FRM Book 3 UPDATED ACTUAL Exam
Questions and CORRECT Answers
What are some of the major risks faced by banks? - CORRECT ANSWER - The major
risks faced by a bank include the following.
-Credit risk from defaults on loans or by counterparties.
-Market risk from declines in the value of trading book assets.
-Operational risk from external events or failure of internal controls.
What is the difference between economic and regulatory capital? - CORRECT ANSWER -
Regulatory capital is the amount of capital that regulators require a bank to hold. Economic
capital is the amount of capital a bank believes it needs to hold based on its own models.
What are some of the regulations put forth by the Basel Committee in regards to Regulatory
Capital - CORRECT ANSWER - -Began as capital requirements for loan and derivatives
contract defaults (credit risk only). Over time, it was added for market and operational risk
-These risks must be quantified by using a standardized model designed by Basel.
-The credit crisis of 2007 to 2009 highlighted that many of the problems arose due to a liquidity
shortage as opposed to a capital shortage.
-Due to these liquidity issues the Basel Committee put forth the liquidity coverage ratio (LCR)
and the net stable funding ratio
Explain the different IB financing arrangements, such as private placement, public offering, best
efforts, firm commitment and Dutch auction approaches - CORRECT ANSWER - Private
placement is like selling a rare collectible directly to a collector, while public offering is like
selling it to the general public. Best efforts is selling as much as possible, firm commitment is
buying the whole collection and reselling it, and Dutch auction is determining the price through
bidding.
,What is the originate to distribute model and what are some of the benefits and drawbacks -
CORRECT ANSWER - The originate-to-distribute model involves banks making loans
and selling them to other parties, many of which pool the loans and issue securities backed by
their cash flows. This model frees up capital for the originating banks and may increase liquidity
in sectors of the loan market. However, it has also led to decreased lending standards and lower
credit quality of the loans sold.
What are the different risks facing insurance companies? - CORRECT ANSWER - Risks
facing insurance companies include insufficient funds to satisfy policyholders' claims, poor
return (market risk) on investments, credit risk, and operational risk.
Why do insurance companies use mortality tables to calculate premium payments for a policy
holder? - CORRECT ANSWER - Mortality tables can be used to compute life insurance
premiums. Mortality tables include information related to the probability of an individual dying
within the next year, the probability of an individual surviving to a specific age, and the
remaining life expectancy of an individual of a specific age.
What is the concept of mortality risk? - CORRECT ANSWER - Mortality risk refers to the
risk of policyholders dying earlier than expected due to illness or disease, for example. From the
perspective of the insurance company, the risk of losses increases due to the earlier-than-
expected life insurance payout.
What is longevity risk? - CORRECT ANSWER - Longevity risk refers to the risk of
policyholders living longer than expected due to better healthcare and healthier lifestyle choices,
for example. From the perspective of the insurance company, the risk of losses increases due to
the longer-than-expected annuity payout period.
What are defined benefit plans and contribution plans - CORRECT ANSWER - Defined
benefit plans explicitly state the amount of the pension that the employee will receive upon
retirement. It is usually calculated as a fixed percentage times the number of years of
employment times the annual salary for a specific period. There is significant risk borne by the
employer because it is obligated to fund the benefit to the employee.
, Defined contribution plans involve both employer and employee contributions being invested in
one or more investment options selected by the employee. There is virtually no risk borne by the
employer because it is obligated simply to make a set contribution and no more. The risk of
underperformance of the plan's investments is borne solely by the employee.
What is an open-end mutual fund, a closed-end mutual fund, and a ETF? - CORRECT
ANSWER - Open-end mutual funds, closed-end mutual funds, and ETFs are different
types of investment pools: open-end funds transact at the end of the day, closed-end funds trade
throughout the day but can't be redeemed directly, and ETFs trade throughout the day at their
NAV with low fees.
What types of trading is considered undesirable for mutual funds? - CORRECT
ANSWER - Undesirable trading behaviors may occur despite rules designed to prevent
fraud and conflicts of interest. These trading behaviors include late trading, market timing, front
running, and directed brokerage.
What is the Net asset value of a fund? - CORRECT ANSWER - The NAV is easily
calculated as the total invested assets of the fund minus any liabilities (typically management
fees payable) all divided by the total shares outstanding. The NAV for an open-end fund is set
after the trading day is over, while the NAV for a closed-end fund and an exchange-traded fund
is calculated continuously throughout the trading day. The NAV is used to determine the number
of shares purchased or sold in a fund.
What is the key difference between a mutual fund and hedge fund? - CORRECT
ANSWER - The key difference between a mutual fund and a hedge fund is that hedge
funds are only available to wealthy and sophisticated investors, have less regulatory oversight,
and can use strategies like leverage and short selling, while mutual funds are open to all investors
and have more restrictions.
How do you calculate the return for the investor when accounting for hedge fund management
fees (2/20) - CORRECT ANSWER - 1. Calculate hedge fund return based on the gain
management fee + incentive fee(% gain - management fee)
2. Calculate how much the fund would get if they had a loss one the year - just the management
fee (2%)
Questions and CORRECT Answers
What are some of the major risks faced by banks? - CORRECT ANSWER - The major
risks faced by a bank include the following.
