Chapter 14 Quiz
Market Risk and the Basel Framework in Practice
16 questions. Answers follow.
1. The Fundamental Review of the Trading Book (FRTB) replaced Value at Risk (VaR) with Expected Shortfall (ES) as the primary market risk measure primarily because:
A) ES is computationally simpler to calculate than VaR for large portfolios B) VaR is blind to the magnitude of losses beyond its confidence threshold, while ES captures average tail losses C) VaR consistently overstated risk, leading to excessive capital requirements D) ES was mandated by IOSCO as the global standard for market risk measurement
2. Under historical simulation VaR, the 99% 1-day VaR is calculated by:
A) Multiplying the portfolio standard deviation by 2.326 (the 99th percentile z-score) B) Running Monte Carlo simulations with 10,000 random scenarios and identifying the 1st percentile loss C) Applying the last 250 days of historical market movements to the current portfolio and identifying the 1st percentile of the resulting P&L distribution D) Using the weighted average of the three worst historical losses in the lookback period
3. The "10-day square root of time" scaling rule (VaR₁₀ = VaR₁ × √10) is based on which assumption?
A) The Basel Committee's conservative risk multiplier applied to internal models B) Daily returns are independently and identically distributed (i.i.d.) C) Portfolio composition changes linearly over a 10-day holding period D) Market liquidity is constant across the 10-day holding period
4. Under FRTB, a trading desk must use the Standardized Approach (rather than the Internal Models Approach) if:
A) The desk's daily trading volume exceeds a threshold set by the regulator B) The desk fails the Profit & Loss Attribution (PLA) test — meaning the risk model's hypothetical P&L does not adequately explain actual trading P&L C) The desk trades instruments with a liquidity horizon greater than 40 days D) The desk has been in operation for less than three years
5. Non-Modellable Risk Factors (NMRFs) under FRTB receive special treatment because:
A) They are excluded from capital calculations as they cannot be modeled B) They require additional disclosure in COREP templates but no capital charge C) They have insufficient market price observations to support historical ES calculation, so capital is calculated using stress scenarios instead D) They are modeled using parametric VaR rather than historical simulation
6. Interest Rate Risk in the Banking Book (IRRBB) differs from trading book market risk primarily in that:
A) IRRBB is a Pillar 1 capital charge while trading book market risk is a Pillar 2 requirement B) IRRBB arises from the bank's structural balance sheet positions (loans, deposits) and is managed through the ICAAP/Pillar 2, while trading book market risk generates a Pillar 1 capital charge C) IRRBB only affects retail banks while trading book market risk applies exclusively to investment banks D) IRRBB is quantified using Expected Shortfall while trading book risk uses VaR
7. The Basel VaR backtesting "traffic light" framework classifies a model as in the "Yellow zone" when the number of backtesting breaches in a 250-day period is:
A) 0–4 breaches B) 5–9 breaches C) 10–14 breaches D) 15 or more breaches
8. The FRTB liquidity horizon for "high yield credit spreads" is:
A) 10 days B) 20 days C) 40 days D) 120 days
9. A bank's trading desk holds a large position in an agricultural commodity with limited market price observations. Under FRTB, this would likely be classified as:
A) A modellable risk factor attracting standard ES capital treatment B) A non-modellable risk factor (NMRF) attracting a stress scenario capital add-on C) A trading book exemption — commodity risk is excluded from FRTB D) An IRRBB exposure — commodities are managed in the banking book
10. The parametric (Delta-Normal) VaR approach assumes that portfolio returns follow a normal distribution. Which real-world characteristic of financial returns makes this assumption most problematic?
A) Financial returns exhibit positive autocorrelation — today's return predicts tomorrow's B) Financial returns exhibit "fat tails" — extreme events occur more frequently than the normal distribution predicts C) Financial returns are always positive due to central bank intervention D) Financial returns are measured in local currencies while VaR is expressed in USD
11. Cornerstone Financial Group's analysis showed that implementing FRTB would increase its market risk capital by approximately £25 million. The primary drivers were:
A) The FRTB standardized approach using higher risk weights than the previous standardized approach B) PLA test failure on the options desk (requiring SA) and NMRF add-ons on the commodity desk C) A higher confidence level (97.5% ES vs. 99% VaR) producing higher capital estimates D) The 10-day holding period being extended to 20 days under FRTB for all asset classes
