has no drifts and the rates decline uniquely with term. The major
aspect of this model is the factor structure and the only factor of this model is the short-term
rate. Now, suppose this short-term rate increases by 20 basis points compounded semi-annually.
What will be the impact on the term structure?

A. Volatility will increase by 20 basis points because of an increase in the short-term rate

B. Convexity will increase by 20 basis points because of an increase in the short-term

rate

C. Rates will increase by 20 basis points because of an increase in the short-term rate

D. Maturity will increase by 20 basis points because of an increase in the short-term rate

The correct answer is: C)

The change in the term structure would be proportional. Therefore, all rates would increase by
20 basis points.

Q.1655 Because of some limitations of Model 1(dr = σdw), another term structure model was
introduced and named as Model 2. The new model is written as:

dr = λ dt + s dw

Suppose r0 = 6.138%, λ = 0.239%, σ =1.20% and the realization of the random variable happens
to be 0.15 over a month. Given these values, find the drift of the rate and standard deviation per
month, respectively.

A. The drift of the rate is 0.239%, and the standard deviation is 0.18% per month

B. The drift of the rate is 0.239%; and standard deviation is 0.01992% per month

C. The drift of the rate is 0.01992%, and the standard deviation is 0.18% per month

D. The drift of the rate is 0.1992%, and the standard deviation is 0.18%% per month

The correct answer is: C)

The drift to the short-term rate is given by λdt while the standard deviation is given by σdt.
Therefore,
λdt = 0.239% * 1/12 = 0.01992% and σdt = 1.20% * 0.15 = 0.18%

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Q.1656 Model 1 and model 2 are usually known as equilibrium term structure models because of
the zero or constant drifts respectively. On the other hand, the model which varies with time is
known as the time-dependent drift. In this model, the drift depends on time and may vary from
date to date. From your understanding, what does the time-dependent drift represent over a
period of time?

A. It represents some combination of the risk premium and some expected changes in the
short-term rate

B. It represents some changes in the market short-term rates over time

C. It represents expected changes in the volatility of short-term rates and market returns
over time

D. It only represents changes in the risk premium occurring over a period of time

The correct answer is: A)

The drift that varies with time is called a time-dependent drift. Just as with constant drift, time-
dependent drift over each time period represents some combination of the risk premium and the
expected changes in the short-term rate.

Q.1657 Whenever any investor is buying or selling any financial instrument, it is of great
importance to match its price with changes in market prices. The same case applies to the choice
of the models for term structure - whether to use arbitrage-free or equilibrium models. What is
the most important use of arbitrage-free models?

A. Quoting the prices of securities that are not actively traded based on the prices of
more liquid securities

B. Quoting the prices of securities that are not actively traded based on time to maturity

C. Quoting the prices of securities that are not actively traded on the basis of the
economic and financial stability of the lending institute

D. Quoting the prices of securities that are not actively traded on the basis of prevailing
interest rate and swap rates

The correct answer is: A)

One important use of arbitrage-free models is for quoting the prices of securities that are not
actively traded based on the prices of more liquid securities.

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Q.1658 Arbitrage-free models are used by practitioners for many purposes which include:
valuing and hedging many derivative securities, using real based assumptions to value the
securities, etc. Why are arbitrage-free models considered potentially superior to other security
models?

A. These models are valuing the securities mainly based on time-dependent variables

B. These models are valuing the securities mainly based on economic and financial
reasoning

C. These models are valuing the securities mainly based on the volatility assumptions and
sophisticated techniques

D. These models are valuing the securities mainly based on parallel shift assumptions

The correct answer is: B)

An arbitrage-free model is a financial engineering model that assigns prices to derivatives or

other instruments in such a way that it is impossible to construct arbitrages between two or
more of those prices. The potential superiority of arbitrage-free models arises from their being
based on economic and financial reasoning.

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Q.1659 A model matching market prices does not necessarily provide true values of the
securities and hedges for derivative securities. The practice of fitting models to market prices is
a good way to incorporate the interest rate behaviors into the model but such a model may have
some limitations and warnings too. What are the main limitations of these types of models?

I. In some cases, adding a time-dependent drift to a parallel shift model to match a set of market
prices will make the model unsuitable for the intended application.
II. Expectation and risk premium built into the volatile assumptions of the model are not true
indicators of the security.
III. In many cases, market prices of the security or instrument are not fair in the context of that
model.
IV. There are no limitations for these models because they incorporate market changes and
prices.

A. I and II

B. I and III

C. IV only

D. II and III

The correct answer is: B)

Firstly, adding a time-dependent drift to a parallel shift model so as to match a set of market
prices will not make the model any more suitable for that application. Secondly, the argument for
fitting market prices assumes that those market prices are not fair in the context of the model.

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Q.1660 Mean reversion is the theory in finance which assumes that returns and prices will solely
get back to their mean or average values. This mean (or average value) can be determined based
on the historical average or average returns and prices of that industrial sector. Assuming that
the short-term rate is characterized by mean reversion, what will be the effect on the rate if: (I) it
is below long-term equilibrium; and (II) if it is above long-term equilibrium?

A. (I) The drift is positive, moving the rate up toward the long term value; (II) The drift is
negative, moving the rate down towards the long-term value

B. (I) The drift is negative, moving the rate down towards the long term value; (II) The
drift is positive, moving the rate up toward the long-term value

C. The drift is parallel based on parallel slope assumption and will behave irrespective of
changes in the long-term equilibrium

D. Short term rates will change with the changes in the economic and financial condition
of that industrial sector irrespective of the changes in long-term values

The correct answer is: A)

When the short-term rate is above its long-run equilibrium value, the drift is negative, driving the
rate down toward this long-run value. When the rate is below its equilibrium value, the drift is
positive, driving the rate up toward this value.

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Q.1661 The risk-neutral dynamics of the Vasicek model can be written as:

dr = k(θ − r) dt + σ dw

Here, the constant θ represents the long term value or the central propensity of the short-term
rate in the risk-neutral process, while “k” represents the quickness of mean reversion. What will
happen if the difference between r and θ increases?

A. The greater the difference between r and θ, the greater the value of the short-term
rate

B. The greater the difference between r and θ, the greater the value of k

C. The greater the difference between r and θ, the greater the expected change in the-
short term rate towards θ

D. The greater the difference between r and θ, the greater the expected change in the
short-term rate towards r

The correct answer is: C)

In finance, the Vasicek model is a mathematical model describing the evolution of interest rates.
It is a type of one-factor short rate model as it describes interest rate movements as driven by
only one source of market risk. In such a scenario, the greater the difference between r and θ,
the greater the expected change in the short-term rate toward θ.

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Q.1662 Taking a numerical example which needs to be solved using the risk-neutral model of
term structuring, let k = 0.020,σ = 125 basis points per year, r∞ = 6.180%, λ = 0.227%, r =
5.212%.
Given these given values, find the expected change in the short-term rate and the standard
deviation over the next month?

A. A 36.084 basis point change in the short-term rate and a standard deviation of 1.70
basis points

B. A 1.70 basis points change in the short-term rate and a standard deviation of 36.08
basis points

C. A 2.053 basis points change in the short-term rate and a standard deviation of 36.08
basis points

D. A 035.04 basis point change in the short-term rate and a standard deviation of 1.54
basis points

The correct answer is: C)

The Vasicek model equation appears as:

dr = k(θ - r)dt + σdw

θ = r ∞ + (λ/k)
= 6.18 + (0.227/0.02) = 17.53%.
The change in short-term rate = 0.020(17.53% - 5.212%)(1/12) = 0.02053 or 2.053 basis points.

The volatility over the next month = 125 * √(1/12) = 36.08 basis points

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Q.1663 Suppose we drew a graph showing the impact of the mean reversion on the terminal.
Risk-neutral distributions at different time horizons for the short-term rate would show the
impact of the mean reversion on the term structures. Which of the following observations would
we most likely make?

A. The mean of the short-term rate, as a function of the time horizon, would remain
constant or relatively constant on the term structure

B. The mean of the short-term rate, as a function of the time horizon, would increase
from the current value to its limiting value of θ

C. The mean of the short-term rate, as a function of the time horizon, will remain
constant from the current value to its limiting value of θ

D. The graph would show an increase in the mean of the short-term rate to match the
market volatility

The correct answer is: B)

We would expect to see the mean of the short-term rate, as a function of the time horizon,
increasing from the current value to its limiting value of θ.

Q.1664 The mean-reverting parameter is not a particularly intuitive way of describing how long
it takes for a factor to return to its long-term goal. A more intuitive way is the half-life.

Suppose the half-life of interest rate is 28.72. What does this indicate?

