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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. Need to assess risk and tell management so they can determine which risks to take on
Importance of communication for risk managers
RAR = relative return of portfolio (RRp)
Shortcomings of risk metrics
Options motivation on volatility
2. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Where is risk coming from
Risk
Performance- related metrics
Risks excluded from operational risk
3. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Treynor measure
Ways risk can be mismeasured
Expected return of two assets
Shortfall risk
4. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Drysdale Securities (Chase Manhattan)
VaR- based analysis (formula)
Basis risk
Carry- backs and carry- forwards
5. Inability to make payment obligations (ex. Margin calls)
EPD or ECOR - Expected Policyholder Deficit (EPD)
Funding liquidity risk
Settlement risk
Models used in ERM framework
6. Hazard - Financial - Operational - Strategic
Parametric VaR
Zero- beta CAPM (two factor model)
Risk types addressed by ERM
Financial Risk
7. Unanticipated movements in relative prices of assets in hedged position
Basic Market risk
Sortino ratio
APT in active portfolio management
Firms becoming more sensitive to changes(bank deregulation)
8. 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
APT for passive portfolio management
Liquidity risk
VaR- based analysis (formula)
Multi- period version of CAPM
9. Probability distribution is unknown (ex. A terrorist attack)
What lead to the exponential growth to derivatives mkt?
VaR- based analysis (formula)
Uncertainty
Where is risk coming from
10. Risk of loses owing to movements in level or volatility of market prices
Traits of ERM
Market imperfections that can create value
Market risk
Risks excluded from operational risk
11. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
EPD or ECOR - Expected Policyholder Deficit (EPD)
Four major types of risk
Differences in financial risk management for financial companies vs industrial companies
Valuation vs. Risk management
12. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Models used in ERM framework
Asset liquidity risk
Ri = Rz + (gamma)(beta)
Basis risk
13. 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
Barings
Forms of Market risk
Uncertainty
Business Risk
14. Cannot exit position in market due to size of the position
Asset liquidity risk
Sovereign risk
Carry- backs and carry- forwards
Forms of Market risk
15. 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
Liquidity risk
Volatility Market risk
Standard deviation of two assets
Ten assumptions underlying CAPM
16. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Recovery rate
Firms becoming more sensitive to changes(bank deregulation)
Allied Irish Bank
Expected return of two assets
17. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Jensen's alpha
Standard deviation of two assets
Sharpe measure
Ri = ai + bi1l1 + bi2l2....+ei
18. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Basis risk
Ten assumptions underlying CAPM
CAPM assumption for EMH
Volatility Market risk
19. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Volatility Market risk
Efficient frontier
Standard deviation of two assets
Nonparametric VaR
20. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Sovereign risk
Risk
Differences in financial risk management for financial companies vs industrial companies
Business Risk
21. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Shape of portfolio possibilities curve
Information ratio
Multi- period version of CAPM
Roles of risk management
22. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Probability of ruin
CAPM (formula)
Effect of non- price- taking behavior on CAPM
Ways firms can fail to account for risks
23. When negative taxable income is moved to a different year to offset future or past taxable income
Settlement risk
Nonparametric VaR
Prices of risk vs sensitivity
Carry- backs and carry- forwards
24. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Shortfall risk
Shortcomings of risk metrics
Basis risk
Ri = ai + bi1l1 + bi2l2....+ei
25. Capital structure (financial distress) - Taxes - Agency and information asymmetries
CAPM with taxes included (equation)
Market imperfections that can create value
Nonmarketable asset impact on CAPM
RAR = relative return of portfolio (RRp)
26. Absolute and relative risk - direction and non-directional
Barings
Parametric VaR
Exposure
Forms of Market risk
27. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Source of need for risk management
Where is risk coming from
3 main types of operational risk
VaR - Value at Risk
28. 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
Firms becoming more sensitive to changes(bank deregulation)
Three main reasons for financial disasters
What lead to the exponential growth to derivatives mkt?
Allied Irish Bank
29. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Correlation coefficient effect on diversification
Security (primary vs secondary)
Where is risk coming from
Liquidity risk
30. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
CAPM (formula)
Forms of Market risk
Sortino ratio
Tracking error
31. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Operational risk
Ways risk can be mismeasured
Jensen's alpha
Business risks
32. 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
Traits of ERM
Drysdale Securities (Chase Manhattan)
Three main reasons for financial disasters
Risk types addressed by ERM
33. 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.
Basis
EPD or ECOR - Expected Policyholder Deficit (EPD)
Shape of portfolio possibilities curve
Risk Management Irrelevance Proposition
34. Covariance = correlation coefficient std dev(a) std dev(b)
Formula for covariance
CAPM with taxes included (equation)
Solvency-related metrics
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
35. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Exposure
Financial risks
Operational risk
Debt overhang
36. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Options motivation on volatility
Financial Risk
Three main reasons for financial disasters
Where is risk coming from
37. 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
Capital market line (CML)
Kidder Peabody
Credit event
Derivative contract
38. 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
Settlement risk
Valuation vs. Risk management
Drysdale Securities (Chase Manhattan)
Multi- period version of CAPM
39. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Traits of ERM
Effect of non- price- taking behavior on CAPM
Sovereign risk
Importance of communication for risk managers
40. 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
Risk
Morningstar Rating System
EPD or ECOR - Expected Policyholder Deficit (EPD)
41. Expected value of unfavorable deviations of a random variable from a specified target level
Effect of heterogeneous expectations on CAPM
Business Risk
LTCM
BTR - Below Target Risk
42. The uses of debt to fall into a lower tax rate
APT for passive portfolio management
Morningstar Rating System
Capital market line (CML)
Tax shield
43. When two payments are exchanged the same day and one party may default after payment is made
APT for passive portfolio management
Settlement risk
Three main reasons for financial disasters
Zero- beta CAPM (two factor model)
44. Modeling approach is typically between statistical analytic models and structural simulation models
Sovereign risk
Ways firms can fail to account for risks
Uncertainty
Models used in ERM framework
45. Returns on any stock are linearly related to a set of indexes
Where is risk coming from
Ri = ai + bi1l1 + bi2l2....+ei
APT in active portfolio management
Shortfall risk
46. 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
Parametric VaR
Sovereign risk
Shortcomings of risk metrics
Volatility Market risk
47. Multibeta CAPM Ri - Rf =
Debt overhang
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Basic Market risk
Prices of risk vs sensitivity
48. Potential amount that can be lost
Barings
Treynor measure
Asset transformers
Exposure
49. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Financial Risk
Treynor measure
Expected return of two assets
Credit event
50. Quantile of a statistical distribution
Roles of risk management
Parametric VaR
Sharpe measure
Shape of portfolio possibilities curve
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