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FRM: Foundations Of Risk Management
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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. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
APT in active portfolio management
Performance- related metrics
Solvency-related metrics
Roles of risk management
2. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Expected return of two assets
Zero- beta CAPM (two factor model)
Shortfall risk
3. Need to assess risk and tell management so they can determine which risks to take on
Forms of Market risk
Importance of communication for risk managers
Prices of risk vs sensitivity
Tracking error
4. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Multi- period version of CAPM
Treynor measure
Asset transformers
Financial risks
5. When negative taxable income is moved to a different year to offset future or past taxable income
Effect of heterogeneous expectations on CAPM
Risk
Liquidity risk
Carry- backs and carry- forwards
6. Unanticipated movements in relative prices of assets in hedged position
Basic Market risk
Recovery rate
Expected return of two assets
Roles of risk management
7. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Risks excluded from operational risk
Traits of ERM
Three main reasons for financial disasters
Solvency-related metrics
8. Potential amount that can be lost
Ways risk can be mismeasured
Credit event
Risk- adjusted performance measure (RAP)
Exposure
9. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Importance of communication for risk managers
Basis risk
Allied Irish Bank
Funding liquidity risk
10. 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
Business Risk
Effect of heterogeneous expectations on CAPM
Source of need for risk management
Options motivation on volatility
11. Probability distribution is unknown (ex. A terrorist attack)
Liquidity risk
LTCM
Uncertainty
Ways firms can fail to account for risks
12. Covariance = correlation coefficient std dev(a) std dev(b)
Recovery rate
Firms becoming more sensitive to changes(bank deregulation)
Formula for covariance
BTR - Below Target Risk
13. The lower (closer to - 1) - the higher the payoff from diversification
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Correlation coefficient effect on diversification
Tracking error
Effect of heterogeneous expectations on CAPM
14. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Capital market line (CML)
Options motivation on volatility
Banker's Trust
VaR- based analysis (formula)
15. Risk of loses owing to movements in level or volatility of market prices
Nonparametric VaR
Tax shield
Market risk
Practical considerations related to ERM implementatio
16. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Nonmarketable asset impact on CAPM
Credit event
Effect of heterogeneous expectations on CAPM
VaR - Value at Risk
17. 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
RAR = relative return of portfolio (RRp)
Kidder Peabody
Risk
Ten assumptions underlying CAPM
18. Curve must be concave - Straight line connecting any two points must be under the curve
Financial Risk
Liquidity risk
Shape of portfolio possibilities curve
Source of need for risk management
19. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Correlation coefficient effect on diversification
Ri = Rz + (gamma)(beta)
Where is risk coming from
Uncertainty
20. When two payments are exchanged the same day and one party may default after payment is made
Asset liquidity risk
Security (primary vs secondary)
Settlement risk
Ways risk can be mismeasured
21. Return is linearly related to growth rate in consumption
Shape of portfolio possibilities curve
Kidder Peabody
Multi- period version of CAPM
Firms becoming more sensitive to changes(bank deregulation)
22. The uses of debt to fall into a lower tax rate
Basis risk
Tax shield
Ten assumptions underlying CAPM
Practical considerations related to ERM implementatio
23. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
3 main types of operational risk
Debt overhang
Carry- backs and carry- forwards
24. Market risk - Liquidity risk - Credit risk - Operational risk
Capital market line (CML)
Basic Market risk
Four major types of risk
What lead to the exponential growth to derivatives mkt?
25. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Barings
Recovery rate
Business Risk
Morningstar Rating System
26. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Security (primary vs secondary)
Debt overhang
Source of need for risk management
Risk Management Irrelevance Proposition
27. Wrong distribution - Historical sample may not apply
Ways risk can be mismeasured
Morningstar Rating System
Asset liquidity risk
Solvency-related metrics
28. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
3 main types of operational risk
Expected return of two assets
Risk- adjusted performance measure (RAP)
Volatility Market risk
29. Quantile of an empirical distribution
Nonparametric VaR
CAPM with taxes included (equation)
Jensen's alpha
Settlement risk
30. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Four major types of risk
Barings
Solve for minimum variance portfolio
Asset transformers
31. Hazard - Financial - Operational - Strategic
Operational risk
Multi- period version of CAPM
Contango
Risk types addressed by ERM
32. 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
Derivative contract
Basis risk
Models used in ERM framework
33. 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 liquidity risk
Contango
LTCM
APT in active portfolio management
34. 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
Debt overhang
Probability of ruin
Security (primary vs secondary)
Uncertainty
35. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
What lead to the exponential growth to derivatives mkt?
Four major types of risk
Traits of ERM
Tracking error
36. Asses firm risks - Communicate risks - Manage and monitor risks
Three main reasons for financial disasters
Roles of risk management
Carry- backs and carry- forwards
Shortfall risk
37. 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
Barings
Where is risk coming from
APT in active portfolio management
Operational risk
38. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
CAPM with taxes included (equation)
Probability of ruin
Treynor measure
Effect of non- price- taking behavior on CAPM
39. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
APT for passive portfolio management
Ways risk can be mismeasured
Business risks
Volatility Market risk
40. 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
Debt overhang
Valuation vs. Risk management
VaR- based analysis (formula)
APT (equation and assumptions)
41. 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
Formula for covariance
Capital market line (CML)
Nonmarketable asset impact on CAPM
What lead to the exponential growth to derivatives mkt?
42. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Ways firms can fail to account for risks
Financial Risk
Risk types addressed by ERM
Performance- related metrics
43. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Tracking error
APT (equation and assumptions)
Asset liquidity risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
44. 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
Risk types addressed by ERM
Traits of ERM
Drysdale Securities (Chase Manhattan)
Practical considerations related to ERM implementatio
45. Interest rate movements - derivatives - defaults
Shortcomings of risk metrics
Banker's Trust
Ways risk can be mismeasured
Financial Risk
46. Cannot exit position in market due to size of the position
Risk- adjusted performance measure (RAP)
Banker's Trust
Asset liquidity risk
Ri = Rz + (gamma)(beta)
47. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Firms becoming more sensitive to changes(bank deregulation)
Market risk
Information ratio
Uncertainty
48. 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
Uncertainty
Roles of risk management
Nonmarketable asset impact on CAPM
Kidder Peabody
49. Prices of risk are common factors and do not change - Sensitivities can change
APT in active portfolio management
Business risks
Performance- related metrics
Prices of risk vs sensitivity
50. Returns on any stock are linearly related to a set of indexes
Operational risk
Ri = ai + bi1l1 + bi2l2....+ei
Standard deviation of two assets
Allied Irish Bank
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