A. The interest rate factor takes 28.72 years to progress towards half of the distance
between its starting value and its goal

B. The interest rate factor takes half of 28.72 years to progress towards its goal

C. The interest rate factor, on a weighted average, takes 28.72 years to progress towards
its goal

D. The interest rate factor, on a weighted average, takes 57.44 years to progress towards
its goal

The correct answer is: A)

A factor's half-life is defined as the time it takes the factor to progress half the distance toward
its goal.

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Q.1665 Using the Vasicek model, we can determine the standard deviation of the terminal
distribution of the short-term rate after T years.

Consider the following scenario:

A mean-reverting parameter has a value of 0.025 and volatility of 126 basis points. The short rate
in 10 years is normally distributed with an expected value of 7.4812%.

What is the standard deviation of the short rate in 10 years?

A. 343 basis points

B. 253 basis points

C. 243 basis points

D. 353 basis points

The correct answer is: D)

In the Vasicek model, the standard deviation of the terminal distribution of the short rate after T
years is given by:

σ2
= √[( )(1 − e−2k T )]
2k
1.262
= √ [( )(1 − e−2×0.025×10)] = 3.53% or 353 basis points
2 × 0.025

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Q.1666 Financial institutions use mean-reverted as well as non-mean-reverted parameters to
match the par rates of securities with those of the market. Mean-reverted parameters can be
used to fit the model with observed term structures more accurately. After graphing the term
structures of mean-reverted as well as non-mean-reverted models, what would you expect?

A. The model with mean reversion and the one without mean reversion would result in
dramatically different term structures of volatility

B. The model with mean reversion and the one without mean reversion would result in
same term structures of volatility

C. Both models would be much more volatile and their patterns cannot be determined
through a small set of data

D. The model with mean reversion would give more accurate term structures than the
one without mean reversion

The correct answer is: A)

A model with mean reversion and another one without mean reversion result in dramatically
different term structures of volatility.

Q.1667 An FRM exam candidate draws a graph showing the volatilities of par rates with different
term structures including short-term as well as long-term term structures. Mean reversion and
volatility parameters are graphed against each other. The model generates a term structure of
volatility that is sloping downwards, as mean reversion lowers the volatility of long term par
rates.

From such a graph, we can conclude that:

A. The model matches the market at longer terms but understates the volatility for
shorter terms

B. The model matches the market at shorter terms but overstates the volatility for longer
terms

C. The model matches the market at longer terms but overstates the prices for shorter
terms

D. The model matches the market at longer terms but overstates the volatility for shorter
terms

The correct answer is: D)

The model matches the market at those longer terms but overstates the volatility for shorter
terms.

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Q.1668 An analyst draws a graph showing the effects of spot rates using the Vasicek model
having a 10-basis-points change in the factor. The graph interprets how the 10 basis point
change in short-term rate affects the spot rate curve. The model is graphed with mean reversion.
What would be the effect on long-term and short-term rates given an increase of 10 basis points
in the interest rate factor?

A. The short-term rates decrease by about 10 basis points but longer-term rates are less
impacted

B. The short-term rates increase by about 10 basis points but longer-term rates are less
impacted

C. The short-term rates increase by about 10 basis points but longer-term rates are
impacted by more than 10 basis points

D. The short-term rates, as well as long-term rates, increase by 10 basis points because
of the increase in volatility

The correct answer is: B)

The spot rate curve is affected by a 10 basis point increase in the short-term rate. By definition,
short-term rates rise by about 10 basis points but longer-term rates are impacted less. The 30-
year spot rate, for example, rises by only 7 basis points. Hence, a model with mean reversion is
not a parallel shift model.

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Q.1669 Using whichever model for term structure, short-term rates are impacted by the changes
in economic and financial conditions of the markets. Long term-rates are less likely to be
impacted by shocks in the market but these incidents largely impact short term rates. Regardless
of the changes, the short-term change is assumed to arrive at long-term goals. Which of the
following is correct regarding short-lived and long-lived news?

A. The news is short-lived if it changes the market's view of the economy many years in
the future; it is long-lived if it changes the market's view of the economy in the near
future.

B. News is long-lived if it changes the market's view of the economy many years in the
future; it is short-lived if it changes the market's view of the economy in the near future.

C. Both types of news impact the economy in short term or long term irrespective of the
types of news.

D. Long-lived news impact long-term instruments and projects while short-lived news
only impact short-term instruments and securities.

The correct answer is: B)

Economic news is said to be long-lived if it changes the market's view of the economy many
years in the future. For example, news of a technological innovation that raises productivity
would be a relatively long-lived shock to the system. Economic news is said to be short-lived if it
changes the market's view of the economy in the near but not for future

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Q.2661 Given the following data:

Current short-term interest rate: 1.5%

Long-run mean reverting level: 4%
Long-run true interest rate: 2%
Interest rate drift: 0.1%

Use the Vasicek model with mean reversion to determine the model’s mean-reverting parameter.

A. 0.040

B. 0.015

C. 0.022

D. 0.050

The correct answer is: D)

Mean reverting parameter:

λ
θ≈η+
k

0.1%
4% ≈ 2% +
k

⇒ k = 0.05

Q.2663 Given the following binomial tree for the six-month spot rate:

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Calculate the expected discounted value of a one-year $1000 face value, zero-coupon bond.

A. $927.93

B. $971.82

C. $974.91

D. $951.13

The correct answer is: D)

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The up and down values for the zero-coupon can be calculated by discounting the face value of
the bond by the up and down value for the six-month rate.

Value if the six month rate is 6% = 1000/(1 + 0.058/2) = 971.82

Value if the six month rate is 4% = 1000/(1 + 0.045/2) = 978

The expected value of the one-year zero can be calculated by multiplying by the probabilities:
½ x 971.82 + ½ 978 = 974.91

The discounted value of this can then be computed by discounting the expected value by the spot
rate = 974.91/(1 + 0.05/2) = 951.13

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Q.4013 Under Model 1 of short-term interest rates, the current value of the short-term rate is
5.26%, that volatility equals 115 basis points per year, and that the time interval under
1
consideration is one month or 12 years. Mathematically, r0 = 5.26%; σ = 1.15%; and dt = 1/12. A
1
month passes and the random variable dw, with its zero mean and its standard deviation of √ 12
or 0.2887, happens to take on a value of 0.25. Determine the short-term rate after one month.

A. 0.035

B. 0.025

C. 0.055

D. 0.002875

The correct answer is: C)

The change in the short-term rate is given by:

dr = σdw
= 1.15% × 0.25 = 0.2875%

Since the short-term rate started at 5.26%, the short-term rate after a month is 5.55%.

New short-term rate = 5.26% + 0.2875% = 5.55%

Q.4014 Under Model 2 of short-term interest rates, the current value of the short-term rate is
5.26%, that volatility equals 115 basis points per year, drift is 0.25%, and that the time interval
1
under consideration is one month or 12 years. Mathematically, r0 = 5.26%; σ = 1.15%; λ =
1
0.25%; and dt = 12 . A month passes and the random variable dw, with its zero mean and its
1
standard deviation of √ 12 or 0.2887, happens to take on a value of 0.25. Determine the short-
term rate after one month.

A. 5.5%

B. 5.5683%

C. 4.5212%

D. 0.3083%

The correct answer is: B)

Under Model 2,

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 dr = λdt + σdw

where:

dr = change in interest rates over small time interval, dt

λ = drift

dt = small time interval (measured in years) (e.g., one month = 1/12, 2 months = 2/12, and so

forth)

σ = annual basis-point volatility of rate changes

dw = normally distributed random variable with mean 0 and standard deviation √dt

Thus, the change in the short-term rate is given by:

dr = λdt + σdw
1
= 0.25% × + 1.15% × 0.25
12
= 0.3083%

Since the short-term rate started at 5.26%, the short-term rate after a month is 5.5683%:

New short-term rate = 5.26% + 0.3083% = 5.5683%

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Q.4015 Consider a Vasicek model with a reversion adjustment parameter of 0.05, annual
standard deviation of 130 basis points, a true long-term interest rate of 5%, a current interest
rate of 6.0%, and annual drift of 0.40%. Determine the forecasted change in the short term rate
for the next one-month period.

A. 0.0292%

B. 6%

C. 13%

D. 0.05%

The correct answer is: A)

First, we have to determine θ , the long-run value of the short-term rate assuming risk neutrality:

λ 0.40%
θ ≈ rl + ≈ 5% + = 13%
k 0.05

It follows that the forecasted change in the short-term rate for the next period is 0.0292%:

dr = k(θ − r)dt
1
= 0.05(13% − 6%) ( ) = 0.0292%
12

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Q.4016 Using Model 1, assume the current short-term interest rate is 3%, annual volatility is
100bps, and dw, a normally distributed random variable with mean 0 and standard deviation √dt,
has an expected value of zero. After one month, the realization of dw is -0.3. What is the change
in the spot rate and the new spot rate?

