The following questions are i to help candidates understand the material.

d the material. They are not actual FRM exam questions.

QUESTIONS
1.1 D escribe and provide exam ples of fundam ental risk fac­ • Second line: Business line that generates, owns and
tors and their sub-risk factors that drive the probability of m anages risk; and
a firm's default • Third line: Periodic independent m anagem ent over­
1.2 W hat are the four com ponents of a risk m anagem ent sight and assurance such as internal audit.
process? A. True
B. False
1.3 Provide an exam ple of w hat is meant by basis risk.
1.18 Reverse stress testing applies its modeling capabilities to
1.4 W hat are two types of liquidity risk?
estim ate the size of potential losses.
1.5 W hat is meant by strategic risk? A. True
1.6 D escribe how risk m anagers becom e involved in business B. False
risk. 1.19 Frank Knight called variability that cannot be quantified at
1.7 W hat Is reputation risk? Provide exam ples in your answer. all as "unknown unknowns."
A. True
1.8 W hat is meant by econom ic capital? Contrast it with
B. False
regulatory capital.
1.20 The e x p e c te d shortfall is the expected loss in the tail of
1.9 W hat is the basic idea of R A R O C ? Provide the RA RO C
the distribution.
equation in your answer.
A. True
1.10 W hat are a few applications of R A R O C ? Provide exam ­ B. False
ples in your answer
1.21 Business risk involves making large, long-term decisions
1.11 D escribe the 4:15 p.m . report about the firm's direction, often accom panied by major
investm ents of capital, human resources, and m anage­
1.12 Provide a list of exam ples of risk m anagem ent that can
ment reputation.
be seen in early history.
A. True
1.13 Provide a list of the key risk m anagem ent building B. False
blocks.
1.22 Enterprise Risk M anagem ent is the m anagem ent of risk at
1.14 Provide a list of the four choices involved in the classic the business unit level.
risk m anagem ent process. A. True
1.15 Unsupervised machine learning can help the risk m anager B. False
identify the "unknown unknowns" through identifying 1.23 Securitization is a mechanism to transfer risk to a third
clusters and correlations without specifying the area of party.
interest in advance. A. True
A. True B. False
B. False
1.24 Business risk applies only to large non-financial corporates.
1.16 Banking regulators are encouraging tools that support A. True
using advanced analytical form ulas to calculate regulatory B. False
operational risk capital.
1.25 E S is
A. True
A. a statistical measure designed to quantify the mean
B. False
risk in the tail of the distribution beyond the cut-off of
1.17 The three lines of defense consists of: the VaR measure.
• First line: Risk m anagers that specialize in risk m anage­ B. the case where R A R O C fails to be greater than a
ment and day-to-day oversight; hurdle rate.

16 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

1.26 Tail risk techniques are dealt by 1 .3 0 O perational risk includes

A. Extrem e Value Theory. A. counterparty risk.
B. VaR Theory. B. cyber risk.
C. Probably of Default Theory. C . reputation risk.
D. standard deviation. D. business risk.

1.27 O perational risk includes 1.31 The purpose of econom ic capital is to absorb
A. legal risk. A. expected loss.
B. business risk. B. unexpected loss.
C. reputation risk. C . tail loss.
D. currency risk. D. all of the above.

1.28 EL for a loan is based on 1 .3 2 Reputation risk

A. probability of default (PD). A. is easy to quantify.
B. exposure at default (EAD ). B. is the responsibility of the chief m arket risk officer.
C. loss given default (LG D ). C . cannot be managed at all.
D. all of the above D. should be monitored by the board.

1.29 W hich of various G reek m easures can be added together

across different currencies?
A. Delta
B. Gam m a
C. Theta
D. None of the above

Chapter 1 The Building Blocks of Risk Management ■ 17

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
ANSWERS
1.1 PD of a firm is driven by a firm's strength or weakness in
term s of key variables such as financial ratios, industry
sector, country, quality of data, and m anagem ent quality.
Each fundam ental set of risk factors is driven by sub­
factors. For exam ple, m anagem ent years of experience is
a sub-factor of the m anagem ent quality variable.
1.2 The risk m anager first attem pts to identify the risk then
next analyzes the risk. Subsequently the risk m anager
assesses the im pact of any risk event and ultim ately man­
ages the risk. In summary, the four com ponents are
1. Identify the risk,
2. Analyze the risk,
3. A ssess Im pact of risk, and
4. Manage the risk.
1.3 A form of m arket risk known as basis risk occurs if a posi­
tion intended to hedge another position might do so
im perfectly.
1.4 The two types are funding liquidity risk and trading
liquidity risk
Funding liquidity risk refers to the case where a firm can­
not access enough liquid cash and assets to m eet its obli­
gations. For exam ple, banks take in short-term deposits
and lend the money out for the longer term at a higher
rate of interest.
Trading liquidity risk refers to a case where markets
tem porarily seize up. For exam ple, if m arket participants
cannot, or will not, take part in the m arket, this may force
a seller to accept an abnorm ally low price, or take away
their ability to turn an asset into cash and funding at any
price.
1.5 Strategic risks involve making large investm ents, in long­
term decisions about the firm's direction, that can affect
its future direction and strategy.
1.6 Risk m anagers have specific skills they can bring to bear
in term s of quantifying aspects of business risk. For
exam ple, credit risk experts often becom e involved in
managing supply chain risk. Risk m anagers should be
involved at the start of business planning. For exam ple,
it may be im possible to fund the construction of a power
station without some form of energy price risk m anage­
ment strategy in place.
18 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management
1.7 Reputation risk is the danger that a firm will suffer a sud­
den fall in its m arket standing or brand with econom ic
consequences. Rumors can be fatal in them selves. For
exam ple, a large failure in credit risk m anagem ent can
lead to rumors about a bank's financial soundness. Inves­
tors and depositors may begin to w ithdraw support in
the expectation that others will also w ithdraw support.
Unethical behavior of m anagers in the firm can hurt its
reputation.
1.8 Econom ic (risk) capital is the amount of capital the firm
requires based on its understanding of its econom ic risks.
Regulatory capital is calculated based on regulatory rules
and m ethodologies.
1.9 R A R O C = Rew ard/Risk. Reward can be described
in term s of After-Tax Risk-Adjusted Expected Return.
Risk can be described in term s of econom ic capital.
R A R O C should be higher than the cost of equity capi­
tal. R A R O C = A fter-Tax Net Risk-Adjusted Expected
Return*/econom ic capital
* After-Tax Expected Return is adjusted for EL
1.10 R A R O C can be used in business com parison, investm ent
analysis, pricing strategy, and cost-benefit analysis.
• Business com parison: For exam ple, com pare the
perform ance of business lines that require different
amounts of econom ic capital.
• Investm ent analysis: For exam ple, assess likely
returns from future investm ents (e.g ., the decision
to offer a new type of credit product).
• Pricing stra teg ies: For exam ple, exam ine pricing
strategy for different custom er segm ents and prod­
ucts (e.g ., it may have set prices too low to make a
risk-adjusted profit).
• Risk m anagem ent co st/b en e fit analysis: For
exam ple, com pare the dollar cost of risk m anage­
ment (e.g ., risk transfer via insurance, to the dollar
benefits).
1.11 Dennis W eatherstone, C E O of J .R Morgan, called for a
report in January 1990 on the total risk of his firm to be
delivered to his desk every day at 4.15 p.m .
1.12 See Figure 1.2 in C hapter 1
The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

1.13 linked to its exposures and activities. The goal is to help

an institution risk manage its activities to avoid the worst
1. The risk m anagem ent process
that might happen.
2 . Identifying known and unknown risks
3. EL, unexpected loss, and tail loss 1.19 False because Frank Knight sets out a fundam ental clas­
4. Risk factor breakdown sification of "know n" versus "unknow n" risk in his classic
5. Structural change from tail risk to system ic crisis paper on risk. Donald Rum sfeld, form er US Secretary of
6 . Human agency and conflicts of interest Defense said that "There are things we know that we
7. Typology of risks and risk interactions know. There are known unknowns . . . But there are also
8. Risk aggregation unknown unknowns".
9. Balancing risk and reward
1.20 True
10. Enterprise risk m anagem ent (ERM)
1.21 False
1.14
1.22 False
1. Avoid Risk
2 . Retain Risk 1.23 True
3. M itigate 1.24 False
4. Transfer
1.25 C . a statistical measure designed to quantify the mean
1.15 True risk in the tail of the distribution beyond the cut-off of
1.16 False because the Basel C om m ittee signaled a change the VaR measure.
of direction in 2016. Basel encourages banks to under­
1.26 A . Extrem e Value Theory.
stand their operational risk using a variety of tools but
capital allocation would be based on a sim pler stan­ 1.27 A . legal risk.
dardized approach using w eighted bank size with a mul­ 1.28 D. because EL = EA D X LG D X PD
tiplier based on the bank's record of larger operational
1.29 D. because G reeks for exam ple do not imply the
risk losses.
same level of risk across markets (e.g ., delta in foreign
1.17 False because business line is traditionally referred to as exchange versus com m odity m arkets).
the first line and risk m anagem ent is referred to as sec­
1.30 B. cyber risk.
ond line.

