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FRM Part I Exam

By AnalystPrep

Questions with Answers - Valuation and Risk Models

Last Updated: Mar 20, 2023

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Table of Contents

47 - Measures of Financial Risk 3

48 - Calculating and Applying VaR 24
49 - Measuring and Monitoring Volatility 62
50 - External and Internal Credit Ratings 113
51 - Country Risk 128
52 - Measuring Credit Risk 146
53 - Operational Risk 188
54 - Stress Testing 215
55 - Pricing Conventions, Discounting, and Arbitrage 263
56 - Interest Rates 285
57 - Bond Yields and Return Calculations 310
58 - Applying Duration, Convexity, and DV01 329
59 - Modeling and Hedging Non-Parallel Term Structure Shifts 355
60 - Binomial Trees 367
61 - The Black-Scholes-Merton Model 396
62 - Option Sensitivity Measures: The “Greeks” 421

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Reading 47: Measures of Financial Risk

Q.939 Billy Marquette has recently joined a small company that provides private commercial jets to
royal families, government officials, and directors of big firms. Marquette is a retired commercial
pilot with a very basic understanding of finance. On his first day, he is handed a report on risk
management measures. T he excerpt from the report says “due to volatility in oil prices, the
company has a weekly 90% VaR of €20,000”. Which of the following is the most appropriate
explanation of the excerpt?

A. T here is a 90% probability that the company will experience a loss of €2,000 on a weekly
basis.

B. T here is a 10% probability that the company will experience a loss of €20,000 in any
given week.

C. T here is a 90% probability, in any given week, that the company will experience a loss of
more than €20,000.

D. T here is a 10% probability, in any given week, that the company will experience a loss in
excess of €20,000.

T he correct answer is D.

VaR is a probabilistic risk measure that measures the potential loss in the value of the portfolio at
any given time.
T he “weekly 90% VaR" means that we are 90% confident that the company will lose not more than
€20,000 in any given week. Put differently, there's a 10% chance that the company will lose more
than €20,000.

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Q.975 Anshuman, a risk consultant working at Dominic Republic Bank, uses VaR to measure the risks
of his bank’s positions. He makes the following statements in his consultant report with regard to
VaR. Which of the following statement(s) can be accepted by the risk committee of the firm?
I. VaR is simply the negative of the qp quantile of the profit and loss (P/L) distribution
II. VaR is defined contingent on two arbitrarily chosen parameters: a confidence level and a holding
or horizon period
III. VaR not only rises with the confidence level but rises at a decreasing rate

A. I only.

B. I and II only.

C. II and III only.

D. All of the above.

T he correct answer is B.

Statement I is correct: VaR is simply the negative of the qp quantile of the profit and loss (P/L)
distribution (where α is the confidence level, and p = 1 - α ).
Statement II is correct: VaR is defined contingent on two arbitrarily chosen parameters: a
confidence level α , which indicates the likelihood that we will get an outcome no worse than our
VaR, and which might be any value between 0 and l; and a holding or horizon period, which is the
period of time until we measure our portfolio profit or loss.

Statement III is incorrect: T he VaR not only rises with the confidence level but also rises at an
i ncreasi ng rate.

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Q.978 ANG National Bank intends to use the coherent risk measure to measure the risk of its assets.
A risk measure is said to be coherent if it satisfies the properties such as:
I. Monotonicity
II. Sub-additivity
III. Homogeneity
IV. T ranslational invariance

A. I, III & IV only

B. I, II & IV only

C. II, III & IV only

D. All of the above

T he correct answer is D.

A risk measure summarizes the entire distribution of dollar returns X by one number, ρ (X). T here
are four desirable properties every risk measure should possess. T hese are:

I. Monotoni ci ty: If X 1 ≤ X 2 , ρ (X 1) ≥ ρ (X 2)

Interpretation: If a portfolio has systematically lower values than another, in each state of

the world, it must have greater risk.

II. Subaddi ti vi ty: ρ (X 1 + X 2) ≤ ρ (X 1 ) + ρ (X 2)

Interpretation: When two portfolios are combined, their total risk should be less than (or

equal to) the sum of their individual risks. Merging of portfolios ought to reduce risk.

III. Homogenei ty: ρ (kX) = kρ (X)

Interpretation: Increasing the size of a portfolio by a factor k should result in a

proportionate scale in its risk measure.

IV. Transl ati on i nvari ance: ρ (X + h) = ρ (X) − h

Interpretation: Adding cash h to a portfolio should reduce its risk by h. Like X , h is measured

in dollars.

Remember that value at risk (VaR) is not a coherent risk measure because it fails the subadditivity
test, whereas expected shortfall (ES) is a coherent risk measure.

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Q.980 John Adams, a newly recruited junior analyst, is asked to compare expected shortfall and Value
at Risk. He jots down the following points in his notes. Which of them are correct?
I. While the expected shortfall (ES) tells what to expect in bad states, i.e., it gives an idea of how bad
might it be, Value at Risk tells us nothing other than to expect a loss higher than the Value at Risk
itself
II. T he expected shortfall-based rule is consistent with expected utility maximization if risks are
rankable by a second-order stochastic dominance rule, while a Value-at-Risk-based rule is only
consistent with expected utility maximization if risks are rankable by a more stringent first-order
stochastic dominance rule
III. T he expected shortfall and Value at Risk always satisfy sub-additivity
IV. Finally, the subadditivity of ES implies that the portfolio risk surface will be convex, and
convexity ensures that portfolio optimization problems using ES measures, unlike ones that use VaR
measures, will always have a unique well-behave optimum

A. I, III & IV only

B. I, II & IV only

C. II, III & IV only

D. All of the above

T he correct answer is B.

Statement I is correct: While the expected shortfall (ES) tells what to expect in bad states, i.e., it
gives an idea of how bad might it be, Value at Risk tells us nothing other than to expect a loss higher
than the Value at Risk itself.
Statement II is correct: T he expected shortfall-based rule is consistent with expected utility
maximization if risks are rankable by a second-order stochastic dominance rule. On the contrary, a
Value-at-Risk-based rule is only consistent with expected utility maximization if risks are rankable by
a more stringent first-order stochastic dominance rule.

Statement III is incorrect: T he expected shortfall always satisfies sub-additivity, while the Value at
Risk does not.

Statement IV is correct: Finally, the subadditivity of ES implies that the portfolio risk surface will be
convex, and convexity ensures that portfolio optimization problems using ES measures, unlike ones
that use VaR measures, will always have a unique well-behaved optimum.

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Q.981 Andrew Simons, a risk analyst, is working on risk measures. He is particularly interested in
the risk aversion property of risk measures.
Which of the following statement(s) is/are true with regard to the risk aversion property of risk
measures?

I. If a user has a ‘well-behaved’ risk-aversion function, then the weights will rise smoothly, and the
rate at which weights rise will be related to the degree of risk aversion: the more risk-averse the
user, the more rapidly the weights will rise
II. Expected shortfall is characterized by all losses in the tail region having the same weight implying
that the user is risk-neutral between tail-region outcomes
III. In case of Value at Risk (VaR), the weight of the loss associated with a p-value equal to α implies
that the user is actually risk-loving

A. I and II only.

B. I only.

C. II and III only.

D. All of the above.

T he correct answer is D.

Statement I is correct: If a user has a ‘well-behaved’ risk-aversion function, then the weights will
rise smoothly, and the rate at which weights rise will be related to the degree of risk aversion: the
more risk-averse the user, the more rapidly the weights will rise.
Statement II is correct: Expected shortfall is characterized by all losses in the tail region having the
same weight implying the user is risk-neutral between tail-region outcomes.

Statement III is correct: With Value at Risk (VaR), a larger weight to the loss associated with a p-
value equal to α and zero weight to any greater loss implies that the user is actually risk-loving

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Q.3325 Which of the following is NOT a property of coherent risk measures?

A. Y ≥ X ⇒ ρ(Y ) ≥ ρ(X )

B. ρ(X + Y ) ≤ ρ(X) + ρ(Y )

C. ρ(hX) = hρ(X) for h > 0

D. ρ(x + n) ≤ ρ(X) − n for some n

T he correct answer is A.

Option A gets monotonicity wrong. It should be: Y ≥ X ⇒ ρ(Y ) ≤ ρ(X )

A risk measure summarizes the entire distribution of dollar returns X by one number, ρ (X). T here

are four desirable properties every risk measure should possess. T hese are:

I. Monotoni ci ty: If X 1 ≤ X 2 , ρ (X 1) ≥ ρ (X 2)

Interpretation: If a portfolio has systematically lower values than another, in each state of

the world, it must have a greater risk.

II. Subaddi ti vi ty: ρ (X 1 + X 2) ≤ ρ (X 1 ) + ρ (X 2)

Interpretation: When two portfolios are combined, their total risk should be less than (or

equal to) the sum of their individual risks. Merging of portfolios ought to reduce risk.

III. Homogenei ty: ρ (kX) = kρ (X)

Interpretation: Increasing the size of a portfolio by a factor k should result in a

proportionate scale in its risk measure.

IV. Transl ati on i nvari ance: ρ (X + h) = ρ (X) − h

Interpretation: Adding cash h to a portfolio should reduce its risk by h. Like X , h is measured

in dollars.

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Q.3328 An investment company has a portfolio which has the following ordered performance by
historical data. Calculate the expected shortfall ES0. 95 .

Probabilty 1% 5% 10% 12% 15%

Profit/Loss −500 −300 −100 −90 −50

A. 300

B. 340

C. 400

D. 425

T he correct answer is B.

Given a discrete distribution, the ES is the equivalent of:

1 1−α th
ES α = ∑ [p highest loss] × [probability of pth highest loss]
1 − α p=0

At α = 0.95,

[(0.01 × 500) + (0.04 × 300)]

ES0. 95 = = 340
0.05

Note: T he sum of probabilities in the numerator must sum to (1 − α)

Al ternati ve Approach

To calculate the expected shortfall, we must ask ourselves, "If we are in the worst 5% of the loss

distribution, what is the expected loss?" T he first column of the given table makes it clear that the

5% tail of the distribution is composed of a 1% probability that the loss is 500 and a 4% probability

that the loss is 300. Conditional on being in the tail of the distribution, there is, therefore, a 1/5

chance that the loss is 500 million and a 4/5 chance that it is 300. T he expected shortfall (in millions

of dollars) is, therefore:

1 4
( ) × 500 + ( ) × 300 = 340
5 5

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Q.3329 An investment company has a portfolio which has the following ordered performance by
historical data. Calculate the expected shortfall, ES0. 99 , i.e., at 99% level of confidence

Probabilty 1% 5% 10% 12% 15%

Profit/Loss −500 −300 −100 −90 −50

A. 168

B. 400

C. 460

D. 500

T he correct answer is D.

T here is only one number 500 beyond 1%, therefore, the average is 500.

Further Expl anati on

T he expected shortfall (also called conditional VaR) is the expected tail loss. It is the average of the

worst 100*(1-a)% of losses. For a discrete distribution, ES is derived as:

1 α
ES α = ∑ (pth loss × probability of pth loss)
1 − α p=0

In words, to determine the expected shortfall at a level of confidence a, we must find the average of

all the outcomes whose probability is less than or equal to 1 − a.

At a 99% confidence level, the significance level is 1%. To establish the expected shortfall at 1%, we

must find the average of all the outcomes whose probability is less than or equal to 1%. in this case,

(0.01 ∗ 500)
Expected shortfall = = 500
0.01

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Q.3397 A hypothetical portfolio of securities exhibits the following expected losses shown:

Name Loss (million dollar) Probability (%)

1 10 40%
2 20 35%
3 50 15%
4 100 5%
5 200 2.5%
6 225 2%
7 250 0.5%

Calculate the expected shortfall at the 95% and 99% confidence level?

A. ES (95%) = $225 million; ES (99%) = $237.5 million

B. ES (95%) = $215 million; ES (99%) = $237.5 million

C. ES (95%) = $217.5 million; ES (99%) = $250 million

D. ES (95%) = $225 million; ES (99%) = $250 million

T he correct answer is B.

Note that the given data are in expected losses. T he expected shortfall (also called conditional VaR)
is the expected tail loss. It is the average of the worst 100*(1-α)% of losses. For discrete
distribution, ES is derived as:

1 α
ESα = ∑ (pth loss × probability of pth loss)
1 − α p=0

In other words, to determine the expected shortfall at a level of confidence α, we must find the
average of all the outcomes whose probability is less than or equal to 1 - α.

At a 95% confidence level, the significance level is 5%. To establish the expected shortfall at 5%, we
must find the average of all the outcomes whose probability is less than or equal to 5%

200 × 2.5% + 225 × 2% + 250 × 0.5%

ES0. 95 = = 215 million dollars
5%

At a 99% confidence level, the significance level is 1%. To establish the expected shortfall at 1%, we
must find the average of all the outcomes whose probability is less than or equal to 1%

225 × 0.5% + 250 × 0.5%

ES0. 99 = = 237.5 million dollars
1%

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Q.3398 T he VaR of a loan portfolio is computed at various confidence levels:

Confidence Level VaR

95.0% 2%
95.5% 5%
96.0% 6%
96.5% 7%
97.0% 9%
97.5% 10%
98.0% 13%
98.5% 15%
99.0% 20%
99.5% 30%

What is the expected shortfall at the 97.5% confidence level?

A. 0.1

B. 0.15

C. 0.195

D. 0.2

T he correct answer is C.

T he expected shortfall at the 97.5% confidence level is computed by averaging all value of risk
greater than the 97.5% confidence level.
Expected shortfall at the 97.5% confidence level = (13% + 15% + 20% + 30%)/4 = 19.5%

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Q.3399 Among the given portfolios, which one falls below the Markowitz efficient frontier?

Portfolio Expected Return Expected Standard

Deviation
A 12% 10%
B 14% 12%
C 15% 12%
D 16% 20%

A. Portfolio A

B. Portfolio B

C. Portfolio B and C

D. Both Portfolio B and D

T he correct answer is B.

T he efficient frontier represents the set of optimal portfolios that offer the highest expected return
for a defined level of risk or the lowest risk for a given level of expected return. Any portfolio that
lies below the efficient frontier is sub-optimal because it does not provide enough return for the
level of risk.
Although portfolios B and C have the same level of risk, C offers a higher return per unit of risk. B is
a sub-optimal allocation since portfolio C, which has the same level of risk, offers a greater return,
hence portfolio B must fall below the efficient frontier.

Even though Portfolio D offers the lowest return per unit of risk, there is no enough information to

tell whether it falls below the efficient frontier.

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Q.3588 Which of the following statement is INCORRECT regarding the efficient frontier?

A. A risk-averse investor will only choose portfolios along the efficient frontier

B. Portfolios that deliver the greatest return on each level of standard deviation make up the
efficient frontier

C. T he graph that shows the efficient frontier has the variance on its Y-axis

D. None of the above

T he correct answer is C.

T he graph that demonstrates the efficient frontier has the standard deviation at its X-axi s and the
return on its Y-axis.
Option A is a correct statement. A well-known fact is that "presumably, investors are risk-averse;
hence, they will choose portfolios on the efficient frontier." Risk-averse investors can still be
rational and will choose portfolios on the left-side portion of the curve. Less risk-averse (more risk-
neutral) investors will choose portfolios on the right of the curve. But given this theory, ALL
rational investors will choose portfolios on the curve.

Option B is a correct statement. Portfolios that deliver the greatest return on each level of standard
deviation (or risk) make up the efficient frontier.

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Q.4639 A hypothetical portfolio has an annual 1% VaR of $45,000. Which of the following statements
is the most l i k el y correct about the portfolio?

A. T he loss over the next year is expected to be at most $45,000 in 1% of the cases.

B. T here is only a 1% chance that we will gain more than $45,000 over the next year.

C. T he likelihood of losing more than $45,000 over the next year is 1%.

D. T he likelihood of losing no more than $45,000 over the next year is 1%.

T he correct answer is C.

T he VaR gives the maximum amount of loss that can be incurred at a given level of confidence. An
annual 1% VaR of 45,000 means that we're 99% confident we'll lose no more than 45,000 over the
next year. It would also be correct to say that there's a 1% likelihood (probability) of the loss
exceeding $45,000. Put differently, the probability of losing more than $45,000 over the next year is
1%.

Option A is incorrect. T he loss over the next year is expected to be at most $45,000 in 99% of the

cases

Option B is incorrect: T here is only a 1% chance that we will l ose more than $45,000 over the next

year

Option D is incorrect: T he likelihood of losing no more than $45,000 over the next year is 99%

Note: 1% VaR refers to the VaR at the 99% level of confidence.

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Q.4640 T he investment returns and the corresponding probabilities are given in the following table:

Returns Probability
20% 0.1
30% 0.3
−10% 0.2
15% 0.3
7% 0.1

What is the standard deviation of the investment returns?

A. 0.142

B. 0.154

C. 0.132

D. 0.138

T he correct answer is A.

T he variance of the return R is given by:

V ar (R) = E (R 2 ) − [E (R)]2

Now,

E(R 2 ) = 0.1 × (20%)2 + 0.3 × (30%)2 + 0.2 × (−10%)2 + 0.3 × (15%)2 + 0.1 × (7%)2 = 0.04024
E (R) = 0.1 × 20% + 0.3 × 30% + 0.2 × −10% + 0.3 × 15% + 0.1 × 7% = 0.142
∴ V ar (R) = 0.04024 − (0.142)2 = 0.020076

T hus the standard deviation is given by:

√0.020076 = 0.1417 = 14.17%

Q.4641 An investor invests his funds in two correlated assets, A and B. T he standard deviation of
asset A is 20%, and that of B is 15%. T he portfolio variance is 2.84%. Given that the investor has
three times as much money in asset A than he has in asset B, what is the correlation coefficient
between assets A and B?

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A. 0.0962

B. 0.2133

C. 0.3994

D. 0.8078

T he correct answer is C.

T he variance of a portfolio is given by:

σp2 = w 2A σA2 + w 2BσB2 + 2ρw A w BσA σB

Where

W A : the weight of asset A

W B : the weight of asset B

σA : standard deviation of asset A

σB : standard deviation of asset B

ρ: correlation coefficient between asset A and B

Now let the amount invested in asset be B be w B and thus:

w A = 3w B
w B + 3w B = 1
1 3
∴ wB = ⇒ wA =
4 4

Now,

w 2AσA2 + w 2B σB2 + 2ρw A w BσA σB = 0.0284

2 2
3 1 3 1
( ) × 0.2 + ( ) × 0.152 + 2 × × × 0.2 × 0.15 × ρ = 0.0284
2

4 4 4 4
2 2
0.0284 − ( 34 ) × 0.22 − ( 14 ) × 0.152
⇒ρ= = 0.39944
2 × 0.15 × 0.2 × 14 × 34

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Q.4642 T he losses from a portfolio for one year are normally distributed with a mean of -10 and a
standard deviation of 20. What is the value of the one-year 99% VaR?

A. 35.6

B. 36.5

C. 37.5

D. 39

T he correct answer is B.

Denote the VaR level by t, then we need:

P (X < t) = 0.99

(Note we can also use P (X < t)=0.01.)

Standardizing the normal distribution with a given mean and standard deviation, we have:

t − −10
P (z < ) = 0.99
20
t + 10
⇒ Φ( ) = (0.99)
20
t + 10
= Φ−1 (0.99)
20
Φ−1 (0.99) = 2.326

V aR = −10 + 2.326 × 20 = 36.52

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Q.4643 T he losses from a portfolio for one year are normally distributed with mean -10 and standard
deviation 20. What is the value of the 99% expected shortfall?

A. 52.85

B. 37.40

C. 42.85

D. 26.43

T he correct answer is C.

We know that:

2
− U
⎛ e 2 ⎞
ES = μ + σ ⎜ ⎟
⎝ (1 − X) √2π ⎠

Now, U = Φ−1 (0.99)=2.33

2. 33 2
−
⎛ e 2 ⎞
ES = −10 + 20 ⎜ ⎟ = 42.85
⎝ (1 − 0.99) √2π⎠

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Reading 48: Calculating and Applying VaR

Q.972 After using of the historical simulation method, you have been provided with the following 30
ordered percentage returns for an asset:
[-18, -16, -14, -12, -10, -9, -7, -7, -6, -6, -6, -5, -5, -4, -4, -4, -2, -1, 0, 0, 2, 3, 6, 12, 12, 13, 15, 15, 18, 28]

T he value-at-risk (VaR) and expected shortfall (ES), at 90% confidence level, respectively, are
closest to:

A. Var: 14; ES: 17

B. Var: 14; ES: 16

C. Var: 12; ES: 16

D. Var: 12; ES: 24

T he correct answer is A.

VaR can be calculated as the [(1 − 0.9) × 30] = 3rd worst observation, which is -14 and hence the VaR

is 14.

T he ES is the arithmetic average of losses that are worse than the VaR. T hus,

(18 + 16)
ES = = 17
2

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Q.973 Stuart Broad, a risk analyst working with Macquarie Bank compiles data of 100 simulated
percentage returns of the bank’s assets:
[-13.33, -12.25, -11.75, -10.66, -8.45, -7.13, -6.48, -5.29 ... 2.89, 3.56, 4.29, 5.38, 6.65, 7.89, 8.54, 9.64,
10.27, 12.28, 13.25]

Using the data, he calculates the expected shortfall (ES) and the value at risk (VAR) of the bank’s
assets at the 95 percent confidence level using the historical simulation method. What is the
expected shortfall and the value at risk computed by Stuart Broad?

A. Expected shortfall: 12; Value at Risk: 9.45

B. Expected shortfall: 11.49; Value at Risk: 9.95

C. Expected shortfall: 12; Value at Risk: 8.45

D. Expected shortfall: 11.49; Value at Risk: 8.45

T he correct answer is C.

VaR can be calculated as the [(1 − 0.95) × 100] = 5th worst observation, which is -8.45 and hence the

VaR is 8.45.

T he ES is the arithmetic average of losses that are worse than the VaR. T hus,

13.33 + 12.25 + 11.75 + 10.66

ES = = 12
4

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Q.982 ANC National Bank handles a portfolio of assets amounting to USD 150 million. Antony Smith,
a risk analyst, analyzes the portfolio and observes that the returns are independently identically
normally distributed. T he annual standard deviation of the portfolio is 0.55. What is the 20 day-Value
at Risk at 95 percent confidence assuming 250 trading days in a year?

A. USD 51.92 million

B. USD 38.50 million

C. USD 53.67 million

D. USD 71.50 million

T he correct answer is B.

V aR = Z × standard deviation × portfolio amount

Annual VaR = 1.65 × 0.55 × 150, 000, 000 = 136, 125, 000
Var (T days) = 1-day VaR × √T … … . formula
Annual VaR
1-day VaR = = $8, 609, 300
√250
20-day VaR = (1-day VaR) × √20 = $38, 501, 694

It’s the standard deviation, σ, that determines where you start. If the σ given is annual, you’ll start by

calculating the annual VaR and then use the square root of the time rule to come up with VaR for

shorter periods. Similarly, if given the daily σ, compute the 1-day VaR and then convert that

appropriately.

Below is the standard normal table to use for this question:

STANDARD NORMAL TABLE pdf

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Q.1146 All the following are false with regards to Worst Case Scenario (WCS) measure, EXCEPT :

A. WCS indicates the number of times portfolio loss exceeds a given limit over a given
period.

B. WCS indicates the maximum a portfolio can lose over a given period.

C. WCS indicates the probability of losing a given limit over a given period.

D. WCS indicates the minimum a portfolio can lose over a given period.

T he correct answer is B.

Worst Case Scenario (WCS) indicates the maximum a portfolio can lose over a given period. For
instance, it can indicate that a portfolio may lose a maximum of 10% over 100 trading days, whereas
VaR indicates the probability of losing a particular limit over a period.

Q.1147 Plain vanilla European options and forwards are good examples of:

A. Linear derivatives.

B. Nonlinear derivatives.

C. A nonlinear and linear derivative, respectively.

D. A linear and nonlinear derivative, respectively.

T he correct answer is C.

A linear derivative is one whose value is directly related to the market price of the underlying
variable. If the underlying makes a move, the value of the derivative moves with a nearly identical
margin. In fact, there is a 1:1 relationship between the derivative and the underlying – explaining why
linear derivatives are said to be “delta-one” products. However, the delta itself need not always be
equal to 1. Examples of linear derivatives include futures and forwards.
A non-linear derivative is one whose value/payoff changes with time and space. Space in this case
refers to the location of the strike/exercise price with respect to the spot/current price. T he payoff
varies with the value of the underlying but also exhibits some non-linear relationship with other
variables, including interest rates, dividends, or even volatility. Non-linear derivatives are generally
referred to as options. For non-linear derivatives, delta is not constant. Rather, it keeps on changing
with the change in the underlying asset. Examples include the Vanilla European option, Vanilla
American option, Bermudan option, etc.

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Q.2616 Arthur Bell is the portfolio manager at FFF Investments. Recently, he bought 5,000 call
options on stocks of one of the local growth-oriented oil refining companies that have never paid
dividends. T he strike price of the options was $50. T he underlying stock is trading at $58 and has an
annual volatility of return of 33%. Bell estimated the delta of these options to be 0.55. What is the
approximate weekly (delta normal) 99% VaR of the position assuming 52 trading weeks in the year?

A. $7,725.57

B. $17,007

C. $6,659.97

D. $14,661.22

T he correct answer is B.

In the delta-normal approach, we first calculate the VaR of the underlying. T hen, we use the equation

below to revalue the derivative by linear approximation (as the delta multiplied by the VaR of the

underlying):

VaR derivative = Δ × VaR underlying

VaR of the underlying (stock) = σ × zcl% × market value

But first, we have to convert the annual volatility, i.e., σ, into a weekly value:

Annual volatility = weekly volatility × √52

(33%)
T hus, weekly volatility = = 0.045763
√52

VaR of the underlying = 0.045763 ∗ 2.33 ∗ $58 = $6.18438

VaR of call option = 0.55 ∗ $6.18 = $3.40
VaR of 5,000 call options = $3.40 × 5, 000 = $17,007

Note: 2.33 is the standard normal deviate at a 99% confidence level.

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Q.2618 An investor is long at a short-term portfolio of at-the-money put options on an underlying

asset. T he notional value of the portfolio is $100,000. Assuming that there is one risk factor with a
corresponding delta of 0.5, what is the amount of change in the portfolio if the value of the
underlying asset changes by 12.5%?

A. $5,500.

B. $6,250.

C. $6,520.

D. $7,500.

T he correct answer is B.

T he change in the portfolio value arising from the change in a risk factor is

ΔP = δΔS

Where
ΔP = change on the portfolio
δ = Delta corresponding to a risk factor
ΔS = change in the underlying asset
T hus in this case we have:

ΔP = 0.5 × 0.125 × 100, 000 = 6, 250

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Q.2619 After a significant increase in the volatility of shares of USY Pharma, Ross Grand, senior
portfolio manager, decides to hedge the existing position by buying 300 at-the-money call options.
Shares of USY are trading at $457 and the daily VaR of the underlying at 99% confidence is $42.59.
What is the daily 99% VaR of the options position using the delta-normal method?

A. $3,457.99

B. $5,791.77

C. $4,524.05

D. $6,388.50

T he correct answer is D.

T he key point here is that the call options are at the money, so we can assume delta = 0.5. (See the

note at the end of the explanation if this is unclear.)

According to the delta-norma method,

VaR of an option = Delta × VaR of underlying

VaR of the position = 0.5 ∗ $42.59 ∗ 300 options = $6, 388.50

Note: At-the-money call options typically have a delta of 0.5, and the delta of out-of-the-money call

options approaches 0 as expiration nears. T he deeper in-the-money the call option, the closer the

delta will be to 1, and the more the option will behave like the underlying asset. Since the delta of an

option ranges between 0 and 1, an at-the-money option is right in between those two numbers.

For put options, at-the-money put options typically have a delta of -0.5, and the delta of out-of-the-

money call options approaches 0 as expiration nears. T he deeper in-the-money put option, the closer

the delta will be to -1,

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Q.2623 Ashli More prepares a presentation to the management board on the application of
derivatives for hedging risk. She struggles with the classification of linear and non-linear derivatives.
Which of the following is an example of linear derivatives?

A. Futures on stocks, forwards on broad market indices, and plain vanilla European options
on bonds.

B. Interest rate swaps, interest rate caps, and plain vanilla American options on stocks.

C. Futures on broad market indices.

D. Futures on stocks and swaptions.

T he correct answer is C.

Prices of both futures are changing proportionally to the changes in underlying.

Options A, B, D are incorrect, as they all include options that are non-linear derivatives.

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Q.2625 T he investment division of a bank is considering an investment of $100,000,000 in one of the

following:

stocks of ALPHA Plc

stocks of APPA Corporation

20-year bonds of APPA Corporation

Although the department seeks the investment with the highest expected return, to comply with
bank’s risk policies, the department cannot open a position with a daily 99% VaR higher than
$6,000,000.
T he investment opportunities presented above have the following features:

Expected Annual Expected annual Modified Market Price

Return volatility of returns Duration
Stocks of ALPHA 20% 50% − $5 per stock
Stocks of APPA 13% 36% − $30 per stock
Bonds of APPA 8% 10% 3.5 99% per $100 nominal

Assuming zero daily returns and 252 trading days per year, which investment should the bank choose?

A. Stocks of ALPHA

B. Stocks of APPA

C. Bonds of APPA

D. None of the above

T he correct answer is B.

1
VaR of ALPHA's stocks = 50% × × 2.33 × $100, 000, 000 = $7, 338, 810.18
√252
1
VaR of APPA's stocks = 36% × × 2.33 × $100, 000, 000 = $5, 283, 943.33
√252
1
VaR of APPA' s bond = 10% × × 2.33 × $100, 000, 000 = $1, 467, 762.036
√252

Both the APPA's bond and APPA's stock have a VaR lower than $6, 000, 000, but the bank should

choose to invest in APPA's stock since it has a higher return than APPA's bond.

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Q.2626 T wo managers - X and Y - are looking to establish the 1-day VaR for a long position in an at-
the-money call option on a non-dividend-paying stock with the following information: Current stock
price: USD 100
Estimated annual stock return volatility: 15%
Current Black-Scholes-Merton call option value: USD 4.80,
Call option delta: 0.5
To compute VaR, manager X uses the delta-normal model, while manager Y opts for the Monte Carlo
simulation method for full revaluation. Which manager will estimate a higher value for the 1-day 99%
VaR?

A. Manager Y.

B. Manager X.

C. Both managers will have the same VaR estimate.

D. Insufficient information to determine.

T he correct answer is B.

T he correct answer is B.

Options are nonlinear derivatives, i.e., their value is related to the market price of the underlying

variable, but under a convex, non-linear relationship. T he payoff of such products varies with the

value of the underlying, but also with other elements (interest rates, volatility, dividends, etc.)

T he option’s price function is convex with respect to the value of the underlying. And for such a

non-linear portfolio, the delta-normal model provides only a linear approximation which does not

capture the positive effect of this curvature on the portfolio value. It understates the probability of

high option values and overstates the probability of low option values.

T herefore, for a long position in the call option, VaR and the expected shortfall under the delta

normal model will be extremely high.

On the other hand, for a short position in the call option, the VaR and the expected shortfall under

the delta-normal model will be extremely low.

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Q.2627 Which of these statements regarding the Structured Monte Carlo (SMC) simulation is
INCORRECT ?

A. T he SMC uses any distribution for the risk factors.

B. T he SMC assumes that distributions used in the simulation are relevant going forward.

C. T he SMC can generate correlated scenarios for multiple risk factors based on
corresponding statistical distributions.

D. Increasing the number of SMC simulations will always improve the outcome of the
simulation.

T he correct answer is D.

In cases when assumed distributions itself or distribution’s parameters are no longer relevant, SMC
simulation outcomes will become not reliable and increasing number of simulations will not solve the
problem.

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Q.3305 Bank A manages interest rate risk by monitoring the VaR using historical data. Bank A collects
interest rate returns for 300 days and the data is sorted ascendingly. T he lowest 10 interest rate
returns are -4.2%, -4.0%, -3.8%, -3.2%, -3.0%, -2.5%, -2.3%, -2.2%, -2.0%, -1.7%. After 30 days, Bank
A collects 30 more data points. However, none of these returns is less than -1.7%. What is the
change in the 98% VaR as compared to the prior 30 days, assuming that all of the lowest 10
observations are still within the 300-day long historical window?

A. Unchanged.

B. VaR has increased by 0.01%.

C. VaR has increased by 0.08%.

D. VaR has increased by 0.11%.

T he correct answer is A.

In general, if there are n ordered observations, and a confidence level cl%, the cl% VaR is given by
the [(1 − cl%) n ]th highest observation. T his is the observation that separates the tail from the body
of the distribution. For instance, if we have 1,000 observations and a confidence level of 95%, the
95% VaR is given by the (1 – 0.95)1,000 = 50st observation. T here are 50 observations in the tail.
Given this information, the 98% VaR, given that n = 300 is:
98% VaR = [(1 - 0.98)300 th value = 6th highest observation
T hus, VaR = -2.5%

One important note about this method is that the length of the historical window is fixed, i.e., the
oldest observations exit the window as new observations are made. In this case, however, 30 more
days have now elapsed (meaning that we have 30 new observations) but there hasn't been a loss big
enough to dislodge any of the worst 10 observations made, which we assume are still within the
historical window of 300 observations. As such, the 98% VaR will sti l l be the 6th highest
observation which happens to be -2.5%. In short, the VaR remains unchanged.

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Q.3307 Bank A manages interest rate risk by monitoring the VaR calculated using historical data. Bank
A collects interest rate returns for 300 days and the data is sorted ascendingly. T he lowest 10
interest rate returns are -4.2%, -4.0%, -3.8%, -3.2%, -3.0%, -2.5%, -2.3%, -2.2%, -2.0%, -1.7%.
Calculate the 98% VaR.

A. -2.0%

B. -2.2%

C. -2.5%

D. -2.4%

T he correct answer is C.

In general, if there are n ordered observations, and a confidence level cl%, the cl% VaR is given by
the [(1 – cl%)n ]th highest observation. T his is the observation that separates the tail from the body
of the distribution. In this case, we have 300 observations and a confidence level of 98%; the 98%
VaR is given by the (1 – 0.98)300 = 6th observation, that's 2.5%

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Q.3313 An option on the INMEX (Mexican) stock index is struck on 2,522 pesos. T he delta of the
option is 0.6, and the annual volatility of the index is 25%. Using delta-normal assumptions, what is
the 10-day VaR of the option at the 95% confidence level? Assume 260 days per year.

A. 204 pesos

B. 61.0 pesos

C. 115.8 pesos

D. 122.4 pesos

T he correct answer is D.

As per the delta-normal method, the VaR of a derivative position is given by:

V aR Derivative = Delta × V aR Underlying risk factor

T hus, the first step is to determine the VaR of the underlying rsk factor. i.e., the index. But before

that, notice that the question asks for the 10-day VaR, which means it is important that we work out

the 1-day VaR and then use the square root of time rule:

T-day volatility = 1-day Volatility × √T

260-day volatility = 1-day volatility × √260

260-day volatility 0. 25
T hus, 1-day volatility = = = 0.0155
√260 √260

Hence,

1-day VaR of the underlying = 2,522 × 0.0155 × 1.65 = 64.5 pesos

10-day VaR = 1-day VaR × √(10) = 64.5 × √(10) = 204 pesos

Finally,

V aR Derivative = Delta × V aR Underlying risk factor

= 0.6 × 204 = 122.4 pesos

Note that this questions mixes concepts from the chapters Calculating and Applying VaR and

Measuring and Monitoring Volatility.

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Q.3314 A futures contract on the S&P 500 is defined as a dollar multiple of the index level. T he S&P
500 future traded on the Chicago Mercantile Exchange is defined as a $250 index. T he 1% VaR of the
S&P 500 index is 2.45. What is the 1% VaR of the S&P 500 futures contract?

A. $61.25

B. $512.50

C. $612.50

D. $1,225

T he correct answer is C.

Since we already know that the 1% VaR of the S&P 500 index is 2.45, to find the 1% VaR of the S&P

500 futures contract, we simply multiply the contract value by the 1% VAR:

($250 × 2.45 = $612.50).

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Q.3316 Consider a non-linear portfolio that depends on a share price. Given that delta and gamma of
the portfolio are 20 and 2.5, respectively. All else constant, what is the corresponding portfolio
change to a stock price increase of $ 0.5?

A. $ 9.45

B. $ 10.63

C. $ 9.38

D. $ 10.31

T he correct answer is D.

Given the delta and gamma of a portfolio, the change in portfolio is given by :

1
ΔP = δΔS + γ(ΔS)2
2

Where
δ = Delta
ΔS = Change in the share price
γ = Gamma
ΔP = Change in portfolio value. T hus,

1
ΔP = 20 × 0.5 + × 2.5 × 0.52 = 10.3125
2

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Q.3318 You have been asked to estimate the VaR of GreenWood Corp. T he company’s stock is
currently trading at USD 308 and the stock has a daily volatility of 1.25%. Using the delta-normal
method, the VaR at the 95% confidence level of a long position in an at-the-money put on this stock
with a delta of -0.5 over a 1-day holding period is closest to:

A. USD 3.12

B. USD 2.15

C. USD 3.167

D. USD 4.52

T he correct answer is C.

In the case of a linear derivative, VaR scales directly with the underlying risk factor, i.e.,

V aR linear derivative = Δ × V aR underlying risk factor

V aR = Δ × 1.645 × σ × S0 = 0.5 × 1.645 × 0.0125 × 308
= 3.1666

Note: Just as the question dictates, this is an estimate: the accurate relationship is non-linear and we

are actually omitting the curvature (option gamma). Also, we ignore the negative sign in the solution

since a negative amount is implied.

Note 2: T his question mixes concepts from the chapters Calculating and Applying VaR and Measuring

and Monitoring Volatility.

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Q.3320 A market risk manager has gathered historical P&L data for his financial institution over the
last 100 days. He intends to determine the VaR and the conditional VaR (CVaR) at 90% level of
confidence using the historical simulation method. T he worst 15 observation gathered (in million
CAD) are:
[-25, -27, -27, -28, -30, -32, -36, -38, -40, -43, -45, -52, -56, -58, -60]

Calculate the VaR and the conditional VaR (CVaR).

A. VaR = 30; Conditional VaR = 46.

B. VaR = 32; Conditional VaR = 47.6.

C. VaR = 36; Conditional VaR = 47.6.

D. VaR = 32; Conditional VaR = 46.

T he correct answer is B.

We arrange the data in ascending order first:

-60, -58, -56, -52, -45, -43, -40, -38, -36, -32, -30, -28, -27, -25

VaR can be calculated as the [(1 - 0.9) × 100] = 10th worst observation, which is -32 and hence the

VaR is 32.

Conditional VaR is simply another name for the expected shortfall. T he ES is the arithmetic average

of losses that are worse than the VaR. T hus,

(60 + 58 + 56 + 52 + 45 + 43 + 40 + 38 + 36)
ES = = 47.6
9

Note: Refer to table 2.3 of your chapter for proof.

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Q.3394 A liquid asset K has a profit/loss distribution that’s independent and identically distributed.
T he position has a one-day VaR of $50,000 at the 95% level of confidence. Estimate the 10-day VaR of
the same position at the 99% level of confidence.

A. $115,114

B. $70,000

C. $223,956

D. $200,000

T he correct answer is C.

T he first step should be to convert the one-day VaR at 95% to a one-day VaR at 99%.
To do this, recall that:

V aR 95% uses the upper 5% point of the normal distribution, i.e., 1.645

And the V aR 99% uses the upper 1% point of the normal distribution, i.e., 2.326

T herefore, to convert the one-day VaR at 95% to a one-day VaR at 99%, we must multiply the former
2. 33
by a scale of 1. 645

2. 33
One-day V aR 99% = × $50, 000 = $70, 821
1. 645

Next, recall that:

V aR (T days) = V aR (1 day) × √T

T herefore,

V aR 10 days = $70, 821 × √10 = $223, 955.67

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Q.3395 Peter McLeish is a risk analyst at Quantum Bank. After estimating the 99%, one-day VaR of
the bank’s portfolio using historical simulation with 900 past days, he is concerned that the VaR is
providing too little information on tail losses. He embarks on a deeper examination of simulation
results. Sorting the simulated daily P&L from worst to best, he constructs the following table:

P & L Rank 1 2 3 4 5
−2, 000 −1, 860 −1, 800 −1, 720 −1, 630
P & L Rank 6 7 8 9 10
−1, 500 −1, 400 −1, 310 −1, 260 −1, 190
P & L Rank 11 12 13 13 15
−1, 110 −1, 050 −990 −820 −750

Determine the 99%, one-day expected shortfall of the portfolio:

A. 1,260

B. 1,653

C. 1,190

D. 1,609

T he correct answer is B.

When dealing with discrete data, let's first find the VaR. VaR can be calculated as the [(1 - 0.99) ×
900] = 9th worst observation, which is -1,260 and hence the VaR is 1,260.
T he ES is the arithmetic average of losses that are worse than the VaR. T hus,
ES = (2,000 + 1,860 + 1,800 + 1,720 + 1,630 + 1,500 + 1,400 + 1,310)/8 = 1,652.50

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Q.4665 Which of the following is NOT true about the historical simulation method of estimating VaR?

A. T his method estimates VaR by using a lookback period.

B. T his method assumes that the past performance of a portfolio is a good indicator of the
near future.

C. T his method assumes asset price returns and volatility follow a normal distribution.

D. All of the above.

T he correct answer is C.

Unlike the Monte Carlo and the parametric methods, the historical simulation method does not need
any distributional assumptions to estimate VaR as it uses historical data to perform the estimation.

Opti on A i s i ncorrect: T he historical simulation method's VaR estimates depend on the lookback

period and, thus, forecasts are highly dependent on the sample data features. T his is the major

drawback of the method.

Opti on B i s i ncorrect: T he historical simulation method assumes that the past performance of a

portfolio is a good indicator of the near future. It involves reorganizing actual historical returns by

putting them in order (from worst to best) and then assumes that the trend will repeat itself, from a

risk perspective.

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Q.4667 T he following are hypothetical ten worst returns for stock T GB from 120 days of data. Find
the 1-day 95% VaR and expected shortfall, respectively. -15.72%, -10.92%, -6.50%, -3.56%, -6.90%,
-2.50%, -5.30%, -4.31%.,-12.12%, -3.45%,

A. 0.053, 0.1043

B. 0.0431, 0.0958

C. 0.0431, 0.1149

D. 0.0431, 0.053

T he correct answer is B.

First, we rearrange starting with the worst day to the least bad day, as shown below:

-15.72%, -12.12%, -10.92%, -6.90%, -6.50%, -5.30%, -4.31%, -3.56%, -3.45%, -2.50%.

In this case, the VaR corresponds to the (5%×120)+1=7th worst day: -4.31%.

T his implies ES is the equivalent to an average of the 6 worst returns:

(−15.72% + −12.12% + −10.92% + −6.90% + −6.5% + −5.30%)

ES = = −9.5767%
6

So ES is 9.5767%

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Q.4668 Consider a linear portfolio consisting of short positions in 50 shares, each worth USD 10, and
a long position in 150 shares each worth USD 25. What is the relative portfolio change (in USD) of
the portfolio if the price of all shares increases by 2%?

A. 85

B. -85

C. 65

D. -65

T he correct answer is C.

T he change in a linear portfolio is given by:

ΔP = ∑ ni ΔSi
i

Where

ni: number of shares of stock i in the portfolio (negative for a short position)

Si: Price of stock i

So,

ΔP = [−50 × (0.02 × 10)] + [150 × (0.02 × 25)]

= −10 + 75 = 65

So the change in the portfolio is an increase of USD 65.

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Q.4669 In a historical simulation where the risk factor is the stock price, 501-day recent historical
data was used to generate 500 scenarios. From the data, the stock price on days 0, 1, 2, 300, ..., 500
are given as USD 20, USD 30, USD 28, USD 26,..., USD 36, respectively. What is the value of the
stock price on the 501st day?

A. 40

B. 30

C. 50

D. 54

T he correct answer is D.

Assuming that today is 500th day (with a current price of USD 36), we wish to know the stock price
on the 501st day. To do this, we use day 0 and 1 change in the stock price from the historical data.
Between day 0 and 1, the stock price increase from USD 20 to USD 30. T herefore the stock price
on the 501st day is given by:

30
36 × = $54
20

Alternatively:

T he stock price increased by 50% between day 0 and day 1, therefore we assume that the stock

price will also increase by 50% between days 500 and 501, and thus, the stock price on the 501st day

is given by:

USD 36 × 1.50 = USD 54

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Q.4670 Given that the one-day standard deviation of a portfolio is 90, what is the 10-day VaR with a
99% confidence level according to the delta-normal model?

A. 604

B. 505

C. 662

D. 645

T he correct answer is C.

According to the delta-normal model, we can assume that the mean change in risk factor is zero for a

short period of time so that VaR is given by:

V aR = σP U

Where

σP : standard deviation of the portfolio

U : point on the normal distribution where X is exceeded

In this case, σP =90 and U =-2.326 and thus VaR is given by:

90 × −2.326 = −209.340

We know that:

V aR (T , X) = √T × V aR (1, X )

T hus the 10-day VaR is given by:

√10 × −209.340 = −661.99

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Q.4671 Given that the standard deviation of portfolio change is 90, what is the 10-day expected
shortfall with a 99% confidence level according to the delta-normal model?

A. 640

B. 759

C. 650

D. 749

T he correct answer is B.

According to the delta-normal model, for a short period of time, we can assume that the mean change

in risk factor is zero so that VaR is given by:

2
− U
⎛ e 2 ⎞
ES = σP ⎜ ⎟
⎝ (1 − X) √2π ⎠

Where

σP : standard deviation of the portfolio

U : point on the normal distribution where X is exceeded

In this case, σP =90 and U =2.326 and thus ES is given by:

(2. 326)2
⎛ e− 2 ⎞
ES = 90 ⎜⎜ ⎟⎟ = 240.0635
⎝ (1 − 0.99) √2π⎠

But we know that:

ES (T , X) = √T × ES (1, X)

T hus the 10-day ES is given by:

√10 × 240.06 = 759.1473 ≈ 759

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Q.4674 In the context of the delta-normal model, which of the following statements is true?

I. T he delta-normal approach assumes that there is a linear relationship between the portfolio
changes and risk factor changes.
II. T he delta normal approach does not consider the curvature of the relationship between the
portfolio value and the corresponding risk factors.
III. Compared to other VaR computation methods, the delta-normal approach is more accurate
since it is easily calculated and assumes a normal distribution.

A. I and II

B. II only

C. III only

D. I and III

T he correct answer is A.

Statement I i s correct: T he delta-normal approach assumes that there is a linear relationship

between the portfolio changes and risk factor changes and thus works well with linear portfolios.

Statement II i s correct: T he delta normal approach does not consider the curvature of the

relationship between the portfolio value and the corresponding risk factors. Consider the following

equation:

ΔP = ∑ ai x i
i

Δsi
Where when percentage changes are used, ai = and x i = δix i and where actual
si

changes are considered ai = ΔSi and x i = δi. T his equation works well with linear portfolios, but it is

an approximation to non-linear portfolios.

Statement III i s i ncorrect: Delta-normal is computationally easy but quite inaccurate compared

to other VaR measurement methods. Put more precisely, it may underestimate the occurrence of

extreme losses because it relies on the normal distribution.

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Q.4675 A risk manager conducts 500 historical simulations to calculate one day, 99% VaR. Which of
the following describes the value of VaR in this case?

A. VaR would be the fifth-worst loss.

B. VaR would be the average of first, second, third, and fourth-worst losses.

C. VaR would be the sixth-worst loss.

D. VaR would be the average of the fifth and sixth loss.

T he correct answer is A.

For the 500 simulations, when the losses are ordered in descending order, VaR would be the fifth

(=1%×500) worst loss.

Opti ons B i s i ncorrect: It describes the expected shortfall.

