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    2013 FRM Practice Exam

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    2013 FRM Practice Exam

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    2013 FRM Practice Exam

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    OGARP | Sz! 2013 Financial Rsk Manager Examination (FRM Practice Exam TABLE OF CONTENTS Introduction 2013 FRM Part | Practice Exam Candidate Answer Sheet . 2013 FRM Part | Practice Exam Questions 2018 FRM Part | Practice Exam Answer Sheet/Answers . 2018 FRM Part | Practice Exam Explanations - 2013 FRM Part Il Practice Exam Candidate Answer Sheet . 2018 FRM Part II Practice Exam Questions 2013 FRM Part Il Practice Exam Answer Sheet/Answers 2013 FRM Part Il Practice Exam Explanations . '© 2012 Globa Association of Ask Professionals Al rghts reserved. ts legato reproduce this materi in ty format without aro" wrter approval of GARP,Globa Association of Rsk Profesional I 2013 Financial Rsk Manager Examination (FRM Practice Exam INTRODUCTION The =RM Exatr isa practice-orientec examination. Its ‘questions are derivee from a combination of theory, as set forth 1 the core readings and ‘real-world’ work experience. Candidates are expected to understand risk management concepts and approaches and how they woule apply to & risk manager's daystorday activities. The FRM Examination is also a comprehensive examina tion testing a risk arofessional on @ number of risk manage- ‘ment concepts and approaches. Its very rare that tisk ‘manager will be faced with an issue that can immediately be slotted inte one category n the rea) world, risk mar- ager must be able to identify any number of risk-elated Issues and be able to dea) with them effectively. ‘The 2013 FRM Practice Exams | and Il have Seen devel> ‘9pe¢ to aid candidates in their reparation for the FRM Examination in May and November 2013. These Practice Exams are based on a sample of questions from the 2010 through 2012 FRM Examinations ane are suggestive ofthe ‘questions that will be in the 2018 FRM Examination. The 2013 FRM Practice Exam for Part | contains 25 ‘multiple-choice questions and the 2013 FRM Practice Exam for Part Ii contains 20 multiple-choice questions. Note that the 2013 ERM Examination Part | will contain 100 multiple= choice questions and the 2013 FRM Examination Part I will contain &C multiple-choice questions, The ractice Exams were designed te be shorter to alow candidates to calibrate their preparedness without being overwhelminc, ‘The 2013 FRM Practice Exams do ot necessarily cover al toples to be tested in the 2018 FRM Examination as the ‘material coveree in the 2018 Study Guide may be different from that that covered by the 201¢ through 2012 Study Guides, The questions selected for inclusion in the Practice Exams were chosen to be broadly reflective of the materia assigned for 2018 as well as to represent the style of question that the FRM Committee considers appropriate based or assignee material. For a complete list of current topics, core readings, ane key learning objectives candidates should refer to the 2013 FRM Examination Study Guide ang AIM Statements. Core teadings were selectec by the FRM Committee to assist candidates in thei review of the subjects coverec by the Exam. Questions For the FRM Examination are derived from the "core" readings. It is strongly suggestec that candidates review these readings in deptt prior to sitting for the Exam. Suggested Use of Practice Exams To maximize the effectiveness of the Practice Exams, cand- dates are encouragec to follow these recommendations: Plan a date and time to take each Practice Exam. Set dates appropriately to give sufficient study/ review time for the Practice Exam prior to the actual Exar 2. Simulate the test environment as closely as possible, + Take eact Practice Exam in 3 quiet place. + Haye only the practice exam, candidate answer shoot, calculator, ane writing instruments (pencils, erasers) available + Minimize possible distractions from other people, call phones ane study material + Allocate 60 minutes for the Practice Exam and set an alarm to alert you when 60 minutes have passec, Complete the exam but note the questions answered after the 60 minute mark + Follow the FRM calculator policy. You may only use 2 Texas Instruments 3A 1! Plus (including the 8A Il Plus Professional), Howlett Packarc 12C (including the HP 12C Platinum ane the Anniversary Edition), Hewlett Packarc 108 Il, Hewlett Packaré T0B Ils or Hewlett Packaré 208 calculator 3. After completing the Practice Exam, + Caleulate your score by comparing your answer sheet with the Practice Exam answer key. Only include questions completed in the first 60 minutes. + Use the Practice Exam Answers and Explanations to better understane correct and incorrect, answers and to identify topics that require addl- tional review. Consult referenced core readings to prepare for Exam, ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 1 format without aor writen approval of GARP Globa Association of Usk Professona®, In Financial Risk Manager (FRM’) Examination 2013 Practice Exam PART | Answer Sheet 2013 Financial Rsk Manager Examination (FRM Practice Exam a b « 4 a b « 4 1 oO Oo [e) oO 16. oO oO ° oO 2 oO Oo Oo oO u Oo O oO oO 3 oO 0 Oo oO 18. Oo oO ° oO 4 oO Oo (e) oO 19. [e) oO oO oO 5 oO oO oO oO 20. ° oO °o oO 6. oO Oo oO oO a. ° oO Oo oO 2. oO Oo ° oO 22. [e) oO ° oO 8. oO O° °o oO 23. ° oO ° oO 9. oO O° [e) oO 24, O° oO [e) oO 10. o oO oO oO 25. oO oO oO oO 1, oO oO [e) oO 12 oO O° ° oO Correct way to complete 13. oO O° °° oO 1 e e e e 14, oO oO °° oO ‘Wrong way to complete 15. oO O° ° oO 1 x oe G ® {© 2012 Globa Associaton of Ask Professionals. All ightsresarved its legal te reproduce ths materia 3 in format without aro" wrter approval of GARP.Globa Association of Rsk Profesional I Financial Risk Manager (FRM’) Examination 2013 Practice Exam PART | Questions 2013 Financial Rsk Manager Examination (FRM Practice Exam 1k Youare deciding betweer ouying a futures contract on an exchange and buying @ forward contract directly from a counterparty on the same underlying asset, Both contracts would have the same maturity and delivery specifications. You finc that the futures price is ess than the forward price. Assuming no arbitrage opportunity exists, what single factor acting alone would be a realistic explenatior for this price difference? ‘a. The futures contract s more liquid and easier to trade. bb. The forward contract counterparty is more likely to default. ‘e.The asset is strongly negatively correlated with interest rate d,_The transaction costs on the futures contract are less than on the forward contract. Eric Meyers is trader 1 the arbitrage unit of a multinational bank, He finds that an asset is trading at USD 