Bionic Turtle FRM Practice Questions

P2.T7. Operational & Integrated Risk Management

Interactive Quiz
By David Harper, CFA FRM CIPM
www.bionicturtle.com
P1.T7. Operational & Integrated Risk Management
P2.T7.700. OPERATIONAL RISK DEFINITION ................................................................................ 3
P2.T7.701. OPERATIONAL RISK GOVERNANCE ............................................................................ 6
P2.T7.702. RISK APPETITE FRAMEWORK (RAF), ENTERPRISE RISK MANAGEMENT (ERM) & THREE
LINES OF DEFENSE ................................................................................................................... 9
P2.T7.703. OPERATIONAL DATA GOVERNANCE PRACTICES .......................................................14
P2.T7.704. LOSS DISTRIBUTION APPROACH (LDA), EXTERNAL LOSS DATA, & BASEL'S
STANDARDIZED MEASUREMENT .................................................................................................18
P1.T7.705. EXTREME VALUE THEORY (EVT) .............................................................................23
P2.T7.706. ECONOMIC CAPITAL ...............................................................................................26
P2.T7.707. LEVERAGE, LIQUIDITY RISK, AND LIQUIDITY-ADJUSTED VALUE AT RISK (LVAR) ...........30

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P1.T7. Operational & Integrated Risk Management
P2.T7.700. Operational risk definition
Concept: These on-line quiz questions are not specifically linked to learning objectives,
but are instead based on recent sample questions. The difficulty level is a notch, or two
notches, easier than bionicturtle.com's typical question such that the intended difficulty
level is nearer to an actual exam question. As these represent "easier than our usual"
practice questions, they are well-suited to online simulation.

700.1. Zoomplanet is a large company in the retail sector and Peter is drafting the first version
of the company's Operational Risk Register. The Operational Risk Register (aka, risk log) is a
repository of each operational risk identified within the company and will be used in the
operational risk management process. Peter starts by analyzing a list of Zoomplanet's historical
loss events in order to identify possible OPERATIONAL risk loss event categories. Each of the
following is an operational risk loss event EXCEPT which is NOT an operational risk but instead
PROBABLY belongs in a different category?

a) Climate change induced flash floods in the Asian region where Zoomplanet's suppliers
are located which disrupted Zoomplanet's supply chain
b) Amazon announces its entry into the space with a new product that will compete directly
with Zoomplanet's flagship product line, which spooks investors
c) Zoomplanet executives are sued for discrimination by an employee group and, due to
leadership problems and lack of training programs, the lawsuit has merit
d) Zoomplanet's third-party vendor experienced a data breach, due to insufficient security
measures, such that some of Zoomplanet's own customers' information was leaked to
the public

700.2. Which of the following is MOST LIKELY to be considered a loss event classified under
operational risk?

a) Oil markets unexpectedly pivot and the price of oil adversely impacts an airline's
quarterly reported profit
b) Sales drop at a fast casual retail chain because an illness outbreak at a rival (i.e.,
competitor's) chain damaged the sector's reputation
c) Acme Bank paid the USD currency it sold in the forward contract but did not receive the
AUD currency that it bought from the counterparty
d) A company's bitcoin wallet software was installed on its own servers, but a cyber attack
crashed the software and private (bitcoin) keys were lost

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700.3. Wayne Financial Enterprises is an international bank that trades publicly. Each of the
following is an operational risk at Wayne EXCEPT which is probably NOT classified as an
operational risk?

a) The new CEO re-engineers the executive organizational structure as part of a five-year
strategic plan, but morale plummets and executives depart, resulting a prolonged
revenue slump
b) Regulators discover that account managers at retail branches, pressured by sales
incentive plans, created over one million checking and saving accounts that customers
never authorized
c) The bank's VaR model is re-calibrated, due to inappropriate pressure from line
managers, which justifies riskier derivative positions; the riskier positions consequently
lead to an unexpected quarterly loss
d) Regulators implicate one of Wayne's major customers in a money laundering scheme in
which large cash sums earned by a criminal enterprise have been diverted into Wayne's
accounts for the purpose of making them appear to be legitimate funds

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Answers:

700.1. B. False: Amazon announces its entry into the space with a new product that will
compete directly with Zoomplanet's flagship product line, which spooks investors. This is
the least likely to be classified as an operational risk because traditionally--albeit this is both
evolving and case specific--competitive disruption was considered a BUSINESS RISK which
included high-level BUSINESS DECISIONS (i.e., strategic risk, organization including
organizational chart) and the BUSINESS ENVIRONMENT (i.e., macroeconomic, competition,
technology).

In regard to (A), (C) and (D), each is TRUE as an operational risk:

 In regard to (A), climate change is an EXTERNAL EVENT (e.g., weather) that may
cause Damage to Physical Assets
 In regard to (C), a discrimination suit is a PEOPLE risk that falls into Employment
Practice and Workplace Safety
 In regard to (D), third-party vendor risk involves an operational PROCESS that falls
under Execution, Delivery and Process Management

700.2. D. TRUE: A company's bitcoin wallet software was installed on its own servers, but
a cyber attack crashed the software and private (bitcoin) keys were lost. In terms of Level
I Event-type categories, this would fall under Business Disruption and Systems Failures
(BDSF).

In regard to (A), (B) and (C), these are unlikely to be classified as operational risk loss events
 In regard to (A), commodity (e.g., oil) price movements and market shifts are MARKET
risks
 In regard to (B), this is maybe debatable because it manifests as reputation risk (which
increasingly some do classify as operational risk), but the key here is that a
COMPETITOR's operational failure is beyond a company's own control and ability to
mitigate, so this is better classified as a BUSINESS ENVIRONMENT risk.
 In regard to (C), counterparty delivery is a settlement risk, which is a counterparty
CREDIT risk (cross-currency settlement is also called Herstatt risk)

700.3. A. TRUE. The new CEO re-engineers the executive organizational structure but it
fails and contributes to lost revenue. Introducing the new CEO is a board-level business
decision and, generally, so are organizational restructurings.
 In regard to (B), this is CONDUCT RISK, among others and is "inspired" by the Wells
Fargo debacle.
 In regard to (C), this is MODEL RISK (an sub-type of operational risk, often) and is
"inspired" by J.P. Morgan
 In regard to (D), anti-money laundering (AML) is a hot topic and important operational
risk for banks; e.g., http://www.finra.org/industry/aml

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definition.10651/

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P2.T7.701. Operational risk governance
Concept: These on-line quiz questions are not specifically linked to learning objectives,
but are instead based on recent sample questions. The difficulty level is a notch, or two
notches, easier than bionicturtle.com's typical question such that the intended difficulty
level is nearer to an actual exam question. As these represent "easier than our usual"
practice questions, they are well-suited to online simulation.