Opti ons C i s i ncorrect: If VaR is a sixth-worst loss, then we would be calculating the one-day

98.8% VaR, which is not what is asked in the question.

Opti on D i s i ncorrect: T his would mean that we want an average of one-day 99% VaR and 98.8%

VaR.

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Q.4676 T he 100-day 99% VaR for a portfolio is 50. What is the corresponding 250-day 99% VaR?

A. 80.54

B. 65.25

C. 79.06

D. 78.54

T he correct answer is C.

Using the formula

V aR (T , X) = √T × V aR (1,X )
V aR (T , X)
⇒ VaR (1, X) =
√T

We, therefore, need first to calculate the one-day 99% VaR and then translate it to 250-day VaR

50
V aR (250, 99%) = √250 × [ ] = 79.06
√100

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Q.4677 A risk manager realizes over a period of one month, a portfolio he manages increased by USD
5 when the stock price increased by USD 0.1.What is the value of portfolio delta?

A. 30

B. 50

C. 40

D. 20

T he correct answer is B.

Greek letter deltas (δ) is defined as:

ΔP
δ=
ΔS

Where ΔS is a small change in risk factors such as stock price and ΔP the corresponding change in

the portfolio value.

So,

5
δ= = 50
0.1

Q.4678 A risk manager estimates 10-day 95% VaR using the delta-model to be USD 50. What is the
corresponding one-day expected shortfall at a 95% confidence level?

A. 66.78

B. 56.78

C. 19.82

D. 94.56

T he correct answer is C.

Since we are dealing with a short time period, then:

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V aR = σP U

2
− U
⎛ e 2 ⎞
ES = σP ⎜ ⎟
⎝ (1 − X) √2π ⎠

X: confidence level

U : point on the normal distribution where X is exceeded

σP :standard deviation of the portfolio change

From the question, we are given that the 10-day 95% VaR is 50, and thus one-day VaR is given by:

50
= 15.81
√10

We have X=95%, then U = 1.645.

⇒ 15.81 = σP × 1.645
15.81
σP = = 9.612
1.645

T herefore, the ES is given by:

2
− U 1. 6452
⎛ e 2 ⎞ ⎛ e− 2 ⎞
ES = σP ⎜ ⎟ = 9.612 ⎜ ⎟ = 19.8220
⎝ (1 − X) √2π ⎠ ⎝ (1 − 0.95) √2π⎠

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Q.4679 Correlation breakdown is a condition wherein periods of high volatility; correlations tend to
be different as compared to normal market conditions. What implication does the correlation
breakdown has on VaR and ES?

A. Calculation of VaR and ES should concentrate on what happens in extreme market

conditions.

B. Calculation of VaR and ES should concentrate on what happens in normal market

conditions.

C. Calculation of VaR and ES should concentrate on what happens in both normal and extreme
market conditions.

D. All of the above.

T he correct answer is A.

Correlations in a high volatility period are quite different from those of normal market conditions.

When calculating VaR or ES, risk managers should determine what will happen in extreme market

conditions. T herefore risk managers should try to determine correlations in extreme conditions

rather than those in normal market conditions.

Opions B, C and D are incorrect since correlation breakdown implies that extreme market conditions

should be considered rather than normal market conditions.

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Q.4680 Risk factors in a historical simulation of calculating VaR are divided into those where
percentage change in the past is used to determine a percentage in the future and those where the
actual change in the past is used to define the actual changes in the future. Which of the following
risk factors are NOT in the same group?

I. Interest rates and credit spreads

II. Exchange rates and stock prices
III. Interest rates and exchange rates
IV. Stock prices and credit spreads

A. I, II and III

B. III and IV

C. II and IV

D. I and III

T he correct answer is B.

Risk factors are broadly classified into:

T hose whose past percentage change is to define the future percentage, for example,

stock prices and exchange rates.

T hose whose past actual change is used to define an actual change in the future, for

example, interest rates and credit spreads.

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Q.4681 You have been given the following 30 ordered percentage returns of an asset:
[-18,-16,-14,-12,-10,-9,-7,-7,-6,-6,-6,-5,-5,-4,-4,-4,-2,-1,0,0,2,3,6,12,12,13,15,15,18,28] What is the
expected shortfall at a 90% confidence level?

A. 16

B. 17

C. 18

D. 17.5

T he correct answer is B.

To locate the 10%, we take the third-worst return (=(1-0.90)*30), which is -14. However, recall that

VaR need not be represented as a negative.

T he ES is the arithmetic average of losses beyond 90%. T hus,

18 + 16
ES = = 17
2

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Reading 49: Measuring and Monitoring Volatility

Q.535 Consider the following statements regarding the estimation of volatility:

I. Under the EWMA model, the weights attached to observations decrease following an exponential
pattern as the observations become older
II. Under the GARCH(1,1) model, the observation’s estimated weights decrease following an
exponential pattern as the observations become older
III. Under the GARCH(1,1) model, the long-run average variance rate has some positive weight
IV. Under the EWMA model, the long-run average variance rate has some positive weight

A. All the above statements are correct.

B. Only I, II, and III are correct.

C. Only I and IV are correct.

D. None of the above statements are correct.

T he correct answer is B.

In both the GARCH and EWMA models, weights decline exponentially with time. In addition, the
GARCH model has a finite unconditional variance. However, the EWMA model has undefined long-run
average variance since α 1 + β sum to 1.

Q.536 Using a daily RiskMetrics EWMA model with a decay factor λ = 0.85 to develop a forecast of
the conditional variance, which weight will be applied to the return that is three days old?

A. 0.1084

B. 0.0921

C. 0

D. 0.153

T he correct answer is A.

T he weight of the last day = 1 − λ = 1 − 0.85 = 0.15

For the day before, the weight is 0.15 * 0.85 and for 3 days ago, 0.15 ∗ 0.852 = 0.1084

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Q.537 Until December 2012, the Kenyan shilling had shown very small historical volatility against the
South African Rand. On December 19th, Kenya abandoned the defense of the currency peg. Assuming
the data from the close of business on December 18th, which of the following methods of calculating
volatility would have shown the greatest jump in measured historical volatility?

A. 150-day equal weight

B. 100-day equal weight

C. Exponentially weighted with a decay factor of 0.92

D. Exponentially weighted with a decay factor of 0.97

T he correct answer is D.

T he EWMA model for updating variance is given by:

σn2 = (1 − λ)r2n −1 + λσn2−1

Where:

r2n −1=most recent observation of the squared return (on day n — 1).

σn2−1=estimate of the variance rate made for the previous day (n — 1)

T he weight given to the most recent variance estimate is λ and the weight given to the new squared

return is 1 − λ.

T hus, the EWMA model with λ = 0.97 (Opti on D) puts a weight of 0.97 on the most recent variance

estimate. T his weight is higher than the 0.92 of the EWMA model with λ = 0.92 (Opti on C). It’s also

higher than 0.01 (= 1/100) and 0.0067 (= 1/150) of the 100-day (Opti on B) and the 150-day (Opti on

A) MAs, respectively.

If there had been a currency peg in place, that implies the exchange rate was fixed. Abandoning such

a policy would immediately trigger an increase in the volatility of the shilling vs the SA Rand. T he

biggest jump would have to involve the volatility measurement method that attaches the greatest

weight on the first peg-free day.

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Q.538 Given that σt2 is the estimated variance at time t and μt is the realized return at time t, select
the GARCH(1,1) model that will take the longest time to revert to its mean.

A. σt2 = 0.05 + 0.03μ2( −1) + 0.91σ(2 −1)

t t

B. σt2 = 0.03 + 0.03μ2( −1) + 0.92σ(2 −1)

t t

C. σt2 = 0.07 + 0.02μ2( −1) + 0.94σ(2 −1)

t t

D. σt2 = 0.03 + 0.04μ2( −1) + 0.91σ(2 −1)

t t

T he correct answer is C.

It’s the model with the highest persistence that takes the longest time to revert to its mean.

Persistence is given by:

Persistence = α 1 + β

Bearing in mind that the general format of GARCH(1,1) models takes the form:

ht = α 0 + α 1 r2t−1 + βh(t−1)

T he persistence is 0.94, 0.95, 0.96, and 0.95 for models A, B, C, and D respectively.

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Q.539 Martin Scholes, FRM, estimates daily variance ht using the following GARCH model on daily
returns rt :

H t = α 0 + α 1r2( −1) + βh(t−1)

t

Where α0 = 0.004, α 1 = 0.05, β = 0.93Approximate the long-run annualized volatility (Assume there
are 252 trading days in a year).

A. 0.20

B. 7.144

C. 0.45

D. 0.5

T he correct answer is B.

In the GARCH(1,1) model, the long-run average variance rate is given by:

α0
h=
(1 − α 1 − β)
0.004
= = 0.20
(1 − 0.05 − 0.93)

Taking the square root, this gives 0.45 for daily volatility.

To determine the annualized volatility, we have to multiply 0.45 by √252, where 252 is the average

number of trading days in a year excluding weekends and holidays.

T hus, annualized volatility = 0.45 ∗ √252 = 7.144

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Q.540 Consider the GARCH(1,1) model:

σt2 = ω + αμ2( −1) + βσ(2 −1)

t t

Where α + β < 1Which of the following statements is INCORRECT regarding the volatility term
structure predicted by the model above?

A. If we assume that the long-run estimated variance remains unchanged as α and β increase,
the volatility term structure predicted by the model reverts to the long-run estimated
variance faster.

B. If we assume that the long-run estimated variance remains unchanged as α and β increase,
the volatility term structure predicted by the model reverts to the long-run estimated
variance more slowly.

C. If the current volatility estimate is above the long-run average volatility, we would expect
the estimated volatility term structure to be downward-sloping.

D. If the current volatility estimate is below the long-run average volatility, we would expect
the estimated volatility term structure to be upward-sloping.

T he correct answer is A.

When σt is lower than the long-run average, the volatility term structure would go up. Higher
persistence represented by α + β would mean that mean reversion is slower, not faster.

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Q.541 A risk manager at Meridian Bank uses the exponentially weighted moving average technique to
model the daily volatility of a security, with λ equal to 0.95. T he current daily volatility estimate
stands at 1.8%. On a certain day, the security registers a closing price of $10 and then $8 the
following day. Determine the updated estimate of volatility:

A. 0.04803

B. 0.0529

C. 0.1521

D. 0.1812

T he correct answer is A.

T he new variance forecast will be given by:

λσ(2 −1) + (1 − λ)u2( −1)

t t

where

σn2 = variance estimate for day n

σ(2 −1) = volatility estimate made at the end of day (t-2) for day (t-1)
t

2
U (2−1) = T he most recent observation of the squared return (on day n — 1) = ( 8−10 ) = (−0.2)2 = 0.04
t 10

λ = exponential constant

T hus, the new variance forecast is

0.95 ∗ 0.0182 + (1 − 0.95) ∗ 0.04 = 0.0023078

Hence

Volatility = √0.0023078 = 0.04803

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Q.542 Consider a portfolio with 60% invested in asset Y and 40% invested in asset Z. T he mean and
variance of the return on Y are 0 and 49 respectively. T he mean and variance of the return on Z are
1 and 84 respectively. Given that the correlation coefficient between Y and Z is 0.4, determine the
portfolio volatility.

A. 43.4

B. 6.59

C. 8.5

D. 23.1

T he correct answer is B.

σp2 = w 2y σy2 + w 2z σ 2z + 2w y ⋅ w z ⋅ Corr (y, z) ⋅ σy ⋅ σz

= 0.62 ∗ 49 + 0.42 ∗ 84 + 2 ∗ 0.6 ∗ 0.4 ∗ 0.4√(49 ∗ 84)
= 17.64 + 13.44 + 12.32 = 43.40

Volatility = √43.40 = 6.59

Q.543 A FRM exam candidate uses the EWMA model with a decay factor of 0.90 to model the returns
of a security listed on the Japanese Stock Exchange. Determine the weight that will be applied to the
return that’s 5 days old.

A. 0.04656

B. 0.09

C. 0.06

D. 0.0656

T he correct answer is D.

T he last day has some weight equivalent to 1 − λ = 1 − 0.9 = 0.1

T he day before would have weight equivalent to (1 − λ)λ = 0.1 ∗ 0.9 = 0.09

And for 5 day-old return, the weight would be (1 − λ)λ4 = 0.1 ∗ 0.94 = 0.0656

Note: T he lower the value of λ, the faster the rate at which old values are ‘forgotten’.

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Q.544 T he decay factor used in an EWMA model is approximated to be 0.97. In addition, daily
volatility is estimated to be 1%. Given that today’s stock market return is 3%, determine the new
estimate of volatility using the EWMA model.

A. 0.00027

B. 0.000124

C. 0.01114

D. 0.00567

T he correct answer is C.

σn2 = λσ(2 −1) + (1 − λ)u2(

n n −1)

Where λ = 0.97 and u(n −1) = 3%

T hus, σn2 = 0.97 ∗ 0.012 + (1 − 0.97) ∗ 0.032 = 0.000097 + 0.000027 = 0.000124

σn = 0.01114 or 1.11%

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Q.545 A generalized autoregressive conditional heteroskedastic (GARCH)(1,1) model has the

following parameters: ω = 0.000003;α = 0.05;β = 0.94Determine the implied long-run volatility
level.

A. 0.0003

B. 0.07132

C. 0.02732

D. 0.01732

T he correct answer is D.

ω 0.000003
T he long-run average variance = = = 0.0003
(1 − α − β) (1 − 0.05 − 0.94)

ω
T he long-run volatility = ⎷( ) = √0.0003 = 0.01732
(1 − α − β)

Q.546 T he dollar/sterling exchange rate at 5 P.M. yesterday was 0.78 and the most recent estimate of
the daily volatility stands at 0.8%. T he EWMA model used in the analysis has λ = 0.9. If the exchange
rate at 5 P.M. today proves to be 0.775, find an estimate of the new daily volatility.

A. 0.007857

B. 7.855E-05

C. 6.4E-05

D. 6.17E-05

T he correct answer is A.

T he proportional daily change is ln(0.775/0.78) = -0.00643.

T he current daily variance estimate = 0.0082 = 0.000064.

New daily variance estimate = 0.9 ∗ 0.000064 + 0.1 ∗ 0.006432

= 0.0000576 + 0.000004109 = 0.0000617

New daily volatility = √0.0000617 = 0.007857 or 0.7857%

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Q.547 An analyst has interest in two assets, A and B. At the close of business yesterday, these assets
had daily volatilities of 1.3% and 2.0% respectively. In addition, the assets were priced at $40 for A
and $80 for B as at the close of business yesterday, and the estimated correlation coefficient
between the two assets stood at 0.25. T he EWMA model used by the analyst had λ = 0.95.
Compute an estimate of the covariance between A and B.

A. 0.000065

B. 0.0006

C. 2.60005

D. 0.05

T he correct answer is A.

Recall that:

Cov(A, B)
Correlation coefficient =
(Volatility A ∗ Volatility B)

T his means that if we make the covariance the subject of the formula, we get:

Cov(A, B) = Correlation coefficient ∗ Volatility A ∗ Volatility B

= 0.25 ∗ 0.013 ∗ 0.02 = 0.000065

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Q.548 An analyst has interest in two assets, A and B. At the close of business yesterday, these assets
had daily volatilities of 1.3% and 2.0% respectively. In addition, the assets were priced at $40 for A
and $80 for B as at the close of business yesterday, and the estimated correlation coefficient
between the two assets stood at 0.25. T he EWMA model used by the analyst had λ = 0.95.
Assuming that the prices of the assets today are $40.5 and $80.5, update the correlation coefficient.

A. 0.00625

B. 0.01954

C. 6.56E-05

D. 0.2589

T he correct answer is D.

Recall that:

Cov(A, B)
Correlation coefficient =
Volatility A ∗ Volatility B

T his means that if we make the covariance the subject of the formula, we get:

Cov(A, B) = Correlation coefficient ∗ Volatility A ∗ Volatility B

= 0.25 ∗ 0.013 ∗ 0.02 = 0.000065

T he return for A is 0.5/40 = 0.0125

Similarly, the return for B is 0.5/80 = 0.00625

T he new covariance estimate 0.95 ∗ 0.000065 + 0.05 ∗ 0.0125 ∗ 0.00625 = 0.00006566

For asset A, the new variance estimate = 0.95 ∗ 0.0132 + 0.05 ∗ 0.01252 = 0.0001684

T herefore, new volatility = √0.0001684 = 0.01298

For asset B, the new variance estimate = 0.95 ∗ 0.022 + 0.05 ∗ 0.006252 = 0.000382

T herefore, new volatility = √0.000382 = 0.01954

0. 00006566
T he new correlation estimate = = 0.2589
(0. 01298∗0. 01954)

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Q.549 GARCH(1,1) models can be used to estimate the volatility of asset returns if and only if:

A. α > β

B. α < β

C. α + β = 0

D. α + β ≤ 1

T he correct answer is D.

For stability to be achieved, α + β must be less or equal to 1. Otherwise, the model would be
unstable.

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Q.556 Robert Kelly, FRM, uses the EWMA model to carry out daily updates of correlation and
covariance rates between two random variables X and Y . T he weight for the most recent
covariance on day n − 1 is 0.80. T he correlation estimate between X and Y on day n − 1 is 0.6. In
addition, on day n − 1, X and Y have estimated standard deviations of 0.013 and 0.019 respectively.
Also, the percentage change on day n − 1 for variables X and Y are 2% and 1% respectively.Calculate
the updated covariance between X and Y on day n.

A. 0.0125

B. 0.41

C. 0.0001586

D. 0.0001482

T he correct answer is C.

T he exponentially weighted moving average (EWMA) model uses the following formula to compute
the updated covariance between 2 random variables X and Y at time n:

Cov n = λ × cov n −1 + (1 − λ)X n −1 × Y n −1

Where:

λ = weight of the most recent covariance on day n − 1

X n −1 = percentage change for variable X on day n − 1

Y n −1 = percentage change for variable Y on day n − 1

We know that Cov xy = ρxy ∗ σx σy

Cov n −1 = 0.6 ∗ 0.013 ∗ 0.019 = 0.0001482

Which gives: Cov n = 0.8 ∗ 0.0001482 + 0.2 ∗ 0.02 ∗ 0.01 = 0.0001586

Q.557 Robert Kelly, FRM, uses the EWMA model to carry out daily updates of correlation and
covariance rates between two random variables X and Y . T he weight for the most recent
covariance on day n − 1 is 0.80. T he correlation estimate between X and Y on day n − 1 is 0.6. In
addition, on day n − 1, X and Y have estimated standard deviations of 0.013 and 0.019 respectively.
Also, the percentage change on day n − 1 for variables X and Y are 2% and 1% respectively.Compute
the updated correlation between X and Y

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A. 0.1586

B. 0.2152

C. 0.3088

D. 0.6152

T he correct answer is D.

Covxy
We know that ρxy = σ xσ y

Updated variance of X = λσX2,n −1 + (1 − λ)X n2−1 = 0.8 ∗ 0.0132 + 0.2 ∗ 0.022 = 0.0002152

Updated variance of Y = λσY2 ,n −1 + (1 − λ)Y n2−1 = 0.8 ∗ 0.0192 + 0.2 ∗ 0.012 = 0.0003088

T he updated covariance between 2 random variables X and Y at time n:

Cov n = λ × cov n −1 + (1 − λ)X n −1 × Y n −1

Where:

λ = weight of the most recent covariance on day n − 1

X n −1 = percentage change for variable X on day n − 1

Y n −1 = percentage change for variable Y on day n − 1

We know that Cov xy = ρxy ∗ σx σy

Cov n −1 = 0.6 ∗ 0.013 ∗ 0.019 = 0.0001482

Which gives:

Cov n = 0.8 ∗ 0.0001482 + 0.2 ∗ 0.02 ∗ 0.01 = 0.0001586

Hence the updated correlation coefficient is,

0.0001586
ρn = = 0.615238
(√0.0002152 ∗ √0.0003088)

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Q.558 A financial analyst uses daily data to estimate a GARCH (1,1) model as follows:

σn2 = 0.000002 + 0.16r2n −1 + 0.74σn2−1

She also has established that the most recent return and variance are 0.04 and 0.02, respectively.
Calculate the updated volatility.

A. 1.51%

B. 11.11%

C. 3.33%

D. 12.27%

T he correct answer is D.

T he Generalized Autoregressive Conditional Heteroskedasticity GARCH(1,1) model is defined as:

σn2 = ω + αr2n −1 + βσn2−1

Where:
σn2 = updated variance at time n
ω = long-term average variance rate
α = weight of the most recent squared return
r2n −1= most recent squared return
β = weight of the most recent variance rate estimate
σn2−1 = most recent variance rate estimate
From the information provided in the question:

σn2 = 0.000002 + 0.16 × 0.042 + 0.74 × 0.02 = 0.015058

Volatility is given by:

Volatility = √σn2 = √0.015058 = 0.12271 ≈ 12.27%

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Q.565 A certain analyst uses the EWMA model with λ = 0.9 to carry out an update of correlation and
covariance rates. On day n − 1, the observed percentage changes for variables X and Y are 3% and
2% respectively. Historical data puts the correlation estimate between X and Y at 0.54 on day n − 1.
Furthermore, the estimated standard deviations on day n − 1 are 1.2% and 1.4% for X and Y
respectively.
Compute the new estimate of the covariance between X and Y on day n.

A. 9.07205

B. 0.1234

C. 0.1416

D. 0.0001416

T he correct answer is D.

Cov n = λ × cov n −1 + (1 − λ)X n −1 × Y n −1

But first, we must determine Cov n −1

We know that Cov xy = ρxy ∗ σx σy

Cov n −1 = 0.54 ∗ 0.012 ∗ 0.014 = 0.00009072

And

Cov n = 0.9 ∗ 0.00009072 + 0.10 ∗ 0.03 ∗ 0.02 = 0.000141648

Q.567 T he following is a variance-covariance matrix:

⎡ 1 0 0.7 ⎤
⎢ 0 1 0.7 ⎥
⎣ 0.7 0.7 1 ⎦

Determine the correlation rate between variables 2 and 3.

A. 0.7

B. 1

C. 0.49

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D. 0

T he correct answer is A.

Generally, a 3 × 3 covariance matrix is given by:

⎡ Var(1) Cov(1, 2) Cov(1, 3) ⎤

⎢ Cov(1, 2) Var(2) Cov(2, 3) ⎥
⎣ Cov(1, 3) Cov(2, 3) Var(3) ⎦

Now,

Cov(2, 3) 0.7
Corr(2, 3) = = = 0.7
Sd(1) × Sd(2) 1×1

Q.568 Kelvin Klein, a financial analyst, uses daily data to estimate a GARCH (1, 1) model as follows:

σn2 = 0.000002 + 0.14r2n −1 + 0.76σn2−1

Kelvin establishes that the estimate of return on day n − 1 is 0.02 and the most recent observation on
variance is 0.01. Calculate the updated estimate of variance, σn2

A. 0.066

B. 0.008

C. 0.088

D. 0.017

T he correct answer is B.

From the information given in the question, we have:

σn2 = 0.000002 + 0.14 × 0.022 + 0.76 × 0.01 = 0.007658 ≈ 0.008

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Q.940 A number of risk measures are based on the parametric approach, which assumes that the
asset returns are normally distributed. However, mathematicians and statisticians have discovered
that in reality, the asset returns deviate from normality. Which of the following options is least likely
consistent with the assumption that the asset returns deviate from normality?

A. Asset returns have fat-tailed distributions which means assets have a higher probability
weight in their tails relative to the normal distribution.

B. Asset returns have skewed distribution, which means that the declines in asset prices are
more severe than increases in prices.

C. Asset returns have unstable parameter values due to varying market conditions.

D. Asset returns have symmetrical distributions which means they are evenly distributed
around the mean returns.

T he correct answer is D.

Option D is least consistent with the assumption that the asset returns deviate from a normal
distribution. Symmetric distribution is the assumption of the normal distribution that indicates that
the returns are evenly distributed around it means that also indicates that there is no skewness in
asset returns.

Q.941 Donald York is a quantitative analyst at Brooklyn Investments Hub, a tech investment
company based in New York. York brings 5 years of experience in quantitative and statistical
analysis. In one of his explanatory articles, he mentioned that when the mean and standard deviation
of asset returns are the same for any given time period, the distribution of returns is said to be an
unconditional distribution. In contrast, if the mean is the same at any time while the standard
deviation of the return change over time, the return distribution is referred to as a conditional
distribution. Identify the correct option from the following.

A. York’s explanation regarding the unconditional distribution is incorrect.

B. York’s explanation regarding the conditional distribution is incorrect.

C. York’s explanation regarding the conditional and unconditional distribution is incorrect.

D. York’s explanation regarding the conditional and unconditional distribution is correct.

T he correct answer is D.

Both definitions are correct. An unconditional normal distribution refers to a case when the mean
and the standard deviation of the asset returns are the same for any given time period. On the other
hand, when the mean is the same at any given day, while the standard deviation of asset returns
changes over time, then the distribution is referred to as conditional normal distribution.

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Q.942 An analyst is conducting fundamental and technical analysis on Pak-China T rading Co (PCT C)
stocks. T he analysis takes into account the stock’s daily returns based on the mean and volatility of
returns. If PCT C returns have a mean of 9.56 bps/day, and a high volatility of 14.25 bps/day and a low
volatility of 6.18 bps/day, then determine which of the following distributions fits the most the
characteristics of PCT C’s return distribution?

A. Unconditional distribution.

B. Regime-switching distribution.

C. Unconditionally lognormal distribution.

D. Conditional distribution.

T he correct answer is B.

In a regime-switching distribution, the volatility of returns switches between low volatilities to high
volatilities. In this distribution, the volatility does not switch to any volatility between the high and
low volatility regimes.

Q.947 Gareth Graham is a senior risk consultant for Poincare Consulting Group. Graham has a strong
reputation in the risk managers community, which is why he is frequently invited as a guest speaker
at various business schools. During a recent seminar at a reputable business school in Vancouver,
Graham mentioned the following comments regarding the cyclicality of volatility:
I. It should be considered while analyzing the risk of financial assets that volatility in financial
markets is time-varying
II. While using a historical data model for analyzing volatility, more weight should be put into recent
data as opposed to earlier data

Which of the following is correct?

A. Only statement I is correct.

B. Only statement II is correct.

C. Both statements are correct.

D. None of the statements is correct.

T he correct answer is C.

Both statements are correct. It should be taken into account while analyzing the risk of assets
returns that the volatility in the financial markets is time-varying and sticky. It should also be
assumed that the more recent data of asset returns provides more information about future volatility.

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Q.948 An analyst is comparing the ST DEV or GARCH methodology with that of the RiskMetric®
approach for estimating VaR using historical data. He wrote down the following similarities between
both methods. Which of the following similarities is incorrect?

A. Both methods belong to the parametric class of risk assessing models.

B. Both methods attempt to estimate conditional volatility.

C. Both methods apply equal weights to all the periods.

D. Both methods use recent historic data for assessing risk.

T he correct answer is C.

T he standard deviation models apply equal weights to all the windows of past data, while the
RiskMetric® and the GARCH approaches apply higher weights on more recent data. T he weights
decline exponentially to zero as returns become older.

Q.951 Selma Kaya is a junior risk analyst at Galileo Investment Bank. She is interested in estimated
the joint density of returns of Algo Corp. and economic growth. Which of the following models should
Kaya most likely use?

A. Risk Metric®.

B. Black-Scholes model.

C. GARCH.

D. Multivariate density estimation (MDE) model.

T he correct answer is D.

T he Multivariate density estimation (MDE) model allows estimating the joint density of returns of
assets and other specified variables like the slope term structure, CPI, economic growth, etc.

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Q.953 Markus Schmidt is an independent risk consultant at a well-known audit firm. He is currently
working as an external risk advisory for George Reed Shipping Inc. During a meeting with the senior
management of the shipping company, Schmidt made the following comments:
I. Using nonparametric is a simple process as it does not impose a specific set of distributional
assumptions; rather it uses the historical data directly
II. Nonparametric methods are better predictors of the future volatility

Which of his comments is/are incorrect?

A. Comment I only.

B. Comment II only.

C. Both comments.

D. None of the comments.

T he correct answer is B.

T he most efficient predictors of future volatility are not nonparametric models but implied volatility
models. Implied volatility models such as the Black-Scholes option pricing model can react better and
quicker to current market conditions.

Q.956 If the covariance between Japanese and English interest rates is 0.089, and the variances of
interest rates in Japan and England are 17.64% and 10.24%, respectively, then which of the following
is closest to the correlation between Japanese and English interest rates?

A. 4.927

B. 1.028

C. 0.6622

D. 0.8736

T he correct answer is C.

Covariance
Correlation =
(Standard deviation (A) ∗ Standard deviation (B))
0.089
Correlation = = 0.6622
(√0.1764 ∗ √0.1024)

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Q.3301 An investment company uses RiskMetrics to calculate the volatility. T he volatility for the
previous day is 0.02 and today’s return is 10%. What is the updated volatility if λ = 0.97 is used?

A. 0.0028

B. 0.0194

C. 0.0262

D. 0.053

T he correct answer is C.

Adaptive volatility using the RiskMetrics model can be found as:

σt2 = λσ2t−1 + (1 − λ)r2t−1,t

2 2
= 0.97 ∗ 0.02 + 0.03 ∗ 0.1 = 0.000688

However, remember that variance is volatility squared.

σt = √0.000688 = 0.0262

TM

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Q.3302 A hedge fund manages risk by calculating future volatility using RiskMetricsTM to calculate
the volatility. T he volatility of the portfolio today is 3% per day and today's observed return is 1%.
T he conditional volatility estimate, assuming that λ = 0.9, is closest to:

A. 2.86%

B. 3.49%

C. 2.50%

D. 3.21%

T he correct answer is A.

T he volatility according to RiskMetrics is given by:

σn2 = (1 − λ) r2n −1 + λσn2−1

Where

λ = T he weight given to the most recent variance estimate.

r2n −1 = estimate of most recent squared return

σn2−1 = Most recent estimate of variance

From the information given,

σn2 = (1 − 0.9) 0.012 + 0.9 × 0.032 = 0.00082

T hus the volatility is

√0.00082 = 0.02863 ≈ 2.86%

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Q.3303 A hedge fund manages risk by calculating future volatility using historical standard deviation.
T he portfolio performance in the past 5 days are 2% (n-1), 4% (n-2), 6% (n-3), 2% (n-4), and 10% (n-
5), respectively. T he hedge fund uses the historical standard deviation (moving average) method to
calculate volatility. What is the volatility estimate?

A. 4.00%

B. 5.66%

C. 3.40%

D. 2.80%

T he correct answer is B.

1 m 2
σn2 = ∑ r
m i=1 n −i
1 2 2 2 2 2
= (0.02 + 0.04 + 0.06 + 0.02 + 0.1 )
5
= 0.0032

Volatility = √0.0032 = 0.0565685

Q.3304 Suppose that λ is 0.97. Using the EWMA approach, what is the weight applied to the squared
return on day n − 3?

A. 0.4

B. 0.97

C. 0.03

D. 0.06

T he correct answer is C.

Let w 0 be the weight applied to the most recent return (i.e., the return on day n − 1). T he weight for
the squared return on day n − 3 is

w 0λ2 = (1 − λ)λ2 = (1 − 0.97) × 0.972 = 0.028227 ≈ 0.03

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Q.3308 For a certain asset, the expected one-period volatility is 0.002. If the speed of the reversion
parameter is 0.7, then what is the two-period volatility?

A. 0.002

B. 0.0024

C. 0.0115

D. 0.0587

T he correct answer is B.

With mean reversion (b < 1), the single-period volatility is σ.

T he two-period volatility is

√1 + b2 × σ

T herefore,

0.002 × √1 + 0.72 = 0.002 × 1.2207 = 0.0024

Q.3310 For a certain asset, the expected one-day volatility 0.002. What is the expected volatility for
30 days assuming non-predictability and the volatility being constant?

A. 0.002

B. 0.005

C. 0.011

D. 0.021

T he correct answer is C.

Here, we simply use the square root rule:

T-day volatility = 1-day volatility × √T

30-day volatility = 0.002 × √30 = 0.002 × 5.48 = 0.011

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Q.3377 T he parameters of a generalized autoregressive conditional heteroskedastic (GARCH)(1,1)

model are α = 0.05, β = 0.91. Long-run volatility is 0.80%. If estimated daily volatility is 2% and
recent stock return is 3%, compute the new estimated volatility using the GARCH (1,1) model.

A. 0.04%

B. 2.50%

C. 1.50%

D. 2.03%

T he correct answer is D.

γ = 1 − α − β = 1 − 0.05 − 0.91 = 1 − 0.96 = 0.04

Weighted long-run variance = ω = γVL = 0.04 ∗ (0.008)2 = 0.00000256

New variance is given by:

σn2 = ω + αu2n −1 + βσn2−1

V ariance = 0.00000256 + 0.05 ∗ 0.032 + 0.91 ∗ 0.022 = 0.00041156

V olatility = √0.00041156 = 0.0203 = 2.03%

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Q.3378 T he decay factor of exponentially weighted moving average (EWMA) model is estimated to
be 0.95. If the estimated daily volatility is 2% and the recent stock return is 3%, compute the new
estimated volatility using the EWMA model.

A. 2.06%

B. 2.03%

C. 0.04%

D. 2.50%

T he correct answer is A.

New variance is given by

σn2 = (1 − λ)u2n −1 + λσn2−1

V ariance = 0.05 ∗ 0.032 + 0.95 ∗ 0.022 = 0.000425

Volatility = √0.000425 = 2.06%

Q.3379 When parameters of a generalized autoregressive conditional heteroskedastic (GARCH)(1,1)

model are set to ω = 0, α = 1 − λ, β = λ, the GARCH (1, 1) model reduces to a (an):

A. Generalized volatility model

B. EWMA model

C. ARCH (1)

D. None

T he correct answer is B.

GARCH (1, 1) model:

σn2 = ω + αu2n −1 + βσn2−1

Put ω = 0, α = 1 − λ, β = λ
, the above model reduces to:

σn2 = (1 − λ)u2n −1 + λσn2−1

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Q.3380 T he parameters of a generalized autoregressive conditional heteroskedastic (GARCH)(1,1)

model are ω, α , β, and γ . Which of the following is the necessary condition for estimating volatility
using GARCH (1, 1)?

A. α > β

B. γ < 0

C. α + β < 1

D. α + β + γ > 1

T he correct answer is C.

α +β +γ = 1
α + β < 1 so that γ>0

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Q.3383 An analyst is trying to updates the estimated covariance by using the exponentially weighted
moving average (EWMA) model with λ = 0.91. T he analyst has gathered the following relevant data.

Estimated standard deviation on day n − 1 for variables X : 2%

Estimated standard deviation on day n − 1 for variables Y : 3%

T he correlation between them: 0.8

T he percentage change on day n − 1 for variable X : 2.5%

T he percentage change on day n − 1 for variable Y : 3.5%

What is the updated estimated covariance between them?

A. cannot be estimated

B. 0.00051000

C. 0.00048000

D. 0.00051555

T he correct answer is D.

Covariance between X and Y on day n– 1 :

Cov n −1 = 0.8 ∗ 0.02 ∗ 0.03 = 0.00048

Updated covariance using EWMA:

Cov n = λCov n-1 + (1 − λ)X n −1 Y n −1

= 0.91 ∗ 0.00048 + 0.09 ∗ 0.025 ∗ 0.035
= 0.00051555

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Q.3384 An analyst is trying to updates the estimated covariance by using the exponentially weighted
moving average (EWMA) model with λ = 0.91. T he analyst has gathered the following relevant data.

Estimated standard deviation on day n − 1 for variables X : 2%

Estimated standard deviation on day n − 1 for variables Y : 3%

T he correlation between them: 0.8

T he observed return on day n − 1 for variable X : 2.5%

T he observed return on day n − 1 for variable Y : 3.5%

Given that the new Covariance between X and Y is 0.00051555, what is the updated estimated
correlation between them?

A. 0.825

B. 0.800

C. 0.910

D. None

T he correct answer is A.

Compute updated standard deviation using EWMA.

σn2 = λσn2−1 + (1 − λ)u2n −1

Updated variance for X = 0.91 ∗ 0.02 ∗ 0.02 + 0.09 ∗ 0.025 ∗ 0.025 = 0.00042025
Updated standard deviation for X = √0.00042025 = 0.0205
Updated variance for Y = 0.91 ∗ 0.03 ∗ 0.03 + 0.09 ∗ 0.035 ∗ 0.035 = 0.00092925
Updated standard deviation for Y = √0.00092925 = 0.030483602

Cov(X,Y ) 0.00051555
Updated correlation = = = 0.824993729 = 0.825
[SD(X) ∗ SD(Y )] 0.0205 ∗ 0.030483602

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Q.3385 Suppose that an analyst has gathered the following relevant data for estimating updated
covariance using the EWMA model:

Estimated standard deviation on day n − 1 for variables X : 2%

Estimated standard deviation on day n − 1 for variables Y : 3%

T he correlation between them: 0.8

T he percentage change on day n − 1 for variable X : 25%

T he percentage change on day n − 1 for variable Y : 35%

Assuming that we choose λ = 0.96, what is the updated estimated covariance between variables X
and Y using the EWMA model?

A. 0.00041

B. 0.00048

C. 0.08402

D. 0.003961

T he correct answer is D.

Cov n −1 = 0.8 × 0.02 × 0.03 = 0.00048

Updated covariance using EWMA model is given by:

Cov n = (λ)Cov n −1 + (1 − λ)X n −1Y n −1

= 0.96 × 0.00048 + 0.04 × 0.25 × 0.35
= 0.0039608 ≈ 0.003961

Q.3386 T he parameters of a generalized autoregressive conditional heteroskedastic (GARCH)(1,1)

model are α = 0.05; and β = 0.91. T he long-run average variance rate is 0.80%. T he analyst has
gathered the following relevant data for estimating updated covariance using the GARCH(1, 1) model.

Estimated standard deviation on day n − 1 for variables X : 2%

Estimated standard deviation on day n − 1 for variables Y : 3%

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T he correlation between them: 0.8

T he return observed on day n − 1 for variable X : 2.5%

T he return observed on day n − 1 for variable Y : 3.5%

What is the updated estimated correlation between the two variables using EWMA model with
λ = 0.96?

A. 0.8840

B. 0.4500

C. 0.5351

D. 0.9270

T he correct answer is C.

Updated standard deviation using the GARCH model:

σn2 = ω + αu2n −1 + βσn2−1

w
VL =
1 −α −β
⇒ w = VL × (1 − α − β) = 0.80% × (1 − 0.05 − 0.91) = 0.00032
Updated variance for X = 0.00032 + 0.05 ∗ 0.025 ∗ 0.025 + 0.91 ∗ 0.02 ∗ 0.02 = 0.00071525
Updated standard deviation for:X = √0.00071525 = 0.026744158

Updated variance for Y = 0.00032 + 0.05 ∗ 0.035 ∗ 0.035 + 0.91 ∗ 0.03 ∗ 0.03 = 0.00120025
Updated standard deviation for Y = √(0.00120025) = 0.034644624

Covariance between X and Y on day n − 1

Cov n-1 = 0.8 × 0.02 × 0.03 = 0.00048

Updated covariance using EWMA model is given by:

Cov n = (λ)Cov n −1 + (1 − λ)X n −1Y n −1

= 0.96 × 0.00048 + 0.04 × 0.025 × 0.035
= 0.0004958

Cov(X Y )
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Cov(X , Y )
Updated correlation =
[SD(X) ∗ SD(Y )]
0.0004958
=
0.026744158 × 0.034644624
= 0.5351

Q.4659 If the daily volatility of the price of gold is 0.3% in a given year, and assuming that a year has
252 trading days, what is the annualized volatility of the gold price? (Assume that there are 252
trading days in a year)

A. 0.0467

B. 0.0356

C. 0.0476

D. 0.0120

T he correct answer is C.

Using the scaling analogy, the corresponding annualized volatility is given by:

σannual = √252 × σdaily = √252 × 0.003 = 0.047624

Q.4661 A stock market investor records the stock price for five consecutive days as 20.20, 20.00,
21.20, 21.00, and 23.30. Estimate the daily volatility using the stock price returns?

A. 10.25%

B. 5.6%

C. 11.45%

D. 12.56%

T he correct answer is B.

T he variance rate is given by:

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1 m
σn2 = ∑ r2n −i
m i=1

Recall that return are calculated by:

Si − Si−1
ri =
Si−1

T he following table gives the consecutive returns:

Day Stock Price ri

1 20.2 −
2 20.0 −0.0099
3 21.2 0.06
4 21.0 −0.00943
5 23.3 0.10952

Now,

1 m
σn2 = ∑ r2n −i
m i=1

1
[(−0.0099)2 + (0.06)2 + (−0.00943)2 + (0.10952)2] = 0.0031563
5

T he volatility is the square root of the variance rate:

∴ σn = √0.0031563 = 0.056 = 5.6%

Note: Your textbook in section 3.3 says the following: "T he usual formula for calculating standard

deviations from sample data would give the volatility estimated for day n from the return on the m

previous days [using m-1]. In risk management, we usually simplify this formula [by replacing] m - 1

by m."

Also, it gives an example on which you can see that we use 1/m as the actual number of days and not

the number of returns.

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Q.4662 Consider a GARCH (1,1) model with ω=0.00005, α=0.025, and β =0.90, what is the value of
long-run average volatility?

A. 0.0245

B. 0.0258

C. 0.0051

D. 0.00735

T he correct answer is B.

GARCH(1,1) model is given by

σn2 = αr2n −1 + βr2n −1 + γVL

Where

VL : long-run average variance rate

α: weight given to the most recent squared returns

β : weight given to the previous variance rate estimate

γ : weight given to long-run average variance rate

VL can be defined as:

ω ω 0.00005
VL = = = = 0.0006667
γ 1−α −β 1 − 0.925

T herefore, the long-run average volatility is given by:

√0.0006667 = 2.58%

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Q.4663 T he current volatility for stock prices is estimated to be 4% per day. Assuming the GARCH
(1,1) model with ω=0.00005, α=0.025, and β =0.90, what is volatility estimate in 50 days?

A. 0.0009

B. 0.0044

C. 0.0303

D. 0.0262

T he correct answer is D.

According to GARCH (1,1), the expected variance rate on day t is given by:

σn2+t = VL + (α + β)t (σn2 − VL )

Where

VL : long-run average variance rate

α: weight given to the most recent squared returns

β : weight given to the previous variance rate estimate

σn2: current volatility estimate

Now,

w
VL =
1−α − β
0.00005
= = 0.00067
1 − 0.025 − 0.90

T hus, σn2+50 = 0.000672 + (0.025 + 0.90)50(0.042 − 0.00067) = 0.0006889

Expected volatility is the square root of the expected variance rate:

σn +50 = √0.0006889 ≈ 0.00262

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Q.4664 An investor notes that the closing stock price for asset A yesterday was USD 50, with a
corresponding volatility if 2.5% per day. Similarly, the closing stock price for asset B was USD 30,
with a corresponding volatility of 1.5% per day. Today, the stock price for asset A closed at USD 45,
and that of B closed at USD 35. T he correlation coefficient between the stocks A and B on close of
trading yesterday was 0.55.
Using the EWMA model with λ=0.85, what is the updated correlation coefficient between stocks A
and B?

A. 0.64

B. -0.64

C. 0.78

D. -0.78

T he correct answer is D.

According to the EWMA model,

s2n = (1−?)r2n −1+?s2n −1

45−50 35−30
For stock A, a return is -0.10 (= ) and that of B is 0.1667 (= ). T herefore, updated volatility
50 30

for stock A is:

sAn = √(1 − 0.85) × (−0.10)2 + 0.85 × 0.0252 ) = 0.04507

And that of B is:

sBn = √(1 − 0.85) × (0.1667)2 + 0.85 × 0.0152 ) = 0.06603

Now using the formula:

Cov(A, B)
Corr(A, B) =
sAsB

?Cov(A, B) = Corr(A, B) × sA sB

So the covariance yesterday was:

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Cov(An −1, Bn −1 ) = 0.55 × 0.025 × 0.015 = 0.00020625

T he covariance is updated using the formula:

cov n =?cov n −1 + (1−?)x n −1y n −1

?Cov(An , Bn ) = 0.85 × 0.00020625 + (1 − 0.85) × −0.10 × 0.1667

= −0.002325

Cov( A,B)
Using the formula Corr(A, B) = once again, the new correlation is given by:
s As B

−0.002325
Corr(An , Bn ) = = −0.7813
0.04507 × 0.06603

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Reading 50: External and Internal Credit Ratings

Q.1041 Which of the following statements is INCORRECT with regard to credit ratings?

A. A credit rating represents the agency’s opinion about the creditworthiness of an obligor
with respect to a particular debt security or other financial obligation.

B. Credit rating also applies to an issuer’s general creditworthiness.

C. T here are generally two types of assessment corresponding to different financial

instruments: short term and long term.

D. Credit ratings from different agencies convey the same information.

T he correct answer is D.

Issuer-specific credit ratings represent the agency’s opinion about the creditworthiness of an obligor
with respect to a particular debt security or other financial obligation.

Issuer credit rating also applies to an issuer’s general creditworthiness.

T here are generally two types of assessment corresponding to different financial instruments: short-

term and long-term.

Credit ratings from various agencies normally convey differentiated information. For instance,

Standard & Poor’s perceives its ratings primarily as an opinion on the likelihood of default of an

issuer, whereas Moody’s ratings tend to reflect the agency’s opinion on the expected loss on a

facility.

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Q.1042 Which of the following statements is NOT true regarding the rating process?

A. T he criteria according to which any assessment is provided are very strictly defined and
constitute the intangible assets of rating agencies.

B. T he rating agency reviews qualitative as well as quantitative factors and compares the
company's performance with that of its peers.

C. T he issuer is notified of the rating and the major considerations supporting it before it is
discussed by the rating committee.

D. When a rating is put on a credit watch list, a comprehensive analysis is undertaken.

T he correct answer is C.

T he criteria according to which any assessment is provided are very strictly defined and constitute
the intangible assets of rating agencies. T he rating agency reviews qualitative as well as quantitative
factors and compares the company's performance with that of its peers. T he issuer is notified of the
rating and the major considerations supporting it only after the committee discusses the lead
analyst’s recommendation before voting on it. When a rating is put on a credit watch list, a
comprehensive analysis is undertaken.

Q.1043 T he rating “outlook” provides information about the:

A. Rating trend.

B. Loss severity independent of probability of default.

C. Loss severity given the probability of default.

D. Probability of default.

T he correct answer is A.

T he rating "outlook" provides information about the rating trend. A positive outlook means that there
is some potential upside conditional to the realization of current assumptions regarding the company.
On the flip side, a negative outlook suggests that the creditworthiness of the company follows a
negative trend.

Options B, C, and D are all incorrect since outlooks only indicate the most likely direction of a rating

over the medium term. Outlooks do not explain anything to do with the probability of default.

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Q.1044 Which of the following factor is part of the quantitative analysis of rating of an industrial
company?

A. Business fundamentals.

B. Operations and cost control.

C. Financial ratios.

D. Both A and B.

T he correct answer is C.

For industrial companies, the rating analysis is commonly split between business reviews (firm
competitiveness, quality of the management and of its policies, business fundamentals, regulatory
actions,markets, operations, cost control, etc.) and quantitative analyses (financial ratios, etc.).

Q.1045 T he rating of an issuer provided by a rating agency is a (an):

A. Mere opinion on the issuer or securities issued by the issuer.

B. Recommendation to purchase, sell, or hold any types of security.

C. Indicator of the issuer's creditworthiness and also gives the price or relative value of
specific securities.

D. Recommendation based on quantitative analyses and business reviews.

T he correct answer is A.

T he agencies persistently emphasize that their ratings are mere opinions.

Option B is incorrect: Ratings do not constitute any recommendation to purchase, sell, or hold any
type of security.

Option C is incorrect: A rating in itself indeed says nothing about the price or relative value of
specific securities.

