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Question 1Risk Management Fundamentals and Governance

A bank's board delegates day-to-day risk oversight to a committee that reviews limits, approves new products, and monitors risk appetite utilization. Which body is this most likely to be?

  1. The compliance helpdesk
  2. The board risk committee Correct answer.
  3. The external audit firm
  4. The internal audit function

Explanation

Board-level risk committees are the standard mechanism through which directors exercise oversight of the risk framework, approving limits and monitoring appetite without managing risks directly. Internal audit provides independent assurance rather than owning limits, and external parties have no governance authority inside the firm.

Question 2Risk Management Fundamentals and Governance

Which statement best describes the 'three lines of defense' model?

  1. Each business line must employ three risk officers
  2. Three separate audit teams report to the chief executive
  3. Risk is managed by the regulator, the board, and shareholders in turn
  4. Business units own risk, a risk function oversees it, and internal audit provides independent assurance Correct answer.

Explanation

The model separates risk ownership in the first line, independent oversight and challenge in the second line, and independent assurance in the third line. Its value comes from that separation of duties, not from headcount or external parties.

Question 3Risk Management Fundamentals and Governance

Enterprise risk management is best characterized by which feature?

  1. Focusing exclusively on market risk in the trading book
  2. Managing each risk in isolation within its own department
  3. Aggregating risks across the whole firm against a shared risk appetite Correct answer.
  4. Eliminating all risks that cannot be insured

Explanation

ERM takes a portfolio view, so that interdependent risks are assessed together and compared with an appetite set at firm level. Siloed management misses correlations and concentrations that only appear in aggregate.

Question 4Risk Management Fundamentals and Governance

A firm defines its risk appetite as the maximum loss it is willing to accept in a severe stress scenario. This statement is an example of which component of the risk framework?

  1. A control self-assessment
  2. A risk register entry
  3. A risk appetite statement Correct answer.
  4. A key risk indicator

Explanation

Risk appetite statements express the amount and type of risk an organization is willing to accept in pursuit of objectives. Registers, indicators and self-assessments are tools used to monitor and evidence that appetite is being respected.

Question 5Risk Management Fundamentals and Governance

Which risk category arises from inadequate or failed internal processes, people, systems, or external events?

  1. Strategic risk
  2. Market risk
  3. Operational risk Correct answer.
  4. Liquidity risk

Explanation

Operational risk is defined by failures in process, people, systems or from external events, and it includes legal and fraud losses. Market and liquidity risks stem from price and funding movements rather than process failure.

Question 6Risk Management Fundamentals and Governance

A risk register entry records an inherent risk rating of high, a control rating of strong, and a resulting residual risk of medium. What does the residual rating represent?

  1. The regulator's assessment of the firm
  2. The risk before any controls are considered
  3. The risk remaining after existing controls are applied Correct answer.
  4. The cost of the controls currently in place

Explanation

Residual risk is the exposure left once the mitigating effect of current controls is taken into account. Inherent risk is the gross exposure before controls, so the two ratings answer different questions.

Question 7Risk Management Fundamentals and Governance

Which of the following is a primary responsibility of a firm's chief risk officer?

  1. Setting the firm's marketing strategy
  2. Challenging business risk-taking and reporting exposures independently to the board Correct answer.
  3. Managing the trading desk's daily positions
  4. Approving the annual financial statements

Explanation

The CRO provides independent oversight, challenges risk-taking, and gives the board an unfiltered view of exposures. Taking positions or setting commercial strategy would compromise that independence.

Question 8Risk Management Fundamentals and Governance

Why does a firm maintain a formal risk culture program with tone-from-the-top statements and escalation channels?

  1. To replace the need for internal audit testing
  2. To reduce the number of regulatory examinations
  3. To guarantee that no risk event can ever occur
  4. To encourage staff to surface concerns and escalate risks without fear of blame Correct answer.

Explanation

Risk culture programs aim to make risk awareness and open escalation normal behavior throughout the organization. No culture program can eliminate risk events or substitute for independent assurance.