1006, the orice of a year futures contract on that asset Is USD 1,010, and the price of a Zeyear futures cone tract 's USD 1,028, Assume that there are no cash flows frorr the asset for 2 years. If the term structure of interest rates is fiat at 1% er year, which of the following is an appropriate arbitrage strategy? ‘a. Short 2-year futures and long hear futures bb, Short hyear futures and long 2ayear futures ‘c. Short Zeyear futures and long the underlying asset funded by borrowing for 2 years ‘d._ Short I-year futures and long the underlying asset fundle¢ by borrowing for | year The price of a sixenonth European call option or a stock is USD 3, The stock price is USD 24. A dividend of USD Tig expected n three months, The continuously compounded risk-free rate for all maturities i= 5% oer year. Which of the following ‘s closest to the value of = put option on the same underlying stock with a strike price of USD 25 and a time to maturity of six months? a USD 3.60 b. USD 240 «USD 437 de USD 183 '© 2012 Globa Association of Ask Professionals. All rights reserved. legato reproduce this materi 5 in format without aro" wrter approval of GARP.Globa Association of Rsk Profesional I 2017 Financia Rsk Manager Examination (FAM) Which of the following statements regarding the trustee named in 2 corporate bond indenture is correct? The trustee has the authority to declare @ default ifthe issuer misses @ payment, The trustee may take action 2eyone the indenture te protect bondholders. The trustee must act at the request of a sufficient number of bondholders, The trustee is paic hy the bondholders or their representatives pore 5. Pear, inc. is a manufacturer that is heavily dependent or plastic parts shipped from Malaysia. Pear wants to nedage its exnosure tc plastic price shocks over the next 7 ¥% months, Futures contracts, however, are not ‘ead- ly available for plastic, After some research, Pear identifies futures contracts or other commodities whose orices are closely correlated tc plastic orices. Futures or Commodity A have e correlation of O85 with the orice of plastic, and futures on Commodity B have a correlation of 9.92 with the orice of plastic. Futures or soth Commodity A anc Commodity B are available with €-month anc 9-month expirations. Ignoring lquiclity considerations which contract would be the best to minimize basis risk? Futures on Commodity A with 6 months to expiration Futures on Commodity A with 9 months to expiration Futures on Commodity 8 with 6 months to expiration Futures on Commodity B with 9 months to expiration peoe You are examining the exchange vate between the USS. dollar and the eure anc are given the following information ‘egarding the USD/EUR exchange rate and the respective domestic risk-free rates Current USD/EUR exchange rate 's 125 Current JSD-denominated tryear risk-free interest rate is 4% per year Currant EUR«denominated year riskefree interest rate ic 7% per year According to the nterest rate parity theorem, what is the t-year forward USD/EUR exchange rate? a 078 b. 0.82 e121 a 128 6 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam [An investor sells a January 2014 call on the stock of XY2 Limited with a strike price of USD 50 for JSD 10, ‘and Suys a January 2014 cal or the same underlying stock with a strike price of USD 6C for USD 2 What Is the name of this strategy, and what s the ‘naximum profit anc loss the investor could incur at expiration? Strategy Maximum Profit Maximum Loss Bear spreac_ USD 8 usp 2 Bull spread USD 8 Unlimited Bear spreac Unlimited usp 2 Bullspread USD 8 usp 2 8. Samantha Xiac is trying to get some insight nto the relationship between the return on stock LMD (Riyo,) and the return on the S&P SOC index (Rs): Using historical data she estimates the following: Annual mean retutn for LMD: 11% Annual mean return for S&P 500 index 1% Annual volatility for S&P 500 index: 18% Covariance between the returns of LMD and S&P 500 index 8% Assuming she uses the same data tc estimate the regression model aiven by: Renee? O+ BR seas #E Using the ordinary least squares technique, which of the following models will she obtain? Riser #202 + O54R aw 4 & a B. Riyy = -0.02 + 185Run HE Ring = 0044 O54Rw, #6, Rosey #004 + LBERis +6 ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 7 format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) 10, n For a sample of 400 firms, the relationship between corporate revenue (Y) and the average years of experience ser employee (xX) is modeled as follows: YEBtBXte if 100 ‘You wish to test the joint null hypothesis that 6, at the 95% confidence level. The pevalue for the t-statistic for 6, is 007, and the o-value for the t-statistic for f, is 0.06. The F-value for the Festatistic for the regression is 0.04E. Whick of the following statements is correct? You can reject the nul hypothesis because each 8 is different from © at the 95% confidence level. ‘You cannot reject the null aypothesis because neither Bis different from O at the 95% confidence level You can reject the nul hypothesis because the F-statistic is significant at the 95% confidence level You cannot reject the null nypothesis because the F-statistic isnot significant at the 95% confidence level aggre AA fixed income portfolic manager currently holds 3 portfolio of bonds of various companies. Assuming all these ‘2onds have the same annualized probability of clofault and that the defaults are independent, the number of defaults in this portfolio over the next year follows which type of distribution? Bernoulli Normal Binomia Exponential pee A portfolic manager has askec each of four analysts to use Monte Carlo simulation to price ¢ path-dependent derivative contract on a stock The detivative expires in nine months and the riskefree rate is 4% per year come ‘sounded continuously. The analysts generate 3 total of 20,000 paths using a geometric Brownian motion ‘nodll, record the payoff for each path, and present the results in the table shown below, Analyst Number of Paths Average Derivati Payoft per Path (USD) 1 2000 4B 2 4906 44 3 10.000 46 4 490 45 What is the estimated price of the derivative? usp 4333, USD 437 USD 44.2 USD 4510 pore © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam 12 Suppose that the correlatior of the return of a portfolio with the return ofits benchmark is 08, the volatility of the return of the portfolio is 5% and the volatility of the return of the benchmark is 45 What is the beta of the port a. 100 b. 0.80 «084 a 100 13, Firms commonly incentivize thelr management to increase the firm's value 2y granting managers securities tiec to the firm's stock. Some securities, however, can reduce managerial incentives to manage ‘isk within the firm. Which is ikely the best example of this type of security? ‘a. Deer in-the-money call