Change in spot New Spot Rate

I. 0.25% 2.25%
II. −3% 0.0%
III. 0.6% 3.6%
IV. −0.3% 2.7%

A. I

B. II

C. III

D. IV

The correct answer is: D)

The change in the short-term spot rate is given by:

dr = σdw
= 1.0% × −0.3 = −0.3%

Since the short-term rate started at 3%, the short-term rate after a month is 2.7%.

New short-term rate = 3% − 0.3% = 2.7%

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Q.4017 The U.S. department of Transport has just announced an unexpected technological
breakthrough that will have a major bearing on the development of self-driving autonomous
vehicles. What is the most likely anticipated impact on a mean-reverting model of interest rates?

A. The economic information is long-lived with a low mean-reversion parameter.

B. The economic information is short-lived with a low mean-reversion parameter.

C. The economic information is long-lived with a high mean-reversion parameter.

D. The economic information is short-lived with a high mean-reversion parameter.

The correct answer is: A)

The economic news is most likely long-term in nature. Therefore, the mean reversion parameter
is low so the mean reversion adjustment per period will be relatively low. Economic news is said
to be long-lived if it changes the market’s view of the economy many years in the future. The
announcement of major technological progress in the development of self-driving cars would
most likely have a long-term and persistent effect on the automobile industry and the economy at
large.

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Q.4018 Consider a Vasicek model with a reversion adjustment parameter of 0.03, annual
standard deviation of 200 basis points, a true long-term interest rate of 6%, a current interest
rate of 5.0%, and annual drift of 0.35%. Determine the expected rate in the model after 10 years:

A. 4.55%

B. 3.70%

C. 8.28%

D. 11.67%

The correct answer is: C)

The expectation of the rate in the Vasicek model after T years is given by:

r0 e−kT + θ(1 − e−kT)

Where:

r0 = current interest rate

K = mean reversion parameter

θ = long-run value of the short-term rate assuming risk neutrality

T = time in years

First, we must work out the value of θ

λ 0.35%
θ ≈ rl + ≈ 6% + = 17.67%
k 0.03

rl is true long-term interest rate, and λ is the annual drift

Thus,

the expected rate after 10 years = 5%e−0.03×10 + 17.67%(1 − e−0.03 ×10)

= 3.7041% + 4.5797%
= 8.2838%

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Q.4019 Consider a Vasicek model with a reversion adjustment parameter of 0.05, annual
standard deviation of 150 basis points, a true long-term interest rate of 6%, a current interest
rate of 5.0%, and annual drift of 0.4%. Determine the half-life of the model

A. 5.8

B. 26.0

C. 13.86

D. 14.50

The correct answer is: C)

Half-life is defined as the time it takes the factor to progress half the distance toward its goal.
The half-life is given by:

ln(2)
Half-life = τyears =
k

Where k is the mean reversion parameter.

Thus,

ln(2)
half-life = = 13.86 years
0.05

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 Reading 74: The Art of Term Structure Models: Volatility and
Distribution

Q.1670 In the same way that we use a time-dependent drift to match the bond or swap rates, we
can also use time-dependent volatility functions to match option prices. These models focus on
the volatility of interest rates for term structure modeling. A simple time-dependent volatility
function can be written as:

dr = λ (t) dt + σ (t) dw

In this function, on which factor does the volatility of the short-rate depend?

A. The volatility of the short-term rate depends on the interest rate

B. The volatility of the short-term rate depends on the volatility of σ

C. The volatility of the short-term rate depends on time

D. The volatility of the short-term rate depends on changes in the market prices of
securities

The correct answer is: C)

The volatility of the short-rate in the equation depends on time.

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Q.1671 Deterministic volatility functions and models are widely used by market makers to exploit
the benefits of interest rate options. Like in trading caplets, the value of caplets depends on the
distribution of short-rates at the time of expiration of these caplets. So, the flexibility of
deterministic functions can be used to match market prices of caplets with distinctive expiration
dates. At expiration, what does a caplet pay?

A. A caplet compensates the difference between the short rate and a strike, if positive

B. A caplet compensates the difference between the short rate and a strike, if negative

C. A caplet compensates the strike price at the time of expiration if the strike price
increases

D. A caplet compensates the short rate only irrespective of the strike price at the time of
expiration

The correct answer is: A)

At expiration, a caplet pays the difference between the short rate and a strike, if positive, on
some notional amount. Furthermore, the value of a caplet depends on the distribution of the
short rate at the caplet's expiration. Therefore, the flexibility of the deterministic functions may
be used to match the market prices of caplets expiring on many different dates.

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Q.1672 Model 3 is similar to the Vasicek Model with mean reversion in many ways. For example,
if the time-dependent drift of model 3 matches the average path of rates of the Vasicek model,
then both modes result in similar terminal distributions. However, these models differ in many
ways. Which of the following statements are true with regard to the differences between these
two models?

I. Model 3 is a parallel shift model just like models without mean reversion.
II. Model 3 is a parallel shift model just like models with mean reversion.
III. The term structure of volatility is flat in Model 3, which is not the case with the Vasicek
Model.
IV. The term structure of volatility is curved in Model 3, which is not the case with the Vasicek
Model.

A. I and IV

B. II and III

C. I and III

D. II and IV

The correct answer is: C)

As is the case for any model without mean reversion, Model 3 is a parallel shift model. Also, the
term structure of volatility in Model 3 is flat. Since the volatility in Model 3 changes over time,
the term structure of volatility is flat at levels that change over time, but it is still always flat.

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Q.1673 Models with time-dependent volatility and those models with time-dependent drift with
mean reversion can be used for different securities based on the features of the securities. For
example, if you want to find the price of a fixed income option, then a model with:

A. Time-dependent drift is suitable, but if you want to price and hedge fixed-income
securities, then a model with time-dependent volatility is preferable

B. Time-dependent volatility is suitable, but if you want to price and hedge fixed-income
securities, then a model with time-dependent drift is preferable.

C. Time-dependent volatility is suitable, but if you want to price and hedge fixed-income
securities, then a model with mean reversion is preferable.

D. Mean reversion is suitable, but if you want to price and hedge fixed-income securities,
then a model with time-dependent volatility is preferable.

The correct answer is: C)

If you want to quote fixed income options prices that are not easily observable, then a model with
time-dependent volatility provides a means of interpolating from known to unknown option
prices. If, however, the purpose of the model is to value and hedge fixed-income securities,
including options, then a model with mean reversion might be preferred.

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Q.1674 Many models of short-term rates assume the annualized standard deviation of dr is
independent of the interest rate level. This makes the models irrelevant and inappropriate during
high inflation times and during periods of high-interest rates in the market. Therefore, a new CIR
is introduced:

dr = k (θ − r) dt + σ√rdw

Which of the following statements is correct regarding the CIR model above?

A. The standard deviation of dr is inversely proportional to the square root of the short
rate

B. The standard deviation of dr is directly proportional to the square root of dw

C. The standard deviation of dr is directly proportional to the square root of dt

D. The standard deviation of dr is directly proportional to the square root of the short
rate

The correct answer is: D)

The annualized standard deviation of dr (i.e., the basis-point volatility) is proportional to the
square root of the rate. Put another way, in the CIR model, the parameter s is constant, but basis-
point volatility is not: annualized basis-point volatility equals σ√r and increases with the level of
the short rate.

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Q.1675 The standard specification of the new CIR model is that the standard deviation of dr
(basis-point volatility) is proportional to the rate. In this model, σ is usually referred to as yield
volatility, and this specification leads to two different models: the Courtadon model and the
Lognormal model.

Keeping the two models in mind, which of the following statements is correct regarding the yield
volatility and the basis-point volatility?

A. The basis-point volatility is constant but the yield volatility equals σr and rises with the
level of the rate

B. The yield volatility is constant but the basis-point volatility equals σr and rises with the
level of the rate

C. The yield volatility as well as the basis-point volatility equal σr and both rise with the
level of the rate

D. The yeld volatility as well as the basis-point volatility equal σ and both decrease with
the level of the rate

The correct answer is: B)

The yield volatility is constant but the basis-point volatility equals σr and increases with the level
of the rate.

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Q.1676 The property of CIR model - that basis-points volatility equals zero when in situations
when short rate is zero - joined with the condition that drift is positive when the rate is zero,
together ensure that the short rate cannot move to negative values. In many aspects, this
property of the CIR model is an improvement over models with constant basis-point volatility.

Keeping this in mind, what is the problem of constant basis-point volatility with regards to
interest rates?

