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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. Volatility of unexpected outcomes
Risk
Expected return of two assets
Tracking error
Barings
2. Probability that a random variable falls below a specified threshold level
Nonmarketable asset impact on CAPM
Asset liquidity risk
Business Risk
Shortfall risk
3. Probability distribution is unknown (ex. A terrorist attack)
Uncertainty
Sortino ratio
Expected return of two assets
Formula for covariance
4. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Derivative contract
Allied Irish Bank
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Asset transformers
5. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Probability of ruin
Performance- related metrics
Shortfall risk
3 main types of operational risk
6. 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
CAPM with taxes included (equation)
Jensen's alpha
Carry- backs and carry- forwards
Probability of ruin
7. When negative taxable income is moved to a different year to offset future or past taxable income
Risks excluded from operational risk
Recovery rate
Barings
Carry- backs and carry- forwards
8. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
EPD or ECOR - Expected Policyholder Deficit (EPD)
Firms becoming more sensitive to changes(bank deregulation)
Basis risk
Recovery rate
9. Multibeta CAPM Ri - Rf =
Sortino ratio
Traits of ERM
Where is risk coming from
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
10. Valuation focuses on mean of distribution vs risk mgmt focuses on potential variation in payoffs - needs more precision for pricing - VAR doesn't b/c noise cancels out
Basis risk
VaR - Value at Risk
Three main reasons for financial disasters
Valuation vs. Risk management
11. Wrong distribution - Historical sample may not apply
Tax shield
Options motivation on volatility
Ten assumptions underlying CAPM
Ways risk can be mismeasured
12. Covariance = correlation coefficient std dev(a) std dev(b)
Debt overhang
Shortcomings of risk metrics
Formula for covariance
Tail VaR or TCE - Tail Conditional Expectation(TCE)
13. 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
Practical considerations related to ERM implementatio
Kidder Peabody
APT (equation and assumptions)
Financial risks
14. Asset-liability/market-liquidity risk
Liquidity risk
Nonmarketable asset impact on CAPM
Firms becoming more sensitive to changes(bank deregulation)
Tracking error
15. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Sortino ratio
What lead to the exponential growth to derivatives mkt?
RAR = relative return of portfolio (RRp)
Banker's Trust
16. Return is linearly related to growth rate in consumption
Effect of heterogeneous expectations on CAPM
Tracking error
Multi- period version of CAPM
Settlement risk
17. Asses firm risks - Communicate risks - Manage and monitor risks
Settlement risk
Efficient frontier
Roles of risk management
Uncertainty
18. Inability to make payment obligations (ex. Margin calls)
Market risk
Asset transformers
Performance- related metrics
Funding liquidity risk
19. Quantile of an empirical distribution
Roles of risk management
Zero- beta CAPM (two factor model)
Sharpe measure
Nonparametric VaR
20. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Banker's Trust
Shortcomings of risk metrics
Uncertainty
CAPM assumption for EMH
21. Law of one price - Homogeneous expectations - Security returns process
Practical considerations related to ERM implementatio
Valuation vs. Risk management
APT (equation and assumptions)
Roles of risk management
22. The uses of debt to fall into a lower tax rate
Tax shield
Banker's Trust
Solvency-related metrics
Risk
23. When two payments are exchanged the same day and one party may default after payment is made
Settlement risk
Financial risks
Effect of non- price- taking behavior on CAPM
Basis
24. 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
Drysdale Securities (Chase Manhattan)
Nonmarketable asset impact on CAPM
Contango
Basis risk
25. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Zero- beta CAPM (two factor model)
Solve for minimum variance portfolio
Solvency-related metrics
Risk Management Irrelevance Proposition
26. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Performance- related metrics
APT for passive portfolio management
Exposure
Practical considerations related to ERM implementatio
27. Hazard - Financial - Operational - Strategic
Risk types addressed by ERM
Funding liquidity risk
Where is risk coming from
Four major types of risk
28. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Financial risks
Differences in financial risk management for financial companies vs industrial companies
Risk types addressed by ERM
LTCM
29. Need to assess risk and tell management so they can determine which risks to take on
Recovery rate
Effect of heterogeneous expectations on CAPM
Importance of communication for risk managers
Settlement risk
30. 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
Prices of risk vs sensitivity
CAPM (formula)
Correlation coefficient effect on diversification
LTCM
31. Rp = XaRa + XbRb
Expected return of two assets
Kidder Peabody
Risk
Contango
32. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
CAPM (formula)
Funding liquidity risk
Settlement risk
Shortcomings of risk metrics
33. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Valuation vs. Risk management
Security (primary vs secondary)
Sovereign risk
Tax shield
34. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Effect of heterogeneous expectations on CAPM
Shape of portfolio possibilities curve
Risk Management Irrelevance Proposition
Parametric VaR
35. Derives value from an underlying asset - rate - or index - Derives value from a security
Financial Risk
Derivative contract
What lead to the exponential growth to derivatives mkt?
Traits of ERM
36. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Morningstar Rating System
Ri = ai + bi1l1 + bi2l2....+ei
Formula for covariance
Where is risk coming from
37. 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
Barings
Ways risk can be mismeasured
Standard deviation of two assets
Solve for minimum variance portfolio
38. Potential amount that can be lost
Exposure
Effect of non- price- taking behavior on CAPM
Carry- backs and carry- forwards
Valuation vs. Risk management
39. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
EPD or ECOR - Expected Policyholder Deficit (EPD)
CAPM assumption for EMH
Roles of risk management
BTR - Below Target Risk
40. Risk of loses owing to movements in level or volatility of market prices
Four major types of risk
Valuation vs. Risk management
Contango
Market risk
41. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Ri = Rz + (gamma)(beta)
Ri = ai + bi1l1 + bi2l2....+ei
Roles of risk management
Zero- beta CAPM (two factor model)
42. 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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43. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Liquidity risk
Effect of non- price- taking behavior on CAPM
Market imperfections that can create value
Ri = ai + bi1l1 + bi2l2....+ei
44. Prices of risk are common factors and do not change - Sensitivities can change
Prices of risk vs sensitivity
Parametric VaR
Risk types addressed by ERM
BTR - Below Target Risk
45. 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 -
3 main types of operational risk
VaR - Value at Risk
Source of need for risk management
Sortino ratio
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
Sortino ratio
Shortcomings of risk metrics
Shortfall risk
VaR- based analysis (formula)
47. Future price is greater than the spot price
Contango
Where is risk coming from
Probability of ruin
Security (primary vs secondary)
48. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Forms of Market risk
Effect of non- price- taking behavior on CAPM
Market risk
Basic Market risk
49. 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)
Sovereign risk
BTR - Below Target Risk
Risks excluded from operational risk
50. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Valuation vs. Risk management
Firms becoming more sensitive to changes(bank deregulation)
LTCM
Effect of heterogeneous expectations on CAPM
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