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45: Measures of Financial Risk

Q.972 You have been given the following 30 ordered percentage returns of an asset:

[-18, -16, -14, -12, -10, -9, -7, -7, -6, -6, -6, -5, -5, -4, -4, -4, -2, -1, 0, 0, 2, 3, 6, 12, 12, 13, 15, 15,
18, 28]

The value-at-risk (VaR) and expected shortfall (ES), at 90% confidence level, respectively, are
closest to:

A. Var: 14; ES: 17

B. Var: 14; ES: 16

C. Var: 12; ES: 16

D. Var: 12; ES: 24

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.
In this case, VaR = [(1 - 0.9)30 + 1]th highest observation = 4th observation = 12
The ES is the arithmetic average of losses beyond the VaR. Thus,
ES = (18 + 16 + 14)/3 = 16

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Q.973 Stuart Broad, a risk analyst working with Macquarie Bank compiles data of 100 simulated
percentage returns of the bank’s assets:

-13.33, -12.25, -11.75,-10.66, -9.45, -8.45, -7.13, -6.48, -5.29 ... ... ... 2.89, 3.56, 4.29, 5.38, 6.65,
7.89, 8.54, 9.64, 10.27, 12.28 and 13.25

Using the data, he calculates the expected shortfall (ES) and the value at risk (VAR) of the bank’s
assets at the 95 percent confidence level using the historical simulation method. What is the
expected shortfall and the value at risk computed by Stuart Broad?

A. Expected shortfall: 12; Value at Risk: 8.45

B. Expected shortfall: 12; Value at Risk: 8.95

C. Expected shortfall: 11.49; Value at Risk: 8.45

D. Expected shortfall: 11.49; Value at Risk: 9.95

The correct answer is: C)

The 95% return among 100 observations would be the fifth-worst observation among the returns.
To locate the full 5% tail "outside" the VaR quantile, we take the sixth-worst return, which is –
8.45%. Remember that VaR is a non-negative value.

The expected shortfall is the average of all the simulated percentage returns that lie at and
below the 5% worst returns. Therefore, expected shortfall = (-13.33 - 12.25 - 11.75 - 10.66 -
9.45) / 5 = -11.49

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Q.974 Pierre Johnson, an analyst, uses the Fishburn measure or the lower partial moment to
measure risk. He makes the following statement(s) on the Fishburn measure. Which of them are
true?

Statement I: The Fishburn measure is defined on two parameters: α, which describes our
attitude to risk, and, t, which specifies the cut-off between the downside that we worry about and
the upside that we don't worry about
Statement II: The down-side semi-variance is closely related to the Fishburn measure, but Roy’s
safety-first criterion is not related to the Fishburn measure
Statement III: The Fishburn measure encompasses the stochastic dominance rules that are
sometimes used for ranking risky alternatives
Statement IV: The expected shortfall is a multiple of the Fishburn measure with α = 1

A. I , II & III only

B. I, III & IV only

C. II, III & IV only

D. All of the above

The correct answer is: B)

The Fishburn measure is defined on two parameters: α, which describes our attitude to risk, and,
t, which specifies the cut-off between the downside that we worry about and the upside that we
don't worry about. The down-side semi-variance is closely related to the Fishburn measure with
α = 2 and t equal to the mean, and Roy’s safety-first criterion corresponds to the Fishburn
measure where α = 1. The Fishburn measure encompasses the stochastic dominance rules that
are sometimes used for ranking risky alternatives. The expected shortfall is a multiple of the
Fishburn measure with α = 1.

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Q.975 Anshuman, a risk consultant working at Dominic Republic Bank, uses VaR to measure
risks of his bank’s positions. He makes the following statements in his consultant report with
regard to VaR. Which of the following statement(s) can be accepted by the risk committee of the
firm?

I. VaR is simply the negative of the qp quantile of the Profit and loss (P/L) distribution
II. VaR is defined contingent on two arbitrarily chosen parameters: a confidence level and a
holding or horizon period
III. VaR not only rises with the confidence level but rises at a decreasing rate
IV. With μ = 0, VaR rises with the square root of the holding period, but with μ > 0, VaR rises at a
lower rate and would in fact eventually turn down

A. I , II & III only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: B)

VaR is simply the negative of the qp quantile of the Profit and loss (P/L) distribution (where α is
the confidence level, and p = 1 - α).
VaR is defined contingent on two arbitrarily chosen parameters: a confidence level a, which
indicates the likelihood that we will get an outcome no worse than our VaR, and which might be
any value between 0 and l; and a holding or horizon period, which is the period of time until we
measure our portfolio profit or loss. The VaR not only rises with the confidence level but also
rises at an increasing rate. With μ = 0, VaR rises with the square root of the holding period, but
with μ > 0, VaR rises at a lower rate and would in fact eventually turn down.

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Q.976 The risk committee of the UK National Bank meets to determine the VaR parameters - the
confidence level and the holding period. Which of the following statements need to be considered
while determining the VaR parameters?

I. A lower confidence level is to be taken into consideration when using risk measures to set firm-
wide capital requirements
II. A higher confidence level needs to be considered when using risk measures for back-testing to
get a reasonable proportion of excess-loss observations
III. The holding period can also depend on the liquidity of the markets in which an institution
operates
IV. A longer holding period is preferable for model validation or backtesting purposes

A. III & IV only

B. I & IV only

C. III only

D. II &III only

The correct answer is: C)

A high confidence level is to be taken into consideration when using risk measures to set firm-
wide capital requirements. A lower confidence level needs to be considered when using risk
measures for back-testing to get a reasonable proportion of excess-loss observations. The
holding period can also depend on the liquidity of the markets in which an institution operates. A
short holding period is preferable for model validation or backtesting purposes.

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Q.977 Michael Antony, a risk analyst working with A&Y Risk Consultants, specializes in VaR.
While delivering a lecture at the Austin State University, he delves extensively into the VaR.
Which of the following is incorrect?

A. Unlike other risk measurement systems, VaR is not subject to model risk or
implementation risk

B. VaR does not indicate the magnitude of losses

C. VaR-defined risk targets give the traders an incentive to sell out-of-the-money options

D. In case of elliptical distributions, the mean-variance framework works well, and the
value of upgrading to a VaR framework is negligible

The correct answer is: A)

There are several advantages of VaR. It is a common, holistic, probabilistic risk measure.
However, VaR also has its drawbacks. VaR estimates can be subject to error. VaR systems can be
subject to model risk (i.e., the risk of errors arising from models being based on incorrect
assumptions) or implementation risk (i.e., the risk of errors arising from the way in which
systems are implemented). If a tail event does occur, we can expect to lose more than the VaR,
but the VaR itself gives us no indication of how much that might be. VaR-defined risk targets for
traders give them an incentive to sell out-of-the- money options that lead to higher income in
most states of the world and the occasional large hit when the firm is unlucky. In the case of
elliptical distributions, the mean-variance framework works well, and the value of upgrading to a
VaR framework is negligible.

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Q.978 ANG National Bank intends to use the coherent risk measure to measure the risk of its
assets. A risk measure is said to be coherent if it satisfies the properties such as:

I. Monotonicity
II. Sub-additivity
III. Positive homogeneity
IV. Translational invariance

A. I, III & IV only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: D)

The risk measure ρ(.) is said to be coherent if it satisfies the properties of:
(a) Monotonicity (Y ≥ X => ρ(Y) ≤ ρ(X));
(b) Sub-additivity (ρ(X+Y) ≤ ρ(X) + ρ(Y));
(c) Positive homogeneity (ρ(hX) = hρ(X) for h > 0); and
(d) Translational invariance (ρ(X+n) = ρ(X) - n) for some certain amount n.

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Q.979 Kronje Khan, a risk analyst working with APZ Risk Consultants, authored an article in the
Asia-Pacific business magazine which highlighted the sub-additivity property of the coherence
risk measure. He made the following statements in the article:

I. If regulators use non-subadditive risk measures to set capital requirements, then a financial
firm might be tempted to break itself up to reduce its regulatory capital requirements
II. Non-sub-additive risk measures can tempt agents trading on an organized exchange to break
up their accounts with separate accounts for separate risks in order to reduce their margin
requirements
III. If risks are sub-additive, adding risks together would give us an overestimate of combined
risk
IV. Value at Risk satisfies the sub-additive property

Which of them are correct?

A. I, II & III only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: A)

If regulators use non-sub-additive risk measures to set capital requirements, then a financial firm
might be tempted to break itself up to reduce its regulatory capital requirements.

Non-sub-additive risk measures can tempt agents trading on an organized exchange to break up
their accounts with separate accounts for separate risks in order to reduce their margin
requirements. This would concern the exchange because the margin requirements on the
separate accounts would no longer cover the combined risks, and would leave the exchange
itself exposed to possible losses.

If regulators use non-sub-additive risk measures to set capital requirements, then a financial firm
might be tempted to break itself up to reduce its regulatory capital requirements because the
sum of the capital requirements of the smaller units would be less than the capital requirement
of the firm as a whole.

If risks are sub-additive, adding risks together would give us an overestimate of combined risk
and this means that we can use the sum of risks as a conservative estimate of combined risk.

Value at Risk is not sub-additive.

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Q.980 John Adams, a newly recruited junior analyst, is asked to compare expected shortfall and
Value at Risk. He jots down the following points in his notes. Which of them are correct?

I. While the expected shortfall (ES) tells what to expect in bad states i.e. it gives an idea of how
bad might it be, Value at Risk tells us nothing other than to expect a loss higher than the Value at
Risk itself
II. The expected shortfall-based rule is consistent with expected utility maximization if risks are
rankable by a second-order stochastic dominance rule, while a Value-at-Risk-based rule is only
consistent with expected utility maximization if risks are rankable by a more stringent first-order
stochastic dominance rule
III. The expected shortfall and Value at Risk always satisfy sub-additivity
IV. Finally, the subadditivity of ES implies that the portfolio risk surface will be convex, and
convexity ensures that portfolio optimization problems using ES measures, unlike ones that use
VaR measures, will always have a unique well-behave optimum

A. I, III & IV only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: B)

While the expected shortfall (ES) tells what to expect in bad states i.e. it gives an idea of how
bad might it be, Value at Risk tells us nothing other than to expect a loss higher than the Value at
Risk itself.

The expected shortfall-based rule is consistent with expected utility maximization if risks are
rankable by a second-order stochastic dominance rule, while a Value-at-Risk-based rule is only
consistent with expected utility maximization if risks are rankable by a more stringent first-order
stochastic dominance rule.

The expected shortfall always satisfies sub-additivity, while the Value at Risk does not.

Finally, the subadditivity of ES implies that the portfolio risk surface will be convex, and
convexity ensures that portfolio optimization problems using ES measures, unlike ones that use
VaR measures, will always have a unique well-behave optimum.

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Q.981 Andrew Simons, a risk analyst, is working on risk measures. He is particularly interested
in the risk aversion property of risk measures. Which of the following statement(s) is/are true
with regard to the risk aversion property of risk measures?

I. The key to coherence is that a risk measure must give lower losses at least the same weight as
higher losses
II. If a user has a ‘well-behaved’ risk-aversion function, then the weights will rise smoothly, and
the rate at which weights rise will be related to the degree of risk aversion: the more risk-averse
the user, the more rapidly the weights will rise
III. Expected shortfall is characterized by all losses in the tail region having the same weight
implying that the user is risk-neutral between tail-region outcomes
IV. In case of Value at Risk (VaR), the weight of the loss associated with a p-value equal to α
implies that the user is actually risk-loving

A. I, III & IV only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: C)

The key to coherence is that a risk measure must give higher losses at least the same weight as
lower losses.

If a user has a ‘well-behaved’ risk-aversion function, then the weights will rise smoothly, and the
rate at which weights rise will be related to the degree of risk aversion: the more risk-averse the
user, the more rapidly the weights will rise.

Expected shortfall is characterized by all losses in the tail region having the same weight
implying the user is risk-neutral between tail-region outcomes.

With Value at Risk (VaR), a larger weight to the loss associated with a p-value equal to α and zero
weight to any greater loss implies that the user is actually risk-loving

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Q.982 ANC National Bank handles a portfolio of assets amounting to USD 150 million. Antony
Smith, a risk analyst, analyzes the portfolio and observes that the returns are independently
identically normally distributed. The annual standard deviation of the portfolio is 0.55. What is
the 20 day-Value at Risk at 95 percent confidence assuming 250 trading days in a year?

A. USD 51.92 million

B. USD 38.50 million

C. USD 53.67 million

D. USD 71.50 million

The correct answer is: B)

VaR = Z × standard deviation × portfolio amount

Annual VaR = 1.65 × 0.55 × 150,000,000 = 136,125,000

Var (T days) = 1-day VaR × sqrt(T)…….formula

1-day VaR = (annual VaR)/sqrt(250) = $8,609,300

20-day VaR = (1-day VaR) × sqrt(20) = $38,501,694

It’s the standard deviation, σ, that determines where you start. If the σ given is annual, you’ll

start by calculating the annual VaR and then use the square root of time rule to come up with

VaR for shorter periods. Similarly, if given the daily σ, compute the 1-day VaR and then convert

that appropriately.

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Q.983 Ricky, an analyst working at an Asian insurance company, uses distortion risk measures to
measure risk. Which of the following statement(s) is/are true with regard to distortion risk
measures?

I. Distortion risk measures are closely related to coherent risk measures

II. Distortion risk measures have been applied to a wide variety of insurance problems, most
particularly to the determination of insurance premiums
III. Like coherent risk measures, distortion risk measures have the properties of homogeneity,
positive homogeneity, and translational invariance
IV. Distortion risk measures also share with spectral risk measures the property of comonotonic
additivity

A. I, III & IV only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: D)

Distortion risk measures are closely related to coherent risk measures but emerged from the
actuarial/insurance literature rather than the mainstream financial risk literature. Distortion risk
measures have been applied to a wide variety of insurance problems, most particularly to the
determination of insurance premiums. Like coherent risk measures, distortion risk measures
have the properties of homogeneity, positive homogeneity, and translational invariance.
Distortion risk measures also share with spectral risk measures the property of comonotonic
additivity.

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Q.3320 A market risk manager uses historical information on 300 days of profit/loss information
and calculates a VaR, at the 95th percentile, of CAD 30 million. Loss observations beyond the
95th percentile are then used to estimate the expected shortfall. These losses (in millions) are
CAD25, 29, 36, 38, 40, 43, 47, 52, 56, and 57. What is the conditional VaR?

A. 42.3

B. 100

C. 30

D. 45.8

The correct answer is: A)

Conditional VaR (Expected shortfall) is the average of tail losses:

ES = [25 + 29 + 36 + 38 + 40 + 43 + 47 + 52 + 56 + 57]/10 = 42.3

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Q.3321 A hedge fund uses this risk-aversion function ( \cfrac {e^{(p-1)/\gamma}}{ \gamma (1-
e^{\frac {-1}{\gamma}})}) to calculate the risk measure. Later on, the hedge fund finds out
that the risk measure does not completely reflect the risk aversion of the fund’s investors. What
is the right action the hedge fund should take to better reflect the investors’ risk aversion?

A. Use VaR instead of the risk-aversion function

B. Use standard deviation instead of the risk-aversion function

C. Use expected shortfall risk instead of the risk-aversion function

D. Use a smaller (\gamma) to calculate the risk measure

The correct answer is: D)

VaR and standard deviation do not take extreme values into account. Therefore, options A and B
are incorrect.

Option C, expected shortfall, uses constant weight. As such, this measure does not change
(increase) the weights of extreme negative values.

Only option D can change (increase) the weights of extreme negative values and increase the
risk-aversion measure.

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Q.3322 Which of the following functions can be a spectral risk measure?

A. (sin(p))

B. (\cfrac {e^{p-1}}{1-e^{-1} })

C. (1-p)

D. (e^{p-1})

The correct answer is: B)

A spectral risk measure is a risk measure given as a weighted average of return quantiles from
the loss distribution. It’s given as a weighted average of outcomes where bad outcomes typically
have more weight. A spectral risk measure is always a coherent risk measure.

Only B has the three properties of a spectral risk measure: non-negativity, normalization, and
weakly increasing.

Non-negativity: (\phi(p) \geq 0) for all (p) in the range [0,1].

Normalization: ∫01 ϕ(p)dp = 1.

Weakly increasing: If some probability p2 exceeds another probability p1 , then p 2 must

have a weight bigger than or equal to that of p1 .

Options A and D are not normalized.

Option C is not weakly increasing.

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Q.3324 An FRM candidate incorporates a risk-averse element into its risk measure. Based on
historical data and the information from interviewing customers, the candidate comes up with
the data in the following table:

Probability 1% 5% 10% 4%

Profit/loss -500 -300 -100 -90

Weight 10/74 6/74 3/74 1/74

What is the spectral risk measure the candidate will get?

A. 128

B. 235

C. 432

D. 476

The correct answer is: B)

The spectral risk measure is:

1 × 500 × 10/74 + 5 × 300 × 6/74 + 10 × 100 × 3/74 + 4 × 90 × 1/74 = 234.59.

Q.3325 Which of the following is NOT a property of coherent risk measures?

A. Y ≥ X ⇒ ρ(Y ) ≥ ρ(X)

B. ρ(X + Y ) ≤ ρ(X) + ρ(Y )

C. ρ(hX) ≥ hρ(X) f or h > 0

D. ρ(x + n) ≤ ρ(X) − n for some n

The correct answer is: A)

Option A gets monotonicity wrong. It should be:

Y ≥ X ⇒ ρ(Y ) ≤ ρ(X)

Option B is subadditivity, C is positive homogeneity, and D is translational invariance.

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Q.3326 An investment company has a portfolio which has the following ordered performance by
historical data. Calculate the difference between the expected shortfall and the (VaR:ES_{0.8}-
VaR_{0.8}.)

Probability 1% 5% 10% 12% 20%

Profit/loss -500 -300 -100 -90 -50

A. 164

B. 90

C. 168

D. 86

The correct answer is: A)

Given a discrete distribution, the ES is the equivalent of:

1 1−α th
ES α = ∑ [p highest loss] × [probability of pth highest loss]
1 − α p =0

At α = 0.80,
ES0.80 = 1/0.2{[0.01 × 500] + [0.05 × 300]+ [0.1 × 100]+ [0.12 × 90]+ [0.2 × 50]} = 254

V AR 0.80 = 90

(ES_{0.2}-VAR_{0.2}=164)

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Q.3328 An investment company has a portfolio which has the following ordered performance by
historical data. Calculate the expected shortfall (ES_{0.95}.)

Probability 1% 5% 10% 12% 15%

Profit/loss -500 -300 -100 -90 -50

A. 300

B. 340

C. 400

D. 425

The correct answer is: B)

Given a discrete distribution, the ES is the equivalent of:

1 1−α th
ES α = ∑ [p highest loss] × [probability of pth highest loss]
1 − α p =0

At α = 0.95,
ES0.95 = 1/0.05{[0.01 × 500] + [0.04 × 300]} = 340

Note: The sum of probabilities in the numerator must sum to (1 - α)

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Q.3329 An investment company has a portfolio which has the following ordered performance by
historical data. Calculate the expected shortfall ES0.01 .

Probability 1% 5% 10% 12% 15%

Profit/loss -500 -300 -100 -90 -50

A. 168

B. 400

C. 460

D. 500

The correct answer is: D)

There is only one number 500 beyond 1%, therefore, the average is 500.

ES0.01 = 500

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Q.3394 A liquid asset K has a profit/loss distribution that’s independent and identically
distributed. The position has a one-day VaR of $50,000 at the 95% level of confidence. Estimate
the 10-day VaR of the same position at the 99% level of confidence.

A. $115,114

B. $70,000

C. $223,570

D. $200,000

The correct answer is: C)

The first step should be to convert the one-day VaR at 95% to a one-day VaR at 99%.

To do this, recall that:

V aR 95% uses the upper 5% point of the normal distribution,i.e.1.645

And the V aR99% uses the upper 1% point of the normal distribution,i.e.2.326

Therefore, to convert the one-day VaR at 95% to a one-day VaR at 99%, we must multiply the
2.33
former by a scale of 1.645

2.33
One-day V aR 99% = × $50, 000 = $70, 699
1.645

Next, recall that:

V aR (T days) = V aR (1 day) × √T

Therefore,

V aR10 d ays = $70 , 699 × √10 = $223, 570

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Q.3395 Peter McLeish is a risk analyst at Quantum Bank. After estimating the 99%, one-day VaR
of the bank’s portfolio using historical simulation with 900 past days, he is concerned that the
VaR is providing too little information on tail losses. He embarks on a deeper examination of
simulation results. Sorting the simulated daily P&L from worst to best, he constructs the
following table:

P &L Rank 1 2 3 4 5
−2, 000 −1, 860 −1, 800 −1, 720 −1, 630
P &L Rank 6 7 8 9 10
−1, 500 −1, 400 −1, 310 −1, 260 −1, 190
P &L Rank 11 12 13 14 15
−1, 110 −1, 050 −990 −820 −750

Determine the 99%, one-day expected shortfall of the portfolio:

A. 1,260

B. 1,653

C. 1,190

D. 1,608.89

The correct answer is: D)

The ES is then the average of observations 1 through 9, i.e.

(2 , 000 + 1 , 860 + 1 , 800 + 1, 720 + 1, 630 + 1, 500 + 1, 400 + 1, 310 + 1, 260)

ES = = 1, 608.89
9

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Q.3396 Which of the following statements about conditional VaR (CVaR) is incorrect?

A. Conditional VaR provides a consistent risk measure across different positions and
takes account of correlations.

B. Conditional VaR tells us what to expect in bad states: It gives an idea of how bad the
portfolio payoff can be expected to be if the portfolio has a bad outcome.

C. CVaR-based rule is consistent with expected utility maximization if risks are ranked by
a second-order stochastic dominance rule.

D. Like VAR, CVaR does not always satisfy subadditivity

The correct answer is: D)

CVaR, like VAR, does provide a consistent measure of risk that takes diversification into account,
so statement A is correct. Unlike VAR, however, CVaR is a subadditive risk measure.

Q.3397 A hypothetical portfolio of securities exhibits the following expected losses shown:

Loss (million dollar) Probability (%)

1 10 40%

2 20 35%

3 50 19%

4 100 11%

5 200 2%

6 225 2.5%

7 250 0.5%

What are the expected losses at the 95% and 99% confidence level?

A. ES (95%) = $225 million; ES (99%) = $237.5 million

B. ES (95%) = $217.5 million; ES (99%) = $237.5 million

C. ES (95%) = $217.5 million; ES (99%) = $250 million

D. ES (95%) = $225 million; ES (99%) = $250 million

The correct answer is: B)

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Note that the given data are in expected losses. The expected shortfall (also called conditional
VaR) is the expected tail loss. It is the average of the worst 100*(1-α)% of losses. For discrete
distribution, ES is derived as:

1 α
ESα = ∑ (pth loss × probability of p th loss)
1 − α p =0

In words, to determine the expected shortfall at a level of confidence α, we must find the average
of all the outcomes whose probability is less than or equal to 1 - α.

At a 95% confidence level, the significance level is 5%. To establish the expected shortfall at 5%,

we must find the average of all the outcomes whose probability is less than or equal to 5%

200 × 2% + 225 × 2.5% + 250 × 0.5%

ES0.95 = = 217.5 million dollars
5%

At a 99% confidence level, the significance level is 1%. To establish the expected shortfall at 1%,

we must find the average of all the outcomes whose probability is less than or equal to 1%

225 × 0.5% + 250 × 0.5%

ES0.99 = = 237.5 million dollars
1%

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Q.3398 The VaR of a loan portfolio is computed at various confidence levels:

Confidence Level VaR

95.0% 2%

95.5% 5%

96.0% 6%

96.5% 7%

97.0% 9%

97.5% 10%

98.0% 13%

98.5% 15%

99.0% 20%

99.5% 30%

What is the expected shortfall at the 97.5% confidence level?

A. 0.1

B. 0.15

C. 0.195

D. 0.2

The correct answer is: C)

The expected shortfall at the 97.5% confidence level is computed by averaging all value of risk
greater than the 97.5% confidence level.

Expected shortfall at the 97.5% confidence level = (13% + 15% + 20% + 30%)/4 = 19.5%

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Q.3399 Among the given portfolios, which one falls below the Markowitz efficient frontier?

Expected Standard
Portfolio Expected Return
Deviation

A 12.00% 10.00%

B 14.00% 12.00%

C 15.00% 12.00%

D 16.00% 20.00%

A. Portfolio A

B. Portfolio B

C. Portfolio C

D. Portfolio D

The correct answer is: B)

The efficient frontier represents the set of optimal portfolios that offer the highest expected
return for a defined level of risk or the lowest risk for a given level of expected return. Any
portfolio that lies below the efficient frontier is sub-optimal because it does not provide enough
return for the level of risk.

Although portfolios B and C have the same level of risk, C offers a higher return per unit of risk.
Hence, portfolio B must fall below the efficient frontier.

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Q.3588 Which of the following statement is INCORRECT regarding the efficient frontier?

A. A risk-averse investor will only choose portfolios along the efficient frontier

B. Portfolios that deliver the greatest return on each level of standard deviation make up
the efficient frontier

C. The graphic that shows the efficient frontier has the variance on its Y-axis

D. None of the above

The correct answer is: C)

The graphic that demonstrates the efficient frontier has the standard deviation at its X-axis and
the return on its Y-axis.

Option A is a correct statement. Markowitz's theory relies on the claim that risk-neutral investors
tend to seek out portfolios on the efficient frontier. A risk-averse investor will choose a portfolio
below the efficient frontier.

Option B is a correct statement. Portfolios that deliver the greatest return on each level of
standard deviation (or risk) make up the efficient frontier.

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 Reading 46: Calculating and Applying VaR

Q.1143 If the interest rates decrease, then the price of a bond with an embedded call option:

A. Increases for every decrease in interest rate

B. Decreases first and then increases for every decrease in interest rate

C. Increases and then remains constant

D. None of the above

The correct answer is: C)

The call option in the bond provides an option to the bond issuer to recall the bond if the interest
rate decreases beyond a certain level. Hence, for a bond with an embedded option, the price of
the bond increases with a decrease in interest rates. However, the moment the bond enters into
the money, the price of the bond does not increase further as the likely hood of the bond being
recalled increases.

Q.1144 Consider the following risks:

I. Interest rate risk

II. Pre-payment risk
III. Default risk
IV. Credit risk

Mortgage-Backed Securities (MBS) are exposed to which of these risks?

A. I

B. I, II & III

C. I, II, III & IV

D. II, III & IV

The correct answer is: C)

The risks to which MBS is exposed are:

1. Interest rate risk: An increase in interest rate increases the probability of default as the
interest burden on the borrower increases
2. Prepayment risk: If the interest rate decreases, the borrower may refinance its mortgage and
prepay the existing mortgage
3. Default risk: The borrower may not repay for various reasons
4. Credit risk: The borrower may default on the debt

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Q.1145 The risk from bonds/securities with embedded options may be measured more accurately
by:

A. Duration

B. Convexity

C. Full revaluation

D. Delta

The correct answer is: C)

Bonds do not have a linear relationship between the price and the yield. In addition, the
presence of options results in sharp changes in duration. Therefore, the most accurate method
by which the risk can be measured is by “full revaluation.”

Q.1146 All the following are false with regards to Worst Case Scenario (WCS) measure, EXCEPT:

A. WCS indicates the number of times portfolio loss exceeds a given limit over a given
period

B. WCS indicates the maximum a portfolio can lose over a given period

C. WCS indicates the probability of losing a given limit over a given period

D. WCS indicates the minimum a portfolio can lose over a given period

The correct answer is: B)

Worst Case Scenario (WCS) indicates the maximum a portfolio can lose over a given period. For
instance, it can indicate that a portfolio may lose a maximum of 10% over 100 trading days,
whereas VaR indicates the probability of losing a particular limit over a period.

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Q.1147 Select the true statement with regards to Scenario analysis and Structured Monte Carlo
(SMC) simulation.

A. Scenario analysis generates the likelihood of the scenarios being tested

B. Scenario analysis and SMC both generate the likelihood of the scenarios being tested

C. SMC generates the likelihood of the scenarios being tested

D. Scenario analysis considers the correlation between different scenarios

The correct answer is: C)

The advantages of SMC over Scenario analysis are:

1. SMC generates the likelihood of the scenarios being tested
2. SMC considers the correlation between different scenarios

Q.2616 Arthur Bell is the portfolio manager at FFF Investments. Recently, he bought 5,000 call
options on stocks of one of the local growth-oriented oil refining companies that have never paid
dividends. The strike price of the options was $50. The underlying stock is trading at $58 and
has the annual volatility of return of 33%. Bell estimated the delta of these options to be 0.55.
What is the approximate weekly (delta normal) 99% VaR of the position assuming 252 trading
days and 52 trading weeks in the year?

A. $7,725.57

B. $17,007

C. $6,659.97

D. $14,661.22

The correct answer is: B)

In the delta-normal approach, we first calculate the VaR of the underlying. Then, we use the
equation below to revalue the derivative by linear approximation (as the delta multiplied by the
VaR of the underlying):

VaRderivative = (\Delta) × VaRunderlying

VaR of the underlying (stock) = σ &times zcl% &times market value

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But first, we have to convert the annual volatility, i.e., σ, into a weekly value:

Annual volatility = weekly volatility × √52

Thus, weekly volatility = (33%)/√52 = 0.045763

VaR of the underlying = 0.045763 * 2.33 * $58 = $6.18438

VaR of call option = 0.55 * $6.18 = $3.40

VaR of 5,000 call options = $3.40 × 5,000 = $17,007

Note: 2.33 is the standard normal deviate at a 99% confidence level.

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Q.2617 Jack Stone, CRO of DCIV Investment Bank, is concerned with increasing the risk
exposure on one of the bank’s corporate bonds, which is currently priced at par in the market.
He asks Emma Fern, a junior analyst, to quickly estimate the 95% VaR of the position under the
assumption of normally distributed returns. Fern has gathered the following information:

Yield to maturity 11.08%

Volatility of the yield 1.2%

Macaulay Duration 6.50

Modified Duration 5.85

Value of the position $58,145,000

Which of the answers below is closest to Emma’s estimate?

A. $6,734,000

B. $7,483,261.50

C. $7,465,600.91

D. $6,734,935

The correct answer is: D)

Return VaR (%) = Modified duration * sigma * yield volatility * Portfolio value
% VaR of the position = 5.85 * 1.65 * 1.2 = 11.58%
Hence, dollar VaR = 0.1158 * $58,145,000 = $6,734,935

Note: Sigma is read off the normal distribution table. It is just the number of standard deviations
at the upper 95% percentage point.
Note: sigma is read off the normal distribution table - the upper 95% point

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Q.2618 An investor is long a short-term at-the-money put option on an underlying portfolio of
equities with a notional value of $100,000. If the 95% VAR of the underlying portfolio is 12.5%,
which of the following statements about the VAR of the option position is correct when second-
order terms are considered?

A. The VAR of the option position is slightly less than $12,500.

B. The VAR of the option position is slightly more than $6,250.

C. The VAR of the option position is slightly less than $6,250.

D. The VAR of the option position is slightly more than $12,500.

The correct answer is: C)

At the money options have a delta of around 0.5, which implies a linear VAR of $100,000 ×
12.5% × 0.5 = $6,250. The position is long an option and has positive gamma. As a result, the
quadratic VAR must be lower than $6,250.

Note:
According to the delta-gamma approach,
Quadratic VaR = |delta| × VAR_underlying - 0.5 × gamma × [VaR_underlying]2
The above equation explains why long positions in options (which always yield positive gamma)
have less risk than with a linear model. Conversely, short positions in options (which always have
negative gamma) have greater risk than implied by a linear model.

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Q.2619 After a significant increase in the volatility of shares of USY Pharma, Ross Grand, senior
portfolio manager, decides to hedge the existing position by buying 300 at the money put option
contracts. Shares are trading at $457 and have the daily volatility of 4%. What is the daily 99%
VaR using the delta-normal method?

A. $3,457.99

B. $5,791.77

C. $4,524.05

D. $6,388.50

The correct answer is: D)

The key point here is that the options are at the money, so we can assume delta = 0.5. (See the
note at the end of the explanation if this is unclear.)
According to the delta-norma method,
VaR of an option = Delta × VaR of underlying

VaR of the underlying = volatility × sigma × price = 4% * 2.33 * $457 = $42.59

VaR of the position = 0.5 * $42.59 * 300 = $6,388.50

Note: At-the-money call options typically have a delta of 0.5, and the delta of out-of-the-money
call options approaches 0 as expiration nears. The deeper in-the-money the call option, the closer
the delta will be to 1, and the more the option will behave like the underlying asset. Since the
delta of an option ranges between 0 and 1, an at-the-money option is right in between those two
numbers.

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Q.2620 Elisabeth Yung is the senior fixed income investment manager at a regional bank. She is
interested in an investment in Rocks Corporation’s medium-term (7-year) zero-coupon bond. The
bond has a yield to maturity of 4.5% compounded annually and a daily yield volatility of 0.59%.
What are the daily 99% VaR and the Macaulay duration of the bond assuming the purchase price
is $10,000,000?

A. Daily 99% VaR = $920,851.67; Macaulay duration = 7

B. Daily 99% VaR = $676,668; Macaulay duration = 7

C. Daily 99% VaR = $676,668.02; Macaulay duration = 6.7

D. Daily 99% VaR = $920,851.67; Macaulay duration = 6.7

The correct answer is: A)

The key point here is that the Macaulay duration of the zero-coupon bond is equal to the
maturity (7).
In the calculations of VaR, we need to use the modified duration.
VaR = Modified duration * sigma * yield volatility * bond price

VaR of the position = 0.59% * 2.33 * 7/(1+4.5%) * $10,000,000 = $920,851.67

Note: modified duration = Macaulay duration/(1 + y/k)

Where y is the annual yield and k is the number of compounding periods per year. (K = 1 here)

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Q.2621 Richard Aften is not satisfied with the current approach used in his firm for calculating
VaR of fixed income instruments, as it is based solely on duration. Using the example of YYK
Brewing Company’s bond, he wants to see how significant the daily 95% VaR change will be if he
adds convexity adjustment in his calculations. Aften’s firm currently has a position with the
market value of $57,787,333.21 in YYK Brewing Company’s issue. The issue has a yield to
maturity of 7% with a corresponding daily volatility yield of 0.5%. The modified duration is 8 and
the convexity is 57

Which answer is the closest to the change in VaR after the addition of the convexity adjustment?

A. + $112,094.79

B. + $513,787.01

C. - $112,094.79

D. - $513,787.01

The correct answer is: C)

The formula for VaR based on the duration of the bond:

daily (1-α)% VaR = MV * (-MD * Φ-1(1-α) * σ)
The formula for VaR based on the duration and the convexity of the bond:
daily (1 - α)% VaR = MV * (MD * Φ-1(1-α) * σ) – MV * 1/2 * Conv. * (Φ-1(1-α) * σ)2

The difference between these two formulas:

- MV * 1/2 * Conv. * (Φ-1 (1 - α) * σ)2 = -$57,787,333.21 * 1/2 * 57 * (1.65*0.5%)2 = - $112,094.79

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Q.2622 Andrea Simpson is calculating the weekly 99% VaR with the delta-gamma approach for
her position in a call option contract on the stock of Blumen PLC with following features:

Blumen PLC current price $25

Daily variance 0.00043

Delta 0.57

Gamma 0.0045

What is closest to the weekly 99% VaR?

A. $1.52

B. $1.82

C. $1.48

D. $1.27

The correct answer is: A)

Daily VaR of the underlying = δ × α × market price

= √ 0.00043 × 2.33 × $25 = $1.2079

According to the square root of time rule,

V aR(T days) = V aR(1 day) × √T
Weekly VaR of the underlying= V aR(5 days) = V aR(1 day) × √5 = $1.2079 × √5 = $2.70
According to the delta-gamma approach to VaR,
V aR pos ition = Δ × V aR(dS) − 12 Γ × [V aR(dS)]2
Where VaR(dS) is the VaR of the underlying
V aR pos ition = 0.57 × 2.7 − 12 × 0.0045 × 2.72 = $1.5226

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Q.2623 Ashli More prepares a presentation to the management board on the application of
derivatives for hedging risk. She struggles with a classification of linear and non-linear
derivatives.
Which of the following is an example of linear derivatives?

A. Futures on stocks, Forwards on broad market indices, and Plain Vanilla European
options on bonds

B. Interest rate swaps, Interest rate caps, and Plain Vanilla American options on stocks

C. Futures on broad market indices, and CFDs (contracts for difference) on stocks

D. Futures on stocks, and Swaptions

The correct answer is: C)

Prices of both Futures and CFDs are changing proportionally to the changes in underlying.

Options A, B, D are incorrect, as they all include options that are non-linear derivatives.

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Q.2624 To perform a Worst Case Scenario analysis, an analyst simulates the performance of
10,000 random normal vectors over 20 and 100 trading days. The results are summarized in the
table below.

The Distribution of the Minimum* H = 20 H = 100

E[number of Z <-2.33] 0.20 1.00

E[number of Z<-1.65] 1.00 5.00

Expected WCS -1.86 -2.51

Percentile of Z

1% -3.26 -3.72

5% -2.77 -3.28

10% -2.53 -3.08

50% -1.82 -2.47

*Z is the lowest observation of a vector of N(O,l)'s of size H

Which of the following statements is correct?

A. Over the next 20 trading days, the 99% VaR is -3.26.

B. Over the next 20 trading days, the worst possible loss is -3.26.

C. Over the next 100 trading days, in the baseline scenario, the losses of -2.33 or more
are expected to occur only once while in the worst case scenario, they will occur 5 times.

D. Over the next 100 trading days, the 95% VaR threshold is expected to be breached 5
times.

The correct answer is: D)

95% VaR correspond to -1.65 in the given simulation. Number of cases of Z < -1.65 = 5

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Q.2625 The investment division of a bank is considering an investment of $100,000,000 in one of
the following:

stocks of ALPHA Plc

stocks of APPA Corporation

20-year bonds of APPA Corporation

Although the department seeks the investment with the highest expected return, to comply with
bank’s risk policies, the department cannot open a position with a daily 99% VaR higher than
$5,000,000.

The investment opportunities presented above have the following features:

Expected
Expected
annual Modified
annual Market Price
volatility of Duration
return
returns

Stocks of ALPHA 20% 50% - $5 per stock

Stocks of APPA 13% 36% - $30 per stock

Bonds of APPA 8% 10% 3.5 99% per $100

nominal

Assuming zero daily returns and 252 trading days per year, which investment should the bank
choose?

A. Stocks of ALPHA

B. Stocks of APPA

C. Bonds of APPA

D. None of the above

The correct answer is: D)

VaR of ALPHA's stocks = (50%)/√252 * 2.33 * $100,000,000 = $7,338,810.18

VaR of APPA's stocks = (36%)/√252 * 2.33 * $100,000,000 = $5,283,943.33
VaR of APPA' s bond = (10%)/√252 * 2.33 * 3.5 * $100,000,000 = $5,137,167.13

All of the investments have a VaR higher than allowed by the bank’s policies.

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Q.2626 Which of the following statements regarding the full revaluation approach for calculating
VaR of non-linear derivatives is correct?

A. The full revaluation approach relies on the assumption of the derivative’s underlying
normally distributed returns.

B. The full revaluation approach relies on the assumption of the derivative’s underlying
lognormally distributed returns.

C. VaR calculated by the delta-normal approach is always higher than the one calculated
by the full revaluation approach.

D. VaR calculated by the delta-normal approach is always lower than the one calculated
by the full revaluation approach.

The correct answer is: C)

As the delta-normal approach does not take into account the convexity of the options payoffs’
distribution, it will always overestimate the true VaR.

A, B, D are incorrect, as the full revaluation approach does not make any assumption on the
underlying’s distribution of returns.

Q.2627 Which of these statements regarding the Structured Monte Carlo (SMC) simulation is
incorrect?

A. The SMC assumes normally distributed returns of derivative’s underlying.

B. The SMC assumes that distributions used in the simulation are relevant going forward.

C. The SMC can generate correlated scenarios for multiple risk factors based on
corresponding statistical distributions.

D. Increasing the number of SMC simulations will always improve the outcome of the
simulation.

The correct answer is: D)

In cases when assumed distributions itself or distribution’s parameters are no longer relevant,
SMC simulation outcomes will become not reliable and increasing number of simulations will not
solve the problem.

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Q.3312 An insurance company just bought $1 million worth of five-year zero-coupon bonds. Each
bond has a par value of $1000 and an annual effective interest rate of 5%.

The insurance company then collects interest rate changes for 300 days and the data is sorted
descendingly. The following table shows the largest positive interest rate changes and the hybrid
weights used to calculate the VaR.

Hybrid
Largest positive
Order cumulative
interest rate changes
weight

1 4.2% 0.0122

2 3.8% 0.0255

3 3.2% 0.0350

4 2.8% 0.0443

5 2.7% 0.0501

6 2.3% 0.0598

Calculate the 4% downside VaR for the bond positions using the full revaluation method.

A. $2065.13

B. $554.00

C. $5540.00

D. $7065.13

The correct answer is: D)

Since the bond prices decrease when interest rates increase, we need to calculate the upside
VaR for the interest rate change.

Using the third and fourth-largest interest rate changes, we interpolate as:
3.2−2.8
3.2 − (0.035 − 0.04) 0.035−0.0443
= 2.98

This means there is a 4% chance that the interest rate can increase by 2.98% or more higher. In
other words, there is a 4% probability that the interest rate of 5% today can increase to
5 × 1.0298 = 5.149% or more.

At 5%, the price of the bond is 10005 = $783.53.

1.05

1000

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 1000
At 5.149%, the price of the bond is = $777.99.
1.051495

Therefore, the negative price change of the portfolio is

1, 000, 000
( ) ∗ (783.53 − 777.99) = 7 , 065.13 or more with a 4 percent chance in one day.
783.53

Q.3313 An option on the INMEX (Mexican) stock index is struck on 2,522 pesos. The delta of the
option is 0.6, and the annual volatility of the index is 25%. Using delta-normal assumptions, what
is the 10-day VAR at the 95% confidence level? Assume 260 days per year.

A. 204 pesos

B. 61.0 pesos

C. 115.8 pesos

D. 122.4 pesos

The correct answer is: D)

As per the delta-normal method, the VaR of a derivative position is given by:
VaRDerivative = Delta × VaRUnderlying risk factor
Thus, the first step is to determine the VaR of the underlying rsk factor. i.e., the index. But before
that, notice that the question asks for the 10-day VaR, which means it is important that we work
out the 1-day VaR and then use the square root of time rule:
T-day volatility = 1-day Volatility × square root(T)
260-day volatility = 1-day volatility × square root(260)
Thus, 1-day volatility = 260-day volatility/square root(260) = 0.25/sqrt(260) = 0.0155

Hence, 1-day VaR of the underlying = 2,522 × 0.0155 × 1.65 = 64.5 pesos
10-day VaR = 1-day VaR × sqrt(10) = 64.5 × sqrt(10) = 204 pesos

Finally, VaRDerivative = Delta × VaRUnderlying risk factor

= 0.6 × 204 = 122.4 pesos

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Q.3314 A futures contract on the S&P 500 is defined as a dollar multiple of the index level. The
S&P 500 future traded on the Chicago Mercantile Exchange is defined as a $250 index. The 1%
VaR of the S&P 500 index is -2.45. What is the 1% VaR of the S&P 500 futures contract?

A. -$61.25

B. -$512.50

C. -$612.50

D. -$1,225

The correct answer is: C)

Here, we simply multiply the contract value by the 1% VAR: $250 × −2.45 = −$612.50.

Q.3315 A firm originally maintains a 5% VaR for a 250-day horizon. Recently, the firm shifted to
the worst-case scenario (WCS) measure. What will be the capital requirement change if the firm
targets a 1% WCS? Refer to the following table for further information.

