Financial Risk Management MCQ Flashcards

A bank's trading desk holds a portfolio with a 1-day 99% VaR of $5 million. Under Basel III, what is the minimum regulatory capital requirement based on this VaR?

Answer: $15 million

Basel III requires trading book capital to be at least 3 times the 10-day 99% VaR; scaling the 1-day figure by √10 ≈ $15.81M, and the multiplier of 3 yields approximately $15M minimum.

Which of the following best describes 'wrong-way risk' in counterparty credit risk?

Answer: Risk that exposure increases precisely when counterparty creditworthiness deteriorates

Wrong-way risk occurs when the exposure to a counterparty is positively correlated with the probability of that counterparty's default, amplifying potential losses.

A portfolio manager uses a delta-gamma approximation for options risk. What additional Greek does this method capture compared to a pure delta hedge?

Answer: Convexity (curvature) of the P&L curve

The gamma term in the delta-gamma approximation accounts for the curvature (convexity) of the option's value with respect to the underlying price, correcting for the linear delta approximation.

In credit risk modeling, what does the 'loss given default' (LGD) measure?

Answer: The fraction of exposure that cannot be recovered after a default

LGD represents the proportion of the exposure that is lost when a borrower defaults, calculated as 1 minus the recovery rate.

A firm's operational risk capital under the Basel Advanced Measurement Approach (AMA) primarily relies on:

Answer: Internal loss data, external loss data, scenario analysis, and business environment factors

AMA requires banks to combine four data elements: internal loss data, external loss data, scenario analysis, and business environment and internal control factors.

What is the primary purpose of a 'stress test' in financial risk management?

Answer: To evaluate potential losses under severe but plausible adverse scenarios

Stress tests examine how a portfolio would perform under extreme, hypothetical scenarios (e.g., market crashes, liquidity crises) that may lie outside the range captured by statistical VaR models.

Which of the following liquidity risk metrics measures the minimum amount of unencumbered high-quality liquid assets a bank must hold to survive a 30-day stress period?

Answer: Liquidity Coverage Ratio (LCR)

The LCR, introduced under Basel III, requires banks to hold sufficient HQLA to cover net cash outflows over a 30-day stress scenario, ensuring short-term resilience.

A credit default swap (CDS) buyer pays a premium to the seller. In exchange, the seller agrees to:

Answer: Make a payment to the buyer if a specified credit event occurs on the reference entity

In a CDS, the protection seller compensates the buyer for losses if a defined credit event (such as default or restructuring) occurs on the reference entity.

Which of the following is a key limitation of the historical simulation method for VaR estimation?

Answer: It assumes the historical period is representative of future conditions

Historical simulation relies on past return data, which may not capture future market regimes or tail events that have not yet occurred, making it backward-looking.

What does the 'duration' of a bond primarily measure?

Answer: The sensitivity of the bond's price to changes in yield

Duration (specifically modified duration) measures the percentage change in a bond's price for a 1% change in yield, making it a key interest rate risk metric.

In the context of market risk, 'basis risk' refers to:

Answer: The risk that a hedging instrument does not perfectly offset the exposure being hedged

Basis risk arises when the price movements of the hedging instrument and the underlying exposure are not perfectly correlated, leaving residual risk in the hedged position.

Which regulatory framework introduced the concept of 'Tier 1' and 'Tier 2' capital for banks?

Answer: Basel I Accord

The Basel I Accord (1988) introduced the Tier 1 and Tier 2 capital classification, along with the 8% minimum capital-to-risk-weighted-assets ratio.

A risk manager wants to reduce the fat-tail sensitivity of a VaR estimate. Which alternative risk measure is most appropriate?

Answer: Expected Shortfall (CVaR)

Expected Shortfall (also called Conditional VaR or CVaR) averages losses beyond the VaR threshold, explicitly capturing tail risk and satisfying the sub-additivity property.

Under the CAPM framework, which component of total risk is compensated by higher expected returns?

Answer: Systematic (market) risk measured by beta

CAPM holds that only systematic risk (measured by beta), which cannot be diversified away, commands a risk premium; idiosyncratic risk is diversifiable and uncompensated.

A firm enters a 5-year interest rate swap, paying fixed and receiving floating. If interest rates rise unexpectedly, the firm's position will:

Answer: Gain value because floating receipts increase

A pay-fixed, receive-floating swap benefits from rising rates because the floating leg increases in value while the fixed payments remain constant.

Which of the following best defines 'concentration risk' in a loan portfolio?

Answer: Risk arising from a single counterparty or sector representing a disproportionately large share of exposures

Concentration risk refers to excessive exposure to a single borrower, industry, or geography, which can lead to large correlated losses if that segment experiences stress.

The 'Greeks' in options risk management — delta, gamma, vega, theta, and rho — measure sensitivity to which respective market factors?

Answer: Underlying price, curvature of delta, implied volatility, time decay, interest rates

Delta measures sensitivity to underlying price; gamma to changes in delta; vega to implied volatility; theta to time decay; rho to interest rates.

In the Merton structural credit model, default occurs when:

Answer: The market value of assets falls below the face value of debt at maturity

The Merton model treats equity as a call option on firm assets; default is triggered when the asset value at debt maturity is less than the debt's face value.

A portfolio has a correlation of 1.0 between all assets. What is the diversification benefit?

Answer: No diversification benefit

When correlations are perfectly positive (1.0), all assets move identically, so combining them provides no reduction in risk relative to holding any single asset.

Which of the following is the correct formula for Credit VaR?

Answer: Credit VaR = Unexpected Loss at a given confidence level

Credit VaR measures the unexpected loss at a given confidence level, defined as the difference between the worst-case loss (at that confidence) and the expected loss.