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Test your basic knowledge |
FRM: Foundations Of Risk Management
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business-skills
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certifications
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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. Country specific - Foreign exchange controls that prohibit counterparty's obligations
CAPM with taxes included (equation)
RAR = relative return of portfolio (RRp)
Sovereign risk
APT in active portfolio management
2. 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
Roles of risk management
Risk
Differences in financial risk management for financial companies vs industrial companies
Probability of ruin
3. Curve must be concave - Straight line connecting any two points must be under the curve
Shape of portfolio possibilities curve
Multi- period version of CAPM
Risks excluded from operational risk
Roles of risk management
4. 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
Importance of communication for risk managers
Banker's Trust
Drysdale Securities (Chase Manhattan)
Credit event
5. Derives value from an underlying asset - rate - or index - Derives value from a security
Uncertainty
Shortcomings of risk metrics
Market risk
Derivative contract
6. 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
Sovereign risk
Practical considerations related to ERM implementatio
Performance- related metrics
Expected return of two assets
7. Unanticipated movements in relative prices of assets in a hedged position - All hedges imply some basis risk
Correlation coefficient effect on diversification
Basis risk
Tax shield
Nonparametric VaR
8. Law of one price - Homogeneous expectations - Security returns process
Treynor measure
Zero- beta CAPM (two factor model)
APT (equation and assumptions)
Correlation coefficient effect on diversification
9. Asset-liability/market-liquidity risk
Allied Irish Bank
Risks excluded from operational risk
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Liquidity risk
10. 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
Ways firms can fail to account for risks
Efficient frontier
RAR = relative return of portfolio (RRp)
11. Returns on any stock are linearly related to a set of indexes
Importance of communication for risk managers
Ri = ai + bi1l1 + bi2l2....+ei
Correlation coefficient effect on diversification
Tracking error
12. Capital structure (financial distress) - Taxes - Agency and information asymmetries
Recovery rate
Solve for minimum variance portfolio
Liquidity risk
Market imperfections that can create value
13. When two payments are exchanged the same day and one party may default after payment is made
Kidder Peabody
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Settlement risk
Treynor measure
14. Occurs the day when two parties exchange payments same day
Settlement risk
Drysdale Securities (Chase Manhattan)
Ways firms can fail to account for risks
Information ratio
15. Return is linearly related to growth rate in consumption
Operational risk
VaR- based analysis (formula)
Multi- period version of CAPM
CAPM assumption for EMH
16. Firms became multinational - - >watched xchange rates more - deregulation and globalization
Asset liquidity risk
Funding liquidity risk
Firms becoming more sensitive to changes(bank deregulation)
Standard deviation of two assets
17. Losses due to market activities ex. Interest rate changes or defaults
Firms becoming more sensitive to changes(bank deregulation)
Uncertainty
Three main reasons for financial disasters
Financial risks
18. Economic Cost of Ruin(ECOR) - Enhancement to probability of ruin where severity of ruin is reflected
Allied Irish Bank
EPD or ECOR - Expected Policyholder Deficit (EPD)
Market risk
Valuation vs. Risk management
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. 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
APT in active portfolio management
Exposure
Source of need for risk management
21. Covariance = correlation coefficient std dev(a) std dev(b)
Three main reasons for financial disasters
Treynor measure
3 main types of operational risk
Formula for covariance
22. Focus on adverse tail of distribution - Relevant for determining economic capital (EC) requirements
Basic Market risk
Options motivation on volatility
Solvency-related metrics
Tax shield
23. Probability distribution is unknown (ex. A terrorist attack)
Traits of ERM
Uncertainty
Market risk
Drysdale Securities (Chase Manhattan)
24. 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
Ways firms can fail to account for risks
Where is risk coming from
Volatility Market risk
Risks excluded from operational risk
25. Expected value of unfavorable deviations of a random variable from a specified target level
Risks excluded from operational risk
