FRM Advanced Topics 2 — Questions and Answers
Question 1: Under Basel III, which capital buffer is designed to be built up in good times and released during periods of stress to reduce procyclicality?
- Capital conservation buffer
- Countercyclical capital buffer (Correct answer)
- G-SIB surcharge
- Leverage ratio buffer
Correct answer: Countercyclical capital buffer
The countercyclical capital buffer is varied by national regulators to lean against credit-driven booms and is released in downturns.
Question 2: A risk manager uses a Cornish-Fisher expansion when computing VaR primarily to adjust for what feature of the return distribution?
- Autocorrelation
- Skewness and kurtosis (Correct answer)
- Mean reversion
- Heteroskedasticity
Correct answer: Skewness and kurtosis
The Cornish-Fisher expansion modifies the normal quantile to account for non-zero skewness and excess kurtosis.
Question 3: In a CDO structure, which tranche absorbs the first losses from the underlying collateral pool?
- Senior tranche
- Mezzanine tranche
- Equity tranche (Correct answer)
- Super-senior tranche
Correct answer: Equity tranche
The equity tranche is the most subordinated and takes the first losses, giving it the highest expected return and risk.
Question 4: The liquidity coverage ratio (LCR) requires banks to hold enough high-quality liquid assets to survive a stress period of how many days?
- 7 days
- 30 days (Correct answer)
- 90 days
- 365 days
Correct answer: 30 days
The LCR ensures sufficient HQLA to cover net cash outflows over a 30-day stress scenario.
Question 5: Which model is most commonly associated with estimating the probability of default from equity prices using the firm's asset value and volatility?
- CreditMetrics
- Merton structural model (Correct answer)
- CreditRisk+
- KMV transition matrix
Correct answer: Merton structural model
The Merton model treats equity as a call option on firm assets, deriving default probability from asset value and volatility.
Question 6: Expected shortfall (ES) is generally preferred over VaR as a risk measure mainly because ES is:
- Easier to backtest
- A coherent risk measure that is subadditive (Correct answer)
- Always lower than VaR
- Independent of the confidence level
Correct answer: A coherent risk measure that is subadditive
Expected shortfall satisfies subadditivity and the other coherence axioms, which VaR can violate.
Question 7: In the Basel framework, which approach for operational risk capital was retained under Basel III, replacing the AMA and earlier basic/standardized methods?
- Internal Models Approach
- Standardized Measurement Approach (SMA) (Correct answer)
- Advanced Measurement Approach
- Scenario-Based Approach
Correct answer: Standardized Measurement Approach (SMA)
Basel III consolidated operational risk capital into a single Standardized Measurement Approach based on a business indicator and loss history.
FRM Advanced Topics 2
Under Basel III, which capital buffer is designed to be built up in good times and released during periods of stress to reduce procyclicality?