1.18 True because risk m angers work back from the reverse 1.31 B. unexpected loss.
stress test to try to understand how those losses were 1.32 D. should be monitored by the board.

Chapter 1 The Building Blocks of Risk Management 19

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

QUESTIONS
2.1 W hat are the key risk m anagem ent com ponents that need
to be re-evaluated on a regular basis for designating a risk
m anagem ent road map?
2.2 Provide several exam ples to dem onstrate that the C-suite
supports a strong risk culture.
2.3 D escribe w hat is m eant by risk appetite in practical
term s.
2.4 Provide exam ples of what factors drive interest rate risk
m anagem ent.
2.13 Airlines have used a sophisticated com bination of swaps,
call options, collars (calls and puts), futures contracts, and
other instruments to manage their price risks since around
the mid-1980s.
A. True
B. False
2.14 MGRM was exposed to a shift in the price curve from
backwardation to contango, which meant that the pro­
gram generated huge margin calls that becam e a severe
and unexpected cash drain.

2.5 Provide exam ples of hedging tips for conservative end A. True
users. B. False

2.15 There is an agreem ent among experts that all airlines

2.6 D escribe why modern firms make such a big deal of finan­
ought to be hedging their je t fuel price risk.
cial risk m anagem ent?
A. True
2.7 Provide exam ples of com m odity derivatives that a brewery B. False
might use to manage their risk.
2.16 If a risk exists then the firm should always hedge it.
2.8 Risk appetite includes asking "W ho are w e?" and "W ho A. True
do our stakeholders think we are?" well before trying to B. False
operationalize a risk appetite.
2.17 M cDonalds uses major capital m arkets, bank financings,
A. True
and derivatives to m eet its financing requirem ents and
B. False
reduce interest expense.
2.9 The M GRM (MG Refining & Marketing) hedging program A. True
in 1993 is a classic exam ple of good communication B. False
about the risk m anagem ent strategy and its potential
2.18 Risk appetite refers to the total amount of risk
consequences.
A. the firm could bear without becom ing insolvent.
A. True
B. the firm is taking today.
B. False
C. the am ount that it would be happy to bear at any one
2.10 A firm can find a com plicated tailored instrum ent that tim e.
always dam pens their exposure to a variable interest rate. D. none of the above.
A. True
2.19 Risk capacity refers to the total am ount of risk
B. False
A. the firm could bear without becom ing insolvent.
2.11 Airlines are heavily exposed to volatile je t fuel prices, with B. the firm is taking today.
as much as 45-60% of airline operating costs burnt in the C. the am ount that it would be happy to bear at any
air. one tim e.
A. True D. none of the above.
B. False
2.20 Transferring risk to a third party includes
2.12 M GRM 's hedging strategy might well have worked if it A. insurance contracts.
had been pursued to the end. B. financial derivatives.
A. True C. all of the above.
B. False D. none of the above.

34 Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

2.21 Exchange-based derivatives are designed to 2.25 Brewers can fix the price they pay per bushel of wheat
A. be traded easily at a relatively low transaction cost. to manage w heat price exposures by buying futures con­
B. be a perfect fit hedge. tracts and
C. avoid basis risk. A. holding these futures contracts until they mature and
D. reduce counterparty credit risk. take delivery specified by the exchange in term s of
quality and location.
2.22 Minimizing counterparty credit exposure can be obtained
through the use of B. selling these futures contracts near the delivery date
and using the proceeds to purchase the w heat now
A. margin requirem ents.
from their favored supplier.
B. netting arrangem ents.
C. all of the above. C . All of the above

D. it cannot be minimized at all. 2.26 O nce the firm /bank makes a risk appetite statem ent

2.23 The agricultural futures contracts first listed on the A. it is com m itted to follow it for at least three years.

Chicago Board of Trade (C BO T) in the

B. it must report it in their annual financial report.
C . the board must approve it.
A. 1860s.
B. 1920s. D. all of the above.

C. 1940s.
D. after the 1950s.

2.24 Do equity investors want m anagers to hedge risk?

A. G enerally yes, if the investor has concentrated their
investm ent in a particular firm
B. Alw ays yes

Chapter 2 How Do Firms Manage Financial Risk? ■ 35

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

ANSWERS
2.1 Re-evaluate regularly changes in: 2.5

• Risk appetite/risk understandings/stakeholder Tips include

view point,
• Business activity and risk environment (remapping), and
• New tools, tactics, cost/benefit analysis.
2.2 The C-Suite can dem onstrate it has a strong risk culture
through:
• Regularly com municating about risk,
• Responding in a tim ely manner to warning signs and
near misses,
• Periodically testing w hether there is a common under­
2.6 The answer lies in two aspects of risk m anagem ent. First,
standing of the firm's risk appetite,
• Dem onstrating that it has an awareness of the firm's
top ten risks, and
• Com m unicating that the success of the risk m anager s
is part of a bigger strategic plan.
2.3 First, it is a statem ent about the firm's willingness to take
• Setting clear goals,
• Keeping instrum ents sim ple,
• Keeping strategies sim ple,
• Disclosing the strategy,
• Explaining ram ifications,
• Setting resources and limits suitable for the strategy,
• Stress testing, and
• Setting early warning indicators.
the need to manage financial risk grew significantly from
the 1970s on because com m odity, interest rate, and
foreign exchange m arkets liberalized and price volatil­
ity shot up. Second, growth in m arket volatility helped
spawn a fast-evolving m arket in financial risk m anage­
ment instruments through the 1980s and 1990s, giving

risk in pursuit of its business goals. Second, it is the sum more opportunities to manage their risk adjusted returns.
of the mechanisms that link this top-level statem ent to the Globalization of com panies and of trading introduced
firm's day-to-day risk management operations. It assesses additional financial risk exposures.

the risk exposures the firm is willing to assume in relations 2.7 These Com m odity derivatives might include
to the expected returns from engaging in risky activities.
• Aluminum swaps,
2.4
• Natural gas and energy derivatives,
Firm Risk A ppetite The firm's risk appetite sets
the key goals. • Exchange-traded w heat futures,

M arket Practicalities It may be easier to raise money • Exchange-traded sugar futures,

in one marketplace and then • Corn swaps, and
shift the risk characteristics (cur­
rency, fixed versus variable etc.) • Rice swaps.
in another using derivatives.
2.8 True
Changing Business M eanwhile, deals roll over,
2.9 False
and Financing Needs businesses grow.
2.10 False, because only true if interest rates stay within cer­
Basic Aim s: Cost The treasurer may be perm it­
C enter versus Profit ted to take a view on the mar­ tain bounds. If interest rates later break through a given
C enter ket direction. ceiling then the firm's financial exposure might increase.

Regulations and The treasurer may need to 2.11 False, because only 15-20% of airline operating costs are
Taxes respond to change in the burnt in the air.
rules of the gam e.
2.12 True
M arket Direction and The treasurer may need to
Behavior prepare for rising interest 2.13 True
rates or respond to yield 2.14 False, because the curve moved from backwardation to
curve behavior.
contango.

36 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

2.15 False, most airlines hedge some of their price risk, 2.20 C. all of the ab o ve1
14
but some prefer to retain it all. The naysayers cite the 2.21 D. reduce counterparty credit risk
expense of hedging programs and fear that they will lock
2.22 C. all of the above
in je t fuel prices at a high point in the m arket, just before
a steep price fall. 2.23 A . 1860s

2.16 False 2.24 G enerally yes. Potentially no in the case where the
investor holds the investm ent as part of a diversified
2.17 True13
portfolio.
2.18 C . the amount that it would be happy to bear at any
2.25 C. all of the above
one time
2.26 The board must approve it.
2.19 A . the firm could bear without becoming insolvent

1 *3
See McDonald's Corporation, Form 10-k annual report for fiscal year 14 See https://www.cnbc.com/amp/2019/01/02/mortgage-applications-
ended December 31, 2017, pages 26-27. plummet-nearly-10percent-to-end-2018-despite-lower-rates.html

Chapter 2 How Do Firms Manage Financial Risk? ■ 37

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

QUESTIONS
True/False Questions
3.1 A fter establishing a risk limit, a bank should plan to 3.4 The board of directors should be responsible for
maintain a risk exposure level just below the limit during overseeing and approving a firm's risk governance.
the normal course of business.
A. True
A. True B. False
B. False 3.5 Conflicts of interest between senior m anagem ent and
3.2 The standards set in the "Basel A cco rd " are legally other internal m anagem ent are referred to as "agency
binding in all banks in most countries. problem s."

A. True A. True
B. False B. False

3.3 Basel III designed a m acroprudential overlay leverage

ratio of 5% intended to reduce system ic risk and lessen
pro-cyclicality.