701.1. Whitestreet Bank is merging with another bank and the newly merged international
financial services firm is developing its executive organizational chart. There is an important
question about the location of operational risk. Put another way, "who will own" operational risk;
or, to which executive or committee will the operational risk report?

Each of the above is plausible but which is the LEAST LIKELY?

a) Operational risk reports to the Chief Risk Officer (CRO)

b) Operational risk reports to Internal Audit (IA)
c) Operational risk reports to Compliance who reports to the COO/CFO
d) Operational risk reports directly to the COO or CFO

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701.2. Peter is developing an operational risk taxonomy (i.e., classification of operational risk
categories) for his firm's operational risk system. His manager says to Peter, "The most
important criteria for your classification framework is that it identifies operational risk losses by
their CAUSE(S) rather than their effect or some other event-type categorization, because we
want to use this to proactively MANAGE operational risk and, in order to manage risk, we need
to act on root causes." In this case, which of the following classifications does the BEST job of
classifying by CAUSES of operational risk rather than effects or some other factor?

a) People; Processes; Systems and technology; and External events

b) Fraud; Employment practices; Workplace safety; Clients; and Products
c) Damage to physical assets; Business disruption, Systems failures; Execution; and
Delivery
d) High-frequency/high-impact (HFHI); High-frequency/Low-impact (HFLI); Low-
frequency/high-impact (LFHI); Low-frequency/Low-impact (LFLI)

701.3. In an effort to re-establish trust with stakeholders in the wake of a public scandal that
exposed key deficiencies in its culture and governance, Alphaholding International Bank has re-
designed and re-staffed its risk management function. In particular, the bank's new operational
risk framework endeavors to reflect "sound practices" and/or "best practices" with respect to
operational risk. Consequently, each of the following is an advisable (or at least plausible)
practice EXCEPT which is the LEAST LIKELY to be a component of the new operational risk
management framework?

a) Senior management develops (for approval by the Board of Directors, BOD) a

governance structure with well-defined, transparent, and consistent lines of
responsibility, and this responsibility entails "three lines of defense:" the business line,
the corporate operational risk function, and the internal audit function
b) The Board (BOD) approves and reviews the bank's Risk Appetite and Tolerance
statement for operational risk; where “risk appetite” reflects the level of aggregate risk
the bank's Board is willing to assume and manage in the pursuit of the bank's business
objectives, and this risk appetite include both quantitative and qualitative elements
c) The bank maps each operational risk loss sub-type to its own general ledger account so
operational risk trends and exposures can be evaluated via historical profit and loss
statements (P&Ls); and so the Board (BOD) can budget quantitative dollar exposure
limits (akin to position limits in market risk) to each operational risk type and sub-type
d) The bank conducts Risk Control Self-assessments (RCSA) which evaluate inherent risks
(i.e., the risk before controls are considered), the effectiveness of the control
environment, and residual risks (i.e., the risk exposure after controls are considered);
scorecards build on the RCSAs by weighting residual risks in order to translate the
RCSA output into metrics

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Answers:

701.1. B. LEAST LIKELY is that Operational Risk reports to Internal Audit. Basel's 2011
"Sound Practices" explicitly forbids operational risk from reporting to Audit, as Audit is
the "third line of defense."
 In regard to each of (A), (C) and (D), these are plausible configurations; see Girling's
Operational Risk Management (Chapter 4: Operational Risk Governance)

701.2. A. TRUE: This highest-level classification by CAUSE is given by: People;

Processes; Systems and technology; and External events
 In regard to (B) and (C), these cumulatively list Basel's seven (Level 1) operational risk
categories but they are known to commingle cause and effect; i.e., is a criticism of them.
 In regard to (D), high/low frequency and high/low impact severity is an important
framework but it does not parse causes!

701.3. C. FALSE. This speaks to a difference between market/credit risk and operational
risk: in general, unlike market/credit risks, operational risks are NOT proactively
assumed such that it is difficult in most cases to ex ante assign dollar limits. For example,
with respect to external fraud or regulatory risk, it is likely that the firm has "no (zero) appetite"
for financial crimes or regulatory breaches.
 In regard to (A), (B) and (D), each of these is TRUE as a best practice or consistent
with a "sound practice" per the Basel Committee (BIS).

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governance.10661/

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P2.T7.702. Risk appetite framework (RAF), enterprise risk
management (ERM) & Three Lines of Defense
Concept: These on-line quiz questions are not specifically linked to learning objectives,
but are instead based on recent sample questions. The difficulty level is a notch, or two
notches, easier than bionicturtle.com's typical question such that the intended difficulty
level is nearer to an actual exam question. As these represent "easier than our usual"
practice questions, they are well-suited to online simulation.

702.1. Acebase International Bank is a new international financial services firm that is the
product of a merger between two different banks with very different geographical footprints,
cultures and a somewhat different mix of business lines. Acebase has just designed a risk
appetite framework (RAF) as the foundational element of its NEW operational risk framework
(ORF). Each of the following features of Acebase's RAF comports with best practice(s)--or is at
least plausible--EXCEPT FOR which of these features is unlikely to be a key feature of its
operational risk appetite framework?

a) The bank defines its operational risk appetite as the amount of operational risk the bank
is willing or not willing ("chooses or not chooses") to assume
b) The board has chief responsibility: the board approves the risk appetite and tolerance;
the board reviews the appropriateness of limits, considering many factors; and the board
monitors management’s adherence to the operational risk appetite and tolerance
c) The bank's primary risk appetite metric is Operational Losses as a Percentage of Gross
Revenue (OLAPGR); to avoid over-reacting to extraordinary one-time losses, OLAPGR
is measured on a cumulative, trailing three-year basis; and to avoid ex post manipulation
the target OLAPGR level will not be revised until the end of the three-year period
d) The bank distinguishes between (i) risk appetite, (ii) risk tolerance and (iii) risk capacity
because in regard to certain categories of operational risk, the bank has a very low--or
even zero--risk appetite for operational losses yet realistically will need to have some
non-zero level of risk tolerance and non-zero level of risk capacity

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702.2. Gogogreen International Bank has a well-developed Operational Risk Governance
framework that utilizes three lines of defense:

