Question #1 of 80 Question ID: 1360337

Money managers are routinely evaluated using a wide array of performance analysis
tools. Examples of risk-adjusted performance measures include Sharpe's measure,
Treynor's measure, Jensen's alpha, and the information ratio. Which of the following
statements regarding these performance analysis measures is most likely correct?

A) The information ratio (IR) is the ratio of annual return to risk.

B) The CAPM assumes the alpha (regression intercept) is positive.

A signi cant t-statistic requires a smaller alpha relative to its standard deviation, as
C)
well as fewer observations.

D) Superior performance, as shown by the Sharpe ratio, implies a negative alpha.

Explanation

The information ratio is the ratio of annual return to risk. As per the CAPM, alpha
should be zero. A significant t-statistic requires a higher alpha relative to its
standard deviation and many observations. Superior performance, as per the
Sharpe ratio, implies a positive alpha.

(Book 5, Module 87.2, LO 87.b)

Question #2 of 80 Question ID: 1360305

Shay Gebay is a credit analyst at a credit rating agency. Gebay is expecting a very
significant economic downturn due to a viral outbreak. She is worried that the senior
executives of several of her portfolio institutions have not experienced very large
losses in the past and therefore may underestimate the amount of potential losses
related to the outbreak. Which behavioral bias best describes her concern?

A) Availability bias.

B) Anchoring bias.

C) Context bias.

D) Inexpert opinion.

Explanation
Availability bias relates to an expert's lack of experience dealing with very large
losses in the past; therefore, the expert may underestimate the frequency and
amount of loss related to a specific event or large shock.

Anchoring bias occurs if an expert limits the range of a loss estimate, given the
expert's own experiences or knowledge of prior loss events. Context bias occurs
when the way a question is framed influences the responses. Inexpert opinion
relates to a scenario when top experts are unavailable to join a workshop, and the
workshop then attracts more junior experts.

(Book 3, Module 41.2, LO 41.d)

Question #3 of 80 Question ID: 1360330

Quantitative Equity Design (QED) is a quantitative equity fund manager. QED forecasts
monthly alphas for stocks in its 3,000 stock universe. The number of independent
forecasts made on a monthly basis is 25. If the model employed by QED has an
information coefficient of 0.15, the information ratio for QED is closest to:

A) 0.75.

B) 2.60.

C) 28.46.

D) 45.00.

Explanation

Under the fundamental law of active management, the information ratio can be
explained by two major components: breadth and the information coefficient.
Breadth is the number of independent forecasts of alpha made in a year. Therefore,
the breadth is 300 (= 25 × 12). The equation for the information ratio under the
fundamental law of active management is:

IR ≈ IC × √BR = 0.15 × √25 × 12 = 2.598 ≈ 2.60

(Book 5, Module 82.1, LO 82.d)

Question #4 of 80 Question ID: 1360317

Callahan, Inc. (Callahan), has a return on assets of 7%, total assets of $5 million, and
equity financing of $2 million. Its cost of debt is 3%. If Callahan decides to double its
leverage factor, by how much will its return on equity (ROE) increase?
A) 4%.

B) 7%.

C) 10%.

D) 13%.

Explanation

Current ROE:

Leverage ratio = $5 million / $2 million = 2.5

ROE = (leverage ratio × ROA) – [(leverage ratio – 1) × cost of debt]

= (2.5 × 7%) – [(2.5 – 1) × 3%]

= 17.5% – 4.5%

= 13%

ROE if double leverage:

Leverage ratio = 2.5 × 2 = 5

ROE = (5 × 7%) – [(5 – 1) × 3%)]

= 35% – 12%

= 23%

ROE increase = 23% – 13% = 10%.

(Book 4, Module 62.2, LO 62.d)

Question #5 of 80 Question ID: 1360324

A U.S. bank decides to obtain a short-term loan from the Federal Reserve (the Fed) at
the discount window. The bank will provide acceptable collateral for the loan and
would like to pay the least amount of interest. Which form of discount window
borrowing from the Fed is most appropriate for the bank?

A) Overnight credit.

B) Primary credit.

C) Seasonal credit.

D) Secondary credit.

Explanation
Seasonal credit carries the lowest interest rate, primary (overnight) credit the
second lowest, and secondary credit the highest.

(Book 4, Module 73.1, LO 73.a)

Question #6 of 80 Question ID: 1360309

The Basel II Accord has been recently revised in an attempt to correct potential flaws
and weaknesses. The improved set of regulations is known as Basel III. Somewhat
similar to the Basel banking regulations is the Solvency II framework, which is a
European Union directive for insurance companies. When compared to Basel II/III,
which of the following statements correctly reflects Solvency II? Solvency II:

considers both solvency capital requirements (SCR) and the minimum capital
A)
requirement (MCR).

focuses on credit, operational, and market risk, which includes illiquidity and
B)
concentration risks, and reputational and strategic risks.

C) acknowledges only Level 1 diversi cation bene ts.

D) computes total and Tier 1 capital ratio on a consolidated basis for subsidiaries.

Explanation

Solvency II considers both SCR and MCR. Solvency II also focuses on underwriting
and reserving, asset-liability management, investments, liquidity and concentration,
as well as operational risk, reinsurance, and other risk-reduction methods. Basel
II/III computes total and Tier 1 capital ratio on a consolidated basis for subsidiaries.
Also, with Basel II/III only Level 1 diversification benefits are acknowledged.

(Book 3, Module 53.2, LO 53.g)

Question #7 of 80 Question ID: 1360308

In 2009, the Supervisory Capital Assessment Program (SCAP) allowed U.S. bank
regulators to assess the capital strength of financial institutions. If there was a gap
between what a bank needed in terms of capital and what it had, regulators had to
find a credible way to fill that gap. When comparing stress tests before and after
SCAP, which of the following statements is incorrect?

Post-SCAP focuses on a comprehensive look at the e ect of the stress scenarios on

A)
the institution.
B) Pre-SCAP explicitly focused on capital adequacy.

C) Pre-SCAP focused on earnings shocks instead of revenues and/or costs.

Post-SCAP considers broad macro scenarios and market-wide stresses with multiple
D)
factors.

Explanation

Pre-SCAP typically focused on earnings shocks (i.e., losses), but not on capital
adequacy. Post-SCAP explicitly focuses on capital adequacy.

(Book 3, Module 49.1, LO 49.a)

Question #8 of 80 Question ID: 1291953

A diversified portfolio has a current value of $100,000, a mean of 8%, and a standard
deviation of 15%. What is the approximate difference between the value at risk (VaR)
measures computed using a normal distribution assumption and a lognormal
distribution assumption assuming a 95% confidence level?

A) Lognormal VaR is greater than normal VaR by $1,800.

B) Lognormal VaR is greater than normal VaR by $1,300.

C) Lognormal VaR is less than normal VaR by $1,300.

D) Lognormal VaR is less than normal VaR by $1,800.

Explanation

Normal VaR(5%) = (−8% + 1.65 × 15%) × 100,000 = $16,750

Lognormal VaR (5%) = 100,000 × (1 − exp [0.08 − 0.15 × 1.65])

= 100,000 × (1 − exp [−0.1675])

= $15,422

Thus, lognormal VaR is less than normal VaR by: $16,750 − $15,422 = $1,328.

(Book 1, Module 1.1, LO 1.b)

Question #9 of 80 Question ID: 1360296

Securitization is the process of selling credit-sensitive assets (i.e., debt obligations) to
a third party that subsequently issues securities backed by the pooled cash flows
(principal and interest) of the same underlying assets. In addition, securitization:

produces interest rate risk that is relevant (a matter of concern) for all investors in
A)
mortgage-backed securities.

allows originators of mortgage-backed securities, their conduits, and structured

B) investment vehicles (SIVs) to take excessive risks due to risk transfer
mechanisms.

o ers diversi cation bene ts due to positive correlations in the default risks of
C)
various mortgages.

can address a moral hazard problem if the originating institution holds the senior
D)
tranche.

Explanation

Due to risk transference mechanisms, the seller of mortgage-backed securities may

have incentive to take excessive risk, because if defaults (in underlying mortgages)
occur, the investors bear the losses.

(Book 2, Module 32.1, LO 32.a)

Question #10 of 80 Question ID: 1360304

Which of the following changes would be considered the least likely motivating factor
for banking industry change?

A) Increasing consolidation in the banking industry.

B) Challenges in retaining strong employees.

C) Technological gaps.

D) Stronger regulatory standards.

Explanation

Increasing consolidation in the banking industry would provide less motivation for
banks to change. Motivating factors for banking industry change include (1) growing
competition from new financial industry entrants, (2) difficulties acquiring and
retaining strong employees, (3) technology gaps revealed by trends in artificial
intelligence and digitization, and (4) stronger regulatory standards and public
perception.

