FRM

PART I

EXPLANATIONS - VAR & RISK MODELS

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Explanations FRM Part I VAR & Risk Models

Answer 1: Correct answer is C

Principal STRIPS typically trade at fair value. Shorter term coupon STRIPS typically trade rich. Longer
term coupon STRIPS tend to trade cheap.

Answer 2: Correct answer is D

The Treasury does not issue zero-coupon notes or bonds. That is why STRIPS were created. A 5-year
Treasury note can be stripped into 11 zero coupon securities, consisting of its 10 coupon payments and
the principal repayment. The U.S. Internal Revenue Service regards the accrued interest on a zero
coupon security as income on which the security holder must pay taxes even though he has not received
a cash interest payment.

Answer 3: Correct answer is C

It might be best to draw a set of timelines for this problem.

The one-year rate that will exist one year from today is:
2

(1.045) /(1.04) 1 = 0.05, or 5%.

The one-year rate that will exist two years from today is:
3

(1.05) /(1.045) 1 = 0.06, or 6%.

The two-year rate that will exist one year from today is:
3

0.5

(1.05) /(1.04)) = (1.113)

= 1.055 1 = 0.055, or 5.5%.

Note that the rate that an investor could earn on a sum invested today for the next three years would be
equal to the three-year spot rate of 5%.

Answer 4: Correct answer is D

N = 4; PV = 93.2775; PMT = 0; FV = 100; CPT I/Y = 1.755%;

z(0.5) = 1.755% 2 = 3.51%.

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Answer 5: Correct answer is D

PV = -148; N = 20; FV = 1,000; PMT = 0; CPT I = 10.02.

Answer 6: Correct answer is C

Reinvestment risk is higher with high-coupon, short maturity bonds. Callable bonds have more
reinvestment risk than noncallable bonds, since their maturity can be shorter than the stated maturity
date.

Answer 7: Correct answer is D

Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a
holding return lower than that expected at purchase. Here, the investor will likely have to reinvest the
coupon at the lower market interest rate, negatively impacting his holding period return.
Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments
are most likely in a declining interest rate environment because it is cheaper to issue replacement debt.
Here, the bond is a Treasury and is noncallable, so the investor can eliminate prepayment risk by holding
the bond until maturity. Liquidity risk addresses how quickly and easily an investor can sell a bond. A
bond that trades thinly or in small amounts exposes an investor to liquidity risk. Liquidity risk is not a
concern with Treasury bonds. Credit risk is the risk that the issuer will be unable to make coupon or
principal payments as scheduled. Any change in the timing of the receipt of cash flows affects the bonds
holding period return. Credit risk is not a concern with Treasury securities.
Answer 8: Correct answer is C

The duration of a bond portfolio is the weighted average of the durations of the bonds in the portfolio. The
weights are the value of each bond divided by the value of the portfolio: portfolio duration =
8*(1050/3000)+6*(1000/3000)+4*(950/3000) = 2.8+2+1.27 = 6.07.
Answer 9: Correct answer is C

I/Y = 9.00; FV = 100; N = 10; PMT = 0.11 x 100 = 11; PV = V0 = 112.84

I/Y = 8.50; FV = 100; N = 10; PMT = 0.11 x 100 = 11; PV = V- = 116.40
I/Y = 9.50; FV = 100; N = 10; PMT = 0.11 x 100 = 11; PV = V+ = 109.42
D = effective duration

= [(V- - V+) / (2V0(y))]

= (116.40 109.42)/(2x112.84x0.005)
= 6.19

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Answer 10: Correct answer is C

PVBP = initial price price if yield changed by 1 bps.

Initial price:
FV = 1000
PMT = 50
N = 14
I/Y = 3%
CPT PV = 1225.92

Price with change:

FV = 1000
PMT = 50
N = 14
I/Y = 3.005
CPT PV = 1225.28

PVBP = 1,225.92 1,225.28 = 0.64

PVBP is always the absolute value.

Answer 11: Correct answer is A

First calculate the probability of a down move as: pd = 1 pu = 1 0.6074 = 0.3926

Next calculate the terminal values of the option at expiration for each node of the tree:
Suu = $30 1.10 1.10 = $36.30, Puu = $0
Sud = $30 1.10 0.90 = $29.70, Pud = $2.80
Sdu = $30 0.9 1.10 = $29.70, Pdu = $2.80
Sdd = $30 0.9 0.9 = $24.30, Puu = $8.20
Since this is an American option, we need to compare the discounted present value of the option to its
intrinsic value after the end of the first 6-month period to see if the option is worth more dead than alive.

Su = $33, which means the intrinsic value of the put in the up node after six months is $0, and the option
is worth more alive than dead.

Su = $27, which means the intrinsic value of the put in the down node after six months is ($32.50 $27) =
$5.50. Since $5.50 > $4.817, the option should be exercised because it is worth more dead than alive.
Finally, we can calculate the price of the American option today as:

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Answer 12: Correct answer is D

The value at any given node in a binomial tree is the present value of the cash flows at the two possible
states immediately to the right of the given node, discounted at the 1-period rate at the node under
examination.

