3.3 Institution

3.3 Institution

Question 1

PE2020Q79 / PE2021Q79 / PE2022Q79
The investment banking division of a large German bank recently engaged a new client whose business is in direct competition with an existing client of the commercial banking division of the bank. A manager in the commercial banking division is concerned about conflicts of interest that may arise from providing both clients with a high level of customer service. What is of greatest concern to the manager regarding this situation?

A. The investment banking division pressuring the banks brokers to buy certain securities for clients
B. The investment banking division pressuring researchers to generate buy recommendations for the new client
C. The investment banking division pressuring commercial bankers to confirm material nonpublic information
D. The investment banking division pressuring commercial bankers to open a banking relationship with the new client

Answer: C
Learning Objective: Describe the potential conflicts of interest among commercial banking, securities services, and investment banking divisions of a bank and recommend solutions to the conflict of interest problems.

C is correct. An investment banker could be advising the new client on an acquisition involving the existing client as either a target or a competing bidder. Investment bankers might ask commercial bankers to confirm material nonpublic information about the existing client.

A is incorrect. While this is a conflict of interest, this is not likely the concern of the commercial banking manager as this conflict deals with the brokerage division.

B is incorrect. While this is a conflict of interest, this is not likely the concern of the commercial banking manager as this conflict deals with the research department of the brokerage division.

D is incorrect. This is not a conflict of interest.

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Question 2

PE2020Q14 / PE2021Q14 / PE2022Q14 / PE2023Q1
The CFO and CRO at a French property-casualty insurer are discussing the impact recent flooding in Europe is having on their company. They are concerned about a surge in property insurance claims causing the company’s regulatory capital to fall below the solvency capital requirement (SCR) prescribed under Solvency II. Which of the following would be a result of this situation?

A. The company will be prevented from writing new property-casualty policies.
B. A plan to bring capital above the minimum capital requirement must be formulated.
C. The company can lower the capital charges assessed for determining the capital requirement by decreasing investment risk.
D. A waiver of capital requirements can be granted by the French insurance regulator.

Answer: C
Learning Objective: Evaluate the capital requirements for life insurance and property-casualty insurance companies.

C is correct. Solvency II provides for capital charges for investment risk, underwriting risk, and operational risk. Lowering any of these risks will lower the related capital charges assessed for determining the capital requirement levels.

A is incorrect. An insurer whose capital falls below the minimum capital requirement may be prevented from taking new business.

B is incorrect. The minimum capital requirement is lower than the solvency capital requirement, so breaching the solvency capital requirement may still leave the company above the minimum capital requirement.

D is incorrect. European insurers are regulated by a European Union regulator, not by state regulators.

Insurance companies are regulated to ensure that they keep enough capital for the risks they are taking.

• A property-casualty company must typically keep more capital for the risks it underwrites than a life insurance company.
• In the European Union, capital for all insurance companies is determined by Solvency II rules.
• Solvency II specifies a minimum capital requirement (MCR) and a solvency capital requirement (SCR).
• In the United States, regulation is a responsibility of states, not the federal government.

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Question 3

Which of these is the biggest risk for whole life insurance?

A. Longevity risk
B. Mortality risk
C. Policies being sold to a third party
D. Inflation

Answer: B
The biggest risk for whole life insurance is that the policyholder dies earlier than expected. This is referred to as mortality risk.
Longevity risk is the risk that the policy holder will live longer than expected, which is the biggest risk for annuities.
Sale of the policy to a third party should make no difference and policies are not inflation-linked.

Classification on life insurance
Whole Life insurance provides insurance for the whole life of the policyholder.

• Variable life insurance: policyholder chooses how surplus funds are invested.
• Lapsing: if stop making premium payments, the policy no longer provides coverage.
• Universal life insurance: the policy holder can reduce premium down to a specified minimum.
• Variable-universal life insurance: features of both variable and universal life insurance.

