Exam Feedback November 2015 Part 2 FRM Exam Feedback

[Paranoid Panda]

Hi,

I think the first line of the question did say that the firm was in financial distress and what would happen if volatility increased...so..senior decrease /sub increase
Also to add to the questions there was one on the stable funding ratio of the bank which totally blew my mind.
and also whether to continue with a hedge strategy of a short put on the JPY USD Exchange if you want to protect yourself from further JPY devaluations.. buy / sell dollars and short more puts and combinations of that were the options
I also remember one that asked what would decrease the impact of collateral-
a short margin period or a high threshold and minimum transfer amount
kind of also remember something on how would the new basel recommendations put a strain on liquidity ..3 of the options were more like improvements and then there was limiting rehypothecation which I chose.
Lastly there was one on how using libor instead of OIS to value the swap positions would affect the trading desk of the bank
It was close between reducing exposure and thereby risk with a smaller discounted value or making funding value adjustment easier.
Do not remember if the position was uncollateralised or not that would make it very easy to decide between the 2.

Also I thought the exam was extremely tough.. I know its supposed to be more challenging than the cfa but this paper made me feel like no matter what I read I would still be stumped by those cases on the exam

Hope this post makes all the confident and not so confident feel better about their chances.

 

[Toy]

From a.lesnar:

"Thanks for the information, but I am convinced there was no hypothesis on the volatility, neither on correlation. The question just stated that the firm went into financial distress. I just found out that in Schweser material the mean value of both senior and subordinated bonds decrease (page 138 book 2). The Credit VaR of the senior bonds increase, but their mean value decreases, If I remember correctly the Credit VaR was not cited in the question
Thanks"

If a firm is in distress, its value will be low. That is the key to this. If you have GARP books, go to page 102 of the Credit book, this is where stulz discusses this. I will type from there:

begin quote
"For a levered firm where firm value has constant volatility, equity is more volatile when firm value is low than when it is high, so that volatility falls as firm value increases".
end of quote.

A levered firm is one with debt. "Volatility falls as firm value increases" has a corollary of "Volatility rises as firm value decreases".

If we move to page 104, just before the graph that illustrates what happens for a low firm value and a high firm value, this is the comments:

begin quote
"Subordinated debt is a portfolio that has a long position in a call option that increases with volatility and a short position in a call options that becomes more costly as volatility increases. If the subordinated debt is unlikely to pay off, the short position in the call is economically unimportant. Consequently, subordinated debt is almost similar to equity and its value its value is an increasing function of the volatility of the firm. Alternatively if the firm is unlikely to default , then the subordinated debt is effectively like senior debt and inherits the characteristic of the senior debt.

The value of subordinated debt can fall as time to maturity decreases. If firm value is low, the value of the debt increases as time to maturity increases because there is a better chance that it will pay something at maturity. If firm value is high and the debt has low rise, it behaves more like senior debt".
end quote

I ask myself, when is a firm unlikely to default? when its value is high. Then it is clear from stulz that a subordinated debt behaves a senior debt when firm value is high.
We can also note that when value of firm is low, subordinated debt behaves like equity.
It is also clear from stulz that equity is more volatile when the value of firm is low. Value of a call option increases with volatility.
Since a senior debt is just a risk free bond less a call option sold to equity holders, its value inevitably decreases when firm value is low.

 

[MissJaguar]

Exactly 2 years ago, i was in your situation and stressed that I failed. I managed to find all the answers to the 80 questions in this forum and looking at other resources. Anyway, I found out that 41 questions correct and all the rest incorrect (with a confidence level of 100% because I remembered exactly what i answered to every questions) and guess what, I scored 1,1,1,2,1. I know its hard to believe but why would I lie, I am not selling anything and you can still check my posts on this forum in 2013, you will see that I was there. So, relax, enjoy your time and i can guarantee that with your 35, 25, 20 you are almost guarantee to pass. Hard to believe but anyone who wants to challenge me on that, be prepared, because I am speaking out of experience (my experience and friends experience too). And the same goes for CAIA that I just cleared (made a LOT of mistakes and still passed it). Just relax

Can I offer you drink in case I pass?

 

[Sidewinder]

kind of also remember something on how would the new basel recommendations put a strain on liquidity ..3 of the options were more like improvements and then there was limiting rehypothecation which I chose.
Lastly there was one on how using libor instead of OIS to value the swap positions would affect the trading desk of the bank
It was close between reducing exposure and thereby risk with a smaller discounted value or making funding value adjustment easier.

I choose Rehypothecation and Reduction of Exposure (Libor > OIS, hence denominator gets bigger and Exposure smaller), FVA with OIS or Libor should be irrelevant or at least not "easier"

 

[Sidewinder]

Can I offer you drink in case I pass?

