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principles of risk management

Questions and Answers of Principles Of Risk Management

What difference does it make to the worst-case scenario in Example 19.1 if(a) the options are American rather than European and (b) the options are barrier options that are knocked out if the asset
Suppose that the positions in the four options in Example 19.1 are changed to 200, −70, −120, and −60. Use the DerivaGem Application Builder and Solver to calculate the worst-case scenario for
Suppose that, in the example in Section 14.1, seven stress scenarios are considered.They lead to losses (in $000s) of 240, 280, 340, 500, 700, 850, and 1,050. The subjective probabilities assigned to
Explain the difference between subjective and objective probabilities.AppendixLO1
What are the advantages and disadvantages of bank regulators choosing some of the scenarios that are considered for stress testing?AppendixLO1
Why is it important for senior management to be involved in stress testing?AppendixLO1
What are traffic light options? What are their drawbacks?AppendixLO1
Why might the regulatory environment lead to a financial institution underestimating the severity of the scenarios it considers?AppendixLO1
What is reverse stress testing? How is it used?AppendixLO1
Explain three different ways that scenarios can be generated for stress testing.AppendixLO1
Use the transition matrix in Table 18.1 and software on the author’s website to calculate the transition matrix over 1.25 years.AppendixLO1
Suppose that a bank has a total of $10 million of small exposures of a certain type. The one-year probability of default is 1%and the recovery rate averages 40%. Estimate the 99.5% one-year credit
Explain carefully the distinction between real-world and risk-neutral default probabilities. Which is higher? A bank enters into a credit derivative where it agrees to pay $100 at the end of one year
Explain what is meant by (a) the specific risk charge and (b) the incremental risk charge.AppendixLO1
What is the autocorrelation for the default rates in Table 11.4, which can also be found on a spreadsheet on the author’s website? What are the implications of this for a Credit Risk Plus
Repeat Problem 18.6 on the assumption that the probability of default is equally likely to be 0.5% and 1.5%.AppendixLO1
A bank has 100 one-year loans each with a 1% probability of defaults. What is the probability of six or more defaults?AppendixLO1
How can historical simulation be used to calculate a one-day 99% VaR for the credit risk of bonds in the trading book? What are the disadvantages?AppendixLO1
Use the transition matrix in Table 18.1 and software on the author’s website to calculate a transition matrix for six months. What is the probability of a Aaa-rated company staying Aaa during the
Use the transition matrix in Table 18.1 to calculate a transition matrix for two years. What is the probability of a Aaa-rated company staying Aaa during the two years? What is the probability of it
Explain what is meant by the constant level of risk assumption.AppendixLO1
Explain the difference between the Vasicek’s model, Credit Risk Plus model, and CreditMetrics as far as the following are concerned: (a) when a credit loss is recognized and (b) the way in which
In Figure 17.3 where the CCP is used, suppose that an extra transaction between A and C which is worth 140 to A is cleared bilaterally. What effect does this have on the tables in Figure
Suppose that the spread between the yield on a three-year riskless zero-coupon bond and a three-year zero-coupon bond issued by a bank is 210 basis points.The Black-Scholes–Merton price of an
Consider a European call option on a non-dividend-paying stock where the stock price is $52, the strike price $50, the risk-free rate is 5%, the volatility is 30%, and the time to maturity is one
Extend Example 17.2 to calculate CVA when default can happen in themiddle of each month. Assume that the default probability per month during the first year is 0.001667 and the default probability
What is rehypothecation?AppendixLO1
A CSA between a dealer and one of its counterparties states that an independent amount of $5 million is required from the counterparty. If the cure period is assumed to be 15 days, under what
What part of CVA risk is included in market risk calculations by Basel III?AppendixLO1
DVA can improve the bottom line when a bank is experiencing financial difficulties.” Explain why this is so.AppendixLO1
“Netting affects the collateral that has to be posted and the settlement in the event of an early termination.” Explain.AppendixLO1
Explain the terms “threshold,” “cure period,” and “minimum transfer amount.”AppendixLO1
What credit risks is a company taking when it becomes a member of a CCP and clears transactions through the CCP?AppendixLO1
In Figure 17.3 where the CCP is used, suppose that half of the transactions between A and B that are represented by the solid line are moved to the CCP.What effect does this have on (a) the average
Give two examples of when (a) wrong-way risk and (b) right-way risk can be expected to be observed.AppendixLO1
What is the difference between an “Event of Default” and an “Early Termination Event” in an ISDA contract?AppendixLO1
Can the existence of default triggers increase default risk? Explain your answer.AppendixLO1
Suppose that the spread between the yield on a three-year riskless zerocoupon bond and a three-year zero-coupon bond issued by a corporation is 120 basis points. By how much do standard option