A. True
B. False

Short Concept Questions

3.6 The Dodd-Frank A ct overhauled the regulation of financial
institutions in the United States, aiming at improving
both consum er protection and system ic stability. List and
discuss three issues that the Dodd-Frank A ct tried to
address?
3.7 D escribe what is involved in risk governance.
3.8 W hat w ent wrong in MF Global after 2010? How was it
related to corporate governance issues?
3.9 D escribe key points involved in constructing a risk
appetite.
3.10 W hat are the four basic choices a bank needs to make
regarding a potential risk exposure?
3.11 How would one assess the stature of the C R O in the
organization?
3 .1 3 W hat is the difference between Tier 1 and Tier 2 limits?
3.14 W hat were three recom m endations from the Financial
Stability Board regarding com pensation after the
2007-2009 financial crisis?
3.15 W hat are the roles of the senior m anagem ent risk
com m ittee?
3.16 W hat are the key roles and responsibilities of an internal
audit function?
3.17 D escribe three key roles and responsibilities of the board
of directors.
3.18 D escribe the roles and responsibilities of the board audit
com m ittee.

3.12 Describe what a "Risk A ppetite Statem ent" (RAS) is and

the objectives of a RAS.

56 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.
Multiple Choice Questions
3.19 According to the Sarbanes-O xley (SOX) A ct, who is
required to certify the accuracy of the financial reports?
A. The chief risk officer (CRO ) only
B. The chief executive officer (C EO ) only
C. The chief financial officer (C FO ) only
D. C E O , C F O , and C R O only
E. C E O and C F O only
3.20 W hich of the following is not a concern of corporate
governance in banks?
A. Ensuring com petitive positioning of the bank in each
market
B. Determ ining the risk appetite
C. Board composition
D. Com pensation policy
3.21 W hich of the following was not an aim of the
Dodd-Frank A ct?
A. Verifying the accuracy of financial reports
B. Living Will and resolution plan
C. Stress testing and scenario analysis
D. Protecting consum ers
Chapter 3 The Governance of Risk Management
3.22 Risk governance does not include
A. setting limits on risk exposures.
B. setting the infrastructure for risk m anagem ent
information flows.
C. allowing for transparency of risk procedures.
D. setting m ethodologies to assess credit risk.
3.23 The major roles of the audit com m ittee do not include
A. reviewing the risk m anagem ent process.
B. preparing the annual financial report.
C. analyzing the integrity of risk governance.
D. affirming the reliability of vetting processes.
3.24 The roles of the senior m anagem ent risk com m ittee
include
A. calculations of the daily VaR.
B. reviewing the daily VaR.
C. planning the scenario analysis.
D. setting risk limits for specific business activities.
■ 57
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
ANSWERS
3.1 False, because the bank should operate well below its
risk limits during the normal course of business
3 .2 False
3.3 False, because the leverage ratio is 3%.
3.4 True
3.5 False, because "agency risk" puts the interests of man­
agem ent squarely against those of a com pany's longer-
term stakeholders.
3.6 Include any of the following seven elem ents.
• Strengthening the F e d : The A ct extended the
regulatory reach of the Federal Reserve (i.e., the Fed)
in the areas concerned with system ic risk. All the sys-
tem ically im portant financial institutions (SIFIs), which
are defined as bank holding firms with more than USD
50 billion of assets, are now regulated by the Federal
Reserve and the Fed's m andate now includes m acro­
prudential supervision.
• Ending too-big-to-fail: Dodd-Frank proposed an end
to "too-big-to-fail" by creating an orderly liquidation
authority (O LA).
• Resolution plan: SI FIs are required to subm it a
so-called "living w ill" to the Federal Reserve and
the Federal Deposit Insurance Corporation (FDIC)
that lays out a corporate governance structure for
resolution planning.
• D erivatives m arkets: The A ct launched a transparency-
focused overhaul of derivatives m arkets regulation
with the aim of helping m arket participants with
counterparty risk.
• The Volcker Rule: This is a prohibition on proprietary
trading, as well as the partial or full ownership/
partnership of hedge funds and private equity funds
by banking entities.
• P rotectin g consum ers: The A ct created a Consum er
Financial Protection Bureau (C FPB) to regulate
consum er financial services and products.
• Stress testin g : The A ct instituted a radically new
approach to scenario analysis and stress testing, with
the following characteristics.
• A top-down approach with m acroeconom ic
scenarios unfolding over several quarters;
58 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management
• A focus on the effects of m acroeconom ic down­
turns on a series of risk types, including credit risk,
liquidity risk, m arket risk, and operational risk;
• An approach that is com putationally dem anding,
because risk drivers are not stationary, as well as
realistic, allowing for active m anagem ent of the
portfolios;
• A stress testing fram ew ork that is fully incorpo­
rated into a bank's business, capital, and liquidity
planning processes; and
• An approach that not only looks at each bank in
isolation, but across all institutions. This allows for
the collection of system ic information showing how
a major common scenario would affect the largest
banks collectively.
3.7 Risk governance involves
• Setting up an organizational infrastructure of human,
IT, and other resources as well as articulating formal
procedures for defining, im plem enting, and o versee­
ing risk m anagem ent; and
• Transparency and the channels of communication
established within the organization as well as with
external stakeholders and regulators.
3.8 Key points include the following.
• Jon Corzine was appointed chairman of the board and
C E O of M F Global In 2010.
• MF Global was experiencing liquidity and com pliance
problem s.
• Despite repeated warnings by the company's chief
risk officer, MF Global made huge proprietary invest­
ments in European sovereign debt. These investm ents
soured in 2011, exacerbating the com pany's liquidity
problem s.
• Liquidity problem s led to the loss of shareholder and
client confidence, and ultim ately to the firm's collapse.
• The com pany allegedly m isappropriated client funds
to m eet the cash crunch.
3.9 Key points include the following.
• Risk appetite is intim ately related to business strategy
and capital planning.
• Certain activities may be categorically inappropriate
for an enterprise given the type of risk involved.
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
• Business planning must take risk m anagem ent into
consideration from the outset.
• The matching of strategic objectives to the risk ap p e­
tite must be incorporated into the planning process.
• Clear communication of the firm's risk position and
risk appetite is essential so that appropriate limits can
be set on various risk-bearing activities.
3.10 The choice to:
• Not undertake certain activities,
• Transfer either all or part of a certain risk to third parties,
• Preem ptively m itigate risk through early detection and
prevention, and
• Assum e the risk while being fully cognizant of both
the upside and downside im plications.
3.11 Q uestions to ask include the following.
• Is the risk m anager a m em ber of the executive
staff and can this position lead to other career
opportunities?
• How independent is the risk m anager?
• W hat authority does the risk m anager hold?
• To whom does the risk m anager report?
• Are risk m anagers com paratively well paid relative to
other em ployees who are rewarded for perform ance?
• Is the enterprise's ethical culture strong and resilient
to the actions of bad actors?
• Has the bank set clear-cut ethical standards and are
these standards actively enforced?
3.12 A risk appetite statem ent:
• Is an im portant com ponent of corporate governance,
• Articulates the level and types of risk a firm is willing
to accept to reach its business goals,
• Includes both qualitative and quantitative statements, and
• Helps to reinforce a strong risk culture.
O bjectives include
• Maintaining a balance between risk and return;
• Retaining a prudent attitude toward tail risk and event
risk;
• Achieving a desired credit rating;
• Linking short-term capital and long-term capital,
financial and strategic plans, as well as com pensation
structure;
Chapter 3 The Governance of Risk Management
• Setting risk appetite and risk tolerance measures
which limit the amounts at risk that are expressed
at the business unit level and on an enterprise
level; and
• Making transparent the relationship between risk
appetite, risk capacity, risk tolerance and a firm's
current risk profile.
3.13 Tier 1 limits:
• Are specific and often include overall limits by asset
class, an overall stress-test limit, and a maximum
drawdown limit; and
• Excesses must be cleared or corrected im m ediately.
Tier 2 limits:
• Are more generalized;
• Relate to areas of business activity and aggregated
exposures to credit ratings, industries, m aturities,
regions, and so on; and
• Excesses are less urgent and can be cleared within a
within a few days or a w eek.
3.14 Recom m endations include:
• The elimination of multi-annual guaranteed bonuses;
• The incorporation of executive downside exposure
through the deferral of certain com pensation, the
adoption of share-based remuneration to incentivize
long-term value creation, and the introduction of
claw back provisions requiring reim bursem ent of
bonuses should longer-term losses be incurred after
bonuses are paid;
• The placem ent of limitations on the amount of
variable com pensation granted to em ployees relative
to total net revenues; and
• The imposition of disclosure requirem ents to enhance
transparency.
3.15 The senior m anagem ent risk com m ittee:
• Reports back to the board risk com m ittee with recom ­
m endations regarding the total at risk deem ed pru­
dent for the latter's consideration and approval;
• Establishes, docum ents, and enforces all corporate
policies in which risk plays a part;
• Sets risk limits for specific business activities, which
are then delivered to the C R O ; and
• D elegates the power to make day-to-day decisions
to the C R O . This delegation includes the power to
■ 59
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
approve risks exceeding preset limits imposed on
the various business activities, provided these e xce p ­
tions remain within the bounds of the overall board-
approved limits.
3.16 Key roles and responsibilities include:
• Independently assessing risk governance as well as
the im plem entation and efficacy of risk m anagem ent;
• Reviewing the risk m anagem ent process, a com pre­
hensive review includes, among other things, assess­
ing adequacy of the organization of the risk control
unit and docum entation;
• Analyzing the integrity of risk governance and the
efficacy of the risk m anagem ent process, including
the integration of risk m easures into daily business
m anagem ent;
• Exam ining the monitoring procedures, for tracking the
progress of risk m anagem ent system upgrades;
• Assessing the adequacy and effectiveness of applica­
tion controls in generating and securing data;
• Affirm ing the reliability of vetting processes;
• Com paring com pliance docum entation with qualita­
tive and quantitative criteria stipulated by regulations;
• Offering its opinion on the reliability of any risk
exporting fram ew ork; and
• Evaluating the risk m easurem ent m ethodologies both
in term s of theory as well as im plem entation, includ­
ing stress-testing m ethodologies.
3.17 Such roles and responsibilities include:
• Assessing the fundam ental risks and rewards engen­
dered in the bank's business strategy, based on a
clear understanding of the latter's direction and goals;
• Harmonizing risk appetite with the bank's strategic plan;
• Being accountable for risk transparency; and
• Making sure that:
• Any major transaction undertaken is in-line with
authorized risk taking as well as with the relevant
business strategies.
• An effective risk m anagem ent system is in place
that enables corporation to further its strategic
objectives within the confines of its risk appetite.
• Procedures for identifying, assessing, and handling
the various kinds of risk are effective.
• Executives are com pensated based on their risk-
adjusted perform ance and that the incentives
60 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management
inherent in such com pensation do not clash with
shareholder interests.
• Disclosure to m anagers and relevant stakeholders
is both adequate and com pliant with internal cor­
porate rules and external regulations.
• The information it obtains concerning the im ple­
mentation of risk m anagem ent is accurate and
reliable.
3 .1 8 The board audit com m ittee is responsible for:
• Assessing the veracity and the quality of the firm's
financial reporting, com pliance, internal control and
risk m anagem ent processes; and
• Com pliance with best-practice standards in non-finan-
cial m atters.
Regulatory, legal, com pliance, and risk m anage­
ment activities also fall under the purview of the audit
com m ittee.
3 .1 9 E. C E O and C F O only
S O X specifically requires the C E O and C F O to affirm the
accuracy of all financial disclosures.
3 .2 0 A . Ensuring com petitive positioning of the bank in each
market
Corporate governance is concerned with proper controls
around the running of a business entity— not the specif­
ics of strategy.
3.21 A . Verifying the accuracy of financial reports
A ccuracy of financial reports was an aim of Sarbanes-
O xley, not Dodd-Frank.
3 .2 2 D. Setting m ethodologies to assess credit risk
The specifics of risk methodologies are not a part of risk
governance. However, risk governance does extend to
ensuring the activities around the developm ent of the
methodologies are appropriately controlled and disclosed.
3 .2 3 B. Preparing the annual financial report
The audit com m ittee serves as a check on processes
and procedures. In this case, the audit com m ittee would
ensure that the process around the report was properly
controlled and delivered accurate results.
3 .2 4 D. Sets risk limits for specific business activities
The senior m anagem ent risk com m ittee em powers the
C R O to have oversight into the specifics of how risk is
reported and analyzed as well as the overall day-to-day
m anagem ent of risk.
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

