Financial Risk Management Financial Risk Management 4 — Questions and Answers
Question 1: Which of the following is an example of operational risk as defined by Basel II/III?
- A trader loses money due to an unexpected interest rate rise
- A rogue trader executes unauthorized trades that result in large losses (Correct answer)
- A bank's loan portfolio suffers defaults during a recession
- A currency hedge fails due to unexpected exchange rate movements
Correct answer: A rogue trader executes unauthorized trades that result in large losses
Operational risk includes losses from inadequate internal processes, people, and systems — unauthorized trading by an employee falls squarely in this category.
Question 2: What is the 'carry trade' and what is its primary risk?
- Borrowing in a high-yield currency to invest in a low-yield currency; primary risk is interest rate risk
- Borrowing in a low-yield currency to invest in a high-yield currency; primary risk is sudden exchange rate reversal (Correct answer)
- Buying undervalued bonds and shorting overvalued bonds; primary risk is spread widening
- Buying futures contracts in the front month; primary risk is roll yield losses
Correct answer: Borrowing in a low-yield currency to invest in a high-yield currency; primary risk is sudden exchange rate reversal
A carry trade borrows cheaply in a low-rate currency to invest in a higher-yielding one, but is vulnerable to sudden currency depreciation that wipes out accumulated carry.
Question 3: A portfolio manager wants to reduce interest rate duration without selling bonds. Which derivative strategy is most appropriate?
- Enter a receiver interest rate swap (receive fixed, pay floating)
- Enter a payer interest rate swap (pay fixed, receive floating) (Correct answer)
- Buy interest rate caps
- Sell interest rate floors
Correct 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.
Question 4: What does 'model risk' refer to in financial risk management?
- The risk that computer systems malfunction during trading
- The risk of loss due to incorrect or misused pricing or risk models (Correct answer)
- The risk that regulatory models change without notice
- The risk of using historical data that does not reflect current market conditions
Correct answer: The risk of loss due to incorrect or misused pricing or risk models
Model risk is the potential for financial loss resulting from errors in model development, implementation, or inappropriate application of a model.
Question 5: Under the standardized approach for credit risk in Basel III, how are risk weights primarily determined?
- Internal bank models based on historical default rates
- External credit ratings from recognized rating agencies (Correct answer)
- The maturity of the exposure
- The industry sector of the borrower
Correct answer: External credit ratings from recognized rating agencies
The standardized approach uses external credit ratings from recognized agencies (like Moody's and S&P) to assign risk weights to different exposures.
Question 6: What is the difference between 'mark-to-market' and 'mark-to-model' valuation?
- Mark-to-market uses observable market prices; mark-to-model uses theoretical pricing models for illiquid instruments (Correct answer)
- Mark-to-model uses exchange prices; mark-to-market uses internal bank estimates
- They are identical except for regulatory reporting purposes
- Mark-to-market is used for equities; mark-to-model is used for bonds
Correct answer: Mark-to-market uses observable market prices; mark-to-model uses theoretical pricing models for illiquid instruments
Mark-to-market values positions using current observable market prices, while mark-to-model is used when no reliable market price exists and a pricing model must be used instead.
Question 7: Which of the following best describes 'rollover risk' in the context of bank funding?
- The risk that short-term liabilities cannot be refinanced when they mature (Correct answer)
- The risk that rolling over futures contracts incurs negative roll yield
- The risk that long-term assets decline in value before maturity
- The risk that interest rates increase when fixed-rate liabilities must be refinanced
Correct answer: The risk that short-term liabilities cannot be refinanced when they mature
Rollover risk is the danger that a bank relying on short-term funding cannot renew that funding at maturity, potentially leading to a liquidity crisis.
Financial Risk Management Financial Risk Management 4
Which of the following is an example of operational risk as defined by Basel II/III?