(Book 3, Module 39.1, LO 39.a)

Question #11 of 80 Question ID: 1360306

In 2004–2005, a popular strategy in credit markets for hedge funds, banks, and
brokerages was to sell protection on the equity tranche and buy protection on the
junior (i.e., mezzanine) tranche of the investment-grade CDS index (CDX. NA.IG). As a
result, the trade was long credit and credit spread risk on the equity tranche and
short credit and credit spread risk on the mezzanine tranche. Which of the following
statements best describe the nature of this trade?

A) As long as correlations decreased, the trade remained pro table.

B) As long as spreads did not widen, the trade remained pro table.

C) The main motivation for the trade was to achieve a negative convex payo pro le.

D) As long as correlations remained static, the trade remained pro table.

Explanation

The CDX trade benefited from a large change in credit spreads and essentially
behaved like an option straddle on credit spreads with an option premium paid to
the owner of the option. The hedge ratio for the CDX index was around 1.5 to 2 in
early 2005, which resulted in a net flow of spread income to the long equity/short
mezzanine trade.

The critical error in the trade, however, was that it was set up at a specific value of
implied correlation. A static correlation was considered a critical flaw, as the deltas
that were used in setting up the trade were partial derivatives that ignored any
changes in correlation. With changes in credit markets, changing correlations
doubled the hedge ratio to close to 4 by the summer of 2005. As a result, traders
now needed to sell protection on nearly twice the notional value of the mezzanine
tranche to maintain portfolio neutrality. Stated differently, as long as correlations
remained static, the trade remained profitable. However, once correlations declined
and spreads did not widen sufficiently, the trade became unprofitable.

(Book 3, Module 45.2, LO 45.c)

Question #12 of 80 Question ID: 1291955

A hedge fund manager has asked her risk analyst to incorporate nonparametric
methods into their statistical modeling program. The analyst, used to parametric
methods, is concerned about using nonparametric methods. Which of the following
statements would accurately reflect the analyst's concerns?

A) Historical data is a relatively small input to the calculations.

B) Model outputs tend to exhibit positive skewness and fat tails.

C) These methods may be less reliable for newer markets or instruments.

Volatile data periods lead to value at risk (VaR) and expected shortfall (ES) estimates
D)
that are too low.

Explanation

Nonparametric methods are heavily dependent on historical data, which is not

readily available for newer markets or instruments. Given the lack of historical data,
these methods will be less reliable than they would be for more established markets
or instruments. One of the advantages of nonparametric methods is they are not
vulnerable to skewness and fat tails. Volatile data periods lead to VaR and expected
shortfall estimates that are too high (rather than too low).

(Book 1, Module 2.1, LO 2.b)

Question #13 of 80 Question ID: 1360686

In the context of serving as a reliable benchmark, which characteristic does the

secured overnight financing rate (SOFR) possess that the London Interbank Offered
Rate (LIBOR) does not possess?

A) Widespread use.

B) Forward-looking.

C) Deep, liquid market.

D) Incorporation of credit and liquidity risk.

Explanation

SOFR is based on a deep and liquid market, while LIBOR is not. That is a major
advantage of SOFR and a major disadvantage of LIBOR. Because LIBOR has 10
different maturities for a 12-month period, LIBOR is a forward-looking rate. SOFR
only has one maturity (overnight rate) for now and repo transactions are overnight
in nature, thereby making SOFR an overnight, backward-looking rate.

(Book 5, Module 99.1, LO 99.b)

Question #14 of 80 Question ID: 1291967

Using the Vasicek model, assume a current short-term rate of 5.2% and an annual
volatility of the interest rate process of 3.5%. Also assume that the long-run mean-
reverting level is 14.2% with a speed of adjustment of 0.4. Within a binomial interest
rate tree, what are the upper and lower node rates after the first month?

Upper Node Lower Node

A) 6.51% 4.49%

B) 6.51% 6.79%

C) 8.81% 6.79%

D) 8.81% 4.49%

Explanation

Using the Vasicek model, the upper and lower nodes for time 1 are computed as
follows:

(0.4)(14.2%−5.2%) 3.5%
upper node = 5.2% + + = 6.51%
12 √12

(0.4)(14.2%−5.2%) 3.5%
lower node = 5.2% + − = 4.49%
12 √12

(Book 1, Module 13.2, LO 13.f)

Question #15 of 80 Question ID: 1360307

Kimco is a bank holding company (BHC) whose capital resource management and
allocation process is currently being assessed by the Federal Reserve. Which of the
following statements does not accurately describe one of the seven principles that will
be applied to this assessment?

A) Internal controls should be documented and subjected to internal audit.

A process should be in place to estimate potential losses and aggregate them on a

B)
rm-wide basis.

Oversight should be managed by a third-party risk assessor appointed by the

C)
BHC’s board of directors.

Loss estimates and capital resources should be considered in determining the

D)
impact on capital adequacy.
Explanation

There is no principle contained within the capital adequacy process that requires a
third- party risk assessor to be appointed by the BHC's board of directors. The
board should, along with senior management, have oversight over all dimensions of
the internal capital risk plan—but a third-party assessor is not a requirement.
Internal controls should be in place which are subjected to internal audit. The BHC
does need to have a process in place to estimate potential losses and aggregate
them on a firm-wide basis. Also, loss estimates and capital resources should be
considered in determining the impact on capital adequacy.

(Book 3, Module 48.1, LO 48.a)

Question #16 of 80 Question ID: 1360321

A bank's risk manager is examining the impact on the term structure of available
assets (TSAA) and term structure of the liquidity generation capacity (TSLGC) of
various financial transactions. If the bank were to pay cash equal to the asset price
less the haircut in exchange for receiving the asset, what would be the impacts on
TSAA and TSLGC, assuming the asset is not repoed?

TSAA TSLGC

A) Increase Increase

B) Increase No impact

C) No impact Increase

D) No impact No impact

Explanation

The transaction described is a reverse repo. For a reverse repo, the TSAA increases
by the repo's notional amount, while TSLGC is not impacted (unless the asset is
repoed).

(Book 4, Module 67.3, LO 67.e)

Question #17 of 80 Question ID: 1291966

A risk analyst uses a decision tree framework to estimate the price of zero-coupon
bonds. This decision tree framework helps him illustrate how interest rate
expectations determine the shape of the yield curve. The analyst assumes that
investors are risk averse and require a risk premium of 50 basis points for each year
of interest rate risk. What is the price that he should calculate for a 2-year zero-
coupon bond with a face value of $100 using expected 1-year returns in 1-year of 10%
in the up node and 6% in the down node of the decision tree? Assume the 1-year spot
rate is equal to 8%.

A) $85.37.

B) $92.59.

C) $92.17.

D) $85.76.

Explanation

The price of a 2-year zero-coupon bond with a 50 basis point risk premium included
is calculated as:

$100 $100
{[( )+( )]/2}
1.105 1.065 [($90.498+$93.897)/2]
= = $85.37
1.08 1.08

(Book 1, Module 12.1, LO 12.a)

Question #18 of 80 Question ID: 1291954

A risk management consultant with Bank ABC uses profit/loss information from the
previous 1,000 trading days to compute a daily portfolio VaR at the 99th percentile of
$10 million. She is interested in examining the loss data beyond the 99th percentile in
order to estimate the portfolio's expected shortfall. If the losses beyond the VaR
threshold (in millions) were $12, $15, $17, $18, $21, $22, $24, $27, and $51, what is the
expected shortfall for this portfolio?

A) $12 million.

B) $21 million.

C) $23 million.

D) $51 million.

Explanation
The expected shortfall provides an estimate of the tail loss by averaging the VaRs for
increasing confidence levels in the tail. The average of the VaRs beyond $10 million
is $207 / 9 = $23 million.

(Book 1, Module 1.2, LO 1.c)

Question #19 of 80 Question ID: 1360295

A financial institution has stress tested its current exposure using a 40% decline in
equity markets, and it reports to management which counterparties are most
vulnerable to such a large-scale equity market decline. A shortcoming of this stress
test is that it does not:

A) incorporate counterparties’ mark-to-market values.

B) provide information on wrong-way risk.

C) indicate how much the counterparties would owe the nancial institution.

D) incorporate the value of collateral.

Explanation

By stress testing a large-scale equity decline, the financial institution can create a
table of its top counterparties with the largest stressed current exposure, which
includes their credit ratings, mark-to-market values, collateral values, and current
exposures. The table indicates to management which counterparties are most
vulnerable to a large-scale equity market decline and how much the counterparties
would owe the financial institution. However, since the stress test omits information
on the credit quality of the counterparty, it does not provide information on wrong-
way risk.

(Book 2, Module 30.2, LO 30.c)

Question #20 of 80 Question ID: 1360294

An investor has recently purchased several over-the-counter (OTC) puts on the S&P
500 exchange-traded fund (ETF). He uses options to hedge risk and to overweight or
underweight asset classes in an efficient and risk conscious fashion. Which of the
following statements best describe the use of long OTC puts in the context of wrong-
way risk (WWR) and right-way risk (RWR)?