Assuming Gogogreen employs good or "best practices," which of the following is TRUE about
its three lines of defense?

a) The third line of defense is required to be an entity that is external to the firm; e.g.,
external auditor and/or regulatory
b) The first line of defense includes the compliance function that reports directly to risk
committee of the board and implements a quality assurance (QA) program
c) A key function of the CORF (second line of defense) is an "independent challenge" to
the business lines’ inputs to--and outputs from--the bank’s risk management,
measurement and reporting systems
d) The second line of defense is responsible for identifying and managing the operational
risks inherent in all products, activities, processes and systems for which line
management is accountable; and for providing adequate resources, tools and training to
business line management to ensure awareness of all operational risks and
effectiveness of assessments

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702.3. Techitrax Corporation has implemented an enterprise risk management (ERM) program
by following these four steps (endorsed by Nooco and Stulz which happens to be an assigned
FRM reading!):

I. Management determined the firm’s risk appetite including chose the probability of
financial distress expected to maximize firm value; in this case, credit ratings were used
as the primary indicator of financial risk, so management determined a target (optimal)
credit rating based on this risk appetite and the cost of reducing its probability of financial
distress and calibrated the firm's target rating at AA3 (Moody's) or AA- (S*P)
II. Given this target rating, management estimated the amount of capital required to
support the risk of its operations.
III. Management determined the optimal combination of capital and risk expected to yield its
target rating.
IV. Management decentralized the risk-capital tradeoff with the help of a capital allocation
and performance evaluation system that motivates managers throughout the
organization to make investment and operating decisions that optimize this tradeoff.

Each of the following is true about this ERM program EXCEPT which is false?
a) The company faces a inherent trade-off between risk and required capital: as VaR or
volatility increase, the firm requires more capital (i.e., the size of its buffer stock of equity
capital) to achieve the same probability of default
b) In this endorsed ERM approach, the company should manage economic without regard
to accounting earnings volatility (because is not cash flow), and the company's level of
equity capital should be calibrated at the lesser of regulatory and economic capital; i.e.
optimal equity = minimum[regulatory capital, economic capital]
c) The company should look beyond value at risk (VaR) because the ERM adds value by
optimizing the probability and expected costs of financial distress (as distinct from
default) which refers to any situation where the company is likely to feel compelled to
pass up positive net present value (NPV) activities
d) Risk management can be viewed as a substitute for (some portion of) equity capital, and
the company should position its combination of risk management and capital "at the
margin" where it is indifferent between decreasing risk and increasing capital: this is the
theoretically optimal level of risk where such that spending another $X million dollars to
decrease risk by Y% will save the firm roughly $X million in equity capital costs.

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Answers:

702.1. C. FALSE. The risk appetite articulation should strive to be forward-looking.

Further, the primary metric in a new organization would not be static over a multi-year period:
risk appetite is dynamically refined as the firm receives data (e.g., internal loss data) and
feedback. Finally, operational losses are rare such that "one-time" loss events are significant!

"For those banks that have established an operational risk appetite and tolerance statement, a
commonly observed practice was the inclusion of a metric such as operational losses as a
percentage of gross revenue. However, these metrics tended to be backward- rather than
forward-looking. Noteworthy practices include defining operational risk appetite and tolerance at
both a divisional and a taxonomy level, utilizing both quantitative and qualitative components,
and setting limits based on established key risk indicators such as loss metrics, deficiencies,
events and residual risk assessments from operational risk identification and assessment.
Overall, banks are encouraged to: continue their work to further articulate and implement
enhanced and forward-looking operational risk appetite and tolerance statements."

 In regard to (A), (B) and (D), each is plausible or reflects a so-called best practice.
 In regard to true (C), from the Principles for the Sound Management of Operational
Risk: "Principle 4: The board of directors should approve and review a risk appetite and
tolerance statement for operational risk that articulates the nature, types and levels of
operational risk that the bank is willing to assume" and this principle implies the following
elements:
o the risk appetite and tolerance articulates the types and levels of operational risk
the bank is willing to assume
o the board approves the risk appetite and tolerance;
o the board reviews the appropriateness of limits, considering many factors; and
o the board monitors management’s adherence to the operational risk appetite and
tolerance

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702.2. C. TRUE. A key function of the CORF (second line of defense) is an "independent
challenge" to the business lines’ inputs to--and outputs from--the bank’s risk
management, measurement and reporting systems
 In regard to false (A), the third line of defense can be internal audit
 In regard to false (B), this (e.g., compliance) refers to the second line of defense
 In regard to false (D), this refers to the first line of defense

For summary reference, per the Review of the Principles:

1. First line of defense [Business Line Management] responsibilities include using

operational risk management tools to identify and manage risks, assessing and
enhancing controls, monitoring and reporting the operational risk profile, ensuring that
the operational risk profile adheres to the established risk appetite and tolerance,
complying with policies, standards and guidelines, and promoting a strong risk culture.
2. Second line of defense [Corporate Operational Risk Function] responsibilities
include designing operational risk management tools used by the business to identify
and manage risks, applying “independent challenge” to the use and output of the
operational risk management tools by the first line of defense, developing and
maintaining policies, standards and guidelines, reviewing and contributing to the
monitoring and reporting of the operational risk profile, designing and providing
operational risk training and awareness, and promoting a strong risk culture.
3. Third line of defense [aka, Audit, Validation and Verification] responsibilities include
independently verifying that the ORMF has been sufficiently well designed and
implemented by both the first and second lines of defense, reviewing the “independent
challenge” applied by the second line of defense to the first line of defence’s use and
output of the operational risk management tools, reviewing the monitoring, reporting and
governance processes, and promoting a strong risk culture.

702.3. B. False. The company probably needs to pay attention to both economic and
accounting earnings; e.g., "While companies should pursue economic outcomes whenever
possible, there will clearly be situations where they need to limit the volatility of reported
accounting earnings. Companies with debt covenants that specify minimal levels of earnings
and net worth are one example. Another is provided by companies that face regulatory
requirements to maintain minimal levels of “statutory” capital, which is typically defined in
standard accounting terms. Yet another are companies whose ability to attract customers
depends in part on credit ratings, which in turn can be affected by earnings volatility." Further,
although these measures are not directly comparable, equity capital would be the maximum of
regulatory or economic capital; if economic capital exceeds regulatory capital, then regulatory
requirements are not binding and, if regulatory capital exceeds economic capital, then the
excess might be referred to as "stranded capital."

