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FRM Updated
What drives funding risk in a defined benefit pension plan?
Funded ratio moves with asset returns, liability discount changes, and actuarial experience — driving sponsor contribution volatility.
What is the regulatory PD floor and how does it affect bank capital?
Basel III final imposes 0.03% PD floor for most IRB portfolios. Prevents model uncertainty and level-plays with standardized. Hartwell's AAA modeled at 0.012% gets floored, raising RWA 60%...
What are the Basel Accords, and how do Basel I, II, and III differ in their approach to bank capital requirements?
The Basel Accords evolved from simple risk-weight categories (Basel I) to a three-pillar framework with internal models (Basel II) to post-crisis reforms with higher capital quality, liquidity requirements, and countercyclical buffers (Basel III). Each iteration addressed shortcomings revealed by financial crises.
How does deposit insurance create moral hazard, and what mechanisms are used to mitigate excessive risk-taking by insured banks?
Deposit insurance creates moral hazard by removing depositors' incentive to monitor bank risk-taking, allowing banks to fund risky activities with artificially cheap insured deposits. Mitigants include risk-based premiums, capital requirements, supervisory examination, and prompt corrective action.
What are the single-point-of-entry and multiple-point-of-entry strategies for cross-border bank resolution?
Single Point of Entry resolves a G-SIB only at the parent level, absorbing losses through bail-in of parent TLAC and keeping subsidiaries operating. Multiple Point of Entry resolves multiple entities simultaneously across jurisdictions. The choice depends on the group's organizational structure.
What is a risk parity portfolio, how does it differ from traditional 60/40 allocation, and what role does leverage play?
Risk parity equalizes risk contributions across asset classes rather than capital weights. A traditional 60/40 portfolio has ~90% of its risk from equities. Risk parity overweights bonds and underweights equities, often adding leverage to achieve competitive returns.
What are the practical limitations of mean-variance optimization, and how do risk managers address them?
Mean-variance optimization is extremely sensitive to input estimates, often producing concentrated and unstable portfolios. Practical remedies include adding allocation constraints, using Black-Litterman to blend equilibrium returns with views, and resampling the efficient frontier.
What is the Default Risk Charge under FRTB and how is it calculated?
The Default Risk Charge captures jump-to-default risk — the sudden loss when an issuer defaults. It is calculated by computing JTD amounts (notional times LGD), netting within the same obligor, applying rating-based risk weights, and aggregating with prescribed correlations.
How does the ARIMA model work for time series forecasting in risk management?
ARIMA stands for AutoRegressive Integrated Moving Average and combines three components: AR(p) for autoregressive terms, I(d) for differencing to achieve stationarity, and MA(q) for moving average error terms. Choosing the right parameters requires stationarity tests and ACF/PACF analysis.
How does SA-CCR compute exposure at default for derivative portfolios?
SA-CCR is the Basel Committee's standardized method for computing Exposure at Default (EAD) for derivative positions. The master formula is EAD = 1.4 x (RC + PFE), where RC is replacement cost and PFE is potential future exposure.
How do you detect heteroskedasticity in a linear regression, and why does it matter for FRM?
Heteroskedasticity is the condition where the variance of regression residuals is not constant across observations. In risk management, this is extremely common due to volatility clustering.
How should risk managers think about event risk — the kind that standard models completely miss?
Event risk involves sudden, severe market dislocations that standard VaR models cannot capture. Practical management combines stress testing, reverse stress testing, scenario analysis, and position limits — supplementing quantitative models with expert judgment.
What are covered bonds, and how do they differ from regular asset-backed securities?
Covered bonds differ from ABS through dual recourse — investors can claim against both the cover pool and the issuing bank. Assets stay on-balance-sheet with dynamic management and overcollateralization, making them structurally safer.
What are the key simulation techniques and variance reduction methods used in risk management?
Monte Carlo estimates are noisy, especially for tail risk metrics. Variance reduction techniques — antithetic variates (using Z and -Z), control variates (benchmarking), and importance sampling (shifting the distribution) — improve precision without extra simulations.
How do CDOs work, and what's the difference between cash CDOs and synthetic CDOs?
A CDO is a securitization where the collateral pool consists of debt instruments. Cash CDOs physically purchase bonds, while synthetic CDOs use CDS contracts to gain credit exposure without buying the underlying assets.
What are regime-switching models and how are they applied to market risk?
Regime-switching models assume that financial markets alternate between distinct states — typically a calm regime and a volatile crisis regime — each governed by different statistical parameters. They capture the abrupt shifts between market conditions that standard GARCH models miss.
Can you explain each of Basel's seven operational risk event types with examples?
Basel's seven operational risk event types provide a consistent taxonomy across banks globally. Here is each with illustrative examples...
How does a defined benefit pension fund approach enterprise risk management?
DB pension risk management is fundamentally ALM: funded-ratio volatility driven by rates, inflation, longevity, and contribution risk.
How does Basel set the correlation parameter R in the IRB formula?
Basel prescribes R: corporate formula interpolates 24% (low PD) to 12% (high PD). QRRE fixed at 4%, mortgage 15%. Higher credit quality = higher systematic correlation...
What is the Residual Risk Add-On (RRAO) under FRTB and which instruments trigger it?
The RRAO is a safety net for exotic risks not captured by the SbM or DRC. It applies at 1.0% of notional for instruments with exotic underlyings (weather, longevity) and 0.1% for complex payoff structures (barriers, digitals, correlation trading).
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