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Test your basic knowledge |
FRM: Foundations Of Risk Management
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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. Changes in vol - implied or actual
Basis risk
Capital market line (CML)
Exposure
Volatility Market risk
2. 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
3. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Ten assumptions underlying CAPM
Efficient frontier
Shortcomings of risk metrics
Sovereign risk
4. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Four major types of risk
Models used in ERM framework
Banker's Trust
Debt overhang
5. Cannot exit position in market due to size of the position
Performance- related metrics
Tail VaR or TCE - Tail Conditional Expectation(TCE)
RAR = relative return of portfolio (RRp)
Asset liquidity risk
6. Quantile of an empirical distribution
Nonparametric VaR
VaR - Value at Risk
VaR- based analysis (formula)
Information ratio
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
Ways risk can be mismeasured
Probability of ruin
CAPM (formula)
Recovery rate
8. Prices of risk are common factors and do not change - Sensitivities can change
Market risk
Prices of risk vs sensitivity
Effect of non- price- taking behavior on CAPM
VaR- based analysis (formula)
9. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Standard deviation of two assets
Business risks
VaR- based analysis (formula)
Risk types addressed by ERM
10. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Options motivation on volatility
Funding liquidity risk
Barings
Basis
11. 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 -
Performance- related metrics
Exposure
Uncertainty
Source of need for risk management
12. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Where is risk coming from
EPD or ECOR - Expected Policyholder Deficit (EPD)
Risk types addressed by ERM
Business risks
13. 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
Effect of heterogeneous expectations on CAPM
What lead to the exponential growth to derivatives mkt?
Drysdale Securities (Chase Manhattan)
VaR- based analysis (formula)
14. 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
Banker's Trust
Asset transformers
Ten assumptions underlying CAPM
Volatility Market risk
15. 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
3 main types of operational risk
Zero- beta CAPM (two factor model)
Security (primary vs secondary)
Traits of ERM
16. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Shortfall risk
APT in active portfolio management
Risks excluded from operational risk
Solvency-related metrics
17. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
APT for passive portfolio management
Effect of heterogeneous expectations on CAPM
Financial Risk
Basis risk
18. The uses of debt to fall into a lower tax rate
Tax shield
LTCM
Risk Management Irrelevance Proposition
Probability of ruin
19. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Importance of communication for risk managers
Morningstar Rating System
Performance- related metrics
VaR- based analysis (formula)
20. Expected value of unfavorable deviations of a random variable from a specified target level
BTR - Below Target Risk
Settlement risk
Credit event
Formula for covariance
21. Concave function that extends from minimum variance portfolio to maximum return portfolio
Shape of portfolio possibilities curve
Efficient frontier
Debt overhang
Prices of risk vs sensitivity
22. Wrong distribution - Historical sample may not apply
Settlement risk
Drysdale Securities (Chase Manhattan)
Ways risk can be mismeasured
Barings
23. 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
Risk- adjusted performance measure (RAP)
Derivative contract
Prices of risk vs sensitivity
Allied Irish Bank
24. When two payments are exchanged the same day and one party may default after payment is made
Settlement risk
Ways risk can be mismeasured
BTR - Below Target Risk
Parametric VaR
25. Losses due to market activities ex. Interest rate changes or defaults
Financial risks
CAPM assumption for EMH
APT (equation and assumptions)
Effect of non- price- taking behavior on CAPM
26. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Shortcomings of risk metrics
CAPM assumption for EMH
Practical considerations related to ERM implementatio
Models used in ERM framework
27. Risk of loses owing to movements in level or volatility of market prices
Market risk
Recovery rate
Shortfall risk
CAPM with taxes included (equation)
28. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Contango
Risks excluded from operational risk
Settlement risk
Sortino ratio
29. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
Allied Irish Bank
CAPM with taxes included (equation)
Models used in ERM framework
Tax shield
30. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Information ratio
Capital market line (CML)
Practical considerations related to ERM implementatio
Risk- adjusted performance measure (RAP)
31. Probability that a random variable falls below a specified threshold level
Shortfall risk
Ways risk can be mismeasured
Expected return of two assets
CAPM (formula)
32. Strategic risk - Business risk - Reputational risk
Debt overhang
Risks excluded from operational risk
Shortfall risk
Ri = Rz + (gamma)(beta)
33. Need to assess risk and tell management so they can determine which risks to take on
Shape of portfolio possibilities curve
Tax shield
Importance of communication for risk managers
APT for passive portfolio management
34. Returns on any stock are linearly related to a set of indexes
Information ratio
Drysdale Securities (Chase Manhattan)
Shortfall risk
Ri = ai + bi1l1 + bi2l2....+ei
35. Hazard - Financial - Operational - Strategic
Debt overhang
Risk Management Irrelevance Proposition
Risk types addressed by ERM
Valuation vs. Risk management
36. Relative portfolio risk (RRiskp) - Based on a one- month investment period
Traits of ERM
Settlement risk
RAR = relative return of portfolio (RRp)
Basis
37. Multibeta CAPM Ri - Rf =
Funding liquidity risk
Morningstar Rating System
Forms of Market risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
38. 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
Probability of ruin
Barings
Source of need for risk management
Funding liquidity risk
39. Rp = XaRa + XbRb
EPD or ECOR - Expected Policyholder Deficit (EPD)
Risk
Asset transformers
Expected return of two assets
40. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Effect of non- price- taking behavior on CAPM
Ten assumptions underlying CAPM
Contango
Kidder Peabody
41. 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
Basis risk
Capital market line (CML)
Ways risk can be mismeasured
Standard deviation of two assets
42. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Market imperfections that can create value
Financial Risk
Risk- adjusted performance measure (RAP)
Exposure
43. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Banker's Trust
Security (primary vs secondary)
Source of need for risk management
Risk
44. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
RAR = relative return of portfolio (RRp)
Risk types addressed by ERM
Performance- related metrics
Morningstar Rating System
45. 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
Kidder Peabody
Drysdale Securities (Chase Manhattan)
Volatility Market risk
Settlement risk
46. 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
Security (primary vs secondary)
Practical considerations related to ERM implementatio
Sovereign risk
Multi- period version of CAPM
47. Return is linearly related to growth rate in consumption
Shape of portfolio possibilities curve
Drysdale Securities (Chase Manhattan)
APT in active portfolio management
Multi- period version of CAPM
48. Future price is greater than the spot price
Ten assumptions underlying CAPM
Source of need for risk management
Risk types addressed by ERM
Contango
49. Asses firm risks - Communicate risks - Manage and monitor risks
Roles of risk management
Risk
Formula for covariance
Sortino ratio
50. Std dev between portfolio return and benchmark return TE = std dev * (Rp- Rb) - Benchmark funds
Tracking error
Nonmarketable asset impact on CAPM
Risk
Carry- backs and carry- forwards