In regard to (A), (C) and (D), each is TRUE.

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P2.T7.703. Operational data governance practices
Concept: These on-line quiz questions are not specifically linked to learning objectives,
but are instead based on recent sample questions. The difficulty level is a notch, or two
notches, easier than bionicturtle.com's typical question such that the intended difficulty
level is nearer to an actual exam question. As these represent "easier than our usual"
practice questions, they are well-suited to online simulation.

703.1. Operational data governance at Alphafind Financial Services includes the following data
quality rules and/or procedures:

I. Each transaction record has a identifier (ID) called the primary key which prevents
duplicates and manages dependencies in the SQL relational database
II. Key data samples from the database are routinely checked against a third-party "system
of record" in order to ensure the values are corroborated by real-life entities
III. Key financial and market variables that are published in, and inform, client
recommendation reports are time-stamped and include an "expiration (aka, to be used
by) date"
IV. When financial values such as trailing 12-month earnings per share (EPS) are
aggregated from different sources into the database, the values employ similar
calculations so that they are comparable and comparisons are reasonable

These data quality rules do reflect EACH of the following desirable data quality dimensions
EXCEPT which is NOT specifically reflected in Alphafind's four rules above?

a) Accuracy
b) Completeness
c) Consistency
d) Uniqueness

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703.2. Basel identifies seven high-level categories (Category Level 1) operational loss types, as
follows:
 Execution, Delivery, and Process Management (EDPM)
 Clients, Products, and Business Practice (CPBP)
 Business Disruption and Systems Failures (BDSF)
 Internal Fraud
 External Fraud
 Employment Practices and Workplace Safety (EPWS)
 Damage to Physical Assets
Consider the following mistakes, mishaps and events:
I. Coding Error: a software code error causes the banks intelligent deposit machines to fail
to create suspicious-transaction reports which leads the regular to impose fines due to a
breach of anti money-laundering (AML) laws
II. Aggressive Sales: Motivated by compensation plans, certain retail branch managers use
aggressive sales tactics to over-sell financial products to their customers, and in some
cases the products are not "suitable" for the customers
III. Misunderstood Order: In the communication chain from client to banker to trader's
assistant to trader, because the client is a foreign-language speaker, the client's trade is
misunderstood and an order for $1,000,000 is placed rather than an order for $100,000
which is the trade the client intended (EDPM: Transaction Capture, Execution and
Maintenance)
IV. Too-expensive Salesforce: The board hires a new chief executive officer (CEO) who re-
organizes the sales force and and the sales incentive plan in order to accelerate cross-
selling to large and national accounts, but the cost structure of the incentive plan is a
persistent drag on profitability especially as competitors shift to cheaper online sales
tactics
Which of these events or mistakes is an operational loss in the classic seven-category
framework?
a) None are operational losses
b) I., II., and III. are operational losses but IV. is not
c) I. and IV. are operational losses, but II. and III. are not
d) All are operational losses

15
703.3. Your colleague Barry shows you the first draft of a new Operational Risk Dashboard that
will contains the firm's operational key risk indicators (KRIs). The Risk Committee of the board
has asked for key risk indicators and, specifically, that requested that the KRIs are distinguished
from key performance indicators (KPIs) and key control indicators (KCIs). Here is Barry's first
draft:

At first glance, all four of these metric sets appear to be plausible key risk indicators (KRIs)
EXCEPT which is the LEAST LIKELY to meet the board's request for KRIs?

a) Bad boss indicators

b) Outdated software indicators
c) Business unit net profitability indicators
d) Client record indicators

16
Answers:

703.1. B. Completeness is not included. Please note:

 I. is an example of Uniqueness: Each transaction record has a identifier (ID) called the
primary key which prevents duplicates and manages dependencies in the SQL relational
database
 II. is an example of Accuracy: II. Key data samples from the database are routinely
checked against a third-party "system of record" in order to ensure the values are
corroborated by real-life entities
 III. is an example of Currency (aka, recency): III. Key financial and market variables that
are published in, and inform, client recommendation reports are time-stamped and
include an "expiration (aka, to be used by) date"
 IV. is an example of Consistency (which is also a basic accounting principle): IV. When
financial values such as trailing 12-month earnings per share (EPS) are aggregated from
different sources into the database, the values employ similar calculations so that they
are comparable and comparisons are reasonable

703.2. B. I., II., and III. are operational losses but IV. is not. Please note:
I. Coding error: This is Systems (Level 2) within Business Disruption and System Failures
(BDSF, Level 1). This example is very real. Austrac recently accused Commonwealth
Bank of Australia (CBA) of 50,000 breaches of money laundering laws. Reporst
http://trtl.bz/2eA2ExS
II. Reckless Sales: This is Suitability, Disclosure and Fiduciary (Level 2) within Clients,
Products and Business Practices (CPBP, Level 1)
III. Misunderstood order: This is Transaction Capture (Level 2) within Execution, Delivery
and Process Management (EDPM, Level 1)
IV. Too-expensive Salesforce: This is not an operational risk

703.3. C. Business unit net profitability indicators. The key problems with net profit are (i) it
is a lagging not leading indicator and (ii) it is too top-down rather than bottom-up. The other
examples are good key risk indicators (KRIs).

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governance-practices.10683/

17
P2.T7.704. Loss distribution approach (LDA), external loss data, &
Basel's Standardized Measurement
Concept: These on-line quiz questions are not specifically linked to learning objectives,
but are instead based on recent sample questions. The difficulty level is a notch, or two
notches, easier than bionicturtle.com's typical question such that the intended difficulty
level is nearer to an actual exam question. As these represent "easier than our usual"
practice questions, they are well-suited to online simulation.