A) Out-of-the-money put options have less WWR than in-the-money put options.

B) Out-of-the-money put options have more WWR than in-the-money put options.
 In-the-money put options do not have any more or less WWR or RWR than out-of-
C)
the-money put options.

A long put option is subject to WWR if both risk exposure and counterparty default
D)
probability decrease.

Explanation

A put option gives the right to the long (buyer) to sell an underlying instrument at a
predetermined price, whereas the short (counterparty) is obligated to buy if the
option is exercised. Thus, out-of-the-money put options have more WWR than in-
the-money put options.

(Book 2, Module 29.3, LO 29.k)

Question #21 of 80 Question ID: 1360298

TRL Security is an asset-backed security supported by a portfolio of three- to five-year

auto loans. Information relating to the receivables underlying TRL and the monthly
principal and interest payments is provided in the following table.

Receivable Category Amounts

Current receivables $35,200,000

Over 30 days past due $4,600,000

Over 60 days past due $2,450,000

Over 90 days past due $905,000

Receivables written off $560,000

Principal and Interest Amounts

Monthly principal
$350,000
payments
Monthly interest
$860,000
payments

A fixed income analyst working for the Bridgeland Fund would like to recommend that
TRL be added to its fund's overall debt portfolio. In providing key ratios to her fund
manager, which of the following statements is most accurate?

A) The default ratio is equal to 1.30%.

B) The monthly payment rate is equal to 0.81%.

C) The constant prepayment rate is equal to 0.82%.

D) The delinquency ratio is equal to approximately 3.39%.

Explanation

The total for receivables is equal to: $43,155,000 ($35,200,000 + $4,600,000 +

$2,450,000 + $905,000).

monthly principal and interest payments equal $1,210,000 ($350,000 + $860,000)

default ratio = $560,000 / $43,155,000 = 1.30%

monthly payment rate (MPR) = $1,210,000 / $43,155,000 = 2.80%

The constant prepayment rate requires a single monthly mortality rate, which is not
given in this question.

The delinquency ratio = $905,000 / $43,155,000 = 2.10%.

(Book 2, Module 33.3, LO 33.g)

Question #22 of 80 Question ID: 1291961

A risk analyst uses the past 600 months of correlation data from the Standard &
Poor's 500 (S&P 500) to estimate the long-run mean correlation of common stocks
and the mean reversion rate. Based on this historical data, the long-run mean
correlation of S&P 500 stocks was 44%, and the regression output estimates the
following regression relationship: Y = 0.334 − 0.79X. Suppose that in July 2017, the
average monthly correlation for all S&P stocks was 37%. What is the estimated one-
period autocorrelation for this time period based on the mean reversion rate
estimated in the regression analysis?

A) 21%.

B) 37%.

C) 56%.

D) 66%.

Explanation

The autocorrelation for a one-period lag is 21% for the same sample. The sum of the
mean reversion rate (79% given the beta coefficient of −0.79) and the one-period
autocorrelation rate will always equal 100%.

(Book 1, Module 8.1, LO 8.b)

Question #23 of 80 Question ID: 1360325

A bank is proposing the use of very short-term repo transactions to earn additional
investment income. Collateral is provided by the borrower, and the haircut is 5%. To
which of the following risks is the bank exposed in the proposed transaction?

A) Counterparty risk.

B) Liquidity risk.

C) Both counterparty risk and liquidity risk.

D) Neither counterparty risk nor liquidity risk.

Explanation

Counterparty risk is the risk of borrower default or nonpayment of its obligations.

Although the repo loan is very short term and secured by collateral and the lender
can recover any amounts owed simply by selling the collateral, counterparty risk still
exists per se.

Liquidity risk is the risk of an adverse change in the value of the collateral. Although
this risk has been reduced with the use of the 5% haircut and the very short term of
the repo, liquidity risk still exists per se.

(Book 4, Module 74.1, LO 74.c)

Question #24 of 80 Question ID: 1291977

Kirkland, Co., is drafting a netting agreement to be used in its derivatives contracts

with their counterparty, Shanty, Inc. A trading analyst for Kirkland is drafting the
agreement and would like to include an exhibit which illustrates the benefit of netting.
The exhibit he plans to include reflects the following table, which depicts four
scenarios regarding two trades.

Mark to Market
Trade 1 Trade 2

Scenario 1 18 4
Scenario 2 12 −3

Scenario 3 8 −5

Scenario 4 −4 7

The netting benefit associated with these trades that will be shown at the bottom of
the exhibit should be closest to:
A) 3.00.

B) 4.25.

C) 7.50.

D) 9.25.

Explanation

The calculation of the netting benefit is shown as follows:

Mark to Market Total Exposure

No Netting
Trade 1 Trade 2 Netting
Netting Benefit

Scenario 1 18 4 22 22 0
Scenario 2 12 −3 12 9 3

Scenario 3 8 −5 8 3 5

Scenario 4 −4 7 7 3 4
EE 12.25 9.25 3

Note that expected exposure (EE) is derived by summing all four values and dividing
by four.

(Book 2, Module 28.2, LO 28.f)

Question #25 of 80 Question ID: 1360293

A derivatives trader is comparing the various wrong-way risk (WWR) modeling

methods. Which of the following models is most likely used to evaluate the historical
link between portfolio exposure and credit spreads?

A) A. Hazard rate approach.

B) B. Structural approach.

C) C. Parametric approach.

D) D. Jump approach.

Explanation
The parametric approach examines the historical link between portfolio exposure
and credit spreads. If high portfolio values are linked to above average credit
spreads it would suggest the presence of WWR. A higher dependency parameter will
indicate a higher CVA. For this method to be reliable, historical data must reflect
current scenarios.

(Book 2, Module 29.3, LO 29.o)

Question #26 of 80 Question ID: 1360326

A newly established bank is attempting to formulate its liquidity transfer pricing

approach. Which method would most likely result in fewer long-term loans being
underwritten?

A) Marginal cost of funds.

B) Pooled average cost of funds.

C) Separate average cost of funds.

D) Zero-cost approach.

Explanation

The maturity-matched marginal cost of funds approach overcomes the

shortcomings of the pooled and separate average cost of funds approaches. The
marginal cost of funds curve is greater than the average cost of funds curve for
long-term assets, which will result in fewer long-term loans being underwritten.

Both the pooled and separate average cost of funds approaches involve assets
being charged the same for liquidity risk, regardless of their maturities. As a result,
longer-term assets, which have greater liquidity risk, are undercharged. Therefore,
both average cost of funds approaches provide incentives for business units to
underwrite more long-term loans.

For the zero-cost approach, the swap curve would represent the cost of funding for
assets and credit for providing funding for liabilities with zero premium or spread
added for liquidity.

(Book 4, Module 75.2, LO 75.c)

Question #27 of 80 Question ID: 1360329

A well-known actively managed mutual fund uses the information ratio (IR) to screen
all investment opportunities. They target an IR of at least 0.60. Two of the junior
analysts have asked for their manager's opinion on how many investment bets the
fund should be placing every year. Analyst 1 thinks that it should be at least 250, but
Analyst 2 thinks that they could achieve their IR goal with less than 25. Their manager
explains to them that the missing puzzle piece is the information coefficient (or
correlation) between the firm's predictions for stocks and the stocks' actual outcomes.
The manager also explains that in order for Analyst 1 to be correct, the information
coefficient could be __________ or lower, while it would need to be at least __________ in
order for Analyst 2 to be right. The manager tells ___________ that their theory is more
conservative.

A) 0.0541; 0.18; Analyst 2.

B) 0.0379; 0.12; Analyst 1.

C) 0.0541; 0.18; Analyst 1.

D) 0.0379; 0.12; Analyst 2.

Explanation

In order for Analyst 1 to be right, the correlation would need to be 0.0379, as shown
below:

0.60 = 0.0379 × √250

In order for Analyst 2 to be right, the correlation would need to be 0.12, as shown
below:

0.60 = 0.12 × √25

The statement by Analyst 1 is more conservative than the statement by Analyst 2.

Placing more investment bets and relying less upon the accuracy of predictions is a
more conservative posture.

(Book 5, Module 82.1, LO 82.d)

Question #28 of 80 Question ID: 1360340

A candidate is interviewing for a data analyst position at a regional bank. The

interviewer has asked the candidate to describe what he knows about machine
learning. Which of the following statements made by the candidate is least accurate?

A) Deep learning models focus on well-de ned and structured datasets.

B) Bootstrapping will involve putting more weight onto scarcer observations.

 Bagging looks to improve a model’s predictive ability by running models on di erent
C)
subsets.

An ensemble groups machine learning models together to improve out-of-sample

D)
predictive abilities.

