EFRM/ CRM Practice Questions

Questions:

1) The bank you work for has a RAROC model. The RAROC model, computed for each specific
activity, measures the ratio of the expected yearly net income to the yearly VAR risk estimate.
You are asked to estimate the RAROC of its $500 million loan business. The average interest
rate is 10%. All loans have the same probability of default of 2% with a loss given default of
50%. Operating costs are $10 million. The funding cost of the business is $30 million.
RAROC is estimated using a credit-VAR for loan businesses, in this case, 7.5% of the $500
million loan business.
The economic capital is invested and earns 6%. What is the RAROC of the bank?

2) A risk manager for ABC Bank has compiled the following data regarding a bond trader and an
equity trader. Assume that the returns are normally distributed and that there are 52 trading
weeks per year. ABC Bank computes its capital using a 99% VAR (z=2.33). Dollar amounts are
in millions.

After- Net Weekly Tax

Tax Book volatilit rate
  Profit Value y
Bond Trader $8 $120 1.10% 40%
Equity
Trader $18 $180 1.94% 40%

Calculate the risk-adjusted performance measure (RAPM) for the bond trader and the equity
trader.

3. Suppose you are given the following information about the operational risk losses at your
bank. What is the estimate of the VAR at the 95% confidence level, including expected loss?
Frequency Distribution Severity Distribution
Probability Frequency Probability Severity
0.5 0 0.6 $1,000
0.3 1 0.3 $10,000
0.2 2 0.1 $100,000

4) The risk-free rate is 5% per year and a one-year corporate bond yields 6% per year.
Assuming a recovery rate of 75% on the corporate bond, what is the approximate market
implied one-year probability of default of the corporate bond?

5) A corporate bond will mature in three years. The marginal probability of default in year one is
3%. The marginal probability of default in year two is 4%. The marginal probability of default in
year three is 6%. What is the cumulative probability that default will occur during the three-year
period?
6) What is the survival rate at the end of three years if the marginal annual default probabilities
are 8%, 12%, and 15% in the first, second, and third years, respectively?

7) Consider a B-rated firm that has marginal default rates of d1 = 5%, d2 = 7% in year 1 and 2
respectively. Compute the cumulative default probabilities for year 1 and 2.

8) Consider an investor had a $10 million portfolio of bonds in a long position Suppose the
confidence interval is 95% ((the z-score for 95% is 1.645). The daily standard deviation of the
portfolio is 3.67%. What is the daily VaR of this portfolio? What is the VaR for a 1-month horizon
(30 days)?

9) We want to back-test the VaR at 98% confidence of a portfolio consisting of two investments.
We have 800 days of data and we observe 19 exceedances. We set the significance level for
the test to be 4%. Should we reject the VaR? Show your calculations.

Here is a table that could be useful for you. The table contains P{X <= n) for X ~ Binomial {n,
800, p).

P{X <= n) p = 0.01 p = 0.02 p = 0.03

n=16 0.9965 0.5660 0.0536
n=17 0.9985 0.6603 0.0839
n=18 0.9994 0.7440 0.1245
n=19 0.9998 0.8144 0.1763
n=20 0.9999 0.8704 0.2388

10) An investment has a 4% chance of a loss of 10 million, a 2% chance of a loss of 1 million,

and a 94% chance of a profit of 1 million. Calculate 95% VaR and ES?

11) You have granted an unsecured loan to a company. This loan will be paid off by a single
payment of $50 million. The company has a 3% chance of defaulting over the life of the
transaction and your calculations indicate that if they default you would recover 70% of your
loan from the bankruptcy courts. If you are required to hold a credit reserve equal to your
expected credit loss, how great a reserve should you hold?

