Financial Risk Management Advanced 2 — Questions and Answers
Question 1: Under the Basel III framework, what is the minimum Common Equity Tier 1 (CET1) capital ratio required for banks?
- 4.5% (Correct answer)
- 6.0%
- 8.0%
- 10.5%
Correct answer: 4.5%
Basel III sets the minimum CET1 ratio at 4.5% of risk-weighted assets, with an additional 2.5% capital conservation buffer on top.
Question 2: Which risk measure captures the expected loss in the tail of the distribution beyond the VaR threshold?
- Expected Shortfall (CVaR) (Correct answer)
- Conditional VaR only at 95%
- Stress VaR
- Incremental Risk Charge
Correct answer: Expected Shortfall (CVaR)
Expected Shortfall (also called CVaR or ES) is the average of losses that exceed the VaR threshold, capturing tail risk more fully than VaR alone.
Question 3: A $100M bond portfolio has a modified duration of 6 and yields rise by 50 bps. What is the approximate price change?
- -$3,000,000 (Correct answer)
- +$3,000,000
- -$6,000,000
- -$300,000
Correct answer: -$3,000,000
Price change ≈ -Modified Duration × ΔYield × Portfolio Value = -6 × 0.005 × $100M = -$3M.
Question 4: In the context of credit risk, what does the Loss Given Default (LGD) represent?
- The fraction of exposure lost when a borrower defaults (Correct answer)
- The probability that a borrower will default
- The total outstanding exposure at the time of default
- The expected recovery rate minus collateral value
Correct answer: The fraction of exposure lost when a borrower defaults
LGD is the proportion of the exposure at default that is not recovered after the borrower defaults, typically expressed as 1 minus the recovery rate.
Question 5: Which stress testing approach involves applying a consistent set of severe but plausible macroeconomic scenarios to a portfolio?
- Scenario analysis (Correct answer)
- Sensitivity analysis
- Historical simulation
- Monte Carlo simulation
Correct answer: Scenario analysis
Scenario analysis stress tests a portfolio using coherent macroeconomic narratives (e.g., recession, rate spike) rather than changing one variable at a time.
Question 6: What is the primary purpose of a Credit Valuation Adjustment (CVA)?
- To adjust the fair value of derivatives for counterparty default risk (Correct answer)
- To calculate regulatory capital for market risk
- To measure operational risk losses from system failures
- To assess interest rate risk in the banking book
Correct answer: To adjust the fair value of derivatives for counterparty default risk
CVA is the market value of counterparty credit risk embedded in OTC derivatives, representing the expected loss due to counterparty default.
Question 7: A bank uses the Internal Ratings-Based (IRB) approach for credit risk. Which parameter does the bank itself estimate under the Foundation IRB (F-IRB) approach?
- Probability of Default (PD) only (Correct answer)
- PD, LGD, and EAD
- LGD and EAD only
- Only the Maturity (M) parameter
Correct answer: Probability of Default (PD) only
Under F-IRB, banks estimate PD internally but use supervisory estimates for LGD, EAD, and maturity; under Advanced IRB, banks estimate all parameters.
Financial Risk Management Advanced 2
Under the Basel III framework, what is the minimum Common Equity Tier 1 (CET1) capital ratio required for banks?