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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. 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
Probability of ruin
Contango
Three main reasons for financial disasters
Risk
2. 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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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
Sharpe measure
Ri = Rz + (gamma)(beta)
APT for passive portfolio management
Allied Irish Bank
4. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Funding liquidity risk
Settlement risk
Performance- related metrics
Differences in financial risk management for financial companies vs industrial companies
5. Expected value of unfavorable deviations of a random variable from a specified target level
Asset transformers
Where is risk coming from
BTR - Below Target Risk
Practical considerations related to ERM implementatio
6. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
3 main types of operational risk
LTCM
Derivative contract
Asset transformers
7. 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 -
Ri = Rz + (gamma)(beta)
APT (equation and assumptions)
Contango
Source of need for risk management
8. Hazard - Financial - Operational - Strategic
BTR - Below Target Risk
Differences in financial risk management for financial companies vs industrial companies
Risk types addressed by ERM
Asset transformers
9. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Shortcomings of risk metrics
Effect of non- price- taking behavior on CAPM
Morningstar Rating System
Risk
10. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
Performance- related metrics
Effect of non- price- taking behavior on CAPM
Uncertainty
11. Covariance = correlation coefficient std dev(a) std dev(b)
Formula for covariance
Risks excluded from operational risk
Firms becoming more sensitive to changes(bank deregulation)
Uncertainty
12. Modeling approach is typically between statistical analytic models and structural simulation models
Traits of ERM
APT (equation and assumptions)
Models used in ERM framework
3 main types of operational risk
13. Occurs the day when two parties exchange payments same day
Nonmarketable asset impact on CAPM
Forms of Market risk
Settlement risk
Ri = Rz + (gamma)(beta)
14. Concave function that extends from minimum variance portfolio to maximum return portfolio
Exposure
Business risks
Efficient frontier
Sovereign risk
15. Unanticipated movements in relative prices of assets in hedged position
Shortfall risk
Basis risk
Ri = ai + bi1l1 + bi2l2....+ei
Basic Market risk
16. The lower (closer to - 1) - the higher the payoff from diversification
LTCM
APT in active portfolio management
Correlation coefficient effect on diversification
Capital market line (CML)
17. Risk of loses owing to movements in level or volatility of market prices
Market risk
Business risks
Performance- related metrics
Asset liquidity risk
18. 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
VaR - Value at Risk
Market imperfections that can create value
Traits of ERM
Four major types of risk
19. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Sortino ratio
Ways firms can fail to account for risks
Solve for minimum variance portfolio
Jensen's alpha
20. Multibeta CAPM Ri - Rf =
CAPM (formula)
Performance- related metrics
CAPM with taxes included (equation)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
21. Strategic risk - Business risk - Reputational risk
Risks excluded from operational risk
Probability of ruin
Basic Market risk
Business risks
22. Law of one price - Homogeneous expectations - Security returns process
Shape of portfolio possibilities curve
VaR - Value at Risk
What lead to the exponential growth to derivatives mkt?
APT (equation and assumptions)
23. 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
Tax shield
What lead to the exponential growth to derivatives mkt?
Uncertainty
24. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Recovery rate
Financial Risk
Importance of communication for risk managers
Firms becoming more sensitive to changes(bank deregulation)
25. Rp = XaRa + XbRb
Sortino ratio
Expected return of two assets
Sharpe measure
APT (equation and assumptions)
26. Potential amount that can be lost
Exposure
Liquidity risk
Solvency-related metrics
Roles of risk management
27. Inability to make payment obligations (ex. Margin calls)
Contango
Performance- related metrics
Funding liquidity risk
Shape of portfolio possibilities curve
28. 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
Risks excluded from operational risk
Jensen's alpha
Drysdale Securities (Chase Manhattan)
LTCM
29. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Solvency-related metrics
Sharpe measure
Risk- adjusted performance measure (RAP)
Effect of heterogeneous expectations on CAPM
30. Need to assess risk and tell management so they can determine which risks to take on
Nonparametric VaR
Uncertainty
Importance of communication for risk managers
Sortino ratio
31. Asset-liability/market-liquidity risk
Probability of ruin
Information ratio
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Liquidity risk
32. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
3 main types of operational risk
Formula for covariance
Credit event
Capital market line (CML)
33. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
EPD or ECOR - Expected Policyholder Deficit (EPD)
Sovereign risk
Effect of non- price- taking behavior on CAPM
Allied Irish Bank
34. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Nonmarketable asset impact on CAPM
Sovereign risk
Basis risk
Risks excluded from operational risk
35. 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
BTR - Below Target Risk
Roles of risk management
Business risks
Kidder Peabody
36. 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
Valuation vs. Risk management
Ri = Rz + (gamma)(beta)
Sortino ratio
37. Wrong distribution - Historical sample may not apply
Ways firms can fail to account for risks
Efficient frontier
Liquidity risk
Ways risk can be mismeasured
38. 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
Carry- backs and carry- forwards
Uncertainty
Formula for covariance
Drysdale Securities (Chase Manhattan)
39. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Risk types addressed by ERM
Morningstar Rating System
Three main reasons for financial disasters
Jensen's alpha
40. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Risk
Sharpe measure
BTR - Below Target Risk
Basic Market risk
41. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
BTR - Below Target Risk
Market risk
Three main reasons for financial disasters
APT for passive portfolio management
42. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
Ways risk can be mismeasured
CAPM with taxes included (equation)
Risk Management Irrelevance Proposition
APT for passive portfolio management
43. Cannot exit position in market due to size of the position
Firms becoming more sensitive to changes(bank deregulation)
Options motivation on volatility
Asset liquidity risk
Three main reasons for financial disasters
44. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Ten assumptions underlying CAPM
Market imperfections that can create value
Asset transformers
Standard deviation of two assets
45. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Effect of heterogeneous expectations on CAPM
Solvency-related metrics
Formula for covariance
Treynor measure
46. Asses firm risks - Communicate risks - Manage and monitor risks
VaR - Value at Risk
Solvency-related metrics
Roles of risk management
Models used in ERM framework
47. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Parametric VaR
Effect of non- price- taking behavior on CAPM
Ri = Rz + (gamma)(beta)
APT (equation and assumptions)
48. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Allied Irish Bank
Multi- period version of CAPM
VaR- based analysis (formula)
Ri = ai + bi1l1 + bi2l2....+ei
49. 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
Solve for minimum variance portfolio
Ways firms can fail to account for risks
Risk- adjusted performance measure (RAP)
Ri = Rz + (gamma)(beta)
50. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
VaR - Value at Risk
Solvency-related metrics
CAPM assumption for EMH
Practical considerations related to ERM implementatio