Operational Risk (Sample) Questions

[Avishek]

David

I shall highlight a few questions over here as and when I solve so that others can benifit from them. These have a probability of being tested as well.

For all members:

Which of the following are the two risks in implementing technological innovations?

A) Discontinuity in customer service and insufficient training of key personnel.

B) Negative net present value of the product and agency conflict.

C) Inadequate design and misrepresented benefits.

D) Negative net present value of the product and escalation of operational risk.

Your answer: B was correct!

The two risks in implementing technological innovation are (1) negative net present value, in which the product may not become successful enough to cover the initial investment and future costs, and (2) agency conflict resulting from managers choosing projects for growth that may be inconsistent with shareholder wealth maximization.

 

[Avishek]

For all Members:

The measure of operational risk in top-down factor models is:

A) R2.

B) operating leverage.

C) estimated factor coefficient.

D) residual variance.

Your answer: D was correct!

A factor model explains the variation in the dependent variable (e.g., stock returns, revenue, or expenses) with macroeconomic factors through regression analysis. The R2 measures the proportion of variation explained by the factors. Operational risk is the idiosyncratic variation left unexplained by the factors, or , called residual variance. Coefficient estimates measure the sensitivity of the operating variable to changes in the associated macroeconomic factor. Operating leverage is the change in variable costs for a given change in total assets. A measure of operational risk is unexpected changes in operating leverage.

 

[Avishek]

Operational risk hedging is limited because:

A) no commercial vendors exist to sell operational risk data.

B) correlations among operational processes are known and fixed.

C) the objective nature of the risk assessment creates rigidity in the analysis.

D) accurately identifying risks that are not yet apparent is difficult.



Your answer: D was correct!

Measuring and identifying operational risk is very subjective, in part, because the potential loss may not have yet occurred in any setting and may be difficult for analysts to imagine. This subjectivity is the impetus for various operational risk measurement models that have been developed. Rather than being known and fixed, correlations among various operational processes are often unobservable or difficult to estimate; in addition, they are likely to change in the face of catastrophic events. Vendors selling operational risk data do exist, but the relevance of the data to different firms and its reliability as an indicator of future risks is uncertain.

 

[Avishek]

In the context of measuring operational risk, operating leverage models:

A) measure the change in the relationship between variable costs and total assets.

B) relate changes in normalized expenses to macroeconomic risk variables through regression analysis.

C) speculate about a set of possible catastrophic events.

D) are relatively subjective.



Your answer: A was correct!

Operating leverage models measure the risk that variable operating costs will increase by more than their historical relation to asset growth would suggest. Although they are a class of expense-based models in some sense, they do not relate expenses to macroeconomic factors. They are relatively objective (not subjective) and do not capture reputational considerations or the opportunity costs. Scenario analysis speculates about a set of possible catastrophic events.

 

[Avishek]

Below is something which David mentioned many times regarding Liquidity/Illiquidity of stocks being traded:

Ques: For a financial institution, model risk would NOT exist if:

A) assets were traded infrequently.

B) accurate prices for financial instruments were observable at all times.

C) all financial assets were simple in design.

D) all financial assets were complex.



Your answer: B was correct!

Model risk is a result of incorrect estimates of market prices. If accurate prices were always observable, there would be no need to estimate market prices and no need to manage model risk. Infrequent trading exacerbates model risk, because it makes asset values difficult to determine based on recent transactions. Model risk exists for both simple and complex instruments when assets are infrequently traded.

 

[Avishek]

If a risk manager assumes that the EMH is valid and that markets are efficient, the best way to manage model risk is to:

A) use models that are specific to each type of asset being valued.

B) backtest models to ensure they work effectively using historical data.

C) find a more sophisticated model.

D) use more than one model to value each asset to ensure that models come up with the same estimate of value.



Your answer: C was correct!

Since the EMH assumes that the price of security will ultimately reflect the securitys true fundamental value, the risk that a model will not price a security correctly must mean that the model is not advanced or realistic enough to obtain the correct value. It follows that the best way to manage model risk under an EMH framework is to find a better or more sophisticated model.

 

[Avishek]

Under the efficient market hypothesis, which of the following statements is FALSE?

A) The most effective way to manage model risk is to either improve the model being used, or find a more sophisticated model.

B) Deviations from an assets true fundamental value will be temporary.

C) With respect to managing model risk, traders and risk managers will have different goals.

D) The source of model risk is that the model being used is not advanced or realistic enough to obtain the correct value.



Your answer: C was correct!

An implication of the efficient market hypothesis is that traders and risk managers will both seek to find the fundamentally correct price for the security. Thus, both will have the same goal: find the most advanced and sophisticated model available.

 

[Avishek]

Balance sheet leverage measures the:

A) amount of borrowing by firms whose debt or equity held in a portfolio.

B) total leverage faced by a hedge fund investing in derivative securities.

C) value of a portfolios equity in relation to the value of the assets.

D) sensitivity of a portfolios derivative positions to price changes in the underlying assets.



Your answer: C was correct!

