2009 Part 2 GARP Practice Exam

2009 FRM Practice Exams

Table of Contents
2009 FRM Level I Practice Exam ‐ Candidate Answer Sheet ............................................. 3
2009 FRM Level I Practice Exam – Questions ................................................................... 5
2009 FRM Level I Practice Exam – Answer Key ............................................................... 19
2009 FRM Level I Practice Exam – Answers & Explanations ........................................... 21
2009 FRM Full Exam FRM Practice Exam I – Candidate Answer Sheet .......................... 47
2009 FRM Full Exam FRM Practice Exam I – Questions .................................................. 49
2009 FRM Full Exam FRM Practice Exam I – Answer Key ............................................... 65
2009 FRM Full Exam FRM Practice Exam I – Answers & Explanations ........................... 67
2009 FRM Full Exam FRM Practice Exam II – Candidate Answer Sheet ......................... 99
2009 FRM Full Exam FRM Practice Exam II – Questions ............................................... 101
2009 FRM Full Exam FRM Practice Exam II – Answer Key ............................................ 117
2009 FRM Full Exam FRM Practice Exam II – Answers & Explanations ........................ 119

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 examination 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 2009 FRM Practice Exams have been developed to aid candidates in their preparation for
the FRM Examination in November 2009. These practice exams are based on a sample of
questions from the 2007 FRM Examination and are representative of the questions that will be
in the 2009 FRM Examination. Wherever necessary and possible, questions, answers and
references have been updated to better reflect the topics and core readings listed in the 2009
FRM Examination Study Guide.
The 2009 FRM Level I Practice Exam and the FRM Full Exam Practice Exams I and II contain 40
and 50 multiple‐choice questions, respectively. Note that the 2009 FRM Level I and Full
Examination will consist of a morning and afternoon session containing 50 and 70 multiple‐
choice questions, respectively. The practice exams were designed to be shorter to allow
candidates to calibrate their preparedness without being overwhelming.

Copyright © 2009 Global Association of Risk Professionals 1
All rights reserved.
The 2009 FRM Practice Exams do not necessarily cover all topics to be tested in the 2009 FRM
Examination. For a complete list of topics and core readings, candidates should refer to the
2009 FRM Examination Study Guide. 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
examination are derived from the “core” readings. It is strongly suggested that candidates
review 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:
• Plan a date and time to take each practice exam. Set dates appropriately to give
sufficient study/review time between each practice exam and prior to the actual exam.
• Simulate the test environment as closely as possible.
o Take each practice exam in a quiet place.
o Have only the practice exam, candidate answer sheet, calculator, and writing
instruments (pencils, erasers) available.
o Minimize possible distractions from other people, cell phones and study
material.
o Allocate 90 minutes for each practice exam and set an alarm to alert you when
90 minutes have passed. Complete each exam but note the questions answered
after the 90 minute mark.
o Follow the FRM calculator policy. You may only use a Texas Instruments BA II
Plus (including the BA II Plus Professional) calculator or a Hewlett Packard 12C
(including the HP 12C Platinum) calculator.
• After completing each practice exam,
o Calculate your score by comparing your answer sheet with the practice exam
answer key. Only include questions completed in the first 90 minutes.
o Use the practice exam Answers & Explanations to better understand correct and
incorrect answers and to identify topics that require additional review. Consult
referenced core readings to prepare for exam.
o Pass/fail status for the actual exam is based on the distribution of scores from all
candidates, so use your scores only to gauge your own progress and
preparedness.


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2009 FRM Full Exam Practice Exam II
Questions

1. The current value of the S&P 500 index is 1457, and each S&P futures contract is for delivery of USD
250 times the index. A long‐only equity portfolio with market value of USD 300,100,000 has beta of
1.1. To reduce the portfolio beta to 0.75, how many S&P futures contract should you sell?

a. 618 contracts
b. 288 contracts
c. 574 contracts
d. 906 contracts
2. The risk‐free rate is 5% per year and a corporate bond yields 6% per year. Assuming a recovery rate
of 75% on the corporate bond, what is the approximate market implied one‐year probability of
default of the corporate bond?

a. 1.33%
b. 4.00%
c. 8.00%
d. 1.60%
3. The following table from Fitch Ratings shows the number of rated issuers migrating between two
ratings categories during one year. Based on this information, what is the probability that an issue
with a rating of A at the beginning of the year will be downgraded by the end of the year?

Year 1 rating
AAA AA A BBB Default Total
Year AAA 45 4 2 0 0 51
0 AA 3 30 4 3 2 42
rating A 2 5 40 2 3 52
BBB 0 1 2 30 1 34
Default 0 0 0 0 0 0
a. 13.46%
b. 13.44%
c. 9.62%
d. 3.85%

4. Beta Bank owns a portfolio of 10 AA‐rated bonds with a total value of 200 million USD. The one‐year
probability of default for each issuer is 5% and the recovery rate for each issue equals 40%. The one‐
year expected loss of the portfolio is:

a. USD 4.0 million
b. USD 5.0 million
c. USD 6.0 million
d. USD 8.0 million
5. Risk Averse Bank (RAB) has made a loan of USD 100 million at 8% per annum. RAB wants to enter
into a total return swap under which it will pay the interest on the loan plus the change in the mark‐
to‐market value of the loan and in exchange, RAB will get LIBOR + 30 basis points. Settlement
payments are made annually. What is the cash flow for RAB on the first settlement date if the mark‐
to‐market value of the loan falls by 2% and LIBOR is 6%?

a. Net inflow of USD 0.3 million
b. Net outflow of USD 0.3 million
c. Net inflow of USD 1.7 million
d. Net outflow of USD 1.7 million
6. Determine the percentage of the following portfolio that is investment grade:

Percentage
Moody's
of
Rating
Portfolio
Aa2 25%
A3 10%
Caa1 2%
Baa3 10%
Ba1 5%
D 3%
Aaa 10%
A1 15%
Baa1 10%
Aa3 10%

a. 70%
b. 80%
c. 90%
d. 95%

7. As part of a currency hedging strategy, a U.S. portfolio manager entered a one‐year forward
contract with a bank to deliver EUR 5,000,000 for US dollars at the end of the year. At the beginning
of the year, the one‐year forward rate was 0.9216 USD/EUR. Six months into the contract the spot
rate is 0.9201 USD/EUR, the U.S. interest rate is 6.5%, and the Euro interest rate is 6.25%. If the
current spot rate (0.9201 USD/EUR) were to continue for the next six months, what is the credit risk
that the portfolio manager would bear at maturity?

a. USD 7,042
b. USD 7,264
c. USD 7,273
d. USD 7,500

8. Realizing the benefits of netting of the counterparty exposure may be challenging because of:

a. Potential downgrade or withdrawal of the counterparty rating
b. Differences in ratings between the rating agencies
c. Trades being booked in different jurisdictions
d. Cross‐product netting

9. In pricing a first‐to‐default credit basket swap, which of the following is true, all else being equal?

a. The lower the correlation between the assets of the basket, the lower the premium.
b. The lower the correlation between the assets of the basket, the higher the premium.
c. The higher the correlation between the assets of the basket, the higher the premium.
d. The correlation between the assets has no impact in the premium of a first‐to‐default credit
basket swap.

10. The spread on a one‐year BBB rated bond relative to the risk‐free treasury of similar maturity is 2%.
It is estimated that the contribution to this spread by all non‐credit factors (e.g., liquidity risk, taxes)
is 0.8%. Assuming the loss given default rate for the underlying credit is 60%, what is approximately
the implied default probability for this bond?

a. 3.33%
b. 5.00%
c. 3.00%
d. 2.00%

11. You are given the following information about firm A:

Market Value of Asset at time 0 = 1000
Market Value of Asset at time 1 = 1200
Short term Debt = 500
Long term Debt = 300
Annualized Asset Volatility = 10%

According to the KMV model, what are the Default Point and the Distance to Default at time 1?

Default Distance to
Point Default
a. 800 3.33
b. 650 7.50
c. 650 4.58
d. 500 5.83
12. Suppose the return on US treasuries is 3% and a risky bond is currently yielding 15%. A trader you
supervise claims that he would be able to make an arbitrage trade earning 5% using US treasuries,
the risky bond and the credit default swap. Which of the following could be the trader’s strategy
and what is the credit default swap premium? Assume there are no transaction costs.

a. Go long the treasury, short the risky bond, and buy the credit default swap with premium of 6%.
b. Go long the treasury, short the risky bond, and sell the credit default swap with premium of 7%.
c. Short the treasury, invest in the risky bond, and sell the credit default swap with premium of 6%.
d. Short the treasury, invest in the risky bond, and buy the credit default swap with premium of
7%.

13. Bank A makes a 10 million USD five‐year loan and wants to offset the credit exposure to the obligor.
A five‐year credit default swap with the loan as the reference asset trades on the market at a swap
premium of 50 basis points paid quarterly. In order to hedge its credit exposure Bank A:

a. Sells the 5 year CDS and receives a quarterly payment of USD 50,000.
b. Buys the 5 year CDS and makes a quarterly payment of USD 12,500.
c. Buys the 5 year CDS and receives a quarterly payment of USD 12,500.
d. Sells the 5 year CDS and makes a quarterly payment of USD 50,000.

