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Test your basic knowledge |
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. Changes in vol - implied or actual
BTR - Below Target Risk
APT (equation and assumptions)
Valuation vs. Risk management
Volatility Market risk
2. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
VaR - Value at Risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
Ways firms can fail to account for risks
CAPM assumption for EMH
3. 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
Shortcomings of risk metrics
Business Risk
Solvency-related metrics
Capital market line (CML)
4. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Recovery rate
Standard deviation of two assets
APT for passive portfolio management
LTCM
5. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Formula for covariance
Solvency-related metrics
Tracking error
APT in active portfolio management
6. 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
Traits of ERM
Differences in financial risk management for financial companies vs industrial companies
Basis
Recovery rate
7. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Firms becoming more sensitive to changes(bank deregulation)
Morningstar Rating System
Probability of ruin
Market imperfections that can create value
8. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Tax shield
CAPM assumption for EMH
Operational risk
Practical considerations related to ERM implementatio
9. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Debt overhang
Asset transformers
Models used in ERM framework
Business Risk
10. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Nonmarketable asset impact on CAPM
Jensen's alpha
CAPM (formula)
Shortfall risk
11. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Parametric VaR
Where is risk coming from
Risk types addressed by ERM
Ri = Rz + (gamma)(beta)
12. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Solvency-related metrics
Three main reasons for financial disasters
Settlement risk
Risk
13. When two payments are exchanged the same day and one party may default after payment is made
EPD or ECOR - Expected Policyholder Deficit (EPD)
APT (equation and assumptions)
Risk Management Irrelevance Proposition
Settlement risk
14. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Operational risk
Security (primary vs secondary)
Correlation coefficient effect on diversification
Sortino ratio
15. Prices of risk are common factors and do not change - Sensitivities can change
Prices of risk vs sensitivity
Options motivation on volatility
Financial Risk
Market risk
16. Volatility of unexpected outcomes
Risk
Ri = ai + bi1l1 + bi2l2....+ei
Morningstar Rating System
Tracking error
17. Curve must be concave - Straight line connecting any two points must be under the curve
Risks excluded from operational risk
CAPM (formula)
BTR - Below Target Risk
Shape of portfolio possibilities curve
18. 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
Market imperfections that can create value
APT for passive portfolio management
Sovereign risk
Basis
19. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Ri = ai + bi1l1 + bi2l2....+ei
Credit event
VaR- based analysis (formula)
Models used in ERM framework
20. Risk of loses owing to movements in level or volatility of market prices
Ri = ai + bi1l1 + bi2l2....+ei
Basis risk
Market risk
Solve for minimum variance portfolio
21. Derives value from an underlying asset - rate - or index - Derives value from a security
Ways firms can fail to account for risks
VaR- based analysis (formula)
Correlation coefficient effect on diversification
Derivative contract
22. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Zero- beta CAPM (two factor model)
Banker's Trust
Sharpe measure
Formula for covariance
23. Occurs the day when two parties exchange payments same day
Drysdale Securities (Chase Manhattan)
Formula for covariance
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Settlement risk
24. Inability to make payment obligations (ex. Margin calls)
Four major types of risk
Debt overhang
Contango
Funding liquidity risk
25. Modeling approach is typically between statistical analytic models and structural simulation models
Ways firms can fail to account for risks
Carry- backs and carry- forwards
Models used in ERM framework
Firms becoming more sensitive to changes(bank deregulation)
26. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Asset transformers
Effect of heterogeneous expectations on CAPM
Basis
CAPM with taxes included (equation)
27. Returns on any stock are linearly related to a set of indexes
Volatility Market risk
Ri = ai + bi1l1 + bi2l2....+ei
Liquidity risk
Expected return of two assets
28. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Risk- adjusted performance measure (RAP)
Performance- related metrics
Carry- backs and carry- forwards
Effect of heterogeneous expectations on CAPM
29. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
Ten assumptions underlying CAPM
VaR- based analysis (formula)
CAPM with taxes included (equation)
Carry- backs and carry- forwards
30. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Market imperfections that can create value
Standard deviation of two assets
Ten assumptions underlying CAPM
31. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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32. Future price is greater than the spot price
Contango
Sharpe measure
APT (equation and assumptions)
Efficient frontier
33. Need to assess risk and tell management so they can determine which risks to take on
Importance of communication for risk managers
Financial risks
LTCM
Risk
34. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Basis risk
RAR = relative return of portfolio (RRp)
APT (equation and assumptions)
VaR- based analysis (formula)
35. Unanticipated movements in relative prices of assets in hedged position
Basic Market risk
Kidder Peabody
Efficient frontier
Options motivation on volatility
36. Potential amount that can be lost
Differences in financial risk management for financial companies vs industrial companies
Exposure
Solve for minimum variance portfolio
Probability of ruin
37. The lower (closer to - 1) - the higher the payoff from diversification
Effect of non- price- taking behavior on CAPM
APT (equation and assumptions)
Ri = Rz + (gamma)(beta)
Correlation coefficient effect on diversification
38. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Recovery rate
Risks excluded from operational risk
Ways risk can be mismeasured
Correlation coefficient effect on diversification
39. Wrong distribution - Historical sample may not apply
Jensen's alpha
Liquidity risk
Debt overhang
Ways risk can be mismeasured
40. Strategic risk - Business risk - Reputational risk
Risks excluded from operational risk
Sortino ratio
Efficient frontier
Treynor measure
41. Covariance = correlation coefficient std dev(a) std dev(b)
Information ratio
Formula for covariance
Derivative contract
Business Risk
42. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
APT in active portfolio management
Effect of heterogeneous expectations on CAPM
Business risks
Solvency-related metrics
43. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Options motivation on volatility
EPD or ECOR - Expected Policyholder Deficit (EPD)
Kidder Peabody
Risk Management Irrelevance Proposition
44. 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
Effect of non- price- taking behavior on CAPM
Allied Irish Bank
Funding liquidity risk
Performance- related metrics
45. Quantile of a statistical distribution
Asset transformers
Parametric VaR
Sovereign risk
Information ratio
46. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
CAPM (formula)
Volatility Market risk
Basis
Liquidity risk
47. 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
Operational risk
Basis
Volatility Market risk
Kidder Peabody
48. 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
Ways firms can fail to account for risks
Valuation vs. Risk management
Models used in ERM framework
Zero- beta CAPM (two factor model)
49. 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
Settlement risk
Operational risk
Valuation vs. Risk management
Standard deviation of two assets
50. Probability distribution is unknown (ex. A terrorist attack)
Risks excluded from operational risk
Uncertainty
Treynor measure
CAPM with taxes included (equation)
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