QUESTIONS
True/False Questions
4.1 The securitization mechanism underlying the subprim e 4.3 C redit Default Swaps allow the transfer of credit risk w ith­
C D O m arket played a central role in bringing about the out impacting funding or relationship m anagem ent.
2007-2009 global financial crisis (G FC ).
A. True
A. True B. False
B. False 4.4 In the originate-to-distribute (O TD) business m odel, there
4.2 The securitization of securities backed by assets such as is little incentive for lenders to monitor the creditw orthi­
car loans, credit card receivables, and equipm ent leases ness of borrowers.
remained a viable activity during and after the G F C . A. True
A. True B. False
B. False

Multiple Choice Questions

4.5 In a typical securitization, the sources of funds are mainly 4.8 Over-the-counter CD Ss helped transfer credit risk in the
several classes of bonds arranged by ratings and a rela­ loan book, but also generated n ew __ of a system ic nature
tively large equity tranche. A. credit spread risk
B. counterparty credit risk
A. True
C . interest rate risk
B. False
D. None of the above
4.6 W hich of the following cannot be used to transfer credit
risk from a bank's balance sheet? 4.9 C redit risk includes
A. C redit derivatives A. the risk of default.
B. the risk of upgrades and dow ngrades.
B. C redit default swaps
C . Securitization C . credit spread risk.

D. US governm ent bond futures D. All the above

4.7 W hich technique below does not contribute to credit risk

m itigation?
A. Bond insurance
B. Buy-and-hold
C . Netting
D. Collateralization

Short Concept Questions

4.10 D escribe the securitization process.

4.11 Fiow do the SEC 's risk retention provisions force banks to
have "skin in the gam e"?

68 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

ANSWERS
4.1 False 4.7 B. Buy-and-hold

The crisis may have had more to do with failings of the Buy-and-hold is an asset acquisition strategy and
pre-crisis securitization process than with the underlying would in fact contribute to the accum ulation of credit
principle of credit risk transfer. exposures.

4.2 True 4.8 B. Counterparty credit risk

More straight-forward securitizations survived the G F C , Even prior to the 2007-2009 financial crisis, regulators
whereas more com plex instrum ents (e.g ., C D O s squared) were concerned about the relatively small number of
are unlikely to be revived. liquidity providers in the credit derivatives m arkets. They

4.3 True feared this nascent m arket could face system ic disruption
if any of the major participants were to experience dis­
CD Ss do not require funding per se, nor do they require
tress (in isolation or in concert).
any participation from the reference creditor.
4.9 D. All the above
4.4 True
All of these are derived from the creditw orthiness (or the
In the O TD m odel, the originating financial institution
perceived creditworthiness) of the borrower
does not suffer any losses in the event of a default.
4.10 A nsw er: See Figure 4.1 and Section 4.3
4.5 False
4.11 The rules require securitizers to retain, without recourse
Equity tranches typically com prise less than 10% of total
to risk transfer or m itigation, at least 5% of the credit
funding.
risk.
4.6 D. U.S. governm ent bond futures

G overnm ent bond futures offer a mechanism to transfer

interest rate risk, not credit risk.

Chapter 4 Credit Risk Transfer Mechanisms ■ 69

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

QUESTIONS
5.1 Is the m arket portfolio the only efficient portfolio that can 5 .1 0 If crA = 20% and a B = 40% and a portfolio if form ed with
be form ed? half the money invested in each stock, then ap must be

5.2 W hat are beta measures? A. 30%.

A. The volatility of the security
B. The joint volatility of any two securities in a portfolio
C. The volatility of a security divided by the volatility of
the m arket index
D. The relative co-m ovem ent of a security with the mar­
ket portfolio
5.3 W hat is the price per unit of beta risk?
A. E(Ri)
B. E(R m) - r
C. r
D. E(Rm)
5.4 W hat are the betas of three stocks in a perfect m arket in
equilibrium ?
5.5 The riskless rate of interest is r = 5% and the m arket
portfolio is characterized by E(R m) = 13% and crM = 15%.
CAPM implies that the expected return of stocks A , B, and
C are
A. E(R a ) = - 3 % , E(Rb) = 5%, E(RC) = 21%
B. E(Ra) = - 5 % , E(R b) = 3%, E(RC) = 21%
C. E(Ra) = 3%, E(R b ) = 5%, E(R C) = 16%
D. None of the above
5.6 If JP I is zero, then TPI detects no excess return.
A. True
B. False
5.7 If fund A is mean-variance inefficient in relation to fund B,
then fund B is expected to outperform fund A according
to SPI.
A. True
B. False
5.8 The rate of return on stock A and stock B will be the same
each month if they have the same beta.
B. between 10% and 40% .
C. between 20% and 40% .
D. between 20% and 60% .
5.11 W hat are the major assum ptions needed to establish
CAPM (as made by Sharpe and Linter)?
5 .1 2 It has been said that the prices of risky assets in a perfect
capital m arket are determ ined as if there was only a single
investor. Is this an accurate statem ent? Explain.
5 .1 3 W hat is the relationship between CAPM and the market
model?
5 .1 4 In a perfect capital m arket, all stocks have the same risk
premium. Is this statem ent consistent with C A PM ? Explain.
5 .1 5 Define system atic risk and nonsystem atic risk.
5 .1 6 According to C A P M , the higher the variance of a security,
the higher its expected return.
A. True
B. False
5 .1 7 Assum e the riskless interest rate is r = 5% and the mar­
ket portfolio is characterized by an expected return
of E(R m) = 13% and a standard deviation of return of
ct /vj = 15%. The expected return on a zero-beta security is
7%. Is the m arket in equilibrium ?
5 .1 8 The beta of a security estim ated from historical returns
is equal to the true beta of the security. True or false?
Discuss.
5 .1 9 Prove that the covariance of stock i with the m arket port­
folio is equal to the sum of the covariances of stock i with
all the n stocks included in the m arket portfolio multiplied
by the corresponding proportions x,.

