Financial Risk Management Financial Risk Management 5 — Questions and Answers
Question 1: What is the primary purpose of a 'collar' options strategy in risk management?
- To maximize upside potential while eliminating all downside risk
- To cap both downside losses and upside gains within a defined range (Correct answer)
- To profit from increased volatility in the underlying asset
- To hedge only against upside risk while retaining full downside exposure
Correct answer: To cap both downside losses and upside gains within a defined range
A collar combines a protective put (limits downside) with a covered call (caps upside), creating a range of outcomes for the hedger.
Question 2: How does the 'Net Stable Funding Ratio' (NSFR) address bank liquidity risk?
- It ensures banks hold enough high-quality liquid assets to survive a 30-day stress scenario
- It requires banks to fund long-term assets with stable, longer-term funding sources (Correct answer)
- It limits the total amount of short-term borrowing a bank can undertake
- It measures the gap between a bank's liquid assets and its total liabilities
Correct answer: It requires banks to fund long-term assets with stable, longer-term funding sources
The NSFR requires banks to maintain a stable funding profile over a one-year horizon, ensuring long-term assets are funded by stable, longer-duration liabilities.
Question 3: A credit analyst notices that a bond's credit spread has widened from 150 bps to 300 bps. Which scenario most likely caused this?
- The issuer's creditworthiness improved significantly
- Risk-free interest rates declined substantially
- Market participants now perceive higher default risk for the issuer (Correct answer)
- The bond's duration increased due to falling interest rates
Correct answer: Market participants now perceive higher default risk for the issuer
Credit spread widening reflects increased market perception of default risk — investors demand more compensation for holding the bond over risk-free assets.
Question 4: What is 'concentration risk' in a loan portfolio and how is it typically managed?
- Risk from investing in too many different asset classes; managed by focusing on core competencies
- Excessive exposure to a single borrower, sector, or geography; managed through diversification and limits (Correct answer)
- Risk that a portfolio is too large to be liquidated; managed by reducing total portfolio size
- The risk of holding too many investment-grade assets; managed by adding high-yield exposure
Correct answer: Excessive exposure to a single borrower, sector, or geography; managed through diversification and limits
Concentration risk arises from outsized exposure to a single borrower, industry, or region, and is managed through diversification strategies and internal exposure limits.
Question 5: Under the Historical Simulation method for VaR, how are future portfolio losses estimated?
- By fitting a normal distribution to past returns and extrapolating future losses
- By applying today's portfolio weights to historically observed risk factor changes (Correct answer)
- By running Monte Carlo simulations calibrated to historical volatility
- By calculating the worst single-day loss from the past 250 trading days
Correct answer: By applying today's portfolio weights to historically observed risk factor changes
Historical Simulation re-prices today's portfolio using actual historical changes in risk factors (e.g., rates, FX, prices), generating an empirical distribution of P&L.
Question 6: What is 'counterparty credit risk' (CCR) in the context of OTC derivatives?
- The risk that the underlying asset in a derivative contract defaults
- The risk that the counterparty to a derivative contract defaults before final settlement (Correct answer)
- The risk that derivative collateral loses value during the margin period of risk
- The risk that regulatory changes make derivative contracts unenforceable
Correct answer: The risk that the counterparty to a derivative contract defaults before final settlement
CCR is the risk that a counterparty to an OTC derivative defaults before the contract matures, causing a loss equal to the contract's replacement cost if in-the-money.
Question 7: Which risk governance principle requires that the risk management function be independent from business lines that generate risk?
- Principle of risk aggregation
- Three Lines of Defense model (Correct answer)
- Risk appetite framework
- Economic capital allocation principle
Correct answer: Three Lines of Defense model
The Three Lines of Defense model separates risk-taking (1st line), risk oversight (2nd line), and independent assurance (3rd line/internal audit) to prevent conflicts of interest.
Financial Risk Management Financial Risk Management 5
What is the primary purpose of a 'collar' options strategy in risk management?