14. A bank is considering buying (i.e. selling protection on) a AAA‐rated super senior tranche [10% ‐
11%] of a synthetic CDO referencing an investment‐grade portfolio. The pricing of the tranche
assumes a fixed recovery of 40% for all names. All else being equal, which one of the following four
changes will make the principal invested more risky?

a. An increase in subordination of 1%, i.e. investing in the [11% ‐ 12%] tranche
b. An increase in the tranche thickness from 1% to 3%, i.e. investing in the [10% ‐ 13%] tranche
c. Using a recovery rate assumption of 50%
d. An increase in default correlation between names in the portfolio

15. Two banks enter into a five‐year first‐to‐default basket credit default swap transaction. The basket
contains three uncorrelated credits, W, X and Y, each with a USUSD 25 million notional amount. The
protection seller has to settle on the credit that defaults first during the transaction. After that, the
protection seller has no obligation and the transaction terminates. Suppose the credits have the
following 5‐year cumulative probability of defaults.

5 –Year Probabilities
Credit
of Default
W 9.68%
X 8.97%
Y 8.02%

Which of the following is the probability of at least one default in the basket during the 5 years?

a. 8.02%
b. 9.68%
c. 24.38%
d. 26.67%

16. Bank A has exposure to 100 million USD of debt issued by Company R. Bank A enters into a credit
default swap transaction with Bank B to hedge its debt exposure to Company R. Bank B would fully
compensate Bank A if Company R defaults in exchange for a premium. Assume that the defaults of
Bank A, Bank B and Company R are independent and that their default probabilities are 0.3%, 0.5%
and 3.6%, respectively. What is the probability that Bank A will suffer a credit loss in its exposure to
Company R?

a. 3.6 %
b. 4.1%
c. 0.0180%
d. 0.0108%

17. A 3‐year credit‐linked note with underlying company Z has a LIBOR + 60 bps semi‐annual coupon.
The face value of the CLN is USD 100. LIBOR is 5% for all maturities. Current 3‐year credit default
swap (CDS) spread for company Z is 90 bps. The fair value of the CLN is closest to:

a. USD 99.19
b. USD 100.00
c. USD 101.65
d. USD 111.05

18. A risk manager estimates the daily variance (ht) using a GARCH model on daily returns (rt):

ht = α0 + α1r2t‐1 + βht‐1

Assume the model parameter values are α0 = 0.005, α = 0.04, β = 0.94. The long‐run annualized
volatility is approximately:

a. 25.00%
b. 13.54%
c. 72.72%
d. 7.94%

19. A bank assigns capital to its traders using component‐VaR, which is based on the trading portfolio’s
VaR estimated at the 99% confidence level. The market value of the bank’s trading portfolio is HKD 1
billion with a daily volatility of 2%. Of this portfolio, 1% is invested in a trading book with a beta of
0.6 relative to the trading portfolio. The closest estimate of the capital assigned to this trading book
is:

a. HKD 167,760
b. HKD 279,600
c. HKD 197,400
d. HKD 1,977,070

20. Consider the following potential operational risks. Due to a rogue trader, we estimate that over a 1
year period there is a 10% chance we could lose anywhere between € 0 and € 100MM (equal
probability for all points within that range and 0 probability of any losses outside that range). Due
to model risk, we estimate that over a 1 year period there is a 20% chance that we will lose € 25MM
normally distributed with a standard deviation of € 5MM. Which of the following statements is
true?

a. The expected loss from a rogue trader is less than the expected loss from model risk.
b. The expected loss from a rogue trader is greater than the expected loss from model risk.
c. The maximum unexpected loss from a rogue trader at the 95% confidence level is less than the
maximum unexpected loss at the 95% confidence level from model risk.
d. The maximum unexpected loss at the 95% level from a rogue trader is greater than the
maximum unexpected loss at the 95% level from model risk.

21. Which of the following statements about liquidity risk elasticity (LRE) is incorrect?

a. In calculating the sensitivity of a firm’s net assets to a change in its funding liquidity premium,
LRE assumes a parallel shift in funding costs across all maturities.
b. LRE is primarily useful for examining marginal changes in funding costs on a net asset/liability
position.
c. The LRE is a cash flow liquidity risk measure, not a present value liquidity risk measure.
d. The LRE is only reliable for small changes in interest costs.

22. The risk of the occurrence of a significant difference between the mark‐to‐model value of a complex
and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in
the market is referred to as:

a. Dynamic Risk
b. Liquidity Risk
c. Mark‐to‐Market Risk
d. Model Risk

23. Which of the following statements regarding economic capital are true?

I. Economic capital is designed to provide a cushion against unexpected losses at a specified
confidence level over a set time horizon.
II. Since regulatory capital models and economic capital models have different objectives,
economic capital models cannot help regulators in setting regulatory capital
requirements.
III. Firms whose capital exceeds their required regulatory capital are firms that employ their
capital inefficiently and their shareholders would benefit if they used some of their capital
to repurchase shares or increase dividends.
IV. Economic capital can be used to validate a firm’s regulatory capital requirement against
its own assessment of the risks it is running.

a. III and IV only
b. I, II and III only
c. I, III and IV only
d. I and IV only
24. You are an analyst at Bank Alpha. You were given the task to determine whether under Basel II your
bank can use the simplified approach to report options exposure instead of the intermediate
approach. Which of the following criteria would your bank have to satisfy in order for it to use the
simplified approach?

a. The bank purchases and writes options and has significant option trading.
b. The bank writes options but its options trading is insignificant in relation to its overall business
activities.
c. The bank purchases and writes options but its option trading is insignificant.
d. The bank solely purchases options and its options trading is insignificant in relation to its overall
business activities.
25. Your bank is using the internal models approach to estimate its general market risk charge. The
multiplication factor ‘k’, set by the regulator, is 3 and banks are allowed to use the square root rule
to scale daily VaR. The previous day’s 1‐day VaR estimate is EUR 3 million, and the average of the
daily VaR over the last 60 days is EUR 2 million. Given the above information, what will be the
market risk charge for your bank?
a. EUR 18.97 million
b. EUR 9.49 million
c. EUR 6.32 million
d. EUR 28.46 million

26. Under the Basel II Capital Accord, banks that have obtained prior regulatory approval can use the
internal models approach to estimate their market risk capital requirement. What approach or
methodology is used under the internal models approach to compute capital requirements?

a. Stress testing and backtesting.
b. Internal rating and vendor models.
c. VaR methodology
d. Expected tail loss, as VaR is not a coherent measure of risk.

27. Bank Z, a medium‐size bank, uses only operational loss data from internal records to model its loss
distribution from operational risk events. The bank reviewed its records and, after confirming that
they were complete records of its historical losses and that its losses could be approximated by a
uniform distribution, it decided against using external loss data to estimate its loss distribution.
Based on that decision, which of the following statements is correct?

a. The estimated loss distribution likely overstates Bank Z’s real risk because many incidences in
the past were likely “one off”.
b. The estimated loss distribution likely accurately represents Bank Z’s real risk because the
records are accurate and complete.
c. The estimated loss distribution likely understates Bank Z’s real risk because the bank has not
experienced a huge loss.
d. The estimated loss distribution likely is the best estimate of Bank Z’s real risk because there is no
better loss data for the bank than its own.

28. A large international bank has a trading book whose size depends on the opportunities perceived by
its traders. The market risk manager estimates the one‐day VaR, at the 95% confidence level, to be
USD 50 million. You are asked to evaluate how good of a job the manager is doing in estimating the
one‐day VaR. Which of the following would be the most convincing evidence that the manager is
doing a poor job, assuming that losses are identically independently distributed?

a. Over the last 250 days, the mean loss is USD 60 million.
b. Over the last 250 days, there is no exceedence.
c. Over the last 250 days, there are 8 exceedences.
d. Over the last 250 days, the largest loss is USD 500 million.

29. To handle the financing of a large complex project, your bank is establishing a special purpose entity
(SPE) for which your bank will act as trustee. Which of the following could result in liability to your
bank through its role as trustee?

a. The SPE was formed to take advantage of a preferable legal jurisdiction.
b. The SPE primary purpose was to allow for the deferral of income taxes.
c. The SPE controls were unable to determine whether its investors used funds derived from
legitimate business opportunities.
d. The SPE structure provided for fewer creditors and a reduced likelihood that the project would
be forced into bankruptcy.

30. Your bank is implementing the advanced IRB approach of Basel II for credit risk and the AMA
approach for operational risk. The bank uses the model approach for market risk. The Chief Risk
Officer (CRO) wants to estimate the bank’s total risk by adding up the regulatory capital for market
risk, credit risk, and operational risk. The CRO asks you to identify the problems with using this
approach to estimate the bank’s total risk. Which of the following statements about this approach is
incorrect?

a. It ignores the interest risk associated with the bank’s loans.
b. It assumes market, credit, and operational risks have zero correlation.
c. It ignores strategic risks.
d. It uses a ten‐day horizon for market risk.

31. The bank you work for has a RAROC model. The RAROC model, computed for each specific activity,
measures the ratio of the expected yearly net income to the yearly VaR risk estimate. You are asked
to estimate the RAROC of its USD 500 million loan business. The average interest rate is 10%. All
loans have the same Probability of Default, PD, of 2% with a Loss Given Default, LGD, of 50%.
Operating costs are USD 10 million. The funding cost of the business is USD 30 million. RAROC is
estimated using a credit‐VaR for loan businesses. In this case, the appropriate credit‐VaR for the
loans is 7.5%. The economic capital is invested and earns 6%. The RAROC is:

a. 32.67%
b. 13.33%
c. 19.33%
d. 46.00%

32. Which of the following statements regarding Basel II non‐advanced approaches is incorrect?

a. The standardized approach uses data from the last three years of gross income to obtain a
bank’s operational risk capital charge.
b. The standardized approach makes it advantageous for a bank to book losses early if doing so
reduces this year’s gross income sufficiently to make it negative.
c. The standardized approach divides the bank into business lines and uses data from the last
three years of a business line’s gross income and a beta factor to obtain the regulatory capital
for that business line.
d. Corporate finance, trading and sales, and payment and settlement are the business lines with
the highest regulatory capital requirements.