option on the firm's stock b. Atsthe-money call option on the firr’s stock Deer outrof-the-money call option on the firm's stock ‘d._Long sosition ir the firm's stock 14. You nave been asked te check for arbitrage opportunities in the Treasury bond market by compating the cash flows of selected bonds with the cast flows of combinations of other bonds. f 2 year zero-coupon bond is priced at USD 9612 and a t-year bond paying 10% coupon semi-annually is pricec at USD 106.20, what should be the price of a I-year Treasury bone that 2ays a coupon af 8% semi-annually? usp 9810 USD 101.238 Usp 103.35 USD 1048 peoe ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material s format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) 16. ” If the current market price of a stock Is USD 50, which of the following options on the stock has the highest gamma? ‘a. Call option expiring 30 days with strike price of USD 50 b. Call option expiring n § days with strike orice of USD 30 ‘e Call option expiring n 5 days with strike price of USD 50 4. Put option expiring in 30 days with strike orice of USD 30 John Starwood is an investment advisor at Metuchen Investment Advisors (MIA). Starwood ie advising Michael Cooke, a weaithy client of MIA. Cooke would like to invest USD 500,000 in @ bond ratec at least AA, Starwood is considering bonds issued by IBM, GE, and Microsoft, and wants to choose « bond that satisfies Cooke's rating requirement, but also has the highest yiele to maturity, He has access tc the following information: IBM___GE__Microsoft S&P Bond Ratine AMY At AAA Semiannual Coupon 75% = 178% 1.69% Term to Maturity in years § 5 5 Price (USD) o7S 873989 Par value (USD) 1000 1000-1000 Which bond should Starwooc purchase for Cooke? a GEbond by IBM bond Microsoft bond d._ Either the Microsoft bond or the GE bone [After evaluating the results of your firm's stress tests, you are recommending that the firm allocate additional ‘economic capital and purchase selective insurance protectior to guarc against particular events. Ir order to give management 3 fully informed assessment, it is mportant that you note the following, related te this strategy: While decreasing liquidity risk exposure it will likely increase “narket risk exposure. While decreasing correlatior risk exposure. it will likely increase credit risk exposure, While slecreasine market risk exposure, it will ikely increase credit risk exposure, While decreasine credit risk exposure. it wil ikely increase model risk exposure. aoee © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 19, 20. 2013 Financial Rsk Manager Examination (FRM Practice Exam A bank’ foreign loan portfolic contains a large concentration of ‘oans te 2 country whose government has been ‘unning large external deficits, To evaluate the transfer risk that might exist in the event of stress, the greatest ‘concern should be giver to the possibility that the sovereign will mpose restrictions or which of the following? a, Imports b, Interest rates Exports 4d. Currency convertibility A portfolic manager bought 1906 call options on @ non-dividend-aaying stock, with a strike price of USD 100 for USD 6 each. The current stock orice is USD 104 with o daily stock returr volatility of 1.89%, anc! the delta of the option is C€. Using the delta-normal approach to calculate VaR, what is an approximation of the Teday 95% VaR of this position? usp 12 USD 1946 usp 3243, USD 5406 aore Which of the following statements concerning the measurement of operational risk is correct? Economic capita should be sufficient to cover ooth expected and worst-case operational risk losses Lose severity and loss frequency tend to be modeled with ognormal distributions, Operational loss data available from data vendors tend te be biased towards small losses. The standardized approach usec by banks ir calculating operational risk capital allows for different seta factors to be assigned te different business lines. pore The oroper selection of factors to include in an ordinary least squares estimation is critical te the accuracy of the result. When does omitted variable bias occur? Omitted variable bias occurs when the omitted variable is correlated with the included regressor and is 3 determinant of the depenclent variable, b, Omitted variable bias occurs when the omitted variable not & determinant of the dependent variable. G Omitted variable bias occurs when the omitted variable is independent of the included regressor and is 3 dleterminant of the depenclent variable. d. Omitted variable bias occurs when the omitted variable not e determinant of the dependent variable, orrelated with the included regressor but is independent of the included regressor but is ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 0" format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) 22% 23, 24, 25, ‘Assume that you are only concerned with systematic risk. Which of the following woul be the best measure to use te rank order funds with different betas based on their riskereturn relationship with the narket portfolio? Treynor ratio Sharpe ratio Jensen's alphe Sorting ratio aore The collapse of Long Term Capital Management (LTCM) is 2 classic risk management case study. Which of the following statements about risk management at LTCM is correct? a. LTCM had no active risk reporting by At LTCNy, stress testing oecame a risk management department exercise that had little influence or the firr’s strategy, & LTCM's use of high leverage is evidence of poor risk management. d._LTCM failed to account properly for the iliquidity of ts largest positions in its risk calculations. Which of the following is 8 potential consequence of violating the GARF Code of Conduct once a forma determination is made that such a violation has occurred? Formal notification te the GARP Member's employer of such 2 violation Suspension of the GARE Member's right to work in the risk management professior Removal of the GARP Member's right tc use the FRM designation Required participation in ethical training aoe Which of the following is assured in the multiple least squares regression model? ‘The dependent variable is stationary. The independent variables are not perfectly multicollinear. The error terms are heteroskedastic. The independent variables are homoskedastic, pee © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc This Page Left tank © 2012 slobal Association of Risk Professionals. All chs served. ts llegal to reproduce this material In ny format without arior witten approval of GARP.Globa Assocation of isk Professional, inc Financial Risk Manager (FRM’) Examination 2013 Practice Exam PART | Answers 2013 Financial Rsk anager Examination (FRM Practice Exam a b. © q, a o 4, 16. 