CBP Financial Risk Management 3 — Questions and Answers
Question 1: Which of the following best describes 'tail risk' in financial risk management?
- The risk of gradual portfolio depreciation over time
- The risk of extreme losses beyond the VaR threshold (Correct answer)
- The risk that interest rates will rise unexpectedly
- The risk that a counterparty defaults on a small transaction
Correct answer: The risk of extreme losses beyond the VaR threshold
Tail risk refers to the probability of extreme loss events that occur in the 'tails' of a probability distribution, beyond typical VaR estimates.
Question 2: Under the Internal Ratings-Based (IRB) approach in Basel III, which parameter represents the percentage of an exposure that is lost if a borrower defaults?
- Probability of Default (PD)
- Loss Given Default (LGD) (Correct answer)
- Exposure at Default (EAD)
- Effective Maturity (M)
Correct answer: Loss Given Default (LGD)
Loss Given Default (LGD) is the proportion of the exposure that is not recovered after a borrower defaults, accounting for collateral and recovery rates.
Question 3: A bank enters into a cross-currency swap to convert fixed USD payments into fixed EUR payments. What primary risk does this hedge?
- Credit risk
- Operational risk
- Foreign exchange and interest rate risk (Correct answer)
- Liquidity risk
Correct answer: Foreign exchange and interest rate risk
Cross-currency swaps simultaneously hedge both currency exchange risk and interest rate risk by swapping principal and interest in different currencies.
Question 4: In risk management, 'Expected Shortfall' (ES) is considered superior to VaR because it:
- Is easier to calculate using historical data
- Captures the average loss beyond the VaR threshold (Correct answer)
- Requires fewer regulatory approvals
- Always produces a lower risk estimate than VaR
Correct answer: Captures the average loss beyond the VaR threshold
Expected Shortfall (also called Conditional VaR) averages all losses beyond the VaR confidence threshold, giving a better picture of tail risk magnitude.
Question 5: Which of the following is an example of a Key Risk Indicator (KRI) for operational risk?
- The bank's net interest margin
- The number of failed trade settlements per week (Correct answer)
- The loan-to-deposit ratio
- The bank's Tier 1 capital ratio
Correct answer: The number of failed trade settlements per week
Failed trade settlements are a KRI for operational risk because they signal process failures, system errors, or human mistakes in the trade lifecycle.
Question 6: A bank holds a large position in 10-year Treasury bonds. If interest rates rise by 100 basis points, the primary risk the bank faces is:
- Credit spread widening
- Duration-driven price decline (Correct answer)
- Currency depreciation
- Counterparty default
Correct answer: Duration-driven price decline
Longer-duration bonds have greater price sensitivity to interest rate changes; a 100 bps rise will cause significant mark-to-market losses for a 10-year Treasury portfolio.
Question 7: The Net Stable Funding Ratio (NSFR) is designed to ensure that banks:
- Maintain short-term liquid assets equal to 30 days of outflows
- Hold capital against market risk exposures
- Fund long-term assets with stable funding sources over a one-year horizon (Correct answer)
- Limit interbank lending to 10% of total assets
Correct answer: Fund long-term assets with stable funding sources over a one-year horizon
The NSFR requires banks to maintain a stable funding profile relative to their long-term assets and activities over a one-year horizon to reduce funding risk.
CBP Financial Risk Management 3
Which of the following best describes 'tail risk' in financial risk management?