Expected 1% 5%
E[Zi < −2.33] E[Zi < −1.65]
WCS WCS WCS

H=250 2.5 12.5 -2.82 -3.92 -3.54

A. 138% decrease

B. 68% decrease

C. 138% increase

D. 68% increase

The correct answer is: C)

The 5% VaR is -1.65 and the 1% WCS is -3.92.

Capital requirement = (\frac{3.92}{1.65} = 2.38)

Thus, it is a 138% increase from the original value of 1 ((2.38 – 1 = 138%).)

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Q.3316 A firm originally maintains a 1% VaR for a 250-day horizon. Recently, the firm shifted to
the worst-case scenario (WCS) measure. What will be the capital requirement change if the firm
targets a 1% WCS? Refer to the following table for further information.

Expected 1% 5%
E[Zi < −2.33] E[Zi < −1.65]
WCS WCS WCS

H=250 2.5 12.5 -2.82 -3.92 -3.54

A. 34% decrease

B. 68% decrease

C. no change

D. 68% increase

The correct answer is: D)

The 5% VaR is -2.33 and the 1% WCS is -3.92.

Capital requirement = (\frac{3.92}{2.33} = 1.68)

Thus, it is a 68% increase from the original value of 1 ((1.68 – 1 = 68%).)

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Q.3317 The following table about a call option on YUK is used to set the position limits for a
trader wishing to write options.

X S0 P0 SV aR PV aR SX trm PXtrm

ATM 1000 1000 80.6 1020 98.4 1200 320.6

OTM 1200 1000 4.22 1020 6.02 1200 70.5

For the option writer, the ATM position is limited to one call option based on the VaR scenario.
The OTM call option is limited to the same dollar amount as the ATM’s based on the VaR
scenario.

Consider the extreme case of the underlying moving from $1,000 to $1,200, noted in the table as
SXtrm for the stock price extreme and P Xtrm for the option price extreme. Compare the ATM call
option writer performance with the OTM call option writer performance.

A. ATM gains $240 and OTM gains $655.44

B. ATM gains $655.44 and OTM gains $240

C. ATM loses $240 and OTM loses $655.44

D. ATM loses $655.44 and OTM loses $240

The correct answer is: C)

The ATM call option writer loses 320.6 − 80.6 = 240.

98.4 − 80.6
The OTM call option writer loses (70.5 − 4.22) × = 655.44.
6.02 − 4.22

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Q.3318 You have been asked to estimate the VaR of GreenWood Corp. The company’s stock is
currently trading at USD 308 and the stock has a daily volatility of 1.25%. Using the delta-normal
method, the VaR at the 95% confidence level of a long position in an at-the-money put on this
stock with a delta of -0.5 over a 1-day holding period is closest to

A. 3.1215

B. 2.1500

C. 3.1666

D. 4.5210

The correct answer is: C)

In the case of a linear derivative, VaR scales directly with the underlying risk factor, i.e.,
VaRlinear derivative = Δ × VaRunderlying risk factor
VaR = Δ × 1.645 × σ × S0 = 0.5 × 1.645 × 0.0125 × 308 = 3.1666

Note: Just as the question dictates, this is an estimate: the accurate relationship is non-linear and

we are actually

omitting the curvature (option gamma). Also, we ignore the negative sign in the solution since a

negative amount is implied.

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Q.3319 An investment company is exposed to a portfolio of bonds. The duration of the portfolio is
8.83 and the convexity of the portfolio is 6.43. What is the change in the price of the portfolio for
a one percentage point increase in the interest rate?

A. -5.5%

B. 2.4%

C. -4.4%

D. -8.8%

The correct answer is: D)

For nonlinear derivative, we can use the first two terms in the Taylor series (the delta-gamma)
for price change approximation. For bonds, the duration and convexity correspond to the first
coefficient and the second coefficient in the Taylor series.

For a one basis point of change in the interest rate, the formula for the bond price change is:

Change in price = [–Modified Duration Change in yield] +[1/2 * Convexity(change in yield)2]

= -8.83 * 0.01 + 6.43/2 * 0.012 = -8.8%

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 Reading 47: Measuring and Monitoring Volatility

Q.938 Linda Christian is a risk consultant at Garson Partners. She is one of an influential and
respected risk manager in the risk management community of Wall Street banks. In a recent
publication, she shared her thoughts on the use of firm-wide VaR at major banks. From the
following, determine which option is least consistent with the actual features of VaR in banks?

A. Firm-wide VaR does not include the funding liquidity risk of banks

B. Firm-wide VaR is not likely to account for all the risks, especially credit risk

C. The higher the correlation between market risk and credit risk, the higher the firm-
wide VaR will be

D. Due to a lack of historical data, it is difficult to determine if the daily VaR is unbiased
or biased

The correct answer is: B)

Credit risk is included in VaR measurements, but the operational risk is not, which is why Firm-
wide VaR does not account for all of the risks.

Option A is accurate because the firm-wide VaR measure does not include the funding liquidity
risk of the bank, which refers to a sudden decrease in the funding.

Option C is accurate because a higher correlation between credit risk and market risk will result
in higher VaR levels.

Option D is accurate because a lack of historical data makes it difficult to determine if the daily
VaR is unbiased or biased upwards or downwards.

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Q.939 Billy Marquette has recently joined a small company that provides private commercial jets
to royal families, government officials, and directors of big firms. Marquette is a retired
commercial pilot with a very basic understanding of finance. On his first day, he is handed a
report on risk management measures. The excerpt from the report says “due to volatility in oil
prices, the company has a weekly 90% VaR of €20,000”. Which of the following is the most
appropriate explanation of the excerpt?

A. There is a probability that the company can experience a loss of €2,000 on a weekly
basis

B. There is a probability that the company can experience a loss of 10% or €20,000 in any
given week

C. There is a 90% probability, in any given week, that the company could experience a
loss of more than €20,000

D. There is a 10% probability, in any given week, that the company will experience a loss
in excess of €20,000

The correct answer is: D)

VaR is a probabilistic risk measure that measures the potential loss in the value of the portfolio
at any given time.
The “weekly 90% VaR" means that we are 90% confident we will lose no more than €20,000 in
any given week. We are 90% confident that if a loss occurs, it will be less than €20,000. Put
differently, there's a 10% chance that if a loss occurs, it will be more than €20,000.

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Q.940 A number of risk measures are based on the parametric approach, which assumes that the
asset returns are normally distributed. However, mathematicians and statisticians have
discovered that in reality, the asset returns deviate from normality. Which of the following
options is least likely consistent with the assumption that the asset returns deviate from
normality?

A. Asset returns have fat-tailed distributions which means assets have a higher
probability weight in their tails relative to the normal distribution

B. Asset returns have skewed distribution, which means that the declines in asset prices
are more severe than increases in prices

C. Asset returns have unstable parameter values due to varying market conditions

D. Asset returns have symmetrical distributions which means they are evenly distributed
around the mean returns

The correct answer is: D)

Option D is least consistent with the assumption that the asset returns deviate from a normal
distribution. Symmetric distribution is the assumption of the normal distribution that indicates
that the returns are evenly distributed around it means that also indicates that there is no
skewness in asset returns.

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Q.941 Donald York is a quantitative analyst at Brooklyn Investments Hub, a tech investment
company based in New York. York brings 5 years of experience in quantitative and statistical
analysis. In one of his explanatory article, he mentioned that when the mean and standard
deviation of asset returns are the same for any given time period, the distribution of returns is
said to be an unconditional distribution. In contrast, if the mean and variance of the return
change over time, the return distribution is referred to as a conditional distribution. Identify the
correct option from the following.

A. York’s explanation regarding the unconditional distribution is incorrect

B. York’s explanation regarding the conditional distribution is incorrect

C. York’s explanation regarding the conditional and unconditional distribution is incorrect

D. York’s explanation regarding the conditional and unconditional distribution is correct

The correct answer is: D)

Both definitions are correct. An unconditional distribution is referred to as a case when the mean
and the standard deviation of the asset returns are the same for any given time periods. On the
other hand, due to changing economic and market dynamics, the mean and variance of asset
returns can change over time. The returns distributions with changing means and variances are
referred to as conditional distributions.

Q.942 An analyst is conducting fundamental and technical analysis on Pak-China Trading Co

(PCTC) stocks. The analysis takes into account the stock’s daily returns based on the mean and
volatility of returns. If PCTC returns have a mean of 9.56 bps/day, and a high volatility of 14.25
bps/day and a low volatility of 6.18 bps/day, then determine which of the following distributions
fits the most the characteristics of PCTC’s return distribution?

A. Unconditional distribution

B. Regime-switching distribution

C. Unconditionally lognormal distribution

D. Conditional distribution

The correct answer is: B)

In a regime-switching distribution, the volatility of returns switches between low volatilities to

high volatilities. In this distribution, the volatility does not switch to any volatility between the
high and low volatility regimes.

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Q.943 VaR is the widely used and reliable measure of assessing risk. One of the most common
ways of estimating VaR is through analyzing historical time series data and deriving the shape of
the distribution of risk. Which of the following VaR estimating approaches does not use historical
data?

A. Implied volatility approach

B. Hybrid approach

C. Parametric approach

D. Nonparametric approach

The correct answer is: A)

The implied volatility approach does not use historical time-series data to determine the shape of
the distribution of risk. Rather, it uses derivatives pricing models such as the Black-Scholes
options pricing model to derive the distribution using implied volatility. On the other hand, the
parametric approach, nonparametric approach, and hybrid approach (mix of parametric and non-
parametric) use historical data.

Q.944 Bloomsdale Investment uses a number of models to assess the VaR of asset returns under
its portfolio. Most of the models it uses belong to a distinctive category of VaR assessing model
classes that use historical data. Which of the following model classes imposes specific
distributional assumptions on conditional asset returns while assessing VaR?

A. Hybrid approach

B. Parametric approach

C. Nonparametric approach

D. Implied volatility approach

The correct answer is: B)

The category of parametric approach models imposes specific distributional assumptions on

conditional asset returns. An example of a model under this class of risk assessing models is the
conditional (log) normal model with time-varying volatility.

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Q.945 In which of the following categories of VaR estimating models can you accurately
categorize the Black-Scholes model?

A. Hybrid models class

B. Parametric models class

C. Nonparametric models class

D. Implied volatility models class

The correct answer is: D)

The implied volatility models class uses derivatives pricing models like the Black-Scholes options
pricing model to estimate VaR using implied volatility. Other classes of models such as the
parametric, nonparametric and hybrid (mix of parametric and non-parametric) classes use
historical data to determine the shape of the distribution of risk.

Q.946 Xaomi Lee, a fresh graduate from the Boston University of Massachusets, has recently
joined a large investment bank as a trainee in the risk management unit. In the second month of
her joining, her senior manager asked Lee to use a VaR estimate model for a risk analysis on a
specific asset. Which of the following VaR estimating models is the simplest model to use for the
trainee?

A. Parametric models

B. Nonparametric models

C. Hybrid models

D. Monte Carlo simulation

The correct answer is: B)

The nonparametric model is the simplest model for estimating VaR. As compared to the
parametric model, the nonparametric model does not impose a specific set of distributional
assumptions; rather it uses historical data directly.

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Q.947 Gareth Graham is a senior risk consultant for Poincare Consulting Group. Graham has a
strong reputation in the risk managers community, which is why he is frequently invited as a
guest speaker at various business schools. During a recent seminar at a reputable business
school in Vancouver, Graham mentioned the following comments regarding the cyclicality of
volatility:

I. It should be considered while analyzing the risk of financial assets that volatility in financial
markets is time-varying
II. While using a historical data model for analyzing volatility, more weight should be put into
recent data as opposed to earlier data

Which of the following is correct?

A. Only statement I is correct

B. Only statement II is correct

C. Both statements are correct

D. None of the statements is correct

The correct answer is: C)

Both statements are correct. It should be taken into account while analyzing the risk of assets
returns that the volatility in the financial markets is time-varying and sticky. It should also be
assumed that the more recent data of asset returns provides more information about future
volatility.

Q.948 An analyst is comparing the STDEV or GARCH methodology with that of the RiskMetric®
approach for estimating VaR using historical data. He wrote down the following similarities
between both methods. Which of the following similarities is incorrect?

A. Both methods belong to the parametric class of risk assessing models

B. Both methods attempt to estimate conditional volatility

C. Both methods apply equal weights to all the periods

D. Both methods use recent historic data for assessing risk

The correct answer is: C)

The standard deviation models apply equal weights to all the windows of past data, while the
RiskMetric® and the GARCH approaches apply higher weights on more recent data. The weights
decline exponentially to zero as returns become older.

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Q.949 Haresh Kumar, a fresh graduate from an Ivy League institute, has recently applied for a
risk analyst position in an investment bank’s risk management unit. During the interview, a
senior manager asked Kumar to identify some of the advantages of nonparametric methods of
estimating VaR. He provided the following four advantages. Identify the one that is incorrect.

A. For the estimation of VaR, nonparametric models do not require assumptions related
to the distribution of returns

B. In nonparametric models, fat tails, skewness, and other deviations from distribution
are not considered in the estimation process of VaR

C. The multivariate density estimation (MDE), a nonparametric model, allows varying

weights based on the relevance of data, rather than the timing of the data

D. The RiskMetrics® model is a nonparametric approach that exponentially smoothens

weights on historical data

The correct answer is: D)

RiskMetrics® is a parametric model. Options A, B and C are appropriate advantages of using

nonparametric model for estimating VaR.

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Q.950 Which of the following is an advantage of the nonparametric approach of estimating VaR
as compared to the parametric approach?

A. Since the data is used less efficiently in nonparametric methods as compared to

parametric methods, large sample sizes are required to estimate the volatility accurately

B. Separating the full sample of data into different market regimes reduces the amount of
usable data for historical simulation models in the nonparametric approach

C. In nonparametric models, fat tails, skewness, and deviations from distribution are
ignored in the estimation process of VaR

D. The multivariate density estimation (MDE), a nonparametric model, requires a large

amount of data that is directly related to the number of conditioning variables used in the
model

The correct answer is: C)

“In nonparametric models, fat tails, skewness, and deviations from distribution are ignored in the
estimation process of VaR” is an advantage of using a nonparametric method for estimating VaR.
Options A, B, and D are clearly disadvantages of using nonparametric methods as compared to
parametric methods of estimating VaR.

Further explanation:
Percentiles around the median (the 50th percentile) are easy to estimate relatively accurately
even in small samples. This is because every observation contributes to the estimation by the
very fact that it is under or over the median. Estimating extreme percentiles, such as the first or
the fifth percentile, is much less precise in small samples. We do not have an infinite amount of
data.

Finally, it might be argued that we can increase the precision of estimates by using more data;
say, 10,000 past daily observations. The issue here is one of regime relevance (regime
switching).

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Q.951 Selma Kaya is a junior risk analyst at Galileo Investment Bank. She is interested in
estimated the joint density of returns of Algo Corp. and economic growth. Which of the following
models should Kaya most likely use?

A. Risk Metric®

B. Black-Scholes model

C. GARCH

D. Multivariate density estimation (MDE) model

The correct answer is: D)

The Multivariate density estimation (MDE) model allows estimating the joint density of returns of
assets and other specified variables like the slope term structure, CPI, economic growth, etc.

Q.952 Samuel Juan has recently joined Arka Investments. Previously, Juan worked as a risk
analyst at one of the well-known credit rating agencies where he learned various advanced
methodologies for assessing risk through estimating VaR. At Arka, Juan is estimating the 10%
VaR of a specific asset by using historical simulations to estimate the percentile of returns and
using exponentially declining weights on past data. This methodology is most likely an example
of:

A. Parametric VaR estimating

B. Nonparametric VaR estimating

C. Hybrid VaR estimating

D. Implied Volatility VaR estimating

The correct answer is: C)

The hybrid VaR estimating methodology is a combination of parametric and nonparametric

methods. Juan’s method of estimating VaR by using historical simulations (nonparametric
method) to estimate the percentile of the returns and using exponentially declining weights
(parametric method) on past data is an example of the hybrid methodology.

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Q.953 Markus Schmidt is an independent risk consultant at a well-known audit firm. He is
currently working as an external risk advisory for George Reed Shipping Inc. During a meeting
with the senior management of the shipping company, Schmidt made the following comments:

I. Using nonparametric is a simple process as it does not impose a specific set of distributional
assumptions; rather it uses the historical data directly
II. Nonparametric methods are better predictors of the future volatility

Which of his comments is/are incorrect?

A. Comment I only

B. Comment II only

C. Both comments

D. None of the comments

The correct answer is: B)

The most efficient predictors of future volatility are not nonparametric models but implied
volatility models. Implied volatility models such as the Black-Scholes option pricing model can
react better and quicker to current market conditions.

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Q.954 In a board meeting at a large Frankfurt bank, one of the senior risk managers provided
the following disadvantages of using implied volatility methods for estimating VaR:

I. As the volatility in implied volatility methods is model dependent, a misspecified model can
generate faulty forecasts
II. Empirical results suggest that the implied volatility is biased downward, as it is generally
lower than realized volatility

Which of these disadvantages is/are incorrect?

A. Only point I

B. Only point II

C. Both points

D. None of the points

The correct answer is: B)

The point regarding the downward bias of implied volatility is incorrect. Empirical results have
shown that the implied volatility does demonstrate an upward bias as it is, on average, higher
than the realized volatility. Point I is correct because the volatility in implied volatility methods is
model dependent and can result in a wrong forecast if the model is misspecified.

Q.955 The process of assessing the risk of assets returns does not end at estimating VaR using
the appropriate methodology, but the risk assessing also requires the testing of VaR. The process
of backtesting is used to compare losses as estimated by the VaR to those actually incurred over
the given testing period. Which of the following attributes of VaR is least likely examined through
the backtesting process?

A. The unbiasedness of VaR estimations

B. The adaptability of VaR estimations

C. The correctness of historical data used for VaR estimations

D. The robustness of VaR estimations

The correct answer is: C)

Backtesting does not evaluate the correctness and accuracy of the historical data used in the
estimation process of VaR. However, the backtesting method of comparing the losses estimated
by the VaR to those actually incurred over the given testing period is essential for evaluating the
unbiasedness, robustness, and adaptability of VaR estimations.

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Q.956 If the covariance between Japanese and English interest rates is 0.089, and the variances
of interest rates in Japan and England are 17.64% and 10.24%, respectively, then which of the
following is closest to the correlation between Japanese and English interest rates?

A. 4.927

B. 1.028

C. 0.6622

D. 0.8736

The correct answer is: C)

Correlation = Covariance / (Standard deviation (A) * Standard deviation (B))

Correlation = 0.089 / (√0.1764 * √0.1024) = 0.6622

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 Reading 48: External and Internal Credit Ratings

Q.1041 Which of the following statements is INCORRECT with regard to credit ratings?

A. A credit rating represents the agency’s opinion about the creditworthiness of an

obligor with respect to a particular debt security or other financial obligation

B. Credit rating also applies to an issuer’s general creditworthiness

C. There are generally two types of assessment corresponding to different financial

instruments: short term and long term

D. Credit ratings from different agencies convey the same information

The correct answer is: D)

Issuer-specific credit ratings represent the agency’s opinion about the creditworthiness of an
obligor with respect to a particular debt security or other financial obligation. Issuer credit
rating also applies to an issuer’s general creditworthiness. There are generally two types of
assessment corresponding to different financial instruments: short term and long term. Credit
ratings from various agencies normally convey differentiated information. For instance, Standard
& Poor’s perceives its ratings primarily as an opinion on the likelihood of default of an issuer,
whereas Moody’s ratings tend to reflect the agency’s opinion on the expected loss on a facility.

Q.1042 Which of the following statements is NOT true regarding the rating process?

A. The criteria according to which any assessment is provided are very strictly defined
and constitute the intangible assets of rating agencies

B. The rating agency reviews qualitative as well as quantitative factors and compares the
company's performance with that of its peers

C. The issuer is notified of the rating and the major considerations supporting it before it
is discussed by the rating committee

D. When a rating is put on a credit watch list, a comprehensive analysis is undertaken

The correct answer is: C)

The criteria according to which any assessment is provided are very strictly defined and
constitute the intangible assets of rating agencies. The rating agency reviews qualitative as well
as quantitative factors and compares the company's performance with that of its peers. The
issuer is notified of the rating and the major considerations supporting it only after the
committee discusses the lead analyst’s recommendation before voting on it. When a rating is put
on a credit watch list, a comprehensive analysis is undertaken.

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Q.1043 The rating “outlook” provides information about the:

A. Rating trend

B. Loss severity independent of probability of default

C. Loss severity given the probability of default

D. Probability of default

The correct answer is: A)

The rating "outlook" provides information about the rating trend. A positive outlook means that
there is some potential upside conditional to the realization of current assumptions regarding the
company. On the flip side, a negative outlook suggests that the creditworthiness of the company
follows a negative trend.

Q.1044 Which of the following factor is part of the quantitative analysis of rating of an industrial
company?

A. Business fundamentals

B. Operations and cost control

C. Financial ratios

D. Both A and B

The correct answer is: C)

For industrial companies, the rating analysis is commonly split between business reviews (firm
competitiveness, quality of the management and of its policies, business fundamentals,
regulatory actions,markets, operations, cost control, etc.) and quantitative analyses (financial
ratios, etc.).

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Q.1045 The rating of an issuer provided by a rating agency is a (an):

A. Mere opinion on the issuer or securities issued by the issuer

B. Recommendation to purchase, sell, or hold any types of security

C. Indicator of the issuer's creditworthiness and also gives the price or relative value of
specific securities

D. Recommendation based on quantitative analyses and business reviews

The correct answer is: A)

The agencies persistently emphasize that their ratings are mere opinions.

Option B is incorrect. Ratings do not constitute any recommendation to purchase, sell, or hold
any type of security. Option C is incorrect. A rating in itself indeed says nothing about the price
or relative value of specific securities. Option D is incorrect. These opinions (not
recommendations) are based on quantitative analyses and business reviews.

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Q.1046 Which of the following statements is true with regard to the relationship between ratings
and probabilities of default?

A. Across all industries, the number of defaults monotonically increases as we move down
the credit rank

B. A given rating is meant to be forward-looking; it is devised to pinpoint a precise

probability of default

C. Ex-post information such as that provided in default tables or transition matrices does
guarantee to provide ex-ante insights regarding future probabilities of default or
migration

D. Both A and B

The correct answer is: A)

Although a rating is meant to be forward-looking, it is not devised to pinpoint a precise

probability of default, but rather to point to a broad risk bucket.

Rating agencies publish on a regular basis tables reporting observed default rates per rating
category, per year, per industry, and per region. They show that ratings tend to have
homogeneous default rates across industries. This implies that in every industry, the number of
defaults increases as we move down the ratings order. However, It is important to bear in mind
that for a given rating category, default rates can vary from industry to industry (e.g., a higher
percentage of banks with a given rating, say BBB, will default when compared with firms in other
industries with the same rating).

Transition matrices serve as indicators of the likely path of a given credit at a given horizon. Ex-
post information such as that provided in default tables or transition matrices does not
guarantee to provide ex-ante insights regarding future probabilities of default or migration.

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Q.1047 Through-the-cycle ratings issued by the rating agencies do NOT:

A. Factor in the effect of cycles

B. Mitigate the effect of cycles on ratings by incorporating the effect of an "average

cycle" in their scenarios

C. Fluctuate much with temporary changes in microeconomic conditions

D. indicate probabilities of default over a wide time horizon.

The correct answer is: C)

Through-the-cycle ratings issued by the rating agencies factor in the effect of cycles, though they
recognize it is not always easy to anticipate them and though cycles are not fully repetitive in
terms of duration, magnitude, and dynamics. Analysts try to mitigate the effect of cycles on
ratings by incorporating the effect of an "average cycle" in their scenarios.
Ratings do not pinpoint a specific PD at a given horizon. They are broad indicators
A through-the-cycle rating does not fluctuate much with temporary changes in macroeconomic
conditions since they are already factored in the rating.

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Q.1048 Which of the following statement is most likely to be true with regard to the impact of a
rating downgrade/upgrade on the price of bonds/stocks?

A. A rating downgrade is somewhat likely to increase the price of a bond

B. A rating downgrade is likely to decrease the price of a bond

C. A rating upgrade is unlikely to increase the price of the stock since the price only
reflects earnings expectations of investors

D. A rating downgrade is unlikely to decrease the price of a stock since the price largely
reflects earnings expectations among consumers

The correct answer is: B)

A rating downgrade is likely to decrease the price of the bond. For instance, a rating agency may
downgrade a bond issue's rating from BBB to BB because of the fall in the firm's debt repayment
ability, for example, the deterioration in the current ratio. This will increase the bond’s yield
substantially and its price will fall. In this particular case, the bond will go from investment-
grade to below investment-grade, which will force many pension funds to sell the bond since
some may only be allowed to hold investment-grade securities; this will put more pressure on the
bond’s already low price. A rating upgrade works in the opposite direction and is likely to
increase the price of the bond.

A rating upgrade is somewhat likely to increase the price of the stock to reflect improved
investor expectations. A rating downgrade is likely to decrease the price of the stock, reflecting a
dip in investor confidence.

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Q.2809 What is the impact of a company’s rating downgrade on prices of corporate securities?

A. The price of the bond, as well as the price of the stock, tend to go down.

B. The yield of the bond, as well as the price of the stock, tend to go down.

C. The price of the bond tends to go down while the price of the stock can go in both
directions.

D. The yield of the bond tends to go down while the price of the stock can go in both
directions.

The correct answer is: C)

The downgrade has a negative impact on the bond price, not the yield.

The impact of the downgrade on the stock price is less obvious. A downgrade due to an increase
in the firm’s risk can indeed be beneficial to equity holders who effectively own a call on the
value of the firm.

Q.2810 The CRO of an investment bank is reviewing the internal rating assessment policies. He
notices that the bank is using the through-the-cycle approach to rate the borrowers. He is
concerned about the effectiveness of the current approach during recessions and asks to
compare it with the at-the-point-in-time approach.

Which of the following statements is correct?

A. During recessions, the through-the-cycle approach tends to over-estimate risk during

recessions.

B. During recessions, the at-the-point-in-time approach tends to over-estimate risk during

recessions.

C. During recessions, both through-the-cycle and at-the-point-in-time approaches tend to

over-estimate risk.

D. During recessions, both through-the-cycle and at-the-point-in-time approaches tend to

under-estimate risk.

The correct answer is: B)

The at-the-point-in-time approach assesses the credit quality over the near term and tends to
amplify the effect of the business cycle. During recessions, the at-the-point-in-time approach
tends to over-estimate risk.

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Q.2811 Greg Teller, a credit risk analyst, was requested by the CRO to check an internal rating
transition matrix prepared by an intern. The matrix is based on actual rating migrations over the
last ten years. The bank has ratings of A, B, C, and D, with A representing the highest credit
quality and D representing a default. The bank currently has a rating of C.

The intern prepares the following table:

Annual Rating Transitions (%, Average Annual)

A B C D

A 95.00 3.00 2.00 -

B 2.00 89.00 5.00 2.00

C - 7.00 83.00 10.00

After a short review, Teller makes the following statement to the CRO:

Statement 1: “The internal rating transition matrix is correct.”

He also decides to incorporate the findings from the matrix in the conclusion of his research
report for LLL Construction (the only C-rated borrower of the bank). He includes the following
sentence in the conclusion of the report:

Statement 2: “The risk management department recommends creating significant loan loss
provisions for LLL’s facility as it has a 10% chance of default with the current rating and a 0%
chance of improvement to an A rating over the longer term.”

Are Teller’s statements correct?

A. Statement 1 is correct while statement 2 is incorrect.

B. Statement 1 is incorrect while statement 2 is correct.

C. Statement 1 is correct, and statement 2 is also correct.

D. Statement 1 is incorrect, and statement 2 is also incorrect.

The correct answer is: D)

Statement 1 is incorrect. The rows of the internal rating transition matrix should sum up to 100.
In the matrix prepared by the intern, the sum of the probabilities in the second row is 98.

Statement 2 is incorrect. Based on the internal rating transition matrix, LLL Construct has no
chance of a rating improvement to A in one year, but there is a non-zero probability of an
improvement over the longer term.

Additional explanation:

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The transition matrix shows 1-year transition probabilities given a particular starting point. The
matrix is interpreted from left to right. This means A, B, and C, as shown on the left side,
indicate the possible starting points.
So, if the bank is currently rated C, a move to A in exactly one year has a zero probability as
indicated by the blank probability representing the CA intersection.
Statement 2 is partly correct because at C, the bank indeed has a 10% chance of transitioning to
D (default). However, the final part of the statement is incorrect, and here’s why:
If we consider the long-term, or rather a period greater than one year, there’s a non-zero chance
of an A rating at some point in the future. For example, in just two years, the bank can move
from C to B with P(7%), then B to A with P(2%).

Q.3436 Simon Bryan, FRM, is scrutinizing historical migration tables published by S&P’s and
Moody’s. Which of the following statements would possibly appear under “additional
information” below such tables?

A. We should expect to see the highest level of rating stability in the intermediate term
(five-year time frame). Risk ratings will tend to have changed more at both the one- year
and ten-year horizons.

B. We should expect to see the highest level of rating stability during the one-year
timeframe. This stability will decline at both the five-year time frame and even more so at
the ten-year horizon.

C. We should expect to see the greatest amount of credit rating stability over long
periods of time (e.g., ten years). Credit ratings will tend to change more during shorter
periods of time.

D. We should expect to see credit ratings change by about the same amount over time.
The ratings transition matrix shows approximately the same figures for the one-year, five-
year, and ten-year time horizons.

The correct answer is: B)

The Rating Transition Matrix tables developed by renowned rating agencies show that credit
ratings are their most stable over a one-year horizon and that stability decreases with longer
horizons.

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Q.3437 ANEX Financials (AF), a U.S. based firm, has just issued a two-year zero-coupon bond
currently rated AA. Market analysts expect that one year from now:

The probability that the rating of AF remains at AA is 90%

The probability that the rating of AF is downgraded to A is 5%

The probability that AF is upgraded to AAA is 5%

The risk-free rate is flat at 2%, and credit spreads for AAA-, AA-, and A-rated debt are flat at 40,
60, and 100 basis points, respectively. All rates are compounded annually. What is the best
approximation of the expected value of the zero-coupon bond a year from today?

A. 97.6

B. 97.5

C. 97.7

D. 97.4

The correct answer is: B)

In a year’s time, the bond will be a 1-year zero-coupon bond.

The bond has different expected values in each of the three scenarios outlined above. Precisely,

100
PAAA = = 97.66
(1 + 0.02 + 0.004)1

100
P AA = = 97.47
(1 + 0.02 + 0.006)1

100
PA = = 97.09
(1 + 0.02 + 0.01)1

Note that as the ratings deteriorate, so does the value.

T he expec ted value = ∑ πi P i = 5% × 97.66 + 90% × 97.47 + 5% × 97.09

= 97.46

Note: 1% = 100 basis points

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Q.3438 Rating agencies make efforts to incorporate the effects associated with an economic
cycle in their ratings. Although this practice is generally valid, it may lead to:

A. Underestimation of the probability of default in an economic recession

B. Overestimation of the probability of default in an economic recession

C. Underestimation of the probability of default in an economic expansion

D. Divergence of the interests of agency analysts and those of management

The correct answer is: A)

Since ratings are generally produced with an eye on a long-term period, they must take into
account any economic/industrial cycle on the horizon. Rating agencies make efforts to
incorporate the effects associated with an economic cycle in their ratings. Although this practice
is generally valid, it can lead to underestimation or overestimation of default if the predicted
economic cycle doesn’t play out exactly as expected. In particular, a firm’s probability of
defaulting during a severe downturn may be underestimated based on the given rating.

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 Reading 49: Country Risk

Q.1028 John Mathews is interested in setting up a new company in a developing country. A risk
analyst working with at the firm is entrusted with the task of analyzing the country risk. Which of
the following is/are likely to be sources of country risk for the new firm?

I. Life cycle of the country

II. Legal risk
III. Economic structure of the country

A. I only

B. I & II only

C. II & III only

D. All of the above

The correct answer is: D)

Young, growth companies are more exposed to risk partly because they have limited resources to
overcome setbacks and partly because they are far more dependent on the macro environment
staying stable to succeed. Countries that are in early growth, with few established businesses
and small markets, being more exposed to risk than larger, more mature countries.

Investors and businesses are dependent upon legal systems that respect their property rights
and enforce those rights in a timely manner.

Some countries are dependent upon a specific commodity, product or service for their economic
success. That dependence can create additional risk for investors and businesses since a drop in
the commodity's price or demand for the product/service can create severe economic pain that
spreads well beyond the companies immediately affected.

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Q.1029 Armenia Bank has opened a new branch in a country where political risk is substantial.
The board of the bank would like to get a report from the risk department on political risks likely
to be faced in other countries. The risk department while presenting the report makes the
following statements:

Statement I: Democratic countries are always less risky than dictatorship countries
Statement II: The chaos of democracy does create more discontinuous risk (policies that change
as governments shift), and dictatorships create more continuous risk
Statement III: Corruption is an implicit tax on income (that does not show up in conventional
income statements as such) that reduces the profitability and returns on investments for
businesses in that country directly and for investors in these businesses indirectly
Statement IV: Countries that are in the midst of physical conflicts, either internal or external, will
expose investors/businesses not only economic costs but also physical costs

Which of these statements are true?

A. II, III & IV only

B. II & III only

C. III & IV only

D. All of the above

The correct answer is: C)

Statements I & II are incorrect. Democratic countries are less or more risky than their
authoritarian countries. The chaos of democracy does create more continuous risk (policies that
change as governments shift), dictatorships create more discontinuous risk.

Statements III & IV are correct. Corruption is an implicit tax on income that reduces the
profitability and returns on investments for businesses in that country directly and for investors
in these businesses indirectly. Countries that are in the midst of physical conflicts, either internal
or external, will expose investors/businesses not only economic costs but also physical costs.

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Q.1030 Simon Fernando, a country risk intern working at Cross Country Ratings Limited, is
preparing a report on services measuring country risk. He lists out the following details in his
report:

Statement I: Many of the entities that develop the methodology and convert them into scores are
not business entities and consider risks that may have little relevance for businesses
Statement II: The country scores used by different services are standardized
Statement III: A country with a risk score of 80, in the PRS scoring mechanism, is twice as safe
as a country with a score of 40
Statement IV: Country risk scores are more useful for measuring relative risks of countries

Which of them are NOT true?

A. II, III & IV only

B. I & III only

C. I & IV only

D. I, II & III only

The correct answer is: A)

Many of the entities that develop the methodology and convert them into scores are not business
entities and consider risks that may have little relevance for businesses. The country scores are
not standardized, and each service uses its own protocol. A country with a risk score of 80, in the
PRS scoring mechanism, is safer than a country with a risk score of 40, but it would be
dangerous to read the scores to imply that it is twice as safe. Country risk scores are more useful
for ranking the countries than for measuring relative risk.

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Q.1031 An analysis of country defaults has shown that:

I. Countries have been more likely to default on sovereign bonds issued than bank debt owed
II. In dollar value terms, Sub-Saharan countries have accounted for much of sovereign defaulted
debt in the last 50 years
III. As per Moody’s, countries are increasingly defaulting on both local and foreign currency debt
at the same time
IV. Defaults since 1960s have been more likely on foreign currency debt than on foreign currency
bonds
Which of the above statements are correct?

A. II, III & IV only

B. I & II only

C. III & IV only

D. All of the above

The correct answer is: C)

Statements I & II are incorrect. Countries have been more likely to default on bank debt owed
than on sovereign bonds issued, in dollar value terms. Latin American countries have accounted
for much of sovereign defaulted debt in the last 50 years.

Statements III & IV are correct. As per Moody’s, countries are increasingly defaulting on both
local and foreign currency debt at the same time. Defaults since the 1960s have been more likely
on foreign currency debt than on foreign currency bonds.

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Q.1032 Country ABC recently defaulted on local currency and foreign currency sovereign debt.
One of the economists of the country writes an article in the leading business weekly of the
country and lists out the short term and long term effects of defaulting on debt:

I. Default has a negative impact on real GDP growth of between 0.5% and 2%, but the bulk of the
decline is in the first year after the default and seems to be short-lived
II. Default does affect a country's long-term sovereign rating and borrowing costs
III. Sovereign default makes banking systems more robust
IV. Sovereign default also increases the likelihood of political change

Which one of them is correct according to research materials available on the subject?

A. II, III & IV only

B. I & II only

C. I, II & IV only

D. All of the above

The correct answer is: C)

Statement I is correct. Default has a negative impact on real GDP growth of between 0.5% and
2%, but the bulk of the decline is in the first year after the default and seems to be short-lived.

Statement II is correct. Default does affect a country’s long term sovereign rating and borrowing
costs. One study of credit ratings in 1995 found that the ratings for countries that had defaulted
at least once since 1970 were one to two notches lower than otherwise similar countries that had
not defaulted. In the same vein, defaulting countries have borrowing costs that are about 0.5 to
1% higher than countries that have not defaulted.

Statement III is incorrect. Sovereign default can make banking systems more fragile. A
study of 149 countries between 1975 and 2000 indicates that the probability of a
banking crisis is 14% in countries that have defaulted, an eleven percentage-point
increase over non-defaulting countries.

Statement IV is correct. Sovereign default also increases the likelihood of political

change. A study of devaluations between 1971 and 2003 finds a 45% increase in the
probability of change in the top leader (prime minister or president) in the country and
a 64% increase in the probability of change in the finance executive (minister of finance
or head of central bank).

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Q.1033 McGrath, a University student, is working on an article titled “Factors
Determining Sovereign Default Risk.” He sources data from around the world on
sovereign default and analyzes the data. Finally, he compiles his findings based on his
understanding and analysis of the data. He seeks your help in verifying the accuracy of
his findings.

Statement I: Income tax-based systems generate more volatile revenues than sales tax
(or value added tax systems)
Statement II: The decision to default is as much a political decision as it is an economic
decision
Statement III: Autocracies are more likely to default than democracies
Statement IV: The independence and power of the central bank will also affect
assessments of default risk

Which of these statements are accurate?

A. II, III & IV only

B. I & II only

C. I, II & IV only

D. All of the above

The correct answer is: D)

Income tax-based systems generate more volatile revenues than sales tax (or value
added tax systems). The decision to default is as much a political decision as it is an
economic decision. Autocracies (where there is less worry about political backlash) are
more likely to default than democracies. The independence and power of the central
bank will also affect assessments of default risk.

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Q.1034 An analysis of the sovereign ratings provided by different rating agencies reveal
that:

I. For the most part, there is a consensus among the rating agencies in the ratings, but
there can be significant differences on individual countries
II. Sovereign ratings change over time but far less than corporate ratings do
III. Sovereign ratings change little on an annual basis for higher-rated countries
compared to lower-rated countries
IV. Rating agencies assess risk at the broader regional level and have been accused of
regional biases

A. II, III & IV only

B. I & II only

C. I, II & IV only

D. All of the above

The correct answer is: D)

For the most part, there is a consensus among the rating agencies in the ratings, but
there can be significant differences on individual countries. Sovereign ratings change
over time but far less than corporate ratings do. Sovereign ratings change little on an
annual basis for higher-rated countries compared to lower-rated countries. Rating
agencies assess risk at the broader regional level. One of the criticisms that rated
countries have mounted against the rating agencies is that they have regional biases,
leading them to underrate entire regions of the world (Latin America and Africa).

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Q.1035 Three economists participate in a discussion on ‘local and foreign currency
sovereign ratings' on live television. The following are the opinions expressed by these
economists on this topic:

Economist 1: The differential between foreign and local currency ratings is primarily a
function of monetary policy independence
Economist 2: Countries that maintain floating rate exchange regimes and fund
borrowing from deep domestic markets will see local currency ratings converge on
foreign currency ratings
Economist 3: For the most part, local currency ratings are at least as high or higher
than the foreign currency rating. There are, however, notable exceptions, where the
local currency rating is lower than the foreign currency rating.

Which economist(s) made (an) accurate statement(s)?

A. Only Economist 3

B. Only Economists 1 and 3

C. Only Economist 1

D. All three economists

The correct answer is: B)

Economist 1 is correct. The differential between foreign and local currency ratings is
primarily a function of monetary policy independence.

Economist 2 is incorrect. Countries that maintain floating rate exchange regimes and

fund borrowing from deep domestic markets will have the largest differences between

local and foreign currency ratings, whereas countries that have given up monetary

policy independence, either through dollarization or joining a monetary union, will see

local currency ratings converge on foreign currency ratings.

Economist 3 is correct. For the most part, local currency ratings are at least as high or

higher than the foreign currency rating, for the obvious reason that governments have

more power to print more of their own currency. There are, however, notable exceptions

where the local currency rating is lower than the foreign currency rating. In March

2010, for instance, India was assigned a local currency rating of Ba2 and a foreign

currency rating of Baa3.

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Q.1036 Each rating agency has its own system for estimating sovereign ratings, but the
processes share a great deal in common. With regard to sovereign ratings provided by
rating agencies and the processes followed by them, identify the statements which are
correct.

I. A sovereign rating is focused on the creditworthiness of the sovereign country to

private creditors and not to official creditors
II. Rating agencies also vary on whether their rating captures only the probability of
default or also incorporates the expected severity
III. The ratings are decided by a vote of the committee
IV. News of a political coup or an economic disaster can lead to a rating review not just
for the country in question but also for surrounding countries

A. II, III & IV only

B. I & II only

C. I, II & IV only

D. All of the above

The correct answer is: D)

A sovereign rating is focused on the creditworthiness of the sovereign country to

private creditors (bondholders and private banks) and not to official creditors (that
includes the World Bank, the IMF, and other entities). Rating agencies also vary on
whether their rating captures only the probability of default or also incorporates the
expected severity. The ratings are decided by a vote of the committee. News of a
political coup or an economic disaster can lead to a rating review not just for the
country in question but also for surrounding countries (that may face a contagion
effect).

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Q.1037 Rating agencies have been criticized for failing investors on several counts in
the case of sovereign ratings. Which of the following are accurate criticisms faced by
rating agencies?

I. Rating agencies have been accused of being far too optimistic in their assessments of
corporate rating as compared to sovereign ratings
II. When one rating agency lowers or raises a sovereign rating, other rating agencies
seem to follow suit
III. Rating agencies take too long to change ratings, and these changes happen too late
to protect investors from a crisis
IV. Once a market is in crisis, there is the perception that rating agencies sometimes
overreact and lower ratings too much, thus creating a feedback effect that makes the
crisis worse

A. II, III & IV only

B. I & II only

C. I, II & IV only

D. All of the above

The correct answer is: A)

Point I is incorrect. Rating agencies have been accused of being far too optimistic in
their assessments of both corporate and sovereign ratings. While the conflict of interest
of having issuers pay for the rating is offered as the rationale for the upward bias in
corporate ratings, that argument does not hold up when it comes to sovereign ratings,
since the issuing government does not pay rating agencies.

Point II is correct. When one rating agency lowers or raises a sovereign rating, other
rating agencies seem to follow suit.

Point III is correct. Rating agencies take too long to change ratings, and that these
changes happen too late to protect investors from a crisis.

Point IV is correct. Once a market is in crisis, there is the perception that rating
agencies sometimes overreact and lower ratings too much, thus creating a feedback
effect that makes the crisis worse.

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Q.1038 Market interest rates and market-based default spreads play an important role
in understanding sovereign ratings. Which of the following statements are true?

I. Market-based spreads are more dynamic than ratings, with changes occurring in real
time
II. Market-based default measures tend to be far more volatile than ratings and can be
affected by variables that have nothing to do with default
III. The sovereign bond market leads rating agencies, with default spreads usually
climbing ahead of a rating downgrade and dropping before an upgrade
IV. Notwithstanding the lead-lag relationship, a change in sovereign ratings is still an
informational event that creates a price impact on the sovereign bonds at the time that
it occurs

A. II, III & IV only

B. I & III only

C. I, II & IV only

D. All of the above

The correct answer is: D)

There is a strong correlation between sovereign ratings and market default spreads.
Market-based spreads are more dynamic than ratings, with changes occurring in real
time. Market-based default measures tend to be far more volatile than ratings and can
be affected by variables that have nothing to do with default. Liquidity and investor
demand can sometimes cause shifts in spreads that have little or nothing to do with
default risk. The sovereign bond market leads rating agencies, with default spreads
usually climbing ahead of a rating downgrade and dropping before an upgrade.
Notwithstanding the lead-lag relationship, a change in sovereign ratings is still an
informational event that creates a price impact at the time that it occurs.

