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FRM: Foundations Of Risk Management

  • Answer 50 questions in 15 minutes.
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  • Match each statement with the correct term.
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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. Cannot exit position in market due to size of the position

2. Efficient frontier with inclusion of risk free rate - Straight line with formula Rc = Rf + ((Ra - Rf)/std dev(a))*std dev(c) - c is the total portfolio - a is the risky asset

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

4. Long in options = expecting volatility increase - Short in options = expecting volatility decrease

5. Obtained unsecured borrowing of 300 million by exploiting flaw in computing US government bond collateral - Had only 20 million in capital - Chase absorbed losses since they brokered deal - Called for better process control and more precise methods f

6. CAPM requires the strong form of the Efficient Market Hypothesis = private information

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

8. Hazard - Financial - Operational - Strategic

9. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations

10. Modeling approach is typically between statistical analytic models and structural simulation models

11. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)

12. Firms became multinational - - >watched xchange rates more - deregulation and globalization

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

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

15. Need to assess risk and tell management so they can determine which risks to take on

16. Probability that a random variable falls below a specified threshold level

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

18. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))

19. 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.

20. Strategic risk - Business risk - Reputational risk

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

22. The lower (closer to - 1) - the higher the payoff from diversification

23. Law of one price - Homogeneous expectations - Security returns process

24. 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

25. Absolute and relative risk - direction and non-directional

26. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities

27. Future price is greater than the spot price

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

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

30. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio

31. Valuation focuses on mean of distribution vs risk mgmt focuses on potential variation in payoffs - needs more precision for pricing - VAR doesn't b/c noise cancels out

32. The need to hedge against risks - for firms need to speculate.

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

34. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios

35. 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

36. Both probability and cost of tail events are considered

37. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated

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

39. 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

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

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

42. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)

43. Inability to make payment obligations (ex. Margin calls)

44. Risks that are assumed willingly - to gain a competitive edge or add shareholder value

45. Concentrate on mid- region of probability distribution - Relevant to owners and proxies

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

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

48. John Rusnak - a currency option trader - produced losses of 691 million by using imaginary trades to disguise large naked positions. - Enforced need for back office controls

49. Sold complex derivatives to Proctor & Gamble and Gibson - Were sued due to claims that they deceived buyers - Need for better controls for matching complexity of trade with client sophistication - Need for price quotes independent of front office Met

50. Leeson took large speculative position in Nikkei 225 disguised as safe transactions by fake customers - Earthquake increased volatility and destroyed short put options - Losses of 1.25 billion and forced bankruptcy - Necessity of an independent tradi