Explanation

Classic model approaches use well-defined and structured datasets. Deep learning
models look to apply multiple layers of algorithms into the learning process to
identify complex patterns—essentially, looking to mimic the human brain. The
statements regarding bootstrapping, bagging, and ensembles are all correct.

(Book 5, Module 92.1, LO 92.a)

Question #29 of 80 Question ID: 1360682

An analyst is evaluating price distortions in bond markets in early March to April 2020
caused by the COVID-19 crisis. Which of the following statements on arbitrage is most
accurate?

Price distortions disappeared quickly, indicating that arbitrage was not a major
A)
factor in normalizing the market.

Price distortions lasted for a prolonged time, indicating that arbitrage was not a
B)
major factor in normalizing the market.

Price distortions disappeared quickly, indicating the importance of arbitrage in

C)
normalizing the market.

Price distortions lasted for a prolonged time, indicating the importance of arbitrage
D)
in normalizing the market.

Explanation

Price dislocations in debt securities during March and April 2020 caused the prices
of investment grade bonds to diverge from high-yield bond. Market and price
distortions lasted for a prolonged time, which indicates that arbitrage was not a
major factor in normalizing the market.

(Book 5, Module 96.1, LO 96.a)

Question #30 of 80 Question ID: 1360681

Which of the following statements regarding physical and transition risks is correct?

A) They are determined independently but viewed in an interrelated manner.

B) They are determined and viewed independently.

C) They are determined in an interrelated manner but viewed independently.

D) They are determined and viewed in an interrelated manner.

Explanation

Physical and transition risks are generally determined independently due to the
complexity of each risk. After the risk determinations, the two should be viewed as
being interrelated.

(Book 5, Module 95.1, LO 95.b)

Question #31 of 80 Question ID: 1291959

An investor purchases a correlation swap with a fixed correlation rate of 0.3 and a
notional value of $750,000 for one year for a portfolio of four assets. The pairwise
correlations of the daily log returns at maturity for the four assets are shown in the
following table.

Correlation
Asset 1 Asset 2 Asset 3 Asset 4
Matrix
Asset 1 1 0.24 0.61 0.08

Asset 2 0.24 1 0.12 0.36

Asset 3 0.61 0.12 1 0.45

Asset 4 0.08 0.36 0.45 1

What is the payoff at maturity for the swap buyer?

A) $7,500.

B) $217,500.

C) $225,000.

D) $232,500.

Explanation
The realized correlation is calculated using this formula:

2
ρ = ∑ρ
realized 2 i,j
n −n
i>j

Applying the numbers from the question and the correlation matrix, the realized
correlation is equal to:

2
ρ = × (0.24 + 0.61 + 0.08 + 0.12 + 0.36 + 0.45) = 0.31
2
4 −4

The payoff is calculated by taking the difference between the realized correlation
and the fixed correlation and multiplying the notional amount, so the payoff is:
$750,000 × (0.31 − 0.30) = $7,500.

(Book 1, Module 7.2, LO 7.c)

Question #32 of 80 Question ID: 1360312

Revisions to Basel III aim to address the failures in preventing systemic shocks that
severely weakened the global economy during the financial crisis of 2007–2009. Which
of the following statements is incorrect regarding the main goals and impacts of these
Basel III reforms?

A) Introduce a leverage ratio bu er for global systemically important banks (G-SIBs).

Create an output oor that is more robust and risk sensitive than the current Basel
B)
II oor.

Expand the use of internal model approaches for credit risk, credit valuation
C)
adjustment (CVA) risk, and operational risk.

Expand the robustness and sensitivity of the standardized approaches (SA) for
D)
measuring credit risk, CVA risk, and operational risk.

Explanation

The internal ratings-based (IRB) approaches for credit risk proved problematic in
application during the financial crisis due to their complexity, lack of comparability
across banks, and lack of robust modeling of some asset classes. Thus, Basel III
reforms aim to restrict the use of internal model approaches for credit risk, CVA risk,
and operational risk.

(Book 3, Module 55.1, LO 55.a)

Question #33 of 80 Question ID: 1291968

Q Question ID: 1291968

Implied volatility is used to price both call and put options. Which of the following
statements best describes the put-call parity in no-arbitrage equilibrium?

A) c + S = p + PV(X).

B) c + p = S − PV(X).

C) c − PV(X) = S + p.

D) c − p = S − PV(X).

Explanation

Put-call parity indicates that the implied volatility used to price call options is the
same used to price put options. This is the no-arbitrage equilibrium relationship for
European call and put option prices:

c − p = S − PV(X)

where:

c = price of call option

p = price of put option

S = price of underlying security

PV(X) = present value of the strike price

(Book 1, Module 15.1, LO 15.b)

Question #34 of 80 Question ID: 1360316

A portfolio manager is attempting to determine the cost of liquidation of a specific

holding in a stressed market. The manager holds 50,000 shares of Lear, Inc. (Lear),
with bid and offer prices of $22.20 and $23.10, respectively. The standard deviation of
the bid-offer spread (assumed normal distribution) is $1.70. The cost of liquidation of
Lear at a 95% level of confidence (1.645 z-score for one-tail and 1.96 z-score for two-
tail) is closest to:

A) $69,900.

B) $92,400.

C) $105,800.

D) $184,800.

Explanation
Bid-offer spread = $23.10 – $22.20 = $0.90

Mid-market price = ($22.20 + $23.10) / 2 = $22.65

Mid-market value = $22.65 × 50,000 = $1,132,500

Mean, proportional bid-offer spread = $0.90 / $22.65 = 0.039735

Standard deviation, proportional bid-offer spread = $1.70 / $22.65 = 0.075055

Cost of liquidation = [$1,132,500 × (0.039735 + (1.645 × 0.075055)] / 2 = $92,412.

(Book 4, Module 61.1, LO 61.a)

Question #35 of 80 Question ID: 1291974

A trader is pricing a derivatives contract with Lakeland Brothers, Inc., and has set a
benchmark return of 4.75%, which equates to the credit value adjustment (CVA). In
deriving the CVA for this contract, the trader has likely accounted for all of the
following components except:

A) existing hedging positions.

B) the default probability for Lakeland.

C) the impact net of existing transactions with Lakeland.

D) the expected return on the contract from the perspective of the trader.

Explanation

While the CVA calculation will account for existing hedging positions, Lakeland's
default probability, and the impact net of existing transactions with Lakeland, the
expected return on the contract from the trader's perspective is not a component of
the CVA calculation.

(Book 2, Module 25.2, LO 25.f)

Question #36 of 80 Question ID: 1360683

Stressed market conditions in February and March 2020 resulted in what impact on
government bond yields in countries such as the United States and Germany?

A) Sharp decrease.

B) Moderate decrease.
C) Sharp increase.

D) Moderate increase.

Explanation

The stressed market conditions during the time led investors to desire greater
safety and liquidity. The result was a sharp decrease in government bond yields that
accounted for both lower term premiums and the expectation of many central
banks to lower their policy rates (e.g., closer to zero in some developed countries).

(Book 5, Module 97.1, LO 97.a)

Question #37 of 80 Question ID: 1360328

An investor's portfolio comprises of only two assets. Asset 1 has losses when the
markets perform poorly. Asset 2 has a low beta. Holding the capital asset pricing
model's (CAPM) assumptions true, which of the following statements is most
accurate?

A) Asset 1 has a low beta.

B) Asset 2 has a high risk premium.

C) Asset 1’s risk premium is greater than asset 2’s risk premium.

D) Asset 2’s beta is higher than asset 1’s beta.

Explanation

Under the CAPM, investors receive risk premiums for holding the asset in bad times.
Since the market portfolio is the risk factor, bad times indicate low market returns.
Asset 1 has losses during periods when the markets perform poorly. This indicates a
high sensitivity to market movements; therefore, asset 1 has a high beta and high
risk premium. Asset 2 is a low beta asset, which has a positive payoff when the
market performs poorly, making it valuable to investors and resulting in a low risk
premium (investors require less compensation to hold this asset). Therefore, the
asset 1 beta and risk premium should exceed the asset 2 beta and risk premium.

(Book 5, Module 80.1, LO 80.a)

Question #38 of 80 Question ID: 1291957

Assume that an equity portfolio has 3,000 stocks. Each stock has a market risk
component and a firm-specific component. If each stock has a corresponding risk
factor, how many covariance terms would be needed to evaluate the correlation
between each risk?

A) 1.5 million.

B) 3.0 million.

C) 4.5 million.

D) 9.0 million.

Explanation

4.5 million covariance terms would be needed (i.e., [3,000 × (3,000 − 1)] / 2 =
4,498,500) to evaluate the correlation between each risk factor.

(Book 1, Module 5.1, LO 5.b)

Question #39 of 80 Question ID: 1291971

In the context of waiting for a company to default, the rate parameter, λ, in the
exponential distribution function is known as the hazard rate. This parameter
indicates the rate at which company defaults will arrive. Given a hazard rate of 0.12,
what is the conditional default probability given survival until time 2?

