2016-FRR Exam Dumps - GARP Financial Risk and Regulation Questions and Answers

Major problems with correlation calculations include:

I. Correlation estimates are not able to capture increases in factor co-movements in extreme market scenarios, as correlations can change significantly during periods of market stress.

II. Correlation estimates tend to be unstable, meaning they can vary widely over time and in different market conditions.

III. Historical correlations may not forecast future correlations correctly, as past data may not always be indicative of future relationships.

IV is incorrect because correlation estimates do not inherently assume normally distributed returns, though the assumption of normality is often used in conjunction with correlation calculations.

Macaulay's duration is a measure of the weighted average time until a bond's cash flows are received. It calculates the time it takes for the price of a bond to be repaid by its internal cash flows. This measure is essential because it helps investors understand the interest rate risk of a bond. The longer the duration, the more sensitive the bond's price is to changes in interest rates. Therefore, Macaulay's duration is crucial for managing interest rate risk and is commonly used in bond portfolio management.

Economic capital models, while useful, have the following disadvantages:

Model Risk: These models may not accurately capture the complexities of financial systems, leading to significant model risk.

Estimation Errors: Potential errors in risk estimation can lead to either underestimation or overestimation of required capital.

Regulatory Differences: These models may not align with regulatory capital requirements, causing discrepancies.

Complexity: The complexity of these models makes them difficult to understand and manage.

References

Source: How Finance Works​

Comprehensive and Detailed In-Depth Explanation:

Securitization involves pooling illiquid assets (e.g., mortgages, loans) and converting them into tradable securities sold to investors, thereby transferring risk and improving balance sheet liquidity. Option C is correct as it describes selling illiquid assets (e.g., loans) via securitization. Option A is vague (“exogenous liquidity” isn’t a standard term), Option B is incorrect (securitization enhances, not reduces, liquidity), and Option D is wrong (liquid assets like cash aren’t typically securitized). GARP’s FRR confirms this process.

Comprehensive and Detailed In-Depth Explanation:

A daily decay factor (e.g., in EWMA models) weights recent data more heavily, but gradually reduces the influence of extreme returns over time, smoothing forecasts. Option B is correct—it mitigates the lasting impact of outliers. Option A is incorrect (recent volatility retains influence). Option C reverses the effect, and Option D is unrelated (decay doesn’t target low volatility). GARP’s FRR discusses this in VaR forecasting.

Exact Extract from Official Source:

GARP FRR Study Notes, Market Risk Section: "A decay factor in P&L forecasting, such as in EWMA, reduces the weight of extreme past returns over time, providing a balanced view of volatility."

BCBS, "Basel III: A Global Regulatory Framework," December 2010, para. 718: "Models using decay factors lessen the persistent effect of extreme events on risk estimates."

Under Basel II, Tier 2 capital, also known as supplementary capital, includes:

Subordinated Debt: This type of debt ranks below other debts with respect to claims on assets or earnings. It is considered Tier 2 capital because it can absorb losses in the event of a winding-up of the bank.

Other Instruments: This category can also include hybrid instruments, undisclosed reserves, revaluation reserves, and general provisions/general loan-loss reserves.

These components enhance the bank's ability to absorb losses beyond the protection provided by Tier 1 capital.

An interest rate cap is a derivative contract that protects the buyer from rising interest rates. It sets a maximum limit on the interest rate that the borrower will have to pay on a floating rate loan. If the floating rate exceeds the cap rate, the seller of the cap pays the difference. This instrument is ideal for James Arthur, who is concerned about potential rises in interest rates, as it limits the maximum interest payment without affecting the benefits of lower rates.

Mathematical valuation and risk assessment models can be misleading or inaccurate for several reasons:

Missing factors in models: Important variables or conditions might be overlooked.

Bad or wrong data: Incorrect or poor-quality data input can lead to faulty outcomes.

Misinterpretation of results: Users might not correctly understand or use the results.

Errors in the derivation of the model: Mistakes in the mathematical formulation or assumptions can lead to errors.

All these factors contribute to the potential inaccuracy or misleading nature of such models.

Comprehensive and Detailed In-Depth Explanation:

Pillar 2 of Basel II (Supervisory Review Process) focuses on ensuring banks have adequate processes to identify, measure, and manage all material risks (beyond just market, credit, and operational risks covered in Pillar 1), including interest rate risk in the banking book, concentration risk, and others. It requires banks to maintain capital above the Pillar 1 minimum if warranted by their risk profile, as assessed by supervisors. Option D describes Pillar 1, not Pillar 2. Option B aligns with Pillar 3 (disclosure), and Option A (reputational risk) is not a specific Pillar 2 focus.

Calculate the weighted average of modified durations:

The modified duration of the portfolio is a weighted average of the durations of the individual bonds, where the weights are the proportions of the total portfolio value.

Calculate the total value of the portfolio: $200 MM (3-year floater) + $120 MM (5-year floater) + $50 MM (10-year fixed) = $370 MM.

Calculate the weights for each bond:

3-year floater: $200 MM / $370 MM = 0.5405

5-year floater: $120 MM / $370 MM = 0.3243

10-year fixed: $50 MM / $370 MM = 0.1351

Multiply each bond's weight by its modified duration and sum the results:

(0.5405 * 0.25) + (0.3243 * 0.25) + (0.1351 * 8) = 0.1351 + 0.0811 + 1.081 = 1.297

Therefore, the weighted average modified duration is approximately 1.30.

ReferencesCalculation based on standard formula and weights derived from the table.