33. Which one of the following statements does not apply to the Basel II Advanced Measurement
Approach (AMA) for operational risk?

a. In contrast to credit risk regulatory capital for corporate loans, banks using the AMA approach
may have to set aside capital for both expected and unexpected operational risk losses.
b. In contrast to the credit risk IRB approaches, banks using the AMA approach may estimate the
correlation between different types of operational risks if their models satisfy regulatory
requirements.
c. To evaluate exposure to high‐severity operational risk events, banks using the AMA approach
may use either scenario analysis of expert opinion, or VaR model estimates based on internal
data using extreme value theory.
d. Reporting of operational risk exposure to senior management is a necessary condition for a
bank’s ability to use the AMA approach.

34. Which of the following approaches for calculating operational risk capital charges leads to a higher
capital charge for a given accounting income as risk increases?

a. The basic indicator approach
b. The standardized approach
c. The advanced measurement approach (AMA)
d. All of the above

35. Which of the following is not included as an element in calculating operational risk capital under the
Advanced Measurement Approach?

a. External data
b. Key risk indicators
c. Factors reflecting the business environment
d. Scenario analysis

36. Your firm’s fixed‐income portfolio has interest‐only CMOs (IO), callable corporate bonds, inverse
floaters, noncallable corporate bonds. Your boss wants to know which of the following securities can
lose value as yields decline.

a. callable corporate only
b. inverse floater only
c. IO and callable corporate bond
d. IO and noncallable corporate bond

37. A bank would like to estimate the number of operational risk events due to problems with tellers
(large mistakes, fraud, and so on). The bank decides to model teller operational risk events as a
Poisson Process with rate λ (number of events per year). With this model, teller operational risk
events are assumed to occur independently of one another and the number of teller operational risk
events in a year is Poisson distributed with mean λ. Other properties of a Poisson distribution with
mean include:

Variance: λ
Skewness: λ‐0.5
Excess kurtosis 1/ λ

Based on historical data regarding the number of teller operational risk events that occurred in
previous years, the bank determines that the average number of events has been 5 per year and
decides to set λ to 5. Which of the following is true regarding that model?

a. The variance of the number of teller operational events in a year is 25.
b. The corresponding exponential distribution that describes the time between two teller
operational risk events has a mean value of 0.25 years.
c. The model is not appropriate if a teller is more likely to have an operational risk event because
his friend who is also a teller has been caught stealing.
d. The number of teller operational risk events in a year cannot exceed 25.

38. All the following are operational risk loss events, except:

a. A loan officer inaccurately enters client financial information into the bank’s proprietary credit
risk model
b. An individual shows up at a branch presenting a check written by a customer for an amount
substantially exceeding the customers low checking account balance. When the bank calls the
customer to ask him for the funds, the phone is disconnected and the bank cannot recover the
funds.
c. During an adverse market movement, the computer network system becomes overwhelmed
and only intermittent pricing information is available to the bank’s trading desk, leading to large
losses as traders become unable to alter their hedges in response to falling prices
d. A bank, acting as a trustee for a loan pool, receives less than the projected funds due to delayed
repayment of certain loans.

39. Suppose you are holding 100 Wheelbarrow Company shares with a current price of USD 50. The
daily historical mean and volatility of the return of the stock is 1% and 2%, respectively. The bid‐ask
spread of the stock varies over time. The daily historical mean and volatility of the spread is 0.5%
and 1%, respectively. Calculate the daily liquidity‐adjusted VaR (LVaR) at 99% confidence level: (Both
the return and spread of the stock are normally distributed):

a. USD 325
b. USD 275
c. USD 254
d. USD 229

40. Suppose you are given the following information about the operational risk losses at your bank.

Frequency distribution Severity Distribution
Probability Frequency Probability Severity
0.5 0 0.6 USD 1,000
0.3 1 0.3 USD 10,000
0.2 2 0.1 USD 100,000

What is the estimate of the VaR at the 95% confidence level, assuming that the frequency and
severity distributions are independent?

a. USD 200,000
b. USD 110,000
c. USD 100,000
d. USD 101,000

41. To control risk taking by traders, your bank links trader compensation with their compliance with
imposed VaR limits on their trading book. Why should your bank be careful in tying compensation
to the VaR of each trader?

a. It encourages traders to select positions with low estimated risks, which leads to an
underestimation of the VaR limits.
b. It encourages traders to select positions with low estimated risks, which leads to an
overestimation of the VaR limits.
c. It encourages traders to select positions with high estimated risks, which leads to an
d. It encourages traders to select positions with high estimated risks, which leads to an

42. The surplus of a pension fund is most important for:

a. A defined contribution fund
b. A defined benefit fund
c. A young workforce
d. A sponsoring company with strong financial status that operates in different industries

43. A mutual fund investing in common stocks has adopted a liquidity risk measure limiting each of its
holdings to a maximum of 30% of its thirty day average value traded. If the fund size is USD 3 billion,
what is the maximum weight that the fund can hold in a stock with a thirty‐day average value traded
of USD 2.4 million?

a. 24.00%
b. 0.08%
c. 0.024%
d. 80.0%

44. An investor is investigating three hedge funds as potential investments. Hedge fund A is an equity
market neutral fund, B is a global macro fund with emphasis on equity markets, and C is a
convertible arbitrage fund. Which answer correctly specifies the funds with the highest exposure to
a worldwide value‐weighted equity index and to a credit‐default swaps index?

Highest equity index exposure Highest credit‐default swap index exposure
a. A B
b. A C
c. B A
d. B C

45. Which of the following is not an approach for detecting style drift of hedge funds?

a. Performance attribution
b. Peer group comparison
c. Cash flow analysis
d. Communication with fund manager

46. All of the following strategies are examples of capital structure arbitrage, except:

a. Long position in the bonds issued by the company, and short position in the company’s stock.
b. Short position in the bonds issued by the company, and long position in the company’s stock.
c. Long position in a credit default swap on the company and writing put options on the company’s
stock.
d. Short position in the preferred stock issued by the company and writing call options on the
company’s stock.

47. You have been asked to evaluate the performance of two hedge funds: Global Asset Management I
and International Momentum II. Both are benchmarked to MSCI EAFE. Which of the two funds had
a higher relative Risk Adjusted Performance (RAP) last year, and what is the RAP?

The volatility of EAFE is 17.5% and the annualized performance is 10.6%. The risk‐free rate is 3.5%.

Fund Volatility Annualized Performance
Global Asset Management I 24.5% 12.5%
International Momentum II 27.3% 13.6%

a. Global Asset Management, 4.85%
b. Global Asset Management, 6.16%
c. International Momentum, 5.42%
d. International Momentum, 1.18%

48. On January 1, 2006, a pension fund has assets of EUR 100 billion and is fully invested in the equity
market. It has EUR 85 billion in liabilities. During 2006, the equity market declined by 15% and yields
increased by 1.2%. If the modified duration of the liabilities is 12.5, what is the pension fund’s
surplus on December 31, 2006?

a. EUR 15.00 billion
b. EUR 12.93 billion
c. EUR 12.75 billion
d. EUR 12.57 billion

49. Which of the following statements regarding Extreme Value Theory (EVT) is incorrect?

a. Conventional approaches for estimating VaR that assume that the distribution of returns follow
a unique distribution for the entire range of values may fail to properly account for the fat tails
of the distribution of returns.
b. In contrast to conventional approaches for estimating VaR, EVT only considers the tail behavior
of the distribution.
c. By smoothing the tail of the distribution, EVT effectively ignores extreme events and losses
which can generally be labeled outliers.
d. EVT attempts to find the optimal point beyond which all values belong to the tail and then
models the distribution of the tail separately.

50. Consider a portfolio with 40% invested in asset X and 60% invested in asset Y. The mean and
variance of return on X are 0 and 25 respectively. The mean and variance of return on Y are 1 and
121 respectively. The correlation coefficient between X and Y is 0.3. What is the nearest value for
portfolio volatility?
e. 9.51%
f. 8.60%
g. 13.38%
h. 7.45%
END OF 2009 FRM FULL EXAM PRACTICE EXAM I

Answer Key

1. a. b. c. d. 26. a. b. c. d.
2. a. b. c. d. 27. a. b. c. d.
3. a. b. c. d. 28. a. b. c. d.
4. a. b. c. d. 29. a. b. c. d.
5. a. b. c. d. 30. a. b. c. d.
6. a. b. c. d. 31. a. b. c. d.
7. a. b. c. d. 32. a. b. c. d.
8. a. b. c. d. 33. a. b. c. d.
9. a. b. c. d. 34. a. b. c. d.
10. a. b. c. d. 35. a. b. c. d.
11. a. b. c. d. 36. a. b. c. d.
12. a. b. c. d. 37. a. b. c. d.
13. a. b. c. d. 38. a. b. c. d.
14. a. b. c. d. 39. a. b. c. d.
15. a. b. c. d. 40. a. b. c. d.
16. a. b. c. d. 41. a. b. c. d.
17. a. b. c. d. 42. a. b. c. d.
18. a. b. c. d. 43. a. b. c. d.
19. a. b. c. d. 44. a. b. c. d.
20. a. b. c. d. 45. a. b. c. d.
21. a. b. c. d. 46. a. b. c. d.
22. a. b. c. d. 47. a. b. c. d.
23. a. b. c. d. 48. a. b. c. d.
24. a. b. c. d. 49. a. b. c. d.
25. a. b. c. d. 50. a. b. c. d.


