PRM Certification 8008 Book

Choice 'c' is the correct answer. The Markov property is the assumption that there is no ratings momentum, and that transition probabilities are dependent only upon where the rating currently is and where it is going to. Where it has come from, or what the past changes in ratings have been, have no effect on the transition probabilities. ('Herstatt risk' refers to settlement risk, and is irrelevant.)

Exposure for derivative instruments can vary significantly over the lifetime of the instrument, depending upon how the market moves. The potential future exposure represents the extremes, not the most likely outcome. The expected exposure is the most suitable measure for pricing the credit risk. Over time, as multiple transactions are entered into, the expectation (or the mean) will be realized - though individual transactions may have more or less by way of exposure.

The notional amount may not be relevant, though for loans it may be the most important contributor to the expected exposure. Mark-to-market will represent the exposure at a given point in time, but cannot be predicted nor be used to price the credit risk.

Expected value = $90 ($100 - 10%)

Value at 99% confidence level = $65

Therefore economic capital required at this level of confidence = $90 - $65 = $25.

Choice 'a' is the correct answer, the other choices are not.

(We can also look at it this way as explained in section III.B.6.2.2 of the handbook: Economic capital is designed to absorb unexpected losses, which are equal to total losses at a given confidence level minus expected losses. (Expected losses are to be covered by credit reserves). Total losses are $100-$65=$35, and expected losses are 10%*$100=$10, therefore economic capital should be $35-$10=$25.)

The greatest model risk when calculating operational risk capital comes from incorrect assumptions about correlations between different operational risks for which standalone risk calculations have been made. Generally, the correlation can be expected to be positive, and would therefore vary between 0 and 1. These two values determine the 'bounds' between which the total operational risk capital would lie, and these bounds are generally quite far apart. Therefore the total value of the operational risk capital is very sensitive to the value chosen for the correlation, and this is the source of the biggest model risk under the AMA.