FRM schweser part 2 book 3 2013 (2 of 2)

SCHWESERNOTES FOR THE TM FRM* EXAM FRM 2013 Part II Book t' 'v \ Operational and Integrated Risk Management of KAPLAN SCHWESER — Topic 45 Cross Reference to CARP Assigned Reading Senior Supervisors Group • LSufficient funding is provided to develop IT systems for the purpose of internal risk reporting; they compete equally with proposals that are revenue generating, for example, • Assessing IT infrastructure and capacity prior to approving new products, Post-implementation reviews of IT systems performed anywhere from 6-18 months * afterward as a check that the systems meet the risk personnel’s needs • The level of governance for outsourced IT activities is the same as if they were done in-house There are no impediments to implementation or access to data due to outsourcing The existence of effective project management offices (PMOs) to ensure that timelines and deliverables are met Specifically, one person is in charge of the PMO, which seems to result in stronger coordination and communication hetween project staff • There is a data administrator as well as a data owner, and the data owner must ensure a sufficiendy high level of data accuracy, integrity, and availability This helps to ensure that IT projects are meeting die users' needs • The board is able to implement relevant internal audit programs to allow for periodic reviews of data maintenance processes and functions The monitoring could he continuous or specific to a product or business line This would allow for the quick correction of any weaknesses detected by internal audit * POOR OR FRAGMENTED IT INFRASTRUCTURE AIM 45.6: Describe factors which could lead to poor or fragmented IT infrastructure at an organization There are live major factors to consider with regard to poor or fragmented IT infrastructures, No common understanding of long-term business strategy between business lines and IT management This factor often results due to internal competition for funding, thereby not permitting important IT infrastructure projects to be completed, Management only makes decisions based on short-term profits As a result of this factor, many IT infrastructure projects are scaled back, delayed, or eliminated Significant turnover in important IT roles within thefirm This factor has resulted in delays in completing FT projects Insufficient data governance and insufficient data management plan within thefirm This factor results in inconsistency across business lines in how to upgrade systems; this is costly if die systems end up being incompatible because of the inconsistencies Merger and acquisition activities This factor results in multiple systems running simultaneously within the reoendy merged firm Data aggregation across products and business lines becomes a significant challenge, ©2013 Kaplan, Inc Page 155 Topic 45 — Cross Reference to CARP Assigned Reading Senior Supervisors Group DATA AGGREGATION BEST PRACTICES AIM 45.7: Explain the challenges and best practices related to data aggregation at an organization The existence of several IT systems being operated simultaneously within a firm results in a lack of integrated IT systems This, in turn, requires a significant amount of manual data entry to allow for proper aggregation of risk data Best practices related to data aggregation at an organization are explained as follows: • To increase efficiency and accuracy, minimize the amount of manual intervention and manual data manipulation (i.e., spreadsheets) by automating the risk data aggregation process * Aggregated risk data needs to be accurate, timely, and comprehensive in order to have value Therefore, there must be standards, cutoff times, and timelines regarding the production of internal risk reports • Single platform centralized datahases with single identifiers and/or consistent naming conventions could allow for the timely retrieval of multiple records of risk data across the firm They also permit data segmentation when required to produce specific data (fie., risk concentrations} • Create data warehouses that will take information from various subsystems and store diem in a warehouse The data is dien filtered and reorganized so that customized reports can be created using specific data from the warehouse • Automated reconciliation will reduce die risk of manual errors and incomplete information For example, off-balance sheet data should not be omitted • Periodic reconciliation of risk and financial data will ensure the accuracy and proper operadon of the IT system For merger and acquisition transactions, ensuring drat legacy IT systems are integrated * into tire chosen IT system as soon as possible When * obtaining approvals for new IT purchases, involve the appropriate technical staff to ensure that the existing systems can process and aggregate data from these new items Page 15fi ©2013 Kaplan, Inc - Topic 45 Cross RefereDM to GARP Assigned Reading Senior Supervisors Group KEY CONCEPTS AIM 45.1 A risk appetite framework (RAF) sets in place a clear, future-oriented perspective of the firm’s target risk profile in a number of different scenarios and maps out a strategy for achieving that risk profile An RAF should start with a risk appetite statement that is essentially a mission statement from a risk perspective Benefits of a well-developed RAF include assisting firms in preparing for the unexpected and greatly improving a firm’s strategic planning and tactical decision-making AIM 45.2 The chief risk officer (CRO) should be easily available to the hoard of directors (hoard) and there should he a strong alliance between the CRO and die chief