Option D is incorrect: T hese opinions (not recommendations) are based on quantitative analyses and
business reviews.

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Q.1046 Which of the following statements is true with regard to the relationship between ratings and
probabilities of default?

A. Across all industries, the number of defaults monotonically increases as we move down
the credit rank.

B. A given rating is meant to be forward-looking; it is devised to pinpoint a precise probability

of default.

C. Ex-post information such as that provided in default tables or transition matrices does
guarantee to provide ex-ante insights regarding future probabilities of default or migration.

D. Both A and B.

T he correct answer is A.

Rating agencies publish on a regular basis table reporting observed default rates per rating category,
per year, per industry, and per region. T hey show that ratings tend to have homogeneous default
rates across industries. T his implies that in every industry, the number of defaults increases as we
move down the ratings order. However, It is important to bear in mind that for a given rating
category, default rates can vary from industry to industry (e.g., a higher percentage of banks with a
given rating, say BBB, will default when compared with firms in other industries with the same
rating).
Option B is incorrect: Although a rating is meant to be forward-looking, it is not devised to pinpoint a
precise probability of default, but rather to point to a broad risk bucket.

Option C is incorrect: T ransition matrices serve as indicators of the likely path of a given credit at a
given horizon. Ex-post information such as that provided in default tables or transition matrices does
not guarantee to provide ex-ante insights regarding future probabilities of default or migration.

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Q.1047 T he following statements are true about through-the-cycle ratings issued by the rating
agencies except:

A. help financial institutions to better manage customers.

B. mitigate the effect of cycles on ratings by incorporating the effect of an “average cycle”
in their scenarios.

C. fluctuate much with temporary changes in microeconomic conditions.

D. valid for a much longer period.

T he correct answer is C.

A through-the-cycle rating does not fluctuate much with temporary changes in macroeconomic

conditions since they are already factored in the rating.

Because of their low volatility, through-the-cycle ratings help financial institutions to better manage

customers. Too many rating changes necessitate changes in the way a bank handles a customer,

including the products the bank is ready to offer.

Analysts try to mitigate the effect of cycles on ratings by incorporating the effect of an "average

cycle" in their scenarios.

T hrough-the-cycle ratings are less volatile than at-the-point ratings and thus are valid for a much

longer period (exceeding one year).

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Q.1048 Which of the following statement is most likely to be true with regard to the impact of a
rating downgrade/upgrade on the price of bonds/stocks?

A. A rating downgrade is somewhat likely to increase the price of a bond.

B. A rating downgrade is likely to decrease the price of a bond.

C. A rating upgrade is unlikely to increase the price of the stock since the price only reflects
the earnings expectations of investors.

D. A rating downgrade is unlikely to decrease the price of a stock since the price largely
reflects earnings expectations among consumers.

T he correct answer is B.

A rating downgrade is likely to decrease the price of the bond. For instance, a rating agency may
downgrade a bond issue's rating from BBB to BB because of the fall in the firm's debt repayment
ability, for example, the deterioration in the current ratio. T his will increase the bond’s yield
substantially and its price will fall. In this particular case, the bond will go from investment-grade to
below investment-grade, which will force many pension funds to sell the bond since some may only
be allowed to hold investment-grade securities; this will put more pressure on the bond’s already low
price. A rating upgrade works in the opposite direction and is likely to increase the price of the bond.
A rating upgrade is somewhat likely to increase the price of the stock to reflect improved investor
expectations. A rating downgrade is likely to decrease the price of the stock, reflecting a dip in
investor confidence.

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Q.2810 T he CRO of an investment bank is reviewing the internal rating assessment policies. He
notices that the bank is using the through-the-cycle approach to rate the borrowers. He is
concerned about the effectiveness of the current approach during recessions and asks to compare it
with the at-the-point-in-time approach.Which of the following statements is correct?

A. During recessions, the through-the-cycle approach tends to over-estimate risk during

recessions.

B. During recessions, the at-the-point-in-time approach tends to over-estimate risk during

recessions.

C. During recessions, both through-the-cycle and at-the-point-in-time approaches tend to

over-estimate risk.

D. During recessions, both through-the-cycle and at-the-point-in-time approaches tend to

under-estimate risk.

T he correct answer is B.

T he at-the-point-in-time approach assesses the credit quality over the near term and tends to amplify

the effect of the business cycle. During recessions, the at-the-point-in-time approach tends to

overestimate risk.

On the other hand, through-the-cycle internal ratings try to evaluate the permanent component of

default risk. Unlike point-in-time ratings, they are said to be nearly independent of cyclical changes in

the creditworthiness of the borrower. T hey are not affected by credit cycles, i.e. they are through

the cycle. As a result, they are less volatile than at-the-point ratings and are valid for a much longer

period (exceeding one year).

Q.2811 Greg Teller, a credit risk analyst, was requested by the CRO to check an internal rating
transition matrix prepared by an intern. T he matrix is based on actual rating migrations over the last
ten years. T he bank has ratings of A, B, C, and D, with A representing the highest credit quality and D
representing a default. T he bank currently has a rating of C. T he intern prepares the following table:

Annual Rating T ransitions (%, Average Annual)

A B C D
A 95.00 3.00 2.00 −
B 2.00 89.00 5.00 2.00
C − 7.00 83.00 10.00

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After a short review, Teller makes the following statement to the CRO: Statement 1: “T he internal
rating transition matrix is correct.” He also decides to incorporate the findings from the matrix in
the conclusion of his research report for LLL Construction (the only C-rated borrower of the bank).
He includes the following sentence in the conclusion of the report: Statement 2: “ T he risk
management department recommends creating significant loan loss provisions for LLL’s facility as it
has a 10% chance of default with the current rating and a 0% chance of improvement to an A rating
over the longer term.” Are Teller’s statements correct?

A. Statement 1 is correct while statement 2 is incorrect.

B. Statement 1 is incorrect while statement 2 is correct.

C. Statement 1 is correct, and statement 2 is also correct.

D. Statement 1 is incorrect, and statement 2 is also incorrect.

T he correct answer is D.

Statement 1 is incorrect. T he rows of the internal rating transition matrix should sum up to 100. In

the matrix prepared by the intern, the sum of the probabilities in the second row is 98.

Statement 2 is incorrect. Based on the internal rating transition matrix, LLL Construct has no chance

of a rating improvement to A in one year, but there is a non-zero probability of an improvement over

the longer term.

Additional explanation:

T he transition matrix shows 1-year transition probabilities given a particular starting point. T he

matrix is interpreted from left to right. T his means A, B, and C, as shown on the left side, indicate the

possible starting points.

So, if the bank is currently rated C, a move to A in exactly one year has a zero probability as

indicated by the blank probability representing the CA intersection.

Statement 2 is partly correct because, at C, the bank indeed has a 10% chance of transitioning to D

(default). However, the final part of the statement is incorrect, and here’s why:

If we consider the long-term, or rather a period greater than one year, there’s a non-zero chance of

an A rating at some point in the future. For example, in just two years, the bank can move from C to

B with P(7%), then B to A with P(2%).

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Q.3436 Simon Bryan, FRM, is scrutinizing historical migration tables published by S&P’s and
Moody’s. Which of the following statements would possibly appear under “additional information”
below such tables?

A. We should expect to see the highest level of rating stability in the intermediate term (five-
year time frame). Risk ratings will tend to have changed more at both the one- year and ten-
year horizons.

B. We should expect to see the highest level of rating stability during the one-year
timeframe. T his stability will decline at both the five-year time frame and even more so at
the ten-year horizon.

C. We should expect to see the greatest amount of credit rating stability over long periods of
time (e.g., ten years). Credit ratings will tend to change more during shorter periods of time.

D. We should expect to see credit ratings change by about the same amount over time. T he
ratings transition matrix shows approximately the same figures for the one-year, five-year,
and ten-year time horizons.

T he correct answer is B.

T he Rating T ransition Matrix tables developed by renowned rating agencies show that credit ratings
are their most stable over a one-year horizon and that stability decreases with longer horizons.

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Q.3437 ANEX Financials (AF), a U.S. based firm, has just issued a two-year zero-coupon bond
currently rated AA. Market analysts expect that one year from now:

T he probability that the rating of AF remains at AA is 90%

T he probability that the rating of AF is downgraded to A is 5%

T he probability that AF is upgraded to AAA is 5%

T he risk-free rate is flat at 2%, and credit spreads for AAA-, AA-, and A-rated debt are flat at 40, 60,
and 100 basis points, respectively. All rates are compounded annually. What is the best approximation
of the expected value of the zero-coupon bond a year from today?

A. 97.6

B. 97.5

C. 97.7

D. 97.4

T he correct answer is B.

In a year’s time, the bond will be a 1-year zero-coupon bond.

T he bond has different expected values in each of the three scenarios outlined above. Precisely,

100
P AAA = = 97.66
(1 + 0.02 + 0.004)1

100
P AA = = 97.47
(1 + 0.02 + 0.006)1

100
PA = = 97.09
(1 + 0.02 + 0.01)1

Note that as the ratings deteriorate, so does the value of the bond.
Expected value = 5%× 97.66 + 90%× 97.47 + 5%×97.09 = 97.46

Note: 1% = 100 basis points

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Q.3438 Rating agencies make efforts to incorporate the effects associated with an economic cycle in
their ratings. Although this practice is generally valid, it may lead to:

A. Underestimation of the probability of default in an economic recession

B. Overestimation of the probability of default in an economic recession

C. Underestimation of the probability of default in an economic expansion

D. Divergence of the interests of agency analysts and those of management

T he correct answer is A.

Since ratings are generally produced with an eye on a long-term period, they must take into account
any economic/industrial cycle on the horizon. Rating agencies make efforts to incorporate the
effects associated with an economic cycle in their ratings. Although this practice is generally valid, it
can lead to underestimation or overestimation of default if the predicted economic cycle doesn’t play
out exactly as expected. In particular, a firm’s probability of defaulting during a severe downturn may
be underestimated based on the given rating.

Q.4682 Given a constant hazard rate of 0.02, what is the survival probability until year 3?

A. 0.9674

B. 0.9418

C. 0.9518

D. 0.942

T he correct answer is B.

T he survival probability to time t is given by;

exp (−ht)

Where h is the hazard rate

T hen, the survival probability to year 3 is given by;

exp (−0.02 × 3) = 0.9418

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Q.4683 Suppose a firm has a debt of $20 million. If the recovery rate is 80%, and that there is a 0.03
chance that the loan will default, what is the expected loss when the loan defaults?

A. 0.12m

B. 0.15m

C. 0.09m

D. 0.06m

T he correct answer is A.

Since the recovery rate is 80%, the loss given default (LGD) is

LGD = 100% − 80% = 20% .

T he expected loss on the loan is, therefore, :

EL = P D × LGD × EAD = 0.03 × 0.20 × $20 million = $0.12 million

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Q.4684 Consider a firm in which the following information rations

i. Working capital to total assets = 0.32

ii. Retained earnings to total assets = 0.44
iii. Earnings before interest and taxes to total assets = 0.80
iv. Market value of equity to book value of total liabilities = 1.2
v. Sales to total assets = 1.8

What is the Altman’s Z-score for the firm?

A. 6.235

B. 6

C. 6.1582

D. 6.2543

T he correct answer is C.

T he Altman’s Z-score is given by:

Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 0.999X 5

= (1.2 × 0.32) + (1.4 × 0.44) + (3.3 × 0.80) + (0.6 × 1.2) + 0.999 × 1.8
= 6.1582

Where:

X 1: Working capital to total assets,

X 2: Retained earnings to total assets,

X 3: Earnings before interest and taxes to total assets,

X 4: Market value of equity to book value of total liabilities, and

X 5: Sales to total assets.

T he firm in this case, is not l i k el y to default since Z-score is greater than 3.

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Q.4685 Suppose the hazard rate for the first three years is 0.01 and the hazard rate for the next
three years is 0.02. What is the probability of default between years 3 and 6?

A. 0.0421

B. 0.0565

C. 0.9434

D. 0.9579

T he correct answer is B.

To calculate the probability of default between year 3 and year 6, we first calculate the average
0. 01+0. 02
hazard rate which equals to = 0.015
2

T he probability of default between years 3 and year 6 is therefore given by:

PD3,6 = default during the first 3 years − default during the first 6 years
= [exp(−0.01 × 3)] − [exp (−0.015 × 6)]
= 0.0565

Q.4686 Suppose that company XYZ has a debt value of $100m and that the value of its assets is
$120m. What is the value of the equity at that future point in time?

A. 0

B. 20m

C. min(20m,0)

D. 83.33m

T he correct answer is B.

Let v be the value of the company’s assets and let d be the value of the debt. T he value of equity is

given by:

max (v − d,0) = max (120 − 100, 0)

= max (20,0) = 20

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Q.4687 Suppose v is the value of the asset, and d is the value of the debt, the firm defaults when:

A. v < d

B. v > d

C. v = d

D. max(v − d) > d

T he correct answer is A.

T he firm defaults when the value of its assets is less than the value of its total debt.

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Reading 51: Country Risk

Q.1029 Armenia Bank has opened a new branch in a country where political risk is substantial. T he
board of the bank would like to get a report from the risk department on political risks likely to be
faced in other countries. T he risk department, while presenting the report, makes the following
statements:
Statement I: Democratic countries are always less risky than dictatorship countries
Statement II: T he chaos of democracy does create more discontinuous risk (policies that change as
governments shift), and dictatorships create more continuous risk
Statement III: Corruption is an implicit tax on income (that does not show up in conventional income
statements as such) that reduces the profitability and returns on investments for businesses in that
country directly and for investors in these businesses indirectly
Statement IV: Countries that are in the midst of physical conflicts, either internal or external, will
expose investors/businesses not only economic costs but also physical costs

Which of these statements are true?

A. II, III & IV only.

B. II & III only.

C. III & IV only.

D. All of the above.

T he correct answer is C.

Statements I & II are incorrect. Democratic countries are less or more risky than their
authoritarian countries. T he chaos of democracy does create more continuous risk (policies that
change as governments shift), dictatorships create more discontinuous risk.
Statements III & IV are correct. Corruption is an implicit tax on income that reduces the
profitability and returns on investments for businesses in that country directly and for investors in
these businesses indirectly. Countries that are in the midst of physical conflicts, either internal or
external, will expose investors/businesses not only economic costs but also physical costs.

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Q.1030 Simon Fernando, a country risk intern working at Cross Country Ratings Limited, is preparing
a report on services measuring country risk. He lists out the following details in his report:
Statement I: T he country scores used by different services are standardized
Statement II: A country with a risk score of 80 in the PRS scoring mechanism is twice as safe as a
country with a score of 40
Statement III: Country risk scores are more useful for measuring relative risk than for ranking the
countries.

Which of these statements are correct?

A. I only.

B. II & III only.

C. All of the above.

D. None of the above.

T he correct answer is D.

Statement I is incorrect: T he country scores are not standardized, and each service uses its own
protocol.
Statement II is incorrect: A country with a risk score of 80 in the PRS scoring mechanism is safer
than a country with a risk score of 40, but it would be dangerous to read the scores to imply that it is
twice as safe.

Statement III is incorrect: Country risk scores are more useful for ranking the countries than for
measuring relative risk.

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Q.1031 An analysis of country defaults has shown that:

I. Countries have been more likely to default on sovereign bonds issued than bank debt owed
II. In dollar value terms, Sub-Saharan countries have accounted for much of sovereign defaulted debt
in the last 50 years
III. As per Moody’s, countries are increasingly defaulting on foreign currency debt
IV. Defaults since the 1960s have been more likely on foreign currency debt than on foreign
currency bonds
Which of the above statements are correct?

A. II, III & IV only.

B. I & II only.

C. III & IV only.

D. All of the above.

T he correct answer is C.

Statements I & II are incorrect. Countries have been more likely to default on bank debt owed than
on sovereign bonds issued, in dollar value terms. Latin American countries have accounted for much
of sovereign defaulted debt in the last 50 years.
Statements III & IV are correct. As per Moody’s, countries are increasingly defaulting on foreign
currency. Defaults since the 1960s have been more likely on foreign currency debt than on foreign
currency bonds.

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Q.1032 Country ABC recently defaulted on local currency and foreign currency sovereign debt. One
of the economists of the country writes an article in the leading business weekly of the country and
lists out the short term and long term effects of defaulting on debt:
I. Default has a negative impact on real GDP growth of between 0.5% and 2%
II. Default does affect a country's long-term sovereign rating and borrowing costs
III. Sovereign default makes banking systems more robust
IV. Sovereign default also increases the likelihood of political change

Which one of them is correct according to research materials available on the subject?

A. II, III & IV only.

B. I & II only.

C. I, II & IV only.

D. All of the above.

T he correct answer is C.

Statement I is correct. Default has a negative impact on real GDP growth of between 0.5% and 2%.
Statement II is correct. Default does affect a country’s long-term sovereign rating and borrowing
costs. One study of credit ratings in 1995 found that the ratings for countries that had defaulted at
least once since 1970 were one to two notches lower than otherwise similar countries that had not
defaulted. In the same vein, defaulting countries have borrowing costs that are about 0.5 to 1%
higher than countries that have not defaulted.

Statement III is i ncorrect. Sovereign default can make banking systems more fragi l e. A study of
149 countries between 1975 and 2000 indicates that the probability of a banking crisis is 14% in
countries that have defaulted, an eleven percentage-point increase over non-defaulting countries.

Statement IV is correct. Sovereign default also increases the likelihood of political change. A study of
devaluations between 1971 and 2003 finds a 45% increase in the probability of change in the top
leader (prime minister or president) in the country and a 64% increase in the probability of change in
the finance executive (minister of finance or head of central bank).

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Q.1033 McGrath, a University student, is working on an article titled “Factors Determining

Sovereign Default Risk.” He sources data from around the world on sovereign default and analyzes
the data. Finally, he compiles his findings based on his understanding and analysis of the data. He seeks
your help in verifying the accuracy of his findings.
Statement I: Income tax-based systems generate more volatile revenues than sales tax (or value-
added tax systems)
Statement II: T he decision to default is as much a political decision as it is an economic decision
Statement III: Autocracies are more likely to default than democracies
Statement IV: T he independence and power of the central bank will also affect assessments of
default risk

Which of these statements are accurate?

A. II, III & IV only.

B. I & II only.

C. I, II & IV only.

D. All of the above.

T he correct answer is D.

Income tax-based systems generate more volatile revenues than sales tax (or value-added tax
systems). T he decision to default is as much a political decision as it is an economic decision.
Autocracies (where there is less worry about political backlash) are more likely to default than
democracies. T he independence and power of the central bank will also affect assessments of default
risk.

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Q.1034 An analysis of the sovereign ratings provided by different rating agencies reveals that:
I. For the most part, there is a consensus among the rating agencies in the ratings, but there can be
significant differences on individual countries
II. Sovereign ratings change over time but far less than corporate ratings do
III. Sovereign ratings change little on an annual basis for higher-rated countries compared to lower-
rated countries
IV. Rating agencies assess risk at the broader regional level and have been accused of regional biases

Which of these are correct statements?

A. II, III & IV only.

B. I & II only.

C. I, II & IV only.

D. All of the above.

T he correct answer is D.

For the most part, there is a consensus among the rating agencies in the ratings, but there can be
significant differences in individual countries. Sovereign ratings change over time but far less than
corporate ratings do. Sovereign ratings change little on an annual basis for higher-rated countries
compared to lower-rated countries. Rating agencies assess risk at the broader regional level. One of
the criticisms that rated countries have mounted against the rating agencies is that they have regional
biases, leading them to underrate entire regions of the world (Latin America and Africa).

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Q.1035 T hree economists participate in a discussion on ‘local and foreign currency sovereign
ratings' on live television. T he following are the opinions expressed by these economists on this
topic:
Economist 1: T he differential between foreign and local currency ratings is primarily a function of
monetary policy independence
Economist 2: Countries that maintain floating rate exchange regimes and fund borrowing from deep
domestic markets will see local currency ratings converge on foreign currency ratings
Economist 3: For the most part, local currency ratings are at least as high or higher than the foreign
currency rating. T here are, however, notable exceptions, where the local currency rating is lower
than the foreign currency rating.

Which economist(s) made (an) accurate statement(s)?

A. Only Economist 3.

B. Only Economists 1 and 3.

C. Only Economist 1.

D. All three economists.

T he correct answer is B.

Economist 1 is correct. T he differential between foreign and local currency ratings is primarily a

function of monetary policy independence.

Economist 2 is incorrect. Countries that maintain floating rate exchange regimes and fund borrowing

from deep domestic markets will have the l argest di fferences between l ocal and forei gn

currency rati ngs, whereas countries that have given up monetary policy independence, either

through dollarization or joining a monetary union, will see local currency ratings converge on foreign

currency ratings.

Economist 3 is correct. For the most part, local currency ratings are at least as high or higher than

the foreign currency rating, for the obvious reason that governments have more power to print

more of their own currency. T here are, however, notable exceptions where the local currency

rating is lower than the foreign currency rating. In March 2010, for instance, India was assigned a

local currency rating of Ba2 and a foreign currency rating of Baa3.

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Q.1036 Each rating agency has its own system for estimating sovereign ratings, but the processes
share a great deal in common. With regard to sovereign ratings provided by rating agencies and the
processes followed by them, identify the correct statements.
I. A sovereign rating is focused on the creditworthiness of the sovereign country to private creditors
and not to official creditors
II. Rating agencies also vary on whether their rating captures only the probability of default or also
incorporates the expected severity
III. T he ratings are decided by a vote of the committee
IV. News of a political coup or an economic disaster can lead to a rating review not just for the
country in question but also for surrounding countries

A. II, III & IV only.

B. I & II only.

C. I, II & IV only.

D. All of the above.

T he correct answer is D.

A sovereign rating is focused on the creditworthiness of the sovereign country to private creditors
(bondholders and private banks) and not to official creditors (that includes the World Bank, the IMF,
and other entities). Rating agencies also vary on whether their rating captures only the probability of
default or also incorporates the expected severity. T he ratings are decided by a vote of the
committee. News of a political coup or an economic disaster can lead to a rating review not just for
the country in question but also for surrounding countries (that may face a contagion effect).

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Q.1037 Rating agencies have been criticized for failing investors on several counts in the case of
sovereign ratings. Which of the following are accurate criticisms faced by rating agencies?
I. Rating agencies have been accused of being far too optimistic in their assessments of corporate
rating as compared to sovereign ratings
II. When one rating agency lowers or raises a sovereign rating, other rating agencies seem to follow
suit
III. Rating agencies take too long to change ratings, and these changes happen too late to protect
investors from a crisis
IV. Once a market is in crisis, there is the perception that rating agencies sometimes overreact and
lower ratings too much, thus creating a feedback effect that makes the crisis worse

A. II, III & IV only.

B. I & II only.

C. I, II & IV only.

D. All of the above.

T he correct answer is A.

Statement I is incorrect: Rating agencies have been accused of being far too optimistic in their
assessments of both corporate and sovereign ratings. While the conflict of interest of having issuers
pay for the rating is offered as the rationale for the upward bias in corporate ratings, that argument
does not hold up when it comes to sovereign ratings, since the issuing government does not pay
rating agencies.
Statement II is correct: When one rating agency lowers or raises a sovereign rating, other rating
agencies seem to follow suit.

Statement III is correct: Rating agencies take too long to change ratings, and that these changes
happen too late to protect investors from a crisis.

Statement IV is correct: Once a market is in crisis, there is the perception that rating agencies
sometimes overreact and lower ratings too much, thus creating a feedback effect that makes the
crisis worse.

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Q.1038 Market interest rates and market-based default spreads play an important role in
understanding sovereign ratings. Which of the following statements are true?
I. Market-based spreads are more dynamic than ratings, with changes occurring in real time
II. Market-based default measures tend to be far more volatile than ratings and can be affected by
variables that have nothing to do with default
III. T he sovereign bond market leads rating agencies, with default spreads usually climbing ahead of a
rating downgrade and dropping before an upgrade
IV. Notwithstanding the lead-lag relationship, a change in sovereign ratings is still an informational
event that creates a price impact on the sovereign bonds at the time that it occurs

A. II, III & IV only.

B. I & III only.

C. I, II & IV only.

D. All of the above.

T he correct answer is D.

T here is a strong correlation between sovereign ratings and market default spreads. Market-based
spreads are more dynamic than ratings, with changes occurring in real-time. Market-based default
measures tend to be far more volatile than ratings and can be affected by variables that have nothing
to do with default. Liquidity and investor demand can sometimes cause shifts in spreads that have
little or nothing to do with default risk. T he sovereign bond market leads rating agencies, with default
spreads usually climbing ahead of a rating downgrade and dropping before an upgrade. Notwithstanding
the lead-lag relationship, a change in sovereign ratings is still an informational event that creates a
price impact at the time that it occurs.

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Q.1039 Bank ABC relies on credit default swaps to assess the default risk of sovereign bonds/debt.
Which of the following statements are true with regard to the relationship between Credit Default
Swaps and default risk?

I. Changes in CDS spreads lead to changes in sovereign bond yields and sovereign ratings
II. T he CDS market is quicker or better at assessing default risks than the government bond market,
from which default spreads can be extracted
III. T he exposure to counterparty and liquidity risk, endemic to the CDS market, can cause changes
in CDS prices that have little to do with default risk
IV. T he narrowness of the CDS market can make individual CDS susceptible to illiquidity problems,
with a concurrent effect on prices

A. I, III & IV only.

B. I & III only.

C. I, II & IV only.

D. All of the above.

T he correct answer is A.

Statement II is incorrect. It is not clear that the CDS market is quicker or better at assessing default
risks than the government bond market, from which we can extract default spreads.
All other statements are correct. Changes in CDS spreads lead to changes in the sovereign bond
yields and in sovereign ratings. T he exposure to counterparty and liquidity risk, endemic to the CDS
market, can cause changes in CDS prices that have little to do with default risk. T he narrowness of
the CDS market can make individual CDS susceptible to illiquidity problems, with a concurrent effect
on prices

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Q.1040 Country XYZ chooses to default in local currency. Which of the following may NOT be a
compelling reason to default in local currency?

A. Following Gold standard in the decades prior to 1971.

B. Shared currency.

C. Foreign currency debt funding local currency assets.

D. Local currency debt funding foreign currency assets.

T he correct answer is D.

In most cases, debt in local currency has been considered safer than debt in foreign currency.

Opti on A i s i ncorrect: In the decades prior to 1971, countries following the gold standard had to

back up their currency with gold reserves putting a limit on how much currency could be printed.

Opti on B i s i ncorrect: Countries following shared currency give up the power to control how

much of the currency they could print in return for a common market and the convenience of a

common currency.

Opti on C i s i ncorrect: When countries have foreign currency debt funding local currency assets,

they may choose to default if printing more local currency pushes up inflation and devalues the local

currency which leads to substantial losses in the value of assets while liabilities remain unchanged.

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Q.2807 Aram Stone recently graduated from one of the most renowned German universities. During
his time as an undergrad, Stone developed a unique algorithm that could completely change the
development of Artificial Intelligence. Stone wants to patent his idea and initiate a startup, but he did
not yet decide on the exact location. To evaluate legal risks, Stone found the rating presented in the
table below:

Region Overall Legal Physical Intellectual

Property Property Property Property
Rights Rights Rights Rights
Central/Eastern Europe 4.78 4.64 5.47 4.22
Asia Oceania 4.77 4.42 5.44 4.44
Middle East & North Africa 4.76 4.61 5.42 4.26
Latin America 4.57 4.23 5.23 4.25
Africa 4.53 4.26 5.17 4.16
best protection <->highest scores

In which of the below regions should Stone register his company and patent if his main concern is
the protection of his algorithm?

A. Central/Eastern Europe

B. Asia & Oceania

C. Middle East & North Africa

D. Latin America

T he correct answer is B.

Since Stone developed a unique algorithm that could completely change the development of Artificial
Intelligence, and that his main concern is the protection of his algorithm, then he should register his
company in a region with the highest rating of Intellectual Property Rights protection. In this case,
he should choose Asia & Oceania.

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Q.3433 Mendoza Valeria, FRM, works as a risk analyst at a Mexican conglomerate. She has been
asked to evaluate USD-based bond investments issued by four different companies. According to her
employer’s guidelines, the firm has a strict policy of only investing in companies with investment-
grade ratings on both the S& P rating scale and Moody’s. In addition, the firm only invests in
countries with favorable sovereign risk quality. Assuming the company is located in the paired
country, which (country, company) pair, as outlined below, would be the most appropriate
investment?

Country Import Ratio Debt Service Ratio Company S&P Rating Moody’s Rating
Jolly World 42 % 300 % Brighter World A Ba
ltd.
Pluto 18 % 30 % Green Leaf A Aa
Corp
Northern 8% 250 % Eastbrom BB Baa
Lights Financial
Norfork 30 % 50 % Helsinki Inc. BBB Ba

A. (Norfork, Helsinki Inc.)

B. (Northern Lights, Eastbrom Financial)

C. (Pluto, Green Leaf Corp)

D. (Jolly World, Brighter World ltd.)

T he correct answer is C.

An investment-grade bond has S&P rating BBB or above or Moody’s ratings Baa or above.
Import ratio is the ratio of total imports of a country to that country's total foreign exchange (FX)
reserves. T he larger the import ratio, the higher the probability of default. T his could possibly lead
to a rescheduling of payments.

T he debt service ratio is the ratio of debt service payments (principal + interest) of a country to
that country's export earnings. T he lower the ratio, the healthier (less risky) a country is deemed to
be.

As you can see above, choice C ticks all three boxes.

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Q.3434 Credit rating agencies like S&Ps and Moody’s issue two different credit ratings for countries
with an appetite for debt. T hese are the local currency debt rating and the foreign currency debt
rating. Historically, it has been observed that defaults on local-currency-denominated debt are less
frequent than foreign-currency-denominated debt.
What’s the main reason behind this observation?

A. Local currency debt has a lower spread compared to that of foreign debt

B. T his is a statistical anomaly – ideally, defaults rates in the two categories of debt should be
more or less equal

C. Foreign currency-denominated debt has fewer political ramifications than local currency-
denominated debt, making it easier to deal with the consequences from the perspective of a
country’s leadership

D. Unlike local currency obligations, foreign currency obligations cannot be settled via
monetary expansion

T he correct answer is D.

T he main reason why we haven’t witnessed too many local-currency-denominated debt defaults is
down to the ability of governments to print money to settle such obligations. No government has
printing rights over foreign currencies, and thus monetary expansion is not a viable option in the
case of foreign debt. T he lower default rate on local-currency-denominated debt is consistent with
the observation that credit ratings are higher. T his effectively rules out statistical errors.
Option A is incorrect: Local currency debt has a lower spread compared to that of foreign debt, but
this is not the main reason why we have more defaults under the latter.

Option C describes a possible reason as to why a government might default on foreign debt, but this
only happens in autocratic countries where the leadership enjoys near-dictatorial powers and
security of tenure.

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Q.3435 Credit ratings have over the years been put to task for issuing credit ratings that do not
accurately capture the risk associated with foreign debt owned by different countries around the
world.
Which of the following statements is false regarding weaknesses of rating agency sovereign debt
ratings?

A. Ratings are often reactive to real life happenings on the lending market

B. Rating agencies exhibit some interdependence while issuing credit ratings

C. Rating agencies use government-provided data to model default risk and come up with a
credit rating

D. None of the above

T he correct answer is D.

Option A is a true statement: Rating agencies have been found to be reactive rather than proactive,
which means they do not properly execute the advisory role they are meant to.
Option B is a true statement: Besides being under the influence of the political class, rating agencies
are also not as independent as they should be. T his plays out in instances where one agency issues a
ratings downgrade on a country and others soon follow suit, without independent analysis of the
prevailing situation.

Option C is a true statement: T he data that the agencies use to rate sovereign ratings generally come
from the governments themselves. As such, there is the potential for governments holding back bad
news and revealing only good news which, in turn, may explain the upward bias in sovereign ratings.

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Reading 52: Measuring Credit Risk

Q.561 T he following is a structure of one-factor models between normally distributed variables, U i:

U i = ai F + √1 − a2iZi

Which of the following is NOT a property of the above model?

A. Every U i has a standard normal distribution with mean = 0 and standard deviation = 1.

B. Every Zi is uncorrelated with each other.

C. T he constant α i is between 0 and 1.

D. F and Zi have standard normal distributions.

T he correct answer is C.

T he one-factor model is defined as:

U i = aiF + √1 − a2i Zi

Where F is a common factor for all U i and Zi is a component of U i that is unrelated to the factor F

and uncorrelated to each other. T he ai are the parameter values that lie between -1 and +1, that is

ai ∈ [−1, +1].

T he variables F and Zi have the standard normal distributions, that is, F ∼ N (0, 1) and Zi ∼ N (0, 1) .

T herefore, U i is a sum of two independent normal distributions, and it is, therefore, a normal

variable with a mean of 0 and a standard deviation of 1. T he variance of U i is 1 since F and Zi are

uncorrelated.

Note: T he Capital Asset Pricing Model is a good example of the one-factor model.

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Q.562 A copula is:

A. A joint probability distribution between two uniformly distributed random variables.

B. A joint probability distribution between two or more uniformly distributed random

variables which still maintains their marginal distributions.

C. T he product of the marginal distributions of two or more random variables.

D. A statistical tool that represents a multivariate distribution while still maintaining their
individual marginal distributions.

T he correct answer is D.

A copula is a multivariate distribution which assesses the dependence between the variables by

retaining their marginal distributions. T he copula is applied in skewed financial market distributions

in which the correlation coefficient cannot be applied to assess interdependence.

A copula maps the marginal distribution of each variable to the standard normal distribution, which,

by definition, has a mean of zero and a standard deviation of one. Copula correlation models create a

joint probability distribution for two or more variables while still preserving their marginal

distributions. T he joint probability of the variables of interest is implicitly defined by mapping them

to other variables whose distribution properties are known.

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Q.1051 Yusuf, a research scholar associated with Dale University, presents a report on expected
loss to the senior management of Glovsky Bank. He makes the following statement(s) in his report:
Statement I: T he expected loss is a certain amount of money a bank is expected to lose over a pre-
determined period of time when extending loans to its customers
Statement II: Even though credit loss levels will fluctuate from year to year, there is an anticipated
average level of losses over time that can be statistically determined
Statement III: Expected loss must be treated as a foreseeable cost of doing business in the lending
business
Statement IV: Expected loss represents the level of losses predicted for the following year based on
the economic cycle

Which of these statements are true?

A. I & II only

B. I, II & III only

C. II, III & IV only

D. I, II & IV only

T he correct answer is B.

Statements I, II & III are true. T he expected loss is a certain amount of money a bank is expected to
lose over a pre-determined period of time when extending loans to its customers. Even though these
credit loss levels will fluctuate from year to year, there is an anticipated average level of losses over
time that can statistically be determined. T he expected loss must be treated as a foreseeable cost of
doing business in the lending business.
Statement IV is false. T he expected loss is not the level of losses predicted for the following year
based on the economic cycle, but rather the long-run average loss level across a range of typical
economic conditions.

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Q.1052 Economic losses are determined using certain components. Which of the following is not a
component that determines economic losses?

A. Probability of default.

B. Exposure amount.

C. Loss rate.

D. All of the three components determine Economic loss.

T he correct answer is D.

Probability of default, exposure amount, and loss rate are the three components that determine
economic losses.

T he probability of default (PD), describes the probability that a borrower will default on contractual

payments before the end of a predetermined period. It is expressed as a percentage.

Exposure amount (EA), also known as exposure at default (EAD), is the loss exposure of a bank at

the time of a loan’s default, expressed as a dollar amount. It is the predicted amount of loss in the

event the borrower defaults.

T he loss rate, also known as the loss-given-default (LGD), is the percentage loss incurred if the

borrower defaults. It can also be described as the expected loss expressed as a percentage.

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Q.1053 American International Bank sanctioned a loan to a corporate client. T he following

particulars are given in the credit note by the credit analyst of the client:
Exposure amount = 100 USD million
Loss rate = 10%
Probability of default = 20%

What is the expected loss of the loan?

A. USD 2 million.

B. USD 20 million.

C. USD 10 million.

D. USD 40 million.

T he correct answer is A.

Expected loss = Probability of default at time H ∗ Exposure amount at time H

∗ Loss rate experienced at time H
= P D ∗ EA ∗ LR
= 100 ∗ 0.2 ∗ 0.1
= 2 million

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Q.1054 Rojan Ortiz, a senior credit risk analyst at Asiana Bank, discusses with his colleague the
components of the economic losses. He makes the following statements with regard to the
components of the economic losses. Which of the following are true?
Statement I: T he loss rate is the fraction of the exposure amount that is lost in the event of default
Statement II: Probability of default is a borrower-specific estimate that is typically linked to the
borrower's risk rating
Statement III: Exposure amount and loss rate reflect and model the product specifics of a borrower's
liability
Statement IV: Probability of default (PD) is a measure of the likelihood that a counterparty goes into
default over a predetermined period of time

A. I & II only.

B. I, II & III only.

C. II, III & IV only.

D. All of the above.

T he correct answer is D.

All statements are correct. T he loss rate is the fraction of the exposure amount that is lost in the
event of default, meaning the amount that is not recovered after the sale of the collateral. PD is a
borrower-specific estimate that is typically linked to the borrower's risk rating. T he remaining two
components reflect and model the product specifics of a borrower's liability. Probability of default
(PD) is a measure to determine whether a counterparty goes into default over a predetermined
period of time

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Q.1055 A bank credit risk is preparing a manual on unexpected losses. Which of the following
statements can be captured in the manual with regard to unexpected loss?
I. It is important to price unexpected losses in a loan's interest rate adequately
II. Unexpected loss in statistical terms is the standard deviation of credit losses, that is, the standard
deviation of actual credit losses around the expected loss average
III. Unexpected loss can be calculated at the transaction and portfolio level
IV. Unexpected loss is the primary driver of the amount of economic capital required for credit risk

A. I & II only.

B. I, II & III only.

C. II, III & IV only.

D. All of the above.

T he correct answer is C.

Statement I is incorrect: Unexpected losses cannot be anticipated and hence cannot be adequately
priced for in a loan's interest rate.
Statements II, III & IV are correct. Unexpected loss, in statistical terms, is the standard deviation of
credit losses, that is, the standard deviation of actual credit losses around the expected loss average.
Unexpected loss can be calculated at the transaction and portfolio level. Unexpected loss is the
primary driver of the amount of economic capital required for credit risk.

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Q.1056 John Sutton, a newly recent finance graduate working at Asana Finance Ltd., approaches his
superior, George Shelton, to understand the differences and similarities between expected losses and
unexpected losses?. Gorge makes the following statements:
Statement I: T he unexpected loss of a specific loan on a stand-alone basis (i.e., ignoring
diversification effects) can be derived from some of the components of expected loss
Statement II: Expected loss is calculated as the mean of a distribution whereas unexpected loss is
calculated as the standard deviation of the same distribution
Statement III: Like expected losses, unexpected losses can also be calculated for various time
periods and for rolling time windows across time
Statement IV: Unexpected losses stem from the (unexpected) occurrence of defaults and
(unexpected) credit migration whereas expected losses must be treated as the foreseeable cost of
doing business in lending markets

Which of these statements are true?

A. Statements I & II only.

B. Statements I, II & III only.

C. Statements II, III & IV only.

D. All of the above.

T he correct answer is D.

T he unexpected loss of a specific loan on a stand-alone basis (i.e., ignoring diversification effects)
can be derived from some of the components of expected losses. T he expected loss is calculated as
the mean of a distribution whereas unexpected loss is calculated as the standard deviation of the
same distribution. Like expected losses, unexpected losses can also be calculated for various time
periods and for rolling time windows across time. Unexpected losses (UL) stem from the
(unexpected) occurrence of defaults and (unexpected) credit migration whereas expected losses
must be treated as the foreseeable cost of doing business in lending markets.

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Q.1057 Which of the following represents the correct relationship between the expected loss,
unexpected loss, and the actual loss?

A. Expected Loss = Unexpected Loss - Actual Loss.

B. Unexpected Loss = Expected Loss - Actual Loss.

C. Actual Loss = Expected Loss + Unexpected Loss.

D. Actual Loss = Expected Loss * Unexpected Loss.

T he correct answer is C.

T he expected loss is the amount a bank can expect to lose, on average, over a predetermined period
when extending credits to its customers. Unexpected loss is the volatility of credit losses around its
expected loss. T hus, the actual loss is the summation of the expected loss and the unexpected loss.

Q.1058 ABX Bank Limited is holding a portfolio of loans. Which of the following, considering a loan at
the portfolio level, is NOT part of the contribution of the single unexpected loss to the overall
portfolio risk?

A. T he loan’s expected loss.

B. T he loan’s exposure amount.

C. T he correlation of the exposure to the rest of the portfolio.

D. None of the above.

T he correct answer is D.

A loan at the portfolio level is not part of the contribution of a single unexpected loss. T he overall
portfolio risk is a function of:
(a) T he loan’s expected loss (because default probability, loss rate, and exposure amount are all part
of the unexpected loss equation)
(b) T he loan’s exposure amount
(c) T he correlation of the exposure to the rest of the portfolio

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Q.1059 Neeson, a quantitative analyst, is preparing a model for estimating unexpected losses. He is
incorporating appropriate distributions for the components of unexpected losses.
Which of the following are true with regard to the distributions of components of unexpected
losses?
I. T he probability of default is a binomial distribution
II. T he loss rate can take a number of shapes, which results in different equations for the variances
of loss rate
III. T he binomial distribution understates the variance of the loss rate as compared to the uniform
distribution
IV. T he uniform distribution assumes that all defaulted borrowers would have the same probability of
losing anywhere between 0 percent and 100 percent

A. I & II only

B. I, II & III only

C. II, III & IV only

D. I, II & IV only

T he correct answer is D.

Statement III is incorrect: T he binomial distribution overstates the variance of the loss rate, since
when a customer defaults, either all of the exposure amount is lost or nothing. On the other hand,
the uniform distribution assumes that all defaulted borrowers would have the same probability of
losing between 0% and 100%.
Statements I, II & IV are correct: Since default is a Bernoulli variable, the probability of default is a
binomial distribution. Unlike the distribution for the probability of default, the loss rate can take a
number of shapes, which results in different equations for the variances of loss rate. Possible
distributions are the binomial, the uniform, or the normal distribution, and the uniform distribution
assumes that all defaulted borrowers would have the same probability of losing anywhere between 0
percent and 100 percent.

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Q.1061 Default correlations play an important role in measuring the marginal contributions of a loan
to a loan portfolio. With regard to default correlations for a loan portfolio containing a large number
of loans:

A. Default correlations are very difficult, if not impossible, to observe.

B. If the loan portfolio contains ‘n’ loans, [n(n-1)]/2 pairwise default correlations need to be
estimated.

C. Default correlations are small, but positive providing considerable benefits to

diversification in credit portfolios.

D. All of the above are true.

T he correct answer is D.

Default correlations are very difficult, if not impossible, to observe where a portfolio of loans
[ n ( n −1)]
consists of many thousand credits. If the loan portfolio contains ‘n’ loans, pairwise default
2
correlations need to be estimated. Default correlations are small, but positive providing considerable
benefits to diversification in credit portfolios.

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Q.1062 Anston Walsh, a credit analyst at Grant Bank, is entrusted with the task of calculating the
economic capital for a portfolio of loans underwritten by the bank. Walsh based his task of computing
economic capital on the following assumptions/statements. Which of them are to be considered in
the computation to determine the most appropriate amount of economic capital?
Statement I: T he amount of economic capital needed is the distance between the expected outcome
and the unexpected (negative) outcome at a certain confidence level
Statement II: T he crucial task in estimating economic capital is the choice of the probability
distribution
Statement III: Credit risks are normally distributed
Statement IV: One distribution often recommended for measuring credit risk is the normal
distribution

A. I & II only.

B. I, II & III only.

C. I, III & IV only.

D. All of the above.

T he correct answer is A.

Statements I & II are correct. T he amount of economic capital needed is the distance between the
expected outcome and the unexpected (negative) outcome at a certain confidence level. T he crucial
task in estimating economic capital is the choice of the probability distribution.
Statements III & IV are incorrect. Credit risks are not normally distributed but highly skewed as the
upward potential is limited to receiving at maximum the promised payments and only in very rare
events to losing a lot of money. One distribution often recommended for measuring credit risk is the
beta distribution which is extremely flexible in the shapes of the distribution it can accommodate.

Q.3074 BYJ commercial bank has $100 million of retail exposures. T he 1-year probability of default
averages 2% and the recovery rate averages 60%. If the correlation parameter is estimated at 0.1,
what will be the 1-year unexpected loss at 99.9% confidence?

A. $7.68 million

B. $8.01 million

C. $4.32 million

D. $12.8 million

T he correct answer is C.

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Assuming the loss distribution is lognormal, the α percentile of the distribution of the default rate

logarithm is

N −1(P D) − √ρN −1(1 − α)

αpercentile for default rate = N ( )
√1 − ρ

T hus, the 99 default rate is given by;

⎡ {N −1(0.02) + √0.1N −1(0.999)}

⎤
V (0.999, 1) = ⎢⎢
N ⎥⎥
⎣ √1 − 0.1 ⎦
−2.05 + √0.1 × 3.09
= = 0.128
√1 − 0.1

T his is showing that the 99.9% worst-case default rate is 12.8%

T he 1-year unexpected loss at 99.9% confidence is given by:

(W CDR − P D) × LGD × EAD

=(0.128 − 0.02) ∗ (1 − 0.6) ∗ 100
=4.32 million

Where:

α is the confidence level

ρ is the correlation between each pair of U i distributions

N −1 is the inverse cumulative normal distribution

W CDR (Worst-Case Default Rate)is the 99.9 percentile of the default rate distribution

LGD is the Loss Given Default(equals one minus the recovery rate).

PD is the Probability of Default

EAD is the total exposure at default (i.e., the sum of the principals of all the loans).

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Q.3440 An investor holds a portfolio of $200 million. T his portfolio consists of AA-rated bonds ($120
million) and BB-rated bonds ($80 million). Assume that the one-year probabilities of default for AA-
rated and BB-rated bonds are 4% and 6%, respectively, and that they are independent. In the event of
default, the recovery rate for AA-rated bonds is 65%, and the recovery rate for BB-rated bonds is
40%. Determine the one-year expected credit loss from this portfolio:

A. $1,680,000

B. $4,560,000

C. $4,500,000

D. $2,880,000

T he correct answer is B.

T he expected loss of the portfolio is the sum of the expected losses of individual assets.

EL = EA × PD × LR

For AA-rated bonds,

EA = $120, 000, 000,
PD = 0.04, and
LR = 0.35
T hus,

EL AA = 120, 000, 000 × 0.04 × 0.35 = $1, 680, 000

For BB-rated bonds,

EA = $80, 000, 000,
PD = 0.06, and
LR = 0.6
T hus,

EL BB = 80, 000, 000 × 0.06 × 0.6 = $2, 880, 000

Portfolio Expected Loss = $1, 680, 000 + $2, 880, 000 = $4, 560, 000

Q.3441 A portfolio consists of two bonds. T he credit VaR – as defined by the bondholder – is the
maximum loss due to defaults at a confidence level of 99%, over a period of one year. T he probability
that the two bonds jointly default is 2%, with a default correlation of 25%. T he bond value, default
probability, and recovery rate are USD 500,000, 5%, and 50% for one bond, and USD 300,000, 3%,
and 30% for the other. Determine the expected credit loss of the portfolio:

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A. USD 18,800

B. USD 12,500

C. USD 18,424

D. USD 12,424

T he correct answer is A.

T he joint default probability and the default correlation are nugatory as far as the expected credit
loss of the portfolio is concerned. In other words, they do no matter.
T he expected loss of the portfolio is simply the sum of the expected losses of individual assets.

