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FRM: Foundations Of Risk Management

Instructions:
  • Answer 50 questions in 15 minutes.
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  • Match each statement with the correct term.
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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. Concave function that extends from minimum variance portfolio to maximum return portfolio






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






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






4. 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






5. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios






6. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements






7. Proportion of loss that is recovered - Also referred to as "cents on the dollar"






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






9. 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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10. Prices of risk are common factors and do not change - Sensitivities can change






11. 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






12. Multibeta CAPM Ri - Rf =






13. Changes in vol - implied or actual






14. Future price is greater than the spot price






15. 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






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






17. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)






18. 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






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






20. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk






21. The lower (closer to - 1) - the higher the payoff from diversification






22. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected






23. 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






24. Simple form of CAPM - but market price of risk is lower than if all investors were price takers






25. Covariance = correlation coefficient std dev(a) std dev(b)






26. 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






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






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






29. Wrong distribution - Historical sample may not apply






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






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






32. Both probability and cost of tail events are considered






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






34. Probability distribution is unknown (ex. A terrorist attack)






35. Derives value from an underlying asset - rate - or index - Derives value from a security






36. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated






37. Modeling approach is typically between statistical analytic models and structural simulation models






38. Return is linearly related to growth rate in consumption






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






40. Inability to make payment obligations (ex. Margin calls)






41. Quantile of a statistical distribution






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






43. The uses of debt to fall into a lower tax rate






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






45. 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






46. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio






47. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)

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48. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks






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






50. 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.







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