Financial Risk Management Financial Risk Management MCQ 5 — Questions and Answers
Question 1: Which of the following describes 'model risk' in financial risk management?
- The risk of losses due to market price movements in a quantitative model's outputs
- The risk that a financial model is incorrectly specified, implemented, or used, leading to flawed decisions (Correct answer)
- The risk that regulators change capital model requirements
- The risk that model parameters become outdated after one quarter
Correct answer: The risk that a financial model is incorrectly specified, implemented, or used, leading to flawed decisions
Model risk arises when a model contains errors in its assumptions, mathematics, implementation, or application, potentially causing material losses or mispricing.
Question 2: A firm uses a variance-covariance (parametric) VaR model. Which assumption is fundamental to this approach?
- Asset returns follow a fat-tailed distribution
- Asset returns are normally distributed (Correct answer)
- Portfolio returns are modeled using Monte Carlo simulation
- VaR is computed using actual historical return sequences
Correct answer: Asset returns are normally distributed
The parametric VaR approach assumes normally distributed returns, allowing VaR to be computed analytically using the mean, standard deviation, and a standard normal z-score.
Question 3: In risk management, what does a 'risk appetite statement' define?
- The maximum regulatory capital the firm must hold
- The types and amounts of risk the organization is willing to accept in pursuit of its objectives (Correct answer)
- The list of prohibited trading strategies
- The formula for calculating economic capital
Correct answer: The types and amounts of risk the organization is willing to accept in pursuit of its objectives
A risk appetite statement articulates the level and types of risk a firm is prepared to accept, guided by its business strategy and stakeholder expectations.
Question 4: Which of the following is an example of 'market liquidity risk'?
- A bank unable to meet deposit withdrawals due to asset-liability mismatch
- An investor unable to sell a large position without significantly moving the market price (Correct answer)
- A firm facing higher borrowing costs due to credit rating downgrades
- A trader losing money due to a rise in implied volatility
Correct answer: An investor unable to sell a large position without significantly moving the market price
Market liquidity risk is the risk that a position cannot be sold quickly enough at a fair price, often because the position is too large relative to the market's depth.
Question 5: The 'probability of default' (PD) in credit risk models is typically estimated over which time horizon for regulatory capital purposes?
- One month
- One year (Correct answer)
- Five years
- The full loan maturity
Correct answer: One year
Under Basel IRB approaches, PD is conventionally estimated as the one-year probability of default, representing the likelihood a borrower defaults within the next 12 months.
Question 6: What is the key difference between 'economic capital' and 'regulatory capital'?
- Economic capital is always higher than regulatory capital
- Economic capital is the firm's own internal estimate of capital needed; regulatory capital is set by external rules (Correct answer)
- Regulatory capital covers operational risk; economic capital covers only market risk
- Economic capital ignores tail risk; regulatory capital uses Expected Shortfall
Correct answer: Economic capital is the firm's own internal estimate of capital needed; regulatory capital is set by external rules
Economic capital reflects a firm's internal risk-based assessment of required capital, while regulatory capital is a minimum floor set by supervisors (e.g., Basel III rules).
Question 7: Which of the following hedging strategies is most effective at eliminating both delta and gamma risk in an options portfolio?
- Delta hedging alone using the underlying asset
- Adding other options to neutralize gamma, then re-hedging delta with the underlying (Correct answer)
- Buying the underlying asset in proportion to the portfolio's net delta
- Using a single put option to hedge the entire portfolio
Correct answer: Adding other options to neutralize gamma, then re-hedging delta with the underlying
To neutralize gamma, you must add other options (since the underlying has zero gamma); once gamma is zeroed, the residual delta is re-hedged with the underlying asset.
Financial Risk Management Financial Risk Management MCQ 5
Which of the following describes 'model risk' in financial risk management?