EL = EA × P D × LR

For the first bond,

EA = $500, 000,

P D = 0.05, and

LR = 0.5

T hus,

EL AA = 500, 000 × 0.05 × 0.5 = $12, 500

For the second bond,

EA = $300, 000,

P D = 0.03, and

LR = 0.7

T hus,

EL BB = 300, 000 × 0.03 × 0.7 = $6, 300

P ortf olio credit loss = $12, 500 + $6, 300 = $18, 800

Note: T he joint probability of default and the default correlation would be important only in the
calculation of the unexpected credit loss of the portfolio.

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Q.3657 Australian Synergies Finance Limited uses beta distributions to measure credit risks. T he
company states that the beta distribution helps in predicting the credit losses accurately. With regard
to the measurement of credit losses, which of the following statements are true?
I. T he beta distribution is often recommended and is a suitable probability distribution for measuring
the credit losses
II. T he beta distribution is especially useful in modeling a random variable that varies between -1 and
+1
III. T he shape of the beta distribution can be completely determined by specifying the parameters α
and β
IV. T he beta distribution is fully characterized by two parameters: expected loss of the portfolio and
unexpected loss of the portfolio

A. I & II only

B. I, III & IV only

C. I, II & IV only

D. II, III & IV only

T he correct answer is B.

Statement II is incorrect. T he beta distribution is especially useful in modeling a random variable that
varies between 0 and c (>0). T his is because the beta distribution nearly always produces positive
outputs. When modeling credit events, losses can vary between 0 and 100%, so that c = 1.
Statements I, III & IV are correct. T he beta distribution is often recommended and is a suitable
probability distribution for measuring credit losses as credit losses are normally distributed but
highly skewed. T he shape of the beta distribution can be completely determined by specifying the
parameters α and β. T he beta distribution is fully characterized by two parameters: expected loss of
the portfolio and unexpected loss of the portfolio.

Q.3662 Nicolson Finance has taken credit exposure to two corporate clients. T he credit risk
characteristics of these two loans have been provided below:
Loan to customer 1: T he sanctioned amount is USD 600 million, the exposure amount is USD 540
million, the probability of default over the next year is 2%, and the loss rate is 20% if the customer
defaults. Moreover, the standard deviations of the probability of default and the loss rate are 3% and
35%, respectively.
Loan to customer 2: T he sanctioned amount is USD 300 million, the exposure amount is USD 200
million, the probability of default over the next year is 1%, and the loss rate is 40% if the customer
defaults. T he standard deviations of the probability of default and the loss rate are 2% and 20%,
respectively.
T he correlation between the two loan accounts is 0.5.

What is the risk contribution of customer 1 and customer 2 to the loan portfolio?

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A. Customer 1: 26.705 million and Customer 2: 2.611 million

B. Customer 1: 27.705 million and Customer 2: 1.611 million

C. Customer 1: 28.619 million and Customer 2: 2.611 million

D. Customer 1: 28.619 million and Customer 2: 1.611 million

T he correct answer is A.

2 + LR 2 × σ 2
UL = EA × √PD × σLR PD

UL customer 1 = 540 × √0.02 × (0.35)2 + 0.202 × 0.032

= USD 26.924 million

UL customer 2 = 200 × √0.01x(0.20)2 + 0.402 × 0.022

= USD 4.308132 million

UL portfolio = √(UL customer 1)2 + (UL customer 2)2 + 2 × UL customer 1 × UL customer 2 × Correlation

= √26.9242 + 4.30812 + (2 × 26.924 × 4.3081 × 0.5)

= 29.316million

In general,

UL customer Y + (CorrX,Y × UL customer Y

Risk contribution of customer X = UL customer X × [
UL portfolio

26.924 + (0.5 × 4.308)

Risk contribution of customer 1 = 26.924 × [ ]
29.316
= USD 26.705 million

4.308 + (0.5 × 26.924)

Risk contribution of customer 2 = 4.308 × ( )
29.316
= USD 2.611 million

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Q.4644 A bank has two assets outstanding, denominated in U.S. dollars. T he correlation between the
two assets is 0.4. Other details are as follows:

Asset A Asset B
EA 1,600, 000 2, 000, 000
PD 1% 2%
LR 30% 40%

Calculate the expected loss (EL) of the portfolio.

A. 22400

B. 20800

C. 18200

D. 20200

T he correct answer is B.

T he expected loss of a portfolio is equal to the summation of expected losses of individual asset.

T hat is,

EL P = ∑EAi × P Di × LGDi
= [1, 600, 000 × 0.01 × 0.3] + [2, 000, 000 × 0.02 × 0.4]
= 20, 800

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Q.4645 T he amount of a loan issued by a bank is $2 million, with a default probability of 0.1% over a
period of one year. If the recovery rate is estimated to be 40%, what it the expected credit loss?

A. $800

B. $1,000

C. $1,200

D. $700

T he correct answer is C.

T he credit loss of a single asset is given by:

EL = EA × P D × LGD

But also

LGD = 1– Recovery Rate

So, the expected credit loss is given by:

EL = $2 million × 0.001 × (1 − 0.4) = $1, 200

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Q.4646 T he amount of a loan issued by a bank is $2 million, with a default probability of 0.1% over
one year. If the recovery rate is estimated to be 40%, what is the standard deviation expected credit
loss?

A. $37,928.35

B. $30,567.65

C. $32, 464.54

D. $35,890.75

T he correct answer is A.

T he standard deviation of the loss is given by:

σi = √pi − p2i [L i (1 − R i )]

=√0.001 − 0.0012 [$2 million (1 − 0.4)] = 0.0379284 = 37, 928.35

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Q.4647 T he Bank of Africa has a portfolio of three $2 million loans, each with a default rate of 0.5%
over one year. If the correlation between the loans is 0.4 and the recovery rate is 40%, what is the
mean of the portfolio credit loss?

A. $18,000

B. $12,000

C. $10,000

D. $9,000

T he correct answer is A.

T he mean of credit loss of a loan is given by:

piL i (1 − R i)

Nevertheless, we are given three loans with the same variables. So the mean of the portfolio is:

=3 × piL i (1 − R i )
3 × 0.005 × 2 million × (1 − 0.4) = $18,000

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Q.4648 T he Bank of Africa has a portfolio of three $2 million loans, each with a default rate of 0.5%
over one year. If the correlation between the loans is 0.4, and the recovery rate is 40%, what is the
standard deviation of the portfolio credit loss?

A. $426,875

B. $38,685

C. $84,600

D. $196,593

T he correct answer is D.

T he variance of the credit loss of a loan portfolio is given by

σP2 = nσ2 + n (n − 1) ρσ 2

Since the loans have equal principal L, recovery rate R and default probabilities, we need to compute

the common standard deviation as:

σi = √p − p2 [L (1 − R)]

= √0.005 − 0.0052 [2 × (1 − 0.4)] = 0.0846

T hus, the variance of the credit loss is given by

σP2 = nσ2 + n (n − 1) ρσ 2
σP2 = 3 × 0.08462 + 3(3 − 1) × 0.4 × 0.08462 =

Hence, the standard deviation of the credit loss is given by

σp = √0.386852 = 0.196593 = $196, 593

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Q.4650 Aiden Bank has a $500 million loan portfolio with a PD of 0.5%. Assuming the Vasicek Model,
what is the 99.9 percentile of the default rate if the correlation parameter is 0.25?

A. 0.1305

B. 0.0165

C. 0.1169

D. 0.0175

T he correct answer is C.

According to the Vasicek model, the 99.9 percentile of the default rate is given by

N −1 (P D) + √ρN −1 (0.999)
99.9 percentile for default rate = N ( )
√1 − ρ
N −1 (0.005) + √0.25N −1 (0.999)
=N( )
√1 − 0.25
−2.576 + 0.5 × 3.09
⇒N( ) = N (−1.1905) = 0.1169 = 11.69%
√1 − 0.25

Q.4652 A bank has a loan portfolio consisting of three loans A, B, and C with standard deviations of
1.25 each. T he correlations matrix appears as follows:

Loan A Loan B Loan C

Loan A 1 0 0.3
Loan B 0 1 0.6
Loan C 0.3 0.6 1

Suppose the size of loan A is increased by 1%. Using the Euler’s theorem, calculate the contribution
of loan A to the total standard deviation.

A. 0.76

B. 0.72

C. 0.80

D. 0.74

T he correct answer is D.

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According to Euler’s theorem,

ΔFi
Qi = x i
Δx i

Where

Δx i = small change in x i

ΔFi = small change in Fi

Δx i
Qi = ratio of ΔFi to a proportional change in x i
xi

We need to first calculate the total loss on the portfolio.

Given a portfolio of three assets, the portfolio standard deviation is given by:

σp = √σ 2 + σB2 + σ 2 + 2ρABσA σB + 2ρACσA σC + 2ρBC σBσC

A C

T he current portfolio standard deviation is

√1.252 + 1.252 + 1.252 + 2 × 0 × 1.25 × 1.25 + 2 × 0.3 × 1.25 × 1.25 + 2 × 0.6 × 1.25 × 1.25
= 2.738613

Now if the size of loan A is increased by 1%, then the new standard deviation of loan A is given by

1.25 × 1.01 = 1.2625

So, the new portfolio standard deviation is

√1.26252 + 1.252 + 1.252 + 2 × 0 × 1.2625 × 1.25 + 2 × 0.3 × 1.2625 × 1.25 + 2 × 0.6 × 1.25 × 1.25
= 2.746048

T he change in portfolio standard deviation = 2.746048 – 2.738613 = 0.007435

So, that

0.007435
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0.007435
QA = = 0.7435 ≈ 0.74
0.01

T he contributions of loans B and C can be calculated in a similar manner, i.e., increasing their

respective standard deviations by 1%, holding all other factors constant.

Q.4653 Credit risk capital for derivatives is challenging to calculate as compared to that of the loans.
Which of the following reason(s) makes this statement true?

A. T he exposure at default for the derivative is relatively less certain than it is for the loans.

B. Derivatives are subject to netting agreements.

C. All of the above.

D. None of the above.

T he correct answer is C.

T he exposure at default for the derivative is relatively less certain than that of the loans.

Moreover, derivatives are subject to netting agreements, so that all of the outstanding derivatives

with a given counterparty may be considered a single derivative in case of a default, making it

difficult to estimate credit risk capital.

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Q.4654 Barclays Bank has a $600 million loan portfolio, and the recovery rate in the event of default
is 40%. Assuming the Vasicek Model, the required regulatory capital is $5 million. T he 99.9
percentile for default rate is 0.0188. What is the probability of default for the loan portfolio?

A. 0.0051

B. 0.0400

C. 0.0049

D. 0.0054

T he correct answer is C.

T he Basel II capital requirement for banks under the IRB approach is given by

(W CDR − P D) × LGD × EAD

Where WCDR is defined as the worst-case default rate, and it is 99.9 percentile of the default rate

distribution defined as in Vasicek model, which in this case is 0.0188.

⇒ (W CDRP D) × LGD × EAD = 5

(0.0188 − P D) × (1 − 0.4) × 600 = 5
∴ P D = 0.004911

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Q.4655 A bank issues a $2 million loan, with a default probability of 0.5% over one year. T he standard
deviation of the expected credit loss is $35,000. What is the recovery rate?

A. 0.752

B. 0.456

C. 0.656

D. 0.764

T he correct answer is A.

T he standard deviation of the loss is given by:

σi = √pi − p2i [L i (1 − R i)]

= √0.005 − 0.0052 [$2 million(1 − R i)] = 0.035

⎡ 0.035 ⎤
⇒ 1− = 0.7519
⎣ 2 × √0.005 − 0.005 2⎦

Q.4656 A bank issues a $7 million loan, with a default probability of 0.5% over a period of one year. If
the recovery rate is estimated to be 35%, what is the expected credit loss on this loan?

A. $23,350

B. $22,750

C. $23,600

D. $22,850

T he correct answer is B.

T he credit loss of a single asset is given by:

EL = EA × P D × LGD
= $7 million × 0.005 × (1 − 0.35) = $22, 750

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Q.4657 An American bank recently issued a USD 5 million loan to a business entity, of which USD 2
million is currently outstanding. According to the bank’s internal rating model, the business entity has
a 0.5% chance of defaulting over the next year. In case that happens, the estimated loss rate is 25%.
T he probability of default and the loss rate have standard deviations of 7% and 17%, respectively.
What is the value of unexpected loss?

A. $41,245.45

B. $42,461.75

C. $40,564.56

D. $45,563.45

T he correct answer is B.

T he unexpected loss is given by:

2 + LR 2 × σ 2
UL = EA × √P D × σLR PD

So in our case.

EA =USD 2,000,000

P D =0.5%

LR =25%

σLR = 0.17

σLR = 0.07

T hus,

= 2,000, 000 × √0.005 × 0.172 + 0.252 × 0.072

= $42,461.75

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Q.4658 T he bank of Aides has a portfolio consisting of 100,000 loans, each amounting to $1 million,
and has a 1% probability of default in a year. T he recovery rate is 40%, and the correlation
coefficient is 0.3. Calculate α , the standard deviation of the loss from the loan portfolio as a
percentage of its size.

A. 0.033

B. 0.045

C. 0.056

D. 0.045

T he correct answer is A.

T he α parameter is given by:

σ√1 + (n − 1) ρ
α=
L√n

For this case,

L = $ 1 million

ρ = 0.1

n = 100,000

R = 0.4

σ = √p − p2 [L (1 − R)]

= √0.01 − 0.012 [1(1 − 0.4)] = 0.05970

T herefore,

0.05970√1 + (100, 000 − 1)0.3

α= = 0.03270
1 × √100,000

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Reading 53: Operational Risk

Q.1069 US International Bank is contemplating assessing operational risk for regulatory capital.
Which of the following approaches can be used to calculate operational risk?
I. Basic indicator approach
II. Standardized approach
III. Advanced measurement approach
IV. Internal Ratings Based approach

A. I, II & III only.

B. I, III & IV only.

C. II, III & IV only.

D. All of the above.

T he correct answer is A.

Banks have three alternatives for determining operational risk regulatory capital: (i) the basic
indicator approach, (ii) the standardized approach, and (iii) the advanced measurement approach.

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Q.1070 A bank follows the basic indicator approach for assessing operational risk for regulatory
purposes. Which of the following statement(s) is/are NOT true with regard to the basic indicator
approach?

A. Under this approach, operational risk capital was set equal to 15% of the three-year
average annual gross income.

B. Gross income is defined as net interest income.

C. Net interest income is the excess of income earned on loans over interest paid on
deposits and other instruments that are used to fund the loans.

D. All of the above are true.

T he correct answer is B.

Under the basic indicator approach, operational risk capital was set equal to 15% of the three-year
average annual gross income.

Gross income is defined as net interest income plus non-interest income.

Net interest income is the excess of income earned on loans over interest paid on deposits and other

instruments that are used to fund the loans.

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Q.1071 Eurasia Bank Limited is following the basic indicator approach for calculating the operational
risk amount for the year 2016. T he financial details of the bank are given below:

Income earned Interest paid Non-interest

(In million USD) income
Year 2015 105 52 18
Year 2014 100 50 20
Year 2013 95 40 16

Based on the original Basel Accord, the bank must hold capital for operational risk for 2016 equal to:

A. USD 10.60 million.

B. USD 10.95 million.

C. USD 11.05 million.

D. USD 7.90 million.

T he correct answer is A.

Based on the original Basel Accord, banks using the basic indicator approach must hold capital for
operational risk equal to the average over the previous three years of a fixed percentage of positive
annual gross income. Gross income is defined as net interest income plus non-interest income.
Net interest income plus non-interest income for the previous three years:

Income Interest Net Non-interest Gross

earned paid Income income Income
(In million USD)
Year 2015 105 52 53 18 71
Year 2014 100 50 50 20 70
Year 2013 95 40 55 16 71

Average gross income over the previous three years: 70.667

Operational risk = 15% of average gross income over the previous three years: 10.60

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Q.1072 American International Bank is using the standardized approach for measuring operational
risk for regulatory capital. T he bank is least likely to:
I. Have an operational risk management function that is responsible for identifying, assessing,
monitoring, and controlling operational risk
II. Keep track of relevant losses by business line and must create incentives for the improvement of
operational risk
III. Have a well-documented operational risk management system
IV. Estimate unexpected losses based on an analysis of relevant internal and external data, and
scenario analyses

A. I & II only.

B. III & IV only.

C. III only.

D. IV only.

T he correct answer is D.

A bank which is using the standardized approach for measuring operational risk for regulatory capital
must satisfy the following conditions:
(a) T he bank must have an operational risk management function that is responsible for identifying,
assessing, monitoring, and controlling operational risk
(b) T he bank must keep track of relevant losses by business line and must create incentives for the
improvement of operational risk
(c) T here must be regular reporting of operational risk losses throughout the bank
(d) T he bank's operational risk management system must be well documented
(e) T he bank's operational risk management processes and assessment system must be subject to
regular independent reviews by internal auditors. It must also be subject to regular review by
external auditors or supervisors or both

To use the AMA approach, the bank must satisfy additional requirements. It must be able to estimate
unexpected losses based on an analysis of relevant internal and external data and scenario analyses.

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Q.1073 T he Basel Committee on Banking Supervision (BCBS) has identified seven categories of
operational risk. Which of the following categories are covered by the Basel Committee?
I. Employment practices and workplace safety
II. Clients, products, and business practices
III. Execution, delivery, and process management
IV. Strategic risk

A. I, II & III only.

B. II, III & IV only.

C. I, II & IV only.

D. All of the above.

T he correct answer is A.

T he Basel Committee on Banking Supervision has identified seven categories of operational risk: (a)
Internal fraud, (b) External fraud, (c) Employment practices and workplace safety, (d) Clients,
products, and business practices, (e) Damage to physical assets, (f) Business disruption and system
failures, and (g) Execution, delivery, and process management.
Strategic risk is not one of the seven categories of operational risk identified by the Basel Committee
on Banking Supervision.

Q.1074 A bank with annual revenues of $4 billion has incurred a loss of $200 million on account of
operational risk. What would be the losses for a bank with a similar business profile but with
revenues of $12 billion? Assume the exponent for scaling losses is 0.23.

A. USD 7.76 million

B. USD 12.76 million

C. USD 257.5 million

D. USD 200.00 million

T he correct answer is C.

Revenue of bank B0. 23

Loss of bank B = ( ) ∗ Loss of bank A
Revenue of bank A
12 0. 23
=( ) ∗ 200
4
= 30. 23 ∗ 200 = 257.5 million

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Q.1075 Your Canadian Bank has been using the standardized approach for the last three years. T he
board of directors has recently decided to use the advanced measurement approach for measuring
operational risk for regulatory risk from the current year onwards. Considering the change in
measurement approach, which of the following process has been adopted from the current year
onwards in the risk management department of the bank?

A. Regular reporting of operational risk losses throughout the bank.

B. Well-documented operational risk management system.

C. Regular independent review of operational risk management processes by internal

auditors, external auditors, and supervisors.

D. Estimation of unexpected losses based on an analysis of relevant internal and external

data, and scenario analyses.

T he correct answer is D.

A bank which is using the standardized approach for measuring operational risk for regulatory capital
must satisfy the following conditions:
(a) T he bank must have an operational risk management function that is responsible for identifying,
assessing, monitoring, and controlling operational risk
(b) T he bank must keep track of relevant losses by business line and must create incentives for the
improvement of operational risk
(c) T here must be regular reporting of operational risk losses throughout the bank
(d) T he bank's operational risk management system must be well documented
(e) T he bank's operational risk management processes and assessment system must be subject to
regular independent reviews by internal auditors. It must also be subject to regular review by
external auditors or supervisors or both

To use the AMA approach, the bank must satisfy additional requirements. It must be able to estimate
unexpected losses based on an analysis of relevant internal and external data and scenario analyses.

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Q.1076 Bank X is following the advanced measurement approach for measuring operational risk.
Which of the following should be the operational risk capital computed for regulatory purposes?

A. T he bank must use 15% of net interest income over the previous three years.

B. T he bank’s activities are divided into eight business lines. T he average gross income over
the last three years for each business line is multiplied by a "beta factor" for that business
line, and the result is summed to determine the total capital.

C. T he bank must estimate one-year 99.9% VaRs for the seven categories of operational
risks identified by the Basel Committee and then aggregate them to determine a single one-
year 99.9% operational risk VaR measure.

D. T he bank must use 15% of net interest income plus non-interest income over the
previous three years.

T he correct answer is C.

Standardi zed measure: T he bank’s activities are divided into eight business lines: corporate
finance, trading and sales, retail banking, commercial banking, payment and settlement, agency
services, asset management, and retail brokerage. T he average gross income over the last three
years for each business line is multiplied by a "beta factor" for that business line and the result is
summed to determine the total capital.
Advanced measurement approach: Banks must estimate one-year 99.9% VaRs for each
combination and then aggregate them to determine a single one-year 99.9% operational risk VaR
measure.

Basi c i ndi cator approach: T he bank must use 15% of net interest income plus non-interest
income over the previous three years.

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Q.1077 Loss severity and loss frequency are two distributions that are important in estimating
potential operational risk losses for a risk type. With regard to these two distributions, which of the
following is true?

A. For loss frequency, the natural probability distribution to use is a Poisson distribution, and
for the loss-severity probability distribution, a lognormal distribution is used.

B. For loss frequency, the natural probability distribution to use is a lognormal distribution,
and for the loss-severity probability distribution, a Poisson distribution is used.

C. For loss frequency, the natural probability distribution to use is a Poisson distribution, and
for the loss-severity probability distribution, a normal distribution is used.

D. For loss frequency, the natural probability distribution to use is a normal distribution, and
for the loss-severity probability distribution, a Poisson distribution is used.

T he correct answer is A.

For loss frequency, the natural probability distribution to use is a Poisson distribution. T his
distribution assumes that losses happen randomly through time so that in any short period of time Δt,
there is a probability λΔt of a loss occurring.
For the loss severity probability distribution, a lognormal distribution is used. T he parameters of this
probability distribution are the mean and standard deviation of the logarithm of the loss.

Q.1078 T he Basel Committee on Banking Supervision (BCBS) requires the implementation of the
advanced measurement approach to involve some elements. T hese include:
I. Internal data
II. External data
III. Strategic analysis
IV. Business environment and internal control factors

A. I, II & III only.

B. II, III & IV only.

C. I, II & IV only.

D. All of the above.

T he correct answer is C.

T he Basel Committee on Banking Supervision (BCBS) requires the implementation of the advanced
measurement approach to involve four elements. T hese include: (a) Internal data, (b) External data,
(c) Scenario analysis, and (d) Business environment and internal control factors.

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Q.1080 New Zealand National Bank uses the advanced measurement approach to compute the
operational risk capital for regulatory purposes. Noria Franti, a financial controller, working at the
bank, analyzes the research reports on internal data and external data. She concludes the following
from the analysis:
I. Banks have done a much better job at documenting their operational losses than their credit risk
losses.
II. Credit card frauds are high-frequency, low-severity losses.
III. When an institution can not use its own data, then external data can be used as a guide.
IV. T he loss frequency distribution must be specific to the bank and based on internal data and
scenario analysis estimates.

Which of these statements is correct?

A. I & III only.

B. III & IV only.

C. I, II & IV only.

D. II, III & IV only.

T he correct answer is D.

Statement II i s correct: Credit card losses are high-frequency low-severity losses, meaning that

they have high expected loss but relatively low unexpected loss.

Statement IV i s al so correct: T he loss frequency distribution must be specific to the bank and

based on internal data and scenario analysis estimates.

Statement III i s al so correct: When an institution can not estimate loss severity from its own

data, then external data can be used as a guide.

Statement I i s i ncorrect: Banks have done a much better job at documenting their credit risk

losses than their operational losses.

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Q.1082 T he operational risk team of the Canadian Insurance Group informs the risk committee that
the company faces higher risk than predicted while insuring a bank against operational losses
because the bank operates recklessly after taking the insurance cover, further increasing the risks it
is exposed to. Which of the following clauses/precautions can be taken to mitigate this risk?
I. Deductible in the insurance policy
II. Coinsurance provision
III. Policy limit
IV. Understanding the controls existing within the bank and the losses that have been experienced

A. I & II only.

B. II & III only.

C. I, II & III only.

D. IV only

T he correct answer is C.

Moral hazard is the risk that the existence of the insurance contract will cause the bank to behave
differently than it otherwise would. For example, a bank that insures itself against robberies. As a
result of the insurance policy, it may be tempted to be lax in its implementation of security
measures, making a robbery more likely than it would otherwise have been.
Insurance companies have traditionally dealt with moral hazard in a number of ways. T ypically there
is a deductible in any insurance policy. T his means that the bank is responsible for bearing the first
part of any loss.

Sometimes there is a co-insurance provision in a policy. In this case, the insurance company pays a
predetermined percentage (less than 100%) of losses in excess of the deductible.

In addition, there is nearly always a policy limit. T his is a limit on the total liability of the insurer. T he
existence of deductibles, coinsurance provisions, and policy limits are likely to provide an incentive
for a bank not to relax security measures in its branches.

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Q.1083 Frank Andrews, an operational risk analyst, is interested in using the power law to assess
operational risk. Which of the following statement(s) is/are true with regard to the power-law?
I. T he power law holds well for large losses experienced by banks
II. Loss data and scenario analysis are employed to estimate the power-law parameters using the
maximum likelihood approach
III. When loss distributions are aggregated, the distribution with the heaviest tails tends to dominate
IV. T he loss with the highest alpha defines the extreme tails of the total loss distribution

A. I & II only.

B. II & III and IV only.

C. I, II & III only.

D. All of the above.

T he correct answer is C.

Statements I, II & III are correct: T he power law holds well for the large losses experienced by
banks. Loss data (internal or external) and scenario analysis are employed to estimate the power-law
parameters using the maximum likelihood approach. When loss distributions are aggregated, the
distributions with the heaviest tails tend to dominate.

Statement IV is incorrect: T he loss with the lowest alpha defines the extreme tails of the total loss

distribution.

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Q.1085 T he existence of an insurance contract causes the bank to behave differently than it
otherwise would and increases the risks to the insurance company. T his risk is known as:

A. Adverse selection.

B. Moral hazard.

C. Wrong-way risk.

D. Operational risk.

T he correct answer is B.

Moral hazard is the risk that the existence of the insurance contract will cause the bank to behave
differently than it otherwise would. T his changed behavior increases the risks to the insurance
company.

Option A is incorrect: Adverse selection describes a situation where the risk seller has more

information than the buyer about a product, putting the buyer at a disadvantage. For example, a

company providing life assurance may unknowingly attract heavy smokers, or even individuals

suffering from terminal illnesses. If this happens, the company effectively takes on many high-risk

persons but very few low-risk individuals. T his may result in a claim experience that’s worse than

initially anticipated.

Option C is incorrect: Wrong-way risk is the risk that a counterparty to a company has a higher

probability of default when the value of outstanding derivatives is negative to the counterparty, thus

positive to the company.

Option D is incorrect: Operational risk refers to the risk of loss resulting from failed processes,

people, or systems within an institution.

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Q.3442 Which of the following statements about the operational risk framework for banks is most
likely incorrect?

A. Under the basic indicator approach, banks must set aside capital equivalent to 15% of the
three-year average annual gross income

B. Under the standardized approach, a bank has to declare its gross income in eight business
lines and then use beta factors to work out the amount of capital required in each line.

C. Banks using the advanced measurement approach must calculate the operational risk
capital charge at a 99 percentile confidence interval and a one-year horizon.

D. According to the Basel committee, operational risk includes legal risk but explicitly
excludes reputational and strategic risks.

T he correct answer is C.

Banks using the advanced measurement approach must calculate the operational risk capital charge
at a 99.9 percenti l e confidence interval and a one-year horizon.

ORCAM A = U L (1 − year, 99.9% conf idence)

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Q.3443 Under the AMA method, insurance can be used to offset up to 20% of the operational risk
charge. Which of the following statements about hedging operational risk are valid?

I. All insurance policies suffer from the problem of moral hazard, but deductibles and
coinsurance provisions help to combat this problem
II. Adverse selection can result in a claim experience that’s worse than initially anticipated
III. A primary disadvantage of insurance as a tool for operational risk management is the
limitation of policy coverage
IV. T he scorecard capital allocation method allocates capital to business lines in a firm as guided
by the results of a risk survey conducted across the firm
V. If an operational risk hedge works properly, a firm will avoid damage to its reputation from a
high-severity operational risk event

A. All of the above

B. III, and V

C. II, III, and V

D. I, II, III, and IV

T he correct answer is D.

Statement V is invalid: Even if a firm is well protected from high-severity operational risk events,
the news of such events will still take a toll on its reputation.
Statement I is valid: To help keep the behavior of the insured in check, insurers use a host of
features that include deductibles, policy limits, and coinsurance provisions.

Statement I I is valid: Adverse selection creates a high-risk pool of policies that are likely to result in
claims, increasing the cash outflows of the insurer relative to inflows.

Statement I II is valid: Most insurance policies have a cover ceiling, meaning there’s always a cap on
the compensation that could be handed to the policyholder.

Statement I V is also valid: Under the scorecard approach, each unit manager is subjected to a survey
which has questions on matters of risk. Each manager’s responses are transformed into a
quantitative measure to come up with an overall score. T his total score represents the unit’s
exposure to risk.

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Q.3444 A risk manager has established that there’s a 90% probability that losses over the next year
will not exceed $30 million. Given that the power law parameter is 0.8, what is the probability of the
loss exceeding $10 million?

A. 22%

B. 24%

C. 20%

D. 23%

T he correct answer is B.

T he power law states that the probability of a random variable x exceeding a value V is given by:

p (v > x) = KV −α

where:
K is constant,
α is the power law parameter.

p (v > x) = KV −α

0.1 = K(30)−(0. 8)

K = 1.5195 T hus,

p (v > x) = 1.5195V −0. 8

when x = 10,

P robability = 1.5195 × 10−0. 8 = 0.24

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Q.4596 One of the major operational risks is compliance risk. Which of the following is/are
example(s) of compliance risks?

A. Money laundering

B. Terrorism financing

C. Failure to comply with sanctions

D. All of the above

T he correct answer is D.

Compliance risks occur when an institution incurs fines due to knowingly, or unknowingly ignoring
the industry’s set rules and regulations, internal policies, or standard best practices. Some examples
of compliance risks include money laundering, financing terrorism activities, and helping clients to
evade taxes.

Q.4597 One of the operational risks is rogue trader risk. To protect itself from rogue trader risk, a
bank should make the front office and back office independent of each other. Which one of the
following statements distinguishes between the back and front office?

A. T rading takes place in the front office while record keeping is done in the back office

B. Record keeping is done in the front office, and trading is done in the back office

C. T he front office is where management works, and the back office is where traders trade

D. None of the above

T he correct answer is A.

To protect itself from the rogue trader risk, a bank should make the front office and back office
independent of each other. T he front office is the one that is responsible for trading, and the back
office is the one responsible for the record-keeping and verifications of the transactions.

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Q.4598 T he average loss frequency of Bank of Africa is estimated to be once every 18 months. What
is the probability of three losses in a year for this bank?

A. 0.0234

B. 0.057

C. 0.0254

D. 0.0507

T he correct answer is C.

We need to find λ which from the question we have:

1
λ= = 0.6667 losses per year
1.5

Now usi ng the Poi sson di stri buti on

e−λ λn
Pr (n) =
n!
−0. 6667
e 0.66673
Pr (3) ⇒ = 0.0254
3!

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Q.4599 Given the mean and the standard deviation of lognormal loss of a ban is 200 and 50
respectively, what is the variance of the logarithm of the loss?

A. 0.0606

B. 0.527

C. 0.069

D. 0.0629

T he correct answer is A.

We know the mean of the logarithm of the loss is given by:

μ
ln ( )
√1 + w

Furthermore, the variance is given by:

ln (1 + w)

Where

2 2
σ 50
w =( ) =( ) = 0.0625
μ 200
⇒ Variance = ln (1.0625) = 0.0606

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Q.4600 Given the mean and the standard deviation of the lognormal loss of a bank is 200 and 50, what
is the standard deviation of the logarithm of the loss?

A. 0.2462

B. 1.0308

C. 0.0606

D. 0.4724

T he correct answer is A.

We know the mean of the logarithm of the loss is given by:

μ
ln ( )
√1 + w

Furthermore, the variance is given by:

ln (1 + w)

Where

2 2
σ 50
w =() =( ) = 0.0625
μ 200
⇒ Variance = ln(1 + w) = ln (1.0625) = 0.0606
∴ Standard deviation = √0.0606 ≈ 0.2462

Q.4601 Over the past ten years, the Bank of Yemen has had losses (in million euros) of 3, 6, 10, 50,
72, 101, and 200. What is the approximate amount of loss component of the bank under the SMA
approach?

A. €656 million

B. €678 million

C. €756 million

D. €442 million

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T he correct answer is C.

Using the formula

7X + 7Y + 5Z

Where X, Y, and Z are the approximations of the average losses from the operational risk over the

past ten years defined as:

X – an average of all losses

Y – an average of losses greater than 10 million

Z – an average of losses greater than 100 million

From the question, the average total loss for the ten years is 442:

3 + 6 + 10 + 50 + 72 + 101 + 200 442

X= = = 44.2
10 10

T he average losses greater than 10 million is:

50 + 72 + 101 + 200 423

Y = = = 42.3
10 10

And the average losses greater than 100 million is:

301
101 + 200 = = 30.1
10

So the loss component is given by:

7 × 44.2 + 7 × 42.3 + 5 × 30.1 = 756

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Q.4602 A manager for the stock trading department suspects that one of his staff has gone rogue.
Which of the following key indicators would the manager use to identify the rogue trader?

A. T he trader fails to take long holidays.

B. T he trader would seek for long holidays.

C. T he trader would always report trading transactions to the relevant authorities.

D. T he trader would seek guidance from the relevant bodies before taking a position in stock
trading.

T he correct answer is A.

T he trade would fail to take holidays to continue hiding his or her unacceptable transactions.

Opti ons B i s i ncorrect: It contradicts option A.

Opti ons C i s i ncorrect: A trader reporting to the relevant authorities promotes transparency, and

hence the trader would not be rogue.

Opti on D: Seeking guidance promotes transparency.

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Q.4603 T he estimation of loss distribution is laden with several data issues. Which of the following is
NOT among them?

A. Inadequate historical records.

B. T he constant purchasing power of money.

C. Firm-specific adjustments.

D. None - all of the above are valid data issues.

T he correct answer is D.

T he estimation of loss distribution is faced with the following data issues:

Inadequate hi stori cal records: T he data available for operational risk losses – including loss
frequency and loss amounts – is grossly inadequate, especially when compared to credit risk data.
T his inadequacy creates problems when trying to model the loss distribution of expected losses.
Infl ati on: When modeling the loss distribution using both external and internal data, an adjustment
must be made for inflation. T he purchasing power of money keeps on changing so that a $10,000 loss
recorded today would not have the same effect as a similar loss recorded, say, ten years ago. When
there is constant purchasing power, it implies that there is no adjustment for inflation when using
both internal and external data. Inadequate historical records and firm-specific adjustments are among
the data issues faced in estimating the loss distribution.
Fi rm-speci fi c adj ustments: No two firms are the same in terms of size, financial structure, and
operational risk management. As such, when using external data, it is essential to make adjustments
to the data in cognizance of the different characteristics of the source and your bank. A simple
proportional adjustment can either underestimate or overestimate the potential loss.

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Q.4604 T he 90-percentile of a loss distribution is 30. Using the power law with α = 4, what is the
value of 95-percentile of the loss distribution?

A. 35.68

B. 30.45

C. 25.56

D. 27.89

T he correct answer is A.

Recall that the power law is given by:

P r (v > x) = Kx −α

T herefore for the 90-percentile loss distribution, we have,

0.10 = K.30−4
0.10
⇒K= = 81, 000
30−4

T hus, for the 95-percentile loss, we have to solve the equation:

0.05 = 81,00x −4
1
−
0.05 4
⇒x=( ) = 35.68
81,000

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Q.4606 Bank A has revenues of USD 50 billion and incurs a loss of USD 300 million. Another bank B
has revenues of USD 40 billion. Given that the estimated loss for bank A is 250 million, which of the
following is closest to the observed loss for Bank (Assume the scale adjustment is 0.23) B?

A. USD 263.2 million

B. USD 200 million

C. USD 312.5 million

D. USD 237.5 million

T he correct answer is D.

Using the scale adjustment:

0. 23
Bank A Revenue
Estimated Losss for Bank A = Observed Loss for Bank B × ( )
Bank B Revenue
0. 23
50
⇒ 250 = Observed Loss for Bank B × ( )
40
−0. 23
50
Observed Loss for Bank B = 250 × ( ) = 237.49
40

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Q.4607 Over the last three years, an American bank earned an interest of USD 300 million and paid
interest of USD 150 million on average. T he bank’s noninterest income over the last three years is
USD 600 million on average. Under the indicator method, what is the value of the operational risk
capital?

A. $75 million

B. $250.40 million

C. $112.50 million

D. $140.50 million

T he correct answer is C.

Under the indicator approach, the required operational risk is equivalent to 15% of annual gross
income over the previous three years. Also, recall that,

Gross income = Interest earned− Interest paid+ Noninterest income

= 300 − 150 + 600 = 750
∴ Gross Income = USD 750 Million

T hus, the required operational risk capital is

15% × 750 = 112.5

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Reading 54: Stress Testing

Q.1086 AIZ bank, a newly set up bank, proposes to use stress testing to measure risk. Which of the
following statements are true with regard to stress testing as a risk management tool in banking?
I. Stress testing is an important risk management tool that banks use as part of their internal risk
management and, through the Basel II capital adequacy framework, is promoted by supervisors
II. Stress testing alerts bank management to unexpected adverse outcomes related to a variety of
risks and provides an indication of how much capital might be needed to absorb losses should large
shocks occur
III. While stress tests provide an indication of the appropriate level of capital necessary to endure
deteriorating economic conditions, a bank alternatively may employ other actions in order to help
mitigate increasing levels of risk
IV. Stress testing is especially important after long periods of benign economic and financial
conditions when fading memory of negative conditions can lead to complacency and the underpricing
of risk

A. I & IV only.

B. II & IV only.

C. I, II & IV only.

D. All of the above.

T he correct answer is D.

Stress testing is an important risk management tool that is used by banks as part of their internal risk
management and, through the Basel II capital adequacy framework, is promoted by supervisors.
Stress testing alerts bank management to unexpected adverse outcomes related to a variety of risks
and provides an indication of how much capital might be needed to absorb losses should large shocks
occur. While stress tests provide an indication of the appropriate level of capital necessary to
endure deteriorating economic conditions, a bank alternatively may employ other actions in order to
help mitigate increasing levels of risk. Stress testing is especially important after long periods of
benign economic and financial conditions when fading memory of negative conditions can lead to
complacency and the underpricing of risk.

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Q.1087 T he financial crisis of 2007-2009 has revealed several weaknesses in organizational aspects
of stress testing programs. Which of the following are some of these weaknesses?
I. Stress testing at some banks was performed mainly at the firm-wide level
II. At some banks, the stress testing program was a mechanical exercise
III. While stress testing for market and credit risk had been practiced for several years, stress
testing for interest rate risk in banks has emerged more recently
IV. Stress testing frameworks were usually not flexible enough to respond quickly as the crisis
evolved

A. I & IV only.

B. II & IV only.

C. I, II & IV only.

D. All of the above.

T he correct answer is B.

Statements I & III are incorrect. Stress testing at some banks was performed mainly as an isolated
exercise by the risk function with little interaction with business areas. While stress testing for
market and interest rate risk had been practiced for several years, stress testing for credit risk in
the banking industry has emerged more recently.
Statement II & IV are correct. At some banks, the stress testing program was a mechanical exercise.
Stress testing frameworks were usually not flexible enough to respond quickly as the crisis evolved.

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Q.1088 With regard to stress testing methodologies, which of the following statement(s) is/are true?
I. Stress tests may be performed at varying degrees of aggregation, from the level of an individual
instrument up to the institutional level
II. Stress tests are performed for different risk types including market, credit, operational, and
liquidity risk
III. At the most fundamental level, weaknesses in infrastructure limit the ability of banks to identify
and aggregate exposures across the bank
IV. Unlike most risk management models, stress tests do not use historical statistical relationships to
assess risk

A. II, III & IV only.

B. I, II & IV only.

C. I, II & III only.

D. All of the above.

T he correct answer is C.

Options I, II & III are correct: Stress tests may be performed at varying degrees of aggregation, from
the level of an individual instrument up to the institutional level. Stress tests are performed for
different risk types, including market, credit, operational and liquidity risk. At the most fundamental
level, weaknesses in infrastructure limited the ability of banks to identify and aggregate exposures
across the bank.
Option IV is incorrect: Most risk management models, including stress tests, use historical statistical
relationships to assess risk. T he financial crisis has again shown that, especially in stressed
conditions, risk characteristics can change rapidly as reactions by market participants within the
system can induce feedback effects and lead to system-wide interactions.

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Q.1089 Scenario selection is very important in measuring the risks of the banks using stress tests.
With regard to scenario selection and stress tests prior to the crisis, which of the following
statements are true?
I. Scenarios tended to reflect mild shocks, assume shorter durations and underestimate the
correlations between different positions, risk types and markets due to system-wide interactions and
feedback effects
II. Sensitivity tests, which are at the most basic level, generally shock individual parameters or
inputs without relating those shocks to an underlying event or real-world outcome
III. Banks also implemented hypothetical stress tests, aiming to capture events that had not yet been
experienced
IV. Scenarios that were considered extreme or innovative were often regarded as implausible by the
board and senior management

A. II, III & IV only.

B. I, II & IV only.

C. I, II & III only.

D. All of the above.

T he correct answer is B.

Statement I i s correct: Scenarios tended to reflect mild shocks, assume shorter durations and

underestimate the correlations between different positions, risk types and markets due to system-

wide interactions and feedback effects.

Statement II i s correct: Sensitivity tests, which are at the most basic level, generally shock

individual parameters or inputs without relating those shocks to an underlying event or real-world

outcome.

Statement III i s i ncorrect: T he scenarios chosen in the stress tests were too moderate and

were based on a short period of time. T he possible correlations between different risk types,

products, and markets were ignored. As such, the stress test relied on the historical scenarios and

left out risks from new products and positions taken by the banks.

Statement IV i s correct: Scenarios that were considered extreme or innovative were often

regarded as implausible by the board and senior management.

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Q.1091 T he senior management of the African Industrial Development Bank is reviewing the stress
program post a severe financial crisis in Africa. With regard to the stress testing program, which of
the following is most accurate?

A. Senior management is ultimately responsible for the overall stress testing program,
whereas the risk department is accountable for the program’s implementation, management,
and oversight.

B. T he Chief Risk Officer is ultimately responsible for the overall stress testing program,
whereas the risk department is accountable for the program’s implementation, management,
and oversight.

C. T he risk committee is ultimately responsible for the overall stress testing program,
whereas the risk department is accountable for the program’s implementation, management,
and oversight.

D. T he board of directors is ultimately responsible for the overall stress testing program,
whereas the senior management is accountable for the program’s implementation,
management, and oversight.

T he correct answer is D.

T he board of directors is ultimately responsible for the overall stress testing program, whereas the
senior management is accountable for the program’s implementation, management and oversight.
Recognizing that many practical aspects of a stress testing program will be delegated, the
involvement of the board in the overall stress testing program and of senior management in the
program's design is essential.

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Q.1092 T he senior management of the African Industrial Development Bank is reviewing the stress
program post a severe financial crisis in Africa. With regard to the stress testing program, which of
the following statements are accurate?
I. T he stress testing program should cover pipeline and warehousing risks. A bank should include
such exposures in its stress tests regardless of the probability of being securitized.
II. A bank should enhance its stress testing methodologies to capture the effect of reputational risk.
T he bank should integrate risks arising from off-balance-sheet vehicles and other related entities in
its stress testing program.
III. A bank should enhance its stress testing approaches for highly leveraged counterparties
considering its vulnerability to specific asset categories or market movements and in assessing
potential wrong-way risk related to risk-mitigating techniques.
IV. T he stress testing program should explicitly cover complex and bespoke products such as
securitized exposures. Stress tests for securitized assets should consider the underlying assets, their
exposure to systematic market factors, relevant contractual arrangements and embedded triggers,
and the impact of leverage, particularly as it relates to the subordination level of the issue structure.

A. II, III & IV only.

B. I, II & IV only.

C. I, II & III only.

D. All of the above.

T he correct answer is D.

T he stress testing program should cover pipeline and warehousing risks. A bank should include such
exposures in its stress tests regardless of the probability of being securitized. A bank should enhance
its stress testing methodologies to capture the effect of reputational risk. T he bank should integrate
risks arising from off-balance-sheet vehicles and other related entities in its stress testing program. A
bank should enhance its stress testing approaches for highly leveraged counterparties in considering
its vulnerability to specific asset categories or market movements and in assessing potential wrong-
way risk related to risk-mitigating techniques. T he stress testing program should explicitly cover
complex and bespoke products such as securitized exposures. Stress tests for securitized assets
should consider the underlying assets, their exposure to systematic market factors, relevant
contractual arrangements and embedded triggers, and the impact of leverage, particularly as it relates
to the subordination level in the issue structure.

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Q.1151 A bank has recently launched a fund for retail investors. T he risk management team carries
out stress testing of the newly launched fund to determine the impact of the fund on the bank’s
overall capital. Jason Bloomberg, a newly recruited risk manager, observes that the bank has an
independent risk management team. He notes that the entire risk assessment and identification
process is carried exclusively through stress testing. While examining the stress testing result, John
observes that the test produces multiple potential losses under various scenarios. Bloomberg also
observes that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and no deviation is
allowed from the procedure.
T he bank’s stress testing results produce multiple potential losses. In view of this, select the most
appropriate option.

A. T he stress testing result must be actionable.

B. T he stress testing results must be integrated into decision-making, but only at the senior-
most level of management.

C. T he stress testing result must accurately specify the exact amount of loss associated with
a given variable.

D. Stress testing produces potential losses and hence no action is required on the results.

T he correct answer is A.

A stress testing result must be actionable and must feed into the decision-making process at the
appropriate management level, including strategic business decisions of the board or senior
management.

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Q.1152 A bank has recently launched a fund for retail investors. T he risk management team carries
out stress testing of the newly launched fund to determine the impact of the fund on the bank’s
overall capital. Jason Bloomberg, a newly recruited risk manager, observes that the bank has an
independent risk management team. He notes that the entire risk assessment and identification
process is carried exclusively through stress testing. While examining the stress testing result, John
observes that the test produces multiple potential losses under various scenarios. Bloomberg also
observes that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and no deviation is
allowed from the procedure.
Inputs from the bank’s top economist were considered while developing the scenario for stress
testing. In view of this, select the most appropriate statement.

A. Inputs from economists make the model more robust.

B. Inputs from all stakeholders such as economists, business managers, fund managers, etc.
must be taken into account.

C. Only inputs from the risk management team in collaboration with the fund manager must
be taken into account.

D. T he risk management team must independently design the models.

T he correct answer is B.

T he identification of relevant stress events requires the collaboration of all the stakeholders like
traders, economists, fund managers, business managers, etc. Inputs from all stakeholders make the
model more robust.

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Q.1153 A bank has recently launched a fund for retail investors. T he risk management team carries
out stress testing of the newly launched fund to determine the impact of the fund on the bank’s
overall capital. Jason Bloomberg, a newly recruited risk manager, observes that the bank has an
independent risk management team. He notes that the entire risk assessment and identification
process is carried exclusively through stress testing. While examining the stress testing result, John
observes that the test produces multiple potential losses under various scenarios. Bloomberg also
observes that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and no deviation is
allowed from the procedure.
Select the most appropriate statement.

A. T he stress testing procedure must be well documented.

B. T he stress testing procedure must be well documented and no deviation must be allowed.

C. T he stress testing procedure must be well documented and it must also allow the bank to
perform flexible and ad-hoc stress tests.

D. T he stress testing procedure should not be documented; only the results should be shown
to the managers.

T he correct answer is C.

