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FRM: Foundations Of Risk Management
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Instructions:
Answer 50 questions in 15 minutes.
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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. Cannot exit position in market due to size of the position
Differences in financial risk management for financial companies vs industrial companies
Four major types of risk
Asset liquidity risk
Credit event
2. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Settlement risk
Ri = Rz + (gamma)(beta)
Nonparametric VaR
Recovery rate
3. Modeling approach is typically between statistical analytic models and structural simulation models
Models used in ERM framework
RAR = relative return of portfolio (RRp)
Market risk
APT in active portfolio management
4. Market risk - Liquidity risk - Credit risk - Operational risk
Morningstar Rating System
Effect of heterogeneous expectations on CAPM
Four major types of risk
Ri = ai + bi1l1 + bi2l2....+ei
5. Curve must be concave - Straight line connecting any two points must be under the curve
CAPM with taxes included (equation)
Information ratio
Roles of risk management
Shape of portfolio possibilities curve
6. Quantile of a statistical distribution
Tail VaR or TCE - Tail Conditional Expectation(TCE)
LTCM
Risk- adjusted performance measure (RAP)
Parametric VaR
7. 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
Ri = Rz + (gamma)(beta)
Debt overhang
EPD or ECOR - Expected Policyholder Deficit (EPD)
Barings
8. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Contango
Credit event
Valuation vs. Risk management
Risk types addressed by ERM
9. Inability to make payment obligations (ex. Margin calls)
Jensen's alpha
Funding liquidity risk
Solvency-related metrics
What lead to the exponential growth to derivatives mkt?
10. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
VaR - Value at Risk
Expected return of two assets
Ri = ai + bi1l1 + bi2l2....+ei
Risk- adjusted performance measure (RAP)
11. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Differences in financial risk management for financial companies vs industrial companies
Zero- beta CAPM (two factor model)
Performance- related metrics
Basis
12. The lower (closer to - 1) - the higher the payoff from diversification
Contango
Correlation coefficient effect on diversification
Recovery rate
EPD or ECOR - Expected Policyholder Deficit (EPD)
13. Asses firm risks - Communicate risks - Manage and monitor risks
Roles of risk management
Options motivation on volatility
Carry- backs and carry- forwards
Sovereign risk
14. Prices of risk are common factors and do not change - Sensitivities can change
Funding liquidity risk
Business Risk
Shortcomings of risk metrics
Prices of risk vs sensitivity
15. Wrong distribution - Historical sample may not apply
Financial Risk
Morningstar Rating System
APT in active portfolio management
Ways risk can be mismeasured
16. 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
Asset transformers
Valuation vs. Risk management
RAR = relative return of portfolio (RRp)
Operational risk
17. 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
Importance of communication for risk managers
Ten assumptions underlying CAPM
Recovery rate
Shortcomings of risk metrics
18. Quantile of an empirical distribution
Probability of ruin
Derivative contract
Nonparametric VaR
Risk types addressed by ERM
19. 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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20. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Tax shield
Formula for covariance
Credit event
Morningstar Rating System
21. The need to hedge against risks - for firms need to speculate.
Risk
Allied Irish Bank
What lead to the exponential growth to derivatives mkt?
Recovery rate
22. Concave function that extends from minimum variance portfolio to maximum return portfolio
Expected return of two assets
Financial risks
Differences in financial risk management for financial companies vs industrial companies
Efficient frontier
23. Derives value from an underlying asset - rate - or index - Derives value from a security
RAR = relative return of portfolio (RRp)
Tax shield
Jensen's alpha
Derivative contract
24. Strategic risk - Business risk - Reputational risk
Allied Irish Bank
Market imperfections that can create value
Shape of portfolio possibilities curve
Risks excluded from operational risk
25. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Three main reasons for financial disasters
Morningstar Rating System
Parametric VaR
VaR- based analysis (formula)
26. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Risk Management Irrelevance Proposition
Effect of heterogeneous expectations on CAPM
Operational risk
Probability of ruin
27. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Settlement risk
Risks excluded from operational risk
Nonparametric VaR
Tracking error
28. Occurs the day when two parties exchange payments same day
Probability of ruin
Settlement risk
CAPM with taxes included (equation)
Prices of risk vs sensitivity
29. 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
RAR = relative return of portfolio (RRp)
Sovereign risk
Risk types addressed by ERM
30. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
CAPM with taxes included (equation)
Standard deviation of two assets
Ri = ai + bi1l1 + bi2l2....+ei
Jensen's alpha
31. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Risk
Asset transformers
Formula for covariance
Market risk
32. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Zero- beta CAPM (two factor model)
BTR - Below Target Risk
Operational risk
Ri = Rz + (gamma)(beta)
33. Covariance = correlation coefficient std dev(a) std dev(b)
Sortino ratio
Three main reasons for financial disasters
Formula for covariance
Firms becoming more sensitive to changes(bank deregulation)
34. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Derivative contract
Ri = Rz + (gamma)(beta)
EPD or ECOR - Expected Policyholder Deficit (EPD)
Jensen's alpha
35. Need to assess risk and tell management so they can determine which risks to take on
APT for passive portfolio management
Effect of non- price- taking behavior on CAPM
Importance of communication for risk managers
Uncertainty
36. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Carry- backs and carry- forwards
Credit event
Debt overhang
Information ratio
37. Hazard - Financial - Operational - Strategic
Asset transformers
Risk types addressed by ERM
Credit event
Morningstar Rating System
38. Asset-liability/market-liquidity risk
APT in active portfolio management
Carry- backs and carry- forwards
Liquidity risk
Ri = ai + bi1l1 + bi2l2....+ei
39. When two payments are exchanged the same day and one party may default after payment is made
Valuation vs. Risk management
LTCM
Tracking error
Settlement risk
40. Interest rate movements - derivatives - defaults
Financial Risk
APT (equation and assumptions)
Contango
Market imperfections that can create value
41. Volatility of unexpected outcomes
Risk
Ri = Rz + (gamma)(beta)
Tracking error
CAPM assumption for EMH
42. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Practical considerations related to ERM implementatio
RAR = relative return of portfolio (RRp)
Asset transformers
Sortino ratio
43. Absolute and relative risk - direction and non-directional
Source of need for risk management
Firms becoming more sensitive to changes(bank deregulation)
Ri = ai + bi1l1 + bi2l2....+ei
Forms of Market risk
44. Future price is greater than the spot price
Morningstar Rating System
Sovereign risk
Contango
Where is risk coming from
45. 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 -
Sovereign risk
APT in active portfolio management
Source of need for risk management
RAR = relative return of portfolio (RRp)
46. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Market imperfections that can create value
Options motivation on volatility
Asset liquidity risk
Multi- period version of CAPM
47. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Three main reasons for financial disasters
Risk
Ri = Rz + (gamma)(beta)
Differences in financial risk management for financial companies vs industrial companies
48. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Risk
Nonmarketable asset impact on CAPM
Source of need for risk management
APT for passive portfolio management
49. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
BTR - Below Target Risk
Valuation vs. Risk management
Allied Irish Bank
APT in active portfolio management
50. When negative taxable income is moved to a different year to offset future or past taxable income
Probability of ruin
Firms becoming more sensitive to changes(bank deregulation)
Allied Irish Bank
Carry- backs and carry- forwards
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