A. Models with constant basis-point volatility permit interest rates to become negative

B. Models with constant basis-point volatility permit interest rates to become positive

C. Models with constant basis-point volatility permit interest rates to change with market
changes in interest rates

D. Models with constant basis-point volatility permit interest rates to change with spot
rates

The correct answer is: A)

The CIR model is an improvement over models with constant basis-point volatility that allows
interest rates to become negative.

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Q.1677 The choice of model mainly depends on the purpose at hand, that is, traders choose
model for term structure modeling on the basis of their purpose of buying or selling a security.
Which of the following statements are true if the traders opt for a constant volatility basis points
model?

I. The current economic environment is best with constant volatility.

II. The current economic environment is very unstable and changes immediately with small
changes in investors’ perception.
III. The negative rates have a minor impact on the valuing of the security under consideration.
IV. The negative rates have a major impact on the valuing of the security under consideration.

A. I and IV

B. I and III

C. II and III

D. II and IV

The correct answer is: B)

A trader who believes that (I) the assumption of constant volatility is best in the current
economic environment, and (II) the possibility of negative rates has a small impact on the pricing
of the securities under consideration might very well opt for a model that allows some
probability of negative rates.

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Q.1678 A model was constructed to estimate the dynamics for a lognormal model with
deterministic drift. The function of the model (time-dependent) is:

d[ln(r)] = α(t)dt + σdw

In this equation, the short rate has a lognormal distribution.

Considering this equation, what will be the distribution of a random variable if its natural
logarithm has a normal distribution?

A. The random variable will be having a lognormal distribution if its natural logarithm
has a normal distribution

B. The random variable will be having a normal distribution if its natural logarithm has a
normal distribution

C. The random variable will be having a standard normal distribution if its natural
logarithm has a normal distribution

D. The random variable will be having an exponential distribution if its natural logarithm
has a normal distribution

The correct answer is: A)

By definition, a random variable has a lognormal distribution if its natural logarithm has a
normal distribution.

Q.1679 A lognormal model with mean reversion is called the Black-Karasinski model. This model
allows the volatility, mean reversion and short rate’s central tendency to depend on time. These
features make this model arbitrage-free. This model shows that the natural logarithm of the
short rate is normally distributed.

What does this model allow the user to do which is not allowed in other models?

A. A user can use or remove as much time dependence as desired

B. A user can change the distributions as desired in any situation

C. A user can change the price of the securities under consideration when needed

D. A user does not have any extra privilege under this model

The correct answer is: A)

A user may use or remove as much time dependence as desired under this time-dependent
model.

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Q.1680 A lognormal model with mean reversion allows certain factors to depend on time, making
it an arbitrage-free model. This model allows the user to make use of time dependence as desired
for the purpose at hand. The dynamics of the model can be written as:

d [ln(r)] = k(t) [lnθ(t) − ln(r)] dt + σ(t)dw

This equation assumes that the natural logarithm of short rates follows a time-dependent version
of the Vasicek model. Keeping this concept in mind, what is the distribution of natural logarithm
short rates in this equation?

A. The lognormal distribution

B. The normal distribution

C. The standard normal distribution

D. The Bernoulli distribution

The correct answer is: B)

According to the equation, the natural logarithm of the short rate is normally distributed. If
viewed another way, the natural logarithm of the short rate follows a time-dependent version of
the Vasicek model.

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Q.1681 Time-dependent volatility functions or models are widely used by financial institutions
because of their flexible features. These models can be used to fit many option prices. A simple
volatility function suggests that the volatility of short rates depends on time. What does σ (1) =
1.25% and σ (2) = 1.28% represent in that equation?

A. The volatility of the short rate in 6 months is 125 basis points while the volatility of the
short rate one year is 128 basis points per year

B. The volatility of the short rate in one year is 128 basis points while the volatility of the
short rate in two years is 125 basis points per year

C. The volatility of the short rate in one year is 125 basis points while the volatility of the
short rate intwo years is 128 basis points per year

D. The time-dependence of the short rate in one year is 125 basis points while the time-
dependence of the short rate in two years is 128 basis points per year

The correct answer is: C)

If the function CY(t) were such that CY (1) = 1.26% and CY(2) = 1.20%, then the volatility of the
short rate in one year would be 126 basis points per year while the volatility of the short rate in
two years would be 120 basis points per year.

Q.1682 A special case of the time-dependent volatility function is Model 3. Model 3 illustrates the
features of time-dependent volatility through the following equation:

dr = λ(t)dt + σe-αtdw

This equation represents the behaviour of the short rate volatility. Which of the following
statements is true about the short rate volatility?

A. The volatility of the short rate starts at the constant σ, and then exponentially
decreases to zero

B. The volatility of the short rate ends at the constant λ, and then exponentially
decreases to zero

C. The volatility of the short rate starts at the constant σ, and then exponentially
increases from zero to infinite

D. The volatility of the short rate starts at the constant λ, and then decreases to zero

The correct answer is: A)

The volatility of the short rate starts at the constant CY and then exponentially declines to zero in
this equation.

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Q.1683 The choice of term structure depends on the purpose at hand. For instance, if the
purpose of the model is to price or hedge fixed-income securities/options, then the mean
reversion model is preferred because many users disagree with the time-dependent volatility
model’s argument that markets have a forecast of short term volatility in the distant future.
Which modification in the new model addresses this objection?

A. Assuming that volatility depends on time in the near future and then settles at a
constant

B. Assuming that the short rate depends on time in the near future and then settles at a
constant

C. Assuming that the volatility depends on time in the distant future and then settles at
an increasing rate

D. Assuming that volatility depends on time in the near future and then settles at a
decreasing rate

The correct answer is: A)

Time-dependent volatility relies on the difficult argument that the market has a forecast of short-
term volatility in the distant future. A modification of the model that addresses this objection is
to assume that volatility depends on time in the near future and then settles at a constant.

Q.1684 Which of the following statements is true about mean-reverting models?

A. They exhibit an upward-sloping factor structure and term structure of volatility which
capture the interest rate behavior movement much better compared to parallel shift
models

B. They exhibit a downward-sloping factor structure and term structure of volatility and
are as good at capturing interest rate behavior as parallel shift models

C. They exhibit a downward-sloping factor structure and term structure of volatility and
capture interest rate behavior better than parallel shift models.

D. They exhibit upward-sloping factor structure and term structure of volatility and
capture interest rate behavior better than parallel shift models

The correct answer is: C)

The downward-sloping factor structure and the term structure of volatility in mean-reverting
models capture the behavior of interest rate movements better than models that yield parallel
shifts or a flat term structure of volatility.

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Q.1685 In the past, many models studied assumed that the basis-point volatility of the short rate
was independent of the level of the short rate, but in certain scenarios, this assumption went
wrong, making the models inappropriate for use (for instance, during times of high inflation).
This argument led to a more specific model that considers basis point volatility of the short rate
as an increasing function.

Which of the following equations truly represents the dynamics of that model?

A. dr = k(λ - r)dt + σ√rdw

B. dr = k(θ - r)dt + σ√rdw

C. dr = k(θ - r)dt + σ√dw

D. dr = k(θ - λ)dt + σ√rdw

The correct answer is: B)

At extreme levels of the short rate, the basis-point volatility of the short rate is not independent
of the short rate. Also, in periods of high inflation, the short-term rate keeps fluctuating, which
means the basis-point volatility is quite high. Economic arguments of this sort have led to
specifying the basis-point volatility of the short rate as an increasing function of the short rate.
The risk-neutral dynamics of the Cox-Ingersoll-Ross (CIR) model are:
dr = k(θ - r)dt + σ√rdw

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Q.1686 Models are always continually improved to make them more suitable in the face of
changing economic conditions. Many models with constant basis-point volatility allow interest
rates to become negative, which is not economically possible and appropriate.

Which property of model CIR guarantees that the short rate cannot become negative?

A. The property that the basis-point volatility equals zero in case the short rate is zero,
joined with the condition that the drift is negative when the rate is zero, guarantees that
the short rate cannot become negative

B. The property that the basis-point volatility equals a constant in case the short rate is
zero, joined with the condition that the drift is positive when the rate is positive,
guarantees that the short rate cannot become negative

C. The property that the basis-point volatility equals a constant in case the short rate is
zero, joined with the condition that the drift is zero when the rate is zero, guarantees that
the short rate cannot become negative

D. The property that the basis-point volatility equals zero in case the short rate is zero,
joined with the condition that the drift is positive when the rate is zero, guarantees that
the short rate cannot become negative

The correct answer is: D)

The property that the basis-point volatility equals zero when the short rate is zero, combined
with the condition that the drift is positive when the rate is zero, guarantees that the short rate
cannot become negative. In some respects, this is an improvement over models with constant
basis-point volatility that allow interest rates to become negative.

