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risk management financial

Financial Risk Manager Handbook 6th Edition Philippe Jorion - Solutions

Capital is used to protect the bank from which of the following risks?a. Risks with an extreme financial impactb. High-frequency, low-loss eventsc. Low-frequency risks with significant financial impactd. High-frequency uncorrelated events
Suppose you are given the following information about the operational risk losses at your bank. What is the estimate of the VAR at the 95% confidence level, including expected loss (EL)?Frequency Distribution Probability Number 0.5 0 0.3 1 0.2 2 Severity Distribution Probability Loss 0.6 USD 1,000
Randy Bartell has collected operational loss data to calibrate frequency and severity distributions. Generally, he regards all data points as a sample from an underlying distribution and therefore gives each data point the same weight or probability in the statistical analysis. However, external
The risk of the occurrence of a significant difference between the markto-model value of a complex instrument and the price at which the same instrument is revealed to have traded in the market is referred to as:a. Liquidity riskb. Dynamic riskc. Model riskd. Mark-to-market risk
All the following are operational risk loss events, except:a. An individual shows up at a branch presenting a check written by a customer for an amount substantially exceeding the customer’s low checking account balance. When the bank calls the customer to ask him for the funds, the phone is
Which of these outcomes is not associated with an operational risk process?a. The sale of call options is booked as a purchase.b. A monthly volatility is inputted in a model that requires a daily volatility.c. A loss is incurred on an option portfolio because ex post volatility exceeded expected
Which of the following credit risk models uses the option-theoretic approach for modeling correlation between the credit-risky assets?a. CreditRisk+b. CreditMetricsc. KMV for public firmsd. Both CreditMetrics and KMV for public firms Which of the following statements correctly applies to the KMV
You are given the following information about a firm. The market value of assets at time 0 is 1,000; at time 1 is 1,200. Short-term debt is 500; long-term debt is 300. The annualized asset volatility is 10%. According to the KMV model, what are the default point and the distance to default at time
A firm’s assets are currently valued at $500 million and its current liabilities are $300 million. The standard deviation of asset values is $80 million. The firm has no other debt. What will be the approximate distance to default using the KMV calculation?a. 2 standard deviationsb. 2.5 standard
When determining the standard deviation of value due to credit quality changes for a single exposure, the CreditMetrics model uses three primary factors. Which of the following is not one of the factors used in this model?a. Credit ratingsb. Seniorityc. Equity pricesd. Credit spreads
A bank computes the distribution of its loan portfolio marked-to-market value one year from now using the CreditMetrics approach of computing values for rating transition outcomes using a rating agency transition matrix, current forward curves, and correlations among rating transition outcomes
A risk analyst is trying to estimate the credit VAR for a portfolio of two risky bonds. The credit VAR is defined as the maximum unexpected loss at a confidence level of 99.9% over a one-month horizon. Assume that each bond is valued at $500,000 one month forward, and the one-year cumulative
A risk analyst is trying to estimate the credit VAR for a risky bond. The credit VAR is defined as the maximum unexpected loss at a confidence level of 99.9% over a one-month horizon. Assume that the bond is valued at$1,000,000 one month forward, and the one-year cumulative default probability is
Mr. Rosenqvist, asset manager, holds a portfolio of SEK 200 million, which consists of BBB-rated bonds. Assume that the one-year probability of default is 4%, the recovery rate is 60%, and defaults are uncorrelated over years.What is the two-year cumulative expected credit loss on Mr.
Following is a set of identical transactions. Assuming all counterparties have the same credit rating, which transaction should preferably be executed?a. Buying gas from a trading firmb. Buying gas from a gas producerc. Buying gas from a distributord. Indifferent among a., b., and c.