financial officer (CFO) The chief executive officer (CEO) should strongly support the RAF and give the CRO the final word on risk decisions The hoard should: he willing to challenge management firm consistent continually revise the RAF, have sufficient technical and business understanding of the risks feeing the firm, be proactive in stating the nature and frequency of the information they need, and set up a reputational risk committee with the RAF, actively work with senior management to operate the to AIM 45.3 The RAF helps to ensure that each business line’s strategies are congruent with the firm’s desired risk profile It also considers the integrated nature of the business lines within die firm AIM 45.4 Many metrics can he monitored as part of an effective RAF Risk metrics should he divided into classes, depending on who is receiving the information within the firm AIM 45.5 A robust data infrastructure results in management heing ahle to make proper decisions regarding a firm’s strategy, risk appetite, and risk management Additionally, it allows for the ability to sufficiendy document and convey the firm’s risk reporting requirements Key elements of an effective IT risk management policy include! clearly defined standards and internal risk reporting requirements, sufficient funding to develop IT systems, assessing IT infrastructure and capacity prior to approving new products, timely post¬ implementation reviews of IT systems, and sufficient governance for outsourced IT activities ©2013 Kaplan, Inc Page 157 Topic 45 Cross Reference to GASP Assigned Reading Senior Supervisors Group — AIM 45.6 Poor or fragmen red IT infrastructures result from a lack of common understanding of long¬ term business strategies between business lines and IT management, managers dunking only about short-term profits, significant turnover in IT roles, insufficient data governance, and merger and acquisition acdvities AIM 45.7 The lack of integrated IT systems is the major challenge related to data aggregations Many best practices regarding data aggregations exist including: minimizing the amount of manual data processes, using single platform centralized datahases, creating data warehouses, automated and periodic data reconciliations, and timely integration of legacy IT systems Page 158 ©2013 Kaplan, Inc Topic 45 Cross Reference to GARP Ass igned Reading Senior Supervisors Group — CONCEPT CHECKERS Which of the following statements regarding the risk appetite framework (RAP) is correct? A The RAF represents die firm's core risk strategy B The RAF should be amended to take advantage of all profitable opportunities C The RAF focuses on which risks die firm is willing to take and under what condidons D The RAF begins with die risk appetite statement that contains many elements, including examining the compos idon of the income statement As a best praedee, which of die following members of senior managemenc should have the final word on significant risk decisions at a firm? A Chief executive officer, B Chief financial officer C Chief operating officer D Chief risk officer Which of die following statements regarding die role of a risk appetite framework (RAF) in managing the risk of individual business lines within a firm is correct? A Individual business lines may collectively cause the firm’s RAF to drift when market condidons change B Sensitivity analysis is a robust tool to assist senior management and/or the board to determine consistency with the RAF C Each individual husiness line's risk appetite allotment according to the RAF is independent of the odiers to ensure objectivity in the process D The business line managers submit long-term business plans to senior management and/or the board to determine if they are consistent with the RAF Which of the following statements is incorrect regarding die key elements of an effective IT risk management policy? A Having a single person in charge of die project managemenc office B Comparable funding for IT projects and revenue-generating projects C Post-implementation reviews of IT systems at least 24 months after implementation D Outsourced and in-house IT activities being subjected to die same level of monitoring Which of die following items is a best practice related to data aggregation at an organization? A Integrating legacy IT systems into the new IT system immediately B The use of one master spreadsheet to accumulate all of die data in one place C Periodic manual reconciliations to reduce the risk of errors and incomplete information D Allowing individual departments as much time as diey require to produce internal reports that are accurate, timely, and comprehensive For additional Book 3, Topic 45 practice questions see: Self- Test Questions: # (page 273) ©2013 Kaplan, Inc Page 154 — Topic 45 Cross Reference to GARP Assigned Reading Senior Supervisors Group CONCEPT CHECKER ANSWERS A D The willingness of the CFO to give the CRO the final word on many risk decisions is a best practice, which has strengthened the importance of the risk management function 3, A Individual business lines may collectively cause the firm's RAF to drift when market conditions change Sensitivity analysis only examines one change in a variable ar a time Vforc robust tools would be stress tests and scenario analyses, for example Each business line’s risk appetite allotment according to the RAF may he amended if another business line encounters an opportunity that requires more capita! The business line managers submit medium-term business plans to senior management and/or the hoard C Post-implementation reviews should be performed fi H months after