Financial Risk Management Advanced 4 — Questions and Answers
Question 1: What does the Incremental Risk Charge (IRC) in Basel 2.5 capture that standard VaR does not?
- Default and migration risk for credit-sensitive positions in the trading book (Correct answer)
- Operational losses from internal process failures
- Systemic risk across the entire financial system
- Interest rate risk in the banking book
Correct answer: Default and migration risk for credit-sensitive positions in the trading book
IRC was introduced to capture the default and credit migration risk for unsecuritized credit products in the trading book over a one-year horizon at 99.9% confidence.
Question 2: In extreme value theory (EVT), the Generalized Pareto Distribution (GPD) is used to model:
- The distribution of losses that exceed a high threshold (Correct answer)
- Normal day-to-day portfolio returns
- Recovery rates on defaulted bonds
- Interest rate term structure dynamics
Correct answer: The distribution of losses that exceed a high threshold
EVT uses GPD to fit the tails of loss distributions, specifically modeling observations that exceed a high threshold to better estimate extreme quantiles like VaR and ES.
Question 3: A firm's operational risk capital under the Basel III Standardized Approach (SA) is primarily driven by:
- Business Indicator (BI) scaled by an Internal Loss Multiplier (Correct answer)
- VaR calculated from operational loss history
- A fixed percentage of gross income
- Regulatory-assigned risk weights by event type
Correct answer: Business Indicator (BI) scaled by an Internal Loss Multiplier
The Basel III SA uses the Business Indicator (a proxy for revenue) multiplied by marginal coefficients and an Internal Loss Multiplier based on the firm's historical losses.
Question 4: Which of the following is a key assumption of the Merton structural model of credit risk?
- A firm defaults when asset value falls below the face value of debt at maturity (Correct answer)
- Default can only occur on coupon payment dates
- Recovery rates are fixed at 40% regardless of asset value
- Default intensity follows a Poisson process
Correct answer: A firm defaults when asset value falls below the face value of debt at maturity
In the Merton model, equity is a call option on firm assets; default occurs if asset value falls below debt face value at the debt's maturity date.
Question 5: Gamma risk in options trading refers to:
- The rate of change of delta with respect to the underlying price (Correct answer)
- Sensitivity of option price to changes in implied volatility
- Sensitivity of option price to the passage of time
- The rate of change of vega with respect to implied volatility
Correct answer: The rate of change of delta with respect to the underlying price
Gamma measures how much delta changes for a unit move in the underlying, indicating the curvature of the option's price-underlying relationship.
Question 6: Under the Liquidity Coverage Ratio (LCR) rule, what minimum percentage of net cash outflows over 30 days must a bank hold in High-Quality Liquid Assets (HQLA)?
- 100% (Correct answer)
- 75%
- 60%
- 125%
Correct answer: 100%
The LCR requires banks to maintain HQLA at least equal to 100% of projected net cash outflows over a 30-day stress period, ensuring short-term resilience.
Question 7: A risk manager observes that a portfolio's historical VaR backtesting shows 12 exceptions over 250 trading days at the 99% confidence level. According to Basel's traffic light framework, this result falls in which zone?
- Red zone — model likely flawed (Correct answer)
- Green zone — acceptable performance
- Yellow zone — increased scrutiny required
- Amber zone — regulatory review pending
Correct answer: Red zone — model likely flawed
The red zone begins at 10 or more exceptions over 250 days; 12 exceptions signals that the model likely underestimates risk and requires immediate review.
Financial Risk Management Advanced 4
What does the Incremental Risk Charge (IRC) in Basel 2.5 capture that standard VaR does not?