Credit provisions should be taken to cover all of the following excepta. Nonperforming loansb. The expected loss of a loan portfolioc. An amount equal to the VAR of the credit portfoliod. Excess credit profits earned during below-average-loss years
Consider the following homogeneous reference portfolio in a synthetic CDO:number of reference entities, 100; CDS spread, s = 150bp; recovery rate f = 50%. Assume that defaults are independent. On a single name the annual default probability is constant over five years and obeys the relation:s = (1
A bank is considering buying (i.e., selling protection on) an AAA-rated super-senior tranche [10%−11%] of a synthetic collateralized debt obligation (CDO) referencing an investment-grade portfolio. The pricing of the tranche assumes a fixed recovery of 40% for all names. All else being equal,
A standard synthetic CDO references a portfolio of 10 corporate names.Assume the following. The total reference notional is X, and the term is Y years. The reference notional per individual reference credit name is X/10.The default correlations between the individual credit names are all equal to
If the assets in the pool are worth USD 450 million, what amount of losses will cause the investor to begin to lose money if he invested in the senior tranche?a. USD 200 millionb. USD 190 millionc. USD 100 milliond. USD 90 million
A fixed-income investor is considering investing in an asset-backed security(ABS) that has the following structure.Senior tranche USD 250 million Junior tranche USD 100 million Subordinated tranche A USD 60 million Subordinated tranche B USD 30 million Total USD 440 million
A three-year credit-linked note (CLN) with underlying company Z has a LIBOR + 60bp semiannual coupon. The face value of the CLN is USD 100. LIBOR is 5% for all maturities. The current three-year CDS spread for company Z is 90bp. The fair value of the CLN is closest toa. USD 100.00b. USD 111.05c.
An investor has sold default protection on the most senior tranche of a CDO.If the default correlation decreases unexpectedly, assuming everything else is unchanged, the investor’s position willa. Gain value since the probability of exercising the protection falls.b. Lose value, since the
A collateralized bond obligation (CBO) consists of several tranches of notes from a repackaging of corporate bonds, ranging from equity to super-senior.Which of the following is generally true of these structures?a. The total yield of all the CBO tranches is slightly less than the underlying
Helman Bank has made a loan of USD 300 million at 6.5% per annum.Helman enters into a total return swap under which it will pay the interest on the loan plus the change in the marked-to-market value of the loan, and in exchange Helman will receive LIBOR + 50 basis points. Settlement payments are
Sylvia, a portfolio manager, established a Yankee bond portfolio. However, she wants to hedge the credit and interest rate risk of her portfolio. Which of the following derivatives will best fit Sylvia’s need?a. A total return swapb. A credit default swapc. A credit spread optiond. A currency swap
You enter into a credit default swap with bank B that settles based on the performance of company C. Assuming that bank B and company C have the same initial credit rating and everything else remains the same, what is the impact on the value of your credit default swap if bank B buys company C?a.
Bank A has exposure to USD 100 million of debt issued by company R.Bank A enters into a credit default swap transaction with bank B to hedge its debt exposure to company R. Bank B would fully compensate bank A if company R defaults in exchange for a premium. Assume that the defaults of bank A, bank
When an institution has sold exposure to another institution (i.e., purchased protection) in a CDS, it has exchanged the risk of default on the underlying asset for which of the following?a. Default risk of the counterpartyb. Default risk of a credit exposure identified by the counterpartyc. Joint
Since the farthest maturity of its exposure to C is three years, CSFB buys a USD 200 million three-year protection on C from UBS. In order to make its purchase of this protection cheaper, based on its views on companies A and B, CSFB decides to sell USD 300 million five-year protection on company A
The table shows the bid-ask quotes by UBS for CDS spreads for companies A, B, and C. CSFB has excessive credit exposure to company C and wants to reduce it through the CDS market.1 Year 3 Years 5 Years A 15/25 21/32 27/36 B 43/60 72/101 112/152 C 71/84 93/113 141/170
Bank A makes a USD 10 million five-year loan and wants to offset the credit exposure to the obligor. A five-year credit default swap (CDS) with the loan as the reference asset trades on the market at a swap premium of 50 basis points paid quarterly. In order to hedge its credit exposure, bank Aa.
