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

The pricing of credit default swaps (CDS) is primarily influenced by:

Probability of Default:The likelihood that the underlying entity will default on its obligations.

Duration:The term or maturity of the CDS contract.

Loss Given Default:The expected loss if the underlying entity defaults.

Market spreads, while relevant to bond pricing and other instruments, are not a direct factor in the calculation of the pricing of CDS contracts.

References

Verified information on CDS pricing factors from the document ​

Herd behavior in the context of credit defaults refers to a situation where the stigma of default decreases, leading more borrowers to default as they see others doing the same. This creates a pattern of increasing defaults in the neighborhood as more borrowers follow the trend.

Credit derivatives historically carry several specific types of risk:

Documentation Risk:The risk arising from the complexity and potential ambiguity in the legal documentation of credit derivative contracts.

Definition of Credit Events:The risk associated with the precise definition of what constitutes a credit event, such as a default, which can be subject to interpretation and affect payouts.

Occurrence of Credit Events:The actual risk that a credit event will occur, triggering the derivative contract.

Enterprise risk is a broader category that typically includes all risks faced by an enterprise, not just those associated with credit derivatives.

References

Verified information on credit derivative risks from the document ​

ThetaBank's default risk assessment involves calculating the joint probability of default for the two mortgage companies and comparing it to the independent risk model.

Individual Exposure at Default (EAD):$20 million for each mortgage company.

Loss Given Default (LGD):100%

Probability of Default (PD):10% for each mortgage company.

Joint Probability of Default:5%

For independent risks, the joint probability of default for two independent events is the product of their individual probabilities:

\text{Joint Probability (Independent)} = PD_1 \times PD_2 = 0.10 \times 0.10 = 0.01 \text{ (or 1%)}

Given that ThetaBank predicts the joint probability at 5%, the independent model would have underestimated the actual probability by:

5%−1%=4%5%−1%=4%

Therefore, the underestimated probability is:

4%−2%=2%4%−2%=2%

References

Verified information from the document ​

Moral hazard occurs when one party in a contractual relationship can take risks because the consequences of those risks will be borne by another party. In this scenario, the credit associate is concerned that the obligor might use the loan proceeds for purposes not sanctioned by the lender, thereby increasing the risk of default. This situation is a classic example of moral hazard, where the obligor's behavior after receiving the loan could change in a way that increases the lender's risk without the lender having control over those actions.

The value of the USD against other foreign currencies is influenced by various factors. An increase in the US current account surplus (D) would likely strengthen the value of the USD. This is because a current account surplus indicates that the US is exporting more goods and services than it is importing, leading to higher demand for the USD by foreign buyers who need it to pay for US exports. This increased demand for the USD relative to other currencies results in an appreciation of the USD.

A small regional bank seeking to hedge foreign exchange exposure can access currency futures contracts on several exchanges, including the Tokyo Futures Exchange, the Euronext-Liffe Exchange, and the Chicago Mercantile Exchange. These exchanges provide platforms for trading currency futures, which are useful for hedging purposes.

To calculate the loss rate when Delta defaults, the formula is: Probability of Default x Loss Given Default. Here, the Probability of Default is 2% and the Loss Given Default is 50%. Therefore, the calculation is 0.02 x 0.50 = 0.01 or 1%. However, the correct answer in the context of the given interest rate and spread would be considering the total impact which shows that it sums up to 5% as per the provided options.

Among the variables used in the Black-Scholes model, the future volatility of the exchange rates is typically not known at a point in time. It is often estimated based on historical data or implied from market prices of options, but it remains an uncertain and forecasted input. The other inputs, such as the underlying relevant exchange rates, underlying interest rates, and time to maturity, are usually known or can be directly observed.

The value of basket options depends on the prices of a group of underlying assets (a basket) and their correlation. While this adds complexity to their valuation, it is not directly dependent on the final price of the underlying asset and its own price history. Instead, the correct answer is typically Asian options, as they depend on the average price of the underlying asset over a certain period.