Question 9Risk Management Fundamentals and Governance

A firm's risk appetite states a maximum tolerance for operational losses of 5 million per year, but actual losses have run at 7 million for two consecutive years. What is the most appropriate governance response?

  1. Reclassify the losses as market risk to stay within tolerance
  2. Immediately dismiss the head of internal audit
  3. Escalate the breach, investigate root causes, and require an approved remediation plan Correct answer.
  4. Take no action because the limit is only a guideline

Explanation

Appetite limits are binding governance thresholds, so a sustained breach must be escalated and remediated with oversight. Reclassifying losses would misstate risk, and treating limits as advisory defeats the framework.

Question 10Risk Management Fundamentals and Governance

A trading unit wants to launch a structured product with unfamiliar payoff features. Under sound governance, which step should occur before launch?

  1. A retrospective review conducted one year after launch
  2. Waiver of risk limits because the product is innovative
  3. Delegation of approval to the sales team that will distribute it
  4. A new product approval process assessing risks, limits, and operational readiness Correct answer.

Explanation

New product approval processes require risk assessment, limit setting, and confirmation that systems and controls can support the product before it is sold. Retrospective review or self-approval by the revenue line removes independent challenge.

Question 11Risk Management Fundamentals and Governance

A risk committee reviews a report showing that a portfolio's value at risk has risen 40 percent in a month while limits are unchanged. What does this most directly signal?

  1. An error, because VaR cannot change without a limit change
  2. Rising exposure relative to the approved limit, requiring review and possible action Correct answer.
  3. That market risk has been fully hedged
  4. A guaranteed loss on the portfolio in the coming month

Explanation

VaR measures potential loss at a confidence level, so a sharp increase means the portfolio's risk profile has grown relative to its limit. It is not a forecast of certain loss, and limits do not mechanically control measured risk.

Question 12Risk Management Fundamentals and Governance

A bank's board wants assurance that its risk framework is working as designed. Which function is best placed to provide that independent assurance?

  1. The external public relations firm
  2. The treasury front office
  3. Internal audit Correct answer.
  4. The first-line business unit

Explanation

Internal audit sits in the third line and independently evaluates whether the risk framework and controls operate effectively. First-line units own and execute controls, so they cannot objectively assure on their own work.

Question 13Risk Management Fundamentals and Governance

Which practice best supports the independence of a firm's risk management function?

  1. Risk staff are compensated mainly on trading profits
  2. The CRO reports to the board or its risk committee rather than to a revenue-generating executive Correct answer.
  3. The risk function is embedded within the sales department
  4. Risk managers approve their own limit exceptions

Explanation

Independence is preserved when the risk function has a reporting line to the board and its compensation is not tied to the business it oversees. Embedding risk in revenue units or letting it self-approve exceptions creates conflicts.

Question 14Risk Management Fundamentals and Governance

A firm maps its risks on a heat map using likelihood and impact. A risk appears in the high-likelihood, high-impact quadrant but has a strong control environment. What is the most useful next step?

  1. Assume the risk is fully eliminated by the controls
  2. Remove the risk from the register because controls exist
  3. Increase the likelihood rating to reflect the controls
  4. Compare residual exposure against appetite and confirm monitoring and ownership Correct answer.

Explanation

Heat maps inform prioritization, but decisions should rest on residual exposure versus appetite, with clear ownership and monitoring. The existence of controls reduces but does not remove a risk.

Question 15Risk Management Fundamentals and Governance

Which of the following best describes the purpose of a risk taxonomy?

  1. To set the firm's maximum acceptable loss level
  2. To provide a consistent classification structure so risks are identified and aggregated comparably Correct answer.
  3. To replace the risk register with a single numeric score
  4. To assign legal liability for each loss event

Explanation

A taxonomy gives a common language and hierarchy so that risks from different units can be compared, aggregated, and reported consistently. It supports identification and reporting rather than setting appetite or allocating blame.

