Financial Risk Management Advanced 5 — Questions and Answers
Question 1: What is the primary distinction between specific risk and general market risk in trading book capital requirements?
- Specific risk relates to individual issuers; general market risk relates to broad market movements (Correct answer)
- Specific risk applies only to equities; general market risk applies only to fixed income
- Specific risk is unmeasurable; general market risk uses VaR
- Specific risk requires scenario analysis; general market risk uses sensitivity analysis
Correct answer: Specific risk relates to individual issuers; general market risk relates to broad market movements
Specific risk capital covers idiosyncratic credit and event risk of individual issuers, while general market risk capital covers broad interest rate, equity, FX, and commodity moves.
Question 2: In a Copula-based credit portfolio model, the Gaussian copula was widely criticized after 2008 primarily because:
- It severely underestimated tail dependence and joint default probabilities during stress (Correct answer)
- It overestimated expected losses in normal market conditions
- It required too many parameters to calibrate to market data
- It could not handle more than two obligors simultaneously
Correct answer: It severely underestimated tail dependence and joint default probabilities during stress
The Gaussian copula assumes asset correlations remain constant and underestimates the tendency for multiple credits to default together in tail scenarios, a fatal flaw in structured products.
Question 3: A bank's Net Stable Funding Ratio (NSFR) is defined as:
- Available Stable Funding divided by Required Stable Funding ≥ 100% (Correct answer)
- Required Stable Funding divided by Available Stable Funding ≥ 100%
- HQLA divided by net cash outflows over 30 days ≥ 100%
- Tier 1 capital divided by risk-weighted assets ≥ 6%
Correct answer: Available Stable Funding divided by Required Stable Funding ≥ 100%
NSFR = ASF / RSF ≥ 100%; it ensures a bank has sufficient stable funding to support its assets and off-balance-sheet activities over a one-year horizon.
Question 4: In the context of market microstructure risk, what does 'adverse selection' refer to for a market maker?
- Trading with informed counterparties who have superior information about the true asset value (Correct answer)
- Difficulty in finding counterparties for large block trades
- The risk that quoted bid-ask spreads are too wide
- Regulatory restrictions limiting the types of trades permitted
Correct answer: Trading with informed counterparties who have superior information about the true asset value
Adverse selection risk means the market maker systematically trades with better-informed counterparties, suffering losses as prices move against the quoted position.
Question 5: Which of the following best describes a 'convexity adjustment' needed when pricing interest rate derivatives?
- A correction to forward rate pricing due to the non-linear relationship between bond prices and yields (Correct answer)
- An adjustment for credit risk in interest rate swaps
- A haircut applied to collateral in repo transactions
- A scaling factor applied to VaR for non-normal distributions
Correct answer: A correction to forward rate pricing due to the non-linear relationship between bond prices and yields
Convexity adjustments correct for the asymmetric (non-linear) price-yield relationship of bonds, particularly important when pricing futures versus forwards on interest rates.
Question 6: Under the Advanced Measurement Approach (AMA) for operational risk, which four data elements must be combined?
- Internal loss data, external loss data, scenario analysis, and business environment factors (Correct answer)
- VaR models, stress tests, audit reports, and insurance recoveries
- Key risk indicators, control assessments, Basel categories, and exposure at default
- Loss given default, probability of default, exposure at default, and maturity
Correct answer: Internal loss data, external loss data, scenario analysis, and business environment factors
AMA requires banks to integrate internal loss data, external industry loss data, scenario analysis, and business environment and internal control factors to model operational risk capital.
Question 7: A risk manager applies a Cornish-Fisher expansion to estimate VaR. Compared to the normal distribution VaR, the adjusted VaR will be higher when the return distribution exhibits:
- Positive excess kurtosis and negative skewness (Correct answer)
- Negative excess kurtosis and positive skewness
- Zero skewness and zero kurtosis
- Positive skewness only
Correct answer: Positive excess kurtosis and negative skewness
Fat tails (positive excess kurtosis) and left skewness both increase the adjusted VaR via the Cornish-Fisher expansion, since extreme losses are more likely than under normality.
Financial Risk Management Advanced 5
What is the primary distinction between specific risk and general market risk in trading book capital requirements?