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Under the KMV Moody's approach to calculating expecting default frequencies (EDF), firms' default on obligations is likely when:
An observed fact that the KMV approach relies upon is that firms do not default when their liabilities exceed assets, but when asset values are somewhere between short term liabilities and the total liabilities. In fact, the 'default point' in the KMV methodology is defined as the short term debt plus half of the long term debt. The difference between expected value of the assets in one year and this 'default point', when expressed in terms of standard deviation of the asset values, is called the 'distance-to-default'.
Therefore Choice 'd' is the correct answer. The other choices are incorrect.
Which of the following statements is true:
Total expected losses which are average and anticipated are equal to the sum of expected losses in the underlying exposures. Total unexpected losses, which are the excess of worst case losses at a certain confidence level over the expected losses, benefit from the diversification effect and are lower than the sum of unexpected losses of the underlying exposures. Therefore Choice 'c' is the correct answer. The other choices are incorrect.
The sum of the stand alone economic capital of all the business units of a bank is:
Economic capital is sub-additive, ie, because of the correlation being less than perfect between the risks of the different business units, the total economic capital for the firm will be less than the sum of the EC for the individual business units. Therefore Choice 'b' is the correct answer.
In practice, correlations are difficult to estimate reliably, and banks often use estimates and corroborate their capital calculations with reference to a number of data points.
Which of the following decisions need to be made as part of laying down a system for calculating VaR:
1. How returns are calculated, eg absoluted returns, log returns or relative/percentage returns
2. Whether VaR is calculated based on historical simulation, Monte Carlo, or is computed parametrically
3. Whether binary/digital options are included in the portfolio positions
4. How volatility is estimated
While conceptually VaR is a fairly straightforward concept, a number of decisions need to be made to select between the different choices available for the exact mechanism to be used for the calculations.
There is more than one way to calculate returns. Absolute returns may be relevant for risk factors where the size of the movement is unrelated to its current value. For other risk factors, the returns might scale with the size of the existing value of the risk factor, eg equity prices. The right return definition needs to be adopted for each risk factor, therefore 'I' is a correct choice.
The risk analyst has a Choice 'b'etween parametric VaR, Monte Carlo, and historical simulation based VaR. 'II' therefore is one of the decisions that needs to be made (though historical simulation is the choice most often made).
The decision as to what to include in a portfolio is not a decision that is affected by choices made for VaR calculations. 'III' is therefore not a correct answer.
There are multiple ways to calculate volatility - including decisions on how long back in time to go for the data, and whether volatility clustering needs to be accounted for using EWMA or GARCH. Therefore 'IV' is a correct answer.
Changes in which of the following do not affect the expected default frequencies (EDF) under the KMV Moody's approach to credit risk?
EDFs are derived from the distance to default. The distance to default is the number of standard deviations that expected asset values are away from the default point, which itself is defined as short term debt plus half of the long term debt. Therefore debt levels affect the EDF. Similarly, asset values are estimated using equity prices. Therefore market capitalization affects EDF calculations. Asset volatilities are the standard deviation that form a place in the denominator in the distance to default calculations. Therefore asset volatility affects EDF too. The risk free rate is not directly factored in any of these calculations (except of course, one could argue that the level of interest rates may impact equity values or the discounted values of future cash flows, but that is a second order effect). Therefore Choice 'b' is the correct answer.