5 e 1 oO e ¢ 3. ) oO 18. oO oO oO e 4. e oO oO 19, ) e Oo oO 5. ) oO oO 20. o oO oO e 6. oO e a. e oO oO oO 2 e oO 22. e oO Oo 8. ) e oO 23, o oO oO e 9. ) oO e 24. oO oO e 0 10. ) oO e 25. o e oO oO 1, ) e oO 12, e oO Oo Correct way to complete 1B ) oO e 1 e e e e 4 y 0 oO e Wrong way to complete 18. » Oo e 1 eS G red, ts legato renroduee this mater 8 sociation of isk Professonas Financial Risk Manager (FRM’) Examination 2013 Practice Exam PART | Explanations 2013 Financial Rsk Manager Examination (FRM Practice Exam 1. You are deciding between auying a futures contract on an exchange and buying a forward contract directly from a counterparty on the same underlying asset, 3oth contracts would nave the same maturity and delivery ‘specifications, You find that the futures price is less than the forward price, Assuming no arbitrage opportunity ‘exists, what single factor acting alone would be a vealistic explanstior for this price difference? ‘a. The futures contract is more liquid and easier to trade. The forward contract counterparty is more likely to default. eThe asset is strongly negatively correlated with interest rates d._ The transaction costs on the futures contract are less than on the forward contract. Correct answer: ¢ Explanation: When an asset is strongly negatively correlated with interest rates, futures prices will tend to be slightly lower thar forward prices. When the underlying asset increases in price, the immediate gain arising from the daily futures settlement will tend to oe invested at a lower than average rate of interest due to the negative correlation In this case futures would sell for slightly less than forward contracts which are not affected by interest rate move- ‘ments in the same manner since forward contracts do not have a daily settlement feature, The other three choices woule all most likely “esult in the futures price being higher than the forward price. Reference: John Hull, Options, Futures and Other Derivatives, 8th Edition (New York: Pearson, 2012), Chapter 5. AIMS: Explain the relationship between forwatc and futures prices Describe the differences between forward and futures contracts and explair the relationship ietween forward and spot prices. Section: Financia Markets and Products ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material ” format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) 2. Eric Meyers is trader ir the arbitrage unit of a multinational bank, He finds that an asset is trading at USD. 1,000, the orice of a iryear futures contract on that asset is USD 1.010, anc the price of a 2-year futures con tract is USD 1,028, Assume that there are no cash flows frorr the asset for 2 years. If the term structure of interest rates is flat at 1% per year, which of the following is an appropriate arbitrage strategy? ‘a. Short 2uyear futures and long fear futures Short ieyear futures and long 2ayear futures ‘c. Short 2-year futures and long the underlying asset funded by borrowing for 2 years d._ Short 1-year futures and long the underlying asset fundec by borrowing for 1 year Correct answer: ¢ Explanation: The I-year futures price should be 1000 * e' The 2eyear futures price shoule be 1000 * e* = 1020.20. 101005 The current 2-year futures orice ir the market is overvalued compares to the theoretical orice, To ock in a profit, you would short the 2 year futures, borrow USD 1000 at 1%, and buy the underlying asset. At the end of 2 years, you will sell the asset at USD 1025 and return the borrowec ‘honey with interest, which would be 1000* ec»? = USD 1020.20, resulting in 2 USD 48¢ gain, Reference: John Hull. Options, Futures anc Other Derivatives, Ath Edition (New York: Pearson, 2012), Chapter 5, p. 92. AIMS: Calculate the forward price, given the underlying asset's price, with or without short sales and/er considere~ tior to the income or yield of the underiying asset. Describe an arbitrage argument in support of these prices, Section: Financial Markets and Products 8 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam The orice of @ sixemonth European call option on a stock is USD 3 The stock price is USD 24. A dividend of USD 1 ie expected in three months, The continuously compounded riskefree rate for all maturities ie 5% oer year, Which of the following is closest to the value of = put option on the same underlying stock with a strike rice of USD 25 and a time to maturity of six months? a USD 360 b. USD 240 & US0.437 di, USD 163 Correct answer: ¢ Explanation: From the equation for put-call parity this can be solved by the following equation: + PV(K) + PV(D) —S, where PV represents the present value, Sc that PV (K) = Ke" and PV (D) = De" Where: represents the put price, isthe call price, kis the strike price of the out option, Dis the dividend, S\'s the current stock price, Tis the time te maturity of the option, anc Tis the time to the next dividene distribution, Calculating PV (0) the present value of the strike price, results in value of 25 * e****or 2438, while PV (D) Is equal te 1002" * of 0.99, Hence © = 2 + 24,88 + 099 ~ 24 = US 437, Reference: John Hul, Options, Futures, and Other Derivatives 8th Edition (New York: Pearson 2012), Chapter 10.2. 158. AIM: Explain the effects of dividends on the putscal parity, the bounds of put an¢ call option orices, and the early exercise feature of American options. Section: Financial Markets and Products ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 6 format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) Which of the following statements regarding the trustee named in 2 corporate bond indenture is correct? The trustee has the authority to declare @ default ifthe issuer misses @ payment, The trustee may take action 2eyone the indenture te protect bondholders. The trustee must act at the request of a sufficient number of bondholders, The trustee is paic hy the bondholders or their representatives pore Correct answer: & Explanation: According to the Trust Indenture Act, if @ corporate issuer fails to pay interest or principal, the trustee may declare 2 default and take such action as may be necessary tc protect the rights of bondholders, Trustees can only gerfarm the actions indicated n the ndenture, but are typically under no obligation to exercise the powers granted by the indenture even at the request of bondholders. The trustee is paic by the debt ssuet, not ay bond- holders or their representatives. Reference: Frank Fabozzi, The Handbook of Fixed Income Securities, 8th Edition (New York: McGraw Hil, 2012), Chapter 12 |AIM: Describe 3 bonc indenture and explain the role of the corporate trustee ir 3 bone indenture, Section: Financia Markets and Products 5. Pear, Inc. is a manufacturer that is heavily depenclent or plastic oarts shipped from Malaysia. Pear wants to nedge its exposure te plastic price shocks over the next 7% months, Futures