8010 Exam Dumps and Practice Questions

Under the contingent claims approach, credit risk is evaluated as the value of the put on the firm's assets with a strike price equal to the face value of the debt and maturity equal to the maturity of the obligation. The Black Scholes model can then be used to value the put, and therefore an increase in volatility and the time to expiry (ie maturity) will increase the value of the debt. An increase in the risk free rate will actually reduce the value of the put, therefore statements I and III are correct and Choice 'b' is the correct answer.

Economic capital in respect of credit risk is intended to absorb unexpected losses. Unexpected losses are the losses above and beyond expected losses and up to the level of confidence that economic capital is being calculated for. The capital required to cover unexpected losses in this case is E - U, and therefore Choice 'a' is the correct answer.

This question does raise an important point - are expected losses a part of economic capital, or are they not? Different text books say different things, and sometimes they say both the things. I have tried to take an approach that uses what I read in the PRMIA handbook.

This writeup - http://www.riskprep.com/all-tutorials/37-exam-3/111-credit-var-an-intuitive-understanding - may help clarify things further.

According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves.

Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt.

Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority.

Choice 'c' is the correct answer. The Markov property is the assumption that there is no ratings momentum, and that transition probabilities are dependent only upon where the rating currently is and where it is going to. Where it has come from, or what the past changes in ratings have been, have no effect on the transition probabilities. ('Herstatt risk' refers to settlement risk, and is irrelevant.)

Top down approaches rely upon available data such as total capital, income volatility, peer group information etc and attempt to imply the capital attributable to operational risk. They do not consider firm specific scenarios or causal factors. Bottom up approaches on the other hand attempt to determine operational risk capital based upon an identification and quantification of firm specific risks. Bottom up approaches help determine a traditional loss distribution from which capital requirements can be determined at a given level of confidence.

Therefore Choice 'd' is the correct answer.