implementation; 24 months or more would likely he too long Having one person in charge of the project management office seems to have resulted in stronger coordination and communication between project staff 5- A Page 160 The RAF represents the firms core risk strategy, The RAF docs not necessarily need to be amended every time there is a profitable opportunity; doing so would cause the RAF to lose its value The RAF also focuses on which risks the firm is unwilling to take The risk appetite statement would not likely include an examination of the composition of the income statement; it would more likely be the balance sheer fi.e., debt, equity), 1L — For merger and acquisition transactions, it is best that legacy IT systems ate integrated into the chosen IT system as soon as possible Spreadsheets ate a form of manual data manipulation and, because they arc not automated, they would not be a best practice Automated reconciliations should be performed, not manual One of the key points about internal risk reports is that they should be produced on a timely basis, therefore, there must be standards, cutoff times, and timelines regarding their production ©211 Kaplan, fnc The following i* i review of (fie Operational and In iterated Risk Management principled designed to address the AIM statements set forth hy GART® This topic is also covered in: STRESS TESTING BANKS Topic 46 EXAM FOCUS This topic focuses on the use of batik testing to determine if liquidity and capital are adequate The discussion focuses primarily on capital adequacy but notes than the issues are similar with respect to liquidity For the exam, understand die derails of the 2009 Supervisory Capital Assessment Program (SCAR), the first stress testing required after the 2007—20(5 K financial crisis Also, be able to explain the issue of coherence in stress testing and describe the challenges with modeling the balance sheet using stress tests in die context of the stress test horizon Finally, understand the differences in disclosure between U.S and European stress tests and the way diat stress test methodologies and disclosure have changed since the 2009 stress SCAR STRESS TESTING In die wake of the 2007-2008 financial crisis, regulators and odier policymakers realized that standard approaches to risk assessment, such as regulatory capital ratio requirements, were not sufficient At that point, supervisory stress testing became a popular tool for measuring bank risk There was a "pop-quiz” quality to the post-hnancial crisis stress tests They were difficult to manipulate because diey were sprung on banks at short notice As a result, die information provided by the stress tests to regulators and the market was truly new This allowed financial markets to better understand bank risks and, as a result, regain a level of trust in die banking sector The goal of stress testing, as well as capital/liquidity and “economic cap italf liquidity* (i.e., internal, bank-specific) models, is to assess how much capital and liquidity a financial institution needs to support its business (i.e., risk taking) activities It is relatively easy for banks to swap out of lower risk assets and into higher risk assets Stress testing provides clarity about the true risk and soundness of hanks Stress testing is an old tool that banks and o tiier firms have used to examine risk It asks the question "what is the institutions resilience to deteriorating conditions?* and simulates financial results given various adverse scenarios Stresses are generally of two basic types: scenarios or sensitivities An example of a scenario is a severe recession An example of sensitivity is a significant increase in interest rates Risk managers can stress test the sensitivity of a single position or loan or an entire portfolio ©2013 Kaplan, Inc Page 161 Topic 46 Cross Reference to GARP Assigned Reading Schuermann - SUPERVISORY CAPITAL ASSESSMENT PROGRAM (SCAP) AIM 46 1: Explain the differences in the features and scope of stress tests before and after the Supervisory Capital Assessment Program (SCAP) In the wake of the financial crisis, there was much uncertainty about the soundness of the U.S banking system Regulators needed to assess the capital strength of financial institutions If there was a gap between what a bank needed in terms of capital and what it had, regulators had to find a credihle way to “fill the hole.” The 2009 U.S hank stress test, known as die Supervisory Capital Assessment Program (LSCAP), was meant to serve that purpose It was die first macro-prudential stress test after the 2007-200K financial crisis Macro-prudential reguladon focuses on die soundness of die hanking system as a whole (i.e., focuses on systematic risks) while micro-prudential regulation focuses on the safety and soundness of the individual institution At this point the Federal government planned to infuse equity capital into hanks diat were undercapitalized hased on stress tesdng The Treasury intended to borrow money and '‘downstream” it as equity in banks via the Treasury’s Capital Assistance Program (CAP) If hanks could not convince investors to fill the hole (i.e., infuse banks with needed equity capital), current investors would be diluted by the government’s equity investment In die end, 19 SCAP banks were required to raise $75 hillion within six months The undercapitalized hanks raised $77 billion of Tier common equity and did not need to draw on the CAP funds 2009, stress testing was relatively simple Figure summarizes the differences in Prior to stress testing preÿSCAP and post-LSCAR Figure 1: Comparison of Stress Testing Pre-SCAP and Post-SCAP Pre-SCAP Primarily