Analyst Prep VRM 2024

FRM Part I Exam
By AnalystPrep
Questions with Answers - Valuation and Risk Models
Last Updated: Sep 19, 2023
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Table of Contents
47 - Measures of Financial Risk 3

48 - Calculating and Applying VaR 18
49 - Measuring and Monitoring Volatility 51
50 - External and Internal Credit Ratings 89
51 - Country Risk 104
52 - Measuring Credit Risk 120
53 - Operational Risk 148
54 - Stress Testing 173
55 - Pricing Conventions, Discounting, and Arbitrage 219
56 - Interest Rates 239
57 - Bond Yields and Return Calculations 265
58 - Applying Duration, Convexity, and DV01 283
59 - Modeling and Hedging Non-Parallel Term Structure Shifts 308
60 - Binomial Trees 320
61 - The Black-Scholes-Merton Model 338
62 - Option Sensitivity Measures: The “Greeks” 363
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© 2014-2023 AnalystPrep.
Reading 47: Measures of Financial Risk
Q.939 Billy Marquette has recently joined a small company that provides private commercial jets to
royal families, government officials, and directors of big firms. Marquette is a retired commercial
pilot with a very basic understanding of finance. On his first day, he is handed a report on risk
management measures. T he excerpt from the report says “due to volatility in oil prices, the
company has a weekly 90% VaR of €20,000”. Which of the following is the most appropriate
explanation of the excerpt?
A. T here is a 90% probability that the company will experience a loss of €2,000 on a weekly
basis.
B. T here is a 10% probability that the company will experience a loss of €20,000 in any
given week.
C. T here is a 90% probability, in any given week, that the company will experience a loss of
more than €20,000.
D. T here is a 10% probability, in any given week, that the company will experience a loss in
excess of €20,000.
T he correct answer is D.
Value at Risk (VaR) is a statistical technique used to measure and quantify the level of financial risk
within a firm or investment portfolio over a specific time frame. T his metric is most commonly used
by investment and commercial banks to determine the extent and occurrence ratio of potential
losses in their institutional portfolios. Risk managers use VaR to measure and control the level of
risk exposure. One can look at VaR as providing an estimate of the potential loss that could be made
on an investment portfolio over a certain period of time, given normal market conditions and a
certain level of confidence. In this case, a 90% VaR of €20,000 means that there is a 10% chance
that the company will experience a loss exceeding €20,000 in any given week. T his is because the
90% confidence level implies that losses will not exceed the VaR estimate 90% of the time.
T herefore, the remaining 10% represents the probability that losses could exceed this amount,
which is exactly what choice D states.
Choi ce A i s i ncorrect. T he statement does not imply a 90% probability of a weekly loss of €2,000.
T he VaR figure given is €20,000, not €2,000.
Choi ce B i s i ncorrect. While it correctly identifies the 10% probability associated with VaR, it
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incorrectly states that this represents the likelihood of a loss exactly equal to €20,000 in any given
week. In reality, VaR represents the minimum loss that could occur with a certain probability.
Choi ce C i s i ncorrect. T his choice incorrectly interprets the 90% confidence level as implying a
90% chance of losses exceeding €20,000 in any given week. In fact, there's only a 10% chance
(100%-90%) that losses will exceed this amount.
Q.975 Anshuman, a risk consultant working at Dominic Republic Bank, uses VaR to measure the risks
of his bank’s positions. He makes the following statements in his consultant report with regard to
VaR. Which of the following statement(s) can be accepted by the risk committee of the firm?
I. VaR is simply the negative of the qp quantile of the profit and loss (P/L) distribution
II. VaR is defined contingent on two arbitrarily chosen parameters: a confidence level and a holding
or horizon period
III. VaR not only rises with the confidence level but rises at a decreasing rate
A. I only.
B. I and II only.
C. II and III only.
D. All of the above.
T he correct answer is B.
T he statements I and II are correct descriptions of Value at Risk (VaR).
Statement I correctly states that VaR is the negative of the qp quantile of the profit and loss (P/L)
distribution. T his means that VaR is a measure of the potential loss in value of a risky financial
instrument or portfolio of financial instruments over a specific time period. It is most often used in
reference to the risk of loss for amounts at risk to be paid in the future.
Statement II is also correct in stating that VaR is defined contingent on two arbitrarily chosen
parameters: a confidence level and a holding or horizon period. T he confidence level represents the
probability that a certain loss will not be exceeded, and the holding period is the time span over
which the risk measurement applies. T hese parameters are chosen based on the risk tolerance and
investment horizon of the institution or individual using VaR.
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Choi ce A i s i ncorrect. While it is true that VaR can be interpreted as the negative of the qp
quantile of the profit and loss (P/L) distribution, this statement alone does not fully capture the
nature of VaR. It fails to mention that VaR also depends on two arbitrarily chosen parameters: a
confidence level and a holding or horizon period.
Choi ce C i s i ncorrect. T his choice includes Statement II which correctly describes VaR as being
defined contingent on two arbitrarily chosen parameters: a confidence level and a holding or horizon
period. However, it also includes Statement III which inaccurately suggests that VaR always rises at
a decreasing rate with the confidence level. In reality, whether or not VaR rises at a decreasing rate
with an increase in confidence level depends on the specific characteristics of the portfolio's return
distribution.
Choi ce D i s i ncorrect. As explained above, while Statements I and II are accurate descriptions of
VaR, Statement III contains an error in its description of how changes in confidence level affect VaR.
Q.978 ANG National Bank intends to use the coherent risk measure to measure the risk of its assets.
A risk measure is said to be coherent if it satisfies the properties such as:
I. Monotonicity
II. Sub-additivity
III. Homogeneity
IV. T ranslational invariance
A. I, III & IV only
B. I, II & IV only
C. II, III & IV only
D. All of the above
A coherent risk measure is a type of risk measure that satisfies four key properties: Monotonicity,
Sub-additivity, Homogeneity, and T ranslational invariance. Monotonicity implies that if a portfolio has
systematically lower values than another, in each state of the world, it must have greater risk. Sub-
additivity suggests that when two portfolios are combined, their total risk should be less than (or
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equal to) the sum of their individual risks. T his property emphasizes the risk-reducing benefits of
portfolio diversification. Homogeneity means that increasing the size of a portfolio by a factor k
should result in a proportionate scale in its risk measure. Lastly, T ranslational invariance indicates
that adding cash h to a portfolio should reduce its risk by h. T herefore, a coherent risk measure must
satisfy all these properties, making choice D the correct answer.
Choi ce A i s i ncorrect. While Monotonicity, Homogeneity, and T ranslational invariance are indeed
properties of a coherent risk measure, this combination omits Sub-additivity. Sub-additivity is a
crucial property that ensures the total risk of a portfolio is not greater than the sum of individual
risks.
Choi ce B i s i ncorrect. T his combination includes Monotonicity, Sub-additivity and T ranslational
invariance but leaves out Homogeneity. T he property of Homogeneity implies that the risk measure
should be directly proportional to the size of positions in the portfolio.
Choi ce C i s i ncorrect. Although it includes Sub-additivity, Homogeneity and T ranslational
invariance, it does not include Monotonicity which states that if one portfolio always results in equal
or less wealth than another then its associated risk should be equal or less as well.
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Q.980 John Adams, a newly recruited junior analyst, is asked to compare expected shortfall and Value
at Risk. He jots down the following points in his notes. Which of them are correct?
I. While the expected shortfall (ES) tells what to expect in bad states, i.e., it gives an idea of how bad
might it be, Value at Risk tells us nothing other than to expect a loss higher than the Value at Risk
itself
II. T he expected shortfall-based rule is consistent with expected utility maximization if risks are
rankable by a second-order stochastic dominance rule, while a Value-at-Risk-based rule is only
consistent with expected utility maximization if risks are rankable by a more stringent first-order
stochastic dominance rule
III. T he expected shortfall and Value at Risk always satisfy sub-additivity
IV. Finally, the subadditivity of ES implies that the portfolio risk surface will be convex, and
convexity ensures that portfolio optimization problems using ES measures, unlike ones that use VaR
measures, will always have a unique well-behave optimum
A. I, III & IV only
B. I, II & IV only
D. All of the above
Statement I is correct: While the expected shortfall (ES) tells what to expect in bad states, i.e., it
gives an idea of how bad might it be, Value at Risk tells us nothing other than to expect a loss higher
than the Value at Risk itself.
Statement II is correct: T he expected shortfall-based rule is consistent with expected utility
maximization if risks are rankable by a second-order stochastic dominance rule. On the contrary, a
Value-at-Risk-based rule is only consistent with expected utility maximization if risks are rankable by
a more stringent first-order stochastic dominance rule.
Statement III is incorrect: T he expected shortfall always satisfies sub-additivity, while the Value at
Risk does not.
Statement IV is correct: Finally, the subadditivity of ES implies that the portfolio risk surface will be
convex, and convexity ensures that portfolio optimization problems using ES measures, unlike ones
that use VaR measures, will always have a unique well-behaved optimum.
Q.981 Andrew Simons, a risk analyst, is working on risk measures. He is particularly interested in
the risk aversion property of risk measures.
Which of the following statement(s) is/are true with regard to the risk aversion property of risk
measures?
I. If a user has a ‘well-behaved’ risk-aversion function, then the weights will rise smoothly, and the
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rate at which weights rise will be related to the degree of risk aversion: the more risk-averse the
user, the more rapidly the weights will rise
II. Expected shortfall is characterized by all losses in the tail region having the same weight implying
that the user is risk-neutral between tail-region outcomes
III. In case of Value at Risk (VaR), the weight of the loss associated with a p-value equal to α implies
that the user is actually risk-loving
A. I and II only.
B. I only.
C. II and III only.
All the statements are true in relation to the risk aversion property of risk measures.
Statement I is correct because a 'well-behaved' risk-aversion function implies that the user's risk
aversion is consistent and predictable. T he weights assigned to different outcomes will increase
smoothly, and the rate of increase will be proportional to the degree of risk aversion. T he more risk-
averse the user, the faster the weights will increase. T his is a fundamental principle of risk aversion
in economics and finance.
Statement II is correct because the expected shortfall is a risk measure that takes into account all
losses in the tail region of a distribution. By assigning the same weight to all these losses, it implies
that the user is risk-neutral between tail-region outcomes. T his is a characteristic feature of the
expected shortfall as a risk measure.
Statement III is correct because Value at Risk (VaR) is a risk measure that assigns a larger weight to
the loss associated with a p-value equal to α and zero weight to any greater loss. T his implies that the
user is actually risk-loving, as they are willing to accept a higher risk for a potential higher return.
T his is a characteristic feature of VaR as a risk measure.
Choi ce A i s i ncorrect. While it correctly identifies that statements I and II are true, it incorrectly
excludes statement III. In the case of Value at Risk (VaR), the weight of the loss associated with a p-
value equal to α does suggest that the user is risk-loving, as they are willing to accept a higher level
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of risk for potential gains.
Choi ce B i s i ncorrect. Although statement I is indeed true, this choice incorrectly excludes
statements II and III which are also accurate descriptions of properties related to risk aversion in
risk measures.
Choi ce C i s i ncorrect. T his choice correctly includes statement II and III but wrongly excludes
statement I which accurately describes how a 'well-behaved' risk-aversion function will have
weights that increase smoothly with the rate of increase being proportional to the degree of risk
aversion.
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Q.3325 Which of the following is NOT a property of coherent risk measures?
A. Y ≥ X ⇒ ρ(Y ) ≥ ρ(X )
B. ρ(X + Y ) ≤ ρ(X) + ρ(Y )
C. ρ(hX) = hρ(X) for h > 0
D. ρ(x + n) ≤ ρ(X) − n for some n
T he correct answer is A.
T he property Y ≥ X ⇒ ho(Y ) ≥ ho(X ) is not a property of coherent risk measures. T his property is
incorrectly stating the principle of monotonicity. T he correct principle of monotonicity is: If a
portfolio X 1 has systematically lower values than another portfolio X 2 in each state of the world, it
must have a greater risk. T herefore, the correct property should be Y ≥ X ⇒ ho(Y ) ≤ ho(X ). T his
means that if portfolio Y has higher or equal values than portfolio X, the risk of portfolio Y should be
less than or equal to the risk of portfolio X. T he incorrect property in choice A suggests the
opposite, which is not coherent with the principles of risk measures.
Choi ce B i s i ncorrect. T his property is known as sub-additivity, which states that the risk of two
portfolios combined should be less than or equal to the sum of their individual risks. T his property
ensures that diversification benefits are taken into account by the risk measure.
Choi ce C i s i ncorrect. T his property is called positive homogeneity, which means that if we scale
up a portfolio by a positive factor h, then its risk should also scale up by the same factor. It ensures
that the size of a portfolio's positions are appropriately reflected in its measured risk.
Choi ce D i s i ncorrect. T he given condition does not represent any coherent risk measure
properties correctly. In fact, it seems to be an incorrectly stated version of translation invariance
property which states ρ(X + n) = ρ(X) − n, meaning if we add a certain amount n to all outcomes of
X, then its measured risk should decrease by n.
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Q.3328 An investment company has a portfolio which has the following ordered performance by
historical data. Calculate the expected shortfall ES0. 95 .
Probabilty 1% 5% 10% 12% 15%

Profit/Loss −500 −300 −100 −90 −50
A. 300
B. 340
C. 400
D. 425
Given a discrete distribution, the ES is the equivalent of:
1 1−α th
ES α = ∑ [p highest loss] × [probability of pth highest loss]
1 − α p=0
At α = 0.95,
[(0.01 × 500) + (0.04 × 300)]

ES0. 95 = = 340
0.05
Note: T he sum of probabilities in the numerator must sum to (1 − α)
Al ternati ve Approach
To calculate the expected shortfall, we must ask ourselves, "If we are in the worst 5% of the loss
distribution, what is the expected loss?" T he first column of the given table makes it clear that the
5% tail of the distribution is composed of a 1% probability that the loss is 500 and a 4% probability
that the loss is 300. Conditional on being in the tail of the distribution, there is, therefore, a 1/5
chance that the loss is 500 million and a 4/5 chance that it is 300. T he expected shortfall (in millions
of dollars) is, therefore:
1 4
( ) × 500 + ( ) × 300 = 340
5 5
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Q.3329 An investment company has a portfolio which has the following ordered performance by
historical data. Calculate the expected shortfall, ES0. 99 , i.e., at 99% level of confidence
Probabilty 1% 5% 10% 12% 15%

Profit/Loss −500 −300 −100 −90 −50
A. 168
B. 400
C. 460
D. 500
T here is only one number 500 beyond 1%, therefore, the average is 500.
Further Expl anati on
T he expected shortfall (also called conditional VaR) is the expected tail loss. It is the average of the
worst 100*(1-a)% of losses. For a discrete distribution, ES is derived as:
1 α
ES α = ∑ (pth loss × probability of pth loss)
1 − α p=0
In words, to determine the expected shortfall at a level of confidence a, we must find the average of
all the outcomes whose probability is less than or equal to 1 − a.
At a 99% confidence level, the significance level is 1%. To establish the expected shortfall at 1%, we
must find the average of all the outcomes whose probability is less than or equal to 1%. in this case,
(0.01 ∗ 500)
Expected shortfall = = 500
0.01
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Q.3397 A hypothetical portfolio of securities exhibits the following expected losses shown:
Name Loss (million dollar) Probability (%)

1 10 40%
2 20 35%
3 50 15%
4 100 5%
5 200 2.5%
6 225 2%
7 250 0.5%
Calculate the expected shortfall at the 95% and 99% confidence level?
A. ES (95%) = $225 million; ES (99%) = $237.5 million
B. ES (95%) = $215 million; ES (99%) = $237.5 million
C. ES (95%) = $217.5 million; ES (99%) = $250 million
D. ES (95%) = $225 million; ES (99%) = $250 million
Note that the given data are in expected losses. T he expected shortfall (also called conditional VaR)
is the expected tail loss. It is the average of the worst 100*(1-α)% of losses. For discrete
distribution, ES is derived as:
1 α
ESα = ∑ (pth loss × probability of pth loss)
1 − α p=0
In other words, to determine the expected shortfall at a level of confidence α, we must find the
average of all the outcomes whose probability is less than or equal to 1 - α.
must find the average of all the outcomes whose probability is less than or equal to 5%
200 × 2.5% + 225 × 2% + 250 × 0.5%

ES0. 95 = = 215 million dollars
5%
must find the average of all the outcomes whose probability is less than or equal to 1%
225 × 0.5% + 250 × 0.5%

ES0. 99 = = 237.5 million dollars
1%
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Q.3398 T he VaR of a loan portfolio is computed at various confidence levels:
Confidence Level VaR

95.0% 2%
95.5% 5%
96.0% 6%
96.5% 7%
97.0% 9%
97.5% 10%
98.0% 13%
98.5% 15%
99.0% 20%
99.5% 30%
What is the expected shortfall at the 97.5% confidence level?
A. 0.1
B. 0.15
C. 0.195
D. 0.2
T he correct answer is C.
T he expected shortfall at the 97.5% confidence level is computed by averaging all value of risk
greater than the 97.5% confidence level.
Expected shortfall at the 97.5% confidence level = (13% + 15% + 20% + 30%)/4 = 19.5%
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Q.3588 Which of the following statement is INCORRECT regarding the efficient frontier?
A. A risk-averse investor will only choose portfolios along the efficient frontier
B. Portfolios that deliver the greatest return on each level of standard deviation make up the
efficient frontier
C. T he graph that shows the efficient frontier has the variance on its Y-axis
D. None of the above
T he statement that the graph showing the efficient frontier has the variance on its Y-axis is
incorrect. In the graphical representation of the efficient frontier, the X-axis typically represents
the standard deviation (a measure of risk), while the Y-axis represents the expected return. T he
efficient frontier is the set of optimal portfolios that offer the highest expected return for a given
level of risk or the lowest risk for a given level of expected return. T herefore, the statement in
choice C is incorrect because it inaccurately describes the axes of the efficient frontier graph.
Choi ce A i s i ncorrect. T his statement accurately describes the behavior of a risk-averse investor.
Such an investor, who prefers to minimize risk for a given level of expected return, will only choose
portfolios along the efficient frontier because these portfolios offer the highest expected return for
each level of risk.
Choi ce B i s i ncorrect. T his statement correctly defines the efficient frontier. T he efficient
frontier comprises those portfolios that provide the maximum possible expected return for each
level of standard deviation (risk). T herefore, this choice accurately represents one of the key
characteristics of the efficient frontier.
Choi ce D i s i ncorrect. As explained above, choices A and B are correct descriptions related to
portfolio theory and investment analysis in terms of efficient frontier concept. Hence, stating that
none of them are accurate does not hold true.
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Q.4639 A hypothetical portfolio has an annual 1% VaR of $45,000. Which of the following statements
is the most l i k el y correct about the portfolio?
A. T he loss over the next year is expected to be at most $45,000 in 1% of the cases.
B. T here is only a 1% chance that we will gain more than $45,000 over the next year.
C. T he likelihood of losing more than $45,000 over the next year is 1%.
D. T he likelihood of losing no more than $45,000 over the next year is 1%.
T he Value at Risk (VaR) metric is a commonly used risk management tool that quantifies the potential
loss that could happen in an investment portfolio over a specified period of time at a given
confidence level. In this case, an annual 1% VaR of $45,000 implies that there is a 1% chance that
the portfolio could experience a loss exceeding $45,000 over the next year. T his is based on the
statistical analysis of historical market trends and volatilities. T he VaR metric is often used by
financial institutions and investment firms to measure the extent of potential losses that could be
incurred in extreme market conditions. T herefore, the statement 'T he likelihood of losing more than
$45,000 over the next year is 1%' accurately reflects the interpretation of the given VaR value.
Choi ce A i s i ncorrect. T he statement is misleading as it suggests that the maximum loss in 1% of
the cases will be $45,000. However, VaR does not provide a maximum loss figure but rather a
minimum loss figure at a certain confidence level.
Choi ce B i s i ncorrect. T his choice incorrectly interprets VaR as a measure of potential gains
rather than potential losses. VaR measures the risk of potential losses, not gains.
Choi ce D i s i ncorrect. T his statement misinterprets VaR by suggesting that there's only 1%
chance of losing no more than $45,000 over the next year which contradicts with the concept of
VaR which states that there's 1% chance we could lose more than $45,000 over next year.
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Q.4640 T he investment returns and the corresponding probabilities are given in the following table:
Returns Probability
20% 0.1
30% 0.3
−10% 0.2
15% 0.3
7% 0.1
What is the standard deviation of the investment returns?
A. 0.142
B. 0.154
C. 0.132
D. 0.138
T he variance of the return R is given by:
V ar (R) = E (R 2 ) − [E (R)]2
Now,
E(R 2 ) = 0.1 × (20%)2 + 0.3 × (30%)2 + 0.2 × (−10%)2 + 0.3 × (15%)2 + 0.1 × (7%)2 = 0.04024
E (R) = 0.1 × 20% + 0.3 × 30% + 0.2 × −10% + 0.3 × 15% + 0.1 × 7% = 0.142
∴ V ar (R) = 0.04024 − (0.142)2 = 0.020076
T hus the standard deviation is given by:
√0.020076 = 0.1417 = 14.17%
Q.4641 An investor invests his funds in two correlated assets, A and B. T he standard deviation of
asset A is 20%, and that of B is 15%. T he portfolio variance is 2.84%. Given that the investor has
three times as much money in asset A than he has in asset B, what is the correlation coefficient
between assets A and B?
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A. 0.0962
B. 0.2133
C. 0.3994
D. 0.8078
T he variance of a portfolio is given by:
σp2 = w 2A σA2 + w 2BσB2 + 2ρw A w BσA σB
Where
W A : the weight of asset A
W B : the weight of asset B
σA : standard deviation of asset A
σB : standard deviation of asset B
ρ: correlation coefficient between asset A and B
Now let the amount invested in asset be B be w B and thus:
w A = 3w B
w B + 3w B = 1
1 3
∴ wB = ⇒ wA =
4 4
Now,
w 2AσA2 + w 2B σB2 + 2ρw A w BσA σB = 0.0284

2 2
3 1 3 1
( ) × 0.2 + ( ) × 0.152 + 2 × × × 0.2 × 0.15 × ρ = 0.0284
2
4 4 4 4
2 2
0.0284 − ( 34 ) × 0.22 − ( 14 ) × 0.152
⇒ρ= = 0.39944
2 × 0.15 × 0.2 × 14 × 34
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Q.4643 T he losses from a portfolio for one year are normally distributed with mean -10 and standard
deviation 20. What is the value of the 99% expected shortfall?
A. 52.85
B. 37.40
C. 42.85
D. 26.43
We know that:
2
− U
⎛ e 2 ⎞
ES = μ + σ ⎜ ⎟
⎝ (1 − X) √2π ⎠
Now, U = Φ−1 (0.99)=2.33
2. 33 2
−
⎛ e 2 ⎞
ES = −10 + 20 ⎜ ⎟ = 42.85
⎝ (1 − 0.99) √2π⎠
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Reading 48: Calculating and Applying VaR
Q.972 After using of the historical simulation method, you have been provided with the following 30
ordered percentage returns for an asset:
[-18, -16, -14, -12, -10, -9, -7, -7, -6, -6, -6, -5, -5, -4, -4, -4, -2, -1, 0, 0, 2, 3, 6, 12, 12, 13, 15, 15, 18, 28]
T he value-at-risk (VaR) and expected shortfall (ES), at 90% confidence level, respectively, are
closest to:
A. Var: 14; ES: 17
B. Var: 14; ES: 16
C. Var: 12; ES: 16
D. Var: 12; ES: 24
VaR can be calculated as the [(1 − 0.9) × 30] = 3rd worst observation, which is -14 and hence the VaR
is 14.
T he ES is the arithmetic average of losses that are worse than the VaR. T hus,
(18 + 16)
ES = = 17
2
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Q.973 Stuart Broad, a risk analyst working with Macquarie Bank compiles data of 100 simulated
percentage returns of the bank’s assets:
[-13.33, -12.25, -11.75, -10.66, -8.45, -7.13, -6.48, -5.29 ... 2.89, 3.56, 4.29, 5.38, 6.65, 7.89, 8.54, 9.64,
10.27, 12.28, 13.25]
Using the data, he calculates the expected shortfall (ES) and the value at risk (VAR) of the bank’s
assets at the 95 percent confidence level using the historical simulation method. What is the
expected shortfall and the value at risk computed by Stuart Broad?
A. Expected shortfall: 12; Value at Risk: 9.45
B. Expected shortfall: 11.49; Value at Risk: 9.95
C. Expected shortfall: 12; Value at Risk: 8.45
D. Expected shortfall: 11.49; Value at Risk: 8.45
VaR can be calculated as the [(1 − 0.95) × 100] = 5th worst observation, which is -8.45 and hence the
VaR is 8.45.
13.33 + 12.25 + 11.75 + 10.66

ES = = 12
4
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Q.982 ANC National Bank handles a portfolio of assets amounting to USD 150 million. Antony Smith,
a risk analyst, analyzes the portfolio and observes that the returns are independently identically
normally distributed. T he annual standard deviation of the portfolio is 0.55. What is the 20 day-Value
at Risk at 95 percent confidence assuming 250 trading days in a year?
A. USD 51.92 million
B. USD 38.50 million
C. USD 53.67 million
D. USD 71.50 million
V aR = Z × standard deviation × portfolio amount

Annual VaR = 1.65 × 0.55 × 150, 000, 000 = 136, 125, 000
Var (T days) = 1-day VaR × √T … … . formula
Annual VaR
1-day VaR = = $8, 609, 300
√250
20-day VaR = (1-day VaR) × √20 = $38, 501, 694
It’s the standard deviation, σ, that determines where you start. If the σ given is annual, you’ll start by
calculating the annual VaR and then use the square root of the time rule to come up with VaR for
shorter periods. Similarly, if given the daily σ, compute the 1-day VaR and then convert that
appropriately.
Below is the standard normal table to use for this question:
STANDARD NORMAL TABLE pdf
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Q.1146 All the following are false with regards to Worst Case Scenario (WCS) measure, EXCEPT :
A. WCS indicates the number of times portfolio loss exceeds a given limit over a given
period.
B. WCS indicates the maximum a portfolio can lose over a given period.
C. WCS indicates the probability of losing a given limit over a given period.
D. WCS indicates the minimum a portfolio can lose over a given period.
T he Worst Case Scenario (WCS) measure indeed indicates the maximum a portfolio can lose over a
given period. T his measure is used to assess the potential losses in a portfolio under extreme market
conditions. It is a critical tool in financial risk management as it helps in preparing for severe market
downturns and ensuring that risk management strategies are robust enough to withstand such
scenarios. T he WCS measure is often used by portfolio managers and risk analysts to estimate the
maximum loss that a portfolio could incur over a specified period. T his measure is particularly useful
in stress testing, where it is used to evaluate the resilience of a portfolio to extreme market events.
T he WCS measure is based on historical data and uses statistical techniques to estimate the
maximum possible loss. However, it is important to note that the WCS measure is a statistical
estimate and, like all estimates, it is subject to uncertainty and should be used with caution.
Choi ce A i s i ncorrect. T he Worst Case Scenario (WCS) does not indicate the number of times
portfolio loss exceeds a given limit over a given period. T his description is more aligned with the
concept of Value at Risk (VaR), which quantifies the level of financial risk within a firm or
investment portfolio over a specific time frame.
Choi ce C i s i ncorrect. WCS does not indicate the probability of losing a given limit over a given
period. T his statement confuses WCS with Probability of Default (PD), which measures the
likelihood that a borrower will default on his financial obligations.
Choi ce D i s i ncorrect. WCS does not indicate the minimum loss in portfolio value over a specified
period, but rather it indicates maximum potential loss that could occur in worst conditions.
23
Q.1147 Plain vanilla European options and forwards are good examples of:
A. Linear derivatives.
B. Nonlinear derivatives.
C. A nonlinear and linear derivative, respectively.
D. A linear and nonlinear derivative, respectively.
A plain vanilla European option is a nonlinear derivative, while a forward is a linear derivative. T he
value of a linear derivative, such as a forward, is directly related to the market price of the
underlying asset. If the underlying asset's price changes, the value of the derivative moves in a
nearly identical margin. T his is why linear derivatives are often referred to as 'delta-one' products.
However, the delta itself need not always be equal to 1. Futures and forwards are examples of linear
derivatives. On the other hand, a nonlinear derivative's value/payoff changes with time and other
variables. T his includes the location of the strike/exercise price with respect to the spot/current
price, interest rates, dividends, or even volatility. For nonlinear derivatives, the delta is not constant
and changes with the change in the underlying asset. Examples of nonlinear derivatives include the
Vanilla European option, Vanilla American option, Bermudan option, etc. T herefore, a plain vanilla
European option is a nonlinear derivative, and a forward is a linear derivative.
Choi ce A i s i ncorrect. Plain vanilla European options and forwards cannot be categorized as linear
derivatives. Linear derivatives have a linear payoff structure, meaning the change in the derivative's
value is directly proportional to the change in the underlying asset's price. However, this is not true
for plain vanilla European options which have a nonlinear payoff structure.
Choi ce B i s i ncorrect. While it's true that plain vanilla European options are nonlinear derivatives
due to their variable payoff structure, forwards are not. Forwards are considered linear derivatives
because their value changes proportionally with changes in the underlying asset's price.
Choi ce D i s i ncorrect. T his choice incorrectly categorizes plain vanilla European options as linear
and forwards as nonlinear which contradicts with their actual characteristics explained above.
24
Q.2616 Arthur Bell is the portfolio manager at FFF Investments. Recently, he bought 5,000 call
options on stocks of one of the local growth-oriented oil refining companies that have never paid
dividends. T he strike price of the options was $50. T he underlying stock is trading at $58 and has an
annual volatility of return of 33%. Bell estimated the delta of these options to be 0.55. What is the
approximate weekly (delta normal) 99% VaR of the position assuming 52 trading weeks in the year?
A. $7,725.57
B. $17,007
C. $6,659.97
D. $14,661.22
In the delta-normal approach, we first calculate the VaR of the underlying. T hen, we use the equation
below to revalue the derivative by linear approximation (as the delta multiplied by the VaR of the
underlying):
VaR derivative = Δ × VaR underlying

VaR of the underlying (stock) = σ × zcl% × market value
But first, we have to convert the annual volatility, i.e., σ, into a weekly value:
Annual volatility = weekly volatility × √52
(33%)
T hus, weekly volatility = = 0.045763
√52
VaR of the underlying = 0.045763 ∗ 2.33 ∗ $58 = $6.18438

VaR of call option = 0.55 ∗ $6.18 = $3.40
VaR of 5,000 call options = $3.40 × 5, 000 = $17,007
Note: 2.33 is the standard normal deviate at a 99% confidence level.
25
Q.2618 An investor is long at a short-term portfolio of at-the-money put options on an underlying
asset. T he notional value of the portfolio is $100,000. Assuming that there is one risk factor with a
corresponding delta of 0.5, what is the amount of change in the portfolio if the value of the
underlying asset changes by 12.5%?
A. $5,500.
B. $6,250.
C. $6,520.
D. $7,500.
T he change in the portfolio value arising from the change in a risk factor is
ΔP = δΔS
Where
ΔP = change on the portfolio
δ = Delta corresponding to a risk factor
ΔS = change in the underlying asset
T hus in this case we have:
ΔP = 0.5 × 0.125 × 100, 000 = 6, 250
26
Q.2619 After a significant increase in the volatility of shares of USY Pharma, Ross Grand, senior
portfolio manager, decides to hedge the existing position by buying 300 at-the-money call options.
Shares of USY are trading at $457 and the daily VaR of the underlying at 99% confidence is $42.59.
What is the daily 99% VaR of the options position using the delta-normal method?
A. $3,457.99
B. $5,791.77
C. $4,524.05
D. $6,388.50
T he key point here is that the call options are at the money, so we can assume delta = 0.5. (See the
note at the end of the explanation if this is unclear.)
According to the delta-norma method,
VaR of an option = Delta × VaR of underlying

VaR of the position = 0.5 ∗ $42.59 ∗ 300 options = $6, 388.50
Note: At-the-money call options typically have a delta of 0.5, and the delta of out-of-the-money call
options approaches 0 as expiration nears. T he deeper in-the-money the call option, the closer the
delta will be to 1, and the more the option will behave like the underlying asset. Since the delta of an
option ranges between 0 and 1, an at-the-money option is right in between those two numbers.
For put options, at-the-money put options typically have a delta of -0.5, and the delta of out-of-the-
money call options approaches 0 as expiration nears. T he deeper in-the-money put option, the closer
the delta will be to -1.
27
Q.2623 Ashli More prepares a presentation to the management board on the application of
derivatives for hedging risk. She struggles with the classification of linear and non-linear derivatives.
Which of the following is an example of linear derivatives?
A. Futures on stocks, forwards on broad market indices, and plain vanilla European options
on bonds.
B. Interest rate swaps, interest rate caps, and plain vanilla American options on stocks.
C. Futures on broad market indices.
D. Futures on stocks and swaptions.
Futures on broad market indices are considered linear derivatives. T his is because the payoff of a
futures contract is linear in nature, meaning it changes proportionally with the changes in the
underlying asset. In other words, if the price of the underlying asset increases, the value of the
futures contract also increases proportionally, and vice versa. T his characteristic makes futures
contracts linear derivatives. Broad market indices are a common underlying asset for futures
contracts, making futures on broad market indices a typical example of linear derivatives.
Choi ce A i s i ncorrect. While futures on stocks and forwards on broad market indices are
examples of linear derivatives, plain vanilla European options on bonds are not. Options, whether
they are European or American, call or put, are non-linear derivatives because their payoff is not
directly proportional to the underlying asset's price movement.
Choi ce B i s i ncorrect. Interest rate swaps can be considered as linear derivatives as their value
changes in proportion with the underlying interest rate. However, interest rate caps and plain vanilla
American options on stocks are non-linear derivatives due to their asymmetrical payoff structure.
Choi ce D i s i ncorrect. Futures on stocks can be classified as linear derivatives but swaptions
cannot be classified under the same category. Swaptions give the holder the right but not obligation
to enter into a swap agreement in future which makes them a type of option and hence a non-linear
derivative.
28
Q.2625 T he investment division of a bank is considering an investment of $100,000,000 in one of the
following:
stocks of ALPHA Plc
stocks of APPA Corporation
20-year bonds of APPA Corporation
Although the department seeks the investment with the highest expected return, to comply with
bank’s risk policies, the department cannot open a position with a daily 99% VaR higher than
$6,000,000.
T he investment opportunities presented above have the following features:
Expected Annual Expected annual Modified Market Price

Return volatility of returns Duration
Stocks of ALPHA 20% 50% − $5 per stock
Stocks of APPA 13% 36% − $30 per stock
Bonds of APPA 8% 10% 3.5 99% per $100 nominal
Assuming zero daily returns and 252 trading days per year, which investment should the bank choose?
A. Stocks of ALPHA
B. Stocks of APPA
C. Bonds of APPA
1
VaR of ALPHA's stocks = 50% × × 2.33 × $100, 000, 000 = $7, 338, 810.18
√252
1
VaR of APPA's stocks = 36% × × 2.33 × $100, 000, 000 = $5, 283, 943.33
√252
1
VaR of APPA' s bond = 10% × × 2.33 × $100, 000, 000 = $1, 467, 762.036
√252
Both the APPA's bond and APPA's stock have a VaR lower than $6, 000, 000, but the bank should
choose to invest in APPA's stock since it has a higher return than APPA's bond.
29
Q.2626 T wo managers - X and Y - are looking to establish the 1-day VaR for a long position in an at-
the-money call option on a non-dividend-paying stock with the following information: Current stock
price: USD 100
Estimated annual stock return volatility: 15%
Current Black-Scholes-Merton call option value: USD 4.80,
Call option delta: 0.5
To compute VaR, manager X uses the delta-normal model, while manager Y opts for the Monte Carlo
simulation method for full revaluation. Which manager will estimate a higher value for the 1-day 99%
VaR?
A. Manager Y.
B. Manager X.
C. Both managers will have the same VaR estimate.
D. Insufficient information to determine.
Manager X, who uses the delta-normal model, will estimate a higher value for the 1-day 99% VaR.
T his is because options are nonlinear derivatives, meaning their value is related to the market price
of the underlying variable in a convex, non-linear relationship. T he payoff of such products varies
not only with the value of the underlying, but also with other elements such as interest rates,
volatility, and dividends. T he option’s price function is convex with respect to the value of the
underlying. For such a non-linear portfolio, the delta-normal model provides only a linear
approximation which does not capture the positive effect of this curvature on the portfolio value. It
understates the probability of high option values and overstates the probability of low option values.
T herefore, for a long position in the call option, VaR and the expected shortfall under the delta
normal model will be extremely high. On the other hand, for a short position in the call option, the
VaR and the expected shortfall under the delta-normal model will be extremely low.
Choi ce A i s i ncorrect. Manager Y, who uses the Monte Carlo simulation method for full
revaluation, is not likely to estimate a higher value for the 1-day 99% VaR. T his method takes into
account all possible price paths and their associated probabilities, which includes both large and small
changes in the option's value. T herefore, it tends to produce a more conservative (lower) VaR
estimate compared to the delta-normal model.
Choi ce C i s i ncorrect. Both managers will not have the same VaR estimate because they are using
30
different methods of calculation. T he delta-normal model used by Manager X assumes that returns
are normally distributed and only considers linear risks such as delta risk. On the other hand, Monte
Carlo simulation used by Manager Y considers all types of risks including non-linear risks such as
gamma and vega risk.
Choi ce D i s i ncorrect. T here is sufficient information to determine which manager will likely
estimate a higher value for 1-day 99% VaR based on their chosen methods of calculation.
31
Q.2627 Which of these statements regarding the Structured Monte Carlo (SMC) simulation is
INCORRECT ?
A. T he SMC uses any distribution for the risk factors.
B. T he SMC assumes that distributions used in the simulation are relevant going forward.
C. T he SMC can generate correlated scenarios for multiple risk factors based on
corresponding statistical distributions.
D. Increasing the number of SMC simulations will always improve the outcome of the
simulation.
T he statement 'Increasing the number of SMC simulations will always improve the outcome of the
simulation' is incorrect. While it is true that increasing the number of simulations can often lead to
more accurate results, this is not always the case. T he accuracy of SMC simulations is not solely
dependent on the number of simulations. T he relevance of the assumed distributions and their
parameters also play a crucial role in the reliability of the simulation outcomes. If the assumed
distributions or their parameters are no longer relevant, increasing the number of simulations will
not necessarily improve the outcome. In fact, it could lead to misleading results. T herefore, it is
essential to ensure that the distributions and their parameters used in the SMC simulation are
relevant and up-to-date.
Choi ce A i s i ncorrect. T he SMC does indeed use any distribution for the risk factors, as long as it
accurately represents the statistical characteristics of those risk factors. T his flexibility is one of
the strengths of SMC, allowing it to model a wide range of scenarios.
Choi ce B i s i ncorrect. It's true that SMC assumes that distributions used in the simulation are
relevant going forward. T his assumption is inherent in most statistical models and simulations, not
just SMC.
Choi ce C i s i ncorrect. One of the key features of SMC is its ability to generate correlated
scenarios for multiple risk factors based on their corresponding statistical distributions. T his allows
for a more realistic representation of potential outcomes in complex financial systems where
various risk factors often interact with each other.
32
Q.3305 Bank A manages interest rate risk by monitoring the VaR using historical data. Bank A collects
interest rate returns for 300 days and the data is sorted ascendingly. T he lowest 10 interest rate
returns are -4.2%, -4.0%, -3.8%, -3.2%, -3.0%, -2.5%, -2.3%, -2.2%, -2.0%, -1.7%. After 30 days, Bank
A collects 30 more data points. However, none of these returns is less than -1.7%. What is the
change in the 98% VaR as compared to the prior 30 days, assuming that all of the lowest 10
observations are still within the 300-day long historical window?
A. Unchanged.
B. VaR has increased by 0.01%.
C. VaR has increased by 0.08%.
D. VaR has increased by 0.11%.
In general, if there are n ordered observations, and a confidence level cl%, the cl% VaR is given by
the [(1 − cl%) n ]th highest observation. T his is the observation that separates the tail from the body
of the distribution. For instance, if we have 1,000 observations and a confidence level of 95%, the
95% VaR is given by the (1 – 0.95)1,000 = 50st observation. T here are 50 observations in the tail.
Given this information, the 98% VaR, given that n = 300 is:
98% VaR = [(1 - 0.98)300 th value = 6th highest observation
T hus, VaR = -2.5%
One important note about this method is that the length of the historical window is fixed, i.e., the
oldest observations exit the window as new observations are made. In this case, however, 30 more
days have now elapsed (meaning that we have 30 new observations) but there hasn't been a loss big
enough to dislodge any of the worst 10 observations made, which we assume are still within the
historical window of 300 observations. As such, the 98% VaR will sti l l be the 6th highest
observation which happens to be -2.5%. In short, the VaR remains unchanged.
33
Q.3307 Bank A manages interest rate risk by monitoring the VaR calculated using historical data. Bank
A collects interest rate returns for 300 days and the data is sorted ascendingly. T he lowest 10
interest rate returns are -4.2%, -4.0%, -3.8%, -3.2%, -3.0%, -2.5%, -2.3%, -2.2%, -2.0%, -1.7%.
Calculate the 98% VaR.
A. -2.0%
B. -2.2%
C. -2.5%
D. -2.4%
In general, if there are n ordered observations, and a confidence level cl%, the cl% VaR is given by
the [(1 – cl%)n ]th highest observation. T his is the observation that separates the tail from the body
of the distribution. In this case, we have 300 observations and a confidence level of 98%; the 98%
VaR is given by the (1 – 0.98)300 = 6th observation, that's 2.5%
34
Q.3313 An option on the INMEX (Mexican) stock index is struck on 2,522 pesos. T he delta of the
option is 0.6, and the annual volatility of the index is 25%. Using delta-normal assumptions, what is
the 10-day VaR of the option at the 95% confidence level? Assume 260 days per year.
A. 204 pesos
B. 61.0 pesos
C. 115.8 pesos
D. 122.4 pesos
As per the delta-normal method, the VaR of a derivative position is given by:
V aR Derivative = Delta × V aR Underlying risk factor
T hus, the first step is to determine the VaR of the underlying rsk factor. i.e., the index. But before
that, notice that the question asks for the 10-day VaR, which means it is important that we work out
the 1-day VaR and then use the square root of time rule:
T-day volatility = 1-day Volatility × √T

260-day volatility = 1-day volatility × √260
260-day volatility 0. 25
T hus, 1-day volatility = = = 0.0155
√260 √260
Hence,
1-day VaR of the underlying = 2,522 × 0.0155 × 1.65 = 64.5 pesos

10-day VaR = 1-day VaR × √(10) = 64.5 × √(10) = 204 pesos
Finally,
V aR Derivative = Delta × V aR Underlying risk factor

= 0.6 × 204 = 122.4 pesos
Note that this questions mixes concepts from the chapters Calculating and Applying VaR and
Measuring and Monitoring Volatility.
35
Q.3314 A futures contract on the S&P 500 is defined as a dollar multiple of the index level. T he S&P
500 future traded on the Chicago Mercantile Exchange is defined as a $250 index. T he 1% VaR of the
S&P 500 index is 2.45. What is the 1% VaR of the S&P 500 futures contract?
A. $61.25
B. $512.50
C. $612.50
D. $1,225
Since we already know that the 1% VaR of the S&P 500 index is 2.45, to find the 1% VaR of the S&P
500 futures contract, we simply multiply the contract value by the 1% VAR:
($250 × 2.45 = $612.50).
36
Q.3316 Consider a non-linear portfolio that depends on a share price. Given that delta and gamma of
the portfolio are 20 and 2.5, respectively. All else constant, what is the corresponding portfolio
change to a stock price increase of $ 0.5?
A. $ 9.45
B. $ 10.63
C. $ 9.38
D. $ 10.31
Given the delta and gamma of a portfolio, the change in portfolio is given by :
1
ΔP = δΔS + γ(ΔS)2
2
Where
δ = Delta
ΔS = Change in the share price
γ = Gamma
ΔP = Change in portfolio value. T hus,
1
ΔP = 20 × 0.5 + × 2.5 × 0.52 = 10.3125
2
37
Q.3318 You have been asked to estimate the VaR of GreenWood Corp. T he company’s stock is
currently trading at USD 308 and the stock has a daily volatility of 1.25%. Using the delta-normal
method, the VaR at the 95% confidence level of a long position in an at-the-money put on this stock
with a delta of -0.5 over a 1-day holding period is closest to:
A. USD 3.12
B. USD 2.15
C. USD 3.167
D. USD 4.52
In the case of a linear derivative, VaR scales directly with the underlying risk factor, i.e.,
V aR linear derivative = Δ × V aR underlying risk factor

V aR = Δ × 1.645 × σ × S0 = 0.5 × 1.645 × 0.0125 × 308
= 3.1666
Note: Just as the question dictates, this is an estimate: the accurate relationship is non-linear and we
are actually omitting the curvature (option gamma). Also, we ignore the negative sign in the solution
since a negative amount is implied.
Note 2: T his question mixes concepts from the chapters Calculating and Applying VaR and Measuring
and Monitoring Volatility.
38
Q.3320 A market risk manager has gathered historical P&L data for his financial institution over the
last 100 days. He intends to determine the VaR and the conditional VaR (CVaR) at 90% level of
confidence using the historical simulation method. T he worst 15 observation gathered (in million
CAD) are:
[-25, -27, -27, -28, -30, -32, -36, -38, -40, -43, -45, -52, -56, -58, -60]
Calculate the VaR and the conditional VaR (CVaR).
A. VaR = 30; Conditional VaR = 46.
B. VaR = 32; Conditional VaR = 47.6.
C. VaR = 36; Conditional VaR = 47.6.
D. VaR = 32; Conditional VaR = 46.
We arrange the data in ascending order first:
-60, -58, -56, -52, -45, -43, -40, -38, -36, -32, -30, -28, -27, -25
VaR can be calculated as the [(1 - 0.9) × 100] = 10th worst observation, which is -32 and hence the
VaR is 32.
Conditional VaR is simply another name for the expected shortfall. T he ES is the arithmetic average
of losses that are worse than the VaR. T hus,
(60 + 58 + 56 + 52 + 45 + 43 + 40 + 38 + 36)
ES = = 47.6
9
Note: Refer to table 2.3 of your chapter for proof.
39
Q.3394 A liquid asset K has a profit/loss distribution that’s independent and identically distributed.
T he position has a one-day VaR of $50,000 at the 95% level of confidence. Estimate the 10-day VaR of
the same position at the 99% level of confidence.
A. $115,114
B. $70,000
C. $223,570
D. $200,000
T he first step should be to convert the one-day VaR at 95% to a one-day VaR at 99%.
To do this, recall that:
V aR 95% uses the upper 5% point of the normal distribution, i.e., 1.645
And the V aR 99% uses the upper 1% point of the normal distribution, i.e., 2.326
T herefore, to convert the one-day VaR at 95% to a one-day VaR at 99%, we must multiply the former
by a scale of 2. 326
1. 645
2. 326
One-day V aR 99% = × $50, 000 = $70, 699
1. 645
Next, recall that:
V aR (T days) = V aR (1 day) × √T
T herefore,
V aR 10 days = $70, 699 × √10 = $223, 569.87
40
Q.3395 Peter McLeish is a risk analyst at Quantum Bank. After estimating the 99%, one-day VaR of
the bank’s portfolio using historical simulation with 900 past days, he is concerned that the VaR is
providing too little information on tail losses. He embarks on a deeper examination of simulation
results. Sorting the simulated daily P&L from worst to best, he constructs the following table:
P & L Rank 1 2 3 4 5
−2, 000 −1, 860 −1, 800 −1, 720 −1, 630
P & L Rank 6 7 8 9 10
−1, 500 −1, 400 −1, 310 −1, 260 −1, 190
P & L Rank 11 12 13 13 15
−1, 110 −1, 050 −990 −820 −750
Determine the 99%, one-day expected shortfall of the portfolio:
A. 1,260
B. 1,653
C. 1,190
D. 1,609
When dealing with discrete data, let's first find the VaR. VaR can be calculated as the [(1 - 0.99) ×
900] = 9th worst observation, which is -1,260 and hence the VaR is 1,260.
ES = (2,000 + 1,860 + 1,800 + 1,720 + 1,630 + 1,500 + 1,400 + 1,310)/8 = 1,652.50
41
Q.4665 Which of the following is NOT true about the historical simulation method of estimating VaR?
A. T his method estimates VaR by using a lookback period.
B. T his method assumes that the past performance of a portfolio is a good indicator of the
near future.
C. T his method assumes asset price returns and volatility follow a normal distribution.
D. T his method involves reorganizing actual historical returns from worst to best.
Unlike the Monte Carlo and the parametric methods, the historical simulation method does not need
any distributional assumptions to estimate VaR as it uses historical data to perform the estimation.
Opti on A i s i ncorrect: T he historical simulation method's VaR estimates depend on the lookback
period and, thus, forecasts are highly dependent on the sample data features. T his is the major
drawback of the method.
Opti on B i s i ncorrect: T he historical simulation method assumes that the past performance of a
portfolio is a good indicator of the near future.
Opti on D i s i ncorrect: T he historical simulation method involves reorganizing actual historical
returns by putting them in order (from worst to best) and then assuming that the trend will repeat
itself from a risk perspective.
42
Q.4667 T he following are hypothetical ten worst returns for stock T GB from 120 days of data. Find
the 1-day 95% VaR and expected shortfall, respectively. -15.72%, -10.92%, -6.50%, -3.56%, -6.90%,
-2.50%, -5.30%, -4.31%.,-12.12%, -3.45%,
A. 0.053, 0.1043
B. 0.0431, 0.0958
C. 0.0431, 0.1149
D. 0.0431, 0.053
First, we rearrange starting with the worst day to the least bad day, as shown below:
-15.72%, -12.12%, -10.92%, -6.90%, -6.50%, -5.30%, -4.31%, -3.56%, -3.45%, -2.50%.
In this case, the VaR corresponds to the (5%×120)=6th worst day: -5.30%.
T his implies ES is equivalent to an average of the 5 worst returns:
(−15.72% + −12.12% + −10.92% + −6.90% + −6.5%)

ES = = −10.43%
5
43
Q.4668 Consider a linear portfolio consisting of short positions in 50 shares, each worth USD 10, and
a long position in 150 shares each worth USD 25. What is the relative portfolio change (in USD) of
the portfolio if the price of all shares increases by 2%?
A. 85
B. -85
C. 65
D. -65
T he change in a linear portfolio is given by:
ΔP = ∑ ni ΔSi
i
Where
ni: number of shares of stock i in the portfolio (negative for a short position)
Si: Price of stock i
So,
ΔP = [−50 × (0.02 × 10)] + [150 × (0.02 × 25)]

= −10 + 75 = 65
So the change in the portfolio is an increase of USD 65.
44
Q.4670 Given that the one-day standard deviation of a portfolio is 90, what is the 10-day VaR with a
99% confidence level according to the delta-normal model?
A. 604
B. 505
C. 662
D. 645
According to the delta-normal model, we can assume that the mean change in risk factor is zero for a
short period of time so that VaR is given by:
V aR = σP U
Where
σP : standard deviation of the portfolio
U : point on the normal distribution where X is exceeded
In this case, σP =90 and U =-2.326 and thus VaR is given by:
90 × −2.326 = −209.340
We know that:
V aR (T , X) = √T × V aR (1, X )
T hus the 10-day VaR is given by:
√10 × −209.340 = −661.99
45
Q.4671 Given that the standard deviation of portfolio change is 90, what is the 10-day expected
shortfall with a 99% confidence level according to the delta-normal model?
A. 640
B. 759
C. 650
D. 749
According to the delta-normal model, for a short period of time, we can assume that the mean change
in risk factor is zero so that VaR is given by:
2
− U
⎛ e 2 ⎞
ES = σP ⎜ ⎟
⎝ (1 − X) √2π ⎠
Where
σP : standard deviation of the portfolio
In this case, σP =90 and U =2.326 and thus ES is given by:
(2. 326)2
⎛ e− 2 ⎞
ES = 90 ⎜⎜ ⎟⎟ = 240.0635
⎝ (1 − 0.99) √2π⎠
But we know that:
ES (T , X) = √T × ES (1, X)
T hus the 10-day ES is given by:
√10 × 240.06 = 759.1473 ≈ 759
46
Q.4674 In the context of the delta-normal model, which of the following statements is true?
I. T he delta-normal approach assumes that there is a linear relationship between the portfolio
changes and risk factor changes.
II. T he delta normal approach does not consider the curvature of the relationship between the
portfolio value and the corresponding risk factors.
III. Compared to other VaR computation methods, the delta-normal approach is more accurate
since it is easily calculated and assumes a normal distribution.
A. I and II
B. II only
C. III only
D. I and III
Statements I and II accurately describe the characteristics and assumptions of the delta-normal
model. T he delta-normal approach assumes a linear relationship between changes in portfolio value
and changes in risk factors. T his assumption works well for linear portfolios, but it is an
approximation for non-linear portfolios. T he equation for this relationship is represented as:
ΔP = ∑ ai x i
i
Δsi
Where when percentage changes are used, ai = and x i = δix i and where actual changes are
si
considered ai = ΔSi and x i = δi. T his equation works well with linear portfolios, but it is an
approximation to non-linear portfolios.
Statement II is also correct. T he delta-normal approach does not consider the curvature of the
relationship between the portfolio value and the corresponding risk factors. T his is a limitation of
the model as it may not accurately reflect the risk in portfolios with non-linear relationships
between portfolio value and risk factors.
Choi ce B i s i ncorrect. While it is true that the delta-normal model does not account for the
curvature in the relationship between portfolio value and associated risk factors, this choice only
47
includes statement II. However, statement I also accurately reflects a characteristic of the delta-
normal model, which presumes a linear relationship between changes in portfolio value and changes
in risk factors.
Choi ce C i s i ncorrect. Statement III suggests that compared to other VaR computation methods,
the delta-normal model is more accurate due to its ease of calculation and assumption of a normal
distribution. T his statement is misleading as accuracy isn't necessarily guaranteed by ease of
calculation or an assumption of normal distribution. In fact, these assumptions can lead to
inaccuracies if actual market conditions deviate from these assumptions.
Choi ce D i s i ncorrect. T his choice includes statements I and III but excludes statement II which
correctly describes one limitation of the delta-normal model - it does not account for curvature
effects (non-linear relationships). Furthermore, as explained above, statement III doesn't accurately
reflect characteristics or assumptions related to accuracy inherent in using the delta-normal method.
48
Q.4675 A risk manager conducts 500 historical simulations to calculate one day, 99% VaR. Which of
the following describes the value of VaR in this case?
A. VaR would be the fifth-worst loss.
B. VaR would be the average of first, second, third, and fourth-worst losses.
C. VaR would be the sixth-worst loss.
D. VaR would be the average of the fifth and sixth loss.
Value at Risk (VaR) is a statistical technique used to measure and quantify the level of financial risk
within a firm or investment portfolio over a specific time frame. In this case, the risk manager is
calculating the one-day, 99% VaR using 500 historical simulations. T his means that the VaR would be
the fifth-worst loss. T his is because when the losses are ordered in descending order, the fifth-worst
loss (which is equivalent to 1% of 500) would represent the VaR. T his value represents the
maximum loss that the financial institution could experience with a 99% confidence level over a one-
day period.
Choi ce B i s i ncorrect. T he Value at Risk (VaR) is not calculated as the average of the first,
second, third, and fourth-worst losses. VaR represents a measure of risk that quantifies potential
losses within a certain confidence level over a specific time horizon. In this case, with 500
simulations and a 99% confidence level, the VaR would be represented by the fifth-worst loss out of
all simulations.
Choi ce C i s i ncorrect. T he VaR would not be represented by the sixth-worst loss in this scenario.
As mentioned above, given 500 simulations and a 99% confidence level, it's the fifth-worst loss that
represents the one-day VaR for this financial institution.
Choi ce D i s i ncorrect. T he calculation of VaR does not involve averaging any set of worst losses -
in this case, it's not an average of fifth and sixth worst losses. It's simply represented by one single
data point - here being the fifth-worst loss from all simulations.
49
Q.4676 T he 100-day 99% VaR for a portfolio is 50. What is the corresponding 250-day 99% VaR?
A. 80.54
B. 65.25
C. 79.06
D. 78.54
Using the formula
V aR (T , X) = √T × V aR (1,X )
V aR (T , X)
⇒ VaR (1, X) =
√T
We, therefore, need first to calculate the one-day 99% VaR and then translate it to 250-day VaR
50
V aR (250, 99%) = √250 × [ ] = 79.06
√100
50
Q.4677 A risk manager realizes over a period of one month, a portfolio he manages increased by USD
5 when the stock price increased by USD 0.1.What is the value of portfolio delta?
A. 30
B. 50
C. 40
D. 20
Greek letter deltas (δ) is defined as:
ΔP
δ=
ΔS
Where ΔS is a small change in risk factors such as stock price and ΔP the corresponding change in
the portfolio value.
So,
5
δ= = 50
0.1
Q.4678 A risk manager estimates 10-day 95% VaR using the delta-model to be USD 50. What is the
corresponding one-day expected shortfall at a 95% confidence level?
A. 66.78
B. 56.78
C. 19.82
D. 94.56
Since we are dealing with a short time period, then:
51
V aR = σP U
2
− U
⎛ e 2 ⎞
ES = σP ⎜ ⎟
⎝ (1 − X) √2π ⎠
X: confidence level
σP :standard deviation of the portfolio change
From the question, we are given that the 10-day 95% VaR is 50, and thus one-day VaR is given by:
50
= 15.81
√10
We have X=95%, then U = 1.645.
⇒ 15.81 = σP × 1.645
15.81
σP = = 9.612
1.645
T herefore, the ES is given by:
2
− U 1. 6452
⎛ e 2 ⎞ ⎛ e− 2 ⎞
ES = σP ⎜ ⎟ = 9.612 ⎜ ⎟ = 19.8220
⎝ (1 − X) √2π ⎠ ⎝ (1 − 0.95) √2π⎠
52
Q.4679 Correlation breakdown is a condition wherein periods of high volatility; correlations tend to
be different as compared to normal market conditions. What implication does the correlation
breakdown has on VaR and ES?
A. Calculation of VaR and ES should concentrate on what happens in extreme market

conditions.
B. Calculation of VaR and ES should concentrate on what happens in normal market

conditions.
C. Calculation of VaR and ES should concentrate on what happens in both normal and extreme
market conditions.
In the context of financial risk management, the phenomenon of correlation breakdown is observed
during periods of high market volatility, where correlations deviate from their usual patterns seen
under normal market conditions. Given this scenario, what should be the primary focus when
calculating Value at Risk (VaR) and Expected Shortfall (ES), two key measures used in risk
management?
Q.4680 Risk factors in a historical simulation of calculating VaR are divided into those where
percentage change in the past is used to determine a percentage in the future and those where the
actual change in the past is used to define the actual changes in the future. Which of the following
risk factors are NOT in the same group?
I. Interest rates and credit spreads

II. Exchange rates and stock prices
III. Interest rates and exchange rates
IV. Stock prices and credit spreads
A. I, II and III
B. III and IV
C. II and IV
D. I and III
53
Risk factors in VaR calculations using historical simulation are divided into two categories. T he first
category includes those where the past percentage change is used to predict future percentage
changes. T his category includes risk factors such as exchange rates and stock prices. T he second
category includes those where the actual change in the past is used to predict actual changes in the
future. T his category includes risk factors such as interest rates and credit spreads.
Given this classification, the pairs of risk factors in Choice B (III and IV) do not belong to the same
category. Interest rates and exchange rates (III) belong to different categories, as do stock prices and
credit spreads (IV).
Choi ce A i s i ncorrect. Interest rates and credit spreads (I) both belong to the same category as
they are typically modeled using percentage changes. Similarly, exchange rates and stock prices (II)
also belong to the same category as they are usually modeled using actual changes. Lastly, interest
rates and exchange rates (III) do not belong to the same category; however, this does not make
choice A correct because it includes pairs that do belong in the same category.
Choi ce C i s i ncorrect. Exchange rates and stock prices (II) are typically modeled using actual
changes, so they do fall into the same category. Stock prices and credit spreads (IV), on the other
hand, do not fall into the same category; however, this does not make choice C correct because it
includes a pair that does belong in the same category.
Choi ce D i s i ncorrect. Interest rates and credit spreads (I) both use percentage changes for
modeling purposes so they fall into one group while interest rates and exchange rates (III), despite
having interest rate common between them, don't fall into one group due to different modeling
methods used for each of them i.e., percentage change vs actual change respectively.
54
Q.4681 You have been given the following 30 ordered percentage returns of an asset:
[-18,-16,-14,-12,-10,-9,-7,-7,-6,-6,-6,-5,-5,-4,-4,-4,-2,-1,0,0,2,3,6,12,12,13,15,15,18,28] What is the
expected shortfall at a 90% confidence level?
A. 16
B. 17
C. 18
D. 17.5
To locate the 10%, we take the third-worst return (=(1-0.90)*30), which is -14. However, recall that
VaR need not be represented as a negative.
T he ES is the arithmetic average of losses beyond 90%. T hus,
18 + 16
ES = = 17
2
55
Reading 49: Measuring and Monitoring Volatility
Q.535 Consider the following statements regarding the estimation of volatility:

I. Under the EWMA model, the weights attached to observations decrease following an exponential
pattern as the observations become older
II. Under the GARCH(1,1) model, the observation’s estimated weights decrease following an
exponential pattern as the observations become older
III. Under the GARCH(1,1) model, the long-run average variance rate has some positive weight
IV. Under the EWMA model, the long-run average variance rate has some positive weight
A. All the above statements are correct.
B. Only I, II, and III are correct.
C. Only I and IV are correct.
D. None of the above statements are correct.
Both the GARCH(1,1) and EWMA models assign weights to observations that decrease exponentially
as the observations become older. T his is a characteristic feature of these models, allowing them to
give more importance to recent observations and less importance to older ones. T his is reflected in
statements I and II, which are therefore correct. Statement III is also correct. In the GARCH(1,1)
model, the long-run average variance rate does carry some positive weight. T his is because the
GARCH model has a finite unconditional variance, which means that the long-run average variance
rate is defined and carries some weight. However, statement IV is incorrect. In the EWMA model,
the long-run average variance rate does not carry any weight. T his is because the sum of the weights
in the EWMA model is equal to 1, which means that the long-run average variance rate is undefined in
this model.
Choi ce A i s i ncorrect. Not all statements are correct. Statement IV is incorrect because in the
EWMA model, the long-run average variance rate does not carry any weight. T he weights assigned to
observations decrease exponentially as the observations age, but there is no concept of a long-run
average variance rate in this model.
Choi ce C i s i ncorrect. Only statement I is correct in this option. Statement IV, as explained above,
is incorrect because there's no concept of a long-run average variance rate in EWMA model.
56
Choi ce D i s i ncorrect. T his choice suggests that none of the statements are correct which isn't
true as Statements I, II and III are indeed accurate descriptions about volatility estimation models
used in financial risk management.
Q.536 Using a daily RiskMetrics EWMA model with a decay factor λ = 0.85 to develop a forecast of
the conditional variance, which weight will be applied to the return that is three days old?
A. 0.1084
B. 0.0921
C. 0
D. 0.153
T he weight of the last day = 1 − λ = 1 − 0.85 = 0.15
For the day before, the weight is 0.15 * 0.85 and for 3 days ago, 0.15 ∗ 0.852 = 0.1084
Q.537 Until December 2012, the Kenyan shilling had shown very small historical volatility against the
South African Rand. On December 19th, Kenya abandoned the defense of the currency peg. It has
been determined that the squared return on day n — 1 is less than the estimate of the variance rate
made for the same day.Assuming the data from the close of business on December 18th, which of the
following methods of calculating volatility would have shown the greatest jump in measured historical
volatility?
A. 150-day equal weight
B. 100-day equal weight
C. Exponentially weighted with a decay factor of 0.92
D. Exponentially weighted with a decay factor of 0.97
T he Exponentially Weighted Moving Average (EWMA) model for updating variance is represented by
57
the formula: σn²=(1-λ)r(n-1)²+λσ(n-1)². In this formula, r(n-1)² is the most recent observation of the
squared return (on day n — 1), and σ(n-1)² is the estimate of the variance rate made for the previous
day (n — 1). T he weight given to the most recent variance estimate is λ, and the weight given to the
new squared return is 1-λ. T herefore, the EWMA model with λ = 0.97 (Option D) assigns a weight of
0.97 to the most recent variance estimate. T his weight is higher than the 0.92 of the EWMA model
with λ = 0.92 (Option C), and also higher than 0.01 (= 1/100) and 0.0067 (= 1/150) of the 100-day
(Option B) and the 150-day (Option A) moving averages, respectively. If a currency peg had been in
place, it would imply that the exchange rate was fixed. Abandoning such a policy would immediately
trigger an increase in the volatility of the shilling versus the South African Rand. T he largest jump
would have to involve the volatility measurement method that assigns the greatest weight on the first
peg-free day. T herefore, the method that would have shown the greatest jump in measured historical
volatility is the Exponentially Weighted Moving Average (EWMA) model with a decay factor of 0.97.
Choi ce A i s i ncorrect. T he 150-day equal weight method would not have shown the most
significant increase in measured historical volatility. T his is because it gives equal importance to all
the data points in the past 150 days, including those when the Kenyan shilling exhibited minimal
historical volatility against the South African Rand. T herefore, this method would dilute the impact of
recent changes in volatility.
Choi ce B i s i ncorrect. Similar to Choice A, a 100-day equal weight method also assigns equal
weights to all data points over a specified period (in this case, 100 days). While it might show a
slightly higher increase in measured historical volatility than choice A due to its shorter time frame
(and hence less influence from periods of minimal volatility), it still wouldn't capture as much of the
recent surge in volatility as an exponentially weighted model.
Choi ce C i s i ncorrect. An exponentially weighted model with a decay factor of 0.92 does give
more importance to recent observations compared to an equally weighted model and hence would
reflect more of the recent increase in volatility than choices A or B. However, since its decay factor
is lower than that for choice D (0.97), it discounts older observations more heavily and therefore
doesn't capture as much information from past volatilities as choice D does.
58
Q.538 Given that σt2 is the estimated variance at time t and μt is the realized return at time t, select
the GARCH(1,1) model that will take the longest time to revert to its mean.
A. σt2 = 0.05 + 0.03μ2( −1) + 0.91σ(2 −1)

t t
B. σt2 = 0.03 + 0.03μ2( −1) + 0.92σ(2 −1)

t t
C. σt2 = 0.07 + 0.02μ2( −1) + 0.94σ(2 −1)

t t
D. σt2 = 0.03 + 0.04μ2( −1) + 0.91σ(2 −1)

t t
T he GARCH(1,1) model that takes the longest time to revert to its mean is the one with the highest
persistence. Persistence in a GARCH(1,1) model is given by the sum of the coefficients of the lagged
squared return (α 1) and the lagged variance ( β). In the given options, the GARCH(1,1) model in
choice C: σt2 = 0.07 + 0.02μ2( −1) + 0.94σ(2 −1) has the highest persistence. T he persistence for this
t t
model is 0.96 (0.02 + 0.94), which is higher than the persistence of the other models. T herefore,
this model will take the longest time to revert to its mean.
Choi ce A i s i ncorrect. T he sum of the ARCH term (0.03) and the GARCH term (0.91) in this
model is 0.94, which is less than that in option C (0.96). T his means that shocks to the variance will
decay more quickly, and hence, the model will revert to its mean faster.
Choi ce B i s i ncorrect. Similar to choice A, the sum of ARCH and GARCH terms here is 0.95
which again indicates a quicker reversion to mean compared to option C.
Choi ce D i s i ncorrect. Despite having a higher ARCH term (0.04), this model's total persistence
(sum of ARCH and GARCH terms = 0.95) remains lower than that in option C, implying a faster mean
reversion time.
Note:In a GARCH(1,1) model, higher values of μ2( −1) or σ(2 −1) coefficients indicate slower decay of
t t
shocks or longer persistence - thus taking longer for variance to revert back to its long-term average
or 'mean'. T herefore, among all options provided here, choice C with highest combined value for
these coefficients would take longest time for mean reversion.
59
Q.539 Martin Scholes, FRM, estimates daily variance ht using the following GARCH model on daily
returns rt :
H t = α 0 + α 1r2( −1) + βh(t−1)

t
Where α0 = 0.004, α 1 = 0.05, β = 0.93Approximate the long-run annualized volatility (Assume there
are 252 trading days in a year).
A. 0.20
B. 7.144
C. 0.45
D. 0.5
In the GARCH(1,1) model, the long-run average variance rate is given by:
α0
h=
(1 − α 1 − β)
0.004
= = 0.20
(1 − 0.05 − 0.93)
Taking the square root, this gives 0.45 for daily volatility.
To determine the annualized volatility, we have to multiply 0.45 by √252, where 252 is the average
number of trading days in a year excluding weekends and holidays.
T hus, annualized volatility = 0.45 ∗ √252 = 7.144
Q.540 Consider the GARCH(1,1) model:
σt2 = ω + αμ2( −1) + βσ(2 −1)

t t
Where α + β < 1Which of the following statements is INCORRECT regarding the volatility term
structure predicted by the model above?
A. If we assume that the long-run estimated variance remains unchanged as α and β increase,
60
the volatility term structure predicted by the model reverts to the long-run estimated
variance faster.
B. If we assume that the long-run estimated variance remains unchanged as α and β increase,
the volatility term structure predicted by the model reverts to the long-run estimated
variance more slowly.
C. If the current volatility estimate is above the long-run average volatility, we would expect
the estimated volatility term structure to be downward-sloping.
D. If the current volatility estimate is below the long-run average volatility, we would expect
the estimated volatility term structure to be upward-sloping.
In the GARCH(1,1) model, the sum of α and β represents the persistence of shocks to the variance.
If this sum is close to 1, shocks to the variance will be highly persistent, meaning that the volatility
term structure will revert to the long-run estimated variance more slowly, not faster. T herefore,
increasing α and β would not result in a faster reversion to the long-run estimated variance, contrary
to what the statement suggests.
Choi ce B i s i ncorrect. T he statement contradicts the behavior of the GARCH(1,1) model. As α
and β increase, assuming that the long-run estimated variance remains unchanged, the volatility term
structure predicted by this model reverts to the long-run estimated variance faster, not slower. T his
is because higher values of α and β imply a greater weight being placed on recent volatility estimates
in determining future volatility.
Choi ce C i s i ncorrect. While it's true that if current volatility estimate is above the long-run
average volatility, we would expect a downward-sloping estimated volatility term structure; however
this statement does not reflect any specific behavior related to changes in α and β parameters of
GARCH(1,1) model which was asked in question.
Choi ce D i s i ncorrect. Similar to choice C, although it's correct that if current volatility estimate
is below the long-run average we would expect an upward-sloping estimated volatility term
structure; but again this statement does not reflect any specific behavior related to changes in α and
β parameters of GARCH(1,1) model which was asked in question.
61
Q.541 A risk manager at Meridian Bank uses the exponentially weighted moving average technique to
model the daily volatility of a security, with λ equal to 0.95. T he current daily volatility estimate
stands at 1.8%. On a certain day, the security registers a closing price of $10 and then $8 the
following day. Determine the updated estimate of volatility:
A. 0.04803
B. 0.0529
C. 0.1521
D. 0.1812
T he new variance forecast will be given by:
λσ(2 −1) + (1 − λ)u2( −1)

t t
where
σn2 = variance estimate for day n
σ(2 −1) = volatility estimate made at the end of day (t-2) for day (t-1)
t
2
U (2−1) = T he most recent observation of the squared return (on day n — 1) = ( 8−10 ) = (−0.2)2 = 0.04
t 10
λ = exponential constant
T hus, the new variance forecast is
0.95 ∗ 0.0182 + (1 − 0.95) ∗ 0.04 = 0.0023078
Hence
Volatility = √0.0023078 = 0.04803
62
Q.542 Consider a portfolio with 60% invested in asset Y and 40% invested in asset Z. T he mean and
variance of the return on Y are 0 and 49 respectively. T he mean and variance of the return on Z are
1 and 84 respectively. Given that the correlation coefficient between Y and Z is 0.4, determine the
portfolio volatility.
A. 43.4
B. 6.59
C. 8.5
D. 23.1
σp2 = w 2y σy2 + w 2z σ 2z + 2w y ⋅ w z ⋅ Corr (y, z) ⋅ σy ⋅ σz

= 0.62 ∗ 49 + 0.42 ∗ 84 + 2 ∗ 0.6 ∗ 0.4 ∗ 0.4√(49 ∗ 84)
= 17.64 + 13.44 + 12.32 = 43.40
Volatility = √43.40 = 6.59
Q.543 A FRM exam candidate uses the EWMA model with a decay factor of 0.90 to model the returns
of a security listed on the Japanese Stock Exchange. Determine the weight that will be applied to the
return that’s 5 days old.
A. 0.04656
B. 0.09
C. 0.06
D. 0.0656
T he last day has some weight equivalent to 1 − λ = 1 − 0.9 = 0.1
T he day before would have weight equivalent to (1 − λ)λ = 0.1 ∗ 0.9 = 0.09
And for 5 day-old return, the weight would be (1 − λ)λ4 = 0.1 ∗ 0.94 = 0.0656
Note: T he lower the value of λ, the faster the rate at which old values are ‘forgotten’.
63
Q.544 T he decay factor used in an EWMA model is approximated to be 0.97. In addition, daily
volatility is estimated to be 1%. Given that today’s stock market return is 3%, determine the new
estimate of volatility using the EWMA model.
A. 0.00027
B. 0.000124
C. 0.01114
D. 0.00567
σn2 = λσ(2 −1) + (1 − λ)u2(

n n −1)
Where λ = 0.97 and u(n −1) = 3%
T hus, σn2 = 0.97 ∗ 0.012 + (1 − 0.97) ∗ 0.032 = 0.000097 + 0.000027 = 0.000124
σn = 0.01114 or 1.11%
64
Q.545 A generalized autoregressive conditional heteroskedastic (GARCH)(1,1) model has the
following parameters: ω = 0.000003;α = 0.05;β = 0.94Determine the implied long-run volatility
level.
A. 0.0003
B. 0.07132
C. 0.02732
D. 0.01732
ω 0.000003
T he long-run average variance = = = 0.0003
(1 − α − β) (1 − 0.05 − 0.94)
ω
T he long-run volatility = ⎷( ) = √0.0003 = 0.01732
(1 − α − β)
Q.546 T he dollar/sterling exchange rate at 5 P.M. yesterday was 0.78 and the most recent estimate of
the daily volatility stands at 0.8%. T he EWMA model used in the analysis has λ = 0.9. If the exchange
rate at 5 P.M. today proves to be 0.775, find an estimate of the new daily volatility.
A. 0.007857
B. 7.855E-05
C. 6.4E-05
D. 6.17E-05
T he proportional daily change is ln(0.775/0.78) = -0.00643.
T he current daily variance estimate = 0.0082 = 0.000064.
New daily variance estimate = 0.9 ∗ 0.000064 + 0.1 ∗ 0.006432

= 0.0000576 + 0.000004109 = 0.0000617
New daily volatility = √0.0000617 = 0.007857 or 0.7857%
65
Q.547 An analyst has interest in two assets, A and B. At the close of business yesterday, these assets
had daily volatilities of 1.3% and 2.0% respectively. In addition, the assets were priced at $40 for A
and $80 for B as at the close of business yesterday, and the estimated correlation coefficient
between the two assets stood at 0.25. T he EWMA model used by the analyst had λ = 0.95.
Compute an estimate of the covariance between A and B.
A. 0.000065
B. 0.0006
C. 2.60005
D. 0.05
Recall that:
Cov(A, B)
Correlation coefficient =
(Volatility A ∗ Volatility B)
T his means that if we make the covariance the subject of the formula, we get:
Cov(A, B) = Correlation coefficient ∗ Volatility A ∗ Volatility B

= 0.25 ∗ 0.013 ∗ 0.02 = 0.000065
66
Q.548 An analyst has interest in two assets, A and B. At the close of business yesterday, these assets
had daily volatilities of 1.3% and 2.0% respectively. In addition, the assets were priced at $40 for A
and $80 for B as at the close of business yesterday, and the estimated correlation coefficient
between the two assets stood at 0.25. T he EWMA model used by the analyst had λ = 0.95.
Assuming that the prices of the assets today are $40.5 and $80.5, update the correlation coefficient.
A. 0.00625
B. 0.01954
C. 6.56E-05
D. 0.2589
Recall that:
Cov(A, B)
Correlation coefficient =
Volatility A ∗ Volatility B
T his means that if we make the covariance the subject of the formula, we get:
Cov(A, B) = Correlation coefficient ∗ Volatility A ∗ Volatility B

= 0.25 ∗ 0.013 ∗ 0.02 = 0.000065
T he return for A is 0.5/40 = 0.0125
Similarly, the return for B is 0.5/80 = 0.00625
T he new covariance estimate 0.95 ∗ 0.000065 + 0.05 ∗ 0.0125 ∗ 0.00625 = 0.00006566
For asset A, the new variance estimate = 0.95 ∗ 0.0132 + 0.05 ∗ 0.01252 = 0.0001684
T herefore, new volatility = √0.0001684 = 0.01298
For asset B, the new variance estimate = 0.95 ∗ 0.022 + 0.05 ∗ 0.006252 = 0.000382
T herefore, new volatility = √0.000382 = 0.01954
0. 00006566
T he new correlation estimate = = 0.2589
(0. 01298∗0. 01954)
67
Q.549 GARCH(1,1) models can be used to estimate the volatility of asset returns if and only if:
A. α > β
B. α < β
C. α + β = 0
D. α + β ≤ 1
T he condition α + β ≤ 1 is a necessary condition for the stability of a GARCH(1,1) model. T he
parameters α and β in a GARCH(1,1) model represent the weights assigned to the lagged squared
error term and the lagged conditional variance, respectively. T he sum of these weights, α + β ,
determines the persistence of a shock to the conditional variance. If α + β > 1, the impact of a shock
to the conditional variance would be permanent, leading to an explosive variance process which is
not desirable in a volatility model. T herefore, for a GARCH(1,1) model to be stable and useful in
estimating volatility, it is necessary that α + β ≤ 1. T his ensures that the impact of a shock to the
conditional variance diminishes over time, which is a desirable property in a volatility model.
Choi ce A i s i ncorrect. T he condition α > β does not ensure the effectiveness of a GARCH(1,1)
model in estimating volatility. In fact, it could lead to an unstable model as the sum of α and β may
exceed 1, which violates the stationarity condition necessary for a GARCH model.
Choi ce B i s i ncorrect. While it's possible that α < β, this alone doesn't guarantee an effective
GARCH(1,1) model for estimating volatility. T he key requirement is that the sum of these
parameters should be less than or equal to 1 to ensure stationarity and persistence in volatility.
Choi ce C i s i ncorrect. α + β = 0 would imply no persistence in volatility over time which
contradicts with one of the main reasons why we use GARCH models - to capture time-varying
volatility.
68
Q.556 Robert Kelly, FRM, uses the EWMA model to carry out daily updates of correlation and
covariance rates between two random variables X and Y . T he weight for the most recent
covariance on day n − 1 is 0.80. T he correlation estimate between X and Y on day n − 1 is 0.6. In
addition, on day n − 1, X and Y have estimated standard deviations of 0.013 and 0.019 respectively.
Also, the percentage change on day n − 1 for variables X and Y are 2% and 1% respectively.Calculate
the updated covariance between X and Y on day n.
A. 0.0125
B. 0.41
C. 0.0001586
D. 0.0001482
T he exponentially weighted moving average (EWMA) model uses the following formula to compute
the updated covariance between 2 random variables X and Y at time n:
Cov n = λ × cov n −1 + (1 − λ)X n −1 × Y n −1
Where:
λ = weight of the most recent covariance on day n − 1
X n −1 = percentage change for variable X on day n − 1
Y n −1 = percentage change for variable Y on day n − 1
We know that Cov xy = ρxy ∗ σx σy
Cov n −1 = 0.6 ∗ 0.013 ∗ 0.019 = 0.0001482
Which gives: Cov n = 0.8 ∗ 0.0001482 + 0.2 ∗ 0.02 ∗ 0.01 = 0.0001586
Q.557 Robert Kelly, FRM, uses the EWMA model to carry out daily updates of correlation and
covariance rates between two random variables X and Y . T he weight for the most recent
covariance on day n − 1 is 0.80. T he correlation estimate between X and Y on day n − 1 is 0.6. In
addition, on day n − 1, X and Y have estimated standard deviations of 0.013 and 0.019 respectively.
Also, the percentage change on day n − 1 for variables X and Y are 2% and 1% respectively.Compute
the updated correlation between X and Y
69
A. 0.1586
B. 0.2152
C. 0.3088
D. 0.6152
Covxy
We know that ρxy = σ xσ y
Updated variance of X = λσX2,n −1 + (1 − λ)X n2−1 = 0.8 ∗ 0.0132 + 0.2 ∗ 0.022 = 0.0002152
Updated variance of Y = λσY2 ,n −1 + (1 − λ)Y n2−1 = 0.8 ∗ 0.0192 + 0.2 ∗ 0.012 = 0.0003088
T he updated covariance between 2 random variables X and Y at time n:
Cov n = λ × cov n −1 + (1 − λ)X n −1 × Y n −1
Where:
λ = weight of the most recent covariance on day n − 1
X n −1 = percentage change for variable X on day n − 1
Y n −1 = percentage change for variable Y on day n − 1
Cov n −1 = 0.6 ∗ 0.013 ∗ 0.019 = 0.0001482
Which gives:
Cov n = 0.8 ∗ 0.0001482 + 0.2 ∗ 0.02 ∗ 0.01 = 0.0001586
Hence the updated correlation coefficient is,
0.0001586
ρn = = 0.615238
(√0.0002152 ∗ √0.0003088)
70
Q.558 A financial analyst uses daily data to estimate a GARCH (1,1) model as follows:
σn2 = 0.000002 + 0.16r2n −1 + 0.74σn2−1
She also has established that the most recent return and variance are 0.04 and 0.02, respectively.
Calculate the updated volatility.
A. 1.51%
B. 11.11%
C. 3.33%
D. 12.27%
T he Generalized Autoregressive Conditional Heteroskedasticity GARCH(1,1) model is defined as:
σn2 = ω + αr2n −1 + βσn2−1
Where:
σn2 = updated variance at time n
ω = long-term average variance rate
α = weight of the most recent squared return
r2n −1= most recent squared return
β = weight of the most recent variance rate estimate
σn2−1 = most recent variance rate estimate
From the information provided in the question:
σn2 = 0.000002 + 0.16 × 0.042 + 0.74 × 0.02 = 0.015058
Volatility is given by:
Volatility = √σn2 = √0.015058 = 0.12271 ≈ 12.27%
71
Q.565 A certain analyst uses the EWMA model with λ = 0.9 to carry out an update of correlation and
covariance rates. On day n − 1, the observed percentage changes for variables X and Y are 3% and
2% respectively. Historical data puts the correlation estimate between X and Y at 0.54 on day n − 1.
Furthermore, the estimated standard deviations on day n − 1 are 1.2% and 1.4% for X and Y
respectively.
Compute the new estimate of the covariance between X and Y on day n.
A. 9.07205
B. 0.1234
C. 0.1416
D. 0.0001416
Cov n = λ × cov n −1 + (1 − λ)X n −1 × Y n −1
But first, we must determine Cov n −1
Cov n −1 = 0.54 ∗ 0.012 ∗ 0.014 = 0.00009072
And
Cov n = 0.9 ∗ 0.00009072 + 0.10 ∗ 0.03 ∗ 0.02 = 0.000141648
Q.567 T he following is a variance-covariance matrix:
⎡ 1 0 0.7 ⎤
⎢ 0 1 0.7 ⎥
⎣ 0.7 0.7 1 ⎦
Determine the correlation rate between variables 2 and 3.

A. 0.7
B. 1
C. 0.49
72
D. 0
Generally, a 3 × 3 covariance matrix is given by:
⎡ Var(1) Cov(1, 2) Cov(1, 3) ⎤

⎢ Cov(1, 2) Var(2) Cov(2, 3) ⎥
⎣ Cov(1, 3) Cov(2, 3) Var(3) ⎦
Now,
Cov(2, 3) 0.7
Corr(2, 3) = = = 0.7
Sd(1) × Sd(2) 1×1
Q.568 Kelvin Klein, a financial analyst, uses daily data to estimate a GARCH (1, 1) model as follows:
σn2 = 0.000002 + 0.14r2n −1 + 0.76σn2−1
Kelvin establishes that the estimate of return on day n − 1 is 0.02 and the most recent observation on
variance is 0.01. Calculate the updated estimate of variance, σn2
A. 0.066
B. 0.008
C. 0.088
D. 0.017
From the information given in the question, we have:
σn2 = 0.000002 + 0.14 × 0.022 + 0.76 × 0.01 = 0.007658 ≈ 0.008
Q.940 A number of risk measures are based on the parametric approach, which assumes that the
asset returns are normally distributed. However, mathematicians and statisticians have discovered
that in reality, the asset returns deviate from normality. Which of the following options is least likely
consistent with the assumption that the asset returns deviate from normality?
73
A. Asset returns have fat-tailed distributions which means assets have a higher probability
weight in their tails relative to the normal distribution.
B. Asset returns have skewed distribution, which means that the declines in asset prices are
more severe than increases in prices.
C. Asset returns have unstable parameter values due to varying market conditions.
D. Asset returns have symmetrical distributions which means they are evenly distributed
around the mean returns.
T he statement that 'Asset returns have symmetrical distributions which means they are evenly
distributed around the mean returns' is least consistent with the assumption that asset returns
deviate from a normal distribution. In a normal distribution, the data is symmetrically distributed with
no skewness, meaning that the mean, median, and mode of the distribution are all the same. T he data
points are evenly distributed around the mean, creating a bell-shaped curve. However, in reality,
asset returns often exhibit skewness and kurtosis, deviating from this symmetrical, bell-shaped
curve of a normal distribution. Skewness refers to the asymmetry in the distribution, while kurtosis
refers to the 'tailedness' of the distribution. T herefore, the assertion that asset returns have
symmetrical distributions is least likely to be consistent with the real-world observations of asset
return distributions.
Choi ce A i s i ncorrect. Empirical evidence and statistical analysis have shown that asset returns
often exhibit fat-tailed distributions, which means they have a higher probability weight in their tails
relative to the normal distribution. T his is a characteristic of many financial market returns and
aligns with the observed reality.
Choi ce B i s i ncorrect. Asset returns are often skewed, meaning that declines in asset prices can
be more severe than increases in prices. T his skewness is another common feature of financial
market returns and aligns with the observed reality.
Choi ce C i s i ncorrect. It's true that asset return parameters can be unstable due to varying
market conditions. T his instability can lead to changes in volatility, skewness, kurtosis etc., which
again aligns with the observed reality of asset return distributions.
74
Q.941 Donald York is a quantitative analyst at Brooklyn Investments Hub, a tech investment
company based in New York. York brings 5 years of experience in quantitative and statistical
analysis. In one of his explanatory articles, he mentioned that when the mean and standard deviation
of asset returns are the same for any given time period, the distribution of returns is said to be an
unconditional distribution. In contrast, if the mean is the same at any time while the standard
deviation of the return change over time, the return distribution is referred to as a conditional
distribution. Identify the correct option from the following.
A. York’s explanation regarding the unconditional distribution is incorrect.
B. York’s explanation regarding the conditional distribution is incorrect.
C. York’s explanation regarding the conditional and unconditional distribution is incorrect.
D. York’s explanation regarding the conditional and unconditional distribution is correct.
Donald York's explanation regarding the conditional and unconditional distribution is correct. In the
field of finance and investment, the distribution of asset returns plays a crucial role in risk
management and investment decision-making. An unconditional distribution, as explained by York, is a
type of probability distribution where the mean and standard deviation of asset returns remain
constant for any given time period. T his implies that the probability of achieving a certain level of
return does not change over time. On the other hand, a conditional distribution is one where the
mean remains constant, but the standard deviation of returns changes over time. T his suggests that
the volatility or risk associated with the asset returns can vary, depending on different conditions or
factors. Both these concepts are fundamental to understanding the behavior of financial markets and
making informed investment decisions. T herefore, York's explanation of both these concepts is
accurate and aligns with the standard definitions used in finance and investment analysis.
Choi ce A i s i ncorrect. York's explanation of an unconditional distribution is correct. An
unconditional distribution does indeed have a constant mean and standard deviation for any given time
period, as it does not take into account any conditions or changes over time.
Choi ce B i s i ncorrect. York's explanation of a conditional distribution is also correct. In a
conditional distribution, the mean remains constant while the standard deviation can vary over time,
reflecting changes in volatility based on different conditions or events.
75
Choi ce C i s i ncorrect. As explained above, both explanations provided by York regarding
unconditional and conditional distributions are accurate.
Q.942 An analyst is conducting fundamental and technical analysis on Pak-China T rading Co (PCT C)
stocks. T he analysis takes into account the stock’s daily returns based on the mean and volatility of
returns. If PCT C returns have a mean of 9.56 bps/day, and a high volatility of 14.25 bps/day and a low
volatility of 6.18 bps/day, then determine which of the following distributions fits the most the
characteristics of PCT C’s return distribution?
A. Unconditional distribution.
B. Regime-switching distribution.
C. Unconditionally lognormal distribution.
D. Conditional distribution.
In a regime-switching distribution, the volatility of returns switches between low volatilities to high
volatilities. In this distribution, the volatility does not switch to any volatility between the high and
low volatility regimes.
Q.947 Gareth Graham is a senior risk consultant for Poincare Consulting Group. Graham has a strong
reputation in the risk managers community, which is why he is frequently invited as a guest speaker
at various business schools. During a recent seminar at a reputable business school in Vancouver,
Graham mentioned the following comments regarding the cyclicality of volatility:
I. It should be considered while analyzing the risk of financial assets that volatility in financial
markets is time-varying
II. While using a historical data model for analyzing volatility, more weight should be put into recent
data as opposed to earlier data
Which of the following is correct?
A. Only statement I is correct.
B. Only statement II is correct.
C. Both statements are correct.
D. None of the statements is correct.
76
Both statements made by Gareth Graham are indeed accurate.
T he first statement emphasizes the time-varying nature of volatility in financial markets. T his is a
well-accepted concept in financial risk management. Volatility, which is a measure of the degree of
variation in the trading price of a financial instrument over time, is not constant. It changes over
time due to various factors such as changes in market sentiment, economic releases, and other
macroeconomic factors. T herefore, when analyzing the risk of financial assets, it is crucial to
consider this time-varying nature of volatility.
T he second statement underscores the importance of giving more weight to recent data when using
a historical data model to analyze volatility. T his is because recent data is more likely to reflect
current market conditions and trends, and therefore, provides more relevant information about
future volatility. Older data, on the other hand, may not be as relevant because it reflects market
conditions and trends that may no longer be applicable.
T herefore, both statements accurately reflect key considerations in the analysis of volatility in
financial markets.
Choi ce A i s i ncorrect. While it is true that the first statement is correct, this option suggests that
the second statement is not, which isn't accurate. T he second statement correctly asserts that more
emphasis should be placed on recent data when using a historical data model to analyze volatility. T his
approach, known as "time decay," gives more weight to recent observations and less weight to older
ones.
Choi ce B i s i ncorrect. T his choice implies that only the second statement made by Gareth
Graham holds true. However, both statements are indeed correct. T he first observation about
volatility in financial markets being time-varying aligns with the concept of conditional
heteroskedasticity in financial econometrics where volatility changes over time.
Choi ce D i s i ncorrect. As explained above, both statements made by Gareth Graham are accurate
reflections of how volatility operates within financial markets and how it should be analyzed using
historical data models.
77
Q.948 An analyst is comparing the ST DEV or GARCH methodology with that of the RiskMetric®
approach for estimating VaR using historical data. He wrote down the following similarities between
both methods. Which of the following similarities is incorrect?
A. Both methods belong to the parametric class of risk assessing models.
B. Both methods attempt to estimate conditional volatility.
C. Both methods apply equal weights to all the periods.
D. Both methods use recent historic data for assessing risk.
A financial analyst is conducting a comparative study between the Standard Deviation (ST DEV) or
Generalized Autoregressive Conditional Heteroskedasticity (GARCH) methodology and the
RiskMetric® approach. T hese methods are used for estimating Value at Risk (VaR) using historical
data. During his study, he noted down a few similarities between these methods. However, which of
the following similarities did he incorrectly note down?
Q.951 Selma Kaya is a junior risk analyst at Galileo Investment Bank. She is interested in estimated
the joint density of returns of Algo Corp. and economic growth. Which of the following models should
Kaya most likely use?
A. Risk Metric®.
B. Black-Scholes model.
C. GARCH.
D. Multivariate density estimation (MDE) model.
Selma Kaya, a junior risk analyst at Galileo Investment Bank, is tasked with the responsibility of
estimating the joint density of returns of Algo Corp. and economic growth. Which model from the
options below would be the most suitable for her to use?
Q.953 Markus Schmidt is an independent risk consultant at a well-known audit firm. He is currently
working as an external risk advisory for George Reed Shipping Inc. During a meeting with the senior
management of the shipping company, Schmidt made the following comments:
I. Using nonparametric is a simple process as it does not impose a specific set of distributional
assumptions; rather it uses the historical data directly
78
II. Nonparametric methods are better predictors of the future volatility
Which of his comments is/are incorrect?
A. Comment I only.
B. Comment II only.
C. Both comments.
D. None of the comments.
T he statement that nonparametric methods are better predictors of future volatility is incorrect.
While nonparametric methods have their advantages, they are not necessarily the most efficient
predictors of future volatility. Instead, implied volatility models, such as the Black-Scholes option
pricing model, are often more effective in predicting future volatility. T hese models are designed to
react more quickly and accurately to current market conditions, making them superior predictors of
future volatility. Nonparametric methods, on the other hand, rely on historical data and do not impose
a specific set of distributional assumptions, which can limit their predictive power in rapidly
changing market conditions.
Choi ce A i s i ncorrect. Schmidt's first comment is correct. Nonparametric methods are indeed
straightforward to use because they do not require a specific set of distributional assumptions and
instead directly utilize historical data. T his makes them flexible and adaptable to various types of data,
which can be particularly useful in risk management where the nature of risks can vary greatly.
Choi ce C i s i ncorrect. As explained above, Schmidt's first comment about nonparametric methods
was accurate, so it cannot be that both comments are incorrect.
Choi ce D i s i ncorrect. Schmidt's second comment that nonparametric methods are superior
predictors of future volatility is not necessarily true. While these methods can provide valuable
insights based on historical data, their predictive power for future events may not always be
superior to other statistical or parametric approaches which take into account more factors and
assumptions about the underlying distribution of the data.
79
Q.956 If the covariance between Japanese and English interest rates is 0.089, and the variances of
interest rates in Japan and England are 17.64% and 10.24%, respectively, then which of the following
is closest to the correlation between Japanese and English interest rates?
A. 4.927
B. 1.028
C. 0.6622
D. 0.8736
Covariance
Correlation =
(Standard deviation (A) ∗ Standard deviation (B))
0.089
Correlation = = 0.6622
(√0.1764 ∗ √0.1024)
Q.3301 An investment company uses RiskMetrics to calculate the volatility. T he volatility for the
previous day is 0.02 and today’s return is 10%. What is the updated volatility if λ = 0.97 is used?
A. 0.0028
B. 0.0194
C. 0.0262
D. 0.053
Adaptive volatility using the RiskMetrics model can be found as:
σt2 = λσ2t−1 + (1 − λ)r2t−1,t

2 2
= 0.97 ∗ 0.02 + 0.03 ∗ 0.1 = 0.000688
However, remember that variance is volatility squared.
σt = √0.000688 = 0.0262
TM
80
Q.3302 A hedge fund manages risk by calculating future volatility using RiskMetricsTM to calculate
the volatility. T he volatility of the portfolio today is 3% per day and today's observed return is 1%.
T he conditional volatility estimate, assuming that λ = 0.9, is closest to:
A. 2.86%
B. 3.49%
C. 2.50%
D. 3.21%
T he volatility according to RiskMetrics is given by:
σn2 = (1 − λ) r2n −1 + λσn2−1
Where
λ = T he weight given to the most recent variance estimate.
r2n −1 = estimate of most recent squared return
σn2−1 = Most recent estimate of variance
From the information given,
σn2 = (1 − 0.9) 0.012 + 0.9 × 0.032 = 0.00082
T hus the volatility is
√0.00082 = 0.02863 ≈ 2.86%
81
Q.3303 A hedge fund manages risk by calculating future volatility using historical standard deviation.
T he portfolio performance in the past 5 days are 2% (n-1), 4% (n-2), 6% (n-3), 2% (n-4), and 10% (n-
5), respectively. T he hedge fund uses the historical standard deviation (moving average) method to
calculate volatility. What is the volatility estimate?
A. 4.00%
B. 5.66%
C. 3.40%
D. 3.35%
m
1 2
σn = ∑ (rn −i − r̄)
⎷ m − 1 i=1
Where:
1 m
r̄ =∑ r
m i=1 n −i
1
= (0.02 + 0.04 + 0.06 + 0.02 + 0.1) = 0.048
5
Now,
1
σn = √ [(0.02 − 0.048)2 + (0.04 − 0.048)2 + (0.06 − 0.048)2 + (0.02 − 0.048)2 + (0.1 − 0.048) 2] ≈ 3.35%
4
82
Q.3304 Suppose that λ is 0.97. Using the EWMA approach, what is the weight applied to the squared
return on day n − 3?
A. 0.4
B. 0.97
C. 0.03
D. 0.06
Let w 0 be the weight applied to the most recent return (i.e., the return on day n − 1). T he weight for
the squared return on day n − 3 is
w 0λ2 = (1 − λ)λ2 = (1 − 0.97) × 0.972 = 0.028227 ≈ 0.03
Q.3308 For a certain asset, the expected one-period volatility is 0.002. If the speed of the reversion
parameter is 0.7, then what is the two-period volatility?
A. 0.002
B. 0.0024
C. 0.0115
D. 0.0587
With mean reversion (b < 1), the single-period volatility is σ.
T he two-period volatility is
√1 + b2 × σ
T herefore,
0.002 × √1 + 0.72 = 0.002 × 1.2207 = 0.0024
83
Q.3310 For a certain asset, the expected one-day volatility 0.002. What is the expected volatility for
30 days assuming non-predictability and the volatility being constant?
A. 0.002
B. 0.005
C. 0.011
D. 0.021
Here, we simply use the square root rule:
T-day volatility = 1-day volatility × √T
30-day volatility = 0.002 × √30 = 0.002 × 5.48 = 0.011
Q.3377 T he parameters of a generalized autoregressive conditional heteroskedastic (GARCH)(1,1)

model are α = 0.05, β = 0.91. Long-run volatility is 0.80%. If estimated daily volatility is 2% and
recent stock return is 3%, compute the new estimated volatility using the GARCH (1,1) model.
A. 0.04%
B. 2.50%
C. 1.50%
D. 2.03%
γ = 1 − α − β = 1 − 0.05 − 0.91 = 1 − 0.96 = 0.04

Weighted long-run variance = ω = γVL = 0.04 ∗ (0.008)2 = 0.00000256
New variance is given by:
σn2 = ω + αu2n −1 + βσn2−1
V ariance = 0.00000256 + 0.05 ∗ 0.032 + 0.91 ∗ 0.022 = 0.00041156

V olatility = √0.00041156 = 0.0203 = 2.03%
84
Q.3378 T he decay factor of exponentially weighted moving average (EWMA) model is estimated to
be 0.95. If the estimated daily volatility is 2% and the recent stock return is 3%, compute the new
estimated volatility using the EWMA model.
A. 2.06%
B. 2.03%
C. 0.04%
D. 2.50%
New variance is given by
σn2 = (1 − λ)u2n −1 + λσn2−1
V ariance = 0.05 ∗ 0.032 + 0.95 ∗ 0.022 = 0.000425

Volatility = √0.000425 = 2.06%
Q.3379 When parameters of a generalized autoregressive conditional heteroskedastic (GARCH)(1,1)

model are set to ω = 0, α = 1 − λ, β = λ, the GARCH (1, 1) model reduces to a (an):
A. Generalized volatility model
B. EWMA model
C. ARCH (1)
D. None
GARCH (1, 1) model:
σn2 = ω + αu2n −1 + βσn2−1
Put ω = 0, α = 1 − λ, β = λ
, the above model reduces to:
σn2 = (1 − λ)u2n −1 + λσn2−1
85
model are ω, α , β, and γ . Which of the following is the necessary condition for estimating volatility
using GARCH (1, 1)?
A. α > β
B. γ < 0
C. α + β < 1
D. α + β + γ > 1
T he condition α + β < 1 is a necessary condition for the GARCH(1,1) model to be stationary and for
volatility to be estimable. T his condition ensures that the weights assigned to past squared residuals
(captured by α ) and past conditional variances (captured by β ) in the GARCH model sum to less than
one. T his is crucial because it ensures that shocks to the variance decay over time and that the
variance is mean-reverting. If α + β were equal to or greater than one, the variance would not be
mean-reverting, and the model would not be stationary, making volatility estimation impossible.
T herefore, the condition α + β < 1 is necessary for estimating volatility using the GARCH(1,1)
model.
Choi ce A i s i ncorrect because the condition α > β is not a necessary condition for estimating
volatility using the GARCH(1,1) model. T he parameters α and β in the GARCH model represent the
weights assigned to past squared residuals and past conditional variances, respectively. While these
weights influence the model's responsiveness to past information, there is no requirement that α
must be greater than β for the model to estimate volatility effectively. T herefore, choice A is not a
necessary condition for estimating volatility using the GARCH(1,1) model.
Choi ce B i s i ncorrect because the condition γ < 0 is not a necessary condition for estimating
volatility using the GARCH(1,1) model. T he parameter γ in the GARCH model is typically used in
extensions of the basic GARCH model, such as the GJR-GARCH model, to capture the effect of
negative shocks on volatility. However, there is no requirement that γ must be less than zero for the
basic GARCH(1,1) model to estimate volatility effectively. T herefore, choice B is not a necessary
condition for estimating volatility using the GARCH(1,1) model.
86
Choi ce D i s i ncorrect because the condition α + β + γ > 1 is not a necessary condition for
estimating volatility using the GARCH(1,1) model. In fact, if α + β + γ were greater than one, the
model would not be stationary, and volatility estimation would be impossible. T he sum of α , β, and γ
must equal one for the model to be stationary and for volatility to be estimable. T herefore, choice D
is not a necessary condition for estimating volatility using the GARCH(1,1) model.
Q.3383 An analyst is trying to updates the estimated covariance by using the exponentially weighted
moving average (EWMA) model with λ = 0.91. T he analyst has gathered the following relevant data.
Estimated standard deviation on day n − 1 for variables X : 2%
Estimated standard deviation on day n − 1 for variables Y : 3%
T he correlation between them: 0.8
T he percentage change on day n − 1 for variable X : 2.5%
T he percentage change on day n − 1 for variable Y : 3.5%
What is the updated estimated covariance between them?
A. cannot be estimated
B. 0.00051000
C. 0.00048000
D. 0.00051555
Covariance between X and Y on day n– 1 :
Cov n −1 = 0.8 ∗ 0.02 ∗ 0.03 = 0.00048
Updated covariance using EWMA:
Cov n = λCov n-1 + (1 − λ)X n −1 Y n −1

= 0.91 ∗ 0.00048 + (1 − 0.91) ∗ 0.025 ∗ 0.035
= 0.00051555
87
Q.3384 An analyst is trying to updates the estimated covariance by using the exponentially weighted
moving average (EWMA) model with λ = 0.91. T he analyst has gathered the following relevant data.
T he observed return on day n − 1 for variable X : 2.5%
T he observed return on day n − 1 for variable Y : 3.5%
Given that the new Covariance between X and Y is 0.00051555, what is the updated estimated
correlation between them?
A. 0.825
B. 0.800
C. 0.910
D. None
Compute updated standard deviation using EWMA.
σn2 = λσn2−1 + (1 − λ)u2n −1
Updated variance for X = 0.91 ∗ 0.02 ∗ 0.02 + 0.09 ∗ 0.025 ∗ 0.025 = 0.00042025
Updated standard deviation for X = √0.00042025 = 0.0205
Updated variance for Y = 0.91 ∗ 0.03 ∗ 0.03 + 0.09 ∗ 0.035 ∗ 0.035 = 0.00092925
Updated standard deviation for Y = √0.00092925 = 0.030483602
Cov(X,Y ) 0.00051555
Updated correlation = = = 0.824993729 = 0.825
[SD(X) ∗ SD(Y )] 0.0205 ∗ 0.030483602
88
Q.3385 Suppose that an analyst has gathered the following relevant data for estimating updated
covariance using the EWMA model:
T he percentage change on day n − 1 for variable X : 25%
T he percentage change on day n − 1 for variable Y : 35%
Assuming that we choose λ = 0.96, what is the updated estimated covariance between variables X
and Y using the EWMA model?
A. 0.00041
B. 0.00048
C. 0.08402
D. 0.003961
Cov n −1 = 0.8 × 0.02 × 0.03 = 0.00048
Updated covariance using EWMA model is given by:
Cov n = (λ)Cov n −1 + (1 − λ)X n −1Y n −1

= 0.96 × 0.00048 + 0.04 × 0.25 × 0.35
= 0.0039608 ≈ 0.003961

model are α = 0.05; and β = 0.91. T he long-run average variance rate is 0.80%. T he analyst has
gathered the following relevant data for estimating updated covariance using the GARCH(1, 1) model.
89
T he return observed on day n − 1 for variable X : 2.5%
T he return observed on day n − 1 for variable Y : 3.5%
What is the updated estimated correlation between the two variables using EWMA model with
λ = 0.96?
A. 0.8840
B. 0.4500
C. 0.5351
D. 0.9270
Updated standard deviation using the GARCH model:
σn2 = ω + αu2n −1 + βσn2−1
w
VL =
1 −α −β
⇒ w = VL × (1 − α − β) = 0.80% × (1 − 0.05 − 0.91) = 0.00032
Updated variance for X = 0.00032 + 0.05 ∗ 0.025 ∗ 0.025 + 0.91 ∗ 0.02 ∗ 0.02 = 0.00071525
Updated standard deviation for:X = √0.00071525 = 0.026744158
Updated variance for Y = 0.00032 + 0.05 ∗ 0.035 ∗ 0.035 + 0.91 ∗ 0.03 ∗ 0.03 = 0.00120025
Updated standard deviation for Y = √(0.00120025) = 0.034644624
Covariance between X and Y on day n − 1
Cov n-1 = 0.8 × 0.02 × 0.03 = 0.00048
Updated covariance using EWMA model is given by:
Cov n = (λ)Cov n −1 + (1 − λ)X n −1Y n −1

= 0.96 × 0.00048 + 0.04 × 0.025 × 0.035
= 0.0004958
Cov(X Y )
90
Cov(X , Y )
Updated correlation =
[SD(X) ∗ SD(Y )]
0.0004958
=
0.026744158 × 0.034644624
= 0.5351
Q.4659 If the daily volatility of the price of gold is 0.3% in a given year, and assuming that a year has
252 trading days, what is the annualized volatility of the gold price? (Assume that there are 252
trading days in a year)
A. 0.0467
B. 0.0356
C. 0.0476
D. 0.0120
Using the scaling analogy, the corresponding annualized volatility is given by:
σannual = √252 × σdaily = √252 × 0.003 = 0.047624
Q.4661 A stock market investor records the stock price for five consecutive days as 20.20, 20.00,
21.20, 21.00, and 23.30. Estimate the daily volatility using the stock price returns?
A. 10.25%
B. 5.6%
C. 11.45%
D. 12.56%
T he variance rate is given by:
91
1 m
σn2 = ∑ r2n −i
m i=1
Recall that return are calculated by:
Si − Si−1
ri =
Si−1
T he following table gives the consecutive returns:
Day Stock Price ri

1 20.2 −
2 20.0 −0.0099
3 21.2 0.06
4 21.0 −0.00943
5 23.3 0.10952
Now,
1 m
σn2 = ∑ r2n −i
m i=1
1
[(−0.0099)2 + (0.06)2 + (−0.00943)2 + (0.10952)2] = 0.0031563
5
T he volatility is the square root of the variance rate:
∴ σn = √0.0031563 = 0.056 = 5.6%
Note: Your textbook in section 3.3 says the following: "T he usual formula for calculating standard
deviations from sample data would give the volatility estimated for day n from the return on the m
previous days [using m-1]. In risk management, we usually simplify this formula [by replacing] m - 1
by m."
Also, it gives an example on which you can see that we use 1/m as the actual number of days and not
the number of returns.
92
Q.4662 Consider a GARCH (1,1) model with ω=0.00005, α =0.025, and β =0.90, what is the value of
long-run average volatility?
A. 0.0245
B. 0.0258
C. 0.0051
D. 0.00735
T he formula for the updated variance rate under GARCH(1,1) model is given by:
σn2 = αr2n −1 + βr2n −1 + γVL
Where
VL : long-run average variance rate
α: weight given to the most recent squared returns
β : weight given to the previous variance rate estimate
γ : weight given to long-run average variance rate
VL can be defined as:
ω ω 0.00005
VL = = = = 0.0006667
γ 1−α −β 1 − 0.925
T herefore, the long-run average volatility is given by:
√0.0006667 = 2.58%
93
Q.4663 T he current volatility for stock prices is estimated to be 4% per day. Assuming the GARCH
(1,1) model with ω=0.00005, α =0.025, and β =0.90, what is volatility estimate in 50 days?
A. 0.0009
B. 0.0044
C. 0.0303
D. 0.0262
According to GARCH (1,1), the expected variance rate on day t is given by:
σn2+t = VL + (α + β)t (σn2 − VL )
Where
VL : long-run average variance rate
α: weight given to the most recent squared returns
β : weight given to the previous variance rate estimate
σn2: current volatility estimate
Now,
w
VL =
1−α − β
0.00005
= = 0.00067
1 − 0.025 − 0.90
T hus, σn2+50 = 0.000672 + (0.025 + 0.90)50(0.042 − 0.00067) = 0.0006889
Expected volatility is the square root of the expected variance rate:
σn +50 = √0.0006889 ≈ 0.00262
94
Q.4664 An investor notes that the closing stock price for asset A yesterday was USD 50, with a
corresponding volatility if 2.5% per day. Similarly, the closing stock price for asset B was USD 30,
with a corresponding volatility of 1.5% per day. Today, the stock price for asset A closed at USD 45,
and that of B closed at USD 35. T he correlation coefficient between the stocks A and B on close of
trading yesterday was 0.55.
Using the EWMA model with λ=0.85, what is the updated correlation coefficient between stocks A
and B?
A. 0.64
B. -0.64
C. 0.78
D. -0.78
According to the EWMA model,
s2n = (1−?)r2n −1+?s2n −1
45−50 35−30
For stock A, a return is -0.10 (= ) and that of B is 0.1667 (= ). T herefore, updated volatility
50 30
for stock A is:
sAn = √(1 − 0.85) × (−0.10)2 + 0.85 × 0.0252 ) = 0.04507
And that of B is:
sBn = √(1 − 0.85) × (0.1667)2 + 0.85 × 0.0152 ) = 0.06603
Now using the formula:
Cov(A, B)
Corr(A, B) =
sAsB
?Cov(A, B) = Corr(A, B) × sA sB
So the covariance yesterday was:
95
Cov(An −1, Bn −1 ) = 0.55 × 0.025 × 0.015 = 0.00020625
T he covariance is updated using the formula:
cov n =?cov n −1 + (1−?)x n −1y n −1
?Cov(An , Bn ) = 0.85 × 0.00020625 + (1 − 0.85) × −0.10 × 0.1667
= −0.002325
Cov( A,B)
Using the formula Corr(A, B) = once again, the new correlation is given by:
s As B
−0.002325
Corr(An , Bn ) = = −0.7813
0.04507 × 0.06603
96
Reading 50: External and Internal Credit Ratings
Q.1041 Which of the following statements is INCORRECT with regard to credit ratings?
A. A credit rating represents the agency’s opinion about the creditworthiness of an obligor
with respect to a particular debt security or other financial obligation.
B. Credit rating also applies to an issuer’s general creditworthiness.
C. T here are generally two types of assessment corresponding to different financial

instruments: short term and long term.
D. Credit ratings from different agencies convey the same information.
T he statement that 'Credit ratings from different agencies convey the same information' is
incorrect. Credit ratings, while generally serving the same purpose of assessing creditworthiness,
can vary significantly between different rating agencies. T his is because each agency has its own
methodology and criteria for rating an issuer or a specific debt security. For example, Standard &
Poor’s perceives its ratings primarily as an opinion on the likelihood of default of an issuer, whereas
Moody’s ratings tend to reflect the agency’s opinion on the expected loss on a facility. T herefore,
the ratings from different agencies often convey differentiated information, providing a more
comprehensive view of the credit risk associated with an issuer or a specific debt security.
Choi ce A i s i ncorrect. T his statement accurately describes the role of a credit rating. It indeed
represents the agency's opinion about the creditworthiness of an obligor with respect to a specific
debt security or other financial obligation.
Choi ce B i s i ncorrect. T his statement is also accurate as credit ratings do apply to an issuer's
general creditworthiness, not just specific financial obligations.
Choi ce C i s i ncorrect. T he statement correctly identifies that there are generally two types of
assessments corresponding to different financial instruments: short term and long term.
97
Q.1042 Which of the following statements is NOT true regarding the rating process?
A. T he criteria according to which any assessment is provided are very strictly defined and
constitute the intangible assets of rating agencies.
B. T he rating agency reviews qualitative as well as quantitative factors and compares the
company's performance with that of its peers.
C. T he issuer is notified of the rating and the major considerations supporting it before it is
discussed by the rating committee.
D. When a rating is put on a credit watch list, a comprehensive analysis is undertaken.
T he issuer is notified of the rating and the major considerations supporting it before it is discussed by
the rating committee. T his statement is not accurate. In the credit rating process, the issuer is
typically informed of the rating and the primary considerations that support it only after the rating
committee has discussed the lead analyst’s recommendation and voted on it. T he issuer is not privy
to the discussions that take place within the rating committee prior to the final decision. T his is to
ensure the integrity and independence of the rating process. T he issuer's involvement is limited to
providing necessary information and clarifications to the rating agency during the rating process.
Once the rating committee has made its decision, the issuer is then notified of the rating and the
major considerations that led to that rating.
Choi ce A i s i ncorrect. T he criteria for assessment in credit rating are indeed strictly defined and
constitute the intangible assets of rating agencies. T hese criteria include a variety of factors such as
financial performance, industry position, and management quality among others.
Choi ce B i s i ncorrect. Rating agencies do review both qualitative and quantitative factors when
assessing a company's creditworthiness. T hey compare the company's performance with that of its
peers to ensure an accurate evaluation.
Choi ce D i s i ncorrect. When a rating is put on a credit watch list, it does trigger a comprehensive
analysis by the rating agency. T his process involves reviewing all relevant information about the
issuer to determine if there has been any change in their risk profile that warrants an adjustment in
their credit rating.
98
Q.1043 T he rating “outlook” provides information about the:
A. Rating trend.
B. Loss severity independent of probability of default.
C. Loss severity given the probability of default.
D. Probability of default.
Thi ngs to Remember
1. Credit ratings are assessments of the creditworthiness of borrowers, issued by credit rating
agencies. T hey help investors and other stakeholders assess the risk of lending to or investing in a
particular company or government.
2. T he 'outlook' in credit ratings refers to the potential direction of the credit rating over the
medium term. It indicates whether the rating is likely to be upgraded, downgraded, or remain stable,
based on the current assumptions about the company's financial health and performance.
3. T he outlook is not about the probability of default or the potential loss in case of default. T hese
are separate aspects of credit risk assessment.
4. Understanding the 'outlook' can help investors and other stakeholders make informed decisions
about lending to or investing in a company. A positive outlook may suggest potential for improved
returns, while a negative outlook may signal increased risk.
99
Q.1044 Which of the following factor is part of the quantitative analysis of rating of an industrial
company?
A. Business fundamentals.
B. Operations and cost control.
C. Financial ratios.
D. Both A and B.
Financial ratios are a part of the quantitative analysis in the rating of an industrial company.
Quantitative analysis involves the use of mathematical and statistical methods to understand behavior
and predict future patterns. In the context of rating analysis for industrial companies, quantitative
analysis typically involves the examination of financial ratios. Financial ratios are mathematical
comparisons of financial statement accounts or categories. T hese relationships between the
financial statement accounts help investors, creditors, and internal company management understand
how well a business is performing and areas of needing improvement. Financial ratios are the most
common tools of managerial decision making and control in the industrial sector. T hey provide a way
of summarizing a large volume of accounting data in the form of understandable and interpretable
figures. T herefore, financial ratios are indeed a part of the quantitative analysis in the rating of an
industrial company.
Choi ce A i s i ncorrect. Business fundamentals are typically part of the business review process,
not the quantitative analysis. T he business review process involves a qualitative assessment of the
company's competitive position, strategy, and management quality.
Choi ce B i s i ncorrect. Operations and cost control also fall under the business review category
rather than quantitative analysis. T his aspect involves evaluating how efficiently a company manages
its operations and controls costs relative to its competitors.
Choi ce D i s i ncorrect. As explained above, both options A and B are components of the business
review process, not quantitative analysis in rating an industrial company.
100
Q.1045 T he rating of an issuer provided by a rating agency is a (an):
A. Mere opinion on the issuer or securities issued by the issuer.
B. Recommendation to purchase, sell, or hold any types of security.
C. Indicator of the issuer's creditworthiness and also gives the price or relative value of
specific securities.
D. Recommendation based on quantitative analyses and business reviews.
T he rating provided by a credit rating agency is indeed a mere opinion on the issuer or securities
issued by the issuer. It is important to understand that these ratings are not absolute or definitive
assessments of an issuer's creditworthiness. Instead, they are subjective evaluations based on the
agency's analysis and interpretation of the issuer's financial condition and future prospects. T hese
ratings are intended to provide investors with a benchmark for comparing the relative credit risk of
different securities. However, they do not guarantee the issuer's ability to meet its financial
obligations, nor do they predict the future performance of the securities issued by the issuer.
T herefore, while these ratings can be a useful tool for investors, they should not be the sole basis
for investment decisions.
Choi ce B i s i ncorrect. Credit ratings are not recommendations to purchase, sell, or hold any types
of security. T hey are simply an assessment of the creditworthiness of the issuer or securities issued
by the issuer.
Choi ce C i s i ncorrect. While credit ratings do indicate an issuer's creditworthiness, they do not
provide information on the price or relative value of specific securities. T he pricing and valuation of
securities involve other factors such as market conditions and investor sentiment which are beyond
the scope of a credit rating agency's analysis.
Choi ce D i s i ncorrect. Although quantitative analyses and business reviews may be part of a rating
agency's process, a credit rating is not a recommendation based on these factors alone. It represents
an overall opinion on the issuer's ability to meet its financial obligations.
101
Q.1046 Which of the following statements is true with regard to the relationship between ratings and
probabilities of default?
A. Across all industries, the number of defaults monotonically increases as we move down
the credit rank.
B. A given rating is meant to be forward-looking; it is devised to pinpoint a precise probability

of default.
C. Ex-post information such as that provided in default tables or transition matrices does
guarantee to provide ex-ante insights regarding future probabilities of default or migration.
D. Both A and B.
In the context of credit ratings and default probabilities, which of the following statements
accurately reflects the relationship between credit ratings and default probabilities?
102
Q.1047 T he following statements are true about through-the-cycle ratings issued by the rating
agencies except:
A. help financial institutions to better manage customers.
B. mitigate the effect of cycles on ratings by incorporating the effect of an “average cycle”
in their scenarios.
C. fluctuate much with temporary changes in microeconomic conditions.
D. valid for a much longer period.
Thi ngs to Remember
T hrough-the-cycle ratings are a type of credit rating that takes into account the average effects of
business cycles, providing a more stable and long-term view of a company's creditworthiness. T hese
ratings are particularly useful for financial institutions, as they provide a stable basis for making
lending decisions and managing customer relationships. Here are some key points to remember about
through-the-cycle ratings:
T hey incorporate the effects of an average business cycle, making them less volatile than
other types of ratings.
T hey do not fluctuate significantly with temporary changes in macroeconomic conditions.
T hey help financial institutions to better manage customers by providing a more stable
basis for making lending decisions.
T hey are typically valid for a period exceeding one year.
Q.1048 Which of the following statement is most likely to be true with regard to the impact of a
rating downgrade/upgrade on the price of bonds/stocks?
A. A rating downgrade is somewhat likely to increase the price of a bond.
B. A rating downgrade is likely to decrease the price of a bond.
C. A rating upgrade is unlikely to increase the price of the stock since the price only reflects
103
the earnings expectations of investors.
D. A rating downgrade is unlikely to decrease the price of a stock since the price largely
reflects earnings expectations among consumers.
A rating downgrade is likely to decrease the price of a bond. Credit ratings are a measure of a bond
issuer's ability to meet its financial obligations. When a rating agency downgrades a bond's rating, it
signals a higher risk of default. T his increased risk makes the bond less attractive to investors,
leading to a decrease in demand and, consequently, a decrease in the bond's price. For instance, if a
rating agency downgrades a bond issue's rating from BBB to BB due to a deterioration in the firm's
debt repayment ability (e.g., a fall in the current ratio), the bond's yield will increase substantially,
and its price will fall. In this case, the bond will transition from investment-grade to below
investment-grade. T his transition may force many pension funds, which may only be allowed to hold
investment-grade securities, to sell the bond. T his selling pressure will further depress the bond's
already low price. Conversely, a rating upgrade, which signals a decrease in default risk, is likely to
increase the bond's price by making it more attractive to investors.
Choi ce A i s i ncorrect. A rating downgrade typically indicates a higher risk of default, which makes
the bond less attractive to investors. As a result, the demand for the bond decreases and so does its
price.
Choi ce C i s i ncorrect. While it's true that stock prices reflect earnings expectations, they also
take into account other factors such as risk level and market sentiment. A rating upgrade usually
signals lower credit risk which can make the stock more appealing to investors, potentially leading to
an increase in its price.
Choi ce D i s i ncorrect. Similar to bonds, stocks are also affected by credit ratings. If a company's
rating is downgraded, it suggests higher financial risk which can negatively impact investor sentiment
and consequently lead to a decrease in the stock's price.
104
Q.2810 T he CRO of an investment bank is reviewing the internal rating assessment policies. He
notices that the bank is using the through-the-cycle approach to rate the borrowers. He is
concerned about the effectiveness of the current approach during recessions and asks to compare it
with the at-the-point-in-time approach.Which of the following statements is correct?
A. During recessions, the through-the-cycle approach tends to over-estimate risk during

recessions.
B. During recessions, the at-the-point-in-time approach tends to over-estimate risk during

recessions.
C. During recessions, both through-the-cycle and at-the-point-in-time approaches tend to

over-estimate risk.
D. During recessions, both through-the-cycle and at-the-point-in-time approaches tend to

under-estimate risk.
T he at-the-point-in-time approach assesses the credit quality over the near term and tends to amplify
the effect of the business cycle. During recessions, the at-the-point-in-time approach tends to
overestimate risk.
On the other hand, through-the-cycle internal ratings try to evaluate the permanent component of
default risk. Unlike point-in-time ratings, they are said to be nearly independent of cyclical changes in
the creditworthiness of the borrower. T hey are not affected by credit cycles, i.e. they are through
the cycle. As a result, they are less volatile than at-the-point ratings and are valid for a much longer
period (exceeding one year).
Q.2811 Greg Teller, a credit risk analyst, was requested by the CRO to check an internal rating
transition matrix prepared by an intern. T he matrix is based on actual rating migrations over the last
ten years. T he bank has ratings of A, B, C, and D, with A representing the highest credit quality and D
representing a default. T he bank currently has a rating of C. T he intern prepares the following table:
Annual Rating T ransitions (%, Average Annual)

A B C D
A 95.00 3.00 2.00 −
B 2.00 89.00 5.00 2.00
C − 7.00 83.00 10.00
105
After a short review, Teller makes the following statement to the CRO: Statement 1: “T he internal
rating transition matrix is correct.” He also decides to incorporate the findings from the matrix in
the conclusion of his research report for LLL Construction (the only C-rated borrower of the bank).
He includes the following sentence in the conclusion of the report: Statement 2: “ T he risk
management department recommends creating significant loan loss provisions for LLL’s facility as it
has a 10% chance of default with the current rating and a 0% chance of improvement to an A rating
over the longer term.” Are Teller’s statements correct?
A. Statement 1 is correct while statement 2 is incorrect.
B. Statement 1 is incorrect while statement 2 is correct.
C. Statement 1 is correct, and statement 2 is also correct.
D. Statement 1 is incorrect, and statement 2 is also incorrect.
Both Statement 1 and Statement 2 made by Greg Teller are incorrect.
Statement 1 is incorrect because the rows of the internal rating transition matrix should sum up to
100. In the matrix prepared by the intern, the sum of the probabilities in the second row is 98, not
100. T his discrepancy indicates that the matrix is not correctly prepared.
Statement 2 is incorrect because it misinterprets the data in the matrix. T he matrix shows 1-year
transition probabilities given a particular starting point. T he matrix is interpreted from left to right.
T his means A, B, and C, as shown on the left side, indicate the possible starting points. So, if the bank
is currently rated C, a move to A in exactly one year has a zero probability as indicated by the blank
probability representing the CA intersection. However, if we consider the long-term, or rather a
period greater than one year, there’s a non-zero chance of an A rating at some point in the future.
For example, in just two years, the bank can move from C to B with P(7%), then B to A with P(2%).
T herefore, Teller's statement that there is a 0% chance of improvement to an A rating over the
longer term is incorrect.
Choi ce A i s i ncorrect. Statement 1 is not correct because the sum of the probabilities in each
row of the matrix should be equal to 100%. However, in this case, for rating A, B and C, the sum of
probabilities are 100%, 98% and 100% respectively. T his indicates that there is an error in the
transition matrix.
106
Choi ce B i s i ncorrect. Although statement 2 correctly identifies that there's a risk for LLL
Construction due to its current C rating and a high chance of defaulting (10%), it incorrectly assumes
that there's a zero percent chance for improvement to an A rating over longer term. T he transition
matrix does not provide any information about long-term transitions or improvements from C to A.
Choi ce C i s i ncorrect. As explained above both statements made by Teller are incorrect.
Q.3436 Simon Bryan, FRM, is scrutinizing historical migration tables published by S&P’s and
Moody’s. Which of the following statements would possibly appear under “additional information”
below such tables?
A. We should expect to see the highest level of rating stability in the intermediate term (five-
year time frame). Risk ratings will tend to have changed more at both the one- year and ten-
year horizons.
B. We should expect to see the highest level of rating stability during the one-year
timeframe. T his stability will decline at both the five-year time frame and even more so at
the ten-year horizon.
C. We should expect to see the greatest amount of credit rating stability over long periods of
time (e.g., ten years). Credit ratings will tend to change more during shorter periods of time.
D. We should expect to see credit ratings change by about the same amount over time. T he
ratings transition matrix shows approximately the same figures for the one-year, five-year,
and ten-year time horizons.
T he Rating T ransition Matrix tables developed by renowned rating agencies show that credit ratings
are their most stable over a one-year horizon and that stability decreases with longer horizons. T his
is because credit ratings are designed to be forward-looking assessments of credit risk, and the
shorter the time horizon, the more accurate these assessments tend to be. Over longer time
horizons, many factors can change, including the financial health of the issuer, economic conditions,
and industry trends, which can all impact the issuer's ability to meet its debt obligations. T herefore,
it is expected that the stability of credit ratings would decline over longer time horizons such as five
years and ten years.
Choi ce A i s i ncorrect. While it might seem logical to assume that rating stability would be highest
107
in the intermediate term, this is not typically the case. Credit ratings are designed to be forward-
looking and incorporate expectations about future changes in a company's financial condition.
T herefore, they are more likely to change over longer time horizons as new information becomes
available and expectations adjust.
Choi ce C i s i ncorrect. T his statement contradicts the nature of credit ratings which are dynamic
and subject to change over time due to various factors such as changes in economic conditions,
industry trends, or company-specific events. Over long periods of time (e.g., ten years), it's more
likely for these factors to cause significant changes in a company's creditworthiness leading to less
stability in credit ratings.
Choi ce D i s i ncorrect. Credit ratings do not tend to change by about the same amount over
different time horizons. T he likelihood of a rating change increases with the length of the horizon
because there's more opportunity for new information that could affect a company's financial
condition or risk profile.
108
Q.3437 ANEX Financials (AF), a U.S. based firm, has just issued a two-year zero-coupon bond
currently rated AA. Market analysts expect that one year from now:
T he probability that the rating of AF remains at AA is 90%
T he probability that the rating of AF is downgraded to A is 5%
T he probability that AF is upgraded to AAA is 5%
T he risk-free rate is flat at 2%, and credit spreads for AAA-, AA-, and A-rated debt are flat at 40, 60,
and 100 basis points, respectively. All rates are compounded annually. What is the best approximation
of the expected value of the zero-coupon bond a year from today?
A. 97.6
B. 97.5
C. 97.7
D. 97.4
In a year’s time, the bond will be a 1-year zero-coupon bond.