T he bank must have a well laid down procedure to carry out stress testing. Proper documentation
must however not impede the bank from carrying out flexible and ad-hoc stress tests to identify and
respond to emerging risk issues.

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Q.1154 A bank has recently launched a fund for retail investors. T he risk management team carries
out stress testing of the newly launched fund to determine the impact of the fund on the bank’s
overall capital. Jason Bloomberg, a newly recruited risk manager, observes that the bank has an
independent risk management team. He notes that the entire risk assessment and identification
process is carried exclusively through stress testing. While examining the stress testing result, John
observes that the test produces multiple potential losses under various scenarios. Bloomberg also
observes that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and no deviation is
allowed from the procedure.
Select the most appropriate statement.

A. Stress testing results must be confidential.

B. Stress testing result must be used only internally.

C. Stress testing results may be disclosed to outsiders with sufficient supporting information.

D. Stress testing must be disclosed only to supervisors.

T he correct answer is C.

In a bank, stress tests play an important role in the communication of risk. It must also play an
important role in external communication with supervisors. A bank may voluntarily disclose the
stress test with outsiders with sufficient background information on the underlying assumptions and
the methodologies.

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Q.1155 XYZ Bank has multiple branches across the country. T he bank has 10 verticals for each of its
products headed by 10 Vice Presidents. T he VPs report directly to the Chairman of the bank. T he
bank also has an independent risk management team that reports directly to the Chairman. Each
vertical carries out its individual stress tests and submits the reports to the vertical head which then
presents them to the Chairman. T he stress test procedure indicates three scenarios which must be
stress tested in each of the verticals, and all the VPs ensure that the procedure is fully complied
with.
T he current capital position of the bank indicates no material threat to the viability of the bank. In
view of this, the bank’s risk management team does not include scenarios that challenge the viability
of the bank in the stress tests. T he risk management team also suggests independent stress testing of
market assets and the funding liquidity. T he bank, in its investor presentation, proudly claims to
stress test each component of the balance sheet.

Each vertical of the bank carries out stress tests independently. In view of this, select the most
appropriate statement.

A. Individual stress testing is desirable.

B. Individual stress testing overestimates the risk.

C. Risk arising due to linkages between the verticals must also be included in the stress
testing.

D. Individual stress testing makes the stress testing process straightforward.

T he correct answer is C.

Stress tests should cover a wide range of risks including at the firm-wide level. T he bank should be
able to integrate effectively, in a meaningful fashion, across the range of its stress testing activities
and deliver a complete picture of firm-wide risk. T he bank must be able to assess the risk arising due
to the linkages between the different verticals.

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Q.1156 XYZ Bank has multiple branches across the country. T he bank has 10 verticals for each of its
products headed by 10 Vice Presidents. T he VPs report directly to the Chairman of the bank. T he
bank also has an independent risk management team that reports directly to the Chairman. Each
vertical carries out its individual stress tests and submits the reports to the vertical head which then
presents them to the Chairman. T he stress test procedure indicates three scenarios that must be
stress tested in each of the verticals, and all the VPs ensure that the procedure is fully complied
with.
T he current capital position of the bank indicates no material threat to the viability of the bank. In
view of this, the bank’s risk management team does not include scenarios that challenge the viability
of the bank in the stress tests. T he risk management team also suggests independent stress testing of
market assets and the funding liquidity. T he bank, in its investor presentation, proudly claims to
stress test each component of the balance sheet.

Select the most appropriate statement.

A. T hree scenarios, as indicated in the stress test procedure, is sufficient to assess the risk.

B. Stress testing must include multiple scenarios.

C. T he stress testing procedure must be flexible and must include forward-looking scenarios.

D. A minimum of 10 scenarios must be used to perform stress testing.

T he correct answer is C.

An effective stress testing consists of scenarios along a spectrum of events and severity levels. In
addition, the stress testing procedure must be flexible in order to identify hidden vulnerabilities and
must be forward-looking. T here is no fixed limit on the scenarios which must be used to enhance the
stress testing procedure.

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Q.1157 XYZ Bank has multiple branches across the country. T he bank has 10 verticals for each of its
products headed by 10 Vice Presidents. T he VPs report directly to the Chairman of the bank. T he
bank also has an independent risk management team that reports directly to the Chairman. Each
vertical carries out its individual stress tests and submits the reports to the vertical head which then
presents them to the Chairman. T he stress test procedure indicates three scenarios that must be
stress-tested in each of the verticals, and all the VPs ensure that the procedure is fully complied
with.
T he current capital position of the bank indicates no material threat to the viability of the bank. In
view of this, the bank’s risk management team does not include scenarios that challenge the viability
of the bank in the stress tests. T he risk management team also suggests independent stress testing of
market assets and the funding liquidity. T he bank, in its investor presentation, proudly claims to
stress test each component of the balance sheet.

Select the most appropriate statement.

A. In the case of bank XYZ, the risk management team is correct not to include scenarios
which challenge the viability of the bank.

B. In the case of bank XYZ, the risk management team must include scenarios with increased
severity but must not challenge the viability of the bank.

C. In the case of bank XYZ, the stress test must not include scenarios which challenge the
viability of the bank.

D. In the case of bank XYZ, the stress test must include scenarios which challenge the
viability of the bank.

T he correct answer is D.

Stress test scenarios must include scenarios that challenge the viability of the bank. Such stress
tests uncover hidden risks and interactions among risks. T he global financial crisis has indicated the
usefulness of such stress testing so that a backup plan can be put in place in the event such
scenarios turn out to be true.

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Q.1159 Select the most appropriate statements.

I. A bank must stress test each component of the balance sheet

II. A bank must stress test off-balance sheet items
III. A bank must only stress test liquid, market-related items, either on or off the balance sheet
IV. T he stress test must include only contractual off-balance sheet items

A. I & II only.

B. I, II & III.

C. I, III & IV.

D. All of the above.

T he correct answer is A.

T he bank’s stress must integrate risks arising from balance sheet assets and off-balance sheet items.
During the global financial crisis, the banks failed to assess the risk arising from off-balance sheet
items such as securitization which proved to be very costly. Furthermore, all off-balance items
whether contractual or non-contractual must be included in the stress test.

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Q.1160 Which of the following statements is/are accurate?

I. Supervisors should verify the active involvement of senior management in the stress testing
program
II. Banks must submit firm-wide stress tests to supervisors at regular intervals
III. Under the Internal Capital Adequacy and Assessment Process (ICAAP), the bank will make
use of internal models to assess, quantify and stress test risk drivers
IV. Stress testing results must not impact the strategic business decisions of the bank

A. II, III & IV

B. I, II & III

C. I & III

D. I & IV

T he correct answer is B.

According to the principles laid down for supervisors:

1. Supervisors should verify the active involvement of senior management in the stress testing
program
2. Banks must submit firm-wide stress tests to supervisors at regular intervals
3. Stress testing must form an integral part of the Internal Capital Adequacy Assessment
Process (ICAAP) and the bank’s liquidity risk management framework
4. Stress testing results must impact the strategic business decisions of the bank
5. Under the Internal Capital Adequacy and Assessment Process (ICAAP), the bank will make
use of internal models to assess, quantify and stress test risk drivers and factors and the
amount of capital required to support them.

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Q.1161 Which of the following statements is/are correct?

I. A bank must not disclose the assumptions made during the stress testing to supervisors
II. Supervisors must not take into account capital freely transferable within banking groups in
times of stress
III. Supervisors must only examine the need of capital for the bank
IV. Supervisors should review the range of remedial actions envisaged by a bank in response to
the results of the stress testing program

A. I only

B. IV only

C. I & III

D. III & IV

T he correct answer is B.

According to the principles of supervisors:

1. A bank must review the assumptions made during the stress testing to supervisors
2. A bank must take into account capital freely transferable within banking groups in times of
stress
3. Supervisors must examine the need for capital and liquidity for the bank
4. Supervisors should review the range of remedial actions envisaged by a bank in response to
the results of the stress testing program

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Q.1162 Select the most appropriate statement.

A. Supervisors must not determine stress scenarios.

B. Supervisors must determine certain stress scenarios.

C. Stress scenarios must be designed exclusively by the bank.

D. Stress scenarios must not be disclosed.

T he correct answer is B.

According to the principles laid down for supervisors:

1. Supervisors must review the stress scenarios

2. Supervisors must determine certain stress scenarios for the banks as it enhances the ability
of supervisors and the bank to assess the impact of specific stress events

In view of the above two principles, option B is correct.

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Q.1163 Supervisors must examine a bank’s stress testing results as prescribed in the Basel II
framework under:

A. Pillar I.

B. Pillar II.

C. Pillar III.

D. None of the above.

T he correct answer is B.

Pillar II of the Basel II framework lays down the supervi sory revi ew process under which the

supervisors must examine a bank’s stress testing results as part of the supervisory review.

Under pillar I; capital adequacy requirements - the credit risk of counterparties should be mirrored

in a new way to calculate the mi ni mum capi tal requi rement in the banking book.

Under pillar III; market discipline - banks are required to disclose mark et i nformati on about

capital allocation and risks taken. Added pressure is therefore pressed on banks for sound risk

management decisions to be made should shareholders and potential investors have more data on

those decisions.

Q.1165 All the following are true for stress testing, EXCEPT :

A. T he goal of stress testing is to identify unusual scenarios which are not covered under
standard VaR models.

B. Stress testing considers all scenarios covered under standard VaR models.

C. Stress testing is helpful in the analysis of events which generally get ignored.

D. Stress testing is helpful in the analysis of extreme events.

T he correct answer is B.

Stress testing generally involves analysis of events which are extreme in nature and not covered
under standard VaR models. VaR and ES are backward-looking. T hat is, they assume that the future
and the past are the same. T his is actually one disadvantage of VaR and ES. On the other hand, stress
testing is forward-looking. It asks the question, “what if?”.

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Q.1166 A bank funds its long-term loans by issuing short-term debt instruments such as commercial
papers, NCDs with residual maturity of less than 1 year, deposits, etc. A risk manager wants to stress
test the bank’s balance sheet to examine its vulnerabilities. T he stress test may include which of the
following scenarios?

I. Availability of surplus liquidity

II. Failure to roll over short-term debt
III. Increase in short-term interest rates
IV. Increases in deposits

A. Only I

B. II & III

C. I & IV

D. III & IV

T he correct answer is B.

T he bank funds its long-term liability by short-term debt. If there is surplus liquidity, the bank would

have no problem rolling over its short-term debt. T herefore, the surplus is not a source of stress for

a bank’s balance sheet. Similarly, an increase in deposits (themselves a liability for the bank) will help

the bank to fund (repay or roll over) its other liabilities. T hus, increased deposits will also not cause

stress on the bank’s balance sheet.

T he bank instances which will cause stress on the bank’s balance sheet are:

1. T he bank is not able to roll over its short-term debt, which will result in a funding gap and
will cause stress on the bank’s balance sheet.
2. An increase in short-term interest rates will result in an increase in the cost of funds for the
bank. T his increase may also result in a decrease in short-term liquidity which will then
impact the bank’s ability to roll over its short-term debt.

T herefore, for stress testing, the suitable scenarios are the inability of the bank to roll over debt and

the increase in short-term interest rates.

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Q.1167 A fund manager examines the annual return generated by fund A for the last 10 years. T he
return generated by the fund is furnished in the table below:

Year Return
2015 +9.45%
2014 −4.45%
2013 +5.34%
2012 −3.35%
2011 +2.45%
2010 −6.56%
2009 +7.41%
2008 −8.83%
2007 +2.33%
2006 +1.32%

T he fund manager intends to stress test Fund A for various scenarios. Select the correct option with
regards to the stress testing of Fund A.

A. As the maximum loss during the last 10 year is 8.83%, the stress test scenario for
maximum loss must not exceed 8.83%.

B. As the average loss during the last 10 years is 5.80%, the stress test scenario for
maximum loss must be equal to 5.80%.

C. T he stress test scenario for maximum loss must be more than the historical maximum
loss posted by the fund.

D. As the average return generated by the fund for the last 10 years is 0.51%, the stress test
scenario for maximum loss must be -0.51%.

T he correct answer is C.

Stress testing generally involves the analysis of events which are extreme in nature and are not
present in historical data. Although the maximum historical loss generated by the fund stood at
8.83%, the stress test scenario for maximum loss must be in excess of 8.83%.

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Q.1168 A risk manager examines a portfolio (AUM- $100 million) and observes that the performance
of the fund is dependent on two variables, α and β. T he manager wants to carry out a stress test of
the portfolio. He defines two scenarios to stress test the portfolio:

I. T he value of α is pushed up by x and the value of β is pushed down by y

II. T he value of α is pushed down by x and the value of β is pushed up by y

After performing the stress test, the risk manager suggests that a contingency fund of $10 million
must be maintained. Select the most appropriate statement.

A. A contingency fund of $10 million must be maintained as suggested by the risk manager.

B. A contingency fund of more than $10 million must be maintained.

C. T he correlation between the two variables must be considered while performing the
stress test.

D. As stress tests generally involve events which rarely occurs, the contingency fund must
not be maintained.

T he correct answer is C.

T he risk manager must consider the correlation between the two variables. T he correlation
between the two variables will correctly determine the contingency fund required to be maintained.

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Q.1170 A fund manager intends to carry out scenario analysis of his portfolio. T he portfolio consists
of 25% government bonds, 60% global equities, and 15% investment in gold ET Fs. T he fund manager
lists the portfolio’s risk factors. He intends to perform a scenario analysis by generating scenarios
based on the adverse movement in the portfolio’s identified risk factors. Such an approach to
scenario analysis is referred to as:

A. Event-driven scenario analysis.

B. Portfolio-driven scenario analysis.

C. Factor push method.

D. Historical method.

T he correct answer is B.

Scenario analysis can generate either event-driven or portfolio-driven scenarios. In the case of

event-driven scenarios, the scenario is formulated from plausible events that generate movements in

the risk factors.

In the case of portfolio-driven scenario analysis, the risk factors of the portfolio are identified and

then translated into adverse movements in risk factors.

In the above case, the fund manager first identifies the risk factors and then performs scenario

analysis by generating adverse movements in the risk factors identified. T herefore, the fund manager

utilizes the portfolio driven approach.

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Q.1171 A financial institution should set out clearly stated and understandable policies and procedures
governing stress testing, which must be adhered to. T he policies and procedures ensure that the
stress testing of parts of a financial institution converges to the same point. T he policies and
procedures should be able to:

A. Explain the purpose of stress testing.

B. State the frequency at which the stress testing can be done.

C. Describe the roles and responsibilities of the parties involved in stress testing.

D. All of the above.

T he correct answer is D.

T he policies and procedures should be able to:

Explain the purpose of stress testing;

Describe the procedures of stress testing;

State the frequency at which the stress testing can be done;

Describe the roles and responsibilities of the parties involved in stress testing;

Provide an explanation of the procedures to be followed while choosing the scenarios;

Describe how the independent reviews of the stress testing will be done;

Give clear documentation on stress testing to third parties (e.g., regulators, external

auditors, and rating agencies);

Explain how the results of the stress testing will be used and by whom;

T hey were amended as the stress testing practices changes as the market conditions

change;

Accommodate tracking of the stress test results as they change through time; and

Document the activities of models and the software acquired from the vendors or other

third parties.

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Q.1172 T he general belief that diversification leads to risk reduction was challenged during the
Global Financial Crisis of 2007-2009. During the crisis, it was observed that the correlation between
different assets increased due to which the concept of diversification failed.
Imagine yourself being a risk manager. In order to assess the likely impact of such events, the most
appropriate tool is the:

A. Scenario analysis.

B. Sensitivity analysis.

C. Historical simulation.

D. Factor push analysis.

T he correct answer is A.

T he event that occurred in the Global Financial Crisis of 2007-2009 can be defined as extreme

events; such events can be examined/analyzed with the use of scenario analysis. Different scenarios

can be modeled, and an analysis of the likely impact can be carried out.

A sensitivity is the result of alternative assumptions relating to a future situation.

Historical Simulation is a method for calculating VaR using historical data.

Factor push analysis involves examining what happens to the portfolio when you take risk factors to

the extreme.

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Q.1173 All the following are true for stress testing, EXCEPT :

A. It is highly subjective.

B. T he events are reported without an attached probability making the result difficult to
interpret.

C. It is not helpful in ensuring the survival of an institution in times of market turmoil.

D. Implausible scenarios may lead to irrelevant potential losses.

T he correct answer is C.

Stress testing requires formulating multiple scenarios; the inputs to these scenarios are highly
subjective. In addition, these scenarios are reported without an attached probability which makes
estimating the likelihood of occurrence of the scenarios difficult to predict. Furthermore, a large
number of scenarios can be generated during the scenario analysis, some of which are implausible
and may provide irrelevant potential loss scenarios.

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Q.1174 Which of the following is/are correct statements?

I. T he worst case loss never exceeds that predicted by VaR measures

II. Stress testing is a replacement for traditional VaR measures
III. Stress testing may lead to a large number of information
IV. Stress testing allows risk managers to assess the blind spots

A. Only I

B. I & II

C. III & IV

D. I & IV

T he correct answer is C.

Statement I is incorrect: T he worst-case loss may exceed that predicted by VaR measures; scenario
analysis helps in modeling such scenarios.
Statement II is incorrect. Stress testing complements traditional VaR measures; it cannot be used to
replace the traditional VaR measures.

Statement III is correct. Stress testing may lead to a large amount of information. Multiple scenarios
may result in large amounts of information during scenario analysis.

Statement IV is correct. Stress testing helps in identifying vulnerability which is generally absent in
historical data. T herefore, it helps risk managers identify the blind spots.

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Q.2812 One of the key elements of sound governance over stress testing is the governance
structure.

Which of the following statements regarding governance structure is incorrect?

A. T he internal audit should provide an independent evaluation of the ongoing performance,

integrity, and reliability of the stress-testing activities.

B. T he board of directors should execute the overall stress testing strategy (including
establishing adequate policies and procedures, assigning competent staff, etc.).

C. An institution should have clear and comprehensive stress testing policies, procedures and
documentation.

D. Stress-testing governance should incorporate validation or another type of independent

review to ensure the integrity of stress-testing processes and results.

T he correct answer is B.

T he execution of the overall stress testing strategy is the responsibility of the senior management,
not the board of directors.
In simple terms, the biggest difference between the board of directors and senior management is that
the board makes decisions while the senior management implements the plan.

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Q.2813 What is the advantage of reverse stress testing?

A. By concentrating on different scenarios, reverse stress testing helps to identify the most
profitable business lines.

B. Reverse stress testing does not consider scenarios beyond its normal business
expectations and concentrates on issues that could affect business during the normal
business operations.

C. Reverse stress testing does not consider scenarios beyond its normal business
expectations and consequently does not require a comprehensive analysis.

D. By evaluating scenarios and circumstances that would render a business unviable, reverse
stress testing identifies potential business vulnerabilities.

T he correct answer is D.

Reverse stress testing starts from an outcome of business failure and identifies circumstances

where this might occur (e.g., potential business vulnerabilities).

Option A is incorrect: Reverse stress testing is not aimed to identify profitable business lines.

Options B and C are incorrect: Reverse stress testing does consider scenarios beyond its normal

business expectations.

Q.2814 During which phase of the economic cycle is stress testing most important?

A. During the beginning of an economic recession.

B. In the middle of an economic recession.

C. In the beginning of an economic expansion.

D. After a long period of economic expansion.

T he correct answer is D.

Stress testing is especially important after long periods of economic growth when the fading memory
of negative conditions can lead to complacency and the underpricing of risk.

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Q.3445 Which of the following parties bears the ultimate responsibility for stress testing programs
in banks?

A. T he risk management function

B. Senior management

C. T he board of directors

D. Internal audit

T he correct answer is C.

T he board of directors is “ultimately” responsible for a firm’s stress tests. Even if board members
don’t immerse themselves into the technical details of stress tests, they should ensure that they stay
sufficiently knowledgeable about stress testing procedures and interpretation of results. T he
members’ engagement is essential for the effective operation of stress testing.

Q.3446 Which of the following options most accurately presents a key governance issue that played
a critical role in the failure of banks in the lead up to the 2007/2009 financial crisis?

A. Senior management played little or no role at all in the development and operation of
stress testing.

B. Stress testing reports would be passed up to the boards of directors without first being
approved by senior management

C. Stress testing did not appear to be sufficiently integrated into institutions’ risk
management frameworks, nor were test results taken into account during decision making

D. Stress testing programs lacked clear, well-detailed policies meant to outline the procedure
to follow from the start to the end, as well as describing the role played by various
employees

T he correct answer is C.

T he financial crisis of 2007/2009 highlighted a critical lesson in relation to governance and stress
testing. Precisely, stress testing did not appear to be sufficiently integrated into institutions’ risk
management frameworks. T he few that had shown more commitment to stress testing did not
examine sufficiently severe scenarios, and test results had little or no consideration in decision
making at the top level of management.

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Q.3447 According to the CRMPG II report and the Basel committee report produced in the aftermath
of the 2007/2009 financial crisis, rigorous stress testing should be a goal of all firms. To make stress
testing more productive, firms should consider all of the following except:

A. Identifying a wide range of scenarios that could result in portfolio losses

B. Simulating the effects of capital problems and illiquidity pressures happening at the same
time

C. Asking risk managers to define and clearly express firm loss tolerance levels

D. Ensuring that the scenarios tested are in line with the direction and long-term strategy set
by the board of directors

T he correct answer is C.

T he role of "Establishing risk tolerance levels" falls under the mandate of business managers or the
board of directors but not the risk managers.

Q.3448 T he following statements regarding stress testing and value at risk methods are incorrect,
EXCEPT :

A. From a practical point of view, VaR measures commonly utilize just a few scenarios

B. Ordinal arrangements are a key feature of VaR methods

C. For regulatory stress tests, the current period is used as the departure point while
generating hypothetical scenarios

D. While VaR methods reveal the causal risk(s), stress tests do not

T he correct answer is C.

For regulatory stress tests, generating hypothetical scenarios uses the current period, not past
history, as the point of origin.
Option A is incorrect. From a practical point of view, VaR measures commonly utilize very many
scenarios, but stress tests accommodate just a few

Option B is incorrect. Ordinal arrangements form part of stress tests, not VaR measures. T he latter
measures make use of cardinal probabilities.

Option D is incorrect. While stress tests reveal the causal risk(s), VaR measures do not

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Q.3451 Prior to the recent crisis, stress testing was marked by several practices including:

I. Inadequate firm-wide perspective

II. Overreliance on sensitivity analysis
III. Limited recognition of interactive effects
IV. A lack of overall organizational view

A. II and III

B. I and IV

C. II only

D. All of the above

T he correct answer is D.

In the years leading up to the recent crisis stress testing in most firms had all of the above
characteristics:

I. Inadequate firm-wide perspective: Business lines were expected to conduct stress tests on
their exposures, which means that there was very little assessment of enterprise-wide
exposure and the correlation between various risks.
II. Banks used to rely on sensitivity analysis which focuses on the impact of a shock on a single
factor while holding other factors constant. By so doing, the banks failed to take into
consideration the spillover effect and feedback effects arising from correlations arising from
various risk factors.
III. T he stress testing models used in the recent financial crisis were not equipped to predict
the interrelationships among various financial securities.
IV. Stress testing was silo-based. Business lines were expected to conduct stress tests on their
exposures, which means that there was very little assessment of enterprise-wide exposure

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Q.3452 Following the 2007/2008 financial crisis, stress testing for securitized products should
consider which of the following features?

I. Contingency funding needs of the issuer

II. Credit ratings of similar securities on the market
III. Quality of underlying asset pool
IV. Subordination level of tranches
V. Systematic market conditions

A. All of the above

B. III and IV

C. II and V

D. I, III, IV, and V

T he correct answer is D.

Assuming that the resulting security has the same risk profile as an apparently similar issue on the
market is inappropriate. Securitized products are complex and possess different risk characteristics
compared to the underlying asset.

T herefore, contingency funding needs of the issuer, quality of the underlying asset pool, and

systematic market conditions should be considered.

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Q.3453 Which of the following statements related to stress testing and Basel II is correct?

I. Basel II requires banks to conduct stress tests and assess capital adequacy at least once
every month
II. In line with Basel II, a bank should take into account both its capital and liquidity needs while
conducting stress tests

A. I only

B. II only

C. Both I and II

D. Neither I nor II is correct

T he correct answer is B.

T he Basel II framework does not impose monthly stress tests on banks.

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Q.3454 Which of the following statements is (are) true?

Prior to the 2007-2008 credit crisis:

I. Stress testing was mostly geared towards individual business lines without considering
comprehensive firm-wide perspective
II. Stress testing was primarily focused on historical or hypothetical scenarios

A. I

B. II

C. Both I and II

D. Neither

T he correct answer is C.

Statement I is correct: Until 2007, stress tests were mostly done internally by banks as part of their
own risk management. Beginning in 2007, governmental regulatory bodies became interested in
conducting their own stress tests to ensure the effective operation of financial institutions. T his is
also the time when stress testing was refined. Nowadays, common tasks associated with Basel III
compliance include: Monte Carlo simulation (including the use of copula methods for credit portfolio
simulation), scenario analysis and stress testing, econometrics for procyclical and countercyclical
analysis, asset-liability modeling, etc.
Statement II is correct: Historical scenarios were frequently implemented based on a significant
market event experienced in the past. Such stress tests were, however, not able to capture risks in
new products that have been at the center of the turmoil. Furthermore, the severity levels and
duration of stress indicated by previous episodes proved to be inadequate.
Banks also implemented hypothetical stress tests, aiming to capture events that had not yet been
experienced. Prior to the crisis, however, banks generally applied only moderate scenarios, either in
terms of severity or the degree of interaction across portfolios or risk types. At many banks, it was
difficult for risk managers to obtain senior management buy-in for more severe scenarios. Scenarios
that were considered extreme or innovative were often regarded as implausible by the board and
senior management

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Q.3455 Which of the following statements is (are) correct?

Stress testing methods consider inter-correlations between:

I. funding and market risks

II. basis and liquidity risks
III. market and pipeline risks
IV. reputational and liquidity risks

A. II only

B. I, II and IV

C. II and III

D. I, II, III and IV

T he correct answer is D.

I. It is difficult to liquidate an asset without loss under deteriorating market stress conditions.

II. Due to a change in basis, an ineffective hedge can result in significant losses as a result of
the unprotected decline in the underlying asset’s value, giving rise to liquidity problems.

III. Because of deteriorating conditions in the securitization market conditions during the recent
financial crisis, banks could not securitize assets and had to keep them in the balance sheet.

IV. Due to reputational risk, a bank may stand ready to inject credit or liquidity to a special
purpose entity (SPE), putting itself under increasing liquidity pressure.

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Q.4557 Which of the following statements correctly distinguish between stress testing and expected
shortfall?

I. Expected shortfall is backward-looking but stress testing is forward-looking

II. Stress testing is backward-looking but expected shortfall is forward-looking
III. Whereas stress testing is based on the future probability distribution, the expected shortfall
is based on past probability distribution.
IV. Expected shortfall analysis often relatively takes a short time but stress testing takes
relatively long periods

A. I and II

B. II and III

C. I and IV

D. IV only

T he correct answer is C.

Statement I i s correct: Expected shortfall is backward-looking. In that, it assumes that the future

and the past are the same. On the other hand, stress testing is forward-looking. It asks the question,

“what if?”.

Statement II i s i ncorrect: It contradicts statement I.

Statement III i s i ncorrect: Stress testing does not involve probabilities, while the expected

shortfall is founded on probability.

Statement IV i s correct: VaR/ES analysis often takes a short period of time, such as a day, while

stress testing takes relatively long periods, such as a decade.

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Q.4558 Which of the following is/are TRUE about the stressed VaR and stressed Estimated shortfall
(ES)?

I. T he data used to calculate stressed Var and stressed ES are drawn from stressful periods,
such as the year 2007.
II. Stressed VaR and stressed ES considers a short period of time in their calculations.
III. Similar to traditional VaR, stressed VaR could be back-tested

A. I only

B. III only

C. I and II only

D. All of the above

T he correct answer is C.

Statement I i s correct: T he data used to calculate stressed VaR and stressed ES is obtained from

stressed periods. Stressed VaR and Stressed ES might be objectively similar, but the time horizon for

the stressed VaR/ES is short (one to ten days), while stress testing considers relatively longer

periods.

Statement II i s correct: Stressed VaR and stressed ES might be objectively similar to stress

testing, but the time horizon for the stressed VaR/ES is short (one to ten days). In contrast, stress

testing considers relatively longer periods.

Statement III i s i ncorrect: Conventional VaR can be back-tested while stressed VaR cannot.

It is difficult to back-test stressed VaR because these measures focus on extreme outcomes, which
do not have any particular observable frequency.

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Q.4559 Which of the following is NOT an internally developed stress test scenario?

A. Historical scenario

B. Baseline scenario

C. Ad hoc scenario

D. None of the above

T he correct answer is B.

Baseline scenario is one of the regulatory scenarios in Comprehensive Capital Analysis and Review

(CCAR), which is a US regulatory stress test on banks with consolidated assets of over USD 50

million.

Opti ons A and C are i ncorrect: T he internally developed stress testing scenarios include the

historical scenarios, ad hoc scenarios, and stressing key variables.

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Q.4560 A bank carries out regular stress testing to determine its appropriate capital level. During a
given year, the bank generates a scenario to assume that the GDP growth rate might decline by 3%.
Under the impending circumstances, which type of scenario will the bank most likely internally
generate?

A. Ad hoc scenarios.

B. Historical scenarios.

C. Stressing key variables scenarios.

D. None of the above.

T he correct answer is C.

A scenario could be built by assuming that a significant change occurs in one or more key variables.

One of the key variables, in this case, is the decline of the GDP growth by 3%.

Opti on A i s i ncorrect: Ad hoc scenarios are developed to reflect the current economic

conditions, specific exposures to the financial institution, and the effect of change in government

policy.

Opti on B i s i ncorrect: Historical scenarios are generated by the use of historical data whose all

relevant variables are assumed to behave in the same manner as in the past.

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Q.4561 Which of the following correctly describes stressed VaR?

A. T here is an X% likelihood that the losses will not exceed the VaR level during a given time
T.

B. If the losses exceed the VaR level at a given time T, then the average loss is equivalent to
the stressed VaR level.

C. If a stressed period is repeated, then there is X% likelihood that over a period of T days,
the losses will not exceed the stressed VaR level.

D. If the losses over a period of T days exceed the stressed VaR level, then the expected loss
is equivalent to the VaR level.

T he correct answer is C.

T he stressed VaR would conclude that if there was a repeat of a stressed period, then there is an X%

likelihood that losses over a period of T days will not surpass the stressed VaR level.

Opti on A i s i ncorrect: It is the description of traditional VaR.

Opti on B i s i ncorrect: T he statement would have described conventional expected shortfall (ES)

if it has mentioned that “If the losses exceed the VaR level at given time T, then the average loss is

equivalent to ES”.

Opti on D i s i ncorrect: T he statement would have described stressed ES if it had mentioned that

“If the losses over a period of T days exceed the stressed VaR level, then the expected loss is

equivalent to stressed VaR level.”

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Q.4563 T he variables stated in the context of scenario analysis are termed as:

A. Core variables

B. Key variables

C. Peripheral variables

D. Volatility variables

T he correct answer is A.

T he variables stated in the context of the stress testing are termed as core variables, while the

remaining variables are termed as peripheral variables whose behavior must be derived from the

behavior of the core variables.

Opti on B i s i ncorrect: Key variables are the important variables from which the stress testing

scenarios can be developed (Stress key variables).

Opti on C i s i ncorrect: Same explanation as in option A.

Opti on D i s i ncorrect: Volatility variable is one that is affected by outside factors.

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Q.4564 While analyzing the stress testing results, analysts should consider the impacts of the stress
testing scenarios and also knock-on effects. What is a knock-on effect?

A. It is an effect due to the way a financial institution responds to an adverse condition.

B. It is an effect on the way financial institutions implement stress testing.

C. It is a negative influence from the staff conducting the stress test.

D. It is an effect that arises due to the involvement of the Board and senior management in
the stress testing process.

T he correct answer is A.

A knock-on effect is a consequence of how financial institutions respond to an adverse scenario,

which in most cases, worsens an adverse scenario.

Opti on B i s i ncorrect: T he process of stress testing is not an effect.

Opti on C i s i ncorrect: T he behavior of the stress testing staff is not a knock-on effect since the

knock-on effect takes place after the scenario has occurred.

Opti on D: It is essential for the Board and senior management to be involved in the process of the

stress testing for it to be taken seriously. T herefore, it is not a knock-on effect.

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Q.4565 In the context of the stress testing, which of the following is INCORRECTLY described?

I. T he primary objective of reverse stress testing is to determine how a financial institution

can fail
II. Stressed VaR gives a high percentile of the distribution of losses over a period of time
conditional on the recurrence of a stressed period
III. Stressed VaR analyses the results of a selected scenario over a short period of time
IV. VaR tells us the minimum amount of loss that could be incurred over a period of T days based
on past data.
V. Knock-on effects are the secondary effects of an adverse scenario

A. I, II and III

B. II only

C. IV only

D. IV and V

T he correct answer is C.

VaR tells us the maxi mum amount of loss that could be incurred over a period of T days based on
past data.
Statement I is correct: Reverse stress testing is the process of identifying the point at which a
financial institution's business model becomes unviable and triggers failure, and then identifying
scenarios and circumstances that might cause this to occur. It seeks to establish the conditions that
would lead to a pre-defined outcome.

Statement II is correct: Stressed VaR and stressed ES produces loss distributions and risk measures
conditioned on a repeat of a given stressed period.

Statement III is correct: One of the differences between stressed VaR and stress testing is that the
former models losses over a short period of time, but stress testing models losses over a longer time
horizon. If we were interested in modeling the impact of a repeat of 2008, for example, the stressed
VaR would tell us the loss that would not be exceeded over T days at a given level of confidence.
Stress testing on the other hand would not concentrate on what would happen during the worst T
days. Rather it would consider the impact of the whole of 2008 being repeated.

Statement V is correct: A knock-on effect reflects the impact of how firms (particularly other
financial institutions) respond to an adverse scenario. In responding to the adverse scenario, the
companies often take actions exacerbating adverse conditions.

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Q.4566 In the context of regulatory stress testing in the United States, which of the following is
true?

A. Comprehensive Capital Analysis and Review (CCAR) is a stress test performed by the
Federal Reserve on banks with consolidated assets of over USD 50 million.

B. Under the CCAR, banks are required to consider three scenarios: baseline, severe, and an
internal scenario.

C. Under the Dodd-Frank Act Stress Test (DFAST ), banks are required to submit a capital
plan.

D. T he Dodd-Frank Act Stress Test (DFAST ) applies to banks with consolidated assets
between USD 10 billion and USD 50 billion.

T he correct answer is D.

Banks with consolidated assets between USD 10 billion, and USD 50 billion are under the Dodd-Fank

Act Stress Test (DFAST ).

Opti on A i s i ncorrect: Comprehensive Capital Analysis and Review (CCAR) is a stress test

performed by the Federal reserve on banks with consolidated assets of over USD 50 bi l l i on.

Opti on B i s i ncorrect: T he four scenarios that banks are required to consider were baseline,

adverse, severel y adverse, and an internal scenario.

Opti on C i s i ncorrect: Unlike CCAR, DFAST does not require banks to submit capital plans.

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Q.4567 A financial institution should have written policies and procedures for stress testing. Which
one of the following is NOT included in policies and procedures of stress testing?

A. Responsibilities and roles of the staff conducting the stress testing.

B. Procedure for defining selection of scenarios.

C. T he description of the consumption of the stress testing results.

D. T he description of the limitation of access to stress testing results by the management.

T he correct answer is D.

T he management is not limited to accessing the results. In fact, the policies and procedures should

allow the management to track changes in the stress testing results over time.

Opti ons A, B, and C are i ncorrect: T hey are contained in the policies and procedure of the

stress testing.

Q.4568 One of the key features of stress test governance is validation and independent review.
Which one of the following is NOT a function of validation and independent review?

A. It continuously monitors the results of the stress testing.

B. Making sure that stress testing is based on the robust theory.

C. It addresses the qualitative aspects of the stress test.

D. It defines how stress testing should be carried out in a financial institution.

T he correct answer is D.

Definition of how the stress test will be carried out is a financial institution is a function of the

Board.

Opti ons A, B, and C are i ncorrect: T hey are all the functions of the validation and independent

review.

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Q.4569 Validation and independent reviews is an essential aspect of stress testing governance. Which
of the following is/are (a) feature(s) for sufficient validation and independent review?

I. T he reviews should be unbiased

II. T he external models from the vendors and the internal models should be subject to the
different reviewers
III. T he Board should ensure that the staff carrying out the stress test have relevant
qualifications
IV. T he Board should ensure that the stress testing documentation is of satisfactory level

A. I, II, III and IV

B. I only

C. IV only

D. I and IV

T he correct answer is B.

Statement I i s correct: the reviews should be unbiased and should assure the board that the stress

test is in accordance with the policies and procedures of the stress test.

Statement II i s i ncorrect: T he external models from the vendors and the internal models should

be subject to the same effecti ve revi ew.

Statement III i s i ncorrect: Ensuring that the staff carrying out the stress test have relevant

qualifications is a function of an i nternal audi t.

Statement IV i s i ncorrect: Similarly, ensuring that the stress testing documentation is

satisfactory is the responsibility of the i nternal audi t.

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Q.4570 Before the 2007-2008 financial crisis, the stress tests were faced with numerous
shortcomings. Which of the following is NOT a feature of the stress test before the financial crisis
as observed by the Basel Committee?

A. T he Board and senior management were not adequately involved in stress testing.

B. Stress testing was taken as a mere mechanical process and did not much impact on
decision making.

C. T he risk exposure was over-aggregated hence exaggerating the overall picture of the
enterprise-wide view of risks.

D. T he scenarios developed were too moderate and the duration involved was too short.

T he correct answer is C.

T he risk exposures were never aggregated to produce an enterprise-wide view of risk impacting a

financial institution.

Opti ons A, B and D are i ncorrect: T hey were the features of the stress tests before the

financial crisis of 2007-2008.

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Q.4571 In the context of Basel Committee Stress Testing Principles, choose the correct
statement(s).

I. T he staff responsible for the stress testing principles should be knowledgeable on the
objectives of the stress testing framework
II. Stress testing models, results, and frameworks should be subject to challenge and regular
review
III. T he models used in stress testing should be well justified and documented

A. I and II

B. I and III

C. II and III

D. I, II, and III

T he correct answer is D.

Statement I i s correct: According to the principle that “stress testing frameworks should

incorporate an effective governance structure,” the staff mandated to carry out stress testing should

know the stress testing framework’s objectives.

Statement II i s correct: T his is the principle called “stress testing models, results, and

frameworks should be subject to challenge and regular review.”

Statement III i s correct: According to the principle that “models and methodologies to assess the

impacts of scenarios and sensitivities should be fit for the purpose,” the models and the

methodologies in a stress test should be adequately justified and documented.

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Reading 55: Pricing Conventions, Discounting, and Arbitrage

Q.997 Kristen Haynes, an analyst working at Jahmal Securities, is explaining the different
terminologies of prices to a new employee. She makes the following statements about mid-market
and full prices per 100 face amount of bonds. Which of these statements are accurate?
Statement I. T he mid-market price is an average of the highest price (bid-price) that a buyer is
willing to pay and the lowest price, (ask-price) that the seller is willing to accept.
Statement II: T he full price is often referred to as the flat or quoted price of the bond

A. Statement I only

B. Statement II only

C. Statements I & II

D. None of the above

T he correct answer is A.

Statement I is correct: T he mid-market price is an average of the highest bid price that a buyer is
willing to pay and the lowest ask price that the seller is willing to accept.

Statement II is incorrect: T he full price is the total amount a buyer pays for a bond, which is the sum

of the flat or quoted price of the bond and the accrued interest.

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Q.998 Joshua Williamson, an associate working at Supreme Bonds, calculates the prices of US
T reasury bonds using the law of one price. However, he observes differences between the market
price of bonds and the prices predicted by the law of one price. Which of the following may be the
reason(s) for the differences in price?
I. T ransaction costs
II. Bid-ask spreads in the financing markets
III. It is only in theory that US T reasury bonds are commodities, i.e., fungible collections of cash
flows

A. I & II only

B. II & III only

C. I & III only

D. All of the above

T he correct answer is D.

T here are transaction costs in doing arbitrage trades which could significantly lower or wipe out any
arbitrage profit. Bid-ask spreads in the financing markets, incurred when shorting securities can also
create arbitrage opportunities. An arbitrageur would have to buy securities at higher ask prices and
sell at lower bid prices. It is only in theory that U.S. T reasury bonds are commodities, i.e., fungible
collections of cash flows. In reality, bonds have idiosyncratic differences that are recognized by the
market and priced accordingly.

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Q.999 With regard to ST RIPS, which of the following statements are true?
I. ST RIPS are created when a particular coupon bond is delivered to the T reasury in exchange for its
coupon and principal components
II. When reconstituting a bond, any C-ST RIPS maturing on a particular date may be applied toward
the coupon payment of that bond on that date
III. ST RIPS prices are essentially discount factors
IV. T he T reasury not only creates ST RIPS but retires them as well

A. I & II only

B. II & III only

C. I & III only

D. All of the above

T he correct answer is D.

Zero-coupon bonds issued by the U.S. T reasury are called ST RIPS. ST RIPS are created when a
particular coupon bond is delivered to the T reasury in exchange for its coupon and principal
components. Coupon or interest ST RIPS are called T INTs, INTs, or C-ST RIPS while principal
ST RIPS are called T Ps, Ps, or P-ST RIPS.
T he T reasury not only creates ST RIPS but retires them as well. Upon delivery of the set of
ST RIPS, the T reasury would reconstitute the bond. It is crucial to note that C-ST RIPS are fungible
while P-ST RIPS are not. When reconstituting a bond, any C-ST RIPS maturing on a particular date
may be applied toward the coupon payment of that bond on that date. By contrast, only P-ST RIPS that
were stripped from a particular bond may be used to reconstitute the principal payment of that bond.

T his feature of the ST RIPS program implies that P-ST RIPS, and not C-ST RIPS, inherit the cheapness
or richness of the bonds from which they came. ST RIPS prices are essentially discount factors.

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Q.1000 A 50-day US T-bill has a quoted price of 1.60. What is the cash price of the bill?

A. 94.75

B. 97.43

C. 100.23

D. 99.78

T he correct answer is D.

Recall that the cash price of a US T-bill is given by:

n
C = 100 − Q
360

where
C = Cash Price
Q = Quoted Price of the T-bill.
n = number of calendar days until the maturity of the T reasury bill
So in this case we have Q =1.60 and n =50 so that:

50
C = 100 − 1.60 ×
360
= 99.77777 ≈ 99.78

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Q.1001 With regard to full price and flat price, which of the following statements are true?
I. T he flat price of the bond per 100 face amount is defined as the full price plus accrued interest
II. When trading bonds day-to-day, it is more intuitive to track the flat prices and negotiate
transactions in those terms
III. Within a coupon period, the full price of a bond, which is just the present value of its cash flows,
increases over time as the bond's payments draw near
IV. From an instant before the coupon payment date to an instant after it, the full price falls by the
coupon payment

A. I, II & III only

B. II, III & IV only

C. I, II & IV only

D. All of the above

T he correct answer is B.

Statement I is incorrect. T he full or invoice price of the bond per 100 face amount is defined as the
quoted price plus accrued interests.
All other statements are accurate. T he full price changes dramatically over time even when the
market is unchanged, including a discontinuous jump on coupon payment dates, while the flat price
changes only gradually over time. T herefore, when trading bonds day-to-day, it is more intuitive to
track flat prices and negotiate transactions in those terms.

Within a coupon period, the full price of the bond, which is just the present value of its cash flows,
increases over time as the bond's payments draw near.

But from an instant before the coupon payment date to an instant after, the full price falls by the
coupon payment: the coupon is included in the present value of the remaining cash flows at the
instant before the payment, but not at the instant after.

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Q.1002 Day conventions play an important role in determining the accrued interest and value of
financial instruments. With regard to day conventions, which of the following statements are true?
I. For most government bonds in the US, the actual/actual day-count convention is used to determine
accrued interests
II. In money markets, the actual/360 day-count convention is used
III. In case of corporate bonds and for the fixed leg of interest rate swaps, the 30/360 convention is
most commonly used
IV. In case of discount securities and for floating legs of interest rate swaps, the 30/360 convention is
most commonly used

A. I, II & III only

B. II, III & IV only

C. I, II & IV only

D. All of the above

T he correct answer is A.

For most government bonds in the US, the actual/actual day-count convention is used to determine
accrued interests. In money markets, for discount securities and floating legs of interest rate swaps,
the actual/360 day-count convention is used. In the case of corporate bonds and for the fixed leg of
interest rate swaps, the 30/360 convention is most commonly used.

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Q.1003 Ronam Ltd. invests in semi-annual US T reasury bonds with face values of USD 1,000 on 15
June 2017. A bond made a coupon payment of USD 40 on February 15, 2017. T he next coupon is due
on August 15, 2017. If the quoted price for the bond for delivery on June 15, 2017, is USD 1001-16,
what is the bond's full price?

A. USD 1,026.52

B. USD 1,013.48

C. USD 1,028.02

D. USD 1,014.98

T he correct answer is C.

We have 120 (13, 31,30, 31, and 15 days in Feb, March, April, May, and June respectively) between

the 1st coupon date (Feb 15, 2017) and the settlement date (June 15, 2017).

We have 61 days from the settlement date to the next coupon payment date (Aug 15, 2017).

Accrued interest using actual/actual day-count- convention:

Accrued interest = USD 40 * (120/181) days = USD 26.5193

Full price = Quoted price + Accrued Interest = 1,001.50 + 26.5193 = USD 1028.0193

Note: 1001-16 = 1,001 + 16/32 = 1,001.5

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Q.1004 A $1,000 par value U.S. corporate bond pays a semiannual 10% coupon. Assume the last
coupon was paid 100 days ago and there are 30 days in each month. T he accrued interest is closest
to:

A. $55

B. $28

C. $25

D. $30

T he correct answer is B.

Number of days from last coupon to the settlement date

AI = Coupon ×
Number of days in coupon period

T hus,

100
AI = $50 × = $27.7778 ≈ 28
180

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Q.2774 A fixed-income trader summarizes in the table below the prices of T reasury Bonds with
semiannual coupon payment. T he data is as of 01/01/17.

Maturity Coupon~Rate Price (per $100 face value)

T ranche 1 30/06/2017 3.5% 99 − 00
T ranche 2 31/12/2017 4% 100 − 16
T ranche 3 30/06/2018 5% 101 − 04

What are the discount factors for 0.5, 1 and 1.5 years?

A. d(0.5) = 0.9730; d(1) = 0.9662; d(1.5) = 0.9393

B. d(0.5) = 0.9551; d(1) = 0.9422; d(1.5) = 0.9102

C. d(0.5) = 0.9633; d(1) = 0.9523; d(1.5) = 0.9085

D. d(0.5) = 0.98990; d(1) = 0.9782; d(1.5) = 0.8787

T he correct answer is A.

T he cash flows are as follow:

T (0.5) T (1.0) T (1.5)

T ranche 1 101.75 − −
T ranche 2 2 102 −
T ranche 3 2.5 2.5 102.5

99.00 = 101.75 ∗ d(0.5)

100.50 = 2 ∗ d(0.5) + 102 ∗ d(1)
101.125 = 2.5 ∗ d(0.5) + 2.5 ∗ d(1) + 102.5 ∗ d(1.5)

d(0.5) = 0.9730
d(1) = 0.9662
d(1.5) = 0.9393

Q.2775 Consider a 2-year T reasury Bond that is currently trading on the market at a price of 97.75.
T he bond has a coupon rate of 5%, which is paid out semiannually.

d(0.5) 0.9777
d(1) 0.9471
d(1.5) ?
d(2) 0.8845

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Given the discount factor structure shown in the table above, d(1.5) is closest to:

A. 0.9385

B. 0.9228

C. 0.9205

D. 0.9107

T he correct answer is D.