Question 16Risk Management Fundamentals and Governance

A risk manager uses scenario analysis alongside historical loss data when assessing operational risk. Why is this combination preferred?

  1. Historical data may omit rare severe events that scenarios can capture Correct answer.
  2. Scenarios eliminate the need for any loss data collection
  3. Historical data always overstate tail losses, so scenarios correct them downward
  4. Scenario analysis is only useful when historical data are complete

Explanation

Loss data capture frequent events but often lack observations of severe tail events, so scenarios supplement them to inform capital and controls. Neither tool alone gives a complete picture of the loss distribution.

Question 17Risk Management Fundamentals and Governance

A firm sets a risk appetite that is deliberately conservative, holding capital well above regulatory minima. What is the main governance benefit of this choice?

  1. Higher returns on equity in all market conditions
  2. Exemption from regulatory capital requirements
  3. A buffer that absorbs unexpected losses and reduces the chance of breaching constraints Correct answer.
  4. Complete protection against reputational damage

Explanation

A conservative appetite builds a cushion so that unexpected losses do not immediately threaten regulatory or contractual constraints. It does not guarantee returns, prevent reputational harm, or exempt the firm from rules.

Question 18Risk Management Fundamentals and Governance

A firm's risk committee charter states that the committee meets quarterly and reviews top risks and limit breaches. Which governance weakness would a reviewer most likely flag?

  1. The committee reviews too many risks to be effective
  2. The charter mentions limit breaches at all
  3. Quarterly review may be too infrequent to respond to fast-moving breaches Correct answer.
  4. The committee has a written charter

Explanation

Effective risk oversight requires meeting frequency matched to the pace of the risks being monitored, and quarterly cycles can lag fast-moving exposures. Having a charter and reviewing breaches are strengths, not weaknesses.

Question 19Risk Management Fundamentals and Governance

Which statement best captures the relationship between risk appetite and risk capacity?

  1. Capacity is set by the risk committee and appetite by regulators
  2. Capacity is the maximum risk the firm can bear before failing; appetite should sit within it Correct answer.
  3. The two terms are interchangeable in governance documents
  4. Appetite is always larger than capacity because it is aspirational

Explanation

Risk capacity is the absolute limit the firm can absorb, such as capital and liquidity constraints, while appetite is the amount management chooses to take within that capacity. Appetite exceeding capacity would be imprudent.

Question 20Risk Management Fundamentals and Governance

A firm identifies a concentration of credit exposure to a single counterparty that exceeds its internal limit. Which action is most consistent with sound risk governance?

  1. Ignore the breach until the annual audit
  2. Increase the limit retroactively without review
  3. Escalate to the risk committee, reduce exposure, and document an approved exception if needed Correct answer.
  4. Reclassify the exposure as operational risk

Explanation

Limit breaches require prompt escalation, remediation, and formal approval of any temporary exception with clear accountability. Retroactive or unreviewed limit changes undermine the control framework.

Question 21Risk Management Fundamentals and Governance

A firm's board includes a risk committee whose members have deep banking and risk expertise but no independent directors. What governance concern does this raise?

  1. Lack of independence may reduce objective challenge of management Correct answer.
  2. The committee will be unable to read risk reports
  3. Expertise makes independence irrelevant
  4. Independent directors are only needed on audit committees

Explanation

Independence supports objective challenge of management's risk-taking, and expertise does not substitute for it. Governance codes generally expect risk committees to include independent non-executive directors.

Question 22Risk Management Fundamentals and Governance

A firm wants to embed risk management into decision-making rather than treat it as a compliance exercise. Which approach best supports this?

  1. Restricting risk reporting to the annual report
  2. Removing risk considerations from product pricing
  3. Assigning risk ownership exclusively to the risk function
  4. Linking risk-adjusted returns and limit compliance to business incentives and performance reviews Correct answer.

Explanation

Incentives drive behavior, so tying performance and rewards to risk-adjusted outcomes and limit compliance embeds risk in decisions. Isolating risk in a single function or reporting cycle keeps it peripheral.

