CRO Market & Credit Risk Analysis 3 — Questions and Answers
Question 1: Under the Fundamental Review of the Trading Book (FRTB), the internal models approach replaces VaR with which primary risk measure?
- Conditional VaR (CVaR)
- Expected Shortfall (ES) at 97.5% (Correct answer)
- Stressed VaR at 99%
- Probability of Default at 99.9%
Correct answer: Expected Shortfall (ES) at 97.5%
FRTB replaces VaR with Expected Shortfall at the 97.5% confidence level to better capture tail risk.
Question 2: In credit portfolio management, 'wrong-way risk' (WWR) occurs when:
- Counterparty exposure and counterparty credit quality deteriorate simultaneously (Correct answer)
- A hedge position gains value when the underlying loses value
- Credit spreads widen while interest rates fall
- Collateral value rises as counterparty defaults
Correct answer: Counterparty exposure and counterparty credit quality deteriorate simultaneously
Wrong-way risk arises when the exposure to a counterparty increases at the same time the counterparty's creditworthiness decreases.
Question 3: A bond portfolio manager uses key rate duration (KRD) to hedge interest rate risk. What does KRD measure that standard duration does not?
- Credit spread sensitivity
- Sensitivity to parallel yield curve shifts only
- Sensitivity to changes at specific maturities along the yield curve (Correct answer)
- The bond's convexity relative to the benchmark
Correct answer: Sensitivity to changes at specific maturities along the yield curve
Key rate duration measures price sensitivity to changes at individual points on the yield curve, capturing non-parallel (twist and butterfly) shifts.
Question 4: Which approach to credit risk measurement explicitly models the loss distribution using a Poisson process for default events and is best suited for large, granular retail portfolios?
- CreditMetrics
- KMV EDF model
- CreditRisk+ (Correct answer)
- Black-Cox structural model
Correct answer: CreditRisk+
CreditRisk+ uses a Poisson distribution to model default events and is designed for homogeneous, granular portfolios rather than concentrated corporate exposures.
Question 5: Market risk capital under the Basel standardized approach uses a 'sensitivities-based method' (SBM). Which Greeks are directly used in computing risk charges under SBM?
- Only Delta
- Delta and Vega
- Delta, Vega, and Curvature (proxy for Gamma) (Correct answer)
- All Greeks including Theta and Rho
Correct answer: Delta, Vega, and Curvature (proxy for Gamma)
The SBM under FRTB uses delta sensitivities, vega sensitivities, and a curvature risk charge as a proxy for gamma/higher-order risks.
Question 6: A risk officer is calculating the Economic Capital (EC) for credit risk at the 99.97% confidence level. This confidence level is typically associated with:
- AA-rated firm target solvency standard (Correct answer)
- BB-rated firm speculative grade threshold
- Regulatory minimum Tier 1 capital ratio
- Expected loss calculation for provisioning
Correct answer: AA-rated firm target solvency standard
A 99.97% confidence level corresponds to a 1-in-3,333-year loss event, consistent with an AA credit rating solvency standard for economic capital.
Question 7: In the context of market risk, 'gap risk' in a stop-loss hedged position refers to:
- The risk of model parameter estimation errors
- The risk that prices jump discontinuously, bypassing the stop-loss trigger (Correct answer)
- The difference between bid and ask spreads at execution
- Reinvestment risk on intermediate cash flows
Correct answer: The risk that prices jump discontinuously, bypassing the stop-loss trigger
Gap risk is the risk that market prices gap (jump discontinuously) past a stop-loss level, leaving the position unhedged at an unexpected level.
CRO Market & Credit Risk Analysis 3
Under the Fundamental Review of the Trading Book (FRTB), the internal models approach replaces VaR with which primary risk measure?