CRO Financial Risk Assessment & Mitigation 2 — Questions and Answers
Question 1: 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?
- $5M multiplied by a factor of at least 3 (Correct answer)
- $5M multiplied by a factor of 1.5
- $5M with no additional multiplier
- $10M flat regardless of VaR
Correct 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.
Question 2: Which stress testing approach applies historical market shocks (e.g., the 2008 financial crisis) directly to a current portfolio?
- Historical scenario analysis (Correct answer)
- Monte Carlo simulation
- Sensitivity analysis
- Reverse stress testing
Correct answer: Historical scenario analysis
Historical scenario analysis replays actual past market events against the current portfolio to estimate potential losses.
Question 3: A CRO notices that two credit exposures are highly positively correlated. How does this affect portfolio credit risk compared to uncorrelated exposures?
- It increases portfolio risk because defaults are likely to occur simultaneously (Correct answer)
- It decreases portfolio risk through natural diversification
- It has no effect on portfolio-level risk
- It only affects market risk, not credit risk
Correct 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.
Question 4: What is the primary purpose of a credit default swap (CDS) in financial risk mitigation?
- To transfer the credit risk of a reference entity to a protection seller (Correct answer)
- To hedge interest rate exposure on a fixed-rate bond
- To convert floating-rate debt to fixed-rate debt
- To speculate on equity price movements
Correct 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.
Question 5: Under the Expected Shortfall (ES) measure, what does the metric represent?
- The average loss in the worst (1-confidence level) percent of scenarios (Correct answer)
- The maximum possible loss under any scenario
- The loss exceeded on exactly 1% of trading days
- The median loss across all simulated scenarios
Correct 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.
Question 6: A firm uses a 250-day equally weighted moving average to estimate volatility for VaR. Which limitation does this introduce?
- Recent market events are weighted the same as events from nearly a year ago (Correct answer)
- The model overweights the most recent observations
- It cannot be used for equity portfolios
- It requires a minimum of 500 data points to be statistically valid
Correct 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.
Question 7: When assessing counterparty credit risk on an OTC derivative, which metric captures the potential future increase in exposure over the life of the contract?
- Potential Future Exposure (PFE) (Correct answer)
- Current Exposure (CE)
- Loss Given Default (LGD)
- Expected Loss (EL)
Correct 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.
CRO Financial Risk Assessment & Mitigation 2
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?