Financial Risk Management Financial Risk Management MCQ 4 — Questions and Answers
Question 1: 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 2: 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 3: 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 4: 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 5: 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 6: 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 7: 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 4
A firm enters a 5-year interest rate swap, paying fixed and receiving floating.
If interest rates rise unexpectedly, the firm's position will: