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FRM Part II

Practice Exam

®

Financial Risk Manager Examination (FRM) Part II Practice Exam

Table of Contents

Introduction to 2016 FRM Part II Practice Exam ............................................ 1

2016 FRM Part II Practice Exam - Candidate Answer Sheet ........................... 3

2016 FRM Part II Practice Exam – Questions .................................................. 4

2016 FRM Part II Practice Exam – Answer Key ............................................. 34

2016 FRM Part II Practice Exam – Answers & Explanations ......................... 35

**© 2016 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material
**

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

1

Financial Risk Manager Examination (FRM) Part II Practice Exam

Introduction

The FRM Exam is a practice-oriented examination. Its questions are derived from a combination of theory, as set forth in

the core readings, and “real-world” work experience. Candidates are expected to understand risk management concepts

and approaches and how they would apply to a risk manager’s day-to-day activities.

The FRM Exam is also a comprehensive examination, testing a risk professional on a number of risk management

concepts and approaches. It is very rare that a risk manager will be faced with an issue that can immediately be slotted

into one category. In the real world, a risk manager must be able to identify any number of risk-related issues and be

able to deal with them effectively.

The 2016 FRM Part I and Part II Practice Exams have been developed to aid candidates in their preparation for the FRM

Exam in May and November 2016. These Practice Exams are based on a sample of questions from prior FRM Exams and

are suggestive of the questions that will be in the 2016 FRM Exam.

The 2016 FRM Part I Practice Exam contains 100 multiple-choice questions and the 2016 FRM Part II Practice Exam

contains 80 multiple-choice questions, the same number of questions that the actual 2016 FRM Exam Part I and 2016

FRM Exam Part II will contain. As such, the Practice Exams were designed to allow candidates to calibrate their

preparedness both in terms of material and time.

The 2016 FRM Practice Exams do not necessarily cover all topics to be tested in the 2016 FRM Exam as any test samples

from the universe of testable possible knowledge points. However, the questions selected for inclusion in the Practice

Exams were chosen to be broadly reflective of the material assigned for 2016 as well as to represent the style of

question that the FRM Committee considers appropriate based on assigned material.

For a complete list of current topics, core readings, and key learning objectives candidates should refer to the 2016 FRM

Exam Study Guide and 2016 FRM Learning Objectives.

Core readings were selected by the FRM Committee to assist candidates in their review of the subjects covered by the

Exam. Questions for the FRM Exam are derived from the core readings. It is strongly suggested that candidates study

these readings in depth prior to sitting for the Exam.

Suggested Use of Practice Exams

To maximize the effectiveness of the practice exams, candidates are encouraged to follow these recommendations:

1. Plan a date and time to take the practice exam.

Set dates appropriately to give sufficient study/review time for the practice exam prior to the actual exam.

2. Simulate the test environment as closely as possible.

• Take the practice exam in a quiet place.

• Have only the practice exam, candidate answer sheet, calculator, and writing instruments (pencils, erasers)

available.

• Minimize possible distractions from other people, cell phones, televisions, etc.; put away any study material

before beginning the practice exam.

• Allocate 4 hours to complete FRM Part I Practice Exam and 4 hours to complete FRM Part II Practice Exam and

keep track of your time. The actual FRM Exam Part I and FRM Exam Part II are 4 hours each.

**© 2016 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material
**

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

1

Inc. • Use the practice exam Answers and Explanations to better understand the correct and incorrect answers and to identify topics that require additional review. Global Association of Risk Professionals. It is illegal to reproduce this material in any format without prior written approval of GARP. there will be no exceptions to this policy. Hewlett Packard 12C (including the HP 12C Platinum and the Anniversary Edition). After completing the FRM Practice Exams • Calculate your score by comparing your answer sheet with the practice exam answer key. Consult referenced core readings to prepare for the exam. Candidates are only allowed to bring certain types of calculators into the exam room. 3. © 2016 Global Association of Risk Professionals. You will not be allowed into the exam room with a personal calculator other than the following: Texas Instruments BA II Plus (including the BA II Plus Professional). 2 . Follow the FRM calculator policy. There is no penalty on the FRM Exam for an incorrect answer. • Remember: pass/fail status for the actual exam is based on the distribution of scores from all candidates. All rights reserved. Hewlett Packard 10B II+ and Hewlett Packard 20B. Points are awarded for correct answers. so use your scores only to gauge your own progress and level of preparedness.Financial Risk Manager Examination (FRM) Part II Practice Exam • • Complete the entire exam and answer all questions. Hewlett Packard 10B II. The only calculators authorized for use on the FRM Exam in 2016 are listed below.

___________ 21.___________ 60.___________ 80.___________ 72.__________ 31.___________ 71.___________ 69.___________ 65.___________ 3.___________ 22.___________ 27.___________ 47.___________ 29.__________ 39.___________ 56.___________ 41.___________ 73.___________ 16.___________ © 2016 Global Association of Risk Professionals.___________ 78. Global Association of Risk Professionals.___________ 43.___________ 48.___________ 55.___________ 74.___________ 26.___________ 59.___________ 61.__________ 32.__________ 57.___________ 25.___________ 62.___________ 75.___________ 10.___________ 54.__________ 30.___________ 4.__________ 38.___________ 20.___________ 51.___________ 46.___________ 63.___________ 49.Financial Risk Manager Examination (FRM) Part II Practice Exam 2016 Practice Exam.___________ 18.___________ 77.___________ 8. Part I – Candidate Answer Sheet 1.___________ 50.___________ 70.__________ 37.___________ 42.___________ 5. It is illegal to reproduce this material in any format without prior written approval of GARP.___________ 13.___________ 45.___________ 28.__________ 35.___________ 58.___________ 2.___________ 9.___________ 24.___________ 12.___________ 52.___________ 15.___________ 61.__________ 33.___________ 6.___________ 79.___________ 23.___________ 7.___________ 11.__________ 34.___________ 19. Inc.___________ 66.__________ 40.___________ 14. All rights reserved.___________ 17.__________ 36.___________ 68. 3 .___________ 67.___________ 53.___________ 44.___________ 76.

The current value of the portfolio is GBP 2. d.Financial Risk Manager Examination (FRM) Part II Practice Exam 1.000. Lognormal VaR is greater than normal VaR by GBP 487.500. return distribution has fat tails relative to the normal distribution. return distribution has thin tails relative to the normal distribution. The The The The returns are normally distributed. b. It is illegal to reproduce this material in any format without prior written approval of GARP.050 Lognormal VaR is greater than normal VaR by GBP 787. c. All rights reserved. c. An analyst is examining a sample of return data. 4 . b. How does the 1-year 95% VaR that is calculated using a normal distribution assumption (normal VaR) compare with the 1-year 95% VaR that is calculated using the lognormal distribution assumption (lognormal VaR)? a. the analyst construct a QQ plot of the data as shown below: Based on an examination of the QQ plot. respectively. Global Association of Risk Professionals.050 © 2016 Global Association of Risk Professionals. return distribution is negatively skewed relative to the normal distribution.050 Lognormal VaR is less than normal VaR by GBP 787. Inc. 2. The annual mean and volatility of a portfolio are 12% and 30%. d. As a first step.050 Lognormal VaR is less than normal VaR by GBP 487. which of the following statements is correct? a.

the buyer will pay the CDS spread.5% per year. A risk analyst is comparing the use of parametric and non-parametric approaches for calculating VaR and is concerned about some of the characteristics present in the loss data. what is the estimate for the CDS spread? a.Financial Risk Manager Examination (FRM) Part II Practice Exam 3. Which of the following distribution characteristics would make parametric approaches the favored method to use? a. If X is normally distributed. To purchase this CDS. The “peaks over threshold” (POT) approach considers a threshold value. the distribution of X must be elliptical and known. It is illegal to reproduce this material in any format without prior written approval of GARP. β. 5 . b. b. one must choose a threshold. which is high enough that the number of observations in excess of u is zero. As the threshold. To apply the POT approach. All rights reserved. c. u. Global Association of Risk Professionals. d. of X and the distribution of excess losses over this threshold. u. c. which is a positive scale parameter. To apply the POT approach. The risk-free rate is 2. 560 basis points 570 basis points 580 basis points 590 basis points © 2016 Global Association of Risk Professionals. Skewness in the distribution Fat tails in the distribution Scarcity of high magnitude loss events Heteroskedasticity in the distribution A risk analyst is valuing a 1-year credit default swap (CDS) contract that will pay the buyer 80% of the face value of a bond issued by a corporation immediately after a default by the corporation. Which of the following statements about this application of extreme value theory is correct? a. Assuming defaults can only occur halfway through the year and that the accrued premium is paid immediately after a default. which is a percentage of the face value. The analyst estimates that the risk-neutral default probability for the corporation is 7% per year. c. b. Inc. 5. increases. 4. d. the distribution of excess losses requires the estimation of only one parameter. d. once at the end of the year. u. the distribution of excess losses over u converges to a generalized Pareto distribution. Let X be a random variable representing the daily loss of your portfolio.

in general.0% b. 6 . and operational risk are well understood and are easy to estimate at the individual firm level. d. market. 12. Global Association of Risk Professionals.9% In its efforts to enhance its enterprise risk management function. Inc. The manager has estimated that the marginal probability of default of the LTM Bank bond is 4% in Year 1. 7% in Year 2.Financial Risk Manager Examination (FRM) Part II Practice Exam 6. Correlations between business units are only relevant in deciding total firm-wide economic capital levels and are not relevant for decisions at the individual business unit or project level. Which of the following statements regarding the correlations between these risks is correct? a. 12. c. What is the probability that the LTM bond makes coupon payments for 3 years and then defaults at the end of Year 3? 7.3% 14. The manager is currently evaluating the impact of various default scenarios to estimate future asset liquidity.6% 14. Correlations between the risks in the asset and liability sides of the balance sheet can be changed by management decisions. a. correlations between broad risk types such as credit. The introduction of correlations into firm-wide risk evaluation will result in a total VaR that. It is illegal to reproduce this material in any format without prior written approval of GARP. All rights reserved. The hedge fund specializes in bank debt and runs a strategy that utilizes both relative value and long-only trades using credit default swaps (CDS) and bonds. One of the new traders at the hedge fund has the positions described in the table below: Bank ABC LTM XYZ Position Long USD 12 million CDS Long USD 6 million bond Short USD 12 million CDS Credit AA BBB A Some of the hedge fund’s newest clients are restricted from withdrawing their funds for three years. Countryside Bank introduced a new decisionmaking process based on economic capital that involves assessing sources of risk across different business units and organizational levels. and 16% in Year 3. c. © 2016 Global Association of Risk Professionals. A risk manager at a small fixed-income hedge fund is evaluating the default conditions of several trade positions. d. b. is greater than or equal to the sum of individual business unit VaRs. Generally.

Global Association of Risk Professionals.500 million USD 6. causing its investment in equities to lose 40% of their market value. The 95% 1-day VaR for each individual position is USD 70. b. b. the manager has recommended increasing the loan equivalent factor to 0. For a typical facility that has an original principal of USD 1 billion and is 35% drawn.4 assigned to the undrawn portion in calculating its risk-adjusted return on capital. The portfolio VaR will increase by USD 20. 9. caused bond yields to decline by 1. At the end of 2014.5 million invested in Stock B.12 million USD -185. In addition. While rebalancing. the portfolio manager decides to sell USD 1 million of Stock A to buy USD 1 million of Stock B.4.195 million USD 8. c.0% for revolving credit facilities with a loan equivalent factor of 0. A bank uses a capital charge of 3. As such. This recommendation has been met with resistance from the loan origination team. All rights reserved. a pension fund had USD 650 million worth of assets that were fully invested in equities and USD 320 million in fixed-income liabilities with a modified duration of 13. c.300 million © 2016 Global Association of Risk Professionals.370. A risk manager of the bank has become concerned that the protective covenants embedded in these loans are weak and may not prevent customers from drawing on the facilities during times of stress. the immediate response from the government — cutting interest rates — to salvage the situation. The portfolio VaR will increase by USD 28.00 million USD -245. the widespread effects of the global energy crisis hit the pension fund. d.775 million USD 18. 10.281.85? a. d. what effect will this have on the 95% 1-day portfolio VaR? a. USD -330. It is illegal to reproduce this material in any format without prior written approval of GARP.800.88 million A portfolio has USD 3 million invested in Stock A and USD 1. The correlation between the returns of Stock A and Stock B is 0. Inc.85. USD 3. c. The portfolio VaR will not change. In 2015. What was the change in the pension fund’s surplus in 2015? a. how much additional economic capital would have to be allocated if the loan equivalent factor is increased from 0.000. d. and senior management has asked the risk manager to quantify the impact of the recommendation.4 to 0. The portfolio VaR will increase by USD 24.Financial Risk Manager Examination (FRM) Part II Practice Exam 8. Assuming that returns are normally distributed and that the rebalancing does not affect the volatility of the individual stocks. 7 .12 million USD -144.8%. b.

Which of the following statements regarding frictions in the securitization of subprime mortgages is correct? a. d. 3 5 8 10 In fixed income portfolio mapping. It is illegal to reproduce this material in any format without prior written approval of GARP. b. The originator will typically have an information advantage over the arranger. A risk manager is analyzing a 1-day 99% VaR model. d.Financial Risk Manager Examination (FRM) Part II Practice Exam 11. 13. The model The model The model The model rate. d. basis-point volatility of the short rate will be proportional to the rate. b. 14. which of the following mapping approaches requires that one risk factor be chosen that corresponds to average portfolio maturity? a. c. d. Which of the following describes this model? a. All rights reserved. and this creates a potential conflict of interest. The major credit rating agencies are paid by investors for their rating service of mortgage-backed securities. 12. at a 95% confidence level. The use of escrow accounts for insurance and tax payments eliminates the risk of foreclosure. Principal mapping Duration mapping Convexity mapping Cash mapping A risk manager is constructing a term structure model and intends to use the Cox-Ingersoll-Ross Model. basis-point volatility of the short rate will be proportional to the square root of the © 2016 Global Association of Risk Professionals. presumes presumes presumes presumes that the that the that the that the volatility of the short rate will increase at a predetermined rate. c. c. 8 . volatility of the short rate will decline exponentially to a constant level. Global Association of Risk Professionals. that the model is calibrated correctly? a. The arranger will typically have an information advantage over the originator with regard to the quality of the loans securitized. c. b. which can create an incentive for the originator to collaborate with the borrower in filing false loan applications. Inc. when the risk factors have been selected. what is the maximum number of daily losses exceeding the 1-day 99% VaR that is acceptable in a 1-year backtest to conclude. Assuming 225 days in a year. b.

The bond is expected to have a default probability of 3%. 16.03 combination combination combination combination A B C D © 2016 Global Association of Risk Professionals.000. b.000 28. Global Association of Risk Professionals. with an expected loss of 75 basis points in the event of default. c. c. Sell credit default swaps on ZTM. c. A financial firm conducts several trades. what is the minimum coupon spread needed on the bond for its expected return to match the risk-free rate? a.000 With the information provided. 90 basis points 120 basis points 180 basis points 240 basis points A credit risk manager for a bank is looking to mitigate counterparty credit risk exposure to ZTM. 9 . d.000 2. As part of its risk control.000. An analyst is reviewing a bond for investment purposes. Implement a netting scheme. what is the most appropriate credit risk mitigation technique in this case? a. 17. Increase collateral.35. Use credit triggers.000. d. Inc. It is illegal to reproduce this material in any format without prior written approval of GARP. b. b. it has entered into netting agreements on 10 equity trade positions with an average correlation of 0.22 B 7 0.000 60.07 D 14 –0.11 C 11 –0.Financial Risk Manager Examination (FRM) Part II Practice Exam 15.000. Currently the bank has the following derivatives contracts with ZTM: Contract Contract Value (HKD) A B C D 40. an A-rated firm. All rights reserved. The firm believes that it can improve upon the diversification benefit of netting by a judicious choice of number of exposures with a favorable correlation coefficient. Which of the following trade combinations would increase the firm’s expected netting benefit the most from the current level? Trade Combination a. If the current risk-free rate is 2%. d. Trade Trade Trade Trade Number of Positions Average Correlation A 5 0.

10 .38% and average bid-ask spread of CAD 0. 1-day 95% VaR? a. The presence of collateral increases the current exposure. Inc. Treasury note is zero.326 5. Using the constant spread approach on a 20. It is illegal to reproduce this material in any format without prior written approval of GARP. how much is the component VaR of stock A? a. c. Treasury note with an effective price volatility of 8%. An underlying exposure with an effective annual price volatility of 6% is collateralized by a 10-year U. The presence of collateral increases the current exposure and increases the volatility of the exposure between remargining periods. but increases the volatility of the exposure between remargining periods.582 7.327 million million million million © 2016 Global Association of Risk Professionals. 19.S. 20. All rights reserved.066 2. Global Association of Risk Professionals. CAD CAD CAD CAD 1. d. b. Which of the following would one expect to observe from this analysis? a. but decreases the volatility of the exposure between remargining periods.14. what is closest to the estimated liquidity-adjusted. The standard deviation of returns of stock A is 16% annually and that of the overall portfolio is 21% annually. DUY has an estimated daily return volatility of 0. The correlation of returns between stock A and the portfolio is 0. The presence of collateral decreases the current exposure.Financial Risk Manager Examination (FRM) Part II Practice Exam 18. EUR EUR EUR EUR 2. A trader observes a quote for Stock DUY. d. Changes in the value of the overall position (exposure plus collateral) are calculated for a 10-day horizon at a 95% confidence interval (assume a year of 250 days).000 share position and assuming the returns of DUY are normally distributed.600 6. Currently. the portfolio is valued at EUR 200 million and contains EUR 15 million in stock A. The correlation between the exposure and the U.600 7. c. Assuming the risk analyst uses a 1-year 99% VaR and that returns are normally distributed.600 A risk analyst is evaluating the risks of a portfolio of stocks.S.600 5. and the midpoint of its current best bid and best ask prices is CAD 45.37. b. c. d. The presence of collateral decreases the current exposure and decreases the volatility of the exposure between remargining periods. b.

. another repo borrower. The use of a central clearinghouse to handle the transactions executed between XYZ's main funding source. Repo Co. c. c. QUESTIONS 22 AND 23 REFER TO THE FOLLOWING INFORMATION XYZ. b. b. Pension fund risk analysis does not consider performance relative to a benchmark. It is illegal to reproduce this material in any format without prior written approval of GARP. ABC feared a run by its investors as news of the fraud spread. but primarily with ABC. who had provided false documentation of non-existent collateral of governmentguaranteed loans. specializes in structuring small business loans and selling the government guaranteed portion to other institutional investors while retaining the riskier portions for high net worth investors..Financial Risk Manager Examination (FRM) Part II Practice Exam 21. Inc. A pension plan’s total VaR is equal to the sum of its policy-mix VaR and active-management VaR. Last week. nominal pension obligations are similar to a short position in a long term bond.'s default risk. d. ABC's funding liquidity risk. if liabilities exceed assets. Global Association of Risk Professionals. © 2016 Global Association of Risk Professionals. From the plan sponsor’s perspective. All rights reserved. ABC and ABC's client. would likely have resulted in a reduction in: a. XYZ's lending risk. XYZ funds its operations by engaging in overnight repurchase agreements (repos) with three firms. In most defined-benefit pension plans. a firm that specializes in pooling funds from community banks and local government agencies and investing them in short-term. Which of the following statements about risk management in the pension fund industry is correct? a. 11 . XYZ learned that ABC had been defrauded by Repo Co. a small investment management firm. government-secured investments. XYZ was informed by ABC that its line had been frozen. d. high-quality. ABC's operational risk. Repo Co. The diagram below illustrates the parties involved: 22. the shortfall does not create a risk for the plan sponsor.

c. which would reduce ABC's counterparty risk. Which of the following Basel II approaches allows a bank to explicitly recognize diversification benefits? a. obligations owed between the two could have been netted once the fraudulent documentation was discovered. d. operational risk. d. and has domestically produced oil and natural gas as its most important exports. b.Financial Risk Manager Examination (FRM) Part II Practice Exam 23. Global Association of Risk Professionals.'s counterparty risk. the LaR can differ significantly from the VaR. Closeout netting would be used. but ABC's counterparty risk would be increased. several scenarios were considered.'s counterparty risk. The CEO of a regional bank understands that failing to anticipate cash flow needs is one of the most serious errors that a firm can make and demands that a good liquidity-at-risk (LaR) measurement system be an essential part of the bank's risk management framework. 26. Pillar 1 of the Basel II framework allows banks to use various approaches to calculate the capital requirements for credit risk.. b. 12 . By using a clearinghouse to handle the repo transactions between ABC and Repo Co. Payment netting would be used. An increase in domestic inflation and appreciation of the NLC A significant increase in crude oil prices and a decrease in the country housing price index A drop in crude oil prices and appreciation of the NLC A sustained decrease in natural gas prices and a decrease in the country’s stock index © 2016 Global Association of Risk Professionals. c. It is illegal to reproduce this material in any format without prior written approval of GARP. Closeout netting would be used. which would reduce ABC's counterparty risk. but this risk would be transferred to other creditors outside the clearinghouse. which would reduce Repo Co. For a hedged portfolio. Which of the following statements concerning LaR is correct? a. c. In a recent stress test of the country’s banking system. 24. b. which would reduce Repo Co. c. All rights reserved. Reducing the basis risk through hedging decreases LaR. b. Which of the following is most consistent with being part of a coherent scenario? a. and market risk. d. but this risk would be transferred to other creditors outside the clearinghouse. Inc. but ABC's counterparty risk would be increased. 25. Hedging using futures has the same impact on LaR as hedging using long option positions. d. A firm's LaR tends to decrease as its credit quality declines. NLC. Payment netting would be used. Which of the following is the most appropriate type of netting to use in this situation and what would be a likely additional impact from using this netting? a. The The The The internal models approach for market risk internal ratings based approach for credit risk basic indicator approach for operational risk standardized approach for operational risk A country with a developed economy maintains its own currency.

risk control is implemented by overweighting the categories with lower risks and underweighting the categories with higher risks. the surplus value will be greater than or equal to: a. When considering a leveraged fund. including funding liquidity risks during periods of market stress. USD -44. c. All rights reserved. and in general if more than 10% of asset prices are based on model prices or broker quotes. It is crucial to assess the fund's valuation policy. d. the specialist should recommend against investment in the fund regardless of other information available about the fund. 29. The screening technique provides superior risk control by concentrating stocks in selected sectors based on expected alpha. c.Financial Risk Manager Examination (FRM) Part II Practice Exam 27. Because of the overwhelming importance of tail risk.9 million USD 0 million A due diligence specialist at a company is evaluating the risk management process of a hedge fund in which the company is considering making an investment. 13 . d. Global Association of Risk Professionals. © 2016 Global Association of Risk Professionals. Quadratic programming allows for risk control through parameter estimation but generally requires many more inputs estimated from market data than other methods require. d. When using the linear programming technique. The advisor can report that. The advisor assumes that annual returns on assets and the annual growth of the liabilities are jointly normally distributed and their correlation coefficient is 0. When using the stratification technique. 28. b. It is illegal to reproduce this material in any format without prior written approval of GARP.99% level when estimating VaR. b. the specialist should assess how the fund estimates risks related to leverage. the advisor estimates the possible surplus values at the end of one year. Which of the following statements best describes criteria used for such an evaluation? a. with a confidence level of 95%.75.4 million USD -2.1 million USD -14. Which statement about risk control in portfolio construction is correct? a. Inc. b. An analyst reports the following fund information to the advisor of a pension fund that currently invests in government and corporate bonds and carries a surplus of USD 10 million: Pension Assets Liabilities Amount (in USD million) Expected Annual Growth Modified Duration Annual Volatility of Growth 150 7% 13 14% 120 9% 10 6% To evaluate the sufficiency of the fund's surplus. c. Today's best practices in risk management require that a fund employ independent risk service providers and that these service providers play important roles in risk-related decisions. the company should not invest in the fund unless it fully accounts for fat tails using extreme value theory at the 99. risk is controlled by selecting the portfolio with the lowest level of active risk.