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Answers & Explanations

1. The current value of the S&P 500 index is 1457, and each S&P futures contract is for delivery of USD
250 times the index. A long‐only equity portfolio with market value of USD 300,100,000 has beta of
1.1. To reduce the portfolio beta to 0.75, how many S&P futures contract should you sell?

a. 618 contracts
b. 288 contracts
c. 574 contracts
d. 906 contracts

CORRECT: B

No of contracts = [0.75 – 1.1)/ 1]* [300,100,000 / {250 * 1,457}] = ‐288.36
Hence we need to sell 288 contracts

INCORRECT: A – ‐617.9135209 = ‐1*(0.75)* (300100000 / (250*1457))
INCORRECT: C – ‐561.74 = ‐1(0.75/1.1)* (300100000 / (250*1457))
INCORRECT: D – ‐906.273164 = ‐1* (1.1)* (300100000 / (250*1457))

Reference: Hull, Options, Futures and Other Derivatives, Chapter 3 and 4; Anthony Saunders,
Financial Institutions Management, Chapter 10

2. The risk‐free rate is 5% per year and a corporate bond yields 6% per year. Assuming a recovery rate
of 75% on the corporate bond, what is the approximate market implied one‐year probability of
default of the corporate bond?

a. 1.33%
b. 4.00%
c. 8.00%
d. 1.60%

CORRECT: B

Using the approximation method, the 1‐year probability of default is (6%‐5%)/(1‐0.75) = 4%

INCORRECT: A – This is calculated using (6% ‐ 5%) / 0.75 = 1.33%

INCORRECT: C – This is calculated using 0.06 / 0.75 = 0.08
INCORRECT: D – This is calculated using 0.06 / (0.05 * 0.75) = 1.6

Reference: Saunders, Financial Institutions Management, 5th edition, Chapter 11, p. 313

3. The following table from Fitch Ratings shows the number of rated issuers migrating between two
ratings categories during one year. Based on this information, what is the probability that an issue
with a rating of A at the beginning of the year will be downgraded by the end of the year?

Year 1 rating
AAA AA A BBB Default Total
AAA 45 4 2 0 0 51
Year 0
AA 3 30 4 3 2 42
rating
A 2 5 40 2 3 52
BBB 0 1 2 30 1 34
Default 0 0 0 0 0 0

a. 13.46%
b. 13.44%
c. 9.62%
d. 3.85%

CORRECT: C

Total Number of ‘A’ rated issuances = 52
Probability of ‘A’ rated issues downgraded to BBB (P1) = 2/52 = 0.0385
Probability of ‘A’ rated issues downgraded to Default (P2) = 3/52 = 0.0577
Probability of ‘A’ rated issues to be downgraded in one year = P1 + P2 = 0.0962 = 9.62%.

INCORRECT: A – Is the number of upgrades from A (2+5)/52= 13.46%
INCORRECT: B – Is the number of downgrades to A 2/51 + 4/42 = 3.92% + 9.52% = 13.44%
INCORRECT: D – Is the number of downgrades to BBB 2/52 = 3.85%

Reference: Hull, Chapter 22.

4. Beta Bank owns a portfolio of 10 AA‐rated bonds with a total value of 200 million USD. The one‐year
probability of default for each issuer is 5% and the recovery rate for each issue equals 40%. The one‐
year expected loss of the portfolio is:

a. USD 4.0 million
b. USD 5.0 million
c. USD 6.0 million
d. USD 8.0 million

CORRECT: C

Expected Loss equals exposure multiplied by the risk of default and by the recovery rate, or
E(L) = Exposure * PD * (1 – Recovery Rate)
E(L) = 200 million USD x 5% x 60% = 6 million USD.
Correlation amongst issuers does not matter for computing expected losses.

INCORRECT: A – Incorrectly set E(L) = 200 * 0.05 * 0.4 = 4.0
INCORRECT: B – Incorrectly set E(L) = 200 * 0.05 * 0.5 = 5.0
INCORRECT: D – Incorrectly set E(L) = 200 * 0.05 * 0.8 = 8.0


5. Risk Averse Bank (RAB) has made a loan of USD 100 million at 8% per annum. RAB wants to enter
into a total return swap under which it will pay the interest on the loan plus the change in the mark‐
to‐market value of the loan and in exchange, RAB will get LIBOR + 30 basis points. Settlement
payments are made annually. What is the cash flow for RAB on the first settlement date if the mark‐
to‐market value of the loan falls by 2% and LIBOR is 6%?

a. Net inflow of USD 0.3 million
b. Net outflow of USD 0.3 million
c. Net inflow of USD 1.7 million
d. Net outflow of USD 1.7 million

CORRECT: A

RAB is the TROR payer and pays to the TROR receiver the interest it receives on the loan adjusted for
changes in the value of the underlying loan. If the value of the underlying loan increases, RAB as the
TROR payer pays to the TROR receiver the interest earned on the loan as well as the price
appreciation. Conversely, if the value of the underlying loan decreases, RAB as the TROR payer pays
to the TROR receiver the interest earned on the loan less the price depreciation. In return, as the TOR
payer, it receives LIBOR plus spread from the TROR receiver.


At the end of the first year, RAB will pay the interest earned on the loan, 8 million USD. The loan
value declined by 2 million USD, thus the return earned by RAB is 6 million USD; this is the payment
made by RAB to the TROR receiver.

The TROR receives will pay to RAB LIBOR plus 30 basis points i.e. 6.3 % with a 6% LIBOR; 6.3% of 100
million USD = 6.3 million USD.

So the payments are + 6.3 million USD – 6.0 million USD or + 0.3 million USD.

Reference: Stulz, Risk Management & Derivatives. Chapter 18 – Credit Risks and Credit Derivatives

6. Determine the percentage of the following portfolio that is investment grade:

Percentage
Moody's
of
Rating
Portfolio
Aa2 25%
A3 10%
Caa1 2%
Baa3 10%
Ba1 5%
D 3%
Aaa 10%
A1 15%
Baa1 10%
Aa3 10%

a. 70%
b. 80%
c. 90%
d. 95%

CORRECT: C

Non‐investment grade assets are those rated below Baa3. Thus Caa1 with 2%, Ba1 with 5%, and D
with 3%, or a total of 10% are non‐investment grade. Thus the investment grade part should equal
90%.


7. As part of a currency hedging strategy, a U.S. portfolio manager entered a one‐year forward
contract with a bank to deliver EUR 5,000,000 for US dollars at the end of the year. At the beginning
of the year, the one‐year forward rate was 0.9216 USD/EUR. Six months into the contract the spot
rate is 0.9201 USD/EUR, the U.S. interest rate is 6.5%, and the Euro interest rate is 6.25%. If the
current spot rate (0.9201 USD/EUR) were to continue for the next six months, what is the credit risk
that the portfolio manager would bear at maturity?

a. USD 7,042
b. USD 7,264
c. USD 7,273
d. USD 7,500

CORRECT: D

Value to the manager at the settlement date = contract cash flow – spot market cash flow [both at
contract maturity].

Contract cash flow = EUR 5,000,000 x 0.9216 USD/EUR = 4,608,000 USD
Spot market cash flow = The amount the portfolio manager could receive if the spot rate after 6
months remained in effect until the settlement date
= EUR 5,000,000 x 0.9201 USD /EUR = 4,600,500 USD
Value to the manager = USD 4,608,000 ‐ USD 4,600,500 = USD 7,500

As the value is positive, the bank owes this amount to the portfolio manager. Since the question asks
the amount of credit risk at maturity, we need not discount this back to six months.

INCORRECT: A – This answer is arrived at by discounting the correct answer for twelve months at the
USD interest rate, which is not a requirement of the question.
INCORRECT: B – This answer is arrived at by discounting the correct answer for six months at the USD
interest rate, which is not a requirement of the question.
INCORRECT: C – The correct answer discounted at the Euro rate for six month.

Reference: Stulz, Risk Management and Derivatives, Chapter 18

8. Realizing the benefits of netting of the counterparty exposure may be challenging because of:

a. Potential downgrade or withdrawal of the counterparty rating
b. Differences in ratings between the rating agencies
c. Trades being booked in different jurisdictions
d. Cross‐product netting

CORRECT: C


This presents a legal challenge to enforcing netting agreement

INCORRECT: A – These credit events do not make netting more challenging
INCORRECT: B – Ratings are not required to establish netting
INCORRECT: D – On contrary, cross‐product netting allows to realize more benefits in reducing
exposure to counterparty

Reference: Culp

9. In pricing a first‐to‐default credit basket swap, which of the following is true, all else being equal?

a. The lower the correlation between the assets of the basket, the lower the premium.
b. The lower the correlation between the assets of the basket, the higher the premium.
c. The higher the correlation between the assets of the basket, the higher the premium.
d. The correlation between the assets has no impact in the premium of a first‐to‐default credit
basket swap.

CORRECT: B

The lower the correlation between the assets of the basket, the higher the premium.
In the case of a first‐to‐default swap, a credit event occurs the first time any of the entities defaults.
This swap provides default protection against losses related to this first default, but not to any
subsequent defaults. Thus, the question is whether the level of correlation between assets of the
basket increases or decreases the likelihood of the triggering event. If the correlation between the
assets in a credit basket swap is lower, the basket would be exposed to greater default risk. For
example, the basket contains assets from different sectors, then the basket would be exposed to the
default risk of each and every sector in the basket. If the basket only contains assets from one sector,
then the correlation is higher, and the default risk is lower.