A six-year CDS on a AA-rated issuer is offered at 150bp with semiannual payments while the yield on a six-year annual coupon bond of this issuer is 8%. There is no counterparty risk on the CDS. The annualized LIBOR rate paid every six months is 4.6% for all maturities. Which strategy would exploit
If an investor holds a five-year IBM bond, it will give a return very close to the return of the following position:a. A five-year IBM credit default swap on which the investor pays fixed and receives a payment in the event of defaultb. A five-year IBM credit default swap on which the investor
Suppose BSM, a large derivative market maker, has six contracts with a counterparty, all transacted in New York (i.e., the same legal jurisdiction).The current market values (PV) for these contracts are: 125, 75, 25, −10,−65, and −140. Suppose BSM does not currently have a legally enforceable
Consider the following information. You have purchased 10,000 barrels of oil for delivery in one year at a price of $25/barrel. The rate of change of the price of oil is assumed to be normally distributed with zero mean and annual volatility of 30%. Margin is to be paid within two days if the
Bank A, which is AAA rated, trades a 10-year interest rate swap (semiannual payments) with Bank B, rated A−. Because of Bank B’s poor credit rating, Bank A is concerned about its 10-year exposure. Which of the following measures would help mitigate Bank A’s credit exposure to Bank B?I.
What are the benefits of novation?a. Both parties are allowed to walk away from the contract in the event of default.b. In a bilateral contract, it is specified that on default, the nondefaulting party nets gains and losses with the defaulting counterparty to a single payment for all covered
Which of the following statements correctly describes the impact of signing a netting agreement with a counterparty?a. It will increase or have no effect on the total credit exposure.b. It will decrease or have no effect on the total credit exposure.c. It will increase exposure if exposure is net
If we assume that the value at risk (VAR) for the portfolio of trades with a given counterparty can be viewed as a measure of potential credit exposure, which of the following could not be used to decrease this credit exposure?a. A netting agreementb. Collateralc. A credit derivative that pays out
BNP Paribas has just entered into a plain-vanilla interest-rate swap as a pay-fixed counterparty. Credit Agricole is the receive-fixed counterparty in the same swap. The forward spot curve is upward-sloping. If LIBOR starts trending down and the forward spot curve flattens, the credit risk from the
Which of the following 10-year swaps has the highest potential credit exposure?a. A cross-currency swap after two yearsb. A cross-currency swap after nine yearsc. An interest rate swap after two yearsd. An interest rate swap after nine years
Which one of the following deals would have the greatest credit exposure for a $1,000,000 deal size (assume the counterparty in each deal is an AAA-rated bank and has no settlement risk)?a. Pay fixed in an Australian dollar (AUD) interest rate swap for one year.b. Sell USD against AUD in a one-year
Assume that you have entered into a fixed-for-floating interest rate swap that starts today and ends in six years. Assume that the duration of your position is proportional to the time to maturity. Also assume that all changes in the yield curve are parallel shifts, and that the volatility of
Assume that the DV01 of an interest rate swap is proportional to its time to maturity (which at the initiation is equal to T). Assume that interest rate curve moves are parallel, stochastic with constant volatility, normally distributed, and independent. At what time will the maximum potential
Assume that a bank enters into a USD 100 million, four-year annual-pay interest rate swap, where the bank receives 6% fixed against 12-month LIBOR. Which of the following numbers best approximates the current exposure at the end of year 1 if the swap rate declines 125 basis points over the year?a.
In determining the amount of credit risk in a derivatives transaction, which of the following factors are used?I. Notional principal amount of the underlying transaction II. Current exposure III. Potential exposure IV. Peak exposure—the replacement cost in a worst-case scenarioa. I and IIb. I,
If a counterparty defaults before maturity, which of the following situations will cause a credit loss?a. You are short euros in a one-year euro/USD forward foreign exchange(FX) contract, and the euro has appreciated.b. You are short euros in a one-year euro/USD forward FX contract, and the euro
Your company has reached its credit limit to Ford but Ford is insisting that your firm provide some increased protection in the event a major project Ford is undertaking results in some unforeseen liability. Ignoring settlement risk and assuming option premiums are paid immediately at the time of
Which of the following will have the greatest potential credit exposure?a. Long 3,000 ounces of gold for delivery in one yearb. Long 3,000 ounces of gold for delivery in two yearsc. Short 3,000 ounces of gold for delivery in two yearsd. Selling an at-the-money call option on 10,000 ounces of gold
Capital Bank is concerned about its counterparty credit exposure to City Bank. Which of the following trades by Capital Bank would increase its credit exposure to City Bank?I. Buying a put option from City Bank II. Selling a call option to City Bank III. Selling a forward contract to City Bank IV.