79%. c. LEM Banking Corporation requests a reduction in the CVA charge it pays. GXT Bank was downgraded from a rating of AA to a rating of A. the credit spread for GTX Bank has increased from 25 bps to 155 bps. with the goal of reducing it to almost zero.63%. Using the criterion of adjusted risk-adjusted return on capital (ARAROC). It is illegal to reproduce this material in any format without prior written approval of GARP. An analyst estimates that the hazard rate for a company is 0. could best achieve this goal? a.Financial Risk Manager Examination (FRM) Part II Practice Exam 30. dominate the market for such derivatives. 33. often enters into transactions with GXT Bank.16 per year. The credit qualities of the counterparties have migrated. GTX Bank requests an increase in the CVA charge it receives. b. Accept the project because the ARAROC is higher than the market expected excess return. c. 14 . all of whom have large notional outstanding contracts with the company. © 2016 Global Association of Risk Professionals. but not significantly enough to justify amending existing CVA arrangements. Reject the project because the ARAROC is higher than the market expected excess return. 11. Accept the project because the ARAROC is lower than the market expected excess return. CVA is no longer a relevant factor. and the company's equity beta is 1. b.39%. if implemented. Which of the following is the most likely action that the counterparties will request on their credit value adjustment (CVA)? a. Suppose that the risk-free rate is 4% per year. The probability of survival in the first year followed by a default in the second year is closest to: a. The company’s management would like to mitigate its overall counterparty exposure. such as credit default swaps LEM Banking Corporation. the company should: a. 14. Reject the project because the ARAROC is lower than the market expected excess return. c. c. The company and a handful of other firms. A chemical company is considering a project that has an estimated risk-adjusted return on capital (RAROC) of 17%. d. b. Ensuring that sufficient collateral is posted by counterparties Diversifying among counterparties Cross-product netting on a single counterparty basis Purchasing credit derivatives. b. and the counterparties should migrate to using other mitigants of counterparty risk. d. a frequent user of swaps. a major provider of swaps. 27. 13. while LEM Banking Corporation was downgraded from a rating of A to a rating of A-. while the credit spread for LEM Banking has increased from 120 bps to 160 bps. 32. All rights reserved. Recently.62%.5. 31. the expected market rate of return is 12% per year. d. A specialist finance company only trades derivatives on rare commodities. Global Association of Risk Professionals. Which of the following methods. Inc. During this time. d.

00% 87. 35.00% 6. It is illegal to reproduce this material in any format without prior written approval of GARP. a firm bought an AA-rated corporate bond at USD 108 per USD 100 face value.25% 0. Inc. b. A position in the stock market index is mapped on a position in a stock within that index. Each position in a corporate bond portfolio is mapped on the bond with the closest maturity among a set of government bonds. All rights reserved. Using market data. Government bonds paying regular coupons are mapped on zero-coupon government bonds. USD/EUR forward contracts are mapped on the USD/JPY spot exchange rate.35% What is the 1-year 95% credit VaR per USD 100 of face value closest to? a. c. At the beginning of the year.Financial Risk Manager Examination (FRM) Part II Practice Exam 34. USD 3 USD 11 USD 18 USD 22 Computing VaR on a portfolio containing a very large number of positions can be simplified by mapping these positions to a smaller number of elementary risk factors. b. Which of the following mappings would be adequate? a. d. the risk manager estimates the 1-year transition probabilities on the AA-rated corporate bond: Rating AAA AA A BBB BB B CCC Default Probability of State 2. 15 .00% 3. d.30% 0. c. © 2016 Global Association of Risk Professionals. the risk manager estimates the following year-end values for the bond based on interest rate simulations informed by the economics team: Rating AAA AA A BBB BB B CCC Default Year-end Bond Value (USD per USD 100 face value) 110 106 101 97 86 76 67 43 In addition. Global Association of Risk Professionals.65% 0.45% 0.

b. Current interest rate volatility is high and the risk manager is concerned about the effect this may have on short-term rates when pricing the option. © 2016 Global Association of Risk Professionals. The risk manager uses a normal distribution of interest rates. d. c. 16 . When short-term rates are negative. estimated using the Black-Scholes-Merton model and the current prices of actively traded European-style options on stock XYZ at various strike prices. It is illegal to reproduce this material in any format without prior written approval of GARP. the risk manager increases the volatility. which of the following long positions will be undervalued? a. the risk manager sets the rate to zero. When short-term rates are negative. c. the risk manager adjusts the risk-neutral probabilities. d. is shown below: Implied Volatility 36. b. Strike Price (GBP) Assuming that the implied volatility at GBP 30 is used to conduct the valuation. 37. An An An An out-of-the-money call in-the-money call at-the-money put in-the-money put A risk manager is pricing a 10-year call option on 10-year Treasury using a successfully tested pricing model. When short-term rates are negative. Global Association of Risk Professionals. All rights reserved.Financial Risk Manager Examination (FRM) Part II Practice Exam A risk manager is in the process of valuing several European option positions on a non-dividend-paying stock XYZ that is currently priced at GBP 30. The implied volatility skew. Inc. Which of the following actions would best address the potential for negative short-term interest rates to arise in the model? a.

which has been used broadly across the firm for several years. Relative to VaR. equally weighted. ES is easier to backtest than VaR. © 2016 Global Association of Risk Professionals. Expected shortfall (ES) is suggested as a better alternative to use during market turmoil. the new model is used in parallel with the existing model for four weeks to estimate the 1-day 95% VaR. A large commercial bank is using VaR as its main risk measurement tool. What should be understood regarding VaR and ES before modifying current practices? a. The new model uses volatilities and correlations estimated over the past four years using the Riskmetrics EWMA method. d. A quantitative analyst in the group quickly develops a new VaR model. It is illegal to reproduce this material in any format without prior written approval of GARP. which uses the delta normal approach. Delta-normal VaR is more appropriate than historical simulation VaR for assets with non-linear payoffs. c. the new VaR model has no exceedances despite consistently estimating VaR to be considerably lower than the existing model's estimates. will understate the risk in the portfolio. After four weeks. the model evaluation team agrees to accept the new model for use by the desk. exponentially weighted. A 95% VaR model that generates no exceedances in four weeks is necessarily conservative. While VaR ensures that the estimate of portfolio risk is less than or equal to the sum of the risks of that portfolio’s positions. c.Financial Risk Manager Examination (FRM) Part II Practice Exam 38. Global Association of Risk Professionals. The analyst argues that the lack of exceedances shows that the new model is unbiased and pressures the bank’s model evaluation team to agree. Which of the following statements about the risk management implications of this replacement is correct? a. 39. b. ES does not. Both VaR and ES account for the severity of losses beyond the confidence threshold. Following an overnight examination of the new model by one junior analyst instead of the customary evaluation that takes several weeks and involves a senior member of the team. b. Question 39 refers to the following information: A profitable derivatives trading desk at a bank decides that its existing VaR model. is too conservative. For testing purposes. d. ES leads to more required economic capital for the same confidence level. Changing the look-back period and weighing scheme from three years. to four years. The desk increased its exposure to model risk due to the potential for incorrect calibration and programming errors related to the new model. The existing VaR model uses a historical simulation over a threeyear look-back period. weighting each day equally. All rights reserved. 17 . Despite being more complicated to calculate. Inc.

b. It is illegal to reproduce this material in any format without prior written approval of GARP. d. d. 1-day 95% VaR? a. what is the estimated liquidity adjusted. b.29% 5. c. 1. which of the following is the best estimate of the bank’s current leverage ratio? a. Which of the following is not a type of operational risk as defined by Basel II and Basel III? a. EUR EUR EUR EUR 108 210 420 528 © 2016 Global Association of Risk Professionals.18. The average bid-ask spread is EUR 0. c. All rights reserved.84% 7.280 Using the Basel III framework.200 share position in an undervalued but illiquid stock TQR that has a current stock price of EUR 76 (expressed as the midpoint of the current bid-ask spread). Global Association of Risk Professionals. 18 . d. The daily return for TQR has an estimated volatility of 0. 42.28%.67% Human error and internal fraud Destruction by fire or other external catastrophes Damaged reputation due to a failed merger Failure or breakdown in internal control processes Consider a 1.38% 8. Inc. The bank's average capital and total exposure for the most recent quarter is as follows: REGULATORY CAPITAL Total Common Equity Tier 1 Capital Additional Tier 1 Capital USD MILLIONS 250 66 Prior to regulatory adjustments Regulatory adjustments 40 8 Total Tier 1 Capital Tier 2 Capital Prior to regulatory adjustments Regulatory adjustments Total Capital Total Average Exposure 316 55 63 8 371 4. The CFO at a bank is preparing a report to the board of directors on its compliance with Basel requirements. Using the constant spread approach and assuming the returns of TQR are normally distributed.Financial Risk Manager Examination (FRM) Part II Practice Exam 40. b. 41. c.

Bank Bank Bank Bank W X Y Z Which of the following is an example of an operational risk loss by Firm A? a. they are in breach of a legal agreement to pay for services rendered. leading to significant losses. Rapid asset growth Positive publicity Credit rating upgrade Increased asset diversification At times. causing major investment losses. c. A counterparty of Firm A fails to settle their debt to Firm A. overnight) repurchase agreements in which creditors held bank securities as collateral against default losses. b. Global Association of Risk Professionals. which bank is most vulnerable to a liquidity crisis? a. large dealer banks have financed significant fractions of their assets using short-term (often. d. After a surprise announcement by the central bank that interest rates would increase.469 1. It is illegal to reproduce this material in any format without prior written approval of GARP. b. Which of the following is an early warning indicator of a potential liquidity problem? a.300 1.669 2. All values are in USD billions. the share price of a company that Firm A invested in falls significantly. 44. The Basel Committee recommends that banks use a set of early warning indicators in order to identify emerging risks and potential vulnerabilities in their liquidity position. b. bond prices fall.Financial Risk Manager Examination (FRM) Part II Practice Exam 43.450 Pledged as collateral 1. Bank W Bank X Bank Y Bank Z Financial instruments owned 2. and in doing this. As a result of an increase in commodity prices.625 In the event that repo creditors become equally nervous about each bank’s solvency.230 2. 19 .100 3.550 1.850 3. d.200 1.870 825 Not pledged 1. The table below shows the quarter-end financing of four broker-dealer financial instruments. The data capture system of Firm A fails to capture the correct market rates causing derivative trades to be done at incorrect prices. All rights reserved. d. c. c. © 2016 Global Association of Risk Professionals. 45. Inc. and Firm A incurs a significant loss on its bond portfolio.

b. It is illegal to reproduce this material in any format without prior written approval of GARP. The risk management group estimates the 1-day 99% VaR on a long-only. market risk distribution is similar to the distribution of the return on a portfolio of securities. credit. Which of the following observations of the bank’s data should be considered unexpected if compared to similar industry data? a. All rights reserved. The The The The operational risk loss distribution has a large number of small losses. c. A daily risk report shows the following information: 1-day 99% VaR Estimates (by approach): Delta-Normal VaR: USD 441.Financial Risk Manager Examination (FRM) Part II Practice Exam 46. operational risk loss distribution is symmetric and fat-tailed. large-cap equity portfolio using a variety of approaches. a risk analyst takes an inventory of firm risks and categorizes these risks as market. 20 . Data problems Differences in model assumptions Endogenous model risk Programming errors While building the bank’s enterprise risk management system. Global Association of Risk Professionals. d. © 2016 Global Association of Risk Professionals.584 Which of the following is the most likely explanation for the variation in VaR estimates? a.906 Historical Simulation VaR: 495. c. b. or operational. Inc. credit risk distribution is asymmetric and fat-tailed.940 Monte Carlo Simulation VaR: USD 473. 47. and therefore a relatively low mode. d.

26. A bank uses the internal models approach for market risk and has generated the following risk measures (in USD million) for the current trading book positions: Average 10-day VaR Average 10-day Stressed VaR 10-day Stressed VaR of Previous of Previous 60 Days 60 Days 305 664 340 743 99. d.502 million million million million © 2016 Global Association of Risk Professionals. 21 . It is illegal to reproduce this material in any format without prior written approval of GARP.9% 757 1. the Basel Committee revised the market risk framework and introduced a stressed VaR requirement. b.489 99. All rights reserved. 35.2% Annual interest rate on loan: 6. d. 49.665 USD 3.977 USD 6.844 Confidence Level Latest Available 10-day VaR 95.726 708 1. A.5% As a result of the credit crisis. Global Association of Risk Professionals.0% of face value of loan Annual operating costs: 1. 10. c.0% of face value of loan Economic capital: 8. Bank BHC is considering a loan to be fully funded by deposits.0% Latest Available The supervisory authority has set the multiplication factors for both the VaR and stressed VaR values to 3. What is the capital requirement for general market risk? a.0% 588 1. with the following parameters: Loan amount: GBP 5 billion Average annual interest rate paid on deposits: 1. Inc. USD 1.5% C.Financial Risk Manager Examination (FRM) Part II Practice Exam 48.5% B.0% Expected loss: 2. 9. c.5% D.0% Average return on economic capital: 4.345 555 1.132 USD 8. b.0% What is the risk-adjusted return on capital for this loan? a.

what would be the loss to the bank if netting is used? a.Financial Risk Manager Examination (FRM) Part II Practice Exam 50. d. Buy the senior tranche and sell the equity tranche. 52.000 and a 0% recovery rate issued by Company K. A bank has many open derivative positions with an investment firm. Consider a 1-year maturity zero-coupon bond with a face value of USD 1. Assuming the excess spread only captures credit risk and that the risk-free rate is 3% per annum.000. USD 0 million USD 12 million USD 21 million USD 33 million © 2016 Global Association of Risk Professionals. c. b. which of the following is a good strategy to pursue? a. Sell the senior tranche and sell the equity tranche. the risk-neutral 1-year probability of default on Company K is closest to which of the following? a. It is illegal to reproduce this material in any format without prior written approval of GARP. Global Association of Risk Professionals. A description and current market values are displayed in the table below: Positions Market Long swaptions Price (USD) 21 million Long credit default swaps -33 million Short currency derivatives 33 million In the event that the investment firm defaults. The fund’s chief economist predicts that the default probability will decrease significantly and that the default correlation will increase. b. 22 . All rights reserved. b. 7% 10% 13% 15% Buy the senior tranche and buy the equity tranche. d. 51. d. Based on this prediction. c. c. The bond is currently trading at 90% of face value. Sell the senior tranche and buy the equity tranche. A hedge fund is considering taking positions in various tranches of a collateralized debt obligation (CDO). Inc.

40 Will gain significant value.33% © 2016 Global Association of Risk Professionals. b. and the marginal default probability in year one is 7%. It is illegal to reproduce this material in any format without prior written approval of GARP. 54. 55. USD 0. a strike price of USD 105. an underlying asset price of USD 85. 3. 23 . d. Inc. d.Financial Risk Manager Examination (FRM) Part II Practice Exam 53. What is the firm’s counterparty credit exposure from this transaction? a. since only expected default losses matter and correlation does not affect expected default losses. The T-bond (a risk-free bond) yields 8% per year. Will lose significant value. c. the investor’s position: a. b. An investor has sold default protection on the most senior tranche of a CDO. All rights reserved. The one-year BB-rated discount bond yields 14% per year. Can either increase or decrease. d. implied volatility of 24% and a risk-free rate of 3%. If the default correlation between assets held in the CDO decreases sharply. since the probability of exercising the protection falls.85% 5.74% 20.68 USD 2. Will neither gain nor lose value. assuming everything else is unchanged. Suppose that you want to estimate the implied default probability for a BB-rated discount corporate bond.00 USD 0. c.38 USD 32. c. If the recovery rate on a BB-rated bond is expected to be 0%. Global Association of Risk Professionals.26% 10. which of the following is the best estimate of the risk-neutral probability that the BB-rated discount bond defaults within the next two years? a. depending on the pricing model used and the market conditions. A financial firm sells a put option on ABC stock with a time to expiration of six months. since the protection will gain value. The two-year BB-rated discount bond yields 21% per year. b.

A. what is the correct order of net exposure per counterparty. A. 24 . b.Financial Risk Manager Examination (FRM) Part II Practice Exam 56. A credit manager overseeing the structured credit book of a bank works on identifying the frictions in the securitization process that caused the recent subprime mortgage crisis in the United States. B D. Global Association of Risk Professionals. c. D. B C. All rights reserved. C. C. d. from lowest to highest? MtM Trades for Four Counterparties (USD million) Opposing Counterparty Counterparty A Counterparty B Counterparty C B C D Trades with positive MtM 12 12 2 Trades with negative MtM -12 -4 -12 A C D Trades with positive MtM 12 0 12 Trades with negative MtM -12 -6 -1 A B D 6 6 3 -12 0 -2 A B C Trades with positive MtM 12 3 1 Trades with negative MtM -2 -12 -1 Trades with positive MtM Trades with negative MtM Counterparty D a. servicer and asset manager: moral hazard. The exhibit below presents a summary of bilateral mark-to-market (MtM) trades for four counterparties. D. Of the following frictions in the securitization process. B. It is illegal to reproduce this material in any format without prior written approval of GARP. which one was not a cause of the subprime crisis? a. B. A. 57. asset manager and investor: principal-agent conflict. d. b. c. Inc. D B. C © 2016 Global Association of Risk Professionals. If netting agreements exist between all pairs of counterparties shown. originator and the arranger: predatory borrowing and lending. Frictions Frictions Frictions Frictions between between between between the the the the mortgagor and the originator: predatory lending.

Global Association of Risk Professionals. b. Inc. c. d. Compared to the lognormal distribution. All rights reserved. thin left tail and a fat right tail. © 2016 Global Association of Risk Professionals. It is illegal to reproduce this material in any format without prior written approval of GARP. The observed volatility skew for a particular equity index slopes downward to the right. Which of the following graphs is an accurate representation of a typical potential future exposure (PFE) profile for the corresponding instrument? 59. the distribution of option prices on this index implied by the Black-Scholes-Merton (BSM) model would have: a.Financial Risk Manager Examination (FRM) Part II Practice Exam 58. A risk manager is examining a firm’s equity index option price assumptions. thin left tail and a thin right tail. 25 . A A A A fat left tail and a thin right tail. fat left tail and a fat right tail.

Financial Risk Manager Examination (FRM) Part II Practice Exam 60. When backtesting using a 90% confidence level.350.000 99.000 98. USD 543 USD 588 USD 621 USD 740 million million million million You are backtesting a bank’s VaR model.0% 503.5% 740.000 97. d. b.000 97.5% 636. the bank calculates a 1-day VaR at the 99% confidence level. c.0% 520.5% 511. The 95% VaR model is less likely to be rejected using backtesting than the 99% VaR model.0% 677.300. 26 .0% 562. Currently.000.350.000 What is the closest estimate of the daily expected shortfall at the 96.000 96. there is a smaller probability of committing a type I error when backtesting a 95% VaR model than with a 99% VaR model.750. Which of the following statements concerning this switch is correct? a.000 95. It is illegal to reproduce this material in any format without prior written approval of GARP.700.250. d. When validating with backtesting at the 90% confidence level.750.5% confidence level? a. A money management firm has USD 33 billion in assets.550. and you are recommending that it switch to a 95% confidence level. Inc.5% 581.0% 605. Global Association of Risk Professionals.150. The risk manager computes the daily VaR at various confidence levels as follows: Confidence Level VaR (USD) 95. there is a smaller probability of incorrectly rejecting a 95% VaR model than a 99% VaR model.000 98. c. 61.000 99. The decision to accept or reject a VaR model based on backtesting results is more reliable with a 95% confidence level VaR model than with a 99% confidence level model. © 2016 Global Association of Risk Professionals.000 96. All rights reserved. b.5% 542.

