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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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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. Need to assess risk and tell management so they can determine which risks to take on
Importance of communication for risk managers
CAPM assumption for EMH
Morningstar Rating System
Information ratio
2. Volatility of unexpected outcomes
Ri = Rz + (gamma)(beta)
Exposure
Drysdale Securities (Chase Manhattan)
Risk
3. CAPM requires the strong form of the Efficient Market Hypothesis = private information
CAPM assumption for EMH
APT for passive portfolio management
Volatility Market risk
Ways firms can fail to account for risks
4. Strategic risk - Business risk - Reputational risk
VaR - Value at Risk
Liquidity risk
Roles of risk management
Risks excluded from operational risk
5. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Security (primary vs secondary)
Business Risk
Effect of heterogeneous expectations on CAPM
Business risks
6. Future price is greater than the spot price
Recovery rate
Shape of portfolio possibilities curve
Ten assumptions underlying CAPM
Contango
7. Quantile of a statistical distribution
Ways firms can fail to account for risks
What lead to the exponential growth to derivatives mkt?
Carry- backs and carry- forwards
Parametric VaR
8. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Morningstar Rating System
Options motivation on volatility
Nonmarketable asset impact on CAPM
VaR - Value at Risk
9. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Market risk
Debt overhang
VaR - Value at Risk
Probability of ruin
10. 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
Nonparametric VaR
Practical considerations related to ERM implementatio
Jensen's alpha
Solvency-related metrics
11. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
CAPM assumption for EMH
Tracking error
Funding liquidity risk
Multi- period version of CAPM
12. Prices of risk are common factors and do not change - Sensitivities can change
Prices of risk vs sensitivity
Importance of communication for risk managers
Differences in financial risk management for financial companies vs industrial companies
Settlement risk
13. Multibeta CAPM Ri - Rf =
Ways risk can be mismeasured
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Sortino ratio
Security (primary vs secondary)
14. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Effect of heterogeneous expectations on CAPM
Jensen's alpha
CAPM with taxes included (equation)
Business Risk
15. Expected value of unfavorable deviations of a random variable from a specified target level
Importance of communication for risk managers
Ri = Rz + (gamma)(beta)
BTR - Below Target Risk
Efficient frontier
16. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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17. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Four major types of risk
Standard deviation of two assets
Market risk
Morningstar Rating System
18. Hazard - Financial - Operational - Strategic
Risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Parametric VaR
Risk types addressed by ERM
19. 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
Solve for minimum variance portfolio
Traits of ERM
Contango
Valuation vs. Risk management
20. 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
Expected return of two assets
Ways firms can fail to account for risks
Risk
Sharpe measure
21. 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
Business Risk
APT for passive portfolio management
Sovereign risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
22. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Efficient frontier
Zero- beta CAPM (two factor model)
Parametric VaR
Correlation coefficient effect on diversification
23. 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 with taxes included (equation)
What lead to the exponential growth to derivatives mkt?
Source of need for risk management
Efficient frontier
24. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Barings
Sharpe measure
VaR- based analysis (formula)
Effect of non- price- taking behavior on CAPM
25. Interest rate movements - derivatives - defaults
Financial Risk
Ways risk can be mismeasured
Shape of portfolio possibilities curve
Information ratio
26. Risk of loses owing to movements in level or volatility of market prices
3 main types of operational risk
Market risk
Roles of risk management
APT (equation and assumptions)
27. Return is linearly related to growth rate in consumption
Multi- period version of CAPM
Jensen's alpha
Volatility Market risk
Risks excluded from operational risk
28. 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
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Shortcomings of risk metrics
Jensen's alpha
Settlement risk
29. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Solve for minimum variance portfolio
Recovery rate
Funding liquidity risk
Business risks
30. Curve must be concave - Straight line connecting any two points must be under the curve
Sharpe measure
Asset transformers
3 main types of operational risk
Shape of portfolio possibilities curve
31. Law of one price - Homogeneous expectations - Security returns process
APT (equation and assumptions)
Contango
RAR = relative return of portfolio (RRp)
BTR - Below Target Risk
32. Occurs the day when two parties exchange payments same day
Four major types of risk
Banker's Trust
Effect of non- price- taking behavior on CAPM
Settlement risk
33. Asses firm risks - Communicate risks - Manage and monitor risks
Settlement risk
Roles of risk management
Standard deviation of two assets
Derivative contract
34. 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
Risk
Risk
Where is risk coming from
Capital market line (CML)
35. When two payments are exchanged the same day and one party may default after payment is made
Effect of non- price- taking behavior on CAPM
Information ratio
Drysdale Securities (Chase Manhattan)
Settlement risk
36. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
CAPM (formula)
Efficient frontier
Funding liquidity risk
Standard deviation of two assets
37. 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
Models used in ERM framework
Debt overhang
Volatility Market risk
Drysdale Securities (Chase Manhattan)
38. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
VaR - Value at Risk
BTR - Below Target Risk
Effect of non- price- taking behavior on CAPM
VaR- based analysis (formula)
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.
Probability of ruin
Risk Management Irrelevance Proposition
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
APT (equation and assumptions)
40. 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
Parametric VaR
LTCM
Risks excluded from operational risk
Ways firms can fail to account for risks
41. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Performance- related metrics
VaR- based analysis (formula)
Jensen's alpha
Asset transformers
42. Probability that a random variable falls below a specified threshold level
Traits of ERM
Four major types of risk
Shortfall risk
Asset liquidity risk
43. Firms became multinational - - >watched xchange rates more - deregulation and globalization
RAR = relative return of portfolio (RRp)
Valuation vs. Risk management
Asset transformers
Firms becoming more sensitive to changes(bank deregulation)
44. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Basis risk
Performance- related metrics
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Prices of risk vs sensitivity
45. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Where is risk coming from
Carry- backs and carry- forwards
Basis
Capital market line (CML)
46. When negative taxable income is moved to a different year to offset future or past taxable income
Morningstar Rating System
Carry- backs and carry- forwards
Ways risk can be mismeasured
LTCM
47. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Risk Management Irrelevance Proposition
Banker's Trust
Ri = ai + bi1l1 + bi2l2....+ei
Risk- adjusted performance measure (RAP)
48. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Operational risk
Tax shield
EPD or ECOR - Expected Policyholder Deficit (EPD)
Credit event
49. Changes in vol - implied or actual
Shape of portfolio possibilities curve
Volatility Market risk
Funding liquidity risk
Effect of non- price- taking behavior on CAPM
50. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Sharpe measure
Effect of heterogeneous expectations on CAPM
Banker's Trust
Recovery rate