704.1. Newzone International employs the loss distribution approach (LDA) to characterize the
operational loss distribution over a one-year horizon. Under LDA, the loss frequency distribution
is tabulated (aka, statistical convolution) with the loss severity distribution. For Newzone, the
frequency and severity distributions are independent from one another and given by:

In this way, the expected frequency, E(F), is a probability weighted-average of 0.750 loss events
per year, and the expected severity, E(S), is $12,000 which is equal to ($1,000 * 65.0%) +
($9,000 * 25.0%) + ($91,000 * 10.0%). What is the one-year operational unexpected loss (UL)
at the 99.0% confidence level, which we could also refer to as the one-year relative (as opposed
to absolute) operational value at risk (OpVaR) at the 99.0% confidence level?

a) $91,000
b) $100,000
c) $141,000
d) $182,000

18
704.2. Sources of EXTERNAL operational loss data include news-based subscription service
(for example, IBM Algo FIRST) or Consortium data (for example, ORX). Each of the following is
true EXCEPT which is unlikely?

a) Subscription service (e.g., Algo FIRST) is likely to be distorted by reporting or availability

bias
b) A combination of ORX (consortium data) and FIRST (subscription service) data provides
a complete data set for a bank to use for benchmarking
c) The Consortium data will probably contain a higher percentage (than the news-based
service) of losses in the Execution, Delivery and Process Management (EDPM) event
type category
d) The Consortium data will probably contain a higher percentage (than the news-based
service) of losses in the External Fraud event type category

704.3. In March 2016, the Basel Committee on Banking Supervision proposed the Standardized
Measurement Approach (SMA) to operational risk regulatory capital. The proposal has been
controversial. Consider the following five summary statements about the proposed SMA:

I. SMA proposes to eliminate the Advanced measurement approach (AMA) which currently
(previously) allowed for the estimation of regulatory capital to be based on a diverse
range of INTERNAL models
II. The SMA multiplies a Business Indicator (BI) Component by a Loss Multiplier (LM)
III. The SMA's Business Indicator (BI) replaces the current (previous) Gross Income (GI)
used in Basel's BIA and STA approaches; the BI
IV. The Business Indicator (BI) consists of profit and loss (P&L) items that are mostly also
found in the composition of Gross Income (GI)
V. The Loss Multiplier (LM) is calculated based on the bank's own historical, internal
operational loss data and the LM is meant to improve the risk sensitivity of the SMA

Which of the above statements is (are) TRUE?

a) None of the statements is accurate
b) II. and IV. only
c) I., III., and V. only
d) All five statements are true.

19
Answers:

704.1. A. $91,000. The unexpected loss (at 99.0%) is equal to the $100,000 worst expected
loss (aka, 99.0% quantile) minus the $9,000 expected loss. See the tabulated (convoluted)
distribution below. Note that we do not need to tabulate the expected loss because it is given by
E(F)*E(S) = 0.750 * $12,000 = $9,000; severity and frequency are independent.

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704.2. B. False. This neglects internal loss data and the important role of scenario
analysis in identifying high-severity events.

In regard to (A), (C) and (D) each is TRUE.

 In regard to true (A), Girling writes (emphasis ours): "There are several challenges
with external data. First, if the external data are gathered from news sources, then
they are subject to a bias in reporting. Only events that are interesting to the press
are reported in the press, resulting in a bias in favor of illegal and dramatic events over
errors. For example, a large fraud will receive intensive coverage, while a major systems
outage might not make it into any press report. It is also unlikely that a major gain will
make the press in the same way that a major loss would, although the same lessons
could be learned in both cases."
 In regard to true (C) and (D), writes Girling: "the FIRST [ie, subscription] database
contains a significantly higher percentage of losses being attributed to Internal Fraud
cases than is indicated in the ORX data. In contrast, the ORX data [consortium] shows
a significantly higher percentage of Execution, Delivery, and Process Management
(EDPM) losses than is indicated in the FIRST data. This may be explained by the fact
that not all EDPM events are reported in the press, so many of those events would not
appear in the FIRST [subscription] database. This is an unavoidable collection bias that
impacts FIRST's data ... It is clear from Figure 8.6 that EDPM events rarely result in
public press coverage, and so are missing from the FIRST data. ORX [consortium]
also has larger number of External Fraud events than FIRST [subscription],
suggesting that External Events are often successfully kept out of the press. The ORX
underlying data show that the dominance of External Fraud events occurs mostly due to
the participation of retail banks in the consortium. (Most, if not all, ORX members had a
retail banking division for the period covered by the report). Retail Banking includes
credit card services, and so it may be that this dominance by the External Fraud
category is driven by many relatively small credit card and retail banking frauds. The
threshold for loss data delivery to ORX is € 20,000, so small losses are obviously only
relatively small when compared to the very large frauds that are covered in the media."

21
704.3. D. True: All five statements are true.

I. SMA proposes to eliminate the Advanced measurement approach (AMA) which currently
(previously) allowed for the estimation of regulatory capital to be based on a diverse
range of INTERNAL models
II. The SMA multiplies a Business Indicator (BI) Component by a Loss Multiplier (LM)
III. The SMA's Business Indicator (BI) replaces the current (previous) Gross Income (GI)
used in Basel's BIA and STA approaches; the BI
IV. The Business Indicator (BI) consists of profit and loss (P&L) items that are mostly also
found in the composition of Gross Income (GI)
V. The Loss Multiplier (LM) is calculated based on the bank's own historical, internal
operational loss data and the LM is meant to improve the risk sensitivity of the SMA

In regard to true (I.), Committee (emphasis ours): "Withdrawal of internal modelling for
operational risk regulatory capital from the Basel Framework: 5. Introduced as part of the Basel
II framework in 2006, the AMA allows for the estimation of regulatory capital to be based on a
diverse range of internal modeling practices subject to supervisory approval. Commensurate
with the relative infancy of the field of operational risk measurement at the time, the AMA’s
principles-based framework was established with a significant degree of flexibility. This flexibility
was expected to considerably narrow over time, and ultimately lead to the emergence of best
practice. 6. A recent review of the measures related to banks’ operational risk modeling
practices and capital outcomes revealed that the Committee’s expectations failed to materialize.
Supervisory experience with the AMA has been mixed. The inherent complexity of the AMA and
the lack of comparability arising from a wide range of internal modeling practices have
exacerbated variability in risk-weighted asset calculations, and have eroded confidence in risk-
weighted capital ratios. The Committee has therefore determined that the withdrawal of
internal modeling approaches for operational risk regulatory capital from the Basel
Framework is warranted."

In regard to true (III.) and true (IV), Committee: "As in the 2014 consultation, the BI is made up
of almost the same P&L items that are found in the composition of Gross Income (GI). The main
difference relates to how the items are combined. The BI uses positive values of its
components, thereby avoiding counterintuitive negative contributions from some of the bank’s
businesses to the capital charge (eg negative P&L on the trading book), which is possible under
the GI. In addition, the BI includes income statement items related to activities that produce
operational risk that are omitted (eg P&L on the banking book) or netted (eg fee expenses, other
operating expenses) in the GI."