T he bond has different expected values in each of the three scenarios outlined above. Precisely,
100
P AAA = = 97.66
(1 + 0.02 + 0.004)1
100
P AA = = 97.47
(1 + 0.02 + 0.006)1
100
PA = = 97.09
(1 + 0.02 + 0.01)1
Note that as the ratings deteriorate, so does the value of the bond.
Expected value = 5%× 97.66 + 90%× 97.47 + 5%×97.09 = 97.46
Note: 1% = 100 basis points
109
Q.3438 Rating agencies make efforts to incorporate the effects associated with an economic cycle in
their ratings. Although this practice is generally valid, it may lead to:
A. Underestimation of the probability of default in an economic recession
B. Overestimation of the probability of default in an economic recession
C. Underestimation of the probability of default in an economic expansion
D. Divergence of the interests of agency analysts and those of management
Underestimation of the probability of default in an economic recession. Rating agencies aim to
provide a long-term view of a firm's creditworthiness, which includes considering the potential
impact of economic cycles. However, this approach can sometimes lead to inaccuracies. In
particular, during an economic recession, the probability of default may be underestimated. T his is
because the severity of the recession may be greater than what was anticipated when the rating was
assigned. As a result, firms may face more financial distress than what was initially expected, leading
to a higher probability of default than what the rating suggests.
Choi ce B i s i ncorrect. Overestimation of the probability of default in an economic recession is
not a potential inaccuracy. In fact, during a recession, the risk of default generally increases due to
deteriorating economic conditions and financial stress on entities. T herefore, it would be more
accurate for rating agencies to anticipate higher probabilities of default during these periods.
Choi ce C i s i ncorrect. Underestimation of the probability of default in an economic expansion is
also not a potential inaccuracy that could arise from a rating agency's efforts to incorporate the
effects of an economic cycle into their ratings. During periods of economic expansion, entities are
generally more financially stable and less likely to default on their obligations; hence underestimating
defaults during such times aligns with general expectations.
Choi ce D i s i ncorrect. T he divergence between the interests of agency analysts and those of
management does not directly relate to inaccuracies arising from incorporating the effects of an
economic cycle into credit ratings. T his choice pertains more towards conflicts-of-interest issues
within rating agencies rather than methodological inaccuracies related to accounting for cyclical
effects.
110
Q.4682 Given a constant hazard rate of 0.02, what is the survival probability until year 3?
A. 0.9674
B. 0.9418
C. 0.9518
D. 0.9365
T he survival probability to time t is given by;
exp (−ht)
Where h is the hazard rate
T hen, the survival probability to year 3 is given by;
exp (−0.02 × 3) = 0.9418
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Q.4683 Suppose a firm has a debt of $20 million. If the recovery rate is 80%, and that there is a 0.03
chance that the loan will default, what is the expected loss?
A. 0.12m
B. 0.15m
C. 0.09m
D. 0.06m
Since the recovery rate is 80%, the loss given default (LGD) is
LGD = 100% − 80% = 20% .
T he expected loss on the loan is, therefore, :
EL = P D × LGD × EAD = 0.03 × 0.20 × $20 million = $0.12 million
112
Q.4684 Consider a firm in which the following information rations
i. Working capital to total assets = 0.32

ii. Retained earnings to total assets = 0.44
iii. Earnings before interest and taxes to total assets = 0.80
iv. Market value of equity to book value of total liabilities = 1.2
v. Sales to total assets = 1.8
What is the Altman’s Z-score for the firm?
A. 6.235
B. 6
C. 6.1582
D. 6.2543
T he Altman’s Z-score is given by:
Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 0.999X 5

= (1.2 × 0.32) + (1.4 × 0.44) + (3.3 × 0.80) + (0.6 × 1.2) + 0.999 × 1.8
= 6.1582
Where:
X 1: Working capital to total assets,
X 2: Retained earnings to total assets,
X 3: Earnings before interest and taxes to total assets,
X 4: Market value of equity to book value of total liabilities, and
X 5: Sales to total assets.
T he firm in this case, is not l i k el y to default since Z-score is greater than 3.
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Q.4685 Suppose the hazard rate for the first three years is 0.01. Suppose further that the cumulative
default probability over six years is 0.035. What is the probability of default between years 3 and 6?
A. 0.0421
B. 0.005446
C. 0.09434
D. 0.2701
To calculate the probability of default between year 3 and year 6, we first calculate the average
hazard rate over six years, which can be obtained as follows:
1 − exp(−h̄ × 6) = 0.035
⇒ h̄ = 0.005938
T he probability of default between years 3 and year 6 is therefore given by:
PD3,6 = Default during the first 3 years − Default during the first 6 years
= [exp(−0.01 × 3)] − [exp (−0.005938 × 6)]
= 0.005446
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Q.4686 Suppose that company XYZ has a debt value of $100m and that the value of its assets is
$120m. What is the value of equity?
A. 0
B. 20m
C. min(20m,0)
D. 83.33m
Let v be the value of the company’s assets and let d be the value of the debt. T he value of equity is
given by:
max (v − d,0) = max (120 − 100, 0)

= max (20,0) = 20
115
Q.4687 Suppose v is the value of the asset, and d is the value of the debt, the firm defaults when:
A. v < d
B. v > d
C. v = d
D. max(v − d) > d
A firm is considered to be in default when the total value of its assets (v) is less than the total value
of its debt (d). T his is because the firm's assets are the primary source of repayment for its debt. If
the value of these assets is less than the debt, the firm will not be able to meet its debt obligations,
leading to default. T his is a fundamental concept in financial risk management, as it helps in
understanding and assessing the credit risk associated with a firm.
Choi ce B i s i ncorrect. If the total value of a firm's assets (v) is greater than the total value of its
debt (d), then the firm would not be in a state of default. T his is because it has more assets than
liabilities, indicating that it can meet its financial obligations.
Choi ce C i s i ncorrect. If the total value of a firm's assets (v) equals to the total value of its debt
(d), then this does not necessarily mean that the firm is in default. It simply means that if all assets
were liquidated, they would just cover all debts, leaving no equity for shareholders but also no
outstanding obligations.
Choi ce D i s i ncorrect. T he condition max(v − d) > d does not make sense in this context as it
implies that maximum difference between asset and debt values should be greater than debt which
doesn't provide any clear indication about default scenario.
116
Reading 51: Country Risk
Q.1039 Bank ABC relies on credit default swaps to assess the default risk of sovereign bonds/debt.
Which of the following statements are true with regard to the relationship between Credit Default
Swaps and default risk?
I. Changes in CDS spreads lead to changes in sovereign bond yields and sovereign ratings
II. T he CDS market is quicker or better at assessing default risks than the government bond market,
from which default spreads can be extracted
III. T he exposure to counterparty and liquidity risk, endemic to the CDS market, can cause changes
in CDS prices that have little to do with default risk
IV. T he narrowness of the CDS market can make individual CDS susceptible to illiquidity problems,
with a concurrent effect on prices
A. I, III & IV only.
B. I & III only.
C. I, II & IV only.
Statement II is incorrect. It is not clear that the CDS market is quicker or better at assessing default
risks than the government bond market, from which we can extract default spreads.
All other statements are correct. Changes in CDS spreads lead to changes in the sovereign bond
yields and in sovereign ratings. T he exposure to counterparty and liquidity risk, endemic to the CDS
market, can cause changes in CDS prices that have little to do with default risk. T he narrowness of
the CDS market can make individual CDS susceptible to illiquidity problems, with a concurrent effect
on prices
Q.2807 Aram Stone recently graduated from one of the most renowned German universities. During
his time as an undergrad, Stone developed a unique algorithm that could completely change the
development of Artificial Intelligence. Stone wants to patent his idea and initiate a startup, but he did
not yet decide on the exact location. To evaluate legal risks, Stone found the rating presented in the
table below:
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Region Overall Legal Physical Intellectual
Property Property Property Property
Rights Rights Rights Rights
Central/Eastern Europe 4.78 4.64 5.47 4.22
Asia Oceania 4.77 4.42 5.44 4.44
Middle East & North Africa 4.76 4.61 5.42 4.26
Latin America 4.57 4.23 5.23 4.25
Africa 4.53 4.26 5.17 4.16
best protection <->highest scores
In which of the below regions should Stone register his company and patent if his main concern is
the protection of his algorithm?
A. Central/Eastern Europe
B. Asia & Oceania
C. Middle East & North Africa
D. Latin America
Thi ngs to Remember
1. Intellectual property rights are legal rights that provide creators protection for their inventions,
literary and artistic works, symbols, names, and images. T hey enable creators to earn recognition or
financial benefit from their inventions.
2. T he protection of intellectual property rights varies from region to region. It's crucial for
inventors and creators to understand the level of protection offered in different regions before
deciding where to register their patents.
3. In this case, Aram Stone should consider not only the overall property rights score but also the
specific score for intellectual property rights. Since his main concern is the protection of his
algorithm, the region with the highest intellectual property rights score would be the most suitable
for him.
4. It's also important to consider other factors when choosing a location for a startup, such as the
local business environment, access to resources, and potential market size.
118
Q.3433 Mendoza Valeria, FRM, works as a risk analyst at a Mexican conglomerate. She has been
asked to evaluate USD-based bond investments issued by four different companies. According to her
employer’s guidelines, the firm has a strict policy of only investing in companies with investment-
grade ratings on both the S& P rating scale and Moody’s. In addition, the firm only invests in
countries with favorable sovereign risk quality. Assuming the company is located in the paired
country, which (country, company) pair, as outlined below, would be the most appropriate
investment?
Country Import Ratio Debt Service Ratio Company S&P Rating Moody’s Rating
Jolly World 42 % 300 % Brighter World A Ba
ltd.
Pluto 18 % 30 % Green Leaf A Aa
Corp
Northern 8% 250 % Eastbrom BB Baa
Lights Financial
Norfork 30 % 50 % Helsinki Inc. BBB Ba
A. (Norfork, Helsinki Inc.)
B. (Northern Lights, Eastbrom Financial)
C. (Pluto, Green Leaf Corp)
D. (Jolly World, Brighter World ltd.)
T he pair (Pluto, Green Leaf Corp) is the most suitable investment according to the conglomerate's
guidelines. An investment-grade bond is defined as a bond that has received a rating of BBB or higher
on the S&P rating scale or a rating of Baa or higher on Moody's rating scale. Green Leaf Corp has
received an A rating on the S&P scale and an Aa rating on Moody's scale, both of which are
considered investment-grade ratings. Furthermore, the country of Pluto has an import ratio of 18%
and a debt service ratio of 30%. T he import ratio is a measure of a country's total imports relative to
its total foreign exchange reserves. A lower import ratio is generally indicative of a lower probability
of default, which could potentially lead to a rescheduling of payments. T he debt service ratio is a
measure of a country's debt service payments (principal + interest) relative to its export earnings. A
lower debt service ratio is generally indicative of a healthier (less risky) country. T herefore, given
the favorable ratings of Green Leaf Corp and the positive economic indicators of Pluto, the pair
(Pluto, Green Leaf Corp) is the most suitable investment according to the conglomerate's guidelines.
Choi ce A i s i ncorrect. Norfork, Helsinki Inc. does not meet the conglomerate's investment policy
119
as it has a Moody's rating of Ba, which is below investment grade.
Choi ce B i s i ncorrect. Northern Lights, Eastbrom Financial also fails to meet the criteria as its
S&P rating is BB, which falls under speculative grade and not investment grade.
Choi ce D i s i ncorrect. Jolly World, Brighter World ltd., despite having an S&P rating of A
(investment-grade), has a Moody's rating of Ba (below investment-grade). T herefore, it does not
comply with the conglomerate's stringent policy that requires both ratings to be at least at the level
of investment-grade.
Q.3434 Credit rating agencies like S&Ps and Moody’s issue two different credit ratings for countries
with an appetite for debt. T hese are the local currency debt rating and the foreign currency debt
rating. Historically, it has been observed that defaults on local-currency-denominated debt are less
frequent than foreign-currency-denominated debt.
What’s the main reason behind this observation?
A. Local currency debt has a lower spread compared to that of foreign debt
B. T his is a statistical anomaly – ideally, defaults rates in the two categories of debt should be
more or less equal
C. Foreign currency-denominated debt has fewer political ramifications than local currency-
denominated debt, making it easier to deal with the consequences from the perspective of a
country’s leadership
D. Unlike local currency obligations, foreign currency obligations cannot be settled via
monetary expansion
T he primary reason for the lower default rate on local-currency-denominated debt compared to
foreign-currency-denominated debt is the ability of governments to use monetary expansion to settle
their local currency obligations. Monetary expansion refers to the process by which a country's
central bank increases the money supply, often by printing more money. T his is a tool that
governments can use to manage their local currency debt, as they have the authority to print their
own currency. However, this option is not available for foreign currency obligations, as no
government has the right to print foreign currencies. T herefore, when a country has foreign
120
currency debt, it cannot use monetary expansion to manage its obligations, making defaults more
likely. T his explanation is consistent with the observation that credit ratings for local-currency-
denominated debt are typically higher than those for foreign-currency-denominated debt.
Choi ce A i s i ncorrect. While it's true that local currency debt often has a lower spread compared
to foreign debt, this doesn't directly explain the trend of fewer defaults on local currency debt. T he
spread is a reflection of the perceived risk associated with the debt, not a cause for default rates.
Choi ce B i s i ncorrect. T his statement suggests that there should be no difference in default rates
between local and foreign currency debts, which contradicts empirical evidence. It's not just a
statistical anomaly; there are fundamental reasons why countries are less likely to default on their
local currency debts.
Choi ce C i s i ncorrect. T he political ramifications of defaulting on any type of debt can be
significant and complex, but this doesn't necessarily make defaults on foreign currency-denominated
debt more common than those on local currency-denominated debt.
Q.3435 Credit ratings have over the years been put to task for issuing credit ratings that do not
accurately capture the risk associated with foreign debt owned by different countries around the
world.
Which of the following statements is false regarding weaknesses of rating agency sovereign debt
ratings?
A. Ratings are often reactive to real life happenings on the lending market
B. Rating agencies exhibit some interdependence while issuing credit ratings
C. Rating agencies use government-provided data to model default risk and come up with a
credit rating
'None of the above' is the false statement in this context. Each of the statements A, B, and C
accurately reflects some of the criticisms often leveled against the practices of credit rating
agencies in relation to sovereign debt ratings. Statement A highlights the reactive nature of ratings,
121
suggesting that agencies often adjust their ratings in response to events rather than anticipating
them. Statement B points to the lack of independence among rating agencies, implying that they often
follow each other's lead rather than conducting independent analyses. Statement C underscores the
reliance of agencies on government-provided data, which could potentially be biased or incomplete.
T herefore, none of these statements is false, making choice D the correct answer.
Choi ce A i s i ncorrect. T he criticism that ratings are often reactive to real life happenings on the
lending market is valid. Critics argue that credit rating agencies tend to adjust their ratings in
response to events rather than proactively predicting them, which undermines their reliability and
usefulness.
Choi ce B i s i ncorrect. It's true that rating agencies exhibit some interdependence while issuing
credit ratings. T his means they often come up with similar ratings for the same entity or debt
instrument, which can be seen as a lack of diversity in opinion and potentially lead to herd behavior
in financial markets.
Choi ce C i s i ncorrect. T he use of government-provided data by rating agencies has been criticized
because it may not always accurately reflect the risk associated with sovereign debt. Governments
may have incentives to present their economic situation in a more favorable light than it actually is,
leading to potential biases in the data used for credit assessments.
Q.5392 Consider the case of the fictional country, Sovland. In 2023, Sovland was an emerging
economy with an ambitious growth agenda, borrowing heavily in both local and foreign currencies to
fund infrastructure and development projects. T he country enjoyed steady growth until 2026 when a
severe economic downturn hit. T he Sovland government found it increasingly difficult to service its
debts and by 2027, it defaulted on both its local and foreign currency obligations. What are the most
plausible reasons that could have led to Sovland's sovereign default?
A. Sovland had insufficient gold reserves to back its currency.
B. T he local currency rating was several notches lower than the foreign currency rating,
causing financial instability.
C. Sovland, a part of a monetary union, could not independently control its monetary policy.
D. T he sovereign default was a culmination of unforeseen financial, economic, and political

issues.
122
Option D reflects the multi-dimensional causes of sovereign defaults, encompassing financial,
economic, and political issues. In the context of Sovland, the "severe economic downturn" can be
seen as an umbrella term for these factors. Financially, the downturn decreases the nation's
revenues, making debt servicing challenging. Economically, problems like inflation or currency
devaluation can intensify debt repayment difficulties, especially for foreign-denominated debt.
Politically, instability or corruption can negatively impact the economy and financial stability. T his
complexity makes (d) the most comprehensive and accurate answer.
A i s i ncorrect. Insufficient gold reserves wouldn't directly lead to a sovereign default. While gold
reserves were important under the gold standard system prior to 1971, modern currencies typically
are not directly backed by gold reserves. T herefore, Sovland's gold reserves (or lack thereof) would
not directly contribute to a default.
A i s i ncorrect. It's not uncommon for a country's local currency rating to be a notch or two higher
than its foreign currency rating. T his discrepancy would not necessarily lead to financial instability
and a sovereign default. Ratings reflect the perceived risk of default, they do not cause defaults.
A i s i ncorrect. T he question does not indicate that Sovland was a part of a monetary union. Even if
it were, not having independent control over monetary policy could contribute to financial
difficulties, but it would be one of several factors leading to a default rather than the sole cause.
123
Q.5393 In the hypothetical country of Eastportia, severe economic recession and political upheavals
have resulted in the country defaulting on its sovereign debt in 2030. In the immediate aftermath of
this event, which of the following consequences is Eastportia most likely to face?
A. Military intervention from the countries to which it owes debt.
B. Immediate liquidation of the country's assets to repay its debts.
C. Significant impediments to its economic development and growth, difficulty raising funds,
and a loss of investor confidence.
D. An immediate improvement in its credit rating due to the recognition of its financial
distress and default.
In the modern era, defaulting on sovereign debt can have serious consequences for a country,
including significant hindrances to its economic development and growth, an increase in difficulty
raising funds, a loss of investor confidence, a deepening of economic downturn, and political
instability. T hese are likely to be the immediate aftermath of Eastportia's default.
A i s i ncorrect. In the modern era, military intervention is not a usual consequence of a country
defaulting on its debt, unlike in the past.
B i s i ncorrect. Unlike a firm that defaults, a country cannot be liquidated. Instead, the debt is
typically restructured or replaced.
D i s i ncorrect. A default typically has a negative impact on a country's credit rating rather than an
improvement, reflecting the increased risk to investors.
124
Q.5394 Consider the case of Zeland, a fictional country with a high level of sovereign debt. Various
factors influence the level of sovereign default risk in Zeland. Which of the following factors is most
likely to influence the level of sovereign default risk?
A. T he country's economic diversification and export base.
B. T he level of political stability and effectiveness of governance.
C. T he currency in which the sovereign debt is issued.
D. T he historical track record of the country in servicing its debt.
Political stability and the effectiveness of governance play a crucial role in determining the level of
sovereign default risk. A stable political environment and effective governance reduce the likelihood
of policy disruptions, economic instability, and political upheavals that could hinder the country's
ability to service its debt. A well-functioning government can implement sound fiscal and monetary
policies, maintain investor confidence, and promote sustainable economic growth, reducing the risk
of default.
A i s i ncorrect. While economic diversification and a strong export base are important for a
country's overall economic stability, they do not directly determine the level of sovereign default
risk. A country could have a diverse economy and strong exports but still face default risk if other
factors such as governance or debt sustainability are problematic.
C i s i ncorrect. T he currency in which the sovereign debt is issued does influence certain aspects
of default risk, such as exchange rate risk. However, it is not the primary factor that determines the
overall level of sovereign default risk. Other factors, such as economic and political stability, have a
more significant impact on default risk.
D i s i ncorrect. While a country's historical track record in servicing its debt can provide insights
into its commitment to meeting obligations, it is not the most influential factor in determining the
level of sovereign default risk. A country's circumstances and the current economic and political
conditions are more critical indicators of default risk than historical performance alone.
125
Q.5395 When rating agencies measure sovereign default risks, which of the following factors is the
most significant in their assessment?
A. Fiscal deficit and government debt levels
B. Political stability and leadership
C. Economic growth and GDP per capita
D. Debt-to-GDP ratio and external debt exposure
When rating agencies measure sovereign default risks, the most significant factor in their
assessment is the debt-to-GDP ratio and external debt exposure. T he debt-to-GDP ratio reflects the
level of a country's government debt relative to its Gross Domestic Product (GDP), providing an
indication of the country's ability to manage and service its debt obligations. A higher debt-to-GDP
ratio increases the risk of default. Additionally, the external debt exposure measures the amount of
debt owed to foreign creditors, which adds another layer of risk to a country's default potential.
A i s i ncorrect. While fiscal deficit and government debt levels are important factors in assessing
sovereign default risks, they are not the most significant in the rating agencies' assessment. T hese
factors contribute to the debt burden of a country, but they do not capture the full picture of default
risk, as they do not consider the country's economic capacity to manage its debt.
B i s i ncorrect. Political stability and leadership are indeed relevant factors in evaluating a
country's overall stability and the potential impact on its ability to meet debt obligations. However,
they are not the most significant factor when rating agencies specifically measure sovereign default
risks. Political stability is often considered alongside other factors in the assessment but may not
have as direct an impact on default risk as the debt-related indicators.
C i s i ncorrect. Economic growth and GDP per capita are important indicators of a country's
economic health, but they are not the most significant factors in the rating agencies' assessment of
sovereign default risks. While economic growth and high GDP per capita can contribute to debt
sustainability, they are not the primary focus when evaluating default risks.
126
Q.5396 T he Republic of Veritas, a highly industrialized nation with robust infrastructure, has an
investment-grade rating by the leading credit rating agencies. However, recently the nation is
experiencing high volatility in its credit spread due to global economic turmoil. An investor, Mr.
Sterling, is examining Veritas's 10-year sovereign bond which has a yield of 6%, given the risk-free
rate in the same currency is 3%. Given the country's investment-grade rating and the characteristics
of sovereign credit spreads, Mr. Sterling is contemplating the factors that might have led to Veritas's
higher credit spread. He is also aware of the relationship between the credit spread and the credit
default swap (CDS) market. Based on the above scenario, which of the following statements best
explains the reasons behind the high credit spread of Veritas's sovereign bond?
A. T he credit rating agencies have recently downgraded Veritas's credit rating.
B. Speculators in the credit default swap market are driving up the cost of protection against
Veritas's debt.
C. Veritas has increased its public debt issuance significantly in the recent past.
D. T he 3% risk-free rate is causing artificial inflation of Veritas's credit spread.
In this case, the credit spread is more volatile and has increased despite the country's investment-
grade rating. One possible reason for this can be speculative activities in the CDS market, which can
affect credit spreads. If speculators drive up the cost of protection on the debt (as in the case of
Greece in 2010), bond holders might consider the yield to be too low, which can increase the credit
spread.
A i s i ncorrect. Veritas has an investment-grade rating. T here is no information provided that
suggests a recent downgrade of its credit rating.
C i s i ncorrect. While an increased debt issuance can put pressure on the country's
creditworthiness, it doesn't directly explain the high credit spread in the face of an investment-grade
rating. More public debt could lead to higher credit spreads, but only if there is a corresponding
increase in perceived default risk.
D i s i ncorrect. T he risk-free rate doesn't cause an artificial inflation of credit spreads. T he credit
spread is defined as the difference between the yield of the sovereign bond and the risk-free rate.
While a low risk-free rate might contribute to a wider credit spread, it would not directly cause a
higher credit spread independent of other factors.
127
Q.5397 Consider the hypothetical country of Norelia. Recently, economic turbulence has raised the
risk of Norelia defaulting on its debts. Norelia's rating has not yet changed, but its credit spread has
widened significantly, reflecting the heightened perceived risk among market participants.
Simultaneously, the Credit Default Swap (CDS) market is experiencing an influx of speculators
betting on Norelia's default, causing the price of protection to surge. Some financial experts argue
that these speculative activities have indirectly pushed Norelia's bond yields up. However, others
counter that Norelia's bonds themselves, rather than its CDS spreads, provide a more accurate
representation of the country's credit spread. Which of the following best describes the factors
contributing to the movements in Norelia's credit spreads and the potential implications?
A. Norelia's widened credit spread primarily reflects speculators driving up the cost of CDS
protection, exacerbating the country's financial difficulties by pushing up bond yields.
B. Norelia's bond yields, rather than its CDS spreads, serve as the primary source of credit
spread data. T herefore, the increase in bond yields directly suggests the country's
deteriorating financial health, independent of speculator activity.
C. Norelia's credit spread is fundamentally tied to its unchanged rating, making the impact of
speculator activity in the CDS market negligible.
D. Norelia's widened credit spread is due to the clustering effect in the CDS market, which
has unfairly penalized Norelia due to its association with other troubled economies.
T he credit spread for sovereign debt in a specific currency is the excess interest paid over the risk-
free rate in that currency. Norelia's bond yields, rather than its CDS spreads, should serve as the
primary source of credit spread data. T his is due to the possibility of the seller of protection
defaulting in a CDS, as well as issues with market illiquidity and clustering. T herefore, if Norelia's
bond yields have increased, it directly suggests the country's deteriorating financial health, regardless
of speculator activity.
A i s i ncorrect because it oversimplifies the role of speculators. While speculator activity might
influence the CDS market, it doesn't necessarily directly drive up a country's bond yields or credit
spreads. Moreover, many researchers argue that bond yields are not affected by CDS spreads.
C i s i ncorrect as the credit spread can adjust more quickly to new information than ratings, and can
therefore diverge from a country's rating. T his is one of the characteristics that make credit spreads
more granular and potentially more informative than ratings.
D i s i ncorrect because while clustering (where the CDS spreads of groups of countries move
128
together) is a phenomenon that can occur in the CDS market, it does not necessarily reflect the
default risk of a specific country. T hus, it would be inaccurate to attribute Norelia's widened credit
spread solely to a clustering effect.
129
Q.5398 T he Sovereign Republic of Midlandia, an emerging economy, has a recent credit rating that
aligns with neighboring nations in its region. However, the Republic of Midlandia's bonds have
exhibited lower credit spreads compared to its counterparts with similar ratings. Market participants
perceive Midlandia as less risky, and there's an influx of foreign direct investments (FDI). Despite
this favorable situation, the Midlandia government is worried about the potential for speculators to
manipulate the credit spreads. Given the circumstances, which of the following measures should the
government of Midlandia primarily consider to manage its credit spread?
A. Diversifying its bondholder base.
B. Strengthening the performance of its central bank.
C. Reducing reliance on ratings, focusing instead on improving economic fundamentals.
D. Seeking legislative measures to limit speculative trades as was done by the European
Union in 2011 to curb bets on the euro zone crisis.
Credit spreads, although correlated to credit ratings, provide more granular information on a
country's ability to repay its debt. T hus, focusing on improving economic fundamentals to reassure
bondholders about the country's ability to repay its debt would be more effective in managing credit
spreads.
A i s i ncorrect. While diversification could reduce the risk of sudden withdrawal of funds, it might
not directly affect the credit spread or reduce the risk from speculators.
B i s i ncorrect. While strengthening the performance of the central bank might improve the
country's overall economic stability, it is not a direct method to control credit spreads or speculative
activities.
D i s i ncorrect. Seeking legislative measures to limit speculative trades similar to the European
Union. While legislation could potentially limit speculators' impact on credit spreads, most
researchers argue that bond yields are not significantly affected by credit default swap (CDS)
spreads. T herefore, this might not be the most effective measure. Moreover, it would need to
consider the possible negative effects of such regulation, like reducing market liquidity.
130
Q.5399 Consider the following scenario: Country X and Country Y both hold the same credit rating
from a prominent credit rating agency. However, the credit spread for Country X's sovereign debt is
significantly lower than that of Country Y, indicating that the market perceives Country X as less
risky. Recently, new information has emerged that signals potential economic trouble for Country X.
As an analyst, how do you expect this new information to impact the credit spreads for Country X
and Country Y, and what implications might this have for their perceived risk?
A. T he credit spread for Country X will decrease, making it perceived as less risky than
Country Y.
B. T he credit spread for Country X will increase, causing no change in the perceived risk of
Country Y.
C. T he credit spread for both countries will increase due to their identical credit ratings.
D. T he credit spread for Country X will increase, possibly causing a reevaluation of the
perceived risk for Country Y.
T he new information signaling economic trouble for Country X will likely cause its credit spread to
increase, reflecting a higher risk of default. As credit spreads are more reactive to new information
than credit ratings, this change can happen quickly. While Country X and Y share the same credit
rating, they do not necessarily share the same credit spread, so an increase in Country X's credit
spread won't automatically affect Country Y's. However, this new perceived risk for Country X
might cause market participants to reevaluate the perceived risk for Country Y, even if Country Y's
economic situation hasn't changed, due to their previous identical credit ratings.
A i s i ncorrect because negative economic information would typically cause a credit spread to
increase, reflecting higher risk.
B i s i ncorrect. T he new information could lead to a reevaluation of perceived risk across similarly
rated countries, including Country Y.
C i s i ncorrect. Credit spreads are more specific and responsive to individual country situations
than ratings. T herefore, a change in one country's credit spread doesn't necessarily trigger a change
in the other's, even if their credit ratings are the same.
131
Q.5400 T he sovereign bond market is facing turbulent times. You are an analyst at a global
investment firm tasked with assessing the risk of various countries. Given recent global events,
there are concerns about the credibility and effectiveness of different metrics to evaluate sovereign
credit risk. Your attention is drawn to the credit spreads and credit ratings assigned to countries X
and Y. Both countries have similar credit ratings from the leading rating agencies. However, the
credit spread for country X is notably lower than that of country Y. T he speculator activity in the
Credit Default Swap (CDS) market for these countries is under scrutiny, and the illiquidity of the CDS
market has recently caused concerns. Which of the following explanations is most likely to account
for the difference in the credit spreads between country X and country Y, despite their similar credit
ratings?
A. Country X and Y are rated by different credit rating agencies.
B. Country Y may have a higher perceived default risk compared to Country X, reflected
more quickly in the credit spread than in the credit rating.
C. T he risk-free rate in Country Y is higher than that in Country X.
D. Speculators in the CDS market are manipulating the credit spreads of Country Y.
Credit spreads and credit ratings aim to capture the same underlying risk: the risk of default by a
country. However, they don't always move in lockstep. Credit spreads can adjust more quickly to
new information than credit ratings, and they are more granular (i.e., there's a range of credit
spreads associated with a given credit rating). As a result, it's possible for two countries to have
similar credit ratings but different credit spreads if the market perceives one country to be riskier
than the other.
A i s i ncorrect. T he same rating agencies typically rate most countries, and it's unlikely that a
discrepancy between agencies would cause such a difference in credit spreads.
C i s i ncorrect. A higher risk-free rate in Country Y could theoretically affect the credit spread, but
it would not likely be the primary factor causing a difference in credit spreads between two
countries with similar credit ratings.
D i s i ncorrect. While it's possible for speculators to influence CDS spreads and, indirectly, credit
spreads, this is not typically the main factor driving credit spreads, especially since regulatory
measures have been taken to limit speculative activity in the CDS market.
132
Q.5401 As the head of risk management at a multinational corporation, you are tasked with evaluating
the risk of expanding the company's operations into three countries: Alpha, Beta, and Gamma. You
decide to use composite measures of risk to evaluate each country's risk profile. You are considering
using Political Risk Services (PRS), Euromoney's country risk scores, and T he Economist's country
risk scores. You're aware that these services use different methodologies and that they all measure a
mixture of political, financial, and economic risk. Your company has significant exposure to
sovereign debt risk and political instability. Given your specific risk exposures and the information
provided by these services, how should you proceed to effectively assess the risk of expanding into
these countries?
A. Assign equal weight to each service's country risk score for each country to come up
with a composite risk measure.
B. Choose the service whose scoring method aligns best with your company's specific risk
exposures and use that service's country risk scores.
C. Combine the country risk scores from all three services but assign higher weight to the
service that best aligns with your company's specific risk exposures.
D. Ignore the numerical scores and solely focus on the rankings of the countries provided by
the services.
Given the different methodologies and considerations of each service, it's most prudent to
incorporate information from all three services. However, because your company has significant
exposures to sovereign debt risk and political instability, you should assign a higher weight to the
service that best assesses these specific risks. T his approach ensures that the specific exposures of
your company are well captured while not ignoring the other aspects of country risk that could
become relevant in the future.
A i s i ncorrect. Assigning equal weight to each service's country risk score doesn't account for the
fact that these services may not equally reflect your company's specific risk exposures.
B i s i ncorrect. Choosing one service that aligns best with your company's risk exposures might
overlook valuable information provided by the other services. Country risk is multifaceted, and a
composite risk measure should incorporate as many relevant factors as possible.
D i s i ncorrect. Ignoring the numerical scores and solely focusing on the rankings of the countries
might be oversimplifying the situation. T he rankings can provide a good overview, but the numerical
133
scores and accompanying narratives can give you much more granular and specific insights.
134
Reading 52: Measuring Credit Risk
Q.561 T he following is a structure of one-factor models between normally distributed variables, U i:
U i = ai F + √1 − a2iZi
Where F is a common factor for all U i and Zi is a component of U i that is unrelated to the factor F
and uncorrelated to each other. Which of the following is NOT a property of the above model?
A. Every U i has a standard normal distribution with mean = 0 and standard deviation = 1.
B. Every Zi is uncorrelated with each other.
C. T he constant α i is between 0 and 1.
D. F and Zi have standard normal distributions.
T he statement that the constant ai is between 0 and 1 is incorrect. In the given one-factor model, the
constant ai can take any value between -1 and +1, not just between 0 and 1. T his range allows for the
possibility of negative correlation between the common factor F and the variable U i . If ai were
restricted to be between 0 and 1, it would imply that F and U i can only be positively correlated or
uncorrelated, which is not necessarily the case in all situations. T herefore, the assertion that ai is
between 0 and 1 does not accurately represent a property of the one-factor model.
Choi ce A i s i ncorrect. Every U i does indeed have a standard normal distribution with mean = 0 and
standard deviation = 1. T his is because the model structure ensures that each U i is a linear
combination of two normally distributed variables, F and Zi , which results in another normally
distributed variable.
Choi ce B i s i ncorrect. It's true that every Zi is uncorrelated with each other. T he model specifies
this as a condition, meaning that the individual components of each variable are independent from one
another.
Choi ce D i s i ncorrect. F and Zi do have standard normal distributions as per the given model
structure. Both these variables are assumed to be normally distributed with mean 0 and variance 1,
which defines a standard normal distribution.
135
Q.562 A copula is:
A. A joint probability distribution between two uniformly distributed random variables.
B. A joint probability distribution between two or more uniformly distributed random

variables which still maintains their marginal distributions.
C. T he product of the marginal distributions of two or more random variables.
D. A statistical tool that represents a multivariate distribution while still maintaining their
individual marginal distributions.
A copula is indeed a statistical tool that represents a multivariate distribution while still maintaining
their individual marginal distributions. T he term 'copula' is derived from the Latin word 'copulare',
which means 'to connect'. In statistics, a copula is used to describe the dependence between random
variables. It is a multivariate distribution function whose marginal probability distribution is uniform
on the interval [0, 1]. T he copula function connects or 'couples' the marginal distributions of each
individual variable to form the joint distribution function. T his allows the copula to capture the
dependence structure between the variables, while the marginal distributions capture the individual
characteristics of each variable. T he use of copulas in financial markets is particularly important as
they allow for the modeling of skewed and heavy-tailed distributions which are often observed in
financial returns.
Choi ce A i s i ncorrect. While a copula does involve the joint probability distribution of random
variables, it is not limited to just two uniformly distributed random variables. It can be applied to two
or more random variables with any type of distribution.
Choi ce B i s i ncorrect. T his choice partially describes a copula but it's incomplete. A copula does
involve the joint probability distribution of two or more uniformly distributed random variables and
maintains their marginal distributions, but this definition doesn't capture the full essence of a copula
which also represents a multivariate distribution while maintaining individual marginal distributions.
Choi ce C i s i ncorrect. T he product of the marginal distributions of two or more random variables
136
defines an independent joint distribution, not a copula. A copula goes beyond this by allowing for
dependence structures between the variables.
Q.1051 Yusuf, a research scholar associated with Dale University, presents a report on expected
loss to the senior management of Glovsky Bank. He makes the following statement(s) in his report:
Statement I: T he expected loss is a certain amount of money a bank is expected to lose over a pre-
determined period of time when extending loans to its customers
Statement II: Even though credit loss levels will fluctuate from year to year, there is an anticipated
average level of losses over time that can be statistically determined
Statement III: Expected loss must be treated as a foreseeable cost of doing business in the lending
business
Statement IV: Expected loss represents the level of losses predicted for the following year based on
the economic cycle
Which of these statements are true?
A. I & II only
B. I, II & III only
D. I, II & IV only
Yusuf, a research scholar, has submitted a report to the senior management of Glovsky Bank. In his
report, he makes four statements about expected loss in the context of banking and lending:
Statement I: T he expected loss is a certain amount of money a bank is expected to lose over a pre-
determined period of time when extending loans to its customers.
Statement II: Despite the fluctuation in credit loss levels from year to year, there is an anticipated
average level of losses over time that can be statistically determined.
Statement III: Expected loss should be considered as a foreseeable cost of doing business in the
lending industry.
Statement IV: Expected loss represents the level of losses predicted for the following year based on
the economic cycle.
Which of these statements accurately reflect the concept of expected loss in banking and lending?
137
Q.1052 Economic losses are determined using certain components. Which of the following is not a
component that determines economic losses?
A. Probability of default.
B. Exposure amount.
C. Loss rate.
D. All of the three components determine Economic loss.
All of the three components mentioned, namely the probability of default, exposure amount, and loss
rate, are indeed used in the determination of economic losses.
T he probability of default (PD) is a measure of the likelihood that a borrower will default on their
contractual payments within a specified period. It is typically expressed as a percentage.
T he exposure amount (EA), also known as exposure at default (EAD), represents the potential loss
that a bank faces at the time of a loan's default. It is expressed as a dollar amount and is essentially a
prediction of the loss that would be incurred if the borrower were to default.
T he loss rate, also known as the loss-given-default (LGD), is the percentage loss that would be
incurred if the borrower defaults. It can also be thought of as the expected loss expressed as a
percentage.
T herefore, all three components are integral to the calculation of economic losses.
Choi ce A i s i ncorrect. T he probability of default is indeed a component used in the calculation of
economic losses. It represents the likelihood that a borrower will fail to meet its debt obligations.
Choi ce B i s i ncorrect. T he exposure amount also plays a crucial role in determining economic
losses. It refers to the total value at risk in the event of a default.
Choi ce C i s i ncorrect. Loss rate, or loss given default, represents the proportion of exposure that
will be lost if a default occurs and hence it's an integral part of calculating economic losses.
138
Q.1053 American International Bank sanctioned a loan to a corporate client. T he following
particulars are given in the credit note by the credit analyst of the client:
Exposure amount = 100 USD million
Loss rate = 10%
Probability of default = 20%
What is the expected loss of the loan?
A. USD 2 million.
B. USD 20 million.
C. USD 10 million.
D. USD 40 million.
Expected loss = Probability of default at time H ∗ Exposure amount at time H

∗ Loss rate experienced at time H
= P D ∗ EA ∗ LR
= 100 ∗ 0.2 ∗ 0.1
= 2 million
139
Q.1054 Rojan Ortiz, a senior credit risk analyst at Asiana Bank, discusses with his colleague the
components of the economic losses. He makes the following statements with regard to the
components of the economic losses. Which of the following are true?
Statement I: T he loss rate is the fraction of the exposure amount that is lost in the event of default
Statement II: Probability of default is a borrower-specific estimate that is typically linked to the
borrower's risk rating
Statement III: Exposure amount and loss rate reflect and model the product specifics of a borrower's
liability
Statement IV: Probability of default (PD) is a measure of the likelihood that a counterparty goes into
default over a predetermined period of time
A. I & II only.
B. I, II & III only.
C. II, III & IV only.
Rojan Ortiz, a senior credit risk analyst at Asiana Bank, is having a conversation with his colleague
about the various elements that contribute to economic losses. He makes four statements regarding
these components. Which of these statements are accurate?
Statement I: T he loss rate is the fraction of the exposure amount that is lost in the event of default
Statement II: Probability of default is a borrower-specific estimate that is typically linked to the
borrower's risk rating
Statement III: Exposure amount and loss rate reflect and model the product specifics of a borrower's
liability
Statement IV: Probability of default (PD) is a measure of the likelihood that a counterparty goes into
default over a predetermined period of time
140
Q.1055 A bank credit risk is preparing a manual on unexpected losses. Which of the following
statements can be captured in the manual with regard to unexpected loss?
I. It is important to price unexpected losses in a loan's interest rate adequately
II. Unexpected loss in statistical terms is the standard deviation of credit losses, that is, the standard
deviation of actual credit losses around the expected loss average
III. Unexpected loss can be calculated at the transaction and portfolio level
IV. Unexpected loss is the primary driver of the amount of economic capital required for credit risk
A. I & II only.
A banking professional specializing in credit risk is in the process of compiling a comprehensive

guide on the concept of unexpected losses. In this context, which of the following statements would
be accurate and could be included in the guide pertaining to the nature and implications of unexpected
loss?
I. T he pricing of unexpected losses should be adequately reflected in the interest rate of a loan
II. In statistical parlance, unexpected loss is the standard deviation of credit losses, i.e., the standard
deviation of actual credit losses from the average expected loss
III. T he computation of unexpected loss can be performed at both the transaction and portfolio
levels
IV. T he primary determinant of the quantum of economic capital required for credit risk is the
unexpected loss
141
Q.1056 John Sutton, a recent finance graduate working at Asana Finance Ltd., approaches his
superior, George Shelton, to understand the differences and similarities between expected losses and
unexpected losses. George makes the following statements:
Statement I: T he unexpected loss of a specific loan on a stand-alone basis (i.e., ignoring
diversification effects) can be derived from some of the components of expected loss
Statement II: Expected loss is calculated as the mean of a distribution whereas unexpected loss is
calculated as the standard deviation of the same distribution
Statement III: Like expected losses, unexpected losses can also be calculated for various time
periods and for rolling time windows across time
Statement IV: Unexpected losses stem from the (unexpected) occurrence of defaults and
(unexpected) credit migration whereas expected losses must be treated as the foreseeable cost of
doing business in lending markets
Which of these statements are true?
A. Statements I & II only.
B. Statements I, II & III only.
C. Statements II, III & IV only.
John Sutton, a recent finance graduate, is currently employed at Asana Finance Ltd. He is keen to
understand the nuances of expected and unexpected losses in the context of financial risk
management. His superior, George Shelton, provides him with four statements to explain the
concepts:
Statement I: T he unexpected loss of a specific loan on a stand-alone basis (i.e., ignoring
diversification effects) can be derived from some of the components of expected loss
Statement II: Expected loss is calculated as the mean of a distribution whereas unexpected loss is
calculated as the standard deviation of the same distribution
Statement III: Like expected losses, unexpected losses can also be calculated for various time
periods and for rolling time windows across time
Statement IV: Unexpected losses stem from the (unexpected) occurrence of defaults and
(unexpected) credit migration whereas expected losses must be treated as the foreseeable cost of
doing business in lending markets
Which of these statements accurately reflect the truth?
142
Q.1057 Which of the following represents the correct relationship between the expected loss,
unexpected loss, and the actual loss?
A. Expected Loss = Unexpected Loss - Actual Loss.
B. Unexpected Loss = Expected Loss - Actual Loss.
C. Actual Loss = Expected Loss + Unexpected Loss.
D. Actual Loss = Expected Loss * Unexpected Loss.
T he actual loss is indeed the sum of the expected loss and the unexpected loss. T he expected loss is
the amount a bank can expect to lose, on average, over a predetermined period when extending
credits to its customers. It is a measure of the average loss that can be expected to occur due to
default or other credit events. On the other hand, the unexpected loss is the volatility of credit
losses around its expected loss. It represents the potential variation in actual loss results around the
expected loss. It is essentially the standard deviation of the loss distribution. T herefore, the actual
loss, which is the real loss experienced, is the summation of the expected loss (the average loss that
can be expected) and the unexpected loss (the potential variation in actual loss). T his relationship is
fundamental in credit risk modeling and is used to determine the economic capital that a bank needs
to hold against unexpected losses.
Choi ce A i s i ncorrect. Expected Loss cannot be calculated by subtracting Actual Loss from
Unexpected Loss. T he Expected Loss is the average loss that a lender can expect to incur, and it's
not dependent on the actual or unexpected loss.
Choi ce B i s i ncorrect. Unexpected Loss cannot be calculated by subtracting Actual Loss from
Expected Loss. T he Unexpected loss represents the potential deviation from the expected loss, and
it's not derived directly from actual or expected losses.
Choi ce D i s i ncorrect. Actual loss cannot be calculated by multiplying Expected Loss with
Unexpected Loss. T hese are distinct concepts in credit risk management and do not have a
multiplicative relationship.
143
Q.1058 ABX Bank Limited is holding a portfolio of loans. Which of the following, considering a loan at
the portfolio level, is NOT part of the contribution of the single unexpected loss to the overall
portfolio risk?
A. T he loan’s expected loss.
B. T he loan’s exposure amount.
C. T he correlation of the exposure to the rest of the portfolio.
D. None of the above.
All the options listed (a, b, and c) do contribute to the single unexpected loss's impact on the overall
portfolio risk. T he expected loss of the loan, the loan's exposure amount, and the correlation of the
exposure to the rest of the portfolio are all factors that contribute to the overall portfolio risk.
T herefore, none of the options listed can be excluded as not contributing to the overall portfolio
risk.
Choi ce A i s i ncorrect. T he expected loss of a loan does contribute to the single unexpected loss's
impact on the overall portfolio risk. T he expected loss is a measure of the average loss that can be
anticipated for a loan, given its probability of default and potential severity of loss.
Choi ce B i s i ncorrect. T he exposure amount of a loan also contributes to the single unexpected
loss's impact on the overall portfolio risk. T he larger the exposure amount, the greater potential for
significant losses which could affect portfolio risk.
Choi ce C i s i ncorrect. T he correlation of an exposure to the rest of the portfolio indeed
contributes to its impact on overall portfolio risk. If an exposure has high correlation with other
exposures in a portfolio, it means that if one asset defaults, others are likely to default as well,
increasing total unexpected losses.
144
Q.1059 Neeson, a quantitative analyst, is preparing a model for estimating unexpected losses. He is
incorporating appropriate distributions for the components of unexpected losses.
Which of the following are true with regard to the distributions of components of unexpected
losses?
I. T he probability of default is a binomial distribution
II. T he loss rate can take a number of shapes, which results in different equations for the variances
of loss rate
III. T he binomial distribution understates the variance of the loss rate as compared to the uniform
distribution
IV. T he uniform distribution assumes that all defaulted borrowers would have the same probability of
losing anywhere between 0 percent and 100 percent
A. I & II only
B. I, II & III only
D. I, II & IV only
Neeson, a quantitative analyst, is in the process of developing a model to estimate unexpected losses
in a financial context. He is considering the use of various distributions for the components of
unexpected losses. Given the following statements, which combination of them accurately reflects
the distributions of components of unexpected losses?
I. T he probability of default is represented by a binomial distribution
II. T he loss rate can assume various forms, leading to different equations for the variances of loss
rate
III. T he binomial distribution underestimates the variance of the loss rate when compared to the
uniform distribution
IV. T he uniform distribution presumes that all defaulting borrowers have an equal probability of
incurring losses ranging from 0 percent to 100 percent
Q.1061 Default correlations play an important role in measuring the marginal contributions of a loan
to a loan portfolio. With regard to default correlations for a loan portfolio containing a large number
of loans:
A. Default correlations are very difficult, if not impossible, to observe.
B. If the loan portfolio contains ‘n’ loans, [n(n-1)]/2 pairwise default correlations need to be
estimated.
C. Default correlations are small, but positive providing considerable benefits to

diversification in credit portfolios.
145
D. All of the above are true.
All the statements provided in the options are indeed true in the context of default correlations in a
large loan portfolio. Default correlations are indeed challenging, if not impossible, to observe,
especially in a portfolio that contains a large number of loans. T his is because the complexity and
variability of factors influencing loan defaults make it difficult to accurately observe and measure
these correlations. Furthermore, the number of pairwise default correlations that need to be
estimated in a portfolio is given by the formula [n(n-1)]/2, where 'n' is the number of loans in the
portfolio. T his is because each loan can potentially have a default correlation with every other loan
in the portfolio, leading to a large number of pairwise correlations. Lastly, default correlations are
typically small but positive. T his means that while the likelihood of two loans defaulting at the same
time is low, it is not zero. T his small but positive correlation provides considerable benefits to
diversification in credit portfolios, as it reduces the overall risk of the portfolio.
Choi ce A i s i ncorrect. While it is true that default correlations can be challenging to observe,
they are not impossible to estimate. Various statistical and financial models exist that allow for the
estimation of default correlations, making this statement inaccurate.
Choi ce B i s i ncorrect. T he formula given in this choice, [n(n-1)]/2, is used to calculate the
number of unique pairs in a set where 'n' represents the total number of items (in this case loans).
However, estimating pairwise default correlations does not necessarily require this many
calculations as there are methods available that simplify the process.
Choi ce C i s i ncorrect. Default correlations are indeed generally small and positive but stating they
provide considerable benefits to diversification in credit portfolios can be misleading. While
diversification can reduce risk, it does not eliminate it entirely and other factors such as
concentration risk and systemic risk must also be considered.
146
Q.1062 Anston Walsh, a credit analyst at Grant Bank, is entrusted with the task of calculating the
economic capital for a portfolio of loans underwritten by the bank. Walsh based his task of computing
economic capital on the following assumptions/statements. Which of them are to be considered in
the computation to determine the most appropriate amount of economic capital?
Statement I: T he amount of economic capital needed is the distance between the expected outcome
and the unexpected (negative) outcome at a certain confidence level
Statement II: T he crucial task in estimating economic capital is the choice of the probability
distribution
Statement III: Credit risks are normally distributed
Statement IV: One distribution often recommended for measuring credit risk is the normal
distribution
A. I & II only.
C. I, III & IV only.
Not numerical
Q.3074 BYJ commercial bank has $100 million of retail exposures. T he 1-year probability of default
averages 2% and the recovery rate averages 60%. If the correlation parameter is estimated at 0.1,
what will be the 1-year unexpected loss at 99.9% confidence?
A. $7.68 million
B. $8.01 million
C. $4.32 million
D. $12.8 million
Assuming the loss distribution is lognormal, the α percentile of the distribution of the default rate
logarithm is
N −1(P D) − √ρN −1(1 − α)

αpercentile for default rate = N ( )
√1 − ρ
147
T hus, the 99 default rate is given by;
⎡ {N −1(0.02) + √0.1N −1(0.999)}

⎤
V (0.999, 1) = N ⎢⎢ ⎥⎥
⎣ √1 − 0.1 ⎦
−2.05 + √0.1 × 3.09
= = 0.128
√1 − 0.1
T his is showing that the 99.9% worst-case default rate is 12.8%
T he 1-year unexpected loss at 99.9% confidence is given by:
(W CDR − P D) × LGD × EAD

=(0.128 − 0.02) ∗ (1 − 0.6) ∗ 100
=4.32 million
Where:
α is the confidence level
ρ is the correlation between each pair of U i distributions
N −1 is the inverse cumulative normal distribution
W CDR (Worst-Case Default Rate)is the 99.9 percentile of the default rate distribution
LGD is the Loss Given Default(equals one minus the recovery rate).
PD is the Probability of Default
EAD is the total exposure at default (i.e., the sum of the principals of all the loans).
148
Q.3440 An investor holds a portfolio of $200 million. T his portfolio consists of AA-rated bonds ($120
million) and BB-rated bonds ($80 million). Assume that the one-year probabilities of default for AA-
rated and BB-rated bonds are 4% and 6%, respectively, and that they are independent. In the event of
default, the recovery rate for AA-rated bonds is 65%, and the recovery rate for BB-rated bonds is
40%. Determine the one-year expected credit loss from this portfolio:
A. $1,680,000
B. $4,560,000
C. $4,500,000
D. $2,880,000
T he expected loss of the portfolio is the sum of the expected losses of individual assets.
EL = EA × PD × LR
For AA-rated bonds,

EA = $120, 000, 000,
PD = 0.04, and
LR = 0.35
T hus,
EL AA = 120, 000, 000 × 0.04 × 0.35 = $1, 680, 000
For BB-rated bonds,

EA = $80, 000, 000,
PD = 0.06, and
LR = 0.6
T hus,
EL BB = 80, 000, 000 × 0.06 × 0.6 = $2, 880, 000
Portfolio Expected Loss = $1, 680, 000 + $2, 880, 000 = $4, 560, 000
Q.3441 A portfolio consists of two bonds. T he credit VaR – as defined by the bondholder – is the
maximum loss due to defaults at a confidence level of 99%, over a period of one year. T he probability
that the two bonds jointly default is 2%, with a default correlation of 25%. T he bond value, default
probability, and recovery rate are USD 500,000, 5%, and 50% for one bond, and USD 300,000, 3%,
and 30% for the other. Determine the expected credit loss of the portfolio:
149
A. USD 18,800
B. USD 12,500
C. USD 18,424
D. USD 12,424
T he joint default probability and the default correlation are nugatory as far as the expected credit
loss of the portfolio is concerned. In other words, they do no matter.
T he expected loss of the portfolio is simply the sum of the expected losses of individual assets.
EL = EA × P D × LR
For the first bond,
EA = $500, 000,
P D = 0.05, and
LR = 0.5
T hus,
EL AA = 500, 000 × 0.05 × 0.5 = $12, 500
For the second bond,
EA = $300, 000,
P D = 0.03, and
LR = 0.7
T hus,
EL BB = 300, 000 × 0.03 × 0.7 = $6, 300
P ortf olio credit loss = $12, 500 + $6, 300 = $18, 800
Note: T he joint probability of default and the default correlation would be important only in the
calculation of the unexpected credit loss of the portfolio.
150
Q.3657 Australian Synergies Finance Limited uses beta distributions to measure credit risks. T he
company states that the beta distribution helps in predicting the credit losses accurately. With regard
to the measurement of credit losses, which of the following statements are true?
I. T he beta distribution is often recommended and is a suitable probability distribution for measuring
the credit losses
II. T he beta distribution is especially useful in modeling a random variable that varies between -1 and
+1
III. T he shape of the beta distribution can be completely determined by specifying the parameters α
and β
IV. T he beta distribution is fully characterized by two parameters: expected loss of the portfolio and
unexpected loss of the portfolio
A. I & II only
B. I, III & IV only
C. I, II & IV only
D. II, III & IV only
Statements I, III, and IV are accurate in the context of measuring credit losses using beta
distributions. T he beta distribution is often recommended and is a suitable probability distribution for
measuring credit losses as credit losses are normally distributed but highly skewed. T his is because
the beta distribution can model the skewness in the distribution of credit losses. T he shape of the
beta distribution can be completely determined by specifying the parameters α and β. T his means
that the beta distribution can be tailored to fit the specific characteristics of the credit loss
distribution for a particular portfolio. T he beta distribution is fully characterized by two parameters:
expected loss of the portfolio and unexpected loss of the portfolio. T hese two parameters are
critical in credit risk management as they provide a measure of the potential losses that a portfolio
could incur due to credit events.
Choi ce A i s i ncorrect. While statement I is true, statement II is not. T he beta distribution models
a random variable that fluctuates between 0 and 1, not -1 and +1.
Choi ce C i s i ncorrect. As explained above, the beta distribution does not model a random variable
that fluctuates between -1 and +1 (statement II). Moreover, the beta distribution isn't characterized
by the expected loss of the portfolio and the unexpected loss of the portfolio (statement IV). It's
151
defined by two shape parameters α and β .
Choi ce D i s i ncorrect. Statement IV incorrectly characterizes the beta distribution as being
defined by expected loss and unexpected loss of a portfolio which isn't accurate. T he correct
parameters are α (alpha) and β (beta).
Q.4644 A bank has two assets outstanding, denominated in U.S. dollars. T he correlation between the
two assets is 0.4. Other details are as follows:
Asset A Asset B
EA 1,600, 000 2, 000, 000
PD 1% 2%
LR 30% 40%
Calculate the expected loss (EL) of the portfolio.
A. 22400
B. 20800
C. 18200
D. 20200
T he expected loss of a portfolio is equal to the summation of expected losses of individual asset.
T hat is,
EL P = ∑EAi × P Di × LGDi
= [1, 600, 000 × 0.01 × 0.3] + [2, 000, 000 × 0.02 × 0.4]
= 20, 800
152
Q.4645 T he amount of a loan issued by a bank is $2 million, with a default probability of 0.1% over a
period of one year. If the recovery rate is estimated to be 40%, what it the expected credit loss?
A. $800
B. $1,000
C. $1,200
D. $700
T he credit loss of a single asset is given by:
EL = EA × P D × LGD
But also
LGD = 1– Recovery Rate
So, the expected credit loss is given by:
EL = $2 million × 0.001 × (1 − 0.4) = $1, 200
153
Q.4646 T he amount of a loan issued by a bank is $2 million, with a default probability of 0.1% over
one year. If the recovery rate is estimated to be 40%, what is the standard deviation expected credit
loss?
A. $37,928.35
B. $30,567.65
C. $32, 464.54
D. $35,890.75
T he standard deviation of the loss is given by:
σi = √pi − p2i [L i (1 − R i )]
=√0.001 − 0.0012 [$2 million (1 − 0.4)] = 0.0379284 = 37, 928.35
154
Q.4647 T he Bank of Africa has a portfolio of three $2 million loans, each with a default rate of 0.5%
over one year. If the correlation between the loans is 0.4 and the recovery rate is 40%, what is the
mean of the portfolio credit loss?
A. $18,000
B. $12,000
C. $10,000
D. $9,000
T he mean of credit loss of a loan is given by:
piL i (1 − R i)
Nevertheless, we are given three loans with the same variables. So the mean of the portfolio is:
=3 × piL i (1 − R i )
3 × 0.005 × 2 million × (1 − 0.4) = $18,000
155
Q.4648 T he Bank of Africa has a portfolio of three $2 million loans, each with a default rate of 0.5%
over one year. If the correlation between the loans is 0.4, and the recovery rate is 40%, what is the
standard deviation of the portfolio credit loss?
A. $426,875
B. $38,685
C. $84,600
D. $196,593
T he variance of the credit loss of a loan portfolio is given by
σP2 = nσ2 + n (n − 1) ρσ 2
Since the loans have equal principal L, recovery rate R and default probabilities, we need to compute
the common standard deviation as:
σi = √p − p2 [L (1 − R)]
= √0.005 − 0.0052 [2 × (1 − 0.4)] = 0.0846
T hus, the variance of the credit loss is given by
σP2 = nσ2 + n (n − 1) ρσ 2
σP2 = 3 × 0.08462 + 3(3 − 1) × 0.4 × 0.08462 =
Hence, the standard deviation of the credit loss is given by
σp = √0.386852 = 0.196593 = $196, 593
156
Q.4650 Aiden Bank has a $500 million loan portfolio with a PD of 0.5%. Assuming the Vasicek Model,
what is the 99.9 percentile of the default rate if the correlation parameter is 0.25?
A. 0.1305
B. 0.0165
C. 0.1169
D. 0.0175
According to the Vasicek model, the 99.9 percentile of the default rate is given by
N −1 (P D) + √ρN −1 (0.999)
99.9 percentile for default rate = N ( )
√1 − ρ
N −1 (0.005) + √0.25N −1 (0.999)
=N( )
√1 − 0.25
−2.576 + 0.5 × 3.09
⇒N( ) = N (−1.1905) = 0.1169 = 11.69%
√1 − 0.25
Q.4652 A bank has a loan portfolio consisting of three loans A, B, and C with standard deviations of
1.25 each. T he correlations matrix appears as follows:
Loan A Loan B Loan C

