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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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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 of loses owing to movements in level or volatility of market prices
Probability of ruin
Tracking error
Ri = Rz + (gamma)(beta)
Market risk
2. Curve must be concave - Straight line connecting any two points must be under the curve
Shape of portfolio possibilities curve
Differences in financial risk management for financial companies vs industrial companies
Barings
Zero- beta CAPM (two factor model)
3. 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
CAPM with taxes included (equation)
Traits of ERM
Models used in ERM framework
APT for passive portfolio management
4. Probability distribution is unknown (ex. A terrorist attack)
Performance- related metrics
Nonmarketable asset impact on CAPM
Uncertainty
CAPM assumption for EMH
5. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Correlation coefficient effect on diversification
RAR = relative return of portfolio (RRp)
Sharpe measure
Solvency-related metrics
6. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
Ri = ai + bi1l1 + bi2l2....+ei
Funding liquidity risk
Derivative contract
7. 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
Shape of portfolio possibilities curve
Financial Risk
Settlement risk
8. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
CAPM with taxes included (equation)
Settlement risk
Differences in financial risk management for financial companies vs industrial companies
Firms becoming more sensitive to changes(bank deregulation)
9. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Information ratio
Traits of ERM
Market imperfections that can create value
LTCM
10. When two payments are exchanged the same day and one party may default after payment is made
Nonparametric VaR
Debt overhang
Basis risk
Settlement risk
11. Interest rate movements - derivatives - defaults
Ri = Rz + (gamma)(beta)
Financial Risk
Formula for covariance
Nonparametric VaR
12. Both probability and cost of tail events are considered
Tax shield
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Performance- related metrics
CAPM assumption for EMH
13. Market risk - Liquidity risk - Credit risk - Operational risk
Solvency-related metrics
Uncertainty
Nonmarketable asset impact on CAPM
Four major types of risk
14. Modeling approach is typically between statistical analytic models and structural simulation models
Ten assumptions underlying CAPM
Traits of ERM
Settlement risk
Models used in ERM framework
15. 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)
Shortcomings of risk metrics
VaR- based analysis (formula)
Settlement risk
16. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
APT in active portfolio management
Four major types of risk
Ways firms can fail to account for risks
Recovery rate
17. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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18. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Risk types addressed by ERM
Where is risk coming from
VaR- based analysis (formula)
Sovereign risk
19. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Operational risk
EPD or ECOR - Expected Policyholder Deficit (EPD)
Credit event
Effect of heterogeneous expectations on CAPM
20. Need to assess risk and tell management so they can determine which risks to take on
Jensen's alpha
Valuation vs. Risk management
Shortfall risk
Importance of communication for risk managers
21. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Sovereign risk
Risk types addressed by ERM
Importance of communication for risk managers
Where is risk coming from
22. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Performance- related metrics
Contango
Tax shield
Market imperfections that can create value
23. Changes in vol - implied or actual
Tax shield
Market risk
Volatility Market risk
Nonmarketable asset impact on CAPM
24. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
Expected return of two assets
Asset liquidity risk
CAPM with taxes included (equation)
Efficient frontier
25. Future price is greater than the spot price
Market risk
Contango
APT (equation and assumptions)
RAR = relative return of portfolio (RRp)
26. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Source of need for risk management
Three main reasons for financial disasters
Market risk
CAPM with taxes included (equation)
27. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Expected return of two assets
Standard deviation of two assets
Debt overhang
Credit event
28. Quantile of an empirical distribution
Liquidity risk
Nonparametric VaR
Risk types addressed by ERM
LTCM
29. Cannot exit position in market due to size of the position
Asset liquidity risk
Solvency-related metrics
Formula for covariance
Valuation vs. Risk management
30. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
CAPM with taxes included (equation)
APT (equation and assumptions)
Solvency-related metrics
Effect of non- price- taking behavior on CAPM
31. 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
Firms becoming more sensitive to changes(bank deregulation)
APT for passive portfolio management
Multi- period version of CAPM
LTCM
32. Law of one price - Homogeneous expectations - Security returns process
Market risk
Risk
Tracking error
APT (equation and assumptions)
33. 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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34. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
What lead to the exponential growth to derivatives mkt?
Credit event
Treynor measure
Risk Management Irrelevance Proposition
35. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Tracking error
APT (equation and assumptions)
Basis
Debt overhang
36. 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
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Capital market line (CML)
Prices of risk vs sensitivity
Risk
37. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Effect of non- price- taking behavior on CAPM
Basis
Risks excluded from operational risk
Contango
38. Losses due to market activities ex. Interest rate changes or defaults
What lead to the exponential growth to derivatives mkt?
Financial risks
Settlement risk
VaR - Value at Risk
39. Asses firm risks - Communicate risks - Manage and monitor risks
Roles of risk management
CAPM with taxes included (equation)
Operational risk
Nonparametric VaR
40. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Jensen's alpha
Treynor measure
Market imperfections that can create value
Standard deviation of two assets
41. Inability to make payment obligations (ex. Margin calls)
Business Risk
Nonmarketable asset impact on CAPM
Funding liquidity risk
Solve for minimum variance portfolio
42. 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
Sharpe measure
Kidder Peabody
Contango
Nonmarketable asset impact on CAPM
43. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Financial risks
Effect of non- price- taking behavior on CAPM
Derivative contract
Treynor measure
44. Asset-liability/market-liquidity risk
Liquidity risk
Sovereign risk
Nonmarketable asset impact on CAPM
Treynor measure
45. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Funding liquidity risk
Risks excluded from operational risk
Options motivation on volatility
Zero- beta CAPM (two factor model)
46. 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
Ways firms can fail to account for risks
Differences in financial risk management for financial companies vs industrial companies
Drysdale Securities (Chase Manhattan)
Traits of ERM
47. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Basis risk
Basis
Information ratio
Sovereign risk
48. Returns on any stock are linearly related to a set of indexes
Multi- period version of CAPM
Ri = ai + bi1l1 + bi2l2....+ei
VaR- based analysis (formula)
Solve for minimum variance portfolio
49. Rp = XaRa + XbRb
Morningstar Rating System
Expected return of two assets
Business risks
What lead to the exponential growth to derivatives mkt?
50. Firms became multinational - - >watched xchange rates more - deregulation and globalization
APT (equation and assumptions)
Roles of risk management
Firms becoming more sensitive to changes(bank deregulation)
Credit event