Term life insurance lasts a specified number of years.
Endowment life insurance is a type of term life insurance. If the policyholder dies during the life of the policy, the payout occurs at the time of death. Otherwise, it occurs at the end of the policy.
Group life insurance is typically purchased by companies for their employees
Annuity Contract: the payments in an annuity contract last for the rest of the policyholder’s life

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Question 4

Which of these is the biggest risk for property-casualty insurance?

A. Longevity risk
B. Mortality risk
C. Natural disasters
D. Inflation

Answer: C
Natural disasters such as hurricanes and earthquakes can lead to a high volume of claims in a year. A, B, and D are not relevant to property-casualty insurance.

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Question 5

What two activities of life insurance companies have opposite exposures to longevity risk?

A. Term life insurance and whole life insurance
B. Term life insurance and endowment life insurance
C. Whole life insurance and annuities
D. None of the above

Answer: C
Most forms of life insurance have mortality risk (i.e., the risk that policyholders will die earlier than expected). Annuities have longevity risk (i.e., the risk that policyholders will live longer than expected).

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Question 6

How is the loss ratio of a property-casualty insurance company defined?

A. Ratio of payouts to premiums
B. Ratio of payouts plus selling expenses to premiums
C. Ratio of all costs to premiums
D. Ratio of all costs to premiums plus interest income

Answer: A
The loss ratio is the ratio of payouts to premiums.
The expense ratio is total expenses divided by premiums received.
The combined ratio is the sum of the loss ratio and the expense ratio.
The insurance company’s operating ratio is a gross profitability measure.

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Question 7

An insurance company offers a policy that pays out if a worker becomes unemployed. Which of the following risks are applicable?

A. Moral hazard, but not adverse selection
B. Adverse selection, but not moral hazard
C. Moral hazard and adverse selection
D. Neither moral hazard nor adverse selection

Answer: C
There is both moral hazard and adverse selection.

The behavior of a policyholder with a job might change (he or she will not be as concerned about being fired as he or she would be if there were no policy) and an employee without a job will not look as hard to find one. This is moral hazard.
Also, the policy is likely to attract people with less secure jobs. This is adverse selection.

Moral hazard is the risk that the existence of insurance will cause the policyholder to behave differently than he or she would without the insurance.

Adverse selection is the phrase used to describe the problems an insurance company has when it cannot distinguish between good and bad risks.

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Question 8

A company’s defined benefit plan invests primarily in equities. Which of the following creates risks for the company? (Assume that equity markets are unaffected by A, B, C and D.)

A. High interest rates
B. Low interest rates
C. Employees working past retirement age
D. An epidemic that shortens life expectancy

Answer: B
Low interest rates will reduce the discount rate used to assess liabilities and therefore increase the present value of the liabilities. High interest rates, employees working past retirement age, and a shortening of life expectancy all lessen risks. (The question states that the impact of A, B, C and D on equity markets should not be considered. ）

In practice a reduction in interest rates tends to lead to an increase in equity prices.

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Question 9

Stocks and futures have different risks. Which of the following should be considered the least common when examining the characteristics of stocks, futures contracts and their trading markets?

A. The supply of the outstanding shares of the stock is limited.
B. Futures contracts have the maximum position size.
C. The period of validity of the stock is fixed.
D. There is a limit to the price movement of futures contracts.

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Question 10

XYZ, a clearinghouse member, has recently contributed funds with its clearinghouse. The funds are designed to give the clearinghouse the ability to meet the financial obligations of any defaulting members. The funds may not be withdrawn by XYZ as long as it remains a member of the clearinghouse. Which of the following amounts best describe XYZ’s contribution?

A. Variation margin
B. Original margin
C. Membership dues
D. Guaranty deposit

Answer: D
Clearinghouse members are required to provide not only original and variation margin to maintain their own and customer positions, but also must maintain a large guaranty deposit with the clearinghouse. The deposit, or reserve, must be maintained with the clearinghouse as long as the firm is a member of the clearinghouse. The deposit can be made with cash, securities, or letters of credit. The clearinghouse has access to the funds at all times to meet the financial needs of any defaulting member.