Loan A 1 0 0.3
Loan B 0 1 0.6
Loan C 0.3 0.6 1
Suppose the size of loan A is increased by 1%. Using the Euler’s theorem, calculate the contribution
of loan A to the total standard deviation.
A. 0.76
B. 0.72
C. 0.80
D. 0.74
157
According to Euler’s theorem,
ΔFi
Qi = x i
Δx i
Where
Δx i = small change in x i
ΔFi = small change in Fi
Δx i
Qi = ratio of ΔFi to a proportional change in x i
xi
We need to first calculate the total loss on the portfolio.
Given a portfolio of three assets, the portfolio standard deviation is given by:
σp = √σ 2 + σB2 + σ 2 + 2ρABσA σB + 2ρACσA σC + 2ρBC σBσC

A C
T he current portfolio standard deviation is
√1.252 + 1.252 + 1.252 + 2 × 0 × 1.25 × 1.25 + 2 × 0.3 × 1.25 × 1.25 + 2 × 0.6 × 1.25 × 1.25
= 2.738613
Now if the size of loan A is increased by 1%, then the new standard deviation of loan A is given by
1.25 × 1.01 = 1.2625
So, the new portfolio standard deviation is
√1.26252 + 1.252 + 1.252 + 2 × 0 × 1.2625 × 1.25 + 2 × 0.3 × 1.2625 × 1.25 + 2 × 0.6 × 1.25 × 1.25
= 2.746048
T he change in portfolio standard deviation = 2.746048 – 2.738613 = 0.007435
So, that
0.007435
158
0.007435
QA = = 0.7435 ≈ 0.74
0.01
T he contributions of loans B and C can be calculated in a similar manner, i.e., increasing their
respective standard deviations by 1%, holding all other factors constant.
Q.4653 Credit risk capital for derivatives is challenging to calculate as compared to that of the loans.
Which of the following reason(s) makes this statement true?
A. T he exposure at default for the derivative is relatively less certain than it is for the loans.
B. Derivatives are subject to netting agreements.
C. All of the above.
Both the reasons mentioned in choices A and B contribute to the complexity of calculating credit risk
capital for derivatives. T he exposure at default for a derivative is less certain than for loans. T his is
because the value of a derivative is dependent on the underlying asset, which can fluctuate over
time. T herefore, the amount that could be lost in the event of a default is less predictable.
Furthermore, derivatives are often subject to netting agreements. In the event of a default, all
outstanding derivatives with a given counterparty may be considered as a single derivative. T his
makes it difficult to estimate the credit risk capital as the netting agreement can significantly reduce
the exposure at default. T herefore, both these factors make the calculation of credit risk capital for
derivatives more challenging than for loans.
Choi ce A i s i ncorrect. While it's true that the exposure at default for a derivative can be less
certain than for loans, this doesn't contribute to the complexity of calculating credit risk capital for
derivatives. T he uncertainty in exposure at default is a characteristic of all financial instruments, not
just derivatives. T herefore, this option does not accurately describe the unique challenges posed by
derivatives.
159
Choi ce B i s i ncorrect. Although netting agreements are common in derivative transactions, they
do not inherently add to the complexity of calculating credit risk capital for derivatives. Netting
agreements can actually simplify the calculation by reducing counterparty credit risk.
Choi ce D i s i ncorrect. T his choice suggests that none of the characteristics listed contribute to
the complexity of calculating credit risk capital for derivatives which contradicts with our correct
answer.
Q.4654 Barclays Bank has a $600 million loan portfolio, and the recovery rate in the event of default
is 40%. Assuming the Vasicek Model, the required regulatory capital is $5 million. T he 99.9
percentile for default rate is 0.0188. What is the probability of default for the loan portfolio?
A. 0.0051
B. 0.0400
C. 0.0049
D. 0.0054
T he Basel II capital requirement for banks under the IRB approach is given by
(W CDR − P D) × LGD × EAD
Where WCDR is defined as the worst-case default rate, and it is 99.9 percentile of the default rate
distribution defined as in Vasicek model, which in this case is 0.0188.
⇒ (W CDRP D) × LGD × EAD = 5

(0.0188 − P D) × (1 − 0.4) × 600 = 5
∴ P D = 0.004911
160
Q.4655 A bank issues a $2 million loan, with a default probability of 0.5% over one year. T he standard
deviation of the expected credit loss is $35,000. What is the recovery rate?
A. 0.752
B. 0.456
C. 0.656
D. 0.764
T he standard deviation of the loss is given by:
σi = √pi − p2i [L i (1 − R i)]
= √0.005 − 0.0052 [$2 million(1 − R i)] = 0.035

⎡ 0.035 ⎤
⇒ 1− = 0.7519
⎣ 2 × √0.005 − 0.005 2⎦
Q.4656 A bank issues a $7 million loan, with a default probability of 0.5% over a period of one year. If
the recovery rate is estimated to be 35%, what is the expected credit loss on this loan?
A. $23,350
B. $22,750
C. $23,600
D. $22,850
T he credit loss of a single asset is given by:
EL = EA × P D × LGD
= $7 million × 0.005 × (1 − 0.35) = $22, 750
161
Q.4657 An American bank recently issued a USD 5 million loan to a business entity, of which USD 2
million is currently outstanding. According to the bank’s internal rating model, the business entity has
a 0.5% chance of defaulting over the next year. In case that happens, the estimated loss rate is 25%.
T he probability of default and the loss rate have standard deviations of 7% and 17%, respectively.
What is the value of unexpected loss?
A. $41,245.45
B. $42,461.75
C. $40,564.56
D. $45,563.45
T he unexpected loss is given by:
2 + LR 2 × σ 2
UL = EA × √P D × σLR PD
So in our case.
EA =USD 2,000,000
P D =0.5%
LR =25%
σLR = 0.17
σLR = 0.07
T hus,
= 2,000, 000 × √0.005 × 0.172 + 0.252 × 0.072

= $42,461.75
162
Q.4658 T he bank of Aides has a portfolio consisting of 100,000 loans, each amounting to $1 million,
and has a 1% probability of default in a year. T he recovery rate is 40%, and the correlation
coefficient is 0.3. Calculate α , the standard deviation of the loss from the loan portfolio as a
percentage of its size.
A. 0.033
B. 0.045
C. 0.056
D. 0.045
T he α parameter is given by:
σ√1 + (n − 1) ρ
α=
L√n
For this case,
L = $ 1 million
ρ = 0.3
n = 100,000
R = 0.4
σ = √p − p2 [L (1 − R)]
= √0.01 − 0.012 [1(1 − 0.4)] = 0.05970
T herefore,
0.05970√1 + (100, 000 − 1)0.3

α= = 0.03270
1 × √100,000
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Reading 53: Operational Risk
Q.1069 US International Bank is contemplating assessing operational risk for regulatory capital.
Which of the following approaches can be used to calculate operational risk?
I. Basic indicator approach
II. Standardized approach
III. Advanced measurement approach
IV. Internal Ratings Based approach
A. I, II & III only.
B. I, III & IV only.
T he Basic Indicator Approach, the Standardized Approach, and the Advanced Measurement Approach
are the three methods that banks can use to determine operational risk regulatory capital. T he Basic
Indicator Approach is the simplest method and is based on the bank's gross income. T he Standardized
Approach is more complex and takes into account the different business lines of the bank. T he
Advanced Measurement Approach is the most complex and allows banks to use their own internal
models to calculate operational risk. T hese three approaches are recognized by the Basel II and
Basel III frameworks, which are international regulatory frameworks for banks.
Choi ce B i s i ncorrect. While the Basic Indicator Approach (I) and Advanced Measurement
Approach (III) are indeed used for calculating operational risk, the Internal Ratings Based approach
(IV) is not. T he Internal Ratings Based approach is a method used to calculate credit risk, not
operational risk.
Choi ce C i s i ncorrect. T he Standardized Approach (II) and Advanced Measurement Approach (III)
are valid methods for calculating operational risk, but again, the Internal Ratings Based approach (IV)
is not applicable as it pertains to credit risk.
Choi ce D i s i ncorrect. As explained above, all three approaches - Basic Indicator Approach (I),
Standardized Approach(II), and Advanced Measurement Approach(III)- can be used to calculate
164
operational risk but the Internal Ratings Based approach(IV), which pertains to credit risk calculation
cannot be used in this context.
Q.1070 A bank follows the basic indicator approach for assessing operational risk for regulatory
purposes. Which of the following statement(s) is/are NOT true with regard to the basic indicator
approach?
A. Under this approach, operational risk capital was set equal to 15% of the three-year
average annual gross income.
B. Gross income is defined as net interest income.
C. Net interest income is the excess of income earned on loans over interest paid on
deposits and other instruments that are used to fund the loans.
D. All of the above are true.
Under the basic indicator approach, operational risk capital was set equal to 15% of the three-year
average annual gross income.
Gross income is defined as net interest income plus non-interest income.
Net interest income is the excess of income earned on loans over interest paid on deposits and other
instruments that are used to fund the loans.
165
Q.1071 Eurasia Bank Limited is following the basic indicator approach for calculating the operational
risk amount for the year 2016. T he financial details of the bank are given below:
Income earned Interest paid Non-interest

(In million USD) income
Year 2015 105 52 18
Year 2014 100 50 20
Year 2013 95 40 16
Based on the original Basel Accord, the bank must hold capital for operational risk for 2016 equal to:
A. USD 10.60 million.
B. USD 10.95 million.
C. USD 11.05 million.
D. USD 7.90 million.
Based on the original Basel Accord, banks using the basic indicator approach must hold capital for
operational risk equal to the average over the previous three years of a fixed percentage of positive
annual gross income. Gross income is defined as net interest income plus non-interest income.
Net interest income plus non-interest income for the previous three years:
Income Interest Net Non-interest Gross

earned paid Income income Income
(In million USD)
Year 2015 105 52 53 18 71
Year 2014 100 50 50 20 70
Year 2013 95 40 55 16 71
Average gross income over the previous three years: 70.667

Operational risk = 15% of average gross income over the previous three years: 10.60
166
Q.1072 American International Bank is using the standardized approach for measuring operational
risk for regulatory capital. T he bank is least likely to:
I. Have an operational risk management function that is responsible for identifying, assessing,
monitoring, and controlling operational risk
II. Keep track of relevant losses by business line and must create incentives for the improvement of
operational risk
III. Have a well-documented operational risk management system
IV. Estimate unexpected losses based on an analysis of relevant internal and external data, and
scenario analyses
A. I & II only.
B. III & IV only.
C. III only.
D. IV only.
Thi ngs to Remember
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and
systems, or from external events. It includes legal risk, but excludes strategic and reputational risk.
T he standardized approach for measuring operational risk for regulatory capital is a simpler and less
flexible approach compared to the Advanced Measurement Approach (AMA). It uses predetermined
risk weights applied to different business lines to calculate operational risk capital.
T he AMA, on the other hand, requires banks to use their own internal models to calculate
operational risk capital. T his involves estimating unexpected losses based on internal and external
data and scenario analyses.
Regardless of the approach used, banks are required to have an operational risk management
function, track relevant losses by business line, and have a well-documented operational risk
management system.
Q.1073 T he Basel Committee on Banking Supervision (BCBS) has identified seven categories of
operational risk. Which of the following categories are covered by the Basel Committee?
167
I. Employment practices and workplace safety
II. Clients, products, and business practices
III. Execution, delivery, and process management
IV. Strategic risk
B. II, III & IV only.
C. I, II & IV only.
T he Basel Committee on Banking Supervision (BCBS) has indeed identified 'Employment practices
and workplace safety', 'Clients, products, and business practices', and 'Execution, delivery, and
process management' as three of the seven categories of operational risk. Operational risk, as
defined by the BCBS, is the risk of loss resulting from inadequate or failed internal processes, people
and systems or from external events. T his definition includes legal risk, but excludes strategic and
reputational risk. 'Employment practices and workplace safety' covers risks related to breaches of
employment law, health and safety regulations, and any other employment or safety-related legal
requirements. 'Clients, products, and business practices' involves risks related to the suitability of
products for clients, marketing practices, and adherence to codes of conduct. 'Execution, delivery,
and process management' includes risks related to transaction processing, system failures, and
management failures. T hese categories are part of the BCBS's comprehensive framework for the
management of operational risk, which aims to ensure that banks have robust methodologies in place
to identify, assess, monitor and control/mitigate operational risk.
Choi ce B i s i ncorrect. While "Clients, products, and business practices" and "Execution, delivery,
and process management" are indeed categories of operational risk identified by the BCBS, "Strategic
risk" is not. Strategic risk refers to the risks that a firm faces due to poor business decisions or
improper implementation of its strategies. It's more related to the overall direction of the company
rather than day-to-day operations.
Choi ce C i s i ncorrect. T his option includes "Employment practices and workplace safety", and
"Clients, products, and business practices", which are correct categories as per BCBS guidelines for
168
operational risk. However it also includes “Strategic Risk” which as explained above is not
considered an operational risk category by BCBS.
Choi ce D i s i ncorrect. As explained above in choices B & C explanations , “Strategic Risk” does
not fall under the purview of operational risks according to Basel Committee on Banking Supervision
(BCBS) guidelines hence all four cannot be correct categories.
Q.1074 A bank with annual revenues of $4 billion has incurred a loss of $200 million on account of
operational risk. What would be the losses for a bank with a similar business profile but with
revenues of $12 billion? Assume the exponent for scaling losses is 0.23.
A. USD 7.76 million
B. USD 12.76 million
Revenue of bank B0. 23

Loss of bank B = ( ) ∗ Loss of bank A
Revenue of bank A
12 0. 23
=( ) ∗ 200
4
= 30. 23 ∗ 200 = 257.5 million
Q.1075 Your Canadian Bank has been using the standardized approach for the last three years. T he
board of directors has recently decided to use the advanced measurement approach for measuring
operational risk for regulatory risk from the current year onwards. Considering the change in
measurement approach, which of the following process has been adopted from the current year
onwards in the risk management department of the bank?
A. Regular reporting of operational risk losses throughout the bank.
B. Well-documented operational risk management system.
C. Regular independent review of operational risk management processes by internal

auditors, external auditors, and supervisors.
169
D. Estimation of unexpected losses based on an analysis of relevant internal and external
data, and scenario analyses.
T he Advanced Measurement Approach (AMA) for operational risk, as per Basel II guidelines,
requires banks to develop their own empirical model to quantify required capital for operational risk.
Banks can use this approach only subject to approval from their local regulators. T he AMA allows
banks to use a wider range of operational risk measurement techniques, provided they can
demonstrate to their supervisor that their techniques are sound, implemented with integrity, and that
they meet a series of qualitative and quantitative standards. One of the key requirements of the AMA
is the estimation of unexpected losses based on an analysis of relevant internal and external data, and
scenario analyses. T his involves the use of internal loss data, relevant external loss data, scenario
analysis, and factors reflecting the business environment and internal control systems. T herefore,
with the shift from the standardized approach to the AMA, the bank would have adopted the process
of estimating unexpected losses based on an analysis of relevant internal and external data, and
scenario analyses, as stated in choice D.
Choi ce A i s i ncorrect. Regular reporting of operational risk losses throughout the bank is a
common practice in both the standardized and advanced measurement approaches. T herefore, this
would not be a new procedure implemented due to the shift in risk measurement methodology.
Choi ce B i s i ncorrect. Having a well-documented operational risk management system is also a
requirement under both methodologies, hence it would not be unique to the advanced measurement
approach.
Choi ce C i s i ncorrect. Regular independent reviews of operational risk management processes by
internal auditors, external auditors, and supervisors are part of good governance practices and are
expected under both methodologies. T hus, this procedure would not have been newly implemented
due to the transition from standardized approach to advanced measurement approach.
Q.1076 Bank X is following the advanced measurement approach for measuring operational risk.
Which of the following should be the operational risk capital computed for regulatory purposes?
170
A. T he bank must use 15% of net interest income over the previous three years.
B. T he bank’s activities are divided into eight business lines. T he average gross income over
the last three years for each business line is multiplied by a "beta factor" for that business
line, and the result is summed to determine the total capital.
C. T he bank must estimate one-year 99.9% VaRs for the seven categories of operational
risks identified by the Basel Committee and then aggregate them to determine a single one-
year 99.9% operational risk VaR measure.
D. T he bank must use 15% of net interest income plus non-interest income over the
previous three years.
T he advanced measurement approach (AMA) is a method for operational risk management under the
Basel II Accord. Under this approach, banks are allowed to develop their own empirical model to
quantify required capital for operational risk. Banks can use this approach only subject to approval
from their local regulators. T he AMA allows a bank to use internal operational risk loss data, relevant
external operational risk loss data, scenario analysis data and business environment and internal
control factors in determining the bank's operational risk capital requirement. In this case, the bank
must estimate one-year 99.9% Value at Risk (VaR) for each of the seven categories of operational
risks identified by the Basel Committee. T hese categories include internal fraud, external fraud,
employment practices and workplace safety, clients, products and business practices, damage to
physical assets, business disruption and system failures, and execution, delivery and process
management. T he bank then aggregates these VaRs to determine a single one-year 99.9% operational
risk VaR measure. T his measure represents the capital that the bank needs to hold to cover
unexpected losses from operational risks over a one-year period with a confidence level of 99.9%.
Choi ce A i s i ncorrect. T he advanced measurement approach (AMA) does not require the bank to
use 15% of net interest income over the previous three years to calculate its operational risk
capital. T his method is too simplistic and does not take into account the specific risks associated with
different types of operations.
Choi ce B i s i ncorrect. While it's true that under Basel II, banks' activities are divided into eight
business lines for operational risk assessment, this method described here refers to the Standardized
Approach (T SA), not AMA. In T SA, average gross income over the last three years for each business
171
line is multiplied by a "beta factor" for that business line, and then summed up to determine total
capital requirement. However, in AMA, banks are allowed to use their own internal models to
estimate operational risk.
Choi ce D i s i ncorrect. Similar to choice A, using 15% of net interest income plus non-interest
income over the previous three years as a measure of operational risk capital does not align with
AMA guidelines set by Basel Committee on Banking Supervision (BCBS). T he AMA requires more
sophisticated modeling techniques that capture all significant aspects of operational risk faced by a
bank.
Q.1077 Loss severity and loss frequency are two distributions that are important in estimating
potential operational risk losses for a risk type. With regard to these two distributions, which of the
following is true?
A. For loss frequency, the natural probability distribution to use is a Poisson distribution, and
for the loss-severity probability distribution, a lognormal distribution is used.
B. For loss frequency, the natural probability distribution to use is a lognormal distribution,
and for the loss-severity probability distribution, a Poisson distribution is used.
C. For loss frequency, the natural probability distribution to use is a Poisson distribution, and
for the loss-severity probability distribution, a normal distribution is used.
D. For loss frequency, the natural probability distribution to use is a normal distribution, and
for the loss-severity probability distribution, a Poisson distribution is used.
In the context of operational risk management, loss frequency and loss severity are two critical
distributions used to estimate potential losses for a specific risk type. For loss frequency, the natural
probability distribution to use is a Poisson distribution. T he Poisson distribution is a discrete
probability distribution that expresses the probability of a given number of events occurring in a
fixed interval of time or space if these events occur with a known constant mean rate and
independently of the time since the last event. T his distribution assumes that losses happen randomly
through time so that in any short period of time Δt, there is a probability λΔt of a loss occurring. For
the loss severity probability distribution, a lognormal distribution is used. T he lognormal distribution
172
is a continuous probability distribution of a random variable whose logarithm is normally distributed.
T he parameters of this probability distribution are the mean and standard deviation of the logarithm
of the loss. T herefore, choice A accurately describes the natural probability distributions used for
loss frequency and loss severity in operational risk management.
Choi ce B i s i ncorrect. T he lognormal distribution is not typically used for loss frequency in
operational risk management. Loss frequency refers to the number of times a loss event occurs,
which can only take on non-negative integer values (0, 1, 2,...). T he Poisson distribution is more
suitable for this purpose as it models events that occur at a constant mean rate with independent
occurrences. On the other hand, the lognormal distribution is continuous and can take any positive
real value, making it unsuitable for modeling count data like loss frequency.
Choi ce C i s i ncorrect. While the Poisson distribution correctly represents loss frequency as
explained above, a normal distribution does not accurately represent loss severity in operational risk
management. Loss severity refers to the magnitude of losses when an event occurs and can take any
non-negative real value (including zero). A normal distribution includes negative values which are not
applicable in this context since losses cannot be negative. Instead, a lognormal distribution which
only takes positive values would be more appropriate.
Choi ce D i s i ncorrect. Neither part of this choice accurately represents natural probability
distributions used in operational risk management. As explained earlier, a normal distribution does not
suitably model loss frequency due to its ability to take negative values while Poisson distributions are
inappropriate for modeling loss severity because they only represent count data.
173
Q.1078 T he Basel Committee on Banking Supervision (BCBS) requires the implementation of the
advanced measurement approach to involve some elements. T hese include:
I. Internal data
II. External data
III. Strategic analysis
IV. Business environment and internal control factors
C. I, II & IV only.
T he advanced measurement approach, as mandated by the Basel Committee on Banking Supervision
(BCBS), requires the inclusion of four key elements. T hese are: (a) Internal data, (b) External data,
(c) Scenario analysis, and (d) Business environment and internal control factors. T he option C
correctly identifies three of these four elements, namely Internal data, External data, and Business
environment and internal control factors. T he only element that is not correctly identified in this
option is the 'Strategic analysis', which should be 'Scenario analysis' as per the BCBS guidelines.
T herefore, despite the slight misrepresentation, option C is the most accurate among the given
choices.
Choi ce A i s i ncorrect. While internal data and external data are indeed elements required by the
BCBS for the implementation of the advanced measurement approach, strategic analysis is not. T he
BCBS does not specifically require strategic analysis as a separate element in this context.
Choi ce B i s i ncorrect. Although external data and business environment and internal control
factors are part of the elements outlined by BCBS, strategic analysis again does not form part of
these specific requirements.
Choi ce D i s i ncorrect. As explained above, all of the listed options do not represent the elements
required by BCBS for implementing advanced measurement approach because strategic analysis (III)
is not one of them.
174
Q.1080 New Zealand National Bank uses the advanced measurement approach to compute the
operational risk capital for regulatory purposes. Noria Franti, a financial controller, working at the
bank, analyzes the research reports on internal data and external data. She concludes the following
from the analysis:
I. Banks have done a much better job at documenting their operational losses than their credit risk
losses.
II. Credit card frauds are high-frequency, low-severity losses.
III. When an institution can not use its own data, then external data can be used as a guide.
IV. T he loss frequency distribution must be specific to the bank and based on internal data and
scenario analysis estimates.
Which of these statements is correct?
A. I & III only.
B. III & IV only.
C. I, II & IV only.
D. II, III & IV only.
Thi ngs to Remember
1. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people,
and systems, or from external events. T his includes legal risk, but excludes strategic and reputational
risk.
2. T he advanced measurement approach (AMA) for operational risk capital computation is a method
that allows banks to develop their own empirical model to quantify required capital for operational
risk. Banks can use this approach only subject to approval from their local regulators.
3. Credit card frauds are a type of operational risk and are typically high-frequency, low-severity
events. T his means that they occur frequently, but each individual event does not result in a
significant loss.
4. When a bank cannot use its own data to estimate loss severity, it can use external data as a guide.
T his is a common practice in risk management, especially when the internal data is insufficient or
unreliable.
175
5. T he loss frequency distribution should be specific to the bank and based on internal data and
scenario analysis estimates. T his helps in accurately reflecting the bank's unique risk profile in the
operational risk model.
176
Q.1082 T he operational risk team of the Canadian Insurance Group informs the risk committee that
the company faces higher risk than predicted while insuring a bank against operational losses
because the bank operates recklessly after taking the insurance cover, further increasing the risks it
is exposed to. Which of the following clauses/precautions can be taken to mitigate this risk?
I. Deductible in the insurance policy
II. Coinsurance provision
III. Policy limit
IV. Understanding the controls existing within the bank and the losses that have been experienced
A. I & II only.
B. II & III only.
C. I, II & III only.
D. IV only
Thi ngs to Remember
1. Moral hazard is a situation where the behavior of the insured party changes when they are
covered by insurance. T his is because the party feels protected against losses and may take on
higher risks.
2. Insurance companies can mitigate the risk of moral hazard by implementing measures such as
incorporating a deductible in the insurance policy, including a coinsurance provision, and setting a
policy limit.
3. A deductible is the amount that the insured party has to pay before the insurance coverage kicks
in. T his ensures that the insured party has a stake in preventing losses.
4. Coinsurance is a provision where the insurance company and the insured party share the losses.
T his again ensures that the insured party has a stake in preventing losses.
5. A policy limit is a cap on the total liability of the insurer. T his limit can provide an incentive for
the insured party not to relax its operational controls as the insurer's liability is limited.
6. While understanding the controls existing within the insured party and the losses that have been
experienced can help in assessing the risk, it does not directly mitigate the risk.
177
Q.1083 Frank Andrews, an operational risk analyst, is interested in using the power law to assess
operational risk. Which of the following statement(s) is/are true with regard to the power-law?
I. T he power law holds well for large losses experienced by banks
II. Loss data and scenario analysis are employed to estimate the power-law parameters using the
maximum likelihood approach
III. When loss distributions are aggregated, the distribution with the heaviest tails tends to dominate
IV. T he loss with the highest alpha defines the extreme tails of the total loss distribution
A. I & II only.
B. II & III and IV only.
Thi ngs to Remember
1. T he power law is a statistical distribution that can be used to model operational risk. It is
particularly applicable to large losses experienced by banks, as it can account for the occurrence of
large, infrequent losses that are often observed in operational risk.
2. T he estimation of the power-law parameters involves the use of loss data and scenario analysis,
employing the maximum likelihood approach. T his approach is a statistical method that estimates the
parameters of a model by maximizing a likelihood function, thus making the observed data most
probable.
3. When loss distributions are aggregated, the distribution with the heaviest tails tends to have a
dominant influence. T his is because the power law, with its heavy tails, can account for the
occurrence of large, infrequent losses that are often observed in operational risk. T herefore, when
aggregating loss distributions, those with the heaviest tails (i.e., those that follow the power law) will
tend to dominate.
4. T he alpha value in the power law is inversely related to the thickness of the tail of the
distribution. T herefore, a lower alpha value corresponds to a heavier tail, which defines the extreme
tails of the total loss distribution. T he statement that the loss with the highest alpha value defines the
extreme tails of the total loss distribution is incorrect.
178
Q.1085 T he existence of an insurance contract causes the bank to behave differently than it
otherwise would and increases the risks to the insurance company. T his risk is known as:
A. Adverse selection.
B. Moral hazard.
C. Wrong-way risk.
D. Operational risk.
Moral hazard is a term used in economics, finance, and insurance to describe the risk that arises
when a party behaves differently because it is protected by an insurance contract. In the context of
banking and insurance, moral hazard refers to the risk that the existence of an insurance contract
will cause the bank to behave differently than it otherwise would. T his changed behavior increases
the risks to the insurance company. T he bank, knowing that it is protected by the insurance, might
take on more risk than it would without the insurance. T his could lead to reckless behavior, such as
lending to high-risk borrowers or investing in risky assets, which could potentially lead to significant
losses for the insurance company. T herefore, moral hazard is a significant concern for insurance
companies and is a critical factor that they need to consider and manage when underwriting
insurance policies.
Choi ce A i s i ncorrect. Adverse selection refers to a situation where an individual's demand for
insurance (either the propensity to buy insurance, or the quantity purchased, or both) is positively
correlated with the individual's risk of loss. It does not refer to a change in behavior due to the
presence of an insurance contract.
Choi ce C i s i ncorrect. Wrong-way risk occurs when exposure to counterparty credit risk
increases as the credit quality of that counterparty deteriorates. T his concept is typically applied in
derivatives markets and does not relate directly to changes in behavior due to an insurance contract.
Choi ce D i s i ncorrect. Operational risk refers to the prospect of loss resulting from inadequate or
failed procedures, systems or policies; employee errors; system failures; fraud or other criminal
179
activity; any event that disrupts business processes. While operational risks may be exacerbated by
poor decisions influenced by moral hazard, they are not directly caused by changes in behavior due to
an insurance contract.
Q.3443 Under the AMA method, insurance can be used to offset up to 20% of the operational risk
charge. Which of the following statements about hedging operational risk are valid?
I. All insurance policies suffer from the problem of moral hazard, but deductibles and
coinsurance provisions help to combat this problem
II. Adverse selection can result in a claim experience that’s worse than initially anticipated
III. A primary disadvantage of insurance as a tool for operational risk management is the
limitation of policy coverage
IV. T he scorecard capital allocation method allocates capital to business lines in a firm as guided
by the results of a risk survey conducted across the firm
V. If an operational risk hedge works properly, a firm will avoid damage to its reputation from a
high-severity operational risk event
A. All of the above
B. III, and V
C. II, III, and V
D. I, II, III, and IV
Statements I, II, III, and IV are all valid in the context of hedging operational risk under the AMA
method. Statement I is valid because insurance policies do indeed suffer from the problem of moral
hazard, but this issue can be mitigated through the use of deductibles and coinsurance provisions.
Statement II is valid because adverse selection can lead to a claim experience that is worse than
initially anticipated, thereby increasing the risk for the insurer. Statement III is valid because one of
the primary disadvantages of using insurance as a tool for operational risk management is the
limitation of policy coverage, which places a cap on the compensation that can be provided to the
policyholder. Finally, Statement IV is valid because the scorecard capital allocation method does
allocate capital to business lines in a firm based on the results of a risk survey conducted across the
180
firm. T his approach allows for a quantitative measure of a unit's exposure to risk, which can guide
capital allocation decisions.
Choi ce A i s i ncorrect. Not all the statements accurately reflect the complexities and challenges
of hedging operational risk under the AMA method. Statement V, which suggests that a firm will avoid
damage to its reputation from a high-severity operational risk event if an operational risk hedge
works properly, is not necessarily true. While hedging can mitigate financial losses, it may not always
protect against reputational damage.
Choi ce B i s i ncorrect. T his option includes statement III and V only. While statement III
correctly identifies a primary disadvantage of insurance as a tool for operational risk management
being the limitation of policy coverage, statement V does not accurately reflect the complexities and
challenges of hedging operational risk under AMA method as explained above.
Choi ce C i s i ncorrect. T his option includes statements II, III and V only. Although statements II
and III are correct in reflecting some aspects of complexity in managing operational risks using AMA
approach, statement V does not provide an accurate reflection as explained above.
181
Q.3444 A risk manager has established that there’s a 90% probability that losses over the next year
will not exceed $30 million. Given that the power law parameter is 0.8, what is the probability of the
loss exceeding $10 million?
A. 22%
B. 24%
C. 20%
D. 23%
T he power law states that the probability of a random variable x exceeding a value V is given by:
p (v > x) = KV −α
where:
K is constant,
α is the power law parameter.
p (v > x) = KV −α
0.1 = K(30)−(0. 8)
K = 1.5195 T hus,
p (v > x) = 1.5195V −0. 8
when x = 10,
P robability = 1.5195 × 10−0. 8 = 0.24
182
Q.4596 One of the major operational risks is compliance risk. Which of the following is/are
example(s) of compliance risks?
A. Money laundering
B. Terrorism financing
C. Failure to comply with sanctions
D. All of the above
Compliance risk is a type of operational risk that arises when a financial institution fails to adhere to
the industry's established rules, regulations, internal policies, or standard best practices. T his can
occur either knowingly or unknowingly. Examples of compliance risks include money laundering,
financing terrorism activities, and failure to comply with sanctions. Money laundering involves the
process of making illegally-gained proceeds appear legal, often by moving the funds around to obscure
the link between the money and the original criminal activity. Terrorism financing refers to activities
that provide financial support to individual terrorists or non-state actors. Failure to comply with
sanctions involves not adhering to the punitive measures imposed by one or more countries against a
targeted country, individual, or entity.
Choi ce A i s i ncorrect. While money laundering is indeed a compliance risk, it does not encompass
all the possible examples of compliance risks. T here are other forms of compliance risks such as
terrorism financing and failure to comply with sanctions which are not covered by this option.
Choi ce B i s i ncorrect. Terrorism financing, similar to money laundering, represents a type of
compliance risk but it does not cover all the potential examples of such risks. Other forms like
money laundering and failure to comply with sanctions are also part of compliance risks.
Choi ce C i s i ncorrect. Failure to comply with sanctions is another example of a compliance risk
but it alone does not represent all possible instances of these types of risks in financial institutions.
Money laundering and terrorism financing also fall under the category of compliance risks.
183
Q.4597 One of the operational risks is rogue trader risk. To protect itself from rogue trader risk, a
bank should make the front office and back office independent of each other. Which one of the
following statements distinguishes between the back and front office?
A. T rading takes place in the front office while record keeping is done in the back office
B. Record keeping is done in the front office, and trading is done in the back office
C. T he front office is where management works, and the back office is where traders trade
T he front office in a bank is typically where trading activities take place. It is the client-facing part
of the bank and is primarily responsible for generating revenue. T he front office includes roles such
as investment banking, sales and trading, and corporate finance. On the other hand, the back office is
responsible for record-keeping and verification of transactions. It provides administrative and
support services, ensuring that transactions are correctly processed, and records are accurately
kept. T his separation of duties is crucial in mitigating rogue trader risk as it allows for independent
verification and control of trading activities.
Choi ce B i s i ncorrect. Record keeping is not done in the front office, and trading is not done in the
back office. T he front office typically handles revenue-generating activities such as trading, while
the back office deals with administrative tasks like record keeping.
Choi ce C i s i ncorrect. T he statement that the front office is where management works, and the
back office is where traders trade does not accurately represent their roles in a banking institution.
While it's true that some management functions may occur in the front office, it's primarily where
revenue-generating activities like trading take place. Conversely, while traders may interact with
back-office staff for operational support, they do not typically conduct their primary trading
activities there.
Choi ce D i s i ncorrect. As explained above, choice A correctly differentiates between the roles of
a bank's front and back offices.
184
Q.4598 T he average loss frequency of Bank of Africa is estimated to be once every 18 months. What
is the probability of three losses in a year for this bank?
A. 0.0234
B. 0.057
C. 0.0254
D. 0.0507
We need to find λ which from the question we have:
1
λ= = 0.6667 losses per year
1.5
Now usi ng the Poi sson di stri buti on
e−λ λn
Pr (n) =
n!
−0. 6667
e 0.66673
Pr (3) ⇒ = 0.0254
3!
185
Q.4599 Given the mean and the standard deviation of lognormal loss of a ban is 200 and 50
respectively, what is the variance of the logarithm of the loss?
A. 0.0606
B. 0.527
C. 0.069
D. 0.0629
We know the mean of the logarithm of the loss is given by:
μ
ln ( )
√1 + w
Furthermore, the variance is given by:
ln (1 + w)
Where
2 2
σ 50
w =( ) =( ) = 0.0625
μ 200
⇒ Variance = ln (1.0625) = 0.0606
186
Q.4600 Given the mean and the standard deviation of the lognormal loss of a bank is 200 and 50, what
is the standard deviation of the logarithm of the loss?
A. 0.2462
B. 1.0308
C. 0.0606
D. 0.4724
We know the mean of the logarithm of the loss is given by:
μ
ln ( )
√1 + w
Furthermore, the variance is given by:
ln (1 + w)
Where
2 2
σ 50
w =( ) =( ) = 0.0625
μ 200
⇒ Variance = ln(1 + w) = ln (1.0625) = 0.0606
∴ Standard deviation = √0.0606 ≈ 0.2462
Q.4601 Over the past ten years, the Bank of Yemen has had losses (in million euros) of 3, 6, 10, 50,
72, 101, and 200. What is the approximate amount of loss component of the bank under the SMA
approach?
A. €656 million
B. €678 million
C. €756 million
D. €442 million
187
Using the formula
7X + 7Y + 5Z
Where X, Y, and Z are the approximations of the average losses from the operational risk over the
past ten years defined as:
X – an average of all losses
Y – an average of losses greater than 10 million
Z – an average of losses greater than 100 million
From the question, the average total loss for the ten years is 442:
3 + 6 + 10 + 50 + 72 + 101 + 200 442

X= = = 44.2
10 10
T he average losses greater than 10 million is:
50 + 72 + 101 + 200 423

Y = = = 42.3
10 10
And the average losses greater than 100 million is:
301
101 + 200 = = 30.1
10
So the loss component is given by:
7 × 44.2 + 7 × 42.3 + 5 × 30.1 = 756
188
Q.4602 A manager for the stock trading department suspects that one of his staff has gone rogue.
Which of the following key indicators would the manager use to identify the rogue trader?
A. T he trader fails to take long holidays.
B. T he trader would seek for long holidays.
C. T he trader would always report trading transactions to the relevant authorities.
D. T he trader would seek guidance from the relevant bodies before taking a position in stock
trading.
Rogue traders often avoid taking long holidays. T his is because their unauthorized activities could
potentially be discovered in their absence. When a trader is constantly present, they can better
manage their unauthorized trades and prevent others from discovering their illicit activities. T his
behavior is a key indicator of a rogue trader. T herefore, if a trader consistently fails to take long
holidays, it could be a sign of rogue trading activities.
Choi ce B i s i ncorrect. A rogue trader would not typically seek long holidays as they need to be
present to manage and hide their unauthorized trades. Extended absences could lead to discovery of
their illicit activities.
Choi ce C i s i ncorrect. Rogue traders are unlikely to report all trading transactions to the relevant
authorities, as this would increase the risk of their unauthorized trades being discovered.
Choi ce D i s i ncorrect. Rogue traders often act independently and without seeking guidance or
approval from relevant bodies before taking a position in stock trading, which contradicts with this
behavior.
Q.4603 T he estimation of loss distribution is laden with several data issues. Which of the following is
NOT among them?
A. Inadequate historical records.
B. T he constant purchasing power of money.
C. Firm-specific adjustments.
189
D. None - all of the above are valid data issues.
T he statement 'None - all of the above are valid data issues' is accurate. All the options listed,
including inadequate historical records, the constant purchasing power of money, and firm-specific
adjustments, are indeed valid data issues encountered during the estimation of loss distribution.
Inadequate historical records pose a challenge as the data available for operational risk losses,
including loss frequency and loss amounts, is often insufficient, especially when compared to credit
risk data. T his inadequacy creates problems when trying to model the loss distribution of expected
losses.
T he constant purchasing power of money implies that there is no adjustment for inflation when using
both internal and external data. T his is a data issue because a $10,000 loss recorded today would not
have the same effect as a similar loss recorded, say, ten years ago.
Firm-specific adjustments are necessary because no two firms are the same in terms of size,
financial structure, and operational risk management. T herefore, when using external data, it is
essential to make adjustments to the data in cognizance of the different characteristics of the source
and your bank. A simple proportional adjustment can either underestimate or overestimate the
potential loss.
Choi ce A i s i ncorrect. Inadequate historical records are indeed a valid data issue when estimating
loss distribution. T he lack of sufficient past data can lead to inaccurate estimations and predictions
about future losses.
Choi ce B i s i ncorrect. T he constant purchasing power of money is not a valid data issue in this
context. T his concept refers to the idea that the value of money remains constant over time, which
is not true due to inflation and other economic factors. T herefore, it does not pose a challenge in
estimating loss distribution.
Choi ce C i s i ncorrect. Firm-specific adjustments are also a valid data issue when estimating loss
distribution as they can significantly impact the accuracy of estimates if not properly accounted for.
190
Choi ce D i s i ncorrect. All of the above options do constitute valid data issues in the process of
estimating loss distribution, hence this choice cannot be correct.
Q.4604 T he 90-percentile of a loss distribution is 30. Using the power law with α = 4, what is the
value of 95-percentile of the loss distribution?
A. 35.68
B. 30.45
C. 25.56
D. 27.89
Recall that the power law is given by:
P r (v > x) = Kx −α
T herefore for the 90-percentile loss distribution, we have,
0.10 = K.30−4
0.10
⇒K= = 81, 000
30−4
T hus, for the 95-percentile loss, we have to solve the equation:
0.05 = 81,00x −4
1
−
0.05 4
⇒x=( ) = 35.68
81,000
191
Q.4606 Bank A has revenues of USD 50 billion and incurs a loss of USD 300 million. Another bank B
has revenues of USD 40 billion. Given that the estimated loss for bank A is 250 million, which of the
following is closest to the observed loss for Bank (Assume the scale adjustment is 0.23) B?
A. USD 263.2 million
B. USD 200 million
Using the scale adjustment:
0. 23
Bank A Revenue
Estimated Losss for Bank A = Observed Loss for Bank B × ( )
Bank B Revenue
0. 23
50
⇒ 250 = Observed Loss for Bank B × ( )
40
0. 23
50
Observed Loss for Bank B = 250/( ) = 237.4929 ≈ 237.5
40
192
Q.4607 Over the last three years, an American bank earned an interest of USD 300 million and paid
interest of USD 150 million on average. T he bank’s noninterest income over the last three years is
USD 600 million on average. Under the indicator method, what is the value of the operational risk
capital?
A. $75 million
B. $250.40 million
C. $112.50 million
D. $140.50 million
Under the indicator approach, the required operational risk is equivalent to 15% of annual gross
income over the previous three years. Also, recall that,
Gross income = Interest earned− Interest paid+ Noninterest income

= 300 − 150 + 600 = 750
∴ Gross Income = USD 750 Million
T hus, the required operational risk capital is
15% × 750 = 112.5
193
Reading 54: Stress Testing
Q.1086 AIZ bank, a newly set up bank, proposes to use stress testing to measure risk. Which of the
following statements are true with regard to stress testing as a risk management tool in banking?
I. Stress testing is an important risk management tool that banks use as part of their internal risk
management and, through the Basel II capital adequacy framework, is promoted by supervisors
II. Stress testing alerts bank management to unexpected adverse outcomes related to a variety of
risks and provides an indication of how much capital might be needed to absorb losses should large
shocks occur
III. While stress tests provide an indication of the appropriate level of capital necessary to endure
deteriorating economic conditions, a bank alternatively may employ other actions in order to help
mitigate increasing levels of risk
IV. Stress testing is especially important after long periods of benign economic and financial
conditions when fading memory of negative conditions can lead to complacency and the underpricing
of risk
A. I & IV only.
B. II & IV only.
C. I, II & IV only.
Stress testing is an important risk management tool that is used by banks as part of their internal risk
management and, through the Basel II capital adequacy framework, is promoted by supervisors.
Stress testing alerts bank management to unexpected adverse outcomes related to a variety of risks
and provides an indication of how much capital might be needed to absorb losses should large shocks
occur. While stress tests provide an indication of the appropriate level of capital necessary to
endure deteriorating economic conditions, a bank alternatively may employ other actions in order to
help mitigate increasing levels of risk. Stress testing is especially important after long periods of
benign economic and financial conditions when fading memory of negative conditions can lead to
complacency and the underpricing of risk.
194
Q.1087 T he financial crisis of 2007-2009 has revealed several weaknesses in organizational aspects
of stress testing programs. Which of the following are some of these weaknesses?
I. Stress testing at some banks was performed mainly at the firm-wide level
II. At some banks, the stress testing program was a mechanical exercise
III. While stress testing for market and credit risk had been practiced for several years, stress
testing for interest rate risk in banks has emerged more recently
IV. Stress testing frameworks were usually not flexible enough to respond quickly as the crisis
evolved
A. I & IV only.
B. II & IV only.
C. I, II & IV only.
Thi ngs to Remember
• Stress testing is a risk management tool used by financial institutions to evaluate their potential
vulnerability to adverse events. It involves simulating scenarios that could potentially harm the
institution and assessing the institution's ability to withstand these scenarios.
• T he financial crisis of 2007-2009 revealed several weaknesses in stress testing programs, including
a mechanical approach to stress testing and a lack of flexibility in stress testing frameworks.
• To be effective, stress testing should be integrated into the broader risk management framework
and business strategy of the institution. It should also be flexible enough to respond to changing
market conditions and risks.
• T he crisis also highlighted the need for more comprehensive and sophisticated stress testing,
including stress testing for credit risk, which has emerged more recently in the banking industry.
Q.1088 With regard to stress testing methodologies, which of the following statement(s) is/are true?
I. Stress tests may be performed at varying degrees of aggregation, from the level of an individual
instrument up to the institutional level
II. Stress tests are performed for different risk types including market, credit, operational, and
liquidity risk
III. At the most fundamental level, weaknesses in infrastructure limit the ability of banks to identify
and aggregate exposures across the bank
195
IV. Unlike most risk management models, stress tests do not use historical statistical relationships to
assess risk
A. II, III & IV only.
B. I, II & IV only.
Statement I i s correct: T his statement indicates that stress testing can be applied at multiple
levels within a financial institution. At the most granular level, a stress test could assess the risk
associated with a single financial instrument, such as a bond or a loan. T he results of these tests can
then be aggregated to assess the risk of a portfolio of instruments, a business line, or even the entire
institution. T his multi-level approach allows for a more comprehensive understanding of risk, as it
captures both the unique risks associated with individual instruments and the systemic risks that can
impact an entire institution.
Statement II i s al so correct:Stress testing involves simulating adverse scenarios to assess their
potential impact on a financial institution. T hese scenarios can encompass a wide range of risks.
Market risk relates to potential losses due to movements in market prices, while credit risk refers
to potential losses if borrowers default on their loans. Operational risk captures potential losses due
to failures in processes, systems, or personnel. Finally, liquidity risk is the risk that an institution
will not be able to meet its financial obligations as they come due. By testing these various types of
risks, stress testing provides a comprehensive assessment of an institution's risk profile.
Statement III i s al so correctT his statement refers to the challenges that banks may face in
implementing effective stress testing. If a bank's infrastructure, including its data systems and risk
management processes, is not robust, it may struggle to identify and aggregate risk exposures across
the institution. For example, if a bank's data systems cannot accurately track the loans it has made, it
may underestimate its credit risk. Similarly, if a bank's risk management processes do not adequately
capture operational risks, it may be unprepared for potential process failures or system disruptions.
T hus, a strong infrastructure is critical for effective stress testing.
196
Statement IV i s parti al l y true: While stress tests do indeed focus on hypothetical 'stress'
scenarios that may not be reflected in historical data, they do not completely disregard historical
statistical relationships. Historical data is often used as a starting point or baseline in stress tests.
From there, stress tests extrapolate extreme but plausible scenarios that may be outside of the
historical experience. T hese scenarios help the institution prepare for adverse events that are
possible but have not yet occurred. T hus, while stress tests may place less emphasis on historical
relationships than other risk management models, they do not ignore them entirely.
Choi ce A i s i ncorrect. T his choice includes statement IV, which is not accurate. While it's true
that stress tests do not rely solely on historical statistical relationships to assess risk, they do use
these relationship
Q.1089 Scenario selection is very important in measuring the risks of the banks using stress tests.
With regard to scenario selection and stress tests prior to the crisis, which of the following
statements are true?
I. Scenarios tended to reflect mild shocks, assume shorter durations and underestimate the
correlations between different positions, risk types and markets due to system-wide interactions and
feedback effects
II. Sensitivity tests, which are at the most basic level, generally shock individual parameters or
inputs without relating those shocks to an underlying event or real-world outcome
III. Banks also implemented hypothetical stress tests, aiming to capture events that had not yet been
experienced
IV. Scenarios that were considered extreme or innovative were often regarded as implausible by the
board and senior management
B. I, II & IV only.
It includes Statements I, II, and IV.
Statement I i s correct: Prior to the crisis, the scenarios selected for stress tests often reflected
mild shocks and assumed shorter durations. T his was due to a tendency to underestimate the
197
correlations between different positions, risk types, and markets. T he interactions and feedback
effects across the system were not adequately considered, leading to an underestimation of potential
risks.
Statement II i s correct: Sensitivity tests, which are at the most basic level of stress testing,
generally shock individual parameters or inputs. T hese shocks are not related to an underlying event
or real-world outcome, which can limit the comprehensiveness of the stress test.
Statement IV i s correct: Scenarios that were considered extreme or innovative were often
regarded as implausible by the board and senior management. T his could potentially limit the range of
scenarios considered in the stress tests, thereby reducing their effectiveness in capturing all
potential risks.
Choi ce A i s i ncorrect. T his option includes statement III, which is not accurate. Prior to the
financial crisis, banks did not typically conduct hypothetical stress tests aimed at capturing events
that had not yet occurred. Instead, they often focused on historical scenarios and known risks.
Choi ce C i s i ncorrect. Similar to choice A, this option also includes statement III which does not
accurately reflect the practices prior to the financial crisis.
Choi ce D i s i ncorrect. As explained above in choices A and C, including statement III makes this
option inaccurate as well.
Q.1091 T he senior management of the African Industrial Development Bank is reviewing the stress
program post a severe financial crisis in Africa. With regard to the stress testing program, which of
the following is most accurate?
A. Senior management is ultimately responsible for the overall stress testing program,
whereas the risk department is accountable for the program’s implementation, management,
and oversight.
B. T he Chief Risk Officer is ultimately responsible for the overall stress testing program,
and oversight.
C. T he risk committee is ultimately responsible for the overall stress testing program,
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and oversight.
D. T he board of directors is ultimately responsible for the overall stress testing program,
whereas the senior management is accountable for the program’s implementation,
management, and oversight.
T he board of directors is ultimately responsible for the overall stress testing program, whereas the
senior management is accountable for the program’s implementation, management, and oversight.
T his is because the board of directors, being the highest governing authority within an organization,
is responsible for the overall strategic direction and governance of the organization, including its risk
management practices. T he senior management, on the other hand, is responsible for the day-to-day
operations of the organization, which includes the implementation, management, and oversight of the
stress testing program. Recognizing that many practical aspects of a stress testing program will be
delegated, the involvement of the board in the overall stress testing program and of senior
management in the program's design is essential. T his ensures that the stress testing program aligns
with the organization's strategic objectives and risk appetite, and that it is effectively managed and
overseen to ensure its ongoing effectiveness and relevance.
Choi ce A i s i ncorrect. While senior management plays a crucial role in the stress testing program,
they are not ultimately responsible for it. T he ultimate responsibility lies with the board of directors
who oversee the overall strategic direction and risk appetite of the bank.
Choi ce B i s i ncorrect. T he Chief Risk Officer (CRO) has a significant role in managing and
overseeing risk, but they are not ultimately responsible for the overall stress testing program. T his
responsibility rests with the board of directors.
Choi ce C i s i ncorrect. Although the risk committee plays an important part in reviewing and
recommending policies related to risk management, it does not hold ultimate responsibility for the
overall stress testing program. T his duty falls on the board of directors as per FRM guidelines.
Q.1092 T he senior management of the African Industrial Development Bank is reviewing the stress
program post a severe financial crisis in Africa. With regard to the stress testing program, which of
the following statements are accurate?
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I. T he stress testing program should cover pipeline and warehousing risks. A bank should include
such exposures in its stress tests regardless of the probability of being securitized.
II. A bank should enhance its stress testing methodologies to capture the effect of reputational risk.
T he bank should integrate risks arising from off-balance-sheet vehicles and other related entities in
its stress testing program.
III. A bank should enhance its stress testing approaches for highly leveraged counterparties
considering its vulnerability to specific asset categories or market movements and in assessing
potential wrong-way risk related to risk-mitigating techniques.
IV. T he stress testing program should explicitly cover complex and bespoke products such as
securitized exposures. Stress tests for securitized assets should consider the underlying assets, their
exposure to systematic market factors, relevant contractual arrangements and embedded triggers,
and the impact of leverage, particularly as it relates to the subordination level of the issue structure.
B. I, II & IV only.
All of the statements are accurate with regard to the stress testing program.
Statement I is correct because the stress testing program should indeed cover pipeline and
warehousing risks, and a bank should include such exposures in its stress tests regardless of the
probability of being securitized.
Statement II is also correct as a bank should enhance its stress testing methodologies to capture the
effect of reputational risk and integrate risks arising from off-balance-sheet vehicles and other
related entities in its stress testing program.
Statement III is accurate as a bank should enhance its stress testing approaches for highly leveraged
counterparties considering its vulnerability to specific asset categories or market movements and in
assessing potential wrong-way risk related to risk-mitigating techniques.
Finally, statement IV is correct as the stress testing program should explicitly cover complex and
bespoke products such as securitized exposures. Stress tests for securitized assets should consider
the underlying assets, their exposure to systematic market factors, relevant contractual
arrangements and embedded triggers, and the impact of leverage, particularly as it relates to the
subordination level of the issue structure.
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Choi ce A i s i ncorrect. T his option excludes statement I, which states that the stress testing
program should cover pipeline and warehousing risks. T his is an inaccurate exclusion as a bank
should indeed include such exposures in its stress tests regardless of the probability of being
securitized.
Choi ce B i s i ncorrect. T his option excludes statement III, which emphasizes on enhancing stress
testing approaches for highly leveraged counterparties considering its vulnerability to specific asset
categories or market movements and in assessing potential wrong-way risk related to risk-mitigating
techniques. Excluding this statement is incorrect as it forms a crucial part of a comprehensive
stress testing program.
Choi ce C i s i ncorrect. Statement IV, which has been excluded in this option, highlights that the
stress testing program should explicitly cover complex and bespoke products such as securitized
exposures. Stress tests for securitized assets should consider the underlying assets, their exposure
to systematic market factors, relevant contractual arrangements and embedded triggers, and the
impact of leverage, particularly as it relates to the subordination level of the issue structure.
Omitting this important aspect makes choice C an incorrect answer.
Q.1151 A bank has recently launched a fund for retail investors. T he risk management team carries
out stress testing of the newly launched fund to determine the impact of the fund on the bank’s
overall capital. Jason Bloomberg, a newly recruited risk manager, observes that the bank has an
independent risk management team. He notes that the entire risk assessment and identification
process is carried exclusively through stress testing. While examining the stress testing result,
Joson observes that the test produces multiple potential losses under various scenarios. He also
observes that the inputs from the bank’s top economists were taken while modeling the stress
testing scenarios. He finds that the stress testing procedures are well documented and no deviation is
allowed from the procedure.
T he bank’s stress testing results produce multiple potential losses. In view of this, select the most
appropriate option.
A. T he stress testing result must be actionable.
B. T he stress testing results must be integrated into decision-making, but only at the senior-
most level of management.
C. T he stress testing result must accurately specify the exact amount of loss associated with
a given variable.
D. Stress testing produces potential losses and hence no action is required on the results.
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T he stress testing result must be actionable. Stress testing is a simulation technique used in banking
institutions to determine their ability to deal with an extremely stressed financial situation. T he
results of stress testing are not just for observation but should be actionable. T his means that the
results should feed into the decision-making process at the appropriate management level, including
strategic business decisions of the board or senior management. T he purpose of stress testing is to
identify potential vulnerabilities in the bank's financial structure and to take corrective actions if
necessary. T herefore, the results of stress testing should be used to make informed decisions about
the bank's risk management strategies, capital allocation, and overall business operations. T he
actionable results of stress testing can help the bank to mitigate potential risks, enhance its financial
stability, and ensure its long-term sustainability.
Choi ce B i s i ncorrect. While it is important for senior management to consider stress testing
results in their decision-making, it should not be limited to them only. All levels of management,
especially those involved in risk management and strategic planning, should integrate these results
into their decisions to ensure a comprehensive approach towards risk mitigation.
Choi ce C i s i ncorrect. Stress testing does not necessarily specify the exact amount of loss
associated with a given variable. Instead, it provides potential losses under various scenarios which
can help in understanding the possible impact on capital under different conditions. T he aim of stress
testing is not precision but rather providing an insight into potential vulnerabilities and risks.
Choi ce D i s i ncorrect. T his statement contradicts the purpose of stress testing which aims at
identifying potential risks and vulnerabilities that could impact an organization's capital or overall
stability. T herefore, actions are indeed required based on the results of stress tests such as adjusting
risk strategies or enhancing contingency plans.
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process is carried exclusively through stress testing. While examining the stress testing result, John
observes that the test produces multiple potential losses under various scenarios. Bloomberg also
Inputs from the bank’s top economist were considered while developing the scenario for stress
testing. In view of this, select the most appropriate statement.
A. Inputs from economists make the model more robust.
B. Inputs from all stakeholders such as economists, business managers, fund managers, etc.
must be taken into account.
C. Only inputs from the risk management team in collaboration with the fund manager must
be taken into account.
D. T he risk management team must independently design the models.
T he identification of relevant stress events requires the collaboration of all the stakeholders like
traders, economists, fund managers, business managers, etc. Inputs from all stakeholders make the
model more robust. T his is because each stakeholder brings a unique perspective and understanding
of the market, which can help in creating a more comprehensive and realistic stress testing
scenario. Economists can provide insights on macroeconomic factors and trends, fund managers can
provide information on the fund's strategy and potential risks, business managers can provide
operational insights, and traders can provide market insights. By incorporating all these diverse
inputs, the stress testing model becomes more robust and capable of capturing a wider range of
potential stress events. T his can help the bank in better managing its risks and ensuring the stability
of its capital.
Choi ce A i s i ncorrect. While inputs from economists can indeed contribute to the robustness of
the model, they are not the only source of valuable input. Stress testing scenarios should incorporate
a wide range of perspectives to ensure comprehensive risk assessment.
Choi ce C i s i ncorrect. T his statement is too restrictive and overlooks the potential contributions
from other stakeholders such as economists and business managers. T heir insights could provide
additional dimensions to stress testing scenarios, enhancing their effectiveness in capturing potential
risks.
203
Choi ce D i s i ncorrect. Although it's important for the risk management team to maintain
independence in its operations, this does not mean that they should be solely responsible for
designing stress testing models. Inputs from various stakeholders can provide valuable insights that
enhance model design and improve risk assessment accuracy.
Q.1153 Which of the following factors is most critical when calibrating a stressed Value at Risk (VaR)
model for a financial institution's risk management framework?
A. Identifying a historical period of significant financial stress that is relevant to the

institution's current portfolio.
B. Ensuring that the institution's trading activities are compliant with internal risk limits on a
day-to-day basis.
C. Evaluating the institution's ability to maintain regulatory capital ratios during normal
market conditions.
D. Assessing the performance of individual trading strategies and optimizing the allocation of
capital across various business units.
T he calibration of a stressed Value at Risk (VaR) model requires the identification of a historical
period of significant financial stress that is relevant to the institution's current portfolio. T his period
should be characterized by extreme market volatility and adverse economic conditions that could
potentially impact the trading portfolio. T he selection of a relevant stress period is crucial as it
allows the financial institution to better understand its risk exposure and the potential for extreme
losses during times of market stress. T his information can be used to strengthen the institution's risk
management framework and improve its resilience to future financial crises. T herefore, this factor
is considered the most critical when calibrating a stressed VaR model.
Choi ce B i s i ncorrect. While ensuring compliance with internal risk limits on a daily basis is
important for overall risk management, it does not directly contribute to the calibration of a stressed
VaR model. T he calibration process primarily focuses on identifying periods of significant financial
stress and adjusting the model accordingly.
204
Choi ce C i s i ncorrect. Evaluating an institution's ability to maintain regulatory capital ratios during
normal market conditions is crucial for assessing its financial stability, but it does not play a direct
role in calibrating a stressed VaR model. T he calibration process requires focusing on periods of
significant financial stress rather than normal market conditions.
Choi ce D i s i ncorrect. Assessing the performance of individual trading strategies and optimizing
capital allocation across business units are important aspects of portfolio management, but they do
not directly influence the calibration of a stressed VaR model. T his process involves identifying
relevant periods of significant financial stress and adjusting the model based on these observations.
process is carried exclusively through stress testing. While examining the stress testing result, John
observes that the test produces multiple potential losses under various scenarios. Bloomberg also
Select the most appropriate statement.
A. Stress testing results must be confidential.
B. Stress testing result must be used only internally.
C. Stress testing results may be disclosed to outsiders with sufficient supporting information.
D. Stress testing must be disclosed only to supervisors.
Stress testing results may be disclosed to outsiders with sufficient supporting information. Stress
testing is a critical tool used by banks to assess their vulnerability to adverse market conditions. T he
results of these tests can provide valuable insights into the bank's risk profile and its ability to
withstand various stress scenarios. While the results of stress tests are often used internally for risk
management and strategic planning purposes, they can also be disclosed to external parties, such as
investors, regulators, and the public. However, when disclosing stress test results externally, it is
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important to provide sufficient supporting information. T his includes details about the assumptions
and methodologies used in the stress test, as well as the context in which the results should be
interpreted. By providing this information, banks can help external parties understand the
significance of the stress test results and make informed decisions based on them.
Choi ce A i s i ncorrect. T here is no rule that stress testing results must be confidential. While it's
true that sensitive information should be handled with care, the disclosure of stress testing results
can actually enhance transparency and trust among stakeholders, provided sufficient supporting
information is given.
Choi ce B i s i ncorrect. Stress testing results are not meant to be used only internally. T hey can
provide valuable insights to external stakeholders such as investors, regulators, and rating agencies
about the bank's risk profile and resilience under various scenarios.
Choi ce D i s i ncorrect. While supervisors are indeed one of the key recipients of stress test
disclosures, they are not the only ones who may have an interest in these results. Other
stakeholders like investors or rating agencies may also find this information useful for their decision-
making processes.
Q.1155 XYZ Bank has multiple branches across the country. T he bank has 10 verticals for each of its
products headed by 10 Vice Presidents. T he VPs report directly to the Chairman of the bank. T he
bank also has an independent risk management team that reports directly to the Chairman. Each
vertical carries out its individual stress tests and submits the reports to the vertical head which then
presents them to the Chairman. T he stress test procedure indicates three scenarios which must be
stress tested in each of the verticals, and all the VPs ensure that the procedure is fully complied
with.
T he current capital position of the bank indicates no material threat to the viability of the bank. In
view of this, the bank’s risk management team does not include scenarios that challenge the viability
of the bank in the stress tests. T he risk management team also suggests independent stress testing of
market assets and the funding liquidity. T he bank, in its investor presentation, proudly claims to
stress test each component of the balance sheet.
Each vertical of the bank carries out stress tests independently. In view of this, select the most
appropriate statement.
A. Individual stress testing is desirable.
B. Individual stress testing overestimates the risk.
206
C. Risk arising due to linkages between the verticals must also be included in the stress
testing.
D. Individual stress testing makes the stress testing process straightforward.
Stress tests should cover a wide range of risks, including those at the firm-wide level. T he bank
should be able to integrate effectively, in a meaningful fashion, across the range of its stress testing
activities and deliver a complete picture of firm-wide risk. T he bank must be able to assess the risk
arising due to the linkages between the different verticals. T his is because the operations of the
bank are not isolated, and the activities in one vertical can have implications for the others. For
instance, a significant loss in one vertical could lead to a reduction in the overall capital of the bank,
which could affect the operations of the other verticals. Similarly, a risk event in one vertical could
lead to a loss of confidence in the bank, leading to a withdrawal of funds that could affect the liquidity
position of the entire bank. T herefore, it is important for the stress tests to take into account the
linkages between the different verticals to provide a comprehensive view of the risk profile of the
bank.
Choi ce A i s i ncorrect. While individual stress testing can provide insights into the risks associated
with each vertical, it does not account for the interdependencies and correlations between different
verticals. T herefore, relying solely on individual stress testing may not be desirable as it could lead to
an underestimation of the overall risk profile of the bank.
Choi ce B i s i ncorrect. Individual stress testing does not necessarily overestimate risk. In fact, it
might underestimate risk if there are significant linkages or correlations between different verticals
that are not captured in individual stress tests.
Choi ce D i s i ncorrect. Although individual stress testing might simplify the process by breaking
down complex systems into manageable parts, this approach overlooks potential interactions and
correlations among different verticals which could amplify or mitigate risks under certain scenarios.
T herefore, stating that individual stress testing makes the process straightforward oversimplifies its
complexity and potential limitations.
207
presents them to the Chairman. T he stress test procedure indicates three scenarios that must be
stress tested in each of the verticals, and all the VPs ensure that the procedure is fully complied
with.
A. T hree scenarios, as indicated in the stress test procedure, is sufficient to assess the risk.
B. Stress testing must include multiple scenarios.
C. T he stress testing procedure must be flexible and must include forward-looking scenarios.
D. A minimum of 10 scenarios must be used to perform stress testing.
An effective stress testing procedure should not only cover a spectrum of events and severity
levels, but it should also be flexible and forward-looking. T he stress testing procedure at XYZ Bank,
as described, includes three scenarios for each vertical. However, this may not be sufficient to
identify hidden vulnerabilities or anticipate future risks. T he bank's current capital position does not
pose a significant threat to its viability, which is why the risk management team does not include
scenarios that challenge the bank's viability in the stress tests. However, this approach may
overlook potential future risks that could threaten the bank's viability. T herefore, the stress testing
procedure should be flexible enough to adapt to changing circumstances and include forward-looking
scenarios that anticipate potential future risks. T his approach would enhance the effectiveness of
the stress testing procedure and provide a more comprehensive assessment of the bank's risk
profile.
Choi ce A i s i ncorrect. While the bank's stress test procedure does indicate three scenarios, it is
not necessarily sufficient to assess all risks. Stress testing should be comprehensive and consider a
variety of scenarios that could potentially impact the bank's financial health.
208
Choi ce B i s i ncorrect. Although stress testing must indeed include multiple scenarios, this
statement alone does not fully capture the requirements for effective stress testing. It lacks
specificity about what kind of scenarios should be included and how they should be selected.
Choi ce D i s i ncorrect. T here isn't a fixed number of scenarios that must be used for stress
testing. T he number can vary depending on the complexity and risk profile of the institution being
tested. T herefore, stating that a minimum of 10 scenarios must be used for stress testing may not
always hold true.
presents them to the Chairman. T he stress test procedure indicates three scenarios that must be
stress-tested in each of the verticals, and all the VPs ensure that the procedure is fully complied
with.
A. In the case of bank XYZ, the risk management team is correct not to include scenarios
which challenge the viability of the bank.
B. In the case of bank XYZ, the risk management team must include scenarios with increased
severity but must not challenge the viability of the bank.
C. In the case of bank XYZ, the stress test must not include scenarios which challenge the
viability of the bank.
D. In the case of bank XYZ, the stress test must include scenarios which challenge the
viability of the bank.
Stress tests should include scenarios that challenge the viability of the bank. T his is because such
stress tests can reveal hidden risks and interactions among risks. T he global financial crisis has
209
demonstrated the importance of such stress testing, as it allows for the development of a
contingency plan in case such scenarios become reality. In the case of XYZ Bank, even though the
current capital position does not indicate any significant threat to the bank's viability, it is still crucial
to include such scenarios in the stress tests. T his will ensure that the bank is prepared for any
potential risks and can take appropriate action to mitigate these risks. T herefore, the statement that
'In the case of bank XYZ, the stress test must include scenarios which challenge the viability of the
bank' is the most accurate.
Choi ce A i s i ncorrect. T he risk management team should include scenarios that challenge the
viability of the bank in their stress tests. T his is because stress tests are designed to assess how a
bank would perform under severe economic conditions, and therefore, should include worst-case
scenarios.
Choi ce B i s i ncorrect. While it's true that the risk management team must include scenarios with
increased severity, these scenarios should also challenge the viability of the bank. By excluding such
scenarios, they may not be fully assessing all potential risks.
Choi ce C i s i ncorrect. As explained above, stress tests need to include worst-case scenarios that
challenge a bank's viability to ensure they are prepared for all possible outcomes.
210
Q.1159 Select the most appropriate statements.
I. A bank must stress test each component of the balance sheet