Question 23Risk Management Fundamentals and Governance

A firm's risk function reports to the chief financial officer, who also oversees the trading businesses whose risks are being measured. What is the most significant governance issue?

  1. The reporting line creates a conflict that can compromise independent challenge Correct answer.
  2. The CFO lacks the technical ability to read risk reports
  3. Risk reports will necessarily contain arithmetic errors
  4. The arrangement violates accounting standards on consolidation

Explanation

Independence requires that risk oversight not be subordinated to the executives whose risk-taking it monitors, since this creates pressure to soften challenge. Technical competence and reporting accuracy are separate matters from structural independence.

Question 24Risk Management Fundamentals and Governance

A firm aggregates risks across business units and finds that individually acceptable exposures combine into a firm-level concentration far above appetite. Which concept does this illustrate?

  1. That diversification guarantees lower total risk
  2. Risk aggregation and correlation effects that siloed oversight would miss Correct answer.
  3. That appetite should be set separately for each unit with no firm-level view
  4. That unit-level limits are always set too loosely

Explanation

Firm-level risk can exceed the sum of unit views when exposures are correlated or concentrated, which is why aggregation and a portfolio perspective are central to ERM. The finding does not imply unit limits are wrong or that diversification always reduces risk.

Question 25Risk Management Fundamentals and Governance

A regulator asks a firm to demonstrate that its risk appetite is operational. Which evidence most convincingly shows this?

  1. Marketing materials describing the firm as risk-aware
  2. A single board resolution adopting a risk appetite statement
  3. A statement that appetite is reviewed whenever convenient
  4. Cascaded limits, metrics, and escalation records tied to each appetite statement Correct answer.

Explanation

An operational appetite is translated into limits and metrics with documented escalation when thresholds are breached. A standalone statement or promotional claim does not demonstrate that appetite influences decisions.

Question 26Risk Management Fundamentals and Governance

Which three components together make up the classic definition of risk used in enterprise risk management?

  1. Hazard, exposure, and vulnerability
  2. Likelihood, impact, and uncertainty Correct answer.
  3. Frequency, severity, and correlation
  4. Volatility, liquidity, and leverage

Explanation

Risk is conventionally described as the combination of the probability that an event occurs, the consequences if it does, and the uncertainty inherent in those estimates. Frequency and severity describe loss data, and hazard and exposure describe insurance perils, but neither set captures uncertainty as a distinct element.

Question 27Risk Management Fundamentals and Governance

In enterprise risk management, what distinguishes a strategic risk from a pure risk?

  1. Strategic risk is measured only qualitatively, while pure risk is always quantified
  2. Strategic risk can produce gains as well as losses, while pure risk offers only downside Correct answer.
  3. Strategic risk arises only from internal decisions, while pure risk arises only externally
  4. Strategic risk is managed by the business, while pure risk is transferred to insurers

Explanation

Pure risks, such as fire or fraud, have only adverse outcomes and are typically handled by mitigation or transfer. Strategic risks arise from business choices and competitive positioning, so they are two-sided: taking them can create value as well as destroy it.

Question 28Risk Management Fundamentals and Governance

A firm defines a risk as having a 1-in-50 annual probability and an estimated loss of 20 million. A manager argues the risk should be ranked above a risk with a 1-in-5 annual probability and an estimated loss of 3 million. Using a simple expected-loss approach, which conclusion is correct?

  1. The two risks rank equally because probability and impact offset each other
  2. The first risk ranks higher because its single-event loss is much larger
  3. The second risk ranks higher because its expected loss of 600,000 exceeds 400,000 Correct answer.
  4. Neither risk can be ranked without knowing the firm's risk appetite

Explanation

Expected loss multiplies probability by impact. The first risk gives 0.02 times 20 million, or 400,000, while the second gives 0.20 times 3 million, or 600,000, so the second ranks higher on this measure. Risk appetite informs tolerance decisions but is not needed to compute expected loss.

