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Test your basic knowledge |
FRM: Foundations Of Risk Management
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Subjects
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business-skills
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certifications
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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. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Solve for minimum variance portfolio
Allied Irish Bank
Prices of risk vs sensitivity
Funding liquidity risk
2. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Basis risk
Source of need for risk management
LTCM
Market imperfections that can create value
3. Law of one price - Homogeneous expectations - Security returns process
Exposure
Financial risks
Multi- period version of CAPM
APT (equation and assumptions)
4. Strategic risk - Business risk - Reputational risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Forms of Market risk
Risks excluded from operational risk
APT for passive portfolio management
5. 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.
Sharpe measure
Where is risk coming from
Risk Management Irrelevance Proposition
Sortino ratio
6. Return is linearly related to growth rate in consumption
VaR- based analysis (formula)
Market risk
Credit event
Multi- period version of CAPM
7. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Derivative contract
Recovery rate
Practical considerations related to ERM implementatio
Ways risk can be mismeasured
8. Probability that a random variable falls below a specified threshold level
Sortino ratio
Multi- period version of CAPM
Information ratio
Shortfall risk
9. 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
EPD or ECOR - Expected Policyholder Deficit (EPD)
Morningstar Rating System
Risk
Shortcomings of risk metrics
10. Covariance = correlation coefficient std dev(a) std dev(b)
Drysdale Securities (Chase Manhattan)
Uncertainty
Business Risk
Formula for covariance
11. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Carry- backs and carry- forwards
Differences in financial risk management for financial companies vs industrial companies
CAPM assumption for EMH
Ri = Rz + (gamma)(beta)
12. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Sharpe measure
Effect of non- price- taking behavior on CAPM
Where is risk coming from
Traits of ERM
13. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Expected return of two assets
Nonmarketable asset impact on CAPM
Information ratio
Traits of ERM
14. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Efficient frontier
Sharpe measure
EPD or ECOR - Expected Policyholder Deficit (EPD)
Risk- adjusted performance measure (RAP)
15. 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
Zero- beta CAPM (two factor model)
Three main reasons for financial disasters
Effect of heterogeneous expectations on CAPM
Traits of ERM
16. 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
Valuation vs. Risk management
VaR- based analysis (formula)
Ways risk can be mismeasured
Forms of Market risk
17. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Asset transformers
Standard deviation of two assets
Models used in ERM framework
Expected return of two assets
18. Both probability and cost of tail events are considered
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Solvency-related metrics
Carry- backs and carry- forwards
Recovery rate
19. 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
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Business Risk
Importance of communication for risk managers
Shortfall risk
20. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Security (primary vs secondary)
Options motivation on volatility
Financial Risk
Liquidity risk
21. Changes in vol - implied or actual
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Three main reasons for financial disasters
VaR - Value at Risk
Volatility Market risk
22. Relative portfolio risk (RRiskp) - Based on a one- month investment period
RAR = relative return of portfolio (RRp)
Ways firms can fail to account for risks
Risk- adjusted performance measure (RAP)
Three main reasons for financial disasters
23. Prices of risk are common factors and do not change - Sensitivities can change
Shortcomings of risk metrics
Differences in financial risk management for financial companies vs industrial companies
CAPM assumption for EMH
Prices of risk vs sensitivity
24. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Solve for minimum variance portfolio
Security (primary vs secondary)
Basic Market risk
CAPM (formula)
25. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Ways risk can be mismeasured
Sharpe measure
Parametric VaR
Expected return of two assets
26. 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
Importance of communication for risk managers
Operational risk
Basis risk
27. Inability to make payment obligations (ex. Margin calls)
Funding liquidity risk
APT in active portfolio management
BTR - Below Target Risk
Liquidity risk
28. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Security (primary vs secondary)
Tracking error
VaR - Value at Risk
CAPM with taxes included (equation)
29. When negative taxable income is moved to a different year to offset future or past taxable income
CAPM assumption for EMH
Carry- backs and carry- forwards
Options motivation on volatility
Jensen's alpha
30. 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
Ten assumptions underlying CAPM
Prices of risk vs sensitivity
Risk Management Irrelevance Proposition
Sharpe measure
31. Absolute and relative risk - direction and non-directional
Information ratio
Risk Management Irrelevance Proposition
Business risks
Forms of Market risk
32. Interest rate movements - derivatives - defaults
Tax shield
Financial risks
Financial Risk
Three main reasons for financial disasters
33. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Exposure
3 main types of operational risk
Information ratio
Basis
34. Occurs the day when two parties exchange payments same day
Settlement risk
Shape of portfolio possibilities curve
Derivative contract
Ri = Rz + (gamma)(beta)
35. Multibeta CAPM Ri - Rf =
Solve for minimum variance portfolio
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Sortino ratio
Traits of ERM
36. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Effect of heterogeneous expectations on CAPM
Formula for covariance
Four major types of risk
Recovery rate
37. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Credit event
Four major types of risk
BTR - Below Target Risk
Risk
38. Probability distribution is unknown (ex. A terrorist attack)
Probability of ruin
Uncertainty
CAPM (formula)
Firms becoming more sensitive to changes(bank deregulation)
39. 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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40. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Volatility Market risk
Effect of non- price- taking behavior on CAPM
Business risks
Prices of risk vs sensitivity
41. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Risk Management Irrelevance Proposition
Forms of Market risk
Credit event
Firms becoming more sensitive to changes(bank deregulation)
42. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Asset liquidity risk
Prices of risk vs sensitivity
Zero- beta CAPM (two factor model)
Sovereign risk
43. Derives value from an underlying asset - rate - or index - Derives value from a security
Derivative contract
Shortfall risk
Treynor measure
Probability of ruin
44. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
VaR- based analysis (formula)
Business Risk
Financial Risk
Risk
45. Asses firm risks - Communicate risks - Manage and monitor risks
Recovery rate
RAR = relative return of portfolio (RRp)
Roles of risk management
Effect of heterogeneous expectations on CAPM
46. Concave function that extends from minimum variance portfolio to maximum return portfolio
Correlation coefficient effect on diversification
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Practical considerations related to ERM implementatio
Efficient frontier
47. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Sharpe measure
Nonmarketable asset impact on CAPM
Solvency-related metrics
What lead to the exponential growth to derivatives mkt?
48. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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49. Curve must be concave - Straight line connecting any two points must be under the curve
CAPM with taxes included (equation)
Shape of portfolio possibilities curve
Differences in financial risk management for financial companies vs industrial companies
Performance- related metrics
50. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Formula for covariance
LTCM
Ri = ai + bi1l1 + bi2l2....+ei
Asset transformers