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FRM Part II Updated
How is factor-based VaR used in stress testing and scenario analysis?
Factor-based stress testing applies extreme scenario shocks to portfolio factor sensitivities, producing estimated P&L impacts. Historical scenarios replay actual crises, while hypothetical scenarios design specific shocks. Multi-factor consistency is critical — factor correlations typically spike during stress.
What is wrong-way risk and how do you measure it?
Wrong-way risk occurs when exposure to a counterparty increases simultaneously with their default probability. Specific WWR involves a direct causal link; general WWR arises from broad economic factors. It is measured through exposure-default correlation, alpha multipliers, or conditional exposure analysis.
How are recovery rates modeled in practice and what factors affect LGD estimation?
Recovery rate modeling is crucial because Loss Given Default directly scales expected and unexpected credit losses. Key factors include seniority of the claim, industry sector, economic conditions at default, and the legal framework of the jurisdiction.
How is Basel III regulatory capital structured, and what is the loss-absorption waterfall?
Basel III regulatory capital is structured in a loss-absorption waterfall: CET1 (common equity) absorbs losses first, followed by CET1 buffers, AT1 contingent convertibles, Tier 2 subordinated debt, and TLAC-eligible senior debt. Each layer has specific instruments, minimum requirements, and triggers.
Why is Expected Shortfall considered superior to VaR, and what makes a risk measure 'coherent'?
Expected Shortfall (ES) is superior to VaR because it satisfies all four properties of a coherent risk measure, including subadditivity — meaning diversification always reduces or maintains risk. VaR can violate subadditivity, telling you diversification increases risk, which is economically nonsensical.
What is Liquidity-Adjusted VaR (LVaR), and how do funding liquidity risk and market liquidity risk interact?
Liquidity risk is one of the most practically important topics in FRM Part II. Market liquidity risk is the inability to sell an asset at fair value without price impact; funding liquidity risk is the inability to meet cash obligations. Liquidity-Adjusted VaR corrects standard VaR by adding a spread-based liquidity cost component.
How do banks design an operational risk appetite statement?
An operational risk appetite statement articulates the type and amount of operational risk a bank is willing to accept in pursuit of its strategic objectives...
How do you measure and manage pension surplus volatility?
Surplus volatility combines asset variance, liability variance, and their covariance — LDI matching drives it down dramatically.
What are the supervisory LGD values under Foundation IRB?
F-IRB uses supervisory LGD: 45% senior unsecured, 75% subordinated, 11.25% covered bonds. Secured uses LGD* formula blending unsecured and collateral LGD. Maturity fixed at 2.5 years...
What are the different levels of external review for green bonds, and how do they affect investor confidence?
Green bond external review ranges from second-party opinions (moderate assurance, most common) to CBI certification (highest assurance, most rigorous). Each type differs in scope, depth, ongoing monitoring, and cost, with certification providing the strongest defense against greenwashing.
What is the difference between portfolio margining and product margining, and how does portfolio margining improve capital efficiency?
Product margining calculates requirements per product with no offsets, while portfolio margining recognizes risk-reducing correlations across products. Portfolio margining typically reduces total margin by 30-70% but relies on correlation assumptions that may break down under stress.
What is DORA, and how does it change ICT risk management requirements for financial institutions?
DORA establishes five pillars of ICT risk management for EU financial institutions: risk framework, incident reporting, resilience testing, third-party risk oversight, and information sharing. The most disruptive change is direct regulatory oversight of critical ICT providers and mandatory threat-led penetration testing.
How are liquidity horizons assigned to risk factors under FRTB, and why do they matter for capital calculations?
Under FRTB, risk factors are assigned liquidity horizons from 10 to 120 days based on how quickly they can be closed during stress. The composite ES aggregates incremental risk at each horizon, significantly increasing capital for positions in illiquid risk factors.
What is the Comprehensive Risk Measure (CRM), and why was it created specifically for correlation trading portfolios?
The Comprehensive Risk Measure was a Basel 2.5 capital charge for correlation trading portfolios like CDO tranches, capturing default correlation changes, tranche leverage, and recovery uncertainty at 99.9% confidence over one year. Under FRTB, it was eliminated and replaced by longer-horizon ES and DRC.
How does the Red/Amber/Green model validation framework work?
The RAG framework classifies model validation findings into Red (critical, immediate remediation), Amber (significant, 6-12 month fix), and Green (minor, next cycle). Classification is based on materiality of impact on capital, P&L, or risk limits.
How do you compute parametric VaR when returns are non-normal? Is there a Cornish-Fisher adjustment?
The Cornish-Fisher expansion modifies the standard normal quantile to account for skewness and excess kurtosis, producing a more accurate VaR estimate without abandoning the parametric approach.
How does the Cornish-Fisher expansion adjust VaR for non-normality, and when should you use it?
The Cornish-Fisher expansion adjusts the normal z-score for skewness and kurtosis, providing a quick analytical VaR correction. It works well for moderate non-normality but breaks down at extreme confidence levels or very fat tails.
How do banks estimate exposure at default (EAD), especially for off-balance-sheet commitments?
EAD for unfunded commitments includes expected drawdowns: EAD = Drawn + CCF x Undrawn. Credit conversion factors reflect the empirical observation that distressed borrowers draw down credit lines before defaulting.
What are the main stress testing frameworks used in bank risk management?
Stress testing is a forward-looking risk management tool that evaluates portfolio performance under severe but plausible adverse scenarios. The main frameworks include sensitivity analysis, historical scenario analysis, hypothetical scenario analysis, and reverse stress testing.
How does the Basel backtesting traffic light system work for validating VaR models?
The Basel backtesting traffic light system validates VaR models by counting exceptions over 250 trading days. Green zone (0-4 exceptions) means the model is accepted with a 3.0x multiplier. Yellow zone (5-9) triggers regulatory inquiry and higher multipliers. Red zone (10+) indicates model failure with a 4.0x multiplier.
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