PRMIA Operational Risk Manager (ORM) Exam Practice Test

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Total 241 questions
Question 1

Financial institutions need to take volatility clustering into account:

1. To avoid taking on an undesirable level of risk

2. To know the right level of capital they need to hold

3. To meet regulatory requirements

4. To account for mean reversion in returns



Answer : B

Volatility clustering leads to levels of current volatility that can be significantly different from long run averages. When volatility is running high, institutions need to shed risk, and when it is running low, they can afford to increase returns by taking on more risk for a given amount of capital. An institution's response to changes in volatility can be either to adjust risk, or capital, or both. Accounting for volatility clustering helps institutions manage their risk and capital and therefore statements I and II are correct.

Regulatory requirements do not require volatility clustering to be taken into account (at least not yet). Therefore statement III is not correct, and neither is IV which is completely unrelated to volatility clustering.


Question 2

Which of the following statements is true in respect of a non financial manufacturing firm?

1. Market risk is not relevant to the manufacturing firm as it does not take proprietary positions

2. The firm faces market risks as an externality which it must bear and has no control over

3. Market risks can make a comparative assessment of profitability over time difficult

4. Market risks for a manufacturing firm are not directionally biased and do not increase the overall risk of the firm as they net to zero over a long term time horizon



Answer : A

A non-financial firm such as a manufacturing company faces market risks similar to those faced by financial firms, except perhaps for not being exposed to risks from the equity markets. Non financial firms commonly face interest rate risks in respect of their debts, commodity price risks in respect of their inputs and products, and foreign currency risks in respect of their overseas operations. It is therefore not correct to say that the manufacturing firm does not face market risk because it does not take proprietary positions. While decisions on positions may not be actively taken, positions in foreign exchange (eg, through overseas debtors owing foreign currency, or liabilities in foreign currencies to overseas suppliers), commodities (through exposure to the need for raw material and inventory of finished goods) and interest rates (through debt financed, whether at fixed or floating rates) exist and create market risk much in the same way as they would for a proprietary position. Therefore statement I is incorrect.

While the firm faces market risks as an externality (as do financial firms for that matter, though often they seek such exposure to profit from their view on which way the externality will express itself), it is incorrect to say that these risks must be borne. They can be measured and hedged. Therefore statement II is incorrect.

The results of a manufacturing firm will include gains and losses arising from exposure to market risk, and will cloud the true profitability of the business. A firm with significant unhedged overseas sales may show vastly different results across time periods due to the FX gains and losses, making comparative assessment of profitability difficult. Therefore statement III is correct.

Market risks for a manufacturing firm may be directionally biased in terms of exposure, ie there may be a consistent 'long' position in a particular commodity that the firm produces, and a consistent 'short' position in the commodities consumed. In the same way, directional biases may exist in FX or interest rate exposures too. Regardless of the bias, the existence of market risk exposures increase the volatility of the income stream and make the firm more risky, even though the long term expected returns from such exposures is zero (ie, returns may be zero but standard deviation is not). Therefore statement IV is not correct as market risks form non financial firms do increase the overall risk of the firm.


Question 3

Which of the following statements is true:

1. Recovery rate assumptions can be easily made fairly accurately given past data available from credit rating agencies.

2. Recovery rate assumptions are difficult to make given the effect of the business cycle, nature of the industry and multiple other factors difficult to model.

3. The standard deviation of observed recovery rates is generally very high, making any estimate likely to differ significantly from realized recovery rates.

4. Estimation errors for recovery rates are not a concern as they are not directionally biased and will cancel each other out over time.



Answer : D

Recovery rates vary a great deal from year to year, and are difficult to predict. Therefore statement III is true. Similarly, any attempt to predict these is hamstrung by a high standard error, which can be as high as the historical mean itself. The error does not cancel itself out due to the effect of the business cycle making the error directionally biased. Thus statement IV is false.

Statement II is true as these are all factors that make forecasting recovery rates for any credit risk model rather difficult. Statement I is false because recovery rates are difficult to predict and assumptions are not easy to make.


Question 4

Random recovery rates in respect of credit risk can be modeled using:



Answer : A

The beta distribution is commonly used to model recovery rates. It is a distribution for variables whose values lie between 0 & 1, and the parameters of the distribution can be estimated using the mean and standard deviation of the data. Therefore Choice 'a' is correct and the others are wrong.

Refer to the tutorial on distributions for an Excel model of the beta distribution.


Question 5

Which of the following formulae describes CVA (Credit Valuation Adjustment)? All acronyms have their usual meanings (LGD=Loss Given Default, ENE=Expected Negative Exposure, EE=Expected Exposure, PD=Probability of Default, EPE=Expected Positive Exposure, PFE=Potential Future Exposure)



Answer : B

The correct definition of CVA is LGD * EPE * PD. All other answers are incorrect.

CVA reflects the adjustment for counterparty default on derivative and other trading book transactions. This reflects the credit charge, that neeeds to be reduced from the expected value of the transaction to determine its true value. It is calculated as a product of the loss given default, the probability of default and the average weighted exposure of future EPEs across the time horizon for the transaction.

The future exposures need to be discounted to the present, and occasionally the equations for CVA will state that explicitly. Similarly, in some more advanced dynamic models the correlation between EPE and PD is also accounted for. The conceptual ideal though remains the same: CVA=LGD*EPE*PD.


Question 6

Which of the following is the most accurate description of EPE (Expected Positive Exposure):



Answer : C

When a derivative transaction is entered into, its value generally is close to zero. Over time, as the value of the underlying changes, the transaction acquires a positive or negative value. It is not possible to predict the future value of the transaction in advance, however distributional assumptions can be made and potential exposure can be measured in multiple ways. Of all the possible future exposures, it is generally positive exposures that are relevant to credit risk because that is the only situation where the bank may lose money from a default of the counterparty.

The maximum (generally a quantile eg, the 97.5th quantile) exposure possible over the time of the transaction is the 'Potential Future Exposure', or PFE.

The average of the distribution of positive exposures at a specified date before the longest trade in the portfolio is called 'Expected Exposure', or EE.

The expected positive exposure calculated as the weighted average of the future positive Expected Exposure across a time horize is called the EPE, or the 'Expected Positive Exposure'.

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date - is the 'fair value', as defined under FAS 157.

Therefore the corect answer is that EPE is the weighted average of the future positive expected exposure across a time horizon.


Question 7

An investor enters into a 5-year total return swap with Bank A, with the investor paying a fixed rate of 6% annually on a notional value of $100m to the bank and receiving the returns of the S&P500 index with an identical notional value. The swap is reset monthly, ie the payments are exchanged monthly. On Jan 1 of the fourth year, after settling the last month's payments, the bank enters bankruptcy. What is the legal claim that the hedge fund has against the bank in the bankruptcy court?



Answer : C

According to ISDA standard definitions, the legal claim for OTC derivatives is the current replacement value of the contract. Therefore Choice 'c' is the correct answer. None of the other choices are correct.


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Total 241 questions