BMO Risk Management & Mitigation 3 — Questions and Answers
Question 1: BMO is considering expanding its mortgage portfolio in a region experiencing rapid house price inflation. Which risk is MOST elevated in this scenario?
- Reputational risk
- Settlement risk
- Collateral risk (Correct answer)
- Compliance risk
Correct answer: Collateral risk
When property values are inflated, collateral supporting mortgages may be overvalued, creating collateral risk if prices correct and borrowers default.
Question 2: A key control in preventing rogue trader risk is:
- Allowing traders to set their own position limits
- Mandatory vacation policies and job rotation (Correct answer)
- Eliminating all proprietary trading activities
- Consolidating all trading into one desk for oversight
Correct answer: Mandatory vacation policies and job rotation
Mandatory vacations force others to cover a trader's book, revealing hidden positions or unauthorized activity that might otherwise remain concealed.
Question 3: What does 'tail risk' refer to in risk management?
- Risk at the end of a product's life cycle
- The risk of rare but severe loss events in the tail of a probability distribution (Correct answer)
- Risk associated with back-office settlement delays
- The risk that a bank's last remaining counterparty defaults
Correct answer: The risk of rare but severe loss events in the tail of a probability distribution
Tail risk refers to the probability of extreme loss events that occur in the far ends (tails) of a return distribution, often underestimated by standard models.
Question 4: BMO's risk committee reviews a scenario where a major counterparty defaults simultaneously with a market downturn. This is an example of:
- Basis risk
- Correlation risk / wrong-way risk (Correct answer)
- Settlement risk
- Prepayment risk
Correct answer: Correlation risk / wrong-way risk
Wrong-way risk occurs when counterparty credit exposure and the probability of counterparty default are positively correlated, worsening losses.
Question 5: Which of the following is an example of a Key Risk Indicator (KRI)?
- The bank's quarterly net income
- The number of failed transaction settlements per week (Correct answer)
- The CEO's tenure at the bank
- Total assets under management
Correct answer: The number of failed transaction settlements per week
KRIs are forward-looking metrics that signal increasing risk exposure; failed settlements indicate potential operational or counterparty issues before they escalate.
Question 6: When a bank uses credit default swaps (CDS) to hedge its loan book, which risk is it primarily mitigating?
- Liquidity risk
- Interest rate risk
- Credit risk (Correct answer)
- Currency risk
Correct answer: Credit risk
A CDS allows the bank to pay a premium in exchange for protection against a borrower's default, directly offsetting credit exposure.
Question 7: A bank's stress testing framework should include scenarios that are:
- Only based on historical market crashes
- Severe but plausible, covering both historical and hypothetical events (Correct answer)
- Mild enough to ensure the bank always passes
- Limited to credit risk events only
Correct answer: Severe but plausible, covering both historical and hypothetical events
Effective stress tests combine historical scenarios (like 2008) with forward-looking hypothetical scenarios to capture a wide range of plausible severe outcomes.
BMO Risk Management & Mitigation 3
BMO is considering expanding its mortgage portfolio in a region experiencing rapid house price inflation.
Which risk is MOST elevated in this scenario?