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Test your basic knowledge |
FRM: Foundations Of Risk Management
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business-skills
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frm
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. 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 -
Ways risk can be mismeasured
Options motivation on volatility
Recovery rate
Source of need for risk management
2. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Settlement risk
Allied Irish Bank
Settlement risk
Credit event
3. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Operational risk
Effect of non- price- taking behavior on CAPM
Effect of heterogeneous expectations on CAPM
Tail VaR or TCE - Tail Conditional Expectation(TCE)
4. Future price is greater than the spot price
Asset liquidity risk
APT in active portfolio management
Source of need for risk management
Contango
5. Inability to make payment obligations (ex. Margin calls)
Funding liquidity risk
Ten assumptions underlying CAPM
Recovery rate
Business Risk
6. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Ri = Rz + (gamma)(beta)
3 main types of operational risk
Banker's Trust
Solve for minimum variance portfolio
7. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Zero- beta CAPM (two factor model)
Standard deviation of two assets
Uncertainty
Credit event
8. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Tax shield
Shortfall risk
Performance- related metrics
Zero- beta CAPM (two factor model)
9. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Business risks
Where is risk coming from
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Banker's Trust
10. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Valuation vs. Risk management
Where is risk coming from
Performance- related metrics
Derivative contract
11. Cannot exit position in market due to size of the position
Treynor measure
Risks excluded from operational risk
Correlation coefficient effect on diversification
Asset liquidity risk
12. 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
Risk- adjusted performance measure (RAP)
Differences in financial risk management for financial companies vs industrial companies
Practical considerations related to ERM implementatio
Asset liquidity risk
13. Rp = XaRa + XbRb
Expected return of two assets
Probability of ruin
Shortcomings of risk metrics
Barings
14. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Efficient frontier
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
15. 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
Volatility Market risk
Ten assumptions underlying CAPM
Basic Market risk
Treynor measure
16. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Financial risks
Capital market line (CML)
Debt overhang
Differences in financial risk management for financial companies vs industrial companies
17. The uses of debt to fall into a lower tax rate
Basic Market risk
Shortcomings of risk metrics
Operational risk
Tax shield
18. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
LTCM
Multi- period version of CAPM
Recovery rate
Three main reasons for financial disasters
19. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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20. 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
CAPM with taxes included (equation)
Asset liquidity risk
Asset transformers
21. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
APT in active portfolio management
Forms of Market risk
Practical considerations related to ERM implementatio
Ten assumptions underlying CAPM
22. 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
Debt overhang
Business risks
Kidder Peabody
Probability of ruin
23. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Firms becoming more sensitive to changes(bank deregulation)
Four major types of risk
Probability of ruin
Security (primary vs secondary)
24. Concave function that extends from minimum variance portfolio to maximum return portfolio
Effect of heterogeneous expectations on CAPM
Options motivation on volatility
Efficient frontier
Tail VaR or TCE - Tail Conditional Expectation(TCE)
25. 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
Solve for minimum variance portfolio
Nonparametric VaR
Differences in financial risk management for financial companies vs industrial companies
LTCM
26. Modeling approach is typically between statistical analytic models and structural simulation models
Shape of portfolio possibilities curve
Models used in ERM framework
Standard deviation of two assets
EPD or ECOR - Expected Policyholder Deficit (EPD)
27. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Morningstar Rating System
Performance- related metrics
Shortcomings of risk metrics
Asset transformers
28. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Settlement risk
Derivative contract
Ri = ai + bi1l1 + bi2l2....+ei
3 main types of operational risk
29. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Ways risk can be mismeasured
Solve for minimum variance portfolio
Tracking error
Traits of ERM
30. Quantile of an empirical distribution
Ten assumptions underlying CAPM
Asset liquidity risk
Nonparametric VaR
Information ratio
31. Market risk - Liquidity risk - Credit risk - Operational risk
Settlement risk
Four major types of risk
Risk
Shape of portfolio possibilities curve
32. Potential amount that can be lost
Differences in financial risk management for financial companies vs industrial companies
Capital market line (CML)
Exposure
Barings
33. Prices of risk are common factors and do not change - Sensitivities can change
Formula for covariance
BTR - Below Target Risk
Prices of risk vs sensitivity
RAR = relative return of portfolio (RRp)
34. 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
Differences in financial risk management for financial companies vs industrial companies
Allied Irish Bank
Carry- backs and carry- forwards
Ways firms can fail to account for risks
35. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Debt overhang
Funding liquidity risk
RAR = relative return of portfolio (RRp)
Risk types addressed by ERM
36. Absolute and relative risk - direction and non-directional
Forms of Market risk
Source of need for risk management
Three main reasons for financial disasters
Four major types of risk
37. Probability that a random variable falls below a specified threshold level
CAPM (formula)
Debt overhang
Shortfall risk
Tax shield
38. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Operational risk
Roles of risk management
VaR- based analysis (formula)
Treynor measure
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.
Morningstar Rating System
Security (primary vs secondary)
3 main types of operational risk
Risk Management Irrelevance Proposition
40. 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
Kidder Peabody
Volatility Market risk
Sharpe measure
Differences in financial risk management for financial companies vs industrial companies
41. 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
Correlation coefficient effect on diversification
CAPM with taxes included (equation)
Shortcomings of risk metrics
CAPM assumption for EMH
42. Strategic risk - Business risk - Reputational risk
Risks excluded from operational risk
Basis risk
APT for passive portfolio management
Uncertainty
43. 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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44. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Practical considerations related to ERM implementatio
Operational risk
Options motivation on volatility
Security (primary vs secondary)
45. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Options motivation on volatility
Business risks
Uncertainty
EPD or ECOR - Expected Policyholder Deficit (EPD)
46. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Business risks
Three main reasons for financial disasters
Shape of portfolio possibilities curve
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
47. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
Solve for minimum variance portfolio
Market imperfections that can create value
Zero- beta CAPM (two factor model)
48. 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
APT for passive portfolio management
Nonmarketable asset impact on CAPM
Asset liquidity risk
Barings
49. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Firms becoming more sensitive to changes(bank deregulation)
Operational risk
Sortino ratio
Three main reasons for financial disasters
50. Wrong distribution - Historical sample may not apply
Three main reasons for financial disasters
Forms of Market risk
Ways risk can be mismeasured
What lead to the exponential growth to derivatives mkt?