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FRM: Foundations Of Risk Management

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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. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages

2. Quantile of a statistical distribution

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

4. 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

5. Market risk - Liquidity risk - Credit risk - Operational risk

6. 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.

7. Risk of loses owing to movements in level or volatility of market prices

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

9. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities

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

11. Asses firm risks - Communicate risks - Manage and monitor risks

12. 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

13. 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

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

15. Returns on any stock are linearly related to a set of indexes

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

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

18. Interest rate movements - derivatives - defaults

19. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely

20. 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

21. Hazard - Financial - Operational - Strategic

22. 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

23. Difference between forward price and spot price - Should approach zero as the contract approaches maturity

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

25. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized

26. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)

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

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

29. Need to assess risk and tell management so they can determine which risks to take on

30. 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

31. Multibeta CAPM Ri - Rf =

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

33. Return is linearly related to growth rate in consumption

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

35. Capital structure (financial distress) - Taxes - Agency and information asymmetries

36. The need to hedge against risks - for firms need to speculate.

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

38. Wrong distribution - Historical sample may not apply

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

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

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

42. Changes in vol - implied or actual

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

44. Country specific - Foreign exchange controls that prohibit counterparty's obligations

45. 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

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

47. Potential amount that can be lost

48. 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

49. 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

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