Reference: Hull, 22, 23

10. The spread on a one‐year BBB rated bond relative to the risk‐free treasury of similar maturity is 2%.
It is estimated that the contribution to this spread by all non‐credit factors (e.g., liquidity risk, taxes)
is 0.8%. Assuming the loss given default rate for the underlying credit is 60%, what is approximately
the implied default probability for this bond?


a. 3.33%
b. 5.00%
c. 3.00%
d. 2.00%

CORRECT: D

The probability of default equals the credit risk spread divided by the loss given default. PD = spread
/ LGD Here, the spread due to credit risk equals 2.0% ‐ 0.8% or 1.2% and the loss given default is
60%. The probability of default is then 2%.

INCORRECT: A – Incorrectly sets PD = 2.0/0.6 = 3.33.
INCORRECT: B – Incorrectly sets PD = 2.0/0.4 = 5.0.
INCORRECT: D – Incorrectly sets PD = 1.2/0.4 = 3.00.

Reference: de Servigny and Renault, Measuring and Managing Credit Risk, (New York: McGraw‐Hill,
2004) chapter 3, 4

11. You are given the following information about firm A:

• Market Value of Asset at time 0 = 1000
• Market Value of Asset at time 1 = 1200
• Short term Debt = 500
• Long term Debt = 300
• Annualized Asset Volatility = 10%

According to the KMV model, what are the Default Point and the Distance to Default at time 1?

Default Distance to
Point Default
a. 800 3.33
b. 650 7.50
c. 650 4.58
d. 500 5.83

CORRECT: C

According to KMV,
Default Point = STD + ½ LTD = 500 +1/2(300) = 650.
Distance to default

= (Market value of asset at time 1 – Default Point)/Annualized Asset volatility at time 1
= (1200‐650)/ (1200*0.1)
= 4.58

INCORRECT: A – Incorrectly sets Default Point as STD + LTD instead (500 + 300).
INCORRECT: B – Incorrectly sets Default Point value as LTD, distance to default = (1200‐STD)/120 =
7.50
INCORRECT: D – Incorrectly sets Default Point as STD only, distance to default = (1200‐500)/120 =
5.83

Reference: de Servigny and Renault, Measuring and Managing Credit Risk, Chapter 4.

12. Suppose the return on US treasuries is 3% and a risky bond is currently yielding 15%. A trader you
supervise claims that he would be able to make an arbitrage trade earning 5% using US treasuries,
the risky bond and the credit default swap. Which of the following could be the trader’s strategy
and what is the credit default swap premium? Assume there are no transaction costs.

a. Go long the treasury, short the risky bond, and buy the credit default swap with premium of 6%.
b. Go long the treasury, short the risky bond, and sell the credit default swap with premium of 7%.
c. Short the treasury, invest in the risky bond, and sell the credit default swap with premium of 6%.
d. Short the treasury, invest in the risky bond, and buy the credit default swap with premium of
7%.

CORRECT: D
To prevent arbitrage, the return on the risk‐free government bond must equal the return on the risky
bond less the premium on the default swap, or the risk corporate bond return must equal the return
on the risk free government bond and the credit default swap premium.

Risk‐free bond return = risky bond return – default swap premium.
In this case, adjustment for the arbitrage profit changes the relationship to
Arbitrage profit = risky bond return – default swap premium – risk‐free government bond return

Risk‐free bond return = 3%
Risky bond return = 15%
Default swap premium = X%
Arbitrage Profit = 5%.

The short position in treasury costs 3%, return from the risky corporate bond is 15%, the default
swap premium is 7%, ends up in an arbitrage profit of 5% (‐3%+15%‐7%). This is a valid arbitrage
strategy.


13. Bank A makes a 10 million USD five‐year loan and wants to offset the credit exposure to the obligor.
A five‐year credit default swap with the loan as the reference asset trades on the market at a swap
premium of 50 basis points paid quarterly. In order to hedge its credit exposure Bank A:

a. Sells the 5 year CDS and receives a quarterly payment of USD 50,000.
b. Buys the 5 year CDS and makes a quarterly payment of USD 12,500.
c. Buys the 5 year CDS and receives a quarterly payment of USD 12,500.
d. Sells the 5 year CDS and makes a quarterly payment of USD 50,000.

CORRECT: B

To offset the credit risk in the loan, the bank needs to buy credit protection using the CDS with same
maturity. Since the bank is buying protection, it pays the insurance premium quarterly. The annual
insurance premium – swap payment ‐ on this transaction would be notional amount x swap premium
or 10,000,000 * 0.005 = 50,000. The quarterly premium is USD 12,500.

INCORRECT: A – Bank A needs to hedge its credit exposure and therefore has to buy the 5 Year CDS
(Bank A buys credit protection)
INCORRECT: C – The quarterly payment is USD 12,500 = notional x swap premium x 90/360 = 10 USD
million x 0.005 x 90/360
INCORRECT: D – Bank A needs to hedge its credit exposure and therefore has to buy the 5 Year CDS
(Bank A buys credit protection)

Reference: Hull Chapter 23.

14. A bank is considering buying (i.e. selling protection on) a AAA‐rated super senior tranche [10% ‐
11%] of a synthetic CDO referencing an investment‐grade portfolio. The pricing of the tranche
assumes a fixed recovery of 40% for all names. All else being equal, which one of the following four
changes will make the principal invested more risky?

a. An increase in subordination of 1%, i.e. investing in the [11% ‐ 12%] tranche
b. An increase in the tranche thickness from 1% to 3%, i.e. investing in the [10% ‐ 13%] tranche
c. Using a recovery rate assumption of 50%
d. An increase in default correlation between names in the portfolio

CORRECT: D

The probability of a senior tranche being hit decreases if the subordination increases or if the fixed
recovery rate increases. The expected loss of a tranche decreases if the tranche thickness increases.
These all lead to the tranche being less risky. As portfolio correlation increases, the loss distribution

exhibits fatter tail and the probability of a senior tranche being hit increases, leading to a more risky
tranche.

Reference: Culp, Chapters 16, 17, 18.

15. Two banks enter into a five‐year first‐to‐default basket credit default swap transaction. The basket
contains three uncorrelated credits, W, X and Y, each with a USUSD 25 million notional amount. The
protection seller has to settle on the credit that defaults first during the transaction. After that, the
protection seller has no obligation and the transaction terminates. Suppose the credits have the
following 5‐year cumulative probability of defaults.

5‐Year Probabilities of
Credit
Default
W 9.68%
X 8.97%
Y 8.02%
Which of the following is the probability of at least one default in the basket during the 5 years?

a. 8.02%
b. 9.68%
c. 24.38%
d. 26.67%

CORRECT: C.

During the 5 years, the probability of no default is (1 – 9.68%) x (1 – 8.97%) x (1 – 8.02%) = 75.62%.
The probability of at least one default is (1 – 75.62%) = 24.38%.

The answer is neither the maximum (B) nor minimum (A) nor the sum (D) of the default probabilities.

Reference: Hull Chapter 23.

16. Bank A has exposure to 100 million USD of debt issued by Company R. Bank A enters into a credit
default swap transaction with Bank B to hedge its debt exposure to Company R. Bank B would fully
compensate Bank A if Company R defaults in exchange for a premium. Assume that the defaults of
Bank A, Bank B and Company R are independent and that their default probabilities are 0.3%, 0.5%
and 3.6%, respectively. What is the probability that Bank A will suffer a credit loss in its exposure to
Company R?


a. 3.6 %
b. 4.1%
c. 0.0180%
d. 0.0108%

CORRECT: C

Bank A will only suffer a loss when Company R and Bank B jointly default. With zero correlation, this
probability is equal to 0.5% x 3.6% = 0.018%.

3.6% is the maximum, 4.1% is the sum, and 0.0108% = 0.3% * 3.6%

Reference: Hull, Chapters 22, 23

17. A 3‐year credit‐linked note with underlying company Z has a LIBOR + 60 bps semi‐annual coupon.
The face value of the CLN is USD 100. LIBOR is 5% for all maturities. Current 3‐year credit default
swap (CDS) spread for company Z is 90 bps. The fair value of the CLN is closest to:

a. USD 99.19
b. USD 100.00
c. USD 101.65
d. USD 111.05

CORRECT: A

This question requires no calculation. Because the discount factor (0.5 * (0.05 + 0.009) = 0.0295) is
greater than the coupon rate, the present value has to be less than the face value – the correct
answer is A.

This question can be worked out by using calculator, where N=6, I/Y=2.95, PMT=2.8, FV=100 ‐>
PV=99.19.

INCORRECT: B – Is the face value.
INCORRECT: C – Is where only Libor rate is used for discounting. N=6, I/Y=2.5, PMT=2.8, FV=100 ‐>
PV=101.65.
INCORRECT: D – Is where only CDS spread is used for discounting. N=6, I/Y=0.9, PMT=2.8, FV=100 ‐>
PV=101.65.

Reference: Hull, Culp

18. A risk manager estimates the daily variance (ht) using a GARCH model on daily returns (rt):
ht = α0 + α1r2t‐1 + βht‐1

Assume the model parameter values are α0 = 0.005, α = 0.04, β = 0.94. The long‐run annualized
volatility is approximately:

a. 25.00%
b. 13.54%
c. 72.72%
d. 7.94%

CORRECT: D

The long‐run variance is 0.005/(1‐0.04‐0.94) =0.005/0.02 = 0.25. The daily vol is thus the square
root, or 0.5% and annual vol 7.935%.

INCORRECT: A – The daily variance is indeed 0.25%, and the daily volatility 0.5% but this needs to be
annualized.
INCORRECT: B – Miscalculates variance as sqrt(0.04/(1 – 0.94 – 0.005)) * 15.87 = 13.54%
INCORRECT: C – Miscalculates variance as 0.04/(1 – 0.94 – 0.005) = 72.72%

Reference: Hull
19. A bank assigns capital to its traders using component‐VaR, which is based on the trading portfolio’s
VaR estimated at the 99% confidence level. The market value of the bank’s trading portfolio is HKD 1
billion with a daily volatility of 2%. Of this portfolio, 1% is invested in a trading book with a beta of
0.6 relative to the trading portfolio. The closest estimate of the capital assigned to this trading book
is:

a. HKD 167,760
b. HKD 279,600
c. HKD 197,400
d. HKD 1,977,070

CORRECT: B

This question assesses candidates’ abilities to carry out CVaR calculations correctly.

