GARP Updated 2016-FRR Exam Questions and Answers by ayoub

Calculate the weighted average of modified durations:

The modified duration of the portfolio is a weighted average of the durations of the individual bonds, where the weights are the proportions of the total portfolio value.

Calculate the total value of the portfolio: $200 MM (3-year floater) + $120 MM (5-year floater) + $50 MM (10-year fixed) = $370 MM.

Calculate the weights for each bond:

3-year floater: $200 MM / $370 MM = 0.5405

5-year floater: $120 MM / $370 MM = 0.3243

10-year fixed: $50 MM / $370 MM = 0.1351

Multiply each bond's weight by its modified duration and sum the results:

(0.5405 * 0.25) + (0.3243 * 0.25) + (0.1351 * 8) = 0.1351 + 0.0811 + 1.081 = 1.297

Therefore, the weighted average modified duration is approximately 1.30.

ReferencesCalculation based on standard formula and weights derived from the table.

Derivatives have several advantages over cash instruments in hedging transactions. These include:

Lower Credit Risk:

Derivatives, especially exchange-traded ones, often have lower credit risk because the clearinghouse guarantees the performance of the contract.

Lower Funding Requirements:

Derivatives typically require lower upfront capital than buying or selling the underlying cash instruments directly. This is due to the leverage they offer, where only a margin is required instead of the full value of the position.

Lower Dealing Costs:

Trading derivatives can be cheaper in terms of transaction costs compared to trading the underlying cash instruments. This is especially true for large positions or frequent trading.

Lower Capital Charges:

Regulatory capital requirements for derivatives can be lower compared to cash instruments because derivatives can be used to hedge and reduce overall portfolio risk, thereby reducing capital charges under regulatory frameworks.

References

Source: How Finance Works​

Comprehensive and Detailed In-Depth Explanation:

The primary objective of a bank’s risk management department is to provide timely and accurate risk information to decision-makers (e.g., senior management, board) to support informed risk-taking and compliance with regulatory standards. This aligns with Basel II’s Pillar 1 and Pillar 2 requirements, which emphasize risk measurement, monitoring, and reporting. Option A is incorrect as risk management advises, not dictates, tolerances. Option B is a trading function, not risk management’s role. Option D is impractical, as eliminating all risk would hinder profitability—risk management balances risk and return.

Day 1:

Bank Milo has $4 million in cash.

$5 million in loans coming due with an expected default rate of 1%.

The proceeds from the loans will be $5 million * (1 - 0.01) = $4.95 million.

Total cash available at the end of Day 1 = $4 million + $4.95 million = $8.95 million.

No outflows on Day 1.

Cumulative liquidity = $8.95 million (positive).

Day 2:

No cash inflow.

$9 million is due for a securities purchase.

Cumulative liquidity = $8.95 million - $9 million = -$0.05 million (negative).

Day 3:

No cash inflow.

$8 million due for commercial paper pay off.

Cumulative liquidity = -$0.05 million - $8 million = -$8.05 million (negative).

Therefore, Bank Milo faces negative cumulative liquidity on Days 2 and 3.