Answer 13: Correct answer is A

T=145/365 = 0.39726
2

d1 = [ln(27/30) + [.04 + .3 /2](.39726)] / (.3.39726)

= (-.10536052 + .0337671) / .18908569
= -.07159342 / .18908569
= -0.37863
d1 = -0.37863 -0.38 N(d1) = 1 -0.6480 = 0.3520
d2 = -0.37863 - .3.39726
= -0.37863 - .18908569
= -.56771569
= -.56772
d2 = -0.56772 -0.57 N(d2) = 1 - 0.7157 = 0.2843
-.04(.39726)

PT = 30e
(1-.2843) 27(1-.352)
= (29.527056 .7157) 17.496
= 21.1325 17.496
p = $3.64

Answer 14: Correct answer is D

This value is obtained using the Black-Scholes model for call option without dividends:
2

So d1=(ln(100/90)+(0.05+0.20 /2))/0.21=0.8768 and using the table, N(0.88)=0.8106. d2=0.87680.21=0.6768, so from the table,N(d2)=N(0.68)=0.7517.
(-0.05)

So the call value is 100(0.8106)-90e

(0.7517)=$16.71.

Answer 15: Correct answer is C

As the value of the underlying increases, the delta of a call option increases. This means more of the
underlying asset is needed to hedge the position.

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Answer 16: Correct answer is C

The delta of forwards is one. The delta of futures is not usually one. Two problems using stop-loss trading
on naked options are transaction costs and stock-price certainty. Gamma is largest when options are atthe-money. For a delta-neutral portfolio, although opposite in sign, theta can serve as a proxy for gamma.

Answer 17: Correct answer is A

Subadditivity the risk of the sum is less than or equal to the sum of the risks. Risk-free condition riskfree assets should be risk less.

Answer 18: Correct answer is C

Only Statement I is correct. The delta-normal VAR model assumes a normal distribution. Statements II,
III, and IV are all disadvantages of the delta-normal VAR model.

Answer 19: Correct answer is B

The Taylor Series approximation adds a second order term (i.e., the second derivative of the value
function) to the slope (i.e., the first derivative of the value function) to estimate the rate of change in the
value of the non-linear derivative. Doing so improves the estimated value change for large changes in the
underlying asset value. The slope by itself only provides a reasonable estimate of price sensitivity for
small changes but when combined with the rate of change, the convexity of the value function for the nonlinear derivative is accounted for. Applying this methodology in the context of a VAR calculation improves
the estimate of potential value loss. For linear derivatives, such as forwards and futures, the linear
approximation and Taylor Series approximation should be equivalent.
Answer 20: Correct answer is C

The value of a linear derivative has a constant linear relationship with the underlying asset. The
relationship does not need to be one-to-one but it must be constant (or approximately constant) and
linear. Forwards, futures, and swaps are generally linear. The value of a nonlinear derivative is a
function of the change in the underlying asset and depends on the state of the underlying asset. Options
generally are nonlinear.

Answer 21: Correct answer is A

An RCSA provides no independent verification of risk measurement and identification.

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Answer 22: Correct answer is C

The use of scorecard data usually results in a lower capital charge than the use of historical loss data.

Answer 23: Correct answer is A

Bottom-up models analyze risk in individual processes. Therefore, they are relatively complex (especially
when processes are aggregated) and can differentiate between HFLS and LFHS events. Bottom-up
approaches are very data intensive in relation to top-down models, which use aggregate data.

Answer 24: Correct answer is A

Moral hazard is the notion that an insured will engage in more risky behavior than would be the case in
the absence of insurance. Deductibles and co-insurance features cause the insured to participate in at
least a portion of losses incurred by the firm. An insurance policy with a deductible does not cover losses
below the deductible amount. A policy with a co-insurance feature does not cover losses above the coinsurance limit. Diversification and reinsurance are techniques insurance companies use to manage other
risks.

Answer 25: Correct answer is D

The bottom-up difference is that the focus is on loss causes rather than just loss indicators. Bottom-up
operational risk measures may be either quantitative or qualitative.

Answer 26: Correct answer is A

The biggest disadvantage of using historical events or historical simulations for stress testing is that it is
limited to only evaluating events that have actually occurred. The stress scenario approach has the
advantage of not being limited to analyzing only events that actually have occurred.

Answer 27: Correct answer is C

One of the main drawbacks to VAR is that it fails to incorporate the loss that may occur beyond the 95%
confidence level, such as the loss that may occur with an extreme market event. This drawback of VAR is
the reason stress testing is necessary. Note that increasing the time period resulting in an increase in
VAR would not be considered a drawback; the fact that VAR is expressed in dollars means the
interpretation would the same for a fixed-income portfolio and that VAR is a forward-looking measure, not
a backward-looking measure.

