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Test your basic knowledge |
FRM: Foundations Of Risk Management
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frm
Instructions:
Answer 50 questions in 15 minutes.
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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. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Four major types of risk
Information ratio
Risk- adjusted performance measure (RAP)
Operational risk
2. Strategic risk - Business risk - Reputational risk
Banker's Trust
VaR - Value at Risk
Risks excluded from operational risk
Effect of heterogeneous expectations on CAPM
3. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Effect of non- price- taking behavior on CAPM
Jensen's alpha
Shortfall risk
Basis
4. 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.
Asset liquidity risk
Traits of ERM
Risk Management Irrelevance Proposition
What lead to the exponential growth to derivatives mkt?
5. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Sovereign risk
Risks excluded from operational risk
Sortino ratio
Barings
6. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Effect of non- price- taking behavior on CAPM
Forms of Market risk
Funding liquidity risk
Basic Market risk
7. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Solvency-related metrics
CAPM with taxes included (equation)
Ways risk can be mismeasured
Risk- adjusted performance measure (RAP)
8. 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
Zero- beta CAPM (two factor model)
Treynor measure
Tracking error
9. Interest rate movements - derivatives - defaults
Roles of risk management
APT for passive portfolio management
Effect of non- price- taking behavior on CAPM
Financial Risk
10. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Risk Management Irrelevance Proposition
Forms of Market risk
Differences in financial risk management for financial companies vs industrial companies
Sortino ratio
11. Covariance = correlation coefficient std dev(a) std dev(b)
Kidder Peabody
Derivative contract
CAPM assumption for EMH
Formula for covariance
12. Quantile of a statistical distribution
Zero- beta CAPM (two factor model)
Sharpe measure
Parametric VaR
Source of need for risk management
13. Modeling approach is typically between statistical analytic models and structural simulation models
Differences in financial risk management for financial companies vs industrial companies
Three main reasons for financial disasters
CAPM assumption for EMH
Models used in ERM framework
14. Asses firm risks - Communicate risks - Manage and monitor risks
Exposure
Shortfall risk
Basis
Roles of risk management
15. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Ways firms can fail to account for risks
Operational risk
Solvency-related metrics
Probability of ruin
16. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Sharpe measure
CAPM assumption for EMH
Sortino ratio
Expected return of two assets
17. Relative portfolio risk (RRiskp) - Based on a one- month investment period
RAR = relative return of portfolio (RRp)
Tracking error
VaR - Value at Risk
Risk Management Irrelevance Proposition
18. 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
Ri = ai + bi1l1 + bi2l2....+ei
Roles of risk management
Debt overhang
Ways firms can fail to account for risks
19. 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
Carry- backs and carry- forwards
Banker's Trust
Allied Irish Bank
Exposure
20. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Debt overhang
Capital market line (CML)
Treynor measure
21. 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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22. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Source of need for risk management
Barings
CAPM assumption for EMH
Capital market line (CML)
23. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Performance- related metrics
Valuation vs. Risk management
Credit event
Three main reasons for financial disasters
24. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Ri = ai + bi1l1 + bi2l2....+ei
Firms becoming more sensitive to changes(bank deregulation)
Risk
Effect of heterogeneous expectations on CAPM
25. Probability distribution is unknown (ex. A terrorist attack)
Treynor measure
3 main types of operational risk
Uncertainty
Parametric VaR
26. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Prices of risk vs sensitivity
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Business risks
Standard deviation of two assets
27. The uses of debt to fall into a lower tax rate
Tax shield
Operational risk
Performance- related metrics
Basic Market risk
28. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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29. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Ri = Rz + (gamma)(beta)
CAPM with taxes included (equation)
Sovereign risk
Debt overhang
30. Inability to make payment obligations (ex. Margin calls)
Funding liquidity risk
Business risks
VaR- based analysis (formula)
Business Risk
31. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Where is risk coming from
Ten assumptions underlying CAPM
Roles of risk management
VaR- based analysis (formula)
32. Asset-liability/market-liquidity risk
Liquidity risk
Probability of ruin
Ri = Rz + (gamma)(beta)
Correlation coefficient effect on diversification
33. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Exposure
Security (primary vs secondary)
Financial risks
CAPM (formula)
34. 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
Risk
Funding liquidity risk
Practical considerations related to ERM implementatio
Effect of non- price- taking behavior on CAPM
35. 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
Basic Market risk
Recovery rate
Traits of ERM
EPD or ECOR - Expected Policyholder Deficit (EPD)
36. Occurs the day when two parties exchange payments same day
Effect of non- price- taking behavior on CAPM
CAPM with taxes included (equation)
Financial risks
Settlement risk
37. Both probability and cost of tail events are considered
Risk
Basic Market risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Options motivation on volatility
38. 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
Drysdale Securities (Chase Manhattan)
Roles of risk management
Differences in financial risk management for financial companies vs industrial companies
LTCM
39. 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
Prices of risk vs sensitivity
APT for passive portfolio management
Kidder Peabody
40. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
Risk
APT (equation and assumptions)
CAPM with taxes included (equation)
Effect of non- price- taking behavior on CAPM
41. Derives value from an underlying asset - rate - or index - Derives value from a security
Ways risk can be mismeasured
Derivative contract
CAPM assumption for EMH
Ri = ai + bi1l1 + bi2l2....+ei
42. Volatility of unexpected outcomes
Risk
Market imperfections that can create value
Asset liquidity risk
Basic Market risk
43. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Ways risk can be mismeasured
Where is risk coming from
Financial Risk
Debt overhang
44. The need to hedge against risks - for firms need to speculate.
Forms of Market risk
Differences in financial risk management for financial companies vs industrial companies
Roles of risk management
What lead to the exponential growth to derivatives mkt?
45. Unanticipated movements in relative prices of assets in hedged position
Correlation coefficient effect on diversification
Basic Market risk
Four major types of risk
Nonparametric VaR
46. The lower (closer to - 1) - the higher the payoff from diversification
Business risks
Correlation coefficient effect on diversification
Recovery rate
LTCM
47. Returns on any stock are linearly related to a set of indexes
RAR = relative return of portfolio (RRp)
Solve for minimum variance portfolio
Ri = ai + bi1l1 + bi2l2....+ei
Source of need for risk management
48. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Valuation vs. Risk management
Risks excluded from operational risk
Market imperfections that can create value
Asset liquidity risk
49. 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
Options motivation on volatility
Multi- period version of CAPM
Probability of ruin
Recovery rate
50. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Exposure
Capital market line (CML)
3 main types of operational risk