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P1.T7.705. Extreme value theory (EVT)
Concept: These on-line quiz questions are not specifically linked to learning objectives,
but are instead based on recent sample questions. The difficulty level is a notch, or two
notches, easier than bionicturtle.com's typical question such that the intended difficulty
level is nearer to an actual exam question. As these represent "easier than our usual"
practice questions, they are well-suited to online simulation.

705.1. Techstreet Hedge Fund has active positions in cryptocurrency futures contracts and
employs the peaks-over-threshold (POT) approach variation to characterize extreme potential
loss tails according to extreme value theory (EVT). The fund estimates both value at risk (VaR)
and expected shortfall (ES) at the 99.0% confidence level. Their choice of threshold, denoted
(u) and shown below, is set at 3.0% which 30 losses among 1,000 observations; e.g., this might
be sub-daily observations within a high-frequency environment. The full set of parameters are
shown below, and further included are the formulas for both VaR and ES implied by the POT
approach:

Each of the following statements is true EXCEPT which is false?

a) The POT 99.0% value at risk (VaR) is about 5.0

b) The POT 99.0% expected shortfall (ES) is about 7.15
c) An increase in the value of the tail index, ξ, will increase both the VaR and the ES
d) An increase in the value of the threshold, u, will decrease both the VaR and the ES

23
705.2. Stephanie is a Risk Analyst who is trying to model the loss tail of an operation loss
distribution that exhibits very low-probability but high-impact events. She decides to lean on
extreme value theory (EVT) and consults with her colleagues. Among the following pieces of
advice, each is basically true (ie., good advice) EXCEPT FOR which is likely untrue?

a) If the loss data exhibits clustering (aka, time dependency), an easy solution is to employ
a generalized extreme value (GEV) distribution according to the "block maxima"
approach
b) If she does employ a generalized extreme value (GEV) distribution but cannot identify
the parent loss distribution, it is advisable to assume a Frechet distribution where the tail
index (ξ) is greater than zero
c) For either EVT approach--i.e., the generalized extreme value (GEV) or peaks-over-
threshold (POT)--it is acceptable if the losses are not i.i.d., but the parent distribution
must be known in order to estimate the limiting distribution
d) If she prefers to rely on maximum likelihood estimation (MLE), regression or semi-
parametric parameter estimation techniques throughout, and thusly avoid arbitrary or
judgmental calibration of parameters, then then GEV is probably better suited than POT

705.3. Kevin Dowd outlines two basic approaches to extreme value tails. The first approach
characterizes the set of each maximum loss within non-overlapping "blocks" of time (block
maxima) with the generalized extreme value (GEV) distribution. The second approach
characterizes the set of extreme losses above a threshold, regardless of their timing, with a
generalized Pareto (GP) distribution. In regard to the extreme value theory (EVT) approach,
which of the following statements is TRUE?

a) POT GP can produce an expected shortfall (ES) estimate, but GEV cannot return an ES
b) Unconditional EVT is useful when forecasting value at risk (VaR) or expected shortfall
(ES) over a long horizon period, but for a short horizon conditional EVT is probably
better
c) If the threshold selected in the GP distribution equals zero, then the peaks-over-
threshold generalized Pareto (GP POT) collapses to the generalized extreme value
(GEV) distribution
d) Due to the central limit theorem (CLT), elliptical copulas are justified is modeling the
dependence structure of a multivariate extreme value distribution

24
Answers:

705.1. D is false as stated. Instead, an increase in the threshold, u, will increase both the
VaR and the ES.

In regard to (A), (B) and (C), each is TRUE.

705.2. C is false. The inverse is true: the elegance and convenience of EVT approaches
(i.e., block maxima GEV or POT GPD) is that, conditional on losses that are independent
and identically distributed (i.i.d.), the parent loss distribution can be unknown and non-
normal

In regard to (A), (B) and (D), each is TRUE.

705.3. B. TRUE: Unconditional EVT is useful when forecasting value at risk (VaR) or
expected shortfall (ES) over a long horizon period, but for a short horizon conditional
EVT is probably better

Dowd: "7.3.1 Conditional EV: The EVT procedures described above are all unconditional: they
are applied directly (i.e., without any adjustment) to the random variable of interest, X. As with
other unconditional applications, unconditional EVT is particularly useful when forecasting VaR
or ES over a long horizon period. However, it will sometimes be the case that we wish to apply
EVT to X adjusted for (i.e., conditional on) some dynamic structure, and this involves
distinguishing between X and the random factors driving it. This conditional or dynamic EVT is
most useful when we are dealing with a short horizon period, and where X has a dynamic
structure that we can model. A good example is where X might be governed by a GARCH
process. In such circumstances we might want to take account of the GARCH process and
apply EVT not to the raw return process itself, but to the random innovations that drive it."

In regard to (A), (C) and (D), each is FALSE.

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25
P2.T7.706. Economic capital
Concept: These on-line quiz questions are not specifically linked to learning objectives,
but are instead based on recent sample questions. The difficulty level is a notch, or two
notches, easier than bionicturtle.com's typical question such that the intended difficulty
level is nearer to an actual exam question. As these represent "easier than our usual"
practice questions, they are well-suited to online simulation.

706.1. Patty is a Risk Analyst who has been asked by her firm's Chief Risk Officer (CRO) to
review the firm's risk modeling practices. She is currently evaluating a popular risk model used
by the firm to asses the risk of its equity portfolios, in particular the firm depends on a parametric
linear value at risk (VaR) approach. Her boss, the CRO, has asked her specifically to ensure
that model risk is mitigated and consistent with best practices. If Patty's mission is to mitigate
model risk, which of the following practices is advisable?

a) Avoid embedding simplifying assumptions into models that specify price behavior
b) Only use volatility and correlation parameters if they are directly and currently observed
c) Avoid mark-to-model approaches because they are discouraged by accounting and
regulatory bodies
d) Ensure that an independent vetting team is provided with a mathematical statement of
the model and its components

706.2. Assume that you want to identify the risk-adjusted return on capital (RAROC) of a new,
contemplated $3.0 billion corporate loan portfolio that offers a headline return of 10.0%. The
bank has an operating direct cost of $15.0 million per annum and an effective tax rate of 30.0%.
The loan portfolio is funded by $3.0 billion of retail deposits with a "transfer priced" interest
charge of 5.0%. Risk analysis of the unexpected losses (UL) associated with the portfolio
indicates that for this portfolio that bank should allocate economic capital (EC) of $360.0 million,
which is 12.0% of the loan amount. This economic capital must be invested in risk-free
securities and the current risk-free interest rate is 3.0%. The expected loss on this portfolio is
assumed to be 3.0% per annum, i.e., $90 million. Finally, the bank's equity beta, β(E), is 1.30,
and the market's excess return is 8.0% such that the equity risk premium is 5.0%.

