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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. 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
Parametric VaR
Traits of ERM
Ways risk can be mismeasured
Liquidity risk
2. Strategic risk - Business risk - Reputational risk
Risks excluded from operational risk
Solve for minimum variance portfolio
Ways risk can be mismeasured
Roles of risk management
3. Quantile of a statistical distribution
Sharpe measure
Roles of risk management
Risks excluded from operational risk
Parametric VaR
4. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Funding liquidity risk
Ri = Rz + (gamma)(beta)
Ways firms can fail to account for risks
Risk- adjusted performance measure (RAP)
5. Returns on any stock are linearly related to a set of indexes
Tracking error
Ri = ai + bi1l1 + bi2l2....+ei
Ten assumptions underlying CAPM
Basis risk
6. 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
Debt overhang
Sharpe measure
Basis risk
7. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Basis risk
Ten assumptions underlying CAPM
Drysdale Securities (Chase Manhattan)
Information ratio
8. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Three main reasons for financial disasters
Differences in financial risk management for financial companies vs industrial companies
Risk Management Irrelevance Proposition
9. 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- adjusted performance measure (RAP)
Importance of communication for risk managers
Risk Management Irrelevance Proposition
VaR- based analysis (formula)
10. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Uncertainty
VaR- based analysis (formula)
Effect of heterogeneous expectations on CAPM
Parametric VaR
11. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Sortino ratio
Options motivation on volatility
VaR - Value at Risk
Derivative contract
12. 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
Expected return of two assets
Recovery rate
Kidder Peabody
Capital market line (CML)
13. When negative taxable income is moved to a different year to offset future or past taxable income
Prices of risk vs sensitivity
Funding liquidity risk
Derivative contract
Carry- backs and carry- forwards
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. 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
Efficient frontier
Market imperfections that can create value
Drysdale Securities (Chase Manhattan)
What lead to the exponential growth to derivatives mkt?
16. CAPM requires the strong form of the Efficient Market Hypothesis = private information
CAPM assumption for EMH
Basis risk
Operational risk
Uncertainty
17. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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18. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Valuation vs. Risk management
Firms becoming more sensitive to changes(bank deregulation)
Practical considerations related to ERM implementatio
Where is risk coming from
19. Concave function that extends from minimum variance portfolio to maximum return portfolio
Volatility Market risk
Efficient frontier
BTR - Below Target Risk
Basis
20. 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
Business risks
Barings
Firms becoming more sensitive to changes(bank deregulation)
Information ratio
21. Asset-liability/market-liquidity risk
Risk types addressed by ERM
Liquidity risk
Firms becoming more sensitive to changes(bank deregulation)
Risk- adjusted performance measure (RAP)
22. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Nonmarketable asset impact on CAPM
Exposure
Correlation coefficient effect on diversification
Probability of ruin
23. Prices of risk are common factors and do not change - Sensitivities can change
Morningstar Rating System
RAR = relative return of portfolio (RRp)
Prices of risk vs sensitivity
Importance of communication for risk managers
24. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Treynor measure
EPD or ECOR - Expected Policyholder Deficit (EPD)
Asset liquidity risk
Risks excluded from operational risk
25. The uses of debt to fall into a lower tax rate
Ways risk can be mismeasured
Correlation coefficient effect on diversification
Tax shield
Settlement risk
26. Expected value of unfavorable deviations of a random variable from a specified target level
Asset transformers
BTR - Below Target Risk
VaR- based analysis (formula)
Tracking error
27. Both probability and cost of tail events are considered
CAPM with taxes included (equation)
Morningstar Rating System
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Zero- beta CAPM (two factor model)
28. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Zero- beta CAPM (two factor model)
Ways firms can fail to account for risks
Sovereign risk
Risks excluded from operational risk
29. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Market imperfections that can create value
Prices of risk vs sensitivity
Firms becoming more sensitive to changes(bank deregulation)
Banker's Trust
30. 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
Prices of risk vs sensitivity
Allied Irish Bank
Nonmarketable asset impact on CAPM
Drysdale Securities (Chase Manhattan)
31. Multibeta CAPM Ri - Rf =
Carry- backs and carry- forwards
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Risk
Risk Management Irrelevance Proposition
32. Future price is greater than the spot price
Ways firms can fail to account for risks
What lead to the exponential growth to derivatives mkt?
Contango
Business Risk
33. Volatility of unexpected outcomes
EPD or ECOR - Expected Policyholder Deficit (EPD)
Four major types of risk
Sovereign risk
Risk
34. Modeling approach is typically between statistical analytic models and structural simulation models
Debt overhang
Models used in ERM framework
Risks excluded from operational risk
Where is risk coming from
35. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Ri = Rz + (gamma)(beta)
Security (primary vs secondary)
Capital market line (CML)
LTCM
36. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Zero- beta CAPM (two factor model)
Morningstar Rating System
Shortfall risk
Roles of risk management
37. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Financial Risk
Effect of heterogeneous expectations on CAPM
Effect of non- price- taking behavior on CAPM
Volatility Market risk
38. Need to assess risk and tell management so they can determine which risks to take on
Zero- beta CAPM (two factor model)
Debt overhang
Importance of communication for risk managers
CAPM (formula)
39. Unanticipated movements in relative prices of assets in hedged position
VaR- based analysis (formula)
Basic Market risk
Shortcomings of risk metrics
Uncertainty
40. Derives value from an underlying asset - rate - or index - Derives value from a security
Treynor measure
Derivative contract
CAPM assumption for EMH
Four major types of risk
41. Quantile of an empirical distribution
Ways risk can be mismeasured
Expected return of two assets
Information ratio
Nonparametric VaR
42. 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
Shortcomings of risk metrics
LTCM
Solvency-related metrics
Ri = Rz + (gamma)(beta)
43. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Firms becoming more sensitive to changes(bank deregulation)
CAPM (formula)
Parametric VaR
Tail VaR or TCE - Tail Conditional Expectation(TCE)
44. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Asset transformers
Prices of risk vs sensitivity
Options motivation on volatility
Settlement risk
45. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Ways firms can fail to account for risks
Barings
APT in active portfolio management
Drysdale Securities (Chase Manhattan)
46. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Basis
LTCM
VaR - Value at Risk
Exposure
47. Probability distribution is unknown (ex. A terrorist attack)
Uncertainty
Financial risks
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Kidder Peabody
48. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
APT in active portfolio management
3 main types of operational risk
CAPM assumption for EMH
LTCM
49. The lower (closer to - 1) - the higher the payoff from diversification
Risks excluded from operational risk
Nonparametric VaR
Correlation coefficient effect on diversification
Morningstar Rating System
50. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Shortfall risk
Ri = ai + bi1l1 + bi2l2....+ei
Prices of risk vs sensitivity
Security (primary vs secondary)
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