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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. Need to assess risk and tell management so they can determine which risks to take on
Importance of communication for risk managers
Barings
Shortcomings of risk metrics
Financial Risk
2. The lower (closer to - 1) - the higher the payoff from diversification
Correlation coefficient effect on diversification
Basic Market risk
Financial risks
Basis
3. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Asset transformers
Jensen's alpha
Firms becoming more sensitive to changes(bank deregulation)
Banker's Trust
4. The need to hedge against risks - for firms need to speculate.
Financial Risk
Business Risk
What lead to the exponential growth to derivatives mkt?
Traits of ERM
5. Hazard - Financial - Operational - Strategic
Financial Risk
Risk types addressed by ERM
Exposure
Expected return of two assets
6. Law of one price - Homogeneous expectations - Security returns process
Liquidity risk
Risk
Operational risk
APT (equation and assumptions)
7. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Practical considerations related to ERM implementatio
Valuation vs. Risk management
Tracking error
Treynor measure
8. Asses firm risks - Communicate risks - Manage and monitor risks
Roles of risk management
Four major types of risk
What lead to the exponential growth to derivatives mkt?
Debt overhang
9. Quantile of a statistical distribution
Parametric VaR
Basic Market risk
Ways firms can fail to account for risks
Contango
10. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Risk- adjusted performance measure (RAP)
Contango
Banker's Trust
Financial risks
11. Risk of loses owing to movements in level or volatility of market prices
Sortino ratio
Market risk
Settlement risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
12. Concave function that extends from minimum variance portfolio to maximum return portfolio
Efficient frontier
APT (equation and assumptions)
Risk
Probability of ruin
13. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Allied Irish Bank
Basis
Risk Management Irrelevance Proposition
Ways risk can be mismeasured
14. Absolute and relative risk - direction and non-directional
Tax shield
Ways risk can be mismeasured
Forms of Market risk
Models used in ERM framework
15. 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
Source of need for risk management
Risk types addressed by ERM
APT for passive portfolio management
APT (equation and assumptions)
16. Future price is greater than the spot price
Debt overhang
Contango
APT for passive portfolio management
Probability of ruin
17. Wrong distribution - Historical sample may not apply
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Morningstar Rating System
Ways risk can be mismeasured
Liquidity risk
18. 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
Uncertainty
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Barings
Valuation vs. Risk management
19. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Options motivation on volatility
LTCM
CAPM (formula)
Traits of ERM
20. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
EPD or ECOR - Expected Policyholder Deficit (EPD)
Operational risk
Ways firms can fail to account for risks
Models used in ERM framework
21. 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
Financial Risk
Prices of risk vs sensitivity
APT (equation and assumptions)
22. 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
Liquidity risk
Financial Risk
Risk Management Irrelevance Proposition
23. Losses due to market activities ex. Interest rate changes or defaults
Financial risks
Funding liquidity risk
Asset transformers
Risk
24. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Ri = ai + bi1l1 + bi2l2....+ei
Recovery rate
APT in active portfolio management
Three main reasons for financial disasters
25. When two payments are exchanged the same day and one party may default after payment is made
Nonparametric VaR
Settlement risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
Standard deviation of two assets
26. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Derivative contract
Morningstar Rating System
VaR - Value at Risk
Performance- related metrics
27. Strategic risk - Business risk - Reputational risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Risks excluded from operational risk
Drysdale Securities (Chase Manhattan)
Roles of risk management
28. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Firms becoming more sensitive to changes(bank deregulation)
Solvency-related metrics
Risk
Business risks
29. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Importance of communication for risk managers
Solvency-related metrics
Funding liquidity risk
Zero- beta CAPM (two factor model)
30. Expected value of unfavorable deviations of a random variable from a specified target level
Traits of ERM
Tax shield
BTR - Below Target Risk
VaR - Value at Risk
31. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Recovery rate
VaR - Value at Risk
Jensen's alpha
Performance- related metrics
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
Probability of ruin
APT for passive portfolio management
Options motivation on volatility
Capital market line (CML)
33. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Basis risk
Practical considerations related to ERM implementatio
Risk types addressed by ERM
Funding liquidity risk
34. 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
Firms becoming more sensitive to changes(bank deregulation)
Probability of ruin
Risks excluded from operational risk
Debt overhang
35. Potential amount that can be lost
Ways firms can fail to account for risks
APT in active portfolio management
Exposure
CAPM assumption for EMH
36. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Valuation vs. Risk management
Nonparametric VaR
Capital market line (CML)
Market imperfections that can create value
37. Inability to make payment obligations (ex. Margin calls)
Shortcomings of risk metrics
Derivative contract
Funding liquidity risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
38. Modeling approach is typically between statistical analytic models and structural simulation models
VaR- based analysis (formula)
Probability of ruin
Risks excluded from operational risk
Models used in ERM framework
39. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
VaR- based analysis (formula)
Effect of non- price- taking behavior on CAPM
VaR - Value at Risk
Ten assumptions underlying CAPM
40. 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.
APT in active portfolio management
Risk Management Irrelevance Proposition
EPD or ECOR - Expected Policyholder Deficit (EPD)
Banker's Trust
41. Unanticipated movements in relative prices of assets in hedged position
Market imperfections that can create value
Information ratio
Ri = ai + bi1l1 + bi2l2....+ei
Basic Market risk
42. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Recovery rate
Formula for covariance
Zero- beta CAPM (two factor model)
LTCM
43. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
3 main types of operational risk
Uncertainty
Financial Risk
Options motivation on volatility
44. 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
Shortcomings of risk metrics
BTR - Below Target Risk
45. Market risk - Liquidity risk - Credit risk - Operational risk
Four major types of risk
What lead to the exponential growth to derivatives mkt?
Shortfall risk
Debt overhang
46. 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
Effect of non- price- taking behavior on CAPM
Basis risk
Shortcomings of risk metrics
CAPM with taxes included (equation)
47. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
RAR = relative return of portfolio (RRp)
Credit event
What lead to the exponential growth to derivatives mkt?
Traits of ERM
48. Curve must be concave - Straight line connecting any two points must be under the curve
Risk
Ri = Rz + (gamma)(beta)
Shape of portfolio possibilities curve
Sovereign risk
49. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Multi- period version of CAPM
Three main reasons for financial disasters
Solve for minimum variance portfolio
CAPM with taxes included (equation)
50. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Options motivation on volatility
Operational risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Ways firms can fail to account for risks
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