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Q.1039 Bank ABC relies on credit default swaps to assess the default risk of sovereign
bonds/debt. Which of the following statements are true with regard to the relationship
between Credit Default Swaps and default risk?

I. Changes in CDS spreads lead to changes in sovereign bond yields and sovereign
ratings
II. The CDS market is quicker or better at assessing default risks than the government
bond market, from which default spreads can be extracted
III. The exposure to counterparty and liquidity risk, endemic to the CDS market, can
cause changes in CDS prices that have little to do with default risk
IV. The narrowness of the CDS market can make individual CDS susceptible to
illiquidity problems, with a concurrent effect on prices

A. I, III & IV only

B. I & III only

C. I, II & IV only

D. All of the above

The correct answer is: A)

Statement II is incorrect. It is not clear that the CDS market is quicker or better at
assessing default risks than the government bond market, from which we can extract
default spreads.

All other statements are correct. Changes in CDS spreads lead changes in the sovereign
bond yields and in sovereign ratings. The exposure to counterparty and liquidity risk,
endemic to the CDS market, can cause changes in CDS prices that have little to do with
default risk. The narrowness of the CDS market can make individual CDS susceptible to
illiquidity problems, with a concurrent effect on prices

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Q.1040 Country XYZ chooses to default in local currency. Which of the following may
NOT be a compelling reason to default in local currency?

A. Following Gold standard in the decades prior to 1971

B. Shared currency

C. Foreign currency debt funding local currency assets

D. Local currency debt funding foreign currency assets

The correct answer is: D)

In the decades prior to 1971, countries following the gold standard had to back up their
currency with gold reserves putting a limit on how much currency could be printed.
Countries following shared currency give up the power to control how much of the
currency they could print in return for a common market and the convenience of a
common currency. When countries have foreign currency debt funding local currency
assets, they may choose to default if printing more local currency pushes up inflation
and devalues the local currency which leads to substantial losses in the value of assets
while liabilities remain unchanged.

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Q.2807 Aram Stone recently graduated from one of the most renowned German
universities. During his time as an undergrad, Stone developed a unique algorithm that
could completely change the development of Artificial Intelligence. Stone wants to
patent his idea and initiate a startup, but he did not yet decide on the exact location. To
evaluate legal risks, Stone found the ranking presented in the table below:

Property Right Protection by Region

Overall Legal Physical Intellectual

Region Property Property Property Property

rights Rights Rights Rights

Central/Eastern Europe 4.78 4.64 5.47 4.22

Asia & Oceania 4.77 4.42 5.44 4.44

Middle East & North

4.76 4.61 5.42 4.26
Africa

Latin America 4.57 4.23 5.23 4.25

Africa 4.53 4.26 5.17 4.16

best protection <-> highest scores

In which of the below regions should Stone register his company and patent if his main
concern is the protection of his algorithm?

A. Central/Eastern Europe

B. Asia & Oceania

C. Middle East & North Africa

D. Latin America

The correct answer is: B)

Asia & Oceania have the highest rating of Intellectual Property Rights protection.

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Q.2808 Which of the following is NOT a factor for determining sovereign default risk?

A. Social Service Commitments made by the government

B. Implicit backing from other entities

C. Deterioration of the sovereign rating of the country

D. The ratio of debt to country’s GDP

The correct answer is: C)

The deterioration of the sovereign ratings of a country is not a factor for determining
sovereign default risk, but the result of increasing sovereign default risk.

Option A is incorrect. Social Service Commitments made by the government limit

revenues that the government has and consequently lead to the higher default risks.

Option B is incorrect. Guarantee that another country would step in to protect the
weaker countries from defaulting leads to lower default risks.

Option D is incorrect. The degree of indebtedness is directly correlated with default

risks.

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Q.3433 Mendoza Valeria, FRM, works as a risk analyst at a Mexican conglomerate. She
has been asked to evaluate USD-based bond investments issued by four different
companies. According to her employer’s guidelines, the firm has a strict policy of only
investing in companies with investment-grade ratings on both the S&P rating scale and
Moody’s. In addition, the firm only invests in countries with favorable sovereign risk
quality. Assuming the company is located in the paired country, which (country,
company) pair, as outlined below, would be the most appropriate investment?

Country I mport Ratio Debt Service Ratio Company S$PRating Moody ′ s R

J olly World 42% 300% Brighter World A Ba
ltd .
P luto 18% 30% Green Leaf A Aa
Corp
N orthern 8% 250% Eastbrom BB Baa
Ligh ts F inancial
N orf ork 30% 50% HelsinkiI nc . BBB Ba

A. (Norfork, Helsinki Inc.)

B. (Northern Lights, Eastbrom Financial)

C. (Pluto, Green Leaf Corp)

D. (Jolly World, Brighter World ltd.)

The correct answer is: C)

An investment-grade bond has S&P rating BBB or above or Moody’s ratings Baa or
above.

Import ratio is the ratio of total imports of a country to that country's total foreign
exchange (FX) reserves. The larger the import ratio, the higher the probability of
default. This could possibly lead to a rescheduling of payments.

Debt service ratio is the ratio of debt service payments (principal + interest) of a
country to that country's export earnings. The lower the ratio, the healthier (less risky)
a country is deemed to be.

As you can see above, choice C ticks all three boxes.

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Q.3434 Credit rating agencies like S&Ps and Moody’s issue two different credit ratings
for countries with an appetite for debt. These are the local currency debt rating and the
foreign currency debt rating. Historically, it has been observed that defaults on local-
currency-denominated debt are less frequent than foreign-currency-denominated debt.
What’s the main reason behind this observation?

A. Local currency debt has a lower spread compared to that of foreign debt

B. This is a statistical anomaly – ideally, defaults rates in the two categories of

debt should be more or less equal

C. Foreign currency-denominated debt has less political ramifications than local

currency-denominated debt, making it easier to deal with the consequences from
the perspective of a country’s leadership

D. Unlike local currency obligations, foreign currency obligations cannot be

settled via monetary expansion

The correct answer is: D)

The main reason why we haven’t witnessed too many local-currency-denominated debt
defaults is down to the ability of governments to print money to settle such obligations.
No government has printing rights over foreign currencies, and thus monetary
expansion is not a viable option in the case of foreign debt. The lower default rate on
local-currency-denominated debt is consistent with the observation that credit ratings
are higher. This effectively rules out statistical errors.

Local currency debt has a lower spread compared to that of foreign debt, but this is not
the main reason why we have more defaults under the latter.

Choice C describes a possible reason as to why a government might default on foreign

debt, but this only happens in autocratic countries where the leadership enjoys near-
dictatorial powers and security of tenure.

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Q.3435 Credit ratings have over the years been put to task for issuing credit ratings
that do not accurately capture the risk associated with foreign debt owned by different
countries around the world. Which of the following statements is false regarding
weaknesses of rating agency sovereign debt ratings?

A. Ratings are often reactive to real life happenings on the lending market

B. Rating agencies exhibit some interdependence while issuing credit ratings

C. Rating agencies use government-provided data to model default risk and

come up with a credit rating

D. None of the above

The correct answer is: D)

Option A is a true statement. Rating agencies have been found to be reactive rather
than proactive, which means they do not properly execute the advisory role they are
meant to.

Option B is a true statement. Besides being under the influence of the political class,

rating agencies are also not as independent as they should be. This plays out in

instances where one agency issues a ratings downgrade on a country and others soon

follow suit, without independent analysis of the prevailing situation.

Option C is a true statement. The data that the agencies use to rate sovereign ratings

generally come from the governments themselves. As such, there is the potential for

governments holding back bad news and revealing only good news which, in turn, may

explain the upward bias in sovereign ratings.

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 Reading 50: Credit Risk and Capital Modeling

Q.1049 Anton Cooper, a senior credit analyst, states the following to his fellow
associates regarding credit risk. Which of the following statements are true with regard
to credit risk?

I. Credit risk is the risk that arises from any nonpayment of any promised payments
II. Credit risk is the risk that arises from any rescheduling of any promised payments
III. Credit risk is the risk that arises from credit migrations of a loan
IV. Credit risk events include changes in the counterparty characteristics but not
changes in the country characteristics

A. I & II only

B. I, II & III only

C. I, II & IV only

D. All of the above

The correct answer is: B)

Credit risk is the risk that arises from any nonpayment or rescheduling of any promised
payments (i.e. default-related events) or from credit migrations of a loan that gives rise
to an economic loss to the bank. Credit risk events include changes in the counterparty
as well as the country's characteristics.

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Q.1051 Yusuf, a research scholar associated with Dale University, presents a report on
expected loss to the senior management of Glovsky Bank. He makes the following
statement(s) in his report:

Statement I: The expected loss is a certain amount of money a bank is expected to lose
over a pre-determined period of time when extending loans to its customers
Statement II: Even though credit loss levels will fluctuate from year to year, there is an
anticipated average level of losses over time that can be statistically determined
Statement III: Expected loss must be treated as a foreseeable cost of doing business in
the lending business
Statement IV: Expected loss represents the level of losses predicted for the following
year based on the economic cycle

Which of these statements are true?

A. I & II only

B. I, II & III only

C. II, III & IV only

D. I, II & IV only

The correct answer is: B)

Statements I, II & III are true. Expected loss is a certain amount of money a bank is
expected to lose over a pre-determined period of time when extending loans to its
customers. Even though these credit loss levels will fluctuate from year to year, there is
an anticipated average level of losses over time that can be statistically determined.
Expected loss must be treated as a foreseeable cost of doing business in the lending
business.

Statement IV is false. Expected loss is not the level of losses predicted for the following
year based on the economic cycle, but rather the long-run average loss level across a
range of typical economic conditions.

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Q.1052 Economic losses are determined using certain components. Which of the
following is not a component that determines economic losses?

A. Probability of default

B. Exposure amount

C. Loss rate

D. All of the three components determine Economic loss

The correct answer is: D)

Probability of default, exposure amount and loss rate are the three components that
determine economic losses.

Q.1053 American International Bank sanctioned a loan to a corporate client. The

following particulars are given in the credit note by credit analyst of the client:

Exposure amount = 100 USD million

Loss rate = 10%
Probability of default = 20%

What is the expected loss of the loan?

A. USD 2 million

B. USD 20 million

C. USD 10 million

D. USD 40 million

The correct answer is: A)

Expected loss = Probability of default at time H * Exposure amount at time H * Loss

rate experienced at time H
= PD * EA * LR
= 100 * 0.2 * 0.1 = 2 million

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Q.1054 Rojan Ortiz, a senior credit risk analyst at Asiana Bank, discusses with his
colleague regarding the components of the economic losses. He makes the following
statements with regard to the components of the economic losses. Which of the
following are true?

Statement I: The loss rate is the fraction of the exposure amount that is lost in the
event of default
Statement II: Probability of default is a borrower-specific estimate that is typically
linked to the borrower's risk rating
Statement III: Exposure amount and loss rate reflect and model the product specifics of
a borrower's liability
Statement IV: Probability of default (PD) is a measure to determine whether a
counterparty goes into default over a predetermined period of time

A. I & II only

B. I, II & III only

C. II, III & IV only

D. All of the above

The correct answer is: D)

All statements are correct. The loss rate is the fraction of the exposure amount that is
lost in the event of default, meaning the amount that is not recovered after the sale of
the collateral. PD is a borrower-specific estimate that is typically linked to the
borrower's risk rating. The remaining two components reflect and model the product
specifics of a borrower's liability. Probability of default (PD) is a measure to determine
whether a counterparty goes into default over a predetermined period of time

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Q.1055 A bank credit risk is preparing a manual on unexpected losses. Which of the
following statements can be captured in the manual with regard to unexpected loss?

I. It is important to price unexpected losses in a loan's interest rate adequately

II. Unexpected losses in statistical terms is the standard deviation of credit losses, that
is, the standard deviation of actual credit losses around the expected loss average
III. Unexpected loss can be calculated at the transaction and portfolio level
IV. Unexpected loss is the primary driver of the amount of economic capital required for
credit risk

A. I & II only

B. I, II & III only

C. II, III & IV only

D. All of the above

The correct answer is: C)

Statement I is incorrect. Unexpected losses cannot be anticipated and hence cannot be

adequately priced for in a loan's interest rate.

Statements II, III & IV are correct. Unexpected loss, in statistical terms, is the standard
deviation of credit losses, that is, the standard deviation of actual credit losses around
the expected loss average. Unexpected loss can be calculated at the transaction and
portfolio level. Unexpected loss is the primary driver of the amount of economic capital
required for credit risk.

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Q.1056 John Sutton, a newly recent finance graduate working at Asana Finance Ltd.,
approaches his superior, George Shelton, to understand the differences and similarities
between expected losses and unexpected losses?. Gorge makes the following
statements:

Statement I: The unexpected loss of a specific loan on a stand-alone basis (i.e., ignoring
diversification effects) can be derived from the components of expected loss
Statement II: Expected loss is calculated as the mean of a distribution whereas
unexpected loss is calculated as the standard deviation of the same distribution
Statement III: Like expected losses, unexpected losses can also be calculated for
various time periods and for rolling time windows across time
Statement IV: Unexpected losses stem from the (unexpected) occurrence of defaults
and (unexpected) credit migration whereasexpected losses must be treated as the
foreseeable cost of doing business in lending markets

Which of these statements are true?

A. Statements I & II only

B. Statements I, II & III only

C. Statements II, III & IV only

D. All of the above

The correct answer is: D)

The unexpected loss of a specific loan on a stand-alone basis (i.e., ignoring

diversification effects) can be derived from the components of expected losses. The
expected loss is calculated as the mean of a distribution whereas unexpected loss is
calculated as the standard deviation of the same distribution. Like expected losses,
unexpected losses can also be calculated for various time periods and for rolling time
windows across time. Unexpected losses (UL) stem from the (unexpected) occurrence of
defaults and (unexpected) credit migration whereas expected losses must be treated as
the foreseeable cost of doing business in lending markets.

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Q.1057 Which of the following statements is/are true regarding unexpected losses for
an individual loan?

I. For an individual loan, the probability of default is dependent on the exposure

amount and the loss rate
II. In most situations, the exposure amount and the loss rate can be viewed as being
independent
III. The unexpected loss is dependent on the default probability, the loss rate, and their
corresponding variances
IV. If there were no uncertainty in the default event and no uncertainty about the
recovery rate, the unexpected loss would be equal to zero

A. I & IV only

B. I, III & IV only

C. II, III & IV only

D. All of the above

The correct answer is: C)

Statement I is incorrect. For an individual loan, the probability of default is

independent of the exposure amount and the loss rate.

Statements II, III & IV are correct. In most situations, the exposure amount and the
loss rate can be viewed as being independent. Since the expected exposure amount can
vary but is (typically) not subject to changes in the credit characteristics itself,
unexpected loss is dependent on the default probability, the loss rate, and their
corresponding variances. If there were no uncertainty in the default event and no
uncertainty about the recovery rate, the unexpected loss would also be equal to zero.

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Q.1058 ABX Bank Limited is holding a portfolio of loans. Which of the following,
considering a loan at the portfolio level, is NOT part of the contribution of the single
unexpected loss to the overall portfolio risk?

A. The loan’s expected loss

B. The loan’s exposure amount

C. The correlation of the exposure to the rest of the portfolio

D. None of the above

The correct answer is: D)

A loan at the portfolio level is not part of the contribution of a single unexpected loss.
The overall portfolio risk is a function of:

(a) The loan’s expected loss (because default probability, loss rate and exposure amount
are all part of the unexpected loss equation)
(b) The loan’s exposure amount
(c) The correlation of the exposure to the rest of the portfolio

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Q.1059 Neeson, a quantitative analyst, is preparing a model for estimating unexpected
losses. He is incorporating appropriate distributions for the components of unexpected
losses. Which of the following are true with regard to the distributions of components
of unexpected losses?

I. The probability of default is a binomial distribution

II. The loss rate can take a number of shapes, which results in different equations for
the variances of loss rate
III. The binomial distribution understates the variance of the loss rate
as compared to the uniform distribution
IV. The uniform distribution assumes that all defaulted borrowers would have the same
probability of losing anywhere between 0 percent and 100 percent

A. I & II only

B. I, II & III only

C. II, III & IV only

D. I, II & IV only

The correct answer is: D)

Statement III is incorrect. The binomial distribution overstates the variance of the loss
rate, since when a customer defaults, either all of the exposure amount is lost or
nothing. On the other hand, the uniform distribution assumes that all defaulted
borrowers would have the same probability of losing between 0% and 100%.

Statements I, II & IV are correct. Since default is a Bernoulli variable, the probability of
default is a binomial distribution. Unlike the distribution for the probability of default,
the loss rate can take a number of shapes, which results in different equations for the
variances of loss rate. Possible distributions are the binomial, the uniform, or the
normal distribution, and the uniform distribution assumes that all defaulted borrowers
would have the same probability of losing anywhere between 0 percent and 100 percent.

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Q.1060 A bank is measuring the marginal contribution of each loan to the overall
portfolio of unexpected loss. In this context, which of the following statement(s) is/are
true?

I. The marginal contribution depends on the weight of the loan in the portfolio, the
correlation between the loan and other loans in the portfolio, and the size of the
portfolio itself
II. The marginal contribution of each loan is constant if the weights of each loan in the
portfolio are held constant when measuring unexpected loss at the portfolio level
III. To calculate the unexpected loss contribution of a single loan analytically, the
marginal impact of the inclusion of this loan on the overall credit portfolio risk is to be
considered
IV. The following formula gives the unexpected loss contribution of loan i:
(ULC_{ i }=UL_{ i }\times \frac { \delta UL_P }{ \delta UL_i })
Where (\delta) represents the partial derivatives.

A. I , II & III only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: C)

Statement I is incorrect. The marginal contribution only depends on the weights of the
different loans in the portfolio, not on the size of the portfolio itself.

Statement II, III & IV are correct. The marginal contribution of each loan is constant if
the weights of each loan in the portfolio are held constant when measuring unexpected
loss at the portfolio level. To calculate the unexpected loss contribution of a single loan
analytically, the marginal impact of the inclusion of this loan on the overall credit
portfolio risk is to be considered. This is done by taking the first partial derivative of
the portfolio unexpected loss with respect to unexpected loss of loan i and multiplying
it by the unexpected loss of loan i.

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Q.1061 Default correlations play an important in measuring the marginal contributions
of a loan to a loan portfolio. With regard to default correlations for a loan portfolio
containing a large number of loans:

A. Default correlations are very difficult, if not impossible, to observe

B. If the loan portfolio contains ‘n’ loans, [n(n-1)]/2 pairwise default correlations
need to be estimated

C. Default correlations are small, but positive providing considerable benefits to

diversification in credit portfolios

D. All of the above are true

The correct answer is: D)

Default correlations are very difficult, if not impossible, to observe where a portfolio of
loans consists of many thousand credits. If the loan portfolio contains ‘n’ loans, [n(1-
1)]/2 pairwise default correlations need to be estimated. Default correlations are small,
but positive providing considerable benefits to diversification in credit portfolios.

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Q.1062 Anston Walsh, a credit analyst at Grant Bank, is entrusted with the task of
calculating the economic capital for a portfolio of loans underwritten by the bank.
Walsh based his task of computing economic capital on the following
assumptions/statements. Which of them are to be considered in the computation to
determine the most appropriate amount of economic capital?

Statement I: The amount of economic capital needed is the distance between the
expected outcome and the unexpected (negative) outcome at a certain confidence level
Statement II: The crucial task in estimating economic capital is the choice of the
probability distribution
Statement III: Credit risks are normally distributed
Statement IV: One distribution often recommended for measuring credit risk is the
normal distribution

A. I & II only

B. I, II & III only

C. I, III & IV only

D. All of the above

The correct answer is: A)

Statements I & II are correct. The amount of economic capital needed is the distance
between the expected outcome and the unexpected (negative) outcome at a certain
confidence level. The crucial task in estimating economic capital is the choice of the
probability distribution.

Statements III & IV are incorrect. Credit risks are not normally distributed but highly
skewed as the upward potential is limited to receiving at maximum the promised
payments and only in very rare events to losing a lot of money. One distribution often
recommended for measuring credit risk is the beta distribution which is extremely
flexible in the shapes of the distribution it can accommodate.

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Q.1063 Australian Synergies Finance Limited uses beta distributions to measure credit
risks. The company states that the beta distribution helps in predicting the credit
losses accurately. With regard to the measurement of credit losses, which of the
following statements are true?

I. The beta distribution is often recommended and is a suitable probability distribution

for measuring the credit losses
II. The beta distribution is especially useful in modeling a random variable that varies
between -1 and +1
III. The shape of the beta distribution can be completely determined by specifying the
parameters α and β
IV. The beta distribution is fully characterized by two parameters: expected loss of the
portfolio and unexpected loss of the portfolio

A. I & II only

B. I, III & IV only

C. I, II & IV only

D. II, III & IV only

The correct answer is: B)

Statement II is incorrect. The beta distribution is especially useful in modeling a

random variable that varies between 0 and c (>0). This is because the beta distribution
nearly always produces positive outputs. When modeling credit events, losses can vary
between 0 and 100%, so that c = 1.

Statements I, III & IV are correct. The beta distribution is often recommended and is a
suitable probability distribution for measuring the credit losses as credit losses are
normally distributed but highly skewed. The shape of the beta distribution can be
completely determined by specifying the parameters α and β. The beta distribution is
fully characterized by two parameters: expected loss of the portfolio and unexpected
loss of the portfolio.

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Q.1064 One of the key concerns in using beta distributions for measuring credit risks is
the difficulty in fitting the beta distribution exactly to the tail of the risk profile of the
credit portfolio. The tail fitting exercise is best accomplished by combining:

A. The normal distribution with a beta distribution

B. The beta distribution with a uniform distribution

C. The beta distribution with a Monte Carlo Simulation

D. The beta distribution with a VaR

The correct answer is: C)

One of the key concerns in using beta distributions for measuring credit risks is the
difficulty in fitting the beta distribution exactly to the tail of the risk profile of the
credit portfolio. The tail fitting exercise is best accomplished by combining the
analytical (beta distribution) solution with a numerical procedure such as a Monte
Carlo simulation

Q.1065 The shape of the beta distribution is determined completely by specifying the
parameters α and β. If α = β, the shape of the beta distribution is:

A. Symmetric

B. U-shaped

C. Inverted

D. Skewed to the left

The correct answer is: A)

The shape of the beta distribution is determined completely by specifying the

parameters α and β. If α = β, the shape of the beta distribution is symmetric.

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Q.1066 Five years ago, American Banking Group approved a loan to Hazard Corp. with a
total commitment of USD 120 million. Today, the outstanding balance of the loan is
USD 80 million. The credit risk department provided the following details with regard
to the riskiness of the loan:

The standard deviation of the probability of default and the loss rate are 4

percent and 15 percent, respectively

The probability of default over the next year is 1%

The loss rate if the customer defaults is 25 percent

What is the unexpected loss for this loan today?

A. USD 2.163 million

B. USD 1.206 million

C. USD 0.769 million

D. USD 1.442 million

The correct answer is: D)

(U nexpec ted loss) = (Exposure 2 + LR2 × σ 2

amount) × √P D × σLR PD

= USD 80 million × √0.01 × (0.15)2 + 0.252 ∗ 0.042 = U SD 1.442 million

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Q.1067 Nicolson Finance has taken credit exposure to two corporate clients. The credit
risk characteristics of these two loans have been provided below:

Loan to customer 1:
Sanctioned amount: USD 600 million
Exposure amount: USD 540 million
Probability of default over the next year: 2%
Loss rate if the customer defaults: 20%
Standard deviation of the probability of default: 3%
Standard deviation of the loss rate: 35%

Loan to customer 2:
Sanctioned amount: USD 300 million
Exposure amount: USD 200 million
Probability of default over the next year: 1%
Loss rate if the customer defaults: 40%
Standard deviation of the probability of default: 2%
Standard deviation of the loss rate: 20%

The correlation between the two loan accounts is 0.5.

What is the unexpected loss of the loan portfolio held by Nicolson Finance?

A. USD 31.23 million

B. USD 34.22 million

C. USD 29.316 million

D. USD 35.22 million

The correct answer is: C)

Unexpected loss = Exposure amount * √{Probability of default * (Standard deviation of

loss rate)2 + Loss rate2 * Standard deviation of probability of default2}
Unexpected loss (customer 1) = USD 540 million * √{0.02 * (0.35)2 + 0.202 * 0.032} =
USD 26.924 million
Unexpected loss (customer 2) = USD 200 million * √{0.01 * (0.20) 2 + 0.402 * 0.022} =
USD 4.308132 million
Unexpected loss on the portfolio = √{Unexpected loss on customer 12 + Unexpected
loss on customer 22 + (2 * Unexpected loss on customer 1 * Unexpected loss on
customer 2 * correlation)}
Unexpected loss on the portfolio = √{26.9242 + 4.30812 + (2 * 26.924 * 4.3081 * 0.5)} =
USD 29.316 million

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Q.1068 Nicolson Finance has taken credit exposure to two corporate clients. The credit
risk characteristics of these two loans have been provided below:

Loan to customer 1: The sanctioned amount is USD 600 million, the exposure amount is
USD 540 million, the probability of default over the next year is 2 percent, and the loss
rate is 20 percent if the customer defaults. Moreover, the standard deviations of the
probability of default and the loss rate are 3 percent and 35 percent respectively.
Loan to customer 2: The sanctioned amount is USD 300 million, the exposure amount is
USD 200 million, the probability of default over the next year is 1 percent, and the loss
rate is 40 percent if the customer defaults. The standard deviations of the probability of
default and the loss rate are 2 percent and 20 percent respectively.
The correlation between the two loan accounts is 0.5.

What is the risk contribution of customer 1 and customer 2 to the loan portfolio?

A. Customer 1: 26.705 million and Customer 2: 2.611 million

B. Customer 1: 27.705 million and Customer 2: 1.611 million

C. Customer 1: 28.619 million and Customer 2: 2.611 million

D. Customer 1: 28.619 million and Customer 2: 1.611 million

The correct answer is: A)

Unexpected loss = Exposure amount * √{Probability of default * (Standard deviation of

loss rate)2 + Loss rate2 * Standard deviation of probability of default2}
Unexpected loss of customer 1 = 540 * √{0.02 * (0.35)2 + 0.202 * 0.032 = USD 26.924
million
Unexpected loss of customer 2 = 200 2{0.01 x (0.20) 2 + 0.402 * 0.022 = USD 4.308132
million
Unexpected loss on the portfolio = √{Unexpected loss on customer 12 + Unexpected
loss on customer 22 + (2 * Unexpected loss on customer 1 * Unexpected loss on
customer 2 * correlation)}
Unexpected loss on the portfolio = √{26.9242 + 4.30812 + (2 * 26.924 * 4.3081)} =
29.316 million

In general,
risk contribution of customer X = Unexpected loss on customer X * [{Unexpected loss
on customer 1 + (Correlation between customers X and Y * Unexpected loss on
customer Y)} / Unexpected loss on the portfolio]
Risk contribution of customer 1 = 26.924 * [{26.924 + (0.5*4.308)}/ 29.316] = USD
26.705 million
Risk contribution of customer 2 = 4.308 * [{4.308 + (0.5*26.924)} / 29.316] = USD
2.611 million

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Q.3439 A bank has booked a loan with a total commitment amounting to $100,000. 80%
of this amount is currently outstanding. The default probability of the loan is assumed
to be 2% for the next year, and the loss given default (LGD) stands at 40%. The standard
deviation of LGD is 30%. Drawdown on default (i.e., the fraction of the undrawn loan) is
assumed to be 70%. Determine the expected and unexpected losses for the bank.

A. Expected loss = USD 640, unexpected loss = USD 5,621

B. Expected loss = USD 640, unexpected loss = USD 6,604

C. Expected loss = USD 752, unexpected loss = USD 6,604

D. Expected loss = USD 752, unexpected loss = USD 5,621

The correct answer is: C)

EL = EA × P D × LR

Exposure at default,

EA = drawn amount + drawdown on default

= 80% × 100, 000 + 70% × (100, 000 − 80% × 100 , 000)
= 80 , 000 + 14 , 000 = 94 , 000

P D = 2%

LR = 40%

Thus,

EL = 94 , 000 × 0.02 × 0.4 = U SD 752

2 + LR2 × σ 2
UL = EA × √P D × σLR PD

2
σLR = 0.32 σP2 D = p (1 − p) = 0.02 × 0.98 = 0.0196

Thus,

U L = 94 , 000 × √0.02 × 0.32 + 0.42 × 0.0196

= US D 6, 604

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Q.3440 An investor holds a portfolio of $200 million. This portfolio consists of AA-rated
bonds ($120 million) and BB-rated bonds ($80 million). Assume that the one-year
probabilities of default for AA-rated and BB-rated bonds are 4% and 6%, respectively,
and that they are independent. In the event of default, the recovery rate for AA-rated
bonds is 65%, and the recovery rate for BB-rated bonds is 40%. Determine the one-year
expected credit loss from this portfolio:

A. $1,680,000

B. $4,560,000

C. $4,500,000

D. $2,880,000

The correct answer is: B)

The expected loss of the portfolio is the sum of the expected losses of individual assets.

EL = EA × P D × LR

For AA-rated bonds,

EA = $120, 000, 000,

P D = 0.04, and

LR = 0.35

Thus,

EL AA = 120, 000 , 000 × 0.04 × 0.35 = $1, 680, 000

For BB-rated bonds,

EA = $80 , 000, 000 ,

P D = 0.06, and

LR = 0.6

Thus,

ELBB = 80 , 000, 000 × 0.06 × 0.6 = $2, 880, 000

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 Portfolio expected loss = $1 , 680 , 000 + $2, 880, 000 = $4, 560, 000

Q.3441 A portfolio consists of two bonds. The credit VaR – as defined by the bondholder
– is the maximum loss due to defaults at a confidence level of 99%, over a period of one
year. The probability that the two bonds jointly default is 2%, with a default correlation
of 25%. The bond value, default probability, and recovery rate are USD 500,000, 5%, and
50% for one bond, and USD 300,000, 3%, and 30% for the other. Determine the expected
credit loss of the portfolio:

A. USD 18,800

B. USD 12,500

C. USD 18,424

D. USD 12,424

The correct answer is: A)

The joint default probability and the default correlation are nugatory as far as the
expected credit loss of the portfolio is concerned. In other words, they do no matter.

The expected loss of the portfolio is simply the sum of the expected losses of individual
assets.

EL = EA × P D × LR

For the first bond,

EA = $500, 000,

P D = 0.05, and

LR = 0.5

Thus,

EL AA = 500 , 000 × 0.05 × 0.5 = $12 , 500

For the second bond,

EA = $300, 000,

P D = 0.03, and

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LR = 0.7

Thus,

EL BB = 300, 000 × 0.03 × 0.7 = $6, 300

P ortfolio credit loss = $12 , 500 + $6, 300 = $18 , 800

Note: The joint probability of default and the default correlation would be important
only in the calculation of the unexpected credit loss of the portfolio.

Q.3646 Economic losses are determined using certain components. Which of the
following is not a component that determines economic losses?

A. Probability of default

B. Exposure amount

C. Loss rate

D. All of the three components determine Economic loss

The correct answer is: D)

Probability of default, exposure amount and loss rate are the three components that
determine economic losses.

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Q.3647 American International Bank sanctioned a loan to a corporate client. The
following particulars are given in the credit note by credit analyst of the client:

Exposure amount = 100 USD million

Loss rate = 10%
Probability of default = 20%

What is the expected loss of the loan?

A. USD 2 million

B. USD 20 million

C. USD 10 million

D. USD 40 million

The correct answer is: A)

Expected loss = Probability of default at time H * Exposure amount at time H * Loss

rate experienced at time H
= PD * EA * LR
= 100 * 0.2 * 0.1 = 2 million

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Q.3648 Rojan Ortiz, a senior credit risk analyst at Asiana Bank, discusses with his
colleague regarding the components of the economic losses. He makes the following
statements with regard to the components of the economic losses. Which of the
following are true?

Statement I: The loss rate is the fraction of the exposure amount that is lost in the
event of default
Statement II: Probability of default is a borrower-specific estimate that is typically
linked to the borrower's risk rating
Statement III: Exposure amount and loss rate reflect and model the product specifics of
a borrower's liability
Statement IV: Probability of default (PD) is a measure to determine whether a
counterparty goes into default over a predetermined period of time

A. I & II only

B. I, II & III only

C. II, III & IV only

D. All of the above

The correct answer is: D)

All statements are correct. The loss rate is the fraction of the exposure amount that is
lost in the event of default, meaning the amount that is not recovered after the sale of
the collateral. PD is a borrower-specific estimate that is typically linked to the
borrower's risk rating. The remaining two components reflect and model the product
specifics of a borrower's liability. Probability of default (PD) is a measure to determine
whether a counterparty goes into default over a predetermined period of time

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Q.3649 A bank credit risk is preparing a manual on unexpected losses. Which of the
following statements can be captured in the manual with regard to unexpected loss?

I. It is important to price unexpected losses in a loan's interest rate adequately

II. Unexpected losses in statistical terms is the standard deviation of credit losses, that
is, the standard deviation of actual credit losses around the expected loss average
III. Unexpected loss can be calculated at the transaction and portfolio level
IV. Unexpected loss is the primary driver of the amount of economic capital required for
credit risk

A. I & II only

B. I, II & III only

C. II, III & IV only

D. All of the above

The correct answer is: C)

Statement I is incorrect. Unexpected losses cannot be anticipated and hence cannot be

adequately priced for in a loan's interest rate.

Statements II, III & IV are correct. Unexpected loss, in statistical terms, is the standard
deviation of credit losses, that is, the standard deviation of actual credit losses around
the expected loss average. Unexpected loss can be calculated at the transaction and
portfolio level. Unexpected loss is the primary driver of the amount of economic capital
required for credit risk.

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Q.3650 John Sutton, a newly recent finance graduate working at Asana Finance Ltd.,
approaches his superior, George Shelton, to understand the differences and similarities
between expected losses and unexpected losses?. Gorge makes the following
statements:

Statement I: The unexpected loss of a specific loan on a stand-alone basis (i.e., ignoring
diversification effects) can be derived from the components of expected loss
Statement II: Expected loss is calculated as the mean of a distribution whereas
unexpected loss is calculated as the standard deviation of the same distribution
Statement III: Like expected losses, unexpected losses can also be calculated for
various time periods and for rolling time windows across time
Statement IV: Unexpected losses stem from the (unexpected) occurrence of defaults
and (unexpected) credit migration whereasexpected losses must be treated as the
foreseeable cost of doing business in lending markets

Which of these statements are true?

A. Statements I & II only

B. Statements I, II & III only

C. Statements II, III & IV only

D. All of the above

The correct answer is: D)

The unexpected loss of a specific loan on a stand-alone basis (i.e., ignoring

diversification effects) can be derived from the components of expected losses. The
expected loss is calculated as the mean of a distribution whereas unexpected loss is
calculated as the standard deviation of the same distribution. Like expected losses,
unexpected losses can also be calculated for various time periods and for rolling time
windows across time. Unexpected losses (UL) stem from the (unexpected) occurrence of
defaults and (unexpected) credit migration whereas expected losses must be treated as
the foreseeable cost of doing business in lending markets.

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Q.3651 Which of the following statements is/are true regarding unexpected losses for
an individual loan?

I. For an individual loan, the probability of default is dependent on the exposure

amount and the loss rate
II. In most situations, the exposure amount and the loss rate can be viewed as being
independent
III. The unexpected loss is dependent on the default probability, the loss rate, and their
corresponding variances
IV. If there were no uncertainty in the default event and no uncertainty about the
recovery rate, the unexpected loss would be equal to zero

A. I & IV only

B. I, III & IV only

C. II, III & IV only

D. All of the above

The correct answer is: C)

Statement I is incorrect. For an individual loan, the probability of default is

independent of the exposure amount and the loss rate.

Statements II, III & IV are correct. In most situations, the exposure amount and the
loss rate can be viewed as being independent. Since the expected exposure amount can
vary but is (typically) not subject to changes in the credit characteristics itself,
unexpected loss is dependent on the default probability, the loss rate, and their
corresponding variances. If there were no uncertainty in the default event and no
uncertainty about the recovery rate, the unexpected loss would also be equal to zero.

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Q.3652 ABX Bank Limited is holding a portfolio of loans. Which of the following,
considering a loan at the portfolio level, is NOT part of the contribution of the single
unexpected loss to the overall portfolio risk?

A. The loan’s expected loss

B. The loan’s exposure amount

C. The correlation of the exposure to the rest of the portfolio

D. None of the above

The correct answer is: D)

A loan at the portfolio level is not part of the contribution of a single unexpected loss.
The overall portfolio risk is a function of:

(a) The loan’s expected loss (because default probability, loss rate and exposure amount
are all part of the unexpected loss equation)
(b) The loan’s exposure amount
(c) The correlation of the exposure to the rest of the portfolio

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Q.3653 Neeson, a quantitative analyst, is preparing a model for estimating unexpected
losses. He is incorporating appropriate distributions for the components of unexpected
losses. Which of the following are true with regard to the distributions of components
of unexpected losses?

I. The probability of default is a binomial distribution

II. The loss rate can take a number of shapes, which results in different equations for
the variances of loss rate
III. The binomial distribution understates the variance of the loss rate as compared to
the uniform distribution
IV. The uniform distribution assumes that all defaulted borrowers would have the same
probability of losing anywhere between 0 percent and 100 percent

A. I & II only

B. I, II & III only

C. II, III & IV only

D. I, II & IV only

The correct answer is: D)

Statement III is incorrect. The binomial distribution overstates the variance of the loss
rate, since when a customer defaults, either all of the exposure amount is lost or
nothing. On the other hand, the uniform distribution assumes that all defaulted
borrowers would have the same probability of losing between 0% and 100%.

Statements I, II & IV are correct. Since default is a Bernoulli variable, the probability of
default is a binomial distribution. Unlike the distribution for the probability of default,
the loss rate can take a number of shapes, which results in different equations for the
variances of loss rate. Possible distributions are the binomial, the uniform, or the
normal distribution, and the uniform distribution assumes that all defaulted borrowers
would have the same probability of losing anywhere between 0 percent and 100 percent.

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Q.3654 A bank is measuring the marginal contribution of each loan to the overall
portfolio of unexpected loss. In this context, which of the following statement(s) is/are
true?

I. The marginal contribution depends on the weight of the loan in the portfolio, the
correlation between the loan and other loans in the portfolio, and the size of the
portfolio itself
II. The marginal contribution of each loan is constant if the weights of each loan in the
portfolio are held constant when measuring unexpected loss at the portfolio level
III. To calculate the unexpected loss contribution of a single loan analytically, the
marginal impact of the inclusion of this loan on the overall credit portfolio risk is to be
considered
IV. The following formula gives the unexpected loss contribution of loan i:
δU LP
ULC i = UL i ×
δ UL i
Where δ represents the partial derivatives.

A. I , II & III only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: C)

Statement I is incorrect. The marginal contribution only depends on the weights of the
different loans in the portfolio, not on the size of the portfolio itself.

Statement II, III & IV are correct. The marginal contribution of each loan is constant if
the weights of each loan in the portfolio are held constant when measuring unexpected
loss at the portfolio level. To calculate the unexpected loss contribution of a single loan
analytically, the marginal impact of the inclusion of this loan on the overall credit
portfolio risk is to be considered. This is done by taking the first partial derivative of
the portfolio unexpected loss with respect to unexpected loss of loan i and multiplying
it by the unexpected loss of loan i.

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Q.3655 Default correlations play an important in measuring the marginal contributions
of a loan to a loan portfolio. With regard to default correlations for a loan portfolio
containing a large number of loans:

A. Default correlations are very difficult, if not impossible, to observe

B. If the loan portfolio contains ‘n’ loans, [n(n-1)]/2 pairwise default correlations
need to be estimated

C. Default correlations are small, but positive providing considerable benefits to

diversification in credit portfolios

D. All of the above are true

The correct answer is: D)

Default correlations are very difficult, if not impossible, to observe where a portfolio of
loans consists of many thousand credits. If the loan portfolio contains ‘n’ loans, [n(1-
1)]/2 pairwise default correlations need to be estimated. Default correlations are small,
but positive providing considerable benefits to diversification in credit portfolios.

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Q.3656 Anston Walsh, a credit analyst at Grant Bank, is entrusted with the task of
calculating the economic capital for a portfolio of loans underwritten by the bank.
Walsh based his task of computing economic capital on the following
assumptions/statements. Which of them are to be considered in the computation to
determine the most appropriate amount of economic capital?

Statement I: The amount of economic capital needed is the distance between the
expected outcome and the unexpected (negative) outcome at a certain confidence level
Statement II: The crucial task in estimating economic capital is the choice of the
probability distribution
Statement III: Credit risks are normally distributed
Statement IV: One distribution often recommended for measuring credit risk is the
normal distribution

A. I & II only

B. I, II & III only

C. I, III & IV only

D. All of the above

The correct answer is: A)

Statements I & II are correct. The amount of economic capital needed is the distance
between the expected outcome and the unexpected (negative) outcome at a certain
confidence level. The crucial task in estimating economic capital is the choice of the
probability distribution.

Statements III & IV are incorrect. Credit risks are not normally distributed but highly
skewed as the upward potential is limited to receiving at maximum the promised
payments and only in very rare events to losing a lot of money. One distribution often
recommended for measuring credit risk is the beta distribution which is extremely
flexible in the shapes of the distribution it can accommodate.

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Q.3657 Australian Synergies Finance Limited uses beta distributions to measure credit
risks. The company states that the beta distribution helps in predicting the credit
losses accurately. With regard to the measurement of credit losses, which of the
following statements are true?

I. The beta distribution is often recommended and is a suitable probability distribution

for measuring the credit losses
II. The beta distribution is especially useful in modeling a random variable that varies
between -1 and +1
III. The shape of the beta distribution can be completely determined by specifying the
parameters α and β
IV. The beta distribution is fully characterized by two parameters: expected loss of the
portfolio and unexpected loss of the portfolio

A. I & II only

B. I, III & IV only

C. I, II & IV only

D. II, III & IV only

The correct answer is: B)

Statement II is incorrect. The beta distribution is especially useful in modeling a

random variable that varies between 0 and c (>0). This is because the beta distribution
nearly always produces positive outputs. When modeling credit events, losses can vary
between 0 and 100%, so that c = 1.

Statements I, III & IV are correct. The beta distribution is often recommended and is a
suitable probability distribution for measuring the credit losses as credit losses are
normally distributed but highly skewed. The shape of the beta distribution can be
completely determined by specifying the parameters α and β. The beta distribution is
fully characterized by two parameters: expected loss of the portfolio and unexpected
loss of the portfolio.

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Q.3658 One of the key concerns in using beta distributions for measuring credit risks is
the difficulty in fitting the beta distribution exactly to the tail of the risk profile of the
credit portfolio. The tail fitting exercise is best accomplished by combining:

A. The normal distribution with a beta distribution

B. The beta distribution with a uniform distribution

C. The beta distribution with a Monte Carlo Simulation

D. The beta distribution with a VaR

The correct answer is: C)

One of the key concerns in using beta distributions for measuring credit risks is the
difficulty in fitting the beta distribution exactly to the tail of the risk profile of the
credit portfolio. The tail fitting exercise is best accomplished by combining the
analytical (beta distribution) solution with a numerical procedure such as a Monte
Carlo simulation

Q.3659 The shape of the beta distribution is determined completely by specifying the
parameters α and β. If α = β, the shape of the beta distribution is:

A. Symmetric

B. U-shaped

C. Inverted

D. Skewed to the left

The correct answer is: A)

The shape of the beta distribution is determined completely by specifying the

parameters α and β. If α = β, the shape of the beta distribution is symmetric.

