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FRM: Foundations Of Risk Management

Instructions:
  • 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. 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






2. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios






3. 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






4. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated






5. Inability to make payment obligations (ex. Margin calls)






6. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio






7. 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






8. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk






9. Simple form of CAPM - but market price of risk is lower than if all investors were price takers






10. 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






11. Changes in vol - implied or actual






12. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business






13. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios






14. Law of one price - Homogeneous expectations - Security returns process






15. 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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16. 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






17. Prices of risk are common factors and do not change - Sensitivities can change






18. 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






19. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM






20. Difference between forward price and spot price - Should approach zero as the contract approaches maturity






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.






22. 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






23. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk






24. 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






25. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized






26. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages






27. When two payments are exchanged the same day and one party may default after payment is made






28. Cannot exit position in market due to size of the position






29. Multibeta CAPM Ri - Rf =






30. Expected value of unfavorable deviations of a random variable from a specified target level






31. The lower (closer to - 1) - the higher the payoff from diversification






32. 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






33. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund






34. Potential amount that can be lost






35. When negative taxable income is moved to a different year to offset future or past taxable income






36. Risks that are assumed willingly - to gain a competitive edge or add shareholder value






37. Hazard - Financial - Operational - Strategic






38. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected






39. 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






40. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)






41. CAPM requires the strong form of the Efficient Market Hypothesis = private information






42. Probability that a random variable falls below a specified threshold level






43. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed






44. Capital structure (financial distress) - Taxes - Agency and information asymmetries






45. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely






46. Asset-liability/market-liquidity risk






47. Probability distribution is unknown (ex. A terrorist attack)






48. 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






49. Returns on any stock are linearly related to a set of indexes






50. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements







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