The credit migration approach to assessing portfolio credit risk involves obtaining a distribution of

future portfolio values from the ratings migration matrix. First, the frequencies in the matrix are used

as probabilities, and expected future values of the securities belonging to each rating category are

calculated. These are then discounted to the present using the discount rate appropriate to the

'future' rating category. This gives us a forward distribution of the value of each security in the

portfolio. These are then combined using the default correlations between the issuers. The default

correlation between the issuers is often proxied using asset returns, and recognizing that default

occurs when asset values fall below a certain threshold. A distribution for the future value of the

portfolio is generated using simulation, and from this distribution the Credit VaR can be calculated.

Thus, we need the migration matrix, the risk horizon from which the present values need to be

calculated, and the forward yield curve or the discount curve for each rating category for the risk

horizon. Thus, Choice 'd' is the correct answer.

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.

Tier 3 capital, or short term subordinated debt, is intended only to cover market risk but only at the

discretion of their national authority.

The Earnings Volatility approach to calculating economic capital is a top down approach that

considers economic capital as being the capital required to make for the worst case fall in earnings,

and calculates EC as equal to the worst case decrease in earnings capitalized at the rate of return

expected of the firm. The worst case decrease in earnings, or the earnings-at-risk can only be stated

at a given confidence level, and is equal to the Expected Earnings less Earnings under the worst case

scenario.

Choice 'a' is the correct answer. Refer to the detailed loss event type classification under Basel II (see

Annex 9 of the accord). You should know the exact names of all loss event types, and examples of

each.

Statement I is true - component VaR for individual assets in the portfolio add up to the total VaR for

the portfolio. This property makes component VaR extremely useful for risk disaggregation and

allocation.

Stateent II is incorrect, the incremental VaRs for the positions in a portfolio do not add up to the

portfolio VaR, in fact their sum would be greater.

Statement III is correct. Marginal VaR for an asset or position in the portfolio is by definition the

change in the VaR as a result of a $1 change in that position. Incremental VaR is the change in the VaR

for a portfolio from a new position added to the portfolio - and if that position is $1, it would be

identical to the marginal VaR.

Statement IV is correct, VaR is sub-additive due to the diversification effect. Adding up the VaRs for

all the positions in a portfolio will add up to more than the VaR for the portfolio as a whole (unless all

the positions are 100% correlated, which effectively would mean they are all identical securities

which means the portfolio has only one asset).

Statement V is in incorrect. As explained for Statement I above, component VaR adds up to the VaR

for the portfolio.

Total expected losses which are average and anticipated are equal to the sum of expected losses in

the underlying exposures. Total unexpected losses, which are the excess of worst case losses at a

certain confidence level over the expected losses, benefit from the diversification effect and are

lower than the sum of unexpected losses of the underlying exposures. Therefore Choice 'c' is the

correct answer. The other choices are incorrect.

When the economy is expanding, firms are less likely to default. Therefore the conditional probability

of default, given an economic expansion, is likely to be lower than the unconditional probability of

default. Therefore Choice 'a' is the correct answer and the other statements are incorrect.

The probability that the security would not default in the next 4 years is equal to the probability of

survival at the end of the four years. In other words, =(1 - 3%)*(1 - 4%)*(1 - 4%)*(1 - 5%) = 84.93%.

Choice 'd' is the correct answer.

Choice 'c' is the correct answer. The Markov property is the assumption that there is no ratings

momentum, and that transition probabilities are dependent only upon where the rating currently is

and where it is going to. Where it has come from, or what the past changes in ratings have been,

have no effect on the transition probabilities. ('Herstatt risk' refers to settlement risk, and is

irrelevant.)

p = k/N. If there are N observations of which K are upto T, then p = k/N allows us to have a

continuous unbroken curve which gets increasingly weighted towards the distribution selected for

the tail as we move towards the 'right', ie the higher values of losses.

The other choices are incorrect and mostly nonsensical.