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FRM Questions and Answers: Foundations of Risk Management

November 14, 2013

The FRM exam is just around the corner on November 16, 2013. I hope that you have mastered a greater part of the subject. If you have doubts and questions on certain topics, you will find what you are looking for right here.

So without further ado, let’s look at some of these questions with their answers!

During this discussion on FRM Foundations of Risk Management, students raised a few interesting questions. Answers were also given by the students! Here is a summary of what had been covered:

Question 1

Bond Duration

Question 2

3 Tiered Securitization Structure

Question 3

Credit Linked Notes

Question 1:

“Following are the closing price (P) and yields(Y) of a particular liquid bond over the past few days:

Monday: P= 106.3 Y= 4.25%

Tuesday: P= 105.8 Y= 4.20%

Wednesday: P= 106.1 Y= 4.23%

What is the approximate duration of the bond?

A 18.8

B 9.4 C. 4.7 01.9

Answer given is B 9.4 but applying formula of Effective duration: BV(-Y) – BV(+Y)/ 213 V*change in yield my answer comes to 4.7. Can you please explain why the correct answer is 9.4?

Source: FRM practice exams 2010.”

Answer 1:

“Take the Wednesday price as base price,

P(y)=P(y=4.23°/0)=106.1,P(y+)=P(4.23°/0+.02°/0=4.25°/0)=106.3,P(y’

)=P(4.23%-.03%=4.2%)=105.8,

Now duration is the average of the 1/P(y)[P(y)-P(y+)/y-y(+)] and1/P(y)[ P(y)-

P(y-)/y-y(-)liduration is % change in price w.r.t %change in yield take average

of the % swings both ways to get an approximate duration]

Duration=.5*(1/P(y))*[P(y)-P(y+)/y-y(+) +P(y)-P(y-)/y-y(-)]

P(y)-P(y+)/y-y(+) =106.1-106.3/4.23%-4.25%=.2/.02%=1000

P(y)-P(y-)/y-y(-)=106.1-105.8/4.23%-4.2%=.3/.0003=1000

duration=.5*[1/106.1]*[1000+1000]=1000/106.1= 9.4”

Because the FRM Level I exam is just around the corner, people are starting to feel jittery. Another question raised during the discussion was:

Question 2:

“In the 3 tier securitization structure there would be Senior tranch, mezanine tranch & equity tranch. Suppose there are enough cash-flow received (say A) from the underline security to pay off the interest to Senior (B) & Mezanine tranch (C) holder & remaining amount of (A-B-C) say K, So, here my question is the remaining amount of K would go first to equity holder or it would be transferred to trust account?? or it is the other way that K will go to equity first then the excess amount remained after paying the equity would go to the trust account??”

Answer 2:

“Hi,

The trust account (which is the same as the o/c account I think) is funded first from any positive excess spread. Equity holders are last in the queue. There is some max amount that can be set aside into the trust account using funds from the excess spread, call it M, so that if you can fully pay M into the trust account using the excess spread (so K> M), only then do equity

holders get what’s left.”

Rahul raised a slightly complex question, but Anil provided the answer in just one line!

Question 3:

“Is my understanding of CLN is correct? I have understood the following steps for creating CLN:

  • Investor A purchases Bond & purchases CDS for protection from default risk.
  • CDS seller B sales CDS to Investor A & gets regular premium from A.
  • Now CDS seller B issue CLN to CLN investors, say C & gets Cash in return from them.

So, as per the above steps CLN seller is a protection seller & reference assets for CLN is a bond that have been purchased by investor A. Hence if any credit event happen with the bond issuer then the investor A will trigger for payment from B & in turn B will get the defaulted bond from A which will be finally transferred to CLN investors. Please state is my understanding is right or wrong??? as many books it is mentioned that CLN issuer is a protection buyer.

Thanks in advance for your reply.”

Answer 3:

“Yes this is correct CLN is a kind of insurance. Here finally defaulted amount should be bear by CLN investors so it is a protection to buyer.”

I hope this answered some of the doubts you had. If you have any queries, comments or questions feel free to post them in the comments section or visit our forum!

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