A) 0.2134.

B) 0.8869.

C) 0.1131.

D) 0.1003.

Explanation

Given a hazard rate of 0.12, the cumulative PD at time 1 would be: 1 − e−0.12(1) =
0.1131. Thus, the survival probability would equal: 1 − 0.1131 = 0.8869. The
cumulative PD at time 2 would be: 1 − e−0.12(2) = 0.2134. Thus, the PD from time 1 to
time 2 equals: 0.2134 − 0.1131 = 0.1003. The conditional PD given survival until time
2 is computed as PD(from time 1 to time 2) / survival probability at time 1 = 0.1003 /
0.8869 = 0.1131.

(Book 2, Module 22.2, LO 22.f)

Q i #40 f 80
Question #40 of 80 Question ID: 1291973

Bank XYZ has a credit portfolio with 1,000 credit positions that has a total value of $1
million. The default probability for each position is 0.5%, the estimated recovery rate
is zero, and the default correlation is zero. The 99th percentile of the number of
defaults is 11. Using a confidence level of 99%, the credit value at risk (VaR) of this
portfolio is approximately:

A) $1,000.

B) $5,000.

C) $6,000.

D) $11,000.

Explanation

The 99th percentile of the credit loss distribution is $11,000 [11 × ($1,000,000 /
1,000)]. The expected loss is $5,000 ($1,000,000 × 0.005). The credit VaR is then
$6,000 ($11,000 − expected loss of $5,000).

(Book 2, Module 23.1, LO 23.c)

Question #41 of 80 Question ID: 1291969

To differentiate solvency from default, an analyst is applying linear discriminant

analysis to calculate a Z-score cutoff using information in the following table.

Data Item Data

Current cutoff point 1.00
Average default rate 3.15%

Current assessment of loss given

38%
default
Opportunity cost 12%

The adjustment needed to the Z-score cutoff is closest to:

A) 2.27.

B) 3.27.

C) 4.58.

D) 5.58.

Explanation
The formula to calculate the Z-score cutoff adjustment using linear discriminant
analysis (LDA) is as follows:

q ×COSTsolv/insolv
⎛ solv ⎞ 96.85%×12%
ln = ln ( ) = 2.27
⎝ qinsolv ×COSTinsolv/solv ⎠ 3.15%×38%

The adjustment needed is 2.27, and when added to the current cutoff point of 1.00,
the new cutoff score will be 3.27.

(Book 2, Module 20.2, LO 20.i)

Question #42 of 80 Question ID: 1360320

A bank liquidity manager is focused on examining factors such as public confidence,

central bank borrowings, and commitments to credit customers. Which approach to
estimating liquidity requirements is the manager most likely using?

A) Discipline of the nancial marketplace.

B) Liquidity indicator.

C) Sources of uses.

D) Structure of funds.

Explanation

The discipline of the financial marketplace (market signals) approach is essentially a

method where a sufficient liquidity position is only gauged by market signals
indicating whether or not that level has been reached. Market signals applicable to
this approach include the following: public confidence, institution's stock price, lost
sales of assets, risk premiums on borrowings, central bank borrowings, and
commitments to credit customers.

The liquidity indicator approach looks at ratios to estimate liquidity needs based on
industry averages and experience—some ratios with a higher output indicate higher
liquidity, and some ratios with a higher value indicate lower liquidity.

The sources of uses approach is based on liquidity changes due to deposits and
loans.

The structure of funds approach divides sources of funds into three categories
based on the likelihood that they will be withdrawn and no longer available to the
bank.

(Book 4, Module 65.2, LO 65.c)

Q estion #43 of 80
Question #43 of 80 Question ID: 1360335

A risk management unit (RMU) monitors an investment management entity's portfolio

risk exposure and ascertains that the exposures are authorized and consistent with
the risk budgets previously set. The objectives of an RMU include how many of the
following statements?

I. Identifying and developing risk measurement and performance attribution

analytical tools.
II. Gathering risk data to be analyzed in making portfolio manager assessments
and market environment assessments.
III. Providing the management team with information to better comprehend risk in
individual portfolios as well as the source of performance.
IV. Assisting the entity in formulating a systematic and rigorous method as to how
risks are identified and dealt with.

A) One statement is correct.

B) Two statements are correct.

C) Three statements are correct.

D) Four statements are correct.

Explanation

The RMU objectives encompass all of these statements as well as several more,
including gathering, monitoring, analyzing, and distributing risk data to managers,
clients, and senior management.

(Book 5, Module 86.2, LO 86.f)

Question #44 of 80 Question ID: 1291960

Suppose mean reversion exists for a variable with a value of 100 at time period t − 1.
Assume that the long-run mean value for this variable is 120, and ignore the
stochastic term included in most regressions of financial data. What is the expected
change in value of the variable for the next period if the mean reversion rate is 0.6?

A) 2.

B) 6.

C) 12.

D) 20.
Explanation

The mean reversion rate, a, indicates the speed of the change or reversion back to
the mean. If the mean reversion rate is 0.6 and the difference between the last
variable and long-run mean is 20 (= 120 − 100), the expected change for the next
period is 12 (i.e., 0.6 × 20 = 12).

(Book 1, Module 8.1, LO 8.b)

Question #45 of 80 Question ID: 1291975

Barkon, Ltd., holds long positions in their interest rate swap portfolio that has the
following mark-to-market values for seven different transactions with the same
counterparty: +8, −3, +2, +6, −4, −1, +5. What is Barkon's total exposure from these
transactions, without and with netting, respectively?

Without Netting With Netting

A) 8 13

B) 8 21

C) 13 8

D) 21 13

Explanation

The exposure without netting is equal to all of the positive values added together:
+8, +2, +6, and +5 will equal 21. The exposure with netting is equal to all values
added together: 8 − 3 + 2 + 6 − 4 − 1 + 5 = 13.

(Book 2, Module 26.1, LO 26.b)

Question #46 of 80 Question ID: 1291962

A portfolio strategist is training a junior analyst recently hired by her fund. The
strategist would like the analyst's help with applying copulas, but she realizes this is
not a concept that the analyst has worked with in the past. To educate the analyst on
both correlation copulas and Gaussian copulas, the strategist is least likely to use
which of the following descriptions?
 A copula correlation model is designed to preserve the original marginal
A)
distributions while de ning a correlation between them.

A Gaussian copula maps the marginal distribution of each variable to a normal

B)
distribution with a mean and standard deviation equal to one.

The purpose of a copula is to build a joint probability distribution between two or

C)
more variables and maintain those variables’ individual marginal distributions.

A correlation copula will convert two or more unknown distributions that have
D)
distinct shapes and map them to a known distribution with well-de ned properties.

Explanation

A Gaussian copula will take the marginal distribution of each variable and map them
to a normal distribution. However, the distribution they are mapped to is the
standard normal distribution, which has a mean of zero and a standard deviation of
one. The other statements about correlation and Gaussian copulas are all correct.

(Book 1, Module 9.1, LO 9.b)

Question #47 of 80 Question ID: 1360338

Fixed income arbitrage funds attempt to obtain profits by exploiting inefficiencies and
price anomalies between related fixed-income securities. The fund managers try to
limit volatility by hedging exposure to interest rate risk. Which of the following types
of fixed-income trades bets that the fixed side of a spread will stay higher than the
floating side of a spread?

A) Swap spread trade.

B) Credit arbitrage trades.

C) Mortgage spread trades.

D) Fixed-income volatility trades.

Explanation

A swap spread trade is a bet that the fixed side of the spread will stay higher than
the floating side of the spread, and stay in a reasonable range according to
historical trends.

(Book 5, Module 88.1, LO 88.f)

Question #48 of 80 Question ID: 1360299

 Q

A fixed income portfolio manager is giving a presentation on subprime mortgages at a

real estate investment conference. The focus of her presentation is on mortgage
securitization, in particular, the frictions in the mortgage securitization process that
directly impacted the subprime mortgage crisis of the late 2000s. On her presentation
slide covering these specific frictions, which bullet point would be least accurate?

Investor and credit rating agency frictions resulted in misguided ratings

A)
assignments.

The servicer and mortgagor friction identi ed the poor quality of the servicer
B)
having a negative impact on cash ows and credit ratings.

The asset manager and investor friction led to an underassessment of risks tied to
C)
higher-yielding structured mortgage products.

The mortgage and originator friction gave rise to inappropriate loans due to the lack
D)
of sophistication of the borrower and the complexity of the product.

Explanation

While the servicer and mortgagor friction does speak to the quality of the servicer
and the impact that has on cash flows and credit ratings, this was not a direct driver
of the subprime mortgage crisis of the 2000s. Misguided ratings assessments
(investor and credit rating agency friction), risk underassessment (asset manager
and investor friction), and inappropriate loans due to unsophisticated borrowers
and product complexity (mortgage and originator friction) were all direct drivers of
the crisis.

