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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. 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.
Four major types of risk
Valuation vs. Risk management
Risk Management Irrelevance Proposition
Risk- adjusted performance measure (RAP)
2. 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 -
Where is risk coming from
Effect of heterogeneous expectations on CAPM
Source of need for risk management
Practical considerations related to ERM implementatio
3. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Settlement risk
Business risks
Effect of non- price- taking behavior on CAPM
Solvency-related metrics
4. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Recovery rate
Risk Management Irrelevance Proposition
Operational risk
Sovereign risk
5. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Asset liquidity risk
BTR - Below Target Risk
RAR = relative return of portfolio (RRp)
Risk types addressed by ERM
6. Modeling approach is typically between statistical analytic models and structural simulation models
Basic Market risk
Importance of communication for risk managers
Source of need for risk management
Models used in ERM framework
7. Wrong distribution - Historical sample may not apply
Barings
Ways risk can be mismeasured
Funding liquidity risk
Risks excluded from operational risk
8. When negative taxable income is moved to a different year to offset future or past taxable income
Carry- backs and carry- forwards
Basis risk
Barings
Ways firms can fail to account for risks
9. Market risk - Liquidity risk - Credit risk - Operational risk
3 main types of operational risk
Source of need for risk management
Four major types of risk
Allied Irish Bank
10. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Basic Market risk
Multi- period version of CAPM
Sharpe measure
Information ratio
11. 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
Ways firms can fail to account for risks
Efficient frontier
EPD or ECOR - Expected Policyholder Deficit (EPD)
Barings
12. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
CAPM with taxes included (equation)
Multi- period version of CAPM
Tracking error
Security (primary vs secondary)
13. Probability distribution is unknown (ex. A terrorist attack)
CAPM assumption for EMH
Uncertainty
Solvency-related metrics
Risk
14. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Risk
Zero- beta CAPM (two factor model)
Sovereign risk
Risk types addressed by ERM
15. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Basis risk
Valuation vs. Risk management
VaR- based analysis (formula)
Debt overhang
16. Occurs the day when two parties exchange payments same day
VaR - Value at Risk
Treynor measure
Settlement risk
3 main types of operational risk
17. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Ri = Rz + (gamma)(beta)
LTCM
Differences in financial risk management for financial companies vs industrial companies
Ten assumptions underlying CAPM
18. 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
Recovery rate
Volatility Market risk
Prices of risk vs sensitivity
Drysdale Securities (Chase Manhattan)
19. Risk of loses owing to movements in level or volatility of market prices
Asset liquidity risk
Importance of communication for risk managers
Effect of non- price- taking behavior on CAPM
Market risk
20. Inability to make payment obligations (ex. Margin calls)
Shortcomings of risk metrics
Funding liquidity risk
Financial risks
Efficient frontier
21. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
VaR- based analysis (formula)
Prices of risk vs sensitivity
Settlement risk
Debt overhang
22. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Settlement risk
Three main reasons for financial disasters
Contango
Effect of non- price- taking behavior on CAPM
23. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Parametric VaR
Asset transformers
Information ratio
Models used in ERM framework
24. 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
Traits of ERM
Derivative contract
Ways risk can be mismeasured
VaR- based analysis (formula)
25. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
APT in active portfolio management
Derivative contract
Ways risk can be mismeasured
Firms becoming more sensitive to changes(bank deregulation)
26. Asset-liability/market-liquidity risk
Barings
Liquidity risk
Efficient frontier
Ways firms can fail to account for risks
27. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Information ratio
Risk types addressed by ERM
Expected return of two assets
Jensen's alpha
28. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Liquidity risk
Where is risk coming from
CAPM (formula)
Uncertainty
29. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Sovereign risk
Operational risk
Sortino ratio
Recovery rate
30. Law of one price - Homogeneous expectations - Security returns process
APT (equation and assumptions)
Carry- backs and carry- forwards
Settlement risk
Ways risk can be mismeasured
31. Losses due to market activities ex. Interest rate changes or defaults
Financial risks
Carry- backs and carry- forwards
Correlation coefficient effect on diversification
Three main reasons for financial disasters
32. 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 non- price- taking behavior on CAPM
Ten assumptions underlying CAPM
Debt overhang
Multi- period version of CAPM
33. Future price is greater than the spot price
RAR = relative return of portfolio (RRp)
Contango
Security (primary vs secondary)
Credit event
34. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Basis risk
Basis
Tracking error
Liquidity risk
35. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Parametric VaR
Ri = Rz + (gamma)(beta)
CAPM assumption for EMH
36. Prices of risk are common factors and do not change - Sensitivities can change
Kidder Peabody
Ways firms can fail to account for risks
Market risk
Prices of risk vs sensitivity
37. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Nonparametric VaR
EPD or ECOR - Expected Policyholder Deficit (EPD)
BTR - Below Target Risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
38. Both probability and cost of tail events are considered
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Debt overhang
Practical considerations related to ERM implementatio
Efficient frontier
39. Interest rate movements - derivatives - defaults
Security (primary vs secondary)
Financial Risk
Business Risk
RAR = relative return of portfolio (RRp)
40. Curve must be concave - Straight line connecting any two points must be under the curve
Sortino ratio
Shortfall risk
Shape of portfolio possibilities curve
Importance of communication for risk managers
41. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
3 main types of operational risk
Ri = Rz + (gamma)(beta)
Banker's Trust
Valuation vs. Risk management
42. 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
Volatility Market risk
Drysdale Securities (Chase Manhattan)
Debt overhang
Probability of ruin
43. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Solve for minimum variance portfolio
Settlement risk
Barings
Zero- beta CAPM (two factor model)
44. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
EPD or ECOR - Expected Policyholder Deficit (EPD)
Zero- beta CAPM (two factor model)
Ri = ai + bi1l1 + bi2l2....+ei
3 main types of operational risk
45. Need to assess risk and tell management so they can determine which risks to take on
VaR- based analysis (formula)
Importance of communication for risk managers
Capital market line (CML)
Funding liquidity risk
46. Changes in vol - implied or actual
Settlement risk
Differences in financial risk management for financial companies vs industrial companies
LTCM
Volatility Market risk
47. Hazard - Financial - Operational - Strategic
Funding liquidity risk
Settlement risk
Risk types addressed by ERM
Risk Management Irrelevance Proposition
48. When two payments are exchanged the same day and one party may default after payment is made
Settlement risk
Nonmarketable asset impact on CAPM
Roles of risk management
VaR- based analysis (formula)
49. The need to hedge against risks - for firms need to speculate.
What lead to the exponential growth to derivatives mkt?
Carry- backs and carry- forwards
Settlement risk
Asset liquidity risk
50. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Shortcomings of risk metrics
Parametric VaR
Market imperfections that can create value
Financial Risk
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