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Test your basic knowledge |
FRM: Foundations Of Risk Management
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business-skills
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frm
Instructions:
Answer 50 questions in 15 minutes.
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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. Volatility of expected outcomes - Outcomes are random but distribution is known or approximated
VaR - Value at Risk
Risk
Kidder Peabody
Practical considerations related to ERM implementatio
2. Law of one price - Homogeneous expectations - Security returns process
Uncertainty
Credit event
APT (equation and assumptions)
Drysdale Securities (Chase Manhattan)
3. Human - created: business cycles - inflation - govt policy changes - wars - Natural: weather - quakes
Where is risk coming from
Shape of portfolio possibilities curve
Three main reasons for financial disasters
Shortfall risk
4. Excess return equated to alpha plus expected systematic return E(Rp) - Rf = alpha + beta(E(Rm) - Rf)
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5. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Ri = ai + bi1l1 + bi2l2....+ei
Jensen's alpha
Business risks
BTR - Below Target Risk
6. Concentrate on mid- region of probability distribution - Relevant to owners and proxies
Performance- related metrics
Ways risk can be mismeasured
Nonmarketable asset impact on CAPM
Operational risk
7. Returns on any stock are linearly related to a set of indexes
Ri = ai + bi1l1 + bi2l2....+ei
CAPM (formula)
Exposure
Sovereign risk
8. (E(Rp) - MAR)/(sqrt((1/T)summation(Rpt- MAR)^2) - MAR - minimum acceptable return
Practical considerations related to ERM implementatio
Sortino ratio
Zero- beta CAPM (two factor model)
Derivative contract
9. Derives value from an underlying asset - rate - or index - Derives value from a security
Three main reasons for financial disasters
Derivative contract
Recovery rate
Firms becoming more sensitive to changes(bank deregulation)
10. CAPM requires the strong form of the Efficient Market Hypothesis = private information
Volatility Market risk
Source of need for risk management
CAPM assumption for EMH
Expected return of two assets
11. 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
Debt overhang
Barings
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
12. Future price is greater than the spot price
Contango
Security (primary vs secondary)
RAR = relative return of portfolio (RRp)
Options motivation on volatility
13. Quantile of a statistical distribution
Basis
Funding liquidity risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Parametric VaR
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
Prices of risk vs sensitivity
Ten assumptions underlying CAPM
Capital market line (CML)
Parametric VaR
15. Hazard - Financial - Operational - Strategic
Efficient frontier
Firms becoming more sensitive to changes(bank deregulation)
Market imperfections that can create value
Risk types addressed by ERM
16. Managing risks is a core activity at financial companies - Industrial companies hedge financial risks
Nonparametric VaR
Sovereign risk
Differences in financial risk management for financial companies vs industrial companies
Business risks
17. Changes in vol - implied or actual
Volatility Market risk
Ri = ai + bi1l1 + bi2l2....+ei
Shortfall risk
Operational risk
18. Wrong distribution - Historical sample may not apply
Basic Market risk
Ways risk can be mismeasured
Importance of communication for risk managers
LTCM
19. Asset-liability/market-liquidity risk
Risk- adjusted performance measure (RAP)
Asset transformers
Liquidity risk
Risk
20. 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
Shape of portfolio possibilities curve
Expected return of two assets
Ways firms can fail to account for risks
Kidder Peabody
21. Relationship drawn from CML - RAP = [(market std dev)/(portfolio std dev)]*(Portfolio return - risk free rate) + risk free rate - annualized
Volatility Market risk
Risk- adjusted performance measure (RAP)
Basis risk
Drysdale Securities (Chase Manhattan)
22. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
3 main types of operational risk
Security (primary vs secondary)
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Sharpe measure
23. Summarizes the worst loss over a period that will not be exceeded by a given level of confidence - Always one tailed
Nonparametric VaR
Tracking error
VaR - Value at Risk
VaR- based analysis (formula)
