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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. Probability distribution is unknown (ex. A terrorist attack)
VaR- based analysis (formula)
Uncertainty
Capital market line (CML)
Four major types of risk
2. Asses firm risks - Communicate risks - Manage and monitor risks
Multi- period version of CAPM
Contango
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Roles of risk management
3. Market risk - Liquidity risk - Credit risk - Operational risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Four major types of risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
Solve for minimum variance portfolio
4. 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
LTCM
Three main reasons for financial disasters
Ways firms can fail to account for risks
Practical considerations related to ERM implementatio
5. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
3 main types of operational risk
Standard deviation of two assets
Solvency-related metrics
Volatility Market risk
6. Derives value from an underlying asset - rate - or index - Derives value from a security
Settlement risk
Drysdale Securities (Chase Manhattan)
Ways risk can be mismeasured
Derivative contract
7. Wrong distribution - Historical sample may not apply
Exposure
Ri = ai + bi1l1 + bi2l2....+ei
Options motivation on volatility
Ways risk can be mismeasured
8. Returns on any stock are linearly related to a set of indexes
APT for passive portfolio management
Exposure
Formula for covariance
Ri = ai + bi1l1 + bi2l2....+ei
9. 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
Information ratio
Shortfall risk
Drysdale Securities (Chase Manhattan)
Allied Irish Bank
10. The lower (closer to - 1) - the higher the payoff from diversification
Market imperfections that can create value
Financial risks
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Correlation coefficient effect on diversification
11. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Debt overhang
Options motivation on volatility
Information ratio
RAR = relative return of portfolio (RRp)
12. Covariance = correlation coefficient std dev(a) std dev(b)
Asset transformers
Formula for covariance
Risk types addressed by ERM
Information ratio
13. 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
Solvency-related metrics
Capital market line (CML)
Differences in financial risk management for financial companies vs industrial companies
Basis
14. Law of one price - Homogeneous expectations - Security returns process
APT (equation and assumptions)
Jensen's alpha
Tax shield
Traits of ERM
15. Cannot exit position in market due to size of the position
Asset liquidity risk
Forms of Market risk
Parametric VaR
Market imperfections that can create value
16. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Effect of heterogeneous expectations on CAPM
Nonparametric VaR
Banker's Trust
Correlation coefficient effect on diversification
17. Absolute and relative risk - direction and non-directional
Roles of risk management
Sovereign risk
Solvency-related metrics
Forms of Market risk
18. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Effect of non- price- taking behavior on CAPM
Zero- beta CAPM (two factor model)
Firms becoming more sensitive to changes(bank deregulation)
Three main reasons for financial disasters
19. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Ri = Rz + (gamma)(beta)
Settlement risk
Business Risk
Treynor measure
20. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Ri = ai + bi1l1 + bi2l2....+ei
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Risk
Nonparametric VaR
21. 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
Probability of ruin
CAPM with taxes included (equation)
Performance- related metrics
Where is risk coming from
22. Potential amount that can be lost
Morningstar Rating System
Asset liquidity risk
Exposure
Recovery rate
23. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Nonmarketable asset impact on CAPM
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Firms becoming more sensitive to changes(bank deregulation)
Expected return of two assets
24. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
Asset transformers
VaR - Value at Risk
Solve for minimum variance portfolio
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
25. Interest rate movements - derivatives - defaults
BTR - Below Target Risk
Where is risk coming from
Financial Risk
Tax shield
26. Prices of risk are common factors and do not change - Sensitivities can change
Allied Irish Bank
Prices of risk vs sensitivity
Parametric VaR
Funding liquidity risk
27. Inability to make payment obligations (ex. Margin calls)
Uncertainty
Effect of non- price- taking behavior on CAPM
Importance of communication for risk managers
Funding liquidity risk
28. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Shape of portfolio possibilities curve
Roles of risk management
Basis
Risks excluded from operational risk
29. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Differences in financial risk management for financial companies vs industrial companies
Debt overhang
Market imperfections that can create value
Sovereign risk
30. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
3 main types of operational risk
RAR = relative return of portfolio (RRp)
Tracking error
Volatility Market risk
31. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Risk- adjusted performance measure (RAP)
Multi- period version of CAPM
Information ratio
Ways firms can fail to account for risks
32. 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
Risk- adjusted performance measure (RAP)
LTCM
Ten assumptions underlying CAPM
CAPM (formula)
33. When two payments are exchanged the same day and one party may default after payment is made
Ri = Rz + (gamma)(beta)
Derivative contract
Probability of ruin
Settlement risk
34. Unanticipated movements in relative prices of assets in hedged position
Probability of ruin
Settlement risk
Basic Market risk
Market risk
35. 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
Drysdale Securities (Chase Manhattan)
Credit event
APT (equation and assumptions)
Practical considerations related to ERM implementatio
36. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
EPD or ECOR - Expected Policyholder Deficit (EPD)
Security (primary vs secondary)
APT (equation and assumptions)
Kidder Peabody
37. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
VaR- based analysis (formula)
Risks excluded from operational risk
Basis
Shape of portfolio possibilities curve
38. 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
Security (primary vs secondary)
Differences in financial risk management for financial companies vs industrial companies
APT for passive portfolio management
Shortcomings of risk metrics
39. When negative taxable income is moved to a different year to offset future or past taxable income
Carry- backs and carry- forwards
Morningstar Rating System
Where is risk coming from
3 main types of operational risk
40. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
CAPM with taxes included (equation)
Nonmarketable asset impact on CAPM
Source of need for risk management
Uncertainty
41. Both probability and cost of tail events are considered
APT in active portfolio management
Jensen's alpha
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Funding liquidity risk
42. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Options motivation on volatility
Importance of communication for risk managers
Nonparametric VaR
Standard deviation of two assets
43. The need to hedge against risks - for firms need to speculate.
Basis
Treynor measure
What lead to the exponential growth to derivatives mkt?
APT in active portfolio management
44. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Sortino ratio
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Derivative contract
Liquidity risk
45. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Volatility Market risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
LTCM
Carry- backs and carry- forwards
46. Return is linearly related to growth rate in consumption
Asset liquidity risk
Multi- period version of CAPM
RAR = relative return of portfolio (RRp)
Risk types addressed by ERM
47. Occurs the day when two parties exchange payments same day
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Basis risk
Security (primary vs secondary)
Settlement risk
48. Future price is greater than the spot price
Sortino ratio
Contango
Probability of ruin
Asset transformers
49. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Correlation coefficient effect on diversification
Funding liquidity risk
Sovereign risk
Tracking error
50. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Sovereign risk
Importance of communication for risk managers
Standard deviation of two assets
Ways firms can fail to account for risks