Pass the PRMIA PRM Certification 8010 Questions and answers with ExamsMirror

Altman's Z-score, the Probit and the Logit models can all be used to assess the credit rating of an individual borrower. There is no such model as the 'distance todefault model', and therefore Choice 'a' is the correct answer.

The correct answer is choice 'a'

A long position in a credit sensitive bond is equivalent to earning the risk free rate and the spread on the bond. The risk freerate can be earned through a long position in a treasury bond, and the spread can be earned in the form of premiums on a CDS, which are received by the protection seller, ie the party short a CDS contract. Therefore we can get the same results as a long bond position using a combination of a long treasury bond and a short position in a CDS. Choice 'a' is the correct answer.

If capital calculations are done in a standard way regardless of risk (as reflected by credit ratings), then it creates a perverse incentive for the lenders' employees to lend to the riskiest borrowers that offer the highest expected returns as there is no incentive to 'save' on economic capital requirements that are equal for both safe and unsafe borrowers. Therefore statement I is correct.

Given that the portfolio of suchan institution is likely to then comprise poor quality borrowers, and economic capital would be based upon 'average' expected ratings, it is likely to carry lower economic capital given its exposures. Therefore any such economic risk capital model is likely to understate economic capital requirements. Therefore statement IV is correct.

Statements II and III are incorrect and Choice 'b' is the correct answer.

Statement I is correct. Data is often divided into two sets - a 'training set' that is used to create and fine-tune the model while the 'control set' is used to prove that the model works on sample data. Back testing is then perfomed using actual data that becomes available over time, or may already be available as historical data.

Statement II is incorrect. A risk manager often spends a great deal of time in managing data,and ensuring that the data being used is accurate enough for the purpose it is being used for. A risk manager can expect to spend a good part of his or her team's time in cleansing data. While he or she can try to get the IT processes and systems to produce correct data in the first place so it requires minimal subsequent cleansing or validation, this task is likely to remain a key part of a risk manager's role for quite some time in the future given the challenges nearly all organizations face in managingrisk data.

Statement III is correct. There was not enough granular data available on the underlying components of some of the derivative debt securities whose markets dried up during the crisis that began in 2007. This was because investors became increasingly unsure of what the value of these securities, such as CDOs was, leading to market seizure and firesale prices.

Statement IV is not correct. There is no easy solution to the lack of enough historical data, which is used to create as well as test models, and construct stress scenarios. Analytical approaches are not a good enough substitute for real market data. During the recent crisis, many instruments had rather short histories and there was not enough data available, and risk managers and portfolio managers relied upon analytical approaches to value and price them. Many of the assumptions that underpinned these approaches were untested in the real world and turned out to be incorrect.

Therefore Choice 'c' is the correct answer and the rest are incorrect.

CreditRisk+ treats default as a binary event, ignoring downgrade risk, capital structures of individual firms in the portfolio or the causes of default. It uses a single parameter, λ or the mean default rate, and derives credit risk based upon the Poisson distribution. Therefore Choice 'c' is the correct answer.

With the passage of time, the range of possible values the FX contract can take increases. Therefore the maximumvalue of the contract, which is when the credit risk would be maximum, would be at maturity. (Note that this is different than an interest rate swap whose value at maturity approaches zero.) Therefore Choice 'a' is the correct answer and the others are incorrect.

The credit spread is equal to thedefault rate times the loss given default, or stated another way, default rate times (1 - recovery rate). It is not equal to the default rate times the recovery rate. Therefore statement I is not correct.

When ratings are upgraded by rating agencies, the spread contracts and not widen. Therefore statement II is not correct.

Both recovery rates and probabilities of default are related to the business cycle, and they move in opposite directions. Economic recessions witness an increase in the default rate anda decrease in the recovery rate, and economic expansions result in a decrease in the default rate and an increase in the recovery rates when default does happen. Therefore statement III is correct.

Bond spreads incorporate both the risk of default, but also considerations of liquidity in the case of corporate bonds. Hence statement IV is correct.

Economic capitalis often calculated with a view to maintaining the credit ratings for a firm. It is the capital available to absorb unexpected losses, and credit ratings are also based upon a certain probability of default. Economic capital is often calculated at a levelequal to the confidence required for the desired credit rating. For example, if the probability of default for a AA rating is 0.02%, and the firm desires to hold an AA rating, then economic capital maintained at a confidence level of 99.98% would allow for such a rating. In this case, economic capital set at a 99.8% level can be thought of as the level of losses that would not be exceeded with a 99.8% probability, and would help get the firm its desired credit rating.

Choice 'c' is the correct answer. Economic capital does not target minimizing the cost of capital, nor is it a provision for losses arising from market risk. The concept of economic capital is unrelated to where an institution or firm is based, therefore Choice 'a' is incorrect as well.

The credit worthiness of the retail customer is certainly a factor for thebank to consider as it will need to price the loan to cover the expectation of default. At the same time, it will need to look at other loans in its portfolio as to avoid unacceptable concentration risk. A corollary of the same theme is that the bank willneed to take a portfolio view of the loan request and consider its contribution to total portfolio risk. Therefore all the choices are appropriate considerations for the bank and Choice 'd' is the correct answer.

The index option is affected by the spot value for the underlying index, as also the risk free interest rate, or the zero rate for the duration of the option. It is also affected by the volatility of the underlying.The 'strike price' is set and is fixed at the time the option is purchased, and therefore is not a risk factor.

Therefore other than IV, all other choices are valid risk factors that underlie an equity index option.

Other instruments may have other risk factors - for example, a long forex position will have the spot exchange rate as the only risk factor.