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Test your basic knowledge |
FRM: Foundations Of Risk Management
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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. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Basis
Information ratio
Debt overhang
Options motivation on volatility
2. Future price is greater than the spot price
Contango
Where is risk coming from
Correlation coefficient effect on diversification
Market imperfections that can create value
3. Prices of risk are common factors and do not change - Sensitivities can change
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Shape of portfolio possibilities curve
Prices of risk vs sensitivity
Debt overhang
4. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Forms of Market risk
Zero- beta CAPM (two factor model)
Three main reasons for financial disasters
Standard deviation of two assets
5. 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
Exposure
Probability of ruin
Financial Risk
RAR = relative return of portfolio (RRp)
6. When negative taxable income is moved to a different year to offset future or past taxable income
Carry- backs and carry- forwards
Risks excluded from operational risk
LTCM
Security (primary vs secondary)
7. The lower (closer to - 1) - the higher the payoff from diversification
Liquidity risk
Operational risk
Correlation coefficient effect on diversification
Kidder Peabody
8. 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
Financial Risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Ri = ai + bi1l1 + bi2l2....+ei
Kidder Peabody
9. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Shortcomings of risk metrics
Morningstar Rating System
Risk- adjusted performance measure (RAP)
RAR = relative return of portfolio (RRp)
10. Asset-liability/market-liquidity risk
Liquidity risk
Asset transformers
Effect of heterogeneous expectations on CAPM
RAR = relative return of portfolio (RRp)
11. 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
Security (primary vs secondary)
Ten assumptions underlying CAPM
Risk
Treynor measure
12. Hazard - Financial - Operational - Strategic
Source of need for risk management
Risk types addressed by ERM
Nonmarketable asset impact on CAPM
Effect of heterogeneous expectations on CAPM
13. Derives value from an underlying asset - rate - or index - Derives value from a security
LTCM
APT (equation and assumptions)
Four major types of risk
Derivative contract
14. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Tax shield
Risk
Risk Management Irrelevance Proposition
RAR = relative return of portfolio (RRp)
15. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Solvency-related metrics
Differences in financial risk management for financial companies vs industrial companies
What lead to the exponential growth to derivatives mkt?
Settlement risk
16. Law of one price - Homogeneous expectations - Security returns process
Practical considerations related to ERM implementatio
Nonparametric VaR
APT (equation and assumptions)
Solve for minimum variance portfolio
17. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Ways risk can be mismeasured
Debt overhang
APT in active portfolio management
Exposure
18. 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
Allied Irish Bank
Prices of risk vs sensitivity
Sovereign risk
LTCM
19. Inability to make payment obligations (ex. Margin calls)
Banker's Trust
Funding liquidity risk
Sortino ratio
Business Risk
20. Interest rate movements - derivatives - defaults
Where is risk coming from
Differences in financial risk management for financial companies vs industrial companies
Financial Risk
Models used in ERM framework
21. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Contango
What lead to the exponential growth to derivatives mkt?
Solvency-related metrics
Market imperfections that can create value
22. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
LTCM
Basis risk
Options motivation on volatility
Sortino ratio
23. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Efficient frontier
CAPM (formula)
VaR- based analysis (formula)
Basic Market risk
24. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Recovery rate
Expected return of two assets
Options motivation on volatility
Sortino ratio
25. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Tracking error
Settlement risk
Business Risk
Banker's Trust
26. Probability distribution is unknown (ex. A terrorist attack)
Nonparametric VaR
Credit event
Funding liquidity risk
Uncertainty
27. Market risk - Liquidity risk - Credit risk - Operational risk
Four major types of risk
Exposure
Models used in ERM framework
Security (primary vs secondary)
28. Changes in vol - implied or actual
Effect of heterogeneous expectations on CAPM
Volatility Market risk
Shortcomings of risk metrics
Asset liquidity risk
29. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Operational risk
Basis
Asset transformers
Basic Market risk
30. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Kidder Peabody
Risks excluded from operational risk
Parametric VaR
Credit event
31. 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
Ways firms can fail to account for risks
Traits of ERM
Capital market line (CML)
Volatility Market risk
32. Cannot exit position in market due to size of the position
Four major types of risk
CAPM with taxes included (equation)
Asset liquidity risk
Jensen's alpha
33. 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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34. 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
CAPM (formula)
Shortcomings of risk metrics
Effect of non- price- taking behavior on CAPM
Kidder Peabody
35. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Importance of communication for risk managers
VaR- based analysis (formula)
Risk
Firms becoming more sensitive to changes(bank deregulation)
36. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Ways firms can fail to account for risks
Market imperfections that can create value
Nonparametric VaR
Zero- beta CAPM (two factor model)
37. 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
APT for passive portfolio management
Shape of portfolio possibilities curve
Ways firms can fail to account for risks
Differences in financial risk management for financial companies vs industrial companies
38. 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
Financial risks
Sharpe measure
Valuation vs. Risk management
Effect of non- price- taking behavior on CAPM
39. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Volatility Market risk
Traits of ERM
VaR- based analysis (formula)
Financial Risk
40. Concave function that extends from minimum variance portfolio to maximum return portfolio
Zero- beta CAPM (two factor model)
Formula for covariance
Operational risk
Efficient frontier
41. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Recovery rate
Ri = Rz + (gamma)(beta)
Valuation vs. Risk management
Market risk
42. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Recovery rate
CAPM assumption for EMH
Financial Risk
Carry- backs and carry- forwards
43. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Probability of ruin
EPD or ECOR - Expected Policyholder Deficit (EPD)
Practical considerations related to ERM implementatio
Settlement risk
44. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Solvency-related metrics
Valuation vs. Risk management
Drysdale Securities (Chase Manhattan)
Exposure
45. Losses due to market activities ex. Interest rate changes or defaults
Risks excluded from operational risk
Ways risk can be mismeasured
Financial risks
Derivative contract
46. Volatility of unexpected outcomes
Source of need for risk management
Risk
Market risk
Risk- adjusted performance measure (RAP)
47. Absolute and relative risk - direction and non-directional
Zero- beta CAPM (two factor model)
Firms becoming more sensitive to changes(bank deregulation)
Liquidity risk
Forms of Market risk
48. Probability that a random variable falls below a specified threshold level
Shortcomings of risk metrics
CAPM assumption for EMH
Shortfall risk
Standard deviation of two assets
49. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Treynor measure
Ten assumptions underlying CAPM
What lead to the exponential growth to derivatives mkt?
Basic Market risk
50. Quantile of a statistical distribution
Parametric VaR
Practical considerations related to ERM implementatio
Kidder Peabody
Banker's Trust