8008 Exam Dumps : PRM Certification - Exam III: Risk Management Frameworks, Operational Risk, Credit Risk, Counterparty Risk, Market Risk, ALM, FTP - 2015 Edition

According to the Basel II framework, Tier 1 capital, also called core capital or basic equity, includes equity capital and disclosed reserves.

Tier 2 capital, also called supplementary capital, includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments and subordinated term debt issued originally for 5 years or longer.

Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the discretion of their national authority. This only includes short term subordinated debt originally issued for 2 or more years.

An interesting thing to note is the difference between 'subordinated term debt' under Tier 2 and the 'short term subordinated debt' under Tier 3. The distinction is based upon the years to maturity at the time the debt was issued. The remaining time to maturity is not relevant. For the subordinated term debt included under Tier 2, the amount that can be counted towards capital is reduced by 20% for every year when the debt is due within 5 years. This takes care of the time to maturity problem for Tier 2 subordinated debt. For Tier 3 short term subordinated debt, this is not an issue because debt will only qualify for Tier 3 if it has a lock-in clause stipulating that the debt is not required to be repaid if the effect of such repayment is to take the bank below minimum capital requirements.

The probability of default would make the future cash flows from both the bonds identical. If p be the probability of default, the cash flows from the risky corporate bond would be

= (cash flows in the event of default x probability of default) + (cash flows without default x (1 - probability of default))

=> p*0 + (1 - p)*(1 + 8.5%) = (1 - p)*1.085.

The cash flows from the treasury bond would be 1.04. These two should be equal, ie,

1.04 = (1- p)*1.085, implying p = 4.15%.

(Note: The above is a simplification intended for the exam. In reality investors would demand a 'credit risk premium' for the corporate bond over and above the expected default loss rate. They are unlikely to be happy with just being compensated with exactly the expected default loss rate plus the risk-fre rate because the expected default loss rate itself is uncertain. They would demand some premium over and above what the default rate alone might mathematically imply above the risk free rate. In this question, this credit risk premium is ignored.)

Normal mixtures address fat or heavy tails, not volatility clustering. Therefore statement I is not correct.

Statement II is not correct. Where VaR is calculated at low levels of confidence, VaR based on normal mixtures may be lower than that under a normal assumption. This is no different than for other fat tailed distributions.

Statement III is correct. In situations where multiple market scenarios can unfold with a given probability, and each scenario is normal, we can express the result with a normal mixture where the underlying normal distributions have the probabilities of the different scenarios.