assessed exposure to single-shocks [c.g., volatility increases OR interest rate increases OR increasing unemployment) Focused on specific hank products or business units (c.g., lending or trust) Page 162 PostSCAP Considers broad macro-scenarios and market-wide stresses with multiple factors occurring/ changing at once, as evidenced in the 2007-2008 financial crisis Focuses on the whole firm, a more comprehensive look at the effect of the stress scenarios on the institution Typically focused on earnings shocks (i.c., losses) but not on capital adequacy Explicidy focuses on capital adequacy Considers the post-stress common equity threshold to ensure that a bank remains viable Focused exclusively on losses Focuses on revenues, costs, and projected losses Stress testing was static in nature Stress testing is now dynamic and path dependent ©2013 Kaplan, Inc Cross Reference to CARP Assigned Reading — Topic 46 Schuermann CHALLENGES WITH COHERENCE AJM 46.2: Describe the problem of coherence in modeling risk factors during the stress testing of banks One of the challenges of designing useful stress tests is coherence The sensitivities and scenarios must he extreme hut must also be reasonable or possible (i.e., coherent) Problems are inherently multi-factored, making it more difficult to design a coherent stress test For example, an increase in volatility can lead to credit markets freezing High unemployment and falling equity prices often go hand-in-hand It is not sufficient to specify one potential problem (i.e., risk factor) because the o titers not remain fixed The supervisor’s key challenge is to specify dte joint outcomes of all relevant risk factors Additionally, not everything goes bad at once For example, if some currencies are depreciating, others must be appreciating If there is a "flight to quality/ there must also be safe haven assets in dte stress model So while it is important to look at, for example, what happens if U.S Treasury debt becomes riskier and is no longer a safe haven, the model would at the same time have to identify the ‘‘risk-free* asset (s) in which capital would flee under those circumstances The problem is even greater when designing stress scenarios for marked-to- market portfolios of traded securities and derivatives Risk is generally managed widt a value at risk (VaR) system Hundreds of thousands of positions in the trading book must be mapped to thousands of risk factors, tracked on a daily basis The data that results is used to estimate volatility and correlation parameters It is very difficult to find coherent outcomes in such a complex, multi-dimensional universe The 2009 SCAP tested rather simple scenarios with three variables: growth in CDP, unemployment, and the house price index (HFI) Historical experience was used for the market risk scenario (i.e., dte financial crisis—a period of "flight to safety,” the failure of Lehman, and higher risk premia) While the market risk scenario did not test for somediing new, the overall framework achieved coherence of financial and other stresses of the time period One tiling to note is that prior to 2011 all supervisory stress tests imposed the same scenarios on all banks (i.e., a one-size-fits-all approach to stress testing) In recognition of the problem, the 2011 and 2012 Comprehensive Capital Analysis and Review (CCAR) asked hanks to submit results from their own stress scenarios in addition to the supervisory stress scenario in an attempt to reveal bank-specific vulnerabilities This was an important step forward from the 2009 SCAP as it gave supervisors a sense of what banks think are the high risk scenarios This provides regulators with not only bank-specific (i.e., mkroprudential) insight but also improves macro-prudential supervision as it higlilights common risks across banks that may have been underemphasized or unnoticed before ©2013 Kaplan, Inc Page 163 Book Past FRM Exam Answers Question from the 2011 FRM Practice Exam, 16, C Both statements arc comcct In the contact of using an ERM framework to decentralize the risk-reward tradeoff in a company, statements I and II arc both correct, (See Topic 4(f) Question from the 2010 FRM Practice Exam, 17, B I only I, True IT, False, If correlations arc loWj there is diversification benefit, III False Asset correlations tend to he higher in times of stress (Sec Topic 40) Question from the 2009 FRM Practice Exam C The estimated loss distribution likely understates Bank Zs real risk because the bank has not experienced a huge loss, One of the biggest issues of Operational Risk modeling is that there is likely not enough internal data to represent a large enough loss as such loss is extremely rare Using an external loss database can help to mitigate this problem, (See Topic 41) Question from the 2012 FRM Practice Exam, 1?, B The tot aJ risk-weighted assets are: RWAj = Kmc + 12.5 X (CRm + CRJ = 47 + 12,5 x (3*2 + 2.S) = USD 121 million Eligible regulatory capital is: RC Tier +-Ticr Deductions In addition, Tier capital must be less than or equal to Tier capital - - Minimum capital requirement is: RC / In this ease, RC > 0.03 * 122 = 9,7b - 0.4 9.6 RC = 6.2 + min(4.8, 6.2) - 0.8 10,2 RC = 6.2 + min{8.4, 6,2) - 2.8 = 9.6 RC - 4,8 + tnin(6.2, 4.8) - 0.0 = 9.6 RC = 6,8 + (3.2, 6.8) n B R’WAc i> 8% (Fails to meet the minimum capital requirement) (Meets the minimum capital requirement) (Fails to meet the minimum capital requirement) (Fails to meet the minimum capital requirement) (LSCC Topic 47) ©2013 Kaplan, Inc Page 295 Rook Past FRM Exam Answers Question from the 2010 FRM Practice Exam 2U B Asset correlations decrease with increasing PDs