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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. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Sharpe measure
Forms of Market risk
Firms becoming more sensitive to changes(bank deregulation)
Performance- related metrics
2. Expected value of unfavorable deviations of a random variable from a specified target level
BTR - Below Target Risk
Credit event
Options motivation on volatility
Exposure
3. Wrong distribution - Historical sample may not apply
Ways risk can be mismeasured
CAPM (formula)
Contango
Uncertainty
4. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Settlement risk
Performance- related metrics
Ri = Rz + (gamma)(beta)
APT in active portfolio management
5. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Operational risk
Liquidity risk
Security (primary vs secondary)
Performance- related metrics
6. The lower (closer to - 1) - the higher the payoff from diversification
Asset transformers
Differences in financial risk management for financial companies vs industrial companies
Risks excluded from operational risk
Correlation coefficient effect on diversification
7. Interest rate movements - derivatives - defaults
Solve for minimum variance portfolio
Performance- related metrics
Credit event
Financial Risk
8. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
APT in active portfolio management
Banker's Trust
Jensen's alpha
Financial risks
9. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Market imperfections that can create value
Effect of non- price- taking behavior on CAPM
Ten assumptions underlying CAPM
Risk types addressed by ERM
10. Quantile of an empirical distribution
Nonparametric VaR
Recovery rate
Derivative contract
Traits of ERM
11. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Practical considerations related to ERM implementatio
Multi- period version of CAPM
Funding liquidity risk
Risk- adjusted performance measure (RAP)
12. 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
Shortfall risk
Three main reasons for financial disasters
Funding liquidity risk
Traits of ERM
13. 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
Forms of Market risk
Risk
Sovereign risk
14. 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
Capital market line (CML)
Correlation coefficient effect on diversification
Formula for covariance
Drysdale Securities (Chase Manhattan)
15. 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.
Ten assumptions underlying CAPM
Risk Management Irrelevance Proposition
EPD or ECOR - Expected Policyholder Deficit (EPD)
LTCM
16. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Uncertainty
Zero- beta CAPM (two factor model)
Debt overhang
Valuation vs. Risk management
17. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Sharpe measure
What lead to the exponential growth to derivatives mkt?
Differences in financial risk management for financial companies vs industrial companies
Four major types of risk
18. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
VaR- based analysis (formula)
Parametric VaR
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Source of need for risk management
19. 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
Asset liquidity risk
Basis risk
Forms of Market risk
Capital market line (CML)
20. 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
Carry- backs and carry- forwards
Allied Irish Bank
Expected return of two assets
Shortfall risk
21. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Credit event
Correlation coefficient effect on diversification
Contango
Business risks
22. Occurs the day when two parties exchange payments same day
Effect of heterogeneous expectations on CAPM
Allied Irish Bank
Settlement risk
Kidder Peabody
23. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Morningstar Rating System
Valuation vs. Risk management
Traits of ERM
3 main types of operational risk
24. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Risk Management Irrelevance Proposition
Tracking error
Where is risk coming from
CAPM (formula)
25. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Firms becoming more sensitive to changes(bank deregulation)
Treynor measure
3 main types of operational risk
Debt overhang
26. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Parametric VaR
CAPM assumption for EMH
Four major types of risk
Volatility Market risk
27. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
CAPM assumption for EMH
Information ratio
Tracking error
Effect of heterogeneous expectations on CAPM
28. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Four major types of risk
Security (primary vs secondary)
Basis
EPD or ECOR - Expected Policyholder Deficit (EPD)
29. 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
Carry- backs and carry- forwards
Formula for covariance
Nonparametric VaR
Kidder Peabody
30. The need to hedge against risks - for firms need to speculate.
Four major types of risk
Solve for minimum variance portfolio
Banker's Trust
What lead to the exponential growth to derivatives mkt?
31. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Forms of Market risk
Security (primary vs secondary)
Recovery rate
Business risks
32. When two payments are exchanged the same day and one party may default after payment is made
Exposure
Firms becoming more sensitive to changes(bank deregulation)
Settlement risk
Shortcomings of risk metrics
33. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Efficient frontier
Information ratio
Solvency-related metrics
Four major types of risk
34. 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
Treynor measure
Business Risk
Carry- backs and carry- forwards
Where is risk coming from
35. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Firms becoming more sensitive to changes(bank deregulation)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Financial Risk
Morningstar Rating System
36. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Valuation vs. Risk management
Recovery rate
Tracking error
Parametric VaR
37. 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
Allied Irish Bank
Nonmarketable asset impact on CAPM
Efficient frontier
Practical considerations related to ERM implementatio
38. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Information ratio
CAPM with taxes included (equation)
Operational risk
Settlement risk
39. When negative taxable income is moved to a different year to offset future or past taxable income
Market risk
Carry- backs and carry- forwards
Source of need for risk management
Expected return of two assets
40. Potential amount that can be lost
3 main types of operational risk
Asset transformers
Kidder Peabody
Exposure
41. 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
CAPM with taxes included (equation)
Solve for minimum variance portfolio
Barings
Options motivation on volatility
42. Market risk - Liquidity risk - Credit risk - Operational risk
Settlement risk
Business Risk
Four major types of risk
Solve for minimum variance portfolio
43. Probability that a random variable falls below a specified threshold level
Shortfall risk
Differences in financial risk management for financial companies vs industrial companies
Operational risk
Debt overhang
44. Returns on any stock are linearly related to a set of indexes
Three main reasons for financial disasters
Risk
Ri = ai + bi1l1 + bi2l2....+ei
Treynor measure
45. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
VaR - Value at Risk
Information ratio
Importance of communication for risk managers
Shortfall risk
46. 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
Operational risk
Source of need for risk management
Valuation vs. Risk management
Shortfall risk
47. Return is linearly related to growth rate in consumption
Multi- period version of CAPM
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
LTCM
Expected return of two assets
48. Volatility of unexpected outcomes
Exposure
Risk
Three main reasons for financial disasters
Risk types addressed by ERM
49. The uses of debt to fall into a lower tax rate
Efficient frontier
Performance- related metrics
Tax shield
RAR = relative return of portfolio (RRp)
50. 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
Risk types addressed by ERM
Forms of Market risk
Carry- backs and carry- forwards
APT for passive portfolio management
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