Financial Risk
BTR - Below Target Risk
Ways risk can be mismeasured
26. Prices of risk are common factors and do not change - Sensitivities can change
Correlation coefficient effect on diversification
Derivative contract
Contango
Prices of risk vs sensitivity
27. When firm has so much debt that it leads to making investment decisions that benefit shareholdser but affect total firm value adversely
Recovery rate
APT for passive portfolio management
Exposure
Debt overhang
28. Make common factor beta - Build optimal portfolios - Judge valuation of securities - Track an index but enhance with stock selection
VaR- based analysis (formula)
APT in active portfolio management
Financial risks
Funding liquidity risk
29. Modeling approach is typically between statistical analytic models and structural simulation models
Models used in ERM framework
Capital market line (CML)
Efficient frontier
Security (primary vs secondary)
30. Security is a financial claim issued to raise capital - Primary securities are backed by real assets - Secondary securities are backed by primary securities
Settlement risk
Kidder Peabody
Security (primary vs secondary)
Financial Risk
31. 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 -
VaR- based analysis (formula)
Shortcomings of risk metrics
Financial Risk
Source of need for risk management
32. 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
Performance- related metrics
Tax shield
BTR - Below Target Risk
33. Risks that are assumed willingly - to gain a competitive edge or add shareholder value
Importance of communication for risk managers
Effect of non- price- taking behavior on CAPM
Business risks
Drysdale Securities (Chase Manhattan)
34. Asses firm risks - Communicate risks - Manage and monitor risks
Ten assumptions underlying CAPM
Roles of risk management
APT in active portfolio management
Ri = ai + bi1l1 + bi2l2....+ei
35. Changes in vol - implied or actual
Volatility Market risk
Operational risk
Debt overhang
Basic Market risk
36. Rp = XaRa + XbRb
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Three main reasons for financial disasters
Risk types addressed by ERM
Expected return of two assets
37. Loss resulting from inadequate/failed internal processes - people or systems - back-office problems - settlement - etc - reconciliation
Four major types of risk
Roles of risk management
Operational risk
Basic Market risk
38. Credit risk that occurs when there is a change in the counterparty's ability to perform its obligations
Credit event
Settlement risk
What lead to the exponential growth to derivatives mkt?
Shortcomings of risk metrics
39. Both probability and cost of tail events are considered
EPD or ECOR - Expected Policyholder Deficit (EPD)
Tail VaR or TCE - Tail Conditional Expectation(TCE)
Solve for minimum variance portfolio
What lead to the exponential growth to derivatives mkt?
40. 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
Solve for minimum variance portfolio
Market imperfections that can create value
APT for passive portfolio management
Risk types addressed by ERM
41. People risk = fraud - etc. - Model risk = flawed valuation models - Legal risk = exposure to fines and lawsuits
Valuation vs. Risk management
Contango
Efficient frontier
3 main types of operational risk
42. 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
Settlement risk
Uncertainty
Traits of ERM
Formula for covariance
43. E(Ri) = Rf + beta[(E(Rm)- Rf)- (tax factor)(dividend yield for market - Rf)] + (tax factor)(dividend yield for stock - Rf)
CAPM with taxes included (equation)
Credit event
Roles of risk management
Drysdale Securities (Chase Manhattan)
44. Potential amount that can be lost
Sortino ratio
Morningstar Rating System
Exposure
Barings
45. Interest rate movements - derivatives - defaults
APT for passive portfolio management
Asset transformers
Financial Risk
Source of need for risk management
46. Volatility of unexpected outcomes
Risk
Information ratio
APT (equation and assumptions)
Valuation vs. Risk management
47. Quantile of a statistical distribution
Firms becoming more sensitive to changes(bank deregulation)
Practical considerations related to ERM implementatio
Shortcomings of risk metrics
Parametric VaR
48. Relative portfolio risk (RRiskp) - Based on a one- month investment period
RAR = relative return of portfolio (RRp)
Basis risk
Settlement risk
Business risks
49. ex. Human capital - Equilibrium return can be higher or lower than it is under standard CAPM
Nonmarketable asset impact on CAPM
Market risk
Asset transformers
Effect of heterogeneous expectations on CAPM
50. The lower (closer to - 1) - the higher the payoff from diversification
Correlation coefficient effect on diversification
Allied Irish Bank
(market beta)(Rm - Rf) + (sensitivity to inflation risk)(price of inflation risk)
Solvency-related metrics