A, Incorrect This is a drawback of the Basel II prescribed IRB model as there can exist correlation between the PDs and LCDs which is not corns idered in the Base! model R Correct This is NOT a drawback of the Basel IT prescribed IRB model as the higher the PD, the higher the idiosyncrati c (individual) risk components of a borrower The default risk depends less on die overall state of the economy and more on individual risk drivers C Incorrect This is a diawhack of the Basel II prescribed IRB model as the portfolio of the financial institutions need not be compictcly granular D Incorrect This is a drawback of the Basel II prescribed IRB model as there can be many system aric risk factors affecting the exposure instead of one single risk factor (See Topic 47) Question from the 2010 FRM Practice Exam 21 B The model should be portfolio invariant so drat the capital required for any given loan depends only on the risk of that loan and docs not depend on the portfolio it is added to A Is incorrect since granularity though an issue, is not the major factor here since the model assumes infinitely granular portfolios R Portfolio invariance is the only correct option for the use of the ASRF in the Rascl IT model C This statement is incorrect but put hem ro confuse unprepared candidates D This statement is not correct since the model is based on a VaR minus Expected Loss approach to computing capital to covet Unexpected Losses (UL) under credit risk exposures (See Topic 47) Question from the 2010 FRM Practice Exam 22 A Market risk charges only Tier capital can only be used to satisfy capital requirements resulting from market risk chaises and cannot be applied ro credit risk charges Other choices are incorrect except choice A (See Topic 47) Question fhtm the 2010 FRM Practice Exam 23 B r; II, and TIT A Incorrect L\A is missing E Correct The RBA, SF and IAA are the cottecr approaches C Incorrect RBA is missing and IMA is wrong since it is for Market Risk D Incorrect IMA is used for Market Risk (Sec Topic 47) Page 2f>6 ©2013 Kaplan Inc Book Past FRM Exam Answers Question from the 2010 FRM Practice Exam 24 B Standardized Approach A Incomcct For all business lines, the Basic Indicator Approach uses a 15% beta factor which Ls higher than retail hanking heta factor oh the Standardized Approach B, Correct, Redhat’s only business line Ls retail hanking Using the Standardized Approach will use a lower beta factor than Basic Indicator Approach, C Incorrect F1RB and AIRB are credit risk capital approaches D Incorrect Because of above (Sec Topic 47) Question from the 2010 FRM Practice Exam 25 C I4 II, and IV only The supervisors duties as part of the supervisory review process include: Cheek compliance with Pillars I and III of Basel TI Accord, which would indude credit risk Access internal mitigation and transparency requirements Review internal control capital management methods employed by the bant So I and II arc correct Note that with the foundation IRB approach, the bank provides its estimates for PD but uses supervisory estimates for LCD and BAD for corporate Joans So III is incorrect Also, the impact of interest rate risk on the bank’s capital position must be assessed by determining the impact of a 200 basis point shock or its equivalent, So IV is also correct Therefore, the correct answer for this question Is choice C (See Topic 47) Question from the 2009 FRM Practice Exam 26 D The hank solely purchases options and its options trading is insignificant in relation to its overall business activities The bank only purchases options and its options trading Ls not significant A* Incorrect If a hank writes options, the intermediate approach must be used B, Incorrect If bank writes options, the intermediate approach must he used C Incorrect If option trading is significant, the intcrmcdia-tc approach must be used (See Topic 47) Question from the 2009 FRM Practice Exam 27 A EUR 18.97 million The required market risk charge would be the square root of 10 times the maximum of previous day VaR and the average daily 60 days VaR, times k VlO * Max(3, 3*2) = 18.97 B Incorrect Vl0*3 = 9.49 C Incorrect VlO * = 6.32 D Incorrect VlO * Max(3 * 3, * 2) = 2S.46 (See Topic 47) ©2013 Kaplan, Inc Page 297 Bonk Past FRM Exam Answers Question from the 2009 FRM Practice Exam 28* C VaR methodology Basel II prescribes a 10-day VaR at 99% confidence level for capital charge computation* However, bants arc free to choose the method to compute VaR* A Incorrect Stress testing and backtesting arc used to supplement and validate the results of capital computation, and arc not the method per sc to be adopted for capital computation B Incorrect Internal rating approach and vendor models are something associated with credit risk rather than market risk* D Incorrect Regulation prescribes VaR and not ETL or CVaR, even when it is known that VaR is not sub-additive at all times (Sec Topic 47) Question from the 2009 FRM Practice Exam 29 B It assumes market, credit, and operational risks have zero correlation The approach as*sumcs a correlation of one There is no capital charge for structural interest rate risk under Basel II* Operational risk includes legal risk* It uses a ten-day horizon for market risk (See Topic 4?) Question from the 2009 FRM Practice Exam 30 B The standardized approach makes it advantageous for a bank to book losses early if doing so reduces this year’s gross income sufficiently to make it negative Only positive gross income is included in the formula* Everything else is correct* (See Topic 47) Question from the 2009 FRM Practice Exam 31 C To evaluate exposure to high-severity operational