II. A bank must stress test off-balance sheet items
III. A bank must only stress test liquid, market-related items, either on or off the balance sheet
IV. T he stress test must include only contractual off-balance sheet items
A. I & II only.
B. I, II & III.
C. I, III & IV.
In the context of banking and financial risk management, stress testing is a critical practice that helps
in identifying potential vulnerabilities in a bank's balance sheet. Given this, consider the following
statements about the components that a bank must stress test: (I) Each component of the balance
sheet must be stress tested. (II) Off-balance sheet items must be stress tested. (III) Only liquid,
market-related items, either on or off the balance sheet, must be stress tested. (IV) T he stress test
must include only contractual off-balance sheet items. Which combination of these statements is
most accurate?
211
Q.1160 Which of the following statements is/are accurate?
I. Supervisors should verify the active involvement of senior management in the stress testing
program
II. Banks must submit firm-wide stress tests to supervisors at regular intervals
III. Under the Internal Capital Adequacy and Assessment Process (ICAAP), the bank will make
use of internal models to assess, quantify and stress test risk drivers
IV. Stress testing results must not impact the strategic business decisions of the bank
A. II, III & IV
B. I, II & III
C. I & III
D. I & IV
Thi ngs to Remember
Stress testing is a critical component of risk management in banking. It involves the use of various
techniques to evaluate the potential impact of adverse market conditions on a bank's financial
condition. T he results of stress tests can provide valuable insights into a bank's risk profile and
capital adequacy, and inform strategic business decisions.
T he Internal Capital Adequacy and Assessment Process (ICAAP) is a comprehensive framework that
requires banks to assess their capital adequacy in relation to their risk profile. It involves the use of
internal models to assess, quantify and stress test risk drivers. T he ICAAP is a key tool for banks to
ensure that they have adequate capital buffers to absorb potential losses and maintain their financial
stability.
Banking supervisors play a crucial role in overseeing the implementation of stress testing and the
ICAAP. T hey verify the active involvement of senior management in these processes and review the
results of firm-wide stress tests submitted by banks at regular intervals. T heir oversight helps to
ensure that banks' risk management practices are robust and aligned with their risk appetite and
strategic objectives.
212
Q.1161 Which of the following statements is/are correct?
I. A bank must not disclose the assumptions made during the stress testing to supervisors
II. Supervisors must not take into account capital freely transferable within banking groups in
times of stress
III. Supervisors must only examine the need of capital for the bank
IV. Supervisors should review the range of remedial actions envisaged by a bank in response to
the results of the stress testing program
A. I only
B. IV only
C. I & III
D. III & IV
Thi ngs to Remember
Stress testing is a critical tool used by banks and supervisors to assess the bank's resilience to
adverse scenarios. It involves the use of various assumptions and scenarios to evaluate the potential
impact on the bank's financial condition. Here are some key points to remember:
Banks are expected to disclose the assumptions used in stress testing to supervisors. T his
helps to ensure transparency and allows supervisors to assess the validity of the
assumptions.
Supervisors consider both capital and liquidity aspects in their assessment of the bank's
financial condition. T his is because both capital and liquidity are critical for the bank's
resilience to stressful scenarios.
Supervisors review the bank's planned remedial actions in response to stress testing
results. T his helps them to assess the bank's risk management capabilities and readiness to
handle stressful situations.
213
Q.1162 Select the most appropriate statement.
A. Supervisors must not determine stress scenarios.
B. Supervisors must determine certain stress scenarios.
C. Stress scenarios must be designed exclusively by the bank.
D. Stress scenarios must not be disclosed.
Supervisors play a crucial role in the process of stress testing in financial risk management.
According to the principles laid down for supervisors, they are required to review and determine
certain stress scenarios for banks. T his is because the determination of stress scenarios by
supervisors enhances the ability of both the supervisors and the bank to assess the impact of
specific stress events. T his practice allows for a more comprehensive understanding of the potential
risks and vulnerabilities that a bank might face under stressful conditions. T herefore, the statement
that 'Supervisors must determine certain stress scenarios' accurately reflects the role and
responsibilities of supervisors in the context of stress testing in financial risk management.
Choi ce A i s i ncorrect. Supervisors do play a role in determining stress scenarios. T hey are not
excluded from this process as their expertise and oversight can provide valuable insights into
potential risks and vulnerabilities.
Choi ce C i s i ncorrect. While banks do have a significant role in designing stress scenarios, it's not
exclusive to them. Supervisors, regulators, and other relevant entities also participate in the process
to ensure a comprehensive assessment of potential risks.
Choi ce D i s i ncorrect. Stress scenarios should be disclosed as part of transparency requirements
in risk management practices. T his allows for better understanding of the bank's risk profile by
various stakeholders including investors, customers, and regulators.
214
Q.1163 Supervisors must examine a bank’s stress testing results as prescribed in the Basel II
framework under:
A. Pillar I.
B. Pillar II.
C. Pillar III.
T he Basel II framework is divided into three pillars: Pillar I, Pillar II, and Pillar III. Each pillar has a
specific focus and set of requirements that banks must adhere to. Pillar II, also known as the
Supervisory Review Process, is focused on ensuring that banks have adequate capital to support all
the risks in their business. It also aims to encourage banks to develop and use better risk
management techniques in monitoring and managing their risks. In the context of Pillar II,
supervisors are required to examine a bank's stress testing results. Stress testing is a risk
management tool used by banks to evaluate their potential vulnerability to certain exceptional but
plausible events or movements in financial variables. T he results of these tests can provide valuable
information to supervisors about the resilience of banks to adverse market conditions.
Choi ce A i s i ncorrect. Pillar I of the Basel II framework focuses on minimum capital
requirements. It does not involve the examination of a bank's stress testing results by supervisors.
Choi ce C i s i ncorrect. Pillar III pertains to market discipline, requiring banks to disclose
information that will allow market participants to assess key pieces of information on the scope of
application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the
institution. It does not involve supervisors examining a bank's stress testing results.
Choi ce D i s i ncorrect. As explained above, Pillar II involves supervisors examining a bank's stress
testing results as part of their review process.
215
Q.1165 All the following are true for stress testing, EXCEPT :
A. T he goal of stress testing is to identify unusual scenarios which are not covered under
standard VaR models.
B. Stress testing considers all scenarios covered under standard VaR models.
C. Stress testing is helpful in the analysis of events which generally get ignored.
D. Stress testing is helpful in the analysis of extreme events.
Stress testing does not consider all scenarios covered under standard Value at Risk (VaR) models. T he
primary purpose of stress testing is to identify and evaluate the potential impact of extreme and
unusual scenarios that are typically not covered under standard VaR models. VaR models are
primarily used to estimate the maximum potential loss that could occur over a specific time period,
given a certain level of confidence. T hese models are based on historical data and assume that future
losses will follow a similar pattern. However, they may not adequately capture the risk associated
with extreme events that have not occurred in the past or are very rare. Stress testing, on the other
hand, is designed to assess the potential impact of such extreme events, regardless of their historical
frequency or probability. It is a forward-looking approach that asks 'what if' questions to identify
potential vulnerabilities and ensure that the institution is prepared for worst-case scenarios.
Choi ce A i s i ncorrect. T he statement accurately represents the purpose of stress testing. Stress
testing indeed aims to identify unusual scenarios that are not covered under standard Value at Risk
(VaR) models, thereby providing a more comprehensive view of potential risks.
Choi ce C i s i ncorrect. T his statement correctly describes one of the objectives of stress testing -
to analyze events which generally get ignored in other risk assessment methods due to their low
probability or high impact nature.
Choi ce D i s i ncorrect. T he statement correctly identifies one key aspect of stress testing - it
helps in analyzing extreme events which could have significant impacts on an organization's financial
health if they were to occur.
216
Q.1166 A bank funds its long-term loans by issuing short-term debt instruments such as commercial
papers, NCDs with residual maturity of less than 1 year, deposits, etc. A risk manager wants to stress
test the bank’s balance sheet to examine its vulnerabilities. T he stress test may include which of the
following scenarios?
I. Availability of surplus liquidity

II. Failure to roll over short-term debt
III. Increase in short-term interest rates
IV. Increases in deposits
A. Only I
B. II & III
C. I & IV
D. III & IV
Not numerical
Q.1167 A fund manager examines the annual return generated by fund A for the last 10 years. T he
return generated by the fund is furnished in the table below:
Year Return
2015 +9.45%
2014 −4.45%
2013 +5.34%
2012 −3.35%
2011 +2.45%
2010 −6.56%
2009 +7.41%
2008 −8.83%
2007 +2.33%
2006 +1.32%
T he fund manager intends to stress test Fund A for various scenarios. Select the correct option with
regards to the stress testing of Fund A.
A. As the maximum loss during the last 10 year is 8.83%, the stress test scenario for
maximum loss must not exceed 8.83%.
B. As the average loss during the last 10 years is 5.80%, the stress test scenario for
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maximum loss must be equal to 5.80%.
C. T he stress test scenario for maximum loss must be more than the historical maximum
loss posted by the fund.
D. As the average return generated by the fund for the last 10 years is 0.51%, the stress test
scenario for maximum loss must be -0.51%.
Stress testing is a simulation technique used in the financial industry to evaluate the potential effects
of severe but plausible events on portfolio values. It is a risk management tool that helps in
understanding the risk exposure under extreme market conditions. T he purpose of stress testing is
not to predict outcomes, but to understand potential vulnerabilities in a portfolio. In this context, the
stress test scenario for maximum loss should be more than the historical maximum loss posted by
the fund. T his is because stress testing is designed to assess the resilience of a fund to extreme
market conditions that may not have been experienced in the past. T herefore, it is not sufficient to
simply consider the maximum historical loss. T he stress test should consider scenarios that are
more severe than those experienced historically to ensure that the fund can withstand extreme
market downturns. T his is why choice C is correct.
Choi ce A i s i ncorrect. While it's true that the maximum loss during the last 10 years was 8.83%,
stress testing is not limited to historical losses. Stress tests are designed to evaluate how a fund
would perform under extreme conditions, which may be worse than any historical scenario.
Choi ce B i s i ncorrect. T he average loss of 5.80% over the past ten years does not necessarily
represent a worst-case scenario for stress testing purposes. Stress tests should consider potential
losses that are significantly greater than average to ensure robustness under severe market
conditions.
Choi ce D i s i ncorrect. T he average return of the fund over the last ten years has no direct
relevance to determining a stress test scenario for maximum loss. Stress tests focus on potential
future losses, not past returns.
Q.1168 A risk manager examines a portfolio (AUM- $100 million) and observes that the performance
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of the fund is dependent on two variables, α and β. T he manager wants to carry out a stress test of
the portfolio. He defines two scenarios to stress test the portfolio:
I. T he value of α is pushed up by x and the value of β is pushed down by y

II. T he value of α is pushed down by x and the value of β is pushed up by y
After performing the stress test, the risk manager suggests that a contingency fund of $10 million
must be maintained. Select the most appropriate statement.
A. A contingency fund of $10 million must be maintained as suggested by the risk manager.
B. A contingency fund of more than $10 million must be maintained.
C. T he correlation between the two variables must be considered while performing the
stress test.
D. As stress tests generally involve events which rarely occurs, the contingency fund must
not be maintained.
T he correlation between the two variables, α and β, must be considered while performing the stress
test. Correlation is a statistical measure that describes the degree to which two variables move in
relation to each other. In the context of this question, the correlation between α and β could
significantly impact the results of the stress test. If the two variables are positively correlated, an
increase in α could coincide with an increase in β, and vice versa. Conversely, if the two variables
are negatively correlated, an increase in one variable could coincide with a decrease in the other. By
considering the correlation between the two variables, the risk manager can more accurately
estimate the potential impact of extreme scenarios on the portfolio, and thus determine a more
appropriate size for the contingency fund. Ignoring the correlation could lead to an underestimation
or overestimation of the potential risks, and consequently, an inappropriate size for the contingency
fund.
Choi ce A i s i ncorrect. While the risk manager has recommended a contingency fund of $10
million, this does not necessarily mean that it must be maintained at this exact amount. T he
contingency fund should be based on the potential losses estimated from the stress test results and
other risk management considerations.
Choi ce B i s i ncorrect. It's not necessary to maintain a contingency fund of more than $10 million
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just because a stress test was conducted. T he size of the contingency fund should be determined by
various factors including but not limited to potential losses estimated from stress tests, risk
tolerance level, and financial capacity of the firm.
Choi ce D i s i ncorrect. Even though stress tests generally involve events which rarely occur, it
doesn't mean that a contingency fund must not be maintained. On contrary, maintaining a contingency
fund can provide financial protection against these rare but potentially severe events.
Q.1170 A fund manager intends to carry out scenario analysis of his portfolio. T he portfolio consists
of 25% government bonds, 60% global equities, and 15% investment in gold ET Fs. T he fund manager
lists the portfolio’s risk factors. He intends to perform a scenario analysis by generating scenarios
based on the adverse movement in the portfolio’s identified risk factors. Such an approach to
scenario analysis is referred to as:
A. Event-driven scenario analysis.
B. Portfolio-driven scenario analysis.
C. Factor push method.
D. Historical method.
Scenario analysis is a process of evaluating possible future events by considering alternative possible
outcomes. It is used to assess the impact of different factors on the value of an investment portfolio.
T here are two main types of scenario analysis: event-driven and portfolio-driven. In event-driven
scenario analysis, scenarios are created based on plausible events that could cause changes in the
risk factors. On the other hand, portfolio-driven scenario analysis involves identifying the risk
factors of a portfolio and then creating scenarios based on adverse movements in these risk factors.
In the given scenario, the fund manager first identifies the risk factors of his portfolio and then
generates scenarios based on the adverse movement of these risk factors. T his approach is
characteristic of portfolio-driven scenario analysis. T herefore, the correct answer is Choice B:
Portfolio-driven scenario analysis.
Choi ce A i s i ncorrect. Event-driven scenario analysis is a type of scenario analysis that focuses on
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specific events, such as a financial crisis or natural disaster, and their potential impact on the
portfolio. T his does not match the approach described in the question where scenarios are generated
based on adverse movement of identified risk factors.
Choi ce C i s i ncorrect. T he factor push method involves changing one factor at a time while
keeping all other factors constant to see how it affects the portfolio. T his differs from the approach
described in the question where multiple risk factors are considered simultaneously.
Choi ce D i s i ncorrect. T he historical method involves creating scenarios based on historical data
and trends, which isn't mentioned in this case. In contrast, this manager's approach involves
generating scenarios based on adverse movements of identified risk factors.
Q.1171 A financial institution should set out clearly stated and understandable policies and procedures
governing stress testing, which must be adhered to. T he policies and procedures ensure that the
stress testing of parts of a financial institution converges to the same point. T he policies and
procedures should be able to:
A. Explain the purpose of stress testing.
B. State the frequency at which the stress testing can be done.
C. Describe the roles and responsibilities of the parties involved in stress testing.
T he policies and procedures for stress testing in a financial institution should indeed encompass all
the options listed. T hey should explain the purpose of stress testing, which is to identify potential
vulnerabilities in a financial institution's risk position, especially during adverse market conditions.
T his helps the institution to understand the impact of different scenarios on its financial condition
and make informed decisions to mitigate risks.
T hey should also state the frequency at which stress testing should be conducted. T his is important
as it ensures that the institution regularly checks its risk position and makes necessary adjustments
in a timely manner. T he frequency can depend on various factors such as the size of the institution,
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the complexity of its operations, and the volatility of the market conditions.
Lastly, they should describe the roles and responsibilities of the parties involved in stress testing.
T his includes the management who oversees the process, the staff who conducts the tests, and the
third parties like auditors and regulators who review the results. Clearly defining these roles and
responsibilities ensures that the process is carried out effectively and efficiently.
Choi ce A i s i ncorrect. While explaining the purpose of stress testing is indeed a part of the
policies and procedures, it alone does not encompass all that these guidelines should be capable of
accomplishing. T hey should also include other aspects such as frequency of testing and roles and
responsibilities.
Choi ce B i s i ncorrect. Stating the frequency at which stress testing can be done is an important
aspect, but it's not the only thing that these policies and procedures should cover. T hey must also
explain the purpose behind stress tests and define roles and responsibilities.
Choi ce C i s i ncorrect. Describing the roles and responsibilities of parties involved in stress
testing forms a crucial part of these guidelines, but they must also address other elements like
purpose behind conducting these tests and their frequency.
Q.1172 T he general belief that diversification leads to risk reduction was challenged during the
Global Financial Crisis of 2007-2009. During the crisis, it was observed that the correlation between
different assets increased due to which the concept of diversification failed.
Imagine yourself being a risk manager. In order to assess the likely impact of such events, the most
appropriate tool is the:
A. Scenario analysis.
B. Sensitivity analysis.
C. Historical simulation.
D. Factor push analysis.
Scenario analysis is a process of examining and evaluating possible events or scenarios that could
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take place in the future and predicting the various feasible outcomes. In the context of the Global
Financial Crisis of 2007-2009, scenario analysis would be an appropriate tool for a risk manager. T his
is because the crisis can be considered an extreme event, and scenario analysis is particularly useful
for examining such events. Different scenarios can be modeled based on the conditions during the
crisis, and an analysis of the likely impact of these scenarios can be carried out. T his would provide a
comprehensive understanding of the potential risks and impacts associated with similar events in the
future, thereby enabling effective risk management strategies.
Choi ce B i s i ncorrect. Sensitivity analysis is a tool used to understand how different values of an
independent variable impact a particular dependent variable under a given set of assumptions.
However, it does not take into account the correlation between different assets or the potential
impact of extreme events like the Global Financial Crisis.
Choi ce C i s i ncorrect. Historical simulation involves re-running risk models based on historical
data to assess potential future outcomes. While this can be useful for understanding how past events
might influence future risks, it may not accurately capture the dynamics of extreme events like the
Global Financial Crisis where correlations between assets increased significantly.
Choi ce D i s i ncorrect. Factor push analysis involves changing one factor at a time while keeping
all other factors constant to see how this impacts the output of a model. T his method would not be
suitable for assessing an event like the Global Financial Crisis where multiple factors and their
interrelationships played significant roles.
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Q.1173 All the following are true for stress testing, EXCEPT :
A. It is highly subjective.
B. T he events are reported without an attached probability making the result difficult to
interpret.
C. It is not helpful in ensuring the survival of an institution in times of market turmoil.
D. Implausible scenarios may lead to irrelevant potential losses.
T he statement that stress testing is not helpful in ensuring the survival of an institution in times of
market turmoil is incorrect. Stress testing is a critical tool used by financial institutions to assess
their resilience to adverse market conditions. It involves the creation of various scenarios, each
representing a potential adverse event, and then assessing the institution's ability to withstand these
events. T he results of stress testing can provide valuable insights into the institution's risk profile
and its ability to survive in times of market turmoil. T herefore, stress testing is indeed helpful in
ensuring the survival of an institution in times of market turmoil.
Choi ce A i s i ncorrect. Stress testing is indeed highly subjective. It involves making assumptions
about extreme but plausible events and their potential impact on an institution's financial health. T he
subjectivity lies in the selection of these scenarios, which can vary greatly depending on the risk
appetite and perception of the institution conducting the test.
Choi ce B i s i ncorrect. In stress testing, events are often reported without an attached probability,
which can make results difficult to interpret. T his is because stress tests focus on extreme
scenarios that may not have occurred in the past or have a very low likelihood of occurrence,
making it challenging to assign precise probabilities.
Choi ce D i s i ncorrect. While it's true that implausible scenarios may lead to irrelevant potential
losses, this does not negate the value of stress testing as a risk management tool. T he purpose of
considering such scenarios in stress testing is to prepare for worst-case situations and ensure
robustness under all conditions.
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Q.2812 One of the key elements of sound governance over stress testing is the governance
structure.
Which of the following statements regarding governance structure is incorrect?
A. T he internal audit should provide an independent evaluation of the ongoing performance,

integrity, and reliability of the stress-testing activities.
B. T he board of directors should execute the overall stress testing strategy (including
establishing adequate policies and procedures, assigning competent staff, etc.).
C. An institution should have clear and comprehensive stress testing policies, procedures and
documentation.
D. Stress-testing governance should incorporate validation or another type of independent

review to ensure the integrity of stress-testing processes and results.
T he statement that the board of directors should execute the overall stress testing strategy is
incorrect. T he execution of the overall stress testing strategy is the responsibility of the senior
management, not the board of directors. T he board of directors is responsible for overseeing the
overall direction and strategy of the organization, while the senior management is responsible for
implementing these strategies and managing the day-to-day operations of the organization. In the
context of stress testing, the senior management would be responsible for establishing adequate
policies and procedures, assigning competent staff, and executing the overall stress testing strategy.
Choi ce A i s i ncorrect. T he internal audit indeed plays a crucial role in providing an independent
evaluation of the ongoing performance, integrity, and reliability of the stress-testing activities. T his
ensures that the stress testing process is robust and reliable.
Choi ce C i s i ncorrect. It's essential for an institution to have clear and comprehensive stress
testing policies, procedures, and documentation. T hese elements form the backbone of a robust
governance structure for stress testing.
Choi ce D i s i ncorrect. Validation or another type of independent review is a key component of
stress-testing governance as it helps ensure the integrity of stress-testing processes and results.
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Q.2813 What is the advantage of reverse stress testing?
A. By concentrating on different scenarios, reverse stress testing helps to identify the most
profitable business lines.
B. Reverse stress testing does not consider scenarios beyond its normal business
expectations and concentrates on issues that could affect business during the normal
business operations.
C. Reverse stress testing does not consider scenarios beyond its normal business
expectations and consequently does not require a comprehensive analysis.
D. By evaluating scenarios and circumstances that would render a business unviable, reverse
stress testing identifies potential business vulnerabilities.
Reverse stress testing is a risk management tool that starts from a hypothetical outcome of business
failure and works backwards to identify the scenarios and circumstances that could lead to this
outcome. T his approach is particularly useful in identifying potential vulnerabilities in a business. By
considering extreme scenarios that could render a business unviable, reverse stress testing allows
businesses to proactively identify and address potential weaknesses, thereby enhancing their
resilience and ability to withstand adverse conditions. T his is the primary advantage of reverse stress
testing.
Choi ce A i s i ncorrect. Reverse stress testing does not focus on identifying the most profitable
business lines. Instead, it focuses on identifying scenarios and circumstances that could potentially
lead to the failure of a business.
Choi ce B i s i ncorrect. T his statement contradicts the purpose of reverse stress testing. Reverse
stress testing specifically considers scenarios beyond normal business expectations to identify
potential vulnerabilities that could lead to business failure.
Choi ce C i s i ncorrect. Again, this statement contradicts the nature of reverse stress testing. It
does consider scenarios beyond its normal business expectations and requires a comprehensive
analysis to identify potential risks and vulnerabilities.
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Q.2814 During which phase of the economic cycle is stress testing most important?
A. During the beginning of an economic recession.
B. In the middle of an economic recession.
C. In the beginning of an economic expansion.
D. After a long period of economic expansion.
Stress testing is particularly important after a long period of economic expansion. During such
periods, the economy is generally performing well, with high employment rates, increased consumer
spending, and robust business growth. However, these conditions can also lead to complacency and
the underpricing of risk. Financial institutions may become overly optimistic, underestimating the
potential for economic downturns and the associated risks. Stress testing during these times helps
institutions prepare for potential economic downturns by assessing their resilience to adverse
scenarios. It allows them to identify vulnerabilities in their risk management strategies and make
necessary adjustments to ensure their financial stability in the event of an economic downturn.
Choi ce A i s i ncorrect. While stress testing is important during the beginning of an economic
recession, it is not the most crucial stage. T his phase typically involves a downturn in economic
activity, and while stress tests can help identify vulnerabilities, they are more critical after a long
period of economic expansion when risks may have built up unnoticed.
Choi ce B i s i ncorrect. In the middle of an economic recession, financial institutions are already
dealing with the impacts of the crisis. Stress testing at this stage can still be useful for managing
ongoing risks but it's not as crucial as after a long period of expansion when potential vulnerabilities
may have accumulated without detection.
Choi ce C i s i ncorrect. At the beginning of an economic expansion, institutions are generally
recovering from a previous downturn and hence less likely to face severe stress scenarios.
T herefore, while stress testing remains important for risk management purposes, it becomes most
crucial after prolonged periods of growth where complacency about risk can set in.
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Q.3445 Which of the following parties bears the ultimate responsibility for stress testing programs
in banks?
A. T he risk management function
B. Senior management
C. T he board of directors
D. Internal audit
T he board of directors is ultimately responsible for a bank's stress tests. T his responsibility stems
from the board's overarching role in setting the strategic direction of the bank and overseeing its
operations. While the board members may not delve into the technical details of stress tests, they
are expected to ensure that they remain sufficiently knowledgeable about the procedures involved in
stress testing and the interpretation of results. T heir engagement in this process is crucial for the
effective operation of stress testing. T hey need to ensure that the stress testing program is robust,
that it adequately captures the bank's risk profile, and that the results are used appropriately in
decision-making. T his includes understanding the assumptions and limitations of the stress tests,
challenging the results where necessary, and ensuring that appropriate actions are taken in response
to the findings of the stress tests.
Choi ce A i s i ncorrect. While the risk management function plays a significant role in conducting
stress tests and analyzing their results, they do not bear the ultimate responsibility for the
implementation and oversight of these programs. T heir role is more operational, focusing on
executing the tests and interpreting the results.
Choi ce B i s i ncorrect. Senior management also has an important role in stress testing, as they are
responsible for ensuring that appropriate resources are allocated to this process and that it aligns
with the bank's overall strategic objectives. However, while they have a key role in implementing
stress testing programs, ultimate oversight responsibility lies elsewhere.
Choi ce D i s i ncorrect. T he internal audit function provides independent assurance on the
effectiveness of risk management processes including stress testing but does not have ultimate
responsibility for its implementation or oversight. T hey review and assess whether all procedures
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are followed correctly but do not set up or oversee these procedures themselves.
Q.3446 Which of the following options most accurately presents a key governance issue that played
a critical role in the failure of banks in the lead up to the 2007/2009 financial crisis?
A. Senior management played little or no role at all in the development and operation of
stress testing.
B. Stress testing reports would be passed up to the boards of directors without first being
approved by senior management
C. Stress testing did not appear to be sufficiently integrated into institutions’ risk
management frameworks, nor were test results taken into account during decision making
D. Stress testing programs lacked clear, well-detailed policies meant to outline the procedure
to follow from the start to the end, as well as describing the role played by various
employees
T he financial crisis of 2007/2009 revealed that stress testing was not adequately integrated into the
risk management frameworks of many banking institutions. T his lack of integration meant that the
results of stress tests were often not taken into account during decision-making processes. T his was
a significant governance issue as it meant that banks were not adequately prepared for the potential
risks they faced. T he few institutions that did show a commitment to stress testing often did not
examine sufficiently severe scenarios, further exacerbating the issue. T his lack of integration and
consideration of stress test results in decision making was a key factor that contributed to the failure
of many banks during the financial crisis.
Choi ce A i s i ncorrect. While it's true that senior management involvement in stress testing was
often lacking, this does not encapsulate the key governance issue. T he main problem was not just
the lack of involvement from senior management, but rather the insufficient integration of stress
testing into overall risk management frameworks and decision-making processes.
Choi ce B i s i ncorrect. Although there may have been instances where stress testing reports
were passed to boards without approval from senior management, this was not a prevalent or
significant contributing factor to bank failures during the crisis. T he more critical issue was that
229
these tests and their results were not adequately incorporated into risk management strategies or
decision making.
Choi ce D i s i ncorrect. While it's accurate that many institutions lacked clear policies for
conducting stress tests, this alone does not capture the primary governance issue at hand during the
financial crisis. T he central problem lay in how these tests were used (or rather, ignored) within
broader risk management frameworks and strategic decisions.
Q.3447 According to the CRMPG II report and the Basel committee report produced in the aftermath
of the 2007/2009 financial crisis, rigorous stress testing should be a goal of all firms. To make stress
testing more productive, firms should consider all of the following except:
A. Identifying a wide range of scenarios that could result in portfolio losses
B. Simulating the effects of capital problems and illiquidity pressures happening at the same
time
C. Asking risk managers to define and clearly express firm loss tolerance levels
D. Ensuring that the scenarios tested are in line with the direction and long-term strategy set
by the board of directors
T he task of defining and clearly expressing firm loss tolerance levels is not typically assigned to risk
managers. Instead, this responsibility usually falls to business managers or the board of directors.
Risk managers are primarily concerned with identifying, assessing, and mitigating risks. T hey provide
the necessary information and analysis to help business managers and the board of directors make
informed decisions about the firm's risk tolerance levels. However, the final decision on these levels
is not within the purview of risk managers. T his is because risk tolerance levels are closely tied to
the firm's strategic objectives, which are determined by the business managers or the board of
directors. T herefore, asking risk managers to define and clearly express firm loss tolerance levels
was not a recommendation made in the CRMPG II report or the Basel committee report following
the 2007/2009 financial crisis.
Choi ce A i s i ncorrect. T he Basel committee and the CRMPG II report did emphasize the
230
importance of identifying a wide range of scenarios that could result in portfolio losses. T his is an
integral part of comprehensive stress testing as it helps firms to understand potential risks and
prepare for them.
Choi ce B i s i ncorrect. Simulating the effects of capital problems and illiquidity pressures
happening at the same time was indeed one of the recommendations made by these bodies. Such
simulations can help firms to assess their resilience in extreme financial conditions.
Choi ce D i s i ncorrect. Ensuring that the scenarios tested are in line with the direction and long-
term strategy set by the board of directors was also among their suggestions. T his ensures that
stress tests are relevant to a firm's specific business model and strategic objectives.
Q.3448 T he following statements regarding stress testing and value at risk methods are incorrect,
EXCEPT :
A. From a practical point of view, VaR measures commonly utilize just a few scenarios
B. Ordinal arrangements are a key feature of VaR methods
C. For regulatory stress tests, the current period is used as the departure point while
generating hypothetical scenarios
D. While VaR methods reveal the causal risk(s), stress tests do not
For regulatory stress tests, generating hypothetical scenarios uses the current period, not past
history, as the point of origin.
Option A is incorrect. From a practical point of view, VaR measures commonly utilize very many
scenarios, but stress tests accommodate just a few
Option B is incorrect. Ordinal arrangements form part of stress tests, not VaR measures. T he latter
measures make use of cardinal probabilities.
Option D is incorrect. While stress tests reveal the causal risk(s), VaR measures do not
Q.3451 Prior to the recent crisis, stress testing was marked by several practices including:
I. Inadequate firm-wide perspective
231
II. Overreliance on sensitivity analysis
III. Limited recognition of interactive effects
IV. A lack of overall organizational view
A. II and III
B. I and IV
C. II only
D. All of the above
Prior to the recent financial crisis, stress testing in financial institutions was indeed marked by all of
the listed practices.
I. Inadequate fi rm-wi de perspecti ve: Stress tests were often conducted on individual
business lines, resulting in a lack of assessment of enterprise-wide exposure and the
correlation between various risks. T his silo-based approach failed to provide a
comprehensive view of the firm's overall risk profile.
II. Overrel i ance on sensi ti vi ty anal ysi s: Financial institutions heavily relied on sensitivity
analysis, which focuses on the impact of a shock on a single factor while holding other
factors constant. T his approach overlooked the potential spillover and feedback effects
arising from correlations among various risk factors.
III. Li mi ted recogni ti on of i nteracti ve effects: T he stress testing models used were not
equipped to predict the interrelationships among various financial securities. T his limited
recognition of interactive effects further compromised the effectiveness of stress testing.
IV. A l ack of overal l organi zati onal vi ew: Similar to the inadequate firm-wide perspective,
stress testing was often conducted in silos, with little assessment of enterprise-wide
exposure. T his resulted in a lack of an overall organizational view of risk.
Choi ce A i s i ncorrect. While it is true that there was an overreliance on sensitivity analysis and a
limited recognition of interactive effects, this choice does not include the inadequate firm-wide
perspective and the lack of overall organizational view which were also characteristic practices
during the period leading up to the recent financial crisis.Choi ce B i s i ncorrect. T his choice only
includes inadequate firm-wide perspective and a lack of overall organizational view. However, it fails
to consider overreliance on sensitivity analysis and limited recognition of interactive effects which
were equally significant issues in stress testing practices during that period.Choi ce C i s i ncorrect.
Overreliance on sensitivity analysis was indeed one of the problems but considering it alone does not
provide a comprehensive picture of all problematic practices in stress testing before the financial
crisis. T he other three issues - inadequate firm-wide perspective, limited recognition of interactive
effects, and a lack of overall organizational view - are missing from this choice.
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Q.3452 Following the 2007/2008 financial crisis, stress testing for securitized products should
consider which of the following features?
I. Contingency funding needs of the issuer

II. Credit ratings of similar securities on the market
III. Quality of underlying asset pool
IV. Subordination level of tranches
V. Systematic market conditions
A. All of the above
B. III and IV
C. II and V
D. I, III, IV, and V
T he contingency funding needs of the issuer, the quality of the underlying asset pool, the
subordination level of the tranches, and the systematic market conditions are all crucial factors to
consider when conducting stress tests for securitized products. T he contingency funding needs of
the issuer can impact the issuer's ability to meet its obligations, especially in times of financial
stress. T he quality of the underlying asset pool is a direct reflection of the risk associated with the
securitized product. T he subordination level of the tranches can affect the distribution of losses,
with lower tranches absorbing losses before higher ones. Lastly, systematic market conditions can
influence the overall performance of the securitized product, as they can affect the value of the
underlying assets and the issuer's ability to meet its obligations.
Choi ce A i s i ncorrect. While it might seem that all factors should be considered, the credit ratings
of similar securities currently available on the market (II) are not necessarily relevant for stress
testing a specific securitized product. Stress tests are designed to evaluate the potential impact of
adverse scenarios on a specific product, and while market comparisons can provide some context,
they do not directly contribute to this evaluation.
Choi ce B i s i ncorrect. T his option only includes the quality of the pool of underlying assets (III)
and the subordination level of tranches (IV). While these are important factors in stress testing
233
securitized products, they do not cover all necessary aspects. T he contingency funding needs of
issuer (I) and systematic market conditions (V) also play crucial roles in comprehensive stress
testing.
Choi ce C i s i ncorrect. T his option only considers credit ratings of similar securities currently
available on the market (II) and systematic market conditions (V). As explained above, choice II does
not directly contribute to stress test evaluations for a specific product. Furthermore, this choice
omits several key features such as contingency funding needs of issuer(I), quality of underlying
assets(III), and subordination level(IV).
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Q.3453 Which of the following statements related to stress testing and Basel II is correct?
I. Basel II requires banks to conduct stress tests and assess capital adequacy at least once
every month
II. In line with Basel II, a bank should take into account both its capital and liquidity needs while
conducting stress tests
A. I only
B. II only
C. Both I and II
D. Neither I nor II is correct
Basel II does indeed require banks to take into account both their capital and liquidity needs while
conducting stress tests. T his is because stress tests are designed to evaluate a bank's ability to
withstand adverse market conditions. In such scenarios, both capital and liquidity are crucial. Capital
is needed to absorb losses, while liquidity is required to meet short-term obligations. T herefore, a
comprehensive stress test should assess a bank's resilience in terms of both these aspects. T his
approach aligns with the overall objective of Basel II, which is to ensure the stability of the banking
system by promoting sound risk management practices.
Choi ce A i s i ncorrect. Basel II does not mandate banks to perform stress tests and evaluate their
capital adequacy on a monthly basis. T he frequency of stress testing is determined by the bank's own
internal policies and procedures, taking into account its risk profile and the nature of its activities.
Choi ce C i s i ncorrect. As explained above, Basel II does not require banks to conduct stress tests
and assess their capital adequacy on a monthly basis, making statement I false.
Choi ce D i s i ncorrect. Statement II accurately reflects the requirements of Basel II that a bank's
stress testing should consider both its capital requirements and liquidity needs, hence option D which
states that neither I nor II are correct is false.
Q.3454 Which of the following statements is (are) true?
235
Prior to the 2007-2008 credit crisis:
I. Stress testing was mostly geared towards individual business lines without considering
comprehensive firm-wide perspective
II. Stress testing was primarily focused on historical or hypothetical scenarios
A. I
B. II
C. Both I and II
D. Neither
Both statements I and II accurately describe the state of stress testing prior to the 2007-2008 credit
crisis. Statement I is correct because, before 2007, stress tests were largely conducted internally
by banks as part of their risk management strategies. T hese tests were often focused on individual
business lines, without taking into account a comprehensive, firm-wide perspective. It was only
after 2007, when regulatory bodies began conducting their own stress tests, that a more holistic
approach to stress testing was adopted. T his shift was part of an effort to ensure the effective
operation of financial institutions and led to the refinement of stress testing methodologies. Today,
tasks associated with Basel III compliance, such as Monte Carlo simulation, scenario analysis, stress
testing, and asset-liability modeling, are common.
Statement II is also correct. Prior to the crisis, stress testing was primarily based on historical or
hypothetical scenarios. Historical scenarios were often based on significant market events from the
past. However, these tests were not able to adequately capture the risks associated with new
financial products that were central to the crisis. Hypothetical stress tests were designed to capture
events that had not yet occurred. However, these tests were often based on moderate scenarios and
struggled to gain acceptance from senior management, who often viewed more severe or innovative
scenarios as implausible.
Choi ce A i s i ncorrect. While it is true that stress testing was predominantly oriented towards
individual business lines, this does not make the statement incorrect. Prior to the 2007-2008 credit
crisis, many financial institutions did not have a comprehensive firm-wide perspective in their stress
236
testing methodologies. T his lack of a holistic approach was one of the factors that contributed to the
severity of the crisis.
Choi ce B i s i ncorrect. T he statement that stress testing was primarily centered on historical or
hypothetical scenarios is accurate and reflects the state of stress testing during this period.
T herefore, this choice cannot be considered as an incorrect statement.
Choi ce D i s i ncorrect. As explained above both statements I and II accurately reflect the state of
stress testing prior to 2007-2008 credit crisis, hence neither can be considered as false.
Q.3455 Which of the following statements is (are) correct?

Stress testing methods consider inter-correlations between:
I. funding and market risks

II. basis and liquidity risks
III. market and pipeline risks
IV. reputational and liquidity risks
A. II only
B. I, II and IV
C. II and III
D. I, II, III and IV
Stress testing methods do consider the inter-correlations between all the mentioned pairs of risks.
1. Funding and market risks: Market stress conditions can make it difficult to liquidate an asset
without loss, thereby affecting the institution's funding.
2. Basis and liquidity risks: Changes in basis can result in ineffective hedges, leading to significant
losses due to the unprotected decline in the underlying asset’s value. T his can give rise to liquidity
problems.
237
3. Market and pipeline risks: Deteriorating conditions in the securitization market, as seen during the
recent financial crisis, can prevent banks from securitizing assets, forcing them to keep these assets
on their balance sheets.
4. Reputational and liquidity risks: Reputational risk can put a bank under increasing liquidity
pressure, especially if the bank feels compelled to inject credit or liquidity into a special purpose
entity (SPE) to protect its reputation.
Choi ce A i s i ncorrect. While it is true that stress testing methods consider the inter-correlation
between basis and liquidity risks, this choice ignores the other combinations of risk inter-
correlations that are also considered in stress testing methods, such as the inter-correlation between
funding and market risks, market and pipeline risks, and reputational and liquidity risks.
Choi ce B i s i ncorrect. T his choice correctly identifies that stress testing methods consider the
inter-correlation between funding and market risks, basis and liquidity risks, as well as reputational
and liquidity risks. However, it fails to acknowledge that these methods also take into account the
inter-correlation between market and pipeline risks.
Choi ce C i s i ncorrect. Although this choice correctly points out that stress testing methods
consider both the inter-correlation between basis & liquidity risk as well as market & pipeline risk;
it overlooks other important correlations such as those existing between funding & market risk or
reputational & liquidity risk.
Q.4557 Which of the following statements correctly distinguish between stress testing and expected
shortfall?
I. Expected shortfall is backward-looking but stress testing is forward-looking

II. Stress testing is backward-looking but expected shortfall is forward-looking
III. Whereas stress testing is based on the future probability distribution, the expected shortfall
is based on past probability distribution.
IV. Expected shortfall analysis often takes a short time but stress testing takes relatively long
periods
A. I and II
238
B. II and III
C. I and IV
D. IV only
Statement I is correct as Expected shortfall is indeed backward-looking. It is based on historical data
and assumes that the future will resemble the past. On the other hand, stress testing is forward-
looking. It is a simulation technique that asks 'what if' questions to determine how certain stress
conditions would affect the institution. It does not rely on historical data but rather on hypothetical
future scenarios. Statement IV is also correct. Value at Risk (VaR) and Expected Shortfall (ES)
analyses often take a short period of time, such as a day, while stress testing takes relatively long
periods, such as a decade. T his is because stress testing involves simulating various scenarios over a
long period to understand the potential impact on the institution's financial health.
Choi ce A i s i ncorrect. T his option suggests that both I and II are the key differences between
stress testing and expected shortfall. However, this is not accurate as statement II does not
accurately differentiate between the two concepts. Stress testing involves evaluating potential
extreme scenarios that could impact a financial institution, while expected shortfall measures the
risk of an investment by estimating the expected loss in value given a specific level of confidence.
Choi ce B i s i ncorrect. T his option suggests that statements II and III accurately differentiate
between stress testing and expected shortfall. However, statement III does not provide an accurate
differentiation as it does not correctly describe either concept.
Choi ce D i s i ncorrect. T his choice implies that only statement IV differentiates between stress
testing and expected shortfall which isn't true because statement I also provides a valid distinction
between these two concepts.
239
Q.4558 Which of the following is/are TRUE about the stressed VaR and stressed Estimated shortfall
(ES)?
I. T he data used to calculate stressed Var and stressed ES are drawn from stressful periods,
such as the year 2007.
II. Stressed VaR and stressed ES considers a short period of time in their calculations.
III. Similar to traditional VaR, stressed VaR could be back-tested
A. I only
B. III only
C. I and II only
D. All of the above
Statement I i s correct: T he data used to calculate stressed VaR and stressed ES is obtained from
stressed periods. Stressed VaR and Stressed ES might be objectively similar, but the time horizon for
the stressed VaR/ES is short (one to ten days), while stress testing considers relatively longer
periods.
Statement II i s correct: Stressed VaR and stressed ES might be objectively similar to stress
testing, but the time horizon for the stressed VaR/ES is short (one to ten days). In contrast, stress
testing considers relatively longer periods.
Statement III i s i ncorrect: Conventional VaR can be back-tested while stressed VaR cannot.
It is difficult to back-test stressed VaR because these measures focus on extreme outcomes, which
do not have any particular observable frequency.
240
Q.4559 Which of the following is NOT an internally developed stress test scenario?
A. Historical scenario
B. Baseline scenario
C. Ad hoc scenario
Baseline scenario is one of the regulatory scenarios in Comprehensive Capital Analysis and Review
(CCAR), which is a US regulatory stress test on banks with consolidated assets of over USD 50
million.
Opti ons A and C are i ncorrect: T he internally developed stress testing scenarios include the
historical scenarios, ad hoc scenarios, and stressing key variables.
241
Q.4560 A bank carries out regular stress testing to determine its appropriate capital level. During a
given year, the bank generates a scenario to assume that the GDP growth rate might decline by 3%.
Under the impending circumstances, which type of scenario will the bank most likely internally
generate?
A. Ad hoc scenarios.
B. Historical scenarios.
C. Stressing key variables scenarios.
In the context of stress testing, a scenario could be constructed by assuming that a significant change
occurs in one or more key variables. In this case, the key variable is the GDP growth rate, which is
assumed to decline by 3%. T his type of scenario is known as 'stressing key variables scenario'. It is a
common practice in stress testing to stress key variables and observe the potential impact on the
bank's capital level. T his helps the bank to prepare for adverse economic conditions and ensure that
it has sufficient capital to withstand potential losses.
Choi ce A i s i ncorrect. Ad hoc scenarios are typically generated in response to specific events or
concerns, and not necessarily linked to key economic variables such as GDP growth rate. T hey are
more event-specific and less systematic than what the question describes.
Choi ce B i s i ncorrect. Historical scenarios are based on actual past events or periods of
significant financial stress. While they may involve changes in GDP, they do not involve hypothetical
changes in key variables like the scenario described in the question.
Choi ce D i s i ncorrect. T he scenario described by the bank involves stressing a key variable (GDP
growth rate), which clearly falls into one of the defined categories of stress testing scenarios, thus
'None of the above' cannot be correct.
242
Q.4561 Which of the following correctly describes stressed VaR?
A. T here is an X% likelihood that the losses will not exceed the VaR level during a given time
T.
B. If the losses exceed the VaR level at a given time T, then the average loss is equivalent to
the stressed VaR level.
C. If a stressed period is repeated, then there is X% likelihood that over a period of T days,
the losses will not exceed the stressed VaR level.
D. If the losses over a period of T days exceed the stressed VaR level, then the expected loss
is equivalent to the VaR level.
T he stressed VaR would conclude that if there was a repeat of a stressed period, then there is an X%
likelihood that losses over a period of T days will not surpass the stressed VaR level.
Opti on A i s i ncorrect: It is the description of traditional VaR.
Opti on B i s i ncorrect: T he statement would have described conventional expected shortfall (ES)
if it has mentioned that “If the losses exceed the VaR level at given time T, then the average loss is
equivalent to ES”.
Opti on D i s i ncorrect: T he statement would have described stressed ES if it had mentioned that
“If the losses over a period of T days exceed the stressed VaR level, then the expected loss is
equivalent to stressed VaR level.”
243
Q.4563 T he variables stated in the context of scenario analysis are termed as:
A. Core variables
B. Key variables
C. Peripheral variables
D. Volatility variables
Core variables are the primary variables identified in the context of scenario analysis. T hese
variables are integral to the process and are often used to derive the behavior of other variables.
T he term 'core' signifies their central role in the analysis. T hey form the basis of the scenarios that
are constructed and are therefore crucial to the outcome of the analysis. T he behavior of these core
variables is often the focus of the analysis, with the aim of understanding how changes in these
variables might impact the overall scenario. T his understanding can then be used to inform decision-
making and risk management strategies.
Choi ce B i s i ncorrect. While the term "key variables" might seem appropriate, it is not the
specific term used in scenario analysis to refer to the primary variables that are identified and used
to construct potential future scenarios. T hese variables are referred to as "core variables".
Choi ce C i s i ncorrect. T he term "peripheral variables" refers to those factors that may have an
indirect or less significant impact on a scenario, not the primary ones that directly shape potential
future scenarios in scenario analysis.
Choi ce D i s i ncorrect. "Volatility variables" specifically refer to those factors that contribute
towards volatility or uncertainty in a model or system, but they do not necessarily represent the
primary drivers of different scenarios in scenario analysis.
244
Q.4564 While analyzing the stress testing results, analysts should consider the impacts of the stress
testing scenarios and also knock-on effects. What is a knock-on effect?
A. It is an effect due to the way a financial institution responds to an adverse condition.
B. It is an effect on the way financial institutions implement stress testing.
C. It is a negative influence from the staff conducting the stress test.
D. It is an effect that arises due to the involvement of the Board and senior management in
the stress testing process.
A knock-on effect, in the context of stress testing in financial risk management, refers to the
subsequent consequences that arise due to the way a financial institution responds to an adverse
condition. T his response could potentially exacerbate the adverse scenario, leading to further
complications. For instance, if a bank responds to a stress scenario by selling off assets to maintain
liquidity, this could potentially lead to a market downturn, causing a knock-on effect. T herefore,
understanding and considering these knock-on effects is crucial for analysts when interpreting the
results of stress tests.
Choi ce B i s i ncorrect. T he 'knock-on effect' does not pertain to the implementation process of
stress testing by financial institutions. Rather, it refers to the subsequent effects that occur due to
how a financial institution responds to adverse conditions.
Choi ce C i s i ncorrect. T he 'knock-on effect' has nothing to do with any negative influence from
the staff conducting the stress test. It is about the cascading effects resulting from an institution's
response to adverse situations, not about personnel conduct or performance during testing.
Choi ce D i s i ncorrect. T he involvement of Board and senior management in stress testing process
does not define a 'knock-on effect'. While their involvement may influence decisions and responses,
it doesn't directly relate to or cause a knock-on effect which specifically refers to subsequent
impacts following an initial response.
Q.4565 In the context of the stress testing, which of the following is INCORRECTLY described?
245
I. T he primary objective of reverse stress testing is to determine how a financial institution
can fail
II. Stressed VaR gives a high percentile of the distribution of losses over a period of time
conditional on the recurrence of a stressed period
III. Stressed VaR analyzes the results of a selected scenario over a short period of time
IV. VaR tells us the minimum amount of loss that could be incurred over a period of T days based
on past data.
V. Knock-on effects are the secondary effects of an adverse scenario
A. I, II and III
B. II only
C. IV only
D. IV and V
T he statement 'VaR tells us the minimum amount of loss that could be incurred over a period of T
days based on past data' is incorrect. In reality, Value at Risk (VaR) is a statistical technique used to
measure and quantify the level of financial risk within a firm or investment portfolio over a specific
time frame. It provides an estimate of the maximum potential loss that could be incurred over a
specified period of time, given a certain level of confidence. For instance, a VaR of $1 million at the
95% confidence level implies that there is a 5% chance that the portfolio will fall in value by more
than $1 million over the specified time period. T herefore, VaR does not indicate the minimum
potential loss, but rather the maximum potential loss that could be incurred.
Choi ce A i s i ncorrect. Statement I, II and III are all accurately described. Reverse stress testing
does aim to identify the circumstances under which a financial institution could fail. Stressed VaR
does represent a high percentile of the distribution of losses over a specific period, conditional on
the recurrence of a stressed period. And Stressed VaR does examine the outcomes of a chosen
scenario over a brief period.
Choi ce B i s i ncorrect. As explained above, statement II is accurately described.
Choi ce D i s i ncorrect. While statement IV is inaccurately described as VaR indicates the
246
maximum potential loss over a period of T days at certain confidence level based on historical data
not minimum, statement V correctly describes knock-on effects as secondary consequences of an
adverse scenario.
247
Q.4566 In the context of regulatory stress testing in the United States, which of the following is
true?
A. Comprehensive Capital Analysis and Review (CCAR) is a stress test performed by the
Federal Reserve on banks with consolidated assets of over USD 50 million.
B. Under the CCAR, banks are required to consider three scenarios: baseline, severe, and an
internal scenario.
C. Under the Dodd-Frank Act Stress Test (DFAST ), banks are required to submit a capital
plan.
D. T he Dodd-Frank Act Stress Test (DFAST ) applies to banks with consolidated assets
between USD 10 billion and USD 50 billion.
T he Dodd-Frank Act Stress Test (DFAST ) indeed applies to banks with consolidated assets between
USD 10 billion and USD 50 billion. T his regulatory requirement is part of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, which was enacted in response to the financial crisis of 2008.
T he DFAST is designed to ensure that these banks have sufficient capital to absorb losses and
support operations during adverse economic conditions. It requires banks to conduct stress tests to
assess their potential losses from hypothetical adverse scenarios. T he results of these tests are then
used to inform the banks' capital planning decisions.
Choi ce A i s i ncorrect. T he Comprehensive Capital Analysis and Review (CCAR) is not performed
on banks with consolidated assets of over USD 50 million. Instead, it applies to bank holding
companies with $100 billion or more in total consolidated assets.
Choi ce B i s i ncorrect. Under the CCAR, banks are required to consider three scenarios: baseline,
adverse, and severely adverse. T here's no requirement for an internal scenario as stated in the
option.
Choi ce C i s i ncorrect. Under the Dodd-Frank Act Stress Test (DFAST ), banks are not required to
submit a capital plan. It's under CCAR that banks are required to submit a capital plan which includes
their planned capital actions over a nine-quarter planning horizon.
248
Q.4567 A financial institution should have written policies and procedures for stress testing. Which
one of the following is NOT included in policies and procedures of stress testing?
A. Responsibilities and roles of the staff conducting the stress testing.
B. Procedure for defining selection of scenarios.
C. T he description of the consumption of the stress testing results.
D. T he description of the limitation of access to stress testing results by the management.
T he description of the limitation of access to stress testing results by the management is not
typically included in the policies and procedures for stress testing. T his is because the management
of a financial institution is not usually restricted from accessing the results of stress testing. In fact,
it is essential for the management to have access to these results as they provide valuable insights
into the potential risks and vulnerabilities of the institution. T he management can use these insights
to make informed decisions about risk mitigation strategies and to track changes in the stress testing
results over time. T herefore, any policies or procedures that limit the management's access to
these results would be counterproductive and are not typically included in the guidelines for stress
testing.
Choi ce A i s i ncorrect. T he roles and responsibilities of the staff conducting the stress testing are
indeed a crucial part of the policies and procedures. T his ensures that everyone involved in the
process understands their tasks, thereby promoting efficiency and accuracy.
Choi ce B i s i ncorrect. T he procedure for defining selection of scenarios is also typically included
in these policies and procedures. It helps to ensure that all potential risk scenarios are considered
during stress testing, thus enhancing its effectiveness.
Choi ce C i s i ncorrect. T he description of how the results from stress testing will be used
(consumption) should be included in these policies and procedures as well. T his provides clarity on
how to interpret and apply these results for decision-making purposes within the financial institution.
249
Q.4568 One of the key features of stress test governance is validation and independent review.
Which one of the following is NOT a function of validation and independent review?
A. It continuously monitors the results of the stress testing.
B. Making sure that stress testing is based on the robust theory.
C. It addresses the qualitative aspects of the stress test.
D. It defines how stress testing should be carried out in a financial institution.
T he task of defining how stress testing should be carried out in a financial institution is not a function
of validation and independent review. T his responsibility typically falls under the jurisdiction of the
institution's Board or senior management. T hey are responsible for establishing the overall stress
testing framework, including the methodologies, scenarios, and assumptions to be used. T he role of
validation and independent review is to ensure that the stress testing process is robust, reliable, and
in line with the institution's risk appetite and strategic objectives. T hey do not define the stress
testing process but rather evaluate and challenge it to ensure its effectiveness.
Choi ce A i s i ncorrect. T he validation and independent review function does indeed continuously
monitor the results of stress testing. T his is to ensure that the stress tests are being conducted
properly and that they are producing reliable results.
Choi ce B i s i ncorrect. Ensuring that stress testing is based on robust theory falls under the
purview of validation and independent review function. It checks whether the assumptions, models,
and methodologies used in stress testing are sound and theoretically robust.
Choi ce C i s i ncorrect. Addressing qualitative aspects of a stress test also falls under this
function's responsibilities. It reviews whether non-quantitative factors like management judgement,
expert opinion etc., have been appropriately considered in the test.
Q.4569 Validation and independent reviews is an essential aspect of stress testing governance. Which
of the following is/are (a) feature(s) for sufficient validation and independent review?
I. T he reviews should be unbiased
250
II. T he external models from the vendors and the internal models should be subject to the
different reviewers
III. T he Board should ensure that the staff carrying out the stress test have relevant
qualifications
IV. T he Board should ensure that the stress testing documentation is of satisfactory level
A. I, II, III and IV
B. I only
C. IV only
D. I and IV
T he only accurate feature of sufficient validation and independent review in the context of stress
testing governance is that the reviews should be unbiased. T his is crucial to ensure that the stress
test is conducted in accordance with the policies and procedures of the stress test. An unbiased
review provides an objective assessment of the stress testing process, thereby assuring the board of
the reliability and effectiveness of the stress test. It helps in identifying any potential issues or
weaknesses in the stress testing process, enabling the board to take appropriate corrective actions.
T herefore, unbiased reviews are an essential feature of sufficient validation and independent review
in stress testing governance.
Choi ce A i s i ncorrect. While it is true that the reviews should be unbiased and the Board should
ensure that the stress testing documentation is of satisfactory level, it's not necessary for external
models from vendors and internal models to be subject to different reviewers. Also, while it's
important for staff carrying out stress tests to have relevant qualifications, this doesn't fall under
validation and independent review.
Choi ce C i s i ncorrect. Although ensuring satisfactory level of stress testing documentation by the
Board is an important aspect of governance, it alone does not constitute adequate validation and
independent review in context of stress testing governance.
Choi ce D i s i ncorrect. While both statements I and IV are correct individually, they do not
collectively represent all features necessary for adequate validation and independent review in
251
context of stress testing governance.
252
Q.4570 Before the 2007-2008 financial crisis, the stress tests were faced with numerous
shortcomings. Which of the following is NOT a feature of the stress test before the financial crisis
as observed by the Basel Committee?
A. T he Board and senior management were not adequately involved in stress testing.
B. Stress testing was taken as a mere mechanical process and did not much impact on
decision making.
C. T he risk exposure was over-aggregated hence exaggerating the overall picture of the
enterprise-wide view of risks.
D. T he scenarios developed were too moderate and the duration involved was too short.
T he statement that 'T he risk exposure was over-aggregated hence exaggerating the overall picture
of the enterprise-wide view of risks' is not accurate. Prior to the financial crisis, risk exposures
were not aggregated to provide an enterprise-wide view of risk. T his was a significant shortcoming
as it prevented a comprehensive understanding of the risk profile of a financial institution.
Aggregating risk exposures allows for a more holistic view of the potential threats to an institution's
financial stability. It enables the identification of areas of vulnerability and the development of
strategies to mitigate these risks. However, this practice was not prevalent in the stress tests
conducted before the financial crisis, leading to a lack of awareness and preparedness for the
impending crisis.
Choi ce A i s i ncorrect. T he Basel Committee did indeed identify that the Board and senior
management were not adequately involved in stress testing. T his lack of involvement led to a
disconnect between the stress test results and strategic decision making.
Choi ce B i s i ncorrect. T he Basel Committee also observed that stress testing was often treated as
a mere mechanical process, with little impact on decision making. T his approach failed to leverage
the potential of stress tests as a tool for risk management and strategic planning.
Choi ce D i s i ncorrect. T he scenarios developed for these tests were indeed found to be too
moderate by the Basel Committee, with durations that were too short to accurately reflect potential
market conditions. T his resulted in an underestimation of potential risks and vulnerabilities.
253
Q.4571 In the context of Basel Committee Stress Testing Principles, choose the correct
statement(s).
I. T he staff responsible for the stress testing principles should be knowledgeable on the
objectives of the stress testing framework
II. Stress testing models, results, and frameworks should be subject to challenge and regular
review
III. T he models used in stress testing should be well justified and documented
A. I and II
B. I and III
C. II and III
D. I, II, and III
All three statements are accurate in the context of the Basel Committee's stress testing principles.
Statement I is correct as it aligns with the principle that an effective governance structure should be
incorporated into stress testing frameworks. T his implies that the staff responsible for stress testing
should be well-versed with the objectives of the stress testing framework.
Statement II is correct as it reflects the principle that stress testing models, results, and
frameworks should be subject to challenge and regular review. T his ensures the reliability and
validity of the stress testing process.
Statement III is correct as it corresponds to the principle that models and methodologies used to
assess the impacts of scenarios and sensitivities should be fit for the purpose. T his means that the
models used in stress testing should be well justified and documented to ensure their appropriateness
and effectiveness.
Choi ce A i s i ncorrect. While statements I and II are accurate, this choice omits statement III
which is also correct. T he models used in stress testing should indeed be thoroughly justified and
documented to ensure transparency and accountability.
Choi ce B i s i ncorrect. Although statements I and III are accurate, this choice fails to include
254
statement II which states that the models, results, and frameworks used in stress testing should be
open to scrutiny and regular evaluation. T his principle ensures that the stress testing process
remains robust over time.
Choi ce C i s i ncorrect. Statements II and III are correct but this option does not include statement
I which emphasizes the importance of personnel understanding the goals of the stress testing
framework for effective implementation.
255
Reading 55: Pricing Conventions, Discounting, and Arbitrage
Q.997 Kristen Haynes, an analyst working at Jahmal Securities, is explaining the different
terminologies of prices to a new employee. She makes the following statements about mid-market
and full prices per 100 face amount of bonds. Which of these statements are accurate?
Statement I. T he mid-market price is an average of the highest price (bid-price) that a buyer is
willing to pay and the lowest price, (ask-price) that the seller is willing to accept.
Statement II: T he full price is often referred to as the flat or quoted price of the bond
A. Statement I only
B. Statement II only
C. Statements I & II
Statement I is correct: T he mid-market price is an average of the highest bid price that a buyer is
willing to pay and the lowest ask price that the seller is willing to accept.
Statement II is incorrect: T he full price is the total amount a buyer pays for a bond, which is the sum
of the flat or quoted price of the bond and the accrued interest.
Q.998 Joshua Williamson, an associate working at Supreme Bonds, calculates the prices of US
T reasury bonds using the law of one price. However, he observes differences between the market
price of bonds and the prices predicted by the law of one price. Which of the following may be the
reason(s) for the differences in price?
I. T ransaction costs
II. Bid-ask spreads in the financing markets
III. It is only in theory that US T reasury bonds are commodities, i.e., fungible collections of cash
flows
A. I & II only
B. II & III only
C. I & III only
D. All of the above
Not numerical
256
Q.999 With regard to ST RIPS, which of the following statements are true?
I. ST RIPS are created when a particular coupon bond is delivered to the T reasury in exchange for its
coupon and principal components
II. When reconstituting a bond, any C-ST RIPS maturing on a particular date may be applied toward
the coupon payment of that bond on that date
III. ST RIPS prices are essentially discount factors
IV. T he T reasury not only creates ST RIPS but retires them as well
A. I & II only
B. II & III only
C. I & III only
D. All of the above
Not numerical
257
Q.1000 A 50-day US T-bill has a quoted price of 1.60. What is the cash price of the bill?
A. 94.75
B. 97.43
C. 100.23
D. 99.78
Recall that the cash price of a US T-bill is given by:
n
C = 100 − Q
360
where
C = Cash Price
Q = Quoted Price of the T-bill.
n = number of calendar days until the maturity of the T reasury bill
So in this case we have Q =1.60 and n =50 so that:
50
C = 100 − 1.60 ×
360
= 99.77777 ≈ 99.78
Q.1001 With regard to full price and flat price, which of the following statements are true?
I. T he flat price of the bond per 100 face amount is defined as the full price plus accrued interest
II. When trading bonds day-to-day, it is more intuitive to track the flat prices and negotiate
transactions in those terms
III. Within a coupon period, the full price of a bond, which is just the present value of its cash flows,
increases over time as the bond's payments draw near
IV. From an instant before the coupon payment date to an instant after it, the full price falls by the
coupon payment
A. I, II & III only
B. II, III & IV only
C. I, II & IV only
D. All of the above
258
Statement II is accurate because when trading bonds on a day-to-day basis, it is more intuitive to
track the flat prices and negotiate transactions in those terms. T his is because the flat price, which
is the price of the bond without considering the accrued interest, changes only gradually over time,
making it easier to track and negotiate.
Statement III is also accurate. T he full price of a bond, which is the present value of its cash flows,
increases over time within a coupon period as the bond's payments approach. T his is because as the
payment date approaches, the present value of the future cash flows increases, leading to an
increase in the full price of the bond.
Statement IV is accurate as well. T he full price of a bond experiences a drop by the coupon payment
from an instant before the coupon payment date to an instant after it. T his is because the coupon
payment is included in the present value of the remaining cash flows at the instant before the
payment, but not at the instant after. T herefore, the full price falls by the coupon payment.
Choi ce A i s i ncorrect. Statement I is inaccurate because the flat price of a bond per 100 face
amount is defined as the full price minus accrued interest, not plus. T he flat price, also known as the
clean price, excludes any consideration of accrued interest.
Choi ce C i s i ncorrect. As explained above, statement I is inaccurate which makes this choice
incorrect.
Choi ce D i s i ncorrect. T his choice includes all statements and since statement I has been
identified as inaccurate, this choice cannot be correct.
Q.1002 Day conventions play an important role in determining the accrued interest and value of
financial instruments. With regard to day conventions, which of the following statements are true?
I. For most government bonds in the US, the actual/actual day-count convention is used to determine
accrued interests
II. In money markets, the actual/360 day-count convention is used
III. In case of corporate bonds and for the fixed leg of interest rate swaps, the 30/360 convention is
most commonly used
IV. In case of discount securities and for floating legs of interest rate swaps, the 30/360 convention is
most commonly used
A. I, II & III only
259
B. II, III & IV only
C. I, II & IV only
D. All of the above
It correctly identifies that statements I, II, and III are true. T he actual/actual day-count convention is
indeed used for most government bonds in the US. T his convention calculates the actual number of
days between two dates, divided by the actual number of days in the year. T his method is most
accurate and fair to the investor, as it takes into account the exact duration of investment. Statement
II is also correct, as the actual/360 day-count convention is commonly used in money markets. T his
convention assumes a year of 360 days, which simplifies interest calculations. Lastly, statement III is
accurate as well. T he 30/360 convention is most often used for corporate bonds and for the fixed leg
of interest rate swaps. T his convention assumes 30 days in a month and 360 days in a year, which
simplifies calculations and is beneficial for investors who prefer regular and predictable interest
payments.
Choi ce B i s i ncorrect. T his choice includes statement IV, which is not accurate. T he 30/360
convention is not typically used for discount securities and for floating legs of interest rate swaps.
Discount securities usually use the actual/actual day-count convention, while the floating leg of an
interest rate swap often uses the actual/360 convention.
Choi ce C i s i ncorrect. Similar to Choice B, this option also includes statement IV which is
inaccurate as explained above.
Choi ce D i s i ncorrect. As explained above, Statement IV included in this choice does not
accurately reflect the use of day-count conventions in different financial contexts.
260
Q.1003 Ronam Ltd. invests in semi-annual US T reasury bonds with face values of USD 1,000 on 15
June 2017. A bond made a coupon payment of USD 40 on February 15, 2017. T he next coupon is due
on August 15, 2017. If the quoted price for the bond for delivery on June 15, 2017, is USD 1001-16,
what is the bond's full price?
A. USD 1,026.52
B. USD 1,013.48
C. USD 1,028.02
D. USD 1,014.98
We have 120 (13, 31,30, 31, and 15 days in Feb, March, April, May, and June respectively) between
the 1st coupon date (Feb 15, 2017) and the settlement date (June 15, 2017).
We have 61 days from the settlement date to the next coupon payment date (Aug 15, 2017).
Accrued interest using actual/actual day-count- convention:
Accrued interest = USD 40 * (120/181) days = USD 26.5193
Full price = Quoted price + Accrued Interest = 1,001.50 + 26.5193 = USD 1028.0193
Note: 1001-16 = 1,001 + 16/32 = 1,001.5
261
Q.1004 Suppose that a U.S. Corporate bond has a face value of $1,000 and is redeemed at par. T he
annual coupon rate is 10%, payable semiannually. Assume the last coupon was paid 100 days ago and
there are 30 days in each month. T he accrued interest is closest to:
A. $55
B. $28
C. $25
D. $30
Number of days from last coupon to the settlement date

