2016-FRR Exam Dumps - Financial Risk and Regulation (FRR) Series

Comprehensive and Detailed In-Depth Explanation:

The recovery rate is the percentage of the original exposure recovered, adjusted for the time value of money and recovery costs. Here, the exposure at default (EAD) is USD 20 million, the gross recovery after one year is USD 10 million, and the recovery cost is USD 1 million. The recovery discount rate is 10%, reflecting the time value of money over one year.

Step-by-step calculation:

Net Recovery Amount:Gross recovery - Recovery costs = USD 10 million - USD 1 million = USD 9 million.

Present Value of Recovery:Since the recovery occurs after one year, discount the net recovery at 10%:PV = USD 9 million / (1 + 0.10) = USD 9 million / 1.1 ≈ USD 8.1818 million.

Recovery Rate:Divide the present value of the recovery by the original exposure:Recovery Rate = (USD 8.1818 million / USD 20 million) × 100 ≈ 40.91%, which rounds to 41%.

This aligns with Basel II/III definitions of Loss Given Default (LGD = 1 - Recovery Rate) and the discounting approach for recovery cash flows in credit risk models.

The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt (T-bills). A decrease in the TED spread suggests that the perceived credit risk in the banking sector has decreased. This is because the lower spread indicates that banks are more confident in lending to each other, reflecting lower default risk on interbank loans. This typically happens in response to improved economic conditions or increased confidence in the banking system's stability.

Option A:Use of benchmarked data reflects similar data collection standards.

Incorrect. Benchmarking ensures that data is collected using similar standards, enhancing comparability and reliability.

Option B:External events are usually not of interest to senior management.

Incorrect. External events provide valuable insights and lessons that are often of significant interest to senior management.

Option C:If the external data is gathered from news sources, it may only reflect events that are interesting to the press.

Verified and correct. Data sourced from news can be biased towards more sensational events, potentially missing out on less newsworthy but equally important incidents.

Option D:They provide a source of data on what operational loss events will occur.

Incorrect. External databases provide historical data that can inform risk assessments but do not predict future events directly.

Kurtosis measures the "tailedness" of the return distribution. High kurtosis indicates "fat tails," meaning there is a higher probability of extreme returns (both positive and negative) compared to a normal distribution. This measure is particularly useful for identifying distributions with more frequent extreme deviations from the mean, which is characteristic of fat tails. Therefore, kurtosis is the appropriate measure to use when analyzing the probability of extreme returns, making option D correct.

Market risk typically involves risks that affect the entire market or market segment. These include:

Unexpected changes in the term structure of interest rates:

This affects the prices of bonds and other interest-rate-sensitive securities.

The JPY depreciating against the USD:

This is an example of foreign exchange risk, which is a type of market risk.

Changes in the oil price due to the discovery of new oil fields:

This affects commodities markets and can have broader economic implications.

Increased default rate on commercial mortgages due to higher interest rates:

This is more of a credit risk than market risk. It specifically relates to the creditworthiness of borrowers rather than the overall market movements.

Thus, the increased default rate on commercial mortgages due to higher interest rates is not a typical source of market risk.

References

Source: How Finance Works​​

Counterparty credit risk assessment differs from traditional credit risk assessment primarily in the features of exposures being netted, the possibility of negative correlation between exposure at default and the probability of default, and the two-way nature of credit exposure. Collateral arrangements in counterparty credit risk management are typically dynamic, not static, as they can change based on market conditions and the credit quality of the counterparty. Therefore, the feature that does not differ is that collateral arrangements are typically static in nature.

Model Definition:Historical frequency models are used to assign an obligor to a class based on risk characteristics at the time of loan origination and estimate default probability based on the past default rates of that class.

Application:These models use historical data to determine the probability of default by analyzing past defaults within the same risk class, providing a statistical basis for risk assessment.

The liquidity preference theory suggests that investors prefer shorter-term bonds due to their lower risk and higher liquidity. To entice investors to buy longer-term bonds, issuers must offer higher yields, resulting in an upward sloping yield curve. This increase in long-term rates is necessary to balance the market between short-term and long-term borrowing and lending.