Price Price Price Price the the the the option option option option on on on on FBX FBX FBX FBX relatively relatively relatively relatively high and price the option on EUR/JPY relatively low. b. for any joint distribution H. b. It is illegal to reproduce this material in any format without prior written approval of GARP.Y) is equal to C[(X – 4)/3. (Y – 5)/3] is equal to C(X. The risk manager wants to model their joint distribution. (Y – 5)/3]. and Y is uniformly distributed between 5 and 8. The Ho-Lee Model: a. H(X. H(X. 3Y + 5) is equal to C[X. Allows for a risk premium to be applied to interest rates that changes over time. b. d. Incorporates drift as a premium to interest rates that remains constant over time. instead of the implied risk-neutral probability distribution. Incorporates drift into the model following the assumption that rates revert to the long-run equilibrium value. d. A risk manager wants to study the behavior of a portfolio that depends on only two economic variables. Incorporates no-risk premium to the interest rate model allowing rates to vary according to their volatility.Y). 63.d] where u is the density marginal distribution of X and d is the density marginal distribution of Y. The practitioners price these options based on two distinct probability distributions of underlying asset prices at the option expiration date: • A lognormal probability distribution • An implied risk-neutral probability distribution obtained from the volatility smile for options of the same maturity Using the lognormal. All rights reserved. H(X.Financial Risk Manager Examination (FRM) Part II Practice Exam 62. d. c. A committee of risk management practitioners discusses the difference between pricing deep out-of-the-money call options on FBX stock and pricing deep out-of-the-money call options on the EUR/JPY foreign exchange rate using the Black-Scholes-Merton (BSM) model. Inc. will tend to: a. low and price the option on EUR/JPY relatively high. 64. low and price the option on EUR/JPY relatively low. H(3X + 4. X is uniformly distributed between 4 and 7. c. An analyst is looking at various models used to incorporate drift into term structure models.Y). Global Association of Risk Professionals. 27 . © 2016 Global Association of Risk Professionals. The theorem of Sklar proves that. there is a copula C such that: a. high and price the option on EUR/JPY relatively high.Y) is equal to C[u. c. H[(X – 4)/3. X and Y.Y].

000 forward contracts on LTM. USD 2.Financial Risk Manager Examination (FRM) Part II Practice Exam 65. 66. d. Assuming 250 trading days in a year and the volatility of LTM is 23% per year.000 deep out-of-the-money call options on LTM. b.000 deep in-the-money call options on LTM and 25. a penalty is given to banks that have more than four exceptions to their 1-day 99% VaR over the course of 250 trading days. A large move in interest rates was combined with a small move in correlations.701 USD 14. The bank’s model calculates interest rate risk based on the median duration of the bonds in the portfolio. Inc. which causes the reliability of the parameter estimates to increase. d. The number of exceedances decreases as the threshold value decreases. The portfolio is made up of 5. The bank increases its intraday trading activity.706 © 2016 Global Association of Risk Professionals. c. Based on Basel II rules for backtesting.235 USD 30. which of the following amounts would be closest to the 1day VaR of the portfolio at the 99 percent confidence level? a. d. All rights reserved. The portfolio also contains 10. c. 28 . b. c. The threshold value is typically chosen near the estimated mean of the underlying loss distribution. It is illegal to reproduce this material in any format without prior written approval of GARP. which of the following is correct? a. The supervisor gives these penalties based on four criteria. A portfolio manager owns a portfolio of options on a non-dividend paying stock LTM. the underlying loss distribution must be either normal or lognormal. To apply EVT. when examining distributions of losses exceeding a threshold value. Global Association of Risk Professionals. LTM is trading at USD 84. According to extreme value theory (EVT). Which of the following causes of exceptions is most likely to lead to a penalty? a. b.151 USD 42. A sudden market crisis in an emerging market leads to losses in the equity positions in that country. As the threshold value is increased. the distribution of exceedances converges to a generalized Pareto distribution. 67.

It is illegal to reproduce this material in any format without prior written approval of GARP. Consider the following two asset portfolios under management at an investment company: Position Value Return Standard (in millions of EUR) Deviation (%) Beta XYZ 560 4.Financial Risk Manager Examination (FRM) Part II Practice Exam 68. Component Component Component Component VaR VaR VaR VaR = = = = USD 32. respectively.7 ABC 640 7. c.200. nominal pension obligations are similar to a short position in a bond. and USD 80.200. All rights reserved. From the plan sponsor’s perspective.0587 0.539. d. In most defined-benefit pension plans.20 0. 29 . Pension fund risk analysis does not consider performance relative to a benchmark.85 1.1258 0. and USD 80. b. c. A pension plan’s total VaR is equal to the sum of its policy-mix VaR and active management VaR.840.200 5. if liabilities exceed assets.840.886.1258 Which of the following statements about risk management in the pension fund industry is correct? a.539. and Marginal Marginal Marginal Marginal VaR = VaR = VaR = VaR = 0. b. 69. at the 95% confidence level? a. and USD 32. © 2016 Global Association of Risk Professionals.5 1. Global Association of Risk Professionals.0587 0. d.886.10 1. the shortfall does not create a risk for the plan sponsor. Inc.0 Asset Portfolio What is the Component VaR of asset XYZ and the Marginal VaR of asset ABC.

what will be the reduction in portfolio VaR? a. Asset Position Individual VaR Marginal VaR VaR Contribution 1 USD 180 USD 41.2 Portfolio USD 360 USD 110. b. d.94 USD 83. 30 . σi is the volatility of the return of asset i and σp is the volatility of the return of the portfolio.94 0. All rights reserved. USD 110.Financial Risk Manager Examination (FRM) Part II Practice Exam Questions 70 and 71 are based on the following information. c. c.88 0. USD 26.94 USD 46. d. b. d. If the alphas are normally distributed with a mean of 0%.88 Let βi = ρip*σi/σp. Global Association of Risk Professionals. It is illegal to reproduce this material in any format without prior written approval of GARP. where ρip denotes the correlation between the return of asset i and the return of the portfolio. What is β2? a.84 USD 41.644 1.575 Cannot determine from information provided. 5 10 20 25 © 2016 Global Association of Risk Professionals. A risk manager assumes that the joint distribution of returns is multivariate normal and calculates the following risk measures for a two-asset portfolio: 70. Inc. b. 72.792 USD 79. The resulting pool of 100 alphas has a residual risk of 18% and an information coefficient of 9%. An analyst regresses the returns of 100 stocks against the returns of a major market index.72 0.6 2 USD 180 USD 83.396 USD 39.72 If Asset 1 is dropped from the portfolio. c. roughly how many stocks have an alpha greater than 4% or less than -4%? a.288 2. 71.

Asset Asset Asset Asset A B C D A risk officer of a bank is evaluating the four rules for credit scoring model performance measurement.6 0. d. The fund is benchmarked to an index and. the manager is considering increasing the holdings of one of the four assets described in the following table: Portfolio Expected Beta to Beta to the Weight Return the Index Portfolio A 1. which asset should the portfolio manager select? a. 74.1. c. © 2016 Global Association of Risk Professionals. d. b. Neyman-Pearson rule minimizes type I error with type II error remaining constant.2% 12% 1. rather than adding a new holding. Global Association of Risk Professionals. d.90 B 0.3 1. Which of the following best describes the impact this has historically had on hedge fund analyses performed using these databases? a. average correlation of hedge fund returns is overstated. “Minimum-Risk” Decision Rule tries to minimize both credit and market risks. It is illegal to reproduce this material in any format without prior written approval of GARP.2 0.10 Asset The portfolio manager wants to select the asset that has the lowest marginal VaR as long as its Treynor ratio is at least 0. A portfolio manager wants to invest a small amount of new money that has recently come into a fund. Which of the following is correct? a.8% 10% 0. c.75 10% 0.Financial Risk Manager Examination (FRM) Part II Practice Exam 73. 75. A significant percentage of hedge funds stop trading each year and drop out of hedge fund databases. All rights reserved. Neyman-Pearson rule minimizes type II error with type I error remaining constant. c.90 C 0.85 D 0. 31 . b. Assuming the risk free rate is 2%. Inc.7 0. The The The The “Minimum-Risk” Decision Rule tries to minimize both type I and type II errors.35 8% 0. b. average volatility of hedge funds is overstated. average Sharpe ratio of hedge fund returns is understated. The The The The average performance of hedge funds is overstated.

c. Which of the following loss severity and loss frequency distribution pairs is the most appropriate to use? a. d. A major regional bank has determined that a counterparty has a constant default probability of 5. normal distribution for frequency. 32 . Poisson distribution for frequency. what is the estimated component VaR of stock XYZ? a. lognormal distribution for severity. c. 4. 79. A company's pension fund is established as a defined benefit plan. Global Association of Risk Professionals. A risk manager is evaluating the risk profile for a portfolio of stocks. The standard deviation of returns of stock XYZ is 11% annually and that of the overall portfolio is 18% annually.397 billion A risk team in the investment banking subsidiary of a bank holding company is setting up a Monte Carlo simulation methodology to estimate the subsidiary’s aggregate loss distribution. Assuming the risk analyst uses a 1-year 95% VaR and that returns are normally distributed. c.524 billion JPY 6. lognormal distribution for frequency. What is the probability of this counterparty defaulting in the fourth year? a. Binomial distribution for frequency. the lower the funding risk. Inc.714 billion JPY 3. b. Funding risk represents the true long-term risk to the plan sponsor. d. The longer the horizon for expected payouts. The funding risk has been effectively transferred to the employees. b. Currently. © 2016 Global Association of Risk Professionals. 77.5% per year. b. c. d. the portfolio is valued at JPY 128 billion and contains JPY 25 billion in stock XYZ. 78. It is illegal to reproduce this material in any format without prior written approval of GARP. Binomial distribution for severity. The correlation of returns between stock XYZ and the portfolio is 0. normal distribution for severity.39% 4.50% JPY 2.91% 5. Which of the following statements about the pension fund’s funding risk is correct? a.838 billion JPY 4.6. d. and therefore the board must consider funding risk. Poisson distribution for severity. Decreases in interest rates will reduce funding risk. All rights reserved.64% 4. b.Financial Risk Manager Examination (FRM) Part II Practice Exam 76.

95%. b. Global Association of Risk Professionals. © 2016 Global Association of Risk Professionals. They consider a scenario in which the bank’s capital and risk-weighted assets are as shown in the table below (all values are in EUR millions): Item Risk-weighted assets Common equity Tier 1 (CET1) capital Additional Tier 1 capital Total Tier 1 capital Tier 2 capital Tier 3 capital Total capital Value 3. d. The CET1 capital ratio plus the capital conservation buffer only. The CET1 capital ratio only.480 145 50 195 98 0 293 Assuming that all Basel III phase-ins have occurred and that the bank’s required countercyclical buffer is 0. The risk management department at a bank is trying to assess the impact of the capital conservation and countercyclical buffers defined in the Basel III framework. None of the above. Inc. which of the capital ratios does the bank satisfy? a. It is illegal to reproduce this material in any format without prior written approval of GARP. All rights reserved.Financial Risk Manager Examination (FRM) Part II Practice Exam 80. 33 . The CET1 capital ratio plus the capital conservation buffer and the countercyclical buffer. c.

___________ 47.___________ 49.___________ 2.___________ 27.___________ 58.___________ 68.___________ 19.__________ 57.___________ 53.__________ 32.___________ 55.___________ 7.___________ 29. All rights reserved.___________ 8.___________ 78.___________ 80.__________ 31.___________ 72.___________ 28.___________ 41.___________ 50.___________ 45.___________ 44.___________ 52.___________ 4.___________ 13.___________ 25. Inc. It is illegal to reproduce this material in any format without prior written approval of GARP.___________ 62.___________ 74.__________ 30.___________ 60.___________ 26.___________ 22.___________ 79.___________ 56.___________ 67.___________ 63.___________ 15.___________ 12.__________ 35.___________ 77.__________ 34.___________ 61.___________ 9.__________ 39.___________ 51.___________ 71.___________ 5.___________ 54. Part II – Candidate Answer Sheet 1.Financial Risk Manager Examination (FRM) Part II Practice Exam 2016 Practice Exam.__________ 38. Global Association of Risk Professionals.___________ 43.__________ 33.___________ 70.___________ 75.__________ 37.___________ 18.___________ © 2016 Global Association of Risk Professionals.___________ 11.__________ 40.__________ 36.___________ 10.___________ 76.___________ 14.___________ 48.___________ 46.___________ 23. 34 .___________ 20.___________ 6.___________ 17.___________ 42.___________ 59.___________ 16.___________ 69.___________ 24.___________ 21.___________ 73.___________ 3.___________ 65.___________ 66.___________ 61.

Inc. A distribution with thin tails would produce a QQ plot with less steep slopes at the tails of the plot than a linear relationship. return distribution has thin tails relative to the normal distribution. Chapter 3. b. Measuring Market Risk. As a first step. © 2016 Global Association of Risk Professionals. the analyst construct a QQ plot of the data as shown below: Based on an examination of the QQ plot. It is not a negatively skewed distribution. A normal distribution would result in a linear QQ plot. 2005). All rights reserved. It is illegal to reproduce this material in any format without prior written approval of GARP. An analyst is examining a sample of return data. Section: Market Risk Management and Measurement Reference: Kevin Dowd. Global Association of Risk Professionals. c.Financial Risk Manager Examination (FRM) Part II Practice Exam 1. d. while this one is steeper at the tails. Second Edition (West Sussex. The The The The returns are normally distributed. as the Q-Q plot is symmetric. Estimating Market Risk Measures: An Introduction and Overview. 35 . return distribution is negatively skewed relative to the normal distribution. which of the following statements is correct? a. Correct answer: d Explanation: This Q-Q plot has steeper slopes at the tails of the plot. England: John Wiley & Sons. Learning objective: Interpret QQ plots to identify the characteristics of a distribution. which indicate fat tails in the distribution. return distribution has fat tails relative to the normal distribution.

3735 = 37. Lognormal VaR is larger than Normal VaR by: 56.000. Inc. Lognormal VaR is greater than normal VaR by GBP 487. Section: Market Risk Management and Measurement Reference: Kevin Dowd.050 Lognormal VaR is greater than normal VaR by GBP 787.500.1948 x GBP 2. b.050 Lognormal VaR is less than normal VaR by GBP 487. Estimating Market Risk Measures: An Introduction and Overview.3) = 0.500.Financial Risk Manager Examination (FRM) Part II Practice Exam 2.645 * 0. Learning Objective: Estimate VaR using a parametric approach for both normal and lognormal return distributions.12 – (1.645 * 0. All rights reserved. respectively.56832 = 56. © 2016 Global Association of Risk Professionals.12 – (1. Measuring Market Risk.35% = 19. Second Edition (West Sussex. How does the 1-year 95% VaR that is calculated using a normal distribution assumption (normal VaR) compare with the 1-year 95% VaR that is calculated using the lognormal distribution assumption (lognormal VaR)? a.48% per year. With a portfolio of GBP 2. Lognormal VaR is calculated as follows: Lognormal VaR (%) = 0. 2005).83% – 37. England: John Wiley & Sons. 36 .000 = GBP 487. Global Association of Risk Professionals. c.050 Lognormal VaR is less than normal VaR by GBP 787.3)] = 0. The current value of the portfolio is GBP 2. Chapter 3.050 Correct answer: a Explanation: Normal VaR is calculated as follows: Normal VaR (%) = Rp – z = 0.500.000 this translates to VaR = 0.12 – e[Rp – z] = 0. It is illegal to reproduce this material in any format without prior written approval of GARP.35% (dropping negative sign) and. The annual mean and volatility of a portfolio are 12% and 30%.83% Hence.050. d.12 – exp [0.

If X is normally distributed. 37 . lognormal. u. of X and the distribution of excess losses over this threshold. β. Inc. © 2016 Global Association of Risk Professionals. the distribution of excess losses requires the estimation of only one parameter. b. Correct answer: d Explanation: The distribution of excess losses over u converges to a generalized Pareto distribution as the threshold value u increases. The distribution of excess losses requires the estimation of two parameters. All rights reserved. u. To apply the POT approach. a positive scale parameter β and a shape or tail index parameter ξ. 2005). Chapter 7. As the threshold. etc. Section: Market Risk Management and Measurement Reference: Kevin Dowd. England: John Wiley & Sons. t. To apply the POT approach. It is illegal to reproduce this material in any format without prior written approval of GARP.. Parametric Approaches (II): Extreme Value. Let X be a random variable representing the daily loss of your portfolio. Οne must choose a threshold u that is high enough so that the theory applies but also low enough so that there are observations in excess of u. which is a positive scale parameter. Second Edition (West Sussex. and will usually be unknown. The distribution of X itself can be any of the commonly used distributions: normal. Global Association of Risk Professionals.Financial Risk Manager Examination (FRM) Part II Practice Exam 3. the distribution of X must be elliptical and known. u. d. c. increases. Learning Objective: Describe the peaks-over-threshold (POT) approach. which is high enough that the number of observations in excess of u is zero. the distribution of excess losses over u converges to a generalized Pareto distribution. one must choose a threshold. Measuring Market Risk. Which of the following statements about this application of extreme value theory is correct? a. The “peaks over threshold” (POT) approach considers a threshold value.

Skewness in the distribution Fat tails in the distribution Scarcity of high magnitude loss events Heteroskedasticity in the distribution Correct answer: c Explanation: Non-parametric approaches can accommodate fat tails. and any other non-normal features that can cause problems for parametric approaches. It is illegal to reproduce this material in any format without prior written approval of GARP. © 2016 Global Association of Risk Professionals. non-parametric methods will often produce risk measures that are too low. 2005). Section: Market Risk Management and Measurement Reference: Kevin Dowd. All rights reserved. Learning Objective: Identify advantages and disadvantages of non-parametric estimation methods. Non-parametric Approaches. Which of the following distribution characteristics would make parametric approaches the favored method to use? a. if the data period that is used in estimation includes few losses or losses with low magnitude. Second Edition (West Sussex. Measuring Market Risk.Financial Risk Manager Examination (FRM) Part II Practice Exam 4. Chapter 4. skewness. However. d. England: John Wiley & Sons. b. Inc. Global Association of Risk Professionals. Hence parametric methods would be more appropriate in those situations. A risk analyst is comparing the use of parametric and non-parametric approaches for calculating VaR and is concerned about some of the characteristics present in the loss data. c. 38 .

8*0. Inc.025 = 0. It is illegal to reproduce this material in any format without prior written approval of GARP.025 = 0. Section: Credit Risk Measurement and Management Reference: Allan Malz.987578 d1. s = 0.Financial Risk Manager Examination (FRM) Part II Practice Exam 5.0 =discount factor for 1-year = e-1. c. Spread Risk and Default Intensity Models.0*r = e-0.5* π + d1. The analyst estimates that the risk-neutral default probability for the corporation is 7% per year.5*d0. d. what is the estimate for the CDS spread? a. Let: r = risk-free rate = 2. Learning Objective: Compare the different ways of representing credit spreads.941603 The payoff leg (in the event of default) = C * d0.5*r = e-0.907038] = s*0.07= 0.055304 Equating the two PVs and solving for the spread: s*0.5% per year. and Institutions (Hoboken. once at the end of the year. the buyer will pay the CDS spread. The risk-free rate is 2. 39 .058734 or a spread of approximately 587 basis points. 2011).5% s = CDS spread. to solve for the CDS spread (s): The PV of payments (premium leg. 560 basis points 570 basis points 580 basis points 590 basis points Correct answer: d Explanation: The key to CDS valuation is to equate the present value (PV) of payments to the PV of expected payoff in the event of default. NJ: John Wiley & Sons. History.034565 + 0. which includes the spread payment and accrual) is: s*[0. A risk analyst is valuing a 1-year credit default swap (CDS) contract that will pay the buyer 80% of the face value of a bond issued by a corporation immediately after a default by the corporation. To purchase this CDS. Global Association of Risk Professionals. © 2016 Global Association of Risk Professionals. π = probability of default during year 1 = 7% C = contingent payment in case of default = 80% d0.5 * π = 0.5 =discount factor for half-year = e-0.5*0.055304 Thus. b. All rights reserved.975310 Therefore. Chapter 7.0*(1-π)] = s*[0. which is a percentage of the face value.941603 = 0.987578*0. Assuming defaults can only occur halfway through the year and that the accrued premium is paid immediately after a default. Financial Risk Management: Models.

© 2016 Global Association of Risk Professionals.6% 14.04) * (1 – 0. b.29% = 14. Spread Risk and Default Intensity Models.Financial Risk Manager Examination (FRM) Part II Practice Exam 6. All rights reserved.16) = 0.07) * (0. and Institutions (Hoboken. where MP stands for marginal probability: P (Default at end of year 3) = (1 – MP year 1 default) * (1 – MP year 2 default)* (MP year 3 default) = (1 – 0. Learning Objective: Explain how default risk for a single company can be modeled as a Bernoulli trial. The hedge fund specializes in bank debt and runs a strategy that utilizes both relative value and long-only trades using credit default swaps (CDS) and bonds. Global Association of Risk Professionals. d. Section: Credit Risk Measurement and Management References: Allan Malz. One of the new traders at the hedge fund has the positions described in the table below: Bank ABC LTM XYZ Position Long USD 12 million CDS Long USD 6 million bond Short USD 12 million CDS Credit AA BBB A Some of the hedge fund’s newest clients are restricted from withdrawing their funds for three years. Chapter 7. Financial Risk Management: Models. A risk manager at a small fixed-income hedge fund is evaluating the default conditions of several trade positions.0% 12. The manager has estimated that the marginal probability of default of the LTM Bank bond is 4% in Year 1. and 16% in Year 3. 7% in Year 2. It is illegal to reproduce this material in any format without prior written approval of GARP. The manager is currently evaluating the impact of various default scenarios to estimate future asset liquidity.3%. History. 2011). NJ: John Wiley & Sons. What is the probability that the LTM bond makes coupon payments for 3 years and then defaults at the end of Year 3? a. c. Inc.1429 = 14. 40 .3% 14.9% Correct answer: c Explanation: The probability that the bond defaults in year 3 can be modeled as a Bernoulli trial given by the following equation. 12.

