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Test your basic knowledge |
FRM: Foundations Of Risk Management
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frm
Instructions:
Answer 50 questions in 15 minutes.
If you are not ready to take this test, you can
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. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Tax shield
Uncertainty
Operational risk
Exposure
2. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Credit event
Capital market line (CML)
Settlement risk
Differences in financial risk management for financial companies vs industrial companies
3. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Basic Market risk
Uncertainty
Effect of heterogeneous expectations on CAPM
Risk Management Irrelevance Proposition
4. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Ten assumptions underlying CAPM
CAPM with taxes included (equation)
Recovery rate
3 main types of operational risk
5. Risk of loses owing to movements in level or volatility of market prices
3 main types of operational risk
Shortfall risk
Carry- backs and carry- forwards
Market risk
6. Expected value of unfavorable deviations of a random variable from a specified target level
VaR- based analysis (formula)
BTR - Below Target Risk
Asset liquidity risk
Barings
7. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Performance- related metrics
Ri = Rz + (gamma)(beta)
Liquidity risk
Financial Risk
8. Need to assess risk and tell management so they can determine which risks to take on
Jensen's alpha
Importance of communication for risk managers
Liquidity risk
Shape of portfolio possibilities curve
9. Future price is greater than the spot price
Kidder Peabody
Contango
Basis risk
Differences in financial risk management for financial companies vs industrial companies
10. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Barings
Basis risk
Sharpe measure
Ten assumptions underlying CAPM
11. Asset-liability/market-liquidity risk
Tax shield
APT (equation and assumptions)
Traits of ERM
Liquidity risk
12. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Risk- adjusted performance measure (RAP)
What lead to the exponential growth to derivatives mkt?
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Derivative contract
13. Potential amount that can be lost
Risk Management Irrelevance Proposition
Exposure
Effect of heterogeneous expectations on CAPM
Four major types of risk
14. Losses due to market activities ex. Interest rate changes or defaults
Ri = ai + bi1l1 + bi2l2....+ei
Tracking error
Probability of ruin
Financial risks
15. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Sortino ratio
Derivative contract
What lead to the exponential growth to derivatives mkt?
Carry- backs and carry- forwards
16. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Valuation vs. Risk management
Performance- related metrics
VaR - Value at Risk
Source of need for risk management
17. Wrong distribution - Historical sample may not apply
Basis
Probability of ruin
Tracking error
Ways risk can be mismeasured
18. 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
Contango
Ten assumptions underlying CAPM
Ri = ai + bi1l1 + bi2l2....+ei
Kidder Peabody
19. 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
Models used in ERM framework
Banker's Trust
Probability of ruin
Risk- adjusted performance measure (RAP)
20. The uses of debt to fall into a lower tax rate
Ri = Rz + (gamma)(beta)
Asset transformers
Formula for covariance
Tax shield
21. Curve must be concave - Straight line connecting any two points must be under the curve
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Jensen's alpha
Ri = Rz + (gamma)(beta)
Shape of portfolio possibilities curve
22. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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23. 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
Funding liquidity risk
Volatility Market risk
Asset transformers
Shortcomings of risk metrics
24. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Tax shield
Basic Market risk
Debt overhang
Carry- backs and carry- forwards
25. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Solvency-related metrics
VaR - Value at Risk
Models used in ERM framework
Barings
26. 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
Effect of heterogeneous expectations on CAPM
Three main reasons for financial disasters
Practical considerations related to ERM implementatio
Shortcomings of risk metrics
27. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Business risks
Source of need for risk management
Jensen's alpha
Effect of non- price- taking behavior on CAPM
28. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Allied Irish Bank
VaR- based analysis (formula)
Effect of heterogeneous expectations on CAPM
Zero- beta CAPM (two factor model)
29. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Treynor measure
Importance of communication for risk managers
Zero- beta CAPM (two factor model)
Ri = ai + bi1l1 + bi2l2....+ei
30. 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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31. 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
Effect of non- price- taking behavior on CAPM
Options motivation on volatility
Drysdale Securities (Chase Manhattan)
Nonmarketable asset impact on CAPM
32. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Settlement risk
Kidder Peabody
Security (primary vs secondary)
Where is risk coming from
33. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Risks excluded from operational risk
Prices of risk vs sensitivity
Zero- beta CAPM (two factor model)
CAPM assumption for EMH
34. Changes in vol - implied or actual
Volatility Market risk
Ways firms can fail to account for risks
Uncertainty
Settlement risk
35. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
BTR - Below Target Risk
Standard deviation of two assets
Liquidity risk
Options motivation on volatility
36. 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 -
Financial Risk
Morningstar Rating System
CAPM with taxes included (equation)
Source of need for risk management
37. Covariance = correlation coefficient std dev(a) std dev(b)
Differences in financial risk management for financial companies vs industrial companies
Recovery rate
Options motivation on volatility
Formula for covariance
38. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
APT (equation and assumptions)
Risk- adjusted performance measure (RAP)
Zero- beta CAPM (two factor model)
VaR- based analysis (formula)
39. Inability to make payment obligations (ex. Margin calls)
Contango
Probability of ruin
Funding liquidity risk
Asset transformers
40. Occurs the day when two parties exchange payments same day
Settlement risk
Banker's Trust
Recovery rate
Solve for minimum variance portfolio
41. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Risk
Uncertainty
Where is risk coming from
CAPM (formula)
42. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Risk types addressed by ERM
Solve for minimum variance portfolio
CAPM with taxes included (equation)
Information ratio
43. Strategic risk - Business risk - Reputational risk
Ways risk can be mismeasured
Exposure
Risks excluded from operational risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
44. Both probability and cost of tail events are considered
Funding liquidity risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Contango
Solvency-related metrics
45. Law of one price - Homogeneous expectations - Security returns process
APT (equation and assumptions)
Settlement risk
Zero- beta CAPM (two factor model)
CAPM with taxes included (equation)
46. Quantile of an empirical distribution
Nonparametric VaR
Asset transformers
APT (equation and assumptions)
Funding liquidity risk
47. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Kidder Peabody
Performance- related metrics
Nonmarketable asset impact on CAPM
Market imperfections that can create value
48. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Practical considerations related to ERM implementatio
Exposure
Three main reasons for financial disasters
Ways risk can be mismeasured
49. When negative taxable income is moved to a different year to offset future or past taxable income
Operational risk
Carry- backs and carry- forwards
Morningstar Rating System
CAPM with taxes included (equation)
50. Derives value from an underlying asset - rate - or index - Derives value from a security
Ten assumptions underlying CAPM
Volatility Market risk
Formula for covariance
Derivative contract