-Credit risk from defaults on loans or by counterparties.
-Market risk from declines in the value of trading book assets.
-Operational risk from external events or failure of internal controls.
What is the difference between economic and regulatory capital? - CORRECT ANSWER -
Regulatory capital is the amount of capital that regulators require a bank to hold. Economic
capital is the amount of capital a bank believes it needs to hold based on its own models.
What are some of the regulations put forth by the Basel Committee in regards to Regulatory
Capital - CORRECT ANSWER - -Began as capital requirements for loan and derivatives
contract defaults (credit risk only). Over time, it was added for market and operational risk
-These risks must be quantified by using a standardized model designed by Basel.
-The credit crisis of 2007 to 2009 highlighted that many of the problems arose due to a liquidity
shortage as opposed to a capital shortage.
-Due to these liquidity issues the Basel Committee put forth the liquidity coverage ratio (LCR)
and the net stable funding ratio
Explain the different IB financing arrangements, such as private placement, public offering, best
efforts, firm commitment and Dutch auction approaches - CORRECT ANSWER - Private
placement is like selling a rare collectible directly to a collector, while public offering is like
selling it to the general public. Best efforts is selling as much as possible, firm commitment is
buying the whole collection and reselling it, and Dutch auction is determining the price through
bidding.
,What is the originate to distribute model and what are some of the benefits and drawbacks -
CORRECT ANSWER - The originate-to-distribute model involves banks making loans
and selling them to other parties, many of which pool the loans and issue securities backed by
their cash flows. This model frees up capital for the originating banks and may increase liquidity
in sectors of the loan market. However, it has also led to decreased lending standards and lower
credit quality of the loans sold.
What are the different risks facing insurance companies? - CORRECT ANSWER - Risks
facing insurance companies include insufficient funds to satisfy policyholders' claims, poor
return (market risk) on investments, credit risk, and operational risk.
Why do insurance companies use mortality tables to calculate premium payments for a policy
holder? - CORRECT ANSWER - Mortality tables can be used to compute life insurance
premiums. Mortality tables include information related to the probability of an individual dying
within the next year, the probability of an individual surviving to a specific age, and the
remaining life expectancy of an individual of a specific age.
What is the concept of mortality risk? - CORRECT ANSWER - Mortality risk refers to the
risk of policyholders dying earlier than expected due to illness or disease, for example. From the
perspective of the insurance company, the risk of losses increases due to the earlier-than-
expected life insurance payout.
What is longevity risk? - CORRECT ANSWER - Longevity risk refers to the risk of
policyholders living longer than expected due to better healthcare and healthier lifestyle choices,
for example. From the perspective of the insurance company, the risk of losses increases due to
the longer-than-expected annuity payout period.
What are defined benefit plans and contribution plans - CORRECT ANSWER - Defined
benefit plans explicitly state the amount of the pension that the employee will receive upon
retirement. It is usually calculated as a fixed percentage times the number of years of
employment times the annual salary for a specific period. There is significant risk borne by the
employer because it is obligated to fund the benefit to the employee.
, Defined contribution plans involve both employer and employee contributions being invested in
one or more investment options selected by the employee. There is virtually no risk borne by the
employer because it is obligated simply to make a set contribution and no more. The risk of
underperformance of the plan's investments is borne solely by the employee.
What is an open-end mutual fund, a closed-end mutual fund, and a ETF? - CORRECT
ANSWER - Open-end mutual funds, closed-end mutual funds, and ETFs are different
types of investment pools: open-end funds transact at the end of the day, closed-end funds trade
throughout the day but can't be redeemed directly, and ETFs trade throughout the day at their
NAV with low fees.
What types of trading is considered undesirable for mutual funds? - CORRECT
ANSWER - Undesirable trading behaviors may occur despite rules designed to prevent
fraud and conflicts of interest. These trading behaviors include late trading, market timing, front
running, and directed brokerage.
What is the Net asset value of a fund? - CORRECT ANSWER - The NAV is easily
calculated as the total invested assets of the fund minus any liabilities (typically management
fees payable) all divided by the total shares outstanding. The NAV for an open-end fund is set
after the trading day is over, while the NAV for a closed-end fund and an exchange-traded fund
is calculated continuously throughout the trading day. The NAV is used to determine the number
of shares purchased or sold in a fund.
What is the key difference between a mutual fund and hedge fund? - CORRECT
ANSWER - The key difference between a mutual fund and a hedge fund is that hedge
funds are only available to wealthy and sophisticated investors, have less regulatory oversight,
and can use strategies like leverage and short selling, while mutual funds are open to all investors
and have more restrictions.
How do you calculate the return for the investor when accounting for hedge fund management
fees (2/20) - CORRECT ANSWER - 1. Calculate hedge fund return based on the gain
management fee + incentive fee(% gain - management fee)
2. Calculate how much the fund would get if they had a loss one the year - just the management
fee (2%)
