Analyst Prep Foundn 2024

FRM Part I Exam
By AnalystPrep
Questions with Answers - Foundations of Risk Management
Last Updated: Sep 19, 2023
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Table of Contents
1 - The Building Blocks of Risk Management 3

2 - How Do Firms Manage Financial Risk? 31
3 - The Governance of Risk Management 48
4 - Credit Risk Transfer Mechanisms 71
Modern Portfolio Theory (MPT) and the Capital Asset Pricing
5 - 84
Model (CAPM)
The Arbitrage Pricing Theory and Multifactor Models of Risk
6 - 139
and Return
7 - Risk Data Aggregation and Reporting Principles 161
8 - Enterprise Risk Management and Future Trends 180
9 - Learning From Financial Disasters 187
10 - Anatomy of the Great Financial Crisis of 2007-2009 213
11 - GARP Code of Conduct 252
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© 2014-2023 AnalystPrep.
Reading 1: The Building Blocks of Risk Management
Q.1 In the context of financial markets, liquidity can be categorized into different types, each with its
unique characteristics and implications. Market liquidity, in particular, is a critical aspect that
investors and financial institutions often consider. Given the following definitions, which one is most
likely to be associated with the concept of market liquidity?
A. T he risk that a bank will not be able to roll over a repo to finance their short-term cash
flow needs.
B. T he risk that depositors will flock into banks and withdraw their funds or that
shareholders will redeem their shares en masse.
C. T he risk that the collateral value of an asset will decline after a derivative position is
established, resulting in an increase in the margin requirement.
D. T he risk that an investor who lends out an asset will be forced to sell at a lower price
once the asset is returned.
T he correct answer is D.
Market liquidity risk, also known as trading liquidity risk, refers to the potential loss in the value of
an asset when markets temporarily seize up. In such situations, a market participant may not be able
to execute a trade or liquidate a position immediately at the best price. T his could force the seller to
accept an abnormally low price, or in some cases, completely lose the ability to convert the asset
into cash. T his scenario is accurately depicted in choice D, where an investor who lends out an asset
may be forced to sell it at a much lower price once the asset is returned, especially if the trading
volume declines due to changes in one or more market factors such as interest rates and inflation.
Choi ce A i s i ncorrect because it describes a scenario related to funding liquidity risk, not market
liquidity risk. Funding liquidity risk is concerned with the ability of a firm or a bank to meet its short-
term cash flow needs. In the given scenario, the risk that a bank will not be able to roll over a repo
to finance their short-term cash flow needs is a clear example of funding liquidity risk. T his is
because it involves the bank's ability to secure short-term debt, which is a liability, to fund its
operations.
Choi ce B i s i ncorrect because it also describes a situation related to funding liquidity risk. T he
risk that depositors will flock into banks and withdraw their funds or that shareholders will redeem
their shares en masse is a scenario that pertains to the ability of a firm to meet its liabilities. T his is a
characteristic of funding liquidity risk, which is concerned with the ability of a solvent institution to
make agreed-upon payments in a timely fashion. T his is different from market liquidity risk, which is
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concerned with the ability to sell an asset at its fair price.
Choi ce C i s i ncorrect because it describes a scenario that is more related to collateral and margin
requirements, which is not directly related to market liquidity risk. T he risk that the collateral value
of an asset will decline after a derivative position is established, resulting in an increase in the margin
requirement, is a risk associated with derivative trading and collateral management. While it may
have implications on liquidity, it does not directly describe market liquidity risk, which is concerned
with the ability to sell an asset at its fair price in the market.
Thi ngs to Remember
Funding liquidity risk and market liquidity risk are two distinct types of liquidity risks in the financial
markets. Funding liquidity risk is concerned with the ability of a firm to meet its liabilities. It
involves scenarios such as the inability of a bank to roll over a repo to finance their short-term cash
flow needs or the risk of mass withdrawals by depositors or redemptions by shareholders. T he
International Monetary Fund (IMF) defines funding liquidity as 'the ability of a solvent institution to
make agreed-upon payments in a timely fashion.'
On the other hand, market liquidity risk, also known as asset liquidity risk, is concerned with the
ability to sell an asset at its fair price. It involves scenarios such as the inability to execute a trade or
liquidate a position immediately at the best price due to market conditions. An example is when an
investor who lends out an asset is forced to sell it at a much lower price once the asset is returned
due to changes in market factors.
Q.3 In 2016, the United Kingdom made a historic decision to exit the European Union, a move
commonly referred to as 'Brexit'. Following this decision, the value of the British pound depreciated
against other major global currencies such as the U.S. dollar and the Chinese Yuan. Which one of the
following risks best explains this observation?
A. Interest rate risk
B. Foreign exchange risk
C. Reputation risk
D. Equity risk
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T he correct answer is B.
Foreign exchange risk, also known as currency risk, is a financial risk that arises from potential
changes in the exchange rate between two currencies. Investors who have investments in foreign
countries are exposed to this risk because the value of the foreign investments will decrease if the
currency of the investment's country weakens against their own domestic currency. In the context
of the question, the Brexit vote led to a decrease in the value of the British pound against other
currencies. T his is a classic example of foreign exchange risk. Investors who held assets
denominated in British pounds would have seen the value of those assets decrease when converted
back to their own domestic currency. T he uncertainty surrounding the economic impact of Brexit,
including potential disruptions to trade agreements and economic ties with the European Union,
contributed to the depreciation of the pound. T herefore, the risk that best explains the observation
in the question is foreign exchange risk.
Choi ce A i s i ncorrect because interest rate risk is the risk that the value