“In the absence of collateral and other transactions between the parties, a long forward contract subject to credit risk is a combination of a short position in a no-default put and a long position
Suppose that a financial institution has two derivatives transactions outstanding with different counterparties, X and Y. Which of the following is true?(a) The total expected exposure in one year on
A company offers to post its own equity as collateral. How would you respond?AppendixLO1
What is meant by a haircut in a collateral agreement?AppendixLO1
Explain why a new transaction by a bank with a counterparty can have the effect of increasing or reducing the bank’s credit exposure to the counterparty.AppendixLO1
Values for the NASDAQ composite index during the 1,500 days preceding March 10, 2006, can be downloaded from the author’s website. Calculate the one-day 99% VaR on March 10, 2006, for a $10 million
The “volatility-updating” procedure in Section 14.3 gives the one-day 99%VaR equal to $602,968. Use the spreadsheets on the author’s website to calculate the one-day 99% VaR when the
The “weighting-of-observations” procedure in Section 14.3 gives the one-day 99% VaR equal to $282,204. Use the spreadsheets on the author’s website to calculate the one-day 99% VaR when the
Investigate the effect of applying extreme value theory to the volatilityadjusted results in Section 14.3 with u = 350.AppendixLO1
Suppose that the portfolio considered in Section 14.1 has (in $000s) 3,000 in DJIA, 3,000 in FTSE, 1,000 in CAC 40, and 3,000 in Nikkei 225. Use the spreadsheet on the author’s website to calculate
Suppose that a one-day 97.5% VaR is estimated as $13 million from 2,000 observations. The one-day changes are approximately normal with mean zero and standard deviation $6 million. Estimate a 99%
Carry out an extreme value theory analysis on the data from the volatilityupdating procedure in Table 14.7 and on the author’s website. Use u = 400.What are the best fit values of and ? Calculate
Change u from 160 to 150 in the application of EVT in Section 14.6. How does this change the maximum likelihood estimates of and ? How does it change the one-day 99% VaR when the confidence limit
In the application of EVT in Section 14.6, what is the one-day VaR with a confidence level of 97%?AppendixLO1
In the application of EVT in Section 14.6, what is the probability that the loss will exceed $400,000?AppendixLO1
The “volatility-updating” procedure in Section 14.3 gives the one-day 99%VaR equal to $602,968 for the example considered. Use the spreadsheets on the author’s website to calculate the one-day
The “weighting-of-observations” procedure in Section 14.3 gives the one-day 99% VaR equal to $282,204 for the example considered. Use the spreadsheets on the author’s website to calculate the
Use the spreadsheets on the author’s website to calculate a one-day 99%VaR, using the basic methodology in Section 14.1, if the portfolio in Section 14.1 is equally divided between the four
The one-day 99% VaR is calculated in Section 14.1 as $253,385. Look at the underlying spreadsheets on the author’s website and calculate (a) the one-day 95% VaR and (b) the one-day 97%
Suppose we estimate the one-day 95% VaR (in millions of dollars) from 1,000 observations as 5. By fitting a standard distribution to the observations, the probability density function of the loss
Show that when approaches 1, the weighting scheme in Section 14.3 approaches the basic historical simulation approach.AppendixLO1
What assumptions are being made when VaR is calculated using the historical simulation approach and 500 days of data?AppendixLO1
A bank has the following balance sheet:Cash 3 Retail Deposits (stable) 25 Treasury Bonds ( 1 yr) 5 Retail Deposits (less stable) 15 Corporate Bonds Rated A 4 Wholesale Deposits 44 Mortgages 18
Explain one way that the Dodd–Frank Act is in conflict with (a) the Basel international regulations and (b) the regulations introduced by other national governments.AppendixLO1
Explain how CoCo bonds work. Why are they attractive to (a) banks and (b)regulators?AppendixLO1
What is CVA? What new regulations concerning CVA were introduced in Basel III?AppendixLO1
How would the Net Stable Funding Ratio in Example 13.1 change if half the wholesale deposits were replaced by stable retail deposits?AppendixLO1
Explain how the Liquidity Coverage Ratio and the Net Stable Funding Ratio are defined.AppendixLO1
Explain how the leverage ratio differs from the usual capital ratios calculated by regulators.AppendixLO1
Suppose that the Tier 1 equity ratio for a bank is 6%. What is the maximum dividend, as a percent of earnings, that can be paid if (a) there is no countercyclical buffer and (b) there is a 2.5%
By how much has the Tier 1 equity capital (including the capital conservation buffer) increased under Basel III compared with the Tier 1 equity capital requirement under Basel I and II?AppendixLO1
What is the difference between the capital required for a AAA-rated ABS with principal of $100 million and a AAA-rated ABS CDO with a principal of$100 million using the standardized
Explain how the incremental risk charge is calculated. Why was it introduced by the Basel Committee?AppendixLO1
What is the difference between VaR as it has been traditionally measured and stressed VaR?Basel 2.5, Basel III, and Dodd–Frank 301 AppendixLO1
What are the six major components of Basel III?AppendixLO1
What are the three major components of Basel 2.5?AppendixLO1
Suppose that the assets of a bank consist of $500 million of loans to BBB-rated corporations. The PD for the corporations is estimated as 0.3%. The average maturity is three years and the LGD is 60%.