© 2016 Global Association of Risk Professionals. Correlations between business units are only relevant in deciding total firm-wide economic capital levels and are not relevant for decisions at the individual business unit or project level. In its efforts to enhance its enterprise risk management function. No. Correlations between the risks in the asset and liability sides of the balance sheet can be changed by management decisions. Learning Objective: Describe the role of and issues with correlation in risk aggregation. 8-20. “Enterprise Risk Management: Theory and Practice. b. and operational risk are well understood and are easy to estimate at the individual firm level. in general. Correct answer: a Explanation: Management has the ability to influence the correlations between these risks by changing the asset/liability mix. correlations between broad risk types such as credit. It is illegal to reproduce this material in any format without prior written approval of GARP. Countryside Bank introduced a new decisionmaking process based on economic capital that involves assessing sources of risk across different business units and organizational levels. and operational risk distributions. market. c. 41 . All rights reserved. Generally. d. Inc. credit risk. Which of the following statements regarding the correlations between these risks is correct? a. Global Association of Risk Professionals. 4 (2006): pp. is greater than or equal to the sum of individual business unit VaRs.Financial Risk Manager Examination (FRM) Part II Practice Exam 7. so management decision-making is indeed quite relevant. Section: Operational and Integrated Risk Management Reference: Brian Nocco and René Stulz. and describe typical properties of a firm’s market risk.” Journal of Applied Corporate Finance 18. The introduction of correlations into firm-wide risk evaluation will result in a total VaR that.

2007).00 million USD -245. 42 .8%.12 million Thus.12 million USD -185. Learning Objective: Describe the investment process of large investors such as pension funds. What was the change in the pension fund’s surplus in 2015? a.88 million Correct answer: c Explanation: The change in the pension fund’s surplus (S) for the year 2015 is equal to the ending surplus (S1) at the end of 2015 less the initial surplus (S0) at the end of 2014. That is.018) * 320 = USD 245. causing its investment in equities to lose 40% of their market value. © 2016 Global Association of Risk Professionals. USD -330. b. d.8%. The initial surplus is calculated as S0 = A0 – L0 = 650 – 320 = USD 330 million. All rights reserved. Chapter 17. where A0 = the firm’s initial assets and L0 = the firm’s initial liabilities. In 2015. the ending surplus for 2015 = S1 = A1 – L1 = 390 – 245.88 – 330 = USD –185.4) * 650 = USD 390 million.Financial Risk Manager Examination (FRM) Part II Practice Exam 8. Section: Risk Management and Investment Management Reference: Philippe Jorion. Next we have to calculate S1. and y = change in yield = –1. In addition. the immediate response from the government — cutting interest rates — to salvage the situation. then the new level of liabilities L1 at the end of 2015 can be calculated as: L1 = [1 – (DM * Δy)] * L0 = (1 – 13*0. Value-at-Risk: The New Benchmark for Managing Financial Risk. Given the 40% decline in the equity market. 3rd Edition (New York: McGraw-Hill. the surplus at the end of 2015. the new level of assets A1 at the end of 2015 is equal to: A1 = (1 – 0. Global Association of Risk Professionals. the widespread effects of the global energy crisis hit the pension fund.88 million Therefore the change in surplus for 2015 = S = S1 – S0 = 144. a pension fund had USD 650 million worth of assets that were fully invested in equities and USD 320 million in fixed-income liabilities with a modified duration of 13. It is illegal to reproduce this material in any format without prior written approval of GARP. c. S = S1 – S0. Since the percentage change in liability value = – DM * y. Inc.12 million USD -144.12 = USD 144. VaR and Risk Budgeting in Investment Management.12 million (which implies the pension fund is actually in a deficit situation at the end of 2015). where DM = modified duration = 13. caused bond yields to decline by 1. At the end of 2014.

Hence we can now calculate the VaR of the new portfolio (after rebalancing) as follows: VaR p 46.000. The portfolio VaR will increase by USD 28. incremental VaR. what effect will this have on the 95% 1-day portfolio VaR? a.000 2 70.000 * 70. It is illegal to reproduce this material in any format without prior written approval of GARP. 3rd Edition. The portfolio VaR will increase by USD 20. The 95% 1-day VaR for each individual position is USD 70. 43 .000 2 2 * 0. The portfolio VaR (before the rebalancing) is therefore: VaR p 70. so VaRA is now equal to (2/3)*($70. the VaR will increase by (141. Correct answer: c Explanation: The first step is to calculate the VaR of the original portfolio of two stocks.370. All rights reserved. The correlation between the returns of Stock A and Stock B is 0.4.4 * 46. Section: Risk Management and Investment Management Reference: Philippe Jorion. b. 161-164.667. A and B. c.667 2 116. A portfolio has USD 3 million invested in Stock A and USD 1.800.667 *116. undiversified portfolio VaR. marginal VaR.932 – 117.281. The portfolio VaR will increase by USD 24. and distinguish between the following portfolio VaR measures: individual VaR. Learning Objective: Define.667 USD 141. © 2016 Global Association of Risk Professionals. component VaR. The portfolio VaR will not change.000 USD 117. the portfolio manager decides to sell USD 1 million of Stock A to buy USD 1 million of Stock B. and diversified portfolio VaR.67)* ($70.667.132). or USD 24. pp.000) = $116.6672 2 * 0. Chapter 7: Portfolio Risk — Analytical Methods. Inc. the market value of the position in Stock A is reduced by one-third. This can be done by using the following equation: VaR p VaR 2 A VaR B2 2 * AB * VaR A * VaR B where ρAB is the correlation coefficient. d.932 Therefore.Financial Risk Manager Examination (FRM) Part II Practice Exam 9.800. While rebalancing. Assuming that returns are normally distributed and that the rebalancing does not affect the volatility of the individual stocks.000) = $46. Value-at-Risk: The New Benchmark for Managing Financial Risk. Meanwhile the market value for the position in B has risen by two-third so that VaRB is now (1. Global Association of Risk Professionals.5 million invested in Stock B.132 After the rebalance.4 * 70. calculate.

A risk manager of the bank has become concerned that the protective covenants embedded in these loans are weak and may not prevent customers from drawing on the facilities during times of stress.4)] * 0.4 assigned to the undrawn portion in calculating its risk-adjusted return on capital. d. A bank uses a capital charge of 3. Section: Operational and Integrated Risk Management Reference: Michel Crouhy. Hence the additional required economic capital would be 27.3 million. b.300 million Correct answer: c Explanation: The required economic capital to support a loan in the RAROC model can be calculated using the following formula: Required Capital=[DRAWN + (UNDRAWN * LEF)]*CF Where: Credit commitment = COM = USD 1 billion Drawn amount = Drawn = 35%*COM = 0. As such. and the required capital if the change is implemented would be: [350 + (650 * 0.775 million USD 18. loan or loan portfolio.195 million USD 8.03 = USD 18. The Essentials of Risk Management. and senior management has asked the risk manager to quantify the impact of the recommendation.85? a.85.4 to 0.4 Capital factor (capital charge) = CF = 3. © 2016 Global Association of Risk Professionals. Capital Allocation and Performance Measurement. For a typical facility that has an original principal of USD 1 billion and is 35% drawn. USD 3. This recommendation has been met with resistance from the loan origination team.3 = USD 8. Chapter 17.075 – 18.0% Therefore the initial required economic capital is calculated as follows: Required Capital = [350 + (650 * 0. Dan Galai and Robert Mark.35*USD 1 billion = USD 350 million Undrawn amount = UnDrawn = COM – Drawn = 65%*COM = USD 650 million Loan equivalent factor = LEF = 0. 2014). Global Association of Risk Professionals.500 million USD 6. Learning Objective: Compute and interpret the RAROC for project. c.03 = USD 27.Financial Risk Manager Examination (FRM) Part II Practice Exam 10.775 million. Inc.85)] * 0. It is illegal to reproduce this material in any format without prior written approval of GARP. how much additional economic capital would have to be allocated if the loan equivalent factor is increased from 0. the manager has recommended increasing the loan equivalent factor to 0.0% for revolving credit facilities with a loan equivalent factor of 0. 44 . 2nd Edition (New York: McGraw-Hill. All rights reserved. and use RAROC to compare business unit performance.075 million.

The major rating agencies are not paid by the investors. and assess the relative contribution of each factor to the subprime mortgage problems. 45 . Which of the following statements regarding frictions in the securitization of subprime mortgages is correct? a. The major credit rating agencies are paid by investors for their rating service of mortgage-backed securities. Inc. c. this could be either construed as predatory lending (where the lender convinces the borrower to borrow too large of a sum given the borrower’s financial situation) or predatory borrowing (the borrower convinces the lender to lend too large a sum). Correct answer: b Explanation: One of the key frictions in the process of securitization involves an information problem between the originator and arranger. b. 318 (March 2008). Section: Credit Risk Measurement and Management Reference: Adam Ashcroft and and Til Schuermann. © 2016 Global Association of Risk Professionals. In particular. It is illegal to reproduce this material in any format without prior written approval of GARP. The arranger will typically have an information advantage over the originator with regard to the quality of the loans securitized. the originator has an information advantage over the arranger with regard to the quality of the borrower.” Federal Bank of New York Staff Reports.Financial Risk Manager Examination (FRM) Part II Practice Exam 11. All rights reserved. “Understanding the Securitization of Subprime Mortgage Credit. The use of escrow accounts for insurance and tax payments eliminates the risk of foreclosure. Learning Objective: Identify and describe key frictions in subprime mortgage securitization. Without adequate safeguards in place. No. Escrow accounts can forestall but not eliminate the risk of foreclosure. The originator will typically have an information advantage over the arranger. Global Association of Risk Professionals. d. Depending on the situation. and this creates a potential conflict of interest. which can create an incentive for the originator to collaborate with the borrower in filing false loan applications. an originator can have the incentive to collabo.rate with a borrower in order to make significant misrepresentations on the loan application.

at a 95% confidence level. It is illegal to reproduce this material in any format without prior written approval of GARP. c. x = 5.96 then. and T is the number of observations = 225. Section: Market Risk Measurement and Management Reference: Philippe Jorion. 2007). Value-at-Risk: The New Benchmark for Managing Financial Risk. And z = 1. Learning Objective: Verify a model based on exceptions or failure rates. If x 0.96 where p represents the failure rate and is equal to 1-99%. that the model is calibrated correctly? a. (New York: McGraw-Hill. All rights reserved. Backtesting VaR. or 1%. Assuming 225 days in a year. d.01* 225 0. So the maximum number of exceedances would be 5 to conclude that the model is calibrated correctly. Chapter 6.96 is the two-tail confidence level quantile.18. what is the maximum number of daily losses exceeding the 1-day 99% VaR that is acceptable in a 1-year backtest to conclude.Financial Risk Manager Examination (FRM) Part II Practice Exam 12.01* 1 0. Inc. A risk manager is analyzing a 1-day 99% VaR model.01* 225 1. Global Association of Risk Professionals. 46 . b. © 2016 Global Association of Risk Professionals. 3 5 8 10 Correct answer: b Explanation: The risk manager will reject the hypothesis that the model is correctly calibrated if the number x of losses exceeding the VaR is such that: x pT p1 p T z 1. 3rd Edition.

which of the following mapping approaches requires that one risk factor be chosen that corresponds to average portfolio maturity? a. A risk manager is constructing a term structure model and intends to use the Cox-Ingersoll-Ross Model. b. 3rd Edition. Fixed Income Securities. one risk factor is chosen that corresponds to the portfolio duration. Chapter 10: The Art of Term Structure Models: Volatility and Distribution. All rights reserved. The model The model The model The model rate. Inc. (New York: McGraw-Hill. c. The annualized basis-point volatility equals ?√ and therefore increases as a function of the square root of the rate. With duration mapping. b. volatility of the short rate will decline exponentially to a constant level. Which of the following describes this model? a. VaR Mapping. presumes presumes presumes presumes that that that that the the the the volatility of the short rate will increase at a predetermined rate. the basis-point volatility of the short rate is not independent of the short rate as other simpler models assume. 14. Value-at-Risk: The New Benchmark for Managing Financial Risk. the portfolio cash flows are grouped into maturity buckets. Section: Market Risk Measurement and Management Reference: Tuckman. when the risk factors have been selected. c. 2007). 47 . Chapter 11. Learning Objective: Differentiate among the three methods of mapping portfolios of fixed income securities. Section: Market Risk Measurement and Management Reference: Philippe Jorion. It is illegal to reproduce this material in any format without prior written approval of GARP. d.Financial Risk Manager Examination (FRM) Part II Practice Exam 13. basis-point volatility of the short rate will be proportional to the rate. one risk factor is chosen that corresponds to the average portfolio maturity. Convexity mapping is not a method of VaR mapping for fixed income portfolios. Global Association of Risk Professionals. With cash flow mapping. In fixed income portfolio mapping. Principal mapping Duration mapping Convexity mapping Cash mapping Correct answer: a Explanation: With principal mapping. © 2016 Global Association of Risk Professionals. basis-point volatility of the short rate will be proportional to the square root of the Correct answer: d Explanation: In the CIR model. 3rd Edition. Learning Objective: Describe the short-term rate process under the Cox-Ingersoll-Ross (CIR) and lognormal models. d.

Chapter 6.75. respectively. Let: PD = 3% EL = 75 bps = 0. Learning Objective: Calculate expected loss from recovery rates. 90 basis points 120 basis points 180 basis points 240 basis points Correct answer: a Explanation: The credit risky bond is preferable when (1 – PD) * (1 + r + z) + PD * RR > 1 + r where PD is the probability of default. Hence. It is illegal to reproduce this material in any format without prior written approval of GARP. d. and the probability of default. the loss given default.25. with an expected loss of 75 basis points in the event of default.5 bps. 48 .00835 or 83. Risk Management: Models. c.97*(1.02 + z) + 0. Therefore RR = 1 – EL/PD = 0. Reference: Allan Malz. Inc. All rights reserved. RR is the recovery rate. then LGD = (EL/PD) = 0. z > 0.02. 2011). and using the relationship above: (1 – 3%) * (1 + 2% + z) + 3% * 75% > 1 + 2%.75/3 = 0. what is the minimum coupon spread needed on the bond for its expected return to match the risk-free rate? a.75% Since EL = PD * LGD. and z is the coupon spread for a risky bond that compensates for the default risk. NJ: John Wiley & Sons. b.Financial Risk Manager Examination (FRM) Part II Practice Exam 15. Also the recovery rate RR = 1 – LGD. r is the coupon paid by a risk-free bond. If the current risk-free rate is 2%. History. An analyst is reviewing a bond for investment purposes. Credit and Counterparty Risk. © 2016 Global Association of Risk Professionals. Global Association of Risk Professionals. Making the calculations simplifies the equation as follows: 0.0225 > 1. Section: Credit Risk Measurement and Management. Let EL and LGD represent expected loss and loss given default. and Institutions (Hoboken. The bond is expected to have a default probability of 3%.

mainly minimum transfer amount and threshold. c. All rights reserved. Sell credit default swaps on ZTM. Correct answer: d Explanation: Increasing collateral would effectively reduce current credit exposure depending on the contract parameters.000 With the information provided. Defining Counterparty Credit Risk.000.Financial Risk Manager Examination (FRM) Part II Practice Exam 16.000 28. UK: John Wiley & Sons. 2012). Inc.000. 49 . d. Learning Objective: Identify and describe the different ways institutions can manage and mitigate counterparty risk. Chapter 3. b. Use credit triggers. Implement a netting scheme. A credit risk manager for a bank is looking to mitigate counterparty credit risk exposure to ZTM. It is illegal to reproduce this material in any format without prior written approval of GARP.000 60.000 2. Currently the bank has the following derivatives contracts with ZTM: Contract Contract Value (HKD) A B C D 40. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets (West Sussex. what is the most appropriate credit risk mitigation technique in this case? a. an A-rated firm.000. Section: Credit Risk Measurement and Management Reference: Jon Gregory. Increase collateral.000. © 2016 Global Association of Risk Professionals. Global Association of Risk Professionals.

there is reduction in netting factor but not as much as in c. Netting factor n nn 1 n 10 10 * 10 10.Financial Risk Manager Examination (FRM) Part II Practice Exam 17.35. c.07 D 14 –0. Number of Positions Average Correlation A 5 0.22 B 7 0. When n = 7 and = 0. When n = 5 and = 0. Global Association of Risk Professionals. 50 . Netting factor n nn 1 11 11* 11 1 0.32% n 5 b is incorrect. d.07 . it has entered into netting agreements on 10 equity trade positions with an average correlation of 0.42% When n = 11 and = – 0.10. A financial firm conducts several trades.11 C 11 –0.81% n 7 © 2016 Global Association of Risk Professionals. Inc. It is illegal to reproduce this material in any format without prior written approval of GARP.10 47.22 61. All rights reserved.35 (current position).35 10 64.07 16.22. b. As part of its risk control.03 Trade combination A Trade combination B Trade combination C Trade combination D Correct answer: c Explanation: Trade combination c is the correct answer. Which of the following trade combinations would increase the firm’s expected netting benefit the most from the current level? Trade Combination a. Netting factor n nn 1 7 7 * 7 10. there is only a modest netting benefit: Netting factor n nn 1 5 5 * 5 10. there is the most reduction in netting factor. Netting factor is expressed as: Netting factor n nn 1 n When n (number of positions) = 10 and (correlation coefficient) = 0. The firm believes that it can improve upon the diversification benefit of netting by a judicious choice of number of exposures with a favorable correlation coefficient.52% n 11 a is incorrect.

Second Edition. Counterparty Credit Risk: A Continuation Challenge for Global Financial Markets. the collateral mitigates the exposure today while increasing the volatility of the position in the future. The overall volatility of the position: (0. The presence of collateral decreases the current exposure. When n = 14 and = –0.Financial Risk Manager Examination (FRM) Part II Practice Exam d is incorrect.03 20. An underlying exposure with an effective annual price volatility of 6% is collateralized by a 10-year U.87% n 14 Section: Credit Risk Measurement and Management Reference: Jon Gregory (2012). Treasury note with an effective price volatility of 8%. © 2016 Global Association of Risk Professionals. UK. The presence of collateral increases the current exposure. Chapter 8.5 = -3. Global Association of Risk Professionals. West Sussex. The presence of collateral increases the current exposure and increases the volatility of the exposure between remargining periods.062 + .082)0.96 * 8% * (10/250)0. Credit Exposure. Treasury note is zero.5 = -3. Learning Objective: Explain the impact of netting on exposure.S. there is a reasonable reduction in netting factor but not as much as in c.96 * 10% * (10/250)0. 18. Correct answer: c Explanation: Worst case change for the value of the collateral is: -1. but decreases the volatility of the exposure between remargining periods. b. Which of the following would one expect to observe from this analysis? a. John Wiley & Sons. d. All rights reserved. but increases the volatility of the exposure between remargining periods. Section: Credit Risk Measurement and Management Reference: Jon Gregory. c.136%. Chapter 8: Credit Exposure.03.10 = 10% Thus the worst case change in the value of this position (exposure + collateral) = -1.920% Thus. The correlation between the exposure and the U. The presence of collateral decreases the current exposure and decreases the volatility of the exposure between remargining periods. and calculate the netting factor. Netting factor n nn 1 14 14 * 14 1 0. Changes in the value of the overall position (exposure plus collateral) are calculated for a 10-day horizon at a 95% confidence interval (assume a year of 250 days). Learning Objective: Identify factors that affect the calculation of the credit exposure profile and summarize the impact of collateral on exposure. It is illegal to reproduce this material in any format without prior written approval of GARP. UK: John Wiley & Sons. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets (West Sussex. 2012). the benefit of correlation. Inc.5 = 0. 51 .S.

what is closest to the estimated liquidity-adjusted.600 Correct answer: b Explanation: The daily 95% VaR = 45 *20. Estimating Liquidity Risks. © 2016 Global Association of Risk Professionals. Therefore the liquidity cost (LC) = 0.0038) = CAD 5. 2005). CAD CAD CAD CAD 1.1/45)* 900. d.600 6. Inc. and the midpoint of its current best bid and best ask prices is CAD 45.000 = CAD 1. c.38% and average bid-ask spread of CAD 0. Section: Operational and Integrated Risk Management Reference: Kevin Dowd.000 = CAD 6. Global Association of Risk Professionals.645 * 0.90.600 7.90 The constant spread approach adds half of the bid-ask spread (as a percent) to the VaR calculation.625.Financial Risk Manager Examination (FRM) Part II Practice Exam 19.000 share position and assuming the returns of DUY are normally distributed.625. 1-day 95% VaR? a.14. 52 . All rights reserved. Learning Objective: Describe and calculate LVaR using the constant spread approach and the exogenous spread approach. using the following formula: Liquidity Cost (LC) = ½*(Spread * P). b.5 * (0.90 + 1. A trader observes a quote for Stock DUY. and Liquidity-adjusted VaR (LVaR) = VaR + LC = 5. Measuring Market Risk. Using the constant spread approach on a 20. where Spread is equal to the actual spread divided by the midpoint and P is the value of the position. England: John Wiley & Sons. Chapter 14. DUY has an estimated daily return volatility of 0. Second Edition (West Sussex.000.000 * (1. It is illegal to reproduce this material in any format without prior written approval of GARP.625.600 5.