risk events, banks using the AMA approach may use either scenario analysis of expert opinion, or VaR model estimates based on internal data using extreme value theory Everything is correct using the 2006 Basel II document except for c* The Basel II document requires the use of scenarios obtained with expert advice for high severity events when the bank uses only internal data (See Topic 47) Question from the 2009 FRM Practice Exam 32 C The advanced measurement approach (AMA) Under AMA, the capital charge is based on the banks internal measurement system Under the other approaches the capital charge is based upon the Gross Income, which has nothing to with risk exposure* (See Topic 47) Page 298 ©2013 Kaplan, Inc* Book Past FRM Exam Answers Question from the 2009 FRM Practice Exam 33- B Key risk indicators KRI is not included in the Basel document at all, (See Topic 47) Question fiom the 2009 FRM Practice Exam , 34, D A bank, acting as a trustee for a Joan pool, receives Jess than the projected funds: due to delayed repayment of certain loans, A broad interpretation of the FDIC and Basel IT rules defining operational risks would consider all, hut alternative d, as operational risk events and operational risk losses, A Joan officer entering inaccurate client financial information into the banks proprietary credit risk model is a process risk and any losses attributable to this employee error should be considered as an operational risk event Customers writing checks exceeding the balance of a checking account and depositing the funds in a savings account is an example of check kiting If during times of adverse market movementÿ the computer network becomes overwhelmed and only delayed pricing information reaches tlie hank’s trading desk and trades arc based on the available information, the bank is subject to business disruption and system failures, "When a bank, acting as a trustee for a Joan pool, receives less than the projected funds due to delayed repayment of certain Joans in the pool , it is not an operational risk loss event (See Topic 47) Question from the 2008 FRM Practice Exam 35, B It is the ratio of the nominal size of the tranche of interest to the notional amount of exposures in the pool A Incorrect, It is not the correct definition, as per Basel II accord, B, Correct, It is the correct definition, as per Basel II accord C Incorrect, It is not the correct definition, as per Basel TI accord D Incorrect It is not the correct definition, as per Basel TI accord, (See Topic 47) Question from the 2008 FRM Practice Exam 36, A LCD* = LCD x (E* / E) A* Correct, The formula for LCD* Is correct, B Incorrect The formula for LCD* is incorrect C, Incorrect The formula for LCD* is incorrect D Incorrect The formula for LCD11 is incorrect (See Topic 47) Question from the 2008 FRM Practice Exam 37, D All of the above A, Incorrect D is the best choice, B Incorrect D is the best choice, C, Incorrect D is the best choice, D Correct, It is the best choice as per Basel II, (See Topic 47) ©2013 Kaplan, Inc Page 299 Book Past FRM Exam Answers Question from the 2008 FRM Practice Exam 38- A Corporate finance A- Correct- It has the highest Beta factor of 18%B- Incorrect It has a Beta factor of 12% C Incorrect It has a Beta factor of 5% D- Incorrect It has a Beta factor of 12% (See Topic 47) Question from the 2008 FRM Practice Exam 39- B Reputation Risk A- Incorrect It is an Operationaf Risk as per Basel IT Accord B Correct- It is not an Ope cation aE Risk as per Basel TJ AccordC- Incorrect It is an Operational Risk as per Basel IT Accord D Incorrect It is a Operational Risk as per Basel II Accord (See Topic 47) Question from the 2008 FRM Practice Exam 40- C Use external ratings for certain assets and use internal ratings for the rest of the assets A Incorrect It is a method allowed by Basel II for measuring Credit Risk B- Incorrect It is a method allowed by Basel II for measuring Credit Risk C- Correct- Basel II committee does not allow cherry pickingD- Incorrect C is correct (See Topic 47) Question from the 2008 FRM Practice Exam 41- D Origination of various types of credit exposures A- Incorrect It is an area of responsibility of Credit Risk Control (unction B- Incorrect It is an area of responsibility of Credit Risk Control function C- Incorrect It is an area of responsibility of Credit Risk Control function D- Correct It is not an area of responsibility of Credit Risk Control function (See Topic 47) Question from the 2008 FRM Practice Exam 41 C II only I This condition is correct U The insurance must be through an unaffiliated third party here 10% owned would be considered an affiliate party HE This condition is correct IV This condition is correct (Sec Topic 47) Question from the 2008 FRM Practice Exam 43- A Under the advanced IRB approach, banks arc allowed to use their own estimates of PD, LCD, EAD, and correlation coefficient, within the risk-weight functions provided by the supervisors Under the advanced IRB approach, banks arc allowed to provide their own estimate of PD, LGD, and EAD, but must use the correlation coefficient formula specified by the supervisor (See Topic 47) Page 300 ©2013 Kaplan, Inc Book Past FRM Exam Answers Questionfrom the 2011 FRM Practice Exam 44 D USD 222,893 Maikct Risk Capital Charge = MAX[40,000 * SQRT(lO) f 1.65 x 2326, x 25,000 x SQRT(10) i 1.65 x 2326] = 222,893 Candidate is required to convert the VaR (95%, l 'day) to a 99% 10-day VaR (See Topic 50) Question from the 2011 FRM Practice Exam 45 D USD 267,471 Maikct Risk Capital Charge = MAX[30,000 x SQRT(10) f 1,65 * 2326, x 20,000 x SQRT(10 ) / 1.65 x 23261 267,471 Candidate