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FRM Part II Updated
How does risk budgeting work using marginal VaR and component VaR?
Risk budgeting uses marginal VaR (sensitivity of portfolio VaR to position changes) and component VaR (each position's additive contribution to total VaR) to decompose and allocate risk capital. Component VaRs sum to total VaR, and negative component VaR indicates a position is reducing portfolio risk.
What is wrong-way risk and can you give concrete examples of how it amplifies credit losses?
Wrong-way risk occurs when exposure to a counterparty increases exactly when that counterparty's default probability rises. Classic examples include commodity swaps with producers, sovereign CDS from local banks, and FX forwards with emerging market counterparties. It can amplify expected losses 2-5x beyond independent models.
How do netting and collateral reduce counterparty credit risk exposure in OTC derivatives?
Netting and collateral are the two primary tools for reducing counterparty credit risk in OTC derivatives. Close-out netting consolidates all trades under an ISDA agreement to a single net amount upon default, while CSA collateral further reduces residual exposure. Together they can reduce gross exposure by 80-95%.
What is model risk, and how do banks validate their risk models to avoid catastrophic failures?
Model risk arises when risk models produce incorrect outputs due to specification errors, implementation bugs, calibration issues, or misapplication. Banks validate models through conceptual soundness reviews, backtesting, benchmarking, sensitivity analysis, and ongoing outcomes monitoring under the SR 11-7 framework.
How does VaR backtesting work under Basel, and what is the traffic light system?
VaR backtesting is where risk models meet regulatory reality. Banks compare daily VaR predictions against actual P&L over a 250-day window. The Basel traffic light system classifies results into green (0-4 exceptions), yellow (5-9, with capital penalty), and red (10+, severe penalty) zones, directly impacting the capital multiplier.
How does a sovereign wealth fund approach risk management?
SWF risk management balances long-horizon real return goals with intergenerational equity, domestic economy diversification, and governance.
What should a Contingency Funding Plan (CFP) include and when does it get activated?
A Contingency Funding Plan (CFP) is a bank's playbook for surviving a liquidity crisis. Essential components include a governance framework, early warning indicators, contingent funding sources, severity-based action playbooks, communication protocols, and a regular testing schedule.
How do banks quantify cyber risk within the operational risk framework?
Cyber risk is arguably the fastest-growing segment of operational risk, and banks are still evolving their approaches. Financial institutions use frameworks like NIST and FAIR to quantify cyber risk within operational risk capital models, but face unique challenges including rapidly evolving threats and correlated losses.
How does the US Stress Capital Buffer (SCB) work and how is it different from the standard capital conservation buffer?
The Stress Capital Buffer (SCB) is a US-specific innovation that personalizes the capital conservation buffer for each large bank based on supervisory stress test results. It equals the maximum CET1 decline during the severely adverse scenario plus four quarters of planned dividends, with a 2.5% floor.
How does the ICMA social bond framework work, and what differentiates social bonds from green bonds?
Social bonds fund projects with positive social outcomes under the ICMA Social Bond Principles, which require dedicated use of proceeds, project evaluation, proceeds management, and impact reporting. They differ from green bonds in measurability challenges and the absence of a standardized social taxonomy.
What is the difference between the independent amount in a CSA and regulatory initial margin, and why do they serve different purposes?
The independent amount is contractually negotiated upfront collateral that can be rehypothecated, while regulatory initial margin is mandated by UMR, calculated via ISDA SIMM, and must be segregated at a third-party custodian to prevent loss in the collecting party's bankruptcy.
How do all the FRTB capital components aggregate into the total market risk capital requirement?
FRTB total market risk capital combines IMES (with multiplier), NMRF add-ons, DRC, and RRAO for IMA desks, plus SBM, DRC_SA, and RRAO for SA desks. An output floor at 72.5% of the full SA calculation ensures IMA capital remains within bounds.
How are credit conversion factors (CCFs) estimated for off-balance-sheet exposures, and why do they matter for EAD?
Credit conversion factors estimate how much of an undrawn commitment a borrower will draw before defaulting, converting off-balance-sheet exposures into EAD. Under Advanced IRB, banks estimate CCFs from historical default data, typically finding that distressed borrowers draw 60-80% of available credit before default.
Why does the Basel IRB formula include a maturity adjustment, and how does longer loan maturity increase capital requirements?
The Basel IRB maturity adjustment increases capital for longer-maturity loans because they face greater migration risk. The adjustment is more pronounced for better-rated borrowers who have more room for downgrade over a longer horizon.
How should a bank calibrate downturn LGD, and why does Basel require it instead of average-cycle LGD?
Downturn LGD is calibrated to reflect losses during economic stress, when default rates rise and recovery rates fall simultaneously. Calibration approaches include using the historical worst period, regression-based macro modeling, or applying supervisory haircuts to average-cycle LGD.
What does an XVA desk do and why do banks need a centralized XVA function?
An XVA desk is a centralized function managing all valuation adjustments across a bank's derivatives book. It prices CVA/FVA/MVA/KVA charges for new trades, hedges counterparty and funding risks portfolio-wide, and optimizes capital and collateral usage.
How does a central counterparty (CCP) allocate losses when a clearing member defaults, and what are assessment powers?
The CCP default waterfall is the sequence of financial resources used to absorb losses when a clearing member defaults. Understanding this waterfall is critical for FRM Part II because CCPs concentrate counterparty risk.
How do banks incorporate climate risk into their stress testing frameworks, and what are the key scenario types?
Climate risk stress testing assesses the financial impact of physical risk (floods, droughts, sea-level rise) and transition risk (carbon taxes, stranded assets, technology shifts) on bank portfolios. Banks use NGFS scenarios spanning decades, which poses unique methodological challenges compared to traditional short-horizon stress tests.
What are counterparty exposure profiles, and how do Expected Exposure and Potential Future Exposure differ?
Counterparty exposure profiles describe how derivative market value and default risk evolve over time. Expected Exposure is the average positive value at each time point, EPE is the time-weighted average used for regulatory capital, and PFE is the high-quantile worst case used for credit limits.
What is filtered historical simulation and how does it fix the problems of standard HS?
Filtered historical simulation combines GARCH volatility modeling with historical simulation. It filters returns by GARCH to extract standardized residuals, then rescales them by current volatility — producing VaR estimates that adapt immediately to changing conditions.
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