[ 2009 FRM ] Medium Practice Exam 2 Q36-40

36. Which of the following model(s) calculates the change in portfolio value due to rating migration of the underlying instruments?

A. CreditRisk+

B. CreditMetrics

C. KMV

D. Both A and C above are true

Correct answer is B

A is incorrect because CreditRisk+ does not calculate the change in portfolio value due to credit migration of the underlying instruments.fficeffice" />

B is correct because CreditMetrics calculates the change in portfolio value due to credit migration of. the underlying bond(s) (eg. change in credit spread).

C is incorrect because KMV does not calculate the change in portfolio value due to credit migration of the underlying instruments.

D is incorrect because A and C are incorrect.

Reference: Arnaud de Servigny and Olivier Renault, Measuring and Managing Credit Risk (ffice:smarttags" />New York: McGraw-Hill, 2004) Chapter 6-Credit Risk Portfolio Models.

37. Which of the following is not a determinant of asset liquidation costs?

A. The liquidation time horizon

B. Asset fungibility

C. Asset type

D. Asset size

Correct answer is D

Explanation: There is not necessarily any economic link between asset size and liquidation cost.

Reference: Culp, Chapter 17

38. Firm A has equity volatility of .3 and debt to firm value (debt to capitalization) of .4. Firm B has the same debt to firm value but its asset volatility is .3. Which statement about firms A and B is true?

A. The capital of Firm A is less than the leverage of Firm B.

B. The volatility of Firm A's operations is greater than the volatility of Firm B's operations.

C. The equity of Firm B is less risky than the equity of Firm A.

D. The equity of Firm A is less risky than the equity of Firm B.

Correct answer is D

A is incorrect because the two firms have the same capital ratio, so they have the same capital if they have the same assets.  As no mention was made of asset size, it could go either way.

B is incorrect Firm A actually has the lower asset volatility and the opposite of the sentence is true.

C is incorrect.  We know that asset volatility is smaller than equity volatility holding constant leverage, so A has the lower asset volatility.  This answer implies its asset volatility is higher.

D is correct.  See c for the explanation.

Reference: Stulz, Risk Management and Derivatives, Chapter 18

39. A junior bond with a face value of 200 matures in 5 years. A senior bond on the same firms also matures in 5 years, and has a face value of 100. Assume σA=.5 and the risk-free rate=.04. Firm value is equal to 400. Using the Merton model, what is the value of the junior bond? (The following table includes figures that will reduce the time required to answer this but it also includes figures that are irrelevant to the problem and some that are strictly wrong).

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A. 99.07

B. 174.55

C. 75.48

D. 16.63

Correct answer is A

A is correct.  To get this answer use the first and last row of the table to make the calculation of the Black-Scholes formula go faster.  Plug in the values given into the B-S formula and use the first row to get the value of the equity if the leverage were just 100 (the face value of the senior bond).  Subtract this off 400 to get the value of the senior bond.  Plug in the values of the B-S formula assuming a strike of 300 (the total debt) to get the value of the equity.  Use the last row of the table to make this go faster.   Subtracting the value of the equity and the senior debt from 400 gives us the answer, a.

B is incorrect because it is the value of the total debt of the firm, not the value of the junior debt alone.

C is incorrect because it is the value of the senior debt, not the junior debt.

D is incorrect because it uses the wrong line in the table to calculate the junior debt.  It uses the second line instead of the first.  One needs to use the B-S to calculate d1 and d2 and find their normal distribution values in the table.  All of the rows except the second line from the bottom have the correct values of d1 and d2 but they do not always have the correct normal distribution value that goes with d1 and d2.   In particular, the middle line is incorrect because a negative value for d2  has a normal distribution value that is less than .5  The second line is easily detected as wrong because the normal area for a large number should be larger than that of a small number ? here they are reversed.

Reference: Stulz, Risk Management and Derivatives, Chapter 18

40. Diseconomies of scale imply that:

A. As the output of a financial institution increases, average costs of production decrease.

B. Small financial institutions are more cost efficient than large ones.

C. Small financial institutions do not prosper in a freely competitive environment.

D. Revenues derived from major technological investments fail to cover development costs providing a distinct advantage to smaller financial institutions.

Correct answer is B

Diseconomies of scale imply that as the output of a financial institution increases, its average costs of production increase.  In general larger institutions have an advantage over smaller

institutions simply due to their size and potential efficiencies when trying to recoup the cost of large technology expenditures.  In this case, if a smaller institution has an advantage, it is considered a diseconomy of scale.

Reference: Anthony Saunders. Financial Institutions Management, 5th ed. Chapter 14.

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