Balance sheet leverage is created when a hedge fund, for example, borrows money to establish investment positions. It is measured by relating the value of the funds assets to its equity. If the hedge fund has not balance sheet leverage, the assets are equal to the equity. However, a fund with no balance sheet leverage can still be exposed to leverage via the investments in the portfolio. For example, a forward contract has instrument or economic leverage because small changes in the underlying asset create large changes in the value of the contract. Total leverage is the combined effect of balance sheet leverage and economic, or instrument, leverage.

 

[Avishek]

The returns in the natural gas futures market in September 2006, which seem to have been responsible for the Amaranth debacle, were:

A) very positive, but they were within a standard confidence interval based upon historical data.

B) very negative and they were outside a standard confidence interval based upon historical data.

C) very negative, but they were within a standard confidence interval based upon historical data.

D) very positive and they were outside a standard confidence interval based upon historical data.



Your answer: C was correct!

The negative returns of 20% or more for some contracts were within a standard confidence interval based on data from 1990 to 2005.

 

[Avishek]

On the NYMEX, natural gas futures are available with maturities:

A) from one to 60 months for every month.

B) from one to 36 months for every month.

C) from one to 60 months, but only for the months of March, June, September, and December.

D) from one to 36 months, but only for the months of March, June, September, and December.



Your answer: A was correct!

On the NYMEX, natural gas futures are available with maturities from one to 60 months for every month.

 

[Avishek]

The primary function of corporate risk management is to:

A) optimize the level of a firms nondiversifiable risk.

B) minimize diversifiable risk.

C) reduce the likelihood of a hostile takeover.

D) protect the companys strategic plan.



Your answer: D was correct!

The primary function of risk management is to protect the companys strategic plan by choosing a total risk level that trades off the benefits of risk taking and the expected costs of the underinvestment problem.

 

[Avishek]

Risk management:

A) exacerbates the need for a firm to hold a reserve of liquid assets.

B) has no effect on the need for the firm to hold liquid assets.

C) is a substitute for investing equity capital in liquid assets.

D) has no impact on the expected costs of financial distress.



Your answer: C was correct!

A company with liquid assets sufficient to fund all of its positive NPV projects would not be exposed to the underinvestment problem when it encountered cash flow deficits. Alternatively, the company can institute a risk management program to insure (at some level of statistical significance) that its operating cash flow will not fall below the level needed to fund valuable projects. Thus, risk management can be viewed as a substitute for investing equity capital in liquid assets.

 

[Avishek]

Which of the following is the most effective way to address differences in counterparty credit quality?

A) Establishing initial margin requirements.

B) Including a force majeure provision in a derivative transaction.

C) Using netting arrangements.

D) Using sophisticated credit pricing models.



Your answer: A was correct!

Using collateral is an effective way to address differences in counterparty transparency and credit quality, and initial margin requirements are one of the key forms of collateral (see Recommendation 5 in CRMPG II report). Note that using credit pricing models and netting arrangements are also important credit risk mitigants, however, the models will help determine credit exposure, while netting arrangements will match payments to reduce exposure neither addresses credit quality differences. A force majeure provision addresses contract terms in the event of an earthquake, war, terrorist attack, or other disaster.

 

[Avishek]

Which of the following is NOT one of the three traits common to past major financial shocks?

A) A lack of market liquidity.

B) A sharp decline in asset prices due to a triggering event.

C) Reliance on overly complex pricing models.

D) Leverage concerns.



Your answer: C was correct!

The three common traits associated with past major financial shocks are:


a triggering event leads to a sharp decline in asset prices.
liquidity pressures.
leverage concerns.

 

[Avishek]

Which of the following describes the most effective means to address the industry-wide problem of unsigned confirmations for credit derivatives?

A) Eliminate the practice of trade assignments.

B) Straight-through processing.

C) Pre-trade reviews.

D) Use of collateral.



Your answer: D was incorrect. The correct answer was B) Straight-through processing.

Unsigned confirmations refer to the operational breakdown where transactions are not agreed to or recognized in writing. It is an industry wide problem that represents a major operational risk. Straight-through processing (STP) refers to the automation of trading systems where confirmation matching would be automatic.

 

[Avishek]

Which of the following risks is most likely to be greater when selling a complex product to a retail investor instead of an institutional investor?

A) Reputational risk.

B) Liquidity risk.

C) Legal risk.

D) Credit risk.



Your answer: A was correct!

Selling complex products to retail investors increases the potential for reputational risks. Retail investors are generally less sophisticated than institutional investors and may not fully understand the risks involved with a complex product. Retail investors who buy a product that blows up are more likely to blame the selling institution, thus damaging its reputation. Note that other risks may also increase, but reputational risk is the biggest factor that changes when dealing with retail investors.

 

[Avishek]

The role of creditors and counterparties in the private pool market:

A) are losing their importance so the PWG no longer addresses their activities.

B) is becoming increasingly important and their activities are specifically addressed by the PWG.

C) have never been important, but the PWG addresses their activities as a formality.

D) were once important, but they are losing their importance, yet the PWG addresses their activities as a matter of formality.



Your answer: B was correct!

The role of creditors and counterparties in the private pool market is becoming increasingly important and their activities are specifically addressed by the PWG.