066 2. The standard deviation of returns of stock A is 16% annually and that of the overall portfolio is 21% annually. Assuming the risk analyst uses a 1-year 99% VaR and that returns are normally distributed. Currently. α(99%) represent the 99% confidence factor for the VaR estimate. Chapter 7. and A. b. component VaR. 3rd Edition.327 million million million million Correct answer: a Explanation: The component VaR for stock A (CVaRA) can be presented as: CVaR A A. calculate.326. how much is the component VaR of stock A? a. d. A risk analyst is evaluating the risks of a portfolio of stocks. Therefore. 53 . VaRA = wA*σA*α(99%) = EUR 15 million x 0. and diversified portfolio VaR.326 5. Value-at-Risk: The New Benchmark for Managing Financial Risk. Global Association of Risk Professionals. Let wA represent the value of stock A.p = correlation coefficient between stock A and the portfolio. and distinguish between the following portfolio VaR measures: individual VaR. incremental VaR. CVaRA = ρA.16 x 2. Inc.37. The correlation of returns between stock A and the portfolio is 0.37 x 5.326 = EUR 5. the portfolio is valued at EUR 200 million and contains EUR 15 million in stock A. (New York: McGraw-Hill. marginal VaR.066 million Section: Risk Management and Investment Management Reference: Philippe Jorion. c. EUR EUR EUR EUR 2. A represent the standard deviation of stock A returns.582 7.582 million. Portfolio Risk: Analytical Methods. Hence.p * VaRA = 0. It is illegal to reproduce this material in any format without prior written approval of GARP. which is 2.Financial Risk Manager Examination (FRM) Part II Practice Exam 20. © 2016 Global Association of Risk Professionals. All rights reserved.582 = EUR 2. 2007). p *VaR A where VaR = VaR of stock A. Learning objective: Define. undiversified portfolio VaR.

d. It is illegal to reproduce this material in any format without prior written approval of GARP. Chapter 17. 2007). 3rd Edition. funding risk and sponsor risk. Inc. active management risk. 54 . A pension plan’s total VaR is equal to the sum of its policy-mix VaR and active-management VaR. Pension fund risk analysis does not consider performance relative to a benchmark.Financial Risk Manager Examination (FRM) Part II Practice Exam 21. b. Section: Risk Management and Investment Management Reference: Philippe Jorion. the shortfall does not create a risk for the plan sponsor. All rights reserved. Learning Objective: Distinguish among the following types of risk: absolute risk. Value-at-Risk: The New Benchmark for Managing Financial Risk. From the plan sponsor’s perspective. nominal pension obligations are similar to a short position in a long term bond. Global Association of Risk Professionals. In most defined-benefit pension plans. relative risk. policy-mix risk. © 2016 Global Association of Risk Professionals. (New York: McGraw-Hill. c. Correct answer: d Explanation: Nominal pension obligations are similar to a short position in a bond. Which of the following statements about risk management in the pension fund industry is correct? a. if liabilities exceed assets. VaR and Risk Budgeting in Investment Management.

government-secured investments. Global Association of Risk Professionals. UK: John Wiley & Sons. ABC feared a run by its investors as news of the fraud spread. © 2016 Global Association of Risk Professionals. c.. but primarily with ABC. specializes in structuring small business loans and selling the government guaranteed portion to other institutional investors while retaining the riskier portions for high net worth investors. high-quality. The diagram below illustrates the parties involved: 22. Reference: Jon Gregory. ABC is not funding from Repo Co. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets. Repo Co. The use of a clearinghouse in this situation does not reduce XYZ’s lending risk. XYZ funds its operations by engaging in overnight repurchase agreements (repos) with three firms.'s default risk. would likely have resulted in a reduction in: a. defaults. b. It is illegal to reproduce this material in any format without prior written approval of GARP. B. C. XYZ learned that ABC had been defrauded by Repo Co. 2nd Edition (West Sussex. therefore. All rights reserved. XYZ was informed by ABC that its line had been frozen. ABC's funding liquidity risk. Chapter 3 – Defining Counterparty Credit Risk Learning Objective: Describe counterparty risk and differentiate it from lending risk. a small investment management firm. a firm that specializes in pooling funds from community banks and local government agencies and investing them in short-term. another repo borrower. Correct answer: d Explanation: If it uses a clearinghouse and the clearinghouse makes a mistake (operational risk) like that made by ABC. Incorrect. XYZ's lending risk. 2012). ABC will have recourse to the clearinghouse and it would have. A. who had provided false documentation of non-existent collateral of governmentguaranteed loans. ABC and ABC's client. ABC's operational risk. d. Incorrect. reduced its operational risk exposure. The use of a central clearinghouse to handle the transactions executed between XYZ's main funding source. Incorrect. Repo Co. Last week.. 55 . The use of a clearinghouse does not change Repo Co. Inc.Financial Risk Manager Examination (FRM) Part II Practice Exam QUESTIONS 22 AND 23 REFER TO THE FOLLOWING INFORMATION XYZ.’s default risk – just ABC’s exposure to Repo Co.

By using a clearinghouse to handle the repo transactions between ABC and Repo Co. Compression. obligations owed between the two could have been netted once the fraudulent documentation was discovered. c. © 2016 Global Association of Risk Professionals. but ABC's counterparty risk would be increased. Which of the following is the most appropriate type of netting to use in this situation and what would be a likely additional impact from using this netting? a.'s counterparty risk. It is illegal to reproduce this material in any format without prior written approval of GARP.Financial Risk Manager Examination (FRM) Part II Practice Exam 23.. Closeout netting occurs if there is an event of default. is that the other party. b. and describe how they fit into the framework of the ISDA master agreement. One of the shortcomings of clearinghouses. and Termination Features Learning Objective: Summarize netting and close-out procedures (including multilateral netting). Chapter 4 – Netting. 2012). Payment netting would be used.'s counterparty risk. to the possible detriment of others. but this risk would be transferred to other creditors outside the clearinghouse. 2nd Edition (West Sussex. which would reduce ABC's counterparty risk. UK: John Wiley & Sons. but ABC's counterparty risk would be increased. particularly those outside the clearinghouse in general. d. in this case ABC Bank. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets. Correct answer: c Explanation: Payment netting per the reading is the simple netting of cash flows due on the same day. which would reduce Repo Co. All rights reserved. Global Association of Risk Professionals. which would include an incidence of fraud. jumps to the head of the queue with its claim on Repo Co. which would reduce Repo Co. Closeout netting would be used. Reference: Jon Gregory. explain their advantages and disadvantages. but this risk would be transferred to other creditors outside the clearinghouse. Resets. and closeout netting as well. 56 . which would reduce ABC's counterparty risk. Payment netting would be used. Closeout netting would be used. Inc.

Hedging using futures has the same impact on LaR as hedging using long option positions. the LaR can be larger than the VaR as the futures contracts create an exposure to margin calls and the potential for cash outflows. © 2016 Global Association of Risk Professionals. in situations where the hedging instruments do not result in potential cash outflows over the measurement period (e. 2005). Global Association of Risk Professionals. Reducing the basis risk through hedging decreases LaR. Estimating Liquidity Risks.g. b. 57 . c. Chapter 14. A firm's LaR tends to decrease as its credit quality declines. Correct answer: c Explanation: The LaR can differ substantially from the VaR in a hedged portfolio. the LaR can be smaller than the VaR. and explain challenges in estimating and modeling LaR. For example.Financial Risk Manager Examination (FRM) Part II Practice Exam 24. For a hedged portfolio. Which of the following statements concerning LaR is correct? a. The CEO of a regional bank understands that failing to anticipate cash flow needs is one of the most serious errors that a firm can make and demands that a good liquidity-at-risk (LaR) measurement system be an essential part of the bank's risk management framework. Inc. While the hedge can reduce the VaR of the portfolio. the LaR can differ significantly from the VaR. Section: Operational and Integrated Risk Management Reference: Kevin Dowd. Alternatively. a portfolio of European options which do not expire during the period). Second Edition (West Sussex. describe the factors that affect future cash flows. and in different situations can be larger or smaller than the VaR. All rights reserved. Measuring Market Risk. England: John Wiley & Sons. Learning Objective: Describe liquidity at risk (LaR) and compare it to VaR. d. consider a portfolio where futures contracts are used to hedge. It is illegal to reproduce this material in any format without prior written approval of GARP.

thus. banks are explicitly allowed to recognize empirical correlations across broad market risk categories. and. Which of the following Basel II approaches allows a bank to explicitly recognize diversification benefits? a. d. c. Chapter 15. Global Association of Risk Professionals. 58 . Pillar 1 of the Basel II framework allows banks to use various approaches to calculate the capital requirements for credit risk. Inc. Fourth Edition. In terms of risk aggregation within market risk. Learning Objective: Describe and contrast the major elements—including a description of the risks covered— of the two options available for the calculation of market risk: Standardized Measurement Method and Internal Models Approach. Basel I. and market risk. Basel II. and Solvency II. subject to a set of qualitative conditions and quantitative standards.Financial Risk Manager Examination (FRM) Part II Practice Exam 25. It is illegal to reproduce this material in any format without prior written approval of GARP. All rights reserved. b. © 2016 Global Association of Risk Professionals. The The The The internal models approach for market risk internal ratings based approach for credit risk basic indicator approach for operational risk standardized approach for operational risk Correct answer: a Explanation: The internal models approach allows banks to use risk measures derived from their own internal risk management models. 2015). operational risk. diversification benefits. (New York: John Wiley & Sons. Section: Operational and Integrated Risk Management Reference: John Hull. Risk Management and Financial Institutions.

It is illegal to reproduce this material in any format without prior written approval of GARP. Stress Testing Banks. b. Inc.Financial Risk Manager Examination (FRM) Part II Practice Exam 26. c. All rights reserved. d. Learning Objective: Explain challenges in designing stress test scenarios. An increase in domestic inflation and appreciation of the NLC A significant increase in crude oil prices and a decrease in the country housing price index A drop in crude oil prices and appreciation of the NLC A sustained decrease in natural gas prices and a decrease in the country’s stock index Correct answer: d Explanation: A scenario is coherent when a change in one factor influences other factors in a logical manner. so therefore a sustained decrease in natural gas prices should lead to a decrease in stock prices as the domestic economy weakens. April 2012. © 2016 Global Association of Risk Professionals. Global Association of Risk Professionals. choice d is a coherent scenario since the country’s economy depends heavily on exports of oil and natural gas. 59 . and has domestically produced oil and natural gas as its most important exports. In stress testing banks. several scenarios were considered. In this case. Section: Operational and Integrated Risk Management Reference: Til Schuermann. it is often challenging to develop scenarios where all factors behave coherently. NLC. Which of the following is most consistent with being part of a coherent scenario? a. including the problem of coherence in modeling risk factors. A country with a developed economy maintains its own currency. In a recent stress test of the country’s banking system.

Portfolio Construction. When using the stratification technique. The screening technique provides superior risk control by concentrating stocks in selected sectors based on expected alpha. risk is controlled by selecting the portfolio with the lowest level of active risk. and quadratic programming. Correct answer: a Explanation: Quadratic programming requires many more inputs than other portfolio construction techniques because it entails estimating volatilities and pair-wise correlations between all assets in a portfolio. c. It is illegal to reproduce this material in any format without prior written approval of GARP. but given the large number of inputs it introduces the potential for noise and poor calibration given the less than perfect nature of most data. Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk. When using the linear programming technique. economic sectors) and implements risk control by ensuring that the weighting in each sector matches the benchmark weighting. Quadratic programming allows for risk control through parameter estimation but generally requires many more inputs estimated from market data than other methods require. screening does not necessarily select stocks evenly across sectors and can ignore entire sectors or classes of stocks entirely if they do not pass the screen. Therefore. the screening technique strives for risk control by including a sufficient number of stocks that meet the screening parameters and by weighting them to avoid concentrations in any particular stock. risk control is implemented by overweighting the categories with lower risks and underweighting the categories with higher risks. All rights reserved. Chapter 14.Financial Risk Manager Examination (FRM) Part II Practice Exam 27. it does not allow for overweighting or underweighting specific categories. Rather. risk control in a screening process is fragmentary at best. 60 . b. Learning Objective: Evaluate the strengths and weaknesses of the following portfolio construction techniques: screens. Stratification separates stocks into categories (for example. it attempts to improve on stratification by introducing many more dimensions of risk control and ensuring that the portfolio approximates the benchmark for all these dimensions. Which statement about risk control in portfolio construction is correct? a. Section: Risk Management and Investment Management Reference: Richard Grinold and Ronald Kahn. Linear programming does not necessarily select the portfolio with the lowest level of active risk. 2000). Therefore. Inc. However. stratification. 2nd Edition (New York: McGraw-Hill. Quadratic programming is a powerful process. d. Global Association of Risk Professionals. On the other hand. linear programming. © 2016 Global Association of Risk Professionals.

61 .645*26.062 – 2*150*120*0. The advisor assumes that annual returns on assets and the annual growth of the liabilities are jointly normally distributed and their correlation coefficient is 0.826 million The expected surplus = VA*(1 + RA) – VL*(1 + RL) = 150*1. with a confidence level of 95%. The required variables can be calculated as follows (note: because of liability. relative risk.142 + 1202*0. c. d.14*0.4 million USD -2. the surplus value will be greater than or equal to: a. policy-mix risk. © 2016 Global Association of Risk Professionals. Value-at-Risk: The New Benchmark for Managing Financial Risk. The advisor can report that. 2007). Global Association of Risk Professionals.429 million.75 = 719.1 million USD -14.826 = USD –14. Section: Risk Management and Investment Management Reference: Philippe Jorion.75. 3rd Edition. funding risk. Inc. the lower bound of the 95% confidence interval = 29. the advisor estimates the possible surplus values at the end of one year.Financial Risk Manager Examination (FRM) Part II Practice Exam 28.7 – 1. b. correlation should be negative 0.06*0. Volatility of surplus 719.9 million USD 0 million Correct answer: c Explanation: The lower bound of the 95% confidence interval is equal to: Expected Surplus – (95% confidence factor * Volatility of Surplus). Learning Objective: Distinguish among the following types of risk: absolute risk.7 million.07 – 120*1.64. It is illegal to reproduce this material in any format without prior written approval of GARP. and sponsor risk. All rights reserved. USD -44.8): Variance of surplus VA2 * A2 VL2 * L2 2 *VA *VL * A * L * AL = 1502*0. An analyst reports the following fund information to the advisor of a pension fund that currently invests in government and corporate bonds and carries a surplus of USD 10 million: Pension Assets Liabilities Amount (in USD million) Expected Annual Growth Modified Duration Annual Volatility of Growth 150 7% 13 14% 120 9% 10 6% To evaluate the sufficiency of the fund's surplus. Chapter 17. VaR and Risk Budgeting in Investment Management. active management risk. Therefore. and so.09 = USD 29.64 USD 26. (New York: McGraw-Hill.

but these firms do not get involved in risk related decision making. with a leveraged fund. Which of the following statements best describes criteria used for such an evaluation? a. Chapter 11. And finally. it is then up to the investor to decide whether to accept the risk unhedged or hedge it on their own. what might be acceptable may differ depending on the strategy of the fund. the specialist should assess how the fund estimates risks related to leverage. All rights reserved. Mirabile. an investor will need to evaluate historical and current changes in leverage. the company should not invest in the fund unless it fully accounts for fat tails using extreme value theory at the 99. and Fund Performance (Hoboken. When considering a leveraged fund. and in general if more than 10% of asset prices are based on model prices or broker quotes. Global Association of Risk Professionals. so while an investor should inquire whether the manager believes that tail risk exists. It is crucial to assess the fund's valuation policy. Learning Objective: Describe criteria that can be evaluated in assessing a fund’s risk management process. 2013). NJ: Wiley Finance.Financial Risk Manager Examination (FRM) Part II Practice Exam 29.99% level when estimating VaR. particularly during times of market stress. while it is important to know what percentage of the assets is exchange-traded and marked to market. Many funds employ independent risk service providers to report risks to investors. d. © 2016 Global Association of Risk Professionals. including funding liquidity risks during periods of market stress. and whether or not it is hedged. the specialist should recommend against investment in the fund regardless of other information available about the fund. Today's best practices in risk management require that a fund employ independent risk service providers and that these service providers play important roles in risk-related decisions. Because of the overwhelming importance of tail risk. c. Section: Risk Management and Investment Management Reference: Kevin R. Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation. Manager Profits. as well as the level of liquidity of the portfolio. A due diligence specialist at a company is evaluating the risk management process of a hedge fund in which the company is considering making an investment. It is illegal to reproduce this material in any format without prior written approval of GARP. b. 62 . Certain strategies may in fact expose an investor to tail risk. Correct answer: c Explanation: Generally speaking. Performing Due Diligence on Specific Managers and Funds. Inc.

2014). Risk Capital Attribution and Risk-Adjusted Performance Measurement. Reject the project because the ARAROC is lower than the market expected excess return. d. Correct answer: b Explanation: ARAROC = (RAROC – Rf)/β = (0.Financial Risk Manager Examination (FRM) Part II Practice Exam 30. © 2016 Global Association of Risk Professionals. Using the criterion of adjusted risk-adjusted return on capital (ARAROC). Accept the project because the ARAROC is lower than the market expected excess return.17 – 0. Risk Management. c. Dan Galai and Robert Mark. A chemical company is considering a project that has an estimated risk-adjusted return on capital (RAROC) of 17%.5 = 8.5. All rights reserved. Section: Operational and Integrated Risk Management Reference: Michel Crouhy.04 = 8%. Global Association of Risk Professionals. Learning Objective: Compute the adjusted RAROC for a project to determine its viability. the company should: a. and the company's equity beta is 1. the expected market rate of return is 12% per year. 2nd edition (New York: McGrawHill. Accept the project because the ARAROC is higher than the market expected excess return. the project should be accepted. 63 . Reject the project because the ARAROC is higher than the market expected excess return. b. Inc. Chapter 17. Suppose that the risk-free rate is 4% per year. where: Rf = risk-free rate of return β = beta of company equity Rm= market rate of return As ARAROC is higher than the market excess return.67%.04)/1. It is illegal to reproduce this material in any format without prior written approval of GARP. Market excess return = Rm – Rf = 0.12 – 0.

such as credit default swaps Correct answer: a Explanation: Counterparty exposure. Inc. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets. Global Association of Risk Professionals. and purchasing credit derivatives would replace the counterparty risk from the individual counterparties with counterparty risk from the institution who wrote the CDS. dominate the market for such derivatives. If the counterparty were to default. Learning Objective: Identify and describe the different ways institutions can manage and mitigate counterparty risk. could best achieve this goal? a. Ensuring that sufficient collateral is posted by counterparties Diversifying among counterparties Cross-product netting on a single counterparty basis Purchasing credit derivatives. such as cash or short-term investment grade government bonds. in theory.parties. Section: Credit Risk Measurement and Management Reference: Jon Gregory. if implemented. Cross-product netting would only reduce the exposure to one of the counter. c. © 2016 Global Association of Risk Professionals. can be almost completely neutralized as long as a sufficient amount of high quality collateral.Financial Risk Manager Examination (FRM) Part II Practice Exam 31. The company’s management would like to mitigate its overall counterparty exposure. Which of the following methods. is held against it. Chapter 3. All rights reserved. A specialist finance company only trades derivatives on rare commodities. all of whom have large notional outstanding contracts with the company. The company and a handful of other firms. 64 . Defining Counterparty Credit Risk. the holder of an open derivative contract with exposure to that counterparty would be allowed to receive the collateral. with the goal of reducing it to almost zero. It is illegal to reproduce this material in any format without prior written approval of GARP. d. b.

Chapter 12. d. 65 . while LEM Banking Corporation was downgraded from a rating of A to a rating of A-. but not significantly enough to justify amending existing CVA arrangements. GTX Bank requests an increase in the CVA charge it receives.” Learning Objective: Explain the motivation for and the challenges of pricing counterparty risk. Section: Credit Risk Measurement and Management Reference: Jon Gregory. © 2016 Global Association of Risk Professionals. the credit spread between the two firms narrowed from 95 bps initially to only 5 bps after the downgrades. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets.Financial Risk Manager Examination (FRM) Part II Practice Exam 32. Recently. Correct answer: c Explanation: Because LEM Banking Corporation has a lower credit rating than GTX Bank. GXT Bank was downgraded from a rating of AA to a rating of A. CVA is no longer a relevant factor. b. a major provider of swaps. "Credit Value Adjustment. LEM Banking Corporation would be in a position to request a reduction in the CVA charge that it pays. it would typically pay a CVA charge to GXT Bank which would be a function of the relative credit spread between the two banks. LEM Banking Corporation requests a reduction in the CVA charge it pays. the credit spread for GTX Bank has increased from 25 bps to 155 bps. After the downgrades of both GTX Bank and LEM Banking Corporation y. During this time. It is illegal to reproduce this material in any format without prior written approval of GARP. Which of the following is the most likely action that the counterparties will request on their credit value adjustment (CVA)? a. The credit qualities of the counterparties have migrated. All rights reserved. a frequent user of swaps. Global Association of Risk Professionals. often enters into transactions with GXT Bank. with the spread much lower between the two banks. Therefore. and the counterparties should migrate to using other mitigants of counterparty risk. LEM Banking Corporation. c. Inc. while the credit spread for LEM Banking has increased from 120 bps to 160 bps.

An analyst estimates that the hazard rate for a company is 0. All rights reserved.14786 = 0.16 per year. and Institutions (Hoboken. c. Financial Risk Management: Models. probability of survival in the first year = 1 – 0. b. d. Thus. 14. 13. NJ: John Wiley & Sons. we can calculate the cumulative probability of default in the first year using the formula 1– exp(–1*λ) = 1 – exp(-0. Global Association of Risk Professionals. 11. © 2016 Global Association of Risk Professionals.85214 = 0. 2011).27385.16) = 0.al default probabilities.16) = 0.27385 – 0.79%. Correct answer: c Explanation: The probability that the firm defaults in the second year is conditional on its surviving the first year.39%. Inc. Spread Risk and Default Intensity Models.85214. History. Chapter 7. Section: Credit Risk Measurement and Management Reference: Allan Malz.14786)/0.62%. The probability of survival in the first year followed by a default in the second year is closest to: a. Learning Objective: Define the hazard rate and use it to define probability functions for default time and condition. Then.Financial Risk Manager Examination (FRM) Part II Practice Exam 33. and the conditional one year default probability given that the firm survived the first year is the difference between the two year cumulative probability of default and the one year probability divided by the probability of survival in the first year = (0. the cumulative probability that the firm defaults in the second year = 1 – exp(–2*λ) = 1 – exp(-2*0. 66 .63%.14785 = 14. It is illegal to reproduce this material in any format without prior written approval of GARP. 27.79%. Using λ to represent the given hazard rate.14786.