T he cash flows are as follow:

T (0.5) T (1.0) T (1.5) T (2.0)

2.5 2.5 2.5 102.5

c1 c2 F + cn
P0 = + +
y y y
1+ 2
1+ 2
1+ 2

Where

P 0 = Price of the bond

c 1 , c 2 .. . c n are semi-annual coupon payments

F is the face value

y is the yield on the bond.

Note this question has given us discount factors:

1 1 1
, and
y1 y2 y4
1+ 2
1+ 2
1+ 2

We need to find the discount factor in the third coupon payment. Also note that the T reasury Bond is

quoted per 100 face value. T hus

97.75 = 2.5 × d(0.5) + 2.5 × d(1) + 2.5 × d(1.5) + 102.5 × d(2)

= 2.5 × 0.9777 + 2.5 × 0.9471 + 2.5 × d(1.5) + 102.5 × 0.8845
⇒ d(1.5) = 0.9107

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Q.2776 A risk manager is concerned with the pricing of one of the bank’s treasury bonds that pays
3% semiannual interest and matures in two years. T he discount factors for different maturities are
as per the following table:

Discount factor
d(0.5) 0.9950
d(1.0) 0.9727
d(1.5) 0.9327
d(2) 0.9045

What is the price of the bond?

A. 93.577

B. 94.187

C. 95.847

D. 96.157

T he correct answer is D.

T he price of the bond is given by:

1.5 ∗ d(0.5) + 1.5 ∗ d(1) + 1.5 ∗ d(1.5) + 101.5 ∗ d(2) = 96.157

Q.2777 At the end of March 2017, a junior trader at an investment bank was requested to provide
information on her portfolio. T he portfolio is presented below:

Maturity Coupon Market Price Frequency

Rate (per100 Face Value)
Bond 1 30/09/2017 2% 99 − 08 semiannual
Bond 2 31/03/2018 4% 101 − 16 semiannual
Bond 3 30/09/2018 5% 105 − 16 semiannual

To revalue the portfolio, the trader uses the following discount factors:

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Discount Factor
d(0.5) 0.9991
d(1) 0.9799
d(1.5) 0.9705

Which of the above bonds is/are trading rich?

A. Bond 1

B. Bond 1 and Bond 2

C. Bond 3

D. Bond 2 and Bond 3

T he correct answer is C.

First, we need to calculate prices based on the trader’s discount factors for all three bond:

Model price of bond 1 = 101 ∗ d(0.5) = 100.909

Model price of bond 2 = 2 ∗ d(0.5) + 102 ∗ d(1)
= 2(0.9991) + 102(0.9799) = 101.948
Model price of bond 3 = 2.5 ∗ d(0.5) + 2.5 ∗ d(1) + 102.5 ∗ d(1.5)
= 2.5(0.9991) + 2.5(0.9799) + 102.5(0.9705)
= 104.424

T hen we need to compare model prices and market prices.

Market Model
Bond 1 99.250 100.909 Cheap
Bond 2 101.500 101.948 Cheap
Bond 3 105.500 104.424 Rich

A bond is said to be trading rich when the quoted market price is greater than the model price. While

you'll usually be given the market price, you'll have to calculate the model price.

T he model price of the bond equals the present value of its future cash flows, namely its principal

plus coupon payment, all times the discount factor for funds to be received. For example, for bond 1

which matures in six months and therefore has just one coupon, model price
2
= (100 + 2 ) d(0.5) = (100 + 1)0.9991 = 100.909. For bond 3 which matures in 1.5 years and therefore
5
has 3 semiannual coupons, model price = × d(0.5) + 52 × d(1) + (100 + 52 ) d(1.5) = 104.424
2

Note that because interest is calculated as per $100, 2% interest = $2, 5% interest = $5 ...etc.

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T he discount factor for a particular term gives the value today, or the present value of one unit of

currency to be received at the end of that term. T he discount factor for t years is denoted by d(t).

T hen, for example, if d (0.5) equals 0.9991 (as given in the question), the present value of $1 to be

received in six months is 1 × 0.9991 = 0.9991 cents.

Note that, bond market prices are quoted in dollars and fractions of a dollar. By market convention,

the normal fraction used for T reasury security prices is 1/32. In the quoted market prices, the

hyphen (-) separates the full dollar portion of the price from the 32nds of a dollar, which are to the

right of the hyphen. T hus the bid quote of 99-08 means $99 plus 8/32 of a dollar, or $99.25, for each

$100 face value of the bond.

Q.2778 Which of the below presented fixed income instruments typically trade rich?

A. Long-term P-ST RIPS.

B. AAA-rated Corporate bonds.

C. Short-term C-ST RIPS.

D. Mortgage-backed securities.

T he correct answer is C.

Short-term (long-term) C-ST RIPS often trade rich(cheap). Recent issues tend to trade at higher
prices than otherwise similar issues. Some of this premium is due to the demand for shorts and the
resulting financing advantage, that is, the ability to borrow money at less than GC rates when using
these bonds as collateral.

Q.2779 A trader prepares a presentation to the investment committee of a bank with a suggestion to
invest $10,000,000 in U.S. T reasury 2 and 3/8s of December 31, 2019, tranche with semiannual
coupon payment frequency. T he trader wants to invest in this tranche, as the quoted market price is
much lower than his estimate of a fair price. To prove the point, the trader includes a table below
with market prices of C-ST RIPs as of June 30, 2017 (valuation date).

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Maturity Market Price

(per 100 face value)
T ranche 1 31/12/2017 $99.753
T ranche 2 30/06/2018 $97.257
T ranche 3 31/12/2018 $95.012
T ranche 4 30/06/2019 $94.332
T ranche 5 31/12/2019 $93.805

What is closest to the price of the T reasury bond?

A. $99.507

B. $105.209

C. $106.235

D. $98.079

T he correct answer is A.

99.753 97.257 95.012

Price of the bond = 1.1875 ∗ + 1.1875 ∗ + 1.1875 ∗
100 100 100
94.332 93.805
+ 1.1875 ∗ + 101.1875 ∗
100 100
= 99.507

Further explanation:

T he price of a bond is simply equal to the present value of all its future payments (coupons plus face

value/redemption value). T his is the logic applied here.

We wish to find the price of US 2 3/8s of June 30, 2017. A 2 3/8 bond implies it pays an annual coupon

of 2% + 3/8% = 2.375%. We always compute the price of bonds per $100 face value.

We are told that the bond pays semiannual coupons. T hat implies a coupon of 2.375%/2 = 1.1875%

every six months. Per $100 face value, that's $1.1875. At redemption, the investor will receive the

face value plus the coupon of the last six-month period, i.e. 100 + 1.1875

Now, we need to discount all these to the present, and that means we need to establish the relevant

discount factors. Luckily, we have the prices of C-ST RIPS maturing at each of those dates. A C-

ST RIP is priced at a discount to face value, just like T-bills.

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price
d(t) × face value = price; therefore, d(t) = face value

Q.3418 T he following table presents the characteristics of three different bonds with semiannual
coupons and different times to maturity:

Maturity Coupon Price

6 months 6.0% 102 − 20
12 months 12% 104 − 08+
18 months 7.5% 98 − 24

If the principal repayment for each bond is $100, which of the following is closest to the discount
factor for 1.5 years?

A. 0.9964

B. 0.8823

C. 0.8865

D. 0.9920

T he correct answer is B.

6%
T he 6-month bond has cash flows only at maturity. It makes its interest payment of $3 ( × $100)
2
plus the principal repayment of $100 at t = 0.5. To find d(0.5) you should equate the present value
(price) of the bond to the cash flows. 102-20 is equivalent to 102 full USD plus 20 fractions of a
dollar where total no. of fractions is 32. Hence,

102 − 20 = 102 + 20/32 = $102.63

$102.63 = $103d(0.5)

d(0.5) = 0.9964

T he 12-month bond makes payments at t = 0.5 and at t = 1:

104 − 08+ = 104 + 8.5/32 = 104.27

Note: A “+” sign at the end of a quote represents half a tick.

104.27 = $6d(0.5) + $106d(1)

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104.27 = $6 × 0.9964 + $106d(1)

104.27 − 5.98
d(1) = = 0.9273
106

Similarly, for the 18-month bond,

98.75 = $3.75d(0.5) + $3.75d(1) + 103.75d(1.5)

98.75 − 3.74 − 3.48

d(1.5) = = 0.8823
103.75

Q.3419 As the chief investment manager of one of your corporate clients, you determine that the
use of ST RIPS (separate trading of registered interest and principal securities) issued by the U.S.
T reasury would help match assets with liabilities at various points in the future. Which of the
following statements regarding ST RIPS is correct?

A. Shorter-term ST RIPS tend to trade cheap while longer-term ST RIPS tend to trade rich

B. Shorter-term ST RIPS tend to trade rich while longer-term ST RIPS tend to trade cheap

C. Shorter-term C-ST RIPS tend to trade at a discount

D. Longer-term C-ST RIPS tend to trade at a premium

T he correct answer is B.

ST RIP stands for Separate T rading of Registered Interest and Principal of Securities. A US T reasury
coupon can have ST RIPS in two distinct securities: T he principal security, also known as the P-
ST RIP, and the detached coupons, also called C-ST RIPS.

Shorter-term ST RIPS tend to trade rich while longer-term ST RIPS tend to trade cheap. Shorter-term

C-ST RIPS tend to trade at a premium, while longer-term C-ST RIPS tend to trade at a discount.

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Q.4578 Suppose that the cash price of a US T reasury bill is 90 per 100 of face value. If the bill has
60 days to maturity, what is the quoted price of the T reasury bill?

A. 60

B. 61

C. 54.75

D. 58.93

T he correct answer is A.

We find the quoted price by the formula,

360
Q= (100 − C)
n

Where

Q = Quoted price of the T reasury bill.

C = Cash price of the T reasury bill.

n = number of calendar days until maturity of the T reasury bill.

360
Q= (100 − 90) = 6(10) = $60
60

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Q.4579 Company ABC wishes to invest in a 184-day T reasury bill from the US government. T he bill
is currently issued at the cash price of 98.50. What is the quoted price of the bill?

A. 2.86

B. 2.08

C. 2.93

D. 2.75

T he correct answer is C.

T he quoted price of the US T-bill is given by:

360
Q= (100 − C)
n

Where
Q = Quoted price of the Bill
C = Cash price of the bill
n = number of calendar days until the maturity of the T reasury bill
T hen we have:

360
Q= (100 − 98.50) = 2.93
184

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Q.4580 Suppose a bond with a par value of 1000 has coupon payments of 10% per annum and a yield
to maturity of 5%. If the bond has 4 years to maturity, what is the price of the bond?

A. 841.51

B. 1,177.30

C. 1,259.57

D. 3,628.22

T he correct answer is B.

Pri ce of the bond i s gi ven by:

C C+ FV
P V = ∑( )+
n
(1 + y) (1 + y)n

Where:

C= coupon payments

y= yield to maturity

n= number of years to maturity of the bond.

FV= face value of the bond

Coupon payments=10% of 1000=$100

100 100 100 100 1000

PV = + + + + = $1, 177.297 ≈ 1, 177.30
2 3 4
1.05 1.05 1.05 1.05 1.054

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Q.4581 A 20-days US treasury bill has a quoted price of 1.50. What is the cash price?

A. 99.84

B. 99.92

C. 98.5

D. 99.98

T he correct answer is B.

We can get the cash price of the bill using the following formula.

360
Q= (100 − C)
n

Where:

n= the number of calendar days until maturity of the treasury bill.

Q= the quote price

C= the cash price

360
1.50 = (100 − C)
20
20
C = 100 − 1.50 × = 99.9166
360

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Reading 56: Interest Rates

Q.1005 Grant Bank pays an interest of 8% with interest getting compounded quarterly. T he effective
annual rate is equal to:

A. 8%

B. 8.2%

C. 8.4%

D. 8.1%

T he correct answer is B.

Let’s assume that a sum of $1000 is invested initially and the annual rate is assumed to be x .

1
x
Sum at the end of 1 year = $1000 ∗ (1 + )
100

As the interest paid by the bank is 8% with quarterly compounding, the aggregate value at the end of

one year is given by:

0.08 4
$1000 ∗ (1 + ) = $1000 ∗ 1.082
4

Hence,

x
$1000 ∗ (1 + ) = $1000 ∗ 1.082
100
x
⇒ 1+ = 1.082
100
x
⇒ = (1.082 − 1) = 0.082
100
x = 8.20%

T herefore, the effective annual rate = 8.20%

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Q.1006 Royal Bank extends a loan of $1000 to a customer for 2 years. T he bank charges interest
with half-yearly compounding frequency. If the spot rate for a 2-year loan is 10% per annum, then
the amount that the customer needs to pay after 2 years is closest to:

A. $1,200

B. $1,216

C. $1,210

D. $1,222

T he correct answer is B.

(T∗Compounding Frequency)
(Spot Rate)
Amount (after T years ) = Principal ∗ (1 + )
(Compounding Frequency)

Where:

Principal = $1000

Spot rate = 10%

Compounding Frequency = Half yearly = 2

T = 2 Years

0.10 2∗2
Amount (After 2 years) = $1000 ∗ (1 + ) = $1, 215.51
2

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Q.1007 T he spot rate for 1 year and 2 years are 10% and 12% respectively. T he forward rate for a
loan to be given in 1 year for a term of 1 year is:

A. 11%

B. 13%

C. 14%

D. 12%

T he correct answer is C.

T he relation between spot rates and forward rate can be indicated by the expression below:

(1 + Spot ratefor T )T = (1 + Spot ratef ort)t ∗ (1 + Forward ratet to T )

Where

Spot rate for 1 year = 10%

Spot rate for 2 years = 12%

T herefore,

(1 + 0.12)2 = (1 + 0.10)1 ∗ (1 + f 1,1 )

(1 + 0.12)2
1 + f 1,1 = = 1.14
(1 + 0.10)1
f 1,1 = 0.14 = 14%

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Q.1008 John Marauder observes that two zero-coupon bonds issued by ACC Limited are currently
trading at prices given in the table below:

Residual maturity Price Face value

1 year $91.74 $100
2 year $82.64 $100

T he 1-year and 2-year spot rates are:

A. 9% and 10% respectively.

B. 10% and 11% respectively.

C. 8% and 9% respectively.

D. 11% and 12% respectively.

T he correct answer is A.

Zero-coupon bonds are bonds that do not carry coupons. Zero coupons bonds trade at a discount to

face value, the discount rates used are the spot rates. Hence the price of a zero-coupon bond can be

calculated by using the expression below:

1
Price (zero-coupon bond of maturity T years) = F V ∗
(1 + ST )T

T herefore, using the above expression the spot rates are:

1
1
$91.74 = $100 ∗ ( )
(1 + S1)
100
1 + S1 = = 1.09
91.74
S1 = 9%
2
1
$82.64 = $100 ∗ ( )
(1 + S2)
100
(1 + S2)2 = = 1.21
82.64
S2 = 10%

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Q.1009 John Marauder observes that two zero-coupon bonds issued by ACC Limited are currently
trading at prices given in the table below:

Residual maturity Price Face value

1 year $91.74 $100
2 year $82.64 $100

ABC T raders Private Limited managers are planning to issue zero-coupon bonds with a maturity of 1
year next year. As per the present market conditions, the price of the zero-coupon bond will most
likely be:

A. $85.09

B. $95.09

C. $80.09

D. $90.09

T he correct answer is D.

Zero-coupon bonds are bonds that do not carry coupons. Zero coupons bonds trade at a discount to

face value, the discount rates used are the spot rates. Hence the price of a zero-coupon bond can be

calculated by using the expression below:

1
Price (zero-coupon bond of maturity T years) = F V ∗
(1 + ST )T

T herefore, using the above expression the spot rates are:

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1
$82.64 = $100 ∗ ( )
(1 + S2)2
100
(1 + S2)2 = = 1.21
82.64
S2 = 10%

T he forward rate can be computed using the following expression:

(1 + Sfor T )T = (1 + Sfor t)t ∗ (1 + f t to T )

Where

1 year spot rate = 9%

2 year pot rate = 10%

f 1,1 = f

T herefore, the 1 year forward rate is equal to:

(1 + 0.10)2 = (1 + 0.09) ∗ (1 + f 1 year rate after 1 year )

(1.1)2
1 + f 1 year rate after 1 year = = 1.11
1.09
f 1 year rate after 1 year = 0.11 = 11%
T he 1 year forward rate after 1 year = 11%

Hence the price of the zero-coupon bond issued for 1 year after 1 year will be:

1
P Zero-coupon bond of maturity T years = F V ∗
(1 + ST )T
$100
P = = $90.09
1.11

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Q.1010 John Marauder observes that two zero-coupon bonds issued by ACC Limited are currently
trading at prices given in the table below:

Residual maturity Price Face value

1 year $91.74 $100
2 year $82.64 $100

Select the most appropriate statement.

A. T he market expects the interest rates to fall, therefore the yield curve is downward
sloping.

B. T he market expects the interest rate to rise, therefore the yield curve is upward sloping.

C. T he market expects the interest rate to remain constant, therefore the yield curve is flat.

D. T he yield curve is always downward sloping.

T he correct answer is B.

T he current 1-year spot rate = 9%

T he 1-year forward rate after 1 year = 11%

Hence, the market expects that the current spot rate of 9% will rise to 11% after one year i.e. the
today’s forward rates are the estimator of tomorrow’s spot rate. T herefore, the market expects the
interest rate to rise and the yield curve is upward sloping.

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Q.1011 If the term structure of spot interest rates is flat, then the term structure of forward
interest rates must be:

A. Upward sloping

B. Downward sloping

C. Flat

D. Humped shaped

T he correct answer is C.

T he term structure of spot rates is basically the spot rates for different maturities. A flat term

structure of spot rates means that the spot rate is the same for different maturities, i.e., the spot

rates for 1 year, 2 year, 3 year, etc. are the same.

Let's assume that the spot rates for 1 year and 2 years is equal to r. T he one-year forward rate

starting in one year is:

(1 + r)2 = (1 + r)1 ∗ (1 + Forward rate1 year to 1 year)

1 + Forward rate1 year to 1 year = 1 + r
Forward rate1 year to 1 year = r

As illustrated above, the forward rates will be the same for different maturities. Hence, if the term

structure of spot rates is flat, the term structure of forward rates will also be flat.

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Q.1012 Jack Mangers observes that the spot rates for 2 years and 3 years are 6% and 8%
respectively while the 2y1y (1-year forward rate beginning after 2 years) rate is 12.50%. Select the
correct statement(s) from the following.
I. T here is an opportunity to generate riskless profit
II. T here is no opportunity to generate riskless profit
III. T he yield curve is upward sloping
IV. T he yield curve is downward sloping

A. Both I and IV are correct.

B. Both II and III are correct.

C. Both I and III are correct.

D. Both II and IV are correct.

T he correct answer is C.

T he 2y1y i.e. 1-year forward rates beginning after 2 years can be computed by the following

expression:

(1 + Spot ratefor 3 )3 = (1 + Spot ratefor 2 )2 ∗ (1 + Forward rate2 to 3 )

Spot ratefor 3 = 8%

Spot ratefor 2 = 6%

(1 + 0.08)3 = (1 + 0.06)2 ∗ (1 + Forward rate2 to 3)

1.083
1 + Forward rate2 to 3 = = 1.1211
1.062
Forward rate2Y 1Y = 0.1211 = 12.11%

As implied by the spot rates, the forward rate for 1-year forward rate after 2 years must be equal to

12.11%. However, it is 12.50%. T herefore, there is an opportunity to generate riskless profit due to

the interest rate differential. Furthermore, as the forward rates are higher, the yield curve is upward

sloping.

Q.1013 Jack Mangers observes that the spot rates for 2 years and 3 years are 6% and 8%
respectively while the 2y1y (1-year forward rate beginning after 2 years) rate is 12.50%. Select the

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most appropriate option.

A. As there is no interest rate discrepancy, no transaction can generate riskless profit.

B. Borrowing funds for 3 years, lending the funds for 2 years and an agreement to lend funds
for 1 year after 2 years will generate a riskless profit of $0.43 per $100.

C. Lending funds for 3 years, borrowing the funds for 2 years and an agreement to lend funds
for 1 year after 2 years will generate riskless profit of $0.50 per $100.

D. Borrowing funds for 3 years, lending the funds for 2 years and an agreement to lend funds
for 1 year after 2 years will generate riskless profit of $0.70 per $100.

T he correct answer is B.

T he following steps will generate a riskless profit:

1. Borrow funds for 3 years (let us assume that $100 is borrowed.)
2. Lend the money for 2 years.
3. After two years lend the money as per the forward rate agreement for 1 year at 12.50%.

T ime Action Cash flow

0 Borrow USD. 100 for 3 years at 8% +$100
Lend the money for 2 years at 6% − $100
2 years $100 is repaid after 2 years +$112.36
T he repaid money is then again lent for 1 year − $112.36
as per the agreement at 12.50%
3 years T he lent money is repaid with 1 year +$126.41
worth of interest ($112.36 *1.125) − $125.97
$100 initially borrowed for 3 years is repaid
Profit = USD. 0.43

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Q.1014 T he details of a bond currently trading is given below:

Face value: $1,000
Coupon: 6%
YT M: 6%
Tenure: 10 years

T he price of the bond is:

A. $1,100

B. 990

C. $1,000

D. 980

T he correct answer is C.

Yield to maturity (YT M) is the discount rate which is used to discount the cash flows of the bond to
arrive at its price.
T he price of the bond is equal to its face value if and only if the YT M is equal to the coupon rate.
T he rate at which the price of the bond is equal to its face value is known as Par rates.

T herefore, in the above case, the price of the bond is equal to $1,000.

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Q.1015 A rate of 5% is quoted with continuous compounding. What is the equivalent rate, quoted
with monthly compounding?

A. 5.01%

B. 6.03%

C. 6.02%

D. 5.59%

T he correct answer is A.

If the rates are equivalent, then the following equation must hold:

Rm m
eR = (1 + )
m

Where

R = Continuously compounded rate of interest

R m = interest rate compounded m-times.

T hen in this case we have:

R 12 12
e0. 05 = (1 + )
12
0. 05
⇒ R 12 = 12[e 12 − 1]
≈ 5.01%

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Q.1016 T he 5-year and 6-year continuously compounded interest rates are 6.75% and 7.25%,
respectively. What is the forward rate of interest between year five and year six?

A. 9.75%

B. 8.25%

C. 7.50%

D. 8.56%

T he correct answer is A.

When the rates are quoted with continuous compound, the forwards rate between times T 1 and T 2 is

given by:

R 2 T 2 − R 1T 1
F =
T2− T1

Where

R 1 = Spot rate for maturity T 1

R 2 = Spot rate for maturity T 2

T hus for this case we have:

0.0725 × 6 − 0.0675 × 5
F= = 9.75%
6− 5

Alternatively, note that the following equation must hold:

e0. 0675×5eF ×1 = e0. 0725×6

⇒ F = (0.0725 × 6) − (0.0675 × 5)
= 0.0975 = 9.75%

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Q.2781 In the table below, an analyst has summarized the current swap rates prevailing on the
market.

Term in Years Swap Rate

0.5 2.00%
1.0 2.80%
1.5 3.20%

What is the 1.5-year discount factor?

A. 0.9533

B. 0.9625

C. 0.9725

D. 0.9804

T he correct answer is A.

Consider an interest rate swap. If we assumed that the notional amount is exchanged, the fixed leg of

the swap would resemble a fixed coupon-paying bond, with fixed leg payments acting like semi-

annual, fixed coupons, and the notional amount acting like the principal payment. We can therefore

write an equation for each “bond” that equates the present value of its cash flows to its price of par.

2
(100 +) ∗ d(0.5) = 100 → d(0.5) = 0.9901
2
2.8 2.8
∗ d(0.5) + (100 + ) ∗ d(1.0) = 100 → d(1.0) = 0.9725
2 2
3.2% 3.2% 3.2%
∗ d(0.5) + ∗ d(1.0) + (100 + ) ∗ d(1.5) = 100 → d(1.5) = 0.9533
2 2 2

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Q.2783 After a recent FED’s announcement, a trader observed significant changes across the whole
spot rates curve. T he correct spot rates are as follows:

Year Spot rate

0.5 2.0%
1.0 2.1%
1.5 2.3%
2.0 2.2%
2.5 2.5%

What is the 6-month forward rate in two years?

A. 0.30%

B. 1.85%

C. 2.21%

D. 3.70%

T he correct answer is D.

2. 5×2
⎡ (1 + 0. 025) ⎤
2
f (2.5) = 2 ⎢⎢⎢ − 1⎥⎥⎥ = 3.70%
2×2
⎣ (1 + 0.2022) ⎦

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Q.2785 Par rates prevailing on the market, are:

Term in years Par Rates

0.5 1.60%
1.0 2.00%
1.5 2.60%
2.0 3.20%

What is the two-year discount factor? (Assume semiannual coupons.)

A. 0.9871

B. 0.9619

C. 0.9421

D. 0.9380

T he correct answer is D.

CT
( ) ∗ AT + d(T ) = 1, where CT is the T year par rate and AT is the annuity factor.
2

Term in years Discount factor Comments

C0. 5
0.5 0.9921 ( ) ∗ d(0.5) + d(0.5) = 1
2
C1. 0
1.0 0.9803 ( ) ∗ (d(0.5) + d(1.0)) + d(1.0) = 1
2
C1. 5
1.5 0.9619 ( ) ∗ (d(0.5) + d(1.0) + d(1.5)) + d(1.5) = 1
2
C2. 0
2.0 0.9380 ( ) ∗ (d(0.5) + d(1.0) + d(1.5) + d(2.0)) + d(2.0) = 1
2

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Q.3421 T he price of a five-year zero-coupon government bond is $72.25. T he price of a similar six-
year bond is $67.34. T he one-year implied forward rate from year 5 to year 6 is closest to:

A. 7.29%

B. 7.00%

C. 6.79%

D. 6.24%

T he correct answer is A.

First, we need to find the 6-year and 5-year spot rates, assuming the price is given per $100 par
value. 5-year spot, S5:

72.25 = 100/(1 + S5)5

S5 = 6.717%
6-year spot, S6:

67.34 = 100/(1 + S6)6

S6 = 6.812%

T hen, recall that:

(1 + 5 year spot)5 * (1 + 1-year forward rate) = (1 + 6-year spot)6 T hus,
(1 + 1-year forward rate) = (1 + 6-year spot)6/(1 + 5-year spot)5
1-year forward rate = 1.484978899/1.38410182 - 1 = 7.288%

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Q.3422 T he term structure of swap rates is:

n − year Swap rate

1 − year 3.5%
2 − year 4%
3 − year 4.5%
4 − year 5%
5 − year 5.5%

T he two-year forward swap rate starting in three years is closest to:

A. 0.5%

B. 4%

C. 7.02%

D. 6.22%

T he correct answer is C.

First, we compute the accrual of a dollar over three and five (3+2) years:
For T = 3, this is (1 + 0.045)3 = 1.1412

For T = 5, this is (1 + 0.055)5 = 1.3070

(1 + R T )T = (1 + R n )n (1 + Fn,T )T −n

W here n<T

1.3070 = 1.1412 × (1 + F3,5 )2

1.3070
F3,5 = √ − 1 = 7.02%
1.1412

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Q.3423 Below is the term structure for swap rates:

Maturity in Swap Rate

Years
1 4.0%
2 4.5%
3 5.0%
4 5.5%
5 6.0%

T he 1-year forward swap rate starting in four years is closest to:

A. 4.0%

B. 6.0%

C. 7.0%

D. 8.0%

T he correct answer is D.

(1 + R T )T = (1 + R n ) (1 + Fn,T )T −n

W here n<T

First, we compute the accrual of a dollar over four and five years:
For T = 4, this is (1 + 0.055)4 = 1.2388

For T = 5, this is (1 + 0.06)5 = 1.3382

1.3382 = 1.2388 × (1 + F4,5 )1

1.3382
F4,5 = − 1 = 8.0%
1.2388

Q.4572 A trader invests $100 million in a savings account. After two years, the total amount in his
account is $150 million. What is the rate of interest compounded semi-annually?

A. 20.32%

B. 21.34%

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C. 22.47%

D. 25.32%

T he correct answer is B.

From the FV formula, we have:

mn
im
FV = PV(1 + )
m

Where

FV = future value

PV = present value

m = number of compounds per year

n = number of years

From the formula above, we have:

4
i2
150 = 100(1 + )
2

Solving for i2, we have:

⎧ 1 ⎫
⎪
⎪
⎪ 150 4 ⎪
⎪
⎪
i2 = 2 ⎨ ( ) − 1⎬ = 0.2134 = 21.34%
⎩ 100
⎪
⎪
⎪ ⎪
⎪
⎭
⎪

An al ternati ve to solving this question is by using the financial calculator. T he variables are as
follows: N = 4, P V = −100, P MT = 0 and F V = 150 so that CP T ⇒ I /Y = 10.67% .
T herefore, the annual rate of interest is 10.67% × 2 = 21.34% . T his is the easi est way!

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Q.4573 If the one-year spot rate is 5% and the two years spot rate is 8%, what is the one-year
forward rate, one year from now?

A. 0.0555

B. 0.111

C. 0.067

D. 0.134

T he correct answer is B.

T he spot rate and the forward rate have the following relationship:

(1 + y 2)2 = (1 + y 1) × (1 + f [1,1] )

Where

y 1 = one-year spot rate

y 2 = two-year spot rate and,

f [1,1] = one-year forward rate, one year from now

(1.08)2 = (1.05)1 × (1 + f [1,1])

1.082
f [1,1] = − 1 = 0.111 = 11.1%
1.05

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Q.4574 1000 is invested in an account that pays an annual nominal interest of 8% compounded
quarterly per year. What is the value of the amount in the account after three years?

A. 1259.71

B. 1268.24

C. 1061.21

D. 2518.17

T he correct answer is B.

mn
im
F V = P V (1 + )
m

Where:

FV= the future value

PV=the present value

m= number of compounds in a year

n= number of years

T he value of the amount in the account after three years is given by:

12
0.08
F V = 1000(1 + ) = 1268.24
4

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Q.4575 Suppose a company is obliged to make annual payments of $5,000 for the premises it
occupies. Payments are due on 1st January 2001, 1st January 2002, and 1st January 2003. If the
company wishes to cover these payments by investing a single sum in its bank account that pays 8%
per annum compound, what sum must be invested on 1st January 2000?

A. 12,885.48

B. 14,853.44

C. 13,916.32

D. 11,298.56

T he correct answer is A.

An annuity is a series of annual payments of PMT until the final time T. T he value of an ordinary

annuity is given by:

1 − (1 + r)−T
P V annuity = P MT
r

Where:

r = discount rate

T his is an annuity ordinary because the first payment would happen a year after January 2000.
T he present value of the annuity on 1st January 2000 is given by:

1 − 1.08−3
5000 ( ) = 12, 885.48
0.08

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Q.4576 Spot rates with semi-annual compounding are as below:

Maturity (years) Spot rates (%)

1.0 2.0
1.5 2.5
2.0 3.0

What is the forward rate for the period between time 1.0 and 1.5, expressed annually?

A. 0.035

B. 0.0175

C. 0.07

D. 0.005

T he correct answer is A.

T he forward rate for the period between time 1.0 and 1.5 is given by:

3 2
0.025 0.02 f1
(1 + ) = (1 + ) (1 + )
2 2 2

Solving for f 1, we have

0.025 3
(1 + )
f1 2
= − 1 = 0.0175
2 0.020 2
(1 + )
2

And therefore, f 1 = 0.0175 × 2 = 0.035 = 3.5%

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Q.4577 Spot rates with semi-annual compounding are as below:

Maturity (years) Spot rates (%)

1.0 2.0
1.5 2.5
2.0 3.0

What is the forward rate for the semi-annual period between time 1.5 and 2, expressed annually?

A. 0.045

B. 0.0225

C. 0.09

D. 0.0977

T he correct answer is A.

T he forward rate between time 1.5 and 2.0 will be:

0.030 4
(1 + )
f2 2
= − 1 = 0.0225
2 0.025 3
(1 + )
2
f 2 = 0.0225 × 2 = 0.045 = 4.5%

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Reading 57: Bond Yields and Return Calculations

Q.1017 Yield-to-maturity is an important measure to describe the pricing of a bond. Which of the
following statements are true with regard to yield-to-maturity?
I. Yield-to-maturity is the single rate such that discounting a security’s cash flows at that rate gives
that security’s market price
II. When the coupon rate exceeds the yield, the bond sells at a discount to its face value
III. When the yield exceeds the coupon rate, the bond sells at a premium to its face value
IV. If the term structure is flat, so that all spot rates and all forward rates equal some single rate,
then the yield-to-maturity of all bonds equals that rate as well

A. I & IV only.

B. II, III & IV only.

C. I, II & IV only.

D. All of the above.

T he correct answer is A.

Statements I & IV are correct. Yield-to-maturity is the single rate such that discounting a security’s

cash flows at that rate gives that security’s market price. If the term structure is flat, so that all spot

rates and all forward rates equal some single rate, then the yield-to-maturity of all bonds equals that

rate as well.

Statements II & III are incorrect. When the yield is equal to the coupon rate, the bond sells for its

face value. When the coupon rate exceeds the yield, the bond sells at a premium to its face value.

When the yield exceeds the coupon rate, the bond sells at a discount to its face value.

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Q.1018 Derek Johnson, an analyst at American Bonds Inc., is interested in understanding the
components of P&L (Profit & Loss) of bonds. With regards to P&L, which of the following
statements are true?
I. P&L is generated by price appreciation plus cash-carry, which consists of explicit cash flows like
coupon payments and financing costs
II. P&L due to carry is meant to convey how much a position earns due to the fact that, as a security
matures, its cash flows are priced at earlier points on the term structure
III. P&L due to roll-down is meant to convey how much a position earns due to the passage of time,
holding everything else constant
IV. T he P&L due to the passage of time excluding cash-carry is called carry-roll-down

A. I & IV only.

B. II & IV only.

C. I, II & IV only.

D. All of the above.

T he correct answer is A.

Statements I & IV are correct. P&L is generated by price appreciation plus cash-carry, which
consists of explicit cash flows like coupon payments and financing costs. T he P&L due to the
passage of time excluding cash-carry is called carry-roll-down.
Statements II & III are incorrect. P&L due to carry is meant to convey how much a position earns
due to the passage of time, holding everything else constant. P&L due to roll-down is meant to
convey how much a position earns due to the fact that. as a security matures, its cash flows are
priced at earlier points on the term structure.

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Q.1019 Consider the details of bonds currently trading:

Bond Coupon YT M Face Value

Bond A 10% 9% 1000
Bond B 6% 8% 1000
Bond C 5% 5% 1000

Select the most appropriate statements:I. PriceBond A > $1000

II. PriceBond B < $1000
III. PriceBond C = $1000
IV. PriceBond A < $1000
V. PriceBond B > $1000
VI. PriceBond C > $1000

A. II, III and V are correct.

B. I, II and III are correct.

C. IV, V and VI are correct.

D. I, III and V are correct.

T he correct answer is B.

PriceBond A > Face Value when coupon > YT M

PriceBond B < Face Value when coupon < YT M
PriceBond C = Face Value when coupon = YT M
Hence, options I, II, and III are correct.

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Q.1020 All the following statements regarding the yield-to-maturity (YT M) are correct, EXCEPT :

A. T he YT M is the discount rate used to discount the bond cash flows to arrive at the price
of the bond.

B. T he YT M is the return realized by the bond investor.

C. T he YT M of a zero-coupon bond is equal to the spot rate.

D. If YT M < Coupon, the bond trades at a premium.

T he correct answer is B.

YT M is the discount rate used to discount the bond cash flows to arrive at the price of the bond.
T he return realized by the bondholder is equal to YT M only when the coupons are reinvested at the
yield same as the YT M. Generally, an investor fails to reinvest the coupons at the YT M due to which
the return realized by the bondholder is not equal to YT M.

Zero-coupon bonds do not pay coupons. Hence the YT M of a zero-coupon bond is equal to the spot
rate.

When YT M < Coupon, then the bond trades at a premium. When YT M > Coupon, then the bond
trades at a discount.

Q.1021 Corporate bonds trade at a positive spread to government bonds because:

A. Corporate bonds are more liquid than government bonds.

B. Corporate bonds have higher credit risks than government bonds.

C. Corporate bonds generate higher returns than government bonds.

D. Corporate bonds pay less coupon than government bonds.

T he correct answer is B.

T he spread at which corporate bonds trade depends mainly on its credit risk. Corporate bonds have a
higher credit risk as compared to government bonds. Due to the higher credit risk, the spread
between the government bond and corporate bond is positive.

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Q.1022 Consider the following details with respect to a bond:

Face value: $1000
Coupon: 10%
Frequency: Semi-annually
Coupon payment dates: January 1st and July 1st

An investor buys the bond on January 22nd at a price of $990.23, and sells it on August 3rd at
$1030.34. T he gross realized return on the bond investment is:

A. 4.05%

B. 9.1%

C. 8.8%

D. 9.4%

T he correct answer is B.

January 22nd: -990.23

July 1st: +50 (Coupon payment)
August 3rd: +1030.34

($1030.34 + $50 − $990.23)

Gross Realized Return = = 9.10%
$990.23

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Q.1023 Consider the following details with respect to a bond:

Face value: $1000
Coupon: 10%
Frequency: Semi-annually
Coupon payment dates: January 1st and July 1st

An investor buys this bond at $1043.43 on January 1st, 2016 and sells it on January 1st, 2017 at
$995.23. T he coupon received is reinvested at a semi-annually compounded rate of 9%. T he realized
gross holding period return is:

A. 0.39%

B. 9.97%

C. 4.99%

D. 5.6%

T he correct answer is B.

January 1st 2016: -1043.43

July 1st 2016: $50 + 50*(1+9%/2) (Coupon payment reinvested for 6 months)
January 1st 2017: +50 (Coupon payment) + $995.23 (Selling the bond) T hus,

995.23 + 50 + 50(1.045) + 50 − 1043.43

Gross Realized Return = = 9.97%
1043.43

Q.1024 A corporate bond has a residual maturity of 2 years and pays a 10% coupon annually.
T wo zero-coupon bonds are currently trading at the price mentioned below:

Price Residual maturity

USD 92.38 1 year
USD 84.17 2 years

T he price of the corporate bond is closest to:

A. USD 101.01

B. USD 117.66

C. USD 101.82

D. USD 93.41

T he correct answer is C.

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A bond is priced using the spot rates as:

C (F V + C)
PriceBond = +
(1 + Spot rate1 )1 (1 + Spot rate2)2
100
Spot Rate1 year = ( ) – 1 = 0.825 = 8.25%
92.38
1
100 2
Spot Rate2 year = ( ) − 1 = 0.900 = 9.00%
84.17

T he price of the bond can be calculated as:

10 100 + 10
Bond Price = +
(1 + 0.0825)1 (1 + 0.09)2
= 9.24 + 8.42 + 84.17 = 101.82

Q.1025 A bond with a residual maturity of 2 years that pays a 10% coupon annually is currently
trading at $102.10. It is also observed that two zero-coupon bonds are currently trading at the price
mentioned below:

Price Residual maturity

$92.38 1 year
$84.17 2 years

T he transaction which will generate riskless profit is:

A. Sell the bond and purchase the zero-coupon bonds.

B. Borrow funds and purchase the zero-coupon bonds.

C. Riskless profit cannot be generated.

D. Buy the bond and sell the zero-coupon bonds.

T he correct answer is A.

A bond is priced using the spot rates as:

(F V + C)
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C (F V + C)
PriceBond = +
(1 + Spot rate1 ) (1 + Spot rate2)2
1

100
Spot Rate1 year = ( ) – 1 = 0.0825 = 8.25%
92.38
1
100 2
Spot Rate2 year = ( ) − 1 = 0.090 = 9.00%
84.17

T he price of the bond can thus be calculated as:

10 (100 + 10)
PriceBond = +
(1 + 0.0825)1 (1 + 0.09)2
= 9.24 + 8.42 + 84.17
= 101.82

As can be observed from the above, the price of the bond is > than $101.82. Hence, the bond is

overvalued.

1. As observed, the bond is overvalued. Hence, the investor must sell the overvalued bond.
2. T he funds obtained by selling the bond must be invested in the zero-coupon bonds.
3. By the above transaction, the investor can make a profit of $102.10 - $101.82 = $0.28 per
$100.

Q.1026 A fund manager is looking for an opportunity to invest in sovereign bonds. Country A has
recently witnessed a major economic recession and has just averted a default on its foreign debt. On
the other hand, country B is a developing economy with a low debt to GDP ratio. T he bonds of
country A and B trade at a spread of a and b with respect to US T reasury bonds.
Select the correct option:

A. a > b

B. a < b

C. a = b

D. a ≤ b

T he correct answer is A.

A riskier bond trades at a higher spread compared to less risky bond. T he bonds of country A are
riskier than the bonds of country B. T herefore, the bonds of A will be traded at a higher spread as
compared to bond B.

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Q.1027 T he bonds of country A is trading at a spread of x with respect to US T reasury bonds in

country B and at a spread of y with respect to US T reasury bonds in country C. A relative value
trader wants to generate returns by trading in bonds of country A. If x > y, then the trade must be:

A. To buy the bond in country B and sell it in country C.

B. To buy the bond in country C and sell it in country B.

C. To sell the bond in country B and C.

D. To buy the bond in country B and C.

T he correct answer is A.

T he bond trades at a higher spread in country B as compared to country C. Hence, the price of the
bond will be lower in country B as compared to country C. T herefore, the bond must be purchased
from country B and sold in country C. T he transaction will generate a profit of (x − y)% .

Q.2786 Aram Bauer is considering an investment in fixed income instruments. He is interested in a

U.S. T reasury tranche as of December 31, 2019. T he tranche pays coupons of 4.5% per year
compounded semiannually. T he price of this tranche as of December 31, 2016, is 97.124.

What is the yield to maturity of the tranche?

A. 2.78%

B. 3.22%

C. 5.55%

D. 6.44%

T he correct answer is C.

To compute a bond’s yield to maturity, we use the following formula:

C1 C2 C3 F + CN
p= + + ⋯+
1 2 3
(1 + y) (1 + y) (1 + y) (1 + y)N

Where:

P = price of the bond

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Ct =annual cash flow in year t

N = time to maturity in years

y = annual yield (YT M to maturity)

F = face value

2.25 2.25 2.25 2.25 2.25 102.25

+ + + + + = 97.124
y 1 y 2 y 3 4 y 5 y 6
(1 + 2 ) (1 + 2 ) (1 + 2 ) (1 + y2 ) (1 + 2 ) (1 + 2 )

Using trial and error, we get y=5.554%

Alternatively, using a financial calculator with the following inputs:

N = 6; PV = -97.124; PMT = 2.25 (=4.5/2); FV = 100

We get, I/Y = 2.777%

⇒ Y T M = 2 × 2.777 = 5.554%

Q.2787 On Jan 1 2017, Commercial Bank of India issued a six-year bond paying an annual coupon of
6% at a price reflecting a yield to maturity of 4%. As of 31 Dec 2017, interest rates remain
unchanged. Holding all other factors constant, and assuming a flat term structure of interest rates,
how was the bond’s price affected? T he price:

A. Remained constant.

B. Decreased.

C. Increased.

D. Increased, but only in the second half of the year.

T he correct answer is B.

From the data given, it’s clear that the bond’s coupon is greater than the yield. As such, the bond
must have traded at a premium – implying the price must have been greater than the face value.
Provided the yield doesn’t change, a bond’s price will always converge to its face value. Since the
price starts higher, it must decrease.

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Q.2788 A trader borrows $3,000,000 with a term of two years at a simple annual interest rate of 2%
from his broker. He purchases at par a bond with a 5% coupon paid annually. T he bond matures
exactly in 10 years. T wo years later, the trader sells the bond at the price of $101 and repays the
loan on an annual basis. Assuming that all of the coupons received are reinvested at the rate of 1.5%,
for a period of 1 year, what is the trader’s net realized return on the transaction described above?

A. +7.0000%

B. +7.0750%

C. +11.0000%

D. +11.0750%

T he correct answer is B.

T he net realized return is the return after financing costs have been subtracted

101
Proceeds from the sale of the bond = $3,000, 000 ∗ = $3, 030, 000.00
100
Coupons received from the bond = $150,000.00 ∗ 1.015 + $150, 000.00 = $302, 250.00
Interest paid to the broker = −$60,000.00 − $60,000.00 = −$120,000
Net proceeds = $3,030, 000.00 + $302, 250.00 − $120, 000 = $3,212, 250.00
($3,212, 250.00 − $3, 000, 000)
Net realized return = = 7.0750%
$3, 000, 000

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Q.2789 Alice T uck invested her annual bonus in a bond with a face value of $55,000. T he bond pays a
5% coupon semiannually and matures in 10 years. At the purchase date, the bond had a yield to
maturity of 7%. Six months later Alice received the coupon and sold the bond at the market yield of
6.5%. What is the net realized return on Alice’s transaction?

A. +7.0000%

B. +7.1250%

C. +7.2312%

D. +7.5475%

T he correct answer is C.

Investment in the bond = $47,183.18

(N = 20; I/Y = 3.5%; PMT = 1,375 (=55,000 *5% / 2); FV = 55,000

CPT => PV = - 47,183.18)

Proceeds from the sale of the bond = $49,220.10

(N = 19; I/Y = 3.25%; PMT = 1,375 (=55,000 *5% / 2); FV = 55,000

CPT => PV = - 49,220.10)

Coupons received from the bond = $1,375

Total proceeds = $49, 220.10 + $1, 375 = $50, 595.10

($50, 595.10 − $47, 183.18)
Net realized return = = 7.2312%
$47, 183.18

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Q.3424 At the start of the year, a bank issues a non-zero-coupon bond maturing in five years. During
the year, the following events are recorded:

I. T he bank’s leverage ratio increases

II. T he bank’s business risk increases
III. T he rate of interest earned on government bonds and T-bills increases

Which of the above-mentioned events would be expected to increase the bond’s yield to maturity?

A. I only

B. I and II only

C. III only

D. I, II, and III

T he correct answer is D.

If interest rates rise, the corporate bond will be competing with T-bonds that offer more than they
were offering at the time of the bond’s issue. As a result, the price of the bond will most likely fall.
T he yield to maturity, however, increases as price decreases. Similarly, an increase in leverage ratio
and increased business risk will increase the bank’s overall risk in the eyes of investors. T he result
will be a decrease in price, increasing the bond’s yield.

Q.3425 Bank A and Bank B both have a credit rating of BBB. Bank A issues a fixed-rate bond with a 10-
year term to maturity, while Bank B issues a similar bond with a 5-year term to maturity. Holding all
other factors constant, which of the following statements is most likely true?

A. Bond A has a higher interest rate risk than bond B

B. Bond B has a higher interest rate than bond A

C. Bond A has a lower coupon rate than bond B

D. Bond B has a higher coupon rate than bond A

T he correct answer is A.

T he longer the bond’s maturity, the greater the risk that the bond’s value could be impacted by
changing interest rates prior to maturity, which may have a negative effect on the price of the bond.
As such, bonds with longer maturities generally have higher interest rate risk than similar bonds
maturing in less time.
To compensate investors for this interest rate risk, long-term bonds generally offer higher coupon
rates than short-term bonds of the same credit quality.

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Q.3426 On Jan 1 2017, a 5-year corporate bond, paying an annual coupon of 8%, was selling at a
discount. As of 31 Dec 2017, interest rates remain unchanged. Holding all other factors constant,
which of the following relationships holds true? (P 0 represents the price of the bond and YT M is the
bond’s yield to maturity.)

A. P 0 < par and YT M < 8%

B. P 0 < par and YT M > 8%

C. P 0 > par and YT M > 8%

D. P 0 > par and YT M < 8%

T he correct answer is B.