Im with you

 

[Esbringa]

¿Can someone remember the question about the rogue trading of Societe Generale?

And another one asking about situations of a well-conducted stress test.

 

[andrettaw]

There were a couple of esoteric qualitative questions and some ambiguity (at least from my point of view, maybe it was clear from wherever it appears in the study guide) about the sign convention for delta of a put (referring to the question asking for directional movements of option deltas in the case of the spot falling from (you had to compute it) 24 to 18; clearly the atm call delta decreases here, but technically so does the put's delta, yet almost anyone would say it increases as it's magnitude does).

Apart from that, I thought the exam was rather trivial, at least far easier than my expectations based on the comments from the last exam in June.[/QUOTE
I thought the same thing on this question. I actually changed my answer since the delta on the put technically gets smaller. Hope they throw that one out.

 

[a.lesnar]

From a.lesnar:

"Thanks for the information, but I am convinced there was no hypothesis on the volatility, neither on correlation. The question just stated that the firm went into financial distress. I just found out that in Schweser material the mean value of both senior and subordinated bonds decrease (page 138 book 2). The Credit VaR of the senior bonds increase, but their mean value decreases, If I remember correctly the Credit VaR was not cited in the question
Thanks"

If a firm is in distress, its value will be low. That is the key to this. If you have GARP books, go to page 102 of the Credit book, this is where stulz discusses this. I will type from there:

begin quote
"For a levered firm where firm value has constant volatility, equity is more volatile when firm value is low than when it is high, so that volatility falls as firm value increases".
end of quote.

A levered firm is one with debt. "Volatility falls as firm value increases" has a corollary of "Volatility rises as firm value decreases".

If we move to page 104, just before the graph that illustrates what happens for a low firm value and a high firm value, this is the comments:

begin quote
"Subordinated debt is a portfolio that has a long position in a call option that increases with volatility and a short position in a call options that becomes more costly as volatility increases. If the subordinated debt is unlikely to pay off, the short position in the call is economically unimportant. Consequently, subordinated debt is almost similar to equity and its value its value is an increasing function of the volatility of the firm. Alternatively if the firm is unlikely to default , then the subordinated debt is effectively like senior debt and inherits the characteristic of the senior debt.

The value of subordinated debt can fall as time to maturity decreases. If firm value is low, the value of the debt increases as time to maturity increases because there is a better chance that it will pay something at maturity. If firm value is high and the debt has low rise, it behaves more like senior debt".
end quote

I ask myself, when is a firm unlikely to default? when its value is high. Then it is clear from stulz that a subordinated debt behaves a senior debt when firm value is high.
We can also note that when value of firm is low, subordinated debt behaves like equity.
It is also clear from stulz that equity is more volatile when the value of firm is low. Value of a call option increases with volatility.
Since a senior debt is just a risk free bond less a call option sold to equity holders, its value inevitably decreases when firm value is low.

Hello
Thanks for the information: I did not recall any assumption on volatility in the question, if this was the case many apologies.
I based my reasoning on page 138 of Schweser book 2, where actually both senior and subordinated bonds' mean value decreases when a firm is under financial distress (while senior debt's Credit VaR increases).

Does anyone remember a question on RAROC and more precisely on its change above/below a threshold?
Thanks

 

[Ranjith21]

the right side is 1/1.05^2 = 0.90702948
the left side is 0.5*(1/1.04+1/1.06)/1.05=0.90711176

So, here we are measuring convexity as a difference in dollar amounts rather than difference in interest rates. Then why do we mention convexity in terms of bps. It should be $0.84 rather than 0.84bps, right?

 

[William_Jose]

So, here we are measuring convexity as a difference in dollar amounts rather than difference in interest rates. Then why do we mention convexity in terms of bps. It should be $0.84 rather than 0.84bps, right?

Exactly my point. This question was doable but just threw me off and wasted my time because of this confusion.

 

[Twol84]

No, the decimal places are correct because you can replicate this by constructing two sets of trees, one with 1.05/1.05 and one with 1.05=>1.04&1.06. Discount $1 and get the differences yourself.

FWIW, not sure if it's a quirk of the question, but 86 bps is actually what you will get if you take 1.05 vs 1.04/1.06.

whether to continue with a hedge strategy of a short put on the JPY USD Exchange

The question was short call on usd and cny right?

a short margin period or a high threshold and minimum transfer amount

High threshold because a high threshold means a higher amount that cannot be collateralized.

new basel recommendations put a strain on liquidity ..3 of the options were more like improvements and then there was limiting rehypothecation which I chose.

Yep, rehypothecation.