12. Which COREP template captures results under the FRTB Internal Models Approach?
A) C 18.00 B) C 24.00 C) C 29.00 D) C 32.00
13. Economic Value of Equity (EVE) sensitivity, a key IRRBB metric, measures:
A) The change in the bank's regulatory capital when interest rates move by one basis point B) The change in the net present value of all bank cash flows when interest rates move — reflecting the impact on the bank's long-run value C) The change in Net Interest Income when interest rates move by 200 basis points over one year D) The equity price sensitivity to changes in market-wide interest rate expectations
14. The "P&L explain" or "P&L attribution" process in market risk involves:
A) Documenting the business rationale for each day's trading gains or losses for the front office B) Comparing the risk model's theoretical P&L (based on risk factor movements) to the actual accounting P&L, and investigating any unexplained residuals C) Allocating the day's P&L between regulated trading book positions and unregulated banking book positions D) Reporting the daily VaR estimate to the board risk committee for approval
15. Priya Nair identifies "position data completeness" as a common market risk management failure. This refers to:
A) Not all positions in the front office trading system being captured in the risk calculation engine — so some risk is simply not measured B) VaR models that do not account for all seven Basel risk categories C) Regulatory reports that are missing required data points in XBRL templates D) Trading desks holding positions that exceed their authorized risk limits
16. The pre-FRTB Internal Models Approach required a "stress VaR" (SVaR) in addition to regular VaR. The SVaR was calculated using:
A) Monte Carlo simulation with extreme tail scenarios B) A 99% VaR calculated using a stressed historical period (e.g., 2007–2009 financial crisis data) rather than recent history C) The worst single-day loss multiplied by a regulatory scaling factor D) The 99.9% VaR instead of the standard 99% VaR
Answer Key
| Q | A | Explanation |
|---|---|---|
| 1 | B | VaR's fundamental weakness: it says "you won't lose more than X 99% of the time" but says nothing about losses in the 1% tail. ES averages those tail losses — FRTB's motivation for switching. |
| 2 | C | Historical simulation: apply historical returns to current portfolio → simulate 250 (or more) P&L outcomes → sort → read the 1st percentile. Non-parametric, no distribution assumption. |
| 3 | B | The √t scaling assumes i.i.d. returns. If true, the variance over t periods equals t × single-period variance, so σ_t = σ₁ × √t. This assumption is stylized — actual returns exhibit volatility clustering. |
| 4 | B | PLA test failure triggers mandatory SA. If the model's risk factors don't explain the desk's actual P&L, the model is not a reliable representation of the desk's risk — so regulators reject it for capital purposes. |
| 5 | C | NMRFs have insufficient price observations to calibrate a historical ES model. FRTB requires a stress scenario approach for NMRFs, which often produces higher capital than model-based ES. |
| 6 | B | Trading book market risk → Pillar 1 capital charge (standardized formula). IRRBB → Pillar 2 / ICAAP → supervisor assesses bank-by-bank. IRRBB arises from the banking book's structural maturity transformation. |
| 7 | B | Traffic light: Green = 0–4 breaches; Yellow = 5–9 (warning zone; multiplier may increase); Red = 10+ (significant concerns; high multiplier likely; model review required). |
| 8 | C | High yield credit spreads: 40-day liquidity horizon under FRTB. Investment grade credit = 20 days; equity (large cap) = 10 days; illiquid credit = 120 days. |
| 9 | B | Agricultural commodity with limited price observations → likely NMRF. Insufficient data for historical ES calculation → stress scenario capital add-on. A common issue for commodity-active banks. |
| 10 | B | Fat tails ("leptokurtosis") mean extreme market moves occur far more often than the normal distribution predicts. The 2008 returns were described as "25σ events" under normal assumptions — essentially impossible. This is not "impossible" under real financial return distributions. |
| 11 | B | Cornerstone's key drivers: PLA test failure on the options desk (the desk uses SA, not IMA — SA is typically higher) and NMRF add-ons on the commodity desk (agricultural basis risk with insufficient market data). |
| 12 | D | C 32.00 captures FRTB IMA results — ES at different liquidity horizons and risk classes. C 31.00 = FRTB SA. C 29.00 = pre-FRTB VaR model data (legacy). C 18.00 = RWA overview. |
| 13 | B | EVE = NPV of all bank balance sheet cash flows. ΔEVE = change when rates move. Unlike NII (which focuses on short-term income), EVE captures the full long-run value impact — including long-dated fixed-rate assets and liabilities. |
| 14 | B | P&L attribution ("explain"): risk model predicts P&L from risk factor movements (delta × rate change, etc.). Actual accounting P&L may differ — the "unexplained" residual. FRTB's PLA test formalizes this: too large a residual → model rejected for IMA. |
| 15 | A | Position completeness: if a position isn't in the risk engine, its risk is invisible. Common cause: new instruments without mapped risk factors; positions booked in systems not connected to the risk engine. |
| 16 | B | Stress VaR: calibrated to a 12-month historical stressed period (typically 2007–2009 or 2001–2002). The theory: if recent history is calm, regular VaR is low — SVaR prevents underestimation by anchoring to a known stress period. FRTB absorbed this concept through ES liquidity horizon scaling. |