A. True
B. False

5.9 If r = 4% and E(R m) = 10%, then a stock with a beta of

1.3 is expected to yield
A. 10.0%.
B. 6.0% .
C. 7.8% .
D. 11.8%.

Chapter 5 Modern Portfolio Theory and Capital Asset Pricing Model ■ 79

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

ANSWERS
5.1 No is based on expected and unobserved variables. It also
provides a method of decom posing asset returns into
5 .2 D. The relative co-m ovem ent of a security with the mar­
two com ponents: a system atic (or market) com ponent
ket portfolio
and a residual (or non-market) com ponent:
5 .3 B. E(R m) - r
rP = aP + b PrM + e P
E(R m) - r is the excess return of the m arket portfolio
where rP = RP - r is the excess return of the portfolio
over the risk-free rate.
return RP over the risk-free rate r and rM = RM - r is the
5 .4
excess return of the m arket portfolio R m over the risk­
P a = - 1 , P b = 0 and p c = 2 free rate r.
5 .5 A . E(R a ) = - 3 % , E(R b) = 5%, E(RC) = 21%
The residual com ponent eP is uncorrelated with the
In equilibrium stocks are on the same security m arket excess return rM. The system atic com ponent is
m arket line: beta multiplied by the m arket excess return. The mar­

E(R,) = r + [E(R m) - r] p, ket model thus appears to be a natural fram ework for
estim ating beta.C A PM is an equilibrium pricing m odel,
5 .6 True
which suggests that each asset is priced so that its
5 .7 True expected return com pensates for its contribution to the
5 .8 False m arket portfolio risk. The asset's expected return is thus
found to be proportional to its beta. For a well-diversi­
The realized return is random. CAPM predicts that the
fied portfolio, an asset's risk contribution will approxi­
expected rates of return for stocks A and B should be the
mate its risk contribution to the m arket portfolio.
sam e.

5 .9 D. 11.8% 5.14 No, the risk premiums for different stocks will not be the
sam e. It is, according to the C A PM :
5 .1 0 B. Between 10% and 40%
coviRj, R m)
5.11 (E(R m) ~ r)

• Investm ents are perfectly divisible;

where cov(R„ R m) is the covariance between the returns
• They are no transaction costs and/or taxes;
of asset i and the returns of the m arket portfolio M.
• Full and costless information is available to all investors;
5.15 System atic, or undiversifiable, risk is that portion of the
• The lending and borrowing rates are equal, and are
risk that is associated with m arket fluctuations and there­
the same for all investors; and
fore cannot be reduced by diversification.
• Each investor can borrow or lend any amount at the
Non-system atic, or diversifiable, risk is that portion of risk
m arket rate.
that can be elim inated by combing the security in ques­
5 .1 2 The statem ent is tru e if, in addition to a perfect capital
tion with others in a diversified portfolio.
m arket, it is assumed that investors are risk averse and
select their optimal investm ent by the mean-variance
Ri,t = a i + EjRMit + eit
criterion. Under these conditions, CAPM applies and all a? = bfah + al
investors select the same m arket portfolio, regardless of the first term is the system atic risk and the second one
their risk aversion and initial wealth. denotes the non-systematic risk
5 .1 3 These models are frequently confused because they both
5.16 False:
dem onstrate a relationship between every asset and
the m arket portfolio.The m arket model is an empirical E(R m) ~ r
E(Ri) = r + ------ Cov(R„ RM)
model based on realized rates of return, whereas CAPM om

80 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.

A security may have a high variance of returns but 5.19

n
still have a low exp ected return because of its low
Cov(R„ Rm) = ^ Xj Cov{Rj, Rj)
(or even negative) covariance with the m arket i= 1
portfolio.
Proof:
5.17
E{Rj) = r + [E(R m) - r] ft
E m ~ 2 x i R j

/= 1
f3; = 0 means that in equilibrium E(R,) = r = 5%
Cov(R„ Rm) = E(R,Rm) - E(R;)E(Rm)
The m arket is not in equilibrium .
Com bining the two equations:
5.18 This statem ent is false. The beta of a security obtained
from past data is only an estim ate of the true beta, which Cov(R„ Rm) = ' Z x j m . R j ) - E(R,)E(Ri)]
is unknown. The estim ate is subject to statistical estim a­ )=1
tion errors and the true beta, at best, can be said to fall
= 2 XjCoviR,, Rj)
within a confidence interval with a given probability (the
i= 1
confidence level).
= x p f + 2 xj CoviR,, Rj)
i=\
j* i

Chapter 5 Modern Portfolio Theory and Capital Asset Pricing Model ■ 81

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

QUESTIONS
6.1 A major disadvantage of A P T is that the theory gives no 6.8 If the return process for 100 firms is a four-factor m arket
insights into what the m acroeconom ic factors might be. m odel, then the number of param eters to be estim ated is
A. 6 .
A. True
B. False
B. 100.
C. 386.
6.2 A P T assumes asset returns are normally distributed.
D. 406.
A. True
6.9 Em pirical studies of the single-factor m arket model show
B. False
the explanatory power of the model is rather high. True or
6.3 A P T requires that investors make decisions based on false? Discuss.
mean and variance.
6.10 Roll noted that well diversified portfolios are nonetheless
A. True highly correlated if the holdings are concentrated within
B. False the same asset class. True or false? Explain.

6.4 W hat is the basic idea of A P T? 6.11 Fama and French (1996) added two risk factors beyond
6.5 The A P T model is derived from the m arket index to explain past average rates of return.
W hich of the following ratios is a risk factor in the Fama-
A. a theoretical model of optimal portfolio selection.
French em pirical model?
B. an extension of the concept of C A PM . A. E B IT D A to total sales
C. arbitraging a few known risk factors in the m arket. B. Current assets to current liabilities
C. Net profit to total assets
D. investors holding efficient portfolios.
D. Book-to-m arket values
6.6 Chen, Roll, and Ross (1986) tested the A P T model and
6.12 In their later work, Fama and French (2015) added two
found several explanatory variables for the average rate of
more factors. W hich of the following is a basis for one of
return on stocks traded on the N YSE. Which of the follow ­
these new risk factors?
ing is not an explanatory variable in their em pirical test?
A. O perating profitability
A. Expected and unexpected inflation
B. Current assets to current liabilities
B. The yield spread between high and low risk corporate
C. Net profit to total assets
bonds
D. Last month perform ance
C. The yield spread between long and short maturity
bonds 6.13 Factor betas in a well-diversified portfolio provide a means
D. The change in money supply in the econom y for constructing a hedging strategy to reduce system atic
risk. True or False? Discuss.
6.7 If a portfolio has 80 securities, the number of covariances
that should be estim ated is
A. 6,320.
B. 6,400.
C. 3,160.
D. 80.

88 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are intended to help candidates understand the material. They are not actual FRM exam questions.
ANSWERS
6.1 True
These factors may include indices on stocks, bonds, and
com m odities, as well as m acroeconom ic factors. How­
ever, the model does not say which of these factors adds
to the explanatory power of the relationship.
6 .2 False
A P T has three underlying assumptions.
1. A sset returns can be explained by system ic factors.
2 . By using diversification, investors can eliminate
specific risk from their portfolios.
3 . There are no arbitrage opportunities among well-
diversified portfolios. If any arbitrage opportunities
were to exist, investors would exploit them away.
6 .3 False
See the previous explanation.
6 .4 The basic idea of A P T is that investors can create a
zero-beta portfolio with zero net investm ent. If such a
portfolio yields positive return, then a sure profit can be
realized by arbitraging. In the real world, any existing
arbitrages would be exploited away.
6 .5 B. an extension of the concept of C A PM .
A rbitrage Pricing Theory (APT) is based on the reasoning
behind C A PM . It differs in that it is a multi-factor model.
6.6 D. The change in money supply in the econom y
The explanatory variables were
• The spread between long-term and short-term inter­
est rates (reflecting shifts in tim e preferences);
• Expected and unexpected inflation;
• Industrial production (reflecting changes in cash flow
expectations); and
• The spread between high-risk and low-risk corporate
bond yields (reflecting changes in risk preferences).
Chapter 6 The Arbitrage Pricing Theory and Multifactor Models of Risk and Return
6.7 C. 3,160.
If there are N different securities, then the number of
correlations equals N(N - 1)/2
6.8 D. 406.
The number of param eters to be estim ated is
MN + M(M — 1)/2 for M common factors and N firms.
6.9 False
Em pirical studies of the single-factor m arket model (i.e.,
CAPM ) show that its explanatory power is rather low.
6.10 True
Roll noted that well-diversified portfolios exhibit high
correlations when constrained to the same asset class,
whereas there is much less correlation when portfolios
are diversified across multiple asset classes.
6.11 D. Book-to-m arket values
HML is the difference between the returns on stocks with
high book-to-market values and those of stocks that have
low book-to-market values.
6.12 A. O perating profitability
Fama and French extended the model in 2015 by sug­
gesting two additional factors:
1. RMW, which is the difference between the returns of
companies with high (robust) and low (weak) operating
profitability; and
2. C M A , which is the difference between the returns of
com panies that invest conservatively and those that
invest aggressively.
6.13 True
Each factor can be used to hedge the same factor that is
reflected in a given security.
89
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

QUESTIONS
7.1 B C B S 239 concerns An additional requirem ent that has em erged since the
A. conducting scenario analysis. original B C SBS 239 principles were published is the
B. liquidity requirem ents in banks. expectation that B C B S 239 principles should also apply to
C. how to deal with data in a bank. banks' regulatory reporting.
D. details of how to im plem ent the Graham -Dodd A ct A. True
B. False
7.2 Is the following statem ent True or False?
7.5 Please provide an exam ple of com pliant risk data gover­
The original tim eline to achieve full com pliance with BCBS
nance in B C B S 239.
239 was not met by any bank.
A. True 7.6 Please provide an exam ple of effective risk reporting in
B. False B C B S 239.