AI = Coupon ×
Number of days in coupon period
T hus,
100
AI = $50 × = $27.7778 ≈ 28
180
262
Q.2774 A fixed-income trader summarizes in the table below the prices of T reasury Bonds with
semiannual coupon payment. T he data is as of 01/01/17.
Maturity Coupon~Rate Price (per $100 face value)

T ranche 1 30/06/2017 3.5% 99 − 00
T ranche 2 31/12/2017 4% 100 − 16
T ranche 3 30/06/2018 5% 101 − 04
What are the discount factors for 0.5, 1 and 1.5 years?
A. d(0.5) = 0.9730; d(1) = 0.9662; d(1.5) = 0.9393
B. d(0.5) = 0.9551; d(1) = 0.9422; d(1.5) = 0.9102
C. d(0.5) = 0.9633; d(1) = 0.9523; d(1.5) = 0.9085
D. d(0.5) = 0.98990; d(1) = 0.9782; d(1.5) = 0.8787
T he cash flows are as follow:
T (0.5) T (1.0) T (1.5)

T ranche 1 101.75 − −
T ranche 2 2 102 −
T ranche 3 2.5 2.5 102.5
99.00 = 101.75 ∗ d(0.5)

100.50 = 2 ∗ d(0.5) + 102 ∗ d(1)
101.125 = 2.5 ∗ d(0.5) + 2.5 ∗ d(1) + 102.5 ∗ d(1.5)
d(0.5) = 0.9730
d(1) = 0.9662
d(1.5) = 0.9393
Q.2775 Consider a 2-year T reasury Bond that is currently trading on the market at a price of 97.75.
T he bond has a coupon rate of 5%, which is paid out semiannually.
d(0.5) 0.9777
d(1) 0.9471
d(1.5) ?
d(2) 0.8845
263
Given the discount factor structure shown in the table above, d(1.5) is closest to:
A. 0.9385
B. 0.9228
C. 0.9205
D. 0.9107
T he cash flows are as follow:
T (0.5) T (1.0) T (1.5) T (2.0)

2.5 2.5 2.5 102.5
c1 c2 F + cn
P0 = + +
y y y
1+ 2
1+ 2
1+ 2
Where
P 0 = Price of the bond
c 1 , c 2 .. . c n are semi-annual coupon payments
F is the face value
y is the yield on the bond.
Note this question has given us discount factors:
1 1 1
, and
y1 y2 y4
1+ 2
1+ 2
1+ 2
We need to find the discount factor in the third coupon payment. Also note that the T reasury Bond is
quoted per 100 face value. T hus
97.75 = 2.5 × d(0.5) + 2.5 × d(1) + 2.5 × d(1.5) + 102.5 × d(2)

= 2.5 × 0.9777 + 2.5 × 0.9471 + 2.5 × d(1.5) + 102.5 × 0.8845
⇒ d(1.5) = 0.9107
264
Q.2776 A risk manager is concerned with the pricing of one of the bank’s treasury bonds that pays
3% semiannual interest and matures in two years. T he discount factors for different maturities are
as per the following table:
Discount factor
d(0.5) 0.9950
d(1.0) 0.9727
d(1.5) 0.9327
d(2) 0.9045
What is the price of the bond?
A. 93.577
B. 94.187
C. 95.847
D. 96.157
T he price of the bond is given by:
1.5 ∗ d(0.5) + 1.5 ∗ d(1) + 1.5 ∗ d(1.5) + 101.5 ∗ d(2) = 96.157
Q.2777 At the end of March 2017, a junior trader at an investment bank was requested to provide
information on her portfolio. T he portfolio is presented below:
Maturity Coupon Market Price Frequency

Rate (per100 Face Value)
Bond 1 30/09/2017 2% 99 − 08 semiannual
Bond 2 31/03/2018 4% 101 − 16 semiannual
Bond 3 30/09/2018 5% 105 − 16 semiannual
To revalue the portfolio, the trader uses the following discount factors:
265
Discount Factor
d(0.5) 0.9991
d(1) 0.9799
d(1.5) 0.9705
Which of the above bonds is/are trading rich?
A. Bond 1
B. Bond 1 and Bond 2
C. Bond 3
D. Bond 2 and Bond 3
First, we need to calculate prices based on the trader’s discount factors for all three bond:
Model price of bond 1 = 101 ∗ d(0.5) = 100.909

Model price of bond 2 = 2 ∗ d(0.5) + 102 ∗ d(1)
= 2(0.9991) + 102(0.9799) = 101.948
Model price of bond 3 = 2.5 ∗ d(0.5) + 2.5 ∗ d(1) + 102.5 ∗ d(1.5)
= 2.5(0.9991) + 2.5(0.9799) + 102.5(0.9705)
= 104.424
T hen we need to compare model prices and market prices.
Market Model
Bond 1 99.250 100.909 Cheap
Bond 2 101.500 101.948 Cheap
Bond 3 105.500 104.424 Rich
A bond is said to be trading rich when the quoted market price is greater than the model price. While
you'll usually be given the market price, you'll have to calculate the model price.
T he model price of the bond equals the present value of its future cash flows, namely its principal
plus coupon payment, all times the discount factor for funds to be received. For example, for bond 1
which matures in six months and therefore has just one coupon, model price
2
= (100 + 2 ) d(0.5) = (100 + 1)0.9991 = 100.909. For bond 3 which matures in 1.5 years and therefore
5
has 3 semiannual coupons, model price = × d(0.5) + 52 × d(1) + (100 + 52 ) d(1.5) = 104.424
2
Note that because interest is calculated as per $100, 2% interest = $2, 5% interest = $5 ...etc.
266
T he discount factor for a particular term gives the value today, or the present value of one unit of
currency to be received at the end of that term. T he discount factor for t years is denoted by d(t).
T hen, for example, if d (0.5) equals 0.9991 (as given in the question), the present value of $1 to be
received in six months is 1 × 0.9991 = 0.9991 cents.
Note that, bond market prices are quoted in dollars and fractions of a dollar. By market convention,
the normal fraction used for T reasury security prices is 1/32. In the quoted market prices, the
hyphen (-) separates the full dollar portion of the price from the 32nds of a dollar, which are to the
right of the hyphen. T hus the bid quote of 99-08 means $99 plus 8/32 of a dollar, or $99.25, for each
$100 face value of the bond.
Q.2778 Which of the below presented fixed income instruments typically trade rich?
A. Long-term P-ST RIPS.
B. AAA-rated Corporate bonds.
C. Short-term C-ST RIPS.
D. Mortgage-backed securities.
Separate T rading of Registered Interest and Principal of Securities (ST RIPS) are debt securities
issued by the U.S. T reasury. T hey are sold at a significant discount to face value and offer no interest
payments because they mature at par. ST RIPS can be either principal-only (P-ST RIPS) or interest-
only (C-ST RIPS), and their market prices are influenced by factors such as interest rates, demand,
and the time to maturity.
Short-term C-ST RIPS often trade at higher prices ('rich') compared to similar issues. T his is partly
due to the high demand for short-term securities, which provides a financing advantage. Specifically,
these securities can be used as collateral to borrow money at rates lower than general collateral
(GC) rates. T his financing advantage makes short-term C-ST RIPS attractive to investors, leading to
higher demand and consequently, higher prices.
267
Choi ce A i s i ncorrect. Long-term P-ST RIPS (Principal ST RIPS) are not typically traded at a
premium. T hey are zero-coupon bonds that pay no interest until maturity, which makes them less
attractive to investors seeking regular income, and hence they do not usually trade rich.
Choi ce B i s i ncorrect. AAA-rated Corporate bonds may trade at a premium due to their high credit
rating and the perceived low risk associated with them. However, they do not typically trade rich as
compared to other fixed income securities because the yield on these bonds is generally lower due
to their high credit quality.
Choi ce D i s i ncorrect. Mortgage-backed securities (MBS) also do not typically trade rich because
of their inherent prepayment risk and the complexity involved in pricing these instruments. T he
uncertainty regarding cash flows from MBS can make them less attractive to certain investors,
thereby reducing demand and preventing them from trading at a premium.
Q.2779 A trader prepares a presentation to the investment committee of a bank with a suggestion to
invest $10,000,000 in U.S. T reasury 2 and 3/8s of December 31, 2019, tranche with semiannual
coupon payment frequency. T he trader wants to invest in this tranche, as the quoted market price is
much lower than his estimate of a fair price. To prove the point, the trader includes a table below
with market prices of C-ST RIPs as of June 30, 2017 (valuation date).
Maturity Market Price

(per 100 face value)
T ranche 1 31/12/2017 $99.753
T ranche 2 30/06/2018 $97.257
T ranche 3 31/12/2018 $95.012
T ranche 4 30/06/2019 $94.332
T ranche 5 31/12/2019 $93.805
What is closest to the price of the T reasury bond?
A. $99.507
B. $105.209
C. $106.235
D. $98.079
99.753 97.257 95.012

268
99.753 97.257 95.012
Price of the bond = 1.1875 ∗ + 1.1875 ∗ + 1.1875 ∗
100 100 100
94.332 93.805
+ 1.1875 ∗ + 101.1875 ∗
100 100
= 99.507
Further explanation:
T he price of a bond is simply equal to the present value of all its future payments (coupons plus face
value/redemption value). T his is the logic applied here.
We wish to find the price of US 2 3/8s of June 30, 2017. A 2 3/8 bond implies it pays an annual coupon
of 2% + 3/8% = 2.375%. We always compute the price of bonds per $100 face value.
We are told that the bond pays semiannual coupons. T hat implies a coupon of 2.375%/2 = 1.1875%
every six months. Per $100 face value, that's $1.1875. At redemption, the investor will receive the
face value plus the coupon of the last six-month period, i.e. 100 + 1.1875
Now, we need to discount all these to the present, and that means we need to establish the relevant
discount factors. Luckily, we have the prices of C-ST RIPS maturing at each of those dates. A C-
ST RIP is priced at a discount to face value, just like T-bills.
price
d(t) × face value = price; therefore, d(t) = face value
Q.3418 T he following table presents the characteristics of three different bonds with semiannual
coupons and different times to maturity:
Maturity Coupon Price

6 months 6.0% 102 − 20
12 months 12% 104 − 08+
18 months 7.5% 98 − 24
If the principal repayment for each bond is $100, which of the following is closest to the discount
factor for 1.5 years?
A. 0.9964
B. 0.8823
C. 0.8865
269
D. 0.9920
6%
T he 6-month bond has cash flows only at maturity. It makes its interest payment of $3 ( × $100)
2
plus the principal repayment of $100 at t = 0.5. To find d(0.5) you should equate the present value
(price) of the bond to the cash flows. 102-20 is equivalent to 102 full USD plus 20 fractions of a
dollar where total no. of fractions is 32. Hence,
102 − 20 = 102 + 20/32 = $102.63
$102.63 = $103d(0.5)
d(0.5) = 0.9964
T he 12-month bond makes payments at t = 0.5 and at t = 1:
104 − 08+ = 104 + 8.5/32 = 104.27
Note: A “+” sign at the end of a quote represents half a tick.
104.27 = $6d(0.5) + $106d(1)
104.27 = $6 × 0.9964 + $106d(1)
104.27 − 5.98
d(1) = = 0.9273
106
Similarly, for the 18-month bond,
98.75 = $3.75d(0.5) + $3.75d(1) + 103.75d(1.5)
98.75 − 3.74 − 3.48

d(1.5) = = 0.8823
103.75
270
Q.3419 As the chief investment manager of one of your corporate clients, you determine that the
use of ST RIPS (separate trading of registered interest and principal securities) issued by the U.S.
T reasury would help match assets with liabilities at various points in the future. Which of the
following statements regarding ST RIPS is correct?
A. Shorter-term ST RIPS tend to trade cheap while longer-term ST RIPS tend to trade rich
B. Shorter-term ST RIPS tend to trade rich while longer-term ST RIPS tend to trade cheap
C. Shorter-term C-ST RIPS tend to trade at a discount
D. Longer-term C-ST RIPS tend to trade at a premium
Shorter-term ST RIPS tend to trade rich while longer-term ST RIPS tend to trade cheap. T his is
because shorter-term ST RIPS are in higher demand due to their lower risk and higher liquidity.
Investors are willing to pay a premium for these securities, causing them to trade rich. On the other
hand, longer-term ST RIPS are riskier and less liquid, causing them to trade cheap. Investors demand a
higher yield for holding these securities, which lowers their price.
Choi ce A i s i ncorrect. Shorter-term ST RIPS do not tend to trade cheap. In fact, the opposite is
true. Shorter-term ST RIPS usually trade rich due to their lower duration and less interest rate risk
compared to longer-term ST RIPS.
Choi ce C i s i ncorrect. T he question does not specify anything about C-ST RIPS, which are a
specific type of ST RIP issued by corporations rather than the U.S T reasury. T herefore, this choice
does not accurately reflect the trading tendencies of U.S T reasury ST RIPS.
Choi ce D i s i ncorrect. Similar to Choice C, this option refers to C-ST RIPS and not U.S T reasury
ST RIPS as specified in the question prompt. Furthermore, it's also important to note that longer-
term securities generally do not trade at a premium due to their higher interest rate risk.
271
Q.4578 Suppose that the cash price of a US T reasury bill is 90 per 100 of face value. If the bill has
60 days to maturity, what is the quoted price of the T reasury bill?
A. 60
B. 61
C. 54.75
D. 58.93
We find the quoted price by the formula,
360
Q= (100 − C)
n
Where
Q = Quoted price of the T reasury bill.
C = Cash price of the T reasury bill.
n = number of calendar days until maturity of the T reasury bill.
360
Q= (100 − 90) = 6(10) = $60
60
272
Q.4579 Company ABC wishes to invest in a 184-day T reasury bill from the US government. T he bill
is currently issued at the cash price of 98.50. What is the quoted price of the bill?
A. 2.86
B. 2.08
C. 2.93
D. 2.75
T he quoted price of the US T-bill is given by:
360
Q= (100 − C)
n
Where
Q = Quoted price of the Bill
C = Cash price of the bill
n = number of calendar days until the maturity of the T reasury bill
T hen we have:
360
Q= (100 − 98.50) = 2.93
184
273
Q.4580 Suppose a bond with a par value of 1000 has coupon payments of 10% per annum and a yield
to maturity of 5%. If the bond has 4 years to maturity, what is the price of the bond?
A. 841.51
B. 1,177.30
C. 1,259.57
D. 3,628.22
Pri ce of the bond i s gi ven by:
C C+ FV
P V = ∑( )+
n
(1 + y) (1 + y)n
Where:
C= coupon payments
y= yield to maturity
n= number of years to maturity of the bond.
FV= face value of the bond
Coupon payments=10% of 1000=$100
100 100 100 100 1000

PV = + + + + = $1, 177.297 ≈ 1, 177.30
2 3 4
1.05 1.05 1.05 1.05 1.054
274
Q.4581 A 20-days US treasury bill has a quoted price of 1.50. What is the cash price?
A. 99.84
B. 99.92
C. 98.5
D. 99.98
We can get the cash price of the bill using the following formula.
360
Q= (100 − C)
n
Where:
n= the number of calendar days until maturity of the treasury bill.
Q= the quote price
C= the cash price
360
1.50 = (100 − C)
20
20
C = 100 − 1.50 × = 99.9166
360
275
Reading 56: Interest Rates
Q.1005 Grant Bank pays an interest of 8% with interest getting compounded quarterly. T he effective
annual rate is equal to:
A. 8%
B. 8.2%
C. 8.4%
D. 8.1%
Let’s assume that a sum of $1000 is invested initially and the annual rate is assumed to be x .
1
x
Sum at the end of 1 year = $1000 ∗ (1 + )
100
As the interest paid by the bank is 8% with quarterly compounding, the aggregate value at the end of
one year is given by:
0.08 4
$1000 ∗ (1 + ) = $1000 ∗ 1.082
4
Hence,
x
$1000 ∗ (1 + ) = $1000 ∗ 1.082
100
x
⇒ 1+ = 1.082
100
x
⇒ = (1.082 − 1) = 0.082
100
x = 8.20%
T herefore, the effective annual rate = 8.20%
276
Q.1006 Royal Bank extends a loan of $1000 to a customer for 2 years. T he bank charges interest
with half-yearly compounding frequency. If the spot rate for a 2-year loan is 10% per annum, then
the amount that the customer needs to pay after 2 years is closest to:
A. $1,200
B. $1,216
C. $1,210
D. $1,222
(T∗Compounding Frequency)
(Spot Rate)
Amount (after T years ) = Principal ∗ (1 + )
(Compounding Frequency)
Where:
Principal = $1000
Spot rate = 10%
Compounding Frequency = Half yearly = 2
T = 2 Years
0.10 2∗2
Amount (After 2 years) = $1000 ∗ (1 + ) = $1, 215.51
2
277
Q.1007 T he spot rate for 1 year and 2 years are 10% and 12% respectively. T he forward rate for a
loan to be given in 1 year for a term of 1 year is:
A. 11%
B. 13%
C. 14%
D. 12%
T he relation between spot rates and forward rate can be indicated by the expression below:
(1 + Spot ratefor T )T = (1 + Spot ratef ort)t ∗ (1 + Forward ratet to T )
Where
Spot rate for 1 year = 10%
Spot rate for 2 years = 12%
T herefore,
(1 + 0.12)2 = (1 + 0.10)1 ∗ (1 + f 1,1 )

(1 + 0.12)2
1 + f 1,1 = = 1.14
(1 + 0.10)1
f 1,1 = 0.14 = 14%
278
Q.1008 John Marauder observes that two zero-coupon bonds issued by ACC Limited are currently
trading at prices given in the table below:
Residual maturity Price Face value

1 year $91.74 $100
2 year $82.64 $100
T he 1-year and 2-year spot rates are:
A. 9% and 10% respectively.
B. 10% and 11% respectively.
C. 8% and 9% respectively.
D. 11% and 12% respectively.
Zero-coupon bonds are bonds that do not carry coupons. Zero coupons bonds trade at a discount to
face value, the discount rates used are the spot rates. Hence the price of a zero-coupon bond can be
calculated by using the expression below:
1
Price (zero-coupon bond of maturity T years) = F V ∗
(1 + ST )T
T herefore, using the above expression the spot rates are:
1
1
$91.74 = $100 ∗ ( )
(1 + S1)
100
1 + S1 = = 1.09
91.74
S1 = 9%
2
1
$82.64 = $100 ∗ ( )
(1 + S2)
100
(1 + S2)2 = = 1.21
82.64
S2 = 10%
279

1 year $91.74 $100
2 year $82.64 $100
ABC T raders Private Limited managers are planning to issue zero-coupon bonds with a maturity of 1
year next year. As per the present market conditions, the price of the zero-coupon bond will most
likely be:
A. $85.09
B. $95.09
C. $80.09
D. $90.09
Zero-coupon bonds are bonds that do not carry coupons. Zero coupons bonds trade at a discount to
face value, the discount rates used are the spot rates. Hence the price of a zero-coupon bond can be
calculated by using the expression below:
1
Price (zero-coupon bond of maturity T years) = F V ∗
(1 + ST )T
T herefore, using the above expression the spot rates are:
( )
1
$91.74 = $100 ∗
(1 + S1) 1
100
1 + S1 = = 1.09
91.74
S1 = 9%
280
1
$82.64 = $100 ∗ ( )
(1 + S2)2
100
(1 + S2)2 = = 1.21
82.64
S2 = 10%
T he forward rate can be computed using the following expression:
(1 + Sfor T )T = (1 + Sfor t)t ∗ (1 + f t to T )
Where
1 year spot rate = 9%
2 year pot rate = 10%
f 1,1 = f
T herefore, the 1 year forward rate is equal to:
(1 + 0.10)2 = (1 + 0.09) ∗ (1 + f 1 year rate after 1 year )

(1.1)2
1 + f 1 year rate after 1 year = = 1.11
1.09
f 1 year rate after 1 year = 0.11 = 11%
T he 1 year forward rate after 1 year = 11%
Hence the price of the zero-coupon bond issued for 1 year after 1 year will be:
1
P Zero-coupon bond of maturity T years = F V ∗
(1 + ST )T
$100
P = = $90.09
1.11

1 year $91.74 $100
2 year $82.64 $100
281
A. T he market expects the interest rates to fall, therefore the yield curve is downward
sloping.
B. T he market expects the interest rate to rise, therefore the yield curve is upward sloping.
C. T he market expects the interest rate to remain constant, therefore the yield curve is flat.
D. T he yield curve is always downward sloping.
T he market expects the interest rate to rise, therefore the yield curve is upward sloping. T he yield
curve is a graphical representation of the interest rates on debt for a range of maturities. It shows
the relationship between the interest rate (or cost of borrowing) and the time to maturity of the
debt for a given borrower in a given currency. In this case, the prices of the bonds suggest that the
yield for the 2-year bond is higher than the yield for the 1-year bond. T his is indicative of an upward
sloping yield curve, which typically occurs when the market expects interest rates to increase in
the future. T he expectation of rising interest rates is inferred from the forward rates calculated
from the bond prices. T he current 1-year spot rate is 9%, and the 1-year forward rate after 1 year is
11%. T his suggests that the market expects the interest rate to rise from 9% to 11% after one year.
T herefore, the yield curve is upward sloping, and the market expects the interest rate to rise.
Choi ce A i s i ncorrect. T he market does not expect the interest rates to fall. If that were the
case, the price of a bond with longer maturity would be higher than that of a shorter maturity bond,
which is not observed in this scenario.
Choi ce C i s i ncorrect. T he market does not expect the interest rate to remain constant. If it did,
then both bonds would have similar prices regardless of their maturities, which contradicts our given
data.
Choi ce D i s i ncorrect. T he yield curve is not always downward sloping. It can be upward sloping
(as in this case), flat or even humped depending on various factors such as market expectations about
future interest rates and risk premiums required by investors for holding long-term bonds.
282
Q.1011 If the term structure of spot interest rates is flat, then the term structure of forward
interest rates must be:
A. Upward sloping
B. Downward sloping
C. Flat
D. Humped shaped
T he term structure of forward rates will also be flat if the term structure of spot rates is flat. T his
is because the forward rate is derived from the spot rates for different maturities. If the spot rates
are the same for all maturities, then the forward rates will also be the same for all maturities. To
illustrate this, let's assume that the spot rates for 1 year and 2 years are equal to r. T he one-year
forward rate starting in one year can be calculated as follows:
(1 + r)2 = (1 + r)1 ∗ (1 + ex tF orwardrateext1yearto1year ) 1 + ex tF orwardrateext1yearto1year = 1 + r ex tF
As shown in the calculation above, the forward rate is equal to the spot rate r. T herefore, if the
term structure of spot rates is flat, the term structure of forward rates will also be flat.
Choi ce A i s i ncorrect. An upward sloping term structure of forward interest rates would imply
that future short-term interest rates are expected to be higher than current short-term rates. T his is
not consistent with a flat term structure of spot interest rates, which implies that all future short-
term rates are expected to be the same as the current rate.
Choi ce B i s i ncorrect. A downward sloping term structure of forward interest rates would
suggest that future short-term interest rates are expected to be lower than current short-term
rates. T his contradicts a flat term structure of spot interest rates, where all future short-term rates
are anticipated to remain at the present level.
Choi ce D i s i ncorrect. A humped shaped term structure of forward interest rate suggests that the
forward rate for some future period will be higher than both the current and more distant future
periods' spot rate, which contradicts with a flat term structure where all maturities have same yield.
283
Q.1012 Jack Mangers observes that the spot rates for 2 years and 3 years are 6% and 8%
respectively while the 2y1y (1-year forward rate beginning after 2 years) rate is 12.50%. Select the
correct statement(s) from the following.
I. T here is an opportunity to generate riskless profit
II. T here is no opportunity to generate riskless profit
III. T he yield curve is upward sloping
IV. T he yield curve is downward sloping
A. Both I and IV are correct.
B. Both II and III are correct.
C. Both I and III are correct.
D. Both II and IV are correct.
T he 2y1y i.e. 1-year forward rates beginning after 2 years can be computed by the following
expression:
(1 + Spot ratefor 3 )3 = (1 + Spot ratefor 2 )2 ∗ (1 + Forward rate2 to 3 )
Spot ratefor 3 = 8%
Spot ratefor 2 = 6%
(1 + 0.08)3 = (1 + 0.06)2 ∗ (1 + Forward rate2 to 3)

1.083
1 + Forward rate2 to 3 = = 1.1211
1.062
Forward rate2Y 1Y = 0.1211 = 12.11%
As implied by the spot rates, the forward rate for 1-year forward rate after 2 years must be equal to
12.11%. However, it is 12.50%. T herefore, there is an opportunity to generate riskless profit due to
the interest rate differential. Furthermore, as the forward rates are higher, the yield curve is upward
sloping.
284
Q.1013 Jack Mangers observes that the spot rates for 2 years and 3 years are 6% and 8%
respectively while the 2y1y (1-year forward rate beginning after 2 years) rate is 12.50%. Select the
most appropriate option.
A. As there is no interest rate discrepancy, no transaction can generate riskless profit.
B. Borrowing funds for 3 years, lending the funds for 2 years and an agreement to lend funds
for 1 year after 2 years will generate a riskless profit of $0.43 per $100.
C. Lending funds for 3 years, borrowing the funds for 2 years and an agreement to lend funds
for 1 year after 2 years will generate riskless profit of $0.50 per $100.
D. Borrowing funds for 3 years, lending the funds for 2 years and an agreement to lend funds
for 1 year after 2 years will generate riskless profit of $0.70 per $100.
Borrowing funds for 3 years, lending the funds for 2 years and an agreement to lend funds for 1 year
after 2 years will generate a riskless profit of $0.43 per $100. T his is because the interest rates for
borrowing and lending are different. T he strategy involves borrowing funds for 3 years at an interest
rate of 8%, then lending these funds for 2 years at a lower interest rate of 6%. After 2 years, the
repaid money is then lent for 1 year as per the forward rate agreement at 12.50%. T he difference in
interest rates allows for a riskless profit to be made. T he cash flow at the end of 3 years is $126.41
(from the repayment of the lent money with 1 year worth of interest) minus $125.97 (the
repayment of the initially borrowed $100 for 3 years), resulting in a profit of $0.43.
Choi ce A i s i ncorrect. T here is indeed an interest rate discrepancy in the market. T he forward
rate for a 1-year period beginning after 2 years (2y1y) is higher than the spot rates for both a 2-year
and a 3-year period, which indicates an arbitrage opportunity.
Choi ce C i s i ncorrect. T his strategy involves lending funds for longer duration and borrowing for
shorter duration, which would not generate riskless profit due to the higher forward rate compared
to spot rates. T he cost of borrowing would exceed the returns from lending, resulting in a loss
rather than profit.
Choi ce D i s i ncorrect. While this strategy involves similar transactions as option B, it incorrectly
estimates the potential riskless profit at $0.70 per $100 borrowed/lent instead of $0.43 per $100
borrowed/lent as calculated using interest rate parity condition.
285
Q.1014 T he details of a bond currently trading is given below:
Face value: $1,000
Coupon: 6%
YT M: 6%
Tenure: 10 years
T he price of the bond is:
A. $1,100
B. 990
C. $1,000
D. 980
Yield to maturity (YT M) is the discount rate which is used to discount the cash flows of the bond to
arrive at its price.
T he price of the bond is equal to its face value if and only if the YT M is equal to the coupon rate.
T he rate at which the price of the bond is equal to its face value is known as Par rates.
T herefore, in the above case, the price of the bond is equal to $1,000.
286
Q.1015 A rate of 5% is quoted with continuous compounding. What is the equivalent rate, quoted
with monthly compounding?
A. 5.01%
B. 6.03%
C. 6.02%
D. 5.59%
If the rates are equivalent, then the following equation must hold:
Rm m
eR = (1 + )
m
Where
R = Continuously compounded rate of interest
R m = interest rate compounded m-times.
T hen in this case we have:
R 12 12
e0. 05 = (1 + )
12
0. 05
⇒ R 12 = 12[e 12 − 1]
≈ 5.01%
287
Q.1016 T he 5-year and 6-year continuously compounded interest rates are 6.75% and 7.25%,
respectively. What is the forward rate of interest between year five and year six?
A. 9.75%
B. 8.25%
C. 7.50%
D. 8.56%
When the rates are quoted with continuous compound, the forwards rate between times T 1 and T 2 is
given by:
R 2 T 2 − R 1T 1
F =
T2− T1
Where
R 1 = Spot rate for maturity T 1
R 2 = Spot rate for maturity T 2
T hus for this case we have:
0.0725 × 6 − 0.0675 × 5
F= = 9.75%
6− 5
Alternatively, note that the following equation must hold:
e0. 0675×5eF ×1 = e0. 0725×6

⇒ F = (0.0725 × 6) − (0.0675 × 5)
= 0.0975 = 9.75%
288
Q.2781 In the table below, an analyst has summarized the current swap rates prevailing on the
market.
Term in Years Swap Rate

0.5 2.00%
1.0 2.80%
1.5 3.20%
What is the 1.5-year discount factor?
A. 0.9533
B. 0.9625
C. 0.9725
D. 0.9804
Consider an interest rate swap. If we assumed that the notional amount is exchanged, the fixed leg of
the swap would resemble a fixed coupon-paying bond, with fixed leg payments acting like semi-
annual, fixed coupons, and the notional amount acting like the principal payment. We can therefore
write an equation for each “bond” that equates the present value of its cash flows to its price of par.
2
(100 + ) ∗ d(0.5) = 100 → d(0.5) = 0.9901
2
2.8 2.8
∗ d(0.5) + (100 + ) ∗ d(1.0) = 100 → d(1.0) = 0.9725
2 2
3.2% 3.2% 3.2%
∗ d(0.5) + ∗ d(1.0) + (100 + ) ∗ d(1.5) = 100 → d(1.5) = 0.9533
2 2 2
289
Q.2783 After a recent FED’s announcement, a trader observed significant changes across the whole
spot rates curve. T he correct spot rates are as follows:
Year Spot rate

0.5 2.0%
1.0 2.1%
1.5 2.3%
2.0 2.2%
2.5 2.5%
What is the 6-month forward rate in two years?
A. 0.30%
B. 1.85%
C. 2.21%
D. 3.70%
2. 5×2
⎡ (1 + 0. 025) ⎤
2
f (2.5) = 2 ⎢⎢⎢ − 1⎥⎥⎥ = 3.70%
2×2
⎣ (1 + 0.2022) ⎦
Q.2785 Par rates prevailing on the market, are:
Term in years Par Rates

0.5 1.60%
1.0 2.00%
1.5 2.60%
2.0 3.20%
What is the two-year discount factor? (Assume semiannual coupons.)
A. 0.9871
B. 0.9619
C. 0.9421
D. 0.9380
290
CT
( ) ∗ AT + d(T ) = 1, where CT is the T year par rate and AT is the annuity factor.
2
Term in years Discount factor Comments

C0. 5
0.5 0.9921 ( ) ∗ d(0.5) + d(0.5) = 1
2
C1. 0
1.0 0.9803 ( ) ∗ (d(0.5) + d(1.0)) + d(1.0) = 1
2
C1. 5
1.5 0.9619 ( ) ∗ (d(0.5) + d(1.0) + d(1.5)) + d(1.5) = 1
2
C2. 0
2.0 0.9380 ( ) ∗ (d(0.5) + d(1.0) + d(1.5) + d(2.0)) + d(2.0) = 1
2
Expanded Approach
Consider an interest rate swap. If we assumed that the notional amount is exchanged, the fixed leg of
the swap would resemble a fixed coupon-paying bond, with fixed leg payments acting like semi-
annual, fixed coupons, and the notional amount acting like the principal payment. We can therefore
write an equation for each “bond” that equates the present value of its cash flows to its price of par.
To work out the discount factors, our swap rates become our "coupon rates"; then we determine
the discounted value of each cash flow and equate the total to 100 (par amount)
----------------------------------------
To get d(0.5), we assume we have a six-month 1.6% coupon bond priced at par. T hat means we have
two cashflows -- 1.6%/2 * 100 and 100. T he discount factor at 0.5 years, i.e., d(0.5), is worked out
using the following equation:
1.6/2 * d(0.5) + 100 * d(0.5) = 100

--> (1.6/2 + 100)d(0.5) = 100
--> d(0.5) = 100/100.8 = 0.9921
----------------------------------------
To get d(1.0), we assume we have a one-year 2.00% coupon bond priced at par. T hat means we have
three cashflows -- 2.0%/2 * 100, 2.0%/2 * 100, and 100. T he discount factor at 1 year, i.e., d(1.0), is
worked out using the following equation:
1 * d(0.5) + 1 * d(1.0) + 100 * d(1.0) = 100
291
We already know the value of d(0.5)
--> 0.9921 + (101)d(1.0) = 100
--> d(1.0) = (100 - 0.9921)/101 = 0.9803
--------------------------------------------
To get d(1.5), we assume we have a one-and-a-half-year 2.60% coupon bond priced at par. T hat means
we have four cashflows -- 2.6%/2 * 100, 2.6%/2 * 100, 2.6%/2 * 100, and 100. T he discount factor at
1.5 years, i.e., d(1.5), is worked out using the following equation:
1.3d(0.5) + 1.3d(1.0) + 1.3d(1.5) + 100d(1.5) = 100

We already have d(0.5) and d(1.0)
--> 1.28973 + 1.27439 + 101.3d(1.5) = 100
--> d(1.5) = (100 - 1.28973 - 1.27439)/101.3 = 0.9619
---------------------------------------------
To get d(2.0), we assume we have a two-year 3.20% coupon bond priced at par. T hat means we have
five cashflows -- 3.2%/2 * 100, 3.2%/2 * 100, 3.2%/2 * 100, 3.2%/2 * 100, and 100. T he discount
factor at 2 years, i.e., d(2.0), is worked out using the following equation:
1.6d(0.5) + 1.6d(1.0) + 1.6d(1.5) + 1.6d(2.0) + 100d(2.0) = 100

We already have d(0.5), d(1.0), and d(2.0)
--> 1.5874 + 1.56848 + 1.53904 + 101.6d(2.0) = 100
--> d(2.0) = (100 - 1.5874 - 1.56848 - 1.53904)/101.6 = 0.9380
292
Q.3421 T he price of a five-year zero-coupon government bond is $72.25. T he price of a similar six-
year bond is $67.34. T he one-year implied forward rate from year 5 to year 6 is closest to:
A. 7.29%
B. 7.00%
C. 6.79%
D. 6.24%
First, we need to find the 6-year and 5-year spot rates, assuming the price is given per $100 par
value. 5-year spot, S5:
72.25 = 100/(1 + S5)5

S5 = 6.717%
6-year spot, S6:
67.34 = 100/(1 + S6)6

S6 = 6.812%
T hen, recall that:

(1 + 5 year spot)5 * (1 + 1-year forward rate) = (1 + 6-year spot)6 T hus,
(1 + 1-year forward rate) = (1 + 6-year spot)6/(1 + 5-year spot)5
1-year forward rate = 1.484978899/1.38410182 - 1 = 7.288%
293
Q.3422 T he term structure of swap rates is:
n − year Swap rate

1 − year 3.5%
2 − year 4%
3 − year 4.5%
4 − year 5%
5 − year 5.5%
T he two-year forward swap rate starting in three years is closest to:
A. 0.5%
B. 4%
C. 7.02%
D. 6.22%
First, we compute the accrual of a dollar over three and five (3+2) years:
For T = 3, this is (1 + 0.045)3 = 1.1412
For T = 5, this is (1 + 0.055)5 = 1.3070
(1 + R T )T = (1 + R n )n (1 + Fn,T )T −n
W here n<T
1.3070 = 1.1412 × (1 + F3,5 )2
1.3070
F3,5 = √ − 1 = 7.02%
1.1412
294
Q.3423 Below is the term structure for swap rates:
Maturity in Swap Rate

Years
1 4.0%
2 4.5%
3 5.0%
4 5.5%
5 6.0%
T he 1-year forward swap rate starting in four years is closest to:
A. 4.0%
B. 6.0%
C. 7.0%
D. 8.0%
(1 + R T )T = (1 + R n ) (1 + Fn,T )T −n
W here n<T
First, we compute the accrual of a dollar over four and five years:
For T = 4, this is (1 + 0.055)4 = 1.2388
For T = 5, this is (1 + 0.06)5 = 1.3382
1.3382 = 1.2388 × (1 + F4,5 )1
1.3382
F4,5 = − 1 = 8.0%
1.2388
Q.4572 A trader invests $100 million in a savings account. After two years, the total amount in his
account is $150 million. What is the rate of interest compounded semi-annually?
A. 20.32%
B. 21.34%
295
C. 22.47%
D. 25.32%
From the FV formula, we have:
mn
im
FV = PV(1 + )
m
Where
FV = future value
PV = present value
m = number of compounds per year
n = number of years
From the formula above, we have:
4
i2
150 = 100(1 + )
2
Solving for i2, we have:
⎧ 1 ⎫
⎪
⎪
⎪ 150 4 ⎪
⎪
⎪
i2 = 2 ⎨ ( ) − 1⎬ = 0.2134 = 21.34%
⎩ 100
⎪
⎪
⎪ ⎪
⎪
⎭
⎪
An al ternati ve to solving this question is by using the financial calculator. T he variables are as
follows: N = 4, P V = −100, P MT = 0 and F V = 150 so that CP T ⇒ I /Y = 10.67% .
T herefore, the annual rate of interest is 10.67% × 2 = 21.34% . T his is the easi est way!
296
Q.4573 If the one-year spot rate is 5% and the two years spot rate is 8%, what is the one-year
forward rate, one year from now?
A. 0.0555
B. 0.111
C. 0.067
D. 0.134
T he spot rate and the forward rate have the following relationship:
(1 + y 2)2 = (1 + y 1) × (1 + f [1,1] )
Where
y 1 = one-year spot rate
y 2 = two-year spot rate and,
f [1,1] = one-year forward rate, one year from now
(1.08)2 = (1.05)1 × (1 + f [1,1])

1.082
f [1,1] = − 1 = 0.111 = 11.1%
1.05
297
Q.4574 1000 is invested in an account that pays an annual nominal interest of 8% compounded
quarterly per year. What is the value of the amount in the account after three years?
A. 1259.71
B. 1268.24
C. 1061.21
D. 2518.17
mn
im
F V = P V (1 + )
m
Where:
FV= the future value
PV=the present value
m= number of compounds in a year
n= number of years
T he value of the amount in the account after three years is given by:
12
0.08
F V = 1000(1 + ) = 1268.24
4
298
Q.4575 Suppose a company is obliged to make annual payments of $5,000 for the premises it
occupies. Payments are due on 1st January 2001, 1st January 2002, and 1st January 2003. If the
company wishes to cover these payments by investing a single sum in its bank account that pays 8%
per annum compound, what sum must be invested on 1st January 2000?
A. 12,885.48
B. 14,853.44
C. 13,916.32
D. 11,298.56
An annuity is a series of annual payments of PMT until the final time T. T he value of an ordinary
annuity is given by:
1 − (1 + r)−T
P V annuity = P MT
r
Where:
r = discount rate
T his is an annuity ordinary because the first payment would happen a year after January 2000.
T he present value of the annuity on 1st January 2000 is given by:
1 − 1.08−3
5000 ( ) = 12, 885.48
0.08
299
Q.4576 Spot rates with semi-annual compounding are as below:
Maturity (years) Spot rates (%)

1.0 2.0
1.5 2.5
2.0 3.0
What is the forward rate for the period between time 1.0 and 1.5, expressed annually?
A. 0.035
B. 0.0175
C. 0.07
D. 0.005
T he forward rate for the period between time 1.0 and 1.5 is given by:
3 2
0.025 0.02 f1
(1 + ) = (1 + ) (1 + )
2 2 2
Solving for f 1, we have
0.025 3
(1 + )
f1 2
= − 1 = 0.0175
2 0.020 2
(1 + )
2
And therefore, f 1 = 0.0175 × 2 = 0.035 = 3.5%
300
Q.4577 Spot rates with semi-annual compounding are as below:
Maturity (years) Spot rates (%)

1.0 2.0
1.5 2.5
2.0 3.0
What is the forward rate for the semi-annual period between time 1.5 and 2, expressed annually?
A. 0.045
B. 0.0225
C. 0.09
D. 0.0977
T he forward rate between time 1.5 and 2.0 will be:
0.030 4
(1 + )
f2 2
= − 1 = 0.0225
2 0.025 3
(1 + )
2
f 2 = 0.0225 × 2 = 0.045 = 4.5%
301
Reading 57: Bond Yields and Return Calculations
Q.1017 Yield-to-maturity is an important measure to describe the pricing of a bond. Which of the
following statements are true with regard to yield-to-maturity?
I. Yield-to-maturity is the single rate such that discounting a security’s cash flows at that rate gives
that security’s market price
II. When the coupon rate exceeds the yield, the bond sells at a discount to its face value
III. When the yield exceeds the coupon rate, the bond sells at a premium to its face value
IV. If the term structure is flat, so that all spot rates and all forward rates equal some single rate,
then the yield-to-maturity of all bonds equals that rate as well
A. I & IV only.
C. I, II & IV only.
Yield-to-maturity is a crucial concept in bond pricing. It is often used to compare the relative
attractiveness of various bonds. Consider the following statements about yield-to-maturity:
I. Yield-to-maturity is the single rate at which the present value of a bond's future cash flows equals
its market price.
II. A bond sells at a discount to its face value when the coupon rate is higher than the yield.
III. A bond sells at a premium to its face value when the yield is higher than the coupon rate.
IV. If the term structure of interest rates is flat, meaning all spot rates and forward rates are the
same, then the yield-to-maturity of all bonds will also be the same.
Which of these statements accurately describe the characteristics of yield-to-maturity?
302
Q.1018 Derek Johnson, an analyst at American Bonds Inc., is interested in understanding the
components of P&L (Profit & Loss) of bonds. With regards to P&L, which of the following
statements are true?
I. P&L is generated by price appreciation plus cash-carry, which consists of explicit cash flows like
coupon payments and financing costs
II. P&L due to carry is meant to convey how much a position earns due to the fact that, as a security
matures, its cash flows are priced at earlier points on the term structure
III. P&L due to roll-down is meant to convey how much a position earns due to the passage of time,
holding everything else constant
IV. T he P&L due to the passage of time excluding cash-carry is called carry-roll-down
A. I & IV only.
B. II & IV only.
C. I, II & IV only.
Thi ngs to Remember
1. P&L in the context of bonds is generated by price appreciation and cash-carry. Cash-carry includes
explicit cash flows such as coupon payments and financing costs.
2. T he P&L due to the passage of time, excluding cash-carry, is referred to as carry-roll-down.
3. P&L due to carry refers to the profit or loss that results from holding a bond over a certain
period, taking into account the income received from coupon payments and the costs of financing the
investment.
4. P&L due to roll-down refers to the profit or loss that results from the pricing of a security's cash
flows at earlier points on the term structure as it matures.
5. Understanding these components of P&L is crucial for bond investors and analysts, as it helps
them evaluate the potential return on a bond investment and make informed investment decisions.
Q.1019 Consider the details of bonds currently trading:
303
Bond Coupon YT M Face Value
Bond A 10% 9% 1000
Bond B 6% 8% 1000
Bond C 5% 5% 1000
Select the most appropriate statements:I. PriceBond A > $1000

II. PriceBond B < $1000
III. PriceBond C = $1000
IV. PriceBond A < $1000
V. PriceBond B > $1000
VI. PriceBond C > $1000
A. II, III and V are correct.
B. I, II and III are correct.
C. IV, V and VI are correct.
D. I, III and V are correct.
T he price of a bond is determined by its coupon rate and its yield to maturity (YT M). When the
coupon rate is higher than the YT M, as is the case with Bond A, the bond's price is greater than its
face value. T his is because the bond's coupon payments are more attractive compared to the market
rate, making the bond more valuable. T herefore, statement I (Price of Bond A > $1000) is correct.
Conversely, when the coupon rate is lower than the YT M, as is the case with Bond B, the bond's
price is less than its face value. T his is because the bond's coupon payments are less attractive
compared to the market rate, making the bond less valuable. T herefore, statement II (Price of Bond
B < $1000) is correct. Finally, when the coupon rate is equal to the YT M, as is the case with Bond C,
the bond's price is equal to its face value. T his is because the bond's coupon payments are exactly in
line with the market rate. T herefore, statement III (Price of Bond C = $1000) is correct. Hence,
options I, II, and III are correct, making choice B the correct answer.
Choi ce A i s i ncorrect. Statement II and III are correct as the price of a bond is inversely related
to its yield to maturity (YT M). So, when the YT M is higher than the coupon rate, as in Bond B, the
price will be less than its face value. Similarly, when YT M equals coupon rate as in Bond C, the price
will be equal to its face value. However, statement V is incorrect because it suggests that Bond B's
304
price would be greater than $1000 which contradicts with statement II and our understanding of bond
pricing.
Choi ce C i s i ncorrect. Statement IV contradicts with statement I from option B which we know
to be correct - if a bond's coupon rate exceeds its YT M (as in case of Bond A), then it trades at a
premium i.e., its price would be more than $1000. Similarly for statements V and VI - they suggest
that Bonds B and C trade at a premium which contradicts our understanding of bond pricing.
Choi ce D i s i ncorrect. While statements I and III are correct for reasons explained above,
statement V isn't because it suggests that Bond B trades at a premium whereas we know from our
understanding of bond pricing that since its YT M exceeds coupon rate, it should trade at discount i.e.,
less than $1000.
305
Q.1020 All the following statements regarding the yield-to-maturity (YT M) are correct, EXCEPT :
A. T he YT M is the discount rate used to discount the bond cash flows to arrive at the price
of the bond.
B. T he YT M is the return realized by the bond investor.
C. T he YT M of a zero-coupon bond is equal to the spot rate.
D. If YT M < Coupon, the bond trades at a premium.
T he statement that the Yield-to-Maturity (YT M) is the return realized by the bond investor is not
entirely accurate. While it's true that the YT M can be seen as the total return anticipated on a bond
if it is held until it matures, this is only the case under certain conditions. Specifically, this assumes
that all coupon payments are reinvested at the same rate as the bond's current yield, and that the
bond is held until maturity. In reality, these conditions are rarely met. Investors may not be able to
reinvest the coupons at the same yield due to changes in interest rates, and they may sell the bond
before it matures. T herefore, the actual return realized by the bondholder may not be equal to the
YT M.
Choi ce A i s i ncorrect. T he statement is accurate. T he yield-to-maturity (YT M) is indeed the
discount rate that equates the present value of a bond's future cash flows to its current market
price.
Choi ce C i s i ncorrect. T he statement accurately describes that for zero-coupon bonds, there are
no periodic interest payments and thus, their yield-to-maturity equals their spot rates.
Choi ce D i s i ncorrect. T his statement correctly states that when a bond's YT M falls below its
coupon rate, it implies that investors require less return than what the bond pays in coupons which
leads to an increase in its price above par value i.e., it trades at a premium.
306
Q.1021 Corporate bonds trade at a positive spread to government bonds because:
A. Corporate bonds are more liquid than government bonds.
B. Corporate bonds have higher credit risks than government bonds.
C. Corporate bonds generate higher returns than government bonds.
D. Corporate bonds pay less coupon than government bonds.
Corporate bonds have higher credit risks than government bonds. Credit risk refers to the risk that a
borrower will default on any type of debt by failing to make required payments. In the context of
bonds, it is the risk that the issuer will not be able to make the required interest payments or to
repay the principal upon maturity. Corporate bonds are issued by companies, which are subject to
business risks and therefore have a higher credit risk compared to government bonds. Government
bonds are considered to be virtually risk-free because they are backed by the full faith and credit of
the government. T herefore, to compensate for the higher credit risk, corporate bonds offer a higher
yield than government bonds, which results in a positive spread.
Choi ce A i s i ncorrect. Corporate bonds are not necessarily more liquid than government bonds. In
fact, government bonds are often considered to be more liquid due to their high demand and the large
volume of trade in the market.
Choi ce C i s i ncorrect. While it's true that corporate bonds can generate higher returns, this isn't
the primary reason for their positive spread compared to government bonds. T he higher return on
corporate bonds is a compensation for the additional risks (including credit risk) associated with
them, which leads us back to option B as being correct.
Choi ce D i s i ncorrect. T he coupon payment of a bond does not directly affect its trading spread.
While it's true that lower coupon payments might make a bond less attractive and therefore could
indirectly lead to wider spreads, this isn't typically the primary factor affecting spreads between
corporate and government bonds.
307
Q.1022 Consider the following details with respect to a bond:
Face value: $1000
Coupon: 10%
Frequency: Semi-annually
Coupon payment dates: January 1st and July 1st
An investor buys the bond on January 22nd at a price of $990.23, and sells it on August 3rd at
$1030.34. T he gross realized return on the bond investment is:
A. 4.05%
B. 9.1%
C. 8.8%
D. 9.4%
January 22nd: -990.23

July 1st: +50 (Coupon payment)
August 3rd: +1030.34
($1030.34 + $50 − $990.23)

Gross Realized Return = = 9.10%
$990.23
Q.1023 Consider the following details with respect to a bond:

Face value: $1000
Coupon: 10%
Frequency: Semi-annually
Coupon payment dates: January 1st and July 1st
An investor buys this bond at $1043.43 on January 1st, 2016 and sells it on January 1st, 2017 at
$995.23. T he coupon received on July 1st, 2016 is reinvested for six months at a semi-annually
compounded rate of 9%. T he realized gross holding period return is:
A. 0.39%
B. 5.18%
C. 4.99%
D. 5.6%
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T he realized gross holding period return (HPR) for a bond can be calculated with the following
formula:
Ending Value
HPR = −1
Beginning Value
In this case, the beginning value of the bond is the purchase price, and the ending value is the sale
price plus the coupon payments received (including any interest earned on reinvested coupons).
Here's how you can calculate each component:
1. Begi nni ng Val ue: T his is the price the investor paid for the bond, which is $1043.43.
2. Endi ng Val ue: T his is the sale price of the bond plus the reinvested coupon. T he bond was
sold for $995.23. T he coupon payment is 10% of the face value, paid semi-annually, so each
payment is $1000 * 10% / 2 = $50. T he July 1st coupon was reinvested for six months at a
semi-annually compounded rate of 9%, so it grew to $50 * (1 + 9%/2) = $51.25. So, the
ending value is $995.23 (sale price) + $50 (January 1st, 2017 coupon) + $52.25 (reinvested
July 1st, 2016 coupon) = $1097.48.
Using these values in the HPR formula:
$1097.48
HPR = −1
$1043.43
T his results in an HPR of approximately 0.0518or 5.18%.
Q.1024 A corporate bond has a residual maturity of 2 years and pays a 10% coupon annually.
T wo zero-coupon bonds are currently trading at the price mentioned below:
Price Residual maturity

USD 92.38 1 year
USD 84.17 2 years
T he price of the corporate bond is closest to:

A. USD 101.01
B. USD 117.66
C. USD 101.82
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D. USD 93.41
A bond is priced using the spot rates as:
C (F V + C)
PriceBond = +
(1 + Spot rate1 )1 (1 + Spot rate2)2
100
Spot Rate1 year = ( ) – 1 = 0.825 = 8.25%
92.38
1
100 2
Spot Rate2 year = ( ) − 1 = 0.900 = 9.00%
84.17
T he price of the bond can be calculated as:
10 100 + 10
Bond Price = +
(1 + 0.0825)1 (1 + 0.09)2
= 9.24 + 8.42 + 84.17 = 101.82
Q.1025 A bond with a residual maturity of 2 years that pays a 10% coupon annually is currently
trading at $102.10. It is also observed that two zero-coupon bonds are currently trading at the price
mentioned below:
Price Residual maturity