A credit loss on market-driven instruments such as swaps and forwards arises if:a. Market rates move in your favor.b. Market rates move against you.c. Market rates move against you and the counterparty defaults.d. Market rates move in your favor and the counterparty defaults.
The Merton model is used to predict default. It builds on several very strong assumptions and its applicability is hampered by practical difficulties. Which of the following statements does not correctly identify limiting assumptions or practical difficulties of using the model?a. The model relies
You have a large position of bonds of firm XYZ. You hedge these bonds with equity using Merton’s debt valuation model. The value of the debt falls unexpectedly, but the value of equity does not fall, so you make a loss.Consider the following statements:I. Interest rates increased.II. Volatility
Using the Merton model, the value of the debt increases if all other parameters are fixed and I. The value of the firm decreases.II. The riskless interest rate decreases.III. Time to maturity increases.IV. The volatility of the firm value decreases.a. I and II onlyb. I and IV onlyc. II and III
The KMV model produces a measure called expected default frequency.Which of the following statements about this variable is correct?a. It decreases when the leverage of the firm falls.b. It increases when the stock price of the firm has been rising.c. It is the risk-neutral probability of default
Given the distance to default, the estimated default probability isa. 2.74%b. 12.78%c. 12.79%d. 30.56%
The capital structure of HighGear Corporation consists of two parts: one fiveyear zero-coupon bond with a face value of $100 million and the rest is equity.The current market value of the firm’s assets is $130 million and the expected rate of change of the firm’s value is 25%. The firm’s
Among the following variables, which one is the main driver of the probability of default in the KMV model?a. Stock pricesb. Bond pricesc. Bond yieldd. Loan prices
To what sort of option on the counterparty’s assets can the current exposure of a credit-risky position better be compared?a. A short callb. A short putc. A short knock-in calld. A binary option
The recovery rate for each in the event of default is 50%. For simplicity, assume that each bond will default only at the end of a coupon period. The market-implied risk-neutral probability of default for XYZ Corp. isa. Greater in the first six-month period than in the secondb. Equal between the
Suppose XYZ Corp. has two bonds paying semiannually according to the following table:Remaining Coupon T-Bill Rate Maturity (sa 30/360) Price (Bank Discount)Six months 8.0% 99 5.5%One year 9.0% 100 6.0%
Which of the following is true?a. Changes in bond spreads tend to lead changes in credit ratings.b. Changes in bond spreads tend to lag changes in credit ratings.c. Changes in bond spreads tend to occur at the exact same time as changes in credit ratings.d. There is absolutely no perceived general
A risk analyst seeks to find out the credit-linked yield spread on a BB-rated one-year coupon bond issued by a multinational petroleum company. If the prevailing annual risk-free rate is 3%, the default rate for BB-rated bonds is 7%, and the loss given default is 60%, then the yield to maturity of
The spread on a one-year BBB-rated bond relative to the risk-free Treasury of similar maturity is 2%. It is estimated that the contribution to this spread by all noncredit factors (e.g., liquidity risk, taxes) is 0.8%. Assuming the loss given default rate for the underlying credit is 60%, what is,
The risk-free rate is 5% per year and a corporate bond yields 6% per year.Assuming a recovery rate of 75% on the corporate bond, what is the approximate market-implied one-year probability of default of the corporate bond?a. 1.33%b. 4.00%c. 8.00%d. 1.60%
Rating agencies typically assign two ratings to debt-issuing countries. The first is the local currency debt rating and the second is the foreign currency debt rating. Historically, defaults have been more frequent on foreigncurrency-denominated debt than on local-currency-denominated debt. What is
In the context of evaluating sovereign risk, which of the following statements is incorrect?a. Bankruptcy law does not typically protect investors from sovereign risk.b. Debt repudiation is a postponement of all current and future foreign debt obligations of a borrower.c. Debt rescheduling occurs
