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Test your basic knowledge |
FRM: Foundations Of Risk Management
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frm
Instructions:
Answer 50 questions in 15 minutes.
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study here
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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. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Risk
Four major types of risk
Basis
Information ratio
2. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Security (primary vs secondary)
Solvency-related metrics
Ri = Rz + (gamma)(beta)
Jensen's alpha
3. 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
Risk Management Irrelevance Proposition
Expected return of two assets
Standard deviation of two assets
Practical considerations related to ERM implementatio
4. 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
Standard deviation of two assets
Ways risk can be mismeasured
Treynor measure
Valuation vs. Risk management
5. 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 in active portfolio management
APT for passive portfolio management
Importance of communication for risk managers
Settlement risk
6. Losses due to market activities ex. Interest rate changes or defaults
Four major types of risk
Multi- period version of CAPM
Security (primary vs secondary)
Financial risks
7. Need to assess risk and tell management so they can determine which risks to take on
Importance of communication for risk managers
Morningstar Rating System
Market imperfections that can create value
Sortino ratio
8. 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
Sortino ratio
Capital market line (CML)
Shortfall risk
Debt overhang
9. Those which corporations assume whillingly to create competitive advantage/add shareholder value - Business Decisions: investment decisions - prod - dev choices - marketing strategies - organizational struct. - Business Environment: competitive and
Business Risk
Debt overhang
Jensen's alpha
Exposure
10. 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
Ten assumptions underlying CAPM
Treynor measure
APT (equation and assumptions)
Sortino ratio
11. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Ri = ai + bi1l1 + bi2l2....+ei
LTCM
Zero- beta CAPM (two factor model)
Effect of non- price- taking behavior on CAPM
12. Prices of risk are common factors and do not change - Sensitivities can change
Prices of risk vs sensitivity
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Nonparametric VaR
Uncertainty
13. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Tracking error
CAPM with taxes included (equation)
Volatility Market risk
Liquidity risk
14. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Three main reasons for financial disasters
VaR - Value at Risk
Information ratio
Efficient frontier
15. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Shortcomings of risk metrics
Asset transformers
Financial risks
Differences in financial risk management for financial companies vs industrial companies
16. Absolute and relative risk - direction and non-directional
Financial risks
Models used in ERM framework
Forms of Market risk
Shortcomings of risk metrics
17. Market risk - Liquidity risk - Credit risk - Operational risk
Four major types of risk
Ways risk can be mismeasured
Settlement risk
CAPM with taxes included (equation)
18. Return is linearly related to growth rate in consumption
Security (primary vs secondary)
Debt overhang
Zero- beta CAPM (two factor model)
Multi- period version of CAPM
19. Inability to make payment obligations (ex. Margin calls)
Expected return of two assets
Volatility Market risk
Funding liquidity risk
RAR = relative return of portfolio (RRp)
20. Asses firm risks - Communicate risks - Manage and monitor risks
VaR - Value at Risk
Nonmarketable asset impact on CAPM
Efficient frontier
Roles of risk management
21. 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
Solvency-related metrics
Debt overhang
Traits of ERM
Barings
22. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Probability of ruin
Information ratio
APT in active portfolio management
Contango
23. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Recovery rate
Funding liquidity risk
Information ratio
Ri = Rz + (gamma)(beta)
24. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Valuation vs. Risk management
Treynor measure
Banker's Trust
Business risks
25. Potential amount that can be lost
Jensen's alpha
Exposure
CAPM with taxes included (equation)
VaR- based analysis (formula)
26. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Liquidity risk
Shortcomings of risk metrics
Shortfall risk
Where is risk coming from
27. Expected value of unfavorable deviations of a random variable from a specified target level
Volatility Market risk
BTR - Below Target Risk
Funding liquidity risk
What lead to the exponential growth to derivatives mkt?
28. Modeling approach is typically between statistical analytic models and structural simulation models
Ten assumptions underlying CAPM
CAPM (formula)
Models used in ERM framework
BTR - Below Target Risk
29. The uses of debt to fall into a lower tax rate
Risk types addressed by ERM
Standard deviation of two assets
Tax shield
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
30. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Ri = Rz + (gamma)(beta)
APT in active portfolio management
Treynor measure
Effect of heterogeneous expectations on CAPM
31. 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
CAPM (formula)
Drysdale Securities (Chase Manhattan)
Correlation coefficient effect on diversification
Models used in ERM framework
32. Covariance = correlation coefficient std dev(a) std dev(b)
Drysdale Securities (Chase Manhattan)
Tax shield
Formula for covariance
Forms of Market risk
33. Both probability and cost of tail events are considered
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Practical considerations related to ERM implementatio
Tracking error
Firms becoming more sensitive to changes(bank deregulation)
34. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Parametric VaR
Credit event
LTCM
Debt overhang
35. 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
Basis risk
Volatility Market risk
Shape of portfolio possibilities curve
Probability of ruin
36. When negative taxable income is moved to a different year to offset future or past taxable income
Carry- backs and carry- forwards
Contango
Sortino ratio
Shape of portfolio possibilities curve
37. 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 -
Three main reasons for financial disasters
Derivative contract
Source of need for risk management
Traits of ERM
38. Curve must be concave - Straight line connecting any two points must be under the curve
Market risk
Shape of portfolio possibilities curve
Forms of Market risk
Financial risks
39. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Liquidity risk
Credit event
Carry- backs and carry- forwards
Shape of portfolio possibilities curve
40. Wrong distribution - Historical sample may not apply
Allied Irish Bank
Ways risk can be mismeasured
Kidder Peabody
Solvency-related metrics
41. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Practical considerations related to ERM implementatio
Market imperfections that can create value
EPD or ECOR - Expected Policyholder Deficit (EPD)
Options motivation on volatility
42. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Recovery rate
Risk types addressed by ERM
Operational risk
Market imperfections that can create value
43. 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
Zero- beta CAPM (two factor model)
Exposure
Jensen's alpha
Traits of ERM
44. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Performance- related metrics
Sovereign risk
Solve for minimum variance portfolio
Nonparametric VaR
45. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Basis risk
Settlement risk
Solve for minimum variance portfolio
Operational risk
46. 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
Tracking error
Three main reasons for financial disasters
47. Quantile of a statistical distribution
Market imperfections that can create value
Basic Market risk
Ri = Rz + (gamma)(beta)
Parametric VaR
48. Probability distribution is unknown (ex. A terrorist attack)
Uncertainty
Source of need for risk management
Exposure
Three main reasons for financial disasters
49. Quantile of an empirical distribution
Zero- beta CAPM (two factor model)
Nonparametric VaR
Debt overhang
Forms of Market risk
50. Relative portfolio risk (RRiskp) - Based on a one- month investment period
RAR = relative return of portfolio (RRp)
Correlation coefficient effect on diversification
Options motivation on volatility
Risk