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FRM Part II Updated
What's the difference between through-the-cycle (TTC) and point-in-time (PIT) PD, and why does it matter for capital?
PIT PD reflects current economic conditions and fluctuates with the business cycle, while TTC PD averages across the entire cycle and remains stable. The choice affects regulatory capital calculations, loan provisioning, and procyclicality.
How does factor-based risk decomposition work for market risk management?
Factor-based risk decomposition breaks portfolio VaR into contributions from identifiable market factors (equity, rates, FX, volatility) plus idiosyncratic risk. This reveals WHY a portfolio has risk, enabling targeted hedging, factor-level limits, and stress testing.
What is CVA and how does DVA work as a bilateral credit adjustment?
CVA is the market value of counterparty default risk (expected loss from their default), while DVA captures the value of your own default risk to the counterparty. The bilateral adjustment is: Value = Risk-Free - CVA + DVA. DVA is controversial because it creates gains when your own credit deteriorates.
Why does default correlation matter so much for credit portfolio losses?
Default correlation measures the tendency for multiple obligors to default together. While it doesn't change expected losses, it dramatically affects the tail of the loss distribution, making Credit VaR and economic capital extremely sensitive to correlation assumptions.
How does the FRTB internal models approach work and what is desk-level approval?
FRTB's internal models approach requires desk-level approval through backtesting and P&L attribution tests. Desks failing either test revert to the standardized approach. Capital is calculated using 97.5% Expected Shortfall with liquidity-adjusted horizons, replacing the previous 99% VaR framework.
How do CCPs reduce systemic risk and what happens when a clearing member defaults?
CCPs interpose themselves between derivative counterparties through novation, absorbing counterparty risk. When a member defaults, losses are covered through a waterfall: defaulter's margin, defaulter's default fund, CCP capital, then mutualized default fund. However, CCPs themselves concentrate systemic risk.
How does a bank conduct liquidity stress testing, and what are the key scenarios?
Liquidity stress testing simulates how a bank's liquidity evolves under adverse scenarios, modeling cash outflows, inflows, and asset monetization to determine the survival horizon. Banks test idiosyncratic, market-wide, and combined scenarios, connecting results to contingency funding plans and regulatory metrics like LCR and NSFR.
What is the Loss Distribution Approach for operational risk, and how do Key Risk Indicators fit in?
The Loss Distribution Approach models operational risk by separately estimating frequency (how many loss events per year) and severity (how large each loss is), then combining them via Monte Carlo simulation. Key Risk Indicators complement LDA by providing forward-looking early warning signals that help management intervene before losses materialize.
How can a pension plan hedge longevity risk?
Longevity swaps, buy-ins, and reinsurance hedge the risk that pensioners live longer than actuarial assumptions predict.
How do sustainability-linked loans work, and what makes their margin ratchet mechanism different from green bonds?
Sustainability-linked loans adjust the borrower's interest rate based on achievement of preset ESG performance targets. Unlike green bonds, SLL proceeds are unrestricted. The margin ratchet mechanism provides direct financial incentives, with safeguards against gaming through materiality requirements and third-party verification.
How does variation margin work mechanically, and how does it differ from initial margin in terms of purpose and daily operations?
Variation margin settles daily mark-to-market changes by exchanging cash between counterparties. Unlike initial margin (which covers future exposure), VM addresses realized gains and losses. The process runs daily with calls subject to MTA thresholds and dispute resolution procedures.
What are the NGFS climate scenarios, and how do banks use them for transition risk assessment?
The NGFS provides six standardized climate scenarios ranging from orderly transition to hot house world. Banks use these to stress-test portfolios by mapping carbon-sensitive exposures, applying scenario-specific carbon price trajectories, and translating impacts into credit metrics like PD and expected losses.
What is the Incremental Risk Charge (IRC), and how does it capture default and migration risk in the trading book?
The Incremental Risk Charge captures default and migration risk for credit-sensitive trading book positions over a 1-year horizon at 99.9% confidence. It assumes a constant level of risk through periodic rebalancing. Under FRTB, the IRC is replaced by the Default Risk Charge.
How does the Internal Models Approach (IMA) for market risk capital work under the FRTB framework?
Under FRTB, the Internal Models Approach calculates market risk capital as the sum of an Expected Shortfall component (with varying liquidity horizons), a Default Risk Charge, and a Stressed Capital Add-On for non-modellable factors. Approval is granted at the individual trading desk level.
What is 'significant risk transfer' in securitization and why does it matter for capital relief?
Significant Risk Transfer is the regulatory test determining whether a bank securitization achieves capital relief. The bank must demonstrate that genuine risk has been transferred to investors through quantitative loss-sharing tests and qualitative checks for implicit support.
Why is backtesting expected shortfall (ES) so much harder than backtesting VaR?
The shift from VaR to expected shortfall (ES) in the FRTB introduced a significant practical challenge: ES is much harder to backtest than VaR. This tension is a key topic in FRM Part II.
What are the financial stability implications of Central Bank Digital Currencies (CBDCs), and what risks should banks prepare for?
Central Bank Digital Currencies introduce significant financial stability risks, primarily through deposit disintermediation — households shifting funds from commercial bank deposits to risk-free central bank digital money. This raises funding costs, amplifies digital bank run risk, and alters monetary policy transmission.
How does ISDA SIMM calculate initial margin for non-cleared derivatives, and what are the key risk buckets?
ISDA SIMM is the industry-standard sensitivity-based method for calculating initial margin on bilateral non-cleared OTC derivatives. It computes delta, vega, and curvature sensitivities across six risk classes, applies prescribed risk weights, and aggregates using a correlation-based framework.
How does Extreme Value Theory (EVT) improve tail risk estimation, and what is the Peaks-over-Threshold approach?
EVT models only the extreme tail of the return distribution using the Generalized Pareto Distribution. The Peaks-over-Threshold method fits exceedances above a high threshold, providing theoretically justified tail risk estimates far more accurate than Normal or Student-t.
What determines loss given default (LGD), and how do workout LGD and market LGD differ?
LGD depends on seniority, collateral, industry, economic conditions, and jurisdiction. Workout LGD tracks actual recovery cash flows over years, while market LGD uses post-default trading prices for quick estimation.
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