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Q.3660 Five years ago, American Banking Group approved a loan to Hazard Corp. with a
total commitment of USD 120 million. Today, the outstanding balance of the loan is
USD 80 million. The credit risk department provided the following details with regard
to the riskiness of the loan:

The standard deviation of the probability of default and the loss rate are 4

percent and 15 percent, respectively

The probability of default over the next year is 1%

The loss rate if the customer defaults is 25 percent

What is the unexpected loss for this loan today?

A. USD 2.163 million

B. USD 1.206 million

C. USD 0.769 million

D. USD 1.442 million

The correct answer is: D)

(U nexpec ted loss) = (Exposure 2 + LR2 × σ 2

amount) × √P D × σLR PD

= USD 80 million × √0.01 × (0.15)2 + 0.252 ∗ 0.042 = U SD 1.442 million

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Q.3661 Nicolson Finance has taken credit exposure to two corporate clients. The credit
risk characteristics of these two loans have been provided below:

Loan to customer 1:
Sanctioned amount: USD 600 million
Exposure amount: USD 540 million
Probability of default over the next year: 2%
Loss rate if the customer defaults: 20%
Standard deviation of the probability of default: 3%
Standard deviation of the loss rate: 35%

Loan to customer 2:
Sanctioned amount: USD 300 million
Exposure amount: USD 200 million
Probability of default over the next year: 1%
Loss rate if the customer defaults: 40%
Standard deviation of the probability of default: 2%
Standard deviation of the loss rate: 20%

The correlation between the two loan accounts is 0.5.

What is the unexpected loss of the loan portfolio held by Nicolson Finance?

A. USD 31.23 million

B. USD 34.22 million

C. USD 29.316 million

D. USD 35.22 million

The correct answer is: C)

Unexpected loss = Exposure amount * √{Probability of default * (Standard deviation of

loss rate)2 + Loss rate2 * Standard deviation of probability of default2}
Unexpected loss (customer 1) = USD 540 million * √{0.02 * (0.35)2 + 0.202 * 0.032} =
USD 26.924 million
Unexpected loss (customer 2) = USD 200 million * √{0.01 * (0.20) 2 + 0.402 * 0.022} =
USD 4.308132 million
Unexpected loss on the portfolio = √{Unexpected loss on customer 12 + Unexpected
loss on customer 22 + (2 * Unexpected loss on customer 1 * Unexpected loss on
customer 2 * correlation)}
Unexpected loss on the portfolio = √{26.9242 + 4.30812 + (2 * 26.924 * 4.3081 * 0.5)} =
USD 29.316 million

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Q.3662 Nicolson Finance has taken credit exposure to two corporate clients. The credit
risk characteristics of these two loans have been provided below:

Loan to customer 1: The sanctioned amount is USD 600 million, the exposure amount is
USD 540 million, the probability of default over the next year is 2 percent, and the loss
rate is 20 percent if the customer defaults. Moreover, the standard deviations of the
probability of default and the loss rate are 3 percent and 35 percent respectively.
Loan to customer 2: The sanctioned amount is USD 300 million, the exposure amount is
USD 200 million, the probability of default over the next year is 1 percent, and the loss
rate is 40 percent if the customer defaults. The standard deviations of the probability of
default and the loss rate are 2 percent and 20 percent respectively.
The correlation between the two loan accounts is 0.5.

What is the risk contribution of customer 1 and customer 2 to the loan portfolio?

A. Customer 1: 26.705 million and Customer 2: 2.611 million

B. Customer 1: 27.705 million and Customer 2: 1.611 million

C. Customer 1: 28.619 million and Customer 2: 2.611 million

D. Customer 1: 28.619 million and Customer 2: 1.611 million

The correct answer is: A)

Unexpected loss = Exposure amount * √{Probability of default * (Standard deviation of

loss rate)2 + Loss rate2 * Standard deviation of probability of default2}
Unexpected loss of customer 1 = 540 * √{0.02 * (0.35)2 + 0.202 * 0.032 = USD 26.924
million
Unexpected loss of customer 2 = 200 2{0.01 x (0.20) 2 + 0.402 * 0.022 = USD 4.308132
million
Unexpected loss on the portfolio = √{Unexpected loss on customer 12 + Unexpected
loss on customer 22 + (2 * Unexpected loss on customer 1 * Unexpected loss on
customer 2 * correlation)}
Unexpected loss on the portfolio = √{26.9242 + 4.30812 + (2 * 26.924 * 4.3081)} =
29.316 million

In general,
risk contribution of customer X = Unexpected loss on customer X * [{Unexpected loss
on customer 1 + (Correlation between customers X and Y * Unexpected loss on
customer Y)} / Unexpected loss on the portfolio]
Risk contribution of customer 1 = 26.924 * [{26.924 + (0.5*4.308)}/ 29.316] = USD
26.705 million
Risk contribution of customer 2 = 4.308 * [{4.308 + (0.5*26.924)} / 29.316] = USD
2.611 million

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Q.3663 A bank has booked a loan with a total commitment amounting to $100,000. 80%
of this amount is currently outstanding. The default probability of the loan is assumed
to be 2% for the next year, and the loss given default (LGD) stands at 40%. The standard
deviation of LGD is 30%. Drawdown on default (i.e., the fraction of the undrawn loan) is
assumed to be 70%. Determine the expected and unexpected losses for the bank.

A. Expected loss = USD 640, unexpected loss = USD 5,621

B. Expected loss = USD 640, unexpected loss = USD 6,604

C. Expected loss = USD 752, unexpected loss = USD 6,604

D. Expected loss = USD 752, unexpected loss = USD 5,621

The correct answer is: C)

EL = EA × P D × LR

Exposure at default,

EA = drawn amount + drawdown on default

= 80% × 100, 000 + 70% × (100, 000 − 80% × 100 , 000)
= 80 , 000 + 14 , 000 = 94 , 000

P D = 2%

LR = 40%

Thus,

EL = 94 , 000 × 0.02 × 0.4 = U SD 752

2 + LR2 × σ 2
UL = EA × √P D × σLR PD

2
σLR = 0.32 σP2 D = p (1 − p) = 0.02 × 0.98 = 0.0196

Thus,

U L = 94 , 000 × √0.02 × 0.32 + 0.42 × 0.0196

= US D 6, 604

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Q.3664 An investor holds a portfolio of $200 million. This portfolio consists of AA-rated
bonds ($120 million) and BB-rated bonds ($80 million). Assume that the one-year
probabilities of default for AA-rated and BB-rated bonds are 4% and 6%, respectively,
and that they are independent. In the event of default, the recovery rate for AA-rated
bonds is 65%, and the recovery rate for BB-rated bonds is 40%. Determine the one-year
expected credit loss from this portfolio:

A. $1,680,000

B. $4,560,000

C. $4,500,000

D. $2,880,000

The correct answer is: B)

The expected loss of the portfolio is the sum of the expected losses of individual assets.

EL = EA × P D × LR

For AA-rated bonds,

EA = $120, 000, 000,

P D = 0.04, and

LR = 0.35

Thus,

EL AA = 120, 000 , 000 × 0.04 × 0.35 = $1, 680, 000

For BB-rated bonds,

EA = $80 , 000, 000 ,

P D = 0.06, and

LR = 0.6

Thus,

ELBB = 80 , 000, 000 × 0.06 × 0.6 = $2, 880, 000

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 Portfolio expected loss = $1 , 680 , 000 + $2, 880, 000 = $4, 560, 000

Q.3665 A portfolio consists of two bonds. The credit VaR – as defined by the bondholder
– is the maximum loss due to defaults at a confidence level of 99%, over a period of one
year. The probability that the two bonds jointly default is 2%, with a default correlation
of 25%. The bond value, default probability, and recovery rate are USD 500,000, 5%, and
50% for one bond, and USD 300,000, 3%, and 30% for the other. Determine the expected
credit loss of the portfolio:

A. USD 18,800

B. USD 12,500

C. USD 18,424

D. USD 12,424

The correct answer is: A)

The joint default probability and the default correlation are nugatory as far as the
expected credit loss of the portfolio is concerned. In other words, they do no matter.

The expected loss of the portfolio is simply the sum of the expected losses of individual
assets.

EL = EA × P D × LR

For the first bond,

EA = $500, 000,

P D = 0.05, and

LR = 0.5

Thus,

EL AA = 500 , 000 × 0.05 × 0.5 = $12 , 500

For the second bond,

EA = $300, 000,

P D = 0.03, and

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LR = 0.7

Thus,

EL BB = 300, 000 × 0.03 × 0.7 = $6, 300

P ortfolio credit loss = $12 , 500 + $6, 300 = $18 , 800

Note: The joint probability of default and the default correlation would be important
only in the calculation of the unexpected credit loss of the portfolio.

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 Reading 51: Operational Risk

Q.1069 US International Bank is contemplating to assess operational risk for regulatory

capital. Which of the following approaches can be used to calculate operational risk?

I. Basic indicator approach

II. Standardized approach
III. Advanced measurement approach
IV. Internal Ratings Based approach

A. I, II & III only

B. I, III & IV only

C. II, III & IV only

D. All of the above

The correct answer is: A)

Banks have three alternatives for determining operational risk regulatory capital: (a)
the basic indicator approach, (b) the standardized approach, and (c) the advanced
measurement approach.

Q.1070 A bank follows the basic indicator approach for assessing operational risk for
regulatory purposes. Which of the following statement(s) is/are NOT true with regard to
the basic indicator approach?

A. Under this approach, operational risk capital is set equal to 15% of annual
gross income over the previous three years

B. Gross income is defined as net interest income

C. Net interest income is the excess of income earned on loans over interest paid
on deposits and other instruments that are used to fund the loans

D. All of the above are true

The correct answer is: B)

Under the basic indicator approach, operational risk capital is set equal to 15% of
annual gross income over the previous three years. Gross income is defined as net
interest income plus non-interest income. Net interest income is the excess of income
earned on loans over interest paid on deposits and other instruments that are used to
fund the loans.

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Q.1071 Eurasia Bank Limited is following the basic indicator approach for calculating
the operational risk amount for the year 2016. The financial details of the bank are
given below:

(In million USD) Income earned Interest paid Non-interest income

Year 2015 105 52 18

Year 2014 100 50 20

Year 2013 95 40 16

Based on the original Basel Accord, the bank must hold capital for operational risk for
2016 equal to:

A. USD 10.60 million

B. USD 10.95 million

C. USD 11.05 million

D. USD 7.90 million

The correct answer is: A)

Based on the original Basel Accord, banks using the basic indicator approach must hold
capital for operational risk equal to the average over the previous three years of a fixed
percentage of positive annual gross income. Gross income is defined as net interest
income plus non-interest income.

Net interest income plus non-interest income for the previous three years:

(In million Income Interest Net interest Non-interest Gross

USD) earned paid income income Income

2015 105 52 53 18 71

2014 100 50 50 20 70

2013 95 40 55 16 71

Average gross income over the previous three years: 70.667

Operational risk = 15% of average gross income over the previous three years: 10.60

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Q.1072 American International Bank is using the standardized approach for measuring
operational risk for regulatory capital. The bank is least likely to:

I. Have an operational risk management function that is responsible for identifying,

assessing, monitoring, and controlling operational risk
II. Keep track of relevant losses by business line and must create incentives for the
improvement of operational risk
III. Have a well-documented operational risk management system
IV. Estimate unexpected losses based on an analysis of relevant internal and external
data, and scenario analyses

A. I & II only

B. III & IV only

C. III only

D. IV only

The correct answer is: D)

A bank which is using the standardized approach for measuring operational risk for
regulatory capital must satisfy the following conditions:

(a) The bank must have an operational risk management function that is responsible
for identifying, assessing, monitoring, and controlling operational risk
(b) The bank must keep track of relevant losses by business line and must create
incentives for the improvement of operational risk
(c) There must be regular reporting of operational risk losses throughout the bank
(d) The bank's operational risk management system must be well documented
(e) The bank's operational risk management processes and assessment system must be
subject to regular independent reviews by internal auditors. It must also be subject to
regular review by external auditors or supervisors or both

To use the AMA approach, the bank must satisfy additional requirements. It must be
able to estimate unexpected losses based on an analysis of relevant internal and
external data, and scenario analyses.

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Q.1073 The Basel Committee on Banking Supervision (BCBS) has identified seven
categories of operational risk. Which of the following categories are covered by the
Basel Committee?

I. Employment practices and workplace safety

II. Clients, products, and business practices
III. Execution, delivery, and process management
IV. Strategic risk

A. I, II & III only

B. II, III & IV only

C. I, II & IV only

D. All of the above

The correct answer is: A)

The Basel Committee on Banking Supervision has identified seven categories of

operational risk: (a) Internal fraud, (b) External fraud, (c) Employment practices and
workplace safety, (d) Clients, products, and business practices, (e) Damage to physical
assets, (f) Business disruption and system failures, and (g) Execution, delivery, and
process management.

Strategic risk is not one of the seven categories of operational risk identified by the
Basel Committee on Banking Supervision.

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Q.1074 A bank with annual revenues of $4 billion has incurred a loss of $200 million on
account of operational risk. What would be the losses for a bank with a similar business
profile but with revenues of $12 billion? Assume the exponent for scaling losses is 0.23.

A. USD 7.76 million

B. USD 12.76 million

C. USD 257.5 million

D. USD 200.00 million

The correct answer is: C)

Loss of bank B = [(Revenue of bank B)/(Revenue of bank A)]0.23 * Loss of bank A

= (12/4)0.23 * 200
= 30.23 * 200
= 257.5 million

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Q.1075 Your Canadian Bank has been using the standardized approach for the last
three years. The board of directors has recently decided to use the advanced
measurement approach for measuring operational risk for regulatory risk from the
current year onwards. Considering the change in measurement approach, which of the
following process has been adopted from the current year onwards in the risk
management department of the bank?

A. Regular reporting of operational risk losses throughout the bank

B. Well-documented operational risk management system

C. Regular independent review of operational risk management processes by

internal auditors, external auditors, and supervisors

D. Estimation of unexpected losses based on an analysis of relevant internal and

external data, and scenario analyses

The correct answer is: D)

A bank which is using the standardized approach for measuring operational risk for
regulatory capital must satisfy the following conditions:

(a) The bank must have an operational risk management function that is responsible
for identifying, assessing, monitoring, and controlling operational risk
(b) The bank must keep track of relevant losses by business line and must create
incentives for the improvement of operational risk
(c) There must be regular reporting of operational risk losses throughout the bank
(d) The bank's operational risk management system must be well documented
(e) The bank's operational risk management processes and assessment system must be
subject to regular independent reviews by internal auditors. It must also be subject to
regular review by external auditors or supervisors or both

To use the AMA approach, the bank must satisfy additional requirements. It must be
able to estimate unexpected losses based on an analysis of relevant internal and
external data, and scenario analyses.

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Q.1076 Bank X is following the advanced measurement approach for measuring
operational risk. Which of the following should be the operational risk capital
computed for regulatory purposes?

A. The bank must use 15% of net interest income over the previous three years.

B. The bank’s activities are divided into eight business lines. The average gross
income over the last three years for each business line is multiplied by a "beta
factor" for that business line, and the result summed to determine the total
capital.

C. The bank must estimate one-year 99.9% VaRs for the seven categories of
operational risks identified by the Basel Committee and then aggregate them to
determine a single one-year 99.9% operational risk VaR measure.

D. The bank must use 15% of net interest income plus non-interest income over
the previous three years.

The correct answer is: C)

Standardized measure: The bank’s activities are divided into eight business lines:
corporate finance, trading and sales, retail banking, commercial banking, payment and
settlement, agency services, asset management, and retail brokerage. The average
gross income over the last three years for each business line is multiplied by a "beta
factor" for that business line and the result summed to determine the total capital.

Advanced measurement approach: Banks must estimate one-year 99.9% VaRs for each
combination and then aggregate them to determine a single one-year 99.9% operational
risk VaR measure.

Basic indicator approach: 15% of net interest income plus non-interest income over the
previous three years.

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Q.1077 Loss severity and loss frequency are two distributions that are important in
estimating potential operational risk losses for a risk type. With regard to these two
distributions, which of the following is true?

A. For loss frequency, the natural probability distribution to use is a Poisson

distribution, and for the loss-severity probability distribution, a lognormal
distribution is used

B. For loss frequency, the natural probability distribution to use is a lognormal

distribution, and for the loss-severity probability distribution, a Poisson
distribution is used

C. For loss frequency, the natural probability distribution to use is a Poisson

distribution, and for the loss-severity probability distribution, a normal
distribution is used

D. For loss frequency, the natural probability distribution to use is a normal

distribution, and for the loss-severity probability distribution, a Poisson
distribution is used

The correct answer is: A)

For loss frequency, the natural probability distribution to use is a Poisson distribution.
This distribution assumes that losses happen randomly through time so that in any
short period of time Δt, there is a probability λΔt of a loss occurring.

For the loss severity probability distribution, a lognormal distribution is used. The
parameters of this probability distribution are the mean and standard deviation of the
logarithm of the loss.

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Q.1078 The Basel Committee on Banking Supervision (BCBS) requires the
implementation of the advanced measurement approach to involve some elements.
These include:

I. Internal data
II. External data
III. Strategic analysis
IV. Business environment and internal control factors

A. I, II & III only

B. II, III & IV only

C. I, II & IV only

D. All of the above

The correct answer is: C)

The Basel Committee on Banking Supervision (BCBS) requires the implementation of

the advanced measurement approach to involve four elements. These include: (a)
Internal data, (b) External data, (c) Scenario analysis, and (d) Business environment
and internal control factors.

Q.1079 When an insurance company cannot distinguish between good and bad risks, it
tends to offer the same price to everyone and inadvertently attracts more of the bad
risks. This risk is known as:

A. Adverse selection

B. Moral hazard

C. Scenario analysis risk

D. Internal selection risk

The correct answer is: A)

Adverse selection is where an insurance company cannot distinguish between good and
bad risks and offers the same price to everyone and inadvertently attracts more of the
bad risks.
To overcome the adverse selection problem, an insurance company must try to
understand the controls that exist within banks and the losses that have been
experienced.

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Q.1080 New Zealand National Bank uses the advanced measurement approach to
compute the operational risk capital for regulatory purposes. Noria Franti, a financial
controller working at the bank, analyzes the research reports on internal data and
external data. She concludes the following from the analysis:

I. Banks have done a much better job at documenting their operational losses than
their credit risk losses
II. Credit card frauds are high-frequency low-severity losses
III. Internal data can be used for the loss severity distribution
IV. The loss frequency distribution must be specific to the bank and based on internal
data and scenario analysis estimates

Which of these statements are correct?

A. I & III only

B. III & IV only

C. I & IV only

D. II & IV only

The correct answer is: D)

Statement II is correct. Credit card losses are high-frequency low-severity losses,

meaning that they have high expected loss but relatively low unexpected loss.
Statement IV is also correct. The loss frequency distribution must be specific to the
bank and based on internal data and scenario analysis estimates.

Statement I is incorrect. Banks have done a much better job at documenting their
credit risk losses than their operational losses. Statement III is also incorrect. External
data can be used for the loss severity distribution.

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Q.1081 Nigerian Bank Ltd. is assessing the operational risk of different
departments/business lines of the company. As a part of the assessment, the company is
asking the managers of business units to identify their operational risks. This process
is known as:

A. Risk control and self-assessment

B. Scenario analysis

C. Internal data assessment

D. Causal relationships assessment

The correct answer is: A)

Risk control and self-assessment involves asking the managers of business units to
identify their operational risks. Sometimes questionnaires and scorecards designed by
senior management or consultants are used.

Scenario analysis is to generate scenarios covering a full range of possible low-

frequency high-severity losses.

Causal relationships try to establish relations between decisions taken and operational
risk losses

Q.1082 The operational risk team of the Canadian Insurance Group informs the risk
committee that the company faces higher risk than predicted while insuring a bank
against operational losses because the insurance contract does not take into account
bank-specific information on governance and control mechanisms. Which of the
following clauses/precautions can be taken to mitigate this risk?

I. Deductible in the insurance policy

II. Coinsurance provision
III. Policy limit
IV. Understanding the controls existing within the bank and the losses that have been
experienced

A. I & II only

B. II & III only

C. I, II & III only

D. IV only

The correct answer is: D)

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The problem describes adverse selection - a situation in which the insured has more
accurate and different information than the insurer. The insurer is at a disadvantage to
the insurer with more information. This asymmetry causes a lack of efficiency in the
pricing of insurance policies such that the premiums payable are not commensurate
with the policy's risk level. For example, poor governance and internal controls may
potentially expose the bank to adverse events that may lead to losses and forwarding of
claims to the insurer. This can result in a claim experience that is significantly higher
than expected, putting the insurer under unprecedented financial strain. To overcome
the adverse selection problem, an insurance company must try to understand the
controls that exist within the bank and the losses that have been experienced in order
to establish the bank's riskiness. That way, the bank would be in a position to price the
contract appropriately.

Choices A, B, and C present ways to mitigate against the moral hazard problem
Moral hazard is the risk that the existence of the insurance contract will cause the bank
to behave differently than it otherwise would. For example, a bank that insures itself
against robberies. As a result of the insurance policy, it may be tempted to be lax in its
implementation of security measures, making a robbery more likely than it would
otherwise have been.

Insurance companies have traditionally dealt with moral hazard in a number of ways.
Typically there is a deductible in any insurance policy. This means that the bank is
responsible for bearing the first part of any loss.

Sometimes there is a co-insurance provision in a policy. In this case, the insurance

company pays a predetermined percentage (less than 100%) of losses in excess of the
deductible.

In addition, there is nearly always a policy limit. This is a limit on the total liability of
the insurer. The existence of deductibles, coinsurance provisions, and policy limits are
likely to provide an incentive for a bank not to relax security measures in its branches.

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Q.1083 Frank Andrews, an operational risk analyst, is interested in using the power law
to assess operational risk. Which of the following statement(s) is/are true with regard
to the power law?

I. The power law holds well for large losses experienced by banks
II. Loss data and scenario analysis are employed to estimate the power law parameters
using the maximum likelihood approach
III. When loss distributions are aggregated, the distribution with the heaviest tails
tends to dominate
IV. The loss with the highest alpha defines the extreme tails of the total loss
distribution

A. I & II only

B. II & III and IV only

C. I, II & III only

D. All of the above

The correct answer is: C)

Statements I, II & III are correct. The power law holds well for the large losses
experienced by banks. Loss data (internal or external) and scenario analysis are
employed to estimate the power law parameters using the maximum likelihood
approach. When loss distributions are aggregated, the distributions with the heaviest
tails tend to dominate. Statement IV is incorrect. The loss with the lowest alpha defines
the extreme tails of the total loss distribution.

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Q.1084 The Sarbanes-Oxley Act of 2002 contains several provisions to contain
operational risk for both financial and non-financial institutions in the United States.
Which of the following statement(s) is/are true with regard to the act?

I. The act specifies rules concerning the composition of the board of directors of public
companies and lists the responsibilities of the board.
II. The Sarbanes-Oxley Act gives the SEC the power to censure the board or give it
additional responsibilities.
III. The audit committee of the board must be made aware of alternative accounting
treatments.
IV. The CEO and CFO are required to return bonuses in the event that financial
statements are restated

A. I & II only

B. II & III and IV only

C. I, II & III only

D. All of the above

The correct answer is: D)

The Sarbanes-Oxley Act requires boards of directors to become much more involved
with day-to-day operations. The Act specifies rules concerning the composition of the
board of directors of public companies and lists the responsibilities of the board. It
gives the SEC the power to censure the board or give it additional responsibilities. A
company's auditors are not allowed to carry out any significant non-auditing services
for the company. The audit committee of the board must be made aware of alternative
accounting treatments. The CEO and CFO must prepare a statement to accompany the
audit report to the effect that the financial statements are accurate, and they are
required to return bonuses in the event that financial statements are restated.

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Q.1085 The existence of an insurance contract causes the bank to behave differently
than it otherwise would and increases the risks to the insurance company. This risk is
known as:

A. Adverse selection

B. Moral hazard

C. Wrong-way risk

D. Power law

The correct answer is: B)

Moral hazard is the risk that the existence of the insurance contract will cause the bank
to behave differently than it otherwise would. This changed behavior increases the risks
to the insurance company.

Q.3442 Which of the following statements about the operational risk framework for
banks is most likely incorrect?

A. Under the basic indicator approach, banks must set aside capital equivalent to
15% of gross income

B. Under the standardized approach, a bank has to declare its gross income in
eight business lines and then use beta factors to work out the amount of capital
required in each line.

C. Banks using the advanced measurement approach must calculate the

operational risk capital charge at a 99 percentile confidence interval and a one-
year horizon.

D. According to the Basel committee, operational risk includes legal risk but
explicitly excludes reputational and strategic risks.

The correct answer is: C)

Banks using the advanced measurement approach must calculate the operational risk
capital charge at a 99.9 percentile confidence interval and a one-year horizon.

ORC AM A = U L (1 − year, 99.9% confidence)

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Q.3443 Under the AMA method, insurance can be used to offset up to 20% of the
operational risk charge. Which of the following statements about hedging operational
risk are valid?

I. All insurance policies suffer from the problem of moral hazard, but deductibles
and coinsurance provisions help to combat this problem
II. Adverse selection can result in a claim experience that’s worse than initially
anticipated
III. A primary disadvantage of insurance as a tool for operational risk management
is the limitation of policy coverage
IV. The scorecard capital allocation method allocates capital to business lines in a
firm as guided by the results of a risk survey conducted across the firm
V. If an operational risk hedge works properly, a firm will avoid damage to its
reputation from a high-severity operational risk event

A. All of the above

B. III, and V

C. II, II, and IV

D. I, II, III, and IV

The correct answer is: D)

Statement V is invalid. Even if a firm is well protected from high-severity operational

risk events, the news of such events will still take a toll on its reputation.

Statement I is valid. To help keep the behavior of the insured in check, insurers use a
host of features that include deductibles, policy limits, and coinsurance provisions.

Statement II is valid. Adverse selection creates a high-risk pool of policies that are
likely to result in claims, increasing the cash outflows of the insurer relative to inflows.

Statement II I is valid. Most insurance policies have a cover ceiling, meaning there’s
always a cap on the compensation that could be handed to the policyholder.

Statement IV is also valid. Under the scorecard approach, each unit manager is
subjected to a survey which has questions on matters risk. Each manager’s responses
are transformed into a quantitative measure to come up with an overall score. This total
score represents the unit’s exposure to risk.

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Q.3444 A risk manager has established that there’s a 90% probability that losses over
the next year will not exceed $30 million. Given that the power law parameter is 0.8,
calculate the probability of the loss exceeding $10 million.

A. 22%

B. 24%

C. 20%

D. 23%

The correct answer is: B)

The power law states that the probability of a random variable x exceeding a value V is
given by:

p (x > v) = KV −α

where:

K is constant,

α is the power law parameter.

p (x > v) = KV −α

0.1 = K(30)−(0.8)

K = 1.5195

Thus,

p (x > v) = 1.5195V −0.8

when v = 10,

probability = 1.5195 × 10 −0.8 = 0.24

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 Reading 52: Stress Testing

Q.1086 AIZ bank, a newly set up bank, proposes to use stress testing to measure risk.
Which of the following statements are true with regard to stress testing as a risk
management tool in banking?

I. Stress testing is an important risk management tool that is used by banks as part of
their internal risk management and, through the Basel II capital adequacy framework,
is promoted by supervisors
II. Stress testing alerts bank management to unexpected adverse outcomes related to a
variety of risks and provides an indication of how much capital might be needed to
absorb losses should large shocks occur
III. While stress tests provide an indication of the appropriate level of capital necessary
to endure deteriorating economic conditions, a bank alternatively may employ other
actions in order to help mitigate increasing levels of risk
IV. Stress testing is especially important after long periods of benign economic and
financial conditions when fading memory of negative conditions can lead to
complacency and the underpricing of risk

A. I & IV only

B. II & IV only

C. I, II & IV only

D. All of the above

The correct answer is: D)

Stress testing is an important risk management tool that is used by banks as part of
their internal risk management and, through the Basel II capital adequacy framework,
is promoted by supervisors. Stress testing alerts bank management to unexpected
adverse outcomes related to a variety of risks and provides an indication of how much
capital might be needed to absorb losses should large shocks occur. While stress tests
provide an indication of the appropriate level of capital necessary to endure
deteriorating economic conditions, a bank alternatively may employ other actions in
order to help mitigate increasing levels of risk. Stress testing is especially important
after long periods of benign economic and financial conditions when fading memory of
negative conditions can lead to complacency and the underpricing of risk.

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Q.1087 The financial crisis of 2007-2009 has revealed several weaknesses in
organizational aspects of stress testing programs. Which of the following are some of
these weaknesses?

I. Stress testing at some banks was performed mainly at the firm-wide level
II. At some banks, the stress testing program was a mechanical exercise
III. While stress testing for market and credit risk had been practiced for several years,
stress testing for interest rate risk in the banking has emerged more recently
IV. Stress testing frameworks were usually not flexible enough to respond quickly as the
crisis evolved

A. I & IV only

B. II & IV only

C. I, II & IV only

D. All of the above

The correct answer is: B)

Statements I & III are incorrect. Stress testing at some banks was performed mainly as
an isolated exercise by the risk function with little interaction with business areas.
While stress testing for market and interest rate risk had been practiced for several
years, stress testing for credit risk in the banking industry has emerged more recently.

Statement II & IV are correct. At some banks, the stress testing program was a
mechanical exercise. Stress testing frameworks were usually not flexible enough to
respond quickly as the crisis evolved.

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Q.1088 With regard to stress testing methodologies, which of the following
statement(s) is/are true?

I. Stress tests may be performed at varying degrees of aggregation, from the level of an
individual instrument up to the institutional level
II. Stress tests are performed for different risk types including market, credit,
operational, and liquidity risk
III. At the most fundamental level, weaknesses in infrastructure limit the ability of
banks to identify and aggregate exposures across the bank
IV. Unlike most risk management models, stress tests do not use historical statistical
relationships to assess risk

A. II, III & IV only

B. I, II & IV only

C. I, II & III only

D. All of the above

The correct answer is: C)

Options I, II & III are correct. Stress tests may be performed at varying degrees of
aggregation, from the level of an individual instrument up to the institutional level.
Stress tests are performed for different risk types including market, credit, operational
and liquidity risk. At the most fundamental level, weaknesses in infrastructure limited
the ability of banks to identify and aggregate exposures across the bank.

Option IV is incorrect. Most risk management models, including stress tests, use
historical statistical relationships to assess risk. The financial crisis has again shown
that, especially in stressed conditions, risk characteristics can change rapidly as
reactions by market participants within the system can induce feedback effects and
lead to system-wide interactions.

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Q.1089 Scenario selection is very important in measuring the risks of the banks using
stress tests. With regard to scenario selection and stress tests prior to the crisis, which
of the following statements are important?

I. Scenarios tended to reflect mild shocks, assume shorter durations and underestimate
the correlations between different positions, risk types and markets due to system-wide
interactions and feedback effects
II. Sensitivity tests, which are at the most basic level, generally shock individual
parameters or inputs without relating those shocks to an underlying event or real-world
outcome
III. Banks also implemented hypothetical stress tests, aiming to capture events that
had not yet been experienced
IV. Scenarios that were considered extreme or innovative were often regarded as
implausible by the board and senior management

A. II, III & IV only

B. I, II & IV only

C. I, II & III only

D. All of the above

The correct answer is: D)

Scenarios tended to reflect mild shocks, assume shorter durations and underestimate
the correlations between different positions, risk types and markets due to system-wide
interactions and feedback effects. Sensitivity tests, which are at the most basic level,
generally shock individual parameters or inputs without relating those shocks to an
underlying event or real-world outcome. Banks also implemented hypothetical stress
tests, aiming to capture events that had not yet been experienced. Scenarios that were
considered extreme or innovative were often regarded as implausible by the board and
senior management.

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Q.1090 During the financial crisis, some credits on which banks and dealers had
purchased protection from monolines to help manage risk on their structured credit
origination activities became impaired at the same time that the creditworthiness of
the monolines deteriorated. This risk is typically known as:

A. Basis risk

B. Wrong-way risk

C. Counterparty credit risk

D. Funding liquidity risk

The correct answer is: B)

During the financial crisis, some credits on which banks and dealers had purchased
protection from monolines to help manage risk on their structured credit origination
activities became impaired at the same time that the creditworthiness of the monolines
deteriorated. This risk is typically known as wrong-way risk.

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Q.1091 The senior management of the African Industrial Development Bank is
reviewing the stress program post a severe financial crisis in Africa. With regard to the
stress testing program, which of the following is most accurate?

A. Senior management is ultimately responsible for the overall stress testing

program, whereas the risk department is accountable for the program’s
implementation, management, and oversight

B. The Chief Risk Officer is ultimately responsible for the overall stress testing
program, whereas the risk department is accountable for the program’s
implementation, management, and oversight

C. The risk committee is ultimately responsible for the overall stress testing
program, whereas the risk department is accountable for the program’s
implementation, management, and oversight

D. The board of directors is ultimately responsible for the overall stress testing
program, whereas the senior management is accountable for the program’s
implementation, management, and oversight

The correct answer is: D)

The board of directors is ultimately responsible for the overall stress testing program,
whereas the senior management is accountable for the program’s implementation,
management and oversight. Recognizing that many practical aspects of a stress testing
program will be delegated, the involvement of the board in the overall stress testing
program and of senior management in the program's design are essential.

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Q.1092 The senior management of the African Industrial Development Bank is
reviewing the stress program post a severe financial crisis in Africa. With regard to the
stress testing program, which of the following statements are accurate?

I. The stress testing program should cover pipeline and warehousing risks. A bank
should include such exposures in its stress tests regardless of the probability of being
securitized.
II. A bank should enhance its stress testing methodologies to capture the effect of
reputational risk. The bank should integrate risks arising from off-balance-sheet
vehicles and other related entities in its stress testing program.
III. A bank should enhance its stress testing approaches for highly leveraged
counterparties considering its vulnerability to specific asset categories or market
movements and in assessing potential wrong-way risk related to risk-mitigating
techniques.
IV. The stress testing program should explicitly cover complex and bespoke products
such as securitized exposures. Stress tests for securitized assets should consider the
underlying assets, their exposure to systematic market factors, relevant contractual
arrangements and embedded triggers, and the impact of leverage, particularly as it
relates to the subordination level of the issue structure.

A. II, III & IV only

B. I, II & IV only

C. I, II & III only

D. All of the above

The correct answer is: D)

The stress testing program should cover pipeline and warehousing risks. A bank should
include such exposures in its stress tests regardless of the probability of being
securitized. A bank should enhance its stress testing methodologies to capture the
effect of reputational risk. The bank should integrate risks arising from off-balance-
sheet vehicles and other related entities in its stress testing program. A bank should
enhance its stress testing approaches for highly leveraged counterparties in
considering its vulnerability to specific asset categories or market movements and in
assessing potential wrong-way risk related to risk-mitigating techniques. The stress
testing program should explicitly cover complex and bespoke products such as
securitized exposures. Stress tests for securitized assets should consider the underlying
assets, their exposure to systematic market factors, relevant contractual arrangements
and embedded triggers, and the impact of leverage, particularly as it relates to the
subordination level in the issue structure.

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Q.1150 A bank has recently launched a fund for retail investors. The risk management
team carries out stress testing of the newly launched fund to determine the impact of
the fund on the bank’s overall capital. Jason Bloomberg, a newly recruited risk
manager, observes that the bank has an independent risk management team. He notes
that the entire risk assessment and identification process is carried exclusively through
stress testing. While examining the stress testing result, John observes that the test
produces multiple potential losses under various scenarios. Bloomberg also observes
that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and
no deviation is allowed from the procedure.

In view of the fact that the bank identifies and assesses risk exclusively through stress
testing, select the correct option.

A. As stress testing requires the modeling of various scenarios, risk

identification through this process is more robust

B. As stress testing requires the modeling of various scenarios, risk is

overestimated

C. Stress testing must complement other risk identification tools and must not
be used exclusively

D. VaR is a better tool to measure risk in a bank’s portfolio rather than stress
testing

The correct answer is: C)

Stress testing must complement other risk management tools like Value at Risk (VaR)
rather than being used exclusively. Stress testing is also used to validate statistical
models like VaR.

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Q.1151 A bank has recently launched a fund for retail investors. The risk management
team carries out stress testing of the newly launched fund to determine the impact of
the fund on the bank’s overall capital. Jason Bloomberg, a newly recruited risk
manager, observes that the bank has an independent risk management team. He notes
that the entire risk assessment and identification process is carried exclusively through
stress testing. While examining the stress testing result, John observes that the test
produces multiple potential losses under various scenarios. Bloomberg also observes
that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and
no deviation is allowed from the procedure.

The bank’s stress testing results produce multiple potential losses. In view of this,
select the most appropriate option.

A. The stress testing result must be actionable

B. The stress testing results must be integrated into decision-making, but only
at the senior-most level of management

C. The stress testing result must accurately specify the exact amount of loss
associated with a given variable

D. Stress testing produces potential losses and hence no action is required on

the results

The correct answer is: A)

A stress testing result must be actionable and must feed into the decision-making
process at the appropriate management level, including strategic business decisions of
the board or senior management.

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Q.1152 A bank has recently launched a fund for retail investors. The risk management
team carries out stress testing of the newly launched fund to determine the impact of
the fund on the bank’s overall capital. Jason Bloomberg, a newly recruited risk
manager, observes that the bank has an independent risk management team. He notes
that the entire risk assessment and identification process is carried exclusively through
stress testing. While examining the stress testing result, John observes that the test
produces multiple potential losses under various scenarios. Bloomberg also observes
that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and
no deviation is allowed from the procedure.

Inputs from the bank’s top economist were considered while developing the scenario
for stress testing. In view of this, select the most appropriate statement.

A. Inputs from economists make the model more robust

B. Inputs from all stakeholders such as economists, business managers, fund

managers, etc. must be taken into account

C. Only inputs from the risk management team in collaboration with the fund
manager must be taken into account

D. The risk management team must independently design the models

The correct answer is: B)

The identification of relevant stress events requires the collaboration of all the
stakeholders like traders, economists, fund managers, business managers, etc. Inputs
from all stakeholders make the model more robust.

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Q.1153 A bank has recently launched a fund for retail investors. The risk management
team carries out stress testing of the newly launched fund to determine the impact of
the fund on the bank’s overall capital. Jason Bloomberg, a newly recruited risk
manager, observes that the bank has an independent risk management team. He notes
that the entire risk assessment and identification process is carried exclusively through
stress testing. While examining the stress testing result, John observes that the test
produces multiple potential losses under various scenarios. Bloomberg also observes
that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and
no deviation is allowed from the procedure.

Select the most appropriate statement.

A. The stress testing procedure must be well documented

B. The stress testing procedure must be well documented and no deviation must
be allowed

C. The stress testing procedure must be well documented and it must also allow
the bank to perform flexible and ad-hoc stress tests

D. The stress testing procedure should not be documented; only the results
should be shown to the managers

The correct answer is: C)

The bank must have a well laid down procedure to carry out stress testing. Proper
documentation must however not impede the bank from carrying out flexible and ad-
hoc stress tests to identify and respond to emerging risk issues.

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Q.1154 A bank has recently launched a fund for retail investors. The risk management
team carries out stress testing of the newly launched fund to determine the impact of
the fund on the bank’s overall capital. Jason Bloomberg, a newly recruited risk
manager, observes that the bank has an independent risk management team. He notes
that the entire risk assessment and identification process is carried exclusively through
stress testing. While examining the stress testing result, John observes that the test
produces multiple potential losses under various scenarios. Bloomberg also observes
that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and
no deviation is allowed from the procedure.

Select the most appropriate statement.

A. Stress testing results must be confidential

B. Stress testing result must be used only internally

C. Stress testing results may be disclosed to outsiders with sufficient supporting

information

D. Stress testing must be disclosed only to supervisors

The correct answer is: C)

In a bank, stress tests play an important role in the communication of risk. It must also
play an important role in external communication with supervisors. A bank may
voluntarily disclose the stress test with outsiders with sufficient background
information on the underlying assumptions and the methodologies.

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Q.1155 XYZ Bank has multiple branches across the country. The bank has 10 verticals
for each of its products headed by 10 Vice Presidents. The VPs report directly to the
Chairman of the bank. The bank also has an independent risk management team that
reports directly to the Chairman. Each vertical carries out its individual stress tests and
submits the reports to the vertical head which then presents it to the Chairman. The
stress test procedure indicates three scenarios which must be stress tested in each of
the verticals, and all the VPs ensure that the procedure is fully complied with.

The current capital position of the bank indicates no material threat to the viability of
the bank. In view of this, the bank’s risk management team does not include scenarios
that challenge the viability of the bank in the stress tests. The risk management team
also suggests independent stress testing of market assets and the funding liquidity. The
bank, in its investor presentation, proudly claims to stress test each component of the
balance sheet.

Each vertical of the bank carries out stress tests independently. In view of this, select
the most appropriate statement.

A. Individual stress testing is desirable

B. Individual stress testing overestimates the risk

C. Risk arising due to linkages between the verticals must also be included in
the stress testing

D. Individual stress testing makes the stress testing process straightforward

The correct answer is: C)

Stress tests should cover a wide range of risks including at the firm-wide level. The
bank should be able to integrate effectively, in a meaningful fashion, across the range
of its stress testing activities and deliver a complete picture of firm-wide risk. The bank
must be able to assess the risk arising due to the linkages between the different
verticals.

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Q.1156 XYZ Bank has multiple branches across the country. The bank has 10 verticals
for each of its products headed by 10 Vice Presidents. The VPs report directly to the
Chairman of the bank. The bank also has an independent risk management team that
reports directly to the Chairman. Each vertical carries out its individual stress tests and
submits the reports to the vertical head which then presents it to the Chairman. The
stress test procedure indicates three scenarios that must be stress tested in each of the
verticals, and all the VPs ensure that the procedure is fully complied with.

The current capital position of the bank indicates no material threat to the viability of
the bank. In view of this, the bank’s risk management team does not include scenarios
that challenge the viability of the bank in the stress tests. The risk management team
also suggests independent stress testing of market assets and the funding liquidity. The
bank, in its investor presentation, proudly claims to stress test each component of the
balance sheet.

Select the most appropriate statement.

A. Three scenarios, as indicated in the stress test procedure, is sufficient to

assess the risk

B. Stress testing must include multiple scenarios

C. The stress testing procedure must be flexible and must include forward-
looking scenarios

D. A minimum of 10 scenarios must be used to perform stress testing

The correct answer is: C)

An effective stress testing consists of scenarios along a spectrum of events and severity
levels. In addition, the stress testing procedure must be flexible in order to identify
hidden vulnerabilities and must be forward-looking. There is no fixed limit on the
scenarios which must be used to enhance the stress testing procedure.

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Q.1157 XYZ Bank has multiple branches across the country. The bank has 10 verticals
for each of its products headed by 10 Vice Presidents. The VPs report directly to the
Chairman of the bank. The bank also has an independent risk management team that
reports directly to the Chairman. Each vertical carries out its individual stress tests and
submits the reports to the vertical head which then presents it to the Chairman. The
stress test procedure indicates three scenarios that must be stress tested in each of the
verticals, and all the VPs ensure that the procedure is fully complied with.

The current capital position of the bank indicates no material threat to the viability of
the bank. In view of this, the bank’s risk management team does not include scenarios
that challenge the viability of the bank in the stress tests. The risk management team
also suggests independent stress testing of market assets and the funding liquidity. The
bank, in its investor presentation, proudly claims to stress test each component of the
balance sheet.

Select the most appropriate statement.