(Book 2, Module 34.1, LO 34.b)

Question #49 of 80 Question ID: 1360322

A bank liquidity manager is attempting to allocate funds for the bank's various
activities, including collateralization. Which category of funding liquidity is most likely
impacted by collateralization?

A) Contingent.

B) Operational.

C) Restricted.

D) Strategic.

Explanation
Restricted liquidity comprises the liquid assets that have stated and predetermined
operational uses, such as collateralization. Because the collateralization is a specific
use, it would not fall under operational liquidity, which are the funds required to
cover the bank's regular day-to-day operational needs.

Contingent liquidity is meant to satisfy general liabilities in stressed situations, and

strategic liquidity is meant to satisfy potential investment opportunities, such as
fixed asset purchases or mergers/acquisitions. Neither of those two forms of
liquidity would apply to collateralization.

(Book 4, Module 69.1, LO 69.a)

Question #50 of 80 Question ID: 1291956

A risk analyst at a large financial services firm has been instructed to backtest the VaR
model of a bank that is an acquisition candidate. The bank uses a one- day 99% VaR
model over an eight-year horizon at a 95% confidence interval. Assuming that daily
returns are identically and independently distributed, and there are 250 trading days
in a year, what is the highest number of daily losses exceeding the one-day 99% VaR
in eight years that is acceptable to affirm that the model is correctly calibrated?

A) 19.

B) 28.

C) 36.

D) 58.

Explanation

The risk analyst will reject the hypothesis that the model is calibrated correctly if the
number of x losses exceeding the VaR is:

x−pT
> z = 1.96
√p(1−p)T

where the failure rate is represented as p and is equal to 1% (1 − 0.99); and T

represents the number of observations = 250 × 8 = 2000; and z = 1.96 is the two-tail
confidence level range.

If:

x−0.01×2,000
= 1.96
√0.01(1−0.01)×2,000

then x = 28. Therefore, the model is calibrated correctly if there are 28 or fewer
losses exceeding the given VaR.

(Book 1, Module 4.1, LO 4.c)

Question #51 of 80 Question ID: 1360310

Using a confidence level of 99.9% over a 1-year time horizon, under the IRB
framework, a bank has an estimated VaR equal to $230 million. If the expected loss is
$130 million, what is the total dollar value of economic capital?

A) $100 million.

B) $130 million.

C) $230 million.

D) $360 million.

Explanation

Expected loss is a cost component of credit business and should be covered by loan
loss provisions and write-offs. Economic capital is used for unexpected variations
from expected losses called unexpected losses. The difference between value at risk
($230 million) and expected loss ($130 million) is the bank's unexpected loss (i.e.,
required economic capital).

(Book 3, Module 53.2, LO 53.e)

Question #52 of 80 Question ID: 1360297

Which of the following is true regarding the special purpose vehicle (SPV) corporate
structure and the SPV trust structure?

When the SPV is set up as a trust, the claims are issued directly against the master
A)
trust.

When the SPV is set up as a corporation, the claims are issued directly against
B)
the assets of the SPV.

For both the corporation and trust structure, claims are issued directly against the
C)
assets of the SPV.

For both the corporation and trust, claims are issued indirectly against the assets of
D)
the SPV.

Explanation
When the corporate structure is used, the SPV buys the assets and issues claims
directly against the assets. When the trust structure is used, the SPV buys the assets
and transfers the assets to another SPV for a beneficial interest. Claims are issued
against the purchasing SPV and so the claims are indirect.

(Book 2, Module 33.1, LO 33.a)

Question #53 of 80 Question ID: 1291976

Assume that counterparty A would like to net five different exposures with
counterparty B. Netting this set of exposures will minimize the risk of default by either
party. Assuming that the average correlation among these five exposures is equal to
40%, what is the netting factor used to quantify the benefit of netting?

A) 28%.

B) 40%.

C) 53%.

D) 72%.

Explanation

The netting factor is computed as:

√n+n(n−1)ρ̄
netting factor =
n

√5+5(5−1)0.4
= = 0.72 = 72%
5

A netting factor will be 100% when there is no netting benefit (correlation is 1) and
0% if the netting benefit is maximized.

(Book 2, Module 28.2, LO 28.f)

Question #54 of 80 Question ID: 1360332

If a combination of two portfolios (A and B) has a VaR of $600 million, and Portfolio A,
on a stand-alone basis, has a VaR of $400 million, the VaR of Portfolio B, on a stand-
alone basis:

A) must equal $200 million.

B) must be at least $200 million.

C) could be less than $200 million.

D) cannot be greater than $200 million.

Explanation

Merging portfolios cannot increase risk. [VaR(X1 + X2) ≤ VaR(X1) + VaR(X2)]. If VaR(X1
+ X2) = 600 and VaR(X1) = 400, then VaR(X2) must be at least 200.

(Book 5, Module 84.1, LO 84.b)

Question #55 of 80 Question ID: 1360301

Which of the following statements is most accurate regarding the implementation of

enterprise risk management (ERM)? ERM:

A) requires business units within an organization to measure risks independently.

relies on unique qualitative methodologies to manage risks facing each business

B)
unit.

C) is an integrated process designed to manage risks outside of a rm’s risk appetite.

D) can use derivatives and insurance products to transfer risks to third parties.

Explanation

Risk transfer is one of seven components of a strong ERM framework. Derivatives,

insurance, and hybrid products can be incorporated into the risk transfer process to
reduce risk. ERM is a centralized and integrated approach to managing risk that is
more effective in managing a company's overall risk compared to the traditional silo
approach of managing risks within each business unit. It should be used to manage
risks within a firm's risk appetite.

(Book 3, Module 37.1, LO 37.b)

Question #56 of 80 Question ID: 1360331

Consider a two-asset portfolio. The portfolio weight of X is 0.35 and Y is 0.65. The total
value of the portfolio is $3.4M and the standard deviation of returns is 9.8%. The
betas of assets X and Y are 0.65 and 1.35, respectively. What is the marginal VaR of
Asset X and the component VaR of Asset Y at a 99% confidence level?

Marginal VaR Asset X Component VaR Asset Y

A) $0.22834 $504,631

B) $0.14842 $504,631

C) $0.22834 $681,252

D) $0.14842 $681,252

Explanation

Diversified VaR = Z-statistic × volatility × portfolio value

Diversified VaR = 2.33 × 0.098 × $3.4M = $776,356

Marginal VaR of X = (VaR / portfolio value) × βX

Marginal VaR of X = $776,356 / $3.4M × 0.65
Marginal VaR of X = $0.14842

Component VaR of Y = VaR × βY × weight of asset Y

Component VaR of Y = $776,356 × 1.35 × 0.65
Component VaR of Y = $681,252

(Book 5, Module 84.1, LO 84.a)

Question #57 of 80 Question ID: 1360318

A bank's liquidity risk manager is already familiar with the general aspects of early
warning indicators (EWIs) and wants to perform a more microanalysis of EWIs by
focusing on intraday liquidity indicators. Which of the following EWI supervisory
guidelines would be most relevant for the risk manager?

A) BCBS (2008).

B) BCBS (2012).

C) Federal Reserve (SR 10-6).

D) OCC (2012).

Explanation
BCBS (2012) specifically focuses on intraday liquidity indicators.

OCC (2012) deals with embedded options and providing advance notice of possible
negative events.

BCBS (2008) and Federal Reserve (SR 10-6) deal with EWIs in general and not
specifically intraday liquidity indicators only.

(Book 4, Module 63.1, LO 63.b)

Question #58 of 80 Question ID: 1360684

Which of the following statements regarding policy steps taken so far and/or to be
taken in response to COVID-19 is most accurate?

A) Short-sale bans and circuit breakers are intended to achieve the same result.

Applying IFRS 9 Expected Credit Loss requirements should be done strictly and with
B)
care.

Insurance companies should maintain or increase their dividend payments to

C)
shareholders.

Central banks have expanded their asset sale programs in attempt to reduce long-
D)
term interest rates.

Explanation

Circuit breakers are intended to avoid panic selling. Both short sale bans and circuit
breakers are intended to decrease the risk of downward price spirals and to
decrease the risk of drying up liquidity that would increase systemic risk. Applying
IFRS 9 Expected Credit Loss requirements should not be done mechanically;
projections must make sense and be realistic, considering the lack of quality
information. Regulatory agencies in some countries have recommended to
insurance companies to restrict dividends payments to maintain the strength of
their capital positions. Central banks have expanded their asset purchase programs
(to increase money supply) to attempt to reduce long-term interest rates.

