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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. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Allied Irish Bank
Recovery rate
Kidder Peabody
Solvency-related metrics
2. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Funding liquidity risk
Asset transformers
Roles of risk management
Correlation coefficient effect on diversification
3. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Risk types addressed by ERM
Ri = ai + bi1l1 + bi2l2....+ei
Formula for covariance
CAPM (formula)
4. 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
Formula for covariance
Forms of Market risk
Business Risk
Risk types addressed by ERM
5. Risk of loses owing to movements in level or volatility of market prices
BTR - Below Target Risk
APT in active portfolio management
Market risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
6. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Morningstar Rating System
Security (primary vs secondary)
Settlement risk
Debt overhang
7. Changes in vol - implied or actual
APT in active portfolio management
Prices of risk vs sensitivity
Volatility Market risk
Three main reasons for financial disasters
8. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Nonmarketable asset impact on CAPM
Options motivation on volatility
Recovery rate
Ways firms can fail to account for risks
9. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Information ratio
Effect of heterogeneous expectations on CAPM
Debt overhang
Tracking error
10. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Kidder Peabody
Operational risk
Settlement risk
Roles of risk management
11. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Correlation coefficient effect on diversification
Kidder Peabody
Volatility Market risk
Options motivation on volatility
12. Strategic risk - Business risk - Reputational risk
Business risks
Capital market line (CML)
Risks excluded from operational risk
Nonmarketable asset impact on CAPM
13. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
APT for passive portfolio management
Source of need for risk management
Jensen's alpha
Morningstar Rating System
14. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Basis
Market risk
Forms of Market risk
What lead to the exponential growth to derivatives mkt?
15. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Solvency-related metrics
Basic Market risk
Basis risk
Sortino ratio
16. 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
Business risks
Debt overhang
LTCM
Settlement risk
17. Multibeta CAPM Ri - Rf =
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Formula for covariance
Volatility Market risk
Options motivation on volatility
18. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
Risks excluded from operational risk
Risk
Differences in financial risk management for financial companies vs industrial companies
CAPM with taxes included (equation)
19. When negative taxable income is moved to a different year to offset future or past taxable income
Importance of communication for risk managers
Options motivation on volatility
Carry- backs and carry- forwards
Differences in financial risk management for financial companies vs industrial companies
20. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Information ratio
APT (equation and assumptions)
VaR - Value at Risk
Performance- related metrics
21. Interest rate movements - derivatives - defaults
Risk- adjusted performance measure (RAP)
Risk
Derivative contract
Financial Risk
22. 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
APT in active portfolio management
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Business Risk
Practical considerations related to ERM implementatio
23. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
What lead to the exponential growth to derivatives mkt?
Shortfall risk
Security (primary vs secondary)
Three main reasons for financial disasters
24. The uses of debt to fall into a lower tax rate
Options motivation on volatility
Jensen's alpha
Risk
Tax shield
25. Quantile of an empirical distribution
Allied Irish Bank
What lead to the exponential growth to derivatives mkt?
Shortcomings of risk metrics
Nonparametric VaR
26. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Risk
Operational risk
Debt overhang
Ten assumptions underlying CAPM
27. 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
Multi- period version of CAPM
Exposure
Drysdale Securities (Chase Manhattan)
Kidder Peabody
28. Probability distribution is unknown (ex. A terrorist attack)
Basis
Risk Management Irrelevance Proposition
3 main types of operational risk
Uncertainty
29. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Correlation coefficient effect on diversification
Treynor measure
Risk Management Irrelevance Proposition
Firms becoming more sensitive to changes(bank deregulation)
30. Modeling approach is typically between statistical analytic models and structural simulation models
Models used in ERM framework
Asset transformers
Risk Management Irrelevance Proposition
Expected return of two assets
31. The need to hedge against risks - for firms need to speculate.
Barings
Derivative contract
Nonparametric VaR
What lead to the exponential growth to derivatives mkt?
32. Occurs the day when two parties exchange payments same day
Correlation coefficient effect on diversification
Settlement risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Barings
33. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
Valuation vs. Risk management
Asset liquidity risk
CAPM assumption for EMH
34. 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
RAR = relative return of portfolio (RRp)
Market risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
Traits of ERM
35. Asses firm risks - Communicate risks - Manage and monitor risks
3 main types of operational risk
Options motivation on volatility
Tax shield
Roles of risk management
36. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Debt overhang
Business risks
Models used in ERM framework
Liquidity risk
37. Unanticipated movements in relative prices of assets in hedged position
Nonmarketable asset impact on CAPM
Ways risk can be mismeasured
Traits of ERM
Basic Market risk
38. The lower (closer to - 1) - the higher the payoff from diversification
3 main types of operational risk
Correlation coefficient effect on diversification
Business risks
Financial Risk
39. 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
RAR = relative return of portfolio (RRp)
Shortfall risk
Formula for covariance
40. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Ways risk can be mismeasured
Business risks
Uncertainty
Carry- backs and carry- forwards
41. Volatility of unexpected outcomes
Risks excluded from operational risk
Sovereign risk
Risk
Solve for minimum variance portfolio
42. Return is linearly related to growth rate in consumption
Multi- period version of CAPM
Market imperfections that can create value
Where is risk coming from
Effect of non- price- taking behavior on CAPM
43. Asset-liability/market-liquidity risk
Liquidity risk
Debt overhang
Sharpe measure
Tax shield
44. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Jensen's alpha
Effect of heterogeneous expectations on CAPM
Business risks
Tax shield
45. 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
Recovery rate
Parametric VaR
APT for passive portfolio management
Traits of ERM
46. Prices of risk are common factors and do not change - Sensitivities can change
Prices of risk vs sensitivity
3 main types of operational risk
RAR = relative return of portfolio (RRp)
Business risks
47. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Risk Management Irrelevance Proposition
Firms becoming more sensitive to changes(bank deregulation)
CAPM assumption for EMH
Source of need for risk management
48. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
CAPM assumption for EMH
Sharpe measure
Market risk
Operational risk
49. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Credit event
What lead to the exponential growth to derivatives mkt?
Risk- adjusted performance measure (RAP)
Solve for minimum variance portfolio
50. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Performance- related metrics
Financial Risk
Traits of ERM
APT in active portfolio management
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