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Test your basic knowledge |
FRM: Foundations Of Risk Management
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business-skills
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certifications
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frm
Instructions:
Answer 50 questions in 15 minutes.
If you are not ready to take this test, you can
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. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Market imperfections that can create value
Basic Market risk
3 main types of operational risk
Ten assumptions underlying CAPM
2. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Exposure
Three main reasons for financial disasters
Standard deviation of two assets
Multi- period version of CAPM
3. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Solvency-related metrics
Formula for covariance
Tracking error
Risk- adjusted performance measure (RAP)
4. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Solve for minimum variance portfolio
Uncertainty
Exposure
Sortino ratio
5. 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
Parametric VaR
3 main types of operational risk
CAPM assumption for EMH
Allied Irish Bank
6. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
RAR = relative return of portfolio (RRp)
Performance- related metrics
Roles of risk management
Market imperfections that can create value
7. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Efficient frontier
Sharpe measure
Valuation vs. Risk management
8. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Where is risk coming from
Performance- related metrics
Treynor measure
Risk
9. Inability to make payment obligations (ex. Margin calls)
Derivative contract
APT in active portfolio management
Funding liquidity risk
Traits of ERM
10. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
Ri = Rz + (gamma)(beta)
VaR - Value at Risk
Effect of heterogeneous expectations on CAPM
CAPM with taxes included (equation)
11. 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
Risk Management Irrelevance Proposition
Operational risk
Ways firms can fail to account for risks
Risk
12. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Correlation coefficient effect on diversification
Differences in financial risk management for financial companies vs industrial companies
Debt overhang
Kidder Peabody
13. 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
Market imperfections that can create value
Three main reasons for financial disasters
Sharpe measure
Ten assumptions underlying CAPM
14. Expected value of unfavorable deviations of a random variable from a specified target level
Carry- backs and carry- forwards
CAPM (formula)
BTR - Below Target Risk
Risk
15. Volatility of unexpected outcomes
Three main reasons for financial disasters
Zero- beta CAPM (two factor model)
Risk
RAR = relative return of portfolio (RRp)
16. The need to hedge against risks - for firms need to speculate.
Firms becoming more sensitive to changes(bank deregulation)
What lead to the exponential growth to derivatives mkt?
Solvency-related metrics
Three main reasons for financial disasters
17. 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
Effect of non- price- taking behavior on CAPM
VaR- based analysis (formula)
Business Risk
Drysdale Securities (Chase Manhattan)
18. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Options motivation on volatility
CAPM assumption for EMH
Multi- period version of CAPM
Standard deviation of two assets
19. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Sortino ratio
BTR - Below Target Risk
Nonmarketable asset impact on CAPM
Valuation vs. Risk management
20. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Roles of risk management
Ri = ai + bi1l1 + bi2l2....+ei
Forms of Market risk
Market imperfections that can create value
21. 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
Forms of Market risk
Practical considerations related to ERM implementatio
Expected return of two assets
Effect of heterogeneous expectations on CAPM
22. Joseph Jett exploited an accounting glitch to book 350 million of false profits (government bonds) - Massive misreporting resulted in loss of confidence in management - Failed to take into account the present value of a forward - Learn to investigate
Treynor measure
CAPM assumption for EMH
Kidder Peabody
Effect of non- price- taking behavior on CAPM
23. Covariance = correlation coefficient std dev(a) std dev(b)
Formula for covariance
Business Risk
APT for passive portfolio management
LTCM
24. 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
Ten assumptions underlying CAPM
Asset transformers
Shortcomings of risk metrics
Effect of heterogeneous expectations on CAPM
25. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Asset liquidity risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
Basis risk
Tax shield
26. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
VaR- based analysis (formula)
Exposure
Financial Risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
27. Quantile of an empirical distribution
Nonparametric VaR
Valuation vs. Risk management
What lead to the exponential growth to derivatives mkt?
Basic Market risk
28. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Contango
RAR = relative return of portfolio (RRp)
Asset liquidity risk
Basic Market risk
29. Strategic risk - Business risk - Reputational risk
Derivative contract
Basic Market risk
Risks excluded from operational risk
APT in active portfolio management
30. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Basis risk
Market risk
Debt overhang
CAPM with taxes included (equation)
31. Multibeta CAPM Ri - Rf =
Settlement risk
Basis risk
Basis
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
32. When two payments are exchanged the same day and one party may default after payment is made
Settlement risk
Banker's Trust
Carry- backs and carry- forwards
Asset liquidity risk
33. 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
Ways firms can fail to account for risks
LTCM
Nonparametric VaR
Standard deviation of two assets
34. The lower (closer to - 1) - the higher the payoff from diversification
Effect of heterogeneous expectations on CAPM
Correlation coefficient effect on diversification
Effect of non- price- taking behavior on CAPM
Tail VaR or TCE - Tail Conditional Expectation(TCE)
35. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Solve for minimum variance portfolio
Ri = ai + bi1l1 + bi2l2....+ei
CAPM (formula)
Three main reasons for financial disasters
36. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Banker's Trust
Solve for minimum variance portfolio
Security (primary vs secondary)
37. 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
Ri = Rz + (gamma)(beta)
Solvency-related metrics
Valuation vs. Risk management
Four major types of risk
38. 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
Volatility Market risk
Barings
Multi- period version of CAPM
Firms becoming more sensitive to changes(bank deregulation)
39. Interest rate movements - derivatives - defaults
Financial Risk
Risks excluded from operational risk
Operational risk
Kidder Peabody
40. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Solve for minimum variance portfolio
Derivative contract
Ri = Rz + (gamma)(beta)
Barings
41. Risk of loses owing to movements in level or volatility of market prices
Derivative contract
Market risk
Prices of risk vs sensitivity
CAPM assumption for EMH
42. 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 -
CAPM assumption for EMH
Information ratio
Ri = ai + bi1l1 + bi2l2....+ei
Source of need for risk management
43. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Zero- beta CAPM (two factor model)
Solvency-related metrics
Information ratio
Ways firms can fail to account for risks
44. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
VaR - Value at Risk
Morningstar Rating System
Contango
45. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Treynor measure
Ways risk can be mismeasured
Contango
Information ratio
46. Changes in vol - implied or actual
VaR - Value at Risk
Volatility Market risk
Sovereign risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
47. Curve must be concave - Straight line connecting any two points must be under the curve
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Ways risk can be mismeasured
Sortino ratio
Shape of portfolio possibilities curve
48. Unanticipated movements in relative prices of assets in hedged position
Roles of risk management
Four major types of risk
Basic Market risk
Sortino ratio
49. Return is linearly related to growth rate in consumption
Multi- period version of CAPM
Settlement risk
Solve for minimum variance portfolio
Source of need for risk management
50. Cannot exit position in market due to size of the position
Sortino ratio
Debt overhang
Multi- period version of CAPM
Asset liquidity risk