A. In the case of bank XYZ, the risk management team is correct not to include
scenarios which challenge the viability of the bank

B. In the case of bank XYZ, the risk management team must include scenarios
with increased severity but must not challenge the viability of the bank

C. In the case of bank XYZ, the stress test must not include scenarios which
challenge the viability of the bank

D. In the case of bank XYZ, the stress test must include scenarios which
challenge the viability of the bank

The correct answer is: D)

Stress test scenarios must include scenarios that challenge the viability of the bank.
Such stress tests uncover hidden risk and interactions among risks. The global
financial crisis has indicated the usefulness of such stress testing so that a backup plan
can be put in place in the event such scenarios turn out to be true.

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Q.1159 Select the most appropriate statements.

I. A bank must stress test each component of the balance sheet

II. A bank must stress test off-balance sheet items
III. A bank must only stress test liquid, market-related items, either on or off the
balance sheet
IV. The stress test must include only contractual off-balance sheet items

A. I & II only

B. I, II & III

C. I, III & IV

D. All of the above

The correct answer is: A)

The bank’s stress must integrate risks arising from balance sheet assets and off-
balance sheet items. During the global financial crisis, the banks failed to assess the
risk arising from off-balance sheet items such as securitization which proved to be very
costly. Furthermore, all off-balance items whether contractual or non-contractual must
be included in the stress test.

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Q.1160 Which of the following statements is/are accurate?

I. Supervisors should verify the active involvement of senior management in the stress
testing program
II. Banks must submit firm-wide stress tests to supervisors at regular intervals
III. Under the Internal Capital Adequacy and Assessment Process (ICAAP), the bank will
make use of internal models to assess, quantify and stress test risk drivers
IV. Stress testing result must not impact the strategic business decisions of the bank

A. II, III & IV

B. I, II & III

C. I & III

D. I & IV

The correct answer is: B)

According to the principles laid down for supervisors:

1. Supervisors should verify the active involvement of senior management in the stress
testing program
2. Banks must submit firm-wide stress tests to supervisor at regular intervals
3. Stress testing must form an integral part of the Internal Capital Adequacy
Assessment Process (ICAAP) and the bank’s liquidity risk management framework
4. Stress testing results must impact the strategic business decisions of the bank

Option III is correct. Under the Internal Capital Adequacy and Assessment Process
(ICAAP), the bank will make use of internal models to assess, quantify and stress test
risk drivers and factors and the amount of capital required to support them.

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Q.1161 Which of the following statements is/are correct?

I. A bank must not disclose the assumptions made during the stress testing to
supervisors
II. Supervisors must not take into account capital freely transferable within banking
groups in times of stress
III. Supervisors must only examine the need of capital for the bank
IV. Supervisors should review the range of remedial actions envisaged by a bank in
response to the results of the stress testing program

A. I only

B. IV only

C. I & III

D. III & IV

The correct answer is: B)

According to the principles of supervisors:

1. A bank must review the assumptions made during the stress testing to supervisors
2. A bank must take into account capital freely transferable within banking groups in
times of stress
3. Supervisors must examine the need for capital and liquidity for the bank
4. Supervisors should review the range of remedial actions envisaged by a bank in
response to the results of the stress testing program

Q.1162 Select the most appropriate statement.

A. Supervisors must not determine stress scenarios

B. Supervisors must determine certain stress scenarios

C. Stress scenarios must be designed exclusively by the bank

D. Stress scenarios must not be disclosed

The correct answer is: B)

According to the principles laid down for supervisors:

1. Supervisors must review the stress scenarios
2. Supervisors must determine certain stress scenario for the banks as it enhances the
ability of supervisors and the bank to assess the impact of specific stress events

In view of the above two principles, option B is correct.

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Q.1163 Supervisors must examine a bank’s stress testing results as prescribed in the
Basel II framework under:

A. Pillar I

B. Pillar II

C. Pillar III

D. None of the above

The correct answer is: B)

Pillar II of the Basel II framework lays down the supervisory review process under
which the supervisors must examine a bank’s stress testing results as part of the
supervisory review.

Q.1165 All the following are true for stress testing, EXCEPT:

A. The goal of stress testing to identify unusual scenarios which are not covered
under standard VaR models

B. Stress testing considers situations which are present in historical data

C. Stress testing is helpful in the analysis of events which generally gets ignored

D. Stress testing is helpful in the analysis of extreme events

The correct answer is: B)

Stress testing generally involves analysis of events which are extreme in nature and not
covered under standard VaR models. The events analyzed during stress testing are
generally absent from historical data.

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Q.1166 A bank funds its long-term loans by issuing short-term debt instruments such as
commercial papers, NCDs with residual maturity of less than 1 year, deposits, etc. A
risk manager wants to stress test the bank’s balance sheet to examine its
vulnerabilities. The stress test may include which of the following scenarios:

I. Availability of surplus liquidity

II. Failure to roll over short-term debt
III. Increase in short-term interest rates
IV. Increases in deposits

A. Only I

B. II & III

C. I & IV

D. III & IV

The correct answer is: B)

The bank funds its long-term liability by short-term debt. If there is surplus liquidity,
the bank would have no problem in rolling over its short-term debt. Therefore, the
surplus is not a source of stress for a bank’s balance sheet. Similarly, an increase in
deposits will help the bank to fund its liability. Thus, increased deposits will also not
cause stress on the bank’s balance sheet.

The bank instances which will cause stress on the bank’s balance sheet are:
1. The bank is not able to roll over its short-term debt, which will result in a funding
gap and will cause stress on the bank’s balance sheet.
2. An increase in short-term interest rates will result in an increase in the cost of funds
for the bank. This increase may also result in a decrease in short-term liquidity which
will then impact the bank’s ability to roll over its short-term debt.

Therefore, for stress testing, the suitable scenarios are the inability of the bank to roll
over debt and the increase in short-term interest rates.

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Q.1167 A fund manager examines the annual return generated by fund A for the last 10
years. The return generated by the fund is furnished in the table below:

Year Return

2015 +9.45%

2014 -4.45%

2013 +5.34%

2012 -3.35%

2011 +2.45%

2010 -6.56%

2009 +7.41%

2008 -8.83%

2007 +2.33%

2006 +1.32%

The fund manager intends to stress test Fund A for various scenarios. Select the correct
option with regards to the stress testing of Fund A.

A. As the maximum loss during the last 10 year is 8.83%, the stress test scenario
for maximum loss must not exceed 8.83%

B. As the average loss during the last 10 years is 5.80%, the stress test scenario
for maximum loss must be equal to 5.80%

C. The stress test scenario for maximum loss must be more than the historical
maximum loss posted by the fund

D. As the average return generated by the fund for the last 10 years is 0.51%, the
stress test scenario for maximum loss must be -0.51%

The correct answer is: C)

Stress testing generally involves the analysis of events which are extreme in nature and
are not present in historical data. Although the maximum historical loss generated by
the fund stood at 8.83%, the stress test scenario for maximum loss must be in excess of
8.83%.

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Q.1168 A risk manager examines a portfolio (AUM- $100 million) and observes that the
performance of the fund is dependent on two variables, α and β. The manager wants to
carry out a stress test of the portfolio. He defines two scenarios to stress test the
portfolio:

I. The value of α is pushed up by x and the value of β is pushed down by y

II. The value of α is pushed down by x and the value of β is pushed up by y

After performing the stress test, the risk manager suggests that a contingency fund of
$10 million must be maintained. Select the most appropriate statement.

A. A contingency fund of $10 million must be maintained as suggested by the

risk manager

B. A contingency fund of more than $10 million must be maintained

C. The correlation between the two variables must be considered while

performing the stress test

D. As stress tests generally involve events which rarely occurs, the contingency
fund must not be maintained

The correct answer is: C)

The risk manager must consider the correlation between the two variables. The
correlation between the two variables will correctly determine the contingency fund
required to be maintained.

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Q.1169 Which of the following is the most appropriate statement regarding sensitivity
analysis?

A. Sensitivity analysis is a simulation designed to determine the ability of a given

financial instrument or financial institution to deal with a past economic crisis

B. Sensitivity analysis requires changing the functional form of the model

C. Sensitivity analysis involves changing inputs or parameters without relating

those changes to an underlying event or real-world outcomes

D. Sensitivity analysis involves changing inputs or parameters by relating those

changes to an underlying event or real-world outcomes

The correct answer is: C)

Sensitivity analysis, or what-if calculations, are able to tweak one key input in a
financial model, to understand the effect of a set of independent variables on some
dependent variable under certain specific conditions. In most cases, sensitivity analysis
involves changing inputs or parameters without relating those changes to an
underlying event or real-world outcomes.

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Q.1170 A fund manager intends to carry out scenario analysis of his portfolio. The
portfolio consists of 25% government bonds, 60% global equities, and 15% investment
in gold ETFs. The fund manager lists the portfolio’s risk factors. He intends to perform
a scenario analysis by generating scenarios based on the adverse movement in the
portfolio’s identified risk factors. Such an approach to scenario analysis is referred to
as:

A. Event-driven scenario analysis

B. Portfolio-driven scenario analysis

C. Factor push method

D. Historical method

The correct answer is: B)

Scenario analysis can generate either event-driven or portfolio-driven scenarios. In the

case of event-driven scenarios, the scenario is formulated from plausible events that
generate movements in the risk factors.

In the case of portfolio-driven scenario analysis, the risk factors of the portfolio are
identified and then translated into adverse movements in risk factors.

In the above case, the fund manager first identifies the risk factors and then performs
scenario analysis by generating adverse movements in the risk factors identified.
Therefore, the fund manager utilizes the portfolio driven approach.

Q.1171 A fund manager has a portfolio that is dominated by government bonds. In

order to assess the underlying risk of the portfolio, the fund manager identifies the key
risk factors and performs stress testing. Select the most appropriate statement.

A. The stress testing overestimates the portfolio risk

B. The stress testing underestimates the portfolio risk

C. The stress testing adequately measures the portfolio risk

D. The stress testing output does not depend on the risk factors

The correct answer is: B)

The process of identifying certain key risk factors may also result in the generation of
hidden risks. For instance, in the above case, bond mapping replaces a continuous yield
curve by a finite number of risk factors. Thus, in the process, some important details
are missed which leads to the underestimation of the portfolio risk.

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Q.1172 The general belief that diversification leads to risk reduction was challenged
during the Global Financial Crisis of 2007-2009. During the crisis, it was observed that
the correlation between different assets increased due to which the concept of
diversification failed.

Imagine yourself to be a risk manager. In order to assess the likely impact of such
events, the most appropriate tool is the:

A. Scenario analysis

B. Sensitivity analysis

C. Historical simulation

D. Push factor

The correct answer is: A)

The event that occurred in the Global Financial Crisis of 2007-2009 can be defined as
extreme events; such events can be examined/analyzed with the use of scenario
analysis. Different scenarios can be modeled and an analysis of the likely impact can be
carried out.

Q.1173 All the following are true for stress testing, EXCEPT:

A. It is highly subjective

B. The events are reported without an attached probability making the result
difficult to interpret

C. It is not helpful in ensuring the survival of an institution in times of market

turmoil

D. Implausible scenarios may lead to irrelevant potential losses

The correct answer is: C)

Stress testing requires formulating multiple scenarios; the inputs to these scenarios
are highly subjective. In addition, these scenarios are reported without an attached
probability which makes estimating the likelihood of occurrence of the scenarios
difficult to predict. Furthermore, a large number of scenarios can be generated during
the scenario analysis, some of which are implausible and may provide irrelevant
potential loss scenarios.

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Q.1174 Which of the following is/are correct statements?

I. The worst case loss never exceeds that predicted by VaR measures
II. Stress testing is a replacement for traditional VaR measures
III. Stress testing may lead to a large number of information
IV. Stress testing allows risk managers to assess the blind spots

A. Only I

B. I & II

C. III & IV

D. I & IV

The correct answer is: C)

Statement I is incorrect. The worst case loss may exceed that predicted by VaR
measures; scenario analysis helps in modeling such scenarios.

Statement II is incorrect. Stress testing complements traditional VaR measures; it

cannot be used to replace the traditional VaR measures.

Statement III is correct. Stress testing may lead to a large number of information.
Multiple scenarios may result in large amounts of information during scenario analysis.

Statement IV is correct. Stress testing helps in identifying vulnerability which is

generally absent in historical data. Therefore, it helps risk managers identify the blind
spots.

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Q.2812 One of the key elements of sound governance over stress testing is the
governance structure.

Which of the following statements regarding governance structure is incorrect?

A. The internal audit should provide an independent evaluation of the ongoing

performance, integrity, and reliability of the stress-testing activities

B. The board of directors should execute the overall stress testing strategy
(including establishing adequate policies and procedures, assigning competent
staff, etc.)

C. An institution should have clear and comprehensive stress testing policies,

procedures and documentation

D. Stress-testing governance should incorporate validation or another type of

independent review to ensure the integrity of stress-testing processes and
results

The correct answer is: B)

The execution of the overall stress testing strategy is the responsibility of the senior
management, not the board of directors.

In simple terms, the biggest difference between the board of directors and senior
management is that the board makes decisions while management implements the
plan.

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Q.2813 What is the advantage of reverse stress testing?

A. By concentrating on different scenarios, reverse stress testing helps to

identify the most profitable business lines

B. Reverse stress testing does not consider scenarios beyond its normal business
expectations and concentrates on issues that could affect business during the
normal business operations

C. Reverse stress testing does not consider scenarios beyond its normal business
expectations and consequently does not require a comprehensive analysis

D. By evaluating scenarios and circumstances that would render a business

unviable, reverse stress testing identifies potential business vulnerabilities

The correct answer is: D)

Reverse stress testing starts from an outcome of business failure and identifies
circumstances where this might occur (e.g., potential business vulnerabilities).

Option A is incorrect. Reverse stress testing is not aimed to identify profitable business
lines.

Options B and C are incorrect. Reverse stress testing does consider scenarios beyond
its normal business expectations.

Q.2814 During which phase of the economic cycle is stress testing most important?

A. During the beginning of an economic recession.

B. In the middle of an economic recession.

C. In the beginning of an economic expansion.

D. After a long period of economic expansion.

The correct answer is: D)

Stress testing is especially important after long periods of economic growth when the
fading memory of negative conditions can lead to complacency and the underpricing of
risk.

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Q.3301 An investment company uses RiskMetrics to calculate the volatility. The
volatility for the previous day is 0.02 and today’s return is 10%. What is the updated
volatility if λ = 0.97 is used?

A. 0.0028

B. 0.0194

C. 0.0262

D. 0.053

The correct answer is: C)

Adaptive volatility using the RiskMetrics model can be found as:

σt2 = λσ2t−1 + (1 − λ)r2t−1 ,t = 0.97 ∗ 0.022 + 0.03 ∗ 0.12 = 0.000688

However, remember that variance is volatility squared.

σt = √0.000688 = 0.0262

Q.3302 A hedge fund manages risk by calculating future volatility using RiskMetricsTM
to calculate the volatility. The portfolio performance for the past 5 days are 2% (n-1),
4% (n-2), 6% (n-3), 2% (n-4), 10% (n-5), respectively. The conditional volatility estimate,
assuming that λ = 0.9, is closest to:

A. 3.41%

B. 3.49%

C. 2.5%

D. 5.21%

The correct answer is: A)

2 3
σn2 = (1 − λ)[λ 0 rn −1 + λ1 r2n−2 + λ2 rn−3 + .. . ] = (1 − 0.90)[1 × 4 + 0.9 × 16 + 0.81 × 36 + 0.729 × 4 +
Conditional volatility = √ 11.6086 = 3.41

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Q.3303 A hedge fund manages risk by calculating future volatility using historical
standard deviation. The portfolio performance in the past 5 days are 2% (n-1), 4% (n-2),
6% (n-3), 2% (n-4), and 10% (n-5), respectively. The hedge fund uses the historical
standard deviation (moving average) method to calculate volatility. What is the
volatility estimate?

A. 4.00%

B. 5.66%

C. 3.40%

D. 2.80%

The correct answer is: B)

1 1
σn2 = ∑m r2
i=1 n −i =
(4 + 16 + 36 + 4 + 100) = 32
m 5

Volatility= √ 32 = 5.66

Q.3304 Using the RiskMetrics® approach, calculate the weight for the most current
historical return, t = 0, when X = 0.97.

A. 0.4

B. 0.97

C. 0.03

D. 0.06

The correct answer is: C)

The weight for the most current historical return, t = 0, when X = 0.97 is calculated as
follows:
(1 - λ)λt = (1 - 0.97)0.970 = 0.03

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Q.3305 Bank A manages interest rate risk by monitoring the VaR using historical data.
Bank A collects interest rate returns for 300 days and the data is sorted ascendingly.
The lowest 10 interest rate returns are -4.2%, -4.0%, -3.8%, -3.2%, -3.0%, -2.5%, -2.3%,
-2.2%, -2.0%, -1.7%. After 30 days, Bank A collects 30 more data points. However, none
of these returns is less than -1.7%. What is the change in the 98% VaR as compared to
the prior 30 days, assuming that all of the lowest 10 observations are still within the
300-day long historical window?

A. Unchanged

B. VaR has increased by 0.01%

C. VaR has increased by 0.08%

D. VaR has increased by 0.11%

The correct answer is: A)

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.

Given this information, the 98% VaR, given that n = 300 is:
98% VaR = [(1 - 0.98)300 + 1]th value = 7th highest observation
Thus, VaR = -2.3%

One important note about this method is that the length of the historical window is
fixed, i.e., the oldest observations exit the window as new observations are made. In this
case, however, 30 more days have now elapsed (meaning that we have 30 new
observations) but there hasn't been a loss big enough to dislodge any of the worst 10
observations made, which we assume are still within the historical window of 300
observations. As such, the 98% VaR will still be the 7th highest observation which
happens to be -2.3%. In short, the VaR remains unchanged.

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Q.3306 Bank A manages interest rate risk by monitoring the VaR calculated using
historical data. Bank A collects interest rate returns for 300 days and the data is sorted
ascendingly. The following table shows the lowest returns and the hybrid weights used
to calculate the VaR.

Order Lowest return Hybrid cumulative weight

1 -4.2% 0.0122

2 -3.8% 0.0255

3 -3.2% 0.0350

4 -2.8% 0.0443

5 -2.7% 0.0501

6 -2.3% 0.0598

7 -1.7% 0.0603

Calculate the 4% VaR.

A. -2.1%

B. -2.4%

C. -2.98%

D. -2.8%

The correct answer is: C)

We use the third and the fourth-lowest return to interpolate:

−3.2 − (−2.8)
V aR4% = −3.2 − (0.035 − 0.04) = −2.98
0.035 − 0.0443

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Q.3307 Bank A manages interest rate risk by monitoring the VaR calculated using
historical data. Bank A collects interest rate returns for 300 days and the data is sorted
ascendingly. The lowest 10 interest rate returns are -4.2%, -4.0%, -3.8%, -3.2%, -3.0%,
-2.5%, -2.3%, -2.2%, -2.0%, -1.7%. Calculate the 98% VaR.

A. -2.0%

B. -2.2%

C. -2.3%

D. -2.4%

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. In this case, we have 300
observations and a confidence level of 98%; the 98% VaR is given by the (1 – 0.98)300 +
1 = 7th observation

That's 2.3%

Q.3308 For a certain asset, the expected one-period volatility is 0.002. If the speed of
the reversion parameter is 0.7, then what is the two-period volatility?

A. 0.002

B. 0.0024

C. 0.0115

D. 0.0587

The correct answer is: B)

With mean reversion (b < 1), the single-period volatility is σ .

The two-period volatility is (\sqrt {1+b^2}×\sigma).

Therefore, (0.002 × \sqrt {1+0.7^2} =0.002 × 1.2207=0.0024 )

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Q.3310 For a certain asset, the expected one-day volatility 0.002. What is the expected
volatility for 30 days assuming non-predictability and the volatility being constant?

A. 0.002

B. 0.005

C. 0.011

D. 0.021

The correct answer is: C)

Here, we simply use the square root rule:

(T-day \quad volatility = 1-day \quad volatility × \sqrt {T})

(30-day \quad volatility = 0.002 × \sqrt {30}=0.002 × 5.48=0.011 )

Q.3391 For a market variable (T), the GARCH (1,1) model is defined as:

σn2 = γ × V L + α × U n2−1 + β × σn2−1

Where:

({ \sigma }{ n }^{ 2 }) = volatility estimate made at the end of day (n-1) for day (n)

({ V }{ L }) = long-run average variance

(\gamma) = weight assigned to ({ V }{ L })

({ U }{ n-1 }) = percentage change in (T) between the end of day (n-2) and end of day
(n-1)

(\alpha) = weight assigned to ({ U }{ n-1 }^{ 2 })

({ \sigma }{ n-1 }) = estimate made at the end of day (n-2) for day (n-1)

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(\beta) = weight assigned to ({ \sigma }{ n-1 }^{ 2 })

Determine the annualized volatility for an option expiring in six days and starting at day
(n) using the GARCH (1,1) model based on the following information:

({ V }{ L }) = 0.000045

(\alpha) = 0.011

(\beta) = 0.65

({ \sigma }{ n }^{ 2 }) = 0.00005

Assume 252 trading days in a year

A. 10.91%

B. 7.5%

C. 173%

D. 0.11%

The correct answer is: A)

The expected variance rate (k) days from now is given by:

E [σn2+k ] = VL + (α + β)k × (σn2 − VL )

Therefore,

({ \sigma }{ n }^{ 2 })=0.00005

({ \sigma }{ n+1 }^{ 2 }=0.000045+{ 0.661 }^{ 1 }\times \left( 0.00005-0.000045

\right) =0.00004831)

({ \sigma }{ n+2 }^{ 2 }=0.000045+{ 0.661 }^{ 2 }\times \left( 0.00005-0.000045

\right) =0.00004718 )

({ \sigma }{ n+3 }^{ 2 }=0.000045+{ 0.661 }^{ 3 }\times \left( 0.00005-0.000045

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\right) =0.00004644)

({ \sigma }{ n+4 }^{ 2 }=0.000045+{ 0.661 }^{ 4 }\times \left( 0.00005-0.000045

\right) =0.00004595)

({ \sigma }_{ n+5 }^{ 2 }=0.000045+{ 0.661 }^{ 5 }\times \left( 0.00005-0.000045
\right) =0.00004563)

The average variance rate over the next 6 days is:

1
[0.00005 + 0.00004831 + 0.00004718 + 0.00004644 + 0.00004595 + 0.00004563]
6

= 0.00004725

Estimated daily volatility =(\sqrt { 0.00004725 } =0.006874)

To convert this into annualized volatility, we multiply by the square root of annual no. of
trading days

So, estimated annualized volatility =(0.006874\times \sqrt { 252 } =0.1091=10.91%)

B is incorrect: This solution incorrectly multiplies the estimated variance rate by the
square root of 252

C is incorrect. This solution incorrectly multiplies the estimated daily volatility by 252

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Q.3392 A financial risk manager wishes to establish the type of distribution that
produces the lowest probability for a variable to exceed a pre-specified extreme value
“y”. Assuming that the distributions at his disposal all have the same mean and
variance, and that (y) is greater than the mean, which type of distribution produces the
lowest probability?

A. The normal distribution

B. A leptokurtic distribution with a kurtosis of 8

C. A leptokurtic distribution with a kurtosis of 16

D. A platykurtic distribution

The correct answer is: D)

By definition, a platykurtic distribution has thinner tails than both the normal
distribution and any leptokurtic distribution. As such, for an extreme value y, the lowest
probability of exceeding it will be found in the distribution with the thinner tails.

Option A is incorrect. The normal distribution has larger tails than a platykurtic
distribution.

Option B is incorrect. A leptokurtic distribution has fatter tails than the normal
distribution. Kurtosis basically indicates the level of fatness in the tails whereby the
higher the kurtosis, the fatter the tails. As such, the probability of exceeding a specified
extreme value will be higher.

Option C is incorrect. Borrowing from the explanation for B above, with a kurtosis of
16, the probability of exceeding the specified extreme value will be even higher.

Q.3393 An analyst is using the hybrid approach to determine the 95% VaR with the most
recent 100 observations. The exhibit below gives the six lowest returns and their
timings:

Six lowest returns N umber o f past periods

−4.8% 24
−3.5% 27
−4.0% 72
−3.8% 45
−3.6% 30
−4.2% 25

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Using a decay factor of 0.96, calculate the VaR at the 5th percentile using the hybrid
approach:

A. -3.8%

B. -3.64%

C. -3.6%

D. -3.2%

The correct answer is: B)

In line with the hybrid approach, the very first step should involve calculating the
weight of each return, followed by ordering of the returns from lowest to highest.

The hybrid weight of a return earned n periods ago= 1−λk × λn −1

1−λ

0.04
For example, the weight of the return observed when n = 24 = × 0.9623 = 0.0159
1−0.96100

0.04
Similarly, the weight of the return observed 30 periods ago = × 0.9629 = 0.0125
1−0.96100

Rank Six Lowest Returns N umber of P ast Hybrid Weight Hybrid Cumulative
P eriods Weight
1 −4.8% 24 0.0159 0.0159
2 −4.2% 25 0.0153 0.0312
3 −4.0% 72 0.00224 0.0334
4 −3.8% 45 0.00675 0.0402
5 −3.6% 30 0.0125 0.0527
6 −3.5% 27 0.0141 0.0668

The 5th percentile for calculating VaR is somewhere between −3.8% and −3.6% . The
halfway mark between these two points are interpolated as −3.7% [(= −3.8% + −3.6%)/2]
with a cumulative weight of 4.65% [= (4.02% + 5.27%)/2].

The 5% VaR using the hybrid approach is calculated as:

0.05 − 0.0465
−3.7% − (−3.7% − −3.6%) [ ] = −3.7% − 0.1% × 0.5645 = −3.644%
0.0527 − 0.0465

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Q.3445 Which of the following parties bears the ultimate responsibility for stress
testing programs in banks?

A. The risk management function

B. Senior management

C. The board of directors

D. Internal audit

The correct answer is: C)

The board of directors is “ultimately” responsible for a firm’s stress tests. Even if board
members don’t immerse themselves into the technical details of stress tests, they
should ensure that they stay sufficiently knowledgeable about stress testing procedures
and interpretation of results. The members’ engagement is essential for the effective
operation of stress testing.

Q.3446 Which of the following options most accurately presents a key governance issue
that played a critical role in the failure of banks in the lead up to the 2007/2009
financial crisis?

A. Senior management played little or no role at all in the development and

operation of stress testing.

B. Stress testing reports would be passed up to the boards of directors without

first being approved by senior management

C. Stress testing did not appear to be sufficiently integrated into institutions’

risk management frameworks, nor were test results taken into account during
decision making

D. Stress testing programmes lacked clear, well-detailed policies meant to

outline the procedure to follow from start to finish, as well as describing the role
played by various employees

The correct answer is: C)

The financial crisis of 2007/2009 highlighted a critical lesson in relation to governance

and stress testing. Precisely, stress testing did not appear to be sufficiently integrated
into institutions’ risk management frameworks. The few that had shown more
commitment to stress testing did not examine sufficiently severe scenarios, and test
results had little or no consideration in decision making at the top level of
management.

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Q.3447 According to the CRMPG II report and the Basel committee report produced in
the aftermath of the 2007/2009 financial crisis, rigorous stress testing should be a goal
of all firms. To make stress testing more productive, firms should consider all of the
following except:

A. Identifying a wide range of scenarios that could result in portfolio losses

B. Simulating the effects of capital problems and illiquidity pressures happening

at the same time

C. Asking risk managers to define and clearly express firm loss tolerance levels

D. Ensuring that the scenarios tested are in line with the direction and long-term
strategy set by the board of directors

The correct answer is: C)

The role of "Establishing risk tolerance levels" falls under the mandate of business
managers or the board of directors but not the risk managers.

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Q.3448 The following statements regarding stress testing and value at risk methods are
incorrect, EXCEPT:

A. From a practical point of view, VaR measures commonly utilize just a few
scenarios

B. Ordinal arrangements are a key feature of VaR methods

C. For regulatory stress tests, the current period is used as the departure point
while generating hypothetical scenarios

D. While VaR methods reveal the causal risk(s), stress tests do not

The correct answer is: C)

For regulatory stress tests, generating hypothetical scenarios uses the current period,
not past history, as the point of origin.

Option A is incorrect. From a practical point of view, VaR measures commonly utilize
very many scenarios, but stress tests accommodate just a few

Option B is incorrect. Ordinal arrangements form part of stress tests, not VaR
measures. The latter measures make use of cardinal probabilities.

Option D is incorrect. While stress tests reveal the causal risk(s), VaR measures do not

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Q.3449 The table below shows Capital Bank’s portfolio of whole exposures:

Rating bucket Balance 1 − year defaul t 2 − year defaul t

rate rate
1 300 0.00 0.00
2 400 0.05 0.07
3 550 0.10 0.15
4 600 0.14 0.19
5 700 0.20 0.22
6 200 1.33 11.58
7 0 2.21 22.59

The bank’s chief risk officer would like to establish just how sensitive the portfolio’s
losses are to changes in the unemployment rate and inflation rate. The CRO conducts a
stress test. Which of the following is least likely to be included as an assumption while
conducting the stress test?

A. Stressed loss rate, e.g., loss rate increases by 30% for all rating buckets

B. Stressed default probabilities, e.g., default probability for bucket 2 increases

by 20%

C. A sudden drop in exposure at risks, e.g., EADs drop by 10%

D. Transition to lower rating buckets, e.g., $600 million transitions from rating 4
to rating 6

The correct answer is: D)

In an attempt to assign a probability to a hypothetical stress scenario, the CRO might

want to establish just where the stress test losses fall within the VaR distribution. Such
a distribution would have to be developed based on the formula:

Expected loss = P D × LGD × EAD

where:

P D = probability of default

LGD = loss given default

EAD = exposure at default

As such, the CRO would most likely come up with assumptions on each one of PD , LGD,
and EAD.

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Q.3450 The changes outlined in the Basel Market Risk Capital Framework as well as in
Basel III require the use of all of the following, EXCEPT:

A. Stressed simulations

B. Stressed parameters

C. Stressed inputs

D. Stress tests

The correct answer is: A)

As per the updated Basel market risk capital framework, stress tests and stressed
inputs should be part of the risk management program of every firm. The updated Basel
III guidelines require the use of stressed parameters.

Q.3451 Prior to the recent crisis, stress testing was marked by several practices:

I. Inadequate firm-wide perspective

II. Overreliance on sensitivity analysis
III. Limited recognition of interactive effects
IV. A lack of overall organizational view

A. II and III

B. I and IV

C. II only

D. All of the above

The correct answer is: D)

In the years leading up to the recent crisis stress testing in most firms had all of the
above characteristics:

I. Inadequate firm-wide perspective: Business lines were expected to conduct

stress tests on their exposures, which means that there was very little
assessment of enterprise-wide exposure and the correlation between various
risks.
II. Banks used to rely on sensitivity analysis which focuses on the impact of a shock
on a single factor while holding other factors constant. By so doing, the banks
failed to take into consideration the spillover effect and feedback effects arising

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 from correlations arising from various risk factors.
III. The stress testing models used in the recent financial crisis were not equipped
to predict the interrelationships among various financial securities.
IV. Stress testing was silo-based. Business lines were expected to conduct stress
tests on their exposures, which means that there was very little assessment of
enterprise-wide exposure

Q.3452 Following the 2007/2008 financial crisis, stress testing for securitized products
should consider which of the following features?

I. Contingency funding needs of the issuer

II. Credit ratings of similar securities on the market
III. Quality of underlying asset pool
IV. Subordination level of tranches
V. Systematic market conditions

A. All of the above

B. III and IV

C. II and V

D. I, III, IV, and V

The correct answer is: D)

Assuming that the resulting security has the same risk profile as an apparently similar
issue on the market is inappropriate. Securitized products are complex and possess
different risk characteristics compared to the underlying asset.

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Q.3453 Which of the following statements related to stress testing and Basel II is
correct?

I. Basel II requires banks to conduct stress tests and assess capital adequacy at
least once every month
II. In line with Basel II, a bank should take into account both its capital and
liquidity needs while conducting stress tests

A. I only

B. II only

C. Both I and II

D. Neither I nor II is correct

The correct answer is: B)

The Basel II framework does not impose monthly stress tests on banks.

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Q.3454 Which of the following statements is (are) true?

Prior to the 2007-2008 credit crisis:

I. Stress testing was mostly geared towards individual business lines without
considering comprehensive firm-wide perspective
II. Stress testing was primarily focused on historical or hypothetical scenarios

A. I

B. II

C. Both I and II

D. Neither

The correct answer is: C)

Until 2007, stress tests were mostly done internally by banks as part of their own risk
management. Beginning in 2007, governmental regulatory bodies became interested in
conducting their own stress tests to insure the effective operation of financial
institutions. This is also the time when stress testing was refined. Nowadays, common
tasks associated with Basel III compliance include: Monte Carlo simulation (including
the use of copula methods for credit portfolio simulation), scenario analysis and stress
testing, econometrics for procyclical and countercyclical analysis, asset-liability
modeling, etc.

Statement II is correct. Historical scenarios were frequently implemented based on a

significant market event experienced in the past. Such stress tests were, however, not
able to capture risks in new products that have been at the center of the turmoil.
Furthermore, the severity levels and duration of stress indicated by previous episodes
proved to be inadequate.
Banks also implemented hypothetical stress tests, aiming to capture events that had
not yet been experienced. Prior to the crisis, however, banks generally applied only
moderate scenarios, either in terms of severity or the degree of interaction across
portfolios or risk types. At many banks, it was difficult for risk managers to obtain
senior management buy-in for more severe scenarios. Scenarios that were considered
extreme or innovative were often regarded as implausible by the board and senior
management

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Q.3455 Which of the following statements is (are) correct?

Stress testing methods consider inter-correlations between:

I. funding and market risks

II. basis and liquidity risks
III. market and pipeline risks
IV. reputational and liquidity risks

A. II only

B. I, II and IV

C. II and III

D. I, II, III and IV

The correct answer is: D)

I. It is difficult to liquidate an asset without loss under deteriorating market stress

conditions.

II. Due to a change in basis, an ineffective hedge can result in significant losses as
a result of the unprotected decline in the underlying asset’s value, giving rise to
liquidity problems.

III. Because of deteriorating conditions in the securitization market conditions

during the recent financial crisis, banks could not securitize assets and had to
keep them in the balance sheet.

IV. Due to reputational risk, a bank may stand ready to inject credit or liquidity to a
special purpose entity (SPE), putting itself under increasing liquidity pressure.

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 Reading 53: Pricing Conventions, Discounting, and Arbitrage

Q.997 Kristen Haynes, an analyst working at Jahmal Securities, is explaining the

different terminologies of prices to a new employee. She makes the following
statements about mid-market and full prices per 100 face amount of bonds. Which of
these statements are accurate?

Statement I. The mid-market price is an average of a lower bid price at which traders
stand ready to buy a bond, and a higher ask price, at which traders stand ready to sell a
bond
Statement 2: The full price is often referred to as the flat or quoted price of the bond

A. Statement I only

B. Statement II only

C. Statements I & II

D. None of the above

The correct answer is: A)

The mid-market price is an average of a lower bid price, at which traders stand ready to
buy a bond, and a higher ask price, at which traders stand ready to sell a bond. The full
price is the total amount a buyer pays for a bond, which is the sum of the flat or quoted
price of the bond and the accrued interest.

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Q.998 Joshua Williamson, an associate working at Supreme Bonds, calculates the prices
of US Treasury bonds using the law of one price. However, he observes differences
between the market price of bonds and the prices predicted by the law of one price.
Which of the following may be the reason(s) for the differences in price?

I. Transaction costs
II. Bid-ask spreads in the financing markets
III. It is only in theory that US Treasury bonds are commodities, i.e., fungible
collections of cash flows

A. I & II only

B. II & III only

C. I & III only

D. All of the above

The correct answer is: D)

There are transaction costs in doing arbitrage trades which could significantly lower or
wipe out any arbitrage profit. Bid-ask spreads in the financing markets, incurred when
shorting securities. An arbitrageur would have to buy securities at higher ask prices
and sell at lower bid prices. It is only in theory that U.S. Treasury bonds are
commodities, i.e., fungible collections of cash flows. In reality, bonds have idiosyncratic
differences that are recognized by the market and priced accordingly.

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Q.999 With regard to STRIPS, which of the following statements are true?

I. STRIPS are created when a particular coupon bond is delivered to the Treasury in
exchange for its coupon and principal components
II. When reconstituting a bond, any C-STRIPS maturing on a particular date may be
applied toward the coupon payment of that bond on that date
III. STRIPS prices are essentially discount factors
IV. The Treasury not only creates STRIPS but retires them as well

A. I & II only

B. II & III only

C. I & III only

D. All of the above

The correct answer is: D)

Zero-coupon bonds issued by the U.S. Treasury are called STRIPS. STRIPS are created
when a particular coupon bond is delivered to the Treasury in exchange for its coupon
and principal components. Coupon or interest STRIPS are called TINTs, INTs, or C-
STRIPS while principal STRIPS are called TPs, Ps, or P-STRIPS.

The Treasury not only creates STRIPS but retires them as well. Upon delivery of the set
of STRIPS, the Treasury would reconstitute the bond. It is crucial to note that C-STRIPS
are fungible while P-STRIPS are not. When reconstituting a bond, any C-STRIPS
maturing on a particular date may be applied toward the coupon payment of that bond
on that date. By contrast, only P-STRIPS that were stripped from a particular bond may
be used to reconstitute the principal payment of that bond.

This feature of the STRIPS program implies that P-STRIPS, and not C-STRIPS, inherit
the cheapness or richness of the bonds from which they came. STRIPS prices are
essentially discount factors.

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Q.1000 Brad Peters, a research scholar on bonds, is working on a research paper on the
idiosyncratic pricing of US Treasury notes and bonds. With regards to the idiosyncratic
pricing of US Treasury notes and bonds, which of the following statements are true?

Statement I: Individual bonds have unique characteristics that are reflected in their
pricing, and the law of one price would not be as accurate an approximation
Statement II: Since C-STRIPS are fungible while P-STRIPS are not, any such pricing
idiosyncrasies would manifest as differences between the prices of P-STRIPS and C-
STRIPS of the same maturity.
Statement III: Bonds have idiosyncratic pricing differences and these differences are
inherited by their respective P-STRIPS.
Statement IV: The largest price difference between the P-STRIPS and C-STRIPS would
occur when P-STRIPS come from the most recently sold or on-the-run bonds/notes

A. I, II & III only

B. II, III & IV only

C. I, II & IV only

D. All of the above

The correct answer is: D)

Individual bonds have unique characteristics that are reflected in pricing, the law of
one price would not be as accurate an approximation.

Since C-STRIPS are fungible while P-STRIPS are not, any such pricing idiosyncrasies
would manifest themselves as differences between the prices of P-STRIPS and C-
STRIPS of the same maturity.

Bonds have idiosyncratic pricing differences and these differences are inherited by
their respective P-STRIPS.

Of particular interest, the largest price difference between P-STRIPS and C-STRIPS
comes from the most recently sold or on-the-run bonds/note, an issue which
traditionally trades rich to other bonds because of its superior liquidity and financing
characteristics.

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Q.1001 With regard to full price and flat price, which of the following statements are
true?

I. The flat price of the bond per 100 face amount is defined as the full price plus
accrued interest
II. When trading bonds day-to-day, it is more intuitive to track the flat prices and
negotiate transactions in those terms
III. Within a coupon period, the full price of a bond, which is just the present value of
its cash flows, increases over time as the bond's payments draw near
IV. From an instant before the coupon payment date to an instant after it, the full price
falls by the coupon payment

A. I, II & III only

B. II, III & IV only

C. I, II & IV only

D. All of the above

The correct answer is: B)

Statement I is incorrect. The full or invoice price of the bond per 100 face amount is
defined as the quoted price plus accrued interests.

All other statements are accurate. The full price changes dramatically over time even
when the market is unchanged, including a discontinuous jump on coupon payment
dates, while the flat price changes only gradually over time. Therefore, when trading
bonds day-to-day, it is more intuitive to track flat prices and negotiate transactions in
those terms.

Within a coupon period, the full price of the bond, which is just the present value of its
cash flows, increases over time as the bond's payments draw near.

But from an instant before the coupon payment date to an instant after, the full price
falls by the coupon payment: the coupon is included in the present value of the
remaining cash flows at the instant before the payment, but not at the instant after.

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Q.1002 Day conventions play an important role in determining the accrued interest and
value of financial instruments. With regard to day conventions, which of the following
statements are true?

I. For most government bonds in the US, the actual/actual day-count convention is used
to determine accrued interests
II. In money markets, the actual/360 day-count convention is used
III. In case of corporate bonds and for the fixed leg of interest rate swaps, the 30/360
convention is most commonly used
IV. In case of discount securities and for floating legs of interest rate swaps, the 30/360
convention is most commonly used

A. I, II & III only

B. II, III & IV only

C. I, II & IV only

D. All of the above

The correct answer is: A)

For most government bonds in the US, the actual/actual day-count convention is used to
determine accrued interests. In money markets, for discount securities and floating
legs of interest rate swaps, the actual/360 day-count convention is used. In the case of
corporate bonds and for the fixed leg of interest rate swaps, the 30/360 convention is
most commonly used.

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Q.1003 Ronam Ltd. invests in semi-annual US Treasury bonds with face values of USD
1,000 of 15 August 2020. A bond made a coupon payment of USD 40 on February 15,
2017. The next coupon is due on August 15, 2017. If the quoted price for the bond for
delivery on June 15, 2017, is USD 1001-16, then what is the full price of the bond?

A. USD 1,026.52

B. USD 1,013.48

C. USD 1,028.02

D. USD 1,014.98

The correct answer is: C)

Previous coupon date (Feb 15, 2017) -> 120 days -> Settlement date (June 15, 2017) ->
61 days -> Next coupon payment date (Aug 15,2017)

Accrued interest using actual/actual day-count- convention:

Accrued interest = USD 40 * (120/181) days = USD 26.5193
Full price = Quoted price + Accrued price = 1,001.50 + 26.5193 = USD 1028.0193

Note: 1001-16 = 1,001 + 16/32 = 1,001.5

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Q.1004 A $1,000 par value U.S. corporate bond pays a semiannual 10% coupon. Assume
the last coupon was paid 100 days ago and there are 30 days in each month. The
accrued interest is closest to:

A. $55

B. $27.78

C. $25

D. $30

The correct answer is: B)

number of days from last coupon to the settlement date

AI = c
number of days in coupon period

where c is the coupon payment

Thus,

100
AI = $50 = $27.78
180

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Q.2774 A fixed-income trader summarizes in the table below the prices of Treasury
Bonds with semiannual coupon payment. The data is as of 01/01/17.

Coupon Price (per $100 face value

Maturity
Rate )

Tranche 1 30/06/2017 3.5% 99-00

Tranche 2 31/12/2017 4% 100-16

Tranche 3 30/06/2018 5% 101-04

What are the discount factors for 0.5, 1 and 1.5 years?

A. d(0.5) = 0.9730; d(1) = 0.9662; d(1.5) = 0.9393

B. d(0.5) = 0.9551; d(1) = 0.9422; d(1.5) = 0.9102

C. d(0.5) = 0.9633; d(1) = 0.9523; d(1.5) = 0.9085

D. d(0.5) = 0.98990; d(1) = 0.9782; d(1.5) = 0.8787

The correct answer is: A)

The cash flows are as follow:

T(0.5) T(1.0) T(1.5)

Tranche 1 101.75 - -

Tranche 2 2 102 -

Tranche 3 2.5 2.5 102.5

99.00 = 101.75*d(0.5)
100.50 = 2*d(0.5) + 102*d(1)
101.125 = 2.5*d(0.5) + 2.5*d(1) + 102.5*d(1.5)

d(0.5) = 0.9730
d(1) = 0.9662
d(1.5) = 0.9393

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Q.2775 Consider a treasury bond that is currently trading on the market at the price of
97-24. The bond has a coupon rate of 5%, which is paid out semiannually.