What is this loan's RAROC and, from the perspective of an adjusted RAROC, is the new
portfolio advisable?

a) RAROC equals 13.140%, and the portfolio is advisable because its ARAROC is greater
than the risk-free rate
b) RAROC equals 10.850%, and the portfolio is advisable because its ARAROC is greater
than the risk-free rate
c) RAROC equals 7.220%, and the portfolio is advisable because its ARAROC is greater
than the risk-free rate
d) RAROC equals 5.980%, and the portfolio is not advisable because its ARAROC is less
than the risk-free rate

26
706.3. Crouhy, Galai, and Mark say that "we should be careful not to confuse the concept of risk
capital (aka, economic capital), which is intended to capture the economic realities of the risks a
firm runs, and regulatory capital. First, regulatory capital only applies to a few regulated
industries, such as banking and insurance companies, where regulators are trying to protect the
interests of small depositors or policy holders. Second, while regulatory capital performs
something of the same function as risk capital in the regulators’ eyes, it is calculated according
to a set of industrywide rules and formulas and sets only a minimum required level of capital
adequacy. It rarely succeeds in capturing the true level of risk in a firm—the gap between a
firm’s regulatory capital and its risk capital can be quite wide. Furthermore, even if regulatory
and risk capital are similar numbers at the level of the firm, they may not be similar for each
constituent business line (i.e., regulatory capital may suggest that an activity is much riskier than
management believes to be the case, or vice versa)."

In addition to the distinction between economic capital and regulatory capital articulated above,
EACH of the following statements is true EXCEPT which is inaccurate?

a) Economic capital normally does NOT absorb expected losses (EL)

b) Economic capital equals risk capital plus (+) goodwill plus (+) burned-out capital
c) Adjusted RAROC is an increasing function of economic capital as a percentage of a loan
portfolio
d) Economic capital is normally unexpected loss (UL) at some selected confidence level
and time horizon

27
Answers:

706.1. D. True: Ensure that an independent vetting team is provided with a mathematical
statement of the model and its components

Crouhy (highly abbreviated): "How Can We Mitigate Model Risk? ... Vetting should consist of
the following phases:
1. Documentation. The vetting team should ask for full documentation of the model,
including both the assumptions underlying the model and its mathematical expression.
This should be independent of any particular implementation, such as a spreadsheet, R
(a statistical programming language), or a C++ computer code, and should include: (i)
The term sheet or, equivalently, a complete description of the transaction; (ii) a
mathematical statement of the model which should include an explicit statement of all
the components of the model; (iii) Implementation features; and (iv) A working version of
the implementation.
2. Soundness of model. An independent model vetter needs to verify that the
mathematical model is a reasonable representation of the instrument that is being
valued. For example, the manager might reasonably accept the use of a particular model
(e.g., the Black model) for valuing a short-term option on a long-maturity bond but reject
(without even looking at the computer code) the use of the same model to value a two-
year option on a three-year bond. At this stage, the risk manager should concentrate on
the finance aspects and not become overly focused on the mathematics.
3. Independent access to financial rates. The model vetter should check that the middle
office has independent access to an independent market risk management financial
rates database (to facilitate independent parameter estimation).
4. Benchmark modeling. The model vetter should develop a benchmark model based on
the assumptions that are being made and on the specifications of the deal.
5. Health check and stress test the model. Also, make sure that the model possesses
the basic properties that all derivatives models should possess, such as put/call parity
and other nonarbitrage conditions. Finally, the vetter should stress test the model. The
model can be stress tested by looking at some limit scenario in order to identify the
range of parameter values for which the model provides accurate pricing. This is
especially important for implementations that rely on numerical techniques.
6. Build a formal treatment of model risk into the overall risk management
procedures, and periodically reevaluate models. Also, reestimate parameters using
best-practice statistical procedures. Experience shows that simple but robust models
tend to work better than more ambitious but fragile models. It is essential to monitor and
control model performance over time."

In regard to the false choices, please note:

 False choice (A) advises "Avoid embedding simplifying assumptions into models that
specify price behavior," but this is too extreme. All financial models embed simplifying
assumptions. They cannot be realistically avoided. Rather, as Crouhy writes
"practitioners find themselves engaged in a continual struggle to find the best
compromise between complexity (to better represent reality) and simplicity (to improve
the tractability of their modeling)." Nevertheless, oversimplification is a problem; e.g.,

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 "Another way to oversimplify a model is to underestimate the number of risk factors that
it must take into account. For simple vanilla investment products, such as a callable
bond, a one-factor term structure model, where the factor represents the spot short-term
rate, may be enough to produce accurate prices and hedge ratios. For more complex
products, such as spread options or exotic structures, not to mention a 30-year
Bermudan swaption contract, a two- or three-factor model may be required, where the
factors are, for example, the spot short-term and long-term rates for a two-factor model."
 False choice (B) advises "Only use volatility and correlation parameters if they are
directly and currently observed." But volatility and correlation are not directly,
instantaneously observed quantities unlike, say, asset price. Crouhy: "Volatilities and
correlations are the hardest input parameters to judge accurately. For example, an
option’s strike price and maturity are fixed, and asset prices and interest rates can easily
be observed directly in the market—but volatilities and correlations must be forecast."
 False choice (C) advises "Avoid mark-to-model approaches because they are
discouraged by accounting and regulatory bodies" but mark-to-model is often necessary.
Crouhy: "In the absence of liquid markets and price discovery mechanisms, theoretical
valuation models have to be used to value (or “mark-to-model”) financial positions. The
mark-to-model approach is accepted today both by the accounting boards (e.g., the
American GAAP and the international IFRS) and by the regulatory bodies (e.g., the
Basel Committee). Models are also used to assess risk exposure and to derive an
appropriate hedging strategy, as we’ve discussed in detail in earlier chapters."

706.2. B. TRUE: RAROC equals 10.850%, and the portfolio is advisable because its
ARAROC is greater than the risk-free rate.