Question 29Risk Management Fundamentals and Governance

A firm is deciding how to treat a risk that it cannot avoid because the activity is core to its strategy, and the potential loss is too large to retain comfortably. Which treatment approach fits best?

  1. Reduce the risk through controls and transfer part of it Correct answer.
  2. Ignore the risk until a loss event occurs
  3. Avoid the risk by exiting the activity entirely
  4. Accept the risk and budget for the expected loss

Explanation

Risk treatment options are avoid, reduce, transfer, and accept. When the activity must be retained but the exposure is uncomfortable, combining mitigation with partial transfer, such as insurance or hedging, lowers the retained exposure while preserving the strategy.

Question 30Risk Management Fundamentals and Governance

A firm's risk governance documents state that business units own their risks while the risk function sets frameworks and challenges assessments. A business unit disputes a risk-function challenge and escalates it. Which principle does this arrangement best illustrate?

  1. Delegation, in which the board transfers its oversight duties to business units
  2. The three-lines model, in which ownership and independent oversight are separated Correct answer.
  3. Centralization, in which all risk decisions are made by the risk function
  4. Outsourcing, in which a third party assumes the firm's risk management

Explanation

Under the three-lines model, the business owns and manages risk in the first line, while an independent risk and compliance function provides oversight and challenge in the second line. Escalation preserves that separation rather than merging ownership with oversight.

Question 31Risk Identification, Measurement and Assessment

Which risk measure directly estimates the largest loss that will not be exceeded over a given horizon at a stated confidence level?

  1. Standard deviation of returns
  2. Value at Risk Correct answer.
  3. Duration gap
  4. Expected shortfall

Explanation

Value at Risk reports a loss threshold such that losses exceed it only with probability equal to one minus the confidence level, so it answers the question of a worst-case loss at that confidence. Expected shortfall instead averages losses beyond that threshold.

Question 32Risk Identification, Measurement and Assessment

A portfolio has a one-day 95% VaR of USD 2 million. Which interpretation is correct?

  1. The average one-day loss is USD 2 million
  2. The maximum possible loss over one day is USD 2 million
  3. Over 95 days the firm will lose exactly USD 2 million
  4. There is a 5% chance that the one-day loss exceeds USD 2 million Correct answer.

Explanation

VaR is a quantile of the loss distribution, so a 95% one-day VaR of USD 2 million means losses are expected to exceed that amount on roughly 5% of days. It is not a worst-case bound and not an average.

Question 33Risk Identification, Measurement and Assessment

Which property does expected shortfall satisfy that Value at Risk generally does not?

  1. It can be computed from historical data
  2. It is sub-additive, so diversification never increases it Correct answer.
  3. It is expressed in currency units
  4. It uses a confidence level

Explanation

Expected shortfall is a coherent risk measure and therefore sub-additive: the combined risk of two books cannot exceed the sum of their standalone risks. VaR can violate sub-additivity, penalising diversification in some distributions.

Question 34Risk Identification, Measurement and Assessment

A bank's trading book shows a 99% ten-day VaR of USD 10 million. Assuming a normal distribution and square-root-of-time scaling, what is the approximate one-day 99% VaR?

  1. USD 5.0 million
  2. USD 3.2 million Correct answer.
  3. USD 1.0 million
  4. USD 7.1 million

Explanation

Under square-root-of-time scaling, the ten-day VaR equals the one-day VaR multiplied by the square root of ten, so the one-day figure is 10 divided by about 3.16, giving roughly USD 3.2 million.

Question 35Risk Identification, Measurement and Assessment

Which statement best describes stress testing as a risk measurement tool?

  1. It evaluates portfolio losses under severe but plausible scenarios Correct answer.
  2. It replaces VaR with a single statistically calibrated number
  3. It measures only day-to-day volatility of earnings
  4. It estimates the probability of a specified loss event occurring

Explanation

Stress tests apply extreme but plausible scenarios, such as sharp rate moves or market crashes, and revalue the portfolio under those conditions. They complement statistical measures by capturing tail events and non-linear exposures that historical data may understate.

