Financial Risk Management Financial Risk Management MCQ — 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.

Question 8: A credit default swap (CDS) buyer pays a premium to the seller. In exchange, the seller agrees to:

Deliver the reference bond to the buyer at par upon credit event
Make a payment to the buyer if a specified credit event occurs on the reference entity (Correct answer)
Provide the buyer with interest payments on the notional amount
Buy the reference entity's equity if the bond defaults

Correct answer: Make a payment to the buyer if a specified credit event occurs on the reference entity

In a CDS, the protection seller compensates the buyer for losses if a defined credit event (such as default or restructuring) occurs on the reference entity.

Question 9: Which of the following is a key limitation of the historical simulation method for VaR estimation?

It requires assumptions about the return distribution
It cannot incorporate fat tails in returns
It assumes the historical period is representative of future conditions (Correct answer)
It ignores correlations between assets

Correct answer: It assumes the historical period is representative of future conditions

Historical simulation relies on past return data, which may not capture future market regimes or tail events that have not yet occurred, making it backward-looking.

Question 10: What does the 'duration' of a bond primarily measure?

The time to maturity of the bond
The sensitivity of the bond's price to changes in yield (Correct answer)
The credit quality of the bond issuer
The coupon frequency of the bond

Correct answer: The sensitivity of the bond's price to changes in yield

Duration (specifically modified duration) measures the percentage change in a bond's price for a 1% change in yield, making it a key interest rate risk metric.

Question 11: In the context of market risk, 'basis risk' refers to:

The risk that a hedging instrument does not perfectly offset the exposure being hedged (Correct answer)
The risk of changes in the risk-free interest rate
The risk that the notional of a derivative exceeds the underlying exposure
The risk of default by a clearinghouse

Correct answer: The risk that a hedging instrument does not perfectly offset the exposure being hedged

Basis risk arises when the price movements of the hedging instrument and the underlying exposure are not perfectly correlated, leaving residual risk in the hedged position.

Question 12: Which regulatory framework introduced the concept of 'Tier 1' and 'Tier 2' capital for banks?

Dodd-Frank Act
Basel I Accord (Correct answer)
Sarbanes-Oxley Act
MiFID II

Correct answer: Basel I Accord

The Basel I Accord (1988) introduced the Tier 1 and Tier 2 capital classification, along with the 8% minimum capital-to-risk-weighted-assets ratio.

Question 13: A risk manager wants to reduce the fat-tail sensitivity of a VaR estimate. Which alternative risk measure is most appropriate?

Standard deviation
Expected Shortfall (CVaR) (Correct answer)
Beta coefficient
Sharpe Ratio

Correct answer: Expected Shortfall (CVaR)

Expected Shortfall (also called Conditional VaR or CVaR) averages losses beyond the VaR threshold, explicitly capturing tail risk and satisfying the sub-additivity property.

Question 14: Under the CAPM framework, which component of total risk is compensated by higher expected returns?

Total risk (standard deviation)
Idiosyncratic (unsystematic) risk
Systematic (market) risk measured by beta (Correct answer)
Liquidity risk

Correct answer: Systematic (market) risk measured by beta

CAPM holds that only systematic risk (measured by beta), which cannot be diversified away, commands a risk premium; idiosyncratic risk is diversifiable and uncompensated.

Question 15: A firm enters a 5-year interest rate swap, paying fixed and receiving floating. If interest rates rise unexpectedly, the firm's position will:

Gain value because floating receipts increase (Correct answer)
Lose value because fixed payments become relatively cheaper
Be unaffected because swaps are marked to zero at inception
Gain value because the fixed rate paid rises

Correct answer: Gain value because floating receipts increase

A pay-fixed, receive-floating swap benefits from rising rates because the floating leg increases in value while the fixed payments remain constant.

Question 16: Which of the following best defines 'concentration risk' in a loan portfolio?

Risk arising from a single counterparty or sector representing a disproportionately large share of exposures (Correct answer)
Risk that all loans in the portfolio have the same maturity
Risk that loan spreads compress due to competitive pricing
Risk of regulatory capital requirements increasing

Correct answer: Risk arising from a single counterparty or sector representing a disproportionately large share of exposures

Concentration risk refers to excessive exposure to a single borrower, industry, or geography, which can lead to large correlated losses if that segment experiences stress.

Question 17: The 'Greeks' in options risk management — delta, gamma, vega, theta, and rho — measure sensitivity to which respective market factors?

Underlying price, curvature of delta, implied volatility, time decay, interest rates (Correct answer)
Interest rates, credit spreads, volatility, time value, dividends
Volatility, correlation, skew, term structure, liquidity
Underlying price, interest rates, implied volatility, dividends, time decay

Correct answer: Underlying price, curvature of delta, implied volatility, time decay, interest rates

Delta measures sensitivity to underlying price; gamma to changes in delta; vega to implied volatility; theta to time decay; rho to interest rates.

Question 18: In the Merton structural credit model, default occurs when:

The company's credit rating drops below investment grade
The market value of assets falls below the face value of debt at maturity (Correct answer)
The company misses a coupon payment
The company's stock price falls by more than 50%

Correct answer: The market value of assets falls below the face value of debt at maturity

The Merton model treats equity as a call option on firm assets; default is triggered when the asset value at debt maturity is less than the debt's face value.

Question 19: A portfolio has a correlation of 1.0 between all assets. What is the diversification benefit?

Maximum diversification benefit
No diversification benefit (Correct answer)
Partial diversification benefit
Negative diversification (diversification penalty)

Correct answer: No diversification benefit

When correlations are perfectly positive (1.0), all assets move identically, so combining them provides no reduction in risk relative to holding any single asset.

Question 20: Which of the following is the correct formula for Credit VaR?

Credit VaR = Expected Loss − Unexpected Loss
Credit VaR = Unexpected Loss at a given confidence level (Correct answer)
Credit VaR = PD × LGD × EAD
Credit VaR = Total Loss − Recovery Amount

Correct answer: Credit VaR = Unexpected Loss at a given confidence level

Credit VaR measures the unexpected loss at a given confidence level, defined as the difference between the worst-case loss (at that confidence) and the expected loss.

Question 21: Under the Value at Risk framework, increasing the confidence level from 95% to 99% while holding the time horizon constant will:

Decrease the VaR estimate
Leave the VaR estimate unchanged
Increase the VaR estimate (Correct answer)
Make VaR undefined

Correct answer: Increase the VaR estimate

A higher confidence level means the threshold loss is set further into the tail of the distribution, so the VaR figure (the minimum loss at that percentile) increases.

Financial Risk Management Financial Risk Management MCQ

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?

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