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Test your basic knowledge |
FRM: Foundations Of Risk Management
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Subjects
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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. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
VaR- based analysis (formula)
Kidder Peabody
Ways firms can fail to account for risks
3 main types of operational risk
2. Prices of risk are common factors and do not change - Sensitivities can change
LTCM
Prices of risk vs sensitivity
Security (primary vs secondary)
Source of need for risk management
3. Modeling approach is typically between statistical analytic models and structural simulation models
Tracking error
BTR - Below Target Risk
Basic Market risk
Models used in ERM framework
4. 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
Banker's Trust
Options motivation on volatility
Ten assumptions underlying CAPM
Capital market line (CML)
5. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Effect of non- price- taking behavior on CAPM
Parametric VaR
Tracking error
Credit event
6. Future price is greater than the spot price
Forms of Market risk
Basic Market risk
Contango
Sovereign risk
7. Probability that a random variable falls below a specified threshold level
3 main types of operational risk
Shortfall risk
Operational risk
Asset transformers
8. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
BTR - Below Target Risk
Effect of heterogeneous expectations on CAPM
Operational risk
Settlement risk
9. Risk of loses owing to movements in level or volatility of market prices
Liquidity risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Market risk
Capital market line (CML)
10. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Shortfall risk
Risk- adjusted performance measure (RAP)
Standard deviation of two assets
Basis risk
11. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Ten assumptions underlying CAPM
Ways firms can fail to account for risks
Valuation vs. Risk management
Morningstar Rating System
12. Wrong distribution - Historical sample may not apply
Jensen's alpha
Basis risk
Ways risk can be mismeasured
Barings
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
Differences in financial risk management for financial companies vs industrial companies
Formula for covariance
Ten assumptions underlying CAPM
14. Interest rate movements - derivatives - defaults
Ways firms can fail to account for risks
Derivative contract
Financial Risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
15. 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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16. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Expected return of two assets
Valuation vs. Risk management
Sharpe measure
Debt overhang
17. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Debt overhang
EPD or ECOR - Expected Policyholder Deficit (EPD)
Sortino ratio
Financial risks
18. Need to assess risk and tell management so they can determine which risks to take on
Importance of communication for risk managers
Information ratio
Risk types addressed by ERM
Market risk
19. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Sovereign risk
3 main types of operational risk
Basis
Debt overhang
20. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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21. 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
VaR- based analysis (formula)
Models used in ERM framework
Kidder Peabody
Ri = Rz + (gamma)(beta)
22. 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
Prices of risk vs sensitivity
Debt overhang
Shortfall risk
Practical considerations related to ERM implementatio
23. The uses of debt to fall into a lower tax rate
Settlement risk
Tax shield
APT (equation and assumptions)
Zero- beta CAPM (two factor model)
24. Multibeta CAPM Ri - Rf =
Risk
Business risks
Liquidity risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
25. Derives value from an underlying asset - rate - or index - Derives value from a security
Market imperfections that can create value
Ten assumptions underlying CAPM
Basis
Derivative contract
26. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Treynor measure
Firms becoming more sensitive to changes(bank deregulation)
Performance- related metrics
Sortino ratio
27. Hazard - Financial - Operational - Strategic
Risk Management Irrelevance Proposition
Credit event
Risk types addressed by ERM
Volatility Market risk
28. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
CAPM with taxes included (equation)
Information ratio
CAPM (formula)
Asset transformers
29. Return is linearly related to growth rate in consumption
CAPM (formula)
BTR - Below Target Risk
Shortcomings of risk metrics
Multi- period version of CAPM
30. 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
Uncertainty
3 main types of operational risk
Shortcomings of risk metrics
APT for passive portfolio management
31. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Formula for covariance
Options motivation on volatility
Shortfall risk
Security (primary vs secondary)
32. Asses firm risks - Communicate risks - Manage and monitor risks
BTR - Below Target Risk
Roles of risk management
Performance- related metrics
Ri = Rz + (gamma)(beta)
33. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Credit event
CAPM (formula)
Basis
Ri = ai + bi1l1 + bi2l2....+ei
34. Both probability and cost of tail events are considered
Shortfall risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Derivative contract
Importance of communication for risk managers
35. Changes in vol - implied or actual
Volatility Market risk
Ways firms can fail to account for risks
Where is risk coming from
Financial Risk
36. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Debt overhang
Zero- beta CAPM (two factor model)
Settlement risk
Expected return of two assets
37. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Shortcomings of risk metrics
Ways firms can fail to account for risks
Recovery rate
Firms becoming more sensitive to changes(bank deregulation)
38. Concave function that extends from minimum variance portfolio to maximum return portfolio
CAPM (formula)
VaR- based analysis (formula)
Efficient frontier
Options motivation on volatility
39. 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.
Risk Management Irrelevance Proposition
Expected return of two assets
CAPM (formula)
BTR - Below Target Risk
40. Curve must be concave - Straight line connecting any two points must be under the curve
3 main types of operational risk
Valuation vs. Risk management
Market imperfections that can create value
Shape of portfolio possibilities curve
41. 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 -
Risk
Source of need for risk management
Nonmarketable asset impact on CAPM
Efficient frontier
42. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
What lead to the exponential growth to derivatives mkt?
Nonmarketable asset impact on CAPM
Basic Market risk
Formula for covariance
43. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Solve for minimum variance portfolio
Three main reasons for financial disasters
Volatility Market risk
Settlement risk
44. 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
Kidder Peabody
Practical considerations related to ERM implementatio
Morningstar Rating System
45. 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
Jensen's alpha
Carry- backs and carry- forwards
Ways firms can fail to account for risks
Shortcomings of risk metrics
46. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Options motivation on volatility
Correlation coefficient effect on diversification
Risk
RAR = relative return of portfolio (RRp)
47. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Shape of portfolio possibilities curve
Financial risks
Effect of heterogeneous expectations on CAPM
VaR - Value at Risk
48. Expected value of unfavorable deviations of a random variable from a specified target level
What lead to the exponential growth to derivatives mkt?
Formula for covariance
Ten assumptions underlying CAPM
BTR - Below Target Risk
49. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Uncertainty
Ri = Rz + (gamma)(beta)
Asset transformers
Tracking error
50. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
CAPM with taxes included (equation)
Asset transformers
Debt overhang
Credit event