7.3 Is the following statem ent True or False? 7.7 W hy was the original tim eline to achieve full com pliance

There is a uniform blueprint in place for B C B S 239 com pli­ with B C B S 239 not met by any bank?

ant infrastructures. 7.8 W hat are the characteristics of a strong risk data aggrega­
A. True tion capability?
B. False
7.9 Explain how model risk is affected by data quality.
7.4 Is the following statem ent True or False?

Chapter 7 Principles for Effective Data Aggregation and Risk Reporting ■ 99

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
ANSWERS
7.1 C. how to deal with data in a bank.
The principles and supervisory expectations outlined in
B C B S 239 apply to risk m anagem ent data and m odels.
These principles cover governance/infrastructure issues,
risk data aggregation procedures and needs, reporting,
and considerations for supervising authorities.
7.2 True
Banks have struggled to com ply with B C B S 239 and the
original tim eline to achieve full com pliance was not met
by any bank.
7 .3 False
Solutions are specific to the individual institution.
7.4 True
The European Central Bank has stated that financial and
regulatory reporting is part of B C B S 239 com pliance.
7.5 Policies are in place that set "out a clear delineation of
roles, incentive schem es, and responsibilities for risk data
m anagem ent (including dedicated staff responsible for
defining risk data exp ectatio n s)."39
7.6 Effective reporting capabilities feature routine risk
reports having useful information and providing
39 Basel Committee on Banking Supervision, January 2013, "Principles
for effective risk data aggregation and risk reporting."
100 Financial Risk Manager Exam Part I: Foundations of Risk Management
preem ptive analyses and dynamic features. A drill down
of risk data from these reports can enable rigorous analy­
ses across different risks and be accessed with an easy-
to-use interface.
7.7
• The underestim ation of the com pliance
efforts required due to the com plexity of the
problem s,
• The exponential increase in the application of Al tech­
niques on large data sets, and
• C ost considerations.
7.8
• To ensure accurate and reliable risk data,
• To capture and aggregate all material risk data
(com pleteness),
• To Produce aggregate risk information on a tim ely
basis (tim eliness), and
• To G enerate ad hoc reports on data and risk
analyses in response to m anagem ent needs
(adaptability).
7.9 The quality of any model is heavily dependent on the
accuracy of the input data. If the quality of data that
feeds the model is garbage, then the adage garbage-in,
garbage-out applies. Data errors can significantly alter
estim ated model param eters.
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

QUESTIONS
8.1 W hat are advantages and disadvantages of scenario 8.16 C C A R does not oblige banks to generate their own sce­
analysis? narios to com plem ent the supervisory scenarios.
A. True
8.2 W hat are three types of US Federal Reserve generated
B. False
supervisory devised m acroeconom ic scenarios?
8.17 For each scenario, Banks project C C A R scenarios over a
8.3 W hat is C C A R (Com prehensive Capital Analysis and
five-quarter horizon.
Review)?
A. True
8.4 W hat are some of the key im provem ents driven by C C A R B. False
over standard stress testing?
8.18 C o C o s focus solely on accounting triggers, such as the
8.5 W hat are CoCos? level of Tier 1 capital.

8.6 Define what is meant by risk culture? A. True

8.7 Provide exam ples of key benefits of enterprise risk man­
agem ent (ERM ).
8.8 Provide exam ples of the kinds of concentration risk that
can creep across enterprises.
8.9 Provide exam ples that com pare ERM with traditional silo-
based risk m anagem ent.
B. False
8.19 Reverse stress testing calls for identifying the full range of
"worst outcomes" then picking the scenarios that gave rise to
these worst tail risks and how the shocks turned into losses.
A. True
B. False
8.20 Northern Rock was the victim of poor trading liquidity risk

8.10 Provide exam ples of ERM dim ensions. m anagem ent.

A. True
8.11 Provide exam ples of key risk culture indicators (KRCIs). B. False
8.12 Provide exam ples of external risk culture drivers. 8.21 The ostrich effect describes the tendency of investors to
8.13 Define and explain each of the following term s: invest in dom estic securities.
A. True
• Anchoring and referencing
B. False
• Feedback effects.
8.22 C C A R is
• Framing
A. requiring all banks to engage in sensitivity testing.
• Groupthink B. required of all relevant banks over an asset threshold.
• Herding C. requiring all commercial banks to perform scenario
analysis.
• Home bias
D. relevant to investm ent banks only.
• Loss aversion
8.23 ERM looks at an integrated view of
• Mental accounting
A. m arket and credit risks only.
• Ostrich effect B. all the risks covered by Basel III.
8.14 Risk that looks threatening at the business line level might C. all the risks, including business risk, strategic risk, and
look trivial in the context of the diversified enterprise risk liquidity risk.
portfolio.
8.24 External risk culture drivers include
A. True A. econom ic cycles.
B. False B. industry practices.
8.15 Risk retention decisions are best made at the enterprise C. professional standards.
level, where the aggregate level of risk exposure can be D. regulatory standards.
understood. E. country risk.
A. True F. all of the above.
B. False G. none of the above.

118 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

ANSWERS
8.1
Advantages
No need to consider risk fre­
quency beyond "plausibility"
Scenarios can take the form
of transparent and intuitive
narratives
Challenges firms to "im agine
the w orst" and gauge the
effect
Can allow firms to focus on
their key exposures and risk
types and the way risk devel­
ops over time
8.4
1. C C A R m acroeconom ic scenarios unfold over several
Disadvantages
quarters (rather than sim ply a point-in-time shock).
Difficult to gauge probability 2. The scenarios drive a series of interlinked factors cov­
of event; does not lead to
ering a variety of risks such as credit risk, m arket risk,
the quantification of risk
operational risk, and so on.
Unfolding scenarios can 3. The risk variables are not held static and all sorts of
becom e com plex with many
underlying risk factors (probability of default, loss given
choices
default) and m arket im pacts (credit spreads, margining,
Firms may not stretch their etc.) need to be adjusted as the scenario unfolds.
imaginations
4. In turn, the bank can allow for its capital planning as
the scenario unfolds.
Only a limited number 5. Im portantly, imposing a standard set of scenarios on
of scenarios can be fully
the largest banks allows regulators to see system ic
developed— are they the
effects and com pare bank risk exposures.
right ones?

Allow s firms to identify w arn­ Are they the right warnings

8.5 C o C o s are bonds issued by a financial institution that are
ing signals and build contin­ and plans, given the scenario written down or convert into common equity if the firm
gency plans selection challenge? gets into a precarious position.

Does not depend on his­
torical data: can be based
around either historical
events or forward-looking
hypothetical events
Firms can make scenario
analysis as sophisticated or
straightforward as they like,
outside regulator defined
programs
The scenarios chosen are
often prom pted by the last
major crisis; im aginative
future scenarios may be dis­
missed as im probable
Scenario analyses vary in
term s of quality and sophis­
tication. Their credibility and
assum ptions can be difficult
to assess.
8.6 Risk culture can be thought of as the values and norms of
behavior that surround risk taking and risk m anagem ent.
It includes the tendency within the firm to com ply with
best-practice risk m anagem ent.
8.7
• Identifies enterprise-scale risks generated at business
line level
• Focuses oversight on most threatening risks

Stress test results can inform Usefulness depends on accu­ • M anages:

risk appetite, risk limits, and racy, com prehensiveness, • Risk concentrations across the enterprise, and
capital adequacy and forward-looking qualities • Em erging enterprise risks (e.g ., cyber risk)
of stress test program
• Supports regulatory com pliance and stakeholder
8.2 reassurance

1. Baseline: representing a consensus econom ic forecast/ • Helps firms to understand risk-type correlations and
outlook; cross-over risks
2. A dverse: corresponding to a declining econom y; and • O ptim izes risk transfer expenses in line with risk scale
3 . Severely A dverse: severe global recession along with and total cost
decline in dem and for long-term fixed income assets.
• Incorporates:
Note: The adverse and severely adverse scenarios
• Stress scenario capital costs into pricing, and
describe hypothetical m acroeconom ic environm ents that
• Risk into business model selection and strategic
test bank resilience.
decisions.
8 .3 From 2011 onward, as part of the Dodd-Frank A ct, the 8.8
Federal Reserve began conducting annual stress test
• G eographical concentrations,
exercises. C C A R is a specific an annual stress test exer­
• Industry concentrations,
cise required for large banks.

