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Test your basic knowledge |
FRM: Foundations Of Risk Management
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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. Concave function that extends from minimum variance portfolio to maximum return portfolio
Efficient frontier
APT for passive portfolio management
CAPM assumption for EMH
Standard deviation of two assets
2. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Risk types addressed by ERM
Shortfall risk
Sharpe measure
Treynor measure
3. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
CAPM assumption for EMH
Where is risk coming from
Financial Risk
Volatility Market risk
4. 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
Financial Risk
Capital market line (CML)
Business Risk
Barings
5. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Ten assumptions underlying CAPM
Sharpe measure
Exposure
Settlement risk
6. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Sovereign risk
Solvency-related metrics
3 main types of operational risk
Solve for minimum variance portfolio
7. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
CAPM assumption for EMH
Risk Management Irrelevance Proposition
Barings
Recovery rate
8. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
What lead to the exponential growth to derivatives mkt?
CAPM (formula)
VaR- based analysis (formula)
Carry- backs and carry- forwards
9. 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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10. Prices of risk are common factors and do not change - Sensitivities can change
Basis risk
Prices of risk vs sensitivity
Risk types addressed by ERM
Importance of communication for risk managers
11. Designate ERM champion - usually CRO - Make ERM part of firm culture - Determining all possible risks - Quantifying operational and strategic risks - Integrating risks (dependencies) - Lack of risk transfer mechanisms - Monitoring
Valuation vs. Risk management
Contango
Practical considerations related to ERM implementatio
Uncertainty
12. Multibeta CAPM Ri - Rf =
Where is risk coming from
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Expected return of two assets
Debt overhang
13. Changes in vol - implied or actual
Options motivation on volatility
Volatility Market risk
Tracking error
Importance of communication for risk managers
14. Future price is greater than the spot price
Contango
Solvency-related metrics
VaR - Value at Risk
Financial Risk
15. 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
Information ratio
Probability of ruin
Three main reasons for financial disasters
Debt overhang
16. Probability that a random variable falls below a specified threshold level
Shape of portfolio possibilities curve
Shortfall risk
Ways risk can be mismeasured
Risk- adjusted performance measure (RAP)
17. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Solve for minimum variance portfolio
Firms becoming more sensitive to changes(bank deregulation)
Shortfall risk
Business 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
Traits of ERM
Security (primary vs secondary)
Ways risk can be mismeasured
BTR - Below Target Risk
19. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Options motivation on volatility
Liquidity risk
Source of need for risk management
Shortfall risk
20. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
APT for passive portfolio management
Basis risk
Models used in ERM framework
Drysdale Securities (Chase Manhattan)
21. The lower (closer to - 1) - the higher the payoff from diversification
Asset liquidity risk
Correlation coefficient effect on diversification
Uncertainty
Four major types of risk
22. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Differences in financial risk management for financial companies vs industrial companies
Importance of communication for risk managers
EPD or ECOR - Expected Policyholder Deficit (EPD)
Financial Risk
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
Prices of risk vs sensitivity
Capital market line (CML)
CAPM with taxes included (equation)
Ways firms can fail to account for risks
24. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Funding liquidity risk
Nonparametric VaR
Effect of non- price- taking behavior on CAPM
Risk- adjusted performance measure (RAP)
25. Covariance = correlation coefficient std dev(a) std dev(b)
Kidder Peabody
RAR = relative return of portfolio (RRp)
Formula for covariance
Risk
26. 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
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Options motivation on volatility
Firms becoming more sensitive to changes(bank deregulation)
27. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Solve for minimum variance portfolio
Financial risks
APT for passive portfolio management
Tracking error
28. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Debt overhang
Options motivation on volatility
Performance- related metrics
Roles of risk management
29. Wrong distribution - Historical sample may not apply
Multi- period version of CAPM
Ways risk can be mismeasured
Credit event
Efficient frontier
30. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Settlement risk
Morningstar Rating System
Allied Irish Bank
Models used in ERM framework
31. Unanticipated movements in relative prices of assets in hedged position
Basic Market risk
Sortino ratio
Capital market line (CML)
Ways risk can be mismeasured
32. Both probability and cost of tail events are considered
Barings
Security (primary vs secondary)
Firms becoming more sensitive to changes(bank deregulation)
Tail VaR or TCE - Tail Conditional Expectation(TCE)
33. CAPM requires the strong form of the Efficient Market Hypothesis = private information
CAPM assumption for EMH
Nonmarketable asset impact on CAPM
Ri = ai + bi1l1 + bi2l2....+ei
Tax shield
34. Probability distribution is unknown (ex. A terrorist attack)
Multi- period version of CAPM
Solvency-related metrics
Risk types addressed by ERM
Uncertainty
35. Derives value from an underlying asset - rate - or index - Derives value from a security
Risk
Sharpe measure
Derivative contract
Market imperfections that can create value
36. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Probability of ruin
Performance- related metrics
Barings
Risk
37. Modeling approach is typically between statistical analytic models and structural simulation models
Risk
Models used in ERM framework
Treynor measure
Options motivation on volatility
38. Return is linearly related to growth rate in consumption
Shortfall risk
Nonmarketable asset impact on CAPM
Credit event
Multi- period version of CAPM
39. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Market risk
Banker's Trust
Operational risk
3 main types of operational risk
40. Inability to make payment obligations (ex. Margin calls)
Nonparametric VaR
Basis risk
Shape of portfolio possibilities curve
Funding liquidity risk
41. Quantile of a statistical distribution
Shortcomings of risk metrics
Correlation coefficient effect on diversification
Parametric VaR
Business risks
42. Cannot exit position in market due to size of the position
Expected return of two assets
Ways firms can fail to account for risks
Asset liquidity risk
Sortino ratio
43. The uses of debt to fall into a lower tax rate
Financial risks
Basis
Kidder Peabody
Tax shield
44. Occurs the day when two parties exchange payments same day
Asset liquidity risk
Tax shield
Settlement risk
Multi- period version of CAPM
45. 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
Ten assumptions underlying CAPM
Options motivation on volatility
Business Risk
Ways risk can be mismeasured
46. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Zero- beta CAPM (two factor model)
Risks excluded from operational risk
Financial Risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
47. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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48. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Ways risk can be mismeasured
Differences in financial risk management for financial companies vs industrial companies
CAPM with taxes included (equation)
Performance- related metrics
49. Losses due to market activities ex. Interest rate changes or defaults
VaR- based analysis (formula)
Volatility Market risk
Debt overhang
Financial risks
50. 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.
Risks excluded from operational risk
Risk Management Irrelevance Proposition
Derivative contract
Differences in financial risk management for financial companies vs industrial companies
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