24. Excess return divided by portfolio beta Tp = (E(Rp) - Rf)/portfolio beta - Better for well diversified portfolios
Treynor measure
Recovery rate
Ways firms can fail to account for risks
Source of need for risk management
25. 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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26. Risk replaced with VaR (Portfolio return - risk free rate)/(portfolio VaR/initial value of portfolio)
Traits of ERM
VaR- based analysis (formula)
Solvency-related metrics
Sharpe measure
27. Need to assess risk and tell management so they can determine which risks to take on
Operational risk
Importance of communication for risk managers
Sovereign risk
APT for passive portfolio management
28. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Correlation coefficient effect on diversification
Four major types of risk
Traits of ERM
Solvency-related metrics
29. Covariance = correlation coefficient std dev(a) std dev(b)
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Security (primary vs secondary)
Formula for covariance
Traits of ERM
30. 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
Standard deviation of two assets
Valuation vs. Risk management
Business Risk
Treynor measure
31. The lower (closer to - 1) - the higher the payoff from diversification
Ri = ai + bi1l1 + bi2l2....+ei
Market imperfections that can create value
Correlation coefficient effect on diversification
Barings
32. 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
Models used in ERM framework
Basic Market risk
Firms becoming more sensitive to changes(bank deregulation)
APT for passive portfolio management
33. Prices of risk are common factors and do not change - Sensitivities can change
Asset transformers
Ri = Rz + (gamma)(beta)
Prices of risk vs sensitivity
Risk
34. Asses firm risks - Communicate risks - Manage and monitor risks
Information ratio
Contango
Roles of risk management
Effect of non- price- taking behavior on CAPM
35. Capital Asset Pricing Model Ri = Rf + beta*(Rm - Rf)
Traits of ERM
Financial Risk
CAPM (formula)
Credit event
36. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Debt overhang
Solvency-related metrics
Risk Management Irrelevance Proposition
Source of need for risk management
37. 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
Probability of ruin
Forms of Market risk
Shortcomings of risk metrics
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
38. Occurs the day when two parties exchange payments same day
Settlement risk
Parametric VaR
CAPM (formula)
Asset liquidity risk
39. 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.
Effect of non- price- taking behavior on CAPM
Risk Management Irrelevance Proposition
Efficient frontier
Market risk
40. Country specific - Foreign exchange controls that prohibit counterparty's obligations
VaR- based analysis (formula)
Differences in financial risk management for financial companies vs industrial companies
Drysdale Securities (Chase Manhattan)
Sovereign risk
41. The uses of debt to fall into a lower tax rate
Tax shield
Debt overhang
Basic Market risk
Market risk
42. 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
Allied Irish Bank
3 main types of operational risk
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Basis
43. 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
3 main types of operational risk
Asset transformers
Capital market line (CML)
Importance of communication for risk managers
44. Rp = XaRa + XbRb
Expected return of two assets
BTR - Below Target Risk
Basic Market risk
Sovereign risk
45. 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
Kidder Peabody
CAPM with taxes included (equation)
Shortfall risk
Drysdale Securities (Chase Manhattan)
46. Sqrt((Xa^2)(variance of a) + (1- Xa)^2(variance of b) + 2(Xa)(1- Xa)(covariance))
EPD or ECOR - Expected Policyholder Deficit (EPD)
Standard deviation of two assets
Traits of ERM
Four major types of risk
47. Absolute and relative risk - direction and non-directional
Sovereign risk
Forms of Market risk
Market imperfections that can create value
Parametric VaR
48. Risk of loses owing to movements in level or volatility of market prices
Prices of risk vs sensitivity
Market risk
Banker's Trust
Roles of risk management
49. Probability that a random variable falls below a specified threshold level
Multi- period version of CAPM
Shortfall risk
Valuation vs. Risk management
Risk
50. Quantile of an empirical distribution
Nonparametric VaR
Business risks
Efficient frontier
Differences in financial risk management for financial companies vs industrial companies