Using, e.g., equation 7.29 from Jorion 2nd edition, we have CVaR = VaRwi βi , where wi is the

share of the ith asset in the portfolio and βi is its beta. Using the information given, VaR = 2.33 *
0.02 * 1,000,000,000 = 46,600,000, so CVaR = 46,600,000 * 0.01 * 0.6 = 279,600.

INCORRECT: A – Incorrectly multiplies the volatility by beta in the VaR calculation.
INCORRECT: C – Incorrectly uses 1.645 in the VaR calculation.
INCORRECT: D – Incorrectly uses the square root of the volatility in the VaR calculation.

Reference: Jorion, VaR, 2nd edition, p. 160, chapter 7 (Portfolio risk: analytical methods).

20. Consider the following potential operational risks. Due to a rogue trader, we estimate that over a 1
year period there is a 10% chance we could lose anywhere between € 0 and € 100MM (equal
probability for all points within that range and 0 probability of any losses outside that range). Due
to model risk, we estimate that over a 1 year period there is a 20% chance that we will lose € 25MM
normally distributed with a standard deviation of € 5MM. Which of the following statements is
true?

a. The expected loss from a rogue trader is less than the expected loss from model risk.
b. The expected loss from a rogue trader is greater than the expected loss from model risk.
c. The maximum unexpected loss from a rogue trader at the 95% confidence level is less than the
maximum unexpected loss at the 95% confidence level from model risk.
d. The maximum unexpected loss at the 95% level from a rogue trader is greater than the
maximum unexpected loss at the 95% level from model risk.

CORRECT: D

This question tests understanding of expected vs. unexpected loss. The rogue trader has an expected
loss (severity multiplied by probability) of €5MM while the model risk has an expected loss of €5MM.
Therefore both A and B are incorrect. We therefore must examine unexpected losses. The rogue
trader has a much wider distribution (Uniform) and a lower probability of occurrence than the model
risk (normal distribution). Therefore the rogue trader has a greater risk of unexpected losses.

Unexpected loss for rogue trader at 95% confidence level: 50MM – 5MM = 45MM

The loss from model risk at the 95th percentile corresponds to the 75th percentile for the normal
distribution with mean 25 and standard deviation 5, so unexpected loss for model risk at 95%
confidence level: < (25MM + 1.645*5MM) – 5MM < 30MM

Reference: Dowd, Chapter 16.

21. Which of the following statements about liquidity risk elasticity (LRE) is incorrect?

a. In calculating the sensitivity of a firm’s net assets to a change in its funding liquidity premium,
LRE assumes a parallel shift in funding costs across all maturities.
b. LRE is primarily useful for examining marginal changes in funding costs on a net asset/liability
position.
c. The LRE is a cash flow liquidity risk measure, not a present value liquidity risk measure.
d. The LRE is only reliable for small changes in interest costs.

CORRECT: C

LRE measures liquidity risk for present values. It is not useful if a firm is concerned about per‐period
cash flows.

Reference: Dowd, Chapter 14 ; Saunders, Chapter 17.

22. The risk of the occurrence of a significant difference between the mark‐to‐model value of a complex
and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in
the market is referred to as:

a. Dynamic Risk
b. Liquidity Risk
c. Mark‐to‐Market Risk
d. Model Risk

CORRECT: D

This is how model risk is defined in the reading.

INCORRECT: A – Undefined term
INCORRECT: B – The risk of not being able to sell an asset quickly
INCORRECT: C – Undefined term


23. Which of the following statements regarding economic capital are true?

I. Economic capital is designed to provide a cushion against unexpected losses at a specified
confidence level over a set time horizon.
II. Since regulatory capital models and economic capital models have different objectives,
economic capital models cannot help regulators in setting regulatory capital
requirements.
III. Firms whose capital exceeds their required regulatory capital are firms that employ their
capital inefficiently and their shareholders would benefit if they used some of their capital
to repurchase shares or increase dividends.
IV. Economic capital can be used to validate a firm’s regulatory capital requirement against
its own assessment of the risks it is running.

a. III and IV only
b. I, II and III only
c. I, III and IV only
d. I and IV only

CORRECT: C

Economic capital is defined as a capital buffer that is required to absorb the impact of unexpected
losses during a time horizon at a portfolio manager’s level of confidence. A firm may employ the
economic capital as its own internal assessment to check the efficiency of overall amount of capital it
holds. Therefore, I and III are correct.

Recent regulatory changes such as the internal ratings based approach in Basel II provides
encouragement for firms to develop their internal risk management models. Therefore, economic
capital will become a key regulatory tool with a converging trend between economic capital and
regulatory capital models. II is incorrect and IV is correct

Reference: Crouhy, Galai, and Mark, Risk Management. Chapter 14 – Capital Allocation and
Performance Measurement

24. You are an analyst at Bank Alpha. You were given the task to determine whether under Basel II your
bank can use the simplified approach to report options exposure instead of the intermediate
approach. Which of the following criteria would your bank have to satisfy in order for it to use the
simplified approach?

a. The bank purchases and writes options and has significant option trading.
b. The bank writes options but its options trading is insignificant in relation to its overall business
activities.
c. The bank purchases and writes options but its option trading is insignificant.
d. The bank solely purchases options and its options trading is insignificant in relation to its overall
business activities.

CORRECT: D

The bank only purchases options and its options trading is not significant.

INCORRECT: A – If a bank writes options, the intermediate approach must be used.
INCORRECT: B – If bank writes options, the intermediate approach must be used.
INCORRECT: C – If option trading is significant, the intermediate approach must be used.

Reference: Basel II: International Convergence of Capital Measurement and Capital Standards: A
Revised Framework ‐ Comprehensive Version

25. Your bank is using the internal models approach to estimate its general market risk charge. The
multiplication factor ‘k’, set by the regulator, is 3 and banks are allowed to use the square root rule
to scale daily VaR. The previous day’s 1‐day VaR estimate is EUR 3 million, and the average of the
daily VaR over the last 60 days is EUR 2 million. Given the above information, what will be the
market risk charge for your bank?
a. EUR 18.97 million
b. EUR 9.49 million
c. EUR 6.32 million
d. EUR 28.46 million

CORRECT: A

The required market risk charge would be square root of 10 times the maximum of previous day VaR
and the average daily 60 days VaR, times k.
√10 * Max(3, 3*2) = 18.97

INCORRECT: B – √10 * 3 = 9.49
INCORRECT: C – √10 * 2 = 6.32

INCORRECT: D – √10 * Max(3*3, 3*2) = 28.46

Revised Framework – Comprehensive Version” (Basel Committee on Banking Supervision Publication,
June 2006).

26. Under the Basel II Capital Accord, banks that have obtained prior regulatory approval can use the
internal models approach to estimate their market risk capital requirement. What approach or
methodology is used under the internal models approach to compute capital requirements?

a. Stress testing and backtesting.
b. Internal rating and vendor models.
c. VaR methodology
d. Expected tail loss, as VaR is not a coherent measure of risk.

CORRECT: C
Basel II prescribes a 10‐day VaR at 99% confidence level for capital charge computation. However,
banks are free to choose the method to compute VaR.

INCORRECT: A – Stress testing and backtesting are used to supplement and validate the results of
capital computation, and are not the method per se to be adopted for capital computation
INCORRECT: B – Internal rating approach and vendor models are something associated with credit
risk rather than market risk
INCORRECT: D – Regulation prescribes VaR and not ETL or CVaR, even when it is known that VaR is
not sub‐additive at all times.

June 2006).

27. Bank Z, a medium‐size bank, uses only operational loss data from internal records to model its loss
distribution from operational risk events. The bank reviewed its records and, after confirming that
they were complete records of its historical losses and that its losses could be approximated by a
uniform distribution, it decided against using external loss data to estimate its loss distribution.
Based on that decision, which of the following statements is correct?

a. The estimated loss distribution likely overstates Bank Z’s real risk because many incidences in
the past were likely “one off”.
b. The estimated loss distribution likely accurately represents Bank Z’s real risk because the
records are accurate and complete.
c. The estimated loss distribution likely understates Bank Z’s real risk because the bank has not
experienced a huge loss.
d. The estimated loss distribution likely is the best estimate of Bank Z’s real risk because there is no
better loss data for the bank than its own.

CORRECT: C

One of the biggest issues of Operational Risk modeling is that there is likely not enough internal data
to represent large enough loss as such loss is extremely rare. Using external loss database can help
to mitigate this problem.

Reference: Allen et al., Chapter 5.
28. A large international bank has a trading book whose size depends on the opportunities perceived by
its traders. The market risk manager estimates the one‐day VaR, at the 95% confidence level, to be
USD 50 million. You are asked to evaluate how good of a job the manager is doing in estimating the
one‐day VaR. Which of the following would be the most convincing evidence that the manager is
doing a poor job, assuming that losses are identically independently distributed?

a. Over the last 250 days, the mean loss is USD 60 million.
b. Over the last 250 days, there is no exceedence.
c. Over the last 250 days, there are 8 exceedences.
d. Over the last 250 days, the largest loss is USD 500 million.

CORRECT: B
Using the Kupiec test, there is an extremely low probability of no exceedence over 250 days.

