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What are the three forms of market efficiency and how is each tested?
The three forms of market efficiency differ by what information is reflected in prices. Weak form covers past price data (tested with serial correlation and runs tests), semi-strong form covers all public information (tested with event studies), and strong form covers all information including private (tested with insider trading studies).
In a step acquisition, what happens to the pre-existing equity interest when you gain control?
In a step acquisition, the previously held equity interest is remeasured to fair value at the date control is achieved. The difference between fair value and carrying amount is recognized as a gain or loss in the income statement.
How does an inventory write-down for obsolescence work, and can a company reverse it under IFRS vs. GAAP?
Both IFRS and US GAAP require inventory to be carried at the lower of cost and net realizable value. When NRV drops below cost, the company records a write-down. The key difference is that IFRS allows reversal of write-downs up to original cost, while US GAAP treats the write-down as permanent.
What's the difference between a bond's maturity and its duration? Why does duration matter more for risk?
Excellent question — the distinction between maturity and duration is fundamental to fixed income analysis and is heavily tested on the CFA Level I exam. Maturity is simply when principal is repaid. Duration, however, measures either the weighted average time to receive cash flows (Macaulay) or the bond's price sensitivity to yield changes (Modified).
How does the PSA prepayment model work for mortgage-backed securities, and what does '200 PSA' actually mean?
The PSA prepayment model ramps the conditional prepayment rate (CPR) from 0.2% in month 1 to 6.0% by month 30, then holds flat. '200 PSA' doubles all these rates (CPR peaks at 12%). Faster prepayments create contraction risk (principal returned early at low rates) while slower prepayments create extension risk.
Can someone walk through a two-stage DDM with actual numbers? I keep getting the terminal value calculation wrong.
The two-stage DDM projects high-growth dividends individually, then calculates a terminal value using the Gordon model at the transition point. The key is computing the terminal value using the NEXT dividend after the transition and discounting it back to today. Common mistakes include using the wrong dividend and forgetting to discount.
What is double materiality, and how does it differ from the single materiality approach used in traditional financial reporting?
Double materiality requires assessing ESG topics from two perspectives: how they affect the company financially (outside-in) and how the company impacts society and environment (inside-out). Required by the EU CSRD, it broadens disclosure beyond traditional financial materiality to capture impact-only material topics.
What are distortion risk measures, and how do they transform probability to capture risk aversion?
Distortion risk measures transform the survival function of losses using a concave distortion function, systematically overweighting extreme loss probabilities. Common distortions include the proportional hazard, dual power, and Wang transform, each producing coherent risk measures used in insurance and risk management.
What is CoVaR, and how does it measure the systemic risk contribution of individual financial institutions?
CoVaR measures the system-wide VaR conditional on a specific institution being in distress. DeltaCoVaR captures the marginal contribution of that institution to systemic risk, revealing hidden interconnectedness that individual VaR cannot detect. It is estimated using quantile regression and has influenced G-SIB capital surcharge calculations.
What is TLAC, how does bail-in work mechanically, and why was it designed for G-SIBs?
TLAC requires G-SIBs to maintain minimum levels of equity and bail-inable debt (18% of RWA) so they can be resolved without taxpayer support. Bail-in writes down or converts TLAC instruments to equity in a waterfall from CET1 through AT1, Tier 2, and senior unsecured debt.
How is the exposure measure calculated for the Basel leverage ratio, and why does it include off-balance-sheet items?
The Basel leverage ratio exposure measure includes on-balance-sheet assets, derivative exposures under SA-CCR, securities financing transactions, and off-balance-sheet commitments with credit conversion factors. This broader measure captures risks that on-balance-sheet accounting misses.
What is Stressed VaR, how is the stress period selected, and how does it enter the market risk capital calculation?
Stressed VaR is calibrated to a 12-month historical stress period that would produce the largest VaR for the bank's current portfolio. It was introduced by Basel 2.5 because regular VaR, calibrated to recent benign data, severely underestimated tail risk during the 2008 crisis.
What is Conditional VaR (CVaR / Expected Shortfall), and why did Basel III replace VaR with ES for market risk capital?
Conditional VaR (CVaR) or Expected Shortfall measures the average loss in the worst alpha-percent of scenarios, capturing tail severity that VaR ignores. Basel III replaced VaR with ES for market risk capital because ES is subadditive, rewards diversification, and penalizes all tail scenarios.
How are risk-weighted assets calculated under the Internal Ratings-Based approach?
The IRB approach uses a regulatory formula that converts PD, LGD, EAD, and maturity into risk-weighted assets. The core concept is computing a conditional PD at the 99.9% confidence level, adjusted for asset correlation and maturity.
Why is the Poisson distribution used for operational loss frequency and how do you apply it?
The Poisson distribution is the standard choice for modeling how many loss events occur in a fixed time period. It's ideal for operational risk because it models the count of rare, independent events with a single parameter lambda.
How does desk-level capital allocation work under the FRTB, and why does it matter?
Under the FRTB, the trading desk is the fundamental unit of capital computation. Each desk must independently qualify for the Internal Models Approach by passing backtesting and P&L attribution tests.
What drives the shape of the volatility term structure, and how does mean reversion flatten it?
The volatility term structure describes how implied or expected volatility changes across different option maturities. Mean reversion is the key force that shapes the long end — when current vol is high, it creates a downward-sloping term structure.
What is P&L attribution, and how does the risk-theoretical P&L compare to actual P&L?
P&L attribution decomposes actual trading profits into risk-factor-driven components using model sensitivities. The gap between risk-theoretical and actual P&L reveals model deficiencies and is a critical FRTB validation requirement.
Why is default correlation so important in credit portfolio management, and how is it measured?
Default correlation determines how likely borrowers are to default together. Even moderate correlation dramatically increases tail losses and capital requirements while leaving expected losses unchanged.
What are the main pitfalls of correlation estimation in risk management, and how can you address them?
Correlation estimation has major pitfalls: correlations spike during crises, Pearson correlation assumes normality, short samples produce noisy estimates, and non-stationarity creates spurious relationships. Solutions include EWMA, copulas, and shrinkage estimators.
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