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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. Both probability and cost of tail events are considered
Allied Irish Bank
Tail VaR or TCE - Tail Conditional Expectation(TCE)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Shortcomings of risk metrics
2. Expected value of unfavorable deviations of a random variable from a specified target level
CAPM (formula)
BTR - Below Target Risk
Source of need for risk management
Capital market line (CML)
3. 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
Three main reasons for financial disasters
Firms becoming more sensitive to changes(bank deregulation)
Allied Irish Bank
APT for passive portfolio management
4. Need to assess risk and tell management so they can determine which risks to take on
Forms of Market risk
Shape of portfolio possibilities curve
Importance of communication for risk managers
EPD or ECOR - Expected Policyholder Deficit (EPD)
5. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Financial risks
Options motivation on volatility
Three main reasons for financial disasters
Differences in financial risk management for financial companies vs industrial companies
6. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Banker's Trust
EPD or ECOR - Expected Policyholder Deficit (EPD)
Shortcomings of risk metrics
Correlation coefficient effect on diversification
7. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Treynor measure
Solve for minimum variance portfolio
Practical considerations related to ERM implementatio
EPD or ECOR - Expected Policyholder Deficit (EPD)
8. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Volatility Market risk
Expected return of two assets
VaR - Value at Risk
9. The need to hedge against risks - for firms need to speculate.
Risks excluded from operational risk
Shortfall risk
What lead to the exponential growth to derivatives mkt?
Ri = Rz + (gamma)(beta)
10. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Source of need for risk management
3 main types of operational risk
Basis
Prices of risk vs sensitivity
11. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Probability of ruin
Ri = Rz + (gamma)(beta)
Drysdale Securities (Chase Manhattan)
Morningstar Rating System
12. 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.
Financial Risk
LTCM
Exposure
Risk Management Irrelevance Proposition
13. 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
Security (primary vs secondary)
Ri = Rz + (gamma)(beta)
Drysdale Securities (Chase Manhattan)
EPD or ECOR - Expected Policyholder Deficit (EPD)
14. Derives value from an underlying asset - rate - or index - Derives value from a security
Risk- adjusted performance measure (RAP)
Ri = Rz + (gamma)(beta)
Risks excluded from operational risk
Derivative contract
15. Interest rate movements - derivatives - defaults
Financial Risk
Sovereign risk
Basis
Treynor measure
16. Probability that a random variable falls below a specified threshold level
Kidder Peabody
Sortino ratio
Treynor measure
Shortfall risk
17. Wrong distribution - Historical sample may not apply
Ri = Rz + (gamma)(beta)
Ways risk can be mismeasured
Recovery rate
Security (primary vs secondary)
18. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Basis
Firms becoming more sensitive to changes(bank deregulation)
Risk
Financial Risk
19. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
APT in active portfolio management
BTR - Below Target Risk
Allied Irish Bank
Tail VaR or TCE - Tail Conditional Expectation(TCE)
20. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Multi- period version of CAPM
Operational risk
Forms of Market risk
Contango
21. The lower (closer to - 1) - the higher the payoff from diversification
APT (equation and assumptions)
Correlation coefficient effect on diversification
Effect of non- price- taking behavior on CAPM
Probability of ruin
22. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Valuation vs. Risk management
Kidder Peabody
Where is risk coming from
Zero- beta CAPM (two factor model)
23. 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
Practical considerations related to ERM implementatio
Basic Market risk
Ways risk can be mismeasured
VaR - Value at Risk
24. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Operational risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Recovery rate
Risk Management Irrelevance Proposition
25. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Ways firms can fail to account for risks
Firms becoming more sensitive to changes(bank deregulation)
Treynor measure
Sovereign risk
26. 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
Debt overhang
Derivative contract
Barings
27. 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
Business Risk
CAPM with taxes included (equation)
Financial Risk
Risk types addressed by ERM
28. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Shape of portfolio possibilities curve
Parametric VaR
Multi- period version of CAPM
Credit event
29. When negative taxable income is moved to a different year to offset future or past taxable income
Business Risk
Risks excluded from operational risk
Carry- backs and carry- forwards
Solvency-related metrics
30. When two payments are exchanged the same day and one party may default after payment is made
Settlement risk
Shortfall risk
Ways risk can be mismeasured
Effect of non- price- taking behavior on CAPM
31. 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
Risk
Sharpe measure
Valuation vs. Risk management
Tracking error
32. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Source of need for risk management
Models used in ERM framework
Firms becoming more sensitive to changes(bank deregulation)
Solve for minimum variance portfolio
33. Future price is greater than the spot price
Contango
CAPM with taxes included (equation)
Asset liquidity risk
Source of need for risk management
34. Unanticipated movements in relative prices of assets in hedged position
Where is risk coming from
Drysdale Securities (Chase Manhattan)
Basic Market risk
Financial Risk
35. Return is linearly related to growth rate in consumption
Asset transformers
Multi- period version of CAPM
Credit event
Debt overhang
36. Volatility of unexpected outcomes
Business Risk
Liquidity risk
Risk
Risk- adjusted performance measure (RAP)
37. Cannot exit position in market due to size of the position
Basis risk
VaR- based analysis (formula)
APT (equation and assumptions)
Asset liquidity risk
38. The uses of debt to fall into a lower tax rate
Business risks
Expected return of two assets
Sovereign risk
Tax shield
39. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Where is risk coming from
Effect of non- price- taking behavior on CAPM
Forms of Market risk
Market imperfections that can create value
40. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Sovereign risk
Derivative contract
Risk
VaR - Value at Risk
41. 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
Basis risk
Firms becoming more sensitive to changes(bank deregulation)
What lead to the exponential growth to derivatives mkt?
42. 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
Models used in ERM framework
Asset transformers
Kidder Peabody
Basic Market risk
43. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Shortcomings of risk metrics
Performance- related metrics
Asset transformers
Options motivation on volatility
44. 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
Settlement risk
Multi- period version of CAPM
VaR- based analysis (formula)
45. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Business risks
Ten assumptions underlying CAPM
Probability of ruin
Practical considerations related to ERM implementatio
46. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Debt overhang
Exposure
Funding liquidity risk
Zero- beta CAPM (two factor model)
47. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Multi- period version of CAPM
Allied Irish Bank
Risk Management Irrelevance Proposition
Sharpe measure
48. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Information ratio
RAR = relative return of portfolio (RRp)
Valuation vs. Risk management
Zero- beta CAPM (two factor model)
49. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
APT (equation and assumptions)
Solvency-related metrics
Traits of ERM
Correlation coefficient effect on diversification
50. Multibeta CAPM Ri - Rf =
Nonparametric VaR
Banker's Trust
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Models used in ERM framework