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FRM: Foundations Of Risk Management
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Answer 50 questions in 15 minutes.
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Match each statement with the correct term.
Don't refresh. All questions and answers are randomly picked and ordered every time you load a test.
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. Market risk - Liquidity risk - Credit risk - Operational risk
Risk
Where is risk coming from
Four major types of risk
Shortcomings of risk metrics
2. RM cannot increase firm value when it costs the same to bear a risk w/in the firm or outside the firm - For RM to increase firm value it must be more expensive to bear risks internally than to pay capital markets to bear them.
Risk Management Irrelevance Proposition
Derivative contract
Four major types of risk
Models used in ERM framework
3. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
CAPM (formula)
Jensen's alpha
Effect of non- price- taking behavior on CAPM
Treynor measure
4. 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
Shortcomings of risk metrics
Derivative contract
Zero- beta CAPM (two factor model)
3 main types of operational risk
5. Wrong distribution - Historical sample may not apply
Formula for covariance
Ways risk can be mismeasured
Models used in ERM framework
Settlement risk
6. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Funding liquidity risk
Settlement risk
Valuation vs. Risk management
Basis
7. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Kidder Peabody
Risk Management Irrelevance Proposition
Tracking error
Where is risk coming from
8. Track an index with a portfolio that excludes certain stocks - Track an index that must include certain stocks - To closely track an index while tailoring the risk exposure
APT for passive portfolio management
Liquidity risk
Morningstar Rating System
Shortfall risk
9. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Differences in financial risk management for financial companies vs industrial companies
Ri = ai + bi1l1 + bi2l2....+ei
Operational risk
Solve for minimum variance portfolio
10. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Solve for minimum variance portfolio
Three main reasons for financial disasters
Performance- related metrics
EPD or ECOR - Expected Policyholder Deficit (EPD)
11. When two payments are exchanged the same day and one party may default after payment is made
Drysdale Securities (Chase Manhattan)
Solvency-related metrics
Roles of risk management
Settlement risk
12. Losses due to market activities ex. Interest rate changes or defaults
Valuation vs. Risk management
Security (primary vs secondary)
Basic Market risk
Financial risks
13. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Settlement risk
Models used in ERM framework
Risk- adjusted performance measure (RAP)
CAPM (formula)
14. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Market risk
Differences in financial risk management for financial companies vs industrial companies
Morningstar Rating System
15. Future price is greater than the spot price
Sortino ratio
Source of need for risk management
VaR - Value at Risk
Contango
16. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Nonmarketable asset impact on CAPM
Differences in financial risk management for financial companies vs industrial companies
Zero- beta CAPM (two factor model)
Prices of risk vs sensitivity
17. Changes in vol - implied or actual
VaR - Value at Risk
Where is risk coming from
Tracking error
Volatility Market risk
18. Returns on any stock are linearly related to a set of indexes
Formula for covariance
CAPM assumption for EMH
Banker's Trust
Ri = ai + bi1l1 + bi2l2....+ei
19. Firms became multinational - - >watched xchange rates more - deregulation and globalization
LTCM
Standard deviation of two assets
Banker's Trust
Firms becoming more sensitive to changes(bank deregulation)
20. Derives value from an underlying asset - rate - or index - Derives value from a security
Three main reasons for financial disasters
Practical considerations related to ERM implementatio
Firms becoming more sensitive to changes(bank deregulation)
Derivative contract
21. Modeling approach is typically between statistical analytic models and structural simulation models
Models used in ERM framework
Four major types of risk
Basis
3 main types of operational risk
22. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Ways risk can be mismeasured
Valuation vs. Risk management
Exposure
Sovereign risk
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
Asset transformers
Ways firms can fail to account for risks
Funding liquidity risk
Debt overhang
24. Strategic risk - Business risk - Reputational risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
Traits of ERM
Risks excluded from operational risk
Banker's Trust
25. Return is linearly related to growth rate in consumption
Models used in ERM framework
Settlement risk
Multi- period version of CAPM
Solve for minimum variance portfolio
26. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Barings
Efficient frontier
Information ratio
VaR- based analysis (formula)
27. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Source of need for risk management
Market imperfections that can create value
CAPM (formula)
Expected return of two assets
28. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Asset transformers
VaR - Value at Risk
Debt overhang
Effect of heterogeneous expectations on CAPM
29. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
LTCM
Exposure
Ri = Rz + (gamma)(beta)
CAPM assumption for EMH
30. When negative taxable income is moved to a different year to offset future or past taxable income
Carry- backs and carry- forwards
Risk types addressed by ERM
Efficient frontier
Basic Market risk
31. 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
BTR - Below Target Risk
Three main reasons for financial disasters
Options motivation on volatility
Practical considerations related to ERM implementatio
32. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Shape of portfolio possibilities curve
Basis risk
Zero- beta CAPM (two factor model)
Market imperfections that can create value
33. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Banker's Trust
Risks excluded from operational risk
Funding liquidity risk
Business risks
34. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Tracking error
Correlation coefficient effect on diversification
Security (primary vs secondary)
Zero- beta CAPM (two factor model)
35. Probability distribution is unknown (ex. A terrorist attack)
Practical considerations related to ERM implementatio
CAPM with taxes included (equation)
Uncertainty
Contango
36. Asses firm risks - Communicate risks - Manage and monitor risks
Jensen's alpha
Roles of risk management
Parametric VaR
Solvency-related metrics
37. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
VaR - Value at Risk
Settlement risk
Models used in ERM framework
CAPM (formula)
38. Both probability and cost of tail events are considered
Market risk
Source of need for risk management
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Business Risk
39. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Practical considerations related to ERM implementatio
Zero- beta CAPM (two factor model)
EPD or ECOR - Expected Policyholder Deficit (EPD)
Ways firms can fail to account for risks
40. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Practical considerations related to ERM implementatio
Ways risk can be mismeasured
Financial Risk
Solvency-related metrics
41. No transaction costs - assets infinitely divisible - no personal tax - perfect competition - investors only care about mean and variance - short- selling allowed - unlimited lending and borrowing - homogeneity: single period - homogeneity: same mean
Importance of communication for risk managers
Ten assumptions underlying CAPM
Contango
Shape of portfolio possibilities curve
42. Curve must be concave - Straight line connecting any two points must be under the curve
Asset transformers
Market risk
Shape of portfolio possibilities curve
Standard deviation of two assets
43. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Effect of heterogeneous expectations on CAPM
Volatility Market risk
Shortcomings of risk metrics
Banker's Trust
44. Expected value of unfavorable deviations of a random variable from a specified target level
Barings
APT in active portfolio management
BTR - Below Target Risk
Prices of risk vs sensitivity
45. Prices of risk are common factors and do not change - Sensitivities can change
Prices of risk vs sensitivity
Nonparametric VaR
Security (primary vs secondary)
What lead to the exponential growth to derivatives mkt?
46. Need to assess risk and tell management so they can determine which risks to take on
Zero- beta CAPM (two factor model)
Traits of ERM
Barings
Importance of communication for risk managers
47. Law of one price - Homogeneous expectations - Security returns process
Zero- beta CAPM (two factor model)
Shortcomings of risk metrics
APT (equation and assumptions)
Information ratio
48. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Tracking error
CAPM assumption for EMH
Asset transformers
Sortino ratio
49. Asset-liability/market-liquidity risk
Source of need for risk management
Information ratio
Liquidity risk
Credit event
50. Potential amount that can be lost
Exposure
Information ratio
Nonparametric VaR
Risks excluded from operational risk
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