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Test your basic knowledge |
FRM: Foundations Of Risk Management
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business-skills
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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. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Risk
Kidder Peabody
Risks excluded from operational risk
Where is risk coming from
2. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
CAPM (formula)
Roles of risk management
CAPM with taxes included (equation)
Performance- related metrics
3. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Debt overhang
Basis
Multi- period version of CAPM
Nonmarketable asset impact on CAPM
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
Security (primary vs secondary)
Business Risk
Ri = Rz + (gamma)(beta)
Ten assumptions underlying CAPM
5. 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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6. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Financial Risk
Models used in ERM framework
Settlement risk
Ri = Rz + (gamma)(beta)
7. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Carry- backs and carry- forwards
Basis
Standard deviation of two assets
Tax shield
8. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Contango
CAPM (formula)
Market imperfections that can create value
Credit event
9. Unanticipated movements in relative prices of assets in hedged position
Basic Market risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Sharpe measure
Valuation vs. Risk management
10. Probability distribution is unknown (ex. A terrorist attack)
Derivative contract
LTCM
Funding liquidity risk
Uncertainty
11. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Expected return of two assets
VaR - Value at Risk
Debt overhang
Derivative contract
12. Prices of risk are common factors and do not change - Sensitivities can change
VaR - Value at Risk
Exposure
Prices of risk vs sensitivity
Derivative contract
13. Probability that a random variable falls below a specified threshold level
Uncertainty
Credit event
Shortfall risk
Volatility Market risk
14. 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
Ten assumptions underlying CAPM
Risks excluded from operational risk
Barings
Source of need for risk management
15. Losses due to market activities ex. Interest rate changes or defaults
Standard deviation of two assets
Financial risks
Roles of risk management
Forms of Market risk
16. 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
Volatility Market risk
Exposure
Risk types addressed by ERM
Allied Irish Bank
17. 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
Parametric VaR
Settlement risk
Differences in financial risk management for financial companies vs industrial companies
Drysdale Securities (Chase Manhattan)
18. 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
Importance of communication for risk managers
Tracking error
Valuation vs. Risk management
19. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Solve for minimum variance portfolio
Debt overhang
Asset liquidity risk
20. Modeling approach is typically between statistical analytic models and structural simulation models
Models used in ERM framework
Risk- adjusted performance measure (RAP)
Where is risk coming from
Differences in financial risk management for financial companies vs industrial companies
21. Interest rate movements - derivatives - defaults
CAPM (formula)
Expected return of two assets
Financial Risk
Nonparametric VaR
22. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Exposure
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Zero- beta CAPM (two factor model)
Multi- period version of CAPM
23. 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
Capital market line (CML)
Nonparametric VaR
CAPM assumption for EMH
Tax shield
24. 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
Options motivation on volatility
Allied Irish Bank
Shortcomings of risk metrics
Ri = ai + bi1l1 + bi2l2....+ei
25. Hazard - Financial - Operational - Strategic
Performance- related metrics
Risk types addressed by ERM
Differences in financial risk management for financial companies vs industrial companies
Zero- beta CAPM (two factor model)
26. When negative taxable income is moved to a different year to offset future or past taxable income
Ri = Rz + (gamma)(beta)
Valuation vs. Risk management
Carry- backs and carry- forwards
CAPM with taxes included (equation)
27. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
BTR - Below Target Risk
APT in active portfolio management
Ways risk can be mismeasured
Standard deviation of two assets
28. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Information ratio
Credit event
Probability of ruin
Treynor measure
29. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Credit event
Risk Management Irrelevance Proposition
Probability of ruin
Uncertainty
30. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Solvency-related metrics
VaR- based analysis (formula)
Barings
Sharpe measure
31. Covariance = correlation coefficient std dev(a) std dev(b)
Recovery rate
Roles of risk management
Formula for covariance
Efficient frontier
32. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Prices of risk vs sensitivity
VaR - Value at Risk
LTCM
Liquidity risk
33. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Sharpe measure
Tax shield
Ri = ai + bi1l1 + bi2l2....+ei
Traits of ERM
34. Capital structure (financial distress) - Taxes - Agency and information asymmetries
CAPM (formula)
Risk types addressed by ERM
Market imperfections that can create value
Business risks
35. 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
Financial Risk
Three main reasons for financial disasters
Capital market line (CML)
Traits of ERM
36. 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
Ri = ai + bi1l1 + bi2l2....+ei
Kidder Peabody
Risks excluded from operational risk
Probability of ruin
37. Asses firm risks - Communicate risks - Manage and monitor risks
Settlement risk
Performance- related metrics
Roles of risk management
Financial risks
38. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Ways firms can fail to account for risks
Shortfall risk
APT for passive portfolio management
Morningstar Rating System
39. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Tax shield
Business risks
APT (equation and assumptions)
Operational risk
40. 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
Forms of Market risk
APT for passive portfolio management
Shortfall risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
41. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Three main reasons for financial disasters
Shape of portfolio possibilities curve
Ten assumptions underlying CAPM
Tracking error
42. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
What lead to the exponential growth to derivatives mkt?
Effect of non- price- taking behavior on CAPM
Business Risk
Shortcomings of risk metrics
43. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Carry- backs and carry- forwards
Sovereign risk
Prices of risk vs sensitivity
Business risks
44. Return is linearly related to growth rate in consumption
3 main types of operational risk
Multi- period version of CAPM
Security (primary vs secondary)
Ri = Rz + (gamma)(beta)
45. Returns on any stock are linearly related to a set of indexes
EPD or ECOR - Expected Policyholder Deficit (EPD)
Allied Irish Bank
APT (equation and assumptions)
Ri = ai + bi1l1 + bi2l2....+ei
46. Both probability and cost of tail events are considered
Risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
EPD or ECOR - Expected Policyholder Deficit (EPD)
Ri = Rz + (gamma)(beta)
47. Changes in vol - implied or actual
Parametric VaR
Performance- related metrics
Volatility Market risk
Credit event
48. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
BTR - Below Target Risk
Sortino ratio
Options motivation on volatility
CAPM with taxes included (equation)
49. 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 -
Source of need for risk management
Nonparametric VaR
Drysdale Securities (Chase Manhattan)
Ri = Rz + (gamma)(beta)
50. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Kidder Peabody
Solve for minimum variance portfolio
Uncertainty
Effect of heterogeneous expectations on CAPM