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Test your basic knowledge |
FRM: Foundations Of Risk Management
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business-skills
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certifications
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frm
Instructions:
Answer 50 questions in 15 minutes.
If you are not ready to take this test, you can
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. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Importance of communication for risk managers
Solvency-related metrics
Ways risk can be mismeasured
Ri = ai + bi1l1 + bi2l2....+ei
2. The uses of debt to fall into a lower tax rate
Volatility Market risk
Settlement risk
Ri = ai + bi1l1 + bi2l2....+ei
Tax shield
3. 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
LTCM
APT for passive portfolio management
Valuation vs. Risk management
VaR - Value at Risk
4. Interest rate movements - derivatives - defaults
Debt overhang
Barings
Financial Risk
Effect of heterogeneous expectations on CAPM
5. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Morningstar Rating System
VaR- based analysis (formula)
Nonparametric VaR
Options motivation on volatility
6. 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
APT for passive portfolio management
Drysdale Securities (Chase Manhattan)
RAR = relative return of portfolio (RRp)
EPD or ECOR - Expected Policyholder Deficit (EPD)
7. Returns on any stock are linearly related to a set of indexes
APT in active portfolio management
Ri = ai + bi1l1 + bi2l2....+ei
Ways risk can be mismeasured
Asset transformers
8. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Sovereign risk
BTR - Below Target Risk
Risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
9. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
LTCM
Performance- related metrics
Tracking error
VaR - Value at Risk
10. When negative taxable income is moved to a different year to offset future or past taxable income
Asset liquidity risk
Sovereign risk
RAR = relative return of portfolio (RRp)
Carry- backs and carry- forwards
11. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Effect of heterogeneous expectations on CAPM
Sharpe measure
Performance- related metrics
CAPM assumption for EMH
12. Rp = XaRa + XbRb
CAPM with taxes included (equation)
Risk Management Irrelevance Proposition
Expected return of two assets
Shape of portfolio possibilities curve
13. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Operational risk
Source of need for risk management
Risk Management Irrelevance Proposition
Business risks
14. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Business Risk
Prices of risk vs sensitivity
Treynor measure
Differences in financial risk management for financial companies vs industrial companies
15. Expected value of unfavorable deviations of a random variable from a specified target level
Zero- beta CAPM (two factor model)
Importance of communication for risk managers
Information ratio
BTR - Below Target Risk
16. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Differences in financial risk management for financial companies vs industrial companies
3 main types of operational risk
Debt overhang
Ways risk can be mismeasured
17. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Standard deviation of two assets
Nonparametric VaR
Security (primary vs secondary)
Shortcomings of risk metrics
18. Strategic risk - Business risk - Reputational risk
VaR - Value at Risk
Risks excluded from operational risk
Morningstar Rating System
Sovereign risk
19. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Effect of heterogeneous expectations on CAPM
Basic Market risk
Tax shield
Efficient frontier
20. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Asset transformers
Where is risk coming from
Drysdale Securities (Chase Manhattan)
APT in active portfolio management
21. 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 Management Irrelevance Proposition
Source of need for risk management
Prices of risk vs sensitivity
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
22. When two payments are exchanged the same day and one party may default after payment is made
Zero- beta CAPM (two factor model)
Settlement risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Tax shield
23. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Zero- beta CAPM (two factor model)
Shortfall risk
Sharpe measure
RAR = relative return of portfolio (RRp)
24. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
APT (equation and assumptions)
Derivative contract
Risk Management Irrelevance Proposition
Tracking error
25. Cannot exit position in market due to size of the position
Asset liquidity risk
VaR- based analysis (formula)
Treynor measure
Credit event
26. Volatility of unexpected outcomes
Sortino ratio
Carry- backs and carry- forwards
BTR - Below Target Risk
Risk
27. The need to hedge against risks - for firms need to speculate.
What lead to the exponential growth to derivatives mkt?
RAR = relative return of portfolio (RRp)
Kidder Peabody
Debt overhang
28. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
CAPM assumption for EMH
Drysdale Securities (Chase Manhattan)
Effect of non- price- taking behavior on CAPM
CAPM with taxes included (equation)
29. Unanticipated movements in relative prices of assets in hedged position
APT in active portfolio management
Basic Market risk
Information ratio
Morningstar Rating System
30. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Credit event
Debt overhang
Sovereign risk
Prices of risk vs sensitivity
31. Inability to make payment obligations (ex. Margin calls)
Business Risk
Funding liquidity risk
LTCM
BTR - Below Target Risk
32. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Asset transformers
Models used in ERM framework
Firms becoming more sensitive to changes(bank deregulation)
Tail VaR or TCE - Tail Conditional Expectation(TCE)
33. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
Source of need for risk management
Ri = ai + bi1l1 + bi2l2....+ei
Risk types addressed by ERM
34. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Morningstar Rating System
Debt overhang
Sharpe measure
EPD or ECOR - Expected Policyholder Deficit (EPD)
35. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Options motivation on volatility
Where is risk coming from
Models used in ERM framework
Risk
36. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Basis
Traits of ERM
Market imperfections that can create value
Options motivation on volatility
37. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Risk Management Irrelevance Proposition
Performance- related metrics
Valuation vs. Risk management
Debt overhang
38. Derives value from an underlying asset - rate - or index - Derives value from a security
APT in active portfolio management
Derivative contract
Models used in ERM framework
Shortcomings of risk metrics
39. Firm may ignore known risk - Somebody in firm may know about risk - but it's not captured by models - Realization of a truly unknown risk
Financial risks
Ways firms can fail to account for risks
LTCM
Risk
40. Asses firm risks - Communicate risks - Manage and monitor risks
Formula for covariance
Debt overhang
Roles of risk management
Uncertainty
41. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Standard deviation of two assets
Basis risk
Roles of risk management
Sovereign risk
42. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Three main reasons for financial disasters
Effect of non- price- taking behavior on CAPM
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Differences in financial risk management for financial companies vs industrial companies
43. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Treynor measure
Correlation coefficient effect on diversification
Solve for minimum variance portfolio
Allied Irish Bank
44. 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
Recovery rate
Ten assumptions underlying CAPM
Kidder Peabody
Zero- beta CAPM (two factor model)
45. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Zero- beta CAPM (two factor model)
CAPM (formula)
Ways risk can be mismeasured
Risk types addressed by ERM
46. 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
Zero- beta CAPM (two factor model)
Parametric VaR
Shortcomings of risk metrics
Tax shield
47. 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
Shortcomings of risk metrics
Debt overhang
Basis risk
Ten assumptions underlying CAPM
48. Risk of loses owing to movements in level or volatility of market prices
APT for passive portfolio management
Market risk
Four major types of risk
Basis
49. 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
Where is risk coming from
Three main reasons for financial disasters
Traits of ERM
Derivative contract
50. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Sortino ratio
Firms becoming more sensitive to changes(bank deregulation)
Capital market line (CML)
Shortcomings of risk metrics