$92.38 1 year
$84.17 2 years
T he transaction which will generate riskless profit is:
A. Sell the bond and purchase the zero-coupon bonds.
B. Borrow funds and purchase the zero-coupon bonds.
C. Riskless profit cannot be generated.
D. Buy the bond and sell the zero-coupon bonds.
T he bond is priced using the spot rates as: T he price of the bond can thus be calculated as:
10 (100 + 10)
310
10 (100 + 10)
ex tP riceextBon d = + = 9.24 + 8.42 + 84.17 = 101.82
(1 + 0.0825) (1 + 0.09)2
1
As can be observed from the above, the price of the bond is > than $101.82. Hence, the bond is
overvalued. As observed, the bond is overvalued. Hence, the investor must sell the overvalued bond.
T he funds obtained by selling the bond must be invested in the zero-coupon bonds. By the above
transaction, the investor can make a profit of $102.10 - $101.82 = $0.28 per $100.
Choi ce B i s i ncorrect. Borrowing funds to purchase the zero-coupon bonds would not result in a
riskless profit. T his is because borrowing costs would need to be considered, and these could
potentially exceed the returns from the zero-coupon bonds, leading to a net loss rather than a profit.
Choi ce C i s i ncorrect. A riskless profit can indeed be generated in this scenario by selling the
bond and purchasing the zero-coupon bonds (as explained in choice A). T herefore, stating that a
riskless profit cannot be generated is incorrect.
Choi ce D i s i ncorrect. Buying the bond and selling the zero-coupon bonds would not result in a
riskless profit either. T he cost of buying the bond ($102.10) exceeds the proceeds from selling both
zero-coupon bonds ($92.38 + $84.17 = $176.55), which means there would be an initial cash outflow
without any guaranteed return, hence no riskless profit can be achieved through this strategy.
311
Q.1026 A fund manager is looking for an opportunity to invest in sovereign bonds. Country A has
recently witnessed a major economic recession and has just averted a default on its foreign debt. On
the other hand, country B is a developing economy with a low debt to GDP ratio. T he bonds of
country A and B trade at a spread of a and b with respect to US T reasury bonds.
Select the correct option:
A. a > b
B. a < b
C. a = b
D. a ≤ b
A fund manager is considering investing in sovereign bonds and is evaluating two potential options.
T he first option is to invest in the bonds of Country A, which has recently experienced a severe
economic recession and narrowly avoided defaulting on its foreign debt. T he second option is to
invest in the bonds of Country B, a developing economy with a low debt-to-GDP ratio. T he bonds of
both countries trade at a spread of 'a' and 'b' respectively over US T reasury bonds. Which of the
following options correctly represents the relationship between the spreads of the bonds of Country
A and Country B?
312
Q.1027 T he bonds of country A is trading at a spread of x with respect to US T reasury bonds in
country B and at a spread of y with respect to US T reasury bonds in country C. A relative value
trader wants to generate returns by trading in bonds of country A. If x > y, then the trade must be:
A. To buy the bond in country B and sell it in country C.
B. To buy the bond in country C and sell it in country B.
C. To sell the bond in country B and C.
D. To buy the bond in country B and C.
T he bond of country A trades at a higher spread in country B as compared to country C. T he spread
of a bond is the difference between its yield and the yield of a risk-free bond, in this case, the US
T reasury bonds. A higher spread indicates a higher yield, which in turn implies a lower price for the
bond due to the inverse relationship between bond prices and yields. T herefore, the bond of country
A is cheaper in country B than in country C. T he relative value trader can take advantage of this
price difference by buying the bond in country B, where it is cheaper, and selling it in country C,
where it is more expensive. T his strategy, known as arbitrage, allows the trader to make a profit
without taking on any risk. T he profit from this trade would be the difference in the spreads, i.e., (x-
y)%, assuming no transaction costs or other market frictions.
Choi ce B i s i ncorrect. Buying the bond in country C and selling it in country B would not be a
profitable strategy because the spread in country C is less than that of country B. T his means that
the bond's yield relative to US T reasury bonds is lower in country C, making it less attractive for
purchase compared to the bond in country B.
Choi ce C i s i ncorrect. Selling the bond in both countries would not take advantage of the
difference in spreads between countries B and C. T he trader's goal should be to exploit this
discrepancy by buying where yields are higher (country B) and selling where they are lower
(country C).
Choi ce D i s i ncorrect. Buying bonds from both countries does not capitalize on the observed
spread difference between them, as there would be no arbitrage opportunity exploited here.
313
Q.2786 Aram Bauer is considering an investment in fixed income instruments. He is interested in a
U.S. T reasury tranche as of December 31, 2019. T he tranche pays coupons of 4.5% per year
compounded semiannually. T he price of this tranche as of December 31, 2016, is 97.124.
What is the yield to maturity of the tranche?
A. 2.78%
B. 3.22%
C. 5.55%
D. 6.44%
To compute a bond’s yield to maturity, we use the following formula:
C1 C2 C3 F + CN
p= + + ⋯+
1 2 3
(1 + y) (1 + y) (1 + y) (1 + y)N
Where:
P = price of the bond
Ct =annual cash flow in year t
N = time to maturity in years
y = annual yield (YT M to maturity)
F = face value
2.25 2.25 2.25 2.25 2.25 102.25

+ + + + + = 97.124
y 1 y 2 y 3 y
4 y 5 y 6
(1 + 2 ) (1 + 2 ) (1 + 2 ) (1 + ) (1 + 2 ) (1 + 2 )
2
Using trial and error, we get y=5.554%
Alternatively, using a financial calculator with the following inputs:
N = 6; PV = -97.124; PMT = 2.25 (=4.5/2); FV = 100
314
We get, I/Y = 2.777%
⇒ Y T M = 2 × 2.777 = 5.554%
Q.2787 On Jan 1 2017, Commercial Bank of India issued a six-year bond paying an annual coupon of
6% at a price reflecting a yield to maturity of 4%. As of 31 Dec 2017, interest rates remain
unchanged. Holding all other factors constant, and assuming a flat term structure of interest rates,
how was the bond’s price affected? T he price:
A. Remained constant.
B. Decreased.
C. Increased.
D. Increased, but only in the second half of the year.
From the data given, it’s clear that the bond’s coupon is greater than the yield. As such, the bond
must have traded at a premium – implying the price must have been greater than the face value.
Provided the yield doesn’t change, a bond’s price will always converge to its face value. Since the
price starts higher, it must decrease.
315
Q.2788 A trader borrows $3,000,000 with a term of two years at a simple annual interest rate of 2%
from his broker. He purchases at par a bond with a 5% coupon paid annually. T he bond matures
exactly in 10 years. T wo years later, the trader sells the bond at the price of $101 and repays the
loan on an annual basis. Assuming that all of the coupons received are reinvested at the rate of 1.5%,
for a period of 1 year, what is the trader’s net realized return on the transaction described above?
A. +7.0000%
B. +7.0750%
C. +11.0000%
D. +11.0750%
T he net realized return is the return after financing costs have been subtracted
101
Proceeds from the sale of the bond = $3,000, 000 ∗ = $3, 030, 000.00
100
Coupons received from the bond = $150,000.00 ∗ 1.015 + $150, 000.00 = $302, 250.00
Interest paid to the broker = −$60,000.00 − $60,000.00 = −$120,000
Net proceeds = $3,030, 000.00 + $302, 250.00 − $120, 000 = $3,212, 250.00
($3,212, 250.00 − $3, 000, 000)
Net realized return = = 7.0750%
$3, 000, 000
316
Q.2789 Alice T uck invested her annual bonus in a bond with a face value of $55,000. T he bond pays a
5% coupon semiannually and matures in 10 years. At the purchase date, the bond had a yield to
maturity of 7%. Six months later Alice received the coupon and sold the bond at the market yield of
6.5%. What is the net realized return on Alice’s transaction?
A. +7.0000%
B. +7.1250%
C. +7.2312%
D. +7.5475%
Investment in the bond = $47,183.18
(N = 20; I/Y = 3.5%; PMT = 1,375 (=55,000 *5% / 2); FV = 55,000
CPT => PV = - 47,183.18)
Proceeds from the sale of the bond = $49,220.10
(N = 19; I/Y = 3.25%; PMT = 1,375 (=55,000 *5% / 2); FV = 55,000
CPT => PV = - 49,220.10)
Coupons received from the bond = $1,375
Total proceeds = $49, 220.10 + $1, 375 = $50, 595.10

($50, 595.10 − $47, 183.18)
Net realized return = = 7.2312%
$47, 183.18
Q.3424 At the start of the year, a bank issues a non-zero-coupon bond maturing in five years. During
the year, the following events are recorded:
I. T he bank’s leverage ratio increases

II. T he bank’s business risk increases
III. T he rate of interest earned on government bonds and T-bills increases
Which of the above-mentioned events would be expected to increase the bond’s yield to maturity?
A. I only
317
B. I and II only
C. III only
D. I, II, and III
All three events - an increase in the bank's leverage ratio, an increase in the bank's business risk, and
an increase in the interest rate on government bonds and T reasury bills - would be expected to
increase the bond's yield to maturity. Here's why:
When the bank's leverage ratio increases, it means the bank is using more borrowed funds to finance
its operations. T his increases the risk of the bank defaulting on its obligations, including the bond
payments. As a result, investors would demand a higher yield to compensate for the increased risk.
Similarly, an increase in the bank's business risk also increases the risk of default. Business risk
refers to the risk associated with the bank's operations and profitability. If the bank's business risk
increases, it could affect the bank's ability to make bond payments, leading to a higher yield to
maturity.
Finally, an increase in the interest rate on government bonds and T reasury bills makes these risk-
free investments more attractive. To compete, the bank's bond would need to offer a higher yield. As
the price of the bond decreases to make the bond more attractive, the yield to maturity increases.
Choi ce A i s i ncorrect. While an increase in the bank's leverage ratio can lead to a higher yield to
maturity due to increased risk, it does not fully explain the scenario as other factors are also at play.
Choi ce B i s i ncorrect. Although both an increase in the bank's leverage ratio and business risk can
contribute to a higher yield to maturity, this choice ignores the impact of rising interest rates on
government bonds and T reasury bills which would also cause an increase in bond's yield to maturity.
Choi ce C i s i ncorrect. Rising interest rates on government bonds and T reasury bills would indeed
cause an increase in bond's yield to maturity, but this choice overlooks the effects of increased bank
leverage ratio and escalated business risk which would also contribute towards a higher yield.
318
Q.3425 Bank A and Bank B both have a credit rating of BBB. Bank A issues a fixed-rate bond with a 10-
year term to maturity, while Bank B issues a similar bond with a 5-year term to maturity. Holding all
other factors constant, which of the following statements is most likely true?
A. Bond A has a higher interest rate risk than bond B
B. Bond B has a higher interest rate than bond A
C. Bond A has a lower coupon rate than bond B
D. Bond B has a higher coupon rate than bond A
Bond A has a higher interest rate risk than bond B. T he term 'interest rate risk' refers to the risk
that the value of a bond or other fixed-income investment will suffer as the result of unexpected
fluctuations in interest rates. In general, the longer the term to maturity of a bond, the greater the
interest rate risk. T his is because the bond's value could be impacted by changing interest rates over
a longer period before it matures. T herefore, a bond with a longer maturity, such as Bond A in this
case, generally has a higher interest rate risk than a similar bond with a shorter maturity, such as
Bond B. To compensate investors for taking on this additional risk, long-term bonds typically offer
higher coupon rates than short-term bonds of the same credit quality. T herefore, it is most likely
that Bond A has a higher interest rate risk than Bond B.
Choi ce B i s i ncorrect. T he interest rate of a bond is not determined by its term to maturity but
rather by the creditworthiness of the issuer and prevailing market conditions. Since both banks have
the same credit rating, it's unlikely that Bond B would have a higher interest rate than Bond A solely
based on its shorter maturity period.
Choi ce C i s i ncorrect. T he coupon rate of a bond, like its interest rate, is determined by factors
such as the issuer's creditworthiness and market conditions, not its term to maturity. T herefore, it's
not accurate to say that Bond A would necessarily have a lower coupon rate than Bond B just
because it has a longer term to maturity.
Choi ce D i s i ncorrect. As explained above in Choice C explanation, the coupon rate of a bond isn't
determined by its term to maturity but rather other factors such as issuer's creditworthiness and
prevailing market conditions. Hence, there isn't enough information provided in this scenario to
319
conclude that Bond B would have higher coupon rates than Bond A.
Q.3426 On Jan 1 2017, a 5-year corporate bond, paying an annual coupon of 8%, was selling at a
discount. As of 31 Dec 2017, interest rates remain unchanged. Holding all other factors constant,
which of the following relationships holds true? (P 0 represents the price of the bond and YT M is the
bond’s yield to maturity.)
A. P 0 < par and YT M < 8%
B. P 0 < par and YT M > 8%
C. P 0 > par and YT M > 8%
D. P 0 > par and YT M < 8%
T he bond is trading at a discount, which means that the price (P 0) is lower than its face value (par).
T his situation typically arises when the bond's coupon rate is less than its yield to maturity (YT M).
T herefore, the relationship P 0 < par and YT M > 8% holds true. As the bond approaches its maturity
date, its price will gradually 'pull to par', meaning it will rise to its face value. T his is because the
market price of a bond tends to move towards its face value as it nears maturity, assuming that the
market interest rates remain constant.
Choi ce A i s i ncorrect. T he bond was purchased at a discount, which means P 0 < par. However,
when a bond is bought at a discount, the yield to maturity (YT M) is greater than the coupon rate.
T herefore, YT M cannot be less than 8%.
Choi ce C i s i ncorrect. Given that the bond was purchased at a discount, it implies that P 0 cannot
be greater than par value. Hence this option contradicts with the given scenario.
Choi ce D i s i ncorrect. T his choice suggests that P 0 > par and YT M < 8%. However, as per the
question's premise where it states that the bond was bought at a discount (P 0
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Q.4582 A zero-coupon bond with three years to maturity has a face value of 100. If the current
market price of the bond is 88, what is the yield to maturity of the bond?
A. 12%
B. 13.6%
C. 4.35%
D. 3.79%
T he yield to maturity of a zero-coupon bond is given by:
1
Face value year to maturity
YT M = ( ) −1
Current price of the bond
In this case,
1
100 3
YT M = ( ) − 1 = 4.35%
88
321
Q.4583 An investor buys a two-year 100 par-value bond at $95 per $100 face value. T he bond pays
semiannual coupons at a rate of 5% per annum. Suppose that after six months, the coupon is invested
and earns 2% for the next 6 months. After 1 year, the investor decides to cash out and sell the bond
at $97. What is the gross realized return for the investor?
A. 7.37%
B. 7.42%
C. 4.22%
D. 2.11%
Ending Value+Coupon-Beginning Value

Gross Realised Return =
Beginning Value
Given that the coupon rate is 5% paid semiannually, then the bond pays coupons of $2.5 after every
6-months, and since the coupon is invested for the next 6-months at 2%, then we have:
In this case,
97 + 2.5 + 2.5 ∗ 1.02 − 95

Gross Realised Return = = 7.421%
95
322
Q.4584 Suppose that James is offered a bond that pays $40 per annum in perpetuity. If the discount
rate is 6%, what is the bond’s expected price?
A. 600
B. 666.67
C. 667.77
D. 666
T he price of a perpetual bond is given by,
P MT
P V perpetuity =
r
Where;
r = the discount rate; and
PMT = the periodic payment.
In this case,
40
P V perpetuity = = $666.67
0.06
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Q.4585 What is the present value of an annuity that pays $100 per year at the end of each year for
the next five years at an effective rate of 5% per annum?
A. 435
B. 432.95
C. 495
D. 487.98
We can find the present value of the annuity using the formula;
1 − (1 + r)−T
P V annuity = P MT ( )
r
Where,
P V annuity = present value of the annuity
PMT = periodic premium payment
r = effective discount rate
In this case,
1 − (1.05)−5
P V annuity = 100 ( ) = $432.95
0.05
324
Reading 58: Applying Duration, Convexity, and DV01
Q.659 On a graduate-level exam on the subject of fixed income investments, students were asked to
define duration in three sentences. One of the students mentioned the following three sentences
associated with duration:
I. T he duration of a zero-coupon bond is a measure that tells how long the holder of the bond has to
wait until the bond is redeemed for its full face value.
II. Since there are no coupons in a zero-coupon bond, the zero-coupon bond does not have duration.
III. T he duration of a coupon bond is equal to its time to maturity.
Which of the sentences are inconsistent with the definition of duration?
A. Statements I and II are inconsistent with the definition of duration.
B. Statements II and III are inconsistent with the definition of duration.
C. Statements I and III are inconsistent with the definition of duration.
D. All of the statements are inconsistent with the definition of duration.
Statements II and III are inconsistent with the definition of duration. Duration is a measure of the
sensitivity of the price of a bond or other debt instrument to a change in interest rates. It is an
important concept in fixed income investing, as it helps investors understand the risk associated with
different bonds.
Statement II is incorrect because it suggests that a zero-coupon bond does not have a duration. T his
is not true. In fact, the duration of a zero-coupon bond is equal to its time to maturity. T his is
because a zero-coupon bond does not pay interest until it matures, so the entire value of the bond is
received at maturity. T herefore, the duration, which measures the weighted average time until a
bond's cash flows are received, is equal to the bond's time to maturity.
Statement III is also incorrect. It suggests that the duration of a coupon bond is equal to its time to
maturity. T his is not accurate. T he duration of a coupon bond is typically less than its time to
maturity. T his is because the bondholder receives some of the bond's value through periodic coupon
payments before the bond matures. T herefore, the weighted average time until the bond's cash
flows are received, which is the duration, is less than the bond's time to maturity.
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Choi ce A i s i ncorrect. Statement I is correct as the duration of a zero-coupon bond is indeed the
time period until the bondholder receives its full face value. T his is because there are no
intermediate cash flows in a zero-coupon bond, so all of its present value comes from the single
payment at maturity. T herefore, its duration equals its time to maturity.
Choi ce C i s i ncorrect. As explained above, statement I correctly describes duration for a zero-
coupon bond. However, statement III incorrectly states that the duration of a coupon bond equals its
time to maturity which isn't always true as it depends on factors such as coupon rate and yield rate.
Choi ce D i s i ncorrect. As explained above, statement I accurately defines duration for a zero-
coupon bond and hence this choice cannot be correct since it claims all statements are inconsistent
with definition of duration.
Q.1175 T he price of a bond at various rates is given in the table below:
Spot rate Price

3.45% 95.8680
3.40% 96.0780
T he DV01 of the bond is:
A. 11.04
B. 1.10
C. 0.042
D. 0.906
ΔP
DV 01 = −
10, 000 ∗ Δy
ΔP = 95.8680 − 96.0780 = −0.21
Δy = 3.45% − 3.40% = 0.05%
−0.21
DV 01 = − = 0.042
10,000 ∗ 0.05%
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Q.1176 T he price of a bond at various rates is given in the table below:
Par rates price

3.45% 95.8680
3.40% 96.0780
3.35% 96.3210
T he effective duration of the bond is:
A. 0.4719
B. 4.7149
C. -4.7149
D. 0.04719
−(P + − P − )
Effective Duration =
(r+ − r− ) ∗ P 0
−(95.8680 − 96.3210)
= = 4.7149
(3.45% − 3.35%) ∗ 96.0780
Q.1178 A fund manager has the option to buy the following bonds:
I. A bond with a coupon of 10% and a tenure of 5 years

II. A bond with a coupon of 5% and a tenure of 5 years
If the fund manager wants to limit the impact of interest rate changes in his portfolio, the ideal
bond(s) to invest in is/are:
A. T he bond with the 10% coupon.
B. T he bond with the 5% coupon.
C. Both bonds, since they react in a similar manner to interest rate changes.
D. Both bonds, since the diversification effect will reduce the impact of interest rate
changes.
327
T he impact of interest rate changes on a bond portfolio is typically measured by the duration of the
portfolio. Duration is a measure of the sensitivity of the price of a bond or a bond portfolio to a
change in interest rates. T he higher the duration, the greater the interest rate risk or reward for
bond prices. It is inversely related to the bond's coupon rate. T his means that a bond with a higher
coupon rate will have a lower duration, and hence, lower sensitivity to interest rate changes.
T herefore, the bond with a 10% coupon (Bond A) will have a smaller duration compared to the bond
with a 5% coupon (Bond B). If the fund manager's objective is to limit the impact of interest rate
changes on his portfolio, he should invest in the bond with the 10% coupon. T his bond will be less
sensitive to interest rate changes, thereby helping the fund manager achieve his objective of limiting
the impact of interest rate changes on his portfolio.
Choi ce B i s i ncorrect. T he bond with a 5% coupon rate would be more sensitive to interest rate
changes compared to the bond with a 10% coupon rate. T his is because the lower the coupon rate,
the higher the duration of a bond, making it more susceptible to interest rate risk.
Choi ce C i s i ncorrect. It's not accurate that both bonds react in a similar manner to interest rate
changes. As mentioned above, bonds with lower coupon rates have higher durations and are
therefore more sensitive to interest rates fluctuations than bonds with higher coupons.
Choi ce D i s i ncorrect. While diversification can reduce certain types of risk in an investment
portfolio, it does not necessarily mitigate the impact of broad market movements such as changes in
interest rates. In this case, since both bonds have similar tenures but different coupons, they will
respond differently to changes in market rates and thus diversification may not effectively reduce
interest rate risk.
Q.1179 A fund manager has the option to buy the following bonds:
I. A bond with 10% coupon and a tenure of 15 years

II. A bond with 10% coupon and a tenure of 10 years
T he fund manager expects the interest rate volatility to increase and wants to compose a portfolio
which will help him generate maximum return due to the volatility. T he fund manager must buy:
A. T he bond with a tenure of 15 years.
328
B. T he bond with a tenure of 10 years.
C. Both, since they react in a similar manner to interest rate volatility.
D. Both, since the diversification effect will help him generate maximum return.
When interest rate volatility increases, bond prices become more sensitive to changes in interest
rates. T his sensitivity is measured by duration. T he higher the duration, the more sensitive the bond
price is to interest rate changes. Given that both bonds have the same coupon rate, the bond with
the shorter tenure (10 years) will have a lower duration than the bond with the longer tenure (15
years). T herefore, the bond with the shorter tenure will be less sensitive to interest rate changes,
and its price will fluctuate less compared to the bond with the longer tenure. In a scenario of
increasing interest rate volatility, the fund manager should buy the bond with the shorter tenure (10
years) since it will generate less volatile returns than the bond with the longer tenure (15 years).
T his strategy will allow the fund manager to maximize returns in a volatile interest rate
environment.
Choi ce A i s i ncorrect. Although a bond with a longer tenure, such as 15 years, will have more
price volatility due to changes in interest rates, it does not necessarily mean that it will generate
maximum return due to increased interest rate volatility. T he fund manager's expectation of an
increase in interest rate volatility could lead to higher potential losses for the bond with a longer
tenure because its price would decrease more significantly if interest rates rise.
Choi ce C i s i ncorrect. It's not accurate to say that both bonds react in a similar manner to
interest rate volatility. While both bonds have the same coupon rate, their different tenures mean
they have different durations and thus different sensitivities to changes in interest rates. T herefore,
their reactions to increased interest rate volatility would be dissimilar.
Choi ce D i s i ncorrect. While diversification can help reduce risk and potentially enhance returns
over time, simply buying both bonds does not guarantee maximum return due to increased interest
rate volatility. T he effect of diversification depends on the correlation between the returns of the
two bonds which may or may not be beneficial depending on how they respond individually and
collectively to changes in market conditions such as an increase in interest rates.
329
Q.1180 All the following are true for convexity, EXCEPT :
A. Convexity is the second derivative of the price rate function.
B. For an option free bond, convexity is always negative.
C. Convexity explains why the price of a bond falls less and rises more in the case of changes
in interest rates.
D. Convexity enhances the bond’s return.
T he statement that 'For an option-free bond, convexity is always negative' is incorrect. Convexity, in
the context of bond pricing, is a measure of the curvature in the relationship between bond prices
and bond yields. Convexity demonstrates how the duration of a bond changes as the interest rate
changes. T his measure is used to protect against interest rate risk. For an option-free bond, the
convexity is always positive, not negative. T his is because the price-yield curve of a bond is convex,
meaning it curves upwards. As interest rates decrease, the price of the bond increases at an
increasing rate. Conversely, as interest rates increase, the price of the bond decreases at a
decreasing rate. T herefore, the statement in choice B is incorrect because it contradicts the
fundamental nature of convexity in bond pricing.
Choi ce A i s i ncorrect. Convexity is indeed the second derivative of the price rate function. T his
means that it measures how the duration of a bond changes as interest rates change, which in turn
affects bond prices.
Choi ce C i s i ncorrect. Convexity does explain why the price of a bond falls less and rises more in
case of changes in interest rates. T his characteristic provides an advantage to bondholders because it
cushions against sudden increases in interest rates while benefiting from decreases.
Choi ce D i s i ncorrect. Convexity does enhance a bond’s return by making its price more sensitive
to changes in interest rates, thus providing potential for higher returns when rates fall and lower
losses when they rise.
330
Q.1181 Details of portfolio X is given below: Note: Portfolio X consists of bonds A, B, C and D, and
the value of each bond is given in the above table. T he duration of portfolio X is:
Bond Value Duration Convexity

Bond A $120, 000 5.453 230.453
Bond B $100, 000 7.213 350.361
Bond C $150, 000 2.348 120.714
Bond D $130, 000 8.190 480.341
A. 5.26
B. 5.59
C. 5.10
D. 5.69
Total value of the portfolio = $120, 000 + $100, 000 + $150, 000 + $130, 000 = $500, 000
$120, 000 ∗ 5.453 + $100, 000 ∗ 7.213 + $150, 000 ∗ 2.348 + $130, 000
Duration of the portfolio =
$500, 000
= 5.59
331
Q.1182 Details of portfolio X is given below:
Bond Value Duration Convexity

Bond A $120, 000 5.453 230.453
Bond B $100, 000 7.213 350.361
Bond C $150, 000 2.348 120.714
Bond D $130, 000 8.190 480.341
Note: Portfolio X consists of bonds A, B, C and D, and the value of each bond is furnished in the
above table.
T he convexity of portfolio X is:
A. 360.426
B. 386.484
C. 200
D. 286.484
Total value of the portfolio = $120, 000 + $100, 000 + $150, 000 + $130, 000 = $500, 000
($120, 000 ∗ 230.453 + $100, 000 ∗ 350.361 + $150, 000 ∗ 120.714 + $130
Convexity of the portfolio =
($500,000)
= 286.484
332
Q.1183 Data on three bonds are given below. Assume the current date is March 31, 2015.
Bond Maturity Price Yield Duration Convexity

A March 31, 2020 110.321 2.32% 4.321 34.09
B March 31, 2030 109.320 3.23% 9.102 78.32
C March 31, 2045 103.211 4.11% 18.112 323.11
T he fund manager is considering purchasing $10 million (face value) of bonds B at the cost of $10.932
million. T he fund manager expects the interest volatility to increase and hence wants to maximize
his returns. However, another fund manager makes the suggestion that instead of investing in bond B,
the fund manager should invest in a combination of bonds A and C. Given that the fund manager has a
surplus of $10.932 million and wants the duration of the portfolio to be equal to that of bond B, the
investments in A and C which can create a portfolio with a duration similar to B is:
A. $5.34 million in bond A and $5.592 million in bond C.
B. $9.321 million in bond A and $1.611 million in bond C.
C. $7.14 million in bond A and $3.79 million in bond C.
D. $8.12 million in bond A and $2.812 million in bond C.
Let the investments in A and C be x and y respectively. T hen, as per the constraints:
x + y = 10.932
1
( ) ∗ (x ∗ 4.321 + y ∗ 18.112) = 9.102
10.932
Solving for x and y :
x = $7.14
y = $3.79
333
A March 31, 2020 110.321 2.32% 4.321 34.09
B March 31, 2030 109.320 3.23% 9.102 78.32
C March 31, 2045 103.211 4.11% 18.112 323.11
T he fund manager is considering purchasing $10 million (face value) of bonds B at the cost of $10.932
million. T he fund manager expects the interest volatility to increase and hence wants to maximize
his returns. However, another fund manager makes the suggestion that instead of investing in bond B,
the fund manager should invest in a combination of bonds A and C. T he fund manager has a surplus of
$10.932 million and wants the duration of the portfolio to be equal to that of bond B. Given that the
fund manager expects increased interest volatility, the fund manager should invest in:
A. $10.932 million of Bond B.
B. $10.932 million of Bond C.
C. $5.12 million of bond A and $5.81 of bond C.
D. $7.14 million of bond A and $3.79 of bond C.
T he fund manager must invest in such a bond/portfolio which has the highest convexity, as higher
convexity will help the fund manager to maximize return due to interest rate volatility.
Let the investments in A and C be x and y respectively. As per the constraint of having a duration of
the portfolio equal to that of bond B (9.102 years):
x + y = 10.932
1
( ) ∗ (x ∗ 4.321 + y ∗ 18.112) = 9.102
10.932
Solving for x and y :
x = $7.14
y = $3.79
7.14 3.79
Portfolio convexity = ( ) ∗ 34.09 + ( ) ∗ 323.11 = 134.29
10.932 10.932
As the convexity of the portfolio is higher than the convexity of bond B and the portfolio meets the
334
duration constraints (as it is equal to bond B), the preferred investment is in a portfolio consisting of
bond A and C.

A March 31, 2020 110.321 2.32% 4.321 34.09
B March 31, 2030 109.320 3.23% 9.102 78.32
C March 31, 2045 103.211 4.11% 18.112 323.11
T he return generated by a portfolio consisting of $7.14 million of bond A and $3.79 million of bond C
in the case the interest rate remains constant is:
A. 0.0232
B. 0.0411
C. 0.0294
D. 0.0151
7.14 3.79
T he return generated in case the rate remains constant = ( ) ∗ 2.32% + ( ) ∗ 4.11%
10.932 10.932
= 2.94%
335
Q.2791 Suppose the yield on a zero-coupon bond declines from 5.00% to 4.99%, and the price of the
bond increases from $50.0 to $51.5. Compute the DV01.
A. $0.0512
B. $1.5
C. $2.5
D. $0.1
ΔBV
DV 01 = −
10, 000 × Δy
Where:
ΔBV = change in bond value
Δy = change in yield
51.5 − 50.0
DV 01 = − = 1.5
10, 000 × −0.0001
336
Q.2792 Ted Oster wants to calculate the DV01 of a new position in a bond with a face value of
$1,000,000. T he bond was bought today for $84.102 for $100 face value. Oster knows that the
Macaulay duration is 5.25.
What is the DV01 of the position if the bond has a yield to maturity of 10% per annum?
A. $401.39
B. $405.40
C. $483.47
D. $492.73
5.25
Modified duration = = 4.7727
(1 + 10%)
DV 01 = Mod dur × 0.0001 × Bond value
84.102
= 4.7727 × 0.0001 × ( ) × $1, 000,000
100
= $401.39
Note that the reason why we multiply by 0.0001 is to get the dollar change for a 1% change in yield
in terms of basis points.
Q.3315 Peter Drury, a risk manager at Capital Bank, is evaluating the price sensitivity of an
investment-grade callable bond using the bank's valuation system. T he table below gives a breakdown
of the bond and the embedded option. T he current interest rate environment is flat at 5%.
Interest rate Bond value Call option value

level per 100 USD face value per 100 USD face value
4.95% 98.2520 1.7480
5.0% 98.0000 1.5000
5.05% 97.7500 1.3225
T he DV01 of a comparable bond with no embedded options and with the same maturity and coupon
rate as the collable bond is closest to:
A. 0.09275
B. 0.08015
337
C. 0.1285
D. 0.07500
T he call option negatively affects the price of a bond because investors lose future coupon
payments if the call option is exercised by the issuer.
T he value of a plain-vanilla bond can be given by:
Price (plain-vanilla bond) = price (callable bond) + price (call option)
T hus, the price of the plain-vanilla bond with no embedded options at a rate of 5.0% would be
99.5000, the price at a rate of 4.95% would be 100.0000, and the price at a rate of 5.05% would be
99.0725.
DV01 is the dollar value change in price (value) of a fixed income instrument, such as a bond, in
response to a change in the yield of the instrument. It is given by:
ΔP
DV 01 = −
10, 000 × ΔY
where:
ΔP = change in price, and
ΔY = change in yield
T hus
99.0725 − 100 −0.9275

DV 01 = − =− = 0.09275
10,000 × (0.0505 − 0.0495) 10
338
Q.3319 T he current price of a bond is 950. T he duration of the bond is 8.83 and the convexity of the
bond is 6.43. What is the change in the price of the bond for a one percentage point increase in the
interest rate?
A. -38.00
B. 52.25
C. 22.80
D. -83.58
For a one basis point of change in the interest rate, the formula for the bond price change is:
1
Change in price = [−Modified Duration × Bond Price × Change in yield] + [ × Convexity × Bond Price
2
6.43
= −8.83 × 0.01 × 950 + × 950 × 0.012 = −83.5796
2
Q.3427 Given the following portfolio of bonds:
Bond Price Par Amount Held Modified Duration

(USD Million)
A 101.22 4 2.45
B 85.53 6 4.25
C 115.50 9 7.61
What is the value of the portfolio’s DV01 (dollar value of a basis point)?
A. $10,960
B. $11,000
C. $11,060
D. $12,600
Portfolio DV01 = Portfolio Modified duration × Portfolio Market Value × 0.0001
339
But we have to compute the portfolio modified duration first:
Modified duration of the portfolio = Weighted Average of Modified Duration of Individual Bonds in the Portfolio
= w 1D1 + w 2 D2 + ⋯ + w kDk
where :
Market value of bond i

wi = Portfolio market value
D i = Modified duration of bond i
k=total no.of bonds in the portfolio
Based on the table above, these are the values for bonds A, B, and C:
Bond Value Weight in

the Portfolio
4,000,000 4,048,800
A = 101.22 × = 4, 048, 800 = 19,575,600 =
0.21
100
6,000,000 5,131,800
B = 85.53 × = 5, 131, 800 = 19,575,600 =
0.26
100
9,000,000 10,395,000
C = 115.5 × = 10, 395, 000 = 19,575,600 =
0.53
100
Portfolio = 4, 048, 800 + 5, 131, 800 + 10, 395, 000
= 19, 575,600
Portfolio Modified Duration = 0.21 × 2.45 + 0.26 × 4.25 + 0.53 × 7.61 = 5.65
T herefore,
Portfolio DV01 = 5.65 × 19, 575, 600 × 0.0001 = $11, 060.2
Q.3428 T he current interest rate environment in a certain developing economy is flat at 5%. A risk
manager has compiled the following data regarding a callable bond in two other interest rate
environments (all values in USD per USD 100 face value):
Level of interest rate Callable bond Call option

4.96% 102.00 2.0893
5.00% 102.4465 2.0255
5.04% 101.2111 2.0021
T he convexity of the callable bond is closest to:
340
A. -102,608
B. -51,304
C. -100,020
D. -103,000
Convexity is the second derivative of the formula for change in bond prices with a change in interest
rates.
1 d2P
Convexity = ×
P dy 2
T his approach can be quite rigorous in terms of computation, so you need to estimate convexity
using the formula:
P −Δy + P +Δy − 2P 0
Convexity =
P 0 × Δy 2
Where:
P −Δy =price estimate if yield decreases by a given amount, Δy
P +Δy =price estimate if yield increases by a given amount, Δy
P 0=initially observed bond price (at the flat rate)
Δy =change in yield in one step, expressed in decimal form (0.04% in this case)
102.00 + 101.2111 − 2 × 102.4465

Convexity =
102.4465 × 0.00042
1.6819
=− = −102, 608
0.00001639
341
Q.3429 A 20-year zero-coupon bond is callable annually at par, starting at the beginning of year 11.
Assuming a flat yield curve of 20%, the bond’s duration is closest to:
A. 20 years
B. 15 years
C. 10 years
D. Cannot be determined based on the data given
Because this is a zero-coupon bond, it will always trade below par, and the call should never be
exercised. Hence, its duration is the maturity of the bond, 20 years.
Q.4609 In the context of the one-factor risk metrics, which of the following is/are correct?
I. DV01 and effective duration hedging provide protection against small parallel shifts of the
term structure
II. DV01 and effective hedging protect against large parallel shifts of the term structure
III. A combination of the convexity and effective duration protects against large parallel shifts in
the term structure
IV. Effective convexity hedging protects against small parallel shifts in the term structure
A. I and IV
B. I and III
C. III only
D. I and II
Statement I is correct as DV01 and effective duration hedging are indeed used to provide protection
against small parallel shifts of the term structure. T his is because dV01 measures the change in the
price of a bond for a 1 basis point change in yield, and effective duration measures the sensitivity of a
bond's price to changes in interest rates. Both these measures are used to hedge against small shifts
in the term structure. Statement III is also correct as a combination of convexity and effective
342
duration is used to protect against large parallel shifts in the term structure. Convexity measures the
sensitivity of a bond's duration to changes in interest rates and is used in conjunction with duration to
provide a more accurate estimate of a bond's price change for large shifts in interest rates.
Choi ce A i s i ncorrect. While statement I is correct, statement IV is not. Effective convexity
hedging does not protect against small parallel shifts in the term structure. Instead, it provides
protection against large non-parallel shifts.
Choi ce C i s i ncorrect. T his choice suggests that only statement III correctly describes the
protection provided by these strategies against shifts in the term structure of interest rates.
However, this isn't true as both statements I and III are correct.
Choi ce D i s i ncorrect. Statement II incorrectly states that DV01 and effective hedging protect
against large parallel shifts of the term structure when they actually provide protection against small
parallel shifts as stated in option I.
343
Q.4611 A bank has a position of USD 2 million with a duration of 10 years. To completely hedge its
position, the bank takes a short position of USD 1.4 million in bond B. What is the duration of bond B?
A. 10
B. 11
C. 13
D. 14
T he position required in the bond to hedge a position is given by:
V DV
P =−
DB
Where
V = a value of the position
DV = duration of the position
DB = duration of the bond
So in this case,
V DV
P =−
DB
2 × 10
⇒ −1.4 = −
DB
20
∴ DB = ≈ 14
1.4
344
Q.4613 Suppose the yield on a zero-coupon bond declines from 7.00% to 6.95% and the price of the
zero increases from $202.45 to $203.87. What is the value of DV01?
A. 0.342
B. 0.324
C. 0.284
D. 0.242
DV01 is defined as:
ΔP
DV 01 = −
Δr
Where
Δr = the size of a parallel shift in the interest rate term structure measured in basi s poi nts
ΔP = resultant change in the value of the position being considered
203.87 − 202.45 1.42

⇒ DV01 = − = = 0.284
(−0.0005) × 10, 000 5
345
Q.4614 T he Macaulay duration of a coupon bond is 10.25. If the yield on the bond is 8% compounded
semi-annually, what is the corresponding modified duration for the bond?
A. 10.25
B. 9.86
C. 11.45
D. 9.54
y
Denoting the bond yield by y, modified duration is calculated by dividing Macaulay duration by (1 + 2 ).
So in this case,
10.25
Modified duration = = 9.86
0.08
(1 + )
2
Q.4615 A four-year T reasury bond has a face value of USD 5 million and an annual coupon payment
of 8% paid semi-annually. T he term structure applicable to the bond is a 10% flat yield. Considering
ten basis point changes, what is the effective convexity of the bond?
A. -13.68
B. 13.68
C. -203.67
D. 203.67
Convexity is given by:
1 P + + P − − 2P
C= [ ]
P (Δr)2
Where
346
P = the price of the bond.
P + = the value of the position when all rates increase by Δr
P − = the value of the position corresponding to the decrease of all rates by Δr (measured in decimal)
T he price of the bond (in millions) with no spread is USD 4,676,839 million. Using a financial
calculator with the variables:
N = 8,
I 10%
= = 5%
Y 2
PV = ?
0.08 × 5
P MT = = 0.2
2
FV = 5
⇒ P V = 4.676839 million
⇒ P = 4,676, 839
I
For an increase in 10 point basis (0.10%) the flat yield is now 10.10% and thus = 5.05% . Using the
Y
financial calculator,
P + = U SD$4, 661, 366
I
For a 10 point basis decrease, the flat yield is now 9.9% and thus = 4.95% .
Y
∴ P − = $4, 692, 376

1 4, 661,366 + 4,692, 376 − 2 × 4, 676,839
⇒C= [ ] = 13.681
4,676, 839 (0.001)2
347
Q.4616 A bond portfolio consists of three bonds:
Bond A worth 9 million with a duration of 4;
Bond B worth 5 million with a duration of 6; and
Bond C worth 6 million with a duration of 7.
What is the duration of the portfolio?
A. 7.8
B. 6.6
C. 5.4
D. 5.7
Recall that the portfolio duration is calculated as the wei ghted sum of the individual durations
where the weight attached to each security is equal to its value as a percentage of total portfolio
value.
T he total value of the portfolio is 9 + 5 + 6 = USD 20 million. T he duration of the bond is given by:
9 5 6
×4+ ×6+ × 7 = 5.4
20 20 20
348
Q.4617 A position worth USD 3 million has a duration of 4 and a convexity of 5. What is the estimated
change in the position for a five-basis-point increase in all rates?
A. Increase by USD 5,998.125
B. Decrease by USD 5,998.125
C. Increase by USD 5,546.670
D. Decrease by USD 5,546.670
By using convexity and duration, the price change estimation is given by:
1
ΔP = −DP Δr + CP (Δr)2
2
1
= −4 × 3 × 0.0005 + × 5 × 3 × (0.0005)2
2
= −0.005998125 = −USD 5,998.125
349
Reading 59: Modeling and Hedging Non-Parallel Term Structure Shifts
Q.1148 All the following are assumptions of Key Rate Shifts, EXCEPT :
A. Rates can be determined as a function of a relatively small number of key rates.
B. T here is a parallel shift of rates across the key rates.
C. T here is a linear shift of rates across the term structure.
D. T he rate of a given term is not affected by its neighboring key rates.
T he statement that 'T he rate of a given term is not affected by its neighboring key rates' is incorrect
in the context of Key Rate Shifts. T he fundamental premise of Key Rate Shifts is that rates can be
determined as a function of a relatively small number of key rates. T his implies that the rate of a
given term is influenced by its neighboring key rates. For example, the 5-year rate could be a
function of the 2-year and 3-year rates. T herefore, the assertion that a given term's rate is
unaffected by its neighboring key rates contradicts the basic assumptions of Key Rate Shifts.
Choi ce A i s i ncorrect. T he assumption that rates can be determined as a function of a relatively
small number of key rates is indeed one of the fundamental principles behind Key Rate Shifts. T his
concept allows for the simplification and modeling of complex interest rate structures.
Choi ce B i s i ncorrect. T he assumption that there is a parallel shift of rates across the key rates
aligns with the assumptions of Key Rate Shifts. In this model, all key rates are assumed to move in
unison, which simplifies analysis and prediction.
Choi ce C i s i ncorrect. T he assumption that there is a linear shift of rates across the term
structure also aligns with Key Rate Shifts' assumptions. T his implies that changes in short-term
interest rates have an equal impact on long-term interest rates, which aids in creating simplified
models for risk management purposes.
Q.2606 A risk manager prepares a presentation on the interest rate risk of the bank’s bond portfolio.
T he table below shows the value of the portfolio in case of shifts in key rates by one basis point and
corresponding key rate duration.
350
Value Key Rate Duration
Initial Curve 500.425
2-year Shift 500.227 3.957
5-year Shift 500.201 4.476
10-year Shift ? 28.476
30-year Shift 499.500 18.484
Total 55.393
What is the value of the portfolio in the case of a 10-year shift?
A. 501.850
B. 500.043
C. 499.500
D. 499.000
1 ∂p
Key rate duration = −
p ∂y
Where:
P = initial bond value/price
∂p = change in bond price
∂y = change in yield
Let the value of the bond portfolio in the case of a 10-year shift be "x"
T hus, the key rate duration with respect to the 10-year shift is calculated as:
1 x − 500.425
Key rate duration = −
500.425 0.01%
1 x − 50.425
⇒ 28.476 = − ×
500.425 0.01%
x − 500.425
⇒ 28.476 × 500.425 = −
0.01%
⇒ 28.476 × 500.425 × 0.01% = −(x − 500.425)
⇒ 28.476 × 500.425 × 0.01% = (500.425 − x)
⇒ 500.425 − 28.476 × 500.425 × 0.01% = x
⇒ x = 499.000
351
Q.2607 Frank Capper wants to estimate the impact of key rate changes on the value of C-ST RIPs.
Capper uses 2-year, 5-year, 10-year, and 30-year key rates in his analysis. He also wants to
incorporate an unexpected 50 basis point shock of the 10-year rate in the model.
Which of the following rates will be affected by the change of the 10-year rate key rate?
A. 2-year and 5-year
B. 30-year rate
C. 5-year and 30-year rates
D. All of the rates will be affected
T he 5-year and 30-year rates will be affected by the change of the 10-year rate key rate. T his is
because each key rate influences the yields from the term of the previous key rate (or zero) to the
term of the next key rate. In this case, the 10-year key rate is sandwiched between the 5-year and
30-year key rates. T herefore, any change in the 10-year key rate will directly impact the 5-year and
30-year rates. T his is a fundamental concept in the analysis of key rate changes and their impact on
the value of financial instruments such as C-ST RIPs.
Choi ce A i s i ncorrect. T he 2-year and 5-year rates are not directly impacted by a change in the 10-
year key rate. Key rates are specific points on the yield curve, and changes in one key rate do not
necessarily affect other key rates, especially those with shorter durations.
Choi ce B i s i ncorrect. While it's true that a change in the 10-year key rate might have some
influence on the 30-year rate due to their relative closeness on the yield curve, this choice ignores
the potential impact on the 5-year rate which can also be affected.
Choi ce D i s i ncorrect. Although all rates could potentially be influenced by market dynamics and
shifts in economic conditions, a shock to a specific key rate (in this case, the 10-year) does not
automatically translate into changes across all other durations. In this context, only those durations
that are close to or longer than the shocked duration would typically be affected.
352
Q.2610 A trader wants to hedge the 2-year and 5-year rates exposure of a portfolio. To perform the
hedge, the trader can use Bond 1 and Bond 2 presented below.
Key Rate ‘01 (per 100 face amount)

Hedging Bonds 2-year 5-year
––––––– –––––––
Bond 1 0.0080 −
Bond 2 0.0099 0.0160
Key Rate ’01($)

2-year 5-year
––––––– –––––––
Fixed Income 250 320
Portfolio
What is the face value of Bond 1 required to perform the hedge?
A. $200,000
B. $650,000
C. $950,000
D. $1,250,000
Let’s denote F(i) as the face amount of hedging bond i that we need to sell.
We have the following equations:
0. 0099 0. 0080
(1): F (2) ∗ + F (1) ∗ = $250
100 100
0. 0160
(2): F (2) ∗ = $320
100
From (2) → F (2) = $2, 000, 000
From (1)and(2) → F (1) = $650, 000
353
Q.2611 T he risk manager of a regional bank is concerned with possible shocks in short-term rates.
He wants to find a transaction that will completely eliminate the 2-year exposure and decrease by
half the current 5-year exposure. A trader proposes the following two bonds as hedging instruments:

Hedging Bonds 2-year 5-year
––––––– –––––––
Bond 1 0.0010 0.0050
Bond 2 0.0015 0.0025
Key Rate ’01($)

2-year 5-year
––––––– –––––––
Fixed Income 1, 000 4, 000
Portfolio
What is the trader’s hedging transaction?
A. Sell $60,000,000 of bond 1; Sell $10,000,000 of bond 2.
B. Sell $10,000,000 of bond 1; Sell $60,000,000 of bond 2.
C. Sell $10,000,000 of bond 1; Buy $60,000,000 of bond 2.
D. Buy $60,000,000 of bond 1; Sell $60,000,000 of bond 2.
To completely hedge the 2-year exposure, F(1) and F(2) should solve the following equation:
0.0015 0.0010
F (2) ∗ + F (1) ∗ = $1000.. . .. . (1)
100 100
To decrease by half the 5-year exposure of $4,000, F(1) and F(2) should solve the following equation:
0.0025 0.0050
F (2) ∗ + F (1) ∗ = $2, 000.... . . (2)
100 100
Solving equation (1) and (2), simultaneously, we get, F (2) = $60, 000, 000 and F (1) = $10, 000, 000
354
Q.2612 T he head of the trading department of a bank suggests speculating on the interest rate curve
by eliminating the exposure of the bond portfolio to long-term rates (10-year and 30-year rates) and
increasing the exposure to medium-term rates. T he table below represents the key rate ‘01s of the
current portfolio and corresponding hedging instruments.

Hedging Bonds 5-year 10-year 30-year
––––––– –––––––– ––––––––
Bond 1 0.0050 − −
Bond 2 0.0170 0.0250 −
Bond 3 0.0100 0.0300 0.0350
Key Rate ’01($)

5-year 10-year 30-year
––––––– –––––––– ––––––––
Fixed Income 1, 000 2, 000 1, 500
Portfolio
What will be the portfolio’s 5-year exposure after hedging 10-year and 30-year exposures?
A. $85.70
B. $171.43
C. $8,570.00
D. $17,143.00
We have the following equations:
0. 0300 0. 025
(1): F (3) ∗ + F (2) ∗ = $2, 000
100 100
0. 0350
(2): F (3) ∗ = $1, 500
100
From (3) → F (3) = $4, 285, 714
From (2) and (3) → F (2) = $2, 857, 143
0. 0170 0. 0100
Finally, the portfolio’s 5-year exposure = $1000 − F (2) ∗ − F (3) ∗ = $85.70
100 100
355
Q.2613 T he risk manager at a regional bank is trying to interpret the results of an interest rate curve
shocks simulation. T he table below represents the key rate '01s for the fixed income portfolio of
the bank.
Value Key Rate '01

Initial Curve 2,000.000
2-year Shift 1,998.500 1.500
5-year Shift 1,998.300 1.700
10-year Shift 1,999.000 1.000
30-year Shift 1,998.000 2.000
Total 6.200
What is the approximate value of the portfolio in the case of a 5 basis point increase of the 2-year
rate and a 10 basis point increase of the 30-year rate?
A. 1,972.500
B. 1,980.000
C. 1,992.500
D. 1,996.500
Portfolio value = 2, 000 − (5 ∗ 1.5 + 10 ∗ 2) = 1, 972.5
356
Q.2614 Anna White, head of the risk management department of a regional bank, asks one of the
interns to analyze the volatility of the bank’s medium-term fixed-income portfolio with a value of
$10,000. For the analysis of the portfolio, the intern uses 2-year rates (annual volatility of 20%) and
5-year rates (annual volatility of 30%). He calculates that the key rate ’01s for 2-year and 5-year
shifts are 2 per $ 100 and 5 per $ 100 respectively.
What is the volatility of the portfolio if the correlation between 2-year and 5-year rates is 0.45?
A. $155.24
B. $171.76
C. $22,570.00
D. $29,500
2 2
2 5
Portfolio variance = ( × 0.20 × 10000) + ( × 0.30 × 10000)
100 100
2 5
+2 × × × 0.20 × 10000 × 0.30 × 10000 × 0.45
100 100
= 29,500
Portfolio volatility = $29,5000. 5 = $171.76.
Q.2615 Initially, a fixed income portfolio of an investment bank had the following key rate ‘01s:
Value Key Rate

Initial Curve 10,000
2-year Shift 9,990 10
Total 60
After a recommendation from the risk management department, a trader completely hedged the 30-
year exposure with a bond that had the following characteristics:
357
Hedging Bond Key Rate '01
(per USD 100 face value)
Initial Curve
2-year Shift −
5-year Shift −
10-year Shift 3
30-year Shift 4
How much will the bank save, if immediately after the hedge, the interest rate curve experienced a
20 basis point upward parallel shift?
A. 320
B. 360
C. 480
D. 560
To hedge the 30-year exposure, the trader will need to sell $400(= $ 16 ∗ 100) face value of hedging
4
3
bond. T he sale of hedging bond will also impact the 10-year exposure by −$12(= − 100 ∗ $400).
T he portfolio key rate ‘01s after hedge will become:
Hedging Bond Key Rate '01

Initial Curve
2-year Shift 10
5-year Shift 15
10-year Shift 7
30-year Shift −
Total 32
T he portfolio value drop without hedging transaction = 20 ∗ 60 = 1, 200
T he portfolio value drop with hedging transaction = 20 ∗ 32 = 640
T he hedging transaction will save the bank 560(= 1, 200 − 640).
358
Q.3430 Kelvin Mertens, FRM, regularly participates in bond trading in the US. He is using key rate
analysis to assess the effect of yield changes on bond prices. He finds that the 20-year yield has
increased by 10 basis points. Moreover, this shock decreases linearly to zero for the 30-year yield.
What is the effect of this shock on the 26-year yield?
A. Increase of zero basis points
B. Increase of six basis points
C. Increase of ten basis points
D. Increase of four basis points
“Linear decline” implies the decline is by the same amount in each time step. T he 10 basis point
shock to the 20-year yield is supposed to decline linearly to zero for the 30-year yield. If one
assumes a simplistic one basis point effect, the impact of each key rate will be one basis point at
each key rate and then a linear decline to the subsequent key rate. T hus, the shock decreases by one
basis point per year and will result in an increase of four basis points for the 26-year yield.
359
Q.3431 T he following table provides the initial price of a C-ST RIP and its present value after the
application of a one basis point shift in four key rates.
Value
Initial value 26.14485
2-year shift 26.14582
T he key rate '01 with respect to the 10-year shift is closest to:
A. -0.004
B. -0.04
C. -4
D. -0.4
ΔBV
Key rate '01 = −
10, 000 × Δy
Where:
ΔBV =change in bond value
Δy =change in yield (0.01%)
T he change in bond value here is measured in reference to the initial bond value.
26.14885 − 26.14485
=− = −0.004
10, 000 × 0.01%
Q.3432 T he following table provides the initial price of a C-ST RIP and its present value after the
application of a one basis point shift in four key rates.
360
Value
Initial value 26.11485
T he key rate duration with respect to the 30-year shift is closest to:
A. 39
B. 51
C. 38
D. 10
First, determine the corresponding key rate ’01:
ΔBV
Key rate '01 = −
10, 000 × Δy
Where:
ΔBV =change in bond value
Δy =change in yield (0.01%)
T he change in bond value here is measured in reference to the initial bond value.
26.01192 − 26.11485
=− = 0.1029
10, 000 × 0.01%
Next, you can now compute the key rate duration using the formula:
DV01 = Duration × 0.0001 × Bond value
T hus,
DV01
Duration =
0.0001 × Bond value
0.1029
=
0.0001 × 26.11485
= 39.41
361
Alternatively, recall that:
1 ∂P
Key rate duration = − ( )
P ∂y
T hus, the key rate duration with respect to the 30-year shift can be calculated as:
1 26.01192 − 26.11485
Key rate duration = −( )×( ) = 39.41
26.11485 0.01%
362
Reading 60: Binomial Trees
Q.1205 Australian Financial Associates is holding the non-dividend paying stock of Neevan Holdings
which is trading at USD 10. T he continuously compounded risk-free rate is 5 percent per annum, and
the annual standard deviation of the stock is 20 percent. What is the value of a 2-year European call
option with a strike price of USD 10 using a two-period binomial model?
A. USD 1.64
B. USD 1.48
C. USD 1.58
D. USD 1.69
To price options in the binomial model, we need:
U = size of the up move factor =eσ√Δt
1
D = size of the down move factor = e−σ√Δt = U
σ is the annual volatility of the underlying asset’s returns and t is the length of the step in the
binomial model (t = 1 in this case).
r
e Δt−D
πu = probability of an up move = U −D
πd = probability of a down move = 1 − Π u
Working with the data provided,
U = 1.2214 and D = 0.8187
πu = 0.5775 and πd = 0.4225
Let S represent the price of the stock and f represent the value of the call:
363
Stock Price Value of the Call
Suu = $10 ∗ 1.2214 ∗ 1.2214 = $14.92 f uu = max($14.92 − $10, $0) = $4.92
Su d = $10 ∗ 1.2214 ∗ 0.8187 = $10 f u d = max($10 − $10, $0) = $0
Sdu = $10 ∗ 0.8187 ∗ 1.2214 = $10 f du = max($10 − $10, $0) = $0
Sdd = $10 ∗ 0.8187 ∗ 0.8187 = $6.70 f dd = max($6.70 − $10, $0) = $0
As the table shows, the value of the call will be positive only when the stock moves upward twice.
T he expected value of the call 2 years from now is given by:
0.5775 × 0.5775 × $4.92 + 0.5775 × 0.4225 × $0

+ 0.4225 × 0.5775 × $0 + 0.4225 × 0.4225 × $0
= $1.64
1.64
Value of the option today = = $1.48
e0. 05×2
364
Q.1207 Chris Fleming, an analyst working at Redberg Financials, constructs binomial trees to price
options. With regard to binomial trees for pricing options, which of the following statement(s) is/are
true?
I. T he underlying assumption in constructing a binomial tree is that the stock price follows a random
walk
II. In the limit, as the time step increases, the binomial tree model valuation of a European option
converges to the Black-Scholes-Merton model valuation
III. An inspection of a typical binomial tree shows that Delta remains constant during the life of an
option
IV. Constructing binomial trees for valuing options on stock indices, currencies, and futures
contracts is very similar to doing so for valuing options on stocks
A. I, III & IV only
B. I, II & IV only
D. All of the above
Statement I i s true: T he underlying assumption in constructing a binomial tree is that the stock
price follows a random walk.
Statement II i s true: In the limit, as the time step increases, the binomial tree model valuation of
a European option converges to the Black-Scholes-Merton model valuation
Statement III i s not true: An inspection of a typical binomial tree shows that delta CHANGES
during the life of an option.
Statement IV i s true: Constructing binomial trees for valuing options on stock indices, currencies,
and futures contracts is very similar to doing so for valuing options on stocks.
Q.1210 David Yung, an analyst working at the New Zealand Bank, uses Girsanov’s T heorem to study
portfolios in a risk-neutral world and in the real world. T he Girsanov’s T heorem states that:
A. When we move from the risk-neutral world to the real world, the expected return from
the stock price changes, but its volatility remains the same.
B. When we move from the risk-neutral world to the real world, the expected return from
the stock price remains the same, but its volatility changes.
365
C. When we move from the risk-neutral world to the real world, both the expected return
from the stock price and its volatility remains the same.
D. When we move from the risk-neutral world to the real world, both the expected return
from the stock price and its volatility change.
Girsanov’s T heorem, a fundamental concept in financial mathematics, states that when we transition
from a risk-neutral world to the real world, the expected return from the stock price changes, but
its volatility remains the same. In a risk-neutral world, all assets are assumed to grow at the risk-free
rate, and risk preferences do not affect asset prices. However, in the real world, investors demand a
risk premium for holding risky assets, which results in a higher expected return. Despite this change
in expected return, the volatility of the stock price, which is a measure of the degree of variation of
a trading price series over time, remains unchanged. T his is because volatility is a function of the
underlying uncertainties and risks inherent in the asset, which are not affected by the transition
from a risk-neutral to a real-world scenario.
Choi ce B i s i ncorrect. According to Girsanov's T heorem, when transitioning from a risk-neutral
world to the real world, the expected return of a stock price changes due to the introduction of risk
premiums. However, its volatility remains constant as it is not affected by this transition. T herefore,
it is incorrect to say that only the volatility changes while the expected return remains the same.
Choi ce C i s i ncorrect. T his choice contradicts Girsanov's T heorem which states that in moving
from a risk-neutral environment to a real-world one, there will be an alteration in expected returns
due to risk premiums but no change in volatility. Hence, it's not accurate to assert that both
expected return and volatility remain unchanged.
Choi ce D i s i ncorrect. As explained above in choices B and C explanations, Girsanov’s T heorem
implies that only the expected return changes when transitioning from a risk-neutral world to the
real world while its volatility stays constant. T hus stating both parameters change isn't correct.
Q.1211 Australian Financial Associates is holding the non-dividend paying stock of Neevan holdings
which is trading at USD 10. T he continuously compounded risk-free rate is 5 percent per year, and
the annual standard deviation of the stock is 20%. What is the value of a 2-year European put option
366
with a strike price of USD 10 using a two-period binomial model?
A. USD 0.5325
B. USD 2.4356
C. USD 0.6884
D. USD 2.3456
T he up-move and down-move factors are given by:
u = eσ√Δt = e0. 20×√1 = 1.2214
1 1
d= = = 0.8187
u 1.2214
Now, we can calculate the risk-neutral probability of an up-move:
erΔt − d e0. 05∗1 − 0.8187

p= = = 0.5775
u−d 1.2214 − 0.8187
Year 0 Year 1 Year 2

Suu = $12.214 × 1.2214 = $14.918
Su = $10 × 1.2214 = $12.214
S0 = $10 Su d = $12.214 × 0.8187 = $10
Sd = $10 × 0.8187 = $8.187
Sdd = $8.187 × 0.8187 = $6.703
T he put option payoff at the 2-year node is given by:
f uu = max(K − S, 0) = max(10 − 14.918, 0) = $0
f u d = max(10 − 10, 0) = $0
f dd = max(10 − 6.703, 0) = $3.297
T he put option payoff at the 1-year node is given by:
f u = e−rΔT [p ∗ f uu + (1 − p) ∗ f u d]
= e−0. 05×1 [0.5775 × 0 + (1 − 0.5775) ∗ 0] = 0
367
f d = e−rΔT [p ∗ f u d + (1 − p) ∗ f dd]
= e−0. 05×1 [0.5775 × 0 + (1 − 0.5775) × 3.297] = 1.3250
Now, the value of the option today is given by:
f 0 = e−rΔT [p ∗ f u + (1 − p) ∗ f d]
= e−0. 05×1 [0.5775 × 0 + (1 − 0.5775) × 1.3250] = $0.5325
368
Q.1212 Which of the following statement(s) is/are true with regard to Delta?
I. Delta is an important parameter in the pricing and hedging of options

II. Delta is the number of units of the stock we should hold for each option shorted in order to
create a riskless portfolio
III. T he construction of a riskless portfolio is sometimes referred to as delta hedging
IV. T he delta of a call option is negative, whereas the delta of a put option is positive
A. I, II & III only
B. I, II & IV only
D. All of the above
T he statements I, II, and III are all accurate descriptions of Delta in the context of options pricing
and hedging. Delta is indeed a crucial parameter in the pricing and hedging of options (Statement I). It
represents the number of units of the stock one should hold for each option shorted to create a
riskless portfolio (Statement II). T his strategy of creating a riskless portfolio is often referred to as
delta hedging (Statement III). T herefore, these three statements collectively provide a
comprehensive understanding of the role and significance of Delta in financial markets.
Choi ce B i s i ncorrect. While statements I and II are true, statement IV is not. T he delta of a call
option is positive, not negative. T his means that the price of the call option increases as the price of
the underlying asset increases. Conversely, the delta of a put option is negative, meaning that its
price decreases as the price of the underlying asset increases.
Choi ce C i s i ncorrect. Statement I about Delta being an important parameter in pricing and
hedging options has been omitted which makes this choice incorrect. Also, statement IV in this
choice is false for reasons explained above.
Choi ce D i s i ncorrect. As explained above, statement IV about Delta's values for call and put
options are false which makes this choice incorrect.
369
Q.1213 Rose Associates is holding stocks of Xerox limited. T he current value of the stock is USD
100 and the current continuously compounded risk-free rate is 3 percent. T he stock pays a dividend
at a continuous dividend yield of 2 percent. T he annual standard deviation of the stock is 9 percent.
What is the risk-neutral probability of an up-move and down-move for a 1-year European call option
on the stock?
A. 0.68 and 0.32
B. 0.78 and 0.22
C. 1.09 and 0.91
D. 0.53 and 0.47
U = size of the up-move factor = eσ√t = e0. 09√1 = 1.094
1
D = size of the down-move factor = = 0.9139
U
T he risk-neutral probabilities of upward and downward movements:
πu = Risk-neutral probability of an up-move

(e(r−q)t − D)
=
(U − D)
(e(0. 03−0. 02)∗1– 0.9139)
= = 0.53
(1.094 − 0.9139)
πd = Risk-neutral probability of a down-move
= 1 − πu = 1 − 0.53
= 0.47
Where r is the risk-free rate and q is the dividend rate
370
Q.3400 Willy Smith, FRM, has a two-year European put with K = $41. T he current price of the
underlying is $40. Over the past year, the stock has exhibited a standard deviation of 20%. T he risk-
free rate of return is 5%. Compute the value of the put today using a two-step Binomial.
A. $2.71
B. $3
C. $0
D. $16.1
u = eσ√Δt = e0. 2×√1 = 1.22
d = e−σ√Δt = e−0. 2×√1 = 0.82
ert − d e0. 05×1 − 0.82

πu = = = 0.5782,
u−d 1.22 − 0.82
πd = 1 − 0.5782 = 0.4218
Let S represent the price of the stock and f represent the value of the put
Stock Price Option Payoff

Suu = $40 × 1.22 × 1.22 = $59.54 f uu = max ($41 − $59.54, 0) = $0
Su d = $40 × 1.22 × 0.82 = $40 f u d = max ($41 − $40, 0) = $1
Sdu = $40 × 0.82 × 1.22 = $40 f du = max ($41 − $40, 0) = $1
Sdd = $40 × 0.82 × 0.82 = $26.90 f dd = max ($41 − $26.90, 0) = $14.10
T he expected value of the put 2 years from now is given by:
0.5782 × 0.5782 × $0 + 0.5782 × 0.4218 × $1

