Financial Risk Assessment & Mitigation Flashcards

A bank's trading book shows a 10-day 99% VaR of $5M. Under Basel III, what is the minimum regulatory capital requirement for market risk using the internal models approach?

Answer: $5M multiplied by a factor of at least 3

Basel III requires market risk capital to be at least 3 times the 10-day 99% VaR (the multiplication factor), plus any surcharge.

Which stress testing approach applies historical market shocks (e.g., the 2008 financial crisis) directly to a current portfolio?

Answer: Historical scenario analysis

Historical scenario analysis replays actual past market events against the current portfolio to estimate potential losses.

A CRO notices that two credit exposures are highly positively correlated. How does this affect portfolio credit risk compared to uncorrelated exposures?

Answer: It increases portfolio risk because defaults are likely to occur simultaneously

High positive correlation means obligors tend to default together, concentrating losses and increasing tail risk in the portfolio.

What is the primary purpose of a credit default swap (CDS) in financial risk mitigation?

Answer: To transfer the credit risk of a reference entity to a protection seller

A CDS allows the protection buyer to transfer the default risk of a reference entity by paying periodic premiums to a protection seller.

Under the Expected Shortfall (ES) measure, what does the metric represent?

Answer: The average loss in the worst (1-confidence level) percent of scenarios

ES (also called CVaR) is the conditional expectation of loss given that losses exceed the VaR threshold, capturing tail risk beyond VaR.

A firm uses a 250-day equally weighted moving average to estimate volatility for VaR. Which limitation does this introduce?

Answer: Recent market events are weighted the same as events from nearly a year ago

Equal weighting means a market shock from 249 days ago has the same influence as yesterday's move, causing delayed reactions to changing volatility regimes.

When assessing counterparty credit risk on an OTC derivative, which metric captures the potential future increase in exposure over the life of the contract?

Answer: Potential Future Exposure (PFE)

PFE estimates the worst-case exposure at a given confidence level at future points in time, accounting for market movements that increase replacement cost.