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Q.2858 James Greenberg, an analyst at HSBC, is employing the Cox-Ingersoll-Ross (CIR) model
for the short-term rate process.

His assumptions include:

The time-step is monthly, dt = 1/12, today's initial rate, r(0) = 2.11%, the annual basis point
volatility, sigma = 3.17%, the long-run rate, theta = 7.64%, the strength of reversion, k = 0.57.

For the first month, dw = 0.160. What is the short-rate in the first month under this CIR process,
r(1/12)?

A. -3.006%

B. -1.336%

C. 2.446%

D. 3.006%

The correct answer is: C)

Recall that from the CIR model, we have:

dr = k (θ − r)dt + σ√rdw

From the data provided in the question:

σ = 0.0317, r = 0.0211, θ = 0.0764, k = 0.57, dw = 0.16

Therefore:
dr = 0.57(0.0764 − 0.0211) × 1⁄12 + 0.0317√0.0211 × 0.16

⇒ dr = 0.00336 = 0.336%

The short rate in the first month under this CIR model is:
2.11% + 0.336% = 2.446%

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Q.2859 What is the implication of basis-point volatility being equal to zero should the short rate
be zero in conjunction with the condition that a zero rate implies a positive drift?

A. The long rate will always be positive

B. The short rate will always be non-negative

C. The long and the short rate will always be equal

D. None of the above

The correct answer is: B)

The property that basis point volatility equals to zero when the short rate is zero combined with
the condition that the drift is positive when the rate is zero guarantees that the short rate cannot
become negative.

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 Reading 75: Volatility Smiles

Q.1705 The Black-Scholes-Merton model is known in the field of Financial Risk Management for
depicting the variance of prices of instruments over a period of time. It is being used by traders
today but with a little variation from the method originally applied by Black, Scholes, and Merton
and this difference is because of:

I. The allowance of the factor of stability to be used for pricing as an option to be dependent on
its strike-price
II. The allowance of the factor of volatility to be used for pricing as an option to be dependent on
its strike-price
III. The allowance of the factor of volatility to be used for pricing as an option to be dependent on
its time to maturity

A. Both I and II

B. Both II and III

C. Both I and III

D. None of the above

The correct answer is: B)

Traders do use the Black-Scholes-Merton model, but not in exactly the way that Black, Scholes,
and Merton originally intended. This is because they allow the volatility used to price an option
to depend on its strike price and time to maturity.

Q.1706 The term "volatility smile" carries significant value in the scope of Financial Risk
Management, and is used traders in equity and foreign currency markets. Which of the following
statements gives the correct definition of a volatility smile?

A. The plot of volatility (implied) of financial markets determining prices of options

B. The plot of volatility (implied) of an option with a defined life span acting as a function
of its strike price

C. The plot of volatility (implied) of an option with an infinite life span acting as a
function of its stated price

D. None of the above

The correct answer is: B)

A plot of the implied volatility of an option with a certain life as a function of its strike price is
known as the volatility smile.

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Q.1707 The term "volatility smile" is a pictorial representation of an option’s implied volatility
and it is being used by the traders as a pricing tool for their financial securities. Which of the
following statement is correct about volatility smiles?

A. The volatility smile for European call-options with a certain maturity and strike price is
the same as that for European put-options with the same maturity and strike price

B. The volatility smile for European call-options with a certain maturity and strike price is
different from that for European put-options with the same maturity and strike price

C. The volatility smile for European call-options with a shorter maturity and same strike
price is the same as that for European put-options with a longer maturity and the same
strike price

D. None of the above

The correct answer is: A)

The implied volatility of a European call option is the same as that of a European put option
when they have the same strike price and time to maturity. The volatility smile provides their
pictorial representation.

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Q.1708 The value of a foreign currency is $0.55. The risk-free interest rate is 4% and 8% per
year in the U.S. and in the foreign country, respectively. The market price of a European call
option on the foreign currency with a maturity of 1 year and a strike price of $0.57 is $0.0325.
The implied volatility of the call is 14.5%. For there to be no arbitrage, the equation of the put-
call parity relationship is to be applied with q equal to the foreign risk-free rate. What is the
value of a put option according to the put-call parity?

A. 0.0725

B. 0.0724

C. 0.0419

D. 0.0687

The correct answer is: B)

Using the put-call parity:

p + S0e-qT = c + Ke-rT

p + 0.55e-0.08*1 = 0.0325 + 0.57e-0.04*1

p + 0.50771399 = 0.58014998
p = 0.58014998 – 0.50771399
p = 0.72435989

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Q.1709 Which of the following statements stands TRUE for the following equation depicting the
put-call parity relationship in regard to the Black-Scholes-Merton model?
PBS - Pmkt = CBS - Cmkt

I. BS in the equation reflects the inclusion of the Black-Scholes-Merton model

II. c and p represent the European call and put prices, respectively
III. There is a no-arbitrage argument reflected in the equation
IV. The dollar pricing error when pricing a European option is the same when using the Black-
Scholes-Merton model provided the option carries the same strike price and time to maturity

A. Both I and II

B. Both II and III

C. All of the above

D. None of the above

The correct answer is: C)

The equation PBS - Pmkt = CBS - Cmkt represents the put-call parity-relationship while using the
Black-Scholes-Merton model to price a European option with the same strike price and maturity
time leading to the same dollar pricing error.

Dollar error pricing is the difference between the value of a European option evaluated using the

Black-Scholes formula and the market value of the same option.

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Q.1710 After reading the following scenario, pick the statement which CORRECTLY depicts it.

Suppose that the implied volatility of a put option = 25% meaning that PBS = Pmkt when volatility
of 25% is being applied in the Black-Scholes-Merton model. From the following equation, PBS -
Pmkt = CBS - Cmkt, then CBS = Cmkt when this volatility is used. The implied volatility of the call is
also 25%.

A. This scenario shows that the implied volatility of a European call option is always the
same as the implied volatility of a European put option when the two have the same
strike prices and maturity dates

B. This scenario shows that the implied volatility of a European call option is always the
different as the implied volatility of a European put option when the two have the same
strike prices and maturity dates

C. This scenario shows that the implied volatility of a European call option is always the
same as the implied volatility of a European put option when the two have different strike
prices and maturity dates

D. This scenario shows that the implied volatility of a European call option is always the
same as the implied volatility of an American put option when the two have the same
strike prices and maturity dates

The correct answer is: A)

For a given strike price and maturity, the correct volatility to use in conjunction with the Black-
Scholes-Merton model to price a European call should always be the same as that used to price a
European put. This means that the volatility smile is the same for European calls and European
puts.

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Q.1711 When it comes to making a decision regarding trading using the Black-Scholes-Merton
model, assumptions must be made regarding the distribution of exchange rates. But at the same
time, the lognormal assumption is deemed as not a right choice for exchange rates, and it’s
advisable to buy deep-out-of-the money call and put options on a variety of different currencies
and wait. This suggestion is supported by the following reasons:

I. The chosen options will be relatively inexpensive

II. Many of the chosen options will close in the money than the prediction of lognormal-model
III. On average, the payoffs’ present value will be more than the options’ cost

A. Both I and II

B. Both I and III

C. All of the above

D. None of the above

The correct answer is: C)

From around the mid-1980s, a few traders knew about the heavy tails of foreign exchange
probability distributions. Everyone else thought that the lognormal assumption of Black-Scholes-
Merton was reasonable. The few traders who were well informed followed the strategy that has
been discussed in the question made tons of money. By the late 1980s, everyone realized that
foreign currency options should be priced with a volatility smile and the trading opportunity
disappeared.

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Q.1713 In practice, exchange rates do not work on the condition of lognormal distribution as the
exchange rate’s volatility is far from constant, and there are frequent jumps. Which of the
following statements stands FALSE for this scenario?

A. Extreme outcomes are expected as a result of the impact of the variable volatility and
jumps

B. The effect of the variable volatility and jumps are independent of the maturity of
options

C. When the maturity of options increases, the volatility smile becomes less pronounced

D. None of the above

The correct answer is: B)

As the maturity of the option increases, the percentage impact of non-constant volatility on
prices becomes more pronounced, but its percentage impact on implied volatility usually
becomes less pronounced. The percentage impact of jumps on both prices and the implied
volatility becomes less pronounced as the maturity of the option is increased. The result of all
this is that the volatility smile becomes less pronounced as option maturity increases.

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Q.1714 It is often stated that the volatility smile (the relationship between implied volatility and
strike price K, dependent on the asset’s current price) is calculated as the relationship between
the implied volatility and K/S0 rather than as the relationship between the implied volatility and
K. Which of the following statements depicts the reason behind this calculation?