Chapter 8 Enterprise Risk Management and Future Trends ■ 119

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
• Product concentrations, and
• Supplier concentrations
8.9
Traditional Risk ERM View
Management
Risk view ed in business line, Risk viewed across busi­
risk-type, and functional silos ness line, functions and risk
types, taking account of
diversification
Risk m anagers work in Risk team integrated using
isolation global risk m anagem ent
com m ittee and C R O
Many different risk metrics Developm ent of rational risk
that cannot be com pared m anagem ent fram eworks
(apples to oranges) and cross-risk universal m et­
rics to integrate risk view
Risk aggregated, if at all, Tools and integrated fram e­
within business lines and risk works make it possible to
types. Difficulty seeing the more accurately measure and
aggregate risk picture track enterprise risk
Each risk type managed Possibility of cutting risk
using particular risk-specific transfer costs through
transfer instruments whole-of-firm and integrated
instruments
Each risk m anagem ent Each risk management
approach— avoid/retain/miti- approach viewed as one
gate/transfer— often treated component of a total cost of
separately with strategy as a risk. Com ponent choice, opti­
whole rarely optim ized mized as far as possible in risk/
reward and cost/benefit terms
Impossible to integrate the Risk m anagem ent increas­
m anagem ent and transfer ingly indistinguishable
of risk with balance sheet from balance sheet, capital
m anagem ent and financing m anagem ent and financing
strategies strategies
8.10 See Table 8.2
ERM Dimension Examples
Targets Enterprise goals: Enterprise risk appetite,
enterprise limit fram ew orks, risk-sensitive
business goals and strategy formulation
Structure How we organize ERM : Board risk over­
sight, global risk com m ittee
Risk O fficer; ERM subcom m ittee; report­
ing lines for ERM ; reporting structures
120 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management
ERM Dimension Examples
Metrics How we measure enterprise risk:
Enterprise-level risk m etrics, enterprise
stress testing, aggregate risk m ea­
sures (Value-at-Risk, Cash-Flow-at-Risk,
Earnings-at-Risk, etc.), "total cost of risk"
approaches, enterprise level risk m ap­
ping and flagging, choice of enterprise-
level risk limit metrics
ERM Strategies How we manage ERM : Enterprise level
risk transfer strategies, enterprise risk
transfer instrum ents, enterprise moni­
toring of business line m anagem ent of
enterprise-scale risks
Culture How we do things: "tone at the to p ",
accountability for key enterprise risks,
openness and effective challenge, risk-
aligned com pensation, staff risk literacy,
whistle-blowing mechanisms
8.11
Indicator Trend Tracking
Leadership Tone Does board and executive com pensa­
tion support the firm's core values? Do
m anagem ent actions support or under­
mine the risk m essage? Can the board
be shown to monitor and com m unicate
how business strategy fits with risk
appetite?
Accountability and Are there clear expectations on risk
Risk Monitoring monitoring and accountability for key
risks? A re escalation processes used?
O penness Is there evidence that opposing views
and Effective from individuals are valued? Are there
Challenge regular assessm ents of "openness to
dissent"? Is risk m anagem ent given
stature?
Risk-Aligned Are com pensation and perform ance
Com pensation m etrics supportive of the firm's risk
appetite and desired culture?
Risk A ppetite Do key staff know the firm's enterprise
Knowledge risk appetite? Can they answer straight­
forward questions about its application
to business decisions?
Risk Literacy/Com - Do staff use a common language to
mon Language describe risk and its effects? Are train­
ing programs available and taken up?
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
Indicator Trend Tracking
Risk Information Can the firm see risk information flow ­
Flows ing up and across the firm that captures
and highlights enterprise-scale risks
and is there a clear link to specific dis­
cussions and decisions?
Risk/Reward Has the firm tested w hether senior
Decisions executives respond to benchm ark risk/
reward questions consistently with each
other and with the firm's risk appetite?
Risk Stature Do the key ERM staff have the right
stature and direct communication with
the Board? W ho hires and fires them ?
Escalation and Do key staff m em bers understand when
W histle Blowing and how they can escalate a suspected
enterprise risk? W hen were escalation
procedures last used? Is there a w histle­
blowing mechanism and is it used?
Board Risk Can the board name the top ten enter­
Priorities prise risks faced by the firm ? Can it
name the key industry disasters associ­
ated with these risks?
Action Against Can the firm show a record of action
Risk O ffenders taken against those acting against its
risk appetite and ethical stance? Do
staff believe action will be taken even if
contravention of the risk appetite leads
to profit rather than loss?
Risk Incident Can the firm show how it identified
and Near Miss culture issues in risk incidents and m ea­
Responses sures taken?
8.12
• Econom ic cycles (e.g ., credit cycles),
• Industry practices/guidelines,
• Professional standards,
• Regulatory standards, and
• Country risk/corruption indices
8.13 See Box 8.3
8.14 True
Diversification at the enterprise level can reduce overall
risk so long as the constituent pieces are not strongly
correlated.
Chapter 8 Enterprise Risk Management and Future Trends
8.15 True
O therw ise situations could arise where business lines
are offsetting risks that might already be offset by other
businesses.
8.16 False
Both D FA ST and C C A R also oblige banks to gener­
ate their own scenarios to com plem ent the supervisory
scenarios.
8.17 False
C C A R obliges banks to project how these scenarios drive
their income statem ents and balance sheets over a nine-
quarter horizon.
8.18 False
The trigger mechanism could also be some m arket-based
event (e.g ., a drop in an institution's share price).
8.19 True
The purpose of reverse stress testing is to force m anage­
ment to visual potential scenarios that could generate
critical levels of losses.
8.20 False
The Northern Rock collapse arose from a failure to man­
age funding liquidity risk.
8.21 False
It describes the irrational tendency to avoid observing
bad news that might precipitate uncom fortable decisions
or actions.
8.22 B. required of all relevant banks over an asset threshold.
C C A R is conducted at the end of the year for banks with
assets above USD 50 billion.
8.23 C . all the risks, including business risk, strategic risk, and
liquidity risk.
Enterprise risk m anagem ent (ERM ) applies the perspec­
tive and resources at the top of the enterprise to manage
the entire portfolio of risks and account for them in stra­
tegic decisions.
8.24 A . all of the above
See Table 8.4.
121
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

QUESTIONS
9.1 W hat does it mean to ride the yield curve? 9.8 LTCM was purported to have had an experienced team
and operated strategies that were perceived as having
9.2 The S&L crisis of the 80s was mainly due to
minimal risk. So, what were the reasons for the collapse of
A. S&Ls failing to manage their interest rate risk.
LTCM in Septem ber 1998? Explain.
B. increased com petition among S&Ls.
C. increased com petition from commercial banks. 9.9 W hich of the financial disasters was not affected by
D. econom ic recession. increased correlations in the m arkets?
A. LTCM
9.3 Explain what the major factors leading to Lehman Brothers
collapse in Septem ber 2008 w ere.
B. M etallgesellschaft
C . The subprim e crisis
9.4 Liquidity risk, which brought the dem ise of Lehman Broth­
D. The London W hale
ers and Continental Illinois, was not caused by
9.10 In the "London W hale" case it is m entioned that ". . . the
A. expanding the business too fast.
SCP trades breached the limits on all five risk m etrics. In
B. reliance on short-term financing.
fact, from January 1 through April 30, 2012, C IO risk limits
C. changes in regulation that required more liquidity
and advisories were breached more than of 330 tim es."
reserves.
How can the inaction of the bank's m anagem ent be
D. worsening m acroeconom ic conditions.
explained?
9.5 In the Northern Rock case one of the lessons is that there
is a tradeoff between funding liquidity and interest rate
9.11 Explain the term "flight to quality" and explain how it

risk: W hen funding liabilities have shorter duration than relates to a financial crisis.

loan assets, the bank is exposed t o ____________ interest rate 9.12 W hat is model risk?
risk a n d ____________ funding liquidity risk. 9.13 G ive some fam ous exam ples of rogue trading.
A. lower, higher
9.14 The Enron failure was due to
B. lower, lower
A. liquidity risk.
C. higher, higher
B. foreign currency risk.
D. higher, lower
C . com m odity risk.
9.6 Rumors about a possible intervention by the Bank of Eng­ D. governance risk.
land contributed to the default of Northern Rock.