is required to convert the VaR (95%, l-day) to a 99% 10-day VaR, - (See Topic 50) ©2013 Kaplan, Inc Page 301 FORMULAS Operational anti Integrated Risk Management Topic 34 economic capital - (operational value at risk} - (expected loss) = unexpected loss risk-adjusted return on capital: RAROC = revenues - expected loss - expenses -f return on economic capital ± transfer price economic capital market risk capital charge = FL(VaR) + F2[max(VaR limit — VaR, 0)J + [max(VaR - VaR limit, 0)] F3 where: F L = a constant that adjusts for the day-to-day event risk not captured in the VaR model F3 = multiplier used to determine the charge for the unused portion of the VaR limit F3 = multiplier used to determine the charge for exceeding die VaR limit adjusted RAROC: ARAROC = (RAROC -Rp} 3E where: |3E = systematic risk of the firm's equity Rp risk-free rate of return - Topic 37 — ——— — ,leverage ratio: L = A = -CE + D)- -f- D — T n E F - leverage effect: ROE (leverage ratio * ROA} - [(leverage ratio - 1} x cost of debt] transactions cost confidence interval: +/- P x H(s + 2.33(T5} where: P = an estimate of the next day asset midprice, usually set to P, the most recent price observation s = expected or typical bid-ask spread o5 = sample standard deviation of die spread spread risk factor: Vi(s + 2.33o5) Page 302 ©2013 Kaplan, Inc Book Form ulus Topic 38 spread = (ask price - bid price) (ask price + bid price) / liquidity-adjusted VaR (constant spread): LVaR = (V x a) + [0.5 x V x spread] x LVaR = VaR + LC where: V = asset (or portfolio) value confidence parameter (T standard deviation of returns = - lognormal VaR: VaR = [1 - exp(p — a x zfl)] x V LVaR VaR =1+ X [1 elasticity: E = — spread exp(—a X za )] AP/P AN/N where: AN/N = size of the trade relative to the entire market AN AP LVaR = VaRx 1-— = VaRx -Ex P LVaR VaR combined LVaR VaR N exiiÿeiiuiu LVaR VaR enclcjjeiKMis ©2013 Kaplan, Inc Page 303 Book $ Formulas Topic 42 standard error for a non- parametric estimator: ] %p) JPGÿP) where: f = the prohahility density function qp - the quantile associated widi probability p and sample size n Topic 47 capital ratio: basic risk- based capital calculation = total capital total risk-weighted assets capital requirement for credit risk under the IRB framework: capital requirement (K) = [conditional EL - EL] x [maturity adjustment] [1 + (M- 2.5)1 xb(PD) [downturn - x G(0,999)} - LGD x PDl x LGDxNf —R l-1.5xb(PD) Topic 49 liquidity coverage ratio: stock of high-quality liquid asse ts >100% total net cash outflows over the next 30 calendar days net stable funding available amount of stable funding >100% required amount ol stable funding ratio: Topic 50 , stressed VaR: max {SVaR, , M Page 304 x SVaRÿ} ©2013 Kaplan, Inc INDEX A conditional VaR 112 accounting date 250 adj usted RAROC advanced measurement approach 191, 243 adverse price impact 63 adverse selection 63 asset-liability management 53 audit findings 143 available stable Rinding sources 224 contingent capital 212 control environment 44 convertible arbitrage hedge funds 54 constant spread approach 74 convolution 111 Cooke ratio 174 corporate operational risk function 138 countercyclical buffers 211 counterparty credit risk 32, 207 CrashMctrics 81 B backtesting 189, 209 baif-in debt 212 balance sheet risk 52 bank run 132 Basel I Accord 173 Basel II Accord 180 Basel III Accord 200 bas ic i ndicator approach 190 basis risk 44 bid-ask spread 72 binomial distribution 108 business environment and internal control fac¬ tors 246 business line management 137 business process mappings l43 c calibration error 88 capital conservation buffer 206 capital ratio 175 capital requirement 177 capital surcharges 212 cash 66 cash flow at risk 80 cash flow mapping 43 coherence 163 cobcrent risk measure 25 collateral markets 55 credit capital charge 17 credit risk 15 credit risk mitigation 178 credit value adjustments 207 crisis'Scenario analyses 81 cross-margin agreements 56 D data aggregation 156 data capture bias 108 date of discovery 250 date of recurrence 250 dealer banks 126 delta-gamma approximation depth 66 diseconomies of scope 129 downturn LG D 85 duration-convexity mapping 43 dynamic strategics 44 E economic capital 13, 25, 99, 105, 11, 184 economics of scope 29 effective expected positive exposure 207, 208 effective maturity S3 comparative advantage 100 comparative analysis 143 comprehensive approach 187 Comprehensive Capital Analysis and Review 163 concentration of funding 227 conditional default threshold 186 elasticity 78 embedded leverage 59 endogenous liquidity 73 enterprise risk management 95 equity exposures 184 event-driven strategies 44 exogenous liquidity 73 exogenous spread approach 76 expected loss 184 expected shortfall 26 exploratory data analysis 253 ©2013 Kaplan, Inc Page 305 Book Index exposure at default 177, S3, 208 external data 246 external operational loss data 143 external ratings' based approach 88 firm-wide VaR 98 fractional-reserve bank 53 frequency distributions 108 liquidity 52 liquidity-adjusted VaR 73 liquidity at risk SO liquidity coverage ratio 213, 220, 259 liquidity risk 43, 52, 72 lognormal VaR 75 loss distribution approach 105 loss given default 177,1113 low frequency high impact events 252 funding liquidity 52 M G mapping 43 margin loans 56 market risk 15,42 market risk capital requirement 16, 237 market risk factors 236 maturity adjustment 77, 187 maturity mismatch 52, 227 merger arbitrage hedge funds 54 minimum capital requirement 260 minimum capital standards 204 modeling thresholds 246 model risk 4l, 87 money market mutual fund 54 monitoring tools 230 monotonicity 25 moral hazard 173 F gap risk 