Question 36Risk Identification, Measurement and Assessment

A bond portfolio has a modified duration of 6 and a market value of USD 50 million. For a parallel upward shift of 50 basis points in yields, what is the approximate change in value?

  1. A loss of about USD 150,000
  2. A loss of about USD 1,500,000 Correct answer.
  3. A loss of about USD 15,000,000
  4. A gain of about USD 1,500,000

Explanation

The percentage price change is approximately minus modified duration times the yield change, so minus 6 times 0.005 equals minus 3%. Applying 3% to USD 50 million gives a loss of about USD 1.5 million.

Question 37Risk Identification, Measurement and Assessment

Which Greek measures the sensitivity of an option's delta to a small change in the underlying price?

  1. Theta
  2. Rho
  3. Vega
  4. Gamma Correct answer.

Explanation

Gamma is the second derivative of option value with respect to the underlying price, equivalently the rate of change of delta. It is largest for at-the-money options near expiry.

Question 38Risk Identification, Measurement and Assessment

A risk manager computes a 95% one-year credit VaR using a default-mode model. Which input is essential to the calculation?

  1. The equity beta of each obligor
  2. The historical volatility of the risk-free rate
  3. The trading liquidity of each bond
  4. The expected recovery rate and default probability for each exposure Correct answer.

Explanation

Default-mode credit VaR requires the probability of default and loss given default, which is one minus the recovery rate, for each exposure, together with exposure at default. These determine the distribution of credit losses.

Question 39Risk Identification, Measurement and Assessment

A firm reports a liquidity coverage ratio of 90% under the Basel standard. What does this indicate?

  1. The firm holds more high-quality liquid assets than required
  2. The firm's leverage ratio is below the minimum
  3. The firm's high-quality liquid assets fall short of its 30-day net cash outflows Correct answer.
  4. The firm has no short-term funding risk

Explanation

The liquidity coverage ratio compares high-quality liquid assets with projected net cash outflows over 30 calendar days, and the minimum is 100%. A ratio of 90% means liquid assets cover only nine-tenths of stressed outflows.

Question 40Risk Identification, Measurement and Assessment

Which best defines operational risk under the Basel framework?

  1. The risk of loss from inadequate or failed internal processes, people, systems, or external events Correct answer.
  2. The risk of loss from adverse movements in market prices
  3. The risk of loss from changes in regulatory capital requirements
  4. The risk of loss from a counterparty failing to pay

Explanation

Operational risk covers losses arising from failed or inadequate internal processes, people, and systems, or from external events, and it explicitly includes legal risk. Market and credit risks are separate categories.

Question 41Risk Identification, Measurement and Assessment

A risk analyst calculates a 99% one-day VaR of USD 4 million and observes 12 exceptions over the past 250 trading days. Which conclusion is most appropriate?

  1. The model overestimates risk because exceptions are too frequent
  2. The exceptions prove the model is invalid and must be discarded
  3. The model appears to underestimate risk and should be reviewed Correct answer.
  4. The model is well calibrated because 12 is close to the expected 2.5 exceptions

Explanation

At 99% confidence, roughly 1% of 250 days, or about 2.5 exceptions, are expected. Twelve observed breaches are far more than expected, suggesting the VaR model understates risk and warrants investigation and recalibration.

Question 42Risk Identification, Measurement and Assessment

Which measure of dispersion is most appropriate for capturing tail risk beyond a specified quantile?

  1. Coefficient of variation
  2. Expected shortfall Correct answer.
  3. Median absolute deviation
  4. Interquartile range

Explanation

Expected shortfall averages losses in the tail beyond the VaR threshold, so it directly reflects the severity of extreme outcomes. The other measures describe central dispersion and ignore tail magnitude.

Question 43Risk Identification, Measurement and Assessment

A portfolio holds two independent assets, each with an annual volatility of 10% and equal weights. What is the portfolio volatility?

  1. 10.0%
  2. 5.0%
  3. 14.1%
  4. 7.1% Correct answer.

