PRMIA 8008 Exam With Confidence Using Practice Dumps

If the marginal probability of default of two securities A and B is P(A) and P(B), then the probability of both of them defaulting together is affected by the default correlation between them. Marginal probability of default means the probability of default of each security on a standalone basis, ie, the probability of default of one security without considering the other security.

The relationship that expresses the probability of joint default of the two is given by the following expression:

It is easy to see that in a situation where the Default Correlation of A & B = 0, ie, the defaults are independent, the combined probability of default is P(A)*P(B), exactly what we would intuitively expect. Also in the other extreme case where the default correlation is equal to 1 and P(A) = P(B) = p, ie the securities behave in an identical way, the expression resolves to just p, which is what we would expect.

From the above relationship, it is clear that the probability of joint default of A and B is the greatest when default correlation between the two is equal to 1, ie the securities behave in an identical way. Therefore Choice 'a' is the correct answer.

The CDS rate is approximated by the [Loss given default x Default hazard rate]. Thus Choice 'b' is the correct answer.

Note that this is also equal to the credit spread on the reference bond over the risk free rate. Therefore credit spreads and CDS rates are generally the same. Also, 'loss given default' is nothing but (1 - Recovery rate). This can be substituted in the formula for the credit spread to get an alternative expression that directly refers to the recovery rate. Therefore all other choices are incorrect.

Basel II requires financial institutions to compare their ex-ante VaR estimates to actual realized P&L. Therefore Choice 'd' is the correct answer. A bank may use hypothetical P&L based upon constant positions to validate its model, but that is not required for Basel II.