Mixed Deck — All Financial Risk Management Topics Flashcards

A portfolio manager wants to reduce interest rate duration without selling bonds. Which derivative strategy is most appropriate?

Answer: Enter a payer interest rate swap (pay fixed, receive floating)

In a payer swap, the manager pays fixed and receives floating, which offsets the fixed-rate exposure of the bond portfolio and reduces duration.

What is 'scenario analysis' used for in operational risk capital modeling?

Answer: Using expert judgment to estimate the frequency and severity of rare but plausible extreme operational loss events not in the historical data

Scenario analysis supplements internal loss data by capturing low-frequency/high-severity events (e.g., a major cyber attack or rogue trader) that haven't occurred recently but could happen.

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.

After entering a pay-fixed, receive-floating swap on top of floating-rate debt, a company's combined debt is effectively:

Answer: Fixed rate

The floating payment received from the swap offsets the floating payment owed on the debt, leaving only the fixed payment due on the swap — converting the exposure to fixed rate.

A portfolio manager uses a duration of 5 years for a bond portfolio. If interest rates rise by 100 basis points, the approximate price change is:

Answer: -5%

The approximate price change equals negative duration times the change in yield, so −5 × 0.01 = −5%.

Under the Historical Simulation method for VaR, how are future portfolio losses estimated?

Answer: By applying today's portfolio weights to historically observed risk factor changes

Historical Simulation re-prices today's portfolio using actual historical changes in risk factors (e.g., rates, FX, prices), generating an empirical distribution of P&L.

Which of the following is an example of specific (idiosyncratic) market risk?

Answer: A single company's stock dropping due to an earnings miss

Idiosyncratic risk is unique to a specific company or security and can be reduced through diversification, unlike systematic market risk.

Scenario analysis in operational risk is primarily used to:

Answer: Replace internal loss data when historical losses are insufficient for tail estimation

Scenario analysis captures low-frequency, high-severity tail risks where limited internal loss data exists, supplementing historical loss databases.

Under the CAPM framework, what does beta greater than 1.0 indicate about a stock?

Answer: The stock is more volatile than the market and amplifies market movements

A beta above 1.0 means the stock tends to amplify market moves — if the market falls 10%, a beta-1.5 stock is expected to fall 15%.

A risk manager says a portfolio has negative skewness. This means:

Answer: The portfolio has more frequent small gains but is exposed to large, infrequent losses

Negative skewness indicates a left-tailed distribution; returns are clustered on the upside but extreme downside events (crashes) occur with significant magnitude.

The optimal hedge ratio in a futures hedge is calculated as:

Answer: The correlation between spot and futures returns multiplied by the ratio of their standard deviations

The optimal hedge ratio h* = ρ × (σS / σF), where ρ is the correlation and σS/σF is the ratio of standard deviations of spot and futures returns.

What is the key distinction between 'systematic risk' and 'idiosyncratic risk'?

Answer: Systematic risk is market-wide and non-diversifiable; idiosyncratic risk is company-specific and diversifiable

Systematic risk (market risk) affects all assets and cannot be diversified away, while idiosyncratic risk is specific to individual securities and can be reduced through diversification.

Under Basel III, the minimum LCR requirement for internationally active banks is:

Answer: 100%

The Basel III LCR standard requires internationally active banks to maintain a minimum LCR of 100% at all times under the fully phased-in framework.

What is 'Pillar 3' of the Basel framework?

Answer: Market discipline through mandatory public disclosure of capital, risk exposures, and risk management practices to enable external stakeholders to assess a bank's risk profile

Pillar 3 harnesses market forces by requiring standardized disclosures so that investors, analysts, and counterparties can compare bank risk profiles and discipline excessive risk-taking through pricing.

Which of these dangers would financial risk management not include?

Answer: Health risk

The goal of risk management in the healthcare industry is to identify, monitor, assess, minimize, and prevent hazards to patients. It entails a complex network of clinical and administrative systems, processes, procedures, and reporting frameworks.

What is 'Pillar 2' in the Basel framework?

Answer: The supervisory review process where regulators assess bank-specific risks not fully captured in Pillar 1 and can impose additional capital requirements

Pillar 2 gives supervisors the authority to require banks to hold capital above the Pillar 1 minimum if their risk profile (concentration risk, interest rate risk in the banking book, etc.) warrants it.

Risk-adjusted return on capital (RAROC) is used to:

Answer: Measure the return earned per unit of economic capital, enabling comparison across business lines

RAROC = risk-adjusted return / economic capital, enabling apples-to-apples comparison of profitability across activities with different risk profiles.

A 'run on the bank' represents which type of liquidity risk?

Answer: Funding liquidity risk from sudden mass withdrawal of deposits

A bank run occurs when depositors simultaneously withdraw funds due to loss of confidence, creating a severe funding liquidity crisis.

What scientific principle favors undertaking a project if it increases shareholder value?

Answer: Finance theory

According to financial theory, an equity share's intrinsic value—the estimated discounted value of its potential return, or dividends—determines its market value.

Expected Credit Loss (ECL) under IFRS 9 requires banks to recognize:

Answer: Forward-looking 12-month or lifetime credit losses as soon as a loan is originated

IFRS 9's ECL model requires immediate recognition of expected losses using forward-looking information, replacing the old incurred loss model.