All rights reserved. the risk manager estimates the 1-year transition probabilities on the AA-rated corporate bond: Rating AAA AA A BBB BB B CCC Default Probability of State 2.35% What is the 1-year 95% credit VaR per USD 100 of face value closest to? a. Using market data. at which the value of the bond would be estimated at 97.45% 0. 95% credit VaR = 108–97 = 11. Inc. USD 3 USD 11 USD 18 USD 22 Correct answer: b Explanation: The 95% credit VaR corresponds to the unexpected loss (UL) at the 95th percentile minus the expected loss (EL). c. Global Association of Risk Professionals. b. the risk manager estimates the following year-end values for the bond based on interest rate simulations informed by the economics team: Rating AAA AA A BBB BB B CCC Default Year-end Bond Value (USD per USD 100 face value) 110 106 101 97 86 76 67 43 In addition.00% 6. Using the probabilities in the given ratings transition matrix. It is illegal to reproduce this material in any format without prior written approval of GARP. but the credit VaR (the difference) is easily derived by subtracting the estimated value given a BBB rating from the current value. At the beginning of the year. Thus.25% 0.00% 87.00% 3.30% 0. a firm bought an AA-rated corporate bond at USD 108 per USD 100 face value. © 2016 Global Association of Risk Professionals.65% 0. or the expected future value at the 95% loss percentile minus the current value. Since cash flows for the bond are not provided.Financial Risk Manager Examination (FRM) Part II Practice Exam 34. d. the 95% percentile corresponds to a downgrade to BBB (lowest investment grade border-line). we cannot derive the precise EL and UL. 67 .

because both categories of bonds are government issued and therefore have a very similar sensitivity to risk factors. USD/EUR forward contracts are mapped on the USD/JPY spot exchange rate. Global Association of Risk Professionals. 35. 2011). changes in interest rates) may differ. History. Correct answer: c Explanation: Mapping government bonds paying regular coupons onto zero coupon government bonds is an adequate process.Financial Risk Manager Examination (FRM) Part II Practice Exam Section: Credit Risk Measurement and Management Reference: Allan Malz. A position in the stock market index is mapped on a position in a stock within that index. Government bonds paying regular coupons are mapped on zero-coupon government bonds. and Institutions (Hoboken. Learning Objective: Define and calculate Credit VaR. Learning Objective: Explain the principles underlying VaR mapping. VaR Mapping. Section: Market Risk Measurement and Management Reference: Philippe Jorion. Financial Risk Management: Models. this is not a perfect mapping since the sensitivity of both classes of bonds to specific risk factors (i. 68 . d. Inc. 3rd Edition. Computing VaR on a portfolio containing a very large number of positions can be simplified by mapping these positions to a smaller number of elementary risk factors.e. However. © 2016 Global Association of Risk Professionals. and describe the mapping process. Chapter 6. NJ: John Wiley & Sons. b. It is illegal to reproduce this material in any format without prior written approval of GARP. Credit and Counterparty Risk. Each position in a corporate bond portfolio is mapped on the bond with the closest maturity among a set of government bonds. Which of the following mappings would be adequate? a. Value-at-Risk: The New Benchmark for Managing Financial Risk. c. All rights reserved. Chapter 11.

“Volatility Smiles. The implied volatility skew. Inc. An An An An out-of-the-money call in-the-money call at-the-money put in-the-money put Correct answer: b Explanation: An in-the-money call has a strike price below 30. Strike Price (GBP) Assuming that the implied volatility at GBP 30 is used to conduct the valuation. which of the following long positions will be undervalued? a. All rights reserved.” Learning Objective: Compare the shape of the volatility smile (or skew) to the shape of the implied distribution of the underlying asset price and to the pricing of options on the underlying asset. 9th Edition. d. c. 69 . Global Association of Risk Professionals. b. so using the at-the-money implied volatility would result in pricing an in-the-money call option lower than its fair price. its implied volatility is greater than the at-the-money volatility. using the chart above. estimated using the Black-Scholes-Merton model and the current prices of actively traded European-style options on stock XYZ at various strike prices. and Other Derivatives. It is illegal to reproduce this material in any format without prior written approval of GARP. Therefore. Chapter 20. Section: Market Risk Measurement and Management Reference: John Hull. © 2016 Global Association of Risk Professionals. Futures. is shown below: Implied Volatility 36.Financial Risk Manager Examination (FRM) Part II Practice Exam A risk manager is in the process of valuing several European option positions on a non-dividend-paying stock XYZ that is currently priced at GBP 30. Options.

Global Association of Risk Professionals. d. Section: Market Risk Measurement and Management Reference: Bruce Tuckman. The risk manager uses a normal distribution of interest rates. Chapter 9. The Art of Term Structure Models: Drift. When short-term rates are negative. the risk manager adjusts the risk-neutral probabilities. Fixed Income Securities. 2011). Learning Objective: Describe methods for addressing the possibility of negative short-term rates in term structure models. the potential for negative rates does not automatically rule out the use of the model. such as in valuing coupon bonds. Inc. Current interest rate volatility is high and the risk manager is concerned about the effect this may have on short-term rates when pricing the option. A risk manager is pricing a 10-year call option on 10-year Treasury using a successfully tested pricing model. especially in cases where the valuation depends more on the average path of the interest rate. NJ: John Wiley & Sons. the risk manager increases the volatility. One method that can be used to address the potential for negative interest rates when constructing interest rate trees is to set all negative interest rates to zero. c. 3rd Edition (Hoboken. When short-term rates are negative. It is illegal to reproduce this material in any format without prior written approval of GARP. Correct answer: d Explanation: Negative short-term interest rates can arise in models for which the terminal distribution of interest rates follows a normal distribution. the risk manager sets the rate to zero. In comparison. it can still be a desirable model to use in certain situations. © 2016 Global Association of Risk Professionals. The existence of negative interest rates does not make much economic sense since market participants would generally not lend cash at negative interest rates when they can hold cash and earn a zero return. When a model displays the potential for negative short-term interest rates. Therefore. This localizes the change in assumptions to points in the distribution corresponding to negative interest rates and preserves the original rate tree for all other observations. All rights reserved. b. When short-term rates are negative.Financial Risk Manager Examination (FRM) Part II Practice Exam 37. 70 . adjusting the risk neutral probabilities would alter the dynamics across the entire range of interest rates and therefore not be an optimal approach. Which of the following actions would best address the potential for negative short-term interest rates to arise in the model? a.

While VaR ensures that the estimate of portfolio risk is less than or equal to the sum of the risks of that portfolio’s positions. 19. All rights reserved. c. Inc. Global Association of Risk Professionals. 71 . ES leads to more required economic capital for the same confidence level. Learning Objective: Compare VaR. b. Relative to VaR. expected shortfall. and other relevant risk measures. Expected shortfall (ES) is suggested as a better alternative to use during market turmoil. In practice. Section: Market Risk Measurement and Management Reference: Basel Committee on Banking Supervision. What should be understood regarding VaR and ES before modifying current practices? a. Therefore. Despite being more complicated to calculate. ES would lead to a higher level of required economic capital than VaR for the same confidence level. A large commercial bank is using VaR as its main risk measurement tool. Both VaR and ES account for the severity of losses beyond the confidence threshold. January 2011. Messages from the Academic Literature on Risk Measurement for the Trading Book. d. Working Paper No. ES does not. since ES accounts for the severity of expected losses beyond a particular confidence level. while VaR measures the maximum expected loss at that confidence level. ES is easier to backtest than VaR. however. It is illegal to reproduce this material in any format without prior written approval of GARP. Correct answer: b Explanation: Expected shortfall is always greater than or equal to VaR for a given confidence level. © 2016 Global Association of Risk Professionals. regulators often correct for the difference between ES and VaR by lowering the required confidence level for banks using ES compared to those using VaR.Financial Risk Manager Examination (FRM) Part II Practice Exam 38.

Following an overnight examination of the new model by one junior analyst instead of the customary evaluation that takes several weeks and involves a senior member of the team. It is illegal to reproduce this material in any format without prior written approval of GARP. 72 . The existing VaR model uses a historical simulation over a threeyear look-back period. Delta-normal VaR is more appropriate than historical simulation VaR for assets with non-linear payoffs. Which of the following statements about the risk management implications of this replacement is correct? a. For testing purposes. where a new VaR model was very quickly introduced for its Synthetic Credit portfolio without appropriate time to test the model in response to increasing losses and multiple exceedances of the earlier VaR model limit in the portfolio. Global Association of Risk Professionals. The new model uses volatilities and correlations estimated over the past four years using the Riskmetrics EWMA method. and Institutions (Hoboken. Changing the look-back period and weighing scheme from three years. the model evaluation team agrees to accept the new model for use by the desk. After four weeks. exponentially weighted. Correct answer: c Explanation: Given the quick implementation of the new VaR model and the insufficient amount of testing that was done. History. d. is too conservative. NJ: John Wiley & Sons. which uses the delta normal approach. the new VaR model has no exceedances despite consistently estimating VaR to be considerably lower than the existing model's estimates. A 95% VaR model that generates no exceedances in four weeks is necessarily conservative. which has been used broadly across the firm for several years. Assessing the Quality of Risk Measures. Section: Operational and Integrated Risk Management Reference: Allan Malz. Inc. This situation is similar to the JP Morgan London Whale case in 2012. A quantitative analyst in the group quickly develops a new VaR model. The analyst argues that the lack of exceedances shows that the new model is unbiased and pressures the bank’s model evaluation team to agree.Financial Risk Manager Examination (FRM) Part II Practice Exam Question 39 refers to the following information: A profitable derivatives trading desk at a bank decides that its existing VaR model. 39. © 2016 Global Association of Risk Professionals. weighting each day equally. b. equally weighted. the desk has increased its exposure to model risk due to the increased potential for incorrect calibration and programming errors. to four years. Learning Objective: Describe ways that errors can be introduced into models. will understate the risk in the portfolio. The desk increased its exposure to model risk due to the potential for incorrect calibration and programming errors related to the new model. Financial Risk Management: Models. 2011). Chapter 11. All rights reserved. c. the new model is used in parallel with the existing model for four weeks to estimate the 1-day 95% VaR.

Global Association of Risk Professionals. Section: Operational and Integrated Risk Management Reference: John Hull. including the required leverage ratio.280 Using the Basel III framework.280= 7. 1. Inc. Basel III.38% 8. Learning Objective: Describe and calculate ratios intended to improve the management of liquidity risk.5. and Dodd-Frank.38%.Financial Risk Manager Examination (FRM) Part II Practice Exam 40. d. All rights reserved. The bank's average capital and total exposure for the most recent quarter is as follows: REGULATORY CAPITAL Total Common Equity Tier 1 Capital Additional Tier 1 Capital USD MILLIONS 250 66 Prior to regulatory adjustments Regulatory adjustments 40 8 Total Tier 1 Capital Tier 2 Capital Prior to regulatory adjustments Regulatory adjustments Total Capital Total Average Exposure 316 55 63 8 371 4. It is illegal to reproduce this material in any format without prior written approval of GARP. The CFO at a bank is preparing a report to the board of directors on its compliance with Basel requirements. Basel 2. the liquidity coverage ratio. 4th Edition (New York: John Wiley & Sons. b. © 2016 Global Association of Risk Professionals. and the net stable funding ratio. which of the following is the best estimate of the bank’s current leverage ratio? a.29% 5. Risk Management and Financial Institutions.84% 7.67% Correct answer: c Explanation: For Basel III purposes. 73 . 2015). Chapter 16. c. the leverage ratio = (Tier 1 Capital)/(Total Exposure) = 316/4.

74 . people and systems or from external events. (Basel Committee on Banking Supervision Publication.. Learning Objective: Summarize the fundamental principles of operational risk management as suggested by the Basel committee. Human error and internal fraud Destruction by fire or other external catastrophes Damaged reputation due to a failed merger Failure or breakdown in internal control processes Correct answer: c Explanation: Basel II and Basel III define operational risk (inclusive of technological risk) as “the risk of direct or indirect loss resulting from inadequate or failed internal processes. b. Inc.g. Which of the following is not a type of operational risk as defined by Basel II and Basel III? a. Global Association of Risk Professionals.Financial Risk Manager Examination (FRM) Part II Practice Exam 41. d. c. All rights reserved. June 2011).” Although a number of financial institutions add reputation risk and strategic risk (e. Section: Operational and Integrated Risk Management Reference: Principles for the Sound Management of Operational Risk. It is illegal to reproduce this material in any format without prior written approval of GARP. they are not within the scope of definition by Basel II/III. © 2016 Global Association of Risk Professionals. due to a failed merger) as part of a broadened definition of operational risk.

Estimating Liquidity Risks. © 2016 Global Association of Risk Professionals. All rights reserved. Therefore. Consider a 1. Using the constant spread approach and assuming the returns of TQR are normally distributed. what is the estimated liquidity adjusted.Financial Risk Manager Examination (FRM) Part II Practice Exam 42. c. Global Association of Risk Professionals. England: John Wiley & Sons.5*0. Measuring Market Risk.07 Section: Operational and Integrated Risk Management Reference: Kevin Dowd. LVaR = VaR + LC = 528.18. 75 . Daily 95% VaR = 76*1. It is illegal to reproduce this material in any format without prior written approval of GARP. The daily return for TQR has an estimated volatility of 0. Inc.200*(1.28%.200 share position in an undervalued but illiquid stock TQR that has a current stock price of EUR 76 (expressed as the midpoint of the current bid-ask spread). d. b.07 Liquidity cost = 76*1.0028) = EUR 420. 2005).200*(0. Second Edition (West Sussex. Chapter 14.645*0. 1-day 95% VaR? a.18/76) = 108 And so. The average bid-ask spread is EUR 0. Learning Objective: Describe and calculate LVaR using the constant spread approach and the exogenous spread approach. EUR EUR EUR EUR 108 210 420 528 Correct answer: d Explanation: The liquidity adjusted VaR (LVaR) derived using the constant spread approach adds half of the bid-ask spread (as a percent) to the VaR calculation. using the following formula: LVaR = VaR + Liquidity Cost (LC) = VaR + ½*(Spread * P) where Spread is equal to the actual spread divided by the midpoint and P is the value of the position.

credit rating upgrade. Inc. Volume 24. Rapid asset growth Positive publicity Credit rating upgrade Increased asset diversification Correct answer: a Explanation: Rapid asset growth is an early warning of a potential liquidity problem. © 2016 Global Association of Risk Professionals. c.Financial Risk Manager Examination (FRM) Part II Practice Exam 43. 76 . b. 51-72. Section: Operational and Integrated Risk Management Reference: Darrell Duffie. Journal of Economic Perspectives (2010. Which of the following is an early warning indicator of a potential liquidity problem? a. and increased asset diversification are all not early warnings of a potential liquidity problem. The Failure Mechanics of Dealer Banks. d. Number 1) pp. Positive publicity. The Basel Committee recommends that banks use a set of early warning indicators in order to identify emerging risks and potential vulnerabilities in their liquidity position. It is illegal to reproduce this material in any format without prior written approval of GARP. All rights reserved. Learning Objective: Identify situations that can cause a liquidity crisis at a dealer bank and explain responses that can mitigate these risks. Global Association of Risk Professionals.

625 24% A liquidity crisis could materialize if repo creditors become nervous about a bank’s solvency and choose not to renew their positions.625 In the event that repo creditors become equally nervous about each bank’s solvency. © 2016 Global Association of Risk Professionals. If enough creditors choose not to renew.100 3. It is illegal to reproduce this material in any format without prior written approval of GARP.669 2.550 1. At times.469 1. Learning Objective: Identify situations that can cause a liquidity crisis at a dealer bank and explain responses that can mitigate these risks. this vulnerability is directly related to the proportion of assets a bank has pledged as collateral.230 60% 2. d.230 2. the bank could likely be unable to raise sufficient cash by other means on such short notice. All rights reserved. Journal of Economic Perspectives (2010.870 825 Not pledged 1. large dealer banks have financed significant fractions of their assets using short-term (often. 51-72.100 3. Inc. b.300 1. thereby precipitating a crisis.Financial Risk Manager Examination (FRM) Part II Practice Exam 44.669 2. which bank is most vulnerable to a liquidity crisis? a.450 Pledged as collateral 1. c.200 1. Bank Bank Bank Bank W X Y Z Correct answer: c Explanation: Bank w Bank x Bank y Bank z Financial instruments owned 2. The Failure Mechanics of Dealer Banks. Number 1) pp. Bank W Bank X Bank Y Bank Z Financial instruments owned 2.300 54% 1. 77 .850 3.850 3.550 1. The table below shows the quarter-end financing of four broker-dealer financial instruments. Global Association of Risk Professionals.e.870 825 Not pledged Fraction Pledged 1. All values are in USD billions.450 Pledged as collateral 1. Volume 24. Bank Y is most vulnerable since it has the largest dependence on short-term repo financing (i.469 45% 1. Section: Operational and Integrated Risk Management Reference: Darrell Duffie. the highest percentage of its assets out of the four banks is pledged as collateral.200 1. However. overnight) repurchase agreements in which creditors held bank securities as collateral against default losses.

the share price of a company that Firm A invested in falls significantly. an increase in interest rates and the fall in the value of an investment. Section: Operational and Integrated Risk Management Reference: “Principles for the Sound Management of Operational Risk. is an example of credit risk exposure. June 2011). A counterparty of Firm A fails to settle their debt to Firm A. causing major investment losses. As a result of an increase in commodity prices. Which of the following is an example of an operational risk loss by Firm A? a. 78 . respectively. All rights reserved. b. failure to repay debt. In (d). they are in breach of a legal agreement to pay for services rendered. The losses are directly due to an operational risk exposure. and Firm A incurs a significant loss on its bond portfolio. Inc. are both examples of market risk exposure. leading to significant losses. The data capture system of Firm A fails to capture the correct market rates causing derivative trades to be done at incorrect prices. © 2016 Global Association of Risk Professionals. systems failure or incorrect systems caused the problem. Correct answer: b Explanation: In (b).” (Basel Committee on Banking Supervision Publication. bond prices fall. In (a) and (c). Global Association of Risk Professionals. Learning Objective: Identify examples of tools which can be used to identify and assess operational risk.Financial Risk Manager Examination (FRM) Part II Practice Exam 45. It is illegal to reproduce this material in any format without prior written approval of GARP. After a surprise announcement by the central bank that interest rates would increase. and in doing this. c. d.

It is illegal to reproduce this material in any format without prior written approval of GARP. The variation in these values does not suggest bigger problems with data or programming/implementation nor is there any reason to suspect endogenous model risk (e. computational and modeling decisions can impact VaR estimates.940 Monte Carlo Simulation VaR: USD 473.g. © 2016 Global Association of Risk Professionals. Assessing the Quality of Risk Measures. Section: Operational and Integrated Risk Management Reference: Allan Malz. and Institutions (Hoboken.584 Which of the following is the most likely explanation for the variation in VaR estimates? a. c. Financial Risk Management: Models. All rights reserved. NJ: John Wiley & Sons. The risk management group estimates the 1-day 99% VaR on a long-only. Chapter 11. 2011). Data problems Differences in model assumptions Endogenous model risk Programming errors Correct answer: b Explanation: VaR measures will vary according to the approach (delta-normal. Inc. b. traders gaming the system to lower risk values). Monte Carlo simulation). Learning Objective: Describe how horizon. Global Association of Risk Professionals. A daily risk report shows the following information: 1-day 99% VaR Estimates (by approach): Delta-Normal VaR: USD 441. History. 79 . d..906 Historical Simulation VaR: 495. historical simulation.Financial Risk Manager Examination (FRM) Part II Practice Exam 46. large-cap equity portfolio using a variety of approaches.

It is illegal to reproduce this material in any format without prior written approval of GARP. pp. d. 8 – 20. b. Inc. so the distribution is asymmetric (and fat-tailed). Which of the following observations of the bank’s data should be considered unexpected if compared to similar industry data? a. credit risk distribution is asymmetric and fat-tailed. 80 . market risk distribution is similar to the distribution of the return on a portfolio of securities. c. a risk analyst takes an inventory of firm risks and categorizes these risks as market. Journal of Applied Corporate Finance (Volume 18. Enterprise Risk Management: Theory and Practice. The The The The operational risk loss distribution has a large number of small losses. Global Association of Risk Professionals. and (d) are consistent with industry data. or operational. with operational risk. Learning Objective: Describe the development and implementation of an ERM system. 2006). (c). and therefore a relatively low mode.Financial Risk Manager Examination (FRM) Part II Practice Exam 47. However. operational risk loss distribution is symmetric and fat-tailed. Section: Operational and Integrated Risk Management Reference: Brian Nocco and René Stulz. While building the bank’s enterprise risk management system. there tends to be large numbers of small losses and a small number of large losses. Correct answer: b Explanation: Statements (a). All rights reserved. credit. Number 4. © 2016 Global Association of Risk Professionals.

5% 400 Section: Operational and Integrated Risk Management Reference: Michel Crouhy. or loan portfolio. Bank BHC is considering a loan to be fully funded by deposits.2% Annual interest rate on loan: 6. and use RAROC to compare business unit performance.000. 2nd Edition (New York: McGraw-Hill.000 x 0.000 Revenue = expected revenue = GBP 5 billion x 0.000. 10.000. 81 . 9. Chapter 17.000 Loss = expected loss = GBP 5 billion x 0. b.Financial Risk Manager Examination (FRM) Part II Practice Exam 48. Dan Galai and Robert Mark. loan.000.0% What is the risk-adjusted return on capital for this loan? a.012 = GBP 60. The Essentials of Risk Management.5% D.06 = GBP 300.2650 26.000.0% of face value of loan Annual operating costs: 1. Global Association of Risk Professionals.02 = GBP 100. c.000 Therefore. Inc.0% Average return on economic capital: 4.08 = GBP 400.000 Income = return on invested economic capital = GBP 400. 2014). with the following parameters: Loan amount: GBP 5 billion Average annual interest rate paid on deposits: 1.0% of face value of loan Economic capital: 8. A. Capital Allocation and Performance Measurement. 26.000 Interest = interest expense = GBP 5 billion x 0.5% B.0% Expected loss: 2.5% C.000.5% Correct answer: c Explanation: The risk-adjusted return on capital (RAROC) is computed by: RAROC Re venue Income Interest Operating Cost Loss Economic Capital Where: Economic Capital = GBP 5 billion x 0. It is illegal to reproduce this material in any format without prior written approval of GARP.000 Operating Cost = GBP 5 billion x 0. RAROC 300 16 60 50 100 0. 35. All rights reserved. Learning Objective: Compute and interpret the RAROC for a project.04 = GBP 16.000.01 = GBP 50. © 2016 Global Association of Risk Professionals. d.