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Answer 28: Correct answer is D

In total, there will be 324 = 24 scenarios (i.e., rows in the table). Therefore, 18 additional rows will have
to be added.

Answer 29: Correct answer is D

Prior to crisis, stress testing methodologies were based on the underlying assumption that risk is
generated by known and non-random processes (which would mean that historical statistical relationships
can be useful in predicting future stress events, an assumption which was certainly disapproved by the
recent turmoil).
Basis is the difference in the prices (or interest rates) between the cash and the futures markets and
basis risk is the change in basis between the opening and closing of a futures position.

Answer 30: Correct answer is D

A Moody's rating of Ba or lower is considered below investment grade.

Answer 31: Correct answer is C

Higher ratings are associated with lower yields, thus meaning a negative correlation between yields and
ratings.

Answer 32: Correct answer is C

Bonds rated Baa and above are considered investment grade, and those rated Ba and below are noninvestment grade.
Answer 33: Correct answer is C

The purpose of through-the-cycle approaches is to have a longer horizon that averages out the effect of
the business cycle.
Answer 34: Correct answer is C

Country risk may be defined as the likelihood of delayed, reduced, or omitted payment of interest and
principal attributable to conditions of the country of the borrower. It is the broadest measure of credit risk
and includes sovereign risk, political risk, and transfer risk. One of the most unfortunate aspects of
country risk is that it is contagiouswhat affects one country tends to affect others.

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Answer 35: Correct answer is C

Borrowers benefits from rescheduling debt:

Lowers the present value (PV) of its future hard currency payments, and thereby increases the
consumption of foreign imports.
Increases the rate of its domestic investment compared to default.

Answer 36: Correct answer is A

INVR =0.38 = real investment /GNP = 38% of GNP

Answer 37: Correct answer is A

Answer 38: Correct answer is B

$200,000 = $5,000,000 (1 RR) (0.05). Therefore, the recovery rate = 20% and loss given default =
80%.

Answer 39: Correct answer is A

Adjusted exposure = OS + (COM OS) UGD

= $8,000,000 + ($12,000,000) (0.75)
= $17,000,000
Answer 40: Correct answer is C

Statement I is incorrect because private borrowers cannot cross check with public rating agencies.
Statement II is a disadvantage to parameterizing credit risk models since any one bank only views its own
loss history and not the population of loan losses. Statement III is correct and so the observable nature of
commitments outstandings is a straightforward factor to parameterize.

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Answer 41: Correct answer is B

Answer 42: Correct answer is A

The standard default model assumes a two-state (binary) default process. Therefore, the variance = EDF
0.5
(1 EDF) = (0.12) (1 0.12) = 0.1056. Thus, standard deviation of default frequency (0.1056) =
0.3496.

Answer 43: Correct answer is A

We can calculate the expected loss as follows:

EL = AE EDF LGD
Adjusted exposure = OS + (COM OS) UGD = $20,000,000 (0.6) + ($800,000) (0.75) =
$18,000,000.
EL = ($18,000,000) (0.02) (0.60) = $216,000.

Ratio = $834,626 / $216,000 = 3.86 (closest to 4.0).

Answer 44: Correct answer is C

The one percent VAR assuming normality corresponds to -2.33 and over the next 100 trading periods a
return worse than -2.33 is expected to occur two times.
Answer 45:
Part 1) Correct answer is D

The correct value is simply the delta of the put option in Exhibit 2.
The incorrect value -$3.61 represents the change due to the volatility divided by 10 multiplied by 1.
The incorrect value -$0.37 calculates the change by dividing the short-term interest rate divided by 100.
The incorrect value $0.67 represents the change in the call option.
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Part 2) Correct answer is C

The correct value 0.0180 is referred to as the put option's Gamma.

The incorrect value -0.3264 is the delta of the put option.
The incorrect value 0.6736 is the call option's delta.
The incorrect value 36.0527 is the put option's Vega.

Answer 46: Correct answer is C

As yields increase, bond prices fall, the price curve gets flatter, and changes in yield have a smaller effect
on bond prices. As yields decrease, bond prices rise, the price curve gets steeper, and changes in yield
have a larger effect on bond prices. Thus, the price increase when interest rates decline must be greater
than the price decrease when interest rates rise (for the same basis point change). Remember that this
applies to percentage changes as well.

Answer 47:
Part 1) Correct answer is A

This is the price value of a basis point (PVBP) per one million dollar par as shown in Table 2.
Part 2) Correct answer is D

PVBP = (0.0001) D (price + accrued interest) 10,000

Note: The 10,000 is to convert the price to $1,000,000 par to match the PVBP units.
Rearranging, D = PVBP (price + interest) = 1,211.2284 (133.75 + 2.5824) = 8.88
Part 3) Correct answer is A

Change in portfolio value = -0.001 duration portfolio value. Change in portfolio value = -0.001
8.88438 $100,000,000 = $888,438.

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