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Question 11

ABC, a clearinghouse member, has not managed its debts very well. As a result, it is unable to meet its open contract obligations. Which of the following statements represents one of the first actions of the clearinghouse?

A. Exchange membership is sold.
B. Under-margined customer positions are transferred to a solvent clearinghouse member.
C. Guaranty fund is used.
D. Fully margined positions are transferred to a solvent clearinghouse member.

Answer: D
The first action of the clearinghouse is to move fully margined customer positions to a solvent clearinghouse member.

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Question 12

Futures exchanges and clearinghouses require members to provide margin in various situations to limit the risk that exchanges may develop through futures trading. Which of the following statements is true?

A. Original margin requirements generally reflect the price volatility of futures contracts.
B. Guaranty deposit is defined as the deposit that the clearing member must make by the start of the trading session.
C. Variation margin is defined as the deposit that the clearing member must make when a trade is initiated.
D. Original margin represents the deposit that the clearing member must maintain at the clearinghouses as long as it remains a member.

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Question 13

To utilize the cash position of assets under management, a portfolio manager enters into a long futures position on the S&P 500 index with a multiplier of $250$. The cash position is USD $15$ million with the current futures value of $1000$, which requires the manager to long $60$ contracts. If the current initial margin is USD $12500$ per contract, and the current maintenance margin is USD $10000$ per contract, what variation margin does the portfolio manager have to advance if the futures contract value falls to USD $995$ at the end of the first day of the position being placed?

A. USD $30000$
B. USD $0$
C. USD $300000$
D. USD $75000$

Answer: B
Step 1:
Initial margin: $12500\times 60=750000$; Maintenance margin: $10000\times 60=600000$

Step 2:
The first day lose: $(1000-995)\times 250\times 60=75000$
So the first day value: $750000-75000=675000600000$

It will not require a variation margin to bring the position to the proper margin level.

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Question 14

In late June, John purchased two December gold futures contracts. Each contract size is $5000$ ounces of silver and the futures price on the date of purchase was USD $18.62$ per ounce. The required initial margin is USD $6000$ and a maintenance margin of USD $4500$. You are given the following price history for the December silver futures:

Day	Futures Price	Daily Gain
June 29	$18.62$	$0$
June 30	$18.69$	$700$
July 1	$18.03$	$-6600$
July 2	$17.72$	$-3100$
July 6	$18.00$	$2800$
July 7	$17.70$	$-3000$
July 8	$17.60$	$-1000$

On which days did John receive a margin call?

A. July 1 only
B. July 1 and July 2 only
C. July 1, July 2 and July 7 only
D. July 1, July 2 and July 8 only

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Question 15

Assume you enter into $5$ long futures contracts to buy July gold for $1,400$ per ounce. A gold futures contract size is $100$ troy ounces. The initial margin is USD $14,000$ per contract and the maintenance margin is $75\%$ of the initial margin. What change in the futures price of gold will lead to a margin call?

A. USD $35$ drop
B. USD $70$ drop
C. USD $175$ drop
D. USD $350$ drop

Answer: A
The maintenance margin: $75\%\times 14000=10500$ per contract.

The margin call occurs when the loss is USD $3500$ per contract or USD $35$ per ounce. That is, if gold drops from USD $1400$ to USD $1365$ then value of margin account, per contract, drop USD $3500$ which is $25\%$ of the initial margin.

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Question 16

On September 10, a trader opens a long position in $100$ December S&P 500 futures contracts. The initial margin requirement is USD $2$ million, and CME requires a maintenance margin of USD $1.5$ million. Assume that the position is kept open until September 14 and no withdrawals take place. The following table summarizes the daily change in value of the position for that period:

Date	December S&P 500 Futures price	Daily Gain/Loss (USD)
September 10	$1734$	-
September 11	$1756$	$550000$
September 12	$1712$	$-1100000$
September 13	$1698$	$-350000$

On what dates will additional margin be required?

A. September 12, but not September 13
B. September 13, but not September 12
C. September 12 and September 13
D. Neither September 12 nor September 13

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Question 17

Which of the following statements least likely describe a problem with bilaterally cleared over-the-counter (OTC) derivatives trades?

