Questions and Answers of Risk Management Financial

Using the supporting documentation along with the case study information (Exhibits 20.9, 20.10, 20.11, and 20.12), provide a list of potential corporate risks that might have been identified by the
Explain three different ways that scenarios can be generated for stress testing.
What is reverse stress testing? How is it used?
Why might the regulatory environment lead to a financial institution underestimating the severity of the scenarios it considers?
What are traffic light options? What are their drawbacks?
Why is it important for senior management to be involved in stress testing?
What are the advantages and disadvantages of bank regulators choosing some of the scenarios that are considered for stress testing?
Explain the difference between subjective and objective probabilities.
What are the investment grade ratings used by S&P.
What is meant by a hazard rate?
Calculate the average hazard rate for a B‐rated company during the first year from the data in Table 17.1. Table 17.1 Average Cumulative Issuer-Weighted Default Rates (%), 1981-2020 Time Horizon
Calculate the average hazard rate for a BB‐rated companyduring the third year from the data in Table 17.1. Table 17.1 Average Cumulative Issuer-Weighted Default Rates (%), 1981-2020 Time Horizon
Explain the difference between the default probabilities calculated from historical default experience and those calculated from credit spreads.
The spread between the yield on a five‐year bond issued by a company and the yield on a similar risk‐free bond is 80 basis points. Assuming a recovery rate of 40%, estimate the implied average
Should researchers use default probabilities calculated from historical data or from credit spreads for (a) calculating credit value at risk and (b) adjusting the price of a derivative for default?
Verify that the numbers in the second column of Table 17.5 are consistent with the numbers in the second column of Table 17.4. Table 17.4 Cumulative Default Probabilities Compared with Credit
The value of a company's equity is $2 million and the volatility of its equity is 50%. The debt that will have to be repaid in one year is $5 million. The risk‐free interest rate is 4% per annum.
A five‐year credit default swap entered into on June 20, 2023, requires quarterly payments at the rate of 400 basis points per year. The principal is $100 million. A default occurs after four years
A company has issued one‐ and two‐year bonds providing 8% coupons, payable annually. The yields on the bonds (expressed with continuous compounding) are 6.0% and 6.6%, respectively. Risk‐free
A company offers to post its own equity as collateral. How would you respond?
“In the absence of collateral and other transactions between the parties, a long forward contract subject to credit risk is a combination of a short position in a no‐default put and a long
Can the existence of default triggers increase default risk? Explain your answer.
Explain the term “cure period.”
“Netting means that CVA cannot be calculated on a transaction‐by‐transaction basis.” Explain this statement.
Give two examples of when (a) wrong‐way risk and (b) right‐way risk can be expected to be observed.
What part of CVA risk is considered a component of market risk by regulators?
A CSA between a dealer and one of its counterparties states that collateral has to be posted by both sides with zero thresholds. If the cure period is assumed to be 10 days, under what circumstances
Explain the difference between Vasicek's model, the Credit Risk Plus model, and CreditMetrics as far as the following are concerned: (a) when a credit loss is recognized and (b) the way in which
Explain what is meant by the constant level of risk assumption.
Use the transition matrix in Table 19.1 to calculate a transition matrix for two years. What is the probability of a company rated AAA being AAA at the end of two years? What is the probability of it
Use the transition matrix in Table 19.1 and software on the author's website to calculate a transition matrix for six months. What is the probability of a company rated Aaa staying Aaa during the six
How can historical simulation be used to calculate a one‐ day 99% VaR for the credit risk of bonds in the trading book? What are the disadvantages?
A bank has 100 one‐year loans, each with a 1% probability of default. What is the probability of six or more defaults, assuming independence?
Repeat Problem 19.6 on the assumption that the probability of default applicable to all loans is uncertain. It is equally likely to be 0.5% or 1.5%. Problem 19.6A bank has 100 one‐year loans, each
What is the autocorrelation for the default rates in Table 9.6? What are the implications of this for a Credit Risk Plus model? Table 9.6 Year Default Rate Year Default Rate Year Default Rate 1981
Use the transition matrix in Table 19.1 and software on the author's website to calculate the transition matrix over 1.25 years. Table 19.1 Initial Rating AAA AA A B CCC/C D AAAAA 89.85 9.35 0.50
What risks are included by regulators in their definition of operational risks? What risks are not included?
Suppose that there is a 90% probability that operational risk losses of a certain type will not exceed $20 million. The power law parameter, α, is 0.8. What is the probability of losses exceeding
Discuss how moral hazard and adverse selection are handled in car insurance.
Give two ways Sarbanes–Oxley affects the CEOs of public companies.
When is a trading loss classified as a market risk and when is it classified as an operational risk?
Discuss whether there is(a) moral hazard (b) adverse selection in life insurance contracts.
What are external loss data? How are they obtained? How are they used in determining operational risk loss distributions for a bank?
What distributions are commonly used for loss frequency and loss severity?
Give two examples of key risk indicators that might be monitored by a central operational risk management group within a bank.