12) Consider a long position of $100 million in a par 10-year note, with duration and modified
duration of 6.75 and 6.14 years. Convexity is 52.79 year-squared. Payments are annual.
Interest rates are at 10 % and the volatility of changes in interest rates is 0.40% over the next
month.

i) Assuming normal distributions for yields, what is the the monthly 95% VAR (z=1.65) of yield
changes?

ii) Ignoring convexity, what is the VAR of the position?

iii) With convexity, what is the VAR of the position?

13) We have a bond with a face value of $1000, a maturity of 3 years and a yearly coupon equal
to 5%. The yield to maturity of the bond is 6%. What is the duration of the bond in years?

14) A call option on a stock has a delta of 0.3. A trader has sold 1,000 options. What position
should the trader take to hedge the position?

15) A firm is going to buy 10,000 barrels of West Texas Intermediate Crude Oil. It plans to
hedge the purchase using the Brent Crude Oil futures contract. The correlation between the
spot and futures prices is 0.72. The volatility of the spot price is 0.35 per year. The volatility of
the Brent Crude Oil futures price is 0.27 per year. What is the hedge ratio for the firm?

16) Suppose you simulate the price of stock XYZ using a Geometric Brownian Motion model

∆S=μS Δt + σS ε√∆t, with drift μ=0.03, volatility σ=0.20, and time step Δt=0.04. Let S t be the
price of stock at time t. If S0= 100, and the first two simulated (randomly selected) standard
normal variables are ε1= - 0.453 and ε2= 0.675, what is the simulated stock price after the
second step?
Answers:

1) The bank you work for has a RAROC model. The RAROC model, computed for each specific
activity, measures the ratio of the expected yearly net income to the yearly VAR risk estimate.
You are asked to estimate the RAROC of its $500 million loan business. The average interest
rate is 10%. All loans have the same probability of default of 2% with a loss given default of
50%. Operating costs are $10 million. The funding cost of the business is $30 million.
RAROC is estimated using a credit-VAR for loan businesses, in this case, 7.5% of the $500
million loan business.
The economic capital is invested and earns 6%. What is the RAROC of the bank?

Revenue = 500 x 10%=$50

Loss due to default= 500 x 2% x (1-0.5) =$5
Operating Costs= $10
Funding costs = $30
Credit Var =7.5% x 500 =37.5
RAROC =( 50-5-10-30+ 6% x 37.5)/37.5=19.33%

2) A risk manager for ABC Bank has compiled the following data regarding a bond trader and an
equity trader. Assume that the returns are normally distributed and that there are 52 trading
weeks per year. ABC Bank computes its capital using a 99% VAR (z=2.33). Dollar amounts are
in millions.

After- Net Weekly Tax

Tax Book volatilit rate
  Profit Value y
Bond Trader $8 $120 1.10% 40%
Equity
Trader $18 $180 1.94% 40%

Calculate the risk-adjusted performance measure (RAPM) for the bond trader and the equity
trader.

After- Net Weekly Tax EC RAPM

Tax Book volatilit rate
  Profit Value y
60.21
Bond Trader $8 $120 1.10% 40% 13.29 %
Equity 51.21
Trader $18 $180 1.94% 40% 35.15 %
3. Suppose you are given the following information about the operational risk losses at your
bank. What is the estimate of the VAR at the 95% confidence level, including expected loss?
Frequency Distribution Severity Distribution
Probability Frequency Probability Severity
0.5 0 0.6 $1,000
0.3 1 0.3 $10,000
0.2 2 0.1 $100,000

Answer:
Because VAR should include EL, there is no need to compute EL separately. The table shows
that the lowest loss, such that the cumulative probability is 95% or more, is $100,000.

