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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.
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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. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Basic Market risk
Nonmarketable asset impact on CAPM
VaR - Value at Risk
Effect of heterogeneous expectations on CAPM
2. Multibeta CAPM Ri - Rf =
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Shortcomings of risk metrics
Ri = ai + bi1l1 + bi2l2....+ei
Where is risk coming from
3. Derives value from an underlying asset - rate - or index - Derives value from a security
Derivative contract
Correlation coefficient effect on diversification
Zero- beta CAPM (two factor model)
CAPM with taxes included (equation)
4. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Asset liquidity risk
Effect of heterogeneous expectations on CAPM
Sortino ratio
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
5. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Recovery rate
Treynor measure
Sharpe measure
Parametric VaR
6. When two payments are exchanged the same day and one party may default after payment is made
CAPM assumption for EMH
Settlement risk
Multi- period version of CAPM
Prices of risk vs sensitivity
7. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Differences in financial risk management for financial companies vs industrial companies
Asset liquidity risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Effect of heterogeneous expectations on CAPM
8. Risk of loses owing to movements in level or volatility of market prices
Volatility Market risk
Zero- beta CAPM (two factor model)
Forms of Market risk
Market risk
9. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Differences in financial risk management for financial companies vs industrial companies
Treynor measure
Debt overhang
Forms of Market risk
10. May not scale over time- Historical data may be meaningless - Not designed to account for catastrophes - VaR says nothing about losses in excess of VaR - May not handle sudden illiquidity
Funding liquidity risk
Shortcomings of risk metrics
Settlement risk
Performance- related metrics
11. The need to hedge against risks - for firms need to speculate.
What lead to the exponential growth to derivatives mkt?
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Volatility Market risk
Sortino ratio
12. Asset-liability/market-liquidity risk
What lead to the exponential growth to derivatives mkt?
VaR - Value at Risk
Liquidity risk
Funding liquidity risk
13. Occurs the day when two parties exchange payments same day
Settlement risk
Firms becoming more sensitive to changes(bank deregulation)
Capital market line (CML)
CAPM (formula)
14. Unanticipated movements in relative prices of assets in hedged position
Barings
Traits of ERM
Basic Market risk
Market imperfections that can create value
15. Asses firm risks - Communicate risks - Manage and monitor risks
Debt overhang
Roles of risk management
Probability of ruin
CAPM assumption for EMH
16. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Risk- adjusted performance measure (RAP)
3 main types of operational risk
Models used in ERM framework
CAPM with taxes included (equation)
17. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
LTCM
Business risks
Risk- adjusted performance measure (RAP)
Ri = ai + bi1l1 + bi2l2....+ei
18. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
Ways risk can be mismeasured
Differences in financial risk management for financial companies vs industrial companies
CAPM (formula)
APT in active portfolio management
19. 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
Three main reasons for financial disasters
Debt overhang
VaR - Value at Risk
Ten assumptions underlying CAPM
20. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Effect of non- price- taking behavior on CAPM
Exposure
Basic Market risk
CAPM assumption for EMH
21. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Tracking error
Basic Market risk
CAPM (formula)
Expected return of two assets
22. 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
Effect of non- price- taking behavior on CAPM
Valuation vs. Risk management
Three main reasons for financial disasters
Formula for covariance
23. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Parametric VaR
Sortino ratio
Standard deviation of two assets
Credit event
24. Law of one price - Homogeneous expectations - Security returns process
Risk
Banker's Trust
APT (equation and assumptions)
Risk types addressed by ERM
25. 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
Financial risks
Parametric VaR
Ways firms can fail to account for risks
Treynor measure
26. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Risk- adjusted performance measure (RAP)
Options motivation on volatility
Four major types of risk
Risk
27. Cannot exit position in market due to size of the position
Asset liquidity risk
Capital market line (CML)
Business risks
RAR = relative return of portfolio (RRp)
28. 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
Risk
LTCM
Debt overhang
Practical considerations related to ERM implementatio
29. Probability that a random variable falls below a specified threshold level
Valuation vs. Risk management
Shortfall risk
Contango
Risk- adjusted performance measure (RAP)
30. Returns on any stock are linearly related to a set of indexes
Debt overhang
Credit event
Ri = ai + bi1l1 + bi2l2....+ei
Asset liquidity risk
31. The lower (closer to - 1) - the higher the payoff from diversification
BTR - Below Target Risk
Correlation coefficient effect on diversification
Business risks
Traits of ERM
32. Potential amount that can be lost
Exposure
Traits of ERM
Sovereign risk
Effect of heterogeneous expectations on CAPM
33. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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34. 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
Liquidity risk
Credit event
Probability of ruin
Sovereign risk
35. Relative portfolio risk (RRiskp) - Based on a one- month investment period
RAR = relative return of portfolio (RRp)
Correlation coefficient effect on diversification
What lead to the exponential growth to derivatives mkt?
Effect of non- price- taking behavior on CAPM
36. Future price is greater than the spot price
Roles of risk management
Contango
Importance of communication for risk managers
Standard deviation of two assets
37. Wrong distribution - Historical sample may not apply
Allied Irish Bank
CAPM with taxes included (equation)
Ways risk can be mismeasured
APT (equation and assumptions)
38. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
VaR - Value at Risk
LTCM
Asset transformers
APT (equation and assumptions)
39. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Security (primary vs secondary)
Information ratio
Ways firms can fail to account for risks
APT (equation and assumptions)
40. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Formula for covariance
Basic Market risk
Ri = Rz + (gamma)(beta)
What lead to the exponential growth to derivatives mkt?
41. 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
Standard deviation of two assets
Ways risk can be mismeasured
Roles of risk management
42. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Multi- period version of CAPM
Market imperfections that can create value
Sovereign risk
Effect of non- price- taking behavior on CAPM
43. 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
EPD or ECOR - Expected Policyholder Deficit (EPD)
Allied Irish Bank
Performance- related metrics
Barings
44. 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
Three main reasons for financial disasters
Traits of ERM
Ways firms can fail to account for risks
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
45. Modeling approach is typically between statistical analytic models and structural simulation models
Financial risks
Effect of non- price- taking behavior on CAPM
Models used in ERM framework
What lead to the exponential growth to derivatives mkt?
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
Basis risk
Parametric VaR
CAPM (formula)
Drysdale Securities (Chase Manhattan)
47. Expected value of unfavorable deviations of a random variable from a specified target level
BTR - Below Target Risk
Where is risk coming from
Kidder Peabody
Ways risk can be mismeasured
48. Strategic risk - Business risk - Reputational risk
Risks excluded from operational risk
What lead to the exponential growth to derivatives mkt?
Funding liquidity risk
Business Risk
49. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
CAPM assumption for EMH
Effect of non- price- taking behavior on CAPM
Drysdale Securities (Chase Manhattan)
Asset liquidity risk
50. The uses of debt to fall into a lower tax rate
Tax shield
Ri = ai + bi1l1 + bi2l2....+ei
Where is risk coming from
Volatility Market risk
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