［2009 FRM］Short Practice ExamQ36--Q40

36. Suppose that a business line of a bank has a loan book of USD 100 million. The average interest rate is 10%. The book is funded at a cost of USD 5.5 million. The economic capital against these loans is USD 7.5 million (7.5% of the loan value) and is invested in low risk securities earning 5.5% per annum. Operating costs are USD 1.5 million per annum and the expected loss on this portfolio is assumed to be 1% per annum (i.e., USD 1 million). The firm's cost of capital is 15%. The risk-adjusted return of the business line used in the computation of RAROC is:

A. USD 2.4125 million

B. USD 3 million

C. USD 1.5875 million

D. USD 2 million

Correct answer is A

The risk-adjusted return used in the computation of RAROC is:fficeffice" />

Expected revenue ? expenses ? expected losses = 100 * 0.01 + 7.5 * 0.055 ? 5.5 ? 1.5 ? 1.0 = 2.4125

37. Suppose that a business line of a bank has a loan book of USD 100 million. The average interest rate is 10%. The book is funded at a cost of USD 5.5 million. The economic capital against these loans is USD 7.5 million (7.5% of the loan value) and is invested in low risk securities earning 5.5% per annum. Operating costs are USD 1.5 million per annum and the expected loss on this portfolio is assumed to be 1% per annum (i.e., USD 1 million). The firm's cost of capital is 15%. The RAROC for this business is:

A. 26.7%

B. 37.1%

C. 21.2%

D. 32.2%

Correct answer is A

The RAROC for this business line is: Risk-adjusted return / Risk-adjusted capital = 2.4125 / 7.5 = 32.2%

Reference: Risk Management, Crouhy, Galai, and Mark, 2001.

38. Your Board of Directors wants a comprehensive review of each business units operational risk activities. As the head of the corporate operational risk unit, you know that little has been done to implement an operational risk process at the business unit level and that you need to immediately come up with a framework. Which of the following statements offers the best strategy?

I. The audit committee of the Board should first define its objectives to ensure that all the firms business units operational risk programs are providing required information

II. The auditing department is to be charged with developing an operational risk program for each business unit, with the business unit being made clearly aware that they will be held accountable for its implementation

III. That your department immediately assess the operational risk for each business unit using independent data feeds to ensure the information fed into the assessment cannot be manipulated

IV. A senior manager from each profit center is to be charged with developing their own operational risk self assessment program based on guidelines you provide.

A. I only

B. I and IV only

C. I and III only

D. IV only

Correct answer is D

I is incorrect.  I is not the responsibility of the Audit Committee of the Board.

II is incorrect.  The auditing department is not the best assessor of an individual business units risk, in fact many audit staff do not fully understand the risks of many of a firms activities.

III is incorrect.  III is duplicative and should not come form the corporate department.

IV is correct.  The best strategy for developing an operational risk framework is to empower business units with the responsibility, accountability and authority to manage their own operational risks.  The business units know their risks the best.

Reference: Risk Management and Capital Adequacy, Gallati, 2003.

39. Which of the following statements about its methodology for calculating an operational risk capital charge in Basel II is correct?

A. Basic Indicator Approach is suitable for institutions with sophisticated operational risk profile.

B. Under the Standardized Approach, capital requirement is measured for each business line.

C. Advanced Measurement Approaches (AMA) will not allow an institution to adopt its own method of assessment of operational risk.

D. AMA is less risk sensitive than the Standardized Approach.

Correct answer is B

B is correct. Under the Standardized Approach, the capital requirement is measured for each business line.

Reference:  "ffice:smarttags" />Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version".

A is incorrect. The Basic Indicator Approach is only suitable for institutions with a relatively simple operational risk exposure.

C is incorrect. AMA allows an institution to use its own methodology of operational risk measurement subject to regulatory approval.

D is incorrect.

40. Portfolio D has an average return over the last year of 13.7% with volatility of 15.2%. Over the same period, the benchmark portfolio has an average return of 12.8% with volatility of 14.6%. Portfolio D's beta is 1.25, and its tracking error was 7%. Assume the risk-free rate is 5%. What is portfolio D's Information Ratio (IR)?

A. 0.2951

B. 0.7200

C. 0.1286

D. 0.5724

Correct answer is C

IR = (0.137 - 0.128) / 0.07 =  0.1286

A is incorrect (0.2951 = (0.137 - 0.128) / (1.25 * 0.146 - 0.152))

B is incorrect (0.7200 = 100 * (0.137 - 0.128) / (1.25))

C is correct.

D is incorrect (0.5724 = (0.137 - 0.05) / 0.152)