INDIAN INSTITUTE OF QUANTITATIVE FINANCE

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OPERATIONAL AND INTEGRATED RISK MANAGEMENT

Model Risk

1. Which of the following statements about model risk is not TRUE?

a. Incorrect assumption of a risk factor as independent is a case of model

specification risk

b. Multiple users using their own set of input values in the model is the case of
model application risk

c. Use of outdated data set for fixing up input values is an indication of calibration
error

d. Issues with the programming logic is a case of implementation error

A. a , b
B. b, c
C. c, d
D. b, d

Answer: D. Multiple users using their own set of input values in the model is an
implementation risk while issues with programming logic is a case of programming error.

2. Which of the following statements about model risk is not TRUE?

a. For effective working of risk management senior management should be expert

modelers

b. Estimation of model risk would essentially involve estimation of distribution of

the unknown parameters

c. Mixing distribution helps to avoid the problem of estimating distribution of

unknown parameters

d. Independent Risk Oversight team should operate under the purview of the
trading team for effective functionality

A. Only d
B. a, b
C. a, c, d
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D. a, b, d

Answer: C. Senior management should be aware of potential model risk issues and should
have necessary checks and balances in place. They need not be expert modelers. Mixing
distribution helps to reduce the limitation of risk with choosing a wrong distribution for a
parameter but does not take the risk away. Independent Risk Oversight team should
operate independently and should not be influenced by trading team functionalities.

3. Which of the following is not a suggested approach to manage model risk?

A. Keep the model as complicated as possible to capture as many risk factors

B. Pay attention to the smaller problems
C. Analyse if the model’s performance is sensitive to key assumptions
D. Where possible back-test and stress the model extensively

Answer: A. Keep the model simple to the requirements and add complications only if really
required. Paying attention to smaller problems is needed as they could lead to bigger issues
in the model.

Enterprise Risk Management

4. Which of the following statements is not among the steps governing the conceptual
framework of ERM implementation?

A. Determine firm’s acceptable level of risk

B. Determine the appropriate capital required to manage the identified risk
C. Identify the appropriate combination of risk and capital
D. Have a centralised risk management system and monitoring in place

Answer: D. For optimum results, risk management should be decentralized as managers

closer to risk source could handle them better.

5. Which of the following statements about ERM is TRUE?

a. Aim of ERM is to minimise total risk of the firm

b. A firm should base its risk management on economic value and not on
accounting value
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c. Aggregation of market, credit and operation risk would generally be more than
firm-wide risk due to interaction effects

d. If regulatory capital requirements are greater than economic capital, the firm is
penalized with having to hold greater amount of cash than what is required

A. a , b
B. b, c
C. c, d
D. b, d

Answer: C. Aim of ERM is to optimise total risk of the firm and not minimise total risk. A
firm’s should have a risk management system in place depending on the primary objective.
If the objective is managing probability of default, then an accounting value approach is
relevant. Instead, if the objective is to manage value of the firm, then an economic value
based approach is more relevant.

Key issues in operational risk capital modelling

6. Which of the following is not among the right methodology towards adoption of Loss
Distribution Approach?

A. Collation of loss-data is essentially a backward-looking process

B. All loss data will have to be fed into a business line/ event type matrix and assigned
weights according to their relative importance and likelihood of occurrence
C. Operational risk loss to be modelled based on frequency and severity of loss of each
matrix item separately
D. Operational risk capital requirements for each business line is obtained by combining
empirical distributions with parametric tail distributions

Answer: B. It is advised to assign equal weights to various business line / event type matrix
items except in cases of split losses, old losses and external losses.

7. Which of the following statements about Loss Distribution Approach is TRUE?

a. LDA facilitates unique characteristics of a firm to be captured

b. LDA being based on past data does not allow for changing nature of operations
and risk management framework
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c. LDA does not facilitate inclusion of decline in revenues or margins due to

operational risks to be explicitly modelled

d. LDA does not facilitate undertaking a ‘what if’ analysis to undertake an effective
cost-benefit analysis

A. a , b
B. b, c
C. a, c
D. b, d

Answer: C. Despite being backward looking, LDA allows for incorporating changing nature
of operations and risk management through time. LDA facilitates cost-benefit analysis to be
effectively undertaken to compare cost of a risk reduction programme with accompanying
benefits.

8. In collating data for setting up a Loss Distribution, we notice a higher correlation between
probability of loss being reported and size of the loss such the bigger losses appear most likely
reported than the smaller value loss. What is the bias inherent in the approach attributable to
this issue?

A. Correlation bias
B. Truncation bias
C. Scale bias
D. Data capture bias

Answer: D. Truncation bias is to do with non-capture of losses below certain threshold.

Scale bias is due to larger firms having larger losses.

9. Which of the following statements about Loss Distribution Approach is TRUE?

a. Frequency distribution for LDA are often modelled using a Poisson or binomial
distribution

b. In capturing severity of distribution for LDA, it is best to model body and tail of
the distribution separately

c. Copula functions are used in LDA models to capture within-cell dependencies

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d. Economic capital is the extent of capital required to manage expected and

unexpected operational losses obtained by using an LDA approach

A. a , b
B. b, c
C. a, c
D. b, d

Answer: A. Copula functions are used to capture between-cell dependencies representing

inter-relationship between losses of various business lines. Economic capital is the capital
needed to manage unexpected losses representing excess of operational value at risk over
expected losses.

Challenges in measuring operational risk

10. Which of the following is not TRUE with respect to challenges and pitfalls in measuring
operational risk?

A. Operational losses are modelled better with a heavy-tailed distribution like Generalised
Pareto Distribution
B. Modelling a heavy tailed distribution is impacted by sample size, dominance of single
large loss and dominance of mixtures of loss distributions considered
C. Using a lognormal distribution to model operational losses requires lesser lower sample
size as compared to normal distribution to achieve a given level of confidence
D. Basel committee mandates losses across individual business units to be aggregated
based on the assumption losses across individual units are independent and identically
distributed

Answer: C. A lognormal distribution to model operational losses requires greater sample

size as compared to normal distribution to achieve a given level of confidence.

Failure mechanics of dealer banks

11. A dealer bank by undertaking custody of securities, clearing, securities lending, cash
management and reporting for hedge funds is offering which of the following services?

A. Merchant Banking
B. Investment Banking
C. Asset Management
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D. Prime Brokerage

Answer: D. The above mentioned services relate to prime brokerage for hedge funds.

12. Which of the following is not TRUE in the context of dealer banks?

A. Dealer banks operate under a holdings company structure to offer an array of services
like investment banking, merchant banking, commercial banking and the like
B. Dealer banks are involved in sponsoring of special purpose entities and generally carry a
moral but not a legal obligation towards these entities
C. Structure of a dealer bank leads to diseconomies of scope from technology and financial
innovation perspective
D. Novation helps to protect an investor from possible counterparty risk from a transaction
with a dealer bank

Answer: C. Diseconomies of scope arise from a risk management perspective and not from
a technology or financial innovation perspective.