Discount factor

d(0.5) 0.9777

d(1) 0.9471

d(1.5) ?

d(2) 0.8845

Given the discount factor structure shown in the table above, d(1.5) is closest to:

A. 0.9385

B. 0.9228

C. 0.9205

D. 0.9107

The correct answer is: D)

The cash flows are as follow:

T(0.5) T(1.0) T(1.5) T(2)

2.5 2.5 2.5 102.5

97.75 = 2.5*d(0.5) + 2.5*d(1) + 2.5*d(1.5) + 102.5*d(2)

d(1.5) = 0.9107

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Q.2776 A risk manager is concerned with the pricing of one of the bank’s treasury
bonds that pays 3% semiannual interest and matures in two years. She asks Alice Bau,
an intern, to calculate the price of the bond. Alice collects the following information on
current market discount structures:

Discount factor

d(0.5) -

d(1) 0.9727

d(1.5) 0.9327

d(2) 0.9045

As the data on discount factors is incomplete, Alice decides to also incorporate in her
analysis the recent sale of a T-Bill that matures in 6 months at 99-16.

What is closest to the price of the bond that Alice was asked to calculate?

A. 93.577

B. 94.187

C. 95.847

D. 96.157

The correct answer is: D)

The price of the T-Bill is 99 + 16/32 = 99.50

Using data on the sale of T-bill we can calculate the corresponding discount factor:
d(0.5) = 99.50/100 = 0.9950

The requested price of the bond is:

1.5*d(0.5) + 1.5*d(1) + 1.5*d(1.5) + 101.5*d(2) = 96.157

Q.2777 At the end of March 2017, a junior trader at an investment bank was requested
to provide information on her portfolio. The portfolio is presented below:

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 Market

Coupon Price (per Coupon

Maturity
Rate 100 face frequency

value )

Bond 1 30/09/2017 2% 99-08 semiannual

Bond 2 31/03/2018 4% 101-16 annual

Bond 3 30/09/2018 5% 105-16 semiannual

To revalue the portfolio, the trader uses the following discount factors:

Discount factor

d(0.5) 0.9991

d(1) 0.9799

d(1.5) 0.9705

Which of the above bonds is/are trading rich?

A. Bond 1

B. Bond 1 and Bond 2

C. Bond 3

D. Bond 2 and Bond 3

The correct answer is: C)

First, we need to calculate prices based on the trader’s discount factors for all three
bond:
Model price of bond 1 = 101*d(0.5) = 100.909
Model price of bond 2 = 104*d(1) = 101.910
Model price of bond 3 = 2.5*d(0.5) + 2.5*d(1) + 102.5*d(1.5) = 104.424

Then we need to compare model prices and market prices.

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 Market Model

Bond 1 99.250 100.909 Cheap

Bond 2 101.500 101.910 Cheap

Bond 3 105.500 104.424 Rich

A bond is said to be trading rich when the quoted market price is greater than the
model price. While you'll usually be given the market price, you'll have to calculate the
model price.

The model price of the bond equals the present value of its future cash flows, namely its

principal plus coupon payment, all times the discount factor for funds to be received.

For example, for bond 1 which matures in six months and therefore has just one

coupon, model price = (100 + 2/2)d(0.5) = (100 + 1)0.9991 = 100.909. For bond 3

which matures in 1.5 years and therefore has 3 semiannual coupons, model price = 5/2

× d(0.5) + 5/2 × d(1) + (100 + 5/2)d(1.5) = 104.424

Note that because interest is calculated as per $100, 2% interest = $2, 5% interest = $5

...etc.

The discount factor for a particular term gives the value today, or the present value of

one unit of currency to be received at the end of that term. The discount factor for t

years is denoted by d(t). Then, for example, if d (0.5) equals 0.9991 (as given in the

question), the present value of $1 to be received in six months is 1 ×0.9991 = 0.9991

cents.

Note and bond market prices are quoted in dollars and fractions of a dollar. By market

convention, the normal fraction used for Treasury security prices is 1/32. In the quoted

market prices, the hyphen (-) separates the full dollar portion of the price from the

32nds of a dollar, which are to the right of the hyphen. Thus the bid quote of 99-08

means $99 plus 8/32 of a dollar, or $99.25, for each $100 face value of the bond.

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Q.2778 Which of the below presented fixed income instruments typically trade rich?

A. Long-term P-STRIPS

B. AAA-rated Corporate bonds

C. Short-term C-STRIPS

D. Mortgage-backed securities

The correct answer is: C)

Short-term (long-term) C-STRIPS often trade rich(cheap). Recent issues tend to trade
at higher prices than otherwise similar issues. Some of this premium is due to the
demand for shorts and the resulting financing advantage, that is, the ability to borrow
money at less than GC rates when using these bonds as collateral.

Q.2779 A trader prepares a presentation to the investment committee of a bank with a

suggestion to invest $10,000,000 in U.S. Treasury 2 and 3/8s of December 31, 2019,
tranche with semiannual coupon payment frequency. The trader wants to invest in this
tranche, as the quoted market price is much lower than his estimate of fair price. To
prove the point, the trader includes a table below with market prices of C-STRIPs as of
June 30, 2017 (valuation date).

Market Price (per 100

Maturity
face value )

Tranche 1 31/12/2017 $99.753

Tranche 2 30/06/2018 $97.257

Tranche 3 31/12/2018 $95.012

Tranche 4 30/06/2019 $94.332

Tranche 5 31/12/2019 $93.805

What is closest to the price of the Treasury bond?

A. $99.507

B. $105.209

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 C. $106.235

D. $98.079

The correct answer is: A)

Price of the bond = 1.1875*99.753/100 + 1.1875*97.257/100 + 1.1875*95.012/100 +

1.1875*94.332/100 + 101.1875*93.805/100 = 99.507

Further explanation:

The price of a bond is simply equal to the present value of all its future payments

(coupons plus face value/redemption value). This is the logic applied here.

We wish to find the price of US 2 3/8s of June 30 2017. A 2 3/8 bond implies it pays an

annual coupon of 2% + 3/8% = 2.375%. We always compute the price of bonds per $100

face value.

We are told that the bond pays semiannual coupons. That implies a coupon of 2.375%/2

= 1.1875% every six months. Per $100 face value, that's $1.1875. At redemption, the

investor will receive the face value plus the coupon of the last six-month period, i.e. 100

+ 1.1875

Now, we need to discount all these to the present, and that means we need to establish

the relevant discount factors. Luckily, we have the prices of C-STRIPS maturing at each

of those dates. A C-STRIP is priced at a discount to face value, just like T-bills.

d(t) × face value = price; therefore, d(t) = price/face value

Q.2780 Narek Baron, FRM, reviews a presentation on the bank’s fixed income
exposures. He notices that there is some missing information in the section “Market
Overview.” Due to a lack of time, he decides to manually calculate the information

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based on the law of one price, without the discount factors. The figures are as of the
end of April 2017.

Market Price

Maturity Coupon Rate (per 100 face

value )

Bond 1 30/10/2017 1% 98-24

Bond 2 31/04/2018 3% 101-16

Bond 3 30/10/2018 4% -

Bond 4 30/04/2019 2% 102-00

Discount factor

d(0.5) 0.9826

d(1) 0.9855

d(1.5) -

d(2) 0.9807

Coupons are paid semiannually.

What is the discount factor for 1.5 years?

A. 0.9845

B. 0.9832

C. 0.9821

D. 0.9812

The correct answer is: D)

On one hand, the price of bond 4 = 1*0.9826 + 1*0.9855 + 1*d(1.5) + 101*0.9807

On the other hand, the price of bond 4 = 102

1*0.9826 + 1*0.9855 + 1*d(1.5) + 101*0.9807 = 102 => d(1.5) = 0.9812

Additional Explanation:
Discount factors give the present value of cash due at some point in the future. In
bonds, these cash flows are made up of interest payments and repayment of principal.

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The 6-month bond has cash flows only at maturity. It makes its interest payment of $0.5
(= 1%/2 ×100) plus the principal repayment of $100 at t = 0.5.
To find d(0.5) you should equate the present value (price) of the bond to these cash
flows.
98-24 is equivalent to 98 full USD plus 24 fractions of a dollar where total no. of
fractions is 32.
Hence, 98-24 = 98 + 24/32 = $98.75 Therefore, 98.75 = (100 + 0.5)d(0.5)
d(0.5) = 98.75/100.5 = 0.9826
This is the same figure that you’ve been given in the question.
To calculate d(1), you ought to follow the same logic, only that you’ll now have to
incorporate the value of d(0.5) because bond 2 has cash flows at two points in time: At t
= 0.5, and at t = 1.
101-16 = 101.5 = 1.5d(0.5) + 101.5d(1)
101.5 = 1.5 × 0.9826 + 101.5d(1)
d(1) = [101.5 – 1.5 × 0.9826]/101.5 = 0.9855
Again, this is the value given. Given coupon rates and price, you can easily compute the
discount factors. The value of d(1.5) can be calculated using the same approach, but
because we haven’t been given the price of bond 3, it’s impossible. But we know that
the price of bond 4 incorporates d(1.5) because the bond has a coupon (of $1) at that
point. Precisely,
102 = 1 × d(0.5) +1 × d(1) + 1 × d(1.5) + 1 × d(2.0)
Since we know the values of d(0.5), d(1), and d(2), we just make d(1.5) the subject of
the formula and find its value.

Q.3419 As the chief investment manager of one of your corporate clients, you determine
that the use of STRIPS (separate trading of registered interest and principal securities)
issued by the U.S. Treasury would help match assets with liabilities at various points in
the future. Which of the following statements regarding STRIPS is correct?

A. Shorter-term STRIPS tend to trade cheap while longer-term STRIPS tend to

trade rich

B. Shorter-term STRIPS tend to trade rich while longer-term STRIPS tend to

trade cheap

C. Shorter-term C-STRIPS tend to trade at a discount

D. Longer-term C-STRIPS tend to trade at a premium

The correct answer is: B)

Shorter-term STRIPS tend to trade rich while longer-term STRIPS tend to trade cheap.
Shorter-term C-STRIPS tend to trade at a premium, while longer-term C-STRIPS tend to
trade at a discount.

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Q.3420 Alphabet has $200 million worth of bond payable outstanding. The $1,000 par,
7% semi-annual coupon bonds are due to mature on 1 February 2020. The coupon dates
are 1 February and 1 August. They follow the 30/360 day count convention and the next
coupon is due on 1 August 2018. Linda Smith bought 1,000 of such bonds from Robert
Piers on 20 July 2018 when the bonds' yield was 0.75%. The market requires the buyer
to compensate the seller for the accrued interest. The clean price of the bond is equal
to:

A. $985.25

B. $1,000

C. $1,094.93

D. $1,090

The correct answer is: C)

Since the bond is valued based on the 30/360 day-count convention, there are 11 days
between the settlement date (July 20, 2018) and the next coupon date (August 1, 2018).

7%
Each coupon payment is valued at × $1, 000 = $35
2

C C C C +F
dirty price = + + +⋯+
k k+1 k +2
(1 + y) (1 + y) (1 + y) (1 + y)k +n −1

Where:

P = price

C = semiannual coupon

k = number of days until the next coupon payment divided by the number of days in the
coupon period, determined as per the relevant day-count convention.

y = periodic required yield

n = number of periods remaining, including the present one.

In this case, n = 4

k = 11/180 = 0.061

35 35 35 35
= + + + = 34.99 + 34.86 + 34.73 + 1023.21
0.061 1.061 2.061
1.00375 1.00375 1.00375 1.003753.061

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 = $1, 127.79

As of 20 July 2018,

180 − 11
accrued interest = $35 × = $32.86
180

Clean price = dirty price less accrued interest = 1, 127.79 − 32.86 = $1094.93

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 Reading 54: Interest Rates

Q.1005 Grant Bank pays an interest of 8% with interest getting compounded quarterly.
The effective annual rate is equal to:

A. 8%

B. 8.2%

C. 8.4%

D. 8.1%

The correct answer is: B)

Let’s assume that a sum of $1000 is invested initially and the annual rate is assumed to
be x.

Sum at the end of 1 year = $1000 * (1 + x/100)1

As the interest paid by the bank is 8% with quarterly compounding the aggregate value
at the end of one year.

Aggregate Value (with quarterly compounding) = $1000 * (1 + 8/(100*4))4

= $1000 * 1.082

Hence,
$1000 * (1 + x/100) = $1000 * 1.082
1 + x/100 = 1.082
x/100 = (1.082-1) = 0.082
x=8.20%

Therefore, the effective annual rate = 8.20%

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Q.1006 Royal Bank extends a loan of $1000 to a customer for 2 years. The bank charges
interest with half-yearly compounding frequency. If the spot rate for a 2-year loan is
10% per annum, then the amount that the customer needs to pay after 2 years is closest
to:

A. $1,200

B. $1,215

C. $1,210

D. $1,222

The correct answer is: B)

Amount (after T years ) = Principal * (1 + (Spot rate)/(Compounding frequency))(T

*Compounding frequency)

Where:
Principal = $1000
Spot rate = 10%
Compounding frequency = Half yearly = 2
T = 2 Years

Amount (After 2 years) = $1000 * (1 + 0.10/2)2*2

= $1,215.51

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Q.1007 The spot rate for 1 year and 2 years are 10% and 12% respectively. The forward
rate for a loan to be given in 1 year for a term of 1 year is:

A. 11%

B. 13%

C. 14%

D. 12%

The correct answer is: C)

The relation between spot rates and forward rate can be indicated by the expression
below:
(1 + Sport ratefor T)T = (1 + Spot ratefor t)t * (1 + Forward ratet to T)

Where
Spot rate for 1 year = 10%
Spot rate for 2 years = 12%
Forward rate1y1y = f

Therefore,
(1 + 0.12)2 = (1 + 0.10)1 * (1 + f1y1y)

1 + f1 year hence for 1 year = (1+0.12)2 / (1+0.10)1 = 1.14

f1y1y = 0.14 = 14%

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Q.1008 John Marauder observes that two zero-coupon bonds issued by ACC Limited are
currently trading at prices given in the table below:

Residual maturity Price Face value

1 year $91.74 $100

2 year $82.64 $100

The 1-year and 2-year spot are:

A. 9% and 10% respectively

B. 10% and 11% respectively

C. 8% and 9% respectively

D. 11% and 12% respectively

The correct answer is: A)

Zero-coupon bonds are bonds that do not carry coupons. Zero coupons bonds trade at a
discount to face value, the discount rates used are the spot rates. Hence the price of a
zero-coupon bond can be calculated by using the expression below:

P (zero-coupon bond of maturity T years) = FV * 1/(1+spot rateT)T

Therefore, using the above expression the spot rates are:
$91.74 = $100 * (1/(1 + Spot rate1 year)1)
1 + Spot rate1 year = 100/91.74 = 1.09
Spot rate1 year = 9%

$82.64 = $100 * (1/(1 + Spot rate2 year)2)

(1 + Spot rate2 year)2 = 100/82.64 = 1.21

Spot rate2 year = 10%

Q.1009 John Marauder observes that two zero-coupon bonds issued by ACC Limited are
currently trading at prices given in the table below:

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Residual maturity Price Face value

1 year $91.74 $100

2 year $82.64 $100

ABC Traders Private Limited managers are planning to issue zero-coupon bonds with a
maturity of 1 year next year. As per the present market conditions, the price of the zero-
coupon bond will most likely be:

A. $85.09

B. $95.09

C. $80.09

D. $90.09

The correct answer is: D)

The price of the zero-coupon bond will depend on the 1-year spot rate after 1 year i.e. 1-
year forward rate after 1 year. The spot rates are calculated as:
P (zero-coupon bond of maturity T years) = FV * 1/(1+spot rateT)T
Therefore, using the above expression the spot rates are:
$91.74 = $100 * (1/(1 + Spot rate1 year)1)
1 + Spot rate1 year = 100/91.74 = 1.09
Spot rate1 year = 9%

$82.64 = $100 * (1/(1 + Spot rate2 year)2)

(1 + Spot rate2 year)2 = 100/82.64 = 1.21

Spot rate2 year = 10%

The forward rate can be computed using the following expression:

(1 + Sport ratefor T)T = (1 + Spot ratefor t)t * (1 + Forward ratet to T)

Where
Spot rate for 1 year = 9%
Spot rate for 2 years = 10%
Forward rate1 year hence for 1 year = f

Therefore, the 1 year forward rate is equal to:

(1+0.10)2 = (1 + 0.09) * (1 + f1 year rate after 1 year)

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1 + f1 year rate after 1 year = (1.1)2/1.09 = 1.11
f1 year rate after 1 year = 0.11 = 11%
The 1 year forward rate after 1 year = 11%

Hence the price of the zero-coupon bond issued for 1 year after 1 year will be:
PZero-coupon bond of maturity T years = FV * 1/(1+Spot rateT)T
P = $100/1.11 = $90.09

Q.1010 John Marauder observes that two zero-coupon bonds issued by ACC Limited are
currently trading at prices given in the table below:

Residual maturity Price Face value

1 year $91.74 $100

2 year $82.64 $100

Select the most appropriate statement.

A. The market expects the interest rates to fall, therefore the yield curve is
downward sloping

B. The market expects the interest rate to rise, therefore the yield curve is
upward sloping

C. The market expects the interest rate to remain constant, therefore the yield
curve is flat

D. The yield curve is always downward sloping

The correct answer is: B)

The current 1-year spot rate = 9%

The 1-year forward rate after 1 year = 11%

Hence, the market expects that the current spot rate of 9% will rise to 11% after one
year i.e. the today’s forward rates are the estimator of tomorrow’s spot rate. Therefore,
the market expects the interest rate to rise and the yield curve is upward sloping.

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Q.1011 If the term structure of spot interest rates is flat, then the term structure of
forward interest rates must be:

A. Upward sloping

B. Downward sloping

C. Flat

D. Humped shaped

The correct answer is: C)

The term structure of spot rates is basically the spot rates for different maturities. A
flat term structure of spot rates means that the spot rate is the same for different
maturities, i.e., the spot rates for 1 year, 2 year, 3 year, etc. are the same.

Let's assume that the spot rates for 1 year and 2 years is equal to r. The one-year
forward rate starting in one year is:
(1+r)2 = (1+r)1 * (1 + Forward rate1 year to 1 year)
1 + Forward rate1 year to 1 year = 1 + r
Forward rate1 year to 1 year = r

As illustrated above, the forward rates will be the same for different maturities. Hence,
if the term structure of spot rates is flat, the term structure of forward rates will also be
flat.

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Q.1012 Jack Mangers observes that the spot rates for 2 years and 3 years are 6% and 8%
respectively while the 2y1y (1-year forward rate beginning after 2 years) rate is 12.50%.
Select the correct statement(s) from the following.

I. There is an opportunity to generate riskless profit

II. There is no opportunity to generate riskless profit
III. The yield curve is upward sloping
IV. The yield curve is downward sloping

A. Both I and IV are correct

B. Both II and III are correct

C. Both I and III are correct

D. Both II and IV are correct

The correct answer is: C)

The 2y1y i.e. 1-year forward rates beginning after 2 years can be computed by the
following expression:
(1 + Spot ratefor 3)3 = (1 + Spot ratefor 2)2 * (1 + Forward rate2 to 3)

Spot ratefor 3 = 8%
Spot ratefor 2 = 6%

(1 + 0.08)3 = (1 + 0.06)2 * (1 + Forward rate2 to 3)

1 + Forward rate2 to 3 = 1.083 / 1.062 = 1.1211

Forward rate2Y1Y = 0.1211 = 12.11%

As implied by the spot rates, the forward rate for 1-year forward rate after 2 years must
be equal to 12.11%. However, it is 12.50%. Therefore, there is an opportunity to
generate riskless profit due to the interest rate differential. Furthermore, as the
forward rates are higher, the yield curve is upward sloping.

Q.1013 Jack Mangers observes that the spot rates for 2 years and 3 years are 6% and 8%
respectively while the 2y1y (1-year forward rate beginning after 2 years) rate is 12.50%.
Select the most appropriate option.

A. As there is no interest rate discrepancy, no transaction can generate riskless

profit

B. Borrowing funds for 3 years, lending the funds for 2 years and an agreement

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 to lend funds for 1 year after 2 years will generate a riskless profit of $0.43 per
$100

C. Lending funds for 3 years, borrowing the funds for 2 years and an agreement
to lend funds for 1 year after 2 years will generate riskless profit of $0.50 per
$100

D. Borrowing funds for 3 years, lending the funds for 2 years and an agreement
to lend funds for 1 year after 2 years will generate riskless profit of $0.70 per
$100

The correct answer is: B)

The following steps will generate a riskless profit:

1. Borrow funds for 3 years (let us assume that $100 is borrowed.)
2. Lend the money for 2 years.
3. After two years lend the money as per the forward rate agreement for 1 year at
12.50%.

Cash
Time Action
flow

0 Borrow $100 for 3 years at 8% +$100

Lend the money for 2 years at 6% -$100

2
$100 is repaid after 2 years +$112.36
years

The repaid money is then again lent for 1 year as per the agreement
-$112.36
at 12.50%

3 The lent money is repaid with 1 year worth of interest ($112.36 *

+$126.41
years 1.125)

$100 initially borrowed for 3 years is repaid -$125.97

Profit = $0.43

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Q.1014 The details of a bond currently trading is given below:

Face value: $1,000

Coupon: 6%
YTM: 6%
Tenure: 10 years

The price of the bond is:

A. $1,100

B. 990

C. $1,000

D. 980

The correct answer is: C)

Yield to maturity (YTM) is the discount rate which is used to discount the cash flows of
the bond to arrive at its price.

The price of the bond is equal to its face value if and only if the YTM is equal to the
coupon rate. The rate at which the price of the bond is equal to its face value is known
as Par rates.

Therefore, in the above case, the price of the bond is equal to $1,000.

Q.1015 A floating rate bond pays coupons based on the three-month LIBOR. The face
value of the bond is $1000. If the coupon reset dates are January 1st, April 1st, July 1st,
and October 1st, then the price of the bond on February 1st will be:

A. $900

B. $1,000

C. $990

D. Insufficient information

The correct answer is: D)

The discount rate, as well as the LIBOR rate and/or the tenure of the bond, is required
to compute the price of the bond. Hence, the price cannot be computed due to
insufficient information.

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Q.1016 A floating rate bond pays coupons based on the three-month LIBOR. The face
value of the bond is $1000. If the coupon reset dates are 1st January, 1st April, 1st July
and 1st Oct, then the price of the bond on April 1st will be:

A. $900

B. $1,000

C. $990

D. Insufficient information

The correct answer is: B)

The discount rate used to discount the future cash flow of the bond is the LIBOR. On
the date of coupon reset, the discount rate as well as the coupon rate are both the
same. Hence, the price of the bond will be equal to its face value.

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Q.2781 In the table below, an analyst has summarized the current swap rates prevailing
on the market.

Term in years Swap Rate

0.5 2.00%

1.0 2.80%

1.5 3.20%

What is the 1.5-year discount factor?

A. 0.9533

B. 0.9625

C. 0.9725

D. 0.9804

The correct answer is: A)

(100 + 2% / 2) * d(0.5) = 100 -> d(0.5) = 0.9901

2.8% / 2 * d(0.5) + (100+2.8% / 2) * d(1.0) = 100 -> d(1.0) = 0.9725

3.2% / 2 * d(0.5) + 3.2% / 2 * d(1.0) + (100+3.2% / 2) * d(1.5) = 100 -> d(1.5) = 0.9533

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Q.2782 A trader at a derivatives trading desk is explaining to his intern the relationship
between spot and swap rates. As an example, he wants to extract the 1.5-year spot rate
from the swap rates structure presented below.

Term in years Swap Rate

0.5 1.00%

1.0 1.60%

1.5 1.88%

What is the implied 1.5-year spot rate?

A. 1.70%

B. 1.80%

C. 1.88%

D. 1.93%

The correct answer is: C)

(100 + 1%/2) * d(0.5) = 100 -> d(0.5) = 0.9950

1.6%/2 * d(0.5) + (100 + 1.6%/2) * d(1.0) = 100 -> d(1.0) = 0.9842

1.88%/2 * d(0.5) + 1.88%/2 * d(1.0) + (100 + 1.88%/2) * d(1.5) = 100 -> d(1.5) = 0.9723

1.5-Year Spot Rate = ((1/0.9723) 1/3 - 1) * 2 = 1.88%

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Q.2783 After a recent FED’s announcement, a trader observed significant changes
across the whole spot rates curve. The correct spot rates are as follows:

Term in years Spot Rates

0.5 0.75%

1.0 1.35%

1.5 1.85%

2.0 2.20%

2.5 2.50%

What is the 6-month forward rate in two years?

A. 0.30%

B. 1.85%

C. 2.21%

D. 3.70%

The correct answer is: D)

f(2.5) = ((1+(2.5%)/2)(2.5*2) / (1+(2.2%)/2)(2.2*2) - 1) * 2 = 3.70%

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Q.2784 A trader was requested to price a bond with a 4% semi-annual coupon rate and a
maturity of 2 years using the following 6-month forward rate curve.

Term in years 6-month Forward Rates

0.5 1.25%

1.0 1.90%

1.5 2.55%

2.0 3.30%

What is the price of the bond?

A. 99.128

B. 101.577

C. 103.440

D. 105.307

The correct answer is: C)

Price = 2/((1+(1.25%)/2)) + 2/((1+(1.25%)/2) * (1+(1.90%)/2)) + 2/((1+(1.25%)/2) * (1+

(1.90%)/2) * (1+(2.55%)/2)) + 102/((1+(1.25%)/2) * (1+(1.90%)/2) * (1+(2.55%)/2) * (1+
(3.30%)/2)) = 103.440

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Q.2785 Par rates prevailing on the market, are:

Term in years Par Rates

0.5 1.60%

1.0 2.00%

1.5 2.60%

2.0 3.20%

What is the two-year discount factor? (Assume semiannual coupons.)

A. 0.9871

B. 0.9619

C. 0.9421

D. 0.9380

The correct answer is: D)

(CT/2) * AT + d(T) = 1, where CT is the T year par rate and AT is the annuity factor.

Term
Discount
in Comments
factor
years

0.5 0.9921 (C0.5 /2) * d(0.5) + d(0.5) = 1

1.0 0.9803 (C1.0 /2) * (d(0.5) + d(1.0)) + d(1.0) = 1

1.5 0.9619 (C1.5 /2) * (d(0.5) + d(1.0) + d(1.5)) + d(1.5) = 1

(C2.0 /2) * (d(0.5) + d(1.0) + d(1.5) + d(2.0)) +

2.0 0.9380
d(2.0) = 1

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Q.3421 The price of a five-year zero-coupon government bond is $72.25. The price of a
similar six-year bond is $67.34. The one-year implied forward rate from year 5 to year 6
is closest to:

A. 7.29%

B. 7%

C. 7.4%

D. 7.1%

The correct answer is: A)

The relationship among the five-year price, the six-year price, and the implied forward
rate from year 5 to year 6 can be summarized as follows:

P5
P6 =
1 + F5,6
72.25
67.34 =
1 + F5,6
72.25
F5, 6 = − 1 = 7.29%
67.34

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Q.3422 The term structure of swap rates is:

n − year Swap rate

1 − year 3.5%
2 − year 4%
3 − year 4.5%
4 − year 5%
5 − year 5.5%

The two-year forward swap rate starting in three years is closest to:

A. 0.5%

B. 4%

C. 7.02%

D. 6.22%

The correct answer is: C)

First, we compute the accrual of a dollar over three and five (3+2) years:

For T = 3, this is (1 + 0.045)3 = 1.1412

For T = 5, this is (1 + 0.055)5 = 1.3070

(1 + R T )T = (1 + Rn )n (1 + Fn, T )T−n

Where n<T

1.3070 = 1.1412 × (1 + F3 ,5 )2

1.3070
F3, 5 = √ − 1 = 7.02%
1.1412

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Q.3423 Below is the term structure for swap rates:

Maturity in Swap Rate

Y ears
1 4.0%
2 4.5%
3 5.0%
4 5.5%
5 6.0%

The 1-year forward swap rate starting in four years is closest to:

A. 4.0%

B. 6.0%

C. 7.0%

D. 8.0%

The correct answer is: D)

(1 + RT )T = (1 + R n ) (1 + Fn,T )T−n

Where n<T

First, we compute the accrual of a dollar over four and five years:

For T = 4, this is (1 + 0.055)4 = 1.2388

For T = 5, this is (1 + 0.06)5 = 1.3382

1.3382 = 1.2388 × (1 + F4 ,5 )1

1.3382
F4 ,5 = − 1 = 8.0%
1.2388

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 Reading 55: Bond Yields and Return Calculations

Q.1017 Yield-to-maturity is an important measure to describe the pricing of a bond.

Which of the following statements are true with regard to yield-to-maturity?

I. Yield-to-maturity is the single rate such that discounting a security’s cash flows at
that rate gives that security’s market price
II. When the coupon rate exceeds the yield, the bond sells at a discount to its face value
III. When the yield exceeds the coupon rate, the bond sells at a premium to its face
value
IV. If the term structure is flat, so that all spot rates and all forward rates equal some
single rate, then the yield-to-maturity of all bonds equals that rate as well

A. I & IV only

B. II, III & IV only

C. I, II & IV only

D. All of the above

The correct answer is: A)

Statements I & IV are correct. Yield-to-maturity is the single rate such that discounting
a security’s cash flows at that rate gives that security’s market price. If the term
structure is flat, so that all spot rates and all forward rates equal some single rate, then
the yield-to-maturity of all bonds equals that rate as well.

Statements II & III are incorrect. When the yield is equal to the coupon rate, the bond
sells for its face value. When the coupon rate exceeds the yield, the bond sells at a
premium to its face value. When the yield exceeds the coupon rate, the bond sells at a
discount to its face value.

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Q.1018 Derek Johnson, an analyst at American Bonds Inc., is interested in
understanding the components of P&L (Profit & Loss) of bonds. With regards to P&L,
which of the following statements are true?

I. P&L is generated by price appreciation plus cash-carry, which consists of explicit cash
flows like coupon payments and financing costs
II. P&L due to carry is meant to convey how much a position earns due to the fact that,
as a security matures, its cash flows are priced at earlier points on the term structure
III. P&L due to roll-down is meant to convey how much a position earns due to the
passage of time, holding everything else constant
IV. The P&L due to the passage of time excluding cash-carry is called carry-roll-down

A. I & IV only

B. II & IV only

C. I, II & IV only

D. All of the above

The correct answer is: A)

Statements I & IV are correct. P&L is generated by price appreciation plus cash-carry,
which consists of explicit cash flows like coupon payments and financing costs. The
P&L due to the passage of time excluding cash-carry is called carry-roll-down.

Statements II & III are incorrect. P&L due to carry is meant to convey how much a
position earns due to the passage of time, holding everything else constant. P&L due to
roll-down is meant to convey how much a position earns due to the fact that. as a
security matures, its cash flows are priced at earlier points on the term structure.

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Q.1019 Consider the details of bonds currently trading:

Bond Coupon YTM Face Value

Bond A 10% 9% $1000

Bond B 6% 8% $1000

Bond C 5% 5% $1000

Select the most appropriate statements:

I. PriceBond A > $1000

II. PriceBond B < $1000
III. PriceBond C = $1000
IV. PriceBond A < $1000
V. PriceBond B > $1000
VI. PriceBond C > $1000

A. II, III and V are correct

B. I, II and III are correct

C. IV, V and VI are correct

D. I, III and V are correct

The correct answer is: B)

PriceBond A > Face Value when coupon > YTM

PriceBond B < Face Value when coupon < YTM
PriceBond C = Face Value when coupon = YTM

Hence, options I, II, and III are correct.

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Q.1020 All the following statements regarding the yield-to-maturity (YTM) are correct,
EXCEPT:

A. The YTM is the discount rate used to discount the bond cash flows to arrive at
the price of the bond

B. The YTM is the return realized by the bond investor

C. The YTM of a zero-coupon bond is equal to the spot rate

D. If YTM < Coupon, the bond trades at a premium

The correct answer is: B)

YTM is the discount rate used to discount the bond cash flows to arrive at the price of
the bond.

The return realized by the bondholder is equal to YTM only when the coupons are
reinvested at the yield same as the YTM. Generally, an investor fails to reinvest the
coupons at the YTM due to which the return realized by the bondholder is not equal to
YTM.

Zero-coupon bonds do not pay coupons. Hence the YTM of a zero-coupon bond is equal
to the spot rate.

When YTM < Coupon, then the bond trades at a premium. When YTM > Coupon, then
the bond trades at a discount.

Q.1021 Corporate bonds trade at a positive spread to government bonds because:

A. Corporate bonds are more liquid than government bonds

B. Corporate bonds have higher credit risks than government bonds

C. Corporate bonds generate higher returns than government bonds

D. Corporate bonds pay less coupon than government bonds

The correct answer is: B)

The spread at which corporate bonds trade depends mainly on its credit risk. Corporate
bonds have higher credit risk as compared to government bonds. Due to the higher
credit risk, the spread between the government bond and corporate bond is positive.

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Q.1022 Consider the following details with respect to a bond:

Face value: $1000

Coupon: 10%
Frequency: Semi-annually
Coupon payment dates: January 1st and July 1st

An investor buys the bond on January 22nd at a price of $990.23, and sells it on August
3rd at $1030.34. The gross realized return on the bond investment is:

A. 4.05%

B. 9.1%

C. 8.8%

D. 9.4%

The correct answer is: B)

January 22nd: -990.23

July 1st: +50 (Coupon payment)
August 3rd: +1030.34

Gross Realized Return = ($1030.34 + $50 - $990.23) / $990.23 = 9.10%

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Q.1023 Consider the following details with respect to a bond:

Face value: $1000

Coupon: 10%
Frequency: Semi-annually
Coupon payment dates: January 1st and July 1st

An investor buys this bond at $1043.43 on February 2nd, 2016 and sells it on January
1st, 2017 at $995.23. The coupon received is reinvested at a semi-annually compounded
rate of 9%. The realized gross holding period is:

A. 5.18%

B. 4.96%

C. 4.5%

D. 5.6%

The correct answer is: A)

February 2nd: -1043.43

July 1st: +50*(1+9%/2) (Coupon payment + Reinvestment for 6 months)
January 1st: +50 (Coupon payment) + $995.23 (Selling the bond)

Gross Realized Return = ($995.23 + $50 + $52.25 - $1043.43) / $1043.43 = 5.18%

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Q.1024 A corporate bond has a residual maturity of 2 years and pays a 10% coupon
annually.

Two zero-coupon bonds are currently trading at the price mentioned below:

Price Residual maturity

USD 92.38 1 year

USD 84.17 2 years

The price of the corporate bond is closest to:

A. USD 101.01

B. USD 117.66

C. USD 101.82

D. USD 93.41

The correct answer is: C)

A bond is priced using the spot rates as:

Price Bond = C/(1+Spot rate1)1 + (FV+C)/(1+Spot rate2)2

Spot Rate1 year = (100/92.38) – 1 = 0.825 = 8.25%

Spot Rate2 year = (100/84.17)1/2 - 1 = 0.900 = 9.00%

The price of the bond can be calculated as:

Price Bond = 10/(1+0.0825)1 + (100+10)/(1+0.09)2
= 9.24 + 8.42 + 84.17 = 101.82

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Q.1025 A bond with a residual maturity of 2 years that pays a 10% coupon annually is
currently trading at $102.10. It is also observed that two zero-coupon bonds are
currently trading at the price mentioned below:

Price Residual maturity

$92.38 1 year

$84.17 2 years

The transaction which will generate riskless profit is:

A. Sell the bond and purchase the zero-coupon bonds

B. Borrow funds and purchase the zero-coupon bonds

C. Riskless profit cannot be generated

D. Buy the bond and sell the zero-coupon bonds

The correct answer is: A)

A bond is priced using the spot rates as:

Price Bond = C/(1+Spot rate1)1 + (FV+C)/(1+Spot rate2)2
Spot Rate1 year = (100/92.38) – 1 = 0.825 = 8.25%

Spot Rate2 year = (100/84.17)1/2 - 1 = 0.900 = 9.00%

The price of the bond can thus be calculated as:

Price Bond = 10/(1+0.0825)1 + (100+10)/(1+0.09)2
= 9.24 + 8.42 + 84.17 = 101.82

As can be observed from the above, the price of the bond is > than $101.82. Hence, the
bond is overvalued.

1. As observed, the bond is overvalued. Hence, the investor must sell the overvalued
bond.
2. The funds obtained by selling the bond must be invested in the zero-coupon bonds.
3. By the above transaction, the investor can make a profit of $102.10 - $101.82 = $0.28
per $100.

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Q.1026 A fund manager is looking for an opportunity to invest in sovereign bonds.
Country A has recently witnessed a major economic recession and has just averted a
default on its foreign debt. On the other hand, country B is a developing economy with
a low debt to GDP ratio. The bonds of country A and B trade at a spread of a and b with
respect to US Treasury bonds.
Select the correct option:

A. a > b

B. a < b

C. a = b

D. a ≤ b

The correct answer is: A)

A riskier bond trades at a higher spread compared to less risky bond. The bonds of
country A are riskier than the bonds of country B. Therefore, the bonds of A will be
traded at a higher spread as compared to bond B.

Q.1027 The bonds of country A is trading at a spread of x with respect to US Treasury

bonds in country B and at a spread of y with respect to US Treasury bonds in country C.
A relative value trader wants to generate returns by trading in bonds of country A. If x
> y, then the trade must be:

A. To buy the bond in country B and sell it in country C

B. buy the bond in country C and sell it in country B

C. To sell the bond in country B and C

D. To buy the bond in country B and C

The correct answer is: A)

The bond trades at a higher spread in country B as compared to country C. Hence, the
price of the bond will be lower in country B as compared to country C. Therefore, the
bond must be purchased from country B and sold in country C. The transaction will
generate a profit of (x-y)%.

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Q.2786 Aram Bauer is considering an investment in fixed income instruments. He is
interested in U.S. Treasury 4 1/2s of December 31, 2019 tranche that has a semiannual
coupon payment frequency. The price of this tranche as of December 31, 2016, is
97.124.

What is the yield to maturity of the tranche?

A. 2.78%

B. 3.22%

C. 5.56%

D. 6.44%

The correct answer is: C)

N = 6; PV = -97.124; PMT = 2.25 (=4.5/2); FV = 100

CPT => I/Y = 2.78
YTM = 2*2.78 = 5.56

Q.2787 On Jan 1 2017, Commercial Bank of India issued a six-year bond paying an
annual coupon of 6% at a price reflecting a yield to maturity of 4%. As of 31 Dec 2017,
interest rates remain unchanged. Holding all other factors constant, and assuming a
flat term structure of interest rates, how was the bond’s price affected? The price:

A. Remained constant

B. Decreased

C. Increased

D. Increased, but only in the second half of the year

The correct answer is: B)

From the data given, it’s clear that the bond’s coupon is greater than the yield. As such,
the bond must have traded at a premium – implying the price must have been greater
than the face value. Provided the yield doesn’t change, a bond’s price will always
converge to its face value. Since the price starts higher, it must decrease.

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Q.2788 A trader borrows $3,000,000 with a term of two years at an annual rate of 2%
from his broker. He purchases at par a bond with a 5% coupon paid annually. The bond
matures exactly in 10 years. Two years later, the trader sells the bond at the price of
$101 and repays the loan.

Assuming that all of the coupons received are reinvested at the rate of 1.5%, what is the
trader’s net realized return on the transaction described above?

A. +7.0000%

B. +7.0750%

C. +11.0000%

D. +11.0750%

The correct answer is: B)

Proceeds from the sale of the bond = $3,000,000 * 101 / 100 = $3,030,000.00
Coupons received from the bond = $150,000.00 * 1.015 + $150,000.00 = $302,250.00
Interest paid to the broker = -$60,000.00 - $60,000.00 = -$120,000
Net proceeds = $3,030,000.00 + $302,250.00 - $120,000 = $3,212,250.00

Net realized return = ($3,212,250.00 -$3,000,000) / $3,000,000 = 7.0750%

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Q.2789 Alice Tuck invested her annual bonus in a bond with a face value of $55,000.
The bond pays a 5% coupon semiannually and matures in 10 years. At the purchase
date, the bond had a yield to maturity of 7%. Six months later Alice received the coupon
and sold the bond at the market yield of 6.5%.

What is the net realized return on Alice’s transaction?

A. +7.0000%

B. +7.1250%

C. +7.2312%

D. +7.5475%

The correct answer is: C)

Investment in the bond = $47,183.18

(N = 20; I/Y = 3.5%; PMT = 1,375 (=55,000 *5% / 2); FV = 55,000
CPT => PV = - 47,183.18)

Proceeds from the sale of the bond = $49,220.10

(N = 19; I/Y = 3.25%; PMT = 1,375 (=55,000 *5% / 2); FV = 55,000
CPT => PV = - 49,220.10)

Coupons received from the bond = $1,375

Total proceeds = $49,220.10 + $1,375 = $50,595.10

Net realized return = ($50,595.10 - $47,183.18) / $47,183.18 = 7.2312%

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Q.2790 At the weekly investment committee, Frida Lauf suggests an investment in a 2-
year Treasury bond with 2% semiannual coupons. According to Lauf, the bond is trading
8 basis points cheaper than the current forward rate curve.

Term in years 6-month Forward Rates

0.5 0.50%

1.0 0.95%

1.5 1.25%

2.0 1.75%

What is the market price of the bond?

A. $99.2761

B. $99.5859

C. $101.6022

D. $101.7616

The correct answer is: C)

Price = 1/((1+(0.50%)/2 + (0.08%)/2)) + 1/((1+(0.50%)/2 + (0.08%)/2) * (1+(0.95%)/2 +

(0.08%)/2)) + 1/((1+(0.50%)/2 + (0.08%)/2) * (1+(0.95%)/2 + (0.08%)/2) * (1+(1.25%)/2
+ (0.08%)/2)) + 101/((1+(0.50%)/2 + (0.08%)/2) * (1+(0.95%)/2 + (0.08%)/2) * (1+
(1.25%)/2 + (0.08%)/2) * (1+(1.75%)/2 + (0.08%)/2)) = 101.6022

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Q.3424 At the start of the year, a bank issues a non-zero-coupon bond maturing in five
years. During the year, the following events are recorded:

I. The bank’s leverage ratio increases

II. The bank’s business risk increases
III. The rate of interest earned on government bonds and T-bills increases

Which of the above-mentioned events would be expected to increase the bond’s yield to
maturity?

A. I only

B. I and II only

C. III only

D. I, II, and III

The correct answer is: D)

If interest rates rise, the corporate bond will be competing with T-bonds that offer more
than they were offering at the time of the bond’s issue. As a result, the price of the
bond will most likely fall. The yield to maturity, however, increases as price decreases.
Similarly, an increase in leverage ratio and increased business risk will increase the
bank’s overall risk in the eyes of investors. The result will be a decrease in price,
increasing the bond’s yield.

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Q.3425 Bank A and Bank B both have a credit rating of BBB. Bank A issues a fixed-rate
bond with a 10-year term to maturity, while Bank B issues a similar bond with a 5-year
term to maturity. Holding all other factors constant, which of the following statements
is most likely true?

A. Bond A has higher interest rate risk than bond B

B. Bond B has higher interest rate than bond A

C. Bond A has a lower coupon rate than bond B

D. Bond B has a higher coupon rate than bond A

The correct answer is: A)

The longer the bond’s maturity, the greater the risk that the bond’s value could be
impacted by changing interest rates prior to maturity, which may have a negative effect
on the price of the bond. As such, bonds with longer maturities generally have higher
interest rate risk than similar bonds maturing in less time.

To compensate investors for this interest rate risk, long-term bonds generally offer
higher coupon rates than short-term bonds of the same credit quality.

Q.3426 On Jan 1 2017, a 5-year corporate bond, paying an annual coupon of 8%, was
selling at a discount. As of 31 Dec 2017, interest rates remain unchanged. Holding all
other factors constant, which of the following relationships holds true? (P 0 represents
the price of the bond and YTM is the bond’s yield to maturity.)