The worksheet used to produce Figure 20.1 is on the author's website. What is the mean and standard deviation of the loss distribution? Modify the inputs to the simulation to test the effect of
Consider two banks, each with a BIC of 200 million euros. Bank A has suffered 10 operational risk losses of 20 million euros in the past 10 years. Bank B has suffered one 200 million euro loss in the
Suppose that there is a 1% probability that operational risk losses of a certain type exceed $10 million. Use the power law to estimate the 99.97% worst‐case operational risk loss when the α
The worksheet used to produce Figure 20.1 is on the author's website. How does the loss distribution change when the loss severity has a beta distribution with upper bound of five, Figure 20.1 0 1 2
What was the transparency problem in the subprime crisis of 2007?
An asset is quoted bid 50, ask 55. What does this mean? What is the proportional bid–ask spread?
Suppose that an investor has shorted shares worth $5,000 of Company A and bought shares worth $3,000 of Company B. The proportional bid–ask spread for Company A is 0.01 and the proportional
Suppose that in Problem 21.3 the bid–ask spreads for the two companies are normally distributed. For Company A the bid–ask spread has a mean of 0.01 and a standard deviation of 0.01. For Company
Explain the difference between the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).
Why is it risky to rely on wholesale deposits for funding?
What was the nature of the funding risk problems of Ashanti Goldfields and Metallgesellschaft?
What is meant by (a) positive feedback trading and (b) negative feedback trading? Which is liable to lead to liquidity problems?
What is meant by liquidity‐adjusted VaR?
Explain how liquidity black holes occur. How can regulation lead to liquidity black holes?
Why is it beneficial to the liquidity of markets for traders to follow diverse trading strategies?
Explain what is meant by (a) marking to market and (b) marking to model.
What are the two categories of model risk identified in SR 11‐7?
Why is it important that a model be fully documented?
“The Black–Scholes–Merton model is nothing more than a sophisticated interpolation tool.” Discuss this viewpoint.
What is the key difference between the models of physics and the models of finance?
How is a financial institution likely to find that it is using a model different from its competitors for valuing a particular type of derivatives product?
Distinguish between within‐model and outside‐model hedging.
What is meant by P&L decomposition?
What is meant by “Level 1,” “Level 2,” and “Level 3” valuations in accounting?
What is meant by over‐fitting and over‐parameterization in model building?
Why does the burning of fossil fuels lead to temperature rises?
What is the goal that was agreed to in Paris in 2015?
What are SSPs?
What is the difference between a carbon tax and a cap and trade system?
What is the difference between physical risks and transition risks?
What are the risks of climate change to insurance companies?
What does ESG stand for?
What is greenwashing?
How can pension plans and mutual funds help solve the global warming problem?
Give examples of activities covered by ESG and sustainability that are not climate risk issues.
Explain the difference between top‐down and bottom‐up approaches to risk management. Why are both necessary in ERM?
What is the Bowman paradox?
What steps can a bank take to encourage employees to consider more than short‐term profits?
What distinguishes enterprise risk management from more traditional approaches to risk management?
A fund's risk appetite is such that it wants to be 90% certain that it will not lose more than 20% in any one year. Using the performance of the S&P 500 between 1970 and 2021 (see Table 24.1),
Calculate the interest rate paid by MdP six years after the beginning of the deal in Business Snapshot 24.2 if the Euribor rate proves to be 8% from year 2 onward. BUSINESS SNAPSHOT 24.2 The
A fund's risk appetite is such that it wants to be 97.5% certain it will not lose more than 25% in any one year. Using the performance of the S&P 500 between 1970 and 2021 (see Table 24.1),
“When a steel company goes bankrupt, other companies in the same industry benefit because they have one less competitor. But when a bank goes bankrupt other banks do not necessarily benefit.”
“The existence of deposit insurance makes it particularly important for there to be regulations on the amount of capital banks hold.” Explain this statement.
An interest rate swap involves the exchange of a fixed rate of interest for a floating rate of interest with both being applied to the same principal. The principals are not exchanged. What is the
In a currency swap, interest on a principal in one currency is exchanged for interest on a principal in another currency. The principals in the two currencies are exchanged at the end of the life of
A four-year interest rate swap currently has a negative value to a financial institution. Is the financial institution exposed to credit risk on the transaction? Explain your answer. How would the
All the derivatives transactions a bank has with a corporate client have a positive value to the bank. What is the value to the bank of netting provisions in its master agreement with the client?
Explain why the final stage in the Basel II calculations for credit risk (IRB), market risk, and operational risk is to multiply by 12.5.
Under Basel I, banks do not like lending to highly creditworthy companies and prefer to help them issue debt securities. Why is this? Do you think this changed as a result of Basel II?
Banks sometimes use what is referred to as regulatory arbitrage to reduce their capital. What do you think this means?
Equation (25.9) gives the formula for the capital required under Basel II. It involves four terms being multiplied together. Explain each of these terms. EAD X LGD X (WCDR - PD) X MA (25.9).
Explain the difference between the simple and the comprehensive approach for adjusting capital requirements for collateral.
Explain the difference between the standardized approach, the IRB approach, and the Advanced IRB approach for calculating credit risk capital under Basel II.
Explain the difference between the basic indicator approach, the standardized approach, and the advanced measurement approach for calculating operational risk capital under Basel II.

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