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FRM: Foundations Of Risk Management

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This is a study tool. The 3 wrong answers for each question are randomly chosen from answers to other questions. So, you might find at times the answers obvious, but you will see it re-enforces your understanding as you take the test each time.
1. Capital structure (financial distress) - Taxes - Agency and information asymmetries

2. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection

3. When two payments are exchanged the same day and one party may default after payment is made

4. Potential amount that can be lost

5. Curve must be concave - Straight line connecting any two points must be under the curve

6. 1971: Fixed Exchange rate system broke down and was replaced by more volatile floating rate - 1973: Oil price shocks - - >high inflation - - >interest rate swings - 1987: Black Monday - OCt 19 - mkt fell 23% - 1989: Japanese stock price bubble -

7. Proportion of loss that is recovered - Also referred to as "cents on the dollar"

8. Covariance = correlation coefficient std dev(a) std dev(b)

9. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses

10. Designate ERM champion - usually CRO - Make ERM part of firm culture - Determining all possible risks - Quantifying operational and strategic risks - Integrating risks (dependencies) - Lack of risk transfer mechanisms - Monitoring

11. Rp = XaRa + XbRb

12. Return is linearly related to growth rate in consumption

13. The uses of debt to fall into a lower tax rate

14. Changes in vol - implied or actual

15. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta

16. Probability distribution is unknown (ex. A terrorist attack)

17. Expected value of unfavorable deviations of a random variable from a specified target level

18. Difference between forward price and spot price - Should approach zero as the contract approaches maturity

19. Occurs the day when two parties exchange payments same day

20. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)

21. Risk of loses owing to movements in level or volatility of market prices

22. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return

23. Firm may ignore known risk - Somebody in firm may know about risk - but it's not captured by models - Realization of a truly unknown risk

24. Both probability and cost of tail events are considered

25. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk

26. Quantile of an empirical distribution

27. Country specific - Foreign exchange controls that prohibit counterparty's obligations

28. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk

29. May not scale over time- Historical data may be meaningless - Not designed to account for catastrophes - VaR says nothing about losses in excess of VaR - May not handle sudden illiquidity

30. Wrong distribution - Historical sample may not apply

31. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages

32. Concave function that extends from minimum variance portfolio to maximum return portfolio

33. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed

34. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized

35. When negative taxable income is moved to a different year to offset future or past taxable income

36. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes

37. Percentile of the distribution corresponding to the point which capital is exhausted - Typically - a minimum acceptable probability of ruin is specified - and economic capital is derived from it

38. Simple form of CAPM - but market price of risk is lower than if all investors were price takers

39. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM

40. Cannot exit position in market due to size of the position

41. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios

42. Derives value from an underlying asset - rate - or index - Derives value from a security

43. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits

44. Prices of risk are common factors and do not change - Sensitivities can change

45. Relative portfolio risk (RRiskp) - Based on a one- month investment period

46. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely

47. Joseph Jett exploited an accounting glitch to book 350 million of false profits (government bonds) - Massive misreporting resulted in loss of confidence in management - Failed to take into account the present value of a forward - Learn to investigate

48. Market risk - Liquidity risk - Credit risk - Operational risk

49. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)

50. Multibeta CAPM Ri - Rf =