(Book 5, Module 97.2, LO 97.c)

Question #59 of 80 Question ID: 1291964

A hedge fund manager is looking for an arbitrage opportunity for the following
binomial tree. The binomial tree is for a 2-year, 5% annual coupon paying bond with a
current market price of $99.791. The probability for each upper and lower branch is
50%.

What arbitrage opportunity exists, if any?

A) No arbitrage opportunity exists.

The hedge fund manager should short the rst year upper node and go long the
B)
rst year lower node.

The hedge fund manager should short the rst year lower node and go long the rst
C)
year upper node.

The hedge fund manager should short the second year upper node and go long the
D)
second year lower node.

Explanation

Using backward induction, it can be demonstrated that no arbitrage opportunity

exists. The upper node value of the bond for the end of period 1 is computed as
follows:

($105×0.5)+(105×0.5)
V1,U = = $98.384
1.06725

The lower node value of the bond for the end of period 1 is computed as follows:

($105×0.5)+(105×0.5)
V1,L = = $100.179
1.048125

The value of the bond for node 0 is equal to the present value of a 50% probability
of obtaining the bond value in the upper or lower period 1 node and is computed as
follows:

($103.384×0.5)+(105.179×0.5)
V0 = = $99.791
1.045

(Book 1, Module 11.1, LO 11.b)

Question #60 of 80 Question ID: 1291965

An asset manager is assigned to evaluate a fixed income portfolio and is questioning

certain techniques that are being used by the organization to value derivatives on
fixed-income securities and bonds with embedded options. In her investigation, she
took note of several assumptions in the organization's valuation models. Which of the
following assumptions would not be correct?

A) A callable bond is assumed to have a convex price-yield curve at high yields.

B) A putable bond is assumed to have a convex price-yield curve at low yields.

The Black-Scholes-Merton option pricing model is one acceptable method for

C)
valuing xed-income derivatives.

D) The price-yield curve for bonds that have no embedded options is convex.

Explanation

Callable bonds have negative convexity at low yields (i.e., concave) but exhibit
positive convexity at high yields. Bonds without embedded options and putable
bonds have a convex shape. The Black-Scholes-Merton option pricing model is not
appropriate for valuing fixed-income derivatives because it assumes there is no
upper limit to the price of the underlying asset, and it assumes the risk-free rate and
bond price volatility are both constant.

(Book 1, Module 11.3, LO 11.j)

Question #61 of 80 Question ID: 1360333

A distressed securities strategy involves speculation in the buying or selling of

distressed securities. There are shareholders, particularly institutional shareholders,
which choose to sell stock in a troubled company, rather than ride it out. Also, it is
sometimes difficult for the market to properly value these situations. Examples of
various returns from distressed securities strategies include all of the following
except:

A) investors may buy shares in a company until it re-emerges from bankruptcy.

banks may wish to sell o some bank debt to clean up their balance sheets, and
B)
investors may purchase this debt.

trade claims are attractive to some investors, since there is payment risk in the
C)
event of a bankruptcy, and these trade claims may be purchased at a discount.
 when the strategy is initiated, a liquidity bu er is posted in order to cover mark
D)
to market adjustments. This liquidity bu er earns short-term interest.

Explanation

Short-term interest from a liquidity buffer is an example of a source of return for

equity long/short hedge fund strategies.

(Book 5, Module 84.2, LO 84.e)

Question #62 of 80 Question ID: 1360302

John Lookwood is the new chief risk officer (CRO) of a commercial bank. Lookwood
takes a holistic view of risks through risk portfolio management by aggregating
individual risk exposures. He also considers strengthening the firm's human
resources (HR) policies around hiring and diversity. Which of these factors are key
components of a strong enterprise risk management (ERM) framework?

A) Risk portfolio management only.

B) HR policies only.

C) Both risk portfolio management and HR policies.

D) Neither risk portfolio management nor HR policies.

Explanation

There are seven components of a strong ERM framework: (1) corporate governance,
(2) line management, (3) portfolio management, (4) risk transfer, (5) risk analytics, (6)
data and technology resources, and (7) stakeholder management. While strong HR
policies are critical in the success of the firm, they are not a component of ERM.

(Book 3, Module 37.1, LO 37.d)

Question #63 of 80 Question ID: 1360341

A risk consultant is creating new hire training on artificial intelligence (AI) in the
financial services industry. On the topic of regulatory compliance, she discovers that a
subset of fintech, known as regtech, uses AI to perform regulatory functions in the
financial markets. Which of the following actions most likely applies to how central
banks would use AI? Central banks are using AI:

A) for fraud detection.

B) to evaluate the impact of changes in monetary policy.

C) for analysis of text to identify violations of marketing rules and restrictions.

for analysis of the huge amount of market and trading data that is currently
D)
available.

Explanation

Central banks are using AI to evaluate the impact of changes in monetary policy as
well as to improve their forecasts of economic variables and their understanding of
the relationships among these variables.

(Book 5, Module 92.1, LO 92.b)

Question #64 of 80 Question ID: 1360311

Bank XYZ has calculated a market risk VaR for the previous day equal to $25 million.
The average VaR over the last 60 days is $6 million. The bank has calculated a stressed
VaR for the previous day equal to $28 million and an average stressed VaR equal to
$31 million. What is the total market risk capital charge, assuming the multiplicative
factor is set to 3?

A) $43 million.

B) $75 million.

C) $109 million.

D) $118 million.

Explanation

The total capital charge = $25 million + ($31 million × 3) = $118 million.

(Book 3, Module 54.1, LO 54.a)

Question #65 of 80 Question ID: 1360300

When comparing credit risks and operational risks to market risks:

A) both credit risks and operational risks have more outliers.

B) only credit risks will have more outliers.

C) only operational risks will have more outliers.

D) both credit risks and operational risks have fewer outliers.

Explanation

Market risks tend to follow a normal distribution. On the other hand, both credit
risks and operational risks typically have an asymmetric distribution with larger
(fatter) tails. Fat-tailed distributions have more outliers than normal distributions.

(Book 3, Module 36.1, LO 36.d)

Question #66 of 80 Question ID: 1360313

Titan Bank is planning to move to the standardized approach for operational risk
capital and wants to incorporate the loss component into its calculation for the
coming fiscal year. The bank opened 8 years ago and only has reliable loss data for
the last 6 years. Will they be able to still use the loss component and the standardized
approach?

No, as the bank must have at least a 10-year observation period overall and
A)
speci cally for loss data.

No, as the bank must be in existence for at least 10 years, with reliable loss data for
B)
the last 5 years.

Yes, as reliable loss data is not required as long as the bank has been in existence
C)
for at least 5 years.

Yes, as the bank will be eligible as long as the loss data covering at least the last
D)
5 years is deemed good quality and reliable.

Explanation

Although the general criteria is that an observation period of 10 or more years is

desirable, as long as a bank moving to the standardized approach has at least 5
years of reliable loss data, an exception can be made.

(Book 3, Module 56.1, LO 56.a)

Question #67 of 80 Question ID: 1360339

A risk consultant is performing due diligence on Fund ABC because he is considering
adding this fund to his portfolio. The consultant likes to look at broad themes when
evaluating a hedge fund manager, which includes the manager's strategy. Which of
the following characteristics would he least likely take into consideration when only
examining the strategy of Fund ABC?

A) Risk management.

B) Types of investments.

C) Fund evolution.

D) Comparison with peers.

Explanation

In evaluating a manager, investors should consider four broad themes including

strategy (e.g., evolution, risk management, quantification, types of investments),
ownership, track record (e.g., comparison with peers, independent verification of
results), and investment management (e.g., manager interviews, reference checks,
background checks).

(Book 5, Module 89.1, LO 89.c)

Question #68 of 80 Question ID: 1360303

A risk manager is reviewing his firm's risk appetite framework (RAF). The RAF is a
strategic decision-making tool that represents his firm's core risk strategy. The
manager notices that the framework sets in place a clear, future-oriented perspective
of the firm's target risk profile in a number of different scenarios and maps out a
strategy for achieving that risk profile. Which of the following statements incorrectly
describes the benefits of a well-developed RAF?

A) It assists rms in preparing for the unexpected.

It focuses on past data and monitors metrics regarding the rm’s risk pro le
B)
before performing relevant stress tests and scenario analyses.

The inherent exibility allows rms to adapt to market changes, especially if

C)
appropriate opportunities arise that require adjustments to the RAF.

D) It improves a rm’s strategic planning and tactical decision-making.

Explanation
The RAF focuses on the future and sets expectations regarding the firm's
consolidated risk profile after performing relevant stress tests and scenario
analyses. Thus, it helps the firm set up a plan for risk taking, loss mitigation, and use
of contingency measures.

(Book 3, Module 38.1, LO 38.a)

Question #69 of 80 Question ID: 1360336

The time-weighted rate of return measures compound growth over a specified time
horizon. Which of the following actions would not be required to compute the annual
time-weighted return for an investment?

Value the portfolio at the end of each month to include signi cant additions or
A)
withdrawals.