I. The lowest point of the volatility smile is usually close to the current exchange rate
II. When the exchange rate decreases, the volatility smile tends to move to the left and when the
exchange rate increases, the volatility smile tends to move to the right
III. When the equity price increases, the volatility skew tends to move to the right and when the
equity price decreases, it tends to move to the left

A. I and II

B. III only

C. All of the above

D. None of the above

The correct answer is: C)

The lowest point of the volatility smile is usually close to the current exchange rate. If the
exchange rate increases, the volatility smile tends to move to the right; if the exchange rate
decreases, the volatility smile tends to move to the left. Similarly, when the equity price
increases, the volatility skew tends to move to the right, and when the equity price decreases, it
tends to move to the left. For this reason, the volatility smile is often calculated as the
relationship between implied volatility and K=S0 rather than as the relationship between implied
volatility and K.

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Q.1715 Which of the following holds true for equity options smiles?

I. Leverage is identified as one of the main reasons for the smile in equity options
II. It is said that when a company's equity declines in terms of value, the company's leverage
then increases making equity riskier, and its volatility increases
III. It is said that when a company's equity increases in terms of value, the company's leverage
then decreases making equity less risky, and its volatility decreases

A. Both I and II

B. Both I and III

C. None of the above

D. All of the above

The correct answer is: D)

the company’s leverage and equity-value are indirectly correlated, which has an impact on the
equity’s risk and volatility.

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Q.1716 Traders use volatility smiles to allow for non-log-normality when trading call and put
options. Which of the following statements stands TRUE about volatility smiles for equity
options?

I. A volatility smile depicts the relationship between the option’s implied volatility and the
option’s strike price
II. Volatility smiles for equity options are drawn as downward slopes on graphs
III. Volatility smiles show that out-of-the-money calls tend to have higher implied volatility as
compared to in-the-money calls
IV. Volatility smiles show that in-the-money puts tend to have higher implied volatility as
compared to out-of-the-money puts

A. I and II

B. III and IV

C. All of the above

D. None of the above

The correct answer is: A)

Statement I is correct. A volatility smile defines the relationship between the implied volatility of
an option and its strike price.

Statement II is correct. For equity options, the volatility smile tends to be downward sloping.
(Refer to the image at the bottom of the page.)

Statement III and IV are incorrect. In-the-money calls and out-of-the-money puts tend to have
high implied volatilities whereas out-of-the-money calls and in-the-money puts tend to have low
implied volatilities. (Again, refer to the image at the bottom of the page.)

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Q.1717 Volatility surfaces (the implied volatility as a function of strike price and time to maturity)
are used as pricing tools by traders when dealing with options. Which of the following
statements defines volatility surface CORRECTLY?

A. When volatility smiles and volatility term structures are combined, they produce a
volatility surface

B. When volatility frowns and volatility term structures are combined, they produce a
volatility surface

C. When volatility smiles and volatility slopes are combined, they produce a volatility
surface

D. None of the above

The correct answer is: A)

Volatility surfaces combine volatility smiles with the volatility term structure to tabulate the
volatilities appropriately.

Q.2860 A foreign currency is valued at $1.73. The foreign currency has a European call option
market price of 0.135 and a strike price of $1.60. In the US, the risk-free interest rate is 7% per
annum and 16% per annum in the foreign country. Determine the price of a European put option
with a 1-year maturity for the foreign currency.

A. $0.254

B. $0.153

C. $0.548

D. $0.004

The correct answer is: B)

The price of a European put option with a strike price of $1.60 and 1-year maturity must satisfy
the following equation:
p + S0 e−qT = c + Ke−rT

From the question, we are provided that:

S0 = $1.73, q =16%, T = 1, c = 0.135, K = $1.60 and r = 7%

Therefore:
p + 1.73 × e−0.16×1 = 0.135 + 1.6e−0.07×1
⇒ p = 0.153

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Q.2862 Suppose that a small-cap stock is priced at $0.6560. Suppose further that the European
call and put options computed by Black-Scholes-Merton model are $0.0249 and $0.0501
respectively. Compute the market price of a FEB $0.75 call option if the market price of a FEB
$0.75 put option is $0.0317.

A. $0.0065

B. $0.0025

C. $0.0337

D. $0.0654

The correct answer is: A)

For the Black-Scholes-Merton model and in the absence of arbitrage opportunities, the put-call
parity satisfies:
pBS + S0 e−qT = cBS Ke−rt

For the market prices, put-call parity holds when arbitrage opportunities are absent such that:
pMKT + S0 e−qT = cMKT Ke−rt

The difference between the two equations is:

pBS − pMKT = cBS − cMKT

From the question we have that:

cBS = 0.0249, pBS = 0.051 and pMKT = 0.0317

Thus:
0.0501 − 0.0317 = 0.0249 − cMKT
⇒ cMKT = 0.0065

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Q.2863 Which of the following condition are necessary for an asset price to have a lognormal
distribution?

I. The asset should have a varying volatility

II. The price of the asset should change smoothly with no jumps
III. The volatility of the asset should be constant

A. I and II

B. I and III

C. II and III

D. All of the above

The correct answer is: C)

Although not usually the case in practical situations, for an asset price to have a lognormal
distribution, the volatility of the asset should not vary and be constant and the change in the
asset price should be smooth without jumps.

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 Reading 76: Fundamental Review of the Trading Book

Q.2362 What’s the number of days of stressed market conditions required for the calculation of
the stressed VaR?

A. 90

B. 150

C. 250

D. 360

The correct answer is: C)

Basel II.5 required banks to calculate a stressed VaR measure in addition to the current measure.
As explained in Chapter 19, this is VaR where calculations are based on the behavior of market
variables during a 250-day period of stressed market conditions. To determine the stressed
period, banks were required to go back through time searching for a 250-day period that would
be particularly difficult for the bank's current portfolio.

Q.2363 In May 2012, the Basel Committee on Banking Supervision issued a consultative
document referred to as the Fundamental Review of the Trading Book (FRTB). FRTB requires the
changes to market variables (referred to as shocks) to be the changes that would take place (in
stressed market conditions) over certain periods of time, referred to as liquidity horizons. The
following are acceptable time frames, EXCEPT:

A. 10 days

B. 20 days

C. 60 days

D. 140 days

The correct answer is: D)

When implementing Basel I and Basel II.5, banks typically consider one-day changes in market
variables so that a one-day VaR is calculated, and then multiply this VaR by the square root of 10
to obtain an estimate of the 10-day VaR. FRTB requires the changes to market variables (referred
to as shocks) to be the changes that would take place (in stressed market conditions) over
periods of time that reflect the differing liquidities of market variables. The periods of time are
referred to as liquidity horizons. Five different liquidity horizons are used: 10 days, 20 days, 40
days, 60 days, and 120 days.

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Q.2364 The December 2014 consultative document by the Basel Committee defined an approach
for implementing varying liquidity horizons in which market variables were divided into
categories. What is the criterion used to place the variables into categories?

A. Length of time horizons

B. Severity of change

C. Size of market

D. Type of product

The correct answer is: A)

One simple approach to implementing varying liquidity horizons would be to use overlapping
time periods. This type of approach was originally considered by the Basel Committee, but in the
December 2014 consultative document, it was rejected in favor of an approach where all
calculations are based on the changes in market variables over 10-day overlapping periods.

Category 1 Variables: Variables with a time horizon of 10 days

Category 2 Variables: Variables with a time horizon of 20 days
Category 3 Variables: Variables with a time horizon of 60 days
Category 4 Variables: Variables with a time horizon of 120 days
Category 5 Variables: Variables with a time horizon of 250 days

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Q.2365 Banks sometimes find it difficult to search for past stressed periods using all market
variables because of a shortage of historical data for some of the variables. The Fundamental
Review of Trading Book (FRTB) allows the stressed period calculations to be based on a subset of
market variables and the results scaled up by the ratio of the expected shortfall for a number of
recent months. What’s the exact number of months as defined by the FRTB?

A. 1

B. 3

C. 6

D. 12

The correct answer is: D)

In practice, banks sometimes find it difficult to search for past stressed periods using all market
variables because of a shortage of historical data for some of the variables. The FRTB, therefore,
allows the stressed period calculations to be based on a subset of market variables and the
results scaled up by the ratio of the expected shortfall for the most recent 12 months using all
market variables to the expected shortfall for the most recent 12 months using the subset of
market variables. (The subset of market variables must account for 75% of the expected
shortfall.)

Q.2366 In May 2012, the Basel Committee on Banking Supervision issued a consultative
document referred to as the Fundamental Review of the Trading Book (FRTB). According to
FRTB, there are several categories of market variables. Which of the following is NOT one of
them?

A. Equity risk

B. Commodity risk

C. Volatility risk

D. Foreign exchange risk

The correct answer is: C)

Volatility risk does not form part of market variables. The market variables are divided into a
number of risk categories – (nterest rate risk, equity risk, foreign exchange risk, commodity risk,
and credit risk.