A. The defaults of individual counterparties could lead to systemic problems.
B. Bilateral OTC derivatives are often non-standard with exotic features.
C. Closing out trades may be difficult.
D. Loss mutualization may not spread all the losses among participants.

Answer: D
Loss mutualization is a feature of central clearing, whereby losses arising from a party’s default are spread across all other members. Bilaterally cleared OTC derivatives do not have a loss mutualization feature.

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Question 18

A feature that is unique to central clearing and is not a feature of bilateral clearing is:

I. Variation margin.
II. Initial margin.

A. I only.
B. Il only.
C. Both I and II.
D. Neither I nor II.

Answer: D
Neither initial margin nor variation margin is unique to centrally cleared trades. It is worth noting, however, that many bilaterally cleared OTC derivatives do not require posting initial margin, or the requirement is lower than under central clearing.

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Question 19

Which of the following functions is least likely performed by an exchange?

A. Derivatives contract design and specifying contract terms.
B. Price negotiation through a bilateral process.
C. Limiting access to approved firms and individuals.
D. Reporting transaction prices to trading participants and data vendors.

Answer: B
Exchanges set specific prices and standardize contracts. They do not negotiate prices bilaterally. Price negotiation through a bilateral process is a feature of the OTC derivatives market.

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Question 20

Alex Dell, a derivatives trader, has some reservations about the central clearing of OTC derivatives with a central counterparty (CCP). Specifically, he is worried that clearing members’ willingness to monitor credit risk may decline since the CCP assumes most of the risks, and that CCPs may increase margin requirements during a period of market stress. Which of the following concepts best describe Dell’s reservations?

	Decline in Willingness	Higher Margin Requirements
A	Moral hazard	Procyclicality
B	Adverse selection	Offsetting
C	Moral hazard	Offsetting
D	Adverse selection	Procyclicality

Answer: A
Dell’s reservations describe moral hazard and procyclicality, respectively.

In central clearing, moral hazard is the risk that members have less incentive to monitor risk knowing that the CCP assumes most of the risks of the transactions.

Procyclicality describes a scenario where a CCP increases margin requirements (initial margin) in volatile markets or during a crisis, which may aggravate systemic risk.

Offsetting describes the elimination of duplicate bilateral contracts by transacting through a CCP, which improves flexibility and reduces costs.

Adverse selection is the risk that participants with a better understanding of product risks and pricing will trade more products whose risks the CCP underprices, and fewer products whose risks the CCP overprices.

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Question 21

PE2022Q89
A risk analyst at a financial institution is preparing a report on capital requirements for the senior management team to be used in risk appetite discussions. The analyst compares regulatory capital and economic capital requirements in the report. Which of the following statements is correct for the analyst to include in the report?

A. The regulatory capital for credit risk is designed to be sufficient to cover a loss that is expected to be exceeded only once every ten years.
B. Regulatory capital is sometimes referred to as going concern capital because it absorbs losses incurred while the bank is still in business.
C. The most important capital for a bank is regulatory capital, which equals the bank’s estimate of its expected losses.
D. Economic capital is an internal risk measure that reflects the amount of capital needed to ensure a company remains solvent with a high level of confidence, given its risk profile.

Answer: D
Learning Objective: Identify the major risks faced by banks and explain ways in which these risks can arise.

D is correct. Economic capital is a bank’s own estimate of the capital it requires. In both cases, capital can be thought of as funds that are available to absorb unexpected losses. A common objective in calculating economic capital is to maintain a high credit rating. Economic capital is allocated to a bank’s business units so that they can be compared using a return on allocated economic capital metric.

A is incorrect. The regulatory capital for credit risk is designed to be sufficient to cover a loss that is expected to be exceeded only once every thousand years.

B is incorrect. Equity capital is sometimes referred to as going concern capital because it absorbs losses while the bank is a going concern (i.e., it remains in business).

C is incorrect. The most important capital is equity capital.

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