Compute the product of (1 + holding period return) for each subperiod t to obtain a
B)
total return for the entire measurement period.

Form subperiods over the evaluation periods that correspond to the dates of
C)
deposits and withdrawals.

D) Compute the holding period return of the portfolio for each subperiod.

Explanation

The first step in computing the time-weighted rate of return is to value the portfolio
immediately preceding significant addition or withdrawals.

(Book 5, Module 87.1, LO 87.a)

Question #70 of 80 Question ID: 1360685

Which of the following actions is most likely to provide cover for money laundering
activities after the pandemic crisis has stabilized? An unusual increase in:

A) bank borrowings.

B) bank loan repayments.

C) cash deposits.

D) cash withdrawals.

Explanation
Many banks have incurred large increases in cash withdrawals during the pandemic
crisis. A corresponding increase in cash deposits after the pandemic crisis might be
a cover for money laundering activities.

(Book 5, Module 98.1, LO 98.a)

Question #71 of 80 Question ID: 1360319

An individual investor would like to invest $500,000 for nine months. He wants
absolute safety for his entire investment, does not want to earn the lowest possible
yield, and wants to have the potential to earn moderate capital gains during his
investment horizon. Based solely on his objectives, which investment vehicle is most
suitable for the investor's needs?

A) Certi cate of deposit (CD).

B) Treasury bill (T-bill).

C) Treasury bond (T-bond).

D) Treasury note (T-note).

Explanation

T-notes at issuance have maturities up to 10 years, including maturities of 1 year or

less that are classified as short-term (money market) securities. Their returns are
typically above the return of T-bills. T-notes also offer the potential for capital gains.

T-bills generally have the lowest yield of all the money market securities, which does
not meet the investor's need to earn more than the lowest possible yield.

T-bonds have maturities greater than 10 years, which does not meet the investor's
investment horizon of nine months.

CDs benefit from federal insurance of up to $250,000 only, which does not meet the
investor's need to have absolute safety over his entire $500,000 investment.

(Book 4, Module 64.1, LO 64.a)

Question #72 of 80 Question ID: 1360327

A manager is considering the addition of several classes of illiquid assets to a pension

fund portfolio to increase its return due to its current negative funded status. Which
asset class under consideration is generally considered the most illiquid?
A) Emerging market debt.

B) Global infrastructure.

C) Hedge funds.

D) Timber.

Explanation

As part of the analysis in Antti Ilmanen's 2011 book Expected Returns, timber is
considered the most illiquid asset (together with venture capital and buyout funds).
Hedge funds are considered somewhat less illiquid (together with fund of funds and
U.S. real estate). Then, emerging market debt and global infrastructure (together
with small-cap equities, emerging market equity, high-yield bonds, and global REITs)
are even less illiquid.

(Book 4, Module 79.2, LO 79.e)

Question #73 of 80 Question ID: 1291963

Assume a relative value trade is established whereby a trader sells a U.S. Treasury
bond and buys a U.S. TIPS to hedge the T-bond. Suppose the DV01 of the T-bond is
0.055 and the DV01 of the TIPS is 0.078. If the trader is selling 50 million of the T-
bond, and the hedge adjustment factor (beta) is equal to 1.02, what is the
approximate face amount of TIPS to purchase in order to hedge the short position?

A) $25 million.

B) $36 million.

C) $49 million.

D) $71 million.

Explanation

F(Real) = 50M × (0.055 / 0.078) × 1.02 = $35.96 million.

(Book 1, Module 10.1, LO 10.d)

Question #74 of 80 Question ID: 1360315

Which of these statements is correct regarding the differences between operational

resilience, traditional business continuity, and disaster recovery approaches?
A) Operational resilience emphasizes events such as natural disasters.

B) Disaster recovery takes a highly integrated view of the organization.

C) Business continuity emphasizes an organization’s ability to respond to threats.

Operational resilience takes an organization-wide focus and looks at impacts

D)
from both an organization-speci c and macroeconomic perspective.

Explanation

Operational resilience takes an organization-wide focus and looks at impacts from

both an organization-specific and macroeconomic perspective. Operational
resilience also emphasizes an organization's ability to respond to threats and takes
a highly integrated view of the organization. Business continuity and disaster
recovery emphasize events such as natural disasters.

(Book 3, Module 60.1, LO 60.a)

Question #75 of 80 Question ID: 1291972

The credit spread on a 1-year B-rated corporate bond relative to the maturity-
matched T-bill is 2.2%. The portion of this spread related to noncredit factors, such as
liquidity risk, is forecasted to be 0.6%. Given a recovery rate in the event of default of
75%, what is the hazard rate (i.e., default intensity) for this corporate bond?

A) 2.2%.

B) 2.1%.

C) 2.9%.

D) 6.4%.

Explanation

The hazard rate is approximately equal to the credit risk spread divided by one
minus the recovery rate (RR). Hazard rate = spread / LGD = spread / (1 − RR). Since
noncredit factors account for a portion of the spread, the credit spread due to credit
risk is: 2.2% − 0.6% = 1.6%. Thus, the hazard rate is: 0.016 / (1 − 0.75) = 6.4%.

(Book 2, Module 22.2, LO 22.h)

Question #76 of 80 Question ID: 1360334

The number of shares outstanding of a security is 5 million. Assuming the daily
volume of the security is 825,000 shares and that the desired maximum daily volume
of any security is 10%, what is the liquidity duration statistic for this security?

A) 5 days.

B) 50 days.

C) 60 days.

D) 83 days.

Explanation

Liquidity duration is an approximation of the number of days necessary to dispose

of a portfolio's holdings without a significant market impact. LD = number of shares
outstanding / (0.10 × daily volume) = 5 million / (0.10 × 840,000) = 59.5 days.

(Book 5, Module 86.2, LO 86.h)

Question #77 of 80 Question ID: 1360323

A bank manager is reviewing the pricing of the bank's deposit accounts for retail
customers. He proposes to introduce a new deposit product that has no service fee
for average monthly balances above $5,000 and a $10 monthly service fee for average
monthly balances of $5,000 or less. No interest is paid on any deposits, but checks
may be written at no charge. The pricing of the proposed deposit product is best
described as:

A) conditional pricing.

B) cost-plus pricing.

C) marginal cost pricing.

D) a combination of two of the pricing methods.

Explanation

The proposed deposit product contains two elements of conditional pricing: (1) free
pricing (free checking) in that interest paid (0%) is likely lower than market rates,
and the customer incurs an opportunity cost in the form of foregone income, and (2)
conditionally free pricing in that small deposit accounts under $5,000 have service
fees, while large deposit accounts over $5,000 are free.

(Book 4, Module 72.2, LO 72.b)

Question #78 of 80 Question ID: 1291958

A risk manager is reviewing the use of either a unified or a compartmentalized risk

measurement method to aggregate risk for bank XYZ. Regarding the differences
between these risk measurement approaches, which of the following statements is
correct?

A compartmentalized approach can capture possible compounding e ects that are

A)
not considered when looking at individual risk measures in isolation.

When calculating capital requirements, banks use a uni ed approach, whereby

B) capital requirements are calculated for individual risk types, such as market risk and
credit risk.

An integrated approach would look at capital requirements for each of the risks
C)
simultaneously and account for potential risk correlations and interactions.

The overall Basel regulatory approach to calculating capital requirements is an

D)
integrated approach to risk measurement.

Explanation

Unified and compartmentalized risk measurement methods aggregate risks for

banks. A compartmentalized approach sums risks separately, whereas a unified, or
integrated, approach considers the interaction among risks. The overall Basel
approach to calculating capital requirements is a non-integrated approach to risk
measurement.

(Book 1, Module 6.1, LO 6.d)

Question #79 of 80 Question ID: 1360314

Regarding ways to increase a firm's financial resilience, which of the following

activities most likely attempts to quantify the severity of a cyberattack that would
cause the financial collapse of the firm?

A) Defense in depth.

B) Reverse stress testing.

C) Counterfactual analysis.

D) Enterprise risk management.

Explanation
The use of reverse stress testing can help increase financial resilience by attempting
to quantify the severity of a cyberattack that would cause the financial collapse of
the firm or to result in credit downgrade.

(Book 3, Module 57.2, LO 57.c)

Question #80 of 80 Question ID: 1291970

A bank is looking at several different artificial intelligence methods to model default

risk. Which of the following statements most accurately reflects these models?

A) A neural network is an example of a heuristic method.

B) An expert system is an example of a numerical method.

C) Heuristic methods use trial by error to generate new knowledge.

Numerical methods are founded on using trial by error to mirror human decision-
D)
making processes.

Explanation

Heuristic methods are designed to mirror human decision making and use trial by
error to generate new knowledge. A neural network is an example of a numerical
method. An expert system is an example of a heuristic method.

(Book 2, Module 20.4, LO 20.m)