Cumulativ
Loss   Probability e
0 0.5 0.5 50.00%
1,000 0.3 × 0.6 0.18 68.00%
2,000 0.2 × 0.6 × 0.6 0.072 75.20%
10,000 0.3 × 0.3 0.09 84.20%
0.2 × 0.6 × 0.3
11,000
×2 0.072 91.40%
20,000 0.2 × 0.3 × 0.3 0.018 93.20%
100,00
0 0.3 × 0.1 0.03 96.20%
101,00 0.2 × 0.1 × 0.6
0 ×2 0.024 98.60%
110,00 0.2 × 0.1 × 0.3
0 ×2 0.012 99.80%
200,00
0 0.2 × 0.1 × 0.1 0.002 100.00%

4) The risk-free rate is 5% per year and a one-year corporate bond yields 6% per year.
Assuming a recovery rate of 75% on the corporate bond, what is the approximate market
implied one-year probability of default of the corporate bond?

b. The spread is 6 − 5 = 1%. Dividing by the loss given default of (1 − f ) = 0.25, we get π = (y∗
− y)/(1 − f ) = 4%.

5) A corporate bond will mature in three years. The marginal probability of default in year one is
3%. The marginal probability of default in year two is 4%. The marginal probability of default in
year three is 6%. What is the cumulative probability that default will occur during the three-year
period?
b. This is one minus the survival rate over three years: S3(R) = (1 − d1)(1 − d2)(1 −d3) = (1 −
0.03) (1 − 0.04) (1 − 0.06) = 0.8753. Hence, the cumulative default rate is 0.1247= 12.47%.

6) What is the survival rate at the end of three years if the marginal annual default probabilities
are 8%, 12%, and 15% in the first, second, and third years, respectively?

The survival rate is S3 = (1 − d1)(1 − d2)(1 − d3) = (1 − 0.08)(1 − 0.12)(1 −0.15) = 68.8%.

7) Consider a B-rated firm that has marginal default rates of d1 = 5%, d2 = 7% in year 1 and 2
respectively. Compute the cumulative default probabilities for year 1 and 2.

In the first year, k1 = d1 = 5%. After one year, the survival rate is S1 = 0.95. The probability of
defaulting in year 2 is then k2 = S1 × d2 = 0.95 × 0.07 = 6.65%. After two years, the survival
rate is (1 − d1)(1 − d2) = 0.95 × 0.93 = 0.8835. Thus, the cumulative probability of defaulting in
years 1 and 2 is 5% + 6.65% = 11.65%.

8) Consider an investor had a $10 million portfolio of bonds in a long position Suppose the
confidence interval is 95% ((the z-score for 95% is 1.645). The daily standard deviation of the
portfolio is 3.67%. What is the daily VaR of this portfolio? What is the VaR for a 1-month horizon
(30 days)?

Solution: Since the confidence level is 95%, the z-score for 95% is 1.645.
And the standard deviation is 3.67%.
According to the method discussed above, we can easily get the 5% VaR of a 1-day horizon is
VaR=$10 million * 1.645 * 3.67% = $603,715
The VaR of a 1-month horizon(30 days) for the investor is VaR
=$10 million * 1.645* 30 *3.67%=$3,306,683

9) We want to back-test the VaR at 98% confidence of a portfolio consisting of two investments.
We have 800 days of data and we observe 19 exceedances. We set the significance level for
the test to be 4%. Should we reject the VaR? Show your calculations.

Here is a table that could be useful for you. The table contains P{X <= n) for X ~ Binomial {n,
800, p).

P{X <= n) p = 0.01 p = 0.02 p = 0.03

n=16 0.9965 0.5660 0.0536
n=17 0.9985 0.6603 0.0839
n=18 0.9994 0.7440 0.1245
n=19 0.9998 0.8144 0.1763
n=20 0.9999 0.8704 0.2388

Answer:
 Confidence 98% p= 2%
Number of observations= 800
Expected number of exceptions= 16

P{X < p= p=
n) 0.01 0.02 p = 0.03
n=16 0.9965 0.5660 0.0536
n=17 0.9985 0.6603 0.0839
n=18 0.9994 0.7440 0.1245
n=19 0.9998 0.8144 0.1763
n=20 0.9999 0.8704 0.2388

Area in the right tail= 1-0.8144= 0.1856 > 0.04; Accept the hypothesis; accept vaR

10) An investment has a 4% chance of a loss of 10 million, a 2% chance of a loss of 1 million,

and a 94% chance of a profit of 1 million. Calculate 95% VaR and ES?

