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FRM Part II Updated
Can you give a clear example of wrong-way risk for a bank trading desk?
Wrong-way risk (WWR) occurs when exposure to a counterparty is positively correlated with the counterparty's probability of default. Example: Fjordline Bank sells USD 300M forward to Bosphorus Ticaret Bank. If the Turkish lira collapses, Fjordline's MtM rises AND Bosphorus's PD rises...
What is maturity transformation and why is it risky yet necessary?
Maturity transformation means funding long assets with short liabilities to earn the term premium. Creates liquidity, rate, and rollover risks — managed via LCR/NSFR.
How do equipment lease ABS work and what is residual value risk?
Equipment lease ABS face residual value risk on true leases plus lessee concentration and repossession risk. Rating agencies haircut residuals heavily and require structural protections.
Why do cross-asset correlations break down during crises?
Stock-bond correlation isn't a physical constant - it depends on the dominant macro driver...
What is basis risk in ALM and when does it bite?
Basis risk arises when assets and liabilities reprice off different reference rates that are historically correlated but not identical.
What is bilateral CVA (BCVA) and how does DVA fit in?
Bilateral CVA recognizes that BOTH parties can default. BCVA = UCVA_Calder − DVA_Calder. DVA reflects the gain a bank recognizes when its OWN credit deteriorates. NEE is E[Max(-MtM, 0)] — the expected amount the bank owes...
What makes student loan ABS different from other ABS types?
Student loan ABS face extreme extension risk from deferments, IDR plans, and forbearance. FFELP SLABS carry federal guarantees; private SLABS carry credit risk.
What are the limitations of beta hedging for equity portfolios?
Beta hedging works well for first-order systematic exposure in normal markets but fails in several important scenarios...
Why is benchmarking against alternative models part of validation?
Benchmarking compares the production model to alternative specifications. It challenges choices, reveals assumptions, and stress-tests interpretability. Distinct from backtesting.
What is the square root law of market impact and how is it used?
Square-root law: impact scales with sqrt(Q/ADV) times volatility. Used for pre-trade cost estimates, capacity analysis, and order scheduling across asset classes.
What are the components of market impact cost?
Market impact splits into permanent impact (information-based, sticky) and temporary impact (liquidity cost, reverts). Size, volatility, urgency, and info content drive magnitude.
How do I calculate unilateral CVA for a derivative?
Unilateral CVA assumes only the counterparty can default. The formula is UCVA = LGD × Σ[EE(ti) × PD(ti-1, ti) × DF(ti)]. Example: Calder Financial enters a 3-year interest rate swap with Northbridge Corp...
What are the main components of market liquidity risk?
Market liquidity has four parts: tightness (spread), depth (size at mid), resilience (price recovery), immediacy (execution time). All worsen in crises.
How does a credit card master trust work and what is the revolving period?
Credit card ABS use master trusts with a revolving phase (interest-only) and amortization phase. Early-amortization triggers protect investors if pool performance deteriorates.
What is correlation risk in dispersion trading?
Dispersion trading sells index volatility and buys single-stock volatility, profiting when realized correlation among constituents is lower than implied...
What should ongoing model monitoring look like between validations?
Ongoing monitoring surveils models between validations. Three tracks: performance (KS/Gini/backtests), input stability (PSI), process (run completeness). Tiered green/amber/red responses.
What are the main methodologies for aggregating risks across different risk types and business units?
Aggregation methods range from simple summation to copula-based Monte Carlo, balancing diversification capture with tail risk realism and regulatory constraints.
How do I calculate the duration gap for a bank balance sheet?
Duration gap = D_A - (L/A) * D_L, where D_A is the dollar-weighted duration of assets, D_L is the dollar-weighted duration of liabilities.
How do I quantify the opportunity cost of unexecuted trades?
Opportunity cost is (close − decision price) × unfilled shares. It captures the return missed on unexecuted portions and is essential to the implementation shortfall framework.
What is the arrival price benchmark and when is it used?
Arrival price is the mid when an order reaches the desk. It isolates execution-team controllable cost, separating desk performance from PM delay.
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