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FRM: Foundations Of Risk Management
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Instructions:
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. When negative taxable income is moved to a different year to offset future or past taxable income
3 main types of operational risk
Risk Management Irrelevance Proposition
Carry- backs and carry- forwards
Basic Market risk
2. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Firms becoming more sensitive to changes(bank deregulation)
CAPM with taxes included (equation)
Financial Risk
Treynor measure
3. Multibeta CAPM Ri - Rf =
Tax shield
VaR- based analysis (formula)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Banker's Trust
4. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Market imperfections that can create value
Performance- related metrics
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Recovery rate
5. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
BTR - Below Target Risk
Basis risk
Sortino ratio
Uncertainty
6. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Barings
Drysdale Securities (Chase Manhattan)
VaR- based analysis (formula)
Risk types addressed by ERM
7. Volatility of unexpected outcomes
What lead to the exponential growth to derivatives mkt?
Roles of risk management
Risk
VaR- based analysis (formula)
8. Risk of loses owing to movements in level or volatility of market prices
Ri = Rz + (gamma)(beta)
Risks excluded from operational risk
Market risk
Basis risk
9. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Ways firms can fail to account for risks
Information ratio
Correlation coefficient effect on diversification
Firms becoming more sensitive to changes(bank deregulation)
10. Losses due to market activities ex. Interest rate changes or defaults
Effect of non- price- taking behavior on CAPM
Financial risks
Tracking error
Operational risk
11. 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
Risk types addressed by ERM
Shortcomings of risk metrics
Exposure
Kidder Peabody
12. Long Term Capital Management - Renowned quants produced great returns with arbitrage- type trades - Unexpected and extreme events resulted in devaluation of Russian Rouble - resulting in a 3.65 billion dollar bailout - Failure to account for illiquid
Ten assumptions underlying CAPM
Business Risk
LTCM
EPD or ECOR - Expected Policyholder Deficit (EPD)
13. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
VaR - Value at Risk
Options motivation on volatility
Capital market line (CML)
Basis risk
14. 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
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15. 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
APT in active portfolio management
Firms becoming more sensitive to changes(bank deregulation)
Probability of ruin
Solve for minimum variance portfolio
16. Derives value from an underlying asset - rate - or index - Derives value from a security
CAPM (formula)
Nonmarketable asset impact on CAPM
Derivative contract
Importance of communication for risk managers
17. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Options motivation on volatility
Importance of communication for risk managers
APT in active portfolio management
Credit event
18. Asset-liability/market-liquidity risk
Settlement risk
Liquidity risk
Risks excluded from operational risk
3 main types of operational risk
19. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Sovereign risk
Solvency-related metrics
Ri = ai + bi1l1 + bi2l2....+ei
Efficient frontier
20. Potential amount that can be lost
Expected return of two assets
Exposure
Credit event
Shortcomings of risk metrics
21. Occurs the day when two parties exchange payments same day
EPD or ECOR - Expected Policyholder Deficit (EPD)
Valuation vs. Risk management
Risk Management Irrelevance Proposition
Settlement risk
22. Unanticipated movements in relative prices of assets in hedged position
Sovereign risk
Basic Market risk
Credit event
Settlement risk
23. Concave function that extends from minimum variance portfolio to maximum return portfolio
Efficient frontier
Parametric VaR
Forms of Market risk
Source of need for risk management
24. Enterprise Risk Management - ERM is a discipline - culture of enterprise - ERM applies to all industries - ERM is not just defensive - adds value - ERM encompasses all risks - ERM addresses all stakeholders
VaR- based analysis (formula)
Ways firms can fail to account for risks
3 main types of operational risk
Traits of ERM
25. The uses of debt to fall into a lower tax rate
Ri = Rz + (gamma)(beta)
Standard deviation of two assets
Tax shield
Nonmarketable asset impact on CAPM
26. 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
Barings
Roles of risk management
Security (primary vs secondary)
Effect of heterogeneous expectations on CAPM
27. 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 -
Allied Irish Bank
Risk types addressed by ERM
Forms of Market risk
Source of need for risk management
28. Asses firm risks - Communicate risks - Manage and monitor risks
Ri = ai + bi1l1 + bi2l2....+ei
Roles of risk management
Kidder Peabody
Risk
29. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Standard deviation of two assets
Ways risk can be mismeasured
Ri = Rz + (gamma)(beta)
Prices of risk vs sensitivity
30. The lower (closer to - 1) - the higher the payoff from diversification
Correlation coefficient effect on diversification
Three main reasons for financial disasters
Risk- adjusted performance measure (RAP)
Nonparametric VaR
31. Returns on any stock are linearly related to a set of indexes
Settlement risk
Ri = ai + bi1l1 + bi2l2....+ei
EPD or ECOR - Expected Policyholder Deficit (EPD)
Risk Management Irrelevance Proposition
32. Return is linearly related to growth rate in consumption
Settlement risk
Source of need for risk management
Effect of heterogeneous expectations on CAPM
Multi- period version of CAPM
33. CAPM requires the strong form of the Efficient Market Hypothesis = private information
LTCM
Shape of portfolio possibilities curve
CAPM assumption for EMH
Ways firms can fail to account for risks
34. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Nonmarketable asset impact on CAPM
Market imperfections that can create value
Models used in ERM framework
Liquidity risk
35. When two payments are exchanged the same day and one party may default after payment is made
Barings
Risk Management Irrelevance Proposition
Effect of heterogeneous expectations on CAPM
Settlement risk
36. Market risk - Liquidity risk - Credit risk - Operational risk
Security (primary vs secondary)
Four major types of risk
BTR - Below Target Risk
Risk Management Irrelevance Proposition
37. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Basis
Volatility Market risk
Differences in financial risk management for financial companies vs industrial companies
Risk
38. Modeling approach is typically between statistical analytic models and structural simulation models
Ways firms can fail to account for risks
Asset transformers
Models used in ERM framework
Banker's Trust
39. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Morningstar Rating System
Solvency-related metrics
What lead to the exponential growth to derivatives mkt?
Nonparametric VaR
40. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Sovereign risk
Sharpe measure
Funding liquidity risk
Shortfall risk
41. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Ways firms can fail to account for risks
Multi- period version of CAPM
Market imperfections that can create value
Solvency-related metrics
42. 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
Settlement risk
Kidder Peabody
Barings
Security (primary vs secondary)
43. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Ri = Rz + (gamma)(beta)
Prices of risk vs sensitivity
Risk- adjusted performance measure (RAP)
Financial Risk
44. Relative portfolio risk (RRiskp) - Based on a one- month investment period
APT in active portfolio management
Settlement risk
RAR = relative return of portfolio (RRp)
What lead to the exponential growth to derivatives mkt?
45. Changes in vol - implied or actual
Financial Risk
Performance- related metrics
Volatility Market risk
Asset transformers
46. Strategic risk - Business risk - Reputational risk
Business Risk
Risks excluded from operational risk
Sharpe measure
Risk
47. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Nonmarketable asset impact on CAPM
Options motivation on volatility
APT (equation and assumptions)
Risks excluded from operational risk
48. Wrong distribution - Historical sample may not apply
Ways risk can be mismeasured
APT in active portfolio management
Expected return of two assets
Funding liquidity risk
49. Quantile of an empirical distribution
Nonparametric VaR
Sortino ratio
Ways risk can be mismeasured
Risk Management Irrelevance Proposition
50. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
APT in active portfolio management
Risks excluded from operational risk
Where is risk coming from
Ri = Rz + (gamma)(beta)
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