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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. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Standard deviation of two assets
Solve for minimum variance portfolio
Source of need for risk management
Asset transformers
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 -
Ri = ai + bi1l1 + bi2l2....+ei
Asset transformers
Source of need for risk management
Security (primary vs secondary)
3. Need to assess risk and tell management so they can determine which risks to take on
Tracking error
Importance of communication for risk managers
Zero- beta CAPM (two factor model)
VaR- based analysis (formula)
4. Multibeta CAPM Ri - Rf =
Market imperfections that can create value
Shape of portfolio possibilities curve
Performance- related metrics
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
5. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Risk
APT (equation and assumptions)
Uncertainty
Risk- adjusted performance measure (RAP)
6. 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
Debt overhang
Shortfall risk
Multi- period version of CAPM
Barings
7. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Treynor measure
Risk Management Irrelevance Proposition
Firms becoming more sensitive to changes(bank deregulation)
Jensen's alpha
8. Covariance = correlation coefficient std dev(a) std dev(b)
Options motivation on volatility
Risk Management Irrelevance Proposition
Basis
Formula for covariance
9. Changes in vol - implied or actual
Valuation vs. Risk management
Credit event
Firms becoming more sensitive to changes(bank deregulation)
Volatility Market risk
10. Relative portfolio risk (RRiskp) - Based on a one- month investment period
BTR - Below Target Risk
Firms becoming more sensitive to changes(bank deregulation)
Operational risk
RAR = relative return of portfolio (RRp)
11. Quantile of a statistical distribution
Asset liquidity risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Parametric VaR
Basis risk
12. Rp = XaRa + XbRb
Morningstar Rating System
Valuation vs. Risk management
VaR - Value at Risk
Expected return of two assets
13. 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
Nonparametric VaR
Business Risk
Effect of heterogeneous expectations on CAPM
Roles of risk management
14. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
VaR- based analysis (formula)
CAPM (formula)
Recovery rate
Where is risk coming from
15. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Sovereign risk
3 main types of operational risk
Ways firms can fail to account for risks
Asset transformers
16. Strategic risk - Business risk - Reputational risk
Forms of Market risk
Treynor measure
Risks excluded from operational risk
Basis
17. The need to hedge against risks - for firms need to speculate.
Sharpe measure
3 main types of operational risk
What lead to the exponential growth to derivatives mkt?
Effect of heterogeneous expectations on CAPM
18. Curve must be concave - Straight line connecting any two points must be under the curve
RAR = relative return of portfolio (RRp)
Shortcomings of risk metrics
Shape of portfolio possibilities curve
Effect of heterogeneous expectations on CAPM
19. When two payments are exchanged the same day and one party may default after payment is made
Financial risks
Settlement risk
Sharpe measure
Ways firms can fail to account for risks
20. Cannot exit position in market due to size of the position
Banker's Trust
Asset liquidity risk
Risk- adjusted performance measure (RAP)
Effect of non- price- taking behavior on CAPM
21. Hazard - Financial - Operational - Strategic
APT for passive portfolio management
Risk types addressed by ERM
Volatility Market risk
Market risk
22. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Settlement risk
What lead to the exponential growth to derivatives mkt?
Prices of risk vs sensitivity
Information ratio
23. Return is linearly related to growth rate in consumption
VaR- based analysis (formula)
Multi- period version of CAPM
Valuation vs. Risk management
Nonparametric VaR
24. The uses of debt to fall into a lower tax rate
Tax shield
Risk- adjusted performance measure (RAP)
Risk
Derivative contract
25. 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
Four major types of risk
Effect of heterogeneous expectations on CAPM
Drysdale Securities (Chase Manhattan)
APT in active portfolio management
26. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Allied Irish Bank
Practical considerations related to ERM implementatio
Sovereign risk
Shortfall risk
27. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Tracking error
Nonmarketable asset impact on CAPM
Kidder Peabody
Market risk
28. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Ways risk can be mismeasured
Operational risk
Where is risk coming from
29. 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
Barings
Operational risk
Carry- backs and carry- forwards
30. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Carry- backs and carry- forwards
Security (primary vs secondary)
Market imperfections that can create value
Basis
31. Risk of loses owing to movements in level or volatility of market prices
Practical considerations related to ERM implementatio
Jensen's alpha
Market risk
Business Risk
32. 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
Capital market line (CML)
Efficient frontier
APT (equation and assumptions)
Treynor measure
33. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Financial risks
Standard deviation of two assets
Basic Market risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
34. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Prices of risk vs sensitivity
Funding liquidity risk
Recovery rate
Business risks
35. 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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36. 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
Debt overhang
Jensen's alpha
Traits of ERM
Shortfall risk
37. Volatility of unexpected outcomes
Solvency-related metrics
Risk
Shape of portfolio possibilities curve
APT in active portfolio management
38. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
What lead to the exponential growth to derivatives mkt?
Financial Risk
Morningstar Rating System
Differences in financial risk management for financial companies vs industrial companies
39. Absolute and relative risk - direction and non-directional
Nonparametric VaR
Debt overhang
Risk
Forms of Market risk
40. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Expected return of two assets
Effect of heterogeneous expectations on CAPM
Treynor measure
Risk- adjusted performance measure (RAP)
41. Law of one price - Homogeneous expectations - Security returns process
Probability of ruin
Solvency-related metrics
Sharpe measure
APT (equation and assumptions)
42. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Performance- related metrics
Models used in ERM framework
Solvency-related metrics
Effect of non- price- taking behavior on CAPM
43. 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
Probability of ruin
RAR = relative return of portfolio (RRp)
Carry- backs and carry- forwards
Allied Irish Bank
44. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
EPD or ECOR - Expected Policyholder Deficit (EPD)
Drysdale Securities (Chase Manhattan)
Standard deviation of two assets
Uncertainty
45. Occurs the day when two parties exchange payments same day
Derivative contract
CAPM (formula)
Market risk
Settlement risk
46. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Financial risks
Tracking error
BTR - Below Target Risk
Multi- period version of CAPM
47. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Information ratio
APT in active portfolio management
Credit event
Solve for minimum variance portfolio
48. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Carry- backs and carry- forwards
Differences in financial risk management for financial companies vs industrial companies
Capital market line (CML)
Tail VaR or TCE - Tail Conditional Expectation(TCE)
49. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Efficient frontier
Ways risk can be mismeasured
Effect of non- price- taking behavior on CAPM
Ten assumptions underlying CAPM
50. 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
CAPM assumption for EMH
Exposure
Ten assumptions underlying CAPM
Recovery rate
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