INCORRECT: A – VaR tells us nothing about the mean loss over time since the size of the trading book
varies over time as opportunities change.
INCORRECT: C – With the same test, the probability of 8 exceedences is higher than the probability of
no exceedence.
INCORRECT: D – The VaR does not tell us the distribution of the maximum loss.

Reference: Jorion, Chapter 6.

29. To handle the financing of a large complex project, your bank is establishing a special purpose entity
(SPE) for which your bank will act as trustee. Which of the following could result in liability to your
bank through its role as trustee?

a. The SPE was formed to take advantage of a preferable legal jurisdiction.
b. The SPE primary purpose was to allow for the deferral of income taxes.
c. The SPE controls were unable to determine whether its investors used funds derived from
legitimate business opportunities.
d. The SPE structure provided for fewer creditors and a reduced likelihood that the project would
be forced into bankruptcy.

CORRECT: C

Reference: Culp

30. Your bank is implementing the advanced IRB approach of Basel II for credit risk and the AMA
approach for operational risk. The bank uses the model approach for market risk. The Chief Risk
Officer (CRO) wants to estimate the bank’s total risk by adding up the regulatory capital for market
risk, credit risk, and operational risk. The CRO asks you to identify the problems with using this
approach to estimate the bank’s total risk. Which of the following statements about this approach is
incorrect?

a. It ignores the interest risk associated with the bank’s loans.
b. It assumes market, credit, and operational risks have zero correlation.
c. It ignores strategic risks.
d. It uses a ten‐day horizon for market risk.

CORRECT: B

The approach assumes a correlation of one. There is no capital charge for structural interest rate risk
under Basel II. Operational risk includes legal risk. It uses a ten‐day horizon for market risk.

June 2006).

31. The bank you work for has a RAROC model. The RAROC model, computed for each specific activity,
measures the ratio of the expected yearly net income to the yearly VaR risk estimate. You are asked
to estimate the RAROC of its USD 500 million loan business. The average interest rate is 10%. All

loans have the same Probability of Default, PD, of 2% with a Loss Given Default, LGD, of 50%.
Operating costs are USD 10 million. The funding cost of the business is USD 30 million. RAROC is
estimated using a credit‐VaR for loan businesses. In this case, the appropriate credit‐VaR for the
loans is 7.5%. The economic capital is invested and earns 6%. The RAROC is:

a. 32.67%
b. 13.33%
c. 19.33%
d. 46.00%

CORRECT: C

(0.1*500 – 5 – 10 – 30 +0.06*37.5)/37.5 = 19.33%

INCORRECT: A – (0.1*500 – 10 – 30 + 0.06*37.5)/37.5 = 32.67%
INCORRECT: B – (0.1*500 – 5 – 10 – 30)/37.5 = 13.33%
INCORRECT: D – (0.1*500 – 5 – 30 + 0.06*37.5)/37.5 = 46.00%

Reference: Crouhy, Galai, Mark, Chapter 14.
32. Which of the following statements regarding Basel II non‐advanced approaches is incorrect?

a. The standardized approach uses data from the last three years of gross income to obtain a
bank’s operational risk capital charge.
b. The standardized approach makes it advantageous for a bank to book losses early if doing so
reduces this year’s gross income sufficiently to make it negative.
c. The standardized approach divides the bank into business lines and uses data from the last
three years of a business line’s gross income and a beta factor to obtain the regulatory capital
for that business line.
d. Corporate finance, trading and sales, and payment and settlement are the business lines with
the highest regulatory capital requirements.

CORRECT: B

Only positive gross income is included in the formula. Everything else is correct.

June 2006).

33. Which one of the following statements does not apply to the Basel II Advanced Measurement
Approach (AMA) for operational risk?

a. In contrast to credit risk regulatory capital for corporate loans, banks using the AMA approach
may have to set aside capital for both expected and unexpected operational risk losses.
b. In contrast to the credit risk IRB approaches, banks using the AMA approach may estimate the
correlation between different types of operational risks if their models satisfy regulatory
requirements.
c. To evaluate exposure to high‐severity operational risk events, banks using the AMA approach
may use either scenario analysis of expert opinion, or VaR model estimates based on internal
data using extreme value theory.
d. Reporting of operational risk exposure to senior management is a necessary condition for a
bank’s ability to use the AMA approach.

CORRECT: C

Everything is correct using the 2006 Basel II document except for c. The Basel II document requires
the use of scenarios obtained with expert advice for high severity events when the bank uses only
internal data.

June 2006).

34. Which of the following approaches for calculating operational risk capital charges leads to a higher
capital charge for a given accounting income as risk increases?

a. The basic indicator approach
b. The standardized approach
c. The advanced measurement approach (AMA)
d. All of the above

CORRECT: C

Under AMA, the capital charge is based on the banks internal measurement system. Under the 2
other approaches the capital charge is based upon the Gross Income, which has nothing to do with
risk exposure.

June 2006).

35. Which of the following is not included as an element in calculating operational risk capital under the
Advanced Measurement Approach?

a. External data
b. Key risk indicators
c. Factors reflecting the business environment
d. Scenario analysis

CORRECT: B

KRI is not included in the Basel document at all

June 2006).

36. Your firm’s fixed‐income portfolio has interest‐only CMOs (IO), callable corporate bonds, inverse
floaters, noncallable corporate bonds. Your boss wants to know which of the following securities can
lose value as yields decline.

a. callable corporate only
b. inverse floater only
c. IO and callable corporate bond
d. IO and noncallable corporate bond

CORRECT: C

The IO decreases in value because a decline in rates implies an increase in mortgage prepayments,
which decreases the notional principal upon which the IO pays its interest

INCORRECT: A – While the price of a callable corporate may decline as the call goes in the money, the
IO also decreases in value
INCORRECT: B – The IO decreases in value, but so can the callable corporate
INCORRECT: D – The noncallable corporate bond increases in value as yields decline

Reference: Tuckman, Chapter 21

37. A bank would like to estimate the number of operational risk events due to problems with tellers
(large mistakes, fraud, and so on). The bank decides to model teller operational risk events as a
Poisson Process with rate λ (number of events per year). With this model, teller operational risk
events are assumed to occur independently of one another and the number of teller operational risk
events in a year is Poisson distributed with mean λ. Other properties of a Poisson distribution with
mean λ include:
Variance: λ
Skewness: λ-0.5
Excess kurtosis 1/ λ
Based on historical data regarding the number of teller operational risk events that occurred in
previous years, the bank determines that the average number of events has been 5 per year and
decides to set λ to 5. Which of the following is true regarding that model?

a. The variance of the number of teller operational events in a year is 25.
b. The corresponding exponential distribution that describes the time between two teller
operational risk events has a mean value of 0.25 years.
c. The model is not appropriate if a teller is more likely to have an operational risk event because
his friend who is also a teller has been caught stealing.
d. The number of teller operational risk events in a year cannot exceed 25.

CORRECT: C

The Poisson model implies that teller events are independent of one another.
INCORRECT: A – The teller operational risk event has a variance of 5.
INCORRECT: B – The exponential probability distribution describes the distribution of the period
between two teller events. If the Poisson Process has a rate of 5, then the associated exponential
distribution model has a mean value of M= 1/5 = 0.2 years.
INCORRECT: D – There is no bound on the number of events that can occur.

Reference: Rachev, Menn, Fabozzi; Chapter 3.

38. All the following are operational risk loss events, except:

a. A loan officer inaccurately enters client financial information into the bank’s proprietary credit
risk model
b. An individual shows up at a branch presenting a check written by a customer for an amount
substantially exceeding the customers low checking account balance. When the bank calls the
customer to ask him for the funds, the phone is disconnected and the bank cannot recover the
funds.
c. During an adverse market movement, the computer network system becomes overwhelmed
and only intermittent pricing information is available to the bank’s trading desk, leading to large
losses as traders become unable to alter their hedges in response to falling prices
d. A bank, acting as a trustee for a loan pool, receives less than the projected funds due to delayed
repayment of certain loans.

CORRECT: D

A broad interpretation of the FDIC and Basel II rules defining operational risks would consider all, but
alternative d, as operational risk events and operational risk losses. A loan officer entering
inaccurate client financial information into the bank’s proprietary credit risk model is a process risk
and any losses attributable to this employee error should be considered as an operational risk event.
Customers writing checks exceeding the balance of a checking account and depositing the funds in a
savings account is an example of check kiting. If during times of adverse market movement, the
computer network becomes overwhelmed and only delayed pricing information reaches the bank’s
trading desk and trades are based on the available information, the bank is subject to business
disruption and system failures. When a bank, acting as a trustee for a loan pool, receives less than
the projected funds due to delayed repayment of certain loans in the pool is not an operational risk
loss event.

June 2006).

39. Suppose you are holding 100 Wheelbarrow Company shares with a current price of USD 50. The
daily historical mean and volatility of the return of the stock is 1% and 2%, respectively. The bid‐ask
spread of the stock varies over time. The daily historical mean and volatility of the spread is 0.5%
and 1%, respectively. Calculate the daily liquidity‐adjusted VaR (LVaR) at 99% confidence level: (Both
the return and spread of the stock are normally distributed):

a. USD 325
b. USD 275
c. USD 254
d. USD 229


CORRECT: C

VaR=USD 50*100*(2.33*0.02‐0.01) =USD 183
Liquidity adjusted=USD 50*100*0.5*(2.33*0.01+0.005) =USD 71
LVaR=VaR+ Liquidity adjusted =USD 254

Reference: Dowd: Chapter 14.