Explanation

For two independent assets with equal weights and equal volatility, portfolio variance is the sum of squared weighted volatilities, giving 0.5 squared plus 0.5 squared times 0.01, so volatility is about 7.1%. Diversification reduces risk below the weighted average.

Question 44Risk Identification, Measurement and Assessment

Which of the following best describes a key rate duration?

  1. The sensitivity of portfolio value to a change in one specific maturity point on the curve Correct answer.
  2. The sensitivity of a bond's price to a change in its credit spread
  3. The sensitivity of portfolio value to a parallel shift in the yield curve
  4. The average time until a bond's cash flows are received

Explanation

Key rate duration isolates the price sensitivity to a shift at a single maturity point while holding other points constant, allowing a portfolio to be hedged against curve reshaping. Parallel-shift sensitivity is captured by effective duration.

Question 45Risk Identification, Measurement and Assessment

A bank uses a historical simulation approach to compute VaR. Which limitation is most characteristic of this method?

  1. It produces results that are always more conservative than parametric VaR
  2. It requires an assumption that returns are normally distributed
  3. It relies on the historical window and may fail to capture unprecedented events Correct answer.
  4. It cannot incorporate correlations between risk factors

Explanation

Historical simulation revalues the portfolio using past risk-factor changes, so its results depend heavily on the chosen window and may miss events absent from that history. It does not impose normality but is still backward-looking.

Question 46Risk Identification, Measurement and Assessment

Which of the following is the primary purpose of a risk register?

  1. To record identified risks, their owners, and assessed likelihood and impact Correct answer.
  2. To measure the duration of a bond portfolio
  3. To compute regulatory capital requirements
  4. To price derivative contracts

Explanation

A risk register is a structured inventory documenting identified risks, their owners, and assessments of likelihood and impact, along with mitigation actions. It supports ongoing monitoring and prioritisation rather than pricing or capital calculation.

Question 47Risk Identification, Measurement and Assessment

A firm's loss distribution shows a 99.9% one-year unexpected loss of USD 80 million and an expected loss of USD 5 million. If economic capital is set to cover unexpected loss only, what amount is required?

  1. USD 5 million
  2. USD 75 million
  3. USD 85 million
  4. USD 80 million Correct answer.

Explanation

Economic capital for credit risk is typically sized to absorb unexpected loss, the gap between the high-quantile loss and expected loss, so the provision for expected loss is handled separately. Here the unexpected loss figure of USD 80 million is the capital requirement.

Question 48Risk Identification, Measurement and Assessment

Which of the following best describes the difference between systematic and idiosyncratic risk?

  1. Both can be fully eliminated in a large portfolio
  2. Systematic risk can be diversified away, while idiosyncratic risk cannot
  3. Neither can be reduced through diversification
  4. Idiosyncratic risk can be diversified away, while systematic risk cannot Correct answer.

Explanation

Idiosyncratic risk is specific to individual assets and can be reduced by holding a diversified portfolio, whereas systematic risk stems from market-wide factors and remains regardless of diversification.

Question 49Risk Identification, Measurement and Assessment

A derivatives desk holds a large short position in options. Which risk is most concerning when the underlying moves sharply?

  1. High vega reducing implied volatility
  2. Positive theta reducing time value
  3. Negative gamma creating accelerating losses Correct answer.
  4. Low rho from interest rate changes

Explanation

A short option position has negative gamma, meaning delta moves against the holder as the underlying price changes, so losses accelerate during sharp moves. This convexity risk is a central concern for option sellers.

Question 50Risk Identification, Measurement and Assessment

Which statement about the risk of a portfolio measured by variance is correct when correlations between assets decrease?

  1. Portfolio variance becomes equal to the sum of individual variances
  2. Portfolio variance increases because assets become less similar
  3. Portfolio variance decreases because diversification benefits improve Correct answer.
  4. Portfolio variance is unaffected by correlations

Explanation

Lower correlations reduce the covariance terms in the portfolio variance formula, improving diversification and lowering total portfolio variance for a given set of weights and volatilities.