A. P0 < par and YTM < 8%

B. P 0 < par and YTM > 8%

C. P0 > par and YTM > 8%

D. P 0 > par and YTM < 8%

The correct answer is: B)

That the bond is trading at a discount means the price is lower than par (face value). It
also means that the bond’s coupon is less than its yield to maturity. The price of the
bond will gradually “pull to par” (rise to par value as maturity approaches).

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 Reading 56: Applying Duration, Convexity, and DV01

Q.1175 The price of a bond at various rates is given in the table below:

Spot rate Price

3.45% 95.8680

3.40% 96.0780

The DV01 of the bond is:

A. 11.04

B. 1.10

C. 0.042

D. 0.906

The correct answer is: C)

DV01 = -ΔP/(10,000 * Δy)

ΔP = 95.8680 - 96.0780 = -0.21
Δy = 3.45% - 3.40% = 0.05%

DV01 = - (-0.21)/(10,000 * 0.05%) = 0.042

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Q.1176 The price of a bond at various rates is given in the table below:

Par rates Price

3.45% 95.8680

3.40% 96.0780

3.35% 96.3210

The duration of the bond is:

A. 0.4719

B. 4.7149

C. -4.7149

D. 0.04719

The correct answer is: B)

Duration = -((P+ - P-)/(r+ - r-)) * 1/P0

Duration = -(95.8680 - 96.3210)/(3.45%-3.35%) * 1/96.0780 = 4.7149

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Q.1177 The price of a bond at various rates is given in the table below:

Par rates Price

3.45% 95.8680

3.40% 96.0780

3.35% 96.3210

Select most appropriate statement from the following.

A. The duration is the same at 3.00% and at 3.40%

B. The duration is greater at 3.00% as compared to at 3.40%

C. The duration is smaller at 3.00% as compared to at 3.40%

D. Duration remains unaffected by the level of interest rates

The correct answer is: B)

As the interest rate decreases, the slope of the tangent becomes steeper. This signifies
that the change in the price of the bond is higher at lower interest rates. As duration
measures the change in the price of the bond with respect to the interest rates,
duration will be higher in the case of lower interest rates.

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Q.1178 A fund manager has the option to buy the following bonds:

I. A bond with a coupon of 10% and a tenure of 5 years

II. A bond with a coupon of 5% and a tenure of 5 years
If the fund manager wants to limit the impact of interest rate changes in his portfolio,
the ideal bond(s) to invest in is/are:

A. The bond with the 10% coupon

B. The bond with the 5% coupon

C. Both bonds, since they react in a similar manner to interest rate changes

D. Both bonds, since the diversification effect will reduce the impact of interest
rate changes

The correct answer is: A)

The impact of interest rate change in a bond portfolio is measured by the duration of
the portfolio. The bond with the higher coupon has a smaller duration compared to the
bond with the lower coupon. Hence, if the fund manager wants to limit the impact of
the interest rate changes on his portfolio, he must invest in the bond with the 10%
coupon, as this bond will have a smaller duration compared to the bond with the 5%
coupon.

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Q.1179 A fund manager has the option to buy the following bonds:

I. A bond with 10% coupon and a tenure of 15 years

II. A bond with 10% coupon and a tenure of 10 years

The fund manager expects the interest rate volatility to increase and wants to compose
a portfolio which will help him generate maximum return due to the volatility. The fund
manager must buy:

A. The bond with a tenure of 15 years

B. The bond with a tenure of 10 years

C. Both bonds, since they react in a similar manner to interest rate volatility

D. Both bonds, since the diversification effect will help him generate maximum
return

The correct answer is: A)

The larger the duration, the more the impact of interest rate volatility is on the
portfolio. It has been observed that bonds with large tenures have higher durations.
Therefore, the bond with a tenure of 15 years will have a higher duration as compared
to the bond with a tenure of 10 years. Therefore, in order to generate maximum return
due to the interest rate volatility, the fund manager must invest in the bond with a
tenure of 15 years.

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Q.1180 All the following are true for convexity, EXCEPT:

A. Convexity is the second derivative of the price rate function

B. For an option free bond, convexity is always negative

C. Convexity explains why the price of bond falls less and rises more in the case
of changes in interest rates

D. Convexity enhances the bond’s return

The correct answer is: B)

Convexity is the second derivative of the price rate function. Due to the convex shape of
the price-interest curve of a bond, for a given change in the interest rates, the bond
price rises more and falls less.

If an increase in interest rates decreases the price of a bond by x, and an equal

decrease of 1% in interest rates increases the price of the same bond by y, then due to
convexity, y > x.

For an option free bond, the convexity is always positive. As the increase in bond price
is larger in value than the decrease in value for the same yield change, convexity
enhances the return of a bond.

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Q.1181 Details of portfolio X is given below:

Bond Value Duration Convexity

Bond A $120,000 5.453 230.453

Bond B $100,000 7.213 350.361

Bond C $150,000 2.348 120.714

Bond D $130,000 8.190 480.341

Note: Portfolio X consists of bonds A, B, C and D, and the value of each bond is given in
the above table.

The duration of portfolio X is:

A. 5.26

B. 5.59

C. 5.10

D. 5.69

The correct answer is: B)

Total value of the portfolio = $120,000 + $100,000 + $150,000 + $130,000 = $500,000

Duration of the portfolio = ($120,000 * 5.453 + $100,000 * 7.213 + $150,000 * 2.348 +

$130,000 * 8.190) / ($500,000)
= 5.59

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Q.1182 Details of portfolio X is given below:

Bond Value Duration Convexity

Bond A $120,000 5.453 230.453

Bond B $100,000 7.213 350.361

Bond C $150,000 2.348 120.714

Bond D $130,000 8.190 480.341

Note: Portfolio X consists of bonds A, B, C and D, and the value of each bond is
furnished in the above table.

The convexity of portfolio X is:

A. 360.426

B. 386.484

C. 200

D. 286.484

The correct answer is: D)

Total value of the portfolio = $120,000 + $100,000 + $150,000 + $130,000 = $500,000

Convexity of the portfolio = ($120,000 * 230.453 + $100,000 * 350.361 + $150,000 *

120.714 +$130,000 * 480.341) / ($500,000)
= 286.484

Q.1183 Data on three bonds are given below. Assume the current date is March 31,
2015.

Bonds Maturity Price Yield Duration Convexity

A March 31, 2020 110.321 2.32% 4.321 34.09

B March 31, 2030 109.320 3.23% 9.102 78.32

C March 31, 2045 103.211 4.11% 18.112 323.11

The fund manager is considering purchasing $10 million (face value) of bonds B at the
cost of $10.932 million. The fund manager expects the interest volatility to increase

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and hence wants to maximize his returns. However, another fund manager makes the
suggestion that instead of investing in bond B, the fund manager should invest in a
combination of bond A and C. Given that the fund manager has a surplus of $10.932
million and wants the duration of the portfolio to be equal to that of bond B, the
investments in A and C which can create a portfolio with a duration similar to B is:
A. $5.34 million in bond A and $5.592 million in bond C

B. $9.321 million in bond A and $1.611 million in bond C

C. $7.14 million in bond A and $3.79 million in bond C

D. $8.12 million in bond A and $2.812 million in bond C

The correct answer is: C)

Let the investments in A and C be x and y respectively. Then, as per the constraints:
x + y = 10.932
(1/10.932) * (x * 4.321 + y * 18.112) = 9.102

Solving for x and y:

x = $7.14
y = $3.79

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Q.1184 Data on three bonds are given below. Assume the current date is March 31,
2015.

Bonds Maturity Price Yield Duration Convexity

A March 31, 2020 110.321 2.32% 4.321 34.09

B March 31, 2030 109.320 3.23% 9.102 78.32

C March 31, 2045 103.211 4.11% 18.112 323.11

The fund manager is considering purchasing $10 million (face value) of bonds B at the
cost of $10.932 million. The fund manager expects the interest volatility to increase
and hence wants to maximize his returns. However, another fund manager makes the
suggestion that instead of investing in bond B, the fund manager should invest in a
combination of bond A and C. The fund manager has a surplus of $10.932 million and
wants the duration of the portfolio to be equal to that of bond B. Given that the fund
manager expects increased interest volatility, the fund manager should invest in:

A. $10.932 million of Bond B

B. $10.932 million of Bond C

C. $5.12 million of bond A and $5.81 of bond C

D. $7.14 million of bond A and $3.79 of bond C

The correct answer is: D)

The fund manager must invest in such a bond/portfolio which has the highest convexity,
as higher convexity will help the fund manager to maximize return due to interest rate
volatility.

Let the investments in A and C be x and y respectively. As per the constraint of having a
duration of the portfolio equal to that of bond B (9.102 years):
x + y = 10.932
(1/10.932) * (x * 4.321 + y * 18.112) = 9.102

Solving for x and y:

x = $7.14 y = $3.79

Portfolio convexity = (7.14/10.932) * 34.09 + (3.79/10.932) * 323.11 = 134.29

As the convexity of the portfolio is higher than the convexity of bond B and the portfolio
meets the duration constraints (as it is equal to bond B), the preferred investment is in
a portfolio consisting of bond A and C.

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Q.1185 Data on three bonds are given below. Assume the current date is March 31,
2015.

Bonds Maturity Price Yield Duration Convexity

A March 31, 2020 110.321 2.32% 4.321 34.09

B March 31, 2030 109.320 3.23% 9.102 78.32

C March 31, 2045 103.211 4.11% 18.112 323.11

The return generated by a portfolio consisting of $7.14 million of bond A and $3.79
million of bond C in the case the interest rate remains constant is:

A. 0.0232

B. 0.0411

C. 0.0294

D. 0.0151

The correct answer is: C)

The return generated in case the rate remains constant = (7.14/10.932) * 2.32% +
(3.79/10.932) * 4.11% = 2.94%

Q.2791 Suppose the yield on a zero-coupon bond declines from 5.00% to 4.99%, and the
price of the zero increases from $50.0 to $51.5. Compute the DV01.

A. $0.0512

B. $1.5

C. $2.5

D. $0.1

The correct answer is: B)

△BV
DV 01 = − 10,000
×△y
Where:
△BV = change in bond value
△y = change in yield
DV 01 = − 1051.5−50.0 = 1.5
,000 ×−0.0001

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Q.2792 Ted Oster wants to calculate the DV01 of a new position in a bond with a face
value of $1,000,000. The bond was bought today for $84.102 for $100 face value. Oster
knows that the Macaulay duration is 5.25.

What is the DV01 of the position if the bond has a yield to maturity of 10%?

A. $401.39

B. $405.40

C. $483.47

D. $492.73

The correct answer is: A)

Modified duration = 5.25 / (1+10%) = 4.7727

DV01 = Mod dur × 0.0001 × Bond value

= 4.7727 × 0.0001 × (84.102 / 100) × $1,000,000 = $401.39

Note that the reason why we multiply by 0.0001 is to get the dollar change for a 1%
change in yield in terms of basis points.

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Q.2793 A risk manager is closely watching for the price movements of the most recent
bond issue of Alpha Corporation as the bank recently opened a position in the tranche.
At the beginning of a trading day when rates were at 5%, the position was valued at
$50,000,000. According to her calculations, she notices that the position would gain
$2,500,000 if rates fell to 4.5% and would lose $2,100,000 if rates rose to 5.5%.

What is the effective duration of the position?

A. 3.8

B. 4.6

C. 7.7

D. 9.2

The correct answer is: D)

Effective duration = (P- – P+) / (2P0Δy)

= (52,500,000 - 47,900,000) / (2 * 50,000,000 * 0.005) = 9.2

Q.2794 A trader at an investment bank sold to the corporate client $10,000,000 worth
of non-standardized call options on bonds. The DV01 of the option is 0.1011. The trader
wants to hedge the options using the same option’s underlying bonds that has a DV01
of 0.2455.

What is the bank’s hedging transition?

A. Sell $4,118,000 face value of U.S. Treasury 3s of December 31, 2020

B. Buy $4,118,000 face value of U.S. Treasury 3s of December 31, 2020

C. Sell $2,428,000 face value of U.S. Treasury 3s of December 31, 2020

D. Buy $2,428,000 face value of U.S. Treasury 3s of December 31, 2020

The correct answer is: B)

Hedge ratio = 0.1011 / 0.2455 = 0.4118

The hedge fund should buy $4,118,000 face value of U.S. Treasury 3s of December 31,
2020.

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Q.3427 Given the following portfolio of bonds:

Bond P rice P ar Amount H eld ($m) Modified Duration

A 101.22 4 2.45
B 85.53 6 4.25
C 115.50 9 7.61

What is the value of the portfolio’s DV01 (Dollar value of a basis point)?

A. $10,960

B. $11,000

C. $11,060

D. $12,600

The correct answer is: C)

Portfolio DV 01 = portfolio modified duration × portfolio market value × 0.0001

But we have to compute the portfolio modified duration first:

Modified duration of portfolio = weighted average of the modified duration of indivi

= w1 D1 + w 2 D2 + ⋯ + w kDk

where :

mar ket value of bo nd i

wi = po rtf olio mar ket value

Di =modified duration of bond i

k=total no.of bonds in the portfolio

Based on the table above, these are the values for bonds A, B, and C :

Bond V alue Weight in the portf olio

4 ,000,000 4 ,048, 800
A = 101.22 × 100 = 4,048,800 = 19,575 ,600=
0.21
6,000 ,000 5 ,131, 800
B = 85.53 × 100 = 5, 131, 800 = 19,575 ,600=
0.26
9,000 ,000 10,395 ,000
C = 115.5 × 100 = 10,395,000 = 19,575 ,600=
0.53
portfolio = 4,048, 800 + 5, 131, 800 + 10, 395, 000 = 19, 575, 600

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 P ortfolio modified duration = 0.21 × 2.45 + 0.26 × 4.25 + 0.53 × 7.61 = 5.65

Therefore,

Portfolio DV 01 = 5.65 × 19, 575, 600 × 0.0001 = $11 , 060.2

Q.3428 The current interest rate environment in a certain developing economy is flat at
5%. A risk manager has compiled the following data regarding a callable bond in two
other interest rate environments:

Value in USD per USD 100 face value

Level of interest rate Callable bond Call op tion

4.96% 102.00 2.0893
5.00% 102.4465 2.0255
5.04% 101.2111 2.0021

The convexity of the callable bond is closest to:

A. -102,608

B. -51,304

C. -100,020

D. -103,000

The correct answer is: A)

Convexity is the second derivative of the formula for change in bond prices with a
change in interest rates.

1 d 2 BV
Convexity = ×
BV dy 2

This approach can be quite rigorous in terms of computation, so you need to estimate
convexity using the formula:

BV −Δy + BV +Δy − 2BV 0

Convexi ty =
BV 0 × Δy 2

Where:

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BV −Δy =price estimate if yield decreases by a given amount, Δy

BV +Δy =price estimate if yield increases by a given amount,Δy

BV 0 =initially observed bond price (at the flat rate)

Δy =change in yield in one step, expressed in decimal form (0.04% in this case)

102.00 + 101.2111 − 2 × 102.4465

Convexity =
102.4465 × 0.00042

1.6819
=− = −102 , 608
0.00001639

Q.3429 A 20-year zero-coupon bond is callable annually at par, starting at the beginning
of year 11. Assuming a flat yield curve of 20%, the bond’s duration is closest to:

A. 20 years

B. 15 years

C. 10 years

D. Cannot be determined based on the data given

The correct answer is: A)

Because this is a zero-coupon bond, it will always trade below par, and the call should
never be exercised. Hence, its duration is the maturity of the bond, 20 years.

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 Reading 57: Modeling and Hedging Non-Parallel Term Structure Shifts

Q.1148 All the following are assumptions of Key Rate Shifts, EXCEPT:

A. Rates can be determined as a function of a relatively small number of key

rates

B. There is a parallel shift of rates across the key rates

C. There is a linear shift of rates across the term structure

D. The rate of a given term is not affected by its neighboring key rates

The correct answer is: D)

The basic idea behind the key rate shifts is the assumption that rates can be
determined as a function of a relatively small number of key rates. Furthermore, the
key rates also assume that there is a parallel shift/linear shift of rates across the term
structure. It also assumes that the rate of the given term is affected by its neighboring
key rates. For instance, it assumes that the 5-year rate is a function of 2-year and 3-year
rates.

Q.1149 An investor who buys a swaption:

A. Has the right to pay the fixed rate on a swap at some time in the future

B. Has the right to pay the floating rate on a swap at some time in the future

C. Has the right to receive the fixed rate on a swap at some time in future

D. None of the above

The correct answer is: A)

A swaption buyer/purchaser has a right to pay a fixed rate on a swap and receive the
floating rate at some time in the future.

Q.2604 The CRO of a regional bank decides to enhance risk management procedures
for the bank’s fixed income portfolio. She asks Lionel Black to calculate the key rate
(KR)'01s for the C-STRIP that will mature in 30 years. Black summarized the following
information using the bank’s pricing application:

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 Value

Initial Curve 100.214

2-year Shift 100.175

5-year Shift 100.088

10-year Shift 100.010

30-year Shift 98.751

What are the KR'01 for a 5-year shift and the approximate DV01 for the bond?

A. KR '01 for a 5-year shift = 0.165; DV01 = 1.832

B. KR '01 for a 5-year shift = 0.165; DV01 = 2.230

C. KR '01 for a 5-year shift = 0.126; DV01 = 1.832

D. KR '01 for a 5-year shift = 0.126; DV01 = 2.230

The correct answer is: C)

KR '01 for i-year shift = Bond’s initial price – Bond’s price in case of the i-year shift.

The sum of the key rate shifts is a parallel shift of par yields. As such, the sums of the
key rate ‘01s are conceptually comparable to the one-factor yield-based DV01.

Calculations are summarized in the table below.

Value Key Rate '01

Initial Curve 100.214

2-year Shift 100.175 0.039

5-year Shift 100.088 0.126

10-year Shift 100.010 0.204

30-year Shift 98.751 1.463

Total 1.832

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Q.2605 An analyst has gathered the following data on the prices of a 10-year zero-
coupon bond simulated for shifts in three key rates:

Value

Initial Curve 103.300

2-year Shift 102.755

5-year Shift 102.504

10-year Shift 102.303

What is the key rate duration for a 10-year shift?

A. 19.61

B. 23.20

C. 96.52

D. 99.70

The correct answer is: C)

KR 'duration for a 10-year shift = -(102.303-103.300) / 103.300 * 10,000 = 96.52

Q.2606 A risk manager prepares a presentation on the interest rate risk of the bank’s
bond portfolio. The table below shows the value of the portfolio in cases of shifts in key
rates and corresponding key rate '01s.

Value Key Rate Duration

Initial Curve 500.425

2-year Shift 500.227 3.957

5-year Shift 500.201 4.476

10-year Shift ? 28.476

30-year Shift 499.500 18.484

Total 55.393

What is the value of the portfolio in the case of a 10-year shift?

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 A. 501.850

B. 500.043

C. 499.500

D. 499.000

The correct answer is: D)

Key rate duration

1 ∂p
= − p ∂y

Where:
P = initial bond value/price
∂p = change in bond price
∂y = change in yield
Let the value of the bond portfolio in the case of a 10-year shift be "x"
Thus, the key rate duration with respect to the 10-year shift is calculated as:
Krd
1 −500.425
= − 500.425x0.01%

1 x−50.425
28.476 = − 500.425×
0.01%

28.476 × 500.425 = − x−500.425

0.01%
28.476 × 500.425 × 0.01% = −(x − 500.425)
28.476 × 500.425 × 0.01% = 500.425 − x)
500.425 − 28.476 × 500.425 × 0.01% = x
x = 499.000

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Q.2607 Frank Capper wants to estimate the impact of key rate changes on the value of
C-STRIPs. Capper uses 2-year, 5-year, 10-year, and 30-year key rates in his analysis. He
also wants to incorporate an unexpected 50 basis point shock of the 10-year rate in the
model.

Which of the following rates will be affected by the change of the 10-year rate key rate?

A. 2-year and 5-year

B. 30-year rate

C. 5-year and 30-year rates

D. All of the rates will be affected

The correct answer is: C)

Each key rate affects the yields from the term of the previous key rate (or zero) to the
term of the next key rate.

Q.2609 A trader expects a significant increase in 30-year rates due to a decreased

demand for long-term bonds. The current position of $300,000 has a duration of 5 and
a 30-year key rate duration of 12. To hedge the portfolio, the trader plans to use a bond
with a duration of 8 and a 30-year key rate exposure of $4 per $100 face value.

What is the trader’s hedging transition?

A. Sell $300 face value of the bond

B. Sell $9,000 face value of the bond

C. Sell $187,500 face value of the bond

D. Sell $480,000 face value of the bond

The correct answer is: B)

The position’s 30-year key rate ‘01 = $300,000 * 12 /10,000 = $360

Let’s denote F as the face amount of the hedging security:

F * 4/100 = $360

F = $9,000

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Q.2610 A trader wants to hedge the 2-year and 5-year rates exposure of a portfolio. To
perform the hedge, the trader can use Bond 1 and Bond 2 presented below.

Key Rate ‘01 (per 100 face amount)

Hedging Bonds 2-year 5-year

Bond 1 0.0080 -

Bond 2 0.0099 0.0160

Key Rate ’01 ($)

2-year 5-year

Fixed Income
250 320
Portfolio

What is the face value of Bond 1 required to perform the hedge?

A. $200,000

B. $650,000

C. $950,000

D. $1,250,000

The correct answer is: B)

Let’s denote F(i) as the face amount of hedging bond i that we need to sell.

We have the following equations:

(1): F(2) * 0.0099/100 + F(1) * 0.0080/100 = $250

(2): F(2) * 0.0160/100 = $320

From (2) -> F(2) = $2,000,000

From (1) and (2) -> F(1) = $650,000

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Q.2611 The risk manager of a regional bank is concerned with possible shocks in short-
term rates. He wants to find a transaction that will completely eliminate the 2-year
exposure and decrease by half the current 5-year exposure. A trader proposes the
following two bonds as hedging instruments:

Key Rate ‘01 (per 100 face amount)

Hedging Bonds 2-year 5-year

Bond 1 0.0010 0.0050

Bond 2 0.0015 0.0025

Key Rate ’01 ($)

2-year 5-year

Fixed Income
1000 4000
Portfolio

What is the trader’s hedging transaction?

A. Sell $60,000,000 of bond 1; Sell $10,000,000 of bond 2

B. Sell $10,000,000 of bond 1; Sell $60,000,000 of bond 2

C. Sell $10,000,000 of bond 1; Buy $60,000,000 of bond 2

D. Buy $60,000,000 of bond 1; Sell $60,000,000 of bond 2

The correct answer is: B)

Let’s denote F(i) as the face amount of hedging bond i that we need to sell.

To completely hedge the 2-year exposure, F(1) and F(2) should solve the following
equation:
(1): F(2) * 0.0015/100 + F(1) * 0.0010/100 = $,1000

To decrease by half the 5-year exposure of $4,000, F(1) and F(2) should solve the
following equation:
(2): F(2) * 0.0025/100 + F(1) * 0.0050/100 = $2,000

(1) * 5 – (2) -> F(2) * (0.0050)/100 = 3,000 -> F(2) = $60,000,000 -> F(1) = $10,000,000

Q.2612 The head of the trading department of a bank suggests speculating on the
interest rate curve by eliminating the exposure of the bond portfolio to long-term rates

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(10-year and 30-year rates) and increasing the exposure to medium-term rates. The
table below represents the key rate ‘01s of the current portfolio and corresponding
hedging instruments.

Key Rate ‘01 (per 100 face amount)

Hedging Bonds 5-year 10-year 30-year

Bond 1 0.0050 - -

Bond 2 0.0170 0.0250 -

Bond 3 0.0100 0.0300 0.0350

Key Rate ’01 ($)

5-year 10-year 30-year

Fixed Income
1,000 2,000 1,500
Portfolio

What will be the portfolio’s 5-year exposure after hedging 10-year and 30-year
exposures?

A. $85.70

B. $171.43

C. $8,570.00

D. $17,143.00

The correct answer is: A)

Let’s denote F(i) as the face amount of hedging bond i that we need to sell.

We have the following equations:

(1): F(3) * 0.0300/100 +F(2) * 0.025/100 = $2,000

(2): F(3) * 0.0350/100 = $1,500

From (3) -> F(3) = $4,285,714

From (2) and (3) -> F(2) = $2,857,143

Finally, the portfolio’s 5-year exposure = $1000 – F(2) * 0.0170 / 100 – F(3) * 0.0100 /
100 = $85.70

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Q.2613 The risk manager at a regional bank is trying to interpret the results of an
interest rate curve shocks simulation. The table below represents the key rate '01s for
the fixed income portfolio of the bank.

Value Key Rate '01

Initial Curve 2,000.000

2-year Shift 1,998.500 1.500

5-year Shift 1,998.300 1.700

10-year Shift 1,999.000 1.000

30-year Shift 1,998.000 2.000

Total 6.200

What is the approximate value of the portfolio in the case of a 5 basis point increase of
the 2-year rate and a 10 basis point increase of the 30-year rate?

A. 1,972.500

B. 1,980.000

C. 1,992.500

D. 1,996.500

The correct answer is: A)

Portfolio value = 2,000 – (5*1.5 + 10*2) = 1,972.5

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Q.2614 Anna White, head of the risk management department of a regional bank, asks
one of the interns to analyze the volatility of the bank’s medium-term fixed-income
portfolio. For the analysis of the portfolio, the intern uses 2-year rates (annual volatility
of 20%) and 5-year rates (annual volatility of 30%). He calculates that the key rate ’01s
for 2-year and 5-year shifts are $2 and $5, respectively.

What is the volatility of the portfolio if the correlation between 2-year and 5-year rates
is 0.45?

A. $15,524

B. $17,176

C. $22,570.00

D. $295,000,000

The correct answer is: B)

Portfolio variance = ($2 * 20% * 10,000)2 + ($5 * 30% * 10,000)2 + 2 * $2* $5 * 20% *
10,000 * 30% * 10,000 * 0.45 = $295,000,000

Portfolio volatility = $295,000,0000.5 = $17,176.

Q.2615 Initially, a fixed income portfolio of an investment bank had the following key
rate ‘01s:

Value Key Rate '01

Initial Curve 10,000

2-year Shift 9,990 10

5-year Shift 9,985 15

10-year Shift 9,981 19

30-year Shift 9,984 16

Total 60

After a recommendation from the risk management department, a trader completely

hedged the 30-year exposure with a bond that had the following characteristics:

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 Key Rate '01(per
Hedging Bond
$100 face value)

Initial Curve

2-year Shift -

5-year Shift -

10-year Shift 3

30-year Shift 4

How much will the bank save, if immediately after the hedge, the interest rate curve
experienced a 20 basis point upward parallel shift?

A. 320

B. 360

C. 480

D. 560

The correct answer is: D)

To hedge the 30-year exposure, the trader will need to sell $400 (=$16/4 * 100) face
value of hedging bond. The sale of hedging bond will also impact the 10-year exposure
by -$12 (=-3/100*$400).

The portfolio key rate ‘01s after hedge will become:

Key Rate '01

Initial Curve

2-year Shift 10

5-year Shift 15

10-year Shift 7

30-year Shift -

Total 32

The portfolio value drop without hedging transaction = 20*60 = 1,200

The portfolio value drop with hedging transaction = 20*32 = 640

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The hedging transaction will save the bank 560 (=1,200-640).

Q.3430 Kelvin Mertens, FRM, regularly participates in bond trading in the US. He is
using key rate analysis to assess the effect of yield changes on bond prices. He finds
that the 20-year yield has increased by 10 basis points. Moreover, this shock decreases
linearly to zero for the 30-year yield. Determine the effect of this shock on the 26-year
yield?

A. Increase of zero basis points

B. Increase of six basis points

C. Increase of ten basis points

D. Increase of four basis points

The correct answer is: D)

“Linear decline” implies the decline is by the same amount in each time step. The 10
basis point shock to the 20-year yield is supposed to decline linearly to zero for the 30-
year yield. If one assumes a simplistic one basis point effect, the impact of each key
rate will be one basis point at each key rate and then a linear decline to the subsequent
key rate. Thus, the shock decreases by one basis point per year and will result in an
increase of four basis points for the 26-year yield.

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Q.3431 The following table provides the initial price of a C-STRIP and its present value
after application of a one basis point shift in four key rates.

V alue
I nitial value 26.14485
2 − year shif t 26.14582
5 − year shif t 26.14885
10 − year shif t 26.14885
30 − year shif t 26.02192

The key rate '01 with respect to the 10-year shift is closest to:

A. -0.004

B. -0.04

C. -4

D. -0.4

The correct answer is: A)

′ ΔBV
Key rate 01 = −
10 , 000 × Δy

Where:

ΔBV =change in bond value

Δy =change in yield (0.01%)

The change in bond value here is measured in reference to the initial bond value.

26.14885 − 26.14485
=− = −0.004
10 , 000 × 0.01%

Q.3432 The following table provides the initial price of a C-STRIP and its present value
after application of a one basis point shift in four key rates.

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 V alue
I nitial value 26.11485
2 − year shif t 26.11582
5 − year shif t 26.11885
10 − year shif t 26.13885
30 − year shif t 26.01192

The key rate duration with respect to the 30-year shift is closest to:

A. 39

B. 0.1

C. 38

D. 10

The correct answer is: A)

′
First, determine the corresponding key rate 01:

′ ΔBV
Key rate 01 = −
10 , 000 × Δy

Where:

ΔBV =change in bond value

Δy =change in yield (0.01%)

The change in bond value here is measured in reference to the initial bond value.

26.01192 − 26.11485
=− = 0.1029
10 , 000 × 0.01%

Next, you can now compute the key rate duration using the formula:

DV 01 = duratio n × 0.0001 × bond value

Thus,

DV 01
duration =
0.0001 × bond value
0.1029
=
0.0001 × 26.11485
= 39.40

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Alternatively, recall that:

1 ∂P
key rate duration = − ( )
P ∂y

Thus, the key rate duration with respect to the 30-year shift can be calculated as:

1 26.01192 − 26.11485
key rate durat ion = − ( )×( ) = 39.40
26.11485 0.01%

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 Reading 58: Binomial Trees

Q.1205 Australian Financial Associates is holding the non-dividend paying stock of

Neevan Holdings which is trading at USD 10. The continuously compounded risk-free
rate is 5 percent per annum, and the annual standard deviation of the stock is 20
percent. What is the value of a 2-year European call option with a strike price of USD 10
using a two-period binomial model?

A. USD 1.64

B. USD 1.48

C. USD 1.58

D. USD 1.69

The correct answer is: B)

To price options in the binomial model, we need:

U = size of the up move factor =eσ√t
D = size of the down move factor = e−σ√ t = 1/U
σ is the annual volatility of the underlying asset’s returns and t is the length of the step
in the binomial model (t = 1 in this case).
ert−D
π u = probability of an up move = U −D
π d = probability of a down move = 1 − Πu

Working with the data provided,

U = 1.2214 and D = 0.8187

({ \pi }{ u }) = 0.5775 and ({ \pi }{ d }) = 0.4225

Let S represent the price of the stock and f represent the value of the call:

Suu = $10 × 1.2214 × 1.2214 = $14.92 fuu = max($14.92 - $10, $0) fuu = $4.92

Sud = $10 × 1.2214 × 0.8187 = $10 fud = max($10 - $10, $0) fud = $0

Sdu = $10 × 0.8187 × 1.2214 = $10 fdu = max($10 - $10, $0) fdu = $0

Sdd = $10 × 0.8187 × 0.8187 = $6.70 fdd = max($6.70 - $10, $0) fdd = $0

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As the table shows, the value of the call will be positive only when the stock moves
upward twice.
The expected value of the put 2 years from now is given by:
0.5775 × 0.5775 × $4.92 + 0.5775 × 0.4225 × $0 + 0.4225 × 0.5775 × $0 + 0.4225 × 0.4225 × $0
Value of the option today = 1.64
0.05 ×2 =
$1.48
e

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Q.1206 Simon Adams holds a portfolio consisting of a long position in Δ shares of the
stock and a short position in one call option so that the portfolio is riskless. The
current stock price is USD 100. After one year, if the value of stock price increases from
USD 100 to USD 125, the value of the option is USD 10. Also, if the current stock price
decreases from USD 100 to USD 85, the option price is 0. What is the Δ which makes
the portfolio riskless?

A. 0.25

B. 0.33

C. 0.5

D. 0.66

The correct answer is: A)

Stock price movements using a binomial tree:

Year 0 Year 1

Su = USD 125 and option price = 10

S0 = USD 100

Sd = USD 85 and option price = 0

If the stock price moves up from USD 100 to USD 125, the value of the shares is 125Δ
and the value of the option is 10 so that the total value of the portfolio is 125Δ - 10.

If the stock price moves down from USD 100 to USD85, the value of the shares is 85Δ
and the value of the option is zero so that the total value of the portfolio is 85Δ

The portfolio is riskless if the value of Δ is chosen so that the final value of the portfolio
is the same for both alternatives.

125Δ– 10 = 85Δ or Δ = 0.25

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Q.1207 Chris Fleming, an analyst working at Redberg Financials, constructs binomial
trees to price options. With regard to binomial trees for pricing options, which of the
following statement(s) is/are true?

I. The underlying assumption in constructing a binomial tree is that the stock price
follows a random walk
II. In the limit, as the time step becomes smaller, the binomial tree model is the same
as the Black-Scholes-Merton model
III. An inspection of a typical binomial tree shows that Delta remains constant during
the life of an option
IV. Constructing binomial trees for valuing options on stock indices, currencies, and
futures contracts is very similar to doing so for valuing options on stocks

A. I, III & IV only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: B)

The underlying assumption in constructing a binomial tree is that the stock price
follows a random walk. In the limit, as the time step becomes smaller, the binomial tree
model is the same as the Black-Scholes-Merton model. An inspection of a typical
binomial tree shows that delta CHANGES during the life of an option. Constructing
binomial trees for valuing options on stock indices, currencies, and futures contracts is
very similar to doing so for valuing options on stocks.

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Q.1209 Rahim Associates manages a portfolio of USD 100 million. After one year, if the
value of the portfolio moves up, the value would be 110 million, and if the value of the
portfolio moves down, the value would be 90 million. The risk-free rate is 6 percent per
annum, compounded continuously. Rahim Associates takes a short options position to
make the portfolio riskless. The value of options would be USD 10 million if the value of
the portfolio moves up to USD 110 million and zero if the value of the portfolio moves
down to USD 90 million. What is the present value of the options?

A. USD 7.62 million

B. USD 8.09 million

C. USD 8.59 million

D. USD 9.15 million

The correct answer is: A)

The portfolio either moves up by 10% or down by 10%.

Thus, up move factor = U = eδ√ t = e0.1 = 1.1
1
down move factor D = 1.1 = 0.9

ert−D 0.06
e −0.9
Probability of an up move = U −D = 1.1−0.9 =
0.809

Value of the option = e−0.06 [0.809 × $10 + 0.191 × $0] = $7.621million

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Q.1210 David Yung, an analyst working at the New Zealand Bank, uses Girsanov’s
Theorem to study portfolios in a risk-neutral world and in the real world. The
Girsanov’s Theorem states that:

A. When we move from the risk-neutral world to the real world, the expected
return from the stock price changes, but its volatility remains the same

B. When we move from the risk-neutral world to the real world, the expected
return from the stock price remains the same, but its volatility changes

C. When we move from the risk-neutral world to the real world, both the
expected return from the stock price and its volatility remain the same

D. When we move from the risk-neutral world to the real world, both the
expected return from the stock price and its volatility change

The correct answer is: A)

Girsanov’s Theorem states that when we move from a risk-neutral world to the real
world, the expected return from the stock price changes, but its volatility remains the
same. When we move from a world with one set of risk preferences to a world with
another set of risk preferences, the expected growth rates in variable change, but their
volatilities remain the same.

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Q.1211 Australian Financial Associates is holding the non-dividend paying stock of
Neevan holdings which is trading at USD 10. The continuously compounded risk-free
rate is 5 percent per year, and the annual standard deviation of the stock is 20%. What
is the value of a 2-year European put option with a strike price of USD 10 using a two-
period binomial model?

A. USD 0.5324

B. USD 2.4356

C. USD 0.6884

D. USD 2.3456

The correct answer is: A)

Year 0 Year 1 Year 2

Suu = $12.214 * 1.2214 = $14.918

Su = $10 * 1.2214 = $12.214

Sud = $12.214 * 0.8187 = $10

S0 = $10
Sdu = $8.187 * 1.2214 = $10

Sd = $10 * 0.8187 = $8.187

$dd = $8.187 * 0.8187 = $6.703

The option will have a positive have only when the price moves upward twice.
Expected call value of the option in two years = (0.5775 * 0.5775 * USD 4.918) +
(0.5775 * 0.4224 * 0) + (0.4224 * 0.5775 * 0) + (0.4224 * 0.4224 * 0) = USD 1.64
Value of the option today = USD1.64/(e(0.05)x2) = USD1.484

Value of put option using put-call parity:

Put = Call – stock + Xe-rT = USD 1.484 – 10 + 10e-(0.05)(2) = USD 0.5324

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Q.1212 Which of the following statement(s) is/are true with regard to Delta?

I. Delta is an important parameter in the pricing and hedging of options

II. Delta is the number of units of the stock we should hold for each option shorted in
order to create a riskless portfolio
III. The construction of a riskless portfolio is sometimes referred to as delta hedging
IV. The delta of a call option is negative, whereas the delta of a put option is positive

A. I, II & III only

B. I, II & IV only

C. II, III & IV only

D. All of the above

The correct answer is: A)

Delta is an important parameter in the pricing and hedging of options. The delta of a
stock option is the ratio of the change in the price of the stock option to the change in
the price. It is the number of units of the stock we should hold for each option shorted
in order to create a riskless portfolio. The construction of a riskless portfolio is
sometimes referred to as delta hedging. The delta of a call option is positive, whereas
the delta of a put option is negative.

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Q.1213 Rose Associates is holding stocks of Xerox limited. The current value of the
stock is USD 100 and the current continuously compounded risk-free rate is 3 percent.
The stock pays a dividend at a continuous dividend yield of 2 percent. The annual
standard deviation of the stock is 9 percent. What is the risk-neutral probability of an
up-move and down-move for a 1-year European call option on the stock?

A. 0.68 and 0.32

B. 0.78 and 0.22

C. 1.09 and 0.91

D. 0.53 and 0.47

The correct answer is: D)

U = size of the up-move factor = eσ√t = e0.09√1 = 1.094

D = size of the down-move factor = 1/U = 0.9139

The risk-neutral probabilities of upward and downward movements:

πu = Risk-neutral probability of an up-move = (e(r-q)t – D) / (U-D)

= (e(0.03-0.02)*1 – 0.9139) / (1.094-0.9139) = 0.53

πd = Risk-neutral probability of a down-move = 1 - πu = 1 - 0.53 = 0.47

Where r is the risk-free rate and q is the dividend rate

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Q.3400 Willy Smith, FRM, has a two-year European put with K = $41. The current price
of the underlying is $40. Over the past year, the stock has exhibited a standard
deviation of 20%. The risk-free rate of return is 5%. Compute the value of the put today.

A. $2.71

B. $3

C. $0

D. $16.1

The correct answer is: A)

u = eσ√t = e0.2×1 = 1.22

d = e−σ√t = e−0.2×1 = 0.82

ert − d e0.05×1 − 0.82

πu = = = 0.5782,
u−d 1.22 − 0.82

πd = 1 − 0.5782 = 0.4218

Let S represent the price of the stock and f represent the value of the put

Suu = $40 × 1.22 × 1.22 = $59.54 fuu = max ($41 − $59.54 , 0) fuu = $0
Su d = $40 × 1.22 × 0.82 = $40 fu d = max ($41 − $40 , 0) fu d = $1
Sd u = $40 × 0.82 × 1.22 = $40 fd u = max ($41 − $40 , 0) fd u = $1
Sdd = $40 × 0.82 × 0.82 = $26.90 fdd = max ($41 − $26.90 , 0) fdd = $14.10

The expected value of the put 2 years from now is given by:
0.5782 × 0.5782 × $0 + 0.5782 × 0.4218 × $1 + 0.4218 × 0.5782 × $1 + 0.4218 × 0.4218 × $14.10

$3
T he value of the pu t today = = $2.71
e0.05×2

Q.3401 ABC stock is currently trading at $15 per share. The stock exhibits annual
volatility of 30% and the risk-free rate of interest is 5%. An American put option expires
in two years with a strike price of $13. What is the value of the option using a two-
period binomial tree with one-year periods?

A. $1.5

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 B. $0

C. $2

D. $1.04

The correct answer is: D)

u = eσ√t = e0.3×1 = 1.35

1
d = e−σ√t = = 0.74
u
e0.05×1 − 0.74
πu = = 0.51
1.35 − 0.74
π d = 1 − 0.51 = 0.49

Let S represent the price of the stock and f represent the value of the put

Su = $15 × 1.35 = $20.25 fu = max (13 − 20.25 , 0) = 0

Sd = $15 × 0.74 = $11.10 fd = max (13 − 11.10 , 0) = 1.9
Suu = $15 × 1.352 = $27.34 fuu = max (13 − 27.34, 0) = 0
Su d = $15 × 1.35 × 0.74 = $15 fu d = max (13 − 15, 0) = 0
Sd u = $15 × 0.74 × 1.35 = $15 fd u = max (13 − 15, 0) = 0
Sdd = $15 × 0.742 = $8.21 fdd = max (13 − 8.21, 0) = 4.79

At the end of year 1, the expected payoff on the option in year 2, given that the year 1
move is an up move is:

$0 × 0.51 + $0 × 1.49
= $0
e0.05 ×1

The payoff from early exercise at the year 1 up node is: max ($13 − 20.25, 0) = $0, since
the option is out-of-the-money Early exercise is not optimal in this case because the
option is worth $0 if exercised. At the end of year 1, the expected payoff on the option
in year 2, given that the year 1 move is a down move is:

$0 × 0.51 + $4.79 × 0.49

= $2.23
e0.05 ×1

The payoff from early exercise given a down move in the first year is:
max ($13 − $11.1, 0) = $1.9 Early exercise is not optimal in this case either, because the
option is worth more unexercised ($2.23) than if exercised ($1.9).

Option T ree

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 $0

╱
$0
╲

C0
╱ $0

╲ $0

╱
$2.23
╲
$4.79

The value of the option today is calculated as:

$0 × 0.51 + $2.23 × 0.49

= $1.04
e0.05 ×1

Q.3402 XY Z stock is a non-dividend-paying stock currently priced at $108. According to

analysis, the annual standard deviation of returns on XY Z stock is 8% and the risk-free
rate on interest, compounded continuously, is 5.5%. Using a two-period binomial model,
compute the value of a 6-month American call option on XY Z stock with a strike price
of $110.

A. $2.43

B. $7.04

C. $2.98

D. $4.58

The correct answer is: C)

up move factor = u = eσ√ t = e0.08×√ 0.25 = 1.041

1
down move factor = d = = 0.961
1.041

e0.055 ×0.25−0.961
probability of an up move = πu = = 0.66
1.041−0.961

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probability of a down move= 1 − πu = 0.34

Let S represent the price of the stock and f represent the value of the call

Su = $108 × 1.041 = $112.43 fu = max (112.43 − 110 , 0) = 2.43

Sd = $108 × 0.961 = $103.79 fd = max (103.79 − 110 , 0) = 0
Suu = $108 × 1.041 2 = $117.04 fuu = max (117.04 − 110, 0) = 7.04
Su d = $108 × 1.041 × 0.961 = $108.04 fu d = max (108.04 − 110, 0) = 0
Sd u = $108 × 0.961 × 1.041 = $108.04 fd u = max (108.04 − 110, 0) = 0
Sdd = $108 × 0.961 2 = $99.74 fdd = max (99.74 − 110, 0) = 0

The $110 call option is in-the-money when the stock price finishes at $117.04 at which
time the call has a value of $7.04. At the end of 3 months(3-month node), the expected
payoff on the option in the next 3 months, given an up move up to that point, is:

$7.04 × 0.66 + $0 × 0.34

= $4.58
e0.055×0.25

In this case, if the holder of the option chose to exercise early, they’d receive a
maximum of max (112.43 − 110 , 0) = 2.43. Since $2.43 < $4.58, it would not be optimal to
exercise the option early. At the end of 3 months(3-month node), the expected payoff on
the option in the next 3 months, given a down move up to that point, is:

$0 × 0.66 + $0 × 34
= $0
e0.055×0.25

If the holder of the option chose to exercise early (3 months following a down move),
they’d receive a maximum of max ($103.79 − 110, 0) = $0. Again, it would not be optimal
to exercise the option early. The value of the option today is:

$4.58 × 0.66 + $0 × 0.34

= $2.98
e0.055×0.25

Q.3403 You have been provided the following information for a call option on the stock
of VeloMedia:

Current stock price = $100

Strike price = $100

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 Time to maturity = 1 year

Exponential compounding interest rate = 10%

Annual standard deviation = 30%

What is the value of a European call option using a two-period binomial tree with two
distinct intervals of 6 months?

