Pass the PRMIA PRM Certification 8008 Questions and answers with ExamsMirror

Statement I is not correct as VaR does not set an upper limit on losses. In this case, the bank expects the losses to exceed $253m 5% of the times, and the VaR number does not indicate any theoretical maximum amount of losses.Statement II is incorrect as there is a 95% (and not 5%) probability that the bank's losses will not exceed $253mStatement III is correct and describes VaR.Statement IV is incorrect, as regulatory capital is a more complex computation for which VaR is only one of the various input.Therefore Choice 'b' is the correct answer.

Under the CreditPortfolio View approach, the credit rating transition matrix is adjusted for the state of the economy in a way as to increase the probability of defaults when the economy is not doing well, and vice versa. Therefore Choice 'a' is the correct answer. The other choices represent nonsensical options.

Component VaR measures the proportion of total VaR that can be allocated to each asset in the portfolio. It is based upon the covariance matrix multiplied by the weights, and each row represents the component VaR for the asset in question. Since the total of such a matrix is the total VaR, component VaR is additive. Component VaR is used to assess the contribution of each asset in the portfolio to total risk and has the useful property of being additive so some sense can be made of the contribution of each asset to total risk.

Incremental VaR, conditional VaR and VaR are sub-additive by definition, and therefore not the correct answer.

Note that events of default under the ISDA MA are caused by one of the parties that is considered 'at fault'. In contrast, "termination events" are events for which no one is at fault, for example changes in legislation, illegality etc that still justify termination of the transactions under the contract.

The ISDA MA describes the following 8 types of events of default:

1. failure of pay or deliver

2. breach of agreement

credit support default

4. misrepresentation

5. default under specified transaction

6. cross default

7. bankruptcy

8. merger without assumption

All of the options presented in the question are events of default.

increasing the timing differences between the two legs of the transaction will increase settlement risk and not reduce it. Using escrow arrangements, such as central clearing houses to settle transactions (eg the DTCC in the United States) reduces settlement risk. Cash settlements based on netting arrangements reduce settlement risk, while physical delivery combined with gross cash payments increase it.

Therefore Choice 'a' is the correct answer.

A situation where a firm has more liabilities than assets does not necessarily imply default, so long as the firm is able to pay its obligations when they come due. Therefore, short term debts have a greater bearing on a firm's default than longer term debt. However, this is not to say that merely having enough to pay off the short term debts (ie debts due within one year) is enough to avoid default. Over time, the long term debt will also be turning to short term debt, and it may not be possible for the firm to roll over its liabilities without lenders considering the long term debt. The KMV approach considers the entire short term debt and half of the long term debt as the critical value of assets below which default will be triggered. Therefore Choice 'c' is the correct answer.

Generally, the probability of default is an input into determining the price of a security. However, if we know the market price of a security, we can back out the probability of default that the market is factoring into pricing that security. Market implied default probabilities are the probabilities of default priced into security prices, and can be determined from both bond prices and CDS spreads. Credit ratings issued by a credit agency do not give us 'market implied default probabilities', and neither does an internal scoring model like Altman's as these do not consider actual market prices in any way.

Therefore Choice 'b' is the correct answer and the others are not.

Three parameters define economic credit capital: the risk horizon, ie the time horizon over which the risk is being assessed; the confidence level, ie the quintile of the loss distribution; and the definition of credit losses, ie whether mark-to-market losses are considered in addition to default-only losses. The probability of default is not a parameter within the control of the risk manager, but an input into the capital calculation process that he has to estimate. Therefore Choice 'c' is the correct answer.

Conditional default probabilities are modeled as a logit function under CreditPortfolio view. That ensures the resulting probabilities are 'well behaved', ie take a value between 0 and 1. The probability may be expressed as = 1/ (1 + exp(I)), where I is a country specific index taking various macro economic factors into account.

All the listed variables are relevant to management monitoring the credit risk profile of an institution, therefore Choice 'd' is the correct answer.