The numerator is after-tax risk-adjusted expected return and the denominator is the economic
capital of $360 million (= $3.0 BB * 12.0%) such that:
 Expected Revenue of $3.0 BB * 10.0% = $300.0 million
 plus Return on Economic Capital (ROEC) of $360.0 million * 3.0% = $10.80 million
 minus Interest Expense of $3.0 BB * 5.0% = 150.0 million
 minus Expected Loss (EL) of $3.0 BB * 3.0% = $90.0 million
 minus Operating (aka, Indirect) Costs of $15.0 million
 Equals $300.0 + 10.8 - 150.0 - 90.0 - 15.0 = $55.80 pre-tax return, which implies:
 An after-tax return of $55.80*(1-30%) = $39.060
 And therefore RAROC = 39.060/360.0 = 10.850%.
ARAROC = 10.850% - 1.30 * (8.0% - 3.0%) = 4.35% which is greater than the risk-free rate.
Alternatively, under the previous (but toward the equivalent conclusion) approach to ARAROC,
we can compute ARAROC = (10.850% - 3.0%)/1.30 = 6.04% which is greater than the equity
risk premium of 5.0%.

706.3. C. False. Adjusted RAROC is generally a decreasing function of economic capital

as a percentage of a loan portfolio because it increases the denominator (while only
slightly increases the numerator due to the additional EC invested at the risk-free rate).

In regard to (A), (B) and (D), each is TRUE.

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29
P2.T7.707. Leverage, liquidity risk, and liquidity-adjusted value at risk
(LVaR)

Concept: These on-line quiz questions are not specifically linked to learning objectives,
but are instead based on recent sample questions. The difficulty level is a notch, or two
notches, easier than bionicturtle.com's typical question such that the intended difficulty
level is nearer to an actual exam question. As these represent "easier than our usual"
practice questions, they are well-suited to online simulation.

707.1. Suppose that a hedge fund account, Lever Brothers Multistrategy Masters Fund LP,
opens with an initial placement of $125.0 million in equity by its owners and $75.0 million in
debt. As such, the firm's initial leverage is 1.60 as illustrated by this economic balance sheet:

Consider the following three transactions in sequence:

 The purchase of stock with a value of $40.0 million (ie., a long equity position) where
50.0% of the purchase is borrowed from the broker (aka, margin loan) and the fund's
cash is used for the remaining $20.0 million
 A three-month currency forward in which the firm is short $30.0 million against the euro
 An at-the-money two-month long call option on S&P 500 equity index futures with an
underlying index value of $100; where the option is assumed to be 50-delta.

What is the leverage of the fund after these three transactions?

a) 1.00
b) 1.60
c) 2.40
d) 3.50

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707.2. A key distinction is between market liquidity risk (aka, transaction liquidity risk) and
funding liquidity risk (aka, balance sheet risk). As Malz (chapter 12) explains, "The term
“liquidity” has been defined in myriad ways that ultimately boil down to two properties,
transactions liquidity, a property of assets or markets, and funding liquidity, which is more
closely related to creditworthiness. Transaction liquidity is the property of an asset being easy to
exchange for other assets. Most financial institutions are heavily leveraged; that is, they borrow
heavily to finance their assets, compared to the typical nonfinancial firm. Funding liquidity is the
ability to finance assets continuously at an acceptable borrowing rate. For financial firms, many
of those assets include short positions and derivatives."

Digging a bit deeper, each of the following statements about liquidity risk is true EXCEPT which
is false?

a) A firm that is "solvent" cannot experience funding (balance sheet) illiquidity, but a firm
that is "insolvent" by definition does necessarily experience funding illiquidity
b) The bid-ask spread is measure of "tightness" (aka, width) and therefore a characteristic
of market liquidity risk; and it can easily be included in liquidity-adjusted value at risk
(LVaR) as an exogenous factor
c) "Depth" describes how large an order it takes to move the market adversely; and if there
is a lack of depth, then LVaR can include this endogenous factor by incorporating the
elasticity of demand, or by scaling VaR according to the "time to escape;" i.e., the
estimated number of days required for orderly liquidation of the position
d) Traditional functions of a commercial bank include "maturity transformation" and
"liquidity transformation," but these functions tend to create balance sheet risk which, in
turn, requires asset-liability management (ALM) techniques

707.3. Peter is a Risk Manager who is analyzing an equity position of 20,000 shares in an semi-
liquid, non-public stock that has a current price of USD $50.00 per share. While Peter assumes
the stock's daily expected return is zero, its estimated daily return volatility is 100 basis points
(1.00%). The mean bid-ask spread is USD $0.40 (80 basis points). The bid-ask spread volatility
is 20 basis points, and Peter will assume the volatility spread multiplier, k = 3.0. Finally, Peter
will assume normally distributed arithmetic returns (he will not assume normally distributed
geometric returns; aka, lognormal).

Which of the following is nearest to the one-day 95.0% confident normal liquidity-adjusted value
at risk (LVaR) using the exogenous spread (aka, volatile spread) approach?

a) $16,450
b) $23,450
c) $29,170
d) $33,330

31
Answers:

707.1. C. True: 2.40. See final economic balance sheet below.

Please note in terms of the economic balance sheet (each transaction set has a different color):
 The stock purchase increases assets by $40.00 but cash is reduced by $20.00 (and the
margin loan is a +$20.0 liability)
 The currency forward increases assets and liabilities by $30.0
 The option position increases assets and liabilities by 50% * $100.0 = $50 million
because delta is 0.50.

707.2. A. False (both clauses!). Solvency is positive balance sheet equity such that a solvent
firm can indeed experience funding illiquidity; on the other hand, an insolvent firm (ie, liabilities
exceed assets) does not necessarily experienced funding illiquidity because insolvency might
be a function of long-term asset/debt imbalance but funding liquidity is the ability to meet short-
term obligations (or refinance short-term borrowing). From a balance sheet perspective, a firm
can be insolvent but liquid, or it can also be solvent but illiquid.

In regard to (B), (C) and (D), each is TRUE.

707.3. B. $23,450.

When the spread is treated as volatile (aka, exogenous) then the liquidity cost (LC) is given by
0.5*(µ + k*σ) which is this case is 0.5*(0.80% + 3*0.20%) = 0.70%; in dollars, that is 0.70% *
(20,000 shares * $50.00) = $7,000.00.

The normal 95.0% VaR equals $1.0 million * 1.0% * 1.645 = $16,449. Therefore, the 95.0%
LVaR = $16,449 + $7,000 = $23,449.
Or, equivalently, in percentage terms, LVaR% = VaR% + LC% = (1.0%*1.645) + 0.5*(0.80% +
3*0.20%) = 1.645% + 0.70% = 2.3449%.

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