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31. You have been asked to help communicate to business unit managers some practical considerations in developing key risk indicators (KRIs) and collecting data. Which of the following should not be on your list of talking points?

A. KRI definitions will consider the rationale for the risk indicator, description of the measurement criteria, and the sources of data.

B. KRIs must be continually validated and refined.

C. Select KRIs based on their data availability first and predictive value second.

D. Each KRI should be weighted in accordance with its significance, or predictive capabilities

Correct answer is C

You would always select KRIs based on their predictive value first and data availability second.fficeffice" />

 

32. Which of the following statements are true?

I. To ensure higher effectiveness in managing operational risk, the operational risk manager's compensation should be linked to trader performance

II. Stop-loss limits are less effective as an operational risk measure than exposure limits because exposure limits consider future market risk movements while stop-loss limits are backward looking

III. As annual audits of listed entities are regulatory and mandatory by nature, they should not be seen as a material part of operational risk management

IV. The long option like feature of most traders' compensation packages substantially increases operational risk

A. I, III and IV

B. II and IV

C. II only

D. IV only

Correct answer is D

Operational risk is increased if traders are highly compensated when they make big profits but do not lose the same type of money when they incur losses (IV). They therefore take higher risks to obtain higher returns.

Statements (I), (II) and (III) are invalid.  To avoid potential conflicts of interest, the operational risk manager's compensation should be independent of traders' performance, exposure limits do not consider future market movements, and annual audits are an integral part of operational risk management.

 

33. Which of the following is not a type of operational risk as defined by Basel II?

A. Human error and internal fraud

B. Destruction by fire or other external catastrophes

C. Damaged reputation due to a failed merger

D. Failure or breakdown in internal control processes

Correct answer is C

The BIS defines operational risk (inclusive of technological risk) as 'the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events'.  Although a number of financial institutions add reputation risk and strategic risk (e.g. due to a failed merger) as part of a broadened definition of operational risk, they are not within the scope of definition by the BIS.

 

34. Under the Internal Ratings Based approach of Basel II, inputs are set by the Basel Committee or the bank which has adopted that approach. Which of the following inputs is always set by the bank?

A. Asset correlation

B. Confidence level

C. Probabilities of default

D. Loss given default

Correct answer is C

Under the Internal Ratings Based approach, the bank sets the probability of default, but not the asset correlation, the confidence level or the loss given default.

 

35. Tim Brown and Steve Parker undertake trades that generate profits of USD 5 million and USD 6 million, respectively. Both trades have face amounts of USD 100 million. Brown trades mortgage-backed securities, with a volatility of 14 percent. Parker trades asset-backed securities, which have a volatility of 16 percent. Based on a 99 percent confidence level RAROC (risk-adjusted return on capital), whose investment is superior?

A. Brown

B. Parker

C. Same

D. Cannot be determined from the information given

Correct answer is B

Using RAROC, the risk-adjusted performance is calculated by:

       RAPM = Profit / (Risk Capital), where

       Risk Capital = Q(c) * sigma * investment level, and

       Q(c) is the quantile of a standard normal distribution at confidence level c.

       So,

       RAPM(Tim Brown) = 5 / (2.326 * 0.14 * 100) = 15.4%

       RAPM(Steve Parker) = 6 / (2.326 * 0.16 * 100) = 16.1%

Using a 99 percent confidence interval RAROC, Steve Parker's investment performance is superior.