Lastly there was one on how using libor instead of OIS to value the swap positions would affect the trading desk of the bank

Not sure the answer is a smaller discounted value -- not that I am denying that a pure ois => Libor change decreases the value of a swap if the projection leg isn't changed, but because there is one answer that makes absolute sense. Changing from OIS to Libor increases the correlation between the discount rate and the overlying credit quality. Can't recall the question properly.

senior decrease /sub increase

Yep.

 

[Paranoid Panda]

¿Can someone remember the question about the rogue trading of Societe Generale?

And another one asking about situations of a well-conducted stress test.

The societe generale question went like what did we learn from it and the options had force people to come back from vacation which was just wrong and then also traders should learn everything about back office operations so I had chosen better internal controls at every level.
Then regarding the stress period horizon i remember the options being really vague ( no surprise) so I chose the bank lines of credit are completely drawn at the time of default ..I remember reading in the BHC Chapter that if youre thinking of estimating losses you should be most conservative and assume everyone defaults or theres a strain of cash flow etc

 

[Paranoid Panda]

There was also a question that asked 2 analysts who manage a pension funds assets are discussing whether to invest in emerging markets for superior returns however one of them says that the markets are unpredictable and the assets value could fall in difficult times...I thought funding risk was way too easy an option ? Could it be sponsor risk since its divided into cash flow risk and economic risk ?

 

[Ranjith21]

Not sure the answer is a smaller discounted value -- not that I am denying that a pure ois => Libor change decreases the value of a swap if the projection leg isn't changed, but because there is one answer that makes absolute sense. Changing from OIS to Libor increases the correlation between the discount rate and the overlying credit quality. Can't recall the question properly.

The correlation increases with credit quality or with credit risk?, because LIBOR should decline if credit quality improves. And do you think this would hold true for all transactions. Maybe the client could be extremely creditworthy that correlation exists with OIS rather than LIBOR.

 

[Twol84]

As I said, I can't recall the question, but I recall that option making absolute sense, at least during the exam, ie wording etc seemed to check out. No, Libor is correlated with decreasing credit quality, which is the point of trading on the ois-libor basis in the first place. It holds true for any transaction for which libor is the designated discount rate.

I think active management risk makes more sense for the pension.

 

[KilJaeden]

Anyone recall the question about the 10,000 usd inflow and outflow? I calculated marginal vars and got that we should add 10,000 of CAD, and remove 10,000 of JPY. Anyone else get the same?

Also the question about diversified and undiversified Var.. I think i had about 300-400k on this one, dont remember. I remember undiversified var was about 700k, then i subtracted diversified var (about 300-400k) to end up with 300-400k.

 

[dundaking]

Does anybody remember the exact question on the netting benefit? I can't. I thought question was about netting benefit and chose (b). If the question was about netting factor, then
the netting factor should decrease as the number of trades netted increase, all things being equal. However if the question was about the relationship between netting benefit and number of trades netting set, then netting benefit will increase with the number of trades in the netting set and tapers off. (Bionic Turtle reading on netting, note that I could not copy the BT formula and manually typed it in).



Netting factor


A majority of netting may occur across instruments of different asset classes that may be

considered to have only a small correlation. One should note that this would still create a

positive benefit. We derive the following formula for the “netting factor” with respect to

exposure under the assumption that future values follow a multivariate normal distribution:



Netting factor = {sqrt(n+ (n-1)p)}/n








  

Where (n) represents the number of exposures and rho-bar is the average correlation. The

netting factor represents the ratio of net to gross exposure and will be +100% if there is no

netting benefit and 0% if the netting benefit is maximum.

I think Toy's correct. Netting factor should tend towards 0 instead then in which case it looks like I changed my answer to an incorrect answer... *sigh*

 

[Tanya Vasileva]

There was also a question that asked 2 analysts who manage a pension funds assets are discussing whether to invest in emerging markets for superior returns however one of them says that the markets are unpredictable and the assets value could fall in difficult times...I thought funding risk was way too easy an option ? Could it be sponsor risk since its divided into cash flow risk and economic risk ?

I have also marked funding risk

 

[Sidewinder]

There was also a question that asked 2 analysts who manage a pension funds assets are discussing whether to invest in emerging markets for superior returns however one of them says that the markets are unpredictable and the assets value could fall in difficult times...I thought funding risk was way too easy an option ? Could it be sponsor risk since its divided into cash flow risk and economic risk ?

I marked Sponsor Risk due to highly Cash Flow / economic risk (high Vola) arising from emerging markets.

 

[babyik]

I have also marked funding risk

Logically it appears to be sponsor risk coz sponsor risk refers to the company's ability to contribute if funding levels fall whereas funding risk is the inability to raise funds due to credit deterioration etc. Sponsor risk is the biggest risk fro DB plans. Dont know what GARP thinks but i went with Sponsor Risk.