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Certification Provider: PRMIA

Exam Name: Operational Risk Manager (ORM) Exam

Number of questions in our database: 241

Exam Version: Jan. 22, 2023

Exam Official Topics:

**Topic 1:**Single Topic

Question #1

Which of the following belong to the family of generalized extreme value distributions:

1. Frechet

2. Gumbel

3. Weibull

4. Exponential

Extreme value theory focuses on the extreme and rare events, and in the case of VaR calculations, it is focused on the right tail of the loss distribution. In very simple and non-technical terms, EVT says the following:

1. Pull a number of large iid random samples from the population,

2. For each sample, find the maximum,

3. Then the distribution of these maximum values will follow a Generalized Extreme Value distribution.

(In some ways, it is parallel to the central limit theorem which says that the the mean of a large number of random samples pulled from any population follows a normal distribution, regardless of the distribution of the underlying population.)

Generalized Extreme Value (GEV) distributions have three parameters: (shape parameter), (location parameter) and (scale parameter). Based upon the value of , a GEV distribution may either be a Frechet, Weibull or a Gumbel. These are the only three types of extreme value distributions.

Question #2

Which of the following decisions need to be made as part of laying down a system for calculating VaR:

1. The confidence level and horizon

2. Whether portfolio valuation is based upon a delta-gamma approximation or a full revaluation

3. Whether the VaR is to be disclosed in the quarterly financial statements

4. Whether a 10 day VaR will be calculated based on 10-day return periods, or for 1-day and scaled to 10 days

While conceptually VaR is a fairly straightforward concept, a number of decisions need to be made to select between the different choices available for the exact mechanism to be used for the calculations.

The Basel framework requires banks to estimate VaR at the 99% confidence level over a 10 day horizon. Yet this is a decision that needs to be explicitly made and documented. Therefore 'I' is a correct choice.

At various stages of the calculations, portfolio values need to be determined. The valuation can be done using a 'full valuation', where each position is explicitly valued; or the portfolio(s) can be reduced to a handful of risk factors, and risk sensitivities such as delta, gamma, convexity etc be used to value the portfolio. The decision between the two approaches is generally based on computational efficiency, complexity of the portfolio, and the degree of exactness desired. 'II' therefore is one of the decisions that needs to be made.

The decision as to disclosing the VaR in financial filings comes after the VaR has been calculated, and is unrelated to the VaR calculation system a bank needs to set up. 'III' is therefore not a correct answer.

Though the Basel framework requires a 10-day VaR to be calculated, it also allows the calculation of the 1-day VaR and and scaling it to 10 days using the square root of time rule. The bank needs to decide whether it wishes to scale the VaR based on a 1-day VaR number, or compute VaR for a 10 day period to begin with. 'IV' therefore is a decision to be made for setting up the VaR system.

Question #3

Which of the following statements are true:

1. Pre-settlement risk is the risk that one of the parties to a contract might default prior to the maturity date or expiry of the contract.

2. Pre-settlement risk can be partly mitigated by providing for early settlement in the agreements between the counterparties.

3. The current exposure from an OTC derivatives contract is equivalent to its current replacement value.

4. Loan equivalent exposures are calculated even for exposures that are not loans as a practical matter for calculating credit risk exposure.

Pre-settlement risk is the risk that one of the counterparties defaults prior to the date for the maturity of the transaction in question. This may be an unrelated default, in fact there may have been no default on that particular contract, but the party may have defaulted on its other obligations, or filed for bankruptcy. To deal with such cases and to protect the interests of both the parties, it is common to provide for immediate termination of positions and settlement based on the current replacement value of the contracts. Therefore statements I and II are correct.

Statement III is correct as well - the exposure from an OTC derivative contract derives from its current replacement value, and not the notional. If the current replacement value is negative, then the credit exposure is considered equal to zero.

Statement IV is correct as it is quite common to restate all exposures - those from credit lines, OTC derivatives etc - in loan equivalent terms prior to estimating credit risk.

Question #4

Which of the following can be used to reduce credit exposures to a counterparty:

1. Netting arrangements

2. Collateral requirements

3. Offsetting trades with other counterparties

4. Credit default swaps

Offsetting trades with other counterparties will not reduce credit exposure to a given counterparty. All other choices represent means of reducing credit risk. Therefore Choice 'c' is the correct answer.

Question #5

The risk that a counterparty fails to deliver its obligation upon settlement while having received the leg owed to it is called:

Choice 'd' is the correct answer. Settlement risk, as the name suggests, arises upon settlement when one of the parties delivers its obligation under the transaction and the other does not. Consider a EUR/USD FX forward contract maturing in a month. At maturity, one of the parties will deliver EURs and the other USDs. If one party fails to deliver, then it constitutes a very large risk to the other party. This risk is much larger than pre-settlement risk, because the amount at risk is the entire notional and not just the replacement value. Of course, settlement risk exists for a very short period of time, no more than a number or hours or a day.

There is no such thing as 'replacement risk', and credit risk is a larger category of which settlement risks is one component. Settlement risk is the most appropriate answer.

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