Financial Risk Management Financial Risk Management MCQ 3 — Questions and Answers
Question 1: 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 2: 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 3: 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 4: 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 5: 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 6: 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 7: 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.
Financial Risk Management Financial Risk Management MCQ 3
A credit default swap (CDS) buyer pays a premium to the seller.
In exchange, the seller agrees to: