CRO Market & Credit Risk Analysis 2 — Questions and Answers
Question 1: A portfolio has a 1-day 99% VaR of $2 million. Under Basel III, what is the minimum capital requirement multiplier applied to the VaR figure for market risk?
- 1.5x
- 2x
- 3x (Correct answer)
- 4x
Correct answer: 3x
Basel III requires a minimum multiplication factor of 3x applied to the VaR figure when calculating market risk capital requirements.
Question 2: Which credit risk model distinguishes between default risk and migration risk, treating rating transitions as a Markov chain?
- CreditMetrics (Correct answer)
- KMV Merton model
- CreditRisk+
- Jarrow-Turnbull model
Correct answer: CreditMetrics
CreditMetrics, developed by JP Morgan, models credit risk through rating migrations modeled as a Markov chain, capturing both default and downgrade risk.
Question 3: Duration gap analysis in a bank measures the sensitivity of net worth to interest rate changes. A positive duration gap means the bank's assets have a longer duration than liabilities, implying:
- Net worth rises when rates rise
- Net worth falls when rates rise (Correct answer)
- Net worth is unaffected by rate changes
- The bank is perfectly hedged
Correct answer: Net worth falls when rates rise
A positive duration gap means assets lose more value than liabilities when rates rise, reducing net worth.
Question 4: In the Merton structural credit model, the probability of default is driven primarily by:
- The firm's credit rating history
- The ratio of asset value to debt face value and asset volatility (Correct answer)
- Macroeconomic GDP growth forecasts
- The firm's dividend payout ratio
Correct answer: The ratio of asset value to debt face value and asset volatility
The Merton model treats equity as a call option on firm assets; default probability depends on the distance between asset value and debt threshold relative to asset volatility.
Question 5: Stressed VaR (SVaR) as introduced under Basel 2.5 requires banks to calibrate VaR using data from:
- The most recent 250 trading days
- A continuous 12-month period of significant financial stress (Correct answer)
- A rolling 3-year historical window
- Forward-looking Monte Carlo scenarios only
Correct answer: A continuous 12-month period of significant financial stress
Basel 2.5 requires SVaR to be computed using a 12-month stressed historical period, typically including the 2007-2009 financial crisis.
Question 6: What is the primary purpose of a credit valuation adjustment (CVA)?
- To set internal transfer pricing for loans
- To account for the risk that a counterparty will default on an OTC derivative (Correct answer)
- To adjust VaR for fat-tailed distributions
- To compute regulatory capital for operational risk
Correct answer: To account for the risk that a counterparty will default on an OTC derivative
CVA represents the market value of counterparty credit risk on OTC derivatives, adjusting fair value for expected losses from counterparty default.
Question 7: A risk manager observes that the correlation between two asset classes spikes to nearly 1.0 during a market crisis. This phenomenon is best described as:
- Basis risk
- Liquidity-adjusted VaR
- Correlation breakdown (Correct answer)
- Convexity risk
Correct answer: Correlation breakdown
Correlation breakdown refers to the tendency for diversification benefits to disappear in crises when asset correlations converge toward 1.0.
CRO Market & Credit Risk Analysis 2
A portfolio has a 1-day 99% VaR of $2 million.
Under Basel III, what is the minimum capital requirement multiplier applied to the VaR figure for market risk?