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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. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Business risks
Effect of heterogeneous expectations on CAPM
Risk
Prices of risk vs sensitivity
2. Wrong distribution - Historical sample may not apply
Asset transformers
Ways risk can be mismeasured
Prices of risk vs sensitivity
Source of need for risk management
3. Changes in vol - implied or actual
Ri = ai + bi1l1 + bi2l2....+ei
Liquidity risk
Where is risk coming from
Volatility Market risk
4. 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
Financial Risk
Ways risk can be mismeasured
Ten assumptions underlying CAPM
Risk Management Irrelevance Proposition
5. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Exposure
Importance of communication for risk managers
VaR- based analysis (formula)
Asset transformers
6. Quantile of an empirical distribution
Business risks
Solvency-related metrics
Nonparametric VaR
Barings
7. The lower (closer to - 1) - the higher the payoff from diversification
Basic Market risk
Barings
Correlation coefficient effect on diversification
Asset liquidity risk
8. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Risk
Security (primary vs secondary)
Recovery rate
Basic Market risk
9. Future price is greater than the spot price
Contango
Carry- backs and carry- forwards
Shape of portfolio possibilities curve
Firms becoming more sensitive to changes(bank deregulation)
10. Expected value of unfavorable deviations of a random variable from a specified target level
BTR - Below Target Risk
Sharpe measure
Business risks
Ten assumptions underlying CAPM
11. Probability distribution is unknown (ex. A terrorist attack)
Asset liquidity risk
Uncertainty
Market imperfections that can create value
Basic Market risk
12. 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
Settlement risk
Shortcomings of risk metrics
Business Risk
Source of need for risk management
13. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Treynor measure
RAR = relative return of portfolio (RRp)
What lead to the exponential growth to derivatives mkt?
Solve for minimum variance portfolio
14. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Three main reasons for financial disasters
Importance of communication for risk managers
Practical considerations related to ERM implementatio
3 main types of operational risk
15. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Credit event
Tracking error
Probability of ruin
CAPM with taxes included (equation)
16. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Asset transformers
Solvency-related metrics
Uncertainty
Treynor measure
17. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Market risk
CAPM assumption for EMH
Basis risk
Where is risk coming from
18. Inability to make payment obligations (ex. Margin calls)
Funding liquidity risk
Firms becoming more sensitive to changes(bank deregulation)
Liquidity risk
Morningstar Rating System
19. Potential amount that can be lost
Exposure
Standard deviation of two assets
Allied Irish Bank
Funding liquidity risk
20. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Information ratio
BTR - Below Target Risk
Debt overhang
Ri = Rz + (gamma)(beta)
21. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
CAPM with taxes included (equation)
Parametric VaR
Shortfall risk
Treynor measure
22. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Risk- adjusted performance measure (RAP)
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Carry- backs and carry- forwards
Risk
23. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Importance of communication for risk managers
Security (primary vs secondary)
Ri = Rz + (gamma)(beta)
Practical considerations related to ERM implementatio
24. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Volatility Market risk
APT in active portfolio management
Security (primary vs secondary)
Debt overhang
25. Firms became multinational - - >watched xchange rates more - deregulation and globalization
RAR = relative return of portfolio (RRp)
Credit event
Firms becoming more sensitive to changes(bank deregulation)
Uncertainty
26. 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
Performance- related metrics
Risk- adjusted performance measure (RAP)
Valuation vs. Risk management
27. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
3 main types of operational risk
Financial Risk
Nonparametric VaR
Three main reasons for financial disasters
28. 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
Basis
Carry- backs and carry- forwards
Shortfall risk
Valuation vs. Risk management
29. Multibeta CAPM Ri - Rf =
Performance- related metrics
CAPM with taxes included (equation)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Basis risk
30. Concave function that extends from minimum variance portfolio to maximum return portfolio
Practical considerations related to ERM implementatio
Efficient frontier
Drysdale Securities (Chase Manhattan)
Basis risk
31. Unanticipated movements in relative prices of assets in hedged position
Basic Market risk
Shape of portfolio possibilities curve
Effect of non- price- taking behavior on CAPM
Sharpe measure
32. 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 -
Models used in ERM framework
Security (primary vs secondary)
Source of need for risk management
CAPM assumption for EMH
33. Asset-liability/market-liquidity risk
Ri = Rz + (gamma)(beta)
Tax shield
Liquidity risk
3 main types of operational risk
34. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Liquidity risk
APT (equation and assumptions)
Performance- related metrics
Basis risk
35. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
BTR - Below Target Risk
Settlement risk
Options motivation on volatility
Market risk
36. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Prices of risk vs sensitivity
Uncertainty
Barings
Operational risk
37. 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
Tax shield
Capital market line (CML)
Business risks
Exposure
38. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Valuation vs. Risk management
Morningstar Rating System
Forms of Market risk
Ways risk can be mismeasured
39. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Kidder Peabody
Basis
CAPM assumption for EMH
Sharpe measure
40. Interest rate movements - derivatives - defaults
Financial Risk
Practical considerations related to ERM implementatio
Carry- backs and carry- forwards
Ri = Rz + (gamma)(beta)
41. 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.
CAPM with taxes included (equation)
Risk Management Irrelevance Proposition
Zero- beta CAPM (two factor model)
Practical considerations related to ERM implementatio
42. Absolute and relative risk - direction and non-directional
Operational risk
Firms becoming more sensitive to changes(bank deregulation)
Morningstar Rating System
Forms of Market risk
43. 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
Banker's Trust
Probability of ruin
Operational risk
Basis
44. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Risk
Ten assumptions underlying CAPM
Sharpe measure
Shortcomings of risk metrics
45. Derives value from an underlying asset - rate - or index - Derives value from a security
Security (primary vs secondary)
Market imperfections that can create value
Firms becoming more sensitive to changes(bank deregulation)
Derivative contract
46. When two payments are exchanged the same day and one party may default after payment is made
Asset liquidity risk
Importance of communication for risk managers
Settlement risk
Probability of ruin
47. Law of one price - Homogeneous expectations - Security returns process
Ways firms can fail to account for risks
Options motivation on volatility
Tax shield
APT (equation and assumptions)
48. The need to hedge against risks - for firms need to speculate.
What lead to the exponential growth to derivatives mkt?
Sovereign risk
Parametric VaR
EPD or ECOR - Expected Policyholder Deficit (EPD)
49. The uses of debt to fall into a lower tax rate
Capital market line (CML)
Performance- related metrics
Tax shield
Drysdale Securities (Chase Manhattan)
50. Covariance = correlation coefficient std dev(a) std dev(b)
Importance of communication for risk managers
Jensen's alpha
Formula for covariance
Information ratio
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