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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. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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2. 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
Forms of Market risk
Traits of ERM
Market imperfections that can create value
Probability of ruin
3. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Risk Management Irrelevance Proposition
Market imperfections that can create value
Nonparametric VaR
Shortcomings of risk metrics
4. CAPM requires the strong form of the Efficient Market Hypothesis = private information
CAPM assumption for EMH
Volatility Market risk
Effect of heterogeneous expectations on CAPM
Shortcomings of risk metrics
5. 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.
Multi- period version of CAPM
Risk Management Irrelevance Proposition
CAPM (formula)
Jensen's alpha
6. 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
Parametric VaR
Contango
Morningstar Rating System
Practical considerations related to ERM implementatio
7. 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
Asset transformers
Probability of ruin
Security (primary vs secondary)
Business Risk
8. Concave function that extends from minimum variance portfolio to maximum return portfolio
Efficient frontier
Where is risk coming from
Risks excluded from operational risk
Asset liquidity risk
9. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Business risks
Recovery rate
Barings
Credit event
10. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Ri = Rz + (gamma)(beta)
Three main reasons for financial disasters
EPD or ECOR - Expected Policyholder Deficit (EPD)
Financial Risk
11. Law of one price - Homogeneous expectations - Security returns process
Shortfall risk
Drysdale Securities (Chase Manhattan)
Settlement risk
APT (equation and assumptions)
12. Probability distribution is unknown (ex. A terrorist attack)
Capital market line (CML)
Roles of risk management
Uncertainty
Efficient frontier
13. 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
Shortcomings of risk metrics
Banker's Trust
Jensen's alpha
14. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Nonparametric VaR
Nonmarketable asset impact on CAPM
CAPM assumption for EMH
Traits of ERM
15. Quantile of an empirical distribution
Operational risk
Risks excluded from operational risk
Settlement risk
Nonparametric VaR
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
Recovery rate
Business risks
LTCM
Roles of risk management
17. Prices of risk are common factors and do not change - Sensitivities can change
Kidder Peabody
Firms becoming more sensitive to changes(bank deregulation)
Prices of risk vs sensitivity
Solvency-related metrics
18. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
Basis
Parametric VaR
CAPM assumption for EMH
19. 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
Three main reasons for financial disasters
RAR = relative return of portfolio (RRp)
Volatility Market risk
Ten assumptions underlying CAPM
20. Modeling approach is typically between statistical analytic models and structural simulation models
Models used in ERM framework
Liquidity risk
Shortfall risk
Ten assumptions underlying CAPM
21. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Treynor measure
Differences in financial risk management for financial companies vs industrial companies
Sovereign risk
Formula for covariance
22. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Practical considerations related to ERM implementatio
Treynor measure
VaR- based analysis (formula)
Asset transformers
23. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Sortino ratio
Barings
Formula for covariance
Effect of heterogeneous expectations on CAPM
24. Cannot exit position in market due to size of the position
Asset liquidity risk
Allied Irish Bank
Operational risk
Ways firms can fail to account for risks
25. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Basis risk
Sharpe measure
Carry- backs and carry- forwards
Risk
26. Rp = XaRa + XbRb
Expected return of two assets
Importance of communication for risk managers
Sortino ratio
Where is risk coming from
27. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Traits of ERM
Capital market line (CML)
RAR = relative return of portfolio (RRp)
Business risks
28. Multibeta CAPM Ri - Rf =
Standard deviation of two assets
EPD or ECOR - Expected Policyholder Deficit (EPD)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Kidder Peabody
29. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Basis risk
LTCM
CAPM (formula)
Parametric VaR
30. Asses firm risks - Communicate risks - Manage and monitor risks
Roles of risk management
Nonparametric VaR
Prices of risk vs sensitivity
Drysdale Securities (Chase Manhattan)
31. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Tracking error
Ways risk can be mismeasured
Risk Management Irrelevance Proposition
What lead to the exponential growth to derivatives mkt?
32. 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
Sovereign risk
Tracking error
Allied Irish Bank
Treynor measure
33. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Models used in ERM framework
Funding liquidity risk
VaR - Value at Risk
Exposure
34. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Where is risk coming from
Ri = Rz + (gamma)(beta)
CAPM assumption for EMH
VaR- based analysis (formula)
35. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Sharpe measure
Nonmarketable asset impact on CAPM
Zero- beta CAPM (two factor model)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
36. 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
3 main types of operational risk
Performance- related metrics
LTCM
Ways firms can fail to account for risks
37. Volatility of unexpected outcomes
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Risk
Contango
Solve for minimum variance portfolio
38. 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
Three main reasons for financial disasters
Risk- adjusted performance measure (RAP)
APT in active portfolio management
Business Risk
39. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Settlement risk
Differences in financial risk management for financial companies vs industrial companies
Firms becoming more sensitive to changes(bank deregulation)
Settlement risk
40. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Solve for minimum variance portfolio
3 main types of operational risk
Formula for covariance
Uncertainty
41. Changes in vol - implied or actual
Volatility Market risk
Jensen's alpha
EPD or ECOR - Expected Policyholder Deficit (EPD)
Banker's Trust
42. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Kidder Peabody
Financial risks
Debt overhang
Formula for covariance
43. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Three main reasons for financial disasters
Tax shield
APT (equation and assumptions)
Settlement risk
44. Unanticipated movements in relative prices of assets in hedged position
Basic Market risk
Effect of non- price- taking behavior on CAPM
Sovereign risk
Drysdale Securities (Chase Manhattan)
45. Strategic risk - Business risk - Reputational risk
Risks excluded from operational risk
Valuation vs. Risk management
Settlement risk
Debt overhang
46. Curve must be concave - Straight line connecting any two points must be under the curve
Financial Risk
Contango
Expected return of two assets
Shape of portfolio possibilities curve
47. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Models used in ERM framework
Ten assumptions underlying CAPM
Correlation coefficient effect on diversification
Operational risk
48. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Formula for covariance
Asset liquidity risk
Recovery rate
EPD or ECOR - Expected Policyholder Deficit (EPD)
49. The need to hedge against risks - for firms need to speculate.
What lead to the exponential growth to derivatives mkt?
Correlation coefficient effect on diversification
Source of need for risk management
Carry- backs and carry- forwards
50. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Differences in financial risk management for financial companies vs industrial companies
Risk- adjusted performance measure (RAP)
Volatility Market risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)