+ 0.4218 × 0.5782 × $1 + 0.4218 × 0.4218 × $14.10
= $3
$3
Value of the put today = = $2.71
e0. 05×2
Q.3402 XY Z stock is a non-dividend-paying stock currently priced at $108. According to analysis, the
annual standard deviation of returns on XY Z stock is 8% and the risk-free rate on interest,
371
compounded continuously, is 5.5%. Using a two-period binomial model, compute the value of a 6-
month American call option on XY Z stock with a strike price of $110.
A. $2.43
B. $7.04
C. $2.98
D. $4.58
up move factor = u = eσ√t = e0. 08×√0. 25 = 1.041

down move factor = d = 1.1041 = 0.961
0. 055×0. 25 −0. 961

e
probability of an up move = πu = 1. 041−0. 961 = 0.66
probability of a down move=1 − πu = 0.34
Let S represent the price of the stock and f represent the value of the call
Stock Price Option Payoff

Su = $108 × 1.041 = $112.43 f u = max (112.43 − 110, 0) = 2.43
Sd = $108 × 0.961 = $103.79 f d = max (103.79 − 110, 0) = 0
Suu = $108 × 1.0412 = $117.04 f uu = max (117.04 − 110, 0) = 7.04
Su d = $108 × 1.041 × 0.961 = $108.04 f u d = max (108.04 − 110, 0) = 0
Sdu = $108 × 0.961 × 1.041 = $108.04 f du = max (108.04 − 110, 0) = 0
Sdd = $108 × 0.9612 = $99.74 f dd = max (99.74 − 110, 0) = 0
T he $110 call option is in the money when the stock price finishes at $117.04 at which time the call
has a value of $7.04. At the end of 3 months(3-month node), the expected payoff on the option in the
next 3 months, given an up move up to that point, is:
$7.04 × 0.66 + $0 × 0.34

= $4.58
e0. 055×0. 25
In this case, if the holder of the option chose to exercise early, they’d receive a maximum of
max (112.43 − 110, 0) = 2.43. Since $2.43 < $4.58, it would not be optimal to exercise the option
early. At the end of 3 months(3-month node), the expected payoff on the option in the next 3 months,
given a down move up to that point, is:
$0 × 0.66 + $0 × 34
= $0
e0. 055×0. 25
372
If the holder of the option chose to exercise early (3 months following a down move), they’d receive
a maximum of max ($103.79 − 110, 0) = $0. Again, it would not be optimal to exercise the option
early. T he value of the option today is:
$4.58 × 0.66 + $0 × 0.34

= $2.98
e0. 055×0. 25
Q.3403 You have been provided the following information for a call option on the stock of VeloMedia:
Current stock price = $100
Strike price = $100
T ime to maturity = 1 year
Exponential compounding interest rate = 10%
Annual standard deviation = 30%
What is the value of a European call option using a two-period binomial tree with two distinct
intervals of 6 months?
A. $15.38
B. $10.21
C. $0
D. $5.86
Binomial parameters:
1
u = eσ√△t = e0. 30√0. 5 = 1.2363, d= = 0.8089
u
Risk-neutral probability:
er×△t − d e0. 10×0. 5 − 0.8089

373
er×△t − d e0. 10×0. 5 − 0.8089
p= = = 0.5671, 1 − p = 0.4329
u−d 1.2363 − 0.8089
X = $100
Cuu = 52.85, Cdu = Cu d = Cdd = 0
p × Cuu + (1 − p) × Cu d 0.5671 × 52.85 + (1 − 0.4329) × 0

Cu = = = 28.51, Cd = 0
er×△t e0. 10×0. 5
0.5671 × 28.51 + (1 − 0.4329) × 0

C= = 15.38
e0. 10×0. 5
u = 1.2363
d = 0.8089
p = 0.5671
1– p = 0.4329
Suu = u ∗ Su
152.85
− Max(152.85 − 100, 0) = 52.85
Su = u ∗ S ╱
123.63
╲
S ╱ Su d = Sdu
− Max(100 − 100, 0) = 0
100
╲ 100
Sd = d ∗ S ╱
80.89
╲
Sdd = d ∗ Sd
65.43
− Max(65.43 − 100, 0) = 0
Q.3404 You have been provided the following information for a European call option on the stock of
VeloMedia:
Strike price = $100
374
What is the call option delta at the current date? Use a two-period binomial tree with two distinct
intervals of 6 months.
A. 0
B. 0.6669
C. 1
D. 0.5
Binomial parameters:
1
u = eσ√△t = e0. 30√0. 5 = 1.2363, d= = 0.8089
u
Risk-neutral probability:
er×△t − d e0. 10×0. 5 − 0.8089

p= = = 0.5671, 1 − p = 0.4329
u−d 1.2363 − 0.8089
X = $100
Cuu = 52.85, Cdu = Cu d = Cdd = 0
p × Cuu + (1 − p) × Cu d 0.5671 × 52.85 + (1 − 0.4329) × 0

Cu = = = 28.51, Cd = 0
er×△t e0. 10×0. 5
0.5671 × 28.51 + (1 − 0.4329) × 0

C= = 15.38
e0. 10×0. 5
u = 1.2363
d = 0.8089
p = 0.5671
1– p = 0.4329
375
Suu = u ∗ Su
152.85
− Max(152.85 − 100, 0) = 52.85
Su = u ∗ S ╱
123.63
╲
S ╱ Su d = Sdu
− Max(100 − 100,0) = 0
100
╲ 100
Sd = d ∗ S ╱
80.89
╲
Sdd = d ∗ Sd
65.43
− Max(65.43 − 100, 0) = 0
Now, the call option delta at the current date is:
△C C − Cd
△= = u
△S Su − Sd
28.51 − 0
= = 0.6669
123.63 − 80.89
376
Q.3405 You have been provided the following information for a put option on the stock of VeloMedia:
Strike price = $100
Compute the value of the European put option using a two-period binomial tree with two distinct
intervals of 6 months.
A. $15.38
B. $5.86
C. $0
D. $10
T he up-move and down-move factors are:
u = eσ√δt = e0. 30×√0. 5 ≈ 1.2363

1 1
d= = ≈ 0.8089
u 1.2363
T he probability of an up-move is thus,
erδt − d e0. 10×0. 5 − 0.8089

p= = ≈ 0.5671
u −d 1.2363 − 0.8089
puu = pdu = pu d = 0, pdd = max (X − Sdd , 0) = max (100 − 100 ∗ 0.8089 ∗ 0.8089, 0) = max (100 − 65.43
p2puu + 2p (1 − p) pu d + (1 − p)2 pdd

P = P V [p2 puu + 2p(1 − p) pu d + (1 − p)2pdd ] =
R2
0.56712 × 0 + 2 × 0.5671 × (1 − 0.5671) × 0 + (1 − 0.5671)2 × 34.87

P =
e0. 10×0. 5×2
(0.4329)2 × 34.57
P = = 5.86
e0. 10
377
Q.3406 A call option has a delta of 0.65. What is the put option delta?
A. -0.65
B. -0.35
C. 0.35
D. None
Call option delta = Put option delta + 1

Put option delta = 0.65 - 1 = -0.35
T he range of call option delta is always 0 to 1.
T he range of put option delta is always -1 to 0.
Q.4697 T he current price of a stock is $40. Its volatility is 10% per annum and the risk-free rate is
5% per annum with continuous compounding. Using a two-step binomial, what is the value of a six-
month European call option on the stock with a strike price of $40?
A. 1.54
B. 2.0
C. 1.58
D. 1.83
In this case,
u = eσ√t = e0. 10√0. 25 = 1.0513

1
d= = 0.9512
1.0513
ert − d e0. 05×0. 25 − 0.9512
p= = = 0.6132
u−d 1.0513 − 0.9512
1 − p = 1 − 0.6132 = 0.3868
378
Where:
u= size of the up-move factor
d= size of the down move factor
σ= volatility of the stock
p= probability of an up move
1 − p= probability of a down move
Using a two-step binomial,
Suu = 44.2093
Su d = 40
Sdu = 40
Sdd = 36.1913
Notice that the only time the option is in the money is when two upward price movements lead to an
ending price of $44.2093 and a call value of $4.2093. T he expected value of the option at the end of
the second period is the value of the option in each state multiplied by the probability of that state
occurring:
Expected call value in two periods = 0.6132 ∗ 0.6132 ∗ 4.2093 = $1.5828
T he value of the call option today is the expected value in six months discounted at the risk-free rate
of 5%:
$1.5828
Call = = $1.5437
e0. 05(0. 5)
Q.4698 A 6-month stock currently trading at $40 pays a continuous dividend of 2%, and the current
continuously compounded risk-free rate is 3%. Assuming an annual standard deviation of 3%, and a
strike price of 40, what is the value of the put today?
A. 0.32
B. 0.28
C. 0.51
D. 0.52
379
In this case,
u = eσ√t = e0. 03√0. 5 = 1.02144

1
d= = 0.97901
1.02144
(e(r−q)t ) − d
p=
u−d
Where:
u= size of the up-move factor
d= size of the down move factor
σ= volatility of the stock
p= probability of an up move
1 − p= probability of a down move
e(0. 03−0. 02)0. 5 − 0.97901

p= = 0.613
1.02144 − 0.97901
Probability of a down move = 1 − 0.613 = 0.387
Let S represent the stock price, and f represent the value of the put option.
Su = 40.84
Sd = 39.16
T he payoffs at the final node are:
f u = max (40 − 40.84,0) = 0

f d = max (40 − 39.16,0) = 0.84
T he value of the put today is given by:
380
f = (f u p + f d (1 − p)) e−rt
= (0 × 0.613 + 0.8396 × 0.387) e−0. 03×0. 5 = 0.32008
381
Reading 61: The Black-Scholes-Merton Model
Q.984 Antony Meech, a research analyst working at FinSearch Inc., is preparing a note on lognormal
distributions and normal distributions. He notes down the following points on lognormal distribution:
I. T he model of stock price behavior used by Black, Scholes, and Merton assumes that percentage
changes in the stock price in a very short period of time are normally distributed
II. A variable that has a lognormal distribution can take any value between zero and infinity
III. Like the normal distribution, the mean, median, and mode are all the same in the lognormal
distribution
Which of them are correct?
A. I & II only
B. II & III only
C. I, II & III only
D. I & III only
Not numerical
382
Q.985 Ricky Gervais, a retired veteran, is holding shares of T MT Limited which are currently
trading at USD 100. T he volatility of the share is 25 percent per year, and the expected return on the
stock is 10 percent for the same period. What is the expected stock price in one year?
A. USD 110.517
B. USD 128.403
C. USD 102.532
D. USD 101.432
T he expected stock price in one year is given by:
E(ST ) = S0eμT = 100e(. 10) = USD 110.517
Where
μ = expected rate of return.
383
Q.986 Mike Finova is holding shares of T MT Limited which are currently trading at USD 100. T he
volatility of the share is 25 percent per year, and the expected return on the stock is 10 percent for
the same period. What is the standard deviation of the stock in one year?
A. USD 787.68
B. USD 28.07
C. USD 14
D. USD 100
2T
T he variance in one year = V ar(ST ) = S02e(2μT ) (eσ − 1)
2 (2∗0. 1∗1) 0. 252
= 100 e (e − 1)
= 10000 ∗ 1.2214 ∗ 0.06449 = 787.68
where
μ = Expected rate of return and,
σ = volatility
Standard deviation of the stock price in 1 year = √787.68 = 28.07
384
Q.988 T he manager at American Derivatives Limited Hedge Fund proposes to use the Black-Scholes-
Merton differential equation to understand the pricing of derivatives dependent on non-dividend
paying stocks. Which of the following assumptions with respect to the Black-Scholes-Merton model
must be made to get accurate results?
I. T he short-selling of securities is not permitted
II. T here are no riskless arbitrage opportunities
III. T he risk-free rate of interest is known and constant
IV. Security trading is continuous
A. I, II & III only
B. I, III & IV only
D. All of the above
T he assumptions underlying the Black-Scholes-Merton differential equation are:

1. T he stock price follows the process with expected return and standard deviation constant
2. T he short selling of securities with full use of proceeds is permitted
3. T here are no transaction costs or taxes. All securities are perfectly divisible
4. T here are no dividends during the life of the derivative
5. T here are no riskless arbitrage opportunities
6. Security trading is continuous
7. T he risk-free rate of interest, r, is known and constant
385
Q.989 With regard to the Black-Scholes-Merton Model, which of the following statements are true?
I. T he Black-Scholes-Merton differential equation does not involve any variables that are affected by
the risk preferences of investors
II. T he current stock price, time to maturity, stock price volatility, and the risk-free rate of interest
are involved
III. T he Black-Scholes-Merton differential equation involves the expected return on the stock and,
therefore, is dependent of risk preferences
IV. T he Black-Scholes-Merton differential equation is an equation that must be satisfied by the price
of any derivative dependent on a non-dividend paying stock.
A. I, II & IV only
B. I, III & IV only
C. II & III only
D. All of the above
T he Black-Scholes-Merton Model is a mathematical model used for pricing derivative investment

instruments. T his model is based on certain assumptions and involves specific variables. Consider the
following statements:
I. T he Black-Scholes-Merton differential equation does not involve any variables that are influenced
by the risk preferences of investors.
II. T he current stock price, time to maturity, stock price volatility, and the risk-free rate of interest
are variables involved in the Black-Scholes-Merton Model.
III. T he Black-Scholes-Merton differential equation involves the expected return on the stock and,
therefore, is dependent on risk preferences.
IV. T he Black-Scholes-Merton differential equation is an equation that must be satisfied by the price
of any derivative dependent on a non-dividend paying stock.
Which of the following combinations of these statements are true according to the Black-Scholes-
Merton Model?
Q.990 Bret Lee, a research student, studying at McJohn University, analyzes academic material on
regular options, employee stock options, and warrants. After analyzing the data, he prepares a brief
to present to his professor. He jots down the following points in the brief:
Statement I: T he exercise of a regular call option has no effect on the number of the company’s
shares outstanding
Statement II: T he exercise of warrants leads to the company issuing more shares and selling them to
the holder of the warrant at the strike price
Statement III: Exercise of warrants tend to dilute the interest of the existing shareholders as the
strike price is usually less than the market price
Statement IV: Exercise of warrants and employee stock options does not have any effect on the
386
number of company’s shares outstanding
Which of these statements are accurate?
A. I, II & III only
B. I, III & IV only
D. All of the above
Statements I, II, and III are accurate.
T he exercise of a regular call option does not affect the number of a company's outstanding shares.
T his is because if the writer of the option does not own the company's shares, they must purchase
them in the market in the usual manner and then sell them to the option holder at the strike price.
T his transaction does not increase or decrease the total number of shares in circulation.
Statement II is also correct. When a warrant is exercised, the company issues more shares and sells
them to the warrant holder at the strike price. T his increases the total number of shares
outstanding. Warrants are a type of derivative that gives the holder the right to buy shares of the
underlying asset at a specific price within a certain time frame. When these rights are exercised,
new shares are created and sold to the warrant holder, increasing the total number of shares
outstanding.
Statement III is accurate as well. T he exercise of warrants can dilute the interest of existing
shareholders. T his is because the strike price of a warrant is typically lower than the market price.
When warrants are exercised, new shares are issued and sold to the warrant holder at this lower
price. T his increases the total number of shares outstanding, which can dilute the value of existing
shares. T his is because the earnings per share (EPS) decreases as the number of shares increases,
assuming the company's earnings remain constant. T his dilution effect can negatively impact the
value of existing shares.
Choi ce B i s i ncorrect. Statement IV is incorrect because the exercise of warrants and employee
387
stock options does impact the number of company’s outstanding shares. When these are exercised,
new shares are issued which increases the total number of outstanding shares.
Choi ce C i s i ncorrect. As explained above, Statement IV is not accurate as it incorrectly states
that the exercise of warrants and employee stock options does not impact the number of company’s
outstanding shares.
Choi ce D i s i ncorrect. T his choice includes all statements, but as previously mentioned,
Statement IV inaccurately describes the effect on a company's outstanding shares when warrants
and employee stock options are exercised.
Q.992 Steyn Associates used implied volatilities in pricing securities instead of historical volatilities.
With regard to volatilities, which of the following statement(s) is/are true?
I. Implied volatilities are the volatilities implied by option prices observed in the market
II. Historical volatilities are backward-looking, whereas implied volatilities are forward-looking
III. T raders often quote the implied volatility of an option rather than its price. T his is convenient
because the implied volatility tends to be less variable than the option price
IV. T he implied volatilities of actively traded options are used by traders to estimate appropriate
implied volatilities for other options
A. I, II & III only
B. I, III & IV only
D. All of the above
Implied volatilities are the volatilities implied by option prices observed in the market. Implied
volatilities are used to monitor the market’s opinion about the volatility of a particular stock.
Historical volatilities are backward-looking, whereas implied volatilities are forward-looking. T raders
often quote the implied volatility of an option rather than its price. T his is convenient because the
implied volatility tends to be less variable than the option price. T he implied volatilities of actively
traded options are used by traders to estimate appropriate implied volatilities for other options.
388
Q.993 Stephen Hawking, a trader working at Orange Securities, collects the following data of a 1-
year European put and call options on the stock Mango Apparel. T he current stock price is USD 120,
and the strike price of the option is USD 125. T he risk-free rate is 10 percent. If the prices of a
European call and European put are USD 10 and USD 15, respectively, then what is the implied
dividend yield of the stock Mango Apparel?
A. 0.11439
B. 0.045323
C. 0.10439
D. 0.055323
Put-call parity:
Call option − Put option = S0 e−qxT − Ke−rxT
Where
S0 = Initial stock price;
q = implied dividend yield;
r = risk-free rate; and
T = time
10 − 15 = 120e−qx1 − 125e−0. 10×1

e−q = 0.9009
ln(0.9009) = −q
Implied dividend yield (q) = 10.439%
389
Q.994 Chinese International Bank is analyzing the stock of Jatoka International. One-year European
call and put options are written on the stock of Jatoka International which is a non-dividend paying
stock. T he initial stock price is Yuan 100 and the risk-free rate is 5%. T he time to maturity is 1 year,
and the strike price is Yuan 125. Furthermore, N (d1) = 0.6925, N(d2 ) = 0.5435. What are the values
of European put and call options (approx.) using the Black-Scholes differential equation?
A. Call option value is USD 4.626 and Put option value is USD 23.52.
B. Call option value is USD 23.52 and put option value is USD 4.626.
C. Call option value is USD 2.626 and Put option value is USD 13.52.
D. Call option value is USD 13.52 and put option value is USD 2.626.
Call value = S0N (d1) − Xe−Rf ×T N (d2)
= [100 × 0.6925] − {125e(−0. 05) ∗ 0.5435}

= USD 4.626
Put value = [Xe−Rf∗T ∗ (1 − N (d2 ))] − [S0 ∗ (1 − N(d1 ))]
= [125e−0. 05 × (1 − 0.5435)] − [100 ∗ (1 − 0.6925)]
= USD 23.52
390
Q.995 Raheja Financials is holding the stock of Duckworth Limited which is trading at USD 50. A
European call option that expires in 3 months with a strike price of USD 51 is available for trading.
T he annualized standard deviation is 20 percent, and the risk-free rate of interest is 4 percent. What
is the value of the European call option using the Black-Scholes-Merton model expiring in 3 months if
N (d1) = 0.48085 and N (d2) = 0.44116?
A. USD 2.422
B. USD 2.224
C. USD 1.767
D. USD 1.259
Value of European call option as per the Black-Scholes-Merton Model:
Call value = S0 N(d1 ) − X e−Rf∗T N (d2 )
= [50 × 0.48085] − {51e(−0. 04∗0. 25) ∗ 0.44116}

= USD 1.767
391
Q.996 Michael Wong is holding the stock of Duckworth limited which is trading at USD 50. A
European put option that expires in 3 months with a strike price of USD 51 is available for trading.
T he annualized standard deviation is 20 percent, and the continuously compounded risk-free rate is 4
percent. What is the value of the European put option using the Black-Scholes-Merton model
expiring in 3 months if N (d1) = 0.48085 and N (d2) = 0.44116?
A. USD 1.77
B. USD 1.26
C. USD 2.19
D. USD 2.26
T he value of European put option as per the Black-Scholes-Merton Model is calculated as follows:
Put value = [Xe−Rf∗T ∗ (1 − N (d2 ))] − [S0 ∗ (1 − N(d1 ))]

−0. 04∗0. 25
= [51e ∗ (1 − 0.44116)] − [50 ∗ (1 − 0.48085)]
= USD 2.26
392
Q.3407 A stock price has an expected return of 10% and a volatility of 30%. T he current price is
$30. What is the probability that a European call option on the stock with an exercise price of $32
and a maturity date in six months will be exercised?
A. 0.5032
B. 0.247
C. 0.4309
D. 0.008
T he required probability is the probability of the stock price being above $32 in six months’ time
since a call option is only exercised if the stock price is higher than the strike price. Suppose that
the stock price in six months is ST . T he probability distribution of ln ST is
0.32
lnST ∼ N (ln30 + (0.10 − ) 0.5, 0.32 × 0.5) ∼ N (3.429, 0.045)
2
T he required probability is given by:
3.466 − 3.429
P (lnST > ln32) = 1 − P (lnST ≤ ln32) = 1 − N ( ) = 1 − N (0.174)
√0.045
Note that:
ln32 = 3.466
From the standard normal distribution tables, N (0.174) = 0.5691
T herefore, the required probability is 1 − 0.5691 = 0.4309
Q.3408 What is the price of a European call option on a non-dividend-paying stock when the stock
price is $68, the strike price is $65, the risk-free interest rate is 16% per annum, the volatility is
39% per annum, and the time to maturity is three months?
A. 5.35
B. 4.85
C. 8.31
393
D. 0.536
Recall that the price of European call option is given by:
c = S0N (d1) − Ke−rT N(d2 )
Where:
S0 2
ln ( ) + (r + σ2 ) T
K
d1 =
σ√T
S0 2
σ
ln( ) + (r − )T
K 2
d1 = = d1 − σ√T
σ√T
In this case,
S0 = 68
K = 65
r = 0.16
σ = 0.39 and,
T = 0.25
2
(ln 68 + (0.16 + 0. 39 ) 0.25) 0.1041
65 2
d1 = = = 0.5338
0.39√0.25 0.195
d2 = d1 − 0.39√0.25 = 0.3388
T he price of the European call is
c = 68 × N (0.5338) − 65e−0. 16×0. 25N (0.3388)

= 68 × 0.7032 − 65 × 0.9608 × 0.6326
= 8.31
Q.3409 Consider a European call option when the stock price is $20, the exercise price is $22, the
time to maturity is six months, the volatility is 20% per annum, and the risk-free interest rate is 15%
394
per annum. T wo equal dividends of $1 are expected during the life of the option, with ex-dividend
dates at the end of two months and five months. What is the value of the option?
A. $0.30
B. $0.40
C. $0.25
D. $0.26
Note that S0 is reduced to S by the present value of the dividends payable, but all other variables
remain the same
S = S0 − P V
Where
Δt1 Δt2 2 5
−(0. 15)
P V = D1 e−(r) m + D2e−(r) m = 1e 12 + 1e−(0. 15) 12 = 1.9147
S = $20 − $1.9147 = $18.09

K = 22,
T = 0.5,
σ = 0.2
ln SK + [R C
f
+ ( 12 × σ 2)] T
d1 =
σ√T
ln 18. 09
+ [0.15 + ( 12 × 0.22 )] 0.5
22
= = −0.7826
0.2√0.5
d2 = d1 − (σ√T ) = −0.7826 − 0.2√0.5 = −0.9241
From statistical tables,
N (d1) = N (−0.7826) = 1 − N (0.7826) = 1 − 0.7831 = 0.2169
And
395
N (d2) = N (−0.9241) = 1 − N (0.9241) = 1 − 0.8223 = 0.1777
c
C0 = [S × N (d1 )] − |K × e−Rf ×T × N (d2) |
= 18.09 × 0.2169 − 22e−0. 15×0. 5 × 0.1777
= 3.9237 − 3.6269 = 0.2968 ≈ 0.30
Q.3410 Consider a European option on a non-dividend paying stock with the following characteristics:
Exercise price = 50
Continuous compounding interest rate = 8%
Standard deviation = 34%
T ime to expiration = 2 years
Calculate the price of the call option and its delta using the Black-Scholes-Merton model.
A. Call = $12.97; Δ = 0.7167
B. Call = $5.57; Δ = 0.7167
C. Call = $5.57; Δ = -0.2832
D. Call = $12.97; Δ = -0.2832
T he price of a call option on a non-dividend-paying stock:
C = S × N (d1 ) − P V (X) × N (d2 )
2
ln [ P VS(X) ] σ√T ln [ SX ] + (r + σ
)T
2
d1 = + = and d2 = d1 − σ√T
σ√T 2 σ√T
2
ln ( 50 ) + (0.08 + 0.234 ) 2
50
d1 = = 0.5732
0.34√2
d2 = 0.5732 − 0.34√2 = 0.0923
From the standard normal table N (d1) = N (0.5732) = 0.7167 and N (d2 ) = N (0.0923) = 0.5367
396
Value of the call = S ∗ N (d1 ) − P V (X) ∗ N (d2)
= 50 ∗ 0.7167 − 50e−0. 08×2 × 0.5367
= 12.9677
Using put-call parity relation,
Value of the put = C + P V (X ) − S = 12.9677 + 50e−0. 08×2 − 50 = 5.5749
Delta of call = N (d1 ) = 0.7167
Delta of put = −N(−d1 ) = −N (−0.5732) = −(1 − 0.7167) = −2833
Where N is the normal distribution.
Thi ngs to Remember
T he delta of a call option is the amount by which the price of the option will change for a given
change in the price of the underlying asset. T he delta is always positive for calls, meaning that as the
underlying asset increases in price, the call will also increase in price. T he size of the delta will
depend on how much time is left until expiration and how far the underlying asset is from the strike
price. At-the-money and near-the-money options will have the largest deltas, while deep in-the-money
and deep out-of-the-money options will have smaller deltas. As expiration approaches, all options will
tend to have deltas closer to 1.0.
As you can see, the delta of the call option here is high because it is at the money.
Delta of a call option = N(d1), where N(x) denotes the cumulative standard normal distribution
function.
Delta of a put option = - N(-d1)
Finally, because the standard normal distribution is symmetric and centered at zero, the standard
normal cumulative distribution function has a very useful property:
N(–x) = 1 – N(x)
– N(–x) = N(x) – 1
397
– N(–d1) = N(d1) – 1
With these in mind, you don't need to calculate the delta of a put once you get the delta of the
corresponding call:
Using the last equation, put delta = call delta - 1 = 0.7167 - 1 = - 0.2833
Q.3411 Consider a European option on a non-dividend paying stock with the following characteristics:
Exercise price = 50
Continuous compounding interest rate = 8%
Standard deviation = 34%
T ime to expiration = 2 years
Calculate the price of a put option and its delta using the Black-Scholes-Merton model.
A. Put = $12.97; Δ = 0.7167
B. Put = $5.57; Δ = 0.7167
C. Put = $5.57; Δ = -0.2832
D. Put = $12.97; Δ = -0.2832
T he price of a put option on a non-dividend-paying stock can be calculated as:
P + S = C + P V (X)
P = S [N (d1 ) − 1] − P V(X ) [N (d2) − 1]
N (d) + N (−d) = 1
P = −S × N (−d1) + P V(X ) × N (−d2)

2
398
σ2
ln [ SX ] + (r + 2
)T
d1 = and d2 = d1 − σ√T
σ√T
T he price of a call option on a non-dividend-paying stock:
C = S × N (d1 ) − P V (X) × N (d2 )
σ2
ln [ P VS(X) ] σ√T ln [ SX ] + (r + )T
2
d1 = + = and d2 = d1 − σ√T
σ√T 2 σ√T
0. 342
ln ( 50
50
) + (0.08 + 2
) 2
d1 = = 0.5732
0.34√2
d2 = 0.5732 − 0.34√2 = 0.0923
From the standard normal table N (d1) = N (0.5732) = 0.7167 and N (d2 ) = N (0.0923) = 0.5367
Value of the call = S ∗ N (d1 ) − P V (X) ∗ N (d2)

= 50 ∗ 0.7167 − 50e−0. 08×2 × 0.5367
= 12.9677
Using put-call parity relation,
Value of the put = C + P V (X ) − S = 12.9677 + 50e−0. 08×2 − 50 = 5.5749
Delta of call = N (d1 ) = 0.7167
Delta of put = −N(−d1 ) = −N (−0.5732) = −(1 − 0.7167) = −2833
Where, N is the normal distribution.
399
Q.3412 Consider a company with N million shares outstanding, each worth So, that is contemplating
issuing M warrants. Each warrant would grant the holder the right to purchase one share with a
strike price of X in a year. Assuming the value of a corresponding 1-year European call option is
worth C, the cost of issuing the warrants would take which of the following forms?
C
A. N +M
MC
B. N +M
MNC
C. N +M
NC
D. N +M
It can be shown the cost of issuing each warrant is given by:
N
× Price of the Warrant
N +M
Where
N = Number of existing shares
M = Number of warrants issued
Note that a warrant is defined as options issued by a company on its own stock. So, in this case, the
cost of issuing M warrants is given by:
N MN C
M× ×C =
N +M N +M
Q.3414 What is the effect of dividends on option prices?
A. Call option prices increase; Put option prices increase
B. Call option prices increase; Put option prices decrease
C. Call option prices decrease; Put option prices increase
D. Call option prices decrease; Put option prices decrease
Dividends have a direct impact on the price of the underlying stock. When a company announces a
dividend, the stock price decreases by the present value of the dividend on the ex-dividend date. T his
400
is because the cash paid out as dividends is no longer part of the company's assets, reducing the
company's overall value. T his decrease in stock price has a corresponding effect on the prices of
call and put options. Call options, which give the holder the right to buy the stock at a predetermined
price, become less valuable when the stock price decreases. T his is because the holder of the call
option would prefer to buy the stock at the lower market price rather than at the higher strike price
of the option. T herefore, the price of the call option decreases. On the other hand, put options,
which give the holder the right to sell the stock at a predetermined price, become more valuable
when the stock price decreases. T his is because the holder of the put option can sell the stock at
the higher strike price of the option rather than at the lower market price. T herefore, the price of
the put option increases. Hence, when dividends are paid, call option prices decrease and put option
prices increase.
Choi ce A i s i ncorrect because it suggests that both call and put option prices increase when
dividends are paid. T his is not accurate. When dividends are paid, the stock price decreases, which
has a negative impact on call option prices and a positive impact on put option prices. Call options
become less valuable because the holder would prefer to buy the stock at the lower market price
rather than at the higher strike price of the option. Conversely, put options become more valuable
because the holder can sell the stock at the higher strike price of the option rather than at the lower
market price. T herefore, the price of the call option decreases and the price of the put option
increases when dividends are paid.
Choi ce B i s i ncorrect because it suggests that call option prices increase and put option prices
decrease when dividends are paid. T his is not accurate. When dividends are paid, the stock price
decreases, which has a negative impact on call option prices and a positive impact on put option
prices. Call options become less valuable because the holder would prefer to buy the stock at the
lower market price rather than at the higher strike price of the option. Conversely, put options
become more valuable because the holder can sell the stock at the higher strike price of the option
rather than at the lower market price. T herefore, the price of the call option decreases and the
price of the put option increases when dividends are paid.
Choi ce D i s i ncorrect because it suggests that both call and put option prices decrease when
dividends are paid. T his is not accurate. When dividends are paid, the stock price decreases, which
has a negative impact on call option
401
Q.4618 A stock has an initial price of $50, an expected annual return of 20%, and annual volatility of
25%. What is the 95% confidence interval for the stock price at the end of 3 years?
A. $22.83< ST <$301.27
B. $44.18< ST <$57.33
C. $31.28< ST <$57.08
D. $35.49< ST <$193.77
In this case, S0=50 , μ=0.20, σ=0.25, and T =3
T he logarithm of the stock follows a normal distribution with the following parameters:
σ2
lnST ∼ N (lnS0 + (μ − ) T , σ√T )
2
Where:
μ= the expected annual return of the stock.
σ= the annual volatility for the stock.
T = time
ST = T he stock price at time T.
σ2
lnST ∼ N (lnS0 + (μ − ) T , σ√T )
2
0.252
= N [ln50 + (0.20 − ) 3, 0.25 × √3]
2
lnST ∼ N (4.418, 0.4332 )
T he distribution has a mean of 4.418 and standard deviation of 0.433
To obtain the 95% confidence interval for stock price using the above data, we will proceed as
402
follows:
lnST ∼ N (4.418,0.4332 )
lnST = μ ± Zα × σ
(In this case,we have σ = 0.433)
and Za = 1.96
4.418 − 1.96 × 0.433 < lnST < 4.418 + 1.96 × 0.433
e3. 56932 < ST < e5. 26668
$35.49 < ST < $193.77
Q.4619 Suppose the current exchange rate for a currency is 1.25, and the exchange rate volatility is
15%. Calculate the value of a call option to buy 1000 units of the currency in 5 years at an exchange
rate of 2.50. T he domestic and foreign risk-free interest rates are 1% and 2%, respectively. Please
click here to view the standard normal table
A. 2.9
B. 3.8
C. 43.5
D. 1249.9
In this case S0=1.25, K=2.50,r=0.01, rf =0.02, s=0.15, and T =5
From BSM pricing formula,
C0 = S0 e−rfT × N (d1) − Ke−rT × N (d2 )
Where:
T = time to maturity
S0= current stock price
K = strike price
r= domestic risk-free rate
403
rf = foreign risk-free rate
s= volatility of the stock price
S0 σ2 1.25 0.152
ln( ) + [r − rf + ( )] T ln + [0.01 − 0.02 + ]5
K 2 2.50 2
d1 = = = −2.05
σ√T 0.15√5
d2 = d1 − σ√T = −2.05 − 0.15√5 = −2.39
From the standard normal tables,
N (d1 ) = N (−2.05) = 1 − 0.9798 = 0.0202

N (d2 ) = N (−2.39) = 1 − 0.9916 = 0.0084
T he value of the call is therefore given by:
C0 = S0 e−rfT × N (d1) − Ke−rT × N (d2 )

−0. 02×5
= 1.25e × 0.0202 − 2.50e−0. 01×5 × 0.0084 = 0.0029
T his is the value of the option to buy one unit of the currency. T he value of an option to buy 1000
units is:
0.0029 × 1000 = 2.9
Q.4620 T he futures price of an asset is USD 40, and the annual volatility of the futures price is 20%.
If the risk-free rate is 5%, what is the value of a put option to sell futures in 6 months for USD 45?
A. USD 2.75
B. USD 5.52
C. USD 2.68
D. USD 4.82
In this case,
404
F0=40, K=45, r=0.05, s=0.20, T =0.5
T he following formula gives the value of the put option:
P 0 = Ke−rT × N (−d2) − F0e−rT × N (−d1 )
Where:
P 0= value of the put option
K= strike price
s= volatility of the futures price
r= risk-free rate
T = time
Now define:
F0= current futures price
T hen we have:
2
F0 0. 202
ln ( ) +T ∗ δ
ln( 40 ) + 0.5 ∗
K 2 45 2
d1 = = = −0.76214
δ√T 0.20√0.5
T hus,
d2 = d1 − δ√T = −0.76214 − 0.20√0.5 = −0.90356
T he value of the put option is given by:
P 0 = Ke−rT × N (−d2) − F0e−rT × N (−d1 )

= 45e−0. 05×0. 5 × 0.8159 − 40e−0. 05×0. 5 × 0.7764 = 5.5197
405
Q.4621 T he current price of a stock is USD 50. If this price grows to USD 74.59 in two years, what
is the realized return on the stock per annum?
A. 0.2
B. 0.49
C. 0.34
D. 0.22
We can derive the formula for calculating the realized return on a stock from the formula for
calculating the expected price of a stock, i.e.,
E (ST ) = S0eμT
1 ST
μ = ln
T S0
Where:
μ= Realized return on a stock
T = time to maturity
S0= initial stock price
ST = stock price at time T
1 74.59
Realized return = ln = 0.20 = 20%
2 50
406
Q.4622 T he following are monthly stock prices in EUR: 21, 35, 40, and 28. From this data, what is
the estimated volatility of the log-returns per month?
A. 0.435
B. 0.189
C. 0.402
D. 0.355
Si Si
Month Stock price, Si X i = ln X 2i
Si-1 Si-1
0 21
1 35 1.6667 0.5108 0.2609
2 40 1.1429 0.1336 0.0178
3 28 0.7000 −0.3567 0.1272
We calculate volatility of returns per month using the variance formula below:
2
1 ⎧ 2
∑X i ⎫
variance = ⎨ ∑ X i − n( ) ⎬
n − 1⎩ n ⎭
In this case:
∑X i 0.2877
∑ X i =0.2877, ∑ X i2=0.4059 ,n=3, = = 0.0959
n 3
T herefore,
1
variance = {0.4059 − 3 × 0.09592 } = 0.1892
2
T he volatility per month is, therefore √0.1892 = 0.435 = 43.5%
407
Reading 62: Option Sensitivity Measures: The “Greeks”
Q.1186 Fintech Company Inc. is planning to purchase a call option on European Airlines. T he
continuous dividend yield is 2 percent and the time to maturity is 2 years. If the continuous risk-free
rate is 5 percent and N(d1) is 0.45, what is the Delta of the call option?
A. 0.432
B. -0.432
C. 0.864
D. -0.864
T he Delta of a call option with a continuous dividend yield is calculated using the formula below:
Delta = N(d1) e(-qT)
Where
Continuous dividend yield (q) = 2%
T ime to maturity = 2 years
Delta = 0.45 * e(-0.02 * 2) = 0.432
Q.1187 John Augustus, an equity analyst at Fintech Inc., is evaluating a portfolio of American Airlines
stock and options on the same stock. T he portfolio is currently Delta neutral but has a positive
Gamma. If Augustus would like to make the portfolio both Delta and Gamma neutral, then Johnson
will:
A. Sell stock of American Airlines and sell Put options on stock of American Airlines.
B. Buy stock of American Airlines and buy Put options on stock of American Airlines.
C. Buy stock of American Airlines and sell Put options on stock of American Airlines.
D. Sell stock of American Airlines and buy Put options on stock of American Airlines.
To achieve both Delta and Gamma neutrality in a portfolio, one must understand the fundamental
concepts of Delta and Gamma in options trading. Delta measures the rate of change of an option's
price with respect to changes in the price of the underlying asset, while Gamma measures the rate
408
of change in Delta with respect to changes in the underlying asset's price. In this scenario, the
portfolio is Delta neutral but has a positive Gamma, indicating that the portfolio's Delta will increase
if the underlying asset's price increases, and decrease if the underlying asset's price decreases. To
make the portfolio Gamma neutral, options on the stock of American Airlines need to be sold, as
selling options results in negative Gamma. However, selling put options on American Airlines will
make the portfolio Delta positive, as put options have a negative Delta and selling them results in
positive Delta. To counteract this and make the portfolio Delta neutral, the stock of American
Airlines needs to be sold. Selling the stock results in negative Delta, which will offset the positive
Delta from selling the put options. T herefore, to make the portfolio both Delta and Gamma neutral,
Augustus should sell stock of American Airlines and sell put options on the same stock, as stated in
choice A.
Choi ce B i s i ncorrect. Buying both the stock and put options on the same stock would increase
the portfolio's Delta, not neutralize it. Additionally, buying more put options would further increase
the portfolio's positive Gamma, which contradicts Augustus' intention to achieve Gamma neutrality.
Choi ce C i s i ncorrect. While buying the stock and selling put options could potentially neutralize
Delta, it would not achieve Gamma neutrality. Selling put options decreases Gamma; however, since
the portfolio already has a positive Gamma, this action alone will not be sufficient to neutralize it.
Choi ce D i s i ncorrect. Selling both American Airlines' stocks and buying Put options on these
stocks will decrease Delta but will increase Gamma due to long position in Put Options which
contradicts with Augustus' intention of achieving both Delta and Gamma neutrality.
409
Q.1188 T renor Johnson, a portfolio manager, working at Sterile Finances Limited, is analyzing the
delta of a portfolio. Which of the following statements is (are) true about the delta of a portfolio?
A. Call options have negative deltas while put options have positive Deltas.
B. Delta on options lie between -1 and +1.
C. T he delta of the underlying asset is always zero.
T he delta of an option is a measure of how much the price of an option is expected to change per $1
change in the price of the underlying asset. It is essentially a measure of the option's sensitivity to
changes in the price of the underlying asset. For call options, the delta ranges from 0 to 1. T his is
because as the price of the underlying asset increases, the price of the call option also increases.
Conversely, for put options, the delta ranges from -1 to 0. T his is because as the price of the
underlying asset increases, the price of the put option decreases. T herefore, the delta of an option,
whether it's a call or a put, will always lie between -1 and +1. T his is a fundamental concept in
options trading and portfolio management, and understanding it is crucial for making informed
investment decisions.
Choi ce A i s i ncorrect. T his statement is not accurate. In the context of options trading, call
options have positive deltas because they increase in value as the price of the underlying asset
increases. Conversely, put options have negative deltas because their value decreases as the price of
the underlying asset increases.
Choi ce C i s i ncorrect. T he delta of an underlying asset is not always zero. In fact, it's typically
one for a long position and negative one for a short position in an asset because a $1 increase in the
price of an underlying asset will result in approximately $1 change in the value of that position.
Choi ce D i s i ncorrect. As explained above, both statements A and C are inaccurate; therefore, this
choice which suggests all statements are correct cannot be true.
410
Q.1189 Which of the following statements is/are true regarding theta?
I. T heta is a measure of the change in the value of the options portfolio with the passage of
time
II. A positive theta implies that the portfolio will increase in value as time passes
III. T heta decreases as the expiration date approaches for at-the-money options
IV. T heta increases as an option which is either out of the money or in the money approaches
expiration
A. I & II
B. III & IV
C. I, III & IV
D. All the above
Thi ngs to Remember
T heta is one of the 'Greeks' in options trading and represents the rate of change of an option's price
with respect to time, also known as time decay. It is particularly important for options traders as it
helps them understand how the value of an option will change as time passes. Here are some key
points to remember about theta:
T heta is always negative for long options, meaning that the value of the option decreases as
time passes.
T heta is highest for at-the-money options and decreases for in-the-money and out-of-the-
money options.
T heta increases as the expiration date of an option approaches, reflecting the accelerating
rate of time decay.
Options sellers benefit from time decay as the value of the option they have sold decreases
over time, increasing their potential profit. T his is reflected in a positive theta.
411
Q.1191 Which of the following statements is true with regard to Gamma?
I. Gamma of a portfolio of options on an underlying asset is the rate of change of the portfolio's
Delta with respect to the price of the underlying asset
II. Gamma is the second partial derivative of the portfolio with respect to asset price
III. If Gamma is highly negative or highly positive, Delta is very sensitive to the price of the
underlying asset
IV. When Gamma is positive, theta tends to be negative
A. I & II only
B. I, II & III only
C. II & III only
D. All the above
Thi ngs to Remember
Gamma is a second-order Greek in options trading, meaning it measures how the delta of an option
changes as the price of the underlying asset changes. It's particularly important for options traders
who are managing large portfolios of options, as it helps them to understand how the price of an
option is likely to change in relation to the price of the underlying asset.
Gamma is highest for at-the-money options and lowest for options that are deep in or out of the
money. T his is because at-the-money options have the greatest uncertainty in terms of whether they
will end up in or out of the money at expiration.
Positive Gamma means that the delta of long calls will become more positive and move toward +1
when the underlying asset price rises, and less positive and move toward 0 when the underlying asset
price falls. Conversely, the delta of long puts will become more negative and move toward -1 when
the underlying asset price falls, and less negative and move toward 0 when the underlying asset price
rises.
T heta and Gamma have an inverse relationship. When options are at-the-money or near expiration,
their Gamma is usually quite high while their T heta is also high, meaning the price sensitivity to time
412
decay is high.
Q.1192 T he Vega of the stock of Amazon is 5. If the volatility of the underlying asset increases by 1
percent, what changes will take place in the price of the call option and put option if the maturity and
exercise prices of both options remain the same?
A. T he price of the call option increases by 0.05 and the price of the put option increases by
0.05.
B. T he price of the call option decreases by 0.05 and the price of the put option decreases
by 0.05.
C. T he price of the call option decreases by 0.05 and the price of the put option increases by
0.05.
D. T he price of the call option increases by 0.05 and the price of the put option decreases by
0.05.
T he vega of a portfolio of derivatives, V , is the rate of change of the value of the portfolio with
respect to the volatility of the underlying asset.
T he change in the price of call and put options is: Vega ∗ Volatility = 5 ∗ 0.01 = 0.05
413
Q.1193 Which of the following statement is NOT true with regard to Vega?
I. T he Vega of a derivative portfolio is the rate of change of the value of the portfolio with the
change in the volatility of the underlying assets
II. T he Vega of a long position is always negative
III. A position in the underlying asset has a Vega equal to zero
IV. At-the-money options have the greatest Vega
A. II and III only
B. III only
C. II only
D. I, II and IV only
T he statement 'T he Vega of a long position is always negative' is not true. In fact, the Vega of a long
position is always positive. T his is because Vega measures the sensitivity of an option's price to
changes in the volatility of the underlying asset. When you have a long position in an option, you
would benefit from an increase in volatility, hence a positive Vega. If volatility increases, the option's
price would also increase, leading to a profit for the holder of the long position. T herefore, the Vega
of a long position is not negative, but positive.
Choi ce A i s i ncorrect. T his choice suggests that both statements II and III are inaccurate.
However, statement III is accurate as a position in the underlying asset does indeed have a Vega equal
to zero because Vega measures the sensitivity of an option's price to changes in volatility of the
underlying asset, and since there is no option involved in a position in the underlying asset, its Vega is
zero.
Choi ce B i s i ncorrect. T his choice suggests that only statement III is inaccurate which isn't true
as explained above.
Choi ce D i s i ncorrect. T his choice implies that statements I, II and IV are all inaccurate.
However, statements I and IV are accurate descriptions of Vega's characteristics: T he vega of a
derivative portfolio does represent the rate of change of its value with respect to changes in
volatility (statement I), and at-the-money options do generally have greater Vegas than out-of-the-
money or in-the-money options (statement IV).
414
Q.1194 Consider a call option on a non-dividend paying stock where the stock price is $95, the risk-
free rate is 5%, the time to maturity is 40 weeks (= 0.7692 years) and N ′ = 0.398185. A 1% increase
in the volatility will increase the value of the option by approximately:
A. -33.176
B. -0.33176
C. 33.176
D. 0.33176
T he Vega of a call option = So √T N ′ (d1)

= $95 ∗ √0.7692 ∗ 0.398185
= 33.176
T hus, a 1% (0.01) increase in the volatility increases the value of the option by approximately
0.01 ∗ 33.176 = 0.33176
Note that:
Both call and put options have the same value of vega and this value is a positive number
415
Q.1195 Which of the following statement is true with regard to Rho?
A. T he Rho of a portfolio of options is the rate of change of the value of the portfolio with
respect to the interest rate.
B. T he Rho of a portfolio of derivatives is the rate of change of the value of the portfolio
with respect to the volatility of the underlying asset.
C. T he Rho of a portfolio of options on an underlying asset is the rate of change of the

portfolio's Delta.
D. T he Rho of a portfolio of options is the rate of change of the value of the portfolio with
respect to the passage of time with all else remaining the same.
Rho is a measure of the sensitivity of an option or options portfolio to changes in the interest rate. It
is part of the group of measures known as the Greeks, which are used to identify the different types
of risks that can affect the price of derivatives. Rho measures the expected change in an option's
price for a 1% change in interest rates. T his is particularly important for options traders because
changes in interest rates can have a significant impact on the price of options. For example, if
interest rates increase, the value of call options generally increases and the value of put options
generally decreases. T herefore, a positive Rho indicates that the price of the option will increase
with an increase in interest rates, while a negative Rho indicates that the price of the option will
decrease with an increase in interest rates.
Choi ce B i s i ncorrect. T he rate of change of the value of a portfolio with respect to the volatility
of the underlying asset is not Rho, but Vega. Vega measures sensitivity to volatility.
Choi ce C i s i ncorrect. T he rate of change of a portfolio's Delta is not described by Rho, but by
Gamma. Gamma measures the rate at which Delta changes for each unit change in the price of the
underlying asset.
Choi ce D i s i ncorrect. T he rate of change in an option's price given a one-unit (day) change in
time, all else remaining constant, is referred to as T heta and not Rho.
416
Q.1196 A stock is currently trading at $25. T he delta of the call option is 0.482. A fund manager buys
100,000 call options with a strike price of $26.50 on the stock. To maintain a delta neutral position,
the fund manager must:
A. Buy 4,820,000 shares
B. Sell 4,820,000 shares
C. Buy 1,000,000 shares
D. Sell 1,000,000 shares
As the fund manager buys 100,000 call options, the delta of the option position is:
δ of option position = 0.482 ∗ 100, 000 = +48, 200
To get a delta neutral position, the fund manager needs to sell 4, 820, 000(= 48, 200 × 100) shares
since 1 call option typically gives the holder the right to buy 100 shares at strike price.
417
Q.1197 A stock is currently trading at $25. T he delta of the call option is 0.482. A fund manager buys
100,000 call option contracts on the stock with a strike price of $29. What action is most likely to be
taken by the fund manager to maintain a delta neutral position?
A. Sell 4,820,000 shares.
B. Buy 4,820,000 shares.
C. Buy 48,200 call options.
D. Sell 48,200 shares.
T he fund manager should sell 4,820,000 shares to maintain a delta-neutral position. T his is because
the delta of the call option is 0.482, which means that for every $1 increase in the price of the
underlying stock, the price of the option will increase by $0.482. Since the fund manager has bought
100,000 options, the portfolio delta is 100,000 X 0.482 = 48,200. However, since each option
contract represents 100 shares, the fund manager should sell 4,820,000 shares (48,200 X 100) of the
underlying stock. T his way, any gain or loss on the option will be offset by a corresponding loss or
gain on the shares, thereby maintaining a delta-neutral position.
Choi ce B i s i ncorrect. Buying 4,820,000 shares would increase the delta of the position rather
than neutralizing it. T he fund manager needs to offset the positive delta of the call options by taking a
position with a negative delta. T herefore, buying shares which have a positive delta would not
achieve this.
Choi ce C i s i ncorrect. Buying additional call options would also increase the overall delta of the
position as call options have a positive delta. T his action would move the portfolio further away from
being delta neutral.
Choi ce D i s i ncorrect. Selling only 48,200 shares will not be sufficient to offset the positive delta
from 100,000 call option contracts and achieve a delta-neutral position. T he number of shares sold
must match with total deltas from all option contracts in order to maintain neutrality.
418
Q.1198 A portfolio manager buys 100 APR 45 call option selling for $3.58 that have a delta of 0.4 and
a gamma of 0.1. If the underlying trades downwards by $1, then the delta of the overall position will
now be:
A. 0.3
B. 30
C. 27
D. 0.27
Gamma reflects the change in delta in response to a one-point movement of the underlying stock
price.
Our gamma here is 0.1. For every one-point move in the price of the underlying, delta of the
corresponding option will change by 0.1. A one point (1 USD) increase in price will prompt a 0.1
increase in delta. Similarly, a one point decrease in price will prompt a 0.1 decrease in delta.
In our case, delta will decrease from 0.4 to 0.3.
But that's delta for just one call option. For 100 options, delta = 0.3 * 100 = 30.
Note that gamma is always a positive number regardless of whether you are buying calls or puts but
is effectively negative when you write options.
Note that:
100 APR 45 call option:
100 here represents the number of call options.
45 here means that an investor can exercise the right to buy the stock at 45 per share.
419
Q.1199 A portfolio of derivatives on a stock has a delta of 2400 and a gamma of –100. Also available
for trading is an option on the stock with a delta of 0.5 and a gamma of 0.04. To make the portfolio
gamma neutral, the portfolio manager should:
A. Buy 2,500 options.
B. Sell 2.500 options.
C. Buy 1,200 options.
D. Sell 1,200 options.
To create a gamma-neutral position (sometimes called gamma-neutral hedging), the manager must add
the appropriate number of options that equals the existing portfolio gamma position. In this case, the
existing gamma position is –100, and an available option exhibits a gamma of 0.04, which translates
into buying approximately 2,500 options (100 / 0.04).
Thi ngs to Remember
Gamma-neutral hedgi ng is the construction of options trading positions that are hedged such that
the total gamma value of the position is zero or near zero. T he goal is to take options combinations
that will make the overall gamma value as close to zero as possible. T his results in the delta value of
the positions remaining stagnant no matter how strongly the underlying stock moves.
Q.1200 A portfolio manager anticipates that the market volatility will increase substantially in the
coming days. He observes two call options which are currently being traded in the market:
I. A call option on stock A, currently trading at $20 with a strike price of $30
II. A call option on stock B, currently trading at $40 with a strike price of $42
T he portfolio manager wants to derive the maximum benefit from the anticipated market volatility.
T he preferred investment should be:
A. Go long on call options on Stock A.
B. Go long on call options on Stock B.
C. Go short on call options on Stock A.
420
D. Go short on call options on Stock B.
T he portfolio manager should go long on call options on Stock B. T his is because the volatility of call
options is highest when the stock price is close to the strike price. In this case, the stock price of
Stock B ($40) is very close to the strike price of the call option ($42). T herefore, if the market
volatility increases as the portfolio manager anticipates, the value of the call option on Stock B is
likely to increase significantly, providing the manager with a substantial profit. T his strategy is
known as a long call strategy, which involves buying call options with the expectation that the
underlying stock price will rise above the strike price before the option expires. T he potential
profit for a long call is unlimited as it is directly proportional to the increase in the underlying stock
price. T herefore, going long on call options on Stock B is the best strategy for the portfolio manager
given his anticipation of increased market volatility.
Choi ce A i s i ncorrect. Going long on call options on Stock A would not be the best choice because
the strike price is significantly higher than the current trading price. T his means that for this option
to be profitable, Stock A's price would need to increase substantially, which may not happen even
with increased market volatility.
Choi ce C i s i ncorrect. Going short on call options on Stock A could potentially lead to unlimited
losses if the stock's price increases significantly due to market volatility. T herefore, this strategy
does not maximize benefits from anticipated market volatility.
Choi ce D i s i ncorrect. Similarly, going short on call options on Stock B could also lead to unlimited
losses if the stock's price increases significantly due to market volatility. Despite the strike price
being close to its current trading value, it still presents a high risk in volatile markets.
421
Q.1201 Stock A is currently trading at $40. A three-month futures contract on Stock A is currently
trading at $40.60. Assume the risk-free rate to be 6%.
T he delta of the futures contract is:
A. 1.02
B. 1.2
C. 1.12
D. 1.22
Δfutures contract = erT
Where
r = Risk-free rate
T = T ime to expiry of the contract
3
(0. 06∗( ))
Δ3 months = e 12 = 1.02
Q.1203 A fund manager sells 200,000 call options on stock A, a non-dividend paying stock. T he delta
of the stock option is 0.45, and the risk-free rate is 6%.
A. T he position can be made delta neutral by selling 9,000,000 shares of the underlying asset.
B. T he position can be made delta neutral by going short 90,000 shares on the underlying
asset.
C. T he position can be made delta neutral by buying 9,000,000 shares of the underlying asset.
D. T he position can be made delta neutral by going short on call options.
T he position can be made delta neutral by buying 9,000,000 shares of the underlying asset. T he delta
of an option measures the rate of change of the option price with respect to changes in the
422
underlying asset's price. In this case, the delta of the call options is 0.45, which means that for every
$1 change in the price of the underlying asset, the price of the option changes by $0.45. Since the
fund manager has sold 200,000 call options, the total delta of the options position is -200,000 * 0.45 =
-90,000. To make the position delta neutral, the fund manager needs to offset this negative delta by
taking a position in the underlying asset with a positive delta of the same magnitude. Since each share
of the underlying asset has a delta of 1 (as the price of the asset changes by $1 for every $1 change
in its own price), the fund manager needs to buy 9,000,000 shares of the underlying asset to make
the position delta neutral. T his is because 9,000,000 shares * 1 = 9,000,000, which offsets the
negative delta of the options position.
Choi ce A i s i ncorrect. Selling 9,000,000 shares of the underlying asset would not make the
position delta neutral. T he delta of a stock is always 1, so selling this many shares would create a
large negative delta that would not offset the positive delta from the call options.
Choi ce B i s i ncorrect. Going short 90,000 shares on the underlying asset also wouldn't render the
position delta neutral. T his action will only create a negative delta of -90,000 which isn't enough to
offset the positive delta from selling call options (200,000 * 0.45 = +90,000).
Choi ce D i s i ncorrect. Going short on additional call options without adjusting for their own deltas
will not necessarily make your position delta neutral as it depends on their individual deltas and
quantities.
423
Q.3415 Which one of the following statements is true regarding option Greeks?
A. Gamma is greatest for in-the-money options with long maturities
B. Delta of deep-in-the-money put options tends toward +1
C. Vega is greatest for at-the-money options with long maturities
D. When buying at-the-money options, theta tends to be positive
Vega is a measure of an option's price sensitivity to changes in the volatility of the underlying asset.
It represents the amount that an option contract's price changes in reaction to a 1% change in the
volatility of the underlying asset. Vega is greatest for at-the-money options with long maturities
because these options have the highest sensitivity to changes in volatility. T his is because at-the-
money options have the greatest uncertainty regarding whether they will end up in-the-money at
expiration. T herefore, any change in the underlying asset's volatility significantly impacts the
option's price. Long maturity options also have higher vegas because the longer the time to
expiration, the more chance there is for the underlying asset's price to move, which increases the
option's price sensitivity to changes in volatility.
Choi ce A i s i ncorrect. Gamma is not greatest for in-the-money options with long maturities. In
fact, gamma is highest for at-the-money options and decreases as the option moves further into or
out of the money. Additionally, gamma decreases as maturity increases.
Choi ce B i s i ncorrect. T he delta of deep-in-the-money put options does not tend toward +1; it
tends towards -1 instead. T his means that if the underlying asset's price increases by $1, the price of
a deep-in-the-money put option would decrease by approximately $1.
Choi ce D i s i ncorrect. When buying at-the-money options, theta does not tend to be positive; it
tends to be negative instead because time decay works against buyers of at-the-money options.
424
Q.3417 A trader has a short option position that’s delta-neutral but has a gamma of -800. In the
market, there’s a tradeable option with a delta of 0.8 and a gamma of 2. To maintain the position
gamma-neutral and delta-neutral, the most appropriate strategy is to:
A. Sell 320 options and buy 400 shares of the underlying
B. Buy 400 options and sell 320 shares of the underlying
C. Buy 400 options and buy 320 shares of the underlying
D. Sell 320 options and buy 320 shares of the underlying
T he trader needs to buy 400 options and sell 320 shares of the underlying. T he current position of
the trader is gamma-negative, which means the trader needs to increase the gamma back to zero.
T his can be achieved by buying call options. T he number of options that need to be added to the
existing portfolio to create a gamma-neutral position is calculated by the formula: -
({Gamma}_{p}/{Gamma}_{T }), where {Gamma}_{p} is the gamma of the existing portfolio position
and {Gamma}_{T } is the gamma of a traded option that can be added. In this case, it is -(-800/2) which
equals 400. T herefore, the trader needs to buy 400 call options. However, buying 400 call options
increases the delta from zero to 320 (calculated as 400*0.8). To restore the delta back to zero, the
trader needs to sell 320 shares. Positions in shares always have zero gamma, hence this strategy will
ensure that the position remains both gamma-neutral and delta-neutral.
Choi ce A i s i ncorrect. Selling 320 options would increase the negative gamma of the position,
making it further from gamma-neutral. Buying 400 shares of the underlying would not affect the
gamma of the position as shares have a gamma of zero.
Choi ce C i s i ncorrect. Buying both options and shares would make the position delta-positive,
which contradicts with maintaining a delta-neutral position.
Choi ce D i s i ncorrect. Selling 320 options and buying 320 shares will not neutralize both delta and
gamma at once because selling more options will increase negative gamma while buying stocks has
no effect on it as stocks have zero gamma.
425

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FRM Part I Exam

Questions with Answers - Valuation and Risk Models

Last Updated: Sep 19, 2023

prohibited. Infringers will be prosecuted in their local jurisdictions. ”

47 - Measures of Financial Risk 3

which is exactly what choice D states.

T he VaR figure given is €20,000, not €2,000.

(100%-90%) that losses will exceed this amount.

C. II and III only.

D. All of the above.

T he statements I and II are correct descriptions of Value at Risk (VaR).

investment horizon of the institution or individual using VaR.

confidence level and a holding or horizon period.

A. I, III & IV only

C. II, III & IV only

D. All of the above

satisfy all these properties, making choice D the correct answer.

properties of a coherent risk measure, this combination omits Sub-additivity. Sub-additivity is a

Choi ce B i s i ncorrect. T his combination includes Monotonicity, Sub-additivity and T ranslational

should be directly proportional to the size of positions in the portfolio.

Choi ce C i s i ncorrect. Although it includes Sub-additivity, Homogeneity and T ranslational

A. I, III & IV only

C. II, III & IV only

D. All of the above

C. II and III only.

D. All of the above.

in economics and finance.

expected shortfall as a risk measure.

T his is a characteristic feature of VaR as a risk measure.

B. ρ(X + Y ) ≤ ρ(X) + ρ(Y )

C. ρ(hX) = hρ(X) for h > 0

D. ρ(x + n) ≤ ρ(X) − n for some n

incorrectly stating the principle of monotonicity. T he correct principle of monotonicity is: If a

opposite, which is not coherent with the principles of risk measures.

properties correctly. In fact, it seems to be an incorrectly stated version of translation invariance

X, then its measured risk should decrease by n.

Probabilty 1% 5% 10% 12% 15%

Given a discrete distribution, the ES is the equivalent of:

[(0.01 × 500) + (0.04 × 300)]

Note: T he sum of probabilities in the numerator must sum to (1 − α)

of dollars) is, therefore:

Probabilty 1% 5% 10% 12% 15%

Further Expl anati on

worst 100*(1-a)% of losses. For a discrete distribution, ES is derived as:

all the outcomes whose probability is less than or equal to 1 − a.

Name Loss (million dollar) Probability (%)

A. ES (95%) = $225 million; ES (99%) = $237.5 million

B. ES (95%) = $215 million; ES (99%) = $237.5 million

C. ES (95%) = $217.5 million; ES (99%) = $250 million

D. ES (95%) = $225 million; ES (99%) = $250 million

200 × 2.5% + 225 × 2% + 250 × 0.5%

225 × 0.5% + 250 × 0.5%

Confidence Level VaR

What is the expected shortfall at the 97.5% confidence level?

D. None of the above

each level of risk.

characteristics of the efficient frontier.

none of them are accurate does not hold true.

Choi ce A i s i ncorrect. T he statement is misleading as it suggests that the maximum loss in 1% of

minimum loss figure at a certain confidence level.