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

Risk reports are used for:

Identification of exceptional situations that require managerial attention: Highlighting issues that need immediate response.

Display the relative risk among different trades: Providing a comparative view of risk levels.

Estimate the overall risk levels of the bank: Summarizing the total risk exposure.

These functions are essential for effective risk management within a financial institution.

Collateralized debt obligations (CDOs) typically have loans or bonds as underlying collateral (Statement I). There is also a correlation among defaults in the CDO collateral, which should be considered in their valuation due to the complexity of these instruments (Statement III). Therefore, the correct statements are I and III.

Identify the transaction details:

Initial value of CDOs = $100

Haircut = 20%

Repo transaction:

With a 20% haircut, the trader can use the CDOs to obtain 80% of their value in cash:

Cash obtained=100×(1−0.20)=80Cash obtained=100×(1−0.20)=80

Explanation:

The trader buys $100 worth of CDOs and then uses these CDOs in a repo transaction to get back $80 (less interest). This fully utilizes the leverage provided by the repo transaction under the specified conditions.

References:

This explanation aligns with standard financial practices for repo transactions and the leverage principles outlined in the document .

Retail products frequently include embedded options, such as early withdrawal options or prepayment options, which customers may not exercise rationally. In contrast, wholesale products typically carry penalties for repayment or include rights to terminate contracts on terms that are different from those in retail products. These distinctions are important for asset and liability management because they affect the predictability and stability of cash flows.

To determine the pound exposure in the aggregated risk reports, we sum the net positions:

Long £500 million:

The bank holds a long position of £500 million.

Short £300 million in delta-equivalent pound options:

This position reduces the exposure by £300 million.

Long £100 million in pound-denominated stocks:

This adds £100 million to the exposure.

Net exposure: 500−300+100=300 million pounds500 - 300 + 100 = 300 \, \text{million pounds}500−300+100=300million pounds

Thus, the pound exposure shown in the aggregated risk reports is £300 million.

ReferencesSource: How Finance Works​

Consortium databases in the context of operational risk management:

Gather loss data from multiple firms to provide a comprehensive view of industry-wide risk events.

Contain anonymous information to protect the identities of the contributing firms while still providing valuable risk data. They do not gather information from news articles, use data only from the top 5% of the industry, or specifically map risk categories with causes.

A clearinghouse serves several vital functions in trading activities, mainly focusing on reducing various types of risk:

Counterparty Risk:

The clearinghouse acts as an intermediary between buyers and sellers, ensuring that each party fulfills its contractual obligations. This reduces the risk that one party will default.

Liquidity Risk:

By centralizing and standardizing transactions, the clearinghouse enhances market liquidity, making it easier to buy and sell without causing significant price changes.

Operational Risk:

The clearinghouse standardizes and streamlines the clearing and settlement processes, reducing the risk of errors and delays.

Credit Risk:

The clearinghouse requires margin deposits and marks positions to market daily, minimizing credit risk.

Thus, the primary purpose of a clearinghouse is to reduce counterparty and liquidity risk.

ReferencesSource: How Finance Works​

Interest rate swaps are over-the-counter (OTC) derivative contracts. They are designed to help banks and customers manage their interest rate exposure without the need to use long-term funding. In an interest rate swap, two parties exchange cash flows from interest rate payments, typically one fixed and one floating rate, based on a notional principal amount. This allows institutions to benefit from the risk/reward profile of long-term interest rates, enabling them to manage their exposure to interest rate fluctuations efficiently.