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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.
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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. Liquidity and maturity transformation - Brokers - Reduces transaction and information costs between households and corporations
Asset transformers
Ri = ai + bi1l1 + bi2l2....+ei
Traits of ERM
Drysdale Securities (Chase Manhattan)
2. 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
Uncertainty
Standard deviation of two assets
Asset liquidity risk
3. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Zero- beta CAPM (two factor model)
Barings
Business Risk
Risk- adjusted performance measure (RAP)
4. Both probability and cost of tail events are considered
Debt overhang
Recovery rate
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Basis risk
5. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Options motivation on volatility
Liquidity risk
Funding liquidity risk
Credit event
6. Occurs the day when two parties exchange payments same day
Basis
Risk
Settlement risk
Models used in ERM framework
7. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Risk- adjusted performance measure (RAP)
CAPM with taxes included (equation)
APT (equation and assumptions)
Solvency-related metrics
8. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
CAPM (formula)
CAPM assumption for EMH
Effect of non- price- taking behavior on CAPM
Nonmarketable asset impact on CAPM
9. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Solve for minimum variance portfolio
CAPM assumption for EMH
EPD or ECOR - Expected Policyholder Deficit (EPD)
Basis
10. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
BTR - Below Target Risk
Market risk
Business risks
Risks excluded from operational risk
11. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
Performance- related metrics
Risk
Ways firms can fail to account for risks
Four major types of risk
12. Interest rate movements - derivatives - defaults
Security (primary vs secondary)
Sortino ratio
Financial Risk
Basis
13. Excess return divided by portfolio volatility (std dev) Sp = (E(Rp) - Rf)/(std dev of Rp) - Better for non- diversified portfolios
Solvency-related metrics
Expected return of two assets
Sharpe measure
Multi- period version of CAPM
14. Too much debt - Causes shareholders to seek projects that create short term capital but long term losses
Kidder Peabody
Parametric VaR
Debt overhang
Risk- adjusted performance measure (RAP)
15. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
APT (equation and assumptions)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Operational risk
Models used in ERM framework
16. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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17. Returns on any stock are linearly related to a set of indexes
BTR - Below Target Risk
Risk
Ri = ai + bi1l1 + bi2l2....+ei
Financial Risk
18. IR = (E(Rp) - E(Rb))/(std dev(Rp- Rb)) - Evaluate manager of a benchmark fund
Sortino ratio
Risk Management Irrelevance Proposition
Information ratio
Settlement risk
19. 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
Capital market line (CML)
Basis
Source of need for risk management
Expected return of two assets
20. 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)
Risk types addressed by ERM
Firms becoming more sensitive to changes(bank deregulation)
Probability of ruin
21. Potential amount that can be lost
Financial risks
Business Risk
Exposure
Market risk
22. Long in options = expecting volatility increase - Short in options = expecting volatility decrease
VaR- based analysis (formula)
Settlement risk
Options motivation on volatility
Sortino ratio
23. Prices of risk are common factors and do not change - Sensitivities can change
Basis
Carry- backs and carry- forwards
Kidder Peabody
Prices of risk vs sensitivity
24. 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
Effect of heterogeneous expectations on CAPM
Settlement risk
Barings
VaR - Value at Risk
25. Volatility of unexpected outcomes
3 main types of operational risk
Risk
Probability of ruin
Risk Management Irrelevance Proposition
26. Risk- adjusted rating (RAR) - Difference between relative returns and relative risk
Debt overhang
CAPM with taxes included (equation)
Basic Market risk
Morningstar Rating System
27. 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
Nonmarketable asset impact on CAPM
Probability of ruin
Ri = Rz + (gamma)(beta)
28. Equilibrium can still be expressed in returns - covariance - and variance - but they become complex weighted averages
Shortcomings of risk metrics
Zero- beta CAPM (two factor model)
Models used in ERM framework
Effect of heterogeneous expectations on CAPM
29. CAPM requires the strong form of the Efficient Market Hypothesis = private information
CAPM with taxes included (equation)
CAPM assumption for EMH
What lead to the exponential growth to derivatives mkt?
Probability of ruin
30. Curve must be concave - Straight line connecting any two points must be under the curve
Sharpe measure
Shape of portfolio possibilities curve
Funding liquidity risk
Derivative contract
31. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Risk
Firms becoming more sensitive to changes(bank deregulation)
Shortfall risk
Multi- period version of CAPM
32. 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
Four major types of risk
Source of need for risk management
Shortcomings of risk metrics
Correlation coefficient effect on diversification
33. 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 in active portfolio management
Efficient frontier
Drysdale Securities (Chase Manhattan)
APT for passive portfolio management
34. Expected value of unfavorable deviations of a random variable from a specified target level
BTR - Below Target Risk
Credit event
Zero- beta CAPM (two factor model)
Risk Management Irrelevance Proposition
35. 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
3 main types of operational risk
What lead to the exponential growth to derivatives mkt?
Volatility Market risk
36. Losses due to market activities ex. Interest rate changes or defaults
What lead to the exponential growth to derivatives mkt?
Financial risks
Nonmarketable asset impact on CAPM
Banker's Trust
37. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Source of need for risk management
Solvency-related metrics
APT (equation and assumptions)
Debt overhang
38. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Nonmarketable asset impact on CAPM
Allied Irish Bank
Volatility Market risk
VaR- based analysis (formula)
39. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
APT in active portfolio management
Business Risk
Funding liquidity risk
Sortino ratio
40. Wrong distribution - Historical sample may not apply
Ways risk can be mismeasured
Risk- adjusted performance measure (RAP)
Ri = ai + bi1l1 + bi2l2....+ei
Debt overhang
41. Market risk - Liquidity risk - Credit risk - Operational risk
Solvency-related metrics
Four major types of risk
Carry- backs and carry- forwards
Three main reasons for financial disasters
42. Derives value from an underlying asset - rate - or index - Derives value from a security
Capital market line (CML)
Derivative contract
Financial risks
Risk
43. Probability distribution is unknown (ex. A terrorist attack)
Uncertainty
Differences in financial risk management for financial companies vs industrial companies
Operational risk
VaR - Value at Risk
44. The uses of debt to fall into a lower tax rate
Tax shield
Ri = Rz + (gamma)(beta)
Business risks
Basis risk
45. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
VaR- based analysis (formula)
Liquidity risk
CAPM (formula)
RAR = relative return of portfolio (RRp)
46. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Basis risk
Sharpe measure
Firms becoming more sensitive to changes(bank deregulation)
CAPM (formula)
47. 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
Exposure
Formula for covariance
Ways firms can fail to account for risks
APT for passive portfolio management
48. Proportion of loss that is recovered - Also referred to as "cents on the dollar"
Prices of risk vs sensitivity
Recovery rate
Exposure
Ways firms can fail to account for risks
49. Probability that a random variable falls below a specified threshold level
VaR - Value at Risk
Shortfall risk
Settlement risk
Kidder Peabody
50. Unanticipated movements in relative prices of assets in hedged position
VaR- based analysis (formula)
Parametric VaR
LTCM
Basic Market risk
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