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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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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. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Ten assumptions underlying CAPM
RAR = relative return of portfolio (RRp)
Risk Management Irrelevance Proposition
Differences in financial risk management for financial companies vs industrial companies
2. 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
RAR = relative return of portfolio (RRp)
Parametric VaR
Banker's Trust
3. Volatility of unexpected outcomes
Ri = ai + bi1l1 + bi2l2....+ei
Shortcomings of risk metrics
Ten assumptions underlying CAPM
Risk
4. 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
Financial risks
CAPM with taxes included (equation)
Sovereign risk
5. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Ri = ai + bi1l1 + bi2l2....+ei
Security (primary vs secondary)
Forms of Market risk
Differences in financial risk management for financial companies vs industrial companies
6. 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.
Business Risk
Jensen's alpha
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Risk Management Irrelevance Proposition
7. Multibeta CAPM Ri - Rf =
Where is risk coming from
LTCM
Risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
8. 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
Ri = ai + bi1l1 + bi2l2....+ei
Shortcomings of risk metrics
Ways firms can fail to account for risks
CAPM with taxes included (equation)
9. 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
Nonparametric VaR
Correlation coefficient effect on diversification
Kidder Peabody
Information ratio
10. 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
Shortcomings of risk metrics
EPD or ECOR - Expected Policyholder Deficit (EPD)
Financial risks
Differences in financial risk management for financial companies vs industrial companies
11. 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
Asset transformers
Effect of heterogeneous expectations on CAPM
Ways risk can be mismeasured
APT for passive portfolio management
12. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Ten assumptions underlying CAPM
Settlement risk
APT in active portfolio management
Nonmarketable asset impact on CAPM
13. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Sovereign risk
Ten assumptions underlying CAPM
Drysdale Securities (Chase Manhattan)
Risk
14. Occurs the day when two parties exchange payments same day
Operational risk
Settlement risk
Risk types addressed by ERM
Asset transformers
15. Law of one price - Homogeneous expectations - Security returns process
Basic Market risk
Ri = ai + bi1l1 + bi2l2....+ei
Importance of communication for risk managers
APT (equation and assumptions)
16. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Barings
Risk
APT in active portfolio management
What lead to the exponential growth to derivatives mkt?
17. Changes in vol - implied or actual
APT in active portfolio management
Settlement risk
Volatility Market risk
Asset transformers
18. When two payments are exchanged the same day and one party may default after payment is made
Exposure
Settlement risk
Shortfall risk
Basis risk
19. Inability to make payment obligations (ex. Margin calls)
Capital market line (CML)
Funding liquidity risk
Where is risk coming from
CAPM with taxes included (equation)
20. The lower (closer to - 1) - the higher the payoff from diversification
Correlation coefficient effect on diversification
Settlement risk
Ri = ai + bi1l1 + bi2l2....+ei
Funding liquidity risk
21. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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22. Prices of risk are common factors and do not change - Sensitivities can change
Information ratio
APT (equation and assumptions)
Prices of risk vs sensitivity
Differences in financial risk management for financial companies vs industrial companies
23. Probability that a random variable falls below a specified threshold level
Shortfall risk
Capital market line (CML)
Importance of communication for risk managers
Kidder Peabody
24. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Allied Irish Bank
Debt overhang
Business risks
Liquidity risk
25. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Solvency-related metrics
Asset transformers
Basis risk
Financial Risk
26. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Sharpe measure
Differences in financial risk management for financial companies vs industrial companies
CAPM with taxes included (equation)
Allied Irish Bank
27. Need to assess risk and tell management so they can determine which risks to take on
Uncertainty
Morningstar Rating System
Standard deviation of two assets
Importance of communication for risk managers
28. Unanticipated movements in relative prices of assets in hedged position
Basic Market risk
Standard deviation of two assets
Sortino ratio
Forms of Market risk
29. Returns on any stock are linearly related to a set of indexes
Contango
Financial Risk
Treynor measure
Ri = ai + bi1l1 + bi2l2....+ei
30. Losses due to market activities ex. Interest rate changes or defaults
LTCM
Valuation vs. Risk management
CAPM (formula)
Financial risks
31. Future price is greater than the spot price
Basis
Standard deviation of two assets
Derivative contract
Contango
32. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
APT in active portfolio management
Probability of ruin
Ri = Rz + (gamma)(beta)
Carry- backs and carry- forwards
33. Concave function that extends from minimum variance portfolio to maximum return portfolio
Credit event
Funding liquidity risk
Efficient frontier
Tax shield
34. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Financial Risk
Basis
Three main reasons for financial disasters
Solve for minimum variance portfolio
35. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Where is risk coming from
Capital market line (CML)
Performance- related metrics
Market risk
36. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Parametric VaR
Credit event
Solvency-related metrics
Where is risk coming from
37. 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
Zero- beta CAPM (two factor model)
Drysdale Securities (Chase Manhattan)
Valuation vs. Risk management
APT (equation and assumptions)
38. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Morningstar Rating System
Differences in financial risk management for financial companies vs industrial companies
Parametric VaR
3 main types of operational risk
39. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
CAPM with taxes included (equation)
BTR - Below Target Risk
Zero- beta CAPM (two factor model)
3 main types of operational risk
40. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Asset liquidity risk
Risk Management Irrelevance Proposition
Ways risk can be mismeasured
Tracking error
41. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Probability of ruin
Correlation coefficient effect on diversification
CAPM with taxes included (equation)
CAPM (formula)
42. 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
Ri = Rz + (gamma)(beta)
Business risks
LTCM
Expected return of two assets
43. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Tax shield
Where is risk coming from
Drysdale Securities (Chase Manhattan)
Practical considerations related to ERM implementatio
44. Strategic risk - Business risk - Reputational risk
Where is risk coming from
Risks excluded from operational risk
Nonmarketable asset impact on CAPM
Basis risk
45. 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
VaR - Value at Risk
Ten assumptions underlying CAPM
CAPM with taxes included (equation)
Four major types of risk
46. The need to hedge against risks - for firms need to speculate.
Risk Management Irrelevance Proposition
Jensen's alpha
Drysdale Securities (Chase Manhattan)
What lead to the exponential growth to derivatives mkt?
47. Cannot exit position in market due to size of the position
Performance- related metrics
Security (primary vs secondary)
Business risks
Asset liquidity risk
48. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Liquidity risk
Drysdale Securities (Chase Manhattan)
Sortino ratio
Expected return of two assets
49. Asses firm risks - Communicate risks - Manage and monitor risks
Standard deviation of two assets
Three main reasons for financial disasters
Roles of risk management
Shortcomings of risk metrics
50. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Probability of ruin
Models used in ERM framework
Recovery rate
CAPM with taxes included (equation)
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