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Test your basic knowledge |
FRM: Foundations Of Risk Management
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business-skills
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certifications
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frm
Instructions:
Answer 50 questions in 15 minutes.
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study here
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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. 1971: Fixed Exchange rate system broke down and was replaced by more volatile floating rate - 1973: Oil price shocks - - >high inflation - - >interest rate swings - 1987: Black Monday - OCt 19 - mkt fell 23% - 1989: Japanese stock price bubble -
Source of need for risk management
What lead to the exponential growth to derivatives mkt?
Shortfall risk
Standard deviation of two assets
2. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Performance- related metrics
What lead to the exponential growth to derivatives mkt?
Treynor measure
Nonparametric VaR
3. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Risk Management Irrelevance Proposition
Solve for minimum variance portfolio
Ri = ai + bi1l1 + bi2l2....+ei
Effect of heterogeneous expectations on CAPM
4. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
VaR- based analysis (formula)
Security (primary vs secondary)
Financial Risk
Risk Management Irrelevance Proposition
5. Unanticipated movements in relative prices of assets in hedged position
Funding liquidity risk
Roles of risk management
Basic Market risk
Information ratio
6. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Tracking error
Nonmarketable asset impact on CAPM
Risk
Ways risk can be mismeasured
7. 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
Credit event
Allied Irish Bank
APT for passive portfolio management
Business Risk
8. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Risk
Four major types of risk
Debt overhang
Capital market line (CML)
9. 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
Morningstar Rating System
Basis
Ways firms can fail to account for risks
Risk- adjusted performance measure (RAP)
10. Law of one price - Homogeneous expectations - Security returns process
APT (equation and assumptions)
Settlement risk
Formula for covariance
Exposure
11. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Risk
APT for passive portfolio management
Effect of non- price- taking behavior on CAPM
Credit event
12. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Risk types addressed by ERM
VaR- based analysis (formula)
Asset transformers
Business risks
13. Covariance = correlation coefficient std dev(a) std dev(b)
Multi- period version of CAPM
APT in active portfolio management
Information ratio
Formula for covariance
14. 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
Ways firms can fail to account for risks
Business Risk
Tax shield
Where is risk coming from
15. 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
Basis risk
Asset transformers
LTCM
Zero- beta CAPM (two factor model)
16. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Four major types of risk
Market imperfections that can create value
Correlation coefficient effect on diversification
APT in active portfolio management
17. 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
Allied Irish Bank
Shortcomings of risk metrics
Basis risk
Formula for covariance
18. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Sortino ratio
What lead to the exponential growth to derivatives mkt?
Correlation coefficient effect on diversification
VaR - Value at Risk
19. Asses firm risks - Communicate risks - Manage and monitor risks
Morningstar Rating System
Roles of risk management
Ri = ai + bi1l1 + bi2l2....+ei
Operational risk
20. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Treynor measure
Solvency-related metrics
Source of need for risk management
CAPM with taxes included (equation)
21. 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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22. Hazard - Financial - Operational - Strategic
Traits of ERM
Efficient frontier
Risk types addressed by ERM
Where is risk coming from
23. Inability to make payment obligations (ex. Margin calls)
Sharpe measure
Funding liquidity risk
3 main types of operational risk
Risk
24. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Basis risk
Ri = Rz + (gamma)(beta)
Drysdale Securities (Chase Manhattan)
Ri = ai + bi1l1 + bi2l2....+ei
25. Need to assess risk and tell management so they can determine which risks to take on
Importance of communication for risk managers
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Volatility Market risk
Ways firms can fail to account for risks
26. The need to hedge against risks - for firms need to speculate.
What lead to the exponential growth to derivatives mkt?
Ri = ai + bi1l1 + bi2l2....+ei
Market risk
Treynor measure
27. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
VaR - Value at Risk
Morningstar Rating System
Three main reasons for financial disasters
Derivative contract
28. When negative taxable income is moved to a different year to offset future or past taxable income
Market imperfections that can create value
Prices of risk vs sensitivity
Solvency-related metrics
Carry- backs and carry- forwards
29. 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
Uncertainty
Valuation vs. Risk management
RAR = relative return of portfolio (RRp)
CAPM (formula)
30. Risk of loses owing to movements in level or volatility of market prices
Forms of Market risk
Market risk
Probability of ruin
Sortino ratio
31. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Zero- beta CAPM (two factor model)
Debt overhang
Carry- backs and carry- forwards
Ri = Rz + (gamma)(beta)
32. 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
Standard deviation of two assets
VaR- based analysis (formula)
Kidder Peabody
Roles of risk management
33. The uses of debt to fall into a lower tax rate
Tax shield
Practical considerations related to ERM implementatio
APT (equation and assumptions)
VaR- based analysis (formula)
34. Returns on any stock are linearly related to a set of indexes
Ri = ai + bi1l1 + bi2l2....+ei
Financial risks
Capital market line (CML)
Tracking error
35. Prices of risk are common factors and do not change - Sensitivities can change
Zero- beta CAPM (two factor model)
Capital market line (CML)
Risk
Prices of risk vs sensitivity
36. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Forms of Market risk
Where is risk coming from
Ten assumptions underlying CAPM
Four major types of risk
37. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Sovereign risk
Standard deviation of two assets
Market risk
Basis
38. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
Shortcomings of risk metrics
3 main types of operational risk
Shape of portfolio possibilities curve
39. Volatility of unexpected outcomes
Risk
Jensen's alpha
Information ratio
Traits of ERM
40. 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
APT in active portfolio management
Importance of communication for risk managers
Shortcomings of risk metrics
Barings
41. 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
Standard deviation of two assets
Information ratio
Banker's Trust
42. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
CAPM with taxes included (equation)
Zero- beta CAPM (two factor model)
Recovery rate
Differences in financial risk management for financial companies vs industrial companies
43. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Settlement risk
Ri = ai + bi1l1 + bi2l2....+ei
RAR = relative return of portfolio (RRp)
Asset transformers
44. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Nonparametric VaR
Solve for minimum variance portfolio
APT in active portfolio management
Firms becoming more sensitive to changes(bank deregulation)
45. Probability distribution is unknown (ex. A terrorist attack)
Credit event
Practical considerations related to ERM implementatio
Market imperfections that can create value
Uncertainty
46. CAPM requires the strong form of the Efficient Market Hypothesis = private information
CAPM assumption for EMH
Forms of Market risk
Security (primary vs secondary)
Roles of risk management
47. Rp = XaRa + XbRb
Jensen's alpha
Practical considerations related to ERM implementatio
Options motivation on volatility
Expected return of two assets
48. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Basic Market risk
Solvency-related metrics
Performance- related metrics
Information ratio
49. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
APT in active portfolio management
LTCM
Security (primary vs secondary)
Recovery rate
50. The lower (closer to - 1) - the higher the payoff from diversification
Ri = ai + bi1l1 + bi2l2....+ei
Correlation coefficient effect on diversification
Ways firms can fail to account for risks
Financial Risk