T hat the bond is trading at a discount means the price is lower than par (face value). It also means
that the bond’s coupon is less than its yield to maturity. T he price of the bond will gradually “pull to
par” (rise to par value as maturity approaches).

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Q.4582 A zero-coupon bond with three years to maturity has a face value of 100. If the current
market price of the bond is 88, what is the yield to maturity of the bond?

A. 12%

B. 13.6%

C. 4.35%

D. 3.79%

T he correct answer is C.

T he yield to maturity of a zero-coupon bond is given by:

1
Face value year to maturity
YT M = ( ) −1
Current price of the bond

In this case,

1
100 3
YT M = ( ) − 1 = 4.35%
88

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Q.4583 An investor buys a two-year 100 par-value bond at $95 per $100 face value. T he bond pays
semiannual coupons at a rate of 5% per annum. Suppose that after six months, the coupon is invested
and earns 2% for the next 6 months. After 1 year, the investor decides to cash out and sell the bond
at $97. What is the gross realized return for the investor?

A. 7.37%

B. 7.42%

C. 4.22%

D. 2.11%

T he correct answer is B.

Ending Value+Coupon-Beginning Value

Gross Realised Return =
Beginning Value

Given that the coupon rate is 5% paid semiannually, then the bond pays coupons of $2.5 after every

6-months, and since the coupon is invested for the next 6-months at 2%, then we have:

In this case,

97 + 2.5 + 2.5 ∗ 1.02 − 95

Gross Realised Return = = 7.421%
95

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Q.4584 Suppose that James is offered a bond that pays $40 per annum in perpetuity. If the discount
rate is 6%, what is the bond’s expected price?

A. 600

B. 666.67

C. 667.77

D. 666

T he correct answer is B.

T he price of a perpetual bond is given by,

P MT
P V perpetuity =
r

Where;

r = the discount rate; and

PMT = the periodic payment.

In this case,

40
P V perpetuity = = $666.67
0.06

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Q.4585 What is the present value of an annuity that pays $100 per year at the end of each year for
the next five years at an effective rate of 5% per annum?

A. 435

B. 432.95

C. 495

D. 487.98

T he correct answer is B.

We can find the present value of the annuity using the formula;

1 − (1 + r)−T
P V annuity = P MT ( )
r

Where,

P V annuity = present value of the annuity

PMT = periodic premium payment

r = effective discount rate

In this case,

1 − (1.05)−5
P V annuity = 100 ( ) = $432.95
0.05

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Reading 58: Applying Duration, Convexity, and DV01

Q.659 On a graduate-level exam on the subject of fixed income investments, students were asked to
define duration in three sentences. One of the students mentioned the following three sentences
associated with duration:
I. T he duration of a zero-coupon bond is a measure that tells how long the holder of the bond has to
wait until the bond is redeemed for its full face value.
II. Since there are no coupons in a zero-coupon bond, the zero-coupon bond does not have duration.
III. T he duration of a coupon bond is equal to its time to maturity.

Which of the sentences are inconsistent with the definition of duration?

A. Statements I and II are inconsistent with the definition of duration.

B. Statements II and III are inconsistent with the definition of duration.

C. Statements I and III are inconsistent with the definition of duration.

D. All of the statements are inconsistent with the definition of duration.

T he correct answer is B.

Statement I is consistent with the definition of duration because the duration of a zero-coupon bond
is a measure that tells how long the holder of the bond has to wait until the bond is redeemed for its
full face value.
Statement II is incorrect because the duration of a zero-coupon bond is typically equal to its time of
maturity.

Statement III is incorrect because the duration of a coupon bond is shorter than its time to maturity.

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Q.1175 T he price of a bond at various rates is given in the table below:

Spot rate Price

3.45% 95.8680
3.40% 96.0780

T he DV01 of the bond is:

A. 11.04

B. 1.10

C. 0.042

D. 0.906

T he correct answer is C.

ΔP
DV 01 = −
10, 000 ∗ Δy
ΔP = 95.8680 − 96.0780 = −0.21
Δy = 3.45% − 3.40% = 0.05%
−0.21
DV 01 = − = 0.042
10,000 ∗ 0.05%

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Q.1176 T he price of a bond at various rates is given in the table below:

Par rates price

3.45% 95.8680
3.40% 96.0780
3.35% 96.3210

T he effective duration of the bond is:

A. 0.4719

B. 4.7149

C. -4.7149

D. 0.04719

T he correct answer is B.

−(P + − P − )
Effective Duration =
(r+ − r− ) ∗ P 0
−(95.8680 − 96.3210)
= = 4.7149
(3.45% − 3.35%) ∗ 96.0780

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Q.1177 T he price of a bond at various rates is given in the table below:

Spot rate Price

3.45% 95.8680
3.40% 96.0780
3.35% 96.3210

Select the most appropriate statement from the following.

A. T he duration is the same at 3.00% and at 3.40%.

B. T he duration is greater at 3.00% as compared to at 3.40%.

C. T he duration is smaller at 3.00% as compared to at 3.40%.

D. Duration remains unaffected by the level of interest rates.

T he correct answer is B.

As the interest rate decreases, the slope of the tangent becomes steeper. T his signifies that the
change in the price of the bond is higher at lower interest rates. As duration measures the change in
the price of the bond with respect to the interest rates, duration will be higher in the case of lower
interest rates.

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Q.1178 A fund manager has the option to buy the following bonds:

I. A bond with a coupon of 10% and a tenure of 5 years

II. A bond with a coupon of 5% and a tenure of 5 years

If the fund manager wants to limit the impact of interest rate changes in his portfolio, the ideal
bond(s) to invest in is/are:

A. T he bond with the 10% coupon.

B. T he bond with the 5% coupon.

C. Both bonds, since they react in a similar manner to interest rate changes.

D. Both bonds, since the diversification effect will reduce the impact of interest rate
changes.

T he correct answer is A.

T he impact of interest rate change in a bond portfolio is measured by the duration of the portfolio.
T he bond with the higher coupon has smaller duration compared to the bond with the lower coupon.
Hence, if the fund manager wants to limit the impact of the interest rate changes on his portfolio, he
must invest in the bond with the 10% coupon, as this bond will have a smaller duration compared to
the bond with the 5% coupon.

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Q.1179 A fund manager has the option to buy the following bonds:

I. A bond with 10% coupon and a tenure of 15 years

II. A bond with 10% coupon and a tenure of 10 years
III.

T he fund manager expects the interest rate volatility to increase and wants to compose a portfolio
which will help him generate maximum return due to the volatility. T he fund manager must buy:

A. T he bond with a tenure of 15 years.

B. T he bond with a tenure of 10 years.

C. Both, since they react in a similar manner to interest rate volatility.

D. Both, since the diversification effect will help him generate maximum return.

T he correct answer is A.

Bond duration is generally considered a direct measure of how much a bond's price will change for an

interest rate change of 100 basis points (1 percent). For example, for every 1 percent change in

interest rates, a bond with a duration of 10 years will change by 10% in price. Generally, bonds with

longer maturities and lower coupons have longer durations. T hese bonds are more sensitive to a

change in market interest rates and thus are more volatile in a changing rate environment. An

investor wishing to take advantage of higher volatility should therefore go for the bond with the

longer maturity. T he investor would effectively be betting that the higher volatility will bring about a

fall in interest rates because that's the only way they would benefit. If interest rates rise, bond

prices fall, and the investor loses.

It follows that a 10% annual coupon bond that matures in 15 years would have a longer duration and

would experience a higher rise in price as interest rates fall than a bond with a 10% coupon that

matures in 10 years. Of course, duration is a double-edged sword that cuts both ways. If interest

rates were to rise, the value of the 15-year bond would fall more than that of the 10-year bond.

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Q.1180 All the following are true for convexity, EXCEPT :

A. Convexity is the second derivative of the price rate function.

B. For an option free bond, convexity is always negative.

C. Convexity explains why the price of a bond falls less and rises more in the case of changes
in interest rates.

D. Convexity enhances the bond’s return.

T he correct answer is B.

Convexity is the second derivative of the price rate function. Due to the convex shape of the price-

interest curve of a bond, for a given change in the interest rates, the bond price rises more and falls

less.

If an increase in interest rates decreases the price of a bond by x , and an equal decrease of 1% in

interest rates increases the price of the same bond by y , then due to convexity, y > x.

For an option-free bond, the convexity is always positive. As the increase in bond price is larger in

value than the decrease in value for the same yield change, convexity enhances the return of a bond.

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Q.1181 Details of portfolio X is given below: Note: Portfolio X consists of bonds A, B, C and D, and
the value of each bond is given in the above table. T he duration of portfolio X is:

Bond Value Duration Convexity

Bond A $120, 000 5.453 230.453
Bond B $100, 000 7.213 350.361
Bond C $150, 000 2.348 120.714
Bond D $130, 000 8.190 480.341

A. 5.26

B. 5.59

C. 5.10

D. 5.69

T he correct answer is B.

Total value of the portfolio = $120, 000 + $100, 000 + $150, 000 + $130, 000 = $500, 000
$120, 000 ∗ 5.453 + $100, 000 ∗ 7.213 + $150, 000 ∗ 2.348 + $130, 000
Duration of the portfolio =
$500, 000
= 5.59

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Q.1182 Details of portfolio X is given below:

Bond Value Duration Convexity

Bond A $120, 000 5.453 230.453
Bond B $100, 000 7.213 350.361
Bond C $150, 000 2.348 120.714
Bond D $130, 000 8.190 480.341

Note: Portfolio X consists of bonds A, B, C and D, and the value of each bond is furnished in the
above table.
T he convexity of portfolio X is:

A. 360.426

B. 386.484

C. 200

D. 286.484

T he correct answer is D.

Total value of the portfolio = $120, 000 + $100, 000 + $150, 000 + $130, 000 = $500, 000
($120, 000 ∗ 230.453 + $100, 000 ∗ 350.361 + $150, 000 ∗ 120.714 + $130
Convexity of the portfolio =
($500,000)
= 286.484

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Q.1183 Data on three bonds are given below. Assume the current date is March 31, 2015.

Bond Maturity Price Yield Duration Convexity

A March 31, 2020 110.321 2.32% 4.321 34.09
B March 31, 2030 109.320 3.23% 9.102 78.32
C March 31, 2045 103.211 4.11% 18.112 323.11

T he fund manager is considering purchasing $10 million (face value) of bonds B at the cost of $10.932
million. T he fund manager expects the interest volatility to increase and hence wants to maximize
his returns. However, another fund manager makes the suggestion that instead of investing in bond B,
the fund manager should invest in a combination of bonds A and C. Given that the fund manager has a
surplus of $10.932 million and wants the duration of the portfolio to be equal to that of bond B, the
investments in A and C which can create a portfolio with a duration similar to B is:

A. $5.34 million in bond A and $5.592 million in bond C.

B. $9.321 million in bond A and $1.611 million in bond C.

C. $7.14 million in bond A and $3.79 million in bond C.

D. $8.12 million in bond A and $2.812 million in bond C.

T he correct answer is C.

Let the investments in A and C be x and y respectively. T hen, as per the constraints:

x + y = 10.932

1
( ) ∗ (x ∗ 4.321 + y ∗ 18.112) = 9.102
10.932

Solving for x and y :

x = $7.14
y = $3.79

Q.1184 Data on three bonds are given below. Assume the current date is March 31, 2015.

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Bond Maturity Price Yield Duration Convexity

A March 31, 2020 110.321 2.32% 4.321 34.09
B March 31, 2030 109.320 3.23% 9.102 78.32
C March 31, 2045 103.211 4.11% 18.112 323.11

T he fund manager is considering purchasing $10 million (face value) of bonds B at the cost of $10.932
million. T he fund manager expects the interest volatility to increase and hence wants to maximize
his returns. However, another fund manager makes the suggestion that instead of investing in bond B,
the fund manager should invest in a combination of bonds A and C. T he fund manager has a surplus of
$10.932 million and wants the duration of the portfolio to be equal to that of bond B. Given that the
fund manager expects increased interest volatility, the fund manager should invest in:

A. $10.932 million of Bond B.

B. $10.932 million of Bond C.

C. $5.12 million of bond A and $5.81 of bond C.

D. $7.14 million of bond A and $3.79 of bond C.

T he correct answer is D.

T he fund manager must invest in such a bond/portfolio which has the highest convexity, as higher

convexity will help the fund manager to maximize return due to interest rate volatility.

Let the investments in A and C be x and y respectively. As per the constraint of having a duration of

the portfolio equal to that of bond B (9.102 years):

x + y = 10.932

1
( ) ∗ (x ∗ 4.321 + y ∗ 18.112) = 9.102
10.932

Solving for x and y :

x = $7.14
y = $3.79

7.14 3.79
Portfolio convexity = ( ) ∗ 34.09 + ( ) ∗ 323.11 = 134.29
10.932 10.932

As the convexity of the portfolio is higher than the convexity of bond B and the portfolio meets the

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duration constraints (as it is equal to bond B), the preferred investment is in a portfolio consisting of

bond A and C.

Q.1185 Data on three bonds are given below. Assume the current date is March 31, 2015.

Bond Maturity Price Yield Duration Convexity

A March 31, 2020 110.321 2.32% 4.321 34.09
B March 31, 2030 109.320 3.23% 9.102 78.32
C March 31, 2045 103.211 4.11% 18.112 323.11

T he return generated by a portfolio consisting of $7.14 million of bond A and $3.79 million of bond C
in the case the interest rate remains constant is:

A. 0.0232

B. 0.0411

C. 0.0294

D. 0.0151

T he correct answer is C.

7.14 3.79
T he return generated in case the rate remains constant = ( ) ∗ 2.32% + ( ) ∗ 4.11%
10.932 10.932
= 2.94%

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Q.2791 Suppose the yield on a zero-coupon bond declines from 5.00% to 4.99%, and the price of the
bond increases from $50.0 to $51.5. Compute the DV01.

A. $0.0512

B. $1.5

C. $2.5

D. $0.1

T he correct answer is B.

ΔBV
DV 01 = −
10, 000 × Δy

Where:
ΔBV = change in bond value
Δy = change in yield

51.5 − 50.0
DV 01 = − = 1.5
10, 000 × −0.0001

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Q.2792 Ted Oster wants to calculate the DV01 of a new position in a bond with a face value of
$1,000,000. T he bond was bought today for $84.102 for $100 face value. Oster knows that the
Macaulay duration is 5.25.

What is the DV01 of the position if the bond has a yield to maturity of 10% per annum?

A. $401.39

B. $405.40

C. $483.47

D. $492.73

T he correct answer is A.

5.25
Modified duration = = 4.7727
(1 + 10%)
DV 01 = Mod dur × 0.0001 × Bond value
84.102
= 4.7727 × 0.0001 × ( ) × $1, 000,000
100
= $401.39

Note that the reason why we multiply by 0.0001 is to get the dollar change for a 1% change in yield

in terms of basis points.

Q.3315 Peter Drury, a risk manager at Capital Bank, is evaluating the price sensitivity of an
investment-grade callable bond using the bank's valuation system. T he table below gives a breakdown
of the bond and the embedded option. T he current interest rate environment is flat at 5%.

Interest rate Bond value Call option value

level per 100 USD face value per 100 USD face value
4.95% 98.2520 1.7480
5.0% 98.0000 1.5000
5.05% 97.7500 1.3225

T he DV01 of a comparable bond with no embedded options and with the same maturity and coupon
rate as the collable bond is closest to:

A. 0.09275

B. 0.08015

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C. 0.1285

D. 0.07500

T he correct answer is A.

T he call option negatively affects the price of a bond because investors lose future coupon

payments if the call option is exercised by the issuer.

T he value of a plain-vanilla bond can be given by:

Price (plain-vanilla bond) = price (callable bond) + price (call option)

T hus, the price of the plain-vanilla bond with no embedded options at a rate of 5.0% would be

99.5000, the price at a rate of 4.95% would be 100.0000, and the price at a rate of 5.05% would be

99.0725.

DV01 is the dollar value change in price (value) of a fixed income instrument, such as a bond, in

response to a change in the yield of the instrument. It is given by:

ΔP
DV 01 = −
10, 000 × ΔY

where:

ΔP = change in price, and

ΔY = change in yield

T hus

99.0725 − 100 −0.9275

DV 01 = − =− = 0.09275
10,000 × (0.0505 − 0.0495) 10

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Q.3319 T he current price of a bond is 950. T he duration of the bond is 8.83 and the convexity of the
bond is 6.43. What is the change in the price of the bond for a one percentage point increase in the
interest rate?

A. -38.00

B. 52.25

C. 22.80

D. -83.58

T he correct answer is D.

For a one basis point of change in the interest rate, the formula for the bond price change is:

1
Change in price = [−Modified Duration × Bond Price × Change in yield] + [ × Convexity × Bond Price
2
6.43
= −8.83 × 0.01 × 950 + × 950 × 0.012 = −83.5796
2

Q.3427 Given the following portfolio of bonds:

Bond Price Par Amount Held Modified Duration

(USD Million)
A 101.22 4 2.45
B 85.53 6 4.25
C 115.50 9 7.61

What is the value of the portfolio’s DV01 (dollar value of a basis point)?

A. $10,960

B. $11,000

C. $11,060

D. $12,600

T he correct answer is C.

Portfolio DV01 = Portfolio Modified duration × Portfolio Market Value × 0.0001

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But we have to compute the portfolio modified duration first:

Modified duration of the portfolio = Weighted Average of Modified Duration of Individual Bonds in the Portfolio

= w 1D1 + w 2 D2 + ⋯ + w kDk

where :

Market value of bond i

wi = Portfolio market value

D i = Modified duration of bond i

k=total no.of bonds in the portfolio

Based on the table above, these are the values for bonds A, B, and C:

Bond Value Weight in

the Portfolio
4,000,000 4,048,800
A = 101.22 × = 4, 048, 800 = 19,575,600 =
0.21
100
6,000,000 5,131,800
B = 85.53 × = 5, 131, 800 = 19,575,600 =
0.26
100
9,000,000 10,395,000
C = 115.5 × = 10, 395, 000 = 19,575,600 =
0.53
100
Portfolio = 4, 048, 800 + 5, 131, 800 + 10, 395, 000
= 19, 575,600

Portfolio Modified Duration = 0.21 × 2.45 + 0.26 × 4.25 + 0.53 × 7.61 = 5.65

T herefore,

Portfolio DV01 = 5.65 × 19, 575, 600 × 0.0001 = $11, 060.2

Q.3428 T he current interest rate environment in a certain developing economy is flat at 5%. A risk
manager has compiled the following data regarding a callable bond in two other interest rate
environments (all values in USD per USD 100 face value):

Level of interest rate Callable bond Call option

4.96% 102.00 2.0893
5.00% 102.4465 2.0255
5.04% 101.2111 2.0021

T he convexity of the callable bond is closest to:

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A. -102,608

B. -51,304

C. -100,020

D. -103,000

T he correct answer is A.

Convexity is the second derivative of the formula for change in bond prices with a change in interest
rates.

1 d2P
Convexity = ×
P dy 2

T his approach can be quite rigorous in terms of computation, so you need to estimate convexity
using the formula:

P −Δy + P +Δy − 2P 0
Convexity =
P 0 × Δy 2

Where:
P −Δy =price estimate if yield decreases by a given amount, Δy

P +Δy =price estimate if yield increases by a given amount, Δy

P 0=initially observed bond price (at the flat rate)

Δy =change in yield in one step, expressed in decimal form (0.04% in this case)

102.00 + 101.2111 − 2 × 102.4465

Convexity =
102.4465 × 0.00042

1.6819
=− = −102, 608
0.00001639

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Q.3429 A 20-year zero-coupon bond is callable annually at par, starting at the beginning of year 11.
Assuming a flat yield curve of 20%, the bond’s duration is closest to:

A. 20 years

B. 15 years

C. 10 years

D. Cannot be determined based on the data given

T he correct answer is A.

Because this is a zero-coupon bond, it will always trade below par, and the call should never be
exercised. Hence, its duration is the maturity of the bond, 20 years.

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Q.4609 In the context of the one-factor risk metrics, which of the following is/are correct?

I. DV01 and effective duration hedging provide protection against small parallel shifts of the
term structure
II. DV01 and effective hedging protect against large parallel shifts of the term structure
III. A combination of the convexity and effective duration protects against large parallel shifts in
the term structure
IV. Effective convexity hedging protects against small parallel shifts in the term structure

A. I and IV

B. I and III

C. III only

D. I and II

T he correct answer is B.

Statement I i s correct: DV01 and effective duration hedging provide protection against small

parallel shifts of the term structure.

Statement II i s i ncorrect: It contradicts statement I.

Statement III i s correct: Using both the duration and convexity in hedging protects against large

parallel shifts in the term structure of interest rates.

Statement IV i s i ncorrect: Convexity and the effective duration are combined with hedging a

position against large parallel shifts in the term structure.

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Q.4611 A bank has a position of USD 2 million with a duration of 10 years. To completely hedge its
position, the bank takes a short position of USD 1.4 million in bond B. What is the duration of bond B?

A. 10

B. 11

C. 13

D. 14

T he correct answer is D.

T he position required in the bond to hedge a position is given by:

V DV
P =−
DB

Where

V = a value of the position

DV = duration of the position

DB = duration of the bond

So in this case,

V DV
P =−
DB
2 × 10
⇒ −1.4 = −
DB
20
∴ DB = ≈ 14
1.4

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Q.4613 Suppose the yield on a zero-coupon bond declines from 7.00% to 6.95% and the price of the
zero increases from $202.45 to $203.87. What is the value of DV01?

A. 0.342

B. 0.324

C. 0.284

D. 0.242

T he correct answer is C.

DV01 is defined as:

ΔP
DV 01 = −
Δr

Where

Δr = the size of a parallel shift in the interest rate term structure measured in basi s poi nts

ΔP = resultant change in the value of the position being considered

203.87 − 202.45 1.42

⇒ DV01 = − = = 0.284
(−0.0005) × 10, 000 5

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Q.4614 T he Macaulay duration of a coupon bond is 10.25. If the yield on the bond is 8% compounded
semi-annually, what is the corresponding modified duration for the bond?

A. 10.25

B. 9.86

C. 11.45

D. 9.54

T he correct answer is B.

y
Denoting the bond yield by y, modified duration is calculated by dividing Macaulay duration by (1 + 2 ).

So in this case,

10.25
Modified duration = = 9.86
0.08
(1 + )
2

Q.4615 A four-year T reasury bond has a face value of USD 5 million and an annual coupon payment
of 8% paid semi-annually. T he term structure applicable to the bond is a 10% flat yield. Considering
ten basis point changes, what is the effective convexity of the bond?

A. -13.68

B. 13.68

C. -203.67

D. 203.67

T he correct answer is B.

Convexity is given by:

1 P + + P − − 2P
C= [ ]
P (Δr)2

Where

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P = the price of the bond.

P + = the value of the position when all rates increase by Δr

P − = the value of the position corresponding to the decrease of all rates by Δr (measured in decimal)

T he price of the bond (in millions) with no spread is USD 4,676,839 million. Using a financial

calculator with the variables:

N = 8,
I 10%
= = 5%
Y 2
PV = ?
0.08 × 5
P MT = = 0.2
2
FV = 5
⇒ P V = 4.676839 million
⇒ P = 4,676, 839

I
For an increase in 10 point basis (0.10%) the flat yield is now 10.10% and thus = 5.05% . Using the
Y
financial calculator,

P + = U SD$4, 661, 366

I
For a 10 point basis decrease, the flat yield is now 9.9% and thus = 4.95% .
Y

∴ P − = $4, 692, 376

1 4, 661,366 + 4,692, 376 − 2 × 4, 676,839
⇒C= [ ] = 13.681
4,676, 839 (0.001)2

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Q.4616 A bond portfolio consists of three bonds:

Bond A worth 9 million with a duration of 4;

Bond B worth 5 million with a duration of 6; and

Bond C worth 6 million with a duration of 7.

What is the duration of the portfolio?

A. 7.8

B. 6.6

C. 5.4

D. 5.7

T he correct answer is C.

Recall that the portfolio duration is calculated as the wei ghted sum of the individual durations

where the weight attached to each security is equal to its value as a percentage of total portfolio

value.

T he total value of the portfolio is 9 + 5 + 6 = USD 20 million. T he duration of the bond is given by:

9 5 6
×4+ ×6+ × 7 = 5.4
20 20 20

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Q.4617 A position worth USD 3 million has a duration of 4 and a convexity of 5. What is the estimated
change in the position for a five-basis-point increase in all rates?

A. Increase by USD 5,998.125

B. Decrease by USD 5,998.125

C. Increase by USD 5,546.670

D. Decrease by USD 5,546.670

T he correct answer is B.

By using convexity and duration, the price change estimation is given by:

1
ΔP = −DP Δr + CP (Δr)2
2
1
= −4 × 3 × 0.0005 + × 5 × 3 × (0.0005)2
2
= −0.005998125 = −USD 5,998.125

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Reading 59: Modeling and Hedging Non-Parallel Term Structure Shifts

Q.1148 All the following are assumptions of Key Rate Shifts, EXCEPT :

A. Rates can be determined as a function of a relatively small number of key rates.

B. T here is a parallel shift of rates across the key rates.

C. T here is a linear shift of rates across the term structure.

D. T he rate of a given term is not affected by its neighboring key rates.

T he correct answer is D.

T he basic idea behind the key rate shifts is the assumption that rates can be determined as a function
of a relatively small number of key rates. Furthermore, the key rates also assume that there is a
parallel shift/linear shift of rates across the term structure. It also assumes that the rate of the given
term is affected by its neighboring key rates. For instance, it assumes that the 5-year rate is a
function of 2-year and 3-year rates.

Q.1149 An investor who buys a payer swaption:

A. Has the right to pay the fixed rate on a swap at some time in the future.

B. Has the right to pay the floating rate on a swap at some time in the future.

C. Has the right to receive the fixed rate on a swap at some time in future.

D. None of the above.

T he correct answer is A.

A payer swaption gives the owner of the swaption the right to enter into a swap where they pay the
fixed leg and receive the floating leg.
Option B is incorrect. A recei ver swaption gives the owner of the swaption the right to enter into a
swap in which they will receive the fixed leg and pay the floating leg.

Options C and D are also incorrect, because they contradict option A.

Q.2606 A risk manager prepares a presentation on the interest rate risk of the bank’s bond portfolio.
T he table below shows the value of the portfolio in case of shifts in key rates by one basis point and
corresponding key rate duration.

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Value Key Rate Duration

Initial Curve 500.425
2-year Shift 500.227 3.957
5-year Shift 500.201 4.476
10-year Shift ? 28.476
30-year Shift 499.500 18.484
Total 55.393

What is the value of the portfolio in the case of a 10-year shift?

A. 501.850

B. 500.043

C. 499.500

D. 499.000

T he correct answer is D.

1 ∂p
Key rate duration = −
p ∂y

Where:

P = initial bond value/price

∂p = change in bond price

∂y = change in yield

Let the value of the bond portfolio in the case of a 10-year shift be "x"

T hus, the key rate duration with respect to the 10-year shift is calculated as:

1 x − 500.425
Key rate duration = −
500.425 0.01%
1 x − 50.425
⇒ 28.476 = − ×
500.425 0.01%
x − 500.425
⇒ 28.476 × 500.425 = −
0.01%
⇒ 28.476 × 500.425 × 0.01% = −(x − 500.425)
⇒ 28.476 × 500.425 × 0.01% = (500.425 − x)
⇒ 500.425 − 28.476 × 500.425 × 0.01% = x
⇒ x = 499.000

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Q.2607 Frank Capper wants to estimate the impact of key rate changes on the value of C-ST RIPs.
Capper uses 2-year, 5-year, 10-year, and 30-year key rates in his analysis. He also wants to
incorporate an unexpected 50 basis point shock of the 10-year rate in the model.

Which of the following rates will be affected by the change of the 10-year rate key rate?

A. 2-year and 5-year

B. 30-year rate

C. 5-year and 30-year rates

D. All of the rates will be affected

T he correct answer is C.

Each key rate affects the yields from the term of the previous key rate (or zero) to the term of the
next key rate.

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Q.2610 A trader wants to hedge the 2-year and 5-year rates exposure of a portfolio. To perform the
hedge, the trader can use Bond 1 and Bond 2 presented below.

Key Rate ‘01 (per 100 face amount)

Hedging Bonds 2-year 5-year
––––––– –––––––
Bond 1 0.0080 −
Bond 2 0.0099 0.0160

Key Rate ’01($)

2-year 5-year
––––––– –––––––
Fixed Income 250 320
Portfolio

What is the face value of Bond 1 required to perform the hedge?

A. $200,000

B. $650,000

C. $950,000

D. $1,250,000

T he correct answer is B.

Let’s denote F(i) as the face amount of hedging bond i that we need to sell.

We have the following equations:

0. 0099 0. 0080
(1): F (2) ∗ + F (1) ∗ = $250
100 100

0. 0160
(2): F (2) ∗ = $320
100

From (2) → F (2) = $2, 000, 000

From (1)and(2) → F (1) = $650, 000

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Q.2611 T he risk manager of a regional bank is concerned with possible shocks in short-term rates.
He wants to find a transaction that will completely eliminate the 2-year exposure and decrease by
half the current 5-year exposure. A trader proposes the following two bonds as hedging instruments:

Key Rate ‘01 (per 100 face amount)

Hedging Bonds 2-year 5-year
––––––– –––––––
Bond 1 0.0010 0.0050
Bond 2 0.0015 0.0025

Key Rate ’01($)

2-year 5-year
––––––– –––––––
Fixed Income 1, 000 4, 000
Portfolio

What is the trader’s hedging transaction?

A. Sell $60,000,000 of bond 1; Sell $10,000,000 of bond 2.

B. Sell $10,000,000 of bond 1; Sell $60,000,000 of bond 2.

C. Sell $10,000,000 of bond 1; Buy $60,000,000 of bond 2.

D. Buy $60,000,000 of bond 1; Sell $60,000,000 of bond 2.

T he correct answer is B.

Let’s denote F(i) as the face amount of hedging bond i that we need to sell.

To completely hedge the 2-year exposure, F(1) and F(2) should solve the following equation:

0.0015 0.0010
F (2) ∗ + F (1) ∗ = $1000.. . .. . (1)
100 100

To decrease by half the 5-year exposure of $4,000, F(1) and F(2) should solve the following equation:

0.0025 0.0050
F (2) ∗ + F (1) ∗ = $2, 000.... . . (2)
100 100

Solving equation (1) and (2), simultaneously, we get, F (2) = $60, 000, 000 and F (1) = $10, 000, 000

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Q.2612 T he head of the trading department of a bank suggests speculating on the interest rate curve
by eliminating the exposure of the bond portfolio to long-term rates (10-year and 30-year rates) and
increasing the exposure to medium-term rates. T he table below represents the key rate ‘01s of the
current portfolio and corresponding hedging instruments.

Key Rate ‘01 (per 100 face amount)

Hedging Bonds 5-year 10-year 30-year
––––––– –––––––– ––––––––
Bond 1 0.0050 − −
Bond 2 0.0170 0.0250 −
Bond 3 0.0100 0.0300 0.0350

Key Rate ’01($)

5-year 10-year 30-year
––––––– –––––––– ––––––––
Fixed Income 1, 000 2, 000 1, 500
Portfolio

What will be the portfolio’s 5-year exposure after hedging 10-year and 30-year exposures?

A. $85.70

B. $171.43

C. $8,570.00

D. $17,143.00

T he correct answer is A.

Let’s denote F(i) as the face amount of hedging bond i that we need to sell.

We have the following equations:

0. 0300 0. 025
(1): F (3) ∗ + F (2) ∗ = $2, 000
100 100

0. 0350
(2): F (3) ∗ = $1, 500
100

From (3) → F (3) = $4, 285, 714

From (2) and (3) → F (2) = $2, 857, 143

0. 0170 0. 0100
Finally, the portfolio’s 5-year exposure = $1000 − F (2) ∗ − F (3) ∗ = $85.70
100 100

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Q.2613 T he risk manager at a regional bank is trying to interpret the results of an interest rate curve
shocks simulation. T he table below represents the key rate '01s for the fixed income portfolio of
the bank.

Value Key Rate '01

Initial Curve 2,000.000
2-year Shift 1,998.500 1.500
5-year Shift 1,998.300 1.700
10-year Shift 1,999.000 1.000
30-year Shift 1,998.000 2.000
Total 6.200

What is the approximate value of the portfolio in the case of a 5 basis point increase of the 2-year
rate and a 10 basis point increase of the 30-year rate?

A. 1,972.500

B. 1,980.000

C. 1,992.500

D. 1,996.500

T he correct answer is A.

Portfolio value = 2, 000 − (5 ∗ 1.5 + 10 ∗ 2) = 1, 972.5

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Q.2614 Anna White, head of the risk management department of a regional bank, asks one of the
interns to analyze the volatility of the bank’s medium-term fixed-income portfolio with a value of
$10,000. For the analysis of the portfolio, the intern uses 2-year rates (annual volatility of 20%) and
5-year rates (annual volatility of 30%). He calculates that the key rate ’01s for 2-year and 5-year
shifts are 2 per $ 100 and 5 per $ 100 respectively.

What is the volatility of the portfolio if the correlation between 2-year and 5-year rates is 0.45?

A. $155.24

B. $171.76

C. $22,570.00

D. $29,500

T he correct answer is B.

2 2
2 5
Portfolio variance = ( × 0.20 × 10000) + ( × 0.30 × 10000)
100 100
2 5
+2 × × × 0.20 × 10000 × 0.30 × 10000 × 0.45
100 100
= 29,500
Portfolio volatility = $29,5000. 5 = $171.76.

Q.2615 Initially, a fixed income portfolio of an investment bank had the following key rate ‘01s:

Value Key Rate

Initial Curve 10,000
2-year Shift 9,990 10
5-year Shift 9,985 15
10-year Shift 9,981 19
30-year Shift 9,984 16
Total 60

After a recommendation from the risk management department, a trader completely hedged the 30-
year exposure with a bond that had the following characteristics:

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Hedging Bond Key Rate '01

(per USD 100 face value)
Initial Curve
2-year Shift −
5-year Shift −
10-year Shift 3
30-year Shift 4

How much will the bank save, if immediately after the hedge, the interest rate curve experienced a
20 basis point upward parallel shift?

A. 320

B. 360

C. 480

D. 560

T he correct answer is D.

To hedge the 30-year exposure, the trader will need to sell $400(= $ 16 ∗ 100) face value of hedging
4
3
bond. T he sale of hedging bond will also impact the 10-year exposure by −$12(= − 100 ∗ $400).

T he portfolio key rate ‘01s after hedge will become:

Hedging Bond Key Rate '01

Initial Curve
2-year Shift 10
5-year Shift 15
10-year Shift 7
30-year Shift −
Total 32

T he portfolio value drop without hedging transaction = 20 ∗ 60 = 1, 200

T he portfolio value drop with hedging transaction = 20 ∗ 32 = 640

T he hedging transaction will save the bank 560(= 1, 200 − 640).

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Q.3430 Kelvin Mertens, FRM, regularly participates in bond trading in the US. He is using key rate
analysis to assess the effect of yield changes on bond prices. He finds that the 20-year yield has
increased by 10 basis points. Moreover, this shock decreases linearly to zero for the 30-year yield.
What is the effect of this shock on the 26-year yield?

A. Increase of zero basis points

B. Increase of six basis points

C. Increase of ten basis points

D. Increase of four basis points

T he correct answer is D.

“Linear decline” implies the decline is by the same amount in each time step. T he 10 basis point
shock to the 20-year yield is supposed to decline linearly to zero for the 30-year yield. If one
assumes a simplistic one basis point effect, the impact of each key rate will be one basis point at
each key rate and then a linear decline to the subsequent key rate. T hus, the shock decreases by one
basis point per year and will result in an increase of four basis points for the 26-year yield.

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Q.3431 T he following table provides the initial price of a C-ST RIP and its present value after the
application of a one basis point shift in four key rates.

Value
Initial value 26.14485
2-year shift 26.14582
5-year shift 26.14885
10-year shift 26.14885
30-year shift 26.02192

T he key rate '01 with respect to the 10-year shift is closest to:

A. -0.004

B. -0.04

C. -4

D. -0.4

T he correct answer is A.

ΔBV
Key rate '01 = −
10, 000 × Δy

Where:
ΔBV =change in bond value

Δy =change in yield (0.01%)

T he change in bond value here is measured in reference to the initial bond value.

26.14885 − 26.14485
=− = −0.004
10, 000 × 0.01%

Q.3432 T he following table provides the initial price of a C-ST RIP and its present value after the
application of a one basis point shift in four key rates.

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Value
Initial value 26.11485
2-year shift 26.11582
5-year shift 26.11885
10-year shift 26.13885
30-year shift 26.01192

T he key rate duration with respect to the 30-year shift is closest to:

A. 39

B. 51

C. 38

D. 10

T he correct answer is A.

First, determine the corresponding key rate ’01:

ΔBV
Key rate '01 = −
10, 000 × Δy

Where:
ΔBV =change in bond value

Δy =change in yield (0.01%)

T he change in bond value here is measured in reference to the initial bond value.

26.01192 − 26.11485
=− = 0.1029
10, 000 × 0.01%

Next, you can now compute the key rate duration using the formula:

DV01 = Duration × 0.0001 × Bond value

T hus,

DV01
Duration =
0.0001 × Bond value
0.1029
=
0.0001 × 26.11485
= 39.41

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Alternatively, recall that:

1 ∂P
Key rate duration = − ( )
P ∂y

T hus, the key rate duration with respect to the 30-year shift can be calculated as:

1 26.01192 − 26.11485
Key rate duration = −( )×( ) = 39.41
26.11485 0.01%

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Reading 60: Binomial Trees

Q.1205 Australian Financial Associates is holding the non-dividend paying stock of Neevan Holdings
which is trading at USD 10. T he continuously compounded risk-free rate is 5 percent per annum, and
the annual standard deviation of the stock is 20 percent. What is the value of a 2-year European call
option with a strike price of USD 10 using a two-period binomial model?

A. USD 1.64

B. USD 1.48

C. USD 1.58

D. USD 1.69

T he correct answer is B.

To price options in the binomial model, we need:

U = size of the up move factor =eσ√Δt

1
D = size of the down move factor = e−σ√Δt = U

σ is the annual volatility of the underlying asset’s returns and t is the length of the step in the

binomial model (t = 1 in this case).

r
e Δt−D
πu = probability of an up move = U −D

πd = probability of a down move = 1 − Π u

Working with the data provided,

U = 1.2214 and D = 0.8187

πu = 0.5775 and πd = 0.4225

Let S represent the price of the stock and f represent the value of the call:

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Stock Price Value of the Call

Suu = $10 ∗ 1.2214 ∗ 1.2214 = $14.92 f uu = max($14.92 − $10, $0) = $4.92
Su d = $10 ∗ 1.2214 ∗ 0.8187 = $10 f u d = max($10 − $10, $0) = $0
Sdu = $10 ∗ 0.8187 ∗ 1.2214 = $10 f du = max($10 − $10, $0) = $0
Sdd = $10 ∗ 0.8187 ∗ 0.8187 = $6.70 f dd = max($6.70 − $10, $0) = $0

As the table shows, the value of the call will be positive only when the stock moves upward twice.

T he expected value of the call 2 years from now is given by:

0.5775 × 0.5775 × $4.92 + 0.5775 × 0.4225 × $0

+ 0.4225 × 0.5775 × $0 + 0.4225 × 0.4225 × $0
= $1.64

1.64
Value of the option today = = $1.48
e0. 05×2

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Q.1207 Chris Fleming, an analyst working at Redberg Financials, constructs binomial trees to price
options. With regard to binomial trees for pricing options, which of the following statement(s) is/are
true?
I. T he underlying assumption in constructing a binomial tree is that the stock price follows a random
walk
II. In the limit, as the time step increases, the binomial tree model valuation of a European option
converges to the Black-Scholes-Merton model valuation
III. An inspection of a typical binomial tree shows that Delta remains constant during the life of an
option
IV. Constructing binomial trees for valuing options on stock indices, currencies, and futures
contracts is very similar to doing so for valuing options on stocks

A. I, III & IV only

B. I, II & IV only

C. II, III & IV only

D. All of the above

T he correct answer is B.

Statement I i s true: T he underlying assumption in constructing a binomial tree is that the stock
price follows a random walk.

Statement II i s true: In the limit, as the time step increases, the binomial tree model valuation of

a European option converges to the Black-Scholes-Merton model valuation

Statement III i s not true: An inspection of a typical binomial tree shows that delta CHANGES

during the life of an option.

Statement IV i s true: Constructing binomial trees for valuing options on stock indices, currencies,

and futures contracts is very similar to doing so for valuing options on stocks.

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Q.1210 David Yung, an analyst working at the New Zealand Bank, uses Girsanov’s T heorem to study
portfolios in a risk-neutral world and in the real world. T he Girsanov’s T heorem states that:

A. When we move from the risk-neutral world to the real world, the expected return from
the stock price changes, but its volatility remains the same.

B. When we move from the risk-neutral world to the real world, the expected return from
the stock price remains the same, but its volatility changes.

C. When we move from the risk-neutral world to the real world, both the expected return
from the stock price and its volatility remains the same.

D. When we move from the risk-neutral world to the real world, both the expected return
from the stock price and its volatility change.

T he correct answer is A.

Girsanov’s T heorem states that when we move from a risk-neutral world to the real world, the
expected return from the stock price changes, but its volatility remains the same. When we move
from a world with one set of risk preferences to a world with another set of risk preferences, the
expected growth rates in variable change, but their volatilities remain the same.

Q.1211 Australian Financial Associates is holding the non-dividend paying stock of Neevan holdings
which is trading at USD 10. T he continuously compounded risk-free rate is 5 percent per year, and
the annual standard deviation of the stock is 20%. What is the value of a 2-year European put option
with a strike price of USD 10 using a two-period binomial model?

A. USD 0.5323

B. USD 2.4356

C. USD 0.6884

D. USD 2.3456

T he correct answer is A.

Year 0 Year 1 Year 2

Suu = $12.214 × 1.2214 = $14.918
Su = $10 × 1.2214 = $12.214
S0 = $10 Su d = $12.214 × 0.8187 = $10
Sd = $10 × 0.8187 = $8.187
Sdd = $8.187 × 0.8187 = $6.703

T he option will have a positive value only when the price moves downward twice.

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Expected put value of the option in two years = (0.5775 * 0.5775 * USD 0) + (0.5775 * 0.4224 * 0) +
(0.4224 * 0.5775 * 0) + (0.4224 * 0.4224 * 3.297) = USD 0.5883
Value of the option today = 0.5883 ∗ e−0. 05×2 = 0.5323

Q.1212 Which of the following statement(s) is/are true with regard to Delta?

I. Delta is an important parameter in the pricing and hedging of options

II. Delta is the number of units of the stock we should hold for each option shorted in order to
create a riskless portfolio
III. T he construction of a riskless portfolio is sometimes referred to as delta hedging
IV. T he delta of a call option is negative, whereas the delta of a put option is positive

A. I, II & III only

B. I, II & IV only

C. II, III & IV only

D. All of the above

T he correct answer is A.

Delta is an important parameter in the pricing and hedging of options. T he delta of a stock option is
the ratio of the change in the price of the stock option to the change in the price. It is the number of
units of the stock we should hold for each option shorted in order to create a riskless portfolio. T he
construction of a riskless portfolio is sometimes referred to as delta hedging. T he delta of a call
option is positive, whereas the delta of a put option is negative.

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Q.1213 Rose Associates is holding stocks of Xerox limited. T he current value of the stock is USD
100 and the current continuously compounded risk-free rate is 3 percent. T he stock pays a dividend
at a continuous dividend yield of 2 percent. T he annual standard deviation of the stock is 9 percent.
What is the risk-neutral probability of an up-move and down-move for a 1-year European call option
on the stock?

A. 0.68 and 0.32

B. 0.78 and 0.22

C. 1.09 and 0.91

D. 0.53 and 0.47

T he correct answer is D.

U = size of the up-move factor = eσ√t = e0. 09√1 = 1.094

1
D = size of the down-move factor = = 0.9139
U

T he risk-neutral probabilities of upward and downward movements:

πu = Risk-neutral probability of an up-move

(e(r−q)t − D)
=
(U − D)
(e(0. 03−0. 02)∗1– 0.9139)
= = 0.53
(1.094 − 0.9139)
πd = Risk-neutral probability of a down-move
= 1 − πu = 1 − 0.53
= 0.47

Where r is the risk-free rate and q is the dividend rate

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Q.3400 Willy Smith, FRM, has a two-year European put with K = $41. T he current price of the
underlying is $40. Over the past year, the stock has exhibited a standard deviation of 20%. T he risk-
free rate of return is 5%. Compute the value of the put today using a two-step Binomial.

A. $2.71

B. $3

C. $0

D. $16.1

T he correct answer is A.

u = eσ√Δt = e0. 2×√1 = 1.22

d = e−σ√Δt = e−0. 2×√1 = 0.82

ert − d e0. 05×1 − 0.82

πu = = = 0.5782,
u−d 1.22 − 0.82

πd = 1 − 0.5782 = 0.4218

Let S represent the price of the stock and f represent the value of the put

Stock Price Option Payoff

Suu = $40 × 1.22 × 1.22 = $59.54 f uu = max ($41 − $59.54, 0) = $0
Su d = $40 × 1.22 × 0.82 = $40 f u d = max ($41 − $40, 0) = $1
Sdu = $40 × 0.82 × 1.22 = $40 f du = max ($41 − $40, 0) = $1
Sdd = $40 × 0.82 × 0.82 = $26.90 f dd = max ($41 − $26.90, 0) = $14.10

T he expected value of the put 2 years from now is given by:

0.5782 × 0.5782 × $0 + 0.5782 × 0.4218 × $1

+ 0.4218 × 0.5782 × $1 + 0.4218 × 0.4218 × $14.10
= $3

$3
Value of the put today = = $2.71
e0. 05×2

Q.3402 XY Z stock is a non-dividend-paying stock currently priced at $108. According to analysis, the
annual standard deviation of returns on XY Z stock is 8% and the risk-free rate on interest,

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compounded continuously, is 5.5%. Using a two-period binomial model, compute the value of a 6-
month American call option on XY Z stock with a strike price of $110.

A. $2.43

B. $7.04

C. $2.98

D. $4.58

T he correct answer is C.

up move factor = u = eσ√t = e0. 08×√0. 25 = 1.041

down move factor = d = 1.1041 = 0.961

0. 055×0. 25 −0. 961

e
probability of an up move = πu = 1. 041−0. 961 = 0.66

probability of a down move=1 − πu = 0.34

Let S represent the price of the stock and f represent the value of the call

Stock Price Option Payoff

Su = $108 × 1.041 = $112.43 f u = max (112.43 − 110, 0) = 2.43
Sd = $108 × 0.961 = $103.79 f d = max (103.79 − 110, 0) = 0
Suu = $108 × 1.0412 = $117.04 f uu = max (117.04 − 110, 0) = 7.04
Su d = $108 × 1.041 × 0.961 = $108.04 f u d = max (108.04 − 110, 0) = 0
Sdu = $108 × 0.961 × 1.041 = $108.04 f du = max (108.04 − 110, 0) = 0
Sdd = $108 × 0.9612 = $99.74 f dd = max (99.74 − 110, 0) = 0

T he $110 call option is in the money when the stock price finishes at $117.04 at which time the call
has a value of $7.04. At the end of 3 months(3-month node), the expected payoff on the option in the
next 3 months, given an up move up to that point, is:

$7.04 × 0.66 + $0 × 0.34

= $4.58
e0. 055×0. 25

In this case, if the holder of the option chose to exercise early, they’d receive a maximum of
max (112.43 − 110, 0) = 2.43. Since $2.43 < $4.58, it would not be optimal to exercise the option
early. At the end of 3 months(3-month node), the expected payoff on the option in the next 3 months,
given a down move up to that point, is:

$0 × 0.66 + $0 × 34
= $0
e0. 055×0. 25

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If the holder of the option chose to exercise early (3 months following a down move), they’d receive
a maximum of max ($103.79 − 110, 0) = $0. Again, it would not be optimal to exercise the option
early. T he value of the option today is:

$4.58 × 0.66 + $0 × 0.34

= $2.98
e0. 055×0. 25

Q.3403 You have been provided the following information for a call option on the stock of VeloMedia:

Current stock price = $100

Strike price = $100

T ime to maturity = 1 year

Exponential compounding interest rate = 10%

Annual standard deviation = 30%

What is the value of a European call option using a two-period binomial tree with two distinct
intervals of 6 months?

