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FRM: Foundations Of Risk Management

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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. Capital structure (financial distress) - Taxes - Agency and information asymmetries

2. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)

3. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)

4. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized

5. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return

6. Return is linearly related to growth rate in consumption

7. Risks that are assumed willingly - to gain a competitive edge or add shareholder value

8. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business

9. Long in options = expecting volatility increase - Short in options = expecting volatility decrease

10. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk

11. CAPM requires the strong form of the Efficient Market Hypothesis = private information

12. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios

13. 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

14. Losses due to market activities ex. Interest rate changes or defaults

15. Risk of loses owing to movements in level or volatility of market prices

16. Concentrate on mid- region of probability distribution - Relevant to owners and proxies

17. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely

18. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses

19. 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

20. Future price is greater than the spot price

21. 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

22. Unanticipated movements in relative prices of assets in hedged position

23. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))

24. Quantile of an empirical distribution

25. 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

26. 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

27. Difference between forward price and spot price - Should approach zero as the contract approaches maturity

28. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes

29. Quantile of a statistical distribution

30. Cannot exit position in market due to size of the position

31. Firms became multinational - - >watched xchange rates more - deregulation and globalization

32. Relative portfolio risk (RRiskp) - Based on a one- month investment period

33. Occurs the day when two parties exchange payments same day

34. 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

35. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits

36. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection

37. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds

38. Hazard - Financial - Operational - Strategic

39. Curve must be concave - Straight line connecting any two points must be under the curve

40. Probability that a random variable falls below a specified threshold level

41. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)

42. 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

43. 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

44. Both probability and cost of tail events are considered

45. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM

46. Expected value of unfavorable deviations of a random variable from a specified target level

47. 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

48. 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

49. Changes in vol - implied or actual

50. 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