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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. Volatility of unexpected outcomes
Risk
Recovery rate
Solve for minimum variance portfolio
Sharpe measure
2. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Effect of non- price- taking behavior on CAPM
Solve for minimum variance portfolio
Tax shield
Source of need for risk management
3. 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
Kidder Peabody
Basic Market risk
Business risks
Three main reasons for financial disasters
4. Asset-liability/market-liquidity risk
Settlement risk
Security (primary vs secondary)
Volatility Market risk
Liquidity risk
5. 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
Allied Irish Bank
Risk types addressed by ERM
Settlement risk
Formula for covariance
6. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Forms of Market risk
APT for passive portfolio management
Barings
Basis
7. Potential amount that can be lost
EPD or ECOR - Expected Policyholder Deficit (EPD)
Formula for covariance
Barings
Exposure
8. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Asset liquidity risk
Business Risk
Shortfall risk
Business risks
9. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
BTR - Below Target Risk
CAPM (formula)
Traits of ERM
Market imperfections that can create value
10. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Asset transformers
Multi- period version of CAPM
Three main reasons for financial disasters
Tax shield
11. 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
Asset transformers
APT (equation and assumptions)
LTCM
Carry- backs and carry- forwards
12. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
EPD or ECOR - Expected Policyholder Deficit (EPD)
Treynor measure
Risk
Risk
13. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Business risks
Zero- beta CAPM (two factor model)
CAPM assumption for EMH
Effect of non- price- taking behavior on CAPM
14. Risk of loses owing to movements in level or volatility of market prices
Ways risk can be mismeasured
Valuation vs. Risk management
Market risk
Contango
15. Concave function that extends from minimum variance portfolio to maximum return portfolio
Exposure
Performance- related metrics
Efficient frontier
APT for passive portfolio management
16. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
LTCM
Morningstar Rating System
Standard deviation of two assets
Solve for minimum variance portfolio
17. Both probability and cost of tail events are considered
Tracking error
Risk types addressed by ERM
Shape of portfolio possibilities curve
Tail VaR or TCE - Tail Conditional Expectation(TCE)
18. 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
Jensen's alpha
Shortcomings of risk metrics
Liquidity risk
Allied Irish Bank
19. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Risk Management Irrelevance Proposition
LTCM
VaR- based analysis (formula)
Shape of portfolio possibilities curve
20. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Operational risk
Exposure
Market imperfections that can create value
VaR - Value at Risk
21. 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
Sovereign risk
Ten assumptions underlying CAPM
Firms becoming more sensitive to changes(bank deregulation)
Business Risk
22. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Settlement risk
Shape of portfolio possibilities curve
3 main types of operational risk
Parametric VaR
23. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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24. Prices of risk are common factors and do not change - Sensitivities can change
Risk- adjusted performance measure (RAP)
Ri = ai + bi1l1 + bi2l2....+ei
Prices of risk vs sensitivity
Where is risk coming from
25. Asses firm risks - Communicate risks - Manage and monitor risks
Standard deviation of two assets
Efficient frontier
LTCM
Roles of risk management
26. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
EPD or ECOR - Expected Policyholder Deficit (EPD)
Performance- related metrics
CAPM with taxes included (equation)
Carry- backs and carry- forwards
27. When negative taxable income is moved to a different year to offset future or past taxable income
Nonparametric VaR
Carry- backs and carry- forwards
Firms becoming more sensitive to changes(bank deregulation)
3 main types of operational risk
28. 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
Drysdale Securities (Chase Manhattan)
Morningstar Rating System
Standard deviation of two assets
Traits of ERM
29. Expected value of unfavorable deviations of a random variable from a specified target level
Capital market line (CML)
Basic Market risk
BTR - Below Target Risk
Financial risks
30. 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
Effect of non- price- taking behavior on CAPM
Operational risk
Traits of ERM
Nonparametric VaR
31. Return is linearly related to growth rate in consumption
CAPM (formula)
Risk
Formula for covariance
Multi- period version of CAPM
32. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Treynor measure
RAR = relative return of portfolio (RRp)
APT in active portfolio management
Effect of non- price- taking behavior on CAPM
33. 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
Probability of ruin
Models used in ERM framework
Morningstar Rating System
Capital market line (CML)
34. Occurs the day when two parties exchange payments same day
Capital market line (CML)
RAR = relative return of portfolio (RRp)
Formula for covariance
Settlement risk
35. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Sortino ratio
Business Risk
Capital market line (CML)
RAR = relative return of portfolio (RRp)
36. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Prices of risk vs sensitivity
Asset liquidity risk
Morningstar Rating System
Contango
37. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Four major types of risk
Prices of risk vs sensitivity
What lead to the exponential growth to derivatives mkt?
Recovery rate
38. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Exposure
Solvency-related metrics
Tax shield
Practical considerations related to ERM implementatio
39. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Shortcomings of risk metrics
Risk types addressed by ERM
Information ratio
Asset transformers
40. Quantile of an empirical distribution
Nonparametric VaR
Asset transformers
Funding liquidity risk
Shortfall risk
41. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Operational risk
Nonmarketable asset impact on CAPM
Efficient frontier
Debt overhang
42. Covariance = correlation coefficient std dev(a) std dev(b)
RAR = relative return of portfolio (RRp)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Sovereign risk
Formula for covariance
43. Modeling approach is typically between statistical analytic models and structural simulation models
Roles of risk management
CAPM with taxes included (equation)
Standard deviation of two assets
Models used in ERM framework
44. 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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45. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Firms becoming more sensitive to changes(bank deregulation)
Operational risk
Basis
CAPM with taxes included (equation)
46. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Sortino ratio
Security (primary vs secondary)
Banker's Trust
Carry- backs and carry- forwards
47. Rp = XaRa + XbRb
Risk
Basis risk
Expected return of two assets
Shortcomings of risk metrics
48. When two payments are exchanged the same day and one party may default after payment is made
Standard deviation of two assets
Exposure
Four major types of risk
Settlement risk
49. Future price is greater than the spot price
Contango
Kidder Peabody
Probability of ruin
Sovereign risk
50. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Allied Irish Bank
Firms becoming more sensitive to changes(bank deregulation)
Credit event
Where is risk coming from
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