A bank has the following transaction with a AA-rated corporation(a) A two-year interest rate swap with a principal of $100 million that is worth $3 million(b) A nine-month foreign exchange forward
Estimate the capital required under Basel I for a bank that has the following transactions with another bank. Assume no netting.(a) A two-year forward contract on a foreign currency, currently worth
Why is there an add-on amount in Basel I for derivatives transactions? “Basel I could be improved if the add-on amount for a derivatives transaction depended on the value of the transaction.”
Section 9.10 discusses how statistics can be used to accept or reject a VaR model. Section 12.6 discusses guidelines for bank supervisors in setting the VaR multiplier mc. It explains that, if the
Suppose that the assets of a bank consist of $200 million of retail loans (not mortgages). The PD is 1% and the LGD is 70%. What is the risk-weighted assets under the Basel II IRB approach? What are
Explain the difference between the basic indicator approach, the standardized approach, and the advanced measurement approach for calculating operational risk capital under Basel II.AppendixLO1
Explain the difference between the standardized approach, the IRB approach, and the advanced IRB approach for calculating credit risk capital under Basel II.AppendixLO1
Explain the difference between the simple and the comprehensive approach for adjusting capital requirements for collateral.AppendixLO1
Equation (12.9) gives the formula for the capital required under Basel II. It involves four terms being multiplied together. Explain each of these terms.AppendixLO1
Banks sometimes use what is referred to as regulatory arbitrage to reduce their capital. What do you think this means?AppendixLO1
Under Basel I, banks do not like lending to highly creditworthy companies and prefer to help them issue debt securities. Why is this? Do you expect the banks’ attitude to this type of lending to
What is the difference between the trading book and the banking book for a bank? A bank currently has a loan of $10 million dollars to a corporate client.At the end of the life of the loan, the
Explain why the final stage in the Basel II calculations for credit risk (IRB), market risk, and operational risk is to multiply by 12.5.AppendixLO1
All the transactions a bank has with a corporate client are loans to the client.What is the value to the bank of netting provisions in its master agreement with the client?AppendixLO1
What is the capital required in Problem 12.6 under Basel I assuming that the 1995 netting amendment applies?AppendixLO1
Estimate the capital required under Basel I for a bank that has the following transactions with a corporation. Assume no netting.(a) A nine-year interest rate swap with a notional principal of $250
A four-year interest rate swap currently has a negative value to a financial institution. Is the financial institution exposed to credit risk on the transaction?Explain your answer. How would the
In a currency swap, interest on a principal in one currency is exchanged for interest on a principal in another currency. The principals in the two currencies are exchanged at the end of the life of
An interest rate swap involves the exchange of a fixed rate of interest for a floating rate of interest with both being applied to the same principal. The principals are not exchanged. What is the
“The existence of deposit insurance makes it particularly important for there to be regulations on the amount of capital banks hold.” Explain this statement.AppendixLO1
“When a steel company goes bankrupt, other companies in the same industry benefit because they have one less competitor. But when a bank goes bankrupt other banks do not necessarily benefit.”
The default rates in the last 15 years for a certain category of loans is 2%, 4%, 7%, 12%, 6%, 5%, 8%, 14%, 10%, 2%, 3%, 2%, 6%, 7%, 9%. Use the maximum likelihood method to calculate the best fit
Suppose that a bank has made a large number loans of a certain type. The oneyear probability of default on each loan is 1.2%. The bank uses a Gaussian copula for time to default. It is interested in
Create an Excel spreadsheet to produce a chart similar to Figure 11.5 showing samples from a bivariate Student t-distribution with four degrees of freedom where the correlation is 0.5. Next suppose
The probability density function for an exponential distribution is e−x where x is the value of the variable and is a parameter. The cumulative probability distribution is 1 − e−x. Suppose

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