345 555 1.5.502 million million million million Correct answer: c Explanation: The revised market risk capital requirement is: Market Risk Capital = max(VaRt-1. and Dodd-Frank.Financial Risk Manager Examination (FRM) Part II Practice Exam 49.132 million Section: Operational and Integrated Risk Management Reference: John Hull.844 Confidence Level Latest Available 10-day VaR 95. © 2016 Global Association of Risk Professionals. A bank uses the internal models approach for market risk and has generated the following risk measures (in USD million) for the current trading book positions: Average 10-day VaR Average 10-day Stressed VaR 10-day Stressed VaR of Previous of Previous 60 Days 60 Days 305 664 340 743 99.665 USD 3. 4th Edition (New York: John Wiley & Sons. 82 . Basel III. What is the capital requirement for general market risk? a. All rights reserved. Chapter 16. c.977 USD 6. Risk Management and Financial Institutions. Global Association of Risk Professionals. mc*VaR60-day Avg) + max(SVaRt-1.132 USD 8. Learning Objective: Describe and calculate the stressed value-at-risk measure introduced in Basel 2. b. USD 1.726 708 1. 3*1489) = USD 6.0% Latest Available The supervisory authority has set the multiplication factors for both the VaR and stressed VaR values to 3. d. and calculate the market risk capital charge. the Basel Committee revised the market risk framework and introduced a stressed VaR requirement. Inc. It is illegal to reproduce this material in any format without prior written approval of GARP.5.489 99. Basel 2. 3*555) + max(1345.9% 757 1.0% 588 1. 2015). ms*SVaR60-day Avg) = max(588. As a result of the credit crisis.

b. 83 . 1 + r = (1 – π) * (1 + y) + πR where π = Probability of default and R = Recovery rate In the situation where the recovery rate is assumed to be zero.000. Learning Objective: Calculate risk-neutral default rates from spreads. the risk-neutral 1-year probability of default on Company K is closest to which of the following? a.000. Global Association of Risk Professionals. Inc. Financial Risk Management: Models.000 * 1. and Institutions (Hoboken. Chapter 7. The bond is currently trading at 90% of face value.Financial Risk Manager Examination (FRM) Part II Practice Exam 50. NJ: John Wiley & Sons. That is. It is illegal to reproduce this material in any format without prior written approval of GARP.000 and a 0% recovery rate issued by Company K. Assuming the excess spread only captures credit risk and that the risk-free rate is 3% per annum. Consider a 1-year maturity zero-coupon bond with a face value of USD 1. Spread Risk and Default Intensity Models. © 2016 Global Association of Risk Professionals. c. All rights reserved.03)/1. 7% 10% 13% 15% Correct answer: a Explanation: This can be calculated by using the formula which equates the future value of a risky bond with yield (y) and default probability (p) to a risk free asset with yield (r). Inputting the data into this equation yields π = 1 – (900.000 = 0.3%. Section: Credit Risk Measurement and Management Reference: Allan Malz. 2011). History. the risk-neutral probability of default can be derived from the following equation: 1 + r = (1 – π) * (FV/MV) where MV = market value and FV = face value. d.073 = 7.

c. All rights reserved. 84 . reducing its value. which of the following is a good strategy to pursue? a. Sell the senior tranche and buy the equity tranche. Section: Credit Risk Measurement and Management Reference: Allan Malz. History. NJ: John Wiley & Sons. Global Association of Risk Professionals. Correct answer: d Explanation: The decrease in probability of default would increase the value of the equity tranche. Sell the senior tranche and sell the equity tranche. Inc. Based on this prediction. and Institutions (Hoboken. Financial Risk Management: Models. 2011). it is better to go long the equity tranche and short the senior tranche.Financial Risk Manager Examination (FRM) Part II Practice Exam 51. d. Thus. due to increased correlation. a default of the equity tranche would increase the probability of default of the senior tranche. It is illegal to reproduce this material in any format without prior written approval of GARP. Structured Credit Risk. Buy the senior tranche and sell the equity tranche. Learning Objective: Explain how the default probabilities and default correlations affect the credit risk in a securitization. Buy the senior tranche and buy the equity tranche. Chapter 9. The fund’s chief economist predicts that the default probability will decrease significantly and that the default correlation will increase. b. Also. A hedge fund is considering taking positions in various tranches of a collateralized debt obligation (CDO). © 2016 Global Association of Risk Professionals.

It is illegal to reproduce this material in any format without prior written approval of GARP. © 2016 Global Association of Risk Professionals. With netting. so that only a net payment has to be made. 2011). Structured Credit Risk. History.Financial Risk Manager Examination (FRM) Part II Practice Exam 52. c. USD 0 million USD 12 million USD 21 million USD 33 million Correct answer: c Explanation: Netting means that the payments between the two counterparties are netted out. Chapter 9. A bank has many open derivative positions with an investment firm. All rights reserved. A description and current market values are displayed in the table below: Positions Market Long swaptions Price (USD) 21 million Long credit default swaps -33 million Short currency derivatives 33 million In the event that the investment firm defaults. what would be the loss to the bank if netting is used? a. Global Association of Risk Professionals. Section: Credit Risk Measurement and Management Reference: Allan Malz. d. Inc. Learning Objective: Explain how the default probabilities and default correlations affect the credit risk in a securitization. and Institutions (Hoboken. NJ: John Wiley & Sons. Financial Risk Management: Models. the investment firm is not required to make the payout of 33 million. b. Hence the loss will be reduced to: USD 21 million + USD 33 million – USD 33 million = USD 21 million. 85 .

Financial Risk Manager Examination (FRM) Part II Practice Exam

53.

A financial firm sells a put option on ABC stock with a time to expiration of six months, a strike price of USD

105, an underlying asset price of USD 85, implied volatility of 24% and a risk-free rate of 3%. What is the

firm’s counterparty credit exposure from this transaction?

a.

b.

c.

d.

USD 0.00

USD 0.68

USD 2.38

USD 32.40

Correct answer: a

Explanation: Selling a put option exposes the firm to zero counterparty credit risk as the premium is paid up

front. The correct answer is therefore (a). All the information necessary to price the option is provided but it is

not necessary.

Section: Credit Risk Measurement and Management

Reference: Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for

Global Financial Markets, 2nd Edition (West Sussex, UK: John Wiley & Sons, 2012). Chapter 3, Defining

Counterparty Credit Risk.

Learning Objective: Describe transactions that carry counterparty risk and explain how counterparty risk can

arise in each transaction.

**© 2016 Global Association of Risk Professionals. All rights reserved. It is illegal to reproduce this material
**

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

86

Financial Risk Manager Examination (FRM) Part II Practice Exam

54.

An investor has sold default protection on the most senior tranche of a CDO. If the default correlation between

assets held in the CDO decreases sharply, assuming everything else is unchanged, the investor’s position:

a.

b.

c.

d.

**Will gain significant value, since the probability of exercising the protection falls.
**

Will lose significant value, since the protection will gain value.

Will neither gain nor lose value, since only expected default losses matter and correlation does not affect

expected default losses.

Can either increase or decrease, depending on the pricing model used and the market conditions.

Correct answer: a

Explanation: The senior tranche will gain value if the default correlation decreases. High correlation implies

that if one name defaults, a large number of other names in the CDO will also default. Low correlation implies

that if one name defaults, there would be little impact on the default probability of the other names.

Therefore, as the correlation decreases, the cumulative probability of enough defaults occurring to exceed the

credit enhancement on the senior tranche will also decrease. Hence the investor who has sold protection on

the senior tranche will see a gain.

**Section: Credit Risk Measurement and Management
**

Reference: Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken, NJ: John Wiley &

Sons, 2011). Chapter 9, Structured Credit Risk.

Learning Objective: Explain how the default probabilities and default correlations affect the credit risk in a

securitization.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

87

Financial Risk Manager Examination (FRM) Part II Practice Exam

55.

Suppose that you want to estimate the implied default probability for a BB-rated discount corporate bond.

The T-bond (a risk-free bond) yields 8% per year.

The one-year BB-rated discount bond yields 14% per year.

The two-year BB-rated discount bond yields 21% per year.

If the recovery rate on a BB-rated bond is expected to be 0%, and the marginal default probability in year one

is 7%, which of the following is the best estimate of the risk-neutral probability that the BB-rated discount bond

defaults within the next two years?

a.

b.

c.

d.

3.85%

5.26%

10.74%

20.33%

Correct answer: d

Explanation: (1 + 0.08)2 = PD * 0 + (1 – PD) * (1 + 0.21)2 → PD = 20.33%

Section: Credit Risk Measurement and Management

Reference: Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for

Global Financial Markets, 2nd Edition (West Sussex, UK: John Wiley & Sons, 2012). Chapter 10, Default

Probability, Credit Spreads, and Credit Derivatives

Learning Objective: Calculate risk-neutral default probabilities, and compare the use of risk-neutral and realworld default probabilities in pricing derivative contracts.

in any format without prior written approval of GARP, Global Association of Risk Professionals, Inc.

88

although important. 89 . Chapter 9. frictions between the mortgagor and the originator: predatory lending have been identified as key frictions that caused the subprime mortgage crisis. A credit manager overseeing the structured credit book of a bank works on identifying the frictions in the securitization process that caused the recent subprime mortgage crisis in the United States. and Institutions (Hoboken. d. Frictions Frictions Frictions Frictions between between between between the the the the mortgagor and the originator: predatory lending. servicer and asset manager: moral hazard. d is incorrect. Of the following frictions in the securitization process. b is incorrect. Inc. these frictions have not been identified as key frictions that caused the subprime mortgage crisis. NJ: John Wiley & Sons. Correct answer: c Explanation: a is incorrect.Financial Risk Manager Examination (FRM) Part II Practice Exam 56. Global Association of Risk Professionals. which one was not a cause of the subprime crisis? a. c. originator and the arranger: predatory borrowing and lending. have been identified as key frictions that caused the subprime mortgage crisis. Learning Objective: Identify the key participants in the securitization process. 2011). Section: Credit Risk Measurement and Management Reference: Allan Malz. have been identified as key frictions that caused the subprime mortgage crisis. c is correct. frictions between the servicer and asset manager or credit ratings agency: moral hazard. asset manager and investor: principal-agent conflict. All rights reserved. It is illegal to reproduce this material in any format without prior written approval of GARP. frictions between the asset manager and investor: principal–agent. Structured Credit Risk. and describe conflicts of interest that can arise in the process. History. b. © 2016 Global Association of Risk Professionals. frictions between the originator and the arranger: predatory borrowing and lending. Financial Risk Management: Models.

b. For counterparty C: A = 6-12 = -8 = $0. d. C = 0-6 = -5 = $0. for a sum of $8. C = 12-4 = $8.Financial Risk Manager Examination (FRM) Part II Practice Exam 57. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets. from lowest to highest? MtM Trades for Four Counterparties (USD million) Opposing Counterparty Counterparty A Counterparty B Counterparty C B C Trades with positive MtM 12 12 2 Trades with negative MtM -12 -4 -12 A C D Trades with positive MtM 12 0 12 Trades with negative MtM -12 -6 -1 A B D Trades with positive MtM 6 6 3 -12 0 -2 A B C Trades with positive MtM 12 3 1 Trades with negative MtM -2 -12 -1 Trades with negative MtM Counterparty D a. for a sum of $11. Chapter 4. 90 . D = 12-1 = $11. the correct sequence of net exposure amounts per counterparty. D B. D = 2-12 = -10 = 0. Note that a negative netted amount means the counterparty has no exposure. B = 3-12 = -9 = $0. is C. For counterparty D: A = 12-2 = $10. Resets. C Correct answer: c Explanation: The properly netted amounts are: For counterparty A: B = 12-12= $0. D A. B = 6-0 = $6. Section: Credit Risk Measurement and Management Reference: Jon Gregory. 2nd Edition (West Sussex. A. Learning Objective: Describe the effectiveness of netting in reducing credit exposure under various scenarios. A. All rights reserved. Therefore. A. D = 3-2= $1. Compression. B. It is illegal to reproduce this material in any format without prior written approval of GARP. (lowest to highest). and Termination Features. Inc. © 2016 Global Association of Risk Professionals. B D. D. For counterparty B: A = 12-12 = $0. 2012). The exhibit below presents a summary of bilateral mark-to-market (MtM) trades for four counterparties. D. If netting agreements exist between all pairs of counterparties shown. B. for a sum of $7. Netting. for a sum of $10. D. B C. B. c. UK: John Wiley & Sons. what is the correct order of net exposure per counterparty. Global Association of Risk Professionals. C. C = 1-1 = $0. C.

Financial Risk Manager Examination (FRM) Part II Practice Exam 58. It is illegal to reproduce this material in any format without prior written approval of GARP. The FX risk of the notional exchange dominates the small contribution due to interest rate exposure. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets. 2012). All rights reserved. Global Association of Risk Professionals. 2nd Edition (West Sussex. UK: John Wiley & Sons. 91 . Which of the following graphs is an accurate representation of a typical potential future exposure (PFE) profile for the corresponding instrument? Correct answer: B Explanation: The risk of cross-currency swaps is driven by a large final payoff. Credit Exposure. Learning Objective: Identify typical credit exposure profiles for various derivative contracts and combination profiles. Inc. and thus the profile increases monotonically until the maturity of the trade. © 2016 Global Association of Risk Professionals. Chapter 8. Section: Credit Risk Measurement and Management Reference: Jon Gregory.

Financial Risk Manager Examination (FRM) Part II Practice Exam 59. d. Futures. Chapter 20. b. Inc. and Other Derivatives. Compared to the lognormal distribution. The observed volatility skew for a particular equity index slopes downward to the right. the distribution of option prices on this index implied by the Black-Scholes-Merton (BSM) model would have: a. Global Association of Risk Professionals. A A A A fat left tail and a thin right tail. A risk manager is examining a firm’s equity index option price assumptions. © 2016 Global Association of Risk Professionals. fat left tail and a fat right tail. Options. It is illegal to reproduce this material in any format without prior written approval of GARP. thin left tail and a thin right tail. 9th Edition. thin left tail and a fat right tail. Section: Market Risk Measurement and Management Reference: John Hull. Learning Objective: Compare the shape of the volatility smile (or skew) to the shape of the implied distribution of the underlying asset price and to the pricing of options on the underlying asset. c. Correct answer: a Explanation: A downward sloping volatility skew indicates that out of the money puts are more expensive than predicted by the Black-Scholes-Merton model and out of the money calls are cheaper than expected predicted by the Black-Scholes-Merton model. Volatility Smiles. The implied distribution has fat left tails and thin right tails. 92 . All rights reserved.

350.000 97.750. A money management firm has USD 33 billion in assets.5% 511. England: John Wiley & Sons.350.857 6 Section: Market Risk Measurement and Management Reference: Kevin Dowd.700.150.000 What is the closest estimate of the daily expected shortfall at the 96.250.300. d.000 96. Learning Objective: Estimate the expected shortfall given P/L or return data.0% 605. © 2016 Global Association of Risk Professionals.842.0% 503. ES 562.000 96.350. Inc.000.550.000 605.5% confidence level? a.0% 520.750.000 USD 620.000 636.000 95. Global Association of Risk Professionals. b.000 97.000 677.000 740. Chapter 3.5% 740. All rights reserved. c. 2nd Edition (West Sussex. USD 543 USD 588 USD 621 USD 740 million million million million Correct answer: c Explanation: An estimate of the expected shortfall (ES) can be obtained by taking the average of the VaRs for the various confidence levels that are greater than 96. Estimating Market Risk Measures: An Introduction and Overview. Therefore. The risk manager computes the daily VaR at various confidence levels as follows: Confidence Level VaR (USD) 95.250.000 98.5% 542.350.300.5%.150.000 98.0% 677.750. It is illegal to reproduce this material in any format without prior written approval of GARP.5% 636.000 99. 93 .Financial Risk Manager Examination (FRM) Part II Practice Exam 60.000 581. 2005).0% 562.5% 581. Measuring Market Risk.000 99.

and you are recommending that it switch to a 95% confidence level. All rights reserved. Correct answer: c Explanation: The concept tested here is the understanding of the difference between the VaR parameter for confidence (here. This in turn increases the power of the backtesting process and makes for a more reliable test. b. When backtesting using a 90% confidence level. namely 95% vs. The 95% VaR model is less likely to be rejected using backtesting than the 99% VaR model. Chapter 6. 2007). c. 94 . Learning Objective: Define and identify type I and type II errors. the bank calculates a 1-day VaR at the 99% confidence level. Section: Market Risk Measurement and Management Reference: Philippe Jorion. Inc.Financial Risk Manager Examination (FRM) Part II Practice Exam 61. It is illegal to reproduce this material in any format without prior written approval of GARP. Using a VaR confidence level creates a narrower rejection region by allowing a greater number of exceptions to be generated. (New York: McGraw-Hill. d. © 2016 Global Association of Risk Professionals. Which of the following statements concerning this switch is correct? a. 99%) and the validation procedure confidence level. When validating with backtesting at the 90% confidence level. Value-at-Risk: The New Benchmark for Managing Financial Risk. and how they interact with one another. Currently. there is a smaller probability of committing a type I error when backtesting a 95% VaR model than with a 99% VaR model. 3rd Edition. You are backtesting a bank’s VaR model. The decision to accept or reject a VaR model based on backtesting results is more reliable with a 95% confidence level VaR model than with a 99% confidence level model. Global Association of Risk Professionals. there is a smaller probability of incorrectly rejecting a 95% VaR model than a 99% VaR model. Backtesting VaR.

In this case u = (X – 4)/3 (the cumulative marginal function of X. c. Section: Market Risk Measurement and Management Reference: Bruce Tuckman. c. Learning Objective: Construct a short-term rate tree under the Ho-Lee Model with time-dependent drift. X is uniformly distributed between 4 and 7. (Y – 5)/3] is equal to C(X. Incorporates no-risk premium to the interest rate model allowing rates to vary according to their volatility. Correct answer: c Explanation: Sklar’s theorem proves that if F(x. An analyst is looking at various models used to incorporate drift into term structure models.Y) is equal to C[(X – 4)/3. Correct answer: c Explanation: Choice c is correct: the Ho-Lee model incorporates a premium to each rate change that can be different at each point in time. then F(x. there is a copula C such that: a. H[(X – 4)/3. It is illegal to reproduce this material in any format without prior written approval of GARP. Correlation Risk Modeling and Management (New York: John Wiley & Sons. H(X. Learning Objective: Explain the purpose of copula functions and the translation of the copula equation. Allows for a risk premium to be applied to interest rates that changes over time.v) such as F(x.y) is a joint distribution function with continuous marginals Fx(x) = u and Fy(y) = v. X and Y. 2011).Y]. NJ: John Wiley & Sons. which is uniformly distributed between 4 and 7) and v = (Y – 5)/3. Section: Market Risk Measurement and Management Reference: Gunter Meissner. and Y is uniformly distributed between 5 and 8. Inc. The Ho-Lee Model: a. d.Financial Risk Manager Examination (FRM) Part II Practice Exam 62. d. 2014). Incorporates drift as a premium to interest rates that remains constant over time. A risk manager wants to study the behavior of a portfolio that depends on only two economic variables. 3rd Edition (Hoboken. b. The Art of Term Structure Models: Drift.Y). Financial Correlation Modeling—Bottom-Up Approaches.d] where u is the density marginal distribution of X and d is the density marginal distribution of Y. All rights reserved. for any joint distribution H. H(X. Chapter 4. H(X. 95 . Global Association of Risk Professionals.y) can be written in terms of a unique function C(u. H(3X + 4. Note: The candidate is not responsible for knowing the properties of the uniform distribution.y) = C(u. b. (Y – 5)/3]. The risk manager wants to model their joint distribution. Chapter 9. 63. © 2016 Global Association of Risk Professionals. Fixed Income Securities. Incorporates drift into the model following the assumption that rates revert to the long-run equilibrium value.v).Y) is equal to C[u.Y). 3Y + 5) is equal to C[X. The theorem of Sklar proves that.

Financial Risk Manager Examination (FRM) Part II Practice Exam 64. will tend to: a. Chapter 20. relatively low and price the option on EUR/JPY relatively high. using the lognormal distribution of prices causes deep-out-of-the-money call options on the underlying to be priced relatively low. 9th Edition. b. Learning Objective: Describe characteristics of foreign exchange rate distributions and their implications on option prices and implied volatility. using the lognormal distribution of prices causes deep-out-of-the-money call options on the underlying to be priced relatively high. relatively high and price the option on EUR/JPY relatively high. All rights reserved. © 2016 Global Association of Risk Professionals. The practitioners price these options based on two distinct probability distributions of underlying asset prices at the option expiration date: • A lognormal probability distribution • An implied risk-neutral probability distribution obtained from the volatility smile for options of the same maturity Using the lognormal. d. and Other Derivatives. Therefore. Volatility Smiles. Correct answer: a Explanation: The implied distribution of the underlying equity prices derived using the general volatility smile of equity options has a heavier left tail and a less heavy right tail than a lognormal distribution of underlying prices. instead of the implied risk-neutral probability distribution. c. The implied distribution of underlying foreign currency prices derived using the general volatility smile of foreign currency options has heavier tails than a lognormal distribution of underlying prices. 96 . Options. Inc. Futures. It is illegal to reproduce this material in any format without prior written approval of GARP. A committee of risk management practitioners discusses the difference between pricing deep out-of-the-money call options on FBX stock and pricing deep out-of-the-money call options on the EUR/JPY foreign exchange rate using the Black-Scholes-Merton (BSM) model. Therefore. Global Association of Risk Professionals. Price Price Price Price the the the the option option option option on on on on FBX FBX FBX FBX relatively high and price the option on EUR/JPY relatively low. Section: Market Risk Measurement and Management Reference: John Hull. relatively low and price the option on EUR/JPY relatively low.

the distribution of exceedances converges to a generalized Pareto distribution. © 2016 Global Association of Risk Professionals. England: John Wiley & Sons. Assuming the threshold is high enough. which causes the reliability of the parameter estimates to increase. etc. excess losses can be modeled using the Generalized Pareto distribution. the distribution of loss exceedances converges to a generalized Pareto distribution. Chapter 7.Financial Risk Manager Examination (FRM) Part II Practice Exam 65. It is illegal to reproduce this material in any format without prior written approval of GARP. Parametric Approaches (II): Extreme Value Learning Objective: Describe extreme value theory (EVT) and its use in risk management. The number of exceedances decreases as the threshold value decreases. As the threshold value is decreased. Choosing the threshold value near the estimated mean of the underlying loss distribution is arbitrary and this method is not typically employed. To apply EVT. b.. Measuring Market Risk. d. Inc. when examining distributions of losses exceeding a threshold value. 97 . 2nd Edition (West Sussex. Correct answer: d Explanation: A key foundation of EVT is that as the threshold value is increased. According to extreme value theory (EVT). the number of exceedances increases. All rights reserved. the underlying loss distribution must be either normal or lognormal. and will usually be unknown. t. Section: Market Risk Measurement and Management Reference: Kevin Dowd. lognormal. Global Association of Risk Professionals. c. To apply EVT. 2005). which of the following is correct? a. the underlying loss distribution can be any of the commonly used distributions: normal. The threshold value is typically chosen near the estimated mean of the underlying loss distribution. As the threshold value is increased.