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Q.2367 The Fundamental Review of Trading Book (FRTB) proposes back-testing be done using a
VaR measure calculated over a certain horizon and the most recent 12 months of data. What’s
the exact time horizon used?

A. Thirty-day horizon

B. Seven-day horizon

C. Two-day horizon

D. One-day horizon

The correct answer is: D)

The FRTB proposes back-testing be done using a VaR measure calculated over a one-day horizon
and the most recent 12 months of data. (This is because it is difficult to back-test a 10-day
expected shortfall directly and not possible to back-test stressed VaR or stressed ES.)

Q.2368 Which of the following presents FRTB's (Fundamental Review of the Trading Book)
proposed change during the measurement of market risk capital?

A. VaR at 99% confidence

B. VaR at 99.99% confidence

C. Expected shortfall with a 97.5% confidence level

D. Expected shortfall with a 99% confidence level

The correct answer is: C)

The Basel I calculations of market risk capital were based on a value at risk (VaR) calculated for
a 10-day horizon with a 99% confidence level.
The FRTB is proposing a change to the measure used for determining market risk capital.
Instead of VaR with a 99% confidence level, expected shortfall (ES) with a 97.5% confidence
level is proposed.

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Q.2369 The Fundamental Review of Trading Book (FRTB), among other things, defines the type
of instruments which should be put either in the trading or the banking book. Which instruments
are marked-to-market?

A. Instruments in the trading book

B. Instruments in the banking book

C. Instruments in both the banking and the trading books

D. None of the above

The correct answer is: A)

The FRTB addresses the issue of whether instruments should be put in the trading book or in the
banking book. Roughly speaking, the trading book consists of instruments that the bank intends
to trade. The banking book consists of instruments that are expected to be held to maturity.
Instruments in the trading book are marked-to-market (i.e., revalued) daily while
instruments in the banking book are not.

Q.2370 According to the Fundamental Review of Trading Book (FRTB), the instruments in the
trading book are subject to:

A. Credit risk capital

B. Market risk capital

C. Operational risk capital

D. Both credit and market risk capital

The correct answer is: B)

Instruments in the banking book are subject to credit risk capital while those in the trading book
are subject to market risk capital.

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Q.2371 Basel II.5 introduced the incremental risk charge (IRC), while the Fundamental Review
of Trading Book (FRTB) provides a modification of the IRC by recognizing that for instruments
dependent on the credit risk of a particular company, two types of risk can be identified. These
are:

A. Downgrade risk and jump-to-default risk

B. Downgrade risk and credit spread risk

C. Credit spread risk and jump-to-default risk

D. Credit spread risk and liquidity risk

The correct answer is: C)

Basel II.5 introduced the incremental risk charge (IRC) to ensure that banks did not reduce
capital requirements by choosing the trading book over the banking book for a credit-dependent
instrument. The FRTB provides a modification of the IRC. It recognizes that for instruments
dependent on the credit risk of a particular company, two types of risk can be identified:

1. Credit spread risk: This is the risk that the company's credit spread will change, causing
the mark-to-market value of the instrument to change.
2. Jump-to-default risk: This is the risk that there will be a default by the company. Typically
this leads to an immediate loss or gain to the bank.

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Q.2998 Billow Bank has sometimes been finding it difficult to search for past stressed periods
using all market variables. This fact can be attributed to a shortage of historical data for some of
the variables. How does the Fundamental Review of Trading Book (FRTB) deal with this
challenge?

A. The FRTB can allow the stressed period computations to be based on a subset of
market variables and the results scaled up by the ratio of the expected shortfall for the
latest 12 months using all variables to the expected shortfall for the latest 12 months
using the subset of the market variables.

B. An intervention at an early stage by supervisors should prevent capital from falling

below the necessary minimum levels to support a particular bank’s risk characteristics,
and a rapid remedial action should be required in case capital is not maintained or
resorted

C. The bank should possess a process for assessing the its overall capital adequacy
relative its strategy for capital level maintenance and risk profile

D. All the above

The correct answer is: A)

To easily search for past stressed periods using all market variables, the calculation of stressed
periods can be based on a subset of market variables and the results scaled up by the ratio of
expected shortfall for the latest 12 months using all variables to the expected shortfall for the
past 12 months using the subset of market variables.

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Q.2999 Which of the following reasons best explains why the Fundamental Review of the Trading
Book (FRTB) proposes that back-testing should be done by applying a VaR measure computed
over a one-day horizon and the latest 12 months of data?

A. This is due to the difficulty in directly backtesting a 10-day expected shortfall and
impossible to back-test stressed VaR or stressed ES

B. The events of a contractual default, acceptable remedies, and opportunities for a

default to be cured, should be well defined in the FRTB. Therefore, termination rights
should also be included in agreements

C. The reasonability of the proposed limitations compared to the institution’s risks in case
of performance failure by the service provider should be ascertained by the senior
management and the Board of Directors in the institution

D. None of the above

The correct answer is: A)

It would be quite difficult for a 10-day expected shortfall to be directly back-tested and also
impossible to back-test stressed VaR or stressed ES.

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Q.4020 In January 2016, the Basel Committee on Banking Supervision (BCBS) issued a revised
framework for Market risk Capital Requirements in part informed by the mass failure of banks
following the 2007-2009 financial crisis. That framework has been widely referred to as the
Fundamental Review of the Trading Book (FRTB). Compared to Basel I and Basel II.5, each of the
following is true about the FRTB EXCEPT which is false?

A. Under Basel I and Basel II.5, market risk capital calculations were based on value at
risk (VaR) with a 99.0% confidence level, but the FRTB requires calculations based on
expected shortfall (ES) with a 97.5% confidence level

B. Under Basel I regulations, banks were required to calculate market risk capital based
on a value at risk calculated for a 10-day horizon with a 99% confidence interval

C. Under Basel II.5, banks had to add a stressed VaR measure to the current value at
risk, both calculated based on a 10-day horizon.

D. Under Basel I and II.5 market risk capital was based on a 10-day time horizon, but the
FRTB uses five different horizons (10, 20, 40, 60, and 120 days) depending on the
liquidity of the market variable

The correct answer is: C)

Basel II.5 regulations required banks to add a stressed VaR measure to the current value
captured with the 10-day VaR. But unlike the VaR, the stressed VaR used a 250-day period. The
purpose of the stressed VaR was to measure the behavior of market variables during a 250-day
period of stressed market conditions.

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Q.4021 In the past, a lack of a clear distinction between the regulatory banking book and the
trading book created an opportunity for regulatory arbitrage. The FRTB attempts to make the
distinction between the trading book and the banking book clearer and less subjective. Which of
the following is FALSE with regard to the FRTB's treatment of the boundary between the two
books?

A. The FRTB establishes a more objective boundary between the regulatory banking and
trading book and severely restricts subsequent movement between the books unless
under extraordinary circumstances

B. Under FRTB, there must be a sincere intent to trade if an asset has to be included in
the trading book

C. FRTB subjects the trading book and banking book to the same set of capital
requirements so as to mitigate regulatory arbitrage

D. In an attempt to further mitigate regulatory arbitrage, FRTB distinguishes two types of

credit risk exposure to a company: credit spread risk and jump-to-default risk

The correct answer is: C)

FRTB recognizes that differences in capital requirements between the trading book and banking
book may give rise to regulatory arbitrage, but it does not propose harmonization of these
requirements as a way to mitigate this risk. Instead, FRTB attempts to establish a clearer
boundary between the two books to make it difficult for banks to misallocate assets.

A, B, and D are all true

Q.4022 Which of the following is not a component of the standardized approach to calculating
regulatory capital for banks under market risk measurement and management.

A. A risk charge calculated using a risk sensitivity approach

B. A residual risk add-on

C. A default risk charge

D. Insolvency risk charge

The correct answer is: D)

Under the standardized approach, the capital requirement is the simple sum of three
components: Risk charges under the sensitivities based method, a default risk charge, and a
residual risk add-on.

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Q.4023 Bank of Baroda has the following taken the following positions:

$100 million in a corporate bond with credit quality of A

$40 million credit default swap but protection on the same issuer

Determine the default risk charge. Assumptions:

There’s zero profit/loss on each exposure, and

The LGD for senior debt is 75%.

Single A credits have a risk weight of 3%

A. $1.50m

B. $2.20m

C. $1.05m

D. $3.30m

The correct answer is: C)

First, we calculate jump to default (JTD) for each position:

J T D (long) = 0.75 ∗ $100million = $75m

JT D (short) = $40m

Next, we determine the net JTD:

N et JT D = $75m − $40m = $35m (long)

Next, we multiply the net JTD by the risk weight to determine the default risk charge:

Default risk charge = $35m ∗ 3% = $1.05m

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Q.4024 Which of the following entities should apply the simplified standardized approach while
calculating their market risk capital?