contracts, however, are not ‘ead- ly available for plastic, After some research, Pear identifies futures contracts or other commodities whose orices are closely correlated te plastic orices, Futures or Commodity A have @ correlation of O85 with the orice of plastic, and futures on Commodity B have a correlation of C.92 with the orice of plastic, Futures or 20th Commodity A and Commodity B are available with €-month and 9-month expirations. Ignoring liquility considerations, which contract would be the best to minimize basis risk? ‘a. Futures on Commodity A with 6 months to expiration by Futures on Commodity A with 9 months to expiration ‘e Futures on Commodity B with 6 months to expiration d. Futures on Commodity B with 9 months to expiration Correct answer: © Explanation: In order to minimize basis risk, one should choose the futures contract with the highest correlation to price changes, and the one with the closest maturity preferably expiring after the duration of the hedge. Reference: John Hull, Options. Futures ano Other Derivatives, 8th Edition (New York Pearson, 2012), Chapter 3 = *Hedging Strategies Using Futures’, 2.47, AIM: Define the basis and the various sources of basis risk, and explain how basis risks arise when nedgine with futures, Section: Financial Markets and Products 20 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam You are examining the exchange vate between the US. dollar and the eure anc are given the following formation ‘egarding the USD/EUR exchange rate and the respective domestic riskefree rates Current USD/EUR exchange “ate 's 125 Current JSD-denominated tryear risk-free interest rate is 4% per year Current EURscenominated ‘+year riskefree interest rate is 7% per year According to the interest rate parity theorem, what is the ‘-year forward USD/EUR exchange rate’ a 078 b. 0.82 © 121 a. 128 Correct answer: Explanation: The forward rate, F, is aiven by the interest rate parity equation F259 "enor where Sois the spot exchange rate, ris the domestic (USD) riskefree rate, and stis the foreign (EUR) riskefree rate Tris the time to delivery Substituting the values in the equation: F,=128 + peowen 21 Reference: Anthony Saunders anc Marcia Millon Cornett, Financial institutions Management: A Risk Management Approach, 7th Edition (New York: McGraw-Hill 2010), Chapter 15. 236, AIM: Describe how a no-arbitrage assumption in the foreign exchange markets leads to the interest rate oarity theorem, use this theorem to calculate forward forelar exchange rates. Section: Financial Markets and Products ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material z format without aor writen approval of GARP Globa Association of Usk Professona®, In 2013 Financia Rsk Manager Examination (FAM) [An investor sells a January 2014 call on the stock of XY2 Limited with a strike price of USD 50 for JSD 10, ‘and Suys a January 2014 cal or the same underlying stock with a strike price of USD 6C for USD 2 What Is the name of this strategy, and what s the ‘naximum profit anc loss the investor could incur at expiration? Strategy Maximum Profit Maximum Loss a Bear spreac USD 8 usp 2 b. Bullspread USD 8 Unlimited Bear spreac Unlimited usp 2 di Bullspread USD 8 usp 2 Correct answer: @ Explanation: This strategy of buying ¢ call option at a higher strike price and selling a call option at lower strike price with the same maturity 's known as a bear spread. To establist e bull spread, one would ouy the call option at a lower price and sell ¢ call or the same security with the same maturity at 2 higher strike orice. The cost of the strategy will be USD -10 + USD 2 = USD -8 (@ reaative cost, which represents an inflow of USE & to the investor) The maximum oayott occurs when the stock price S; < USD 50 and is equal tc USD 8 (the cash inflow from establishing the position) as none of the options will be exercisec. The maximum loss occurs when the stock price 5; 2 60 at expiration, a8 both options wil be exercised. The nvestor would then be forced te sell XYZ shares at 50 to ‘meet the obligations an the call option sold, but coule exercise the second call te buy the shares back at 60 for a loss of USD -10, However, since the investor received an inflow of USD & by establishing the strategy the total orofit would be USD 8 - USD 10 = USD +2 When the stock price is USD 50 < S; $ USD 60, only the call option sold by the investor would be exercised, hence the payoff will be 50 — S;. Since the inflow from establishing the original strategy was USD 8, the ret profit will be 5e = S,, which woule’ always be higher than JSD +2 Reference: John Hull, Options, Futures, andi Other Derivatives, 8th Edition (New York: Pearson 2012), ‘Chapter 10, 9p. 167-168. AIM: Identify, interpret and compute upper anc lower bound for option prices. Section: Financial Markets and Products 22 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam Samantha Xiac i trying to get some insight into the relationship between the return on stock LMD (Rw) and the return on the S&P 5OC dex (Ran). Using historical dats she estimates the following Annual mean return for LMD: 11% Annual mean return for S&P 500 index 1% Annual volatility for S&P 500 index: 18% Covariance between the returns of LMD and S&P 500 index 8% Assuming she uses the same data te estimate the rearession model siven by: Renee O+ BR sane Using the ordinary least squares technique, which of the following models will she obtain? Be Rigs 0.02 + OBAR sn + 6 Be Ryuey 0.02 + 1.B5Reiy + & G Risgy 7004 + O54R a, +E A. Re O04 # BSR + 6 Corract answer: b Explanation: The rearession coefficients for 2 madel specified oy Y= 6 X +2 +£ are obtained usine the formula: b= S/S, In this example: Sq = 0.0€ 5, 2018 Eqy)= 0m Then b= 006/ (018) = 1.85 EY) = b'E00 = O = C.88'0.07) = -002 where ¢ represents the error term Reference: James Stock and Mark Watson, Introduction to Econometrics, Brief Edition (Boston; Pearson Education, 2008), Chapter 4, p. 64, ‘AIM: Explain how regression analysis in econometrics measures the relationship between dependent anc independent variables Section: Quantitative Analysis ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 2 format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) For a sample of 400 firms, the relationship between corporate revenue (Y) and the average years of experience ser employee (xX) is modeled as follows: YEBtBXte if 00 ‘You wish to test the joint null hypothesis that 6, at the 95% confidence level. The pevalue for the t-statistic for 6, is 007, and the o-value for the t-statistic for f, is 0.06. The F-value for the Festatistic for the regression is 0.04E. Whick of the following statements is correct? ‘a. You can reject the nul hypothesis because each 8 is different from 0 at the 95% confidence level. b. You cannot reject