FRM 2: Book 3 Questions with Complete Solutions 100% Verified| Latest Update Graded A+
Challenges with quantitative validation Validation of inputs and parameters
Model replication
Benchmarking and hypothetical portfolio testing
Backtesting
Profit and loss attribution
Assessing Interest Rate Risk Prepayments through embedded options, Bank's pricing
behavior (due to general market behavior, customer relationships, bank commercial power,
and optimal commercial policies), and The choice of stress scenarios (not based on probability,
not sensitive to current rate environment or slope of the yield curve)
BIS recommendations for supervisors Show impact of models on decision making
Economic Capital results are transparent
Risk measurement process is thorough
Know pros/cons of risk measures
Quality of the measurement risk components
Thorough model validation
Appropriateness of inputs
Trade-offs of counterparty credit risk measuring methods
Examine embedded options closely
Supervisory Capital Assessment Program (SCAP) Consider broad macro-scenarios and
market wide stresses with multiple factors occurring at once.
A more comprehensive looks at the effect of the stress scenarios on the institution.
Consider the post stress common equity threshold to ensure that a bank remains viable.
Focus on revenues, costs, and projected losses.
, Stress testing is now dynamic and path dependent.
Dealer Banks Intermediary functions for OTC derivatives, repos, and securities. Prime broker
for hedge funds and asset management for individuals and institutions. Provides commercial,
merchant, and investment banking, brokerage, and off-balance sheet partnership activities.
Basel Assets to Capital < 5%, On and off-balance sheet items had to be used to calculate risk
weighted assets (Cooke's ratio) which measures the bank's total credit exposure - must exceed
8%. Basel 2 is applied to large banks only and VaR is calculated over a 1-year time horizon at
99.69% confidence.
Basel Tier 1 and 2 capital Tier 1 Absorbs losses: Equity (minus goodwill), Non-cumulative
perpetual preferred stock
Tier 2 Protects depositors: Cumulative perpetual preferred stock, 99-year debentures,
Subordinate debt with 5+yrs original maturity
1996 Amendment Convert VaR into a capital requirement. VaR is calculated with a 10-
trading day time horizon and a 99% confidence level. Backtest the one-day, 99% VaR over the
previous 250 days.
Basel 2 Pillars 1) Minimum capital requirements
Total Cap = 8% * (Credit risk + Mkt risk + Ops risk)
2) Supervisory review
3) Market discipline (transparency of risks and capital)
Solvency 1&2 Framework (for Insurance companies) 1) Capital requirements for
underwriting risks of insurance companies.
2) Will replace 1 and consider operational and investment risks
Challenges with quantitative validation Validation of inputs and parameters
Model replication
Benchmarking and hypothetical portfolio testing
Backtesting
Profit and loss attribution
Assessing Interest Rate Risk Prepayments through embedded options, Bank's pricing
behavior (due to general market behavior, customer relationships, bank commercial power,
and optimal commercial policies), and The choice of stress scenarios (not based on probability,
not sensitive to current rate environment or slope of the yield curve)
BIS recommendations for supervisors Show impact of models on decision making
Economic Capital results are transparent
Risk measurement process is thorough
Know pros/cons of risk measures
Quality of the measurement risk components
Thorough model validation
Appropriateness of inputs
Trade-offs of counterparty credit risk measuring methods
Examine embedded options closely
Supervisory Capital Assessment Program (SCAP) Consider broad macro-scenarios and
market wide stresses with multiple factors occurring at once.
A more comprehensive looks at the effect of the stress scenarios on the institution.
Consider the post stress common equity threshold to ensure that a bank remains viable.
Focus on revenues, costs, and projected losses.
, Stress testing is now dynamic and path dependent.
Dealer Banks Intermediary functions for OTC derivatives, repos, and securities. Prime broker
for hedge funds and asset management for individuals and institutions. Provides commercial,
merchant, and investment banking, brokerage, and off-balance sheet partnership activities.
Basel Assets to Capital < 5%, On and off-balance sheet items had to be used to calculate risk
weighted assets (Cooke's ratio) which measures the bank's total credit exposure - must exceed
8%. Basel 2 is applied to large banks only and VaR is calculated over a 1-year time horizon at
99.69% confidence.
Basel Tier 1 and 2 capital Tier 1 Absorbs losses: Equity (minus goodwill), Non-cumulative
perpetual preferred stock
Tier 2 Protects depositors: Cumulative perpetual preferred stock, 99-year debentures,
Subordinate debt with 5+yrs original maturity
1996 Amendment Convert VaR into a capital requirement. VaR is calculated with a 10-
trading day time horizon and a 99% confidence level. Backtest the one-day, 99% VaR over the
previous 250 days.
Basel 2 Pillars 1) Minimum capital requirements
Total Cap = 8% * (Credit risk + Mkt risk + Ops risk)
2) Supervisory review
3) Market discipline (transparency of risks and capital)
Solvency 1&2 Framework (for Insurance companies) 1) Capital requirements for
underwriting risks of insurance companies.
2) Will replace 1 and consider operational and investment risks