A sudden market crisis in an emerging market leads to losses in the equity positions in that country. b. However. © 2016 Global Association of Risk Professionals. Backtesting VaR. (New York: McGraw-Hill. In the case of bad luck. It is illegal to reproduce this material in any format without prior written approval of GARP. Chapter 6. a penalty should be considered. Inc. but it is not necessarily given. no penalty is given. The bank’s model calculates interest rate risk based on the median duration of the bonds in the portfolio. when risk models are not precise enough. a penalty is typically given since model accuracy could have easily been improved. All rights reserved. Which of the following causes of exceptions is most likely to lead to a penalty? a. Learning Objective: Describe the Basel rules for backtesting. d.Financial Risk Manager Examination (FRM) Part II Practice Exam 66. Global Association of Risk Professionals. as would be the case for a bank affected by unpredictable movements in rates or markets. Value-at-Risk: The New Benchmark for Managing Financial Risk. 3rd Edition. Correct answer: c Explanation: In the case of a bank that changed positions more frequently during the day. Based on Basel II rules for backtesting. The supervisor gives these penalties based on four criteria. 98 . The bank increases its intraday trading activity. Section: Market Risk Measurement and Management Reference: Philippe Jorion. 2007). c. a penalty is given to banks that have more than four exceptions to their 1-day 99% VaR over the course of 250 trading days. A large move in interest rates was combined with a small move in correlations.

706 Section: Market Risk Measurement and Management Reference: Philippe Jorion. A deep in-the-money call has a delta of approximately 1.000 + 1*10. and options. The portfolio also contains 10. Global Association of Risk Professionals. It is illegal to reproduce this material in any format without prior written approval of GARP.701 USD 14. c.Financial Risk Manager Examination (FRM) Part II Practice Exam 67. forward rate agreements.33 * 84 * 15.000 + 0*25. b. (New York: McGraw-Hill.23/sqrt(250) = USD 42.000 deep out-of-the-money call options on LTM. Chapter 11.000 and is approximately gamma neutral.000 deep in-the-money call options on LTM and 25. d.000 * 0. a deep out-of-the-money call has a delta of approximately zero and forwards have a delta of 1. © 2016 Global Association of Risk Professionals.000 σ = volatility of LTM = 0. All rights reserved.151 USD 42.23 Therefore.706 Correct answer: d Explanation: We need to map the portfolio to a position in the underlying stock LTM.33 (99% confidence level) S = price per share of stock LTM = USD 84 = delta of the position = 15.000 forward contracts on LTM. interest rate swaps. the 1-day VaR estimate at 99 percent confidence level is computed as follows: a * S * Δ * σ * sqrt(1/T) = 2. 2007). Learning Objective: Describe the method of mapping forwards.235 USD 30. Let: a = 2. 3rd Edition. Assuming 250 trading days in a year and the volatility of LTM is 23% per year. The portfolio is made up of 5. The net portfolio has a delta of about 1*5. LTM is trading at USD 84. which of the following amounts would be closest to the 1day VaR of the portfolio at the 99 percent confidence level? a.000 = 15. Inc. USD 2. Value-at-Risk: The New Benchmark for Managing Financial Risk. 99 . VaR Mapping. A portfolio manager owns a portfolio of options on a non-dividend paying stock LTM.

1258 Section: Risk Management and Investment Management Reference: Philippe Jorion. 100 . at the 95% confidence level? a.000 = USD 100. All rights reserved. Global Association of Risk Professionals.0 Asset Portfolio What is the Component VaR of asset XYZ and the Marginal VaR of asset ABC.Financial Risk Manager Examination (FRM) Part II Practice Exam 68.840 Marginal VaR of Asset ABC = VaRp*βabc /portfolio value = USD 100.10 1. incremental VaR.5/USD 1. c.1258 Correct answer: c Explanation: VaRp = *portfolio standard deviation*portfolio value = 1. d.539.200) = USD 32. Learning Objective: Define.5 1. Chapter 7: Portfolio Risk — Analytical Methods.1258 0.000 Component VaR of Asset XYZ = VaRp*βxyz*Wxyz = USD 100. and USD 80.000*1. and USD 32.20 0. b.674.200.000*0. component VaR.645*0.840.674.200.000 = 0. Component Component Component Component VaR VaR VaR VaR = = = = USD 32. and distinguish between the following portfolio VaR measures: individual VaR.000.0587 0.886.7*(560/1. 3rd Edition.000.85 1. © 2016 Global Association of Risk Professionals. marginal VaR. Consider the following two asset portfolios under management at an investment company: Position Value Return Standard (in millions of EUR) Deviation (%) Beta XYZ 560 4. Inc.051*USD 1.539. 161-164.7 ABC 640 7. and USD 80. Value-at-Risk: The New Benchmark for Managing Financial Risk.674. and Marginal Marginal Marginal Marginal VaR = VaR = VaR = VaR = 0. respectively.200 5.886.200.0587 0. and diversified portfolio VaR. undiversified portfolio VaR. It is illegal to reproduce this material in any format without prior written approval of GARP. pp. calculate.200.840.886.

d. Correct answer: d Explanation: Liabilities at a pension fund are typically composed of accumulated benefit obligations. Inc. Pension fund risk analysis does not consider performance relative to a benchmark. From the plan sponsor’s perspective. Chapter 17. Learning Objective: Describe the investment process of large investors such as pension funds . Global Association of Risk Professionals. All rights reserved. A pension plan’s total VaR is equal to the sum of its policy-mix VaR and active management VaR. Value-at-Risk: The New Benchmark for Managing Financial Risk.Financial Risk Manager Examination (FRM) Part II Practice Exam 69. In most defined-benefit pension plans. measured by the present value of all pension benefits owed to employees discounted by an approximate interest rate. VaR and Risk Budgeting in Investment Management. 3rd Edition. 101 . their value in general will behave like a short position in a long-term bond. Section: Risk Management and Investment Management Reference: Philippe Jorion. c. nominal pension obligations are similar to a short position in a bond. the shortfall does not create a risk for the plan sponsor. © 2016 Global Association of Risk Professionals. When liabilities consist mostly of nominal payments. if liabilities exceed assets. b. Which of the following statements about risk management in the pension fund industry is correct? a. It is illegal to reproduce this material in any format without prior written approval of GARP.

161-164. So.88).396 USD 39.288 2.792 * 360 / 110. calculate. and diversified portfolio VaR. c. d. 3rd Edition. incremental VaR.84. βi = Marginal VaRi*Portfolio Value /Portfolio VaR = β2 = 0. the portfolio will contain only Asset 2. Inc. What is β2? a. and distinguish between the following portfolio VaR measures: individual VaR.88 Correct answer: a Explanation: If Asset 1 is dropped.USD 83.644 1.575 Cannot determine from information provided.94 USD 83.88 = USD 26. c.94 USD 46.Financial Risk Manager Examination (FRM) Part II Practice Exam Questions 70 and 71 are based on the following information.72 USD 110. Chapter 7: Portfolio Risk — Analytical Methods.792 USD 79. component VaR. d. 0. It is illegal to reproduce this material in any format without prior written approval of GARP.6 2 USD 180 USD 83. Then the new portfolio VaR is that of Asset 2 alone (USD 83.84 USD 41. Correct answer: c Explanation: Marginal VaRi = βi*(Portfolio VaR)/(Portfolio Value).94 0. 102 .72 = 2. Value-at-Risk: The New Benchmark for Managing Financial Risk.575 Section: Risk Management and Investment Management Reference: Philippe Jorion. All rights reserved. undiversified portfolio VaR. Asset Position Individual VaR Marginal VaR VaR Contribution 1 USD 180 USD 41. marginal VaR. Learning Objective: Define. USD 26.72 . σi is the volatility of the return of asset i and σp is the volatility of the return of the portfolio. 71. which implies that dropping Asset 1 will result in a reduction in portfolio VaR of USD 110.72 If Asset 1 is dropped from the portfolio.88 0. Global Association of Risk Professionals. pp.2 Portfolio USD 360 USD 110. Let βi = ρip*σi/σp. what will be the reduction in portfolio VaR? a. b. © 2016 Global Association of Risk Professionals. b. A risk manager assumes that the joint distribution of returns is multivariate normal and calculates the following risk measures for a two-asset portfolio: 70. where ρip denotes the correlation between the return of asset i and the return of the portfolio.

d. Section: Risk Management and Investment Management Reference: Richard Grinold and Ronald Kahn. Marcus. b.02. © 2016 Global Association of Risk Professionals. roughly how many stocks have an alpha greater than 4% or less than -4%? a. and proper alpha coverage. b. Learning Objective: Explain the difficulties in measuring the performance of hedge funds. the average performance increases. 73. c. The Sharpe ratio tends to get inflated due to survivorship bias. The The The The average performance of hedge funds is overstated. c. 10th Edition (New York: McGraw-Hill. Learning Objective: Assess the impact of practical issues in portfolio construction such as determination of risk aversion. The removal of poor performers could actually reduce average volatility and the correlation of returns. Which of the following best describes the impact this has historically had on hedge fund analyses performed using these databases? a. Portfolio Construction. average Sharpe ratio of hedge fund returns is understated. The resulting pool of 100 alphas has a residual risk of 18% and an information coefficient of 9%. average correlation of hedge fund returns is overstated. 2014). Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk.10 = 0. Chapter 14. Inc. 4%]. 4% is twice the standard deviation of the alphas.20 * 0. All rights reserved. so roughly there are 5 alphas that are out of the range. Alex Kane. Portfolio Performance Evaluation.Financial Risk Manager Examination (FRM) Part II Practice Exam 72. It is illegal to reproduce this material in any format without prior written approval of GARP. 2000). 103 . 2nd Edition (New York: McGraw-Hill. If the alphas are normally distributed with a mean of 0%. Correct answer: a Explanation: As poor performers drop out of the database. and Alan J. The total number of stocks is 100. d. average volatility of hedge funds is overstated. A significant percentage of hedge funds stop trading each year and drop out of hedge fund databases. Investments. So. An analyst regresses the returns of 100 stocks against the returns of a major market index. so about 5% of the alphas are out of the interval [-4%. Global Association of Risk Professionals. 5 10 20 25 Correct answer: a Explanation: The standard deviation (std) of the alphas = Residual Risk (volatility) x Information Coefficient (IC) = 0. Section: Risk Management and Investment Management Reference: Zvi Bodie. Chapter 24. The alphas follow normal distribution with mean 0. incorporation of specific risk aversion.

2% 12% 1.75 10% 0. Value-at-Risk: The New Benchmark for Managing Financial Risk. Chapter 7 .200 0. Of these.Portfolio Risk: Analytical Methods. d. which asset should the portfolio manager select? a. rather than adding a new holding. Learning Objective: Explain the difference between risk management and portfolio management.6 0. Assuming the risk free rate is 2%. Global Association of Risk Professionals.85 0.2% 12% 1. The fund is benchmarked to an index and. D have Treynor measures greater than 0.10 0.90 C 0.75 10% 0.90 0. Portfolio Expected Beta to Beta to Correct Incorrect Asset Weight Return the Index the Portfolio Treynor Treynor A 1. All rights reserved.Financial Risk Manager Examination (FRM) Part II Practice Exam 74.089 C 0. C has the lowest marginal VaR as its Beta to the portfolio is the lowest. Assets B.7 0.111 B 0. A portfolio manager wants to invest a small amount of new money that has recently come into a fund. C.3 1.3 1.35 8% 0.7 0. and describe how to use marginal VaR in portfolio management.90 B 0.85 D 0.094 D 0. © 2016 Global Association of Risk Professionals. Inc.90 0.6 0.10 Asset The portfolio manager wants to select the asset that has the lowest marginal VaR as long as its Treynor ratio is at least 0.8% 10% 0.083 0.8% 10% 0. 104 .1.2 0.35 8% 0. b. c.133 0.2 0. 3rd Edition.114 0. the manager is considering increasing the holdings of one of the four assets described in the following table: Portfolio Expected Beta to Beta to the Weight Return the Index Portfolio A 1. It is illegal to reproduce this material in any format without prior written approval of GARP. Asset Asset Asset Asset A B C D Correct answer: c Explanation: The Treynor measure is calculated as (Expected Return – Risk Free Rate)/Beta to Index.1.055 Section: Risk Management and Investment Management Reference: Philippe Jorion.

055)(0. and Minimax. “Minimum-Risk” Decision Rule tries to minimize both credit and market risks.64% 4.64%. It is illegal to reproduce this material in any format without prior written approval of GARP.055) = 0. The “Minimum-Risk” Decision Rule tries to minimize the risk of misclassification. b. Choice c is incorrect. Default Risk: Quantitative Methodologies. © 2016 Global Association of Risk Professionals. c.0439 = 4. Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets. “Minimum-Risk”. 105 .Financial Risk Manager Examination (FRM) Part II Practice Exam 75. d. Choice d is incorrect.055)(1–0. 76. which equals 5. Section: Credit Risk Measurement and Management Reference: Arnaud de Servigny and Olivier Renault. Which of the following is correct? a. Choice a is incorrect. It is simply the default probability per year. Neyman-Pearson and Minimax. 2012). It is the probability of default in year five = (1–0. 4.0491 = 4. Hence d is wrong. 2nd Edition (West Sussex. It has nothing to do with market risk.39%.91% 5.055)(0.055)(1–0. A risk officer of a bank is evaluating the four rules for credit scoring model performance measurement. There are four rules “Minimum-Error”. c.055)(0. Neyman-Pearson. and compare the use of risk-neutral and realworld default probabilities in pricing derivative contracts.055) = 0. Chapter 3. Global Association of Risk Professionals.50% Correct answer: b Explanation: The probability of default in year 4 = (1–0. Neyman-Pearson rule minimizes type II error with type I error remaining constant.055)(1–0. Correct answer: c Explanation: The Neyman-Pearson rule minimizes type I error with type II error remaining constant.055)(1–0. b.91%. minimum risk. Learning Objective: Differentiate between the following decision rules: minimum error. What is the probability of this counterparty defaulting in the fourth year? a. Credit Spreads. Default Probability.06054 = 4. Section: Credit Risk Measurement and Management Reference: Jon Gregory. d. Inc.055) = 0. The The The The “Minimum-Risk” Decision Rule tries to minimize both type I and type II errors. Measuring and Managing Credit Risk. A major regional bank has determined that a counterparty has a constant default probability of 5.055) (1–0. All rights reserved. It is the probability of default in year three = (1–0.5%.39% 4.055)(1– 0.5% per year. and Credit Derivatives Learning Objective: Calculate risk-neutral default probabilities. Chapter 10. Neyman-Pearson rule minimizes type I error with type II error remaining constant. UK: John Wiley & Sons.

will reduce funding risk. relative risk. All rights reserved. © 2016 Global Association of Risk Professionals. essentially matching duration of assets and liabilities. 3rd Edition (New York: McGraw Hill.Financial Risk Manager Examination (FRM) Part II Practice Exam 77. d. The funding risk has been effectively transferred to the employees. VaR and Risk Budgeting in Investment Management. Which of the following statements about the pension fund’s funding risk is correct? a. and therefore the board must consider funding risk. Correct answer: d Explanation: The time horizon of payouts does not eliminate funding risk. c. policy-mix risk. Global Association of Risk Professionals. and sponsor risk. however the value of the liabilities are likely to increase more thereby exacerbating funding risk. The longer the horizon for expected payouts. funding risk. Inc. 106 . Immunizing the portfolio. the lower the funding risk. Learning Objective: Distinguish among the following types of risk: absolute risk. A company's pension fund is established as a defined benefit plan. active management risk. Value-at-Risk: The New Benchmark for Managing Financial Risk. b. Funding risk represents the true long-term risk to the plan sponsor. Funding risk is transferred to employees with a defined contribution plan. It is illegal to reproduce this material in any format without prior written approval of GARP. In fact it is the mismatch between assets and liabilities that creates funding risk. Chapter 17. In an low interest rate environment the value of equities will rise. Decreases in interest rates will reduce funding risk. Section: Risk Management and Investment Management Reference: Philippe Jorion. 2007).

calculate. the portfolio is valued at JPY 128 billion and contains JPY 25 billion in stock XYZ. undiversified portfolio VaR. VaRXYZ = wXYZ*XYZ*(95%) = JPY 25 million x 0. d. 3rd Edition. marginal VaR. Currently. The standard deviation of returns of stock XYZ is 11% annually and that of the overall portfolio is 18% annually. c. Global Association of Risk Professionals. Section: Risk Management and Investment Management Reference: Philippe Jorion. what is the estimated component VaR of stock XYZ? a. Assuming the risk analyst uses a 1-year 95% VaR and that returns are normally distributed. and distinguish between the following portfolio VaR measures: individual VaR.524 billion JPY 6. It is illegal to reproduce this material in any format without prior written approval of GARP. Inc. b. 107 . A risk manager is evaluating the risk profile for a portfolio of stocks. incremental VaR. © 2016 Global Association of Risk Professionals. which is 1.Financial Risk Manager Examination (FRM) Part II Practice Exam 78. and wXYZ represent the value of stock XYZ. (New York: McGraw-Hill.524 = JPY 2.6 x 4. 2007). All rights reserved.714 billion JPY 3. The correlation of returns between stock XYZ and the portfolio is 0.714 billion.645. and diversified portfolio VaR.6.397 billion Correct answer: a Explanation: Let (95%) represent the 95% confidence factor for the VaR estimate. Value-at-Risk: The New Benchmark for Managing Financial Risk.11 x 1. Therefore. Chapter 7: Portfolio Risk: Analytical Methods. JPY 2. component VaR.645 = JPY 4. Learning Objective: Define.838 billion JPY 4.524 billion Component VaRXYZ = *VaRXYZ = 0.

d. Chapter 12. 108 . 2013).Financial Risk Manager Examination (FRM) Part II Practice Exam 79. Poisson and Negative Binomial distributions are appropriate for loss frequency. normal distribution for severity. Section: Operational and Integrated Risk Management Reference: Philippa X. lognormal distribution for frequency. normal distribution for frequency. b. Binomial distribution for frequency. © 2016 Global Association of Risk Professionals. Capital Modeling. Which of the following loss severity and loss frequency distribution pairs is the most appropriate to use? a. A risk team in the investment banking subsidiary of a bank holding company is setting up a Monte Carlo simulation methodology to estimate the subsidiary’s aggregate loss distribution. c. Inc. lognormal distribution for severity. Operational Risk Management: A Complete Guide to a Successful Operational Risk Framework (Hoboken: John Wiley & Sons. Learning Objective: Explain how frequency and severity distributions of operational losses are obtained. It is illegal to reproduce this material in any format without prior written approval of GARP. Girling. All rights reserved. Global Association of Risk Professionals. Binomial distribution for severity. Poisson distribution for severity. including commonly used distributions and suitability guidelines for probability distributions. Correct answer: d Rationale: Pareto and lognormal distributions (fat-tailed) are generally used for loss severity. Poisson distribution for frequency.

b. Basel 2. All rights reserved. Section: Operational and Integrated Risk Management Reference: John Hull.5% + 0. and does not meet the additional countercyclical buffer of 0.5% minimum CET1 capital requirement. 109 . © 2016 Global Association of Risk Professionals.Financial Risk Manager Examination (FRM) Part II Practice Exam 80. Global Association of Risk Professionals. c. d. which of the capital ratios does the bank satisfy? a. 2015). The CET1 capital ratio only.95 = 7. Risk Management and Financial Institutions.5. Correct answer: d Rationale: The bank has CET1 capital ratio of (195/3. This ratio does not meet the 4. Inc.5% capital conservation buffer. None of the above.95% (= 4.480 145 50 195 98 0 293 Assuming that all Basel III phase-ins have occurred and that the bank’s required countercyclical buffer is 0.95%. does not meet the additional 2.5% + 2. Learning Objective: Define in the context of Basel III and calculate where appropriate: o Tier 1 capital and its components o Tier 2 capital and its components o Required Tier 1 equity capital. Chapter 16. The risk management department at a bank is trying to assess the impact of the capital conservation and countercyclical buffers defined in the Basel III framework. and Dodd-Frank.480) = 4. The CET1 capital ratio plus the capital conservation buffer and the countercyclical buffer. and total capital. They consider a scenario in which the bank’s capital and risk-weighted assets are as shown in the table below (all values are in EUR millions): Item Risk-weighted assets Common equity Tier 1 (CET1) capital Additional Tier 1 capital Total Tier 1 capital Tier 2 capital Tier 3 capital Total capital Value 3. It is illegal to reproduce this material in any format without prior written approval of GARP. total Tier 1 capital.95%). Basel III. 4rd Edition (New York: John Wiley & Sons. The CET1 capital ratio plus the capital conservation buffer only.2%.

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