8008 Practice Online

All of the above

Statement I is correct. Data is often divided into two sets - a 'training set' that is used to create and fine-tune the model while the 'control set' is used to prove that the model works on sample data. Back testing is then perfomed using actual data that becomes available over time, or may already be available as historical data.

Statement II is incorrect. A risk manager often spends a great deal of time in managing data, and ensuring that the data being used is accurate enough for the purpose it is being used for. A risk manager can expect to spend a good part of his or her team's time in cleansing data. While he or she can try to get the IT processes and systems to produce correct data in the first place so it requires minimal subsequent cleansing or validation, this task is likely to remain a key part of a risk manager's role for quite some time in the future given the challenges nearly all organizations face in managing risk data.

Statement III is correct. There was not enough granular data available on the underlying components of some of the derivative debt securities whose markets dried up during the crisis that began in 2007. This was because investors became increasingly unsure of what the value of these securities, such as CDOs was, leading to market seizure and firesale prices.

Statement IV is not correct. There is no easy solution to the lack of enough historical data, which is used to create as well as test models, and construct stress scenarios. Analytical approaches are not a good enough substitute for real market data. During the recent crisis, many instruments had rather short histories and there was not enough data available, and risk managers and portfolio managers relied upon analytical approaches to value and price them. Many of the assumptions that underpinned these approaches were untested in the real world and turned out to be incorrect.

Therefore Choice 'c' is the correct answer and the rest are incorrect.

Evaluating interrelationships between counterparties when considering liquidity risks

Choice 'c' relates to operational risk and process capabilities, generally not a concern when evaluating market risk of a portfolio. Choice 'a', Choice 'b' and Choice 'd' represent real concerns for the risk manager when building stress tests for the value of a portfolio.

Choice 'a' is relevant because certain shocks may be inconsistent with each other, and therefore implausible. For example, an increase in futures prices may be inconsistent with without spot prices and/or interest rates increasing according to the no-arbitrage condition. Choice 'b' is relevant when modeling a covariance matrix in a stressed situation with higher correlations, as a hypothetical covariance matrix which is not positive semi-definite may give absurd results (negative variance). Choice 'd' is relevant as liquidity risks may affect the price that can be realized for positions held.