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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. Multibeta CAPM Ri - Rf =
Liquidity risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Security (primary vs secondary)
Capital market line (CML)
2. Wrong distribution - Historical sample may not apply
Ways risk can be mismeasured
Jensen's alpha
Four major types of risk
Risks excluded from operational risk
3. 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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4. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Four major types of risk
3 main types of operational risk
Effect of heterogeneous expectations on CAPM
Financial risks
5. Probability distribution is unknown (ex. A terrorist attack)
Risk types addressed by ERM
What lead to the exponential growth to derivatives mkt?
Financial Risk
Uncertainty
6. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Debt overhang
Ways risk can be mismeasured
APT for passive portfolio management
EPD or ECOR - Expected Policyholder Deficit (EPD)
7. Both probability and cost of tail events are considered
EPD or ECOR - Expected Policyholder Deficit (EPD)
Treynor measure
Allied Irish Bank
Tail VaR or TCE - Tail Conditional Expectation(TCE)
8. Occurs the day when two parties exchange payments same day
Shortfall risk
Settlement risk
Correlation coefficient effect on diversification
Ways risk can be mismeasured
9. Ri = Rz + (Rm - Rz)*beta - Rz = return on zero- beta portfolio
Contango
Sortino ratio
Zero- beta CAPM (two factor model)
Asset liquidity risk
10. Prices of risk are common factors and do not change - Sensitivities can change
Correlation coefficient effect on diversification
Risk- adjusted performance measure (RAP)
Volatility Market risk
Prices of risk vs sensitivity
11. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Derivative contract
Four major types of risk
Security (primary vs secondary)
Recovery rate
12. When negative taxable income is moved to a different year to offset future or past taxable income
Nonmarketable asset impact on CAPM
Roles of risk management
Security (primary vs secondary)
Carry- backs and carry- forwards
13. Derives value from an underlying asset - rate - or index - Derives value from a security
Tracking error
Morningstar Rating System
Derivative contract
Four major types of risk
14. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Recovery rate
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Basic Market risk
Debt overhang
15. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Formula for covariance
Risk
APT in active portfolio management
Ri = ai + bi1l1 + bi2l2....+ei
16. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Four major types of risk
Financial risks
Allied Irish Bank
Sovereign risk
17. Misleading reporting (incorrect market info) - Due to large market moves - Due to conduct of customer business
Market risk
Debt overhang
Standard deviation of two assets
Three main reasons for financial disasters
18. Covariance = correlation coefficient std dev(a) std dev(b)
Basis risk
3 main types of operational risk
Formula for covariance
Solvency-related metrics
19. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Ri = ai + bi1l1 + bi2l2....+ei
CAPM assumption for EMH
Shape of portfolio possibilities curve
Information ratio
20. Returns on any stock are linearly related to a set of indexes
Ri = ai + bi1l1 + bi2l2....+ei
Multi- period version of CAPM
Solve for minimum variance portfolio
Nonparametric VaR
21. Quantile of a statistical distribution
Parametric VaR
VaR- based analysis (formula)
Forms of Market risk
Sharpe measure
22. 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 -
Contango
Exposure
Source of need for risk management
Asset transformers
23. 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
Options motivation on volatility
Capital market line (CML)
Debt overhang
Practical considerations related to ERM implementatio
24. 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
Traits of ERM
Effect of non- price- taking behavior on CAPM
Recovery rate
Importance of communication for risk managers
25. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Performance- related metrics
Standard deviation of two assets
CAPM (formula)
EPD or ECOR - Expected Policyholder Deficit (EPD)
26. 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
Business risks
Three main reasons for financial disasters
Credit event
Ways firms can fail to account for risks
27. The uses of debt to fall into a lower tax rate
Tax shield
Basis risk
Correlation coefficient effect on diversification
Effect of non- price- taking behavior on CAPM
28. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Contango
Kidder Peabody
Where is risk coming from
Efficient frontier
29. Absolute and relative risk - direction and non-directional
Kidder Peabody
Forms of Market risk
Funding liquidity risk
Drysdale Securities (Chase Manhattan)
30. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Solve for minimum variance portfolio
Funding liquidity risk
Probability of ruin
Effect of non- price- taking behavior on CAPM
31. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
CAPM assumption for EMH
Information ratio
Settlement risk
Nonmarketable asset impact on CAPM
32. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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33. Risk of loses owing to movements in level or volatility of market prices
Importance of communication for risk managers
Drysdale Securities (Chase Manhattan)
Market risk
Solve for minimum variance portfolio
34. Asset-liability/market-liquidity risk
Effect of non- price- taking behavior on CAPM
Liquidity risk
Zero- beta CAPM (two factor model)
Settlement risk
35. 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
Three main reasons for financial disasters
Effect of heterogeneous expectations on CAPM
Allied Irish Bank
Risk
36. Curve must be concave - Straight line connecting any two points must be under the curve
Shape of portfolio possibilities curve
Three main reasons for financial disasters
Contango
APT for passive portfolio management
37. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Nonparametric VaR
Risk types addressed by ERM
Differences in financial risk management for financial companies vs industrial companies
Models used in ERM framework
38. Cannot exit position in market due to size of the position
Business Risk
Kidder Peabody
Options motivation on volatility
Asset liquidity risk
39. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Valuation vs. Risk management
Risk
Prices of risk vs sensitivity
Carry- backs and carry- forwards
40. 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
Risk
Where is risk coming from
LTCM
41. Hazard - Financial - Operational - Strategic
Business risks
Risk types addressed by ERM
Nonmarketable asset impact on CAPM
Banker's Trust
42. 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
APT (equation and assumptions)
Expected return of two assets
Business Risk
Forms of Market risk
43. 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
Valuation vs. Risk management
EPD or ECOR - Expected Policyholder Deficit (EPD)
Risk
Ten assumptions underlying CAPM
44. Asses firm risks - Communicate risks - Manage and monitor risks
What lead to the exponential growth to derivatives mkt?
Roles of risk management
Derivative contract
Treynor measure
45. When two payments are exchanged the same day and one party may default after payment is made
Recovery rate
Settlement risk
Uncertainty
Sharpe measure
46. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Probability of ruin
Tracking error
Sharpe measure
Risk Management Irrelevance Proposition
47. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Market imperfections that can create value
Drysdale Securities (Chase Manhattan)
Capital market line (CML)
VaR - Value at Risk
48. Modeling approach is typically between statistical analytic models and structural simulation models
Models used in ERM framework
Effect of heterogeneous expectations on CAPM
Business Risk
Traits of ERM
49. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Exposure
Debt overhang
Standard deviation of two assets
Source of need for risk management
50. Probability that a random variable falls below a specified threshold level
Shortfall risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Nonparametric VaR
Performance- related metrics
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