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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.
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. 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
APT in active portfolio management
What lead to the exponential growth to derivatives mkt?
Probability of ruin
Risk Management Irrelevance Proposition
2. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Performance- related metrics
Kidder Peabody
Market imperfections that can create value
Solve for minimum variance portfolio
3. Strategic risk - Business risk - Reputational risk
Shortfall risk
Credit event
Risks excluded from operational risk
Debt overhang
4. Difference between forward price and spot price - Should approach zero as the contract approaches maturity
3 main types of operational risk
Capital market line (CML)
Where is risk coming from
Basis
5. Potential amount that can be lost
Security (primary vs secondary)
Ways firms can fail to account for risks
Exposure
Basic Market risk
6. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Operational risk
Risk
Credit event
Derivative contract
7. 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 -
Risk
Shortcomings of risk metrics
Debt overhang
Source of need for risk management
8. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Solvency-related metrics
Barings
Risk
Recovery rate
9. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Market risk
Business Risk
Risk- adjusted performance measure (RAP)
CAPM (formula)
10. Asses firm risks - Communicate risks - Manage and monitor risks
Contango
Correlation coefficient effect on diversification
Ways firms can fail to account for risks
Roles of risk management
11. Prices of risk are common factors and do not change - Sensitivities can change
Effect of heterogeneous expectations on CAPM
Prices of risk vs sensitivity
Importance of communication for risk managers
CAPM with taxes included (equation)
12. Return is linearly related to growth rate in consumption
What lead to the exponential growth to derivatives mkt?
Multi- period version of CAPM
Morningstar Rating System
Barings
13. Concave function that extends from minimum variance portfolio to maximum return portfolio
Carry- backs and carry- forwards
Allied Irish Bank
Efficient frontier
Traits of ERM
14. Gamma = market price of the consumption beta - Beta = E(r) of zero consumption beta
Differences in financial risk management for financial companies vs industrial companies
Roles of risk management
VaR- based analysis (formula)
Ri = Rz + (gamma)(beta)
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
APT for passive portfolio management
Drysdale Securities (Chase Manhattan)
Ways firms can fail to account for risks
Solve for minimum variance portfolio
16. 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
Ri = Rz + (gamma)(beta)
Nonmarketable asset impact on CAPM
Exposure
APT for passive portfolio management
17. The lower (closer to - 1) - the higher the payoff from diversification
Shortcomings of risk metrics
Ten assumptions underlying CAPM
Correlation coefficient effect on diversification
Uncertainty
18. Covariance = correlation coefficient std dev(a) std dev(b)
Parametric VaR
Efficient frontier
Settlement risk
Formula for covariance
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. When two payments are exchanged the same day and one party may default after payment is made
Options motivation on volatility
Kidder Peabody
Market risk
Settlement risk
21. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Solvency-related metrics
Security (primary vs secondary)
Valuation vs. Risk management
Effect of heterogeneous expectations on CAPM
22. Expected value of unfavorable deviations of a random variable from a specified target level
Basis
BTR - Below Target Risk
Risk
Nonparametric VaR
23. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Debt overhang
Security (primary vs secondary)
Formula for covariance
Asset liquidity risk
24. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Asset liquidity risk
Parametric VaR
Debt overhang
Market imperfections that can create value
25. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
VaR - Value at Risk
Information ratio
Risk- adjusted performance measure (RAP)
Nonmarketable asset impact on CAPM
26. Country specific - Foreign exchange controls that prohibit counterparty's obligations
Sovereign risk
Shortcomings of risk metrics
Forms of Market risk
Capital market line (CML)
27. Need to assess risk and tell management so they can determine which risks to take on
Effect of non- price- taking behavior on CAPM
Market imperfections that can create value
Importance of communication for risk managers
Financial risks
28. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Zero- beta CAPM (two factor model)
Treynor measure
Carry- backs and carry- forwards
Asset transformers
29. When negative taxable income is moved to a different year to offset future or past taxable income
Carry- backs and carry- forwards
Models used in ERM framework
Treynor measure
Risk
30. Unanticipated movements in relative prices of assets in hedged position
3 main types of operational risk
Asset transformers
Basic Market risk
Forms of Market risk
31. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Practical considerations related to ERM implementatio
Ways risk can be mismeasured
Morningstar Rating System
Standard deviation of two assets
32. Simple form of CAPM - but market price of risk is lower than if all investors were price takers
Performance- related metrics
Effect of non- price- taking behavior on CAPM
Tracking error
Financial Risk
33. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Basis risk
Financial Risk
VaR- based analysis (formula)
EPD or ECOR - Expected Policyholder Deficit (EPD)
34. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Probability of ruin
Tax shield
Sharpe measure
3 main types of operational risk
35. 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
Barings
Formula for covariance
Where is risk coming from
Settlement risk
36. Asset-liability/market-liquidity risk
Where is risk coming from
Risk
Liquidity risk
Practical considerations related to ERM implementatio
37. Cannot exit position in market due to size of the position
VaR- based analysis (formula)
Nonparametric VaR
EPD or ECOR - Expected Policyholder Deficit (EPD)
Asset liquidity risk
38. Occurs the day when two parties exchange payments same day
Ri = Rz + (gamma)(beta)
Shape of portfolio possibilities curve
Settlement risk
Four major types of risk
39. Risk of loses owing to movements in level or volatility of market prices
Market risk
Roles of risk management
Asset transformers
Contango
40. Wrong distribution - Historical sample may not apply
VaR- based analysis (formula)
APT (equation and assumptions)
Ways risk can be mismeasured
Business risks
41. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Market risk
Information ratio
Asset transformers
Firms becoming more sensitive to changes(bank deregulation)
42. 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
Settlement risk
Information ratio
Tracking error
Valuation vs. Risk management
43. Law of one price - Homogeneous expectations - Security returns process
Importance of communication for risk managers
Carry- backs and carry- forwards
APT (equation and assumptions)
Differences in financial risk management for financial companies vs industrial companies
44. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
Correlation coefficient effect on diversification
Standard deviation of two assets
Market risk
Firms becoming more sensitive to changes(bank deregulation)
45. Changes in vol - implied or actual
Shortfall risk
Volatility Market risk
Ways firms can fail to account for risks
Tracking error
46. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Ten assumptions underlying CAPM
Risk Management Irrelevance Proposition
Risk- adjusted performance measure (RAP)
Correlation coefficient effect on diversification
47. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
Kidder Peabody
Basis risk
Options motivation on volatility
Nonparametric VaR
48. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Basis risk
Basic Market risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Settlement risk
49. 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.
Risk Management Irrelevance Proposition
CAPM (formula)
Standard deviation of two assets
What lead to the exponential growth to derivatives mkt?
50. Probability that a random variable falls below a specified threshold level
Shortfall risk
What lead to the exponential growth to derivatives mkt?
Practical considerations related to ERM implementatio
Ten assumptions underlying CAPM