VaR= 1 million; ES= (4% x 10+ 1% x 1)/5% = 8.2 million

11) You have granted an unsecured loan to a company. This loan will be paid off by a single
payment of $50 million. The company has a 3% chance of defaulting over the life of the
transaction and your calculations indicate that if they default you would recover 70% of your
loan from the bankruptcy courts. If you are required to hold a credit reserve equal to your
expected credit loss, how great a reserve should you hold?

The Expected Credit Loss (ECL) is the notional amount times the probability of default times the
loss given default. This is $50,000,000 × 0.03 × (1 − 70%) = $450,000.

12) Consider a long position of $100 million in a par 10-year note, with duration and modified
duration of 6.75 and 6.14 years. Convexity is 52.79 year-squared. Payments are annual.
Interest rates are at 10 % and the volatility of changes in interest rates is 0.40% over the next
month.

i) Assuming normal distributions for yields, what is the the monthly 95% VAR (z=1.65) of yield
changes?

ii) Ignoring convexity, what is the VAR of the position?

iii) With convexity, what is the VAR of the position?

i) 1.64 x 0.40%= 0.66 %

ii) -6.14x 0.66% x 100= -4.05 Million; VaR=4.05 Million

iii) [-6.14x 0.66%+ ½ x 52.79 x (0.66%)^2 ]x 100=-3.94 Million; VaR=3.94 Million

13) We have a bond with a face value of $1000, a maturity of 3 years and a yearly coupon equal
to 5%. The yield to maturity of the bond is 6%. What is the duration of the bond in years?

F= 1000
C= 5%

Duration
Year CF Rate DCF tx DCF = 2.86
1 50 6.00% 47.17 47.17
2 50 6.00% 44.50 89.00
3 1050 6.00% 881.60 2644.80
973.27 2780.97

14) A call option on a stock has a delta of 0.3. A trader has sold 1,000 options. What position
should the trader take to hedge the position?

Buy 0.3 x 1000= 300 shares; When the stock price increases by a small amount, the option
price increases by 30% of this amount. The trader therefore has a hedged position if he or she
buys 300 shares. For small changes the gain or loss on the stock position is equal and opposite
to the loss or gain on the option position.

15) A firm is going to buy 10,000 barrels of West Texas Intermediate Crude Oil. It plans to
hedge the purchase using the Brent Crude Oil futures contract. The correlation between the
spot and futures prices is 0.72. The volatility of the spot price is 0.35 per year. The volatility of
the Brent Crude Oil futures price is 0.27 per year. What is the hedge ratio for the firm?

0.72 x 0.35/0.27 = 0.93333

16) Suppose you simulate the price of stock XYZ using a Geometric Brownian Motion model

∆S=μS Δt + σS ε√∆t, with drift μ=0.03, volatility σ=0.20, and time step Δt=0.04. Let S t be the
price of stock at time t. If S0= 100, and the first two simulated (randomly selected) standard
normal variables are ε1= - 0.453 and ε2= 0.675, what is the simulated stock price after the
second step?

∆S=μS Δt + σS ε√∆t =
1st step: ∆S= [0.03x 0.04+(-0.453) x 0.20 x √0.04] x 100 = -1.692; S1= 100-1.692= 98.309

2nd step: ∆S= [0.03x 0.04+0.675 x 0.20 x √0.04] x 98.309 = 2.772; S2= 98.309+2.772= 101.08

Alternatively:

S1=S0 exp (μ Δt + σ ε√∆t) =100 exp (0.03x 0.04+(-0.453) x 0.20 x √0.04)= 98.32

S2=S1 exp (μ Δt + σ ε√∆t) =98.32 exp (0.03x 0.04+0.675) x 0.20 x √0.04)= 101.13