15 generalized Pareto distribution 110, 121 goodness-of-fir tests 253 gross leverage 61 gross loss 244 H haircut 55 heavy-tailed losses 119 high frequency low impact events 252 high-quality liquid assets 220 I implementation risk 88 independent operational risk management function 138 independent reviews 138 independent risk oversight unit 91 Internal Capital Adequacy Assessment Process 263 internal loss data 246 internal loss data threshold 245 internal models approach 189 internal operational loss data 143 internal ratings-based approach 174 intrinsic value 61 inventory management 63 IT infrastructure 155 IT risk management policy 54 K key performance indicators 43 key risk indicators 143 L level assets 221 level assets 22 leveraged buyouts 54 leverage effect 57 leverage ratio 57,211 Page 306 N negative binomial distribution 108 cash outflows 221 net leverage 61 net loss 244 net stable funding ratio 2l3, 223, 259 novation 130 net o old losses 108 operational risk 15, 42, 137 operational risk categories 251 operational risk governance 137 operational risk management framework 142, 247 operational risk measurement system 247 OTC derivatives market 126 outsourcing 145 Own Risk and So Ivency Assessment 264 V pcaks-ovcr-thrcshold 110 Pillar 191,262 Pillar 192,263 Pillar 194,266 ©2013 Kaplan, Inc Book Index Poisson distribution 108 portfolio invariant 186 positive homogeneity 25 prime broker 127 probability of default 177, 183 procyclical amplification 211 programming errors 88 public private investment partnership 133 R ratings-based approach 178 rebate 56 reference dates 249 regulatory capital 4, 99, 105 rehypothecation 55 remargining 55 rcplcdging 55 repo market 127 standardized approach (operational risk) ] 90 standardized method (market risk) 188 stressed value at risk 237 stress testing 161,209 structured investment vehicle 129 subadditivity 25 sub-exponential distributions 253 Supervisory Capital Assessment Program 162 supervisory formula approach 178,188 supervisory review process 192 systematic funding risks 54 systematic risk 95 systemic risk 52 T technology risk 145 Tier capital 180 Tier capital 181, 203 Tier capital 181 tightness 66 repos 56, 128 required stable funding 226 residual risks 193 resiliency 66 risk-adjusted return on capital 13 risk aggregation 27 risk and performance indicators 143 risk appetite framework time value 61 too-big-to-fail 173 total return swaps 56 toxic assets 133 trade processing costs 63 transactions cost 64 transactions liquidity 52 translation invariance 25 transparency 205 Troubled Asset Relief Program 133 risk assessments 143 risk data infrastructure 154 risk-weighted assets 164, 177, 204 rollover risk 52 truncation bias 108 s scale bias 08 scenario analysis l43, 246 securities lending 56 severity distributions 109 simpl c approach 187 slippage 63 solvency capital requirements 260 Solvency II 258 special purpose entity 129, 187 specific risk charges 235 split Josses 108 spread risk factor 64 standard deviation 26 standardized approach (credit risk) 176, 181 u unencumbered assets 228 unexpected losses 184 unpl edged assets 66 V validation 248 value at risk 16, 26 VaR model 42 verification 248 w wrong-way risk 208 ©2013 Kaplan, Inc Pagp 307 Notes Book Past FRM Exam Questions 4, Which of the following statements correctly describes the risks of commercial banking? I, II, III, Commercial banking is more exposed to operational risk than credit risk, Commercial banking is less exposed to market risk dran operational risk, Commercial banking is more exposed to credit risk dian market risk, A I only B II and III C Ill only D, I and III Jeremy Park and Brian Larksen are both portfolio managers who hold identical long positions worth GBP 100 million in the FTSE 1000 index To hedge their respective portfolios, Park shorts FTSE 1000 futures contracts while Larksen buys put options on the FTSE 1000, Who has a higher Liquidity-at-Risk (LaR) measure? A Larksen Park C Both have the same LaR D, Insufficient information to determine B, Major Investments is an asset management firm with USD 25 billion under managjement It owns 20% of the stock of a company Major Investments’ risk manager is concerned that, in the event the entire posidon needs to be sold, it size would affect the market price His estimate of the price elasticity of demand is -0,5, What is die increase in Major Investments’ Value-at-Risk estimate for this position if a liquidity adjustment is made? A 4% B, 10% C 15% D 20% 7, You are a manager of a renowned hedge fund and are analyzing a 1,000 share position in an undervalued but illiquid stock BNA, which has a current stock price of USD 72 (expressed as the midpoint of the current bid-ask spread) Daily return for BNA has an estimated volatility of 1.24% The average bid-ask spread is USD 0.16, Assuming returns of BNA are normally distributed, what is the estimated liquidity-adjusted daily 95% VaR, using the constant spread approach? A USD 1,3S9 B USD 1,469 C USD 1,549 D USD 1,629 ©2013 Kaplan, Inc Page 279 ... the foundation IRB approach produces the following risk weights: PD 0. 03% 1% 5% 20 % Risk Weight 14.44% 92. 32 % 149.86% 23 8 . 23 % While it is unlikely that you will he tested on these exact risk weightings,... Figure 3: Minimum Risk Weights for Claims on Banks Options and Credit Evaluation of Sovereign Risk weight (1) AAAtoAA— A* to A- BBB+ to BB3~ 20 % Credit Evaluation of Banks Risk weight (2) Risk... short¬ term claims (2) BB+ 100% 50% to B- 100% AAAtoAA— A* to A— BBB+ to BBB- BB+ to B- Below B- Unrated 150% 100% Below B- Unrated 20 % 50% 50% 100% 150% 100% 20 % 20 % 20 % 50% 150% 20 % Figure 4: Minimum