A. $15.38

B. $10.21

C. $0

D. $5.86

The correct answer is: A)

Binomial parameters:

1
u = eσ√△t = e0.30√ 0.5 = 1.2363, d= = 0.8089
u

Risk-neutral probability:

er×△t − d e0.10×0.5 − 0.8089

p= = = 0.5671, 1 − p = 0.4329
u− d 1.2363 − 0.8089

X = $100

C uu = 52.85 , Cd u = C ud = C dd = 0

p × Cuu + (1 − p) × C ud 0.5671 × 52.85 + (1 − 0.4329) × 0

Cu = = = 28.51, Cd = 0
er×△t e0.10 ×0.5

0.5671 × 28.51 + (1 − 0.4329) × 0

C= = 15.38
e0.10×0.5

u = 1.2363

d = 0.8089

p = 0.5671

1– p = 0.4329

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 Suu = u ∗ Su
152.85
− Max(152.85 − 100, 0) = 52.85

Su = u ∗ S ╱
123.63
╲
S ╱ Sud = Sdu
− Max(100 − 100, 0) = 0
100
╲ 100

Sd = d ∗ S ╱
80.89
╲
Sdd = d ∗ Sd
65.43
− Max(65.43 − 100, 0) = 0

Q.3404 You have been provided the following information for a call option on the stock
of VeloMedia:

Current stock price = $100

Strike price = $100

Time to maturity = 1 year

Exponential compounding interest rate = 10%

Annual standard deviation = 30%

What is the hedge ratio (or call option delta) at the current date? Use a two-period
binomial tree with two distinct intervals of 6 months.

A. 0

B. 0.6669

C. 1

D. 0.5

The correct answer is: B)

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Binomial parameters:

1
u = eσ√△t = e0.30√ 0.5 = 1.2363, d= = 0.8089
u

Risk-neutral probability:

er×△t − d e0.10×0.5 − 0.8089

p= = = 0.5671, 1 − p = 0.4329
u− d 1.2363 − 0.8089

X = $100

C uu = 52.85 , Cd u = C ud = C dd = 0

p × Cuu + (1 − p) × C ud 0.5671 × 52.85 + (1 − 0.4329) × 0

Cu = = = 28.51, Cd = 0
er×△t e0.10 ×0.5

0.5671 × 28.51 + (1 − 0.4329) × 0

C= = 15.38
e0.10×0.5

u = 1.2363

d = 0.8089

p = 0.5671

1– p = 0.4329

Suu = u ∗ Su
152.85
− Max(152.85 − 100, 0) = 52.85

Su = u ∗ S ╱
123.63
╲
S ╱ Sud = Sdu
− Max(100 − 100, 0) = 0
100
╲ 100

Sd = d ∗ S ╱
80.89
╲
Sdd = d ∗ Sd
65.43
− Max(65.43 − 100, 0) = 0

△C C −C 28.51 − 0
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 △C Cu − C d 28.51 − 0
△= = = = 0.6669
△S Su − Sd 123.63 − 80.89

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Q.3405 You have been provided the following information for a call option on the stock
of VeloMedia:

Current stock price = $100

Strike price = $100

Time to maturity = 1 year

Exponential compounding interest rate = 10%

Annual standard deviation = 30%

Compute the value of the European put option using a two-period binomial tree with
two distinct intervals of 6 months.

A. $15.38

B. $5.86

C. $0

D. $10

The correct answer is: B)

p uu = pd u = pu d = 0, pdd = max(X − Suu , 0) = max(100 − 65.43 , 0) = 34.57

p2 p uu + 2p (1 − p) p ud + (1 − p)2 p dd
P = P V [p 2 puu + 2p (1 − p) pu d + (1 − p)2 pdd ] =
R2

0.56712 × 0 + 2 × 0.5671 × (1 − 0.5671) × 0 + (1 − 0.5671)2 × 34.87

P =
e0.10 ×0.5×2

(0.4329)2 × 34.57
P = = 5.86
e0.10

Note: we would arrive at the same answer if we compute the value of the corresponding
call (15.38 in this case) and then use the put-call parity to find the value of the put.

P + S = C + PV (X)

P = 15.38 + 100 × e−0.10∗1 − 100 = 5.86

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Q.3406 A call option has a delta of 0.65. What is the put option delta?

A. -0.65

B. -0.35

C. 0.35

D. None

The correct answer is: B)

Call option delta = Put option delta + 1

Put option delta = 0.65 - 1 = -0.35

The range of call option delta is always 0 to 1.

The range of put option delta is always -1 to 0.

Q.3418 The following table presents the characteristics of three different bonds with
semiannual coupons and different times to maturity:

Maturity Coupon P rice

6 months 6.0% 102 − 20
12 mon ths 12% 104 − 08+
18 mon ths 7.5% 98 − 24

Which of the following is closest to the discount factor for 1.5 years?

A. 0.9964

B. 0.8822

C. 0.8865

D. 0.9920

The correct answer is: B)

The 6-month bond has cash flows only at maturity. It makes its interest payment of
6%
$3 ( × $100) plus the principal repayment of $100 at t = 0.5. To find d (0.5) you should
2
equate the present value (price) of the bond to the cash flows. 102-20 is equivalent to
102 full USD plus 20 fractions of a dollar where total no. of fractions is 32. Hence,

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 102 − 20 = 102 + 20/32 = $102.63

$102.63 = $103d (0.5)

d (0.5) = 0.9964

The 12-month bond makes payments at t = 0.5 and at t = 1:

104 − 08+ = 104 + 8.5/32 = 104.27

Note: A “+” sign at the end of a quote represents half a tick.

104.27 = $6d (0.5) + $106d (1)

104.27 = $6 × 0.9964 + $106d (1)

104.27 − 5.98
d (1) = = 0.9273
106

Similarly, for the 18-month bond,

98.75 = $3.75d (0.5) + $3.75d (1) + 103.75d (1.5)

98.75 − 3.74 − 3.48

d (1.5) = = 0.8822
103.75

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 Reading 59: The Black-Scholes-Merton Model

Q.984 Antony Meech, a research analyst working at FinSearch Inc., is preparing a note
on lognormal distributions and normal distributions. He notes down the following
points on lognormal distribution:

I. The model of stock price behavior used by Black, Scholes, and Merton assumes that
percentage changes in the stock price in a very short period of time are normally
distributed
II. A variable that has a lognormal distribution can take any value between zero and
infinity
III. Like the normal distribution, the mean, median, and mode are all the same in the
lognormal distribution

Which of them are correct?

A. I & II only

B. II & III only

C. I, II & III only

D. I & III only

The correct answer is: A)

The model of stock price behavior used by Black, Scholes, and Merton assumes that
percentage changes in the stock price in a very short period of time are normally
distributed. A variable that has a lognormal distribution can take any value between
zero and infinity. Unlike the normal distribution, it is skewed so that the mean, median,
and mode are all different in the lognormal distribution.

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Q.985 Ricky Gervais, a retired veteran, is holding shares of TMT Limited which are
currently trading at USD 100. The volatility of the share is 25 percent per year, and the
expected return on the stock is 10 percent for the same period. What is the expected
stock price in one year?

A. USD 110.517

B. USD 128.403

C. USD 102.532

D. USD 101.432

The correct answer is: A)

The expected stock price in one year = E(ST) = S0eμT

Where
μ = Expected rate of return= 100e(.10) = USD 110.517

Q.986 Mike Finova is holding shares of TMT Limited which are currently trading at USD
100. The volatility of the share is 25 percent per year, and the expected return on the
stock is 10 percent for the same period. What is the standard deviation of the stock in
one year?

A. USD 787.68

B. USD 28.07

C. USD 14

D. USD 100

The correct answer is: B)

2T
The variance in one year = Var(ST) = S02e(2μT)(eσ -1)
2
= 1002e(2*0.1*1)(e0.25 -1)
= 10000*1.2214*0.06449 = 787.68
where μ = Expected rate of return and,
σ = volatility

Standard deviation of the stock price in 1 year = √787.68 = 28.07

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Q.987 Donald Morisette, a risk analyst at TNZ Associates, collects 20 days data on the
stock price of ANH. The analysis of the collected data gives an estimate of the yearly
volatility of the stock as 15.45%. What is the standard error of the estimate (approx.)?

A. 0.0244

B. 0.0039

C. 0.0345

D. 0.0691

The correct answer is: A)

Standard error of the estimate = Volatility/√(2n)

Standard error of the estimate = 0.1545/√(2 x 20) = 0.0244

Q.988 The manager at American Derivatives Limited Hedge Fund proposes to use the
Black-Scholes-Merton differential equation to understand the pricing of derivatives
dependent on non-dividend paying stocks. Which of the following assumptions with
respect to the Black-Scholes-Merton model must be made to get accurate results?

I. The short-selling of securities is not permitted

II. There are no riskless arbitrage opportunities
III. The risk-free rate of interest is known and constant
IV. Security trading is continuous

A. I, II & III only

B. I, III & IV only

C. II, III & IV only

D. All of the above

The correct answer is: C)

The assumptions underlying the Black-Scholes-Merton differential equation are:

1. The stock price follows the process with expected return and standard deviation
constant
2. The short selling of securities with full use of proceeds is permitted
3. There are no transaction costs or taxes. All securities are perfectly divisible
4. There are no dividends during the life of the derivative
5. There are no riskless arbitrage opportunities
6. Security trading is continuous
7. The risk-free rate of interest, r, is known and constant

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Q.989 With regard to the Black-Scholes-Merton Model, which of the following
statements are true?

I. The Black-Scholes-Merton differential equation does not involve any variables that
are affected by the risk preferences of investors
II. The current stock price, time, stock price volatility, and the risk-free rate of interest
are involved
III. The Black-Scholes-Merton differential equation involves the expected return on the
stock and, therefore, is dependent of risk preferences
IV. The Black-Scholes-Merton differential equation is an equation that must be satisfied
by the price of any derivative dependent on a non-dividend paying stock

A. I, II & IV only

B. I, III & IV only

C. II & III only

D. All of the above

The correct answer is: A)

The Black-Scholes-Merton differential equation is an equation that must be satisfied by

the price of any derivative dependent on a non-dividend paying stock. It does not
involve any variables that are affected by the risk preferences of investors. The current
stock price, time, stock price volatility, and the risk-free rate of interest are involved,
and all these are independent of risk preferences.

Point III is incorrect. The Black-Scholes-Merton differential equation is independent of

risk preferences if it involved the expected return, μ, on the stock.

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Q.990 Bret Lee, a research student, studying at McJohn University, analyzes academic
material on regular options, employee stock options, and warrants. After analyzing the
data, he prepares a brief to present to his professor. He jots down the following points
in the brief:

Statement I: The exercise of a regular call option has no effect on the number of the
company’s shares outstanding
Statement II: The exercise of warrants leads to the company issuing more shares and
selling them to the holder of the warrant at the strike price
Statement III: Exercise of warrants tend to dilute the interest of the existing
shareholders as the strike price is usually less than the market price
Statement IV: Exercise of warrants and employee stock options does not have any effect
on the number of company’s shares outstanding

Which of these statements are accurate?

A. I, II & III only

B. I, III & IV only

C. II, III & IV only

D. All of the above

The correct answer is: A)

Statements I, II & III are correct. The exercise of a regular call option has no effect on
the number of the company’s shares outstanding. If the writer of the option does not
own the company’s shares, he or she must buy them in the market in the usual way and
then sell them to the option holder for the strike price. The exercise of warrants of
employee stock options leads to the company issuing more shares and selling them to
the holder of the warrant at the strike price.

Statement IV is incorrect. Exercise of warrants and employee stock options tend to

dilute the interest of the existing shareholders as the strike price is usually less than
the market price.

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Q.991 A company with 20 million shares worth $50 each is considering issuing 1 million
warrants each giving the holder the right to buy one share with a strike price of $75 in
4 years. The interest rate is 5 percent per annum, and the volatility is 25 percent per
year. The company pays no dividends. The value of a 4-year European call option on the
stock is USD 6.1867. Assuming the market perceives no benefits from the warrant
issue, the stock price is expected to decline by:

A. USD 5.892

B. USD 0.2946

C. USD 1.1789

D. USD 3.3402

The correct answer is: B)

The value of each warrant = N/(N+M) * Value of the 4-year European call option on the
stock

where N = number of shares outstanding

and M = Number of warrants issued

The value of each warrant = [(20 million)/(20 million+1 million)] * 6.1867 = USD
5.8920
Total cost of warrants = USD 5.8920 * 1 million = 5.892 million
Assuming the market perceives no benefits from the warrant issue, the stock price
must decline by 5.892 million/20 million shares = USD 0.2946

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Q.992 Steyn Associates used implied volatilities in pricing securities instead of
historical volatilities. With regard to volatilities, which of the following statement(s)
is/are true?

I. Implied volatilities are the volatilities implied by option prices observed in the market
II. Historical volatilities are backward-looking, whereas implied volatilities are forward-
looking
III. Traders often quote the implied volatility of an option rather than its price. This is
convenient because the implied volatility tends to be less variable than the option price
IV. The implied volatilities of actively traded options are used by traders to estimate
appropriate implied volatilities for other options

A. I, II & III only

B. I, III & IV only

C. II, III & IV only

D. All of the above

The correct answer is: D)

Implied volatilities are the volatilities implied by option prices observed in the market.
Implied volatilities are used to monitor the market’s opinion about the volatility of a
particular stock. Historical volatilities are backward-looking, whereas implied
volatilities are forward-looking. Traders often quote the implied volatility of an option
rather than its price. This is convenient because the implied volatility tends to be less
variable than the option price. The implied volatilities of actively traded options are
used by traders to estimate appropriate implied volatilities for other options.

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Q.993 Stephen Hawking, a trader working at Orange Securities, collects the following
data of a 1-year European put and call options on the stock Mango Apparel. The current
stock price is USD 120, and the strike price of the option is USD 125. The risk-free rate
is 10 percent. If the prices of a European call and European put are USD 10 and USD
15, respectively, then what is the implied dividend yield of the stock Mango Apparel?

A. 0.11439

B. 0.045323

C. 0.10439

D. 0.055323

The correct answer is: C)

Put-call parity:
Call option – Put option = S0e-qxT - Ke-rxT

Where
S0 = Initial stock price;
q = implied dividend yield;
r = risk-free rate; and
T = time

10-15 = 120e-qx1 - 125e-0.10 x 1

e-q = 0.9009
ln(0.9009) = -q
Implied dividend yield (q) = 10.439%

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Q.994 Chinese International Bank is analyzing the stock of Jatoka International. One-
year European call and put options are written on the stock of Jatoka International
which is a non-dividend paying stock. The initial stock price is Yuan 100 and the risk-
free rate is 5%. The time to maturity is 1 year, and the strike price is Yuan 125.
Furthermore, N(d1) = 0.6925, N(d2) = 0.5435. What are the values of European put and
call options (approx.) using the Black-Scholes differential equation?

A. Call option value is USD 4.626 and Put option value is USD 23.52

B. Call option value is USD 23.52 and put option value is USD 4.626

C. Call option value is USD 2.626 and Put option value is USD 13.52

D. Call option value is USD 13.52 and put option value is USD 2.626

The correct answer is: A)

Call value = S0N(d1) – Xe-Rf x TN(d2)

=100 x 0.6925] – {125e(-0.05) * 0.5435}

= USD 4.626

Put value = [Xe-Rf * T * (1-N(d2))] – [S0 * (1 - N(d1))]

= [125e-0.05 x (1 - 0.5435)] – [100 * (1 - 0.6925)] = USD 23.52

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Q.995 Raheja Financials is holding the stock of Duckworth Limited which is trading at
USD 50. A European call option that expires in 3 months with a strike price of USD 51
is available for trading. The annualized standard deviation is 20 percent, and the risk-
free rate of interest is 4 percent. What is the value of the European call option using
the Black-Scholes-Merton model expiring in 3 months if N(d1) = 0.48085 and N(d2) =
0.44116?

A. USD 2.422

B. USD 2.224

C. USD 1.767

D. USD 1.259

The correct answer is: C)

Value of European call option as per the Black-Scholes-Merton Model:

Call value = S0N(d1) – Xe-Rf * TN(d2)

= [50 x 0.48085] – {51e(-0.04 * 0.25) * 0.44116}

= USD 1.767

Q.996 Michael Wong is holding the stock of Duckworth limited which is trading at USD
50. A European put option that expires in 3 months with a strike price of USD 51 is
available for trading. The annualized standard deviation is 20 percent, and the
continuously compounded risk-free rate is 4 percent. What is the value of the European
put option using the Black-Scholes-Merton model expiring in 3 months if N(d1) =
0.48085 and N(d2) = 0.44116?

A. USD 1.767

B. USD 1.259

C. USD 2.189

D. USD 2.259

The correct answer is: D)

Value of European put option as per the Black-Scholes-Merton Model:

Put value = [Xe-Rf * T * (1-N(d2))] – [S0 * (1 - N(d1))]

= [51e-0.04 * 0.25 * (1 - 0.44116)] – [50 * (1 - 0.48085)]

= USD 2.25975

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Q.3407 A stock price has an expected return of 10% and a volatility of 30%. The current
price is $30. What is the probability that a European call option on the stock with an
exercise price of $32 and a maturity date in six months will be exercised?

A. 0.5032

B. 0.247

C. 0.4305

D. 0.008

The correct answer is: C)

The required probability is the probability of the stock price being above $32 in six
months’ time. Suppose that the stock price in six months is ST . The probability
distribution of ln ST is

0.32
lnST ∼ {ln30 + (0.10 − ) 0.5, 0.32 × 0.5} ∼ (3.429, 0.212 2 )
2

ln32 = 3.466

The required probability is given by:

3.466 − 3.429
1−N( ) = 1 − N (0.175)
0.212

From the normal distribution tables, N (0.175) = 0.5695 Therefore, the required
probability is 0.4305

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Q.3408 What is the price of a European call option on a non-dividend-paying stock when
the stock price is $68, the strike price is $65, the risk-free interest rate is 16% per
annum, the volatility is 39% per annum, and the time to maturity is three months?

A. 5.35

B. 4.85

C. 8.31

D. 0.536

The correct answer is: C)

In this case,

S0 = 68

K = 65

r = 0.16

σ = 0.39 and,

T = 0.25

0.39 2
(ln 68 + (0.16 + ) 0.25) 0.1041
65 2
d1 = = = 0.5338
0.39√0.25 0.195
d 2 = d 1 − 0.39√0.25 = 0.3388

The price of the European call is

68N (0.5338) − 65e−0.16×0.25 N (0.3388)

= 68 × 0.7032 − 65 × 0.9608 × 0.6326
= 8.31

Q.3409 Consider an American call option when the stock price is $20, the exercise price
is $22, the time to maturity is six months, the volatility is 20% per annum, and the risk-
free interest rate is 15% per annum. Two equal dividends of $1 are expected during the
life of the option, with ex-dividend dates at the end of two months and five months. Use
Black’s approximation to value the option.

A. $0.2968

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 B. $0.40

C. $0.25

D. $0.26

The correct answer is: B)

Black’s approximation sets the value of an American call option as the maximum of two
European prices:

A European call with the same maturity as the American call being valued, but with the
stock price reduced by the present value of the dividend. This implies that S0 is reduced
to S by the present value of the dividends payable, but all other variables remain the
same

S = S0 − P V

Where

Δt 1 Δt 2 2 5
−(0.15) −(0.15)
P V = D1 e−(r) m + D2 e−(r) m = 1e 12 + 1e 12 = 1.9147

S = $20 − $1.9147 = $18.09

K = 22,

T = 0.5,

σ = 0.2

ln SK + [R C
f
+ (0.5 × σ 2)] T
d1 =
σ√ T
ln 18.09 + [0.15 + (0.5 × 0.22 )] 0.5
22
= = −0.7826
0.2√ 0.5
d 2 = d 1 − (σ√T ) = −0.7826 − 0.2√0.5 = −0.9241

From statistical tables,

N (d1 ) = N (−0.7826) = 1 − N (0.7826) = 1 − 0.7831 = 0.2169

And

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 N (d2 ) = N (−0.9241) = 1 − N (0.9241) = 1 − 0.8223 = 0.1777
c
C 0 = [S × N (d1 )] − |K × e−Rf ×T × N (d 2 ) |
= 18.09 × 0.2169 − 22e−0.15×0.5 × 0.1777
= 3.9237 − 3.6269 = 0.2968

A European option maturing just before the final ex-dividend date of the A-option. This
implies that time to maturity is trimmed down to just before the final dividend is paid,
in this case, 5 months. The PV of dividends other than the final one must be deducted
from S0 .

S = S0 − P V

Where

Δ t1
−0.15 × 2
P V = D1 e−(r ) m = 1e 12 = 0.9753

S = $20 − $0.9753 = $19.02,

K = 22,

T = 5/12 ,

σ = 0.2

ln SK + [R C 2
f + (0.5 × σ )] T
d1 =
σ√T
ln 19.02
22
+ (0.15 + (0.5 × 0.22 )) 0.4167
= = −0.5791
0.2√ 0.4167
d2 = d1 − (σ√T ) = −0.5791 − 0.2√0.4167 = −0.7082

From statistical tables,

N (d1 ) = N (−0.5791) = 1 − N (0.5791) = 1 − 0.7187 = 0.2813

And

N (d2 ) = N (−0.7082) = 1 − N (0.7082) = 1 − 0.7605 = 0.2395

−Rc T
C 0 = [S × N (d1 )] − |K × e f × × N (d 2 ) |
= 19.02 × 0.2813 − 22e−0.15×0.4167 × 0.2395

5.3503 − 4.9497 = 0.4006

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0.2968 < 0.4006,

Therefore, the call option’s value is $0.40

Note: interpolation is used to get precise values for N (d 1 ) and N (d 2 )

Q.3410 Consider a European option on a non-dividend paying stock with the following
characteristics:

Current stock price = $50

Exercise price = 50

Continuous compounding interest rate = 8%

Standard deviation = 34%

Time to expiration = 2 years

Calculate the price of the call option and its delta using the Black-Scholes-Merton
model.

A. Call = $12.97; Δ = 0.7167

B. Call = $5.57; Δ = 0.7167

C. Call = $5.57; Δ = -0.2832

D. Call = $12.97; Δ = -0.2832

The correct answer is: A)

The price of a call option on a non-dividend-paying stock:

C = S × N (d1 ) − P V (X) × N (d2 )

2
ln [ P VS(X) ] σ√ T ln [ SX ] + (r + σ
)T
2
d1 = + = and d2 = d1 − σ√T
σ√ T 2 σ√T

P V (X) = Xe−rT

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 Share Price (S) 50.00

Exercise Price (X) 50.00

Time to expiration of the option in years (T) 2.0000

Annual standard deviation of the stock return 34.00%

Risk-free rate (Continuous or Annual) 8.00%

PV (X) = X ∗ exp[−r ∗ T ]orX/(1 + r)T 42.607189

d1 = [1/(S D√T )] ∗ ln[S/P V (X)] + S D√T /2 0.573172

d2 = d1 − SD√ T 0.092340

N(d1 ) = N ORMSDIST (d 1 ) 0.716736

N(d2 ) = N ORMSDIST (d 2 ) 0.536786

S ∗ N (d 1 ) 35.836801

PV (X) ∗ N(d 2 ) 22.870942

Call V alue = S ∗ N(d 1 ) − P V (X) ∗ N(d 2) 12.965860

Pu t V alue = C + P V (X) − S 5.573049

Delta Call = N (d 1 ) 0.716736

Delta Pu t = −N (−d1 ) -0.283264

Where, N is the normal distribution.

Q.3411 Consider a European option on a non-dividend paying stock with the following
characteristics:

Current stock price = $50

Exercise price = 50

Continuous compounding interest rate = 8%

Standard deviation = 34%

Time to expiration = 2 years

Calculate the price of a put option and its delta using the Black-Scholes-Merton model.

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 A. Call = $12.97; Δ = 0.7167

B. Call = $5.57; Δ = 0.7167

C. Call = $5.57; Δ = -0.2832

D. Call = $12.97; Δ = -0.2832

The correct answer is: C)

The price of a put option on a non-dividend-paying stock can be calculated as:

P + S = C + P V (X)

P = S [N (d1 ) − 1] − P V (X) [N (d 2 ) − 1]

N (d) + N (−d) = 1

P = −S × N (−d1 ) + P V (X) × N (−d 2 )

2
ln [ P VS(X) ] σ√ T ln [ SX ] + (r + σ
)T
2
d1 = + = and d2 = d1 − σ√T
σ√ T 2 σ√T

P V (X) = Xe−rT

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 Share Price (S) 50.00

Exercise Price (X) 50.00

Time to expiration of the option in years (T) 2.0000

Annual standard deviation of the stock return 34.00%

Risk-free rate (Continuous or Annual) 8.00%

PV (X) = X ∗ exp[−r ∗ T ]orX/(1 + r)T 42.607189

d1 = [1/(S D√T )] ∗ ln[S/P V (X)] + S D√T /2 0.573172

d2 = d1 − SD√ T 0.092340

N(d1 ) = N ORMSDIST (d 1 ) 0.716736

N(d2 ) = N ORMSDIST (d 2 ) 0.536786

S ∗ N (d 1 ) 35.836801

PV (X) ∗ N(d 2 ) 22.870942

Call V alue = S ∗ N(d 1 ) − P V (X) ∗ N(d 2) 12.965860

Pu t V alue = C + P V (X) − S 5.573049

Delta Call = N (d 1 ) 0.716736

Delta Pu t = −N (−d1 ) -0.283264

Where, N is the normal distribution.

Q.3412 Consider a company with N million shares outstanding, each worth So, that is
contemplating issuing M warrants. Each warrant would grant the holder the right to
purchase one share with a strike price of X in a year. Assuming the value of a
corresponding 1-year European call option is worth C, the decrease in the stock price
would take which of the following forms?

A. N C
+M

NC
B. N+M

C. M NC
N +M

D. NM+M
C

The correct answer is: D)

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Current number of shares outstanding = N ; each worth S0

The number of new options (warrants) contemplating = M with strike price X Value of
company today = N S0

This value does not change as a result of the warrants issue.

At warrant’s maturity, stock price without warrants issue = ST

Total value at time T (including warrants) = N ST

Cash inflow from exercising warrants = MX

After exercising warrants, the total value = N ST + MX

Total number of shares outstanding = N + M

N S T +MX
Share price immediately after exercising warrants = S = N +M

Value of each warrant:

Payoff to the option holder = WT = S − X

NST + MX N (ST − X) NC
−X = =
N+M N+M N +M

Value of regular call option at time T = C = ST − X

Total cost of issuing warrants:

MN C
Total payoff (from M Warrants) = M ∗ W T = N+M

This amount reduces to previous stockholders’ value.

MC
Total payoff per N shares = N+M

Reduction in stock price = NM+M

C

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Q.3414 What is the effect of dividends on option prices?

A. Call option prices increase; Put option prices increase

B. Call option prices increase; Put option prices decrease

C. Call option prices decrease; Put option prices increase

D. Call option prices decrease; Put option prices decrease

The correct answer is: C)

Because of a dividend, the net stock price decreases in value.

Effective S = S − P V (Dividend)

When a stock price decreases, the call price decreases and the put price increases.

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 Reading 60: Option Sensitivity Measures: The “Greeks”

Q.1186 Fintech Company Inc. is planning to purchase a call option on European

Airlines. The continuous dividend yield is 2 percent and the time to maturity is 2 years.
If the continuous risk-free rate is 5 percent and N(d1) is 0.45, what is the Delta of the
call option?

A. 0.432

B. -0.432

C. 0.864

D. -0.864

The correct answer is: A)

The Delta of a call option with a continuous dividend yield is calculated using the
formula below:
Delta = N(d1) e(-qT)

Where
Continuous dividend yield (q) = 2%
Time to maturity = 2 years

Delta = 0.45 * e(-0.02 * 2) = 0.432

Q.1187 John Augustus, an equity analyst at Fintech Inc., is evaluating a portfolio of

American Airlines stock and options on the same stock. The portfolio is currently Delta
neutral but has a positive Gamma. If Augustus would like to make the portfolio both
Delta and Gamma neutral, then Johnson will:

A. Sell stock of American Airlines and sell Put options on stock of American
Airlines

B. Buy stock of American Airlines and buy Put options on stock of American
Airlines

C. Buy stock of American Airlines and sell Put options on stock of American
Airlines

D. Sell stock of American Airlines and buy Put options on stock of American
Airlines

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The correct answer is: A)

To make the portfolio Gamma neutral, options on the stock of American Airlines are to
be sold. Selling put options on American Airlines makes the portfolio Delta positive. To
make the portfolio Delta neutral, the stock of American Airlines need to be sold.

Detailed Answer

Here's what you need to have in mind to solve just about every problem of this type.

(I) All long options, calls and puts, are positive Gamma. All short options, calls and

puts, are negative Gamma.

(II) The delta value of calls is always positive (somewhere between 0 and 1) and with

puts, it's always negative (somewhere between 0 and -1). Stocks effectively have a delta

value of 1.

In this case, we have positive gamma; we are long gamma, To attain a gamma-neutral

status, we have to go short gamma. i.e., sell options.

Now, look at the choices; only (a) and (c) involve selling options, which are actually put

options. We know that puts have a negative delta, so selling them will render the

position delta positive (long delta). To attain an equilibrium, we will need to neutralize

the "positive" by selling the underlying stock (short delta). If we buy the underlying

stock (which has a delta of 1) we will end up even more delta positive.

Thus, choice (a) is correct.

The best way to approach this type of question is via the elimination of choices as we

just did. Get rid of the wrong choices based on what you already know.

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Q.1188 Trenor Johnson, a portfolio manager, working at Sterile Finances Limited, is
analyzing the delta of a portfolio. Which of the following statements is (are) true about
the delta of a portfolio?

A. Call options have negative deltas while put options have positive Deltas

B. Delta on options lie between -1 and +1

C. The delta of the underlying asset is always zero

D. All of the above

The correct answer is: B)

The delta for a call option always ranges from 0 to 1 because as the underlying asset
increases in price, call options increase in price. Put option deltas always range from -1
to 0 because as the underlying security increases, the value of put options decrease.
Therefore, the delta will lie between -1 and +1, while the delta of the underlying asset
is always 1. The delta of a put option is negative reflecting an inverse relationship with
the price of the underlying.

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Q.1189 Which of the following statements is/are true regarding theta?

I. Theta is a measure of the change in the value of the options portfolio with the
passage of time

II. A positive theta implies that the portfolio will increase in value as time passes

III. Theta decreases as the expiration date approaches for at-the-money options

IV. Theta increases as an option which is either out of the money or in the money
approaches expiration

A. I & II

B. III & IV

C. I, III & IV

D. All the above

The correct answer is: A)

Points I and II are correct.

Points III and IV are incorrect. Theta increases as the expiration date approaches for
at-the-money options.
Theta decreases as an option that is either out of money or in the money approaches
expiration.

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Q.1190 Robin Williams is considering call options and shares of Xerox Inc. for
constructing a portfolio for investment purposes. The 120-day USD 80 call option on
Xerox Inc. is trading at USD 2.65. The call option has a Delta of 0.4563. Williams sells
2,500 call option contracts (the multiplier is 100) and purchases 114,075 shares of
Xerox Inc. The current market price of the stock of Xerox Inc is USD 75. The following
month, the prices of both the stock and the call option decrease and, as a result, Delta
decreases to 0.4168. Which of the following is the number of shares to be
sold/purchased by Williams to make the portfolio Delta neutral?

A. Sell 9875 shares

B. Purchase 9875 shares

C. Sell 99 shares

D. Purchase 99 shares

The correct answer is: A)

Number of calls = 2,500 contracts * 100 = 250,000 calls.

Number of shares to be purchased/sold to make the portfolio Delta neutral = (Number

of calls) * (New Delta – Old Delta)

= 250,000 x (0.4168 – 0.4563) = -9875 shares

=> Sell 9875 shares as the sign is negative

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Q.1191 Which of the following statements is true with regard to Gamma?

I. Gamma of a portfolio of options on an underlying asset is the rate of change of the

portfolio's Delta with respect to the price of the underlying asset
II. Gamma is the second partial derivative of the portfolio with respect to asset price
III. If Gamma is highly negative or highly positive, Delta is very sensitive to the price of
the underlying asset
IV. When Gamma is positive, theta tends to be negative

A. I & II only

B. I, II & III only

C. II & III only

D. All the above

The correct answer is: D)

Gamma of a portfolio of options on an underlying asset is the rate of change of the

portfolio's Delta with respect to the price of the underlying asset. It is the second
partial derivative of the portfolio with respect to asset price. If Gamma is highly
negative or highly positive, Delta is very sensitive to the price of the underlying asset.
When Gamma is positive, theta tends to be negative.

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Q.1192 The Vega of the stock of Amazon is 5. If the volatility of the underlying asset
increases by 1 percent, what changes will take place in the price of the call option and
put option if the maturity and exercise prices of both options remain the same?

A. The price of the call option increases by 0.05 and the price of the put option
increases by 0.05

B. The price of the call option decreases by 0.05 and the price of the put option
decreases by 0.05

C. The price of the call option decreases by 0.05 and the price of the put option
increases by 0.05

D. The price of the call option increases by 0.05 and the price of the put option
decreases by 0.05

The correct answer is: A)

The vega of a portfolio of derivatives, V, is the rate of change of the value of the
portfolio with respect to the volatility of the underlying asset. The change in the price
of call and put options is:
Vega * Volatility = 5 * 0.01 = 0.05

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Q.1193 Which of the following statement is NOT true with regard to Vega?

I. The Vega of a derivative portfolio is the rate of change of the value of the portfolio
with the change in the volatility of the underlying assets
II. The Vega of a long position is always negative
III. A position in the underlying asset has a Vega equal to zero
IV. At-the-money options have the greatest Vega

A. II and III only

B. III only

C. II only

D. I, II and IV only

The correct answer is: C)

The Vega of a long position is always positive.

All three other statements are correct. The Vega of a derivative portfolio is the rate of
change of the value of the portfolio with the change in the volatility of the underlying
assets. A position in the underlying asset has a Vega equal to zero. At-the-money
options have the greatest Vega.

Q.1194 Consider a call option on a non-dividend paying stock where the stock price is
$95, the risk-free rate is 5%, the time to maturity is 40 weeks (= 0.7692 years) and N’ =
0.398185. A 1% increase in the volatility will increase the value of the option by
approximately:

A. -33.176

B. -0.33176

C. 33.176

D. 0.33176

The correct answer is: D)

The Vega of a call option = So√TN‘(d1) = $95 * √0.7692 * 0.398185 = 33.176

Thus, a 1% (0.01) increase in the volatility increases the value of the option by
approximately 0.01 * 33.176 = 0.33176

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Q.1195 Which of the following statement is true with regard to Rho?

A. The Rho of a portfolio of options is the rate of change of the value of the
portfolio with respect to the interest rate.

B. The Rho of a portfolio of derivatives is the rate of change of the value of the
portfolio with respect to the volatility of the underlying asset.

C. The Rho of a portfolio of options on an underlying asset is the rate of change

of the portfolio's Delta.

D. The Rho of a portfolio of options is the rate of change of the value of the
portfolio with respect to the passage of time with all else remaining the same.

The correct answer is: A)

The Rho of a portfolio of options is the rate of change of the value of the portfolio with
respect to the interest rate.

Q.1196 A stock is currently trading at $25. The delta of the call option is 0.482. A fund
manager buys 100,000 call options with a strike price of $26.50 of the stock. To
maintain a delta neutral position the fund manager must:

A. Buy 48,200 shares

B. Sell 48,200 shares

C. Buy 10,000 shares

D. Sell 10,000 shares

The correct answer is: B)

As the fund manager buys 100,000 call options, the delta of the option position is:
δ of option position = 0.482 * 100,000 = +48,200

To get a delta neutral position, the fund manager needs to sell 48,200 shares.

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Q.1197 A stock is currently trading at $25. The delta of the call option is 0.482. A fund
manager buys 100,000 call options with a strike price of $26.50 of the stock.

If the share price of the stock increases to $26, the most likely action taken by the fund
manager to maintain a delta neutral position is to:

A. Sell shares

B. Buy shares

C. Buy more call options

D. None of the above

The correct answer is: A)

As the price of the stock approaches the strike price i.e. $26.50, the delta of the option
increases. Hence, when the price of the stock increases to $26, the delta of the option
increases from 0.482. Therefore, the delta of the new position is:
Δnew position > 48,200

To maintain a delta neutral position the fund manager needs to sell more shares.
Hence, to maintain a delta hedge, the portfolio needs rebalancing every time the
factors affecting the delta changes.

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Q.1198 A portfolio manager buys 100 APR 45 call option selling for $3.58 that have a
delta of 0.4 and a gamma of 0.1. If the underlying trades downwards by $1, then the
delta of the overall position will now be:

A. 0.3

B. 30

C. 27

D. 0.27

The correct answer is: B)

Gamma reflects the change in delta in response to a one-point movement of the

underlying stock price.

Our gamma here is 0.1. For every one-point move in the price of the underlying, delta of

the corresponding option will change by 0.1. A one point (1 USD) increase in price will

prompt a 0.1 increase in delta. Similarly, a one point decrease in price will prompt a 0.1

decrease in delta.

In our case, delta will decrease from 0.4 to 0.3.

But that's delta for just one call option. For 100 options, delta = 0.3 * 100 = 30.

Note that gamma is always a positive number regardless of whether you are buying

calls or puts but is effectively negative when you write options.

Q.1199 A stock is currently trading at $30. A portfolio manager buys 37,500 shares and
sells 150,000 call options having a delta of 0.25. The portfolio has a gamma of 5,000.
The fund manager observes that a call option with delta 0.50 and gamma 2.5 is trading
in the market.

Select the correct statement(s).

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I. After selling 2000 call options, the portfolio is both delta and gamma neutral

II. After selling 2000 call options, the portfolio is only gamma neutral

III. The portfolio manager needs to sell 1000 underlying assets to maintain delta
neutrality

IV. The portfolio manager needs to buy 1000 underlying assets to maintain delta
neutrality

A. Only I is correct

B. Both II and IV are correct

C. Both II and III are correct

D. Only II is correct

The correct answer is: B)

The portfolio initially consists of shares and call options.

Δcall option = -0.25 * 150,000 = -37,500

Δshares = + 37,500

Hence, the initial portfolio is delta neutral.

After selling 2000 call options, the portfolio is made gamma neutral. However, the delta
of the portfolio changes by:

Δnew call options = -0.50 * 2000 = -1000

Hence the effective delta of the new portfolio is:

Δnew portfolio = -1000

Therefore, to maintain a delta neutral portfolio, the portfolio manager needs to buy
1000 underlying assets.

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Q.1200 A portfolio manager anticipates that the market volatility will increase
substantially in the coming days. He observes two call options which are currently
being traded in the market:

I. A call option on stock A, currently trading at $20 with a strike price of $30
II. A call option on stock B, currently trading at $40 with a strike price of $42

The portfolio manager wants to derive the maximum benefit from the anticipated
market volatility. The preferred investment should be:

A. Go long on call options on Stock A

B. Go long on call options on Stock B

C. Go short on call options on Stock A

D. Go short on call options on Stock B

The correct answer is: B)

The volatility of call options is highest when the stock price approaches the strike price.
As the portfolio manager wants to derive benefit from the anticipated volatility, he must
go long on call options on Stock B, as the share price is near the strike price of the call
option.

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Q.1201 Stock A is currently trading at $40. A three-month futures contract on Stock A
is currently trading at $40.60. Assume the risk-free rate to be 6%.

The delta of the futures contract is:

A. 1.02

B. 1.2

C. 1.12

D. 1.22

The correct answer is: A)

Δfutures contract = erT

Where
r = Risk-free rate
T = Time to expiry of the contract

Δ3 months = e(0.06*(3/12)) = 1.02

Q.1203 A fund manager sells 200,000 call options on stock A, a non-dividend paying
stock. The delta of the stock option is 0.45, and the risk-free rate is 6%.

Select the most appropriate statement.

A. The position can be made delta and gamma neutral by buying 90,000 shares
of the underlying asset

B. The position can be made delta neutral by going short 90,000 shares on the
underlying asset

C. The position can be made delta neutral by buying 90,000 shares of the
underlying asset

D. The position can be made delta neutral by going short on call options

The correct answer is: C)

ΔCall options = -200,000 * 0.45 = -90,000

Since the fund manager has sold call options, he has a short position. Going long
90,000 shares will make the position delta neutral.

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Q.3415 Which one of the following statements is true regarding option Greeks?

A. Gamma is greatest for in-the-money options with long maturities

B. Delta of deep-in-the-money put options tends toward +1

C. Vega is greatest for at-the-money options with long maturities

D. When buying at-the-money options, theta tends to be positive

The correct answer is: C)

An option's vega becomes less and less the further your option is from the at the money
strike. In other words, vega is greatest for at-the-money options.

Option A is incorrect. For in-the-money options, gamma is small.

Option B is incorrect. For in-the-money puts, delta tends toward -1

Option D is incorrect. When buying at-the-money options for long-term keeping, theta
is negative.

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Q.3416 Mark Twine, FRM, owns a portfolio of stocks that exhibits high unfavorable
sensitivity to an increase in implied volatility. Twine has also experienced significant
daily losses with the passage of time. As a market analyst, which of the following
hedging strategies would you recommend to Twine?

A. Buy both long-dated and short-dated options

B. Sell both short-dated and long-dated options

C. Buy short-dated options and sell long-dated options

D. Sell short-dated options and buy long-dated options

The correct answer is: D)

Such a portfolio is short vega (volatility) and short theta (time). Short vega in that
increases volatility has led to losses, ceteris paribus. Short theta in the sense that as
time to expiration nears, losses have been piling up. As such, Twine needs to implement
a hedge that is delta-neutral, involving buying and selling options with different
maturities.

Long positions in short-dated options have high negative theta and low positive vega.
Hedging can be achieved by selling short-term options and buying long-term options.

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Q.3417 A trader has a short option position that’s delta-neutral but has a gamma of
-800. In the market, there’s a tradeable option with a delta of 0.8 and a gamma of 2. To
maintain the position gamma-neutral and delta-neutral, the most appropriate strategy
is to:

A. Sell 320 options and buy 400 shares of the underlying

B. Buy 400 options and sell 320 shares of the underlying

C. Buy 400 options and buy 320 shares of the underlying

D. Sell 320 options and buy 320 shares of the underlying

The correct answer is: B)

As it stands, the position is gamma-negative, and therefore the trader has to buy calls
to increase gamma back to zero. The number of options that must be added to the
existing portfolio to generate a gamma-neutral position is given by:

Γp
−( )
ΓT

Where: Γp=gamma of the existing portfolio position ΓT =gamma of a traded option that
can be added

800
= − (− ) = 400
2

Buying 400 calls, however, increases delta from zero to 320 (= 400 × 0.8). Therefore, the
trader has to sell 320 shares to restore the delta to zero. Positions in shares always
have zero gamma.

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