the null nypothesis because neither Bis different from © at the 95% confidence level. You can reject the nul hypothesis because the F-statistic is significant at the 95% confidence le You cannot reject the null aypothesis because the F-statistic is not significant at the 95% confidence level Correct answer: © Explanation: The T-test woul not be suffcientto test the joint hypothesis In order to test the joint null hypothesis, exarrine the Festatistic, which in this case is statistically significant at the 95% confidence level. Thus the nul can be rejected, Referenc james Stock and Mark Watson, Introduction to Econometrics, Brief edition (Boston, Pearson Education 2008), Chapter 7. pp. 128-129. ‘AIM: Describe and interpret tests of single restrictions involvine multiple coefficients, Define anc interpret the Festatistic Section: Quantitative Analysis 2 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam 10, A fixed income portfolio manager currently holds 2 portfolio of bonds of various companies Assuming all these onds have the same annualized probability of clefault and that the defaults are independent, the number of defaults in this portfolic over the next year follows which type of distribution? Bernoulli Normal Binomia Exponential aoee Correct answer: © Explanation: The result would follow @ Binomial distribution as there is a fixed number of random variables, each With the same annualized probability of default tis rot » Bernoull distribution, as a Bernoull distribution would describe the ikelinood of default of one of the individual bonds rather than of the entire portfolio (i. 8 Binomial distribution essentially describes a grour of 3ernoulli distributed variables). A normal distribution is used to mode! continuous variables, while in this case the number of defaults within the portfolio is discrete. References: Michael Miler, Mathematics and Statistics for Financial Risk Management (Haboken, NJ: John Wiley & Sons, 2012), Chapter 4. Svetlozar Rachev, Christian Menn, and Frank Fabozz (2005), Chapter 3: Continuous Probability Distributions, Fat-Talled and Skewed Asset Return Distributians: Implications for Risk Management, Portfolla Selection and Option Pricing (Hoboken, NJ: Wiley and Sons, 2005), Chapter 2: Discrete Probability Distributions ‘AIM: Describe the key properties of the uniform distribution, Bernoull distribution, Binomial distribution, Poisson distribution, normal distribution anc lognormal distribution, ang identify common occurrences of each distribution. Section: Quantitative Analysis ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 2 format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) TA portfolic manager has askec each of four analysts to use Monte Carlo simulation to price ¢ pathedependent derivative contract on 2 stock The derivative expires in nine months and the riskefree rate is 4% per year com Sounded continuously. The analysts generate a total of 20,000 paths using a geometric Brownian motion ‘node, record the payoff for each path, and present the results in the table shown below, Analyst Number of Paths Average Derivative Payoff per Path (USD) 1 2000 B 2 490¢ 44 3 10.000 46 4 490 45 What is the estimated price of the derivative? usb 4333 USD 43.7 USD 44.2 USD 4510 aoge ‘Corract answer: b Explanation: Following the risk neutral valuation methodology, the price of the derivative s obtained by calculsting the weighted average nine month payoff and then discounting this figure by the “sk free rate Average payoff calculation: (2000"43 + 4000°44 +10000°46 + 4000°45)/20000 510 Discounted payoff calculation ABIO*esDeer = A377 Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk; 3rd Edition (New York MeGraw-Hil, 2007), Chapter 12: Monte Carlo Methods, 9p. 167, 17C. AIM: Explain how simulations can be used for computing VaR ang pricing options. Section: Quantitative Analysis 26 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam 12 Suppose that the correlatior of the return of a portfolio with the return ofits benchmark is 08, the volatility of the return of the portfolio is 5% and the volatility of the return of the benchmark is 45 What is the beta of the port a. 100 b. 0.80 «084 a 100 Correct answer: & Explanation: The following equation is used te calculate beta + monte ogy G25 - aeenormans ~ 98" Zqq 100 pe where p represents the correlation coefficient and o the volatility Reference: Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Anaiysis (West Sussex, England: Wiley, 2003), Chapter 4, section 42. |AIM: Define bata and calculate the eta of 2 portfolio. Section: Foundations of Risk Management ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 2 format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) 13, Firms commonly incentivize thelr management te increase the firm's value oy granting managers securities tiec to the firm’s stock, Some securities, however, can reduce managerial incentives te manage ‘isk within the firm. Which is tkely the best example of this type of security? ‘a Deeg inthe-money call option on the firm's stock by Atethesmoney call option on the firr’s stock Deer outrofstheemoney call option on the firm's stock d.__Long sosition ir the firm's stock Correct answer: © Explanation: Deep out-of-the-money calls have no value unless the firm value increases substantially, ¢ providing deer out-of-the-money calls as an incentive could cause managers tc take substantially higher risks and perform less hedging, With an at-the-money call, managers could still 0 incentivizes te take greater risks Sut they would not have to aim for as large of a stock price increase to recognize significant value from their options, so the dan- ger of mismanaging risk is less. A deep ir-the-money call would have a similar investment proflle 5 long equity position and oth of the latter choices would provide the least managerial incentive to reduce visk management, References: "Risk Taking: A Corporate Governance Perspective,” (International Finance Corporation, World Bank Grour, June 2012.) John Hul, Options, Futures and Other Derivatives. 8th Edition, Chapter 1. René Stulz, Risk Management & Derivatives (Florence, KY. Thomson South-Western, 2002), Chapter 3, p. 30. AIM: Identify the methods a firm can use to exploit risk better than its competitors and exelain how an organization can create ¢ culture of prudent “isketaking among its employees, AIM: Calculate and identify option and forward contract payoffs, Sections: Foundations of Risk Management, Financial Markets and Products 28 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam 14, You nave been asked te check for arbitrage opportunities in the Treasury bond market by comparing the cash fiows of selected bonds with the cast flows of combinations of other bonds. 