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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.
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
Effect of heterogeneous expectations on CAPM
Financial Risk
Basis
Ways risk can be mismeasured
2. Quantile of an empirical distribution
Volatility Market risk
Nonparametric VaR
EPD or ECOR - Expected Policyholder Deficit (EPD)
Effect of non- price- taking behavior on CAPM
3. The uses of debt to fall into a lower tax rate
Tax shield
LTCM
Market imperfections that can create value
CAPM with taxes included (equation)
4. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Parametric VaR
Security (primary vs secondary)
Options motivation on volatility
Market imperfections that can create value
5. Future price is greater than the spot price
Basic Market risk
Contango
Debt overhang
EPD or ECOR - Expected Policyholder Deficit (EPD)
6. Curve must be concave - Straight line connecting any two points must be under the curve
Parametric VaR
Efficient frontier
Settlement risk
Shape of portfolio possibilities curve
7. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Banker's Trust
Treynor measure
VaR - Value at Risk
Traits of ERM
8. Potential amount that can be lost
What lead to the exponential growth to derivatives mkt?
Settlement risk
Effect of non- price- taking behavior on CAPM
Exposure
9. Rp = XaRa + XbRb
Expected return of two assets
CAPM assumption for EMH
Allied Irish Bank
APT for passive portfolio management
10. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Asset liquidity risk
Options motivation on volatility
Multi- period version of CAPM
Tracking error
11. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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12. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Sharpe measure
Zero- beta CAPM (two factor model)
APT in active portfolio management
CAPM assumption for EMH
13. Probability distribution is unknown (ex. A terrorist attack)
Uncertainty
Efficient frontier
Sharpe measure
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
14. Cannot exit position in market due to size of the position
Asset liquidity risk
Basis
Volatility Market risk
Shape of portfolio possibilities curve
15. Return is linearly related to growth rate in consumption
Multi- period version of CAPM
Basis
Credit event
Volatility Market risk
16. Expected value of unfavorable deviations of a random variable from a specified target level
EPD or ECOR - Expected Policyholder Deficit (EPD)
Roles of risk management
Shape of portfolio possibilities curve
BTR - Below Target Risk
17. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Barings
Risk- adjusted performance measure (RAP)
Effect of non- price- taking behavior on CAPM
Probability of ruin
18. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
EPD or ECOR - Expected Policyholder Deficit (EPD)
Solve for minimum variance portfolio
Roles of risk management
APT in active portfolio management
19. Occurs the day when two parties exchange payments same day
Sovereign risk
Market risk
Settlement risk
Forms of Market risk
20. Changes in vol - implied or actual
Ways firms can fail to account for risks
Volatility Market risk
Uncertainty
Basis
21. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
3 main types of operational risk
Operational risk
Practical considerations related to ERM implementatio
Ways risk can be mismeasured
22. 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
Effect of heterogeneous expectations on CAPM
APT (equation and assumptions)
Ways firms can fail to account for risks
CAPM assumption for EMH
23. 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 -
Basis risk
Standard deviation of two assets
Source of need for risk management
Tail VaR or TCE - Tail Conditional Expectation(TCE)
24. When negative taxable income is moved to a different year to offset future or past taxable income
Probability of ruin
Carry- backs and carry- forwards
Basic Market risk
Parametric VaR
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
What lead to the exponential growth to derivatives mkt?
Shortcomings of risk metrics
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Settlement risk
26. Covariance = correlation coefficient std dev(a) std dev(b)
Settlement risk
Basis
Asset transformers
Formula for covariance
27. Losses due to market activities ex. Interest rate changes or defaults
Financial risks
Financial Risk
Risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
28. Concave function that extends from minimum variance portfolio to maximum return portfolio
Drysdale Securities (Chase Manhattan)
Financial Risk
Credit event
Efficient frontier
29. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Firms becoming more sensitive to changes(bank deregulation)
Sovereign risk
Sharpe measure
Treynor measure
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
Nonparametric VaR
VaR- based analysis (formula)
Traits of ERM
APT in active portfolio management
31. 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
Effect of heterogeneous expectations on CAPM
Asset liquidity risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Ten assumptions underlying CAPM
32. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Business risks
CAPM assumption for EMH
Solvency-related metrics
Practical considerations related to ERM implementatio
33. Prices of risk are common factors and do not change - Sensitivities can change
Recovery rate
Market imperfections that can create value
Ten assumptions underlying CAPM
Prices of risk vs sensitivity
34. CAPM requires the strong form of the Efficient Market Hypothesis = private information
CAPM assumption for EMH
Differences in financial risk management for financial companies vs industrial companies
Shortfall risk
Market imperfections that can create value
35. Market risk - Liquidity risk - Credit risk - Operational risk
Models used in ERM framework
Morningstar Rating System
Asset liquidity risk
Four major types of risk
36. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Business risks
RAR = relative return of portfolio (RRp)
Importance of communication for risk managers
Security (primary vs secondary)
37. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Asset transformers
Risk
Roles of risk management
Derivative contract
38. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
APT for passive portfolio management
Expected return of two assets
What lead to the exponential growth to derivatives mkt?
Where is risk coming from
39. Unanticipated movements in relative prices of assets in hedged position
Ri = ai + bi1l1 + bi2l2....+ei
Basic Market risk
Allied Irish Bank
Exposure
40. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Firms becoming more sensitive to changes(bank deregulation)
Options motivation on volatility
Treynor measure
Efficient frontier
41. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Ri = Rz + (gamma)(beta)
Jensen's alpha
Shortcomings of risk metrics
Parametric VaR
42. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Security (primary vs secondary)
Capital market line (CML)
Exposure
Kidder Peabody
43. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Risk
Liquidity risk
Settlement risk
Firms becoming more sensitive to changes(bank deregulation)
44. 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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45. Risk of loses owing to movements in level or volatility of market prices
APT in active portfolio management
Market risk
Sovereign risk
VaR- based analysis (formula)
46. 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
Risk
Market risk
Drysdale Securities (Chase Manhattan)
Security (primary vs secondary)
47. 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
Risk Management Irrelevance Proposition
Performance- related metrics
Probability of ruin
Sortino ratio
48. Multibeta CAPM Ri - Rf =
Probability of ruin
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Drysdale Securities (Chase Manhattan)
Market risk
49. 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
RAR = relative return of portfolio (RRp)
Derivative contract
APT for passive portfolio management
Allied Irish Bank
50. Hazard - Financial - Operational - Strategic
Allied Irish Bank
Barings
Derivative contract
Risk types addressed by ERM
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