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Test your basic knowledge |
FRM: Foundations Of Risk Management
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Answer 50 questions in 15 minutes.
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Match each statement with the correct term.
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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. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Solvency-related metrics
Debt overhang
Nonmarketable asset impact on CAPM
Sharpe measure
2. Probability distribution is unknown (ex. A terrorist attack)
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Uncertainty
Settlement risk
Market risk
3. 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
Valuation vs. Risk management
Firms becoming more sensitive to changes(bank deregulation)
LTCM
Risks excluded from operational risk
4. Quantile of a statistical distribution
Parametric VaR
Kidder Peabody
Capital market line (CML)
CAPM with taxes included (equation)
5. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Recovery rate
Shortfall risk
Ri = Rz + (gamma)(beta)
Risk Management Irrelevance Proposition
6. Multibeta CAPM Ri - Rf =
Business Risk
Basis
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
APT in active portfolio management
7. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
CAPM with taxes included (equation)
Allied Irish Bank
Ways firms can fail to account for risks
VaR- based analysis (formula)
8. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Information ratio
Correlation coefficient effect on diversification
Risk- adjusted performance measure (RAP)
Asset transformers
9. Concave function that extends from minimum variance portfolio to maximum return portfolio
Tax shield
Banker's Trust
Shortcomings of risk metrics
Efficient frontier
10. 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
Asset transformers
Carry- backs and carry- forwards
Drysdale Securities (Chase Manhattan)
Asset liquidity risk
11. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Solve for minimum variance portfolio
Effect of heterogeneous expectations on CAPM
LTCM
Probability of ruin
12. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Probability of ruin
What lead to the exponential growth to derivatives mkt?
Asset transformers
Risk Management Irrelevance Proposition
13. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
Uncertainty
Credit event
CAPM with taxes included (equation)
Barings
14. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Debt overhang
Exposure
Options motivation on volatility
Operational risk
15. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Ways firms can fail to account for risks
Models used in ERM framework
Market imperfections that can create value
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
16. Future price is greater than the spot price
Differences in financial risk management for financial companies vs industrial companies
Contango
Shortcomings of risk metrics
Tracking error
17. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
Kidder Peabody
Ways risk can be mismeasured
CAPM assumption for EMH
18. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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19. The uses of debt to fall into a lower tax rate
VaR- based analysis (formula)
Security (primary vs secondary)
APT (equation and assumptions)
Tax shield
20. 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
Parametric VaR
Options motivation on volatility
Four major types of risk
21. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Basis risk
Solvency-related metrics
Zero- beta CAPM (two factor model)
Financial Risk
22. 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 -
CAPM assumption for EMH
Performance- related metrics
Source of need for risk management
Credit event
23. When two payments are exchanged the same day and one party may default after payment is made
Business Risk
Risk types addressed by ERM
Market imperfections that can create value
Settlement risk
24. Strategic risk - Business risk - Reputational risk
Zero- beta CAPM (two factor model)
Risks excluded from operational risk
CAPM (formula)
Settlement risk
25. 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
Ten assumptions underlying CAPM
Shortcomings of risk metrics
Liquidity risk
Risk- adjusted performance measure (RAP)
26. 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
Carry- backs and carry- forwards
Barings
Risks excluded from operational risk
LTCM
27. Curve must be concave - Straight line connecting any two points must be under the curve
Barings
Where is risk coming from
CAPM assumption for EMH
Shape of portfolio possibilities curve
28. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Formula for covariance
Tracking error
APT for passive portfolio management
Options motivation on volatility
29. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Settlement risk
Barings
Basis risk
Formula for covariance
30. 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
Jensen's alpha
Barings
Traits of ERM
Exposure
31. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Risks excluded from operational risk
APT in active portfolio management
Credit event
Multi- period version of CAPM
32. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Basis
Debt overhang
Risks excluded from operational risk
Volatility Market risk
33. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
VaR- based analysis (formula)
Differences in financial risk management for financial companies vs industrial companies
Shortcomings of risk metrics
CAPM (formula)
34. Quantile of an empirical distribution
Effect of non- price- taking behavior on CAPM
Settlement risk
Nonparametric VaR
Parametric VaR
35. Relative portfolio risk (RRiskp) - Based on a one- month investment period
RAR = relative return of portfolio (RRp)
Zero- beta CAPM (two factor model)
Financial Risk
Business risks
36. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Market risk
VaR - Value at Risk
Morningstar Rating System
Effect of heterogeneous expectations on CAPM
37. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Importance of communication for risk managers
Information ratio
Debt overhang
Performance- related metrics
38. Covariance = correlation coefficient std dev(a) std dev(b)
Market imperfections that can create value
CAPM (formula)
Formula for covariance
Solvency-related metrics
39. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Derivative contract
Sharpe measure
Credit event
Parametric VaR
40. Return is linearly related to growth rate in consumption
Where is risk coming from
Debt overhang
Multi- period version of CAPM
VaR- based analysis (formula)
41. Changes in vol - implied or actual
Capital market line (CML)
Volatility Market risk
Importance of communication for risk managers
Carry- backs and carry- forwards
42. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Solvency-related metrics
Shortcomings of risk metrics
Where is risk coming from
VaR - Value at Risk
43. 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
Carry- backs and carry- forwards
Differences in financial risk management for financial companies vs industrial companies
Kidder Peabody
Financial Risk
44. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Nonparametric VaR
Firms becoming more sensitive to changes(bank deregulation)
Security (primary vs secondary)
Probability of ruin
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
Performance- related metrics
Valuation vs. Risk management
Tracking error
Basic Market risk
46. 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
VaR - Value at Risk
Financial risks
Treynor measure
Probability of ruin
47. Inability to make payment obligations (ex. Margin calls)
Four major types of risk
Correlation coefficient effect on diversification
Funding liquidity risk
Jensen's alpha
48. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Sortino ratio
Operational risk
Solvency-related metrics
EPD or ECOR - Expected Policyholder Deficit (EPD)
49. Returns on any stock are linearly related to a set of indexes
Risk
Ri = ai + bi1l1 + bi2l2....+ei
Four major types of risk
Options motivation on volatility
50. Market risk - Liquidity risk - Credit risk - Operational risk
CAPM (formula)
RAR = relative return of portfolio (RRp)
Four major types of risk
APT in active portfolio management
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