Pass the GARP Financial Risk and Regulation 2016-FRR Questions and answers with ExamsMirror

Modified duration of a bond measures the sensitivity of the bond's price to changes in interest rates. It approximates the percentage change in the price of the bond for a 1% change in yield, helping investors understand the bond's interest rate risk.

Retail products frequently include embedded options, such as early withdrawal options or prepayment options, which customers may not exercise rationally. In contrast, wholesale products typically carry penalties for repayment or include rights to terminate contracts on terms that are different from those in retail products. These distinctions are important for asset and liability management because they affect the predictability and stability of cash flows.

An asset-sensitive bank has more rate-sensitive assets than rate-sensitive liabilities. This results in a positive cumulative gap, meaning the bank will benefit from rising interest rates. As interest rates increase, the income from rate-sensitive assets will increase more than the expense on rate-sensitive liabilities, improving the bank's net interest income.

In this scenario, the trade was mistakenly accounted for as a sell order instead of a buy order. If the price of Eureka Corporation bonds goes up, this mistake would result in a larger loss than if the market remained stable. Conversely, if the market drops, the customer would benefit from the incorrect accounting. This example illustrates how market risk (the change in the price of the bonds) can magnify operational risk (the error in accounting for the trade incorrectly).

To determine the pound exposure in the aggregated risk reports, we sum the net positions:

Long £500 million:

The bank holds a long position of £500 million.

Short £300 million in delta-equivalent pound options:

This position reduces the exposure by £300 million.

Long £100 million in pound-denominated stocks:

This adds £100 million to the exposure.

Net exposure: 500−300+100=300 million pounds500 - 300 + 100 = 300 \, \text{million pounds}500−300+100=300million pounds

Thus, the pound exposure shown in the aggregated risk reports is £300 million.

References

Source: How Finance Works​

According to JPMorgan Chase's definitions in their annual report, the following are considered non-trading risk exposures:

Loans held to maturity: These are not traded and are held until they are repaid.

Mortgage servicing rights: These involve servicing mortgages rather than trading them.

Derivatives used to manage asset/liability exposure: These derivatives are used for hedging purposes rather than trading.

Short term equity investments are typically considered trading exposures.

When computing VaR using parametric methods, a common implicit assumption is that both the mean and standard deviation of returns are constant over time.

Constant Mean: The expected return of the asset or portfolio does not change over the time period considered.

Constant Standard Deviation: The volatility of returns, which measures the dispersion of returns from the mean, is assumed to be constant.

This assumption simplifies the calculations as it allows the use of historical data to estimate future risks. However, it may not always hold true in real-world scenarios where markets can exhibit changing volatility and return patterns.

References

How Finance Works.pdf, p. 201 ​

Explanation:

The convexity of a portfolio of bonds is calculated as the value-weighted average convexity of the individual bonds. This considers the proportion of each bond's value in relation to the total portfolio value.

ReferencesExplanation based on portfolio management principles.

The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt (Treasuries). A rising TED spread indicates that lenders believe the risk of default on interbank loans is increasing. This typically reflects increased credit risk, market risk, and liquidity risk among banks. Higher TED spreads suggest that banks are less willing to lend to each other due to concerns about their solvency and liquidity positions.

A bank customer can use either a plain vanilla option or an option contract with volumetric flexibility to reduce market risk and basis risk. Market risk involves the risk of changes in market prices, and basis risk involves the risk that the derivative's price does not move perfectly with the underlying asset. Operational risk, on the other hand, involves risks related to internal processes, systems, or external events, which are not typically managed through financial derivatives like options.

References

Verified from the discussion on managing market and basis risks with options in the book "How Finance Works"​​.