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FRM: Foundations Of Risk Management

  • Answer 50 questions in 15 minutes.
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  • Match each statement with the correct term.
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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. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation

2. Strategic risk - Business risk - Reputational risk

3. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations

4. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)

5. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks

6. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk

7. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund

8. Inability to make payment obligations (ex. Margin calls)

9. Derives value from an underlying asset - rate - or index - Derives value from a security

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

11. Quantile of a statistical distribution

12. 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

13. The need to hedge against risks - for firms need to speculate.

14. Probability that a random variable falls below a specified threshold level

15. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely

16. Risks that are assumed willingly - to gain a competitive edge or add shareholder value

17. Future price is greater than the spot price

18. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities

19. Difference between forward price and spot price - Should approach zero as the contract approaches maturity

20. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected

21. Potential amount that can be lost

22. When negative taxable income is moved to a different year to offset future or past taxable income

23. 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

24. Capital structure (financial distress) - Taxes - Agency and information asymmetries

25. Concentrate on mid- region of probability distribution - Relevant to owners and proxies

26. Return is linearly related to growth rate in consumption

27. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta

28. 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

29. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios

30. Long in options = expecting volatility increase - Short in options = expecting volatility decrease

31. Firms became multinational - - >watched xchange rates more - deregulation and globalization

32. Probability distribution is unknown (ex. A terrorist attack)

33. Rp = XaRa + XbRb

34. The uses of debt to fall into a lower tax rate

35. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations

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

37. 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

38. Multibeta CAPM Ri - Rf =

39. Hazard - Financial - Operational - Strategic

40. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))

41. 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

42. Market risk - Liquidity risk - Credit risk - Operational risk

43. 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

44. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)

45. When two payments are exchanged the same day and one party may default after payment is made

46. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)

47. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses

48. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM

49. Prices of risk are common factors and do not change - Sensitivities can change

50. Losses due to market activities ex. Interest rate changes or defaults