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FRM: Foundations Of Risk Management

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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. Hazard - Financial - Operational - Strategic

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

3. Future price is greater than the spot price

4. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely

5. Difference between forward price and spot price - Should approach zero as the contract approaches maturity

6. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized

7. Covariance = correlation coefficient std dev(a) std dev(b)

8. When negative taxable income is moved to a different year to offset future or past taxable income

9. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business

10. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk

11. Prices of risk are common factors and do not change - Sensitivities can change

12. Unanticipated movements in relative prices of assets in hedged position

13. 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

14. Potential amount that can be lost

15. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements

16. Market risk - Liquidity risk - Credit risk - Operational risk

17. 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

18. Law of one price - Homogeneous expectations - Security returns process

19. Long in options = expecting volatility increase - Short in options = expecting volatility decrease

20. Quantile of a statistical distribution

21. The need to hedge against risks - for firms need to speculate.

22. Asset-liability/market-liquidity risk

23. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation

24. 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

25. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated

26. Concave function that extends from minimum variance portfolio to maximum return portfolio

27. Modeling approach is typically between statistical analytic models and structural simulation models

28. 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

29. Derives value from an underlying asset - rate - or index - Derives value from a security

30. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations

31. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return

32. Returns on any stock are linearly related to a set of indexes

33. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))

34. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds

35. Probability distribution is unknown (ex. A terrorist attack)

36. Cannot exit position in market due to size of the position

37. Absolute and relative risk - direction and non-directional

38. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes

39. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio

40. Interest rate movements - derivatives - defaults

41. 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

42. 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

43. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)

44. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)

45. Country specific - Foreign exchange controls that prohibit counterparty's obligations

46. 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

47. Volatility of unexpected outcomes

48. 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

49. 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

50. Expected value of unfavorable deviations of a random variable from a specified target level