A. True
B. False
9.7 In which of the following cases did the firm default due to
fraud?
A. M etallgesellschaft Refining and Marketing
B. Northern Rock Bank
C. Victor N iederhoffer
D. None of the above

138 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
ANSWERS
9.1 Maintain positive spreads between interest rates earned
on longer-term assets (e.g ., loans) and interest paid on
shorter-term liabilities (e.g ., deposits).
9.2 A. S&Ls failing to manage their interest rate risk.
Interest rate risk led to the US savings and loan (S&L)
crisis in the mid-1980s.
9.3 Concerns about the valuation of the firm's real estate-
based assets led to a loss in m arket confidence. Counter­
parties began to reduce their exposure significantly and
the firm could not roll over its debt. A ttem pts to orga­
nize an industry rescue failed.
9.4 C. changes in regulation that required more liquidity
reserves.
In each case, the liquidity crisis was brought on by
changing conditions in the w ider econom y and the credit
m arkets.
9.5 A. lower, higher
Banks must consider the significant tradeoff between a
short-term funding strategy with low rates but frequent
rollovers (and thus more liquidity risk) and a long-term
funding strategy with higher rates (and thus higher costs)
but less frequent rollovers.
9.6 True
W hen Northern Rock becam e unable to fund itself
through interbank loans, UK authorities discussed vari­
ous strategies to relieve the bank's difficulties. News of
the Bank of England's planned support operation for
Northern Rock leaked, setting the scene for a run on
deposits between Septem ber 14 and Septem ber 17.
9.7 C. None of the above
The fraud exam ples included Barings Bank and Enron.
9.8 LTCM failed because its models did not anticipate the
vicious circle of losses that would arise as volatilities
increased, correlations between various instruments and
m arkets approached 1, and liquidity vanished. LTCM also
succum bed to a liquidity crunch caused by large margin
38 Frierson, R. D. (2013, June 7). Re: Docket No. 1457 and RIN
7100-AD-95 on Large Bank Assessments [Letter to United States Senate
Committee on Homeland Security and Governmental Affairs].
Chapter 9 Learning from Financial Disasters
calls on its futures holdings. Ironically, LTCM's strategies
actually were valid in the medium term , and as the crisis
ended, the banks that took over LTCM realized a sub­
stantial profit.
9.9 B. M etallgesellschaft
M etallgesellschaft was hurt by change in the shape of the
price curve.
9.10 Fail ure in corporate governance and poor risk culture.
Specifically, the whale trades showed that breaches in
risk limits were frequently ignored, risk m etrics were
often criticized or dow nplayed, and risk m odels were
misused by em ployees to set capital requirem ents that
were artificially low.38
9.11 W hen investors are worried about the econom ic and
m arket environm ent, they tend to rebalance their
portfolio by investing heavily in "secure" assets from
"safe heaven" countries (e.g ., the United States). As
a consequence, the yield on US securities goes down
during a financial crisis, whereas interest rates in other
countries go up.
9.12 Trading of financial securities, especially derivative prod­
ucts, relies heavily on mathematical m odels. Trading
losses can be the consequence of model errors due to
incorrect assum ptions about the underlying asset price
process, errors in the calibration of key input param eters
such as volatility and correlations, and errors in the deri­
vation of the hedge ratios.
Note that when m arkets becom e illiquid (e.g ., during a
financial crisis), even the best model might not be able
to help in hedging the risk of a trading position because
traders might not be able to execute the hedge in the
market.
9.13 Barings
9.14 D. governance risk.
Enron was a poster child of corporate governance failure
and poor risk m anagem ent.
■ 139
The following questions are i to help candidates understand the material. They are not actual FRM exam questions.

QUESTIONS
10.1 Securitization didn't play a major role in the G F C . 10.9 In order to securitize m ortgages off their balance sheet,
A. True banks structured bankruptcy remote com panies called
B. False A. SUVs.
B. SIVs.
10.2 The G F C was contained in the United States and didn't
spread out to the rest of the world.
C. VIPs.
A. True 10.10 A s early as the sum mer of 2007, the short-term wholesale
B. False funding m arkets started to freeze. A s a consequence,
there was a significant increase in
10.3 Subprim e borrowers were required to pay a
A. the Libor-OIS spread.
down-paym ent of at least 10% to buy a house.
A. True B. repo haircuts.

B. False
C. A and B.
10.11 Between the fall of 2007 and the end of 2008, the Fed
10.4 The G reat Financial Crisis (G FC ) started
came up with several programs to inject liquidity into the
A. with the failure of Lehman Brothers.
financial m arket, including
B. in the high-tech sector.
A. TA F
C. in the subprim e m ortgage market.
B. P D C F
10.5 The G F C appears to have been triggered by
C. TARP
A. a liquidity crisis that led to a solvency crisis.
D. All of the above
B. a solvency crisis that led to a liquidity crisis.
E. None of the above
10.6 During the sum mer of 2007 banks, such as Northern
10.12 The Lehman Brothers collapse
Rock in the U .K ., started to run into funding problem s,
A. could have been easily predicted from the ratings of
because of the shutdown of
Lehman's debt instruments.
A. the asset back commercial paper (A BCP) market.
B. could have been predicted from the financial reports
B. the repo m arkets.
of the com pany.
C. A and B.
C. all of the above.
10.7 W hich major U.S. investm ent bank(s) was/were converted D. none of the above.
into bank holding com panies in 2008? Select all that
10.13 W hat are N IN JA loans?
apply.
10.14 Explain in a few words: W hat is the originate-to-distribute
A. Citibank
(O TD) business model?
B. J.P. Morgan
C. Goldm an Sachs 10.15 Describe in a few words the system ic im pact of the
D. Morgan Stanley default of a major O T C derivatives dealer such as
E. All of the above Lehman Brothers.

10.8 Subprim e borrowers started to default when

A. the value of their house fell below the nominal value
of the m ortgage loan.
B. banks stopped refinancing m ortgage loans after the
initial "teaser" period.
C. A and B.

150 ■ Financial Risk Manager Exam Part I: Foundations of Risk Management

The following questions are i to help candidates understand the material. They are not actual FRM exam questions.
ANSWERS
10.1 False
Securitization expanded the capacity of the financial sys­
tem to generate credit assets but outpaced its capacity
to manage the associated risks.
10.2 False
Unlike previous U.S. credit crises, the G F C affected inves­
tors all over the world.
10.3 False
In 2005, 43% of first-time home buyers paid zero down
paym ent.
10.4 C. in the subprim e m ortgage market
The cascade of events that came be known as the G reat
Financial Crisis of 2007-2009 (G FC ) began with a dow n­
turn in the US subprim e m ortgage m arket in the summer
of 2007.
10.5 A. a liq uidity crisis that led to a solvency crisis.
This is especially true for highly levered institutions which
relied heavily on short-term wholesale funding.
10.6 C. A and B
By the sum mer of 2007, the short-term wholesale fund­
ing m arkets started to freeze, including both the A B C P
m arket and the repo market.
10.7 C. Goldm an Sachs
D. Morgan Stanley
The last two major investm ent banks in the United
States, Morgan Stanley and Goldm an Sachs, were con­
verted to bank holding com panies and becam e regu­
lated by the Federal Reserve.
10.8 D. A and B
W hen housing prices fell, subprim e m ortgage balances
quickly began to exceed the m arket value of the homes
that collateralized the loans.
Teaser rates were not much of a problem if a borrower
could refinance the m ortgage before the reset date. But
if the borrower could not refinance, and if interest rates
increased, the monthly m ortgage costs could rise very
quickly.
Chapter 10 Anatomy of the Great Financial Crisis of 2007-2009
10.9 B. SI Vs.
An SIV is a lim ited-purpose, bankruptcy remote com pany
used by banks to purchase assets funded with short-term
commercial paper as well as some medium-term notes
and capital.
10.10 C . A and B
The OlS-swap spread exploded (as shown in Figure 10.1)
in the summer of 2007. It remained high during the crisis,
jumped again when Lehman Brothers failed, and never came
back to pre-crisis levels. A t the same time, there was system­
atic increase in haircuts, from zero pre-crisis to more than 45%
when Lehman failed in September 2008 (see Figure 10.2).
10.11 D. All of the above
• Term Auction Facility (TAF) is a program im plem ented
in D ecem ber 2007 and designed to provide funds to
depository institutions by auctioning funds against
a wide range of collateral. TA F was subsequently
expanded in March 2008, following the collapse of
Bear Stearns, to include other types of institutions.
• Primary D ealer C redit Facility (PD C F), created in
March 2008, through which the Fed lent funds via
repos to primary dealers.
• Troubled A sset Relief Program (TARP) was introduced
in O ctober 2008.
10.12 D. None of the above
Note that Lehman satisfied the Basel minimum regula­
tory capital requirem ents before it failed.
10.13 N IN JA Ioans refer to applicants who had "no incom e, no
job, and no assets."
10.14 In the originate-to-distribute business m odel, banks:
• Extend loans;
• Securitize the loans; and
• Sell the securities to investors.
10.15 Lehman's default triggered a cascade of defaults among
its counterparties, who could not get back their col­
lateral. Dealers which had no direct link to Lehman, but
were counterparties of failed direct counterparties of
Lehman, also defaulted.
■ 151