Banking Exam Financial Risk Management 4 — Questions and Answers
Question 1: A bank sells credit default swaps (CDS) to hedge its loan portfolio credit risk. What new risk does this strategy introduce?
- Prepayment risk
- Counterparty credit risk (Correct answer)
- Basis point value risk
- Convexity risk
Correct answer: Counterparty credit risk
Selling CDS introduces counterparty risk because if the CDS buyer defaults before a credit event occurs, the bank may not receive its hedging payment.
Question 2: What does the Net Stable Funding Ratio (NSFR) primarily measure?
- A bank's short-term liquidity over 30 days
- The adequacy of stable funding relative to illiquid assets over a one-year horizon (Correct answer)
- Capital adequacy against risk-weighted assets
- The ratio of non-performing loans to total loans
Correct answer: The adequacy of stable funding relative to illiquid assets over a one-year horizon
NSFR ensures banks have enough stable funding to support their long-term assets and activities over a one-year stressed period.
Question 3: Which risk management approach involves identifying the scenarios that would cause a bank to fail and then assessing their likelihood?
- Forward stress testing
- Reverse stress testing (Correct answer)
- Scenario analysis
- Sensitivity analysis
Correct answer: Reverse stress testing
Reverse stress testing starts from a defined failure outcome and works backward to identify plausible scenarios that could cause it.
Question 4: A bank's trading book position loses $2M when interest rates rise by 1 basis point. What risk metric does this describe?
- Duration
- Value at Risk (VaR)
- DV01 (Dollar Value of 01) (Correct answer)
- Expected Shortfall
Correct answer: DV01 (Dollar Value of 01)
DV01, or PVBP (Price Value of a Basis Point), measures the dollar change in a position's value for a one-basis-point move in interest rates.
Question 5: Under the standardized approach to credit risk, which risk weight is typically assigned to residential mortgage loans in the U.S.?
- 0%
- 20%
- 50% (Correct answer)
- 100%
Correct answer: 50%
Residential mortgages are generally assigned a 50% risk weight under the standardized approach, reflecting their lower risk compared to unsecured commercial loans.
Question 6: What is 'wrong-way risk' in derivatives and counterparty credit risk management?
- Risk that the hedge moves in the same direction as the exposure
- Risk that exposure to a counterparty increases when the counterparty's creditworthiness decreases (Correct answer)
- Risk of settlement failure due to time-zone differences
- Risk that margin calls cannot be met in volatile markets
Correct answer: Risk that exposure to a counterparty increases when the counterparty's creditworthiness decreases
Wrong-way risk exists when the counterparty's credit quality deteriorates precisely when the bank's exposure to that counterparty is largest.
Question 7: What is the primary function of a bank's risk appetite statement (RAS)?
- To specify minimum return on equity targets for each business line
- To define the types and levels of risk the bank is willing to accept in pursuit of its strategy (Correct answer)
- To outline procedures for reporting regulatory capital ratios
- To set compensation limits for risk-taking employees
Correct answer: To define the types and levels of risk the bank is willing to accept in pursuit of its strategy
A Risk Appetite Statement formally documents the aggregate level and types of risk a bank is willing to assume consistent with its business strategy and capital position.
Banking Exam Financial Risk Management 4
A bank sells credit default swaps (CDS) to hedge its loan portfolio credit risk.
What new risk does this strategy introduce?