A. Large systematically important banks (SIBs)

B. Small banks with a low concentration of trading book activity

C. Central banks

D. Banks heavily invested in securitized assets

The correct answer is: B)

In June 2017, the Basel committee put forward a consultative document outlining a simplified
version of the standardized approach for use by small banks. Eligible users are banks with a low
concentration of trading book activity, or those with insufficient infrastructure to successfully
implement the sensitivities-based method.

Q.4025 Under FRTB, the term liquidity horizon represents "the time required to sell a financial
instrument or hedge all its material risks, in a stressed market, without materially affecting
market prices." All of the following liquidity horizons have been proposed by the Basel
Committee under the FRTB framework EXCEPT:

A. 10 days

B. 30-days

C. 60 days

D. 120 days

The correct answer is: B)

Researchers and the Basel Committee on Supervision agree that a uniform 10-day liquidity
horizon as originally proposed in Basel regulations is inappropriate because it is nearly
impossible for banks to exit all risk positions within a 10-day period due to market illiquidity. As
such, five different liquidity horizons have been proposed: 10 days, 20 days, 60 days, 120
days, and 250 days. For example, the calculation of regulatory capital for a 120-day horizon
(essentially 6 months' worth of trading days) is intended to shield a bank from significant risks
while waiting six months to recover from underlying price volatility

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Q.4026 Under Basel I regulations, banks were required to calculate market risk capital based on
a     calculated for a     horizon with a     confidence interval.

A. Value at risk; 250-day; 99.5%

B. Value at risk; 10-day; 99%

C. Expected shortfall; 10-day; 99.9%

D. Expected shortfall; 10-day; 95%

The correct answer is: B)

Under Basel I regulations, banks were required to calculate market risk capital based on a value
at risk calculated for a 10-day horizon with a 99 % confidence interval. This process
generated a very "current" VaR because the 10-day horizon incorporated a recent period of time,
typically one to four years.

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Q.4027 Under the standardized approach, the capital requirement is the simple sum of three
components: risk charges under the sensitivities based method, a default risk charge, and a
residual risk add-on. Which of the following is not a risk class as defined under the sensitivities-
based method.

A. General interest rate risk

B. Foreign exchange risk

C. Commodity risk

D. Funding risk

The correct answer is: D)

Under the first component (risk charges under the sensitivities based method), seven risk classes
(corresponding to trading desks) are defined:

General interest rate risk,

Foreign exchange risk,

Commodity risk,

Equity risk,

Credit spread risk – non securitization,

Credit spread risk – securitization,

Credit spread risk – securitization correlation trading portfolio

For each of these classes, a delta risk charge, vega risk charge, and curvature risk charge are
calculated.

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Q.4028 Under FRTB, the term liquidity horizon refers to:

A. The time taken to find a willing buyer for a security or commodity

B. The time taken to successfully execute a sale transaction that guarantees a minimum
level of profit

C. The time it takes to buy a security or commodity

D. The time required to sell a security in a stressed market, without materially affecting
market prices

The correct answer is: D)

Under FRTB, the term liquidity horizon represents "the time required to sell a financial
instrument or hedge all its material risks, in a stressed market, without materially affecting
market prices."

Q.4029 One of the issues extensively addressed in FRTB has much to do with regulatory
modifications with respect to the trading book and banking book. Which of the following is a
major reason behind these modifications?

A. Internal fraud

B. Default risk

C. Interest rate risk

D. Regulatory arbitrage

The correct answer is: D)

Modifications to the trading book and banking book are largely informed by the need to stump
out regulatory arbitrage. This is a situation where firms take advantage of the fact that the
capital needed with respect to each book differs. As such, some banks may attempt to allocate
instruments to the book that results in the most favorable capital requirements. For example,
some banks are on record for holding credit-dependent instruments in the trading book because
by so doing, they are subject to less regulatory capital than they would be if they had been
placed in the banking book.

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Q.4030 To allocate an asset to the trading book, FRTB proposes two major conditions:

I. bank must be able to trade the asset, and physically manage the associated risks of the
underlying asset on the trading desk.
II. asset must be traded on an exchange
III. The day-to-day price fluctuations must affect the bank’s equity position and pose a risk to
bank solvency.
IV. There must be significant default risk on the part of the obligor

A. I and IV

B. II and III

C. I and III

D. IIV only

The correct answer is: C)

FRTB has attempted to make the distinction between the banking book and the trading book
clearer and less subjective. To be allocated to the trading book, the bank must demonstrate more
than an intent to trade. Precisely, some two criteria must be met:

1. The bank must be able to trade the asset, and physically manage the associated risks of
the underlying asset on the trading desk.
2. The day-to-day price fluctuations must affect the bank’s equity position and pose a risk to
bank solvency.

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Q.4031 Which of the following approaches should banks use to compute capital with respect to
assets held under a securitization business model?

A. Internal models approach

B. Standardized approach

C. Advanced measurement approach

D. Revised internal models approach

The correct answer is: B)

Basel II.5 introduced the Comprehensive Risk Measure (CRM) charge to cover the risks in
securitized assets such as asset-backed securities and collateralized debt obligations. Under
Basel II.5 guidelines, a bank (with regulatory approval) is free to use its own models to
determine the CRM charge.

Through the FRTB, the Basel Committee is of the view that this is unsatisfactory because it

results in too much variation in the capital charges calculated by different banks for the same

portfolio. Therefore, FRTB requires banks to use the standardized approach for securitizations.

Q.4032 Richard Glen, FRM, is evaluating market capital requirements for Exim Bank. He starts
by comparing the trading desk’s 1-day static value-at-risk measure (calibrated to the most recent
12 months’ data, equally weighted) at both the 97.5th percentile and the 99th percentile, using
two years of current observations of the desk’s one-day P&L. The desk experiences 13 exceptions
at the 99th percentile and 32 exceptions at the 97.5th percentile. Based on the results, which of
the following models should Exim bank use to determine its capital needs going forward?

A. Internal models approach

B. Standardized approach

C. Advanced measurement approach

D. Revised internal models approach

The correct answer is: B)

Use of the internal models approach is conditioned on an experience of not more than 12
exceptions at 99% or not more than 30 exceptions at 97.5% in the most recent 12 month period.
Otherwise, all positions must be capitalized using the standardized approach. Positions must
continue to be capitalized using the standardized method until the desk no longer exceeds the
above thresholds over the prior 12 months.

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Q.4033 A bond portfolio, currently worth $500 million in assets, has a probability of default of
3%. An analyst evaluates the risk of the portfolio using a 95% value at risk (VaR) and a 95%
expected shortfall (ES). Which of the following is correct?

A. The VaR shows no loss while the expected shortfall shows a $500 million loss.

B. Both measures will show the same result.

C. The VaR shows no loss while the expected shortfall shows a $300 million loss.

D. The VaR shows a loss of $300 million while the expected shortfall shows no loss.

The correct answer is: C)

The VaR measure would show a $0 loss because the probability of default is less than 5%. A 3%
probability of default implies that three out of five times, in the tail, the portfolio will experience
a total loss. The potential loss is $300 million (= 3/5 × $500million) .

Q.4034 During a workshop set up by a banking regulator regarding market capital calculations,
an intern makes the following statements regarding the differences between Basel I, Basel II. 5,
and the Fundamental Review of the Trading Book (FRTB). Which statement is incorrect?

A. Both Basel I and Basel II. 5 require calculation of VaR with a 99% confidence interval.

B. FRTB requires the calculation of expected shortfall with a 97.5% confidence interval.

C. FRTB requires adding a stressed VaR measure to complement the expected shortfall
calculation.

D. The 10-day time horizon for market risk capital proposed under Basel I incorporates a
recent period of time, which typically ranges from one to four years.

The correct answer is: C)

Under FRTB proposals banks no longer have to combine the 10-day VaR and the 250-day
stressed VaR risk measures. Instead, they are required to calculate capital based exclusively on
expected shortfall using a 250-day stressed period. However, banks have retained the freedom to
self-select a 250-day window of exceptionally difficult financial stress.

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Q.4035 Which of the following risks is specifically recognized by the incremental risk
charge(IRC)?

A. Jump to default risk

B. Interest rate risk

C. Foreign exchange risk

D. Equity price risk

The correct answer is: A)

The two types of risk recognized by the incremental risk charge are: (1) credit spread risk, and
(2) jump-to-default risk. Credit spread risk can be addressed by calculating the expected
shortfall, while Jump-to-default risk is measured by 99% VaR and not 97.5% expected shortfall.

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