The recovery rate on credit instruments is defined as 1 minus the loss rate.The loss rate can be significantly influenced by the volatility of the value of a firm’s assets before default. All other things being equal, in the event of a default, which type of company would we expect to have the
Moody’s estimates the average recovery rate for senior unsecured debt to be nearest toa. 20%b. 40%c. 60%d. 80%
As a result of the credit crunch, a small retail bank wants to better predict and model the likelihood that its larger commercial loans might default.It is developing an internal ratings-based approach to assess its commercial customers. Given this one-year transition matrix, what is the
A two-year zero-coupon bond issued by ABC Co. is currently rated A. The market expects that one year from now the probability that the rating of ABC remains at A, is downgraded to BBB, or is upgraded to AA are, respectively, 80%, 15%, and 5%. Suppose that the risk-free rate is flat at 1% and that
Fitch Ratings provides a table indicating that the number of A-rated issuers migrating to AAA is 2, to AA is 5, staying at A is 40, migrating to BBB is 2, and going into default is 3. Based on this information, what is the probability that an issue with a rating of A at the beginning of the year
A rating transition table includes sufficient information to find all but which of the following items?a. The likelihood that an AA-rated firm will fall to a BB rating over five yearsb. The price of a bond that has been downgraded to BB from BBBc. The probability of default on a B-rated bondd. The
What is the difference between the marginal default probability and the cumulative default probability?a. Marginal default probability is the probability that a borrower will default in any given year, whereas the cumulative default probability is over a specified multiyear period.b. Marginal
The marginal default probabilities for an A-rated issue are, respectively, for years 1, 2, and 3: 0.300%, 0.450%, and 0.550%. Assume that defaults, if they take place, happen only at the end of the year. Calculate the cumulative default rate at the end of each of the next three years.a. 0.300%,
What is the survival rate at the end of three years if the annual default probabilities are 8%, 12%, and 15% in the first, second, and third years, respectively?a. 68.8%b. 39.1%c. 99.9%d. 65.0%
If the default probability for an A-rated company over a three-year period is 0.3%, the most likely probability of default for this company over a six-year period is:a. 0.30%b. Between 0.30% and 0.60%c. 0.60%d. Greater than 0.60%
Company ABC was incorporated on January 1, 2004. It has an expected annual default rate of 10%. Assuming a constant quarterly default rate, what is the probability that company ABC will not have defaulted by April 1, 2004?a. 2.40%b. 2.50%c. 97.40%d. 97.50%
If Moody’s and S&P are equally good at rating bonds, the average default rate on BB bonds by S&P will be lower than the average default rate on bonds rated by Moody’s asa. Baa3b. Ba1c. Bad. Ba3
You are considering an investment in one of three different bonds. Your investment guidelines require that any bond you invest in carry an investmentgrade rating from at least two recognized bond rating agencies. Which, if any, of the bonds listed would meet your investment guidelines?a. Bond A
There are 10 bonds in a credit default swap basket. The probability of default for each of the bonds is 5%. The probability of any one bond defaulting is completely independent of what happens to the other bonds in the basket.What is the probability that exactly one bond defaults?a. 5%b. 50%c.
A portfolio of bonds consists of five bonds whose default correlation is zero. The one-year probabilities of default of the bonds are: 1%, 2%, 5%, 10%, and 15%. What is the one-year probability of no default within the portfolio?a. 71%b. 67%c. 85%d. 99%
Consider an A-rated bond and a BBB-rated bond. Assume that the one-year probabilities of default for the A- and BBB-rated bonds are 2% and 4%, respectively, and that the joint probability of default of the two bonds is 0.15%. What is the default correlation between the two bonds?a. 0.07%b. 2.6%c.