A. $15.38

B. $10.21

C. $0

D. $5.86

T he correct answer is A.

Binomial parameters:

1
u = eσ√△t = e0. 30√0. 5 = 1.2363, d= = 0.8089
u

Risk-neutral probability:

er×△t − d e0. 10×0. 5 − 0.8089

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er×△t − d e0. 10×0. 5 − 0.8089

p= = = 0.5671, 1 − p = 0.4329
u−d 1.2363 − 0.8089

X = $100

Cuu = 52.85, Cdu = Cu d = Cdd = 0

p × Cuu + (1 − p) × Cu d 0.5671 × 52.85 + (1 − 0.4329) × 0

Cu = = = 28.51, Cd = 0
er×△t e0. 10×0. 5

0.5671 × 28.51 + (1 − 0.4329) × 0

C= = 15.38
e0. 10×0. 5

u = 1.2363
d = 0.8089

p = 0.5671

1– p = 0.4329

Suu = u ∗ Su
152.85
− Max(152.85 − 100, 0) = 52.85

Su = u ∗ S ╱
123.63
╲
S ╱ Su d = Sdu
− Max(100 − 100, 0) = 0
100
╲ 100

Sd = d ∗ S ╱
80.89
╲
Sdd = d ∗ Sd
65.43
− Max(65.43 − 100, 0) = 0

Q.3404 You have been provided the following information for a European call option on the stock of
VeloMedia:

Current stock price = $100

Strike price = $100

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T ime to maturity = 1 year

Exponential compounding interest rate = 10%

Annual standard deviation = 30%

What is the call option delta at the current date? Use a two-period binomial tree with two distinct
intervals of 6 months.

A. 0

B. 0.6669

C. 1

D. 0.5

T he correct answer is B.

Binomial parameters:

1
u = eσ√△t = e0. 30√0. 5 = 1.2363, d= = 0.8089
u

Risk-neutral probability:

er×△t − d e0. 10×0. 5 − 0.8089

p= = = 0.5671, 1 − p = 0.4329
u−d 1.2363 − 0.8089

X = $100

Cuu = 52.85, Cdu = Cu d = Cdd = 0

p × Cuu + (1 − p) × Cu d 0.5671 × 52.85 + (1 − 0.4329) × 0

Cu = = = 28.51, Cd = 0
er×△t e0. 10×0. 5

0.5671 × 28.51 + (1 − 0.4329) × 0

C= = 15.38
e0. 10×0. 5

u = 1.2363
d = 0.8089

p = 0.5671

1– p = 0.4329

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Suu = u ∗ Su
152.85
− Max(152.85 − 100, 0) = 52.85

Su = u ∗ S ╱
123.63
╲
S ╱ Su d = Sdu
− Max(100 − 100,0) = 0
100
╲ 100

Sd = d ∗ S ╱
80.89
╲
Sdd = d ∗ Sd
65.43
− Max(65.43 − 100, 0) = 0

Now, the call option delta at the current date is:

△C C − Cd
△= = u
△S Su − Sd
28.51 − 0
= = 0.6669
123.63 − 80.89

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Q.3405 You have been provided the following information for a put option on the stock of VeloMedia:

Current stock price = $100

Strike price = $100

T ime to maturity = 1 year

Exponential compounding interest rate = 10%

Annual standard deviation = 30%

Compute the value of the European put option using a two-period binomial tree with two distinct
intervals of 6 months.

A. $15.38

B. $5.86

C. $0

D. $10

T he correct answer is B.

puu = pdu = pu d = 0, pdd = max (X − Suu , 0) = max (100 − 65.43, 0) = 34.57

2 2 p2puu + 2p (1 − p) pu d + (1 − p)2 pdd

P = P V [p puu + 2p(1 − p) pu d + (1 − p) pdd ] =
R2

0.56712 × 0 + 2 × 0.5671 × (1 − 0.5671) × 0 + (1 − 0.5671)2 × 34.87

P =
e0. 10×0. 5×2

(0.4329)2 × 34.57
P = = 5.86
e0. 10

Note: we would arrive at the same answer if we compute the value of the corresponding call (15.38
in this case) and then use the put-call parity to find the value of the put.
P + S = C + P V (X)

P = 15.38 + 100 × e−0. 10∗1 − 100 = 5.86

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Q.3406 A call option has a delta of 0.65. What is the put option delta?

A. -0.65

B. -0.35

C. 0.35

D. None

T he correct answer is B.

Call option delta = Put option delta + 1

Put option delta = 0.65 - 1 = -0.35

T he range of call option delta is always 0 to 1.

T he range of put option delta is always -1 to 0.

Q.4697 T he current price of a stock is $40. Its volatility is 10% per annum and the risk-free rate is
5% per annum with continuous compounding. Using a two-step binomial, what is the value of a six-
month European call option on the stock with a strike price of $40?

A. 1.54

B. 2.0

C. 1.58

D. 1.83

T he correct answer is A.

In this case,

u = eσ√t = e0. 10√0. 25 = 1.0513

1
d= = 0.9512
1.0513
ert − d e0. 05×0. 25 − 0.9512
p= = = 0.6132
u−d 1.0513 − 0.9512
1 − p = 1 − 0.6132 = 0.3868

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Where:

u= size of the up-move factor

d= size of the down move factor

σ= volatility of the stock

p= probability of an up move

1 − p= probability of a down move

Using a two-step binomial,

Suu = 44.2093
Su d = 40
Sdu = 40
Sdd = 36.1913
Notice that the only time the option is in the money is when two upward price movements lead to an
ending price of $44.2093 and a call value of $4.2093. T he expected value of the option at the end of
the second period is the value of the option in each state multiplied by the probability of that state
occurring:

Expected call value in two periods = 0.6132 ∗ 0.6132 ∗ 4.2093 = $1.5828

T he value of the call option today is the expected value in six months discounted at the risk-free rate

of 5%:

$1.5828
Call = = $1.5437
e0. 05(0. 5)

Q.4698 A 6-month stock currently trading at $40 pays a continuous dividend of 2%, and the current
continuously compounded risk-free rate is 3%. Assuming an annual standard deviation of 3%, and a
strike price of 40, what is the value of the put today?

A. 0.32

B. 0.28

C. 0.51

D. 0.52

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T he correct answer is A.

In this case,

u = eσ√t = e0. 03√0. 5 = 1.02144

1
d= = 0.97901
1.02144
(e(r−q)t ) − d
p=
u−d

Where:

u= size of the up-move factor

d= size of the down move factor

σ= volatility of the stock

p= probability of an up move

1 − p= probability of a down move

e(0. 03−0. 02)0. 5 − 0.97901

p= = 0.613
1.02144 − 0.97901
Probability of a down move = 1 − 0.613 = 0.387

Let S represent the stock price, and f represent the value of the put option.

Su = 40.84
Sd = 39.16

T he payoffs at the final node are:

f u = max (40 − 40.84,0) = 0

f d = max (40 − 39.16,0) = 0.84

T he value of the put today is given by:

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f = (f u p + f d (1 − p)) e−rt
= (0 × 0.613 + 0.8396 × 0.387) e−0. 03×0. 5 = 0.32008

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Reading 61: The Black-Scholes-Merton Model

Q.984 Antony Meech, a research analyst working at FinSearch Inc., is preparing a note on lognormal
distributions and normal distributions. He notes down the following points on lognormal distribution:
I. T he model of stock price behavior used by Black, Scholes, and Merton assumes that percentage
changes in the stock price in a very short period of time are normally distributed
II. A variable that has a lognormal distribution can take any value between zero and infinity
III. Like the normal distribution, the mean, median, and mode are all the same in the lognormal
distribution

Which of them are correct?

A. I & II only

B. II & III only

C. I, II & III only

D. I & III only

T he correct answer is A.

T he model of stock price behavior used by Black, Scholes, and Merton assumes that percentage

changes in the stock price in a very short period of time are normally distributed. A variable that has

a lognormal distribution can take any value between zero and infinity. Unlike the normal distribution,

it is skewed so that the mean, median, and mode are all different in the lognormal distribution.

Note that, When the return on a stock over a short period is normally distributed, the stock price at

the end of a relatively long period has a lognormal distribution. i.e

i. stock price; over a short period is normally distributed.

ii. stock price; over a relatively long period is lognormally distributed.

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Q.985 Ricky Gervais, a retired veteran, is holding shares of T MT Limited which are currently
trading at USD 100. T he volatility of the share is 25 percent per year, and the expected return on the
stock is 10 percent for the same period. What is the expected stock price in one year?

A. USD 110.517

B. USD 128.403

C. USD 102.532

D. USD 101.432

T he correct answer is A.

T he expected stock price in one year is given by:

E(ST ) = S0eμT = 100e(. 10) = USD 110.517

Where

μ = expected rate of return.

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Q.986 Mike Finova is holding shares of T MT Limited which are currently trading at USD 100. T he
volatility of the share is 25 percent per year, and the expected return on the stock is 10 percent for
the same period. What is the standard deviation of the stock in one year?

A. USD 787.68

B. USD 28.07

C. USD 14

D. USD 100

T he correct answer is B.

2T
T he variance in one year = V ar(ST ) = S02e(2μT ) (eσ − 1)
2 (2∗0. 1∗1) 0. 252
= 100 e (e − 1)
= 10000 ∗ 1.2214 ∗ 0.06449 = 787.68

where

μ = Expected rate of return and,

σ = volatility

Standard deviation of the stock price in 1 year = √787.68 = 28.07

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Q.988 T he manager at American Derivatives Limited Hedge Fund proposes to use the Black-Scholes-
Merton differential equation to understand the pricing of derivatives dependent on non-dividend
paying stocks. Which of the following assumptions with respect to the Black-Scholes-Merton model
must be made to get accurate results?
I. T he short-selling of securities is not permitted
II. T here are no riskless arbitrage opportunities
III. T he risk-free rate of interest is known and constant
IV. Security trading is continuous

A. I, II & III only

B. I, III & IV only

C. II, III & IV only

D. All of the above

T he correct answer is C.

T he assumptions underlying the Black-Scholes-Merton differential equation are:

1. T he stock price follows the process with expected return and standard deviation constant
2. T he short selling of securities with full use of proceeds is permitted
3. T here are no transaction costs or taxes. All securities are perfectly divisible
4. T here are no dividends during the life of the derivative
5. T here are no riskless arbitrage opportunities
6. Security trading is continuous
7. T he risk-free rate of interest, r, is known and constant

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Q.989 With regard to the Black-Scholes-Merton Model, which of the following statements are true?
I. T he Black-Scholes-Merton differential equation does not involve any variables that are affected by
the risk preferences of investors
II. T he current stock price, time, stock price volatility, and the risk-free rate of interest are
involved
III. T he Black-Scholes-Merton differential equation involves the expected return on the stock and,
therefore, is dependent of risk preferences
IV. T he Black-Scholes-Merton differential equation is an equation that must be satisfied by the price
of any derivative dependent on a non-dividend paying stock

A. I, II & IV only

B. I, III & IV only

C. II & III only

D. All of the above

T he correct answer is A.

T he Black-Scholes-Merton differential equation is an equation that must be satisfied by the price of

any derivative dependent on a non-dividend paying stock. It does not involve any variables that are
affected by the risk preferences of investors. T he current stock price, time, stock price volatility,
and the risk-free rate of interest are involved, and all these are independent of risk preferences.
Point III is incorrect. T he Black-Scholes-Merton differential equation is independent of risk
preferences if it involved the expected return, μ, on the stock.

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Q.990 Bret Lee, a research student, studying at McJohn University, analyzes academic material on
regular options, employee stock options, and warrants. After analyzing the data, he prepares a brief
to present to his professor. He jots down the following points in the brief:
Statement I: T he exercise of a regular call option has no effect on the number of the company’s
shares outstanding
Statement II: T he exercise of warrants leads to the company issuing more shares and selling them to
the holder of the warrant at the strike price
Statement III: Exercise of warrants tend to dilute the interest of the existing shareholders as the
strike price is usually less than the market price
Statement IV: Exercise of warrants and employee stock options does not have any effect on the
number of company’s shares outstanding

Which of these statements are accurate?

A. I, II & III only

B. I, III & IV only

C. II, III & IV only

D. All of the above

T he correct answer is A.

Statements I, II & III are correct. T he exercise of a regular call option has no effect on the number
of the company’s shares outstanding. If the writer of the option does not own the company’s shares,
he or she must buy them in the market in the usual way and then sell them to the option holder for
the strike price. T he exercise of warrants of employee stock options leads to the company issuing
more shares and selling them to the holder of the warrant at the strike price.
Statement IV is incorrect. Exercise of warrants and employee stock options tend to dilute the
interest of the existing shareholders as the strike price is usually less than the market price.

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Q.992 Steyn Associates used implied volatilities in pricing securities instead of historical volatilities.
With regard to volatilities, which of the following statement(s) is/are true?
I. Implied volatilities are the volatilities implied by option prices observed in the market
II. Historical volatilities are backward-looking, whereas implied volatilities are forward-looking
III. T raders often quote the implied volatility of an option rather than its price. T his is convenient
because the implied volatility tends to be less variable than the option price
IV. T he implied volatilities of actively traded options are used by traders to estimate appropriate
implied volatilities for other options

A. I, II & III only

B. I, III & IV only

C. II, III & IV only

D. All of the above

T he correct answer is D.

Implied volatilities are the volatilities implied by option prices observed in the market. Implied
volatilities are used to monitor the market’s opinion about the volatility of a particular stock.
Historical volatilities are backward-looking, whereas implied volatilities are forward-looking. T raders
often quote the implied volatility of an option rather than its price. T his is convenient because the
implied volatility tends to be less variable than the option price. T he implied volatilities of actively
traded options are used by traders to estimate appropriate implied volatilities for other options.

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Q.993 Stephen Hawking, a trader working at Orange Securities, collects the following data of a 1-
year European put and call options on the stock Mango Apparel. T he current stock price is USD 120,
and the strike price of the option is USD 125. T he risk-free rate is 10 percent. If the prices of a
European call and European put are USD 10 and USD 15, respectively, then what is the implied
dividend yield of the stock Mango Apparel?

A. 0.11439

B. 0.045323

C. 0.10439

D. 0.055323

T he correct answer is C.

Put-call parity:

Call option − Put option = S0 e−qxT − Ke−rxT

Where

S0 = Initial stock price;

q = implied dividend yield;

r = risk-free rate; and

T = time

10 − 15 = 120e−qx1 − 125e−0. 10×1

e−q = 0.9009
ln(0.9009) = −q

Implied dividend yield (q) = 10.439%

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Q.994 Chinese International Bank is analyzing the stock of Jatoka International. One-year European
call and put options are written on the stock of Jatoka International which is a non-dividend paying
stock. T he initial stock price is Yuan 100 and the risk-free rate is 5%. T he time to maturity is 1 year,
and the strike price is Yuan 125. Furthermore, N (d1) = 0.6925, N(d2 ) = 0.5435. What are the values
of European put and call options (approx.) using the Black-Scholes differential equation?

A. Call option value is USD 4.626 and Put option value is USD 23.52.

B. Call option value is USD 23.52 and put option value is USD 4.626.

C. Call option value is USD 2.626 and Put option value is USD 13.52.

D. Call option value is USD 13.52 and put option value is USD 2.626.

T he correct answer is A.

Call value = S0N (d1) − Xe−Rf ×T N (d2)

= [100 × 0.6925] − {125e(−0. 05) ∗ 0.5435}

= USD 4.626
Put value = [Xe−Rf∗T ∗ (1 − N (d2 ))] − [S0 ∗ (1 − N(d1 ))]
= [125e−0. 05 × (1 − 0.5435)] − [100 ∗ (1 − 0.6925)]
= USD 23.52

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Q.995 Raheja Financials is holding the stock of Duckworth Limited which is trading at USD 50. A
European call option that expires in 3 months with a strike price of USD 51 is available for trading.
T he annualized standard deviation is 20 percent, and the risk-free rate of interest is 4 percent. What
is the value of the European call option using the Black-Scholes-Merton model expiring in 3 months if
N (d1) = 0.48085 and N (d2) = 0.44116?

A. USD 2.422

B. USD 2.224

C. USD 1.767

D. USD 1.259

T he correct answer is C.

Value of European call option as per the Black-Scholes-Merton Model:

Call value = S0 N(d1 ) − X e−Rf∗T N (d2 )

= [50 × 0.48085] − {51e(−0. 04∗0. 25) ∗ 0.44116}

= USD 1.767

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Q.996 Michael Wong is holding the stock of Duckworth limited which is trading at USD 50. A
European put option that expires in 3 months with a strike price of USD 51 is available for trading.
T he annualized standard deviation is 20 percent, and the continuously compounded risk-free rate is 4
percent. What is the value of the European put option using the Black-Scholes-Merton model
expiring in 3 months if N (d1) = 0.48085 and N (d2) = 0.44116?

A. USD 1.77

B. USD 1.26

C. USD 2.19

D. USD 2.26

T he correct answer is D.

T he value of European put option as per the Black-Scholes-Merton Model is calculated as follows:

Put value = [Xe−Rf∗T ∗ (1 − N (d2 ))] − [S0 ∗ (1 − N(d1 ))]

−0. 04∗0. 25
= [51e ∗ (1 − 0.44116)] − [50 ∗ (1 − 0.48085)]
= USD 2.26

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Q.3407 A stock price has an expected return of 10% and a volatility of 30%. T he current price is
$30. What is the probability that a European call option on the stock with an exercise price of $32
and a maturity date in six months will be exercised?

A. 0.5032

B. 0.247

C. 0.4309

D. 0.008

T he correct answer is C.

T he required probability is the probability of the stock price being above $32 in six months’ time
since a call option is only exercised if the stock price is higher than the strike price. Suppose that
the stock price in six months is ST . T he probability distribution of ln ST is

0.32
lnST ∼ N (ln30 + (0.10 − ) 0.5, 0.32 × 0.5) ∼ N (3.429, 0.045)
2

T he required probability is given by:

3.466 − 3.429
P (lnST > ln32) = 1 − P (lnST ≤ ln32) = 1 − N ( ) = 1 − N (0.174)
√0.045

Note that:

ln32 = 3.466

From the standard normal distribution tables, N (0.174) = 0.5691

T herefore, the required probability is 1 − 0.5691 = 0.4309

Q.3408 What is the price of a European call option on a non-dividend-paying stock when the stock
price is $68, the strike price is $65, the risk-free interest rate is 16% per annum, the volatility is
39% per annum, and the time to maturity is three months?

A. 5.35

B. 4.85

C. 8.31

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D. 0.536

T he correct answer is C.

Recall that the price of European call option is given by:

c = S0N (d1) − Ke−rT N(d2 )

Where:

S0 2
ln ( ) + (r + σ2 ) T
K
d1 =
σ√T

S0 2
σ
ln( ) + (r − )T
K 2
d1 = = d1 − σ√T
σ√T

In this case,
S0 = 68

K = 65

r = 0.16

σ = 0.39 and,

T = 0.25

2
(ln 68 + (0.16 + 0. 39 ) 0.25) 0.1041
65 2
d1 = = = 0.5338
0.39√0.25 0.195
d2 = d1 − 0.39√0.25 = 0.3388

T he price of the European call is

c = 68 × N (0.5338) − 65e−0. 16×0. 25N (0.3388)

= 68 × 0.7032 − 65 × 0.9608 × 0.6326
= 8.31

Q.3409 Consider a European call option when the stock price is $20, the exercise price is $22, the
time to maturity is six months, the volatility is 20% per annum, and the risk-free interest rate is 15%

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per annum. T wo equal dividends of $1 are expected during the life of the option, with ex-dividend
dates at the end of two months and five months. What is the value of the option?

A. $0.30

B. $0.40

C. $0.25

D. $0.26

T he correct answer is A.

Note that S0 is reduced to S by the present value of the dividends payable, but all other variables
remain the same

S = S0 − P V

Where

Δt1 Δt2 2 5
−(0. 15)
P V = D1 e−(r) m + D2e−(r) m = 1e 12 + 1e−(0. 15) 12 = 1.9147

S = $20 − $1.9147 = $18.09

K = 22,

T = 0.5,

σ = 0.2

ln SK + [R C
f
+ ( 12 × σ 2)] T
d1 =
σ√T
ln 18. 09
+ [0.15 + ( 12 × 0.22 )] 0.5
22
= = −0.7826
0.2√0.5
d2 = d1 − (σ√T ) = −0.7826 − 0.2√0.5 = −0.9241

From statistical tables,

N (d1) = N (−0.7826) = 1 − N (0.7826) = 1 − 0.7831 = 0.2169

And

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N (d2) = N (−0.9241) = 1 − N (0.9241) = 1 − 0.8223 = 0.1777

c
C0 = [S × N (d1 )] − |K × e−Rf ×T × N (d2) |
= 18.09 × 0.2169 − 22e−0. 15×0. 5 × 0.1777
= 3.9237 − 3.6269 = 0.2968 ≈ 0.30

Q.3410 Consider a European option on a non-dividend paying stock with the following characteristics:

Current stock price = $50

Exercise price = 50

Continuous compounding interest rate = 8%

Standard deviation = 34%

T ime to expiration = 2 years

Calculate the price of the call option and its delta using the Black-Scholes-Merton model.

A. Call = $12.97; Δ = 0.7167

B. Call = $5.57; Δ = 0.7167

C. Call = $5.57; Δ = -0.2832

D. Call = $12.97; Δ = -0.2832

T he correct answer is A.

T he price of a call option on a non-dividend-paying stock:

C = S × N (d1 ) − P V (X) × N (d2 )

2
ln [ P VS(X) ] σ√T ln [ SX ] + (r + σ
)T
2
d1 = + = and d2 = d1 − σ√T
σ√T 2 σ√T

2
ln ( 50 ) + (0.08 + 0.234 ) 2
50
d1 = = 0.5732
0.34√2

d2 = 0.5732 − 0.34√2 = 0.0923

From the standard normal table N (d1) = N (0.5732) = 0.7167 and N (d2 ) = N (0.0923) = 0.5367

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Value of the call = S ∗ N (d1 ) − P V (X) ∗ N (d2)

= 50 ∗ 0.7167 − 50e−0. 08×2 × 0.5367
= 12.9677

Using put-call parity relation,

Value of the put = C + P V (X ) − S = 12.9677 + 50e−0. 08×2 − 50 = 5.5749

Delta of call = N (d1 ) = 0.7167

Delta of put = −N(−d1 ) = −N (−0.5732) = −(1 − 0.7167) = −2833

Where N is the normal distribution.

Thi ngs to Remember

T he delta of a call option is the amount by which the price of the option will change for a given

change in the price of the underlying asset. T he delta is always positive for calls, meaning that as the

underlying asset increases in price, the call will also increase in price. T he size of the delta will

depend on how much time is left until expiration and how far the underlying asset is from the strike

price. At-the-money and near-the-money options will have the largest deltas, while deep in-the-money

and deep out-of-the-money options will have smaller deltas. As expiration approaches, all options will

tend to have deltas closer to 1.0.

As you can see, the delta of the call option here is high because it is at the money.

Delta of a call option = N(d1), where N(x) denotes the cumulative standard normal distribution
function.

Delta of a put option = - N(-d1)

Finally, because the standard normal distribution is symmetric and centered at zero, the standard

normal cumulative distribution function has a very useful property:

N(–x) = 1 – N(x)

– N(–x) = N(x) – 1

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– N(–d1) = N(d1) – 1

With these in mind, you don't need to calculate the delta of a put once you get the delta of the

corresponding call:

Using the last equation, put delta = call delta - 1 = 0.7167 - 1 = - 0.2833

Q.3411 Consider a European option on a non-dividend paying stock with the following characteristics:

Current stock price = $50

Exercise price = 50

Continuous compounding interest rate = 8%

Standard deviation = 34%

T ime to expiration = 2 years

Calculate the price of a put option and its delta using the Black-Scholes-Merton model.

A. Put = $12.97; Δ = 0.7167

B. Put = $5.57; Δ = 0.7167

C. Put = $5.57; Δ = -0.2832

D. Put = $12.97; Δ = -0.2832

T he correct answer is C.

T he price of a put option on a non-dividend-paying stock can be calculated as:

P + S = C + P V (X)

P = S [N (d1 ) − 1] − P V(X ) [N (d2) − 1]

N (d) + N (−d) = 1

P = −S × N (−d1) + P V(X ) × N (−d2)

2

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σ2
ln [ SX ] + (r + 2
)T
d1 = and d2 = d1 − σ√T
σ√T

T he price of a call option on a non-dividend-paying stock:

C = S × N (d1 ) − P V (X) × N (d2 )

σ2
ln [ P VS(X) ] σ√T ln [ SX ] + (r + )T
2
d1 = + = and d2 = d1 − σ√T
σ√T 2 σ√T

0. 342
ln ( 50
50
) + (0.08 + 2
) 2
d1 = = 0.5732
0.34√2

d2 = 0.5732 − 0.34√2 = 0.0923

From the standard normal table N (d1) = N (0.5732) = 0.7167 and N (d2 ) = N (0.0923) = 0.5367

Value of the call = S ∗ N (d1 ) − P V (X) ∗ N (d2)

= 50 ∗ 0.7167 − 50e−0. 08×2 × 0.5367
= 12.9677

Using put-call parity relation,

Value of the put = C + P V (X ) − S = 12.9677 + 50e−0. 08×2 − 50 = 5.5749

Delta of call = N (d1 ) = 0.7167

Delta of put = −N(−d1 ) = −N (−0.5732) = −(1 − 0.7167) = −2833

Where, N is the normal distribution.

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Q.3412 Consider a company with N million shares outstanding, each worth So, that is contemplating
issuing M warrants. Each warrant would grant the holder the right to purchase one share with a
strike price of X in a year. Assuming the value of a corresponding 1-year European call option is
worth C, the cost of issuing the warrants would take which of the following forms?

C
A. N +M

MC
B. N +M

MNC
C. N +M

NC
D. N +M

T he correct answer is C.

It can be shown the cost of issuing each warrant is given by:

N
× Price of the Warrant
N +M

Where
N = Number of existing shares
M = Number of warrants issued
Note that a warrant is defined as options issued by a company on its own stock. So, in this case, the
cost of issuing M warrants is given by:

N MN C
M× ×C =
N +M N +M

Q.3414 What is the effect of dividends on option prices?

A. Call option prices increase; Put option prices increase

B. Call option prices increase; Put option prices decrease

C. Call option prices decrease; Put option prices increase

D. Call option prices decrease; Put option prices decrease

T he correct answer is C.

Because of a dividend, the net stock price decreases in value.

Effective S = S − P V (Dividend)

When a stock price decreases, the call price decreases and the put price increases.

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Q.4618 A stock has an initial price of $50, an expected annual return of 20%, and annual volatility of
25%. What is the 95% confidence interval for the stock price at the end of 3 years?

A. $22.83< ST <$301.27

B. $44.18< ST <$57.33

C. $31.28< ST <$57.08

D. $35.49< ST <$193.77

T he correct answer is D.

In this case, S0=50 , μ=0.20, σ=0.25, and T =3

T he logarithm of the stock follows a normal distribution with the following parameters:

σ2
lnST ∼ N (lnS0 + (μ − ) T , σ√T )
2

Where:

μ= the expected annual return of the stock.

σ= the annual volatility for the stock.

T = time

ST = T he stock price at time T.

σ2
lnST ∼ N (lnS0 + (μ − ) T , σ√T )
2
0.252
= N [ln50 + (0.20 − ) 3, 0.25 × √3]
2
lnST ∼ N (4.418, 0.4332 )

T he distribution has a mean of 4.418 and standard deviation of 0.433

To obtain the 95% confidence interval for stock price using the above data, we will proceed as

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follows:

lnST ∼ N (4.418,0.4332 )
lnST = μ ± Zα × σ
(In this case,we have σ = 0.433)
and Za = 1.96
4.418 − 1.96 × 0.433 < lnST < 4.418 + 1.96 × 0.433
e3. 56932 < ST < e5. 26668
$35.49 < ST < $193.77

Q.4619 Suppose the current exchange rate for a currency is 1.25, and the exchange rate volatility is
15%. Calculate the value of a call option to buy 1000 units of the currency in 5 years at an exchange
rate of 2.50. T he domestic and foreign risk-free interest rates are 1% and 2%, respectively.

A. 2.9

B. 3.8

C. 43.5

D. 1249.9

T he correct answer is A.

In this case S0=1.25, K=2.50,r=0.01, rf =0.02, s=0.15, and T =5

From BSM pricing formula,

C0 = S0 e−rfT × N (d1) − Ke−rT × N (d2 )

Where:

T = time to maturity

S0= current stock price

K = strike price

r= domestic risk-free rate

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rf = foreign risk-free rate

s= volatility of the stock price

S0 σ2 1.25 0.152
ln( ) + [r − rf + ( )] T ln + [0.01 − 0.02 + ]5
K 2 2.50 2
d1 = = = −2.05
σ√T 0.15√5
d2 = d1 − σ√T = −2.05 − 0.15√5 = −2.39

From the standard normal tables,

N (d1 ) = N (−2.05) = 1 − 0.9798 = 0.0202

N (d2 ) = N (−2.39) = 1 − 0.9916 = 0.0084

T he value of the call is therefore given by:

C0 = S0 e−rfT × N (d1) − Ke−rT × N (d2 )

−0. 02×5
= 1.25e × 0.0202 − 2.50e−0. 01×5 × 0.0084 = 0.0029

T his is the value of the option to buy one unit of the currency. T he value of an option to buy 1000

units is:

0.0029 × 1000 = 2.9

Q.4620 T he futures price of an asset is USD 40, and the annual volatility of the futures price is 20%.
If the risk-free rate is 5%, what is the value of a put option to sell futures in 6 months for USD 45?

A. USD 2.75

B. USD 5.52

C. USD 2.68

D. USD 4.82

T he correct answer is B.

In this case,

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F0=40, K=45, r=0.05, s=0.20, T =0.5

T he following formula gives the value of the put option:

P 0 = Ke−rT × N (−d2) − F0e−rT × N (−d1 )

Where:

P 0= value of the put option

K= strike price

s= volatility of the futures price

r= risk-free rate

T = time

Now define:

F0= current futures price

T hen we have:

2
F0 0. 202
ln ( ) +T ∗ δ
ln( 40 ) + 0.5 ∗
K 2 45 2
d1 = = = −0.76214
δ√T 0.20√0.5

T hus,

d2 = d1 − δ√T = −0.76214 − 0.20√0.5 = −0.90356

T he value of the put option is given by:

P 0 = Ke−rT × N (−d2) − F0e−rT × N (−d1 )

= 45e−0. 05×0. 5 × 0.8159 − 40e−0. 05×0. 5 × 0.7764 = 5.5197

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Q.4621 T he current price of a stock is USD 50. If this price grows to USD 74.59 in two years, what
is the realized return on the stock per annum?

A. 0.2

B. 0.49

C. 0.34

D. 0.22

T he correct answer is A.

We can derive the formula for calculating the realized return on a stock from the formula for

calculating the expected price of a stock, i.e.,

E (ST ) = S0eμT
1 ST
μ = ln
T S0

Where:

μ= Realized return on a stock

T = time to maturity

S0= initial stock price

ST = stock price at time T

1 74.59
Realized return = ln = 0.20 = 20%
2 50

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Q.4622 T he following are monthly stock prices in EUR: 21, 35, 40, and 28. From this data, what is
the estimated volatility of the log-returns per month?

A. 0.435

B. 0.189

C. 0.402

D. 0.355

T he correct answer is A.

Si Si
Month Stock price, Si X i = ln X 2i
Si-1 Si-1
0 21
1 35 1.6667 0.5108 0.2609
2 40 1.1429 0.1336 0.0178
3 28 0.7000 −0.3567 0.1272

We calculate volatility of returns per month using the variance formula below:

2
1 ⎧ 2
∑X i ⎫
variance = ⎨ ∑ X i − n( ) ⎬
n − 1⎩ n ⎭

In this case:

∑X i 0.2877
∑ X i =0.2877, ∑ X i2=0.4059 ,n=3, = = 0.0959
n 3

T herefore,

1
variance = {0.4059 − 3 × 0.09592 } = 0.1892
2

T he volatility per month is, therefore √0.1892 = 0.435 = 43.5%

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Reading 62: Option Sensitivity Measures: The “Greeks”

Q.1186 Fintech Company Inc. is planning to purchase a call option on European Airlines. T he
continuous dividend yield is 2 percent and the time to maturity is 2 years. If the continuous risk-free
rate is 5 percent and N(d1) is 0.45, what is the Delta of the call option?

A. 0.432

B. -0.432

C. 0.864

D. -0.864

T he correct answer is A.

T he Delta of a call option with a continuous dividend yield is calculated using the formula below:
Delta = N(d1) e(-qT)
Where
Continuous dividend yield (q) = 2%
T ime to maturity = 2 years

Delta = 0.45 * e(-0.02 * 2) = 0.432

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Q.1187 John Augustus, an equity analyst at Fintech Inc., is evaluating a portfolio of American Airlines
stock and options on the same stock. T he portfolio is currently Delta neutral but has a positive
Gamma. If Augustus would like to make the portfolio both Delta and Gamma neutral, then Johnson
will:

A. Sell stock of American Airlines and sell Put options on stock of American Airlines.

B. Buy stock of American Airlines and buy Put options on stock of American Airlines.

C. Buy stock of American Airlines and sell Put options on stock of American Airlines.

D. Sell stock of American Airlines and buy Put options on stock of American Airlines.

T he correct answer is A.

To make the portfolio Gamma neutral, options on the stock of American Airlines are to be sold.
Selling put options on American Airlines makes the portfolio Delta positive. To make the portfolio
Delta neutral, the stock of American Airlines need to be sold.
Detai l ed Answer
Here's what you need to have in mind to solve just about every problem of this type.
(I) All long options, calls and puts, are positive Gamma. All short options, calls and puts, are negative
Gamma.
(II) T he delta value of calls is always positive (somewhere between 0 and 1) and with puts, it's
always negative (somewhere between 0 and -1). Stocks effectively have a delta value of 1.

In this case, we have positive gamma; we are long gamma, To attain a gamma-neutral status, we have
to go short gamma. i.e., sell options.
Now, look at the choices; only (a) and (c) involve selling options, which are actually put options. We
know that puts have a negative delta, so selling them will render the position delta positive (long
delta). To attain an equilibrium, we will need to neutralize the "positive" by selling the underlying
stock (short delta). If we buy the underlying stock (which has a delta of 1) we will end up even more
delta positive.
T hus, choice (a) is correct.
T he best way to approach this type of question is via the elimination of choices as we just did. Get
rid of the wrong choices based on what you already know.

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Q.1188 T renor Johnson, a portfolio manager, working at Sterile Finances Limited, is analyzing the
delta of a portfolio. Which of the following statements is (are) true about the delta of a portfolio?

A. Call options have negative deltas while put options have positive Deltas.

B. Delta on options lie between -1 and +1.

C. T he delta of the underlying asset is always zero.

D. All of the above.

T he correct answer is B.

T he delta for a call option always ranges from 0 to 1 because as the underlying asset increases in
price, call options increase in price. Put option deltas always range from -1 to 0 because as the
underlying security increases, the value of put options decrease. T herefore, the delta will lie
between -1 and +1, while the delta of the underlying asset is always 1. T he delta of a put option is
negative reflecting an inverse relationship with the price of the underlying.

Q.1189 Which of the following statements is/are true regarding theta?

I. T heta is a measure of the change in the value of the options portfolio with the passage of
time
II. A positive theta implies that the portfolio will increase in value as time passes
III. T heta decreases as the expiration date approaches for at-the-money options
IV. T heta increases as an option which is either out of the money or in the money approaches
expiration

A. I & II

B. III & IV

C. I, III & IV

D. All the above

T he correct answer is A.

Points I and II are correct.

Points III and IV are incorrect. T heta i ncreases as the expiration date approaches for at-the-money
options. On the other hand, theta decreases as an option that is either out of money or in the money
approaches expiration.

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Q.1191 Which of the following statements is true with regard to Gamma?

I. Gamma of a portfolio of options on an underlying asset is the rate of change of the portfolio's
Delta with respect to the price of the underlying asset
II. Gamma is the second partial derivative of the portfolio with respect to asset price
III. If Gamma is highly negative or highly positive, Delta is very sensitive to the price of the
underlying asset
IV. When Gamma is positive, theta tends to be negative

A. I & II only

B. I, II & III only

C. II & III only

D. All the above

T he correct answer is D.

Gamma of a portfolio of options on an underlying asset is the rate of change of the portfolio's Delta
with respect to the price of the underlying asset. It is the second partial derivative of the portfolio
with respect to asset price. If Gamma is highly negative or highly positive, Delta is very sensitive to
the price of the underlying asset. When Gamma is positive, theta tends to be negative.

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Q.1192 T he Vega of the stock of Amazon is 5. If the volatility of the underlying asset increases by 1
percent, what changes will take place in the price of the call option and put option if the maturity and
exercise prices of both options remain the same?

A. T he price of the call option increases by 0.05 and the price of the put option increases by
0.05.

B. T he price of the call option decreases by 0.05 and the price of the put option decreases
by 0.05.

C. T he price of the call option decreases by 0.05 and the price of the put option increases by
0.05.

D. T he price of the call option increases by 0.05 and the price of the put option decreases by
0.05.

T he correct answer is A.

T he vega of a portfolio of derivatives, V , is the rate of change of the value of the portfolio with

respect to the volatility of the underlying asset.

T he change in the price of call and put options is: Vega ∗ Volatility = 5 ∗ 0.01 = 0.05

Q.1193 Which of the following statement is NOT true with regard to Vega?
I. T he Vega of a derivative portfolio is the rate of change of the value of the portfolio with the
change in the volatility of the underlying assets
II. T he Vega of a long position is always negative
III. A position in the underlying asset has a Vega equal to zero
IV. At-the-money options have the greatest Vega

A. II and III only

B. III only

C. II only

D. I, II and IV only

T he correct answer is C.

T he Vega of a long position is always positive.

All three other statements are correct. T he Vega of a derivative portfolio is the rate of change of the
value of the portfolio with the change in the volatility of the underlying assets. A position in the
underlying asset has a Vega equal to zero. At-the-money options have the greatest Vega.

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Q.1194 Consider a call option on a non-dividend paying stock where the stock price is $95, the risk-
free rate is 5%, the time to maturity is 40 weeks (= 0.7692 years) and N ′ = 0.398185. A 1% increase
in the volatility will increase the value of the option by approximately:

A. -33.176

B. -0.33176

C. 33.176

D. 0.33176

T he correct answer is D.

T he Vega of a call option = So √T N ′ (d1)

= $95 ∗ √0.7692 ∗ 0.398185
= 33.176

T hus, a 1% (0.01) increase in the volatility increases the value of the option by approximately

0.01 ∗ 33.176 = 0.33176

Note that:

Both call and put options have the same value of vega and this value is a positive number

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Q.1195 Which of the following statement is true with regard to Rho?

A. T he Rho of a portfolio of options is the rate of change of the value of the portfolio with
respect to the interest rate.

B. T he Rho of a portfolio of derivatives is the rate of change of the value of the portfolio
with respect to the volatility of the underlying asset.

C. T he Rho of a portfolio of options on an underlying asset is the rate of change of the

portfolio's Delta.

D. T he Rho of a portfolio of options is the rate of change of the value of the portfolio with
respect to the passage of time with all else remaining the same.

T he correct answer is A.

T he Rho of a portfolio of options is the rate of change of the value of the portfolio with respect to
the interest rate.

Q.1196 A stock is currently trading at $25. T he delta of the call option is 0.482. A fund manager buys
100,000 call options with a strike price of $26.50 on the stock. To maintain a delta neutral position,
the fund manager must:

A. Buy 4,820,000 shares

B. Sell 4,820,000 shares

C. Buy 1,000,000 shares

D. Sell 1,000,000 shares

T he correct answer is B.

As the fund manager buys 100,000 call options, the delta of the option position is:

δ of option position = 0.482 ∗ 100, 000 = +48, 200

To get a delta neutral position, the fund manager needs to sell 4, 820, 000(= 48, 200 × 100) shares

since 1 call option typically gives the holder the right to buy 100 shares at strike price.

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Q.1197 A stock is currently trading at $25. T he delta of the call option is 0.482. A fund manager buys
100,000 call option contracts on the stock with a strike price of $29. What action is most likely to be
taken by the fund manager to maintain a delta neutral position?

A. Sell 4,820,000 shares.

B. Buy 4,820,000 shares.

C. Buy 48,200 call options.

D. Sell 48,200 shares.

T he correct answer is A.

Since the trader has a long position in the call option, he or she should sell the underlying shares to

attain a delta-neutral position. But how many shares exactly should he or she sell?

Each long call option has a delta of 0.482. Since the trader has bought 100,000 options, the portfolio

delta is 100,000 X 0.482 = 48,200. But since each option holds the right to 100 shares, he or she

should sell 4,820,000 shares of the underlying. T he gain (or loss) on the option will then be offset by

the loss(or gain) on the shares.

Scenari o One
If the price of the underlying stock increases by $1 to $26 per share, we would then expect the
option price to increase by about $0.482 (= 1 X 0.482) per option. T he gain on the overall long
option position will be:
100, 000 × $0.482 × 100 = $4, 820, 000
T he loss on the 100,000 shares will be $1 × $4, 820, 000 =
T his would reduce the net gain to zero.
Scenari o Two
If the price of the underlying stock decreases by $1 to $24 per share, we would then expect the
option price to decrease by about $0.482(= 1 × 0.482) per option. T he loss on the overall short
option position will be:
100, 000 × $0.482 × 100 = $4, 820, 000
T he gain on the 100,000 shares will be 1 × $4, 820, 000 = $4, 80, 000
T his would reduce the net loss to zero

Thi ngs to Remember

Whereas a call option position comes with positive delta, a short call position comes with negative
delta. On the other hand, a long put position comes with negative delta while a short put position
comes with positive delta.

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Q.1198 A portfolio manager buys 100 APR 45 call option selling for $3.58 that have a delta of 0.4 and
a gamma of 0.1. If the underlying trades downwards by $1, then the delta of the overall position will
now be:

A. 0.3

B. 30

C. 27

D. 0.27

T he correct answer is B.

Gamma reflects the change in delta in response to a one-point movement of the underlying stock

price.

Our gamma here is 0.1. For every one-point move in the price of the underlying, delta of the

corresponding option will change by 0.1. A one point (1 USD) increase in price will prompt a 0.1

increase in delta. Similarly, a one point decrease in price will prompt a 0.1 decrease in delta.

In our case, delta will decrease from 0.4 to 0.3.

But that's delta for just one call option. For 100 options, delta = 0.3 * 100 = 30.

Note that gamma is always a positive number regardless of whether you are buying calls or puts but

is effectively negative when you write options.

Note that:

100 APR 45 call option:

100 here represents the number of call options.

45 here means that an investor can exercise the right to buy the stock at 45 per share.

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Q.1199 A portfolio of derivatives on a stock has a delta of 2400 and a gamma of –100. Also available
for trading is an option on the stock with a delta of 0.5 and a gamma of 0.04. To make the portfolio
gamma neutral, the portfolio manager should:

A. Buy 2,500 options.

B. Sell 2.500 options.

C. Buy 1,200 options.

D. Sell 1,200 options.

T he correct answer is A.

To create a gamma-neutral position (sometimes called gamma-neutral hedging), the manager must add

the appropriate number of options that equals the existing portfolio gamma position. In this case, the

existing gamma position is –100, and an available option exhibits a gamma of 0.04, which translates

into buying approximately 2,500 options (100 / 0.04).

Thi ngs to Remember

Gamma-neutral hedgi ng is the construction of options trading positions that are hedged such that

the total gamma value of the position is zero or near zero. T he goal is to take options combinations

that will make the overall gamma value as close to zero as possible. T his results in the delta value of

the positions remaining stagnant no matter how strongly the underlying stock moves.

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Q.1200 A portfolio manager anticipates that the market volatility will increase substantially in the
coming days. He observes two call options which are currently being traded in the market:

I. A call option on stock A, currently trading at $20 with a strike price of $30
II. A call option on stock B, currently trading at $40 with a strike price of $42

T he portfolio manager wants to derive the maximum benefit from the anticipated market volatility.
T he preferred investment should be:

A. Go long on call options on Stock A.

B. Go long on call options on Stock B.

C. Go short on call options on Stock A.

D. Go short on call options on Stock B.

T he correct answer is B.

T he volatility of call options is highest when the stock price approaches the strike price. As the
portfolio manager wants to derive benefit from the anticipated volatility, he must go long on call
options on Stock B, as the share price is near the strike price of the call option.

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Q.1201 Stock A is currently trading at $40. A three-month futures contract on Stock A is currently
trading at $40.60. Assume the risk-free rate to be 6%.
T he delta of the futures contract is:

A. 1.02

B. 1.2

C. 1.12

D. 1.22

T he correct answer is A.

Δfutures contract = erT

Where

r = Risk-free rate

T = T ime to expiry of the contract

3
(0. 06∗( ))
Δ3 months = e 12 = 1.02

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Q.1203 A fund manager sells 200,000 call options on stock A, a non-dividend paying stock. T he delta
of the stock option is 0.45, and the risk-free rate is 6%.
Select the most appropriate statement.

A. T he position can be made delta neutral by selling 9,000,000 shares of the underlying asset.

B. T he position can be made delta neutral by going short 90,000 shares on the underlying
asset.

C. T he position can be made delta neutral by buying 9,000,000 shares of the underlying asset.

D. T he position can be made delta neutral by going short on call options.

T he correct answer is C.

ΔCall options = −200, 000 ∗ 0.45 × 100 = −9, 000, 000

Since the fund manager has sold call options, he has a short position. Going long 9,000,000shares will

make the position delta neutral.

Q.3415 Which one of the following statements is true regarding option Greeks?

A. Gamma is greatest for in-the-money options with long maturities

B. Delta of deep-in-the-money put options tends toward +1

C. Vega is greatest for at-the-money options with long maturities

D. When buying at-the-money options, theta tends to be positive

T he correct answer is C.

An option's vega becomes less and less the further your option is from the at the money strike. In
other words, vega is greatest for at-the-money options.
Option A is incorrect. For in-the-money options, gamma is small.

Option B is incorrect. For in-the-money puts, delta tends toward -1

Option D is incorrect. When buying at-the-money options for long-term keeping, theta is negative.

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Q.3417 A trader has a short option position that’s delta-neutral but has a gamma of -800. In the
market, there’s a tradeable option with a delta of 0.8 and a gamma of 2. To maintain the position
gamma-neutral and delta-neutral, the most appropriate strategy is to:

A. Sell 320 options and buy 400 shares of the underlying

B. Buy 400 options and sell 320 shares of the underlying

C. Buy 400 options and buy 320 shares of the underlying

D. Sell 320 options and buy 320 shares of the underlying

T he correct answer is B.

As it stands, the position is gamma-negative, and therefore the trader has to buy calls to increase
gamma back to zero. T he number of options that must be added to the existing portfolio to generate a
gamma-neutral position is given by:

Γp
−( )
ΓT

Where: Γp=gamma of the existing portfolio position ΓT =gamma of a traded option that can be added

800
= − (− ) = 400
2

Buying 400 calls, however, increases delta from zero to 320 (= 400 × 0.8). T herefore, the trader has
to sell 320 shares to restore the delta to zero. Positions in shares always have zero gamma.

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