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FRM Part II Updated
What is intraday liquidity risk and why did regulators start requiring banks to monitor it?
Intraday liquidity risk is the risk that a bank cannot meet its payment and settlement obligations in real time during the business day. BCBS 248 requires banks to monitor specific intraday metrics including peak usage, available liquidity, and throughput ratios.
What are Key Risk Indicators (KRIs) and how do banks set thresholds for them?
Key Risk Indicators (KRIs) are quantifiable metrics that signal changes in the operational risk profile before losses materialize. They function as early warning dashboards with green/amber/red escalation thresholds based on historical analysis and expert calibration.
What's the difference between the LCR and NSFR under Basel III?
The LCR and NSFR are Basel III's two pillars of liquidity regulation, but they address fundamentally different risks. The LCR measures short-term survival over a 30-day stress scenario, while the NSFR assesses structural funding stability over a 1-year horizon.
How do biodiversity credit markets work, and what financial integrity challenges do they face?
Biodiversity credits represent verified positive biodiversity outcomes from ecosystem restoration or protection. Unlike fungible carbon credits, they face fundamental challenges in measurement standardization, permanence, additionality, and comparability across different ecosystem types.
How does a CCP determine the size of each clearing member's default fund contribution, and what methodologies are used?
CCPs size the total default fund to cover simultaneous default of the two largest members under stress (Cover-2 standard), then allocate contributions based on each member's risk profile using pro-rata, stress-loss-based, or hybrid methods with periodic recalculation.
How do the threshold and minimum transfer amount in a CSA create residual unsecured exposure, and how is this quantified?
The threshold allows exposure up to its level without collateral, and the MTA prevents calls below a minimum amount. Together with the margin period of risk, the maximum unsecured exposure equals H + MTA + potential market move during the MPOR.
What is the Residual Risk Add-On under FRTB, and which exotic instruments are in scope?
The Residual Risk Add-On charges 0.1% or 1.0% of gross notional for instruments with residual risks not captured by standard sensitivity measures. It applies to exotic underlyings (weather, catastrophe) and other complex features (barriers, lookbacks, autocallables) with no netting allowed.
How should banks govern machine learning models used in risk management, and what unique challenges do ML models pose for model validation?
ML model governance extends traditional model risk management by addressing interpretability challenges, automated feature engineering risks, and data distribution drift. Banks must implement post-hoc explainability tools, bias testing, champion-challenger deployment, and continuous monitoring with revalidation triggers.
What is the Hurst exponent, and how does it distinguish between mean-reverting, random, and trending time series?
The Hurst exponent quantifies whether a time series trends (H > 0.5), mean-reverts (H < 0.5), or follows a random walk (H = 0.5). Estimated via Rescaled Range analysis, it guides strategy selection: momentum for persistent series, mean-reversion for anti-persistent ones.
What are the key data and modeling requirements for estimating PD, LGD, and EAD under the Advanced IRB approach?
Under A-IRB, banks must estimate PD (5+ years data, through-the-cycle calibration), LGD (7+ years, downturn conditions), and EAD (5+ years, credit conversion factors for undrawn commitments). Each parameter has specific data requirements and calibration rules.
What is the difference between the Foundation IRB and Advanced IRB approaches under Basel, and who estimates which parameters?
Foundation IRB and Advanced IRB use the same risk-weight function but differ in which parameters the bank estimates. Under F-IRB, banks estimate only PD while LGD, EAD, and maturity use supervisory values. Under A-IRB, banks estimate all parameters, potentially achieving lower capital charges.
What is Funding Valuation Adjustment (FVA) and how does it relate to CVA/DVA?
FVA captures the cost or benefit of funding uncollateralized derivative positions at a rate above risk-free. It includes a Funding Cost Adjustment for positive exposures (a cost) and a Funding Benefit Adjustment for negative exposures (a benefit).
What are the risk retention rules for securitizations, and why do they require 'skin in the game'?
Risk retention rules were among the most important regulatory responses to the 2008 crisis. Post-crisis regulations require originators to retain at least 5% of the credit risk of securitizations they issue.
How does the Standardized Measurement Approach (SMA) calculate operational risk capital under Basel III?
The Standardized Measurement Approach (SMA) calculates operational risk capital using a Business Indicator derived from financial statements, mapped through marginal coefficients that increase with bank size, and adjusted by an Internal Loss Multiplier that incorporates 10 years of historical loss experience.
What are CDX and iTraxx credit indices, and how are they used for portfolio hedging and trading?
CDX and iTraxx are standardized credit default swap indices referencing baskets of corporate entities. They provide liquid, tradeable exposure to broad credit risk but introduce basis risk when used to hedge single-name positions.
How does non-parametric (historical simulation) VaR work, and what are its strengths and weaknesses?
Historical simulation computes VaR directly from past returns with no distributional assumptions. It naturally captures fat tails and correlations, but suffers from backward-looking bias, ghost effects, and equal-weighting of all observations.
What's the difference between logistic regression credit scoring and the Altman Z-score, and when would you use each?
The Altman Z-score uses five fixed financial ratios to classify firms into safe, grey, or distress zones, while logistic regression directly estimates default probability using customizable predictors. Modern banks use logistic regression for Basel IRB models.
What is marginal VaR and how does it relate to optimal portfolio construction?
Marginal VaR is the rate of change of portfolio VaR per unit change in a position's weight: MVaRᵢ = ∂VaR/∂wᵢ. At the optimal portfolio, the ratio of excess return to marginal VaR is equal across all positions, enabling efficient risk budgeting.
How does collateral management work in OTC derivatives and what are best practices?
Collateral management under ISDA CSAs involves daily MTM-based variation margin calls (threshold, MTA, eligible collateral) plus initial margin for uncleared OTC derivatives under ISDA SIMM. Post-2008 rules mandate two-way, segregated initial margin exchange.
Can someone walk through how the CreditMetrics model works step by step?
CreditMetrics is a mark-to-market credit portfolio model that estimates the distribution of portfolio value changes due to credit migrations and defaults. It combines transition matrices, asset correlations, and bond revaluation across scenarios.
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