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Test your basic knowledge |
FRM: Foundations Of Risk Management
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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. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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2. 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
Models used in ERM framework
APT in active portfolio management
Basic Market risk
3. Expected value of unfavorable deviations of a random variable from a specified target level
RAR = relative return of portfolio (RRp)
Standard deviation of two assets
BTR - Below Target Risk
Three main reasons for financial disasters
4. Changes in vol - implied or actual
Models used in ERM framework
Source of need for risk management
Market risk
Volatility Market risk
5. Inability to make payment obligations (ex. Margin calls)
Funding liquidity risk
Basis
Risk
Derivative contract
6. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Recovery rate
CAPM (formula)
Differences in financial risk management for financial companies vs industrial companies
Risk- adjusted performance measure (RAP)
7. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Banker's Trust
Market risk
Risk
Sharpe measure
8. 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
Importance of communication for risk managers
Multi- period version of CAPM
Risk
Business Risk
9. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Recovery rate
Differences in financial risk management for financial companies vs industrial companies
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Operational risk
10. Law of one price - Homogeneous expectations - Security returns process
Probability of ruin
Risk- adjusted performance measure (RAP)
Solve for minimum variance portfolio
APT (equation and assumptions)
11. Curve must be concave - Straight line connecting any two points must be under the curve
Models used in ERM framework
Carry- backs and carry- forwards
Importance of communication for risk managers
Shape of portfolio possibilities curve
12. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Solvency-related metrics
Barings
Shortcomings of risk metrics
Kidder Peabody
13. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
BTR - Below Target Risk
Formula for covariance
Differences in financial risk management for financial companies vs industrial companies
VaR- based analysis (formula)
14. Modeling approach is typically between statistical analytic models and structural simulation models
Models used in ERM framework
Differences in financial risk management for financial companies vs industrial companies
Information ratio
Tail VaR or TCE - Tail Conditional Expectation(TCE)
15. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Kidder Peabody
Zero- beta CAPM (two factor model)
Standard deviation of two assets
Valuation vs. Risk management
16. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Expected return of two assets
Recovery rate
BTR - Below Target Risk
Nonmarketable asset impact on CAPM
17. 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
Where is risk coming from
Expected return of two assets
Traits of ERM
Treynor measure
18. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Financial Risk
Practical considerations related to ERM implementatio
Asset liquidity risk
3 main types of operational risk
19. Prices of risk are common factors and do not change - Sensitivities can change
Prices of risk vs sensitivity
Morningstar Rating System
Tax shield
Source of need for risk management
20. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Asset liquidity risk
Solve for minimum variance portfolio
Ri = Rz + (gamma)(beta)
APT for passive portfolio management
21. Asses firm risks - Communicate risks - Manage and monitor risks
Credit event
Banker's Trust
Forms of Market risk
Roles of risk management
22. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Settlement risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
Risk
Risks excluded from operational risk
23. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Where is risk coming from
Sharpe measure
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Derivative contract
24. Wrong distribution - Historical sample may not apply
Efficient frontier
Sharpe measure
Ways risk can be mismeasured
BTR - Below Target Risk
25. Market risk - Liquidity risk - Credit risk - Operational risk
Settlement risk
Credit event
Four major types of risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
26. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
What lead to the exponential growth to derivatives mkt?
3 main types of operational risk
Basis risk
Information ratio
27. 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.
VaR- based analysis (formula)
Sharpe measure
Risk Management Irrelevance Proposition
Treynor measure
28. Covariance = correlation coefficient std dev(a) std dev(b)
Valuation vs. Risk management
Sovereign risk
Carry- backs and carry- forwards
Formula for covariance
29. Asset-liability/market-liquidity risk
Prices of risk vs sensitivity
Liquidity risk
Roles of risk management
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
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. Hazard - Financial - Operational - Strategic
Risk types addressed by ERM
Sortino ratio
Ri = ai + bi1l1 + bi2l2....+ei
Efficient frontier
32. Quantile of an empirical distribution
APT for passive portfolio management
Nonparametric VaR
Credit event
APT (equation and assumptions)
33. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Asset transformers
Importance of communication for risk managers
APT in active portfolio management
Solve for minimum variance portfolio
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
Probability of ruin
Tail VaR or TCE - Tail Conditional Expectation(TCE)
BTR - Below Target Risk
Asset transformers
35. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
VaR - Value at Risk
Sortino ratio
Debt overhang
Standard deviation of two assets
36. Derives value from an underlying asset - rate - or index - Derives value from a security
Information ratio
Derivative contract
Options motivation on volatility
Importance of communication for risk managers
37. Unanticipated movements in relative prices of assets in hedged position
Standard deviation of two assets
Debt overhang
Basic Market risk
Shortfall risk
38. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Recovery rate
Treynor measure
Operational risk
Sovereign risk
39. Occurs the day when two parties exchange payments same day
CAPM assumption for EMH
Settlement risk
Drysdale Securities (Chase Manhattan)
CAPM with taxes included (equation)
40. Losses due to market activities ex. Interest rate changes or defaults
Where is risk coming from
Risk types addressed by ERM
Asset liquidity risk
Financial risks
41. Probability that a random variable falls below a specified threshold level
LTCM
Shortfall risk
Effect of heterogeneous expectations on CAPM
Risk Management Irrelevance Proposition
42. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Uncertainty
Ten assumptions underlying CAPM
Basis
Risk Management Irrelevance Proposition
43. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
CAPM assumption for EMH
Funding liquidity risk
Performance- related metrics
Banker's Trust
44. 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
LTCM
What lead to the exponential growth to derivatives mkt?
Risk Management Irrelevance Proposition
Asset transformers
45. 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
Barings
Importance of communication for risk managers
Business risks
Valuation vs. Risk management
46. When negative taxable income is moved to a different year to offset future or past taxable income
APT (equation and assumptions)
Traits of ERM
Carry- backs and carry- forwards
3 main types of operational risk
47. 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
Traits of ERM
Drysdale Securities (Chase Manhattan)
Capital market line (CML)
Basic Market risk
48. 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)
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Ways risk can be mismeasured
Sharpe measure
49. 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
Basis risk
Practical considerations related to ERM implementatio
Asset liquidity risk
Expected return of two assets
50. 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
Capital market line (CML)
Liquidity risk
Performance- related metrics
Asset transformers