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FRM: Foundations Of Risk Management
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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. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Multi- period version of CAPM
Jensen's alpha
Risks excluded from operational risk
Business risks
2. Changes in vol - implied or actual
Volatility Market risk
Sovereign risk
Where is risk coming from
Solve for minimum variance portfolio
3. 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
Operational risk
Prices of risk vs sensitivity
Practical considerations related to ERM implementatio
Formula for covariance
4. Return is linearly related to growth rate in consumption
Multi- period version of CAPM
APT for passive portfolio management
Security (primary vs secondary)
Traits of ERM
5. Absolute and relative risk - direction and non-directional
Sharpe measure
Forms of Market risk
Settlement risk
Shortcomings of risk metrics
6. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Derivative contract
Ways risk can be mismeasured
Ri = Rz + (gamma)(beta)
CAPM with taxes included (equation)
7. Multibeta CAPM Ri - Rf =
Differences in financial risk management for financial companies vs industrial companies
Nonmarketable asset impact on CAPM
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Credit event
8. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
CAPM (formula)
Asset transformers
Risk types addressed by ERM
Nonmarketable asset impact on CAPM
9. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
APT in active portfolio management
Credit event
Three main reasons for financial disasters
LTCM
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
Risk types addressed by ERM
Valuation vs. Risk management
Nonmarketable asset impact on CAPM
Performance- related metrics
11. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Risk
Ri = Rz + (gamma)(beta)
Effect of non- price- taking behavior on CAPM
Debt overhang
12. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Solvency-related metrics
BTR - Below Target Risk
Risk types addressed by ERM
VaR - Value at Risk
13. 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 -
Performance- related metrics
Treynor measure
Where is risk coming from
Source of need for risk management
14. The uses of debt to fall into a lower tax rate
Tax shield
Performance- related metrics
Efficient frontier
Importance of communication for risk managers
15. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Banker's Trust
Solvency-related metrics
Ri = ai + bi1l1 + bi2l2....+ei
Uncertainty
16. 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
CAPM with taxes included (equation)
Source of need for risk management
APT for passive portfolio management
Uncertainty
17. Volatility of unexpected outcomes
Risk
Four major types of risk
Three main reasons for financial disasters
Probability of ruin
18. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Firms becoming more sensitive to changes(bank deregulation)
Market imperfections that can create value
Ways firms can fail to account for risks
Liquidity risk
19. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
APT in active portfolio management
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Options motivation on volatility
APT (equation and assumptions)
20. Probability that a random variable falls below a specified threshold level
Shortfall risk
Risk
RAR = relative return of portfolio (RRp)
Sovereign risk
21. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Efficient frontier
Four major types of risk
Sharpe measure
Recovery rate
22. Risk of loses owing to movements in level or volatility of market prices
Multi- period version of CAPM
Market risk
Security (primary vs secondary)
Asset liquidity risk
23. Expected value of unfavorable deviations of a random variable from a specified target level
BTR - Below Target Risk
Banker's Trust
Risk
Performance- related metrics
24. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Traits of ERM
Exposure
Effect of heterogeneous expectations on CAPM
RAR = relative return of portfolio (RRp)
25. Cannot exit position in market due to size of the position
APT in active portfolio management
Effect of heterogeneous expectations on CAPM
Asset liquidity risk
Models used in ERM framework
26. Derives value from an underlying asset - rate - or index - Derives value from a security
Funding liquidity risk
Probability of ruin
Derivative contract
Volatility Market risk
27. When two payments are exchanged the same day and one party may default after payment is made
Settlement risk
Credit event
Effect of non- price- taking behavior on CAPM
Sortino ratio
28. 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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29. Quantile of a statistical distribution
Sharpe measure
Financial risks
Firms becoming more sensitive to changes(bank deregulation)
Parametric VaR
30. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Treynor measure
Risk- adjusted performance measure (RAP)
Expected return of two assets
Risk
31. Wrong distribution - Historical sample may not apply
Morningstar Rating System
Ways risk can be mismeasured
Basis risk
Risk Management Irrelevance Proposition
32. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Solve for minimum variance portfolio
VaR- based analysis (formula)
Settlement risk
Asset liquidity risk
33. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Where is risk coming from
Security (primary vs secondary)
Tracking error
Debt overhang
34. Prices of risk are common factors and do not change - Sensitivities can change
Shape of portfolio possibilities curve
Settlement risk
Prices of risk vs sensitivity
APT for passive portfolio management
35. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
APT in active portfolio management
Effect of non- price- taking behavior on CAPM
Basic Market risk
Prices of risk vs sensitivity
36. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Standard deviation of two assets
Correlation coefficient effect on diversification
Treynor measure
Solve for minimum variance portfolio
37. When negative taxable income is moved to a different year to offset future or past taxable income
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Options motivation on volatility
Carry- backs and carry- forwards
Jensen's alpha
38. Unanticipated movements in relative prices of assets in hedged position
VaR - Value at Risk
Ways firms can fail to account for risks
Basic Market risk
Probability of ruin
39. Strategic risk - Business risk - Reputational risk
Risks excluded from operational risk
Banker's Trust
Business risks
Correlation coefficient effect on diversification
40. 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
Risks excluded from operational risk
Drysdale Securities (Chase Manhattan)
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Ways risk can be mismeasured
41. 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
Probability of ruin
Traits of ERM
Zero- beta CAPM (two factor model)
Three main reasons for financial disasters
42. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Business Risk
Prices of risk vs sensitivity
Ri = Rz + (gamma)(beta)
Tracking error
43. The need to hedge against risks - for firms need to speculate.
Practical considerations related to ERM implementatio
What lead to the exponential growth to derivatives mkt?
Derivative contract
Operational risk
44. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Three main reasons for financial disasters
Effect of heterogeneous expectations on CAPM
Morningstar Rating System
Exposure
45. 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
Contango
Performance- related metrics
Effect of non- price- taking behavior on CAPM
Business Risk
46. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Debt overhang
Financial risks
Sharpe measure
Financial Risk
47. Occurs the day when two parties exchange payments same day
LTCM
Settlement risk
Roles of risk management
Risk- adjusted performance measure (RAP)
48. Future price is greater than the spot price
Contango
Banker's Trust
Barings
Market imperfections that can create value
49. 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
Liquidity risk
Probability of ruin
Three main reasons for financial disasters
Tracking error
50. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Business Risk
Treynor measure
CAPM with taxes included (equation)
Standard deviation of two assets
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