2 Fyear zerorcoupon bond is priced at USD 96,2 and a t-year oond paying a 10% coupon semi-annually is pricec at USD 106.20, what should be the orice of a I-year Treasury lone that oays a coupon of 8% semi-annually? a USD 9810 b. USD 101.23 fe USO 10835 d. uso 10418 Correct answer: Explanation: The solution is te replicate the 1 year 8% bone using the other two treasury bonds. In order te replicate the cash flows of the 8% bond, you coulc solve a system of equations te determine the weight factors, F° and F2, which cortespone te the proportion of the zero and the 10% bone to be held, respectively The two equations are as follows (100* FI) + (105 *F2)=104 (replicating the cash flow including principal and interest payments at the tnd of t year), and (SF2) = 4 (replicating the cash flow from the coupon payment in 6 months.) Solving the two equations gives us F” = 0:2 and F2 = 0.8, Thus the price of the 8% bond should 9e 0.2 (96112) + 08 (06.2) = 10418 Reference: Bruce Tuckmar, Fixed Incame Securities, 3rd Edition (Hoboken, NJ: Wiley & Sons, 2011), Chapter 1. Originally sased on the 2ne Edition. AIM: Derive a replicating aortfolic using multiple fixec income securities in order to match the cash flows of 2 single given fixed income security Section: Valuation and Risk Models ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 29 format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) 15, if the current market price of a stock is USD 50, which of the following options on the stock has the highest gamma? ‘a. Call option expiring 30 days with strike price of USD 50 b. Call option expiring n § days with strike orice of USD 30 ‘e Call option expiring n 5 days with strike price of USD 50 4. Put option expiring in 30 days with strike orice of USD 30 Correct answer: < Explanation: Gamme is defined as the rate of change of an option’s delta with respect to the price of the underlying asset, or the secone derivative of the option orice with respect to the asset price. Therefore the highest gamme Is observed ir shorter maturity anc at-the-money options, since options with these characteristics are much more sensitive to changes in the underlying asset price The correct choice is a call option both at-the-money and with the shorter maturity Reference: John Hull, Options Futures, ane! Other Derivatives, Ath Edition (New York: Pearson, 2012), Chapter 18 = The Greok Lettors, ©, 104, ‘AIM: Define and describe theta, gamma, vega, anc rho for option positions. Section: Valuation and Risk Models, 30 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam 16, John Starwood is an investment advisor at Metuchen Investment Advisors (MIA). Starwood advising Michael Cooke, a wealthy client of MIA, Cooke would like to invest USD 500,000 in a bond ratec at least AA. Starwood is considering bonds issued by IBM, GE, and Microsoft, and wants to choose e bond that satisfies Cooke's rating requirement, but also has the highest yiele to maturity, He has access te the following information: IBM _GE__ Microsoft S&P Bond Rating AAs At AAA Semiannual Coupon 175% 178% 160% Term te Maturity in years 5 5 5 Price (USD) 975 973980 Par value (USD) 1000 10001000 Which bond should Starwooc purchase for Cooke? a. GE bone b. IBM bond Microsoft bond 4d. Either the Microsoft bond or the GE bone Correct answer: b Explanation: To reach the correct ansvier, fine the bone with the highest yield te maturity (YTM) that qualifies for Inclusion in Cooke's portfolic, Although we can calculate the YTM for each bonc using @ moderr business calcula to itis unnecessary tc do so ir this case. Of the three bonds, the GE bond does not qualify for the portfolic as its rating of A+ is below the AA rating required by Cooke, This leaves the IBM bond and the Microsoft bond, ‘Comparing the two bonds, the IBW bone pays @ higher coupon than the Microsoft bond, yet itis cheaper as well ‘Therefore the yield onthe IBM bond is higher. To formally calculate the yield, you could also use the following equatior describing the relationshie between price and yield sien) Guy Using this equation (or an equivalent calculator function), the YTM for the IBM bone equals 4.057%, while the YTM for the Microsoft bond equals 3.62%, Reference: Bruce Tuckmar, Fixed Income Securities, 2nd Ealtion (Hoboken, NJ: Wiley & Sons, 2002), Chapter 3 = Yield to Maturity. |AIM: Compute a 20ne’s YTM given a bond structure and price. Section: Valuation and Risk Models ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material a format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) 17, After evaluating the results of your firm's stress tests, you are recommending that the firm allocate additional ‘economic capital and purchase selective insurance protectior te guarc against particular events, Ir order to give management 2 fully informed assessment, it is mportant that you note the following, related to this strategy: While decreasine liquidity risk exposure it will likely increase ~narket risk exposure. While decreasing correlatior risk exposure. it wil ikely increase credit risk exposure, While decreasing market risk exposure, it will likely increase credit risk exposure While decreasing credit risk exposure. it will ikely increase mociel risk exposure. aege Correct answer: © Explanation: The purchase of insurance protection can transform market risk into counterparty credit risk. Reference: Philipce Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd Edition (New York McGraweHil 2007), Chapter 14, p. 264. ‘AIM: Explain how the results of « stress test can 9e used to Improve our risk analysis and risk management systems. Section: Valuation and Risk Models 18. A bank's foreign loan portfolic contains 3 large concentration of ans te 2 country whose government has been ‘running large external deficits, To evaluate the transfer risk that might exist in the evant of stress, the greatest concern should be alver to the oossibilty that the sovereign will mpose restrictions or which of the following? a. Imports b. Interest rates Exports de Currency convertibility Correct answer: Explanation: Transfer “sk arises when central banks or governments impose restrictions on currency convertibility. The consequences include oayment defaults anc debt restructurings, Reference: John Caouette, Edvard Altman, Paul Narayanan and Robert Nimme (2008), Managing Credit Risk: The Great Challenge for the Global Financial Markets, 2nd Edition, (Hoboken, Nut John Wiley & Sons, 2008), Chapter 23.p. 176 AIM: Define ang differentiate betweer country risk ans transfer risk anc describe some of the factors that might lead to each, Describe some of the challenges in country risk analysis. Section: Valuation and Risk Models 32 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam 18. A portfolic manager bought 1906 call options on 2 nonsdividendepaying stock, with a strike price of USD 100 for USD 6 each. The current stock orice is USD 104 with 2 dally stock returr volatility of 1.89%, and the delta cof the option is O&, Using the delta-normal approach to calculate VaR, what is an approximation of the T-clay 95% VaR of this position? a USDI2 b. USD 1946 fe USD 5,243 d, us 5.406 Correct answer: bb Explanation: The delta of the option is ©. The VaR of the underlying is. 189% #185 * 104 = 5.24 Therefore, the VaR of one option s: 062 £246, and multiplying by 100C provides the VaR of the entire position: 1946. Reference: Linds Aller, Jacob Boucoukh and Anthony Saunders (2004), Understanding Market, Credit and Operational Risk: The Value at Risk Approach (Oxford, Blackwell Publishing. 