40. Suppose you are given the following information about the operational risk losses at your bank.

Frequency distribution Severity Distribution
Probability Frequency Probability Severity
0.5 0 0.6 USD 1,000
0.3 1 0.3 USD 10,000
0.2 2 0.1 USD 100,000

What is the estimate of the VaR at the 95% confidence level, assuming that the frequency and
severity distributions are independent?

a. USD 200,000
b. USD 110,000
c. USD 100,000
d. USD 101,000

CORRECT: C

The loss distribution is:

Total loss Probability
0 0.5
1,000 0.18
2,000 0.072
10,000 0.09
11,000 0.072
20,000 0.018
100,000 0.03
101,000 0.024
110,000 0.012
200,000 0.002

The 95% VaR is 100,000. The other answers are from this distribution, but not corresponding to the
95% VaR.

Reference: Allen et al., chapter 5.

41. To control risk taking by traders, your bank links trader compensation with their compliance with
imposed VaR limits on their trading book. Why should your bank be careful in tying compensation
to the VaR of each trader?

a. It encourages traders to select positions with low estimated risks, which leads to an
b. It encourages traders to select positions with low estimated risks, which leads to an
c. It encourages traders to select positions with high estimated risks, which leads to an
d. It encourages traders to select positions with high estimated risks, which leads to an

CORRECT: A

If a trader uses an estimated variance‐covariance matrix to select trading positions, the trader would
opt for a position with low estimated risks. Selecting positions with low estimated risks biases the
variance‐covariance matrix, and leads to an underestimation of the VaR position limits.

Reference: Dowd, Measuring Market Risk.

42. The surplus of a pension fund is most important for:

a. A defined contribution fund
b. A defined benefit fund
c. A young workforce
d. A sponsoring company with strong financial status that operates in different industries

CORRECT: B.

Under a defined contribution, beneficiaries are entitled for a percentage regardless of its value.
Under a defined benefit plan, they are entitled for a value. The older the work force is and the lower
the surplus value, the higher the risk of the pension plan and the more important is the surplus.

Reference: Jorion, Chapter 17.

43. A mutual fund investing in common stocks has adopted a liquidity risk measure limiting each of its
holdings to a maximum of 30% of its thirty day average value traded. If the fund size is USD 3 billion,
what is the maximum weight that the fund can hold in a stock with a thirty‐day average value traded
of USD 2.4 million?

a. 24.00%
b. 0.08%
c. 0.024%
d. 80.0%

CORRECT: C

Thirty day average value traded = USD 2.4 million
30% of thirty day average value traded = 30% x USD 2.4 = USD 0.72 million
% of Portfolio = USD 0.72 million/USD 3 billion = 0.024%

Reference: Grinold, Kahn, Chapters, 14,17.

44. An investor is investigating three hedge funds as potential investments. Hedge fund A is an equity
market neutral fund, B is a global macro fund with emphasis on equity markets, and C is a
convertible arbitrage fund. Which answer correctly specifies the funds with the highest exposure to
a worldwide value‐weighted equity index and to a credit‐default swaps index?

Highest equity index exposure Highest credit‐default swap index exposure
a. A B
b. A C
c. B A
d. B C

CORRECT: D

Hedge fund B, global macro, has highest equity exposure. Hedge fund A (equity market neutral) has
no net equity exposure as long positions are offset by short positions with regards to equity
exposure. Similarly, little outright market risk for convertible arbitrage fund C as it involves arbitrage
to a large extent.
With regards to credit risk, convertible arbitrage fund C has highest credit risk, since it invests in
interest rate sensitive instruments highly affected by changes in credit ratings.

Reference: Lars Jaeger, Through the Alpha Smoke Screens: A Guide to Hedge Fund Return Sources,
Chapter 5

45. Which of the following is not an approach for detecting style drift of hedge funds?

a. Performance attribution
b. Peer group comparison
c. Cash flow analysis
d. Communication with fund manager

CORRECT: C

Cash Flow analysis for the fund cannot detect style drift

INCORRECT: A – Performance attribution can determine if each performance component is consistent
with the per‐determined style of fund.
INCORRECCT: B – Peer group can be used to determine the consistency of the fund’s risk and return
profile
INCORRECT: D – Discussion with fund manager can reveal change in style and strategy of the fund.

Reference: Lars Jaeger, ed., The New Generation of Risk Management for Hedge Funds and Private
Equity Investments, Chapter 27

46. All of the following strategies are examples of capital structure arbitrage, except:

a. Long position in the bonds issued by the company, and short position in the company’s stock.
b. Short position in the bonds issued by the company, and long position in the company’s stock.
c. Long position in a credit default swap on the company and writing put options on the company’s
stock.
d. Short position in the preferred stock issued by the company and writing call options on the
company’s stock.

CORRECT: D
A long position in the bonds issued by the company and short position in the company’s stock, and a
short position in the bonds issued by the company and a long position in the company’s stock are
both capitalizing on the different speed of adjustment to information in the bond and equities
markets. A long position in a credit default swap on the company and writing put options on the
company’s stock capitalizes on the differences in the volatility surface between bonds and equity.
Short position in the preferred stock issued by the company and writing call options on the
company’s stock in fact is a net short position which should not be sensitive to relative changes in the
difference between the two instruments.

Reference: Jaeger, Through the Alpha Smokescreens, Chapter 5

47. You have been asked to evaluate the performance of two hedge funds: Global Asset Management I
and International Momentum II. Both are benchmarked to MSCI EAFE. Which of the two funds had
a higher relative Risk Adjusted Performance (RAP) last year, and what is the RAP?

The volatility of EAFE is 17.5% and the annualized performance is 10.6%. The risk‐free rate is 3.5%.

Fund Volatility Annualized Performance
Global Asset Management I 24.5% 12.5%
International Momentum II 27.3% 13.6%

a. Global Asset Management, 4.85%
b. Global Asset Management, 6.16%
c. International Momentum, 5.42%
d. International Momentum, 1.18%

CORRECT: C

The annualized risk adjusted performance is σm/ σp(Rp – Rm) + Rf =
σm – benchmark volatility
σp – portfolio volatility
Rp– portfolio return
Rm – benchmark return
Rf – risk‐free return

The risk adjusted performance for Global is then σm/ σp(Rp – Rm) + Rf = 17.5/24.5 x (12.5 – 10.6) + 3.5
= 4.85%
The risk adjusted performance for International is then σm/ σp(Rp – Rm) + Rf = 17.5/27.3 x (13.6 – 10.6)
+ 3.5 = 5.42%. International has a greater RAP.

Reference: Grinold, Kahn, Chapters 14, 17.

48. On January 1, 2006, a pension fund has assets of EUR 100 billion and is fully invested in the equity
market. It has EUR 85 billion in liabilities. During 2006, the equity market declined by 15% and yields
increased by 1.2%. If the modified duration of the liabilities is 12.5, what is the pension fund’s
surplus on December 31, 2006?

a. EUR 15.00 billion
b. EUR 12.93 billion
c. EUR 12.75 billion
d. EUR 12.57 billion


CORRECT: C

The surplus at the beginning of the year was 100 – 85 or 15 billion EUR. During the year, the equity
portfolio declines 15%, or 15 billion EUR, to 85 billion EUR. Due to the increase in yields, the dollar
value of the liabilities decreases by 12.5 * 1.2% * 85 billion EUR, or 12.75. Thus at the end of the
year, the assets are worth (100 – 15) = 85 billion EUR and the liabilities (85 – 12.75) = 72.25 billion.
The surplus is then 12.75, a decrease of 2.25 billion EUR.

INCORRECT: A – 15 is the equity loss in 2006
INCORRECT: B – 12.93 = 15 * (1 – (.15‐.012))
INCORRECT: D – 12.57 = 15 * (1 – (.15+.012))

Reference: Jorion, VaR, 3rd ed, Chapter 17.

49. Which of the following statements regarding Extreme Value Theory (EVT) is incorrect?

a. Conventional approaches for estimating VaR that assume that the distribution of returns follow
a unique distribution for the entire range of values may fail to properly account for the fat tails
of the distribution of returns.
b. In contrast to conventional approaches for estimating VaR, EVT only considers the tail behavior
of the distribution.
c. By smoothing the tail of the distribution, EVT effectively ignores extreme events and losses
which can generally be labeled outliers.
d. EVT attempts to find the optimal point beyond which all values belong to the tail and then
models the distribution of the tail separately.

CORRECT: C

Statements a, b, and d are valid statements. Statement c is incorrect – outliers are a big concern in
risk analysis and cannot be ignored.


50. Consider a portfolio with 40% invested in asset X and 60% invested in asset Y. The mean and
variance of return on X are 0 and 25 respectively. The mean and variance of return on Y are 1 and
121 respectively. The correlation coefficient between X and Y is 0.3. What is the nearest value for
portfolio volatility?
a. 9.51%
b. 8.60%
c. 13.38%
d. 7.45%
CORRECT: D

The portfolio volatility is calculated as follows:

portfolio variance = w x2σ x2 + w y2σ y2 + 2w x w y ρ xy σ xσ y

= 0.4 2 * 25 + 0.62 * 121 + 2 * 0.4 * 0.6 * 0.3 * 5 * 11
= 55.48

portfolio volatility = (portfolio variance)0.5 = (55.48) 0.5 = 7.45

INCORRECT: A – This solution incorrectly calculates the portfolio variance using wx and wy instead of
wx2 and wy2.
INCORRECT: B – This solution incorrectly omits the correlation between X and Y in the portfolio
variance calculation.
INCORRECT: C – This solution incorrectly omits the weighting terms in the portfolio variance
calculation.

Reference: Philippe Jorion, Value at Risk, 3rd edition. Chapter 7.

END OF 2009 FRM FULL EXAM PRACTICE EXAM II
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Using, e.g., equation 7.29 from Jorion 2nd edition, we have CVaR = VaRwi βi , where wi is the

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