FRM Exam 1 Definitions UPDATED
ACTUAL Exam Questions and CORRECT
Answers
Shortcomings of risk metrics - CORRECT ANSWER - -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
Importance of communication for risk managers - CORRECT ANSWER - Need to assess
risk and tell management so they can determine which risks to take on
Ways firms can fail to account for risks - CORRECT ANSWER - -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 risk can be mismeasured - CORRECT ANSWER - -Wrong distribution
-Historical sample may not apply
Roles of risk management - CORRECT ANSWER - -Asses firm risks
-Communicate risks
-Manage and monitor risks
Practical considerations related to ERM implementation - CORRECT ANSWER --
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
Models used in ERM framework - CORRECT ANSWER - Modeling approach is typically
between statistical analytic models and structural simulation models
Risk types addressed by ERM - CORRECT ANSWER - -Hazard
-Financial
-Operational
-Strategic
Traits of ERM - CORRECT ANSWER - -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
Arbitrage Pricing Theory - CORRECT ANSWER - a theory of risk-return relationships
derived from no-arbitrage considerations in large capital markets
1. Create factor portfolio
2.Derive returns for each factor portfolio
3. Calculate risk premiums for each factor portfolio
APT for passive portfolio management - CORRECT ANSWER - -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
APT (assumptions) - CORRECT ANSWER - -Returns on any stock are linearly related to
a set of indexes
-Law of one price
-Returns follow k-factor process
-Well diversified portfolios can be formed
-No arbitrage opp exists
Prices of risk vs sensitivity - CORRECT ANSWER - -Prices of risk are common factors
and do not change
-Sensitivities can change
Effect of non-price-taking behavior on CAPM - CORRECT ANSWER - Simple form of
CAPM, but market price of risk is lower than if all investors were price takers
Effect of heterogeneous expectations on CAPM - CORRECT ANSWER - Equilibrium can
still be expressed in returns, covariance, and variance, but they become complex weighted
averages
Nonmarketable asset impact on CAPM - CORRECT ANSWER - -ex. Human capital
-Equilibrium return can be higher or lower than it is under standard CAPM
Risk - CORRECT ANSWER - -Volatility of expected outcomes
-Outcomes are random but distribution is known or approximated
Derivative contract - CORRECT ANSWER - -Derives value from an underlying asset,
rate, or index
-Derives value from a security
, Nonparametric VaR - CORRECT ANSWER - -Quantile of an empirical distribution
Parametric VaR - CORRECT ANSWER - -Quantile of a statistical distribution
Four major types of risk - CORRECT ANSWER - -Market risk
-Liquidity risk
-Credit risk
-Operational risk
Basis risk - CORRECT ANSWER - -Unanticipated movements in relative prices of assets
in a hedged position
-All hedges imply some basis risk
Funding-liquidity risk - CORRECT ANSWER - Inability to make payment obligations
(ex. Margin calls)
Asset-liquidity risk - CORRECT ANSWER - Cannot exit position in market due to size of
the position
Exposure - CORRECT ANSWER - Potential amount that can be lost
Recovery rate - CORRECT ANSWER - -Proportion of loss that is recovered
-Also referred to as "cents on the dollar"
Sovereign risk - CORRECT ANSWER - -Country specific
-Foreign exchange controls that prohibit counterparty's obligations
ACTUAL Exam Questions and CORRECT
Answers
Shortcomings of risk metrics - CORRECT ANSWER - -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
Importance of communication for risk managers - CORRECT ANSWER - Need to assess
risk and tell management so they can determine which risks to take on
Ways firms can fail to account for risks - CORRECT ANSWER - -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 risk can be mismeasured - CORRECT ANSWER - -Wrong distribution
-Historical sample may not apply
Roles of risk management - CORRECT ANSWER - -Asses firm risks
-Communicate risks
-Manage and monitor risks
Practical considerations related to ERM implementation - CORRECT ANSWER --
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
Models used in ERM framework - CORRECT ANSWER - Modeling approach is typically
between statistical analytic models and structural simulation models
Risk types addressed by ERM - CORRECT ANSWER - -Hazard
-Financial
-Operational
-Strategic
Traits of ERM - CORRECT ANSWER - -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
Arbitrage Pricing Theory - CORRECT ANSWER - a theory of risk-return relationships
derived from no-arbitrage considerations in large capital markets
1. Create factor portfolio
2.Derive returns for each factor portfolio
3. Calculate risk premiums for each factor portfolio
APT for passive portfolio management - CORRECT ANSWER - -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
APT (assumptions) - CORRECT ANSWER - -Returns on any stock are linearly related to
a set of indexes
-Law of one price
-Returns follow k-factor process
-Well diversified portfolios can be formed
-No arbitrage opp exists
Prices of risk vs sensitivity - CORRECT ANSWER - -Prices of risk are common factors
and do not change
-Sensitivities can change
Effect of non-price-taking behavior on CAPM - CORRECT ANSWER - Simple form of
CAPM, but market price of risk is lower than if all investors were price takers
Effect of heterogeneous expectations on CAPM - CORRECT ANSWER - Equilibrium can
still be expressed in returns, covariance, and variance, but they become complex weighted
averages
Nonmarketable asset impact on CAPM - CORRECT ANSWER - -ex. Human capital
-Equilibrium return can be higher or lower than it is under standard CAPM
Risk - CORRECT ANSWER - -Volatility of expected outcomes
-Outcomes are random but distribution is known or approximated
Derivative contract - CORRECT ANSWER - -Derives value from an underlying asset,
rate, or index
-Derives value from a security
, Nonparametric VaR - CORRECT ANSWER - -Quantile of an empirical distribution
Parametric VaR - CORRECT ANSWER - -Quantile of a statistical distribution
Four major types of risk - CORRECT ANSWER - -Market risk
-Liquidity risk
-Credit risk
-Operational risk
Basis risk - CORRECT ANSWER - -Unanticipated movements in relative prices of assets
in a hedged position
-All hedges imply some basis risk
Funding-liquidity risk - CORRECT ANSWER - Inability to make payment obligations
(ex. Margin calls)
Asset-liquidity risk - CORRECT ANSWER - Cannot exit position in market due to size of
the position
Exposure - CORRECT ANSWER - Potential amount that can be lost
Recovery rate - CORRECT ANSWER - -Proportion of loss that is recovered
-Also referred to as "cents on the dollar"
Sovereign risk - CORRECT ANSWER - -Country specific
-Foreign exchange controls that prohibit counterparty's obligations