2004), Chapter 3. AIM: Describe the delta-normal approact to calculating VaR for non-linear derivatives. Section: Valuation and Risk Models 20. Which of the following statements concerning the measurement of operational riskis correct? Economic capita should be sufficient to cover ooth expected and worstecase operational risk losses. Loss severity and loss frequency tend to be modeled with ognormal distributions, Operational loss date avallable from data vendors tend te be biased towards smal losses. The standardized approach usec by banks ir calculating operational risk capital allows for different seta factors to be assigned te different business line poge Correct answer: © Explanation: In the standardized approach to calculating operational risk, @ bank’ activities are divided ur into seve eral different business lines, and a beta factor is calculated for each ine of business. Economic capita covers the difference between the worst-case loss and the expected loss. Loss severity tends to be nnodeled with é lognormal distribution, but loss frequency is typically modeled using 3 Poisson distribution. Operational ioss date available from date vendors tends to be biased towards arge losses. Reference: John Hull, Risk Management and Financial Institutions, 2nd Eaition (Boston: Pearsor Prentice Hall, 2010), Chapter 18 — Operational Risk, ©. 243, |AIM: Describe the allocation of operational isk capital and the use of scorecards, Section: Valuation and Risk Models, ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 2B format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) a The oroper selection of factors to include in an ordinary least squares estimation is critical tc the accuracy of the result, When does omitted variable bias occur? ‘@ Omitted variable bias occurs when the omitted variable determinant of the dependent variable. 'b, Omitted variable bias occurs when the omitted variable is correlated with the included regressor but is not e determinant of the dependent variable, Omitted variable bias occurs when the omitted variable is independent of the included regressor and is @ determinant of the depenclent variable. d. Omitted variable bias occurs when the omitted variable is independent of the included rearessor but is not & determinant of the dependent variable, orrelated with the included regressor and is 8 Correct answer: @ Explanation: Omitted variable bias occurs when @ mode! improperly omits one or more variables that are critical determinants of the dependent variable and are correlated with one or more of the other included independent variables, Omitted variable bias results ir an over- or under-estimation of the regression sarameters. Reference: James Stack and Mark Watson (2008), Introduction to Econometrics, Briet Edition (Boston, Pearson Education, 2008), Chapter 8, 99. 186-190 |AIM: Define. interpret, anc describe methods for addressing omitted vatiable bias. Section: Quantitative Analysis 54 © 2013 Global Assocation af Risk Professionals Al -ights reserved ti legal to raprodue ths material iin any ormat without arior witter approva of GARP Globa Assocation of tisk Professionals Inc 2013 Financial Rsk Manager Examination (FRM Practice Exam 22, Assume that you are only concerned with systematic risk. Which of the following woule be the best measure to use te rank order funds with different betas based on their riskereturn relationship with the narket portfolio? Treynor ratio Sharpe ratio Jensen's alphe Sorting ratio aore Correct answer: & Explanation: Systematic isk of 3 portfolio is that risk which is inherent in the market anc thus cannot 9¢ diversified ‘away. In this situation you should seek 2 measure which ranks funds based on systematic risk only, which is reflect ed in the bets as defined below: Bo nw "Op "0.0% where p »» is the correlation coefficient betweer the portfolio anc the market, g, represents the standard deviation of the portfolio and o,, represents the standard deviation of the market. In @ well diversified portfolio (where one is normally only concernec with systematic risk), it can be assumed that the correlation coefficient is close te 1, there- fote beta can be approximates to an aven simpler equation: Bo™ On/e In either case, beta explains the volatility of the oortfolio compared te the volatility of the market, which captures only systematic risk; ‘The Treynor ratio is the correct ratio te use in this case, The formulas: T, =[ECR.)-R]/ Bp which describes the difference between the expected return of the portfolio, (R,) and the risk free rato R, divide by the portfolio 2ets 8. Therefore, t plots excess roturr over systematic risk. Reference: Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Anaiysis (West Sussex, England! Wiley, 2003), Chapter 4, Section 4,2 — Applying the CAPM to Performance Measurement Single-index Performance Measurement Indicators, page IS) ‘AIM: Calculate, compare, and evaluate the Treynor measure, the Sharpe measure, and Jensen's alpha. Section: Foundations of Risk Management ‘Slobal Association of Risk Professionals All igh served. ts legal to reproduce this material 5 format without aor writen approval of GARP Globa Association of Usk Professona®, In 2017 Financia Rsk Manager Examination (FAM) 23, The collapse of Long Term Capital Management (LTCM) is 3 classic risk management case study. Which of the following statements about risk management at LTCM is correct? a._LTCM had no active risk -eporting b. At LTCYy, stress testing 2ecame a risk management department exercise that had ttle influence or the firrr’s strategy. & LTCMs use of nigh leverage is evidence of poor risk management. .__LTCM failed to account properly for the illiquidity of ts largest positions in its risk calculations. Correct answer: Explanation: A major contributing factor te the collapse of LTCM is that it did not account properly for the illiquid ty of its largest oositions in its risk calculations. LTCM received valuation reports from dealers who only

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