Financial Risk Management Financial Risk Management MCQ 2 — Questions and Answers
Question 1: A bank's trading desk holds a portfolio with a 1-day 99% VaR of $5 million. Under Basel III, what is the minimum regulatory capital requirement based on this VaR?
- $5 million
- $15 million (Correct answer)
- $50 million
- $3.29 million
Correct answer: $15 million
Basel III requires trading book capital to be at least 3 times the 10-day 99% VaR; scaling the 1-day figure by √10 ≈ $15.81M, and the multiplier of 3 yields approximately $15M minimum.
Question 2: Which of the following best describes 'wrong-way risk' in counterparty credit risk?
- Risk that a counterparty defaults when market conditions are favorable
- Risk that exposure increases precisely when counterparty creditworthiness deteriorates (Correct answer)
- Risk of underestimating exposure at default
- Risk that collateral value rises with exposure
Correct answer: Risk that exposure increases precisely when counterparty creditworthiness deteriorates
Wrong-way risk occurs when the exposure to a counterparty is positively correlated with the probability of that counterparty's default, amplifying potential losses.
Question 3: A portfolio manager uses a delta-gamma approximation for options risk. What additional Greek does this method capture compared to a pure delta hedge?
- Vega
- Theta
- Convexity (curvature) of the P&L curve (Correct answer)
- Rho
Correct answer: Convexity (curvature) of the P&L curve
The gamma term in the delta-gamma approximation accounts for the curvature (convexity) of the option's value with respect to the underlying price, correcting for the linear delta approximation.
Question 4: In credit risk modeling, what does the 'loss given default' (LGD) measure?
- The probability that a borrower will default within a year
- The fraction of exposure that cannot be recovered after a default (Correct answer)
- The total exposure at the time of default
- The time between default and recovery
Correct answer: The fraction of exposure that cannot be recovered after a default
LGD represents the proportion of the exposure that is lost when a borrower defaults, calculated as 1 minus the recovery rate.
Question 5: A firm's operational risk capital under the Basel Advanced Measurement Approach (AMA) primarily relies on:
- Market prices of traded instruments
- Internal loss data, external loss data, scenario analysis, and business environment factors (Correct answer)
- Credit ratings from external agencies
- VaR models applied to the trading book
Correct answer: Internal loss data, external loss data, scenario analysis, and business environment factors
AMA requires banks to combine four data elements: internal loss data, external loss data, scenario analysis, and business environment and internal control factors.
Question 6: What is the primary purpose of a 'stress test' in financial risk management?
- To calculate the exact probability of a loss event
- To assess portfolio performance under normal market conditions
- To evaluate potential losses under severe but plausible adverse scenarios (Correct answer)
- To optimize the risk-return tradeoff of a portfolio
Correct answer: To evaluate potential losses under severe but plausible adverse scenarios
Stress tests examine how a portfolio would perform under extreme, hypothetical scenarios (e.g., market crashes, liquidity crises) that may lie outside the range captured by statistical VaR models.
Question 7: Which of the following liquidity risk metrics measures the minimum amount of unencumbered high-quality liquid assets a bank must hold to survive a 30-day stress period?
- Net Stable Funding Ratio (NSFR)
- Liquidity Coverage Ratio (LCR) (Correct answer)
- Loan-to-Deposit Ratio (LDR)
- Current Ratio
Correct answer: Liquidity Coverage Ratio (LCR)
The LCR, introduced under Basel III, requires banks to hold sufficient HQLA to cover net cash outflows over a 30-day stress scenario, ensuring short-term resilience.
Financial Risk Management Financial Risk Management MCQ 2
A bank's trading desk holds a portfolio with a 1-day 99% VaR of $5 million.
Under Basel III, what is the minimum regulatory capital requirement based on this VaR?