Suppose Bank Z lends EUR 1 million to X and EUR 5 million to Y. Over the next year, the PD for X is 0.2 and for Y is 0.3. The PD of joint default is 0.1.The loss given default is 40% for X and 60% for Y. What is the expected loss of default in one year for the bank?a. EUR 0.72 millionb. EUR 0.98
Continuing with the previous question, what is the best estimate of the unexpected credit loss (away from the ECL), or credit VAR, for this portfolio?a. USD 570,000b. USD 400,000c. USD 360,000d. USD 370,000
A portfolio consists of two bonds. The credit VAR is defined as the maximum loss due to defaults at a confidence level of 98% over a one-year horizon.The probability of joint default of the two bonds is 1.27%, and the default correlation is 30%. The bond value, default probability, and recovery
An investor holds a portfolio of $100 million. This portfolio consists of A-rated bonds ($40 million) and BBB-rated bonds ($60 million). Assume that the one-year probabilities of default for A-rated and BBB-rated bonds are 3% and 5%, respectively, and that they are independent. If the recovery
Define unexpected loss (UL) as the standard deviation of losses and expected loss (EL) as the average loss. Further define LGD as loss given default, and EDF as the expected default frequency. Which of the following statements hold(s) true?I. EL increases linearly with increasing EDF.II. EL is
A bank has booked a loan with total commitment of $50,000 of which 80%is currently outstanding. The default probability of the loan is assumed to be 2% for the next year and loss given default (LGD) is estimated at 50%. The standard deviation of LGD is 40%. Drawdown on default (i.e., the fraction
You have granted an unsecured loan to a company. This loan will be paid off by a single payment of $50 million. The company has a 3% chance of defaulting over the life of the transaction and your calculations indicate that if it defaults you would recover 70% of your loan from the bankruptcy
Which one of the following statements about multilateral netting systems is not accurate?a. Systemic risks can actually increase because they concentrate risks on the central counterparty, the failure of which exposes all participants to risk.b. The concentration of risks on the central
Which one of the following statements about multilateral netting systems is not accurate?a. Systemic risks can actually increase because they concentrate risks on the central counterparty, the failure of which exposes all participants to risk.b. The concentration of risks on the central
George Smith is an analyst in the risk management department and he is reviewing a pool of mortgages. Prepayment risk introduces complexity to the valuation of mortgages. Which of the following factors are generally considered to affect prepayment risk for a mortgage?I. Changes to interest rates
Which of following statements about mortgage-backed securities isincorrect?a. An MBS price is more sensitive to yield curve twists than are zero-coupon bonds.b. When the yield is higher than the coupon rate of an MBS, the MBS behaves similarly to corporate bonds as interest rates change.c. As yield
As the chief risk officer (CRO) of a firm specializing in MBSs, you have been asked to explain how interest-only (IO) strips and principal-only (PO) strips would react if interest rates change. Which of the following is true?a. When interest rates fall, both PO and IO strips will increase in
Which of the following mortgage-backed securities has a negative duration?a. Interest-only (IO) stripsb. Inverse floatersc. Mortgage pass-throughsd. Principal-only (PO) strips
Which of the following statements most accurately reflects characteristics of a reverse floater (with no options attached)?a. A portfolio of reverse floaters carries a marginally higher duration risk than a portfolio of similar-maturity normal floaters.b. A holder of a reverse floater can
With LIBOR at 4%, a manager wants to increase the duration of his portfolio.Which of the following securities should he acquire to increase the duration of his portfolio the most?a. A 10-year reverse floater that pays 8% − LIBOR, payable annuallyb. A 10-year reverse floater that pays 12% − 2 ×
Suppose that the coupon and the modified duration of a 10-year bond priced to par are 6.0% and 7.5, respectively. What is the approximate modified duration of a 10-year inverse floater priced to par with a coupon of 18% −2 × LIBOR?a. 7.5b. 15.0c. 22.5d. 0.0

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