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

Kurtosis measures the "tailedness" of the return distribution. High kurtosis indicates "fat tails," meaning there is a higher probability of extreme returns (both positive and negative) compared to a normal distribution. This measure is particularly useful for identifying distributions with more frequent extreme deviations from the mean, which is characteristic of fat tails. Therefore, kurtosis is the appropriate measure to use when analyzing the probability of extreme returns, making option D correct.

To calculate the required return using CAPM: Required return = risk-free rate + beta × market risk premium

Substituting the given values: Required return = 5% + 2.5 × 8% Required return = 5% + 20% Required return = 25%

Therefore, the estimated rate of return using the given statistics is 25%.

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

A very strong positive linear relationship between the returns on two assets means that their correlation is close to 1, which is 100%. This indicates that the returns on the two assets move almost perfectly in tandem with each other.

Short-selling is associated with several risks:

Potential for extreme losses: If the price of the shorted asset increases significantly, the losses can be unlimited.

Risk associated with the availability of shares to borrow: Short-sellers need to borrow shares to sell them, and there may be situations where shares are not available.

Market behavior risk: Market conditions can change rapidly, affecting the prices of shorted assets.

Liquidity risk: Short-sellers may face difficulty in covering their positions if the market lacks sufficient liquidity.

When a bank has a large number of auto loans and finds it difficult to sell them individually, it can take the following steps to raise cash:

Packaging into a Securitized Vehicle: The bank can package these auto loans into a securitized vehicle, such as a collateralized loan obligation (CLO) or an asset-backed security (ABS). By doing so, the bank can create a portfolio of loans that can be sold as a single security.

Selling the Low-Risk Portion: Once the loans are securitized, the bank can sell the low-risk portion of the portfolio to investors. This part of the portfolio is more attractive to investors because it typically offers lower risk and stable returns, making it easier to sell compared to individual loans.

References: This approach is detailed in "How Finance Works," where securitization is described as a method for banks to sell illiquid assets by packaging them into marketable securities​​.

Securitization helps banks make their retail assets highly liquid and their balance sheet easier to manage through the following mechanisms:

I. Accommodating Lack of Capital: By securitizing assets, any lack of capital can be accommodated by selling the securitized bonds. This process enables banks to raise funds quickly by selling bonds backed by their assets.

II. Diversifying Credit Risk: Banks can achieve credit risk diversification by selling their own securitized bonds and buying other bonds that increase diversification. This helps spread the risk across different types of assets and reduces the overall credit risk exposure of the bank.

III. Promoting Hedging: Securitization can be used to promote hedging by using limited market instruments. By securitizing assets, banks can better hedge their positions and manage the risks associated with their assets more effectively.

References: These points align with the principles outlined in the "How Finance Works" document regarding the benefits of securitization for improving liquidity and managing balance sheets​​.

VaR calculations depend heavily on the confidence level chosen. Bank G's 1-year VaR of USD 20 million is calculated at a 99% confidence level, while Bank H's 1-year VaR of USD 10 million is calculated at a 95% confidence level. These different confidence levels mean that the probabilities associated with the potential losses are not directly comparable. The 99% confidence level implies a more conservative risk estimate compared to the 95% confidence level, hence no direct risk comparison can be accurately made.

Identify the variables:

Haircut in a repo transaction: 20%

This implies that the lender will provide cash equivalent to 80% of the value of the collateral (CDOs in this case).

Calculate the maximum leverage factor:

The leverage factor can be calculated as the reciprocal of the proportion of the value after the haircut.

Leverage factor=1Haircut percentageLeverage factor=Haircut percentage1​

Given a 20% haircut, the calculation is:

Leverage factor=10.20=5Leverage factor=0.201​=5

However, in practice, leverage is often cited with respect to the additional amount borrowed relative to the initial equity. Thus, the effective leverage factor here is:

Leverage factor=10.20−1=4Leverage factor=0.201​−1=4

References:

This detailed calculation is consistent with the principles outlined in financial risk management practices and the information provided in the document.

Basis point value refers to the change in the value of a fixed income position for a very small change in yields. This measure is crucial in understanding the sensitivity of the position to changes in interest rates, which is a fundamental aspect of fixed income securities and interest rate risk management.