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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.
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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. 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
Ri = Rz + (gamma)(beta)
Sharpe measure
Probability of ruin
Expected return of two assets
2. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
BTR - Below Target Risk
CAPM assumption for EMH
CAPM with taxes included (equation)
APT in active portfolio management
3. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Information ratio
Morningstar Rating System
3 main types of operational risk
Security (primary vs secondary)
4. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Debt overhang
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Risk types addressed by ERM
Morningstar Rating System
5. Both probability and cost of tail events are considered
Ways firms can fail to account for risks
Basis
Exposure
Tail VaR or TCE - Tail Conditional Expectation(TCE)
6. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Sharpe measure
Carry- backs and carry- forwards
Forms of Market risk
Security (primary vs secondary)
7. When two payments are exchanged the same day and one party may default after payment is made
Debt overhang
Settlement risk
LTCM
CAPM with taxes included (equation)
8. Volatility of unexpected outcomes
Firms becoming more sensitive to changes(bank deregulation)
Correlation coefficient effect on diversification
Risk
Risk types addressed by ERM
9. Concave function that extends from minimum variance portfolio to maximum return portfolio
Solvency-related metrics
Where is risk coming from
Efficient frontier
Settlement risk
10. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Where is risk coming from
Effect of heterogeneous expectations on CAPM
Security (primary vs secondary)
11. 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
Four major types of risk
Three main reasons for financial disasters
Barings
Drysdale Securities (Chase Manhattan)
12. 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 types addressed by ERM
Basic Market risk
VaR- based analysis (formula)
Risk Management Irrelevance Proposition
13. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Recovery rate
Zero- beta CAPM (two factor model)
Exposure
Shape of portfolio possibilities curve
14. Quantile of a statistical distribution
Parametric VaR
Security (primary vs secondary)
Funding liquidity risk
Forms of Market risk
15. The uses of debt to fall into a lower tax rate
Allied Irish Bank
Tax shield
Financial Risk
Source of need for risk management
16. Modeling approach is typically between statistical analytic models and structural simulation models
Settlement risk
Differences in financial risk management for financial companies vs industrial companies
Risk Management Irrelevance Proposition
Models used in ERM framework
17. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Operational risk
Firms becoming more sensitive to changes(bank deregulation)
VaR - Value at Risk
Basis risk
18. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
APT in active portfolio management
Prices of risk vs sensitivity
Shortcomings of risk metrics
Efficient frontier
19. Strategic risk - Business risk - Reputational risk
Kidder Peabody
Risks excluded from operational risk
RAR = relative return of portfolio (RRp)
Liquidity risk
20. Multibeta CAPM Ri - Rf =
Ri = ai + bi1l1 + bi2l2....+ei
Sovereign risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Valuation vs. Risk management
21. 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
Risk Management Irrelevance Proposition
Capital market line (CML)
Options motivation on volatility
VaR - Value at Risk
22. 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
Volatility Market risk
Barings
Models used in ERM framework
Nonparametric VaR
23. Curve must be concave - Straight line connecting any two points must be under the curve
Shape of portfolio possibilities curve
Shortcomings of risk metrics
Nonmarketable asset impact on CAPM
Debt overhang
24. The need to hedge against risks - for firms need to speculate.
What lead to the exponential growth to derivatives mkt?
Debt overhang
Models used in ERM framework
Uncertainty
25. Cannot exit position in market due to size of the position
Risk
Firms becoming more sensitive to changes(bank deregulation)
Multi- period version of CAPM
Asset liquidity risk
26. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Effect of non- price- taking behavior on CAPM
Capital market line (CML)
Treynor measure
Jensen's alpha
27. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Forms of Market risk
Risk
Ways firms can fail to account for risks
What lead to the exponential growth to derivatives mkt?
28. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Carry- backs and carry- forwards
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Firms becoming more sensitive to changes(bank deregulation)
Basic Market risk
29. 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
LTCM
Differences in financial risk management for financial companies vs industrial companies
Contango
Business risks
30. The lower (closer to - 1) - the higher the payoff from diversification
Correlation coefficient effect on diversification
Shortfall risk
Probability of ruin
Zero- beta CAPM (two factor model)
31. Capital structure (financial distress) - Taxes - Agency and information asymmetries
CAPM assumption for EMH
Sharpe measure
Market imperfections that can create value
Recovery rate
32. Losses due to market activities ex. Interest rate changes or defaults
Volatility Market risk
Financial risks
Probability of ruin
Multi- period version of CAPM
33. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Roles of risk management
What lead to the exponential growth to derivatives mkt?
Nonparametric VaR
Debt overhang
34. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Where is risk coming from
Sortino ratio
Settlement risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
35. 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
Valuation vs. Risk management
Banker's Trust
Settlement risk
Barings
36. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Debt overhang
Standard deviation of two assets
Uncertainty
Ri = Rz + (gamma)(beta)
37. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Importance of communication for risk managers
Credit event
Four major types of risk
Allied Irish Bank
38. Interest rate movements - derivatives - defaults
What lead to the exponential growth to derivatives mkt?
Zero- beta CAPM (two factor model)
Where is risk coming from
Financial Risk
39. Returns on any stock are linearly related to a set of indexes
Zero- beta CAPM (two factor model)
Ri = ai + bi1l1 + bi2l2....+ei
Solve for minimum variance portfolio
Sovereign risk
40. Asset-liability/market-liquidity risk
Liquidity risk
Carry- backs and carry- forwards
Ten assumptions underlying CAPM
LTCM
41. Derives value from an underlying asset - rate - or index - Derives value from a security
Ri = ai + bi1l1 + bi2l2....+ei
Probability of ruin
Solvency-related metrics
Derivative contract
42. When negative taxable income is moved to a different year to offset future or past taxable income
Practical considerations related to ERM implementatio
Tax shield
Uncertainty
Carry- backs and carry- forwards
43. Market risk - Liquidity risk - Credit risk - Operational risk
Correlation coefficient effect on diversification
Risk Management Irrelevance Proposition
Four major types of risk
Basis risk
44. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Nonparametric VaR
Solvency-related metrics
Efficient frontier
Multi- period version of CAPM
45. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Debt overhang
Risks excluded from operational risk
Sovereign risk
Zero- beta CAPM (two factor model)
46. Potential amount that can be lost
VaR- based analysis (formula)
CAPM with taxes included (equation)
Nonparametric VaR
Exposure
47. Quantile of an empirical distribution
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Operational risk
Nonparametric VaR
What lead to the exponential growth to derivatives mkt?
48. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Ten assumptions underlying CAPM
Performance- related metrics
Zero- beta CAPM (two factor model)
Roles of risk management
49. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
VaR- based analysis (formula)
Practical considerations related to ERM implementatio
APT (equation and assumptions)
Shortfall risk
50. 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
Four major types of risk
Sortino ratio
Market risk
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