Choice 'b' is the correct answer. All other answers are incorrect.

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.

For a dataset with 250 observations, the top 2% of the losses will be the top 5 observations. Expected shortfall is the average of the losses beyond the VaR threshold. Therefore the correct answer is (20 + 19 + 19 + 17 + 16)/5 = 18.2m .

Note that Expected Shortfall is also called conditional VaR (cVaR), Expected Tail Loss and Tail average.

Monte Carlo VaR computations generally include the following steps:

1. Generate multivariate normal random numbers, based upon the correlation matrix of the risk factors

2. Based upon these correlated random numbers, calculate the new level of the risk factor (eg, an index value, or interest rate)

3. Use the new level of the risk factor to revalue each of the underlying assets, and calculate the difference from the initial valuation of the portfolio. This is the portfolio P & L.

4. Use the portfolio P & L to estimate the desired percentile (eg, 99th percentile) to get and estimate of the VaR.

Monte Carlo based VaR calculations rely upon full portfolio revaluations, as opposed to delta/delta-gamma approximations. As a result, they are also computationally more intensive. Because they are not limited by the range of instruments and the properties they can cover, they can capture a wide range of distributional assumptions for asset returns. They also tend to provide more robust estimates for the tail, including portions of the tail that lie beyond the VaR cutoff.

Therefore I and III are true, and the other two are not.

Choice 'a' is the correct answer. Exposures such as those to a line of credit of which only a part (or none) may be drawn at the time of assessment present a difficulty when attempting to quantify credit risk. It is not correct to take the entire amount of the line as the exposure at default, and likewise the current exposure is likely to be too aggressively low a number to consider.

While the borrower has an information advantage in that he would be aware of the deterioration in credit standing before the bank and would probably draw cash prior to default, it is unlikely that the entire amount of the line of credit would be drawn in all cases. In some cases, none may be drawn. In other cases, the bank would become aware of the situation and curtail or cancel access to the credit line in a timely fashion.

Therefore a fixed proportion of existing credit lines is considered a reasonable approximation of the exposure at default against credit lines.

The correct answer is Choice 'd'. The following is a brief description of the major approaches available to model credit risk, and the analysis that underlies them:

1. CreditMetrics: based on the credit migration framework. Considers the probability of migration to other credit ratings and the impact of such migrations on portfolio value.

2. CreditPortfolio View: similar to CreditMetrics, but adds the impact of the business cycle to the evaluation.

3. The contingent claims approach: uses option theory by considering a debt as a put option on the assets of the firm.

4. KMV's EDF (expected default frequency) based approach: relies on EDFs and distance to default as a measure of credit risk.

5. CreditRisk+: Also called the 'actuarial approach', considers default as a binary event that either happens or does not happen. This approach does not consider the loss of value from deterioration in credit quality (unless the deterioration implies default).

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.

Therefore any losses from poor strategic planning will not be a part of operational risk. Choice 'd' is the correct answer.

Note that floods, earthquakes and the like are covered under the definition of operational risk as losses arising from loss or damage to physical assets from natural disaster or other events.

Governance structures specify the policies, principles and procedures for making decisions about corporate direction. They distribute rights and responsibiliies among stakeholders that typically include executive management, employees, the board etc. Statement I is therefore correct.

"Cybernetics is a transdisciplinary approach for exploring regulatory systems, their structures, constraints, and possibilities. In the 21st century, the term is often used in a rather loose way to imply "control of any system using technology" (Wikipedia). Governance literature has been affected by cybernetics, which is not the same thing as information security or cyber security. Statement II is incorrect.

Corporate governance includes risk governance, and not the other way round. Therefore statement III is incorrect.

The Cadbury Report, titled Financial Aspects of Corporate Governance, was a report issued in the UK in December 1992 by "The Committee on the Financial Aspects of Corporate Governance". The report is eponymous with the chair of the committee, and set out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures. Statement IV is therefore correct.

A non-financial firm such as a manufacturing company faces market risks similar to those faced by financial firms, except perhaps for not being exposed to risks from the equity markets. Non financial firms commonly face interest rate risks in respect of their debts, commodity price risks in respect of their inputs and products, and foreign currency risks in respect of their overseas operations. It is therefore not correct to say that the manufacturing firm does not face market risk because it does not take proprietary positions. While decisions on positions may not be actively taken, positions in foreign exchange (eg, through overseas debtors owing foreign currency, or liabilities in foreign currencies to overseas suppliers), commodities (through exposure to the need for raw material and inventory of finished goods) and interest rates (through debt financed, whether at fixed or floating rates) exist and create market risk much in the same way as they would for a proprietary position. Therefore statement I is incorrect.

While the firm faces market risks as an externality (as do financial firms for that matter, though often they seek such exposure to profit from their view on which way the externality will express itself), it is incorrect to say that these risks must be borne. They can be measured and hedged. Therefore statement II is incorrect.

The results of a manufacturing firm will include gains and losses arising from exposure to market risk, and will cloud the true profitability of the business. A firm with significant unhedged overseas sales may show vastly different results across time periods due to the FX gains and losses, making comparative assessment of profitability difficult. Therefore statement III is correct.

Market risks for a manufacturing firm may be directionally biased in terms of exposure, ie there may be a consistent 'long' position in a particular commodity that the firm produces, and a consistent 'short' position in the commodities consumed. In the same way, directional biases may exist in FX or interest rate exposures too. Regardless of the bias, the existence of market risk exposures increase the volatility of the income stream and make the firm more risky, even though the long term expected returns from such exposures is zero (ie, returns may be zero but standard deviation is not). Therefore statement IV is not correct as market risks form non financial firms do increase the overall risk of the firm.

Offsetting trades with other counterparties will not reduce credit exposure to a given counterparty. All other choices represent means of reducing credit risk. Therefore Choice 'c' is the correct answer.

Extreme value theory focuses on the extreme and rare events, and in the case of VaR calculations, it is focused on the right tail of the loss distribution. In very simple and non-technical terms, EVT says the following:

1. Pull a number of large iid random samples from the population,

2. For each sample, find the maximum,

3. Then the distribution of these maximum values will follow a Generalized Extreme Value distribution.

(In some ways, it is parallel to the central limit theorem which says that the the mean of a large number of random samples pulled from any population follows a normal distribution, regardless of the distribution of the underlying population.)

Generalized Extreme Value (GEV) distributions have three parameters: ξ (shape parameter), μ (location parameter) and σ (scale parameter). Based upon the value of ξ, a GEV distribution may either be a Frechet, Weibull or a Gumbel. These are the only three types of extreme value distributions.