Financial Risk Management Advanced 3 — Questions and Answers
Question 1: Which of the following best describes the 'wrong-way risk' in counterparty credit risk?
- Exposure increases precisely when counterparty creditworthiness deteriorates (Correct answer)
- Exposure decreases when market volatility rises
- Collateral value increases when counterparty defaults
- Netting agreements reduce exposure when correlation is high
Correct answer: Exposure increases precisely when counterparty creditworthiness deteriorates
Wrong-way risk arises when the exposure to a counterparty is positively correlated with the counterparty's probability of default, amplifying potential losses.
Question 2: In a variance-covariance VaR model, increasing the holding period from 1 day to 10 days scales VaR by which factor (assuming i.i.d. returns)?
- √10 ≈ 3.162 (Correct answer)
- 10
- √252 ≈ 15.87
- 2
Correct answer: √10 ≈ 3.162
Under the square-root-of-time rule for i.i.d. returns, VaR scales by the square root of the holding period, so 1-day VaR × √10 gives the 10-day VaR.
Question 3: Which liquidity risk metric measures the time it would take to liquidate a portfolio under stressed market conditions?
- Liquidity-Adjusted VaR (LVaR) (Correct answer)
- Net Stable Funding Ratio (NSFR)
- Liquidity Coverage Ratio (LCR)
- Current Ratio
Correct answer: Liquidity-Adjusted VaR (LVaR)
LVaR incorporates bid-ask spreads and market depth to estimate losses from unwinding positions over a realistic liquidation horizon under stress.
Question 4: A credit default swap (CDS) with a notional of $10M and a 200 bps spread requires annual premium payments of:
- $200,000 (Correct answer)
- $2,000,000
- $20,000
- $1,000,000
Correct answer: $200,000
Annual premium = Notional × CDS spread = $10,000,000 × 0.0200 = $200,000.
Question 5: Under FRTB (Fundamental Review of the Trading Book), which risk measure replaces VaR as the primary internal model metric?
- Expected Shortfall at 97.5% (Correct answer)
- VaR at 99.9%
- Stressed VaR at 99%
- Incremental Default Risk at 99.9%
Correct answer: Expected Shortfall at 97.5%
FRTB mandates Expected Shortfall at 97.5% confidence (calibrated to a stressed period) in place of the previous 99% VaR, better capturing tail risk.
Question 6: A portfolio manager wants to hedge the vega risk of a long options position. The most direct approach is to:
- Buy or sell options with offsetting vega exposure (Correct answer)
- Short the underlying asset
- Enter an interest rate swap
- Buy Treasury bonds
Correct answer: Buy or sell options with offsetting vega exposure
Vega risk (sensitivity to implied volatility changes) can only be hedged with instruments that also have vega, primarily other options.
Question 7: The Herfindahl-Hirschman Index (HHI) is used in credit risk to measure:
- Concentration risk within a loan portfolio (Correct answer)
- Market risk in equity portfolios
- Operational risk event frequency
- Liquidity risk in funding markets
Correct answer: Concentration risk within a loan portfolio
HHI sums the squared exposure shares of each borrower or sector, providing a measure of portfolio concentration; a high HHI signals elevated concentration risk.
Financial Risk Management Advanced 3
Which of the following best describes the 'wrong-way risk' in counterparty credit risk?