Free PRMIA 8010 Exam Practice Questions & Explanations
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Economic capital under the Earnings Volatility approach is calculated as:
The Earnings Volatility approach to calculating economic capital is a top down approach that considers economic capital as being the capital required to make for the worst case fall in earnings, and calculates EC as equal to the worst case decrease in earnings capitalized at the rate of return expected of the firm. The worst case decrease in earnings, or the earnings-at-risk can only be stated at a given confidence level, and is equal to the Expected Earnings less Earnings under the worst case scenario.
Which of the following statements are correct in relation to the financial system just prior to the current financial crisis:
1. The system was robust against small random shocks, but not against large scale disturbances to key hubs in the network
2. Financial innovation helped reduce the complexity of the financial network
3. Knightian uncertainty refers to risk that can be quantified and measured
4. Feedback effects under stress accentuated liquidity problems
Statement I is correct. The financial system proved to be stable against small shocks and disturbances, or shocks of a particular type (eg, the dotcom crash, the wars in the Persian Gulf); but rather fragile against other types of shocks, including disturbances to key market participants caused by a worsening of mortgage defaults. Statement II is incorrect. Financial innovation, in particular the slicing and dicing of 'risk' through securitization, significantly increased interrelationships, dependence on the same risk factors, and the complexity of the system as a whole. Statement III is incorrect. A distinction is sometimes made between risk that is knowable, measureable, and quantifiable through parameters; and uncertainty, where the parameters are not known at all. The latter is called 'Knightian uncertainty' after the name of the scholar who came up with the distinction between the two. Statement IV is correct. Feedback effects had the greatest impact on liquidity which was tended to be hoarded, and on asset prices that tumbled as market participants tried to sell assets to become more liquid. Thus, choice is a the correct answer.
A risk management function is best organized as:
The point that this question is trying to emphasize is the independence of the risk management function. The risk function should be segregated from the risk taking functions as to maintain independence and objectivity.
Choice 'd', Choice 'c' and Choice 'a' run contrary to this requirement of independence, and are therefore not correct. The risk function should report directly to senior levels, for example directly to the audit committee, and not be a part of the risk taking functions.
Which of the following can be used to reduce credit exposures to a counterparty:
1. Netting arrangements
2. Collateral requirements
3. Offsetting trades with other counterparties
4. Credit default swaps
Offsetting trades with other counterparties will not reduce credit exposure to a given counterparty. All other choices represent means of reducing credit risk. Therefore Choice 'c' is the correct answer.
For a given notional amount, which of the following carries the greatest counterparty exposure (assuming the same counterparty credit rating for each):
The exposure at default is the greatest for the certificate of deposit as the entire notional amount is exposed to the risk of default. The other choices represent derivatives for which the current replacement value, which would be far less than notional, would be the credit exposure.
Said another way - if the counterparty were to default, the entire money in the CD would be at risk, whereas for the derivative contracts it would only be the replacement value that would be at risk.