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Test your basic knowledge |
FRM: Foundations Of Risk Management
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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. 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 -
Probability of ruin
APT (equation and assumptions)
EPD or ECOR - Expected Policyholder Deficit (EPD)
Source of need for risk management
2. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Ri = Rz + (gamma)(beta)
Sovereign risk
Sharpe measure
Options motivation on volatility
3. 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
Sovereign risk
Options motivation on volatility
Ri = Rz + (gamma)(beta)
Capital market line (CML)
4. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Correlation coefficient effect on diversification
Firms becoming more sensitive to changes(bank deregulation)
Market risk
Asset transformers
5. Strategic risk - Business risk - Reputational risk
Liquidity risk
Banker's Trust
Firms becoming more sensitive to changes(bank deregulation)
Risks excluded from operational risk
6. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
Formula for covariance
Basis
Basis risk
Morningstar Rating System
7. Unanticipated movements in relative prices of assets in hedged position
Shortcomings of risk metrics
Morningstar Rating System
Forms of Market risk
Basic Market risk
8. Xmvp = ((variance of b) - covariance)/((variance of a) + (variance of b) - 2 * covariance)
CAPM with taxes included (equation)
Zero- beta CAPM (two factor model)
Solve for minimum variance portfolio
VaR - Value at Risk
9. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Volatility Market risk
Morningstar Rating System
CAPM assumption for EMH
Sharpe measure
10. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Traits of ERM
Security (primary vs secondary)
Standard deviation of two assets
Risk Management Irrelevance Proposition
11. 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
Business Risk
Financial Risk
Settlement risk
BTR - Below Target Risk
12. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
Correlation coefficient effect on diversification
Ten assumptions underlying CAPM
CAPM with taxes included (equation)
Shortcomings of risk metrics
13. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Ways risk can be mismeasured
Source of need for risk management
Treynor measure
Basis risk
14. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
CAPM assumption for EMH
Information ratio
Forms of Market risk
Effect of non- price- taking behavior on CAPM
15. 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
Drysdale Securities (Chase Manhattan)
Effect of non- price- taking behavior on CAPM
Operational risk
Derivative contract
16. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Nonmarketable asset impact on CAPM
Solvency-related metrics
Morningstar Rating System
Asset transformers
17. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Forms of Market risk
Shortcomings of risk metrics
Debt overhang
APT in active portfolio management
18. Losses due to market activities ex. Interest rate changes or defaults
Risk Management Irrelevance Proposition
Capital market line (CML)
Financial risks
Tracking error
19. 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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20. Prices of risk are common factors and do not change - Sensitivities can change
Market imperfections that can create value
Firms becoming more sensitive to changes(bank deregulation)
Prices of risk vs sensitivity
Expected return of two assets
21. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
CAPM (formula)
CAPM assumption for EMH
BTR - Below Target Risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
22. Volatility of unexpected outcomes
Risk
Forms of Market risk
Nonmarketable asset impact on CAPM
APT in active portfolio management
23. Future price is greater than the spot price
Shortcomings of risk metrics
Recovery rate
Contango
Risk- adjusted performance measure (RAP)
24. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Business Risk
Contango
Sortino ratio
Allied Irish Bank
25. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Ways firms can fail to account for risks
Information ratio
Financial Risk
CAPM with taxes included (equation)
26. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Firms becoming more sensitive to changes(bank deregulation)
Security (primary vs secondary)
Ways risk can be mismeasured
Basic Market risk
27. Capital structure (financial distress) - Taxes - Agency and information asymmetries
What lead to the exponential growth to derivatives mkt?
Market imperfections that can create value
Forms of Market risk
Financial Risk
28. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Security (primary vs secondary)
Banker's Trust
RAR = relative return of portfolio (RRp)
Barings
29. The need to hedge against risks - for firms need to speculate.
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Models used in ERM framework
What lead to the exponential growth to derivatives mkt?
Source of need for risk management
30. 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
Ten assumptions underlying CAPM
Treynor measure
Debt overhang
Valuation vs. Risk management
31. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Practical considerations related to ERM implementatio
Financial risks
3 main types of operational risk
Operational risk
32. The uses of debt to fall into a lower tax rate
Probability of ruin
Efficient frontier
Tax shield
Credit event
33. Covariance = correlation coefficient std dev(a) std dev(b)
Ways risk can be mismeasured
Formula for covariance
Derivative contract
Debt overhang
34. Quantile of a statistical distribution
Risks excluded from operational risk
Solve for minimum variance portfolio
Parametric VaR
Shortfall risk
35. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Three main reasons for financial disasters
Security (primary vs secondary)
Effect of heterogeneous expectations on CAPM
Market imperfections that can create value
36. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Debt overhang
Asset liquidity risk
Funding liquidity risk
APT in active portfolio management
37. Probability that a random variable falls below a specified threshold level
Risks excluded from operational risk
VaR - Value at Risk
Practical considerations related to ERM implementatio
Shortfall risk
38. Curve must be concave - Straight line connecting any two points must be under the curve
Sovereign risk
Volatility Market risk
Shape of portfolio possibilities curve
Effect of non- price- taking behavior on CAPM
39. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
VaR- based analysis (formula)
Options motivation on volatility
Shortfall risk
Solvency-related metrics
40. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Performance- related metrics
Morningstar Rating System
Roles of risk management
Traits of ERM
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
Risk- adjusted performance measure (RAP)
Barings
Importance of communication for risk managers
Where is risk coming from
42. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Prices of risk vs sensitivity
Settlement risk
Risk
VaR - Value at Risk
43. Potential amount that can be lost
CAPM with taxes included (equation)
Shortfall risk
Settlement risk
Exposure
44. 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
Banker's Trust
Exposure
Shortcomings of risk metrics
Kidder Peabody
45. 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
Drysdale Securities (Chase Manhattan)
CAPM assumption for EMH
Probability of ruin
Basis
46. When two payments are exchanged the same day and one party may default after payment is made
Probability of ruin
Settlement risk
Financial risks
Options motivation on volatility
47. Expected value of unfavorable deviations of a random variable from a specified target level
APT (equation and assumptions)
Financial Risk
BTR - Below Target Risk
CAPM with taxes included (equation)
48. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
APT (equation and assumptions)
Business risks
EPD or ECOR - Expected Policyholder Deficit (EPD)
Business Risk
49. Derives value from an underlying asset - rate - or index - Derives value from a security
Tracking error
EPD or ECOR - Expected Policyholder Deficit (EPD)
Sovereign risk
Derivative contract
50. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
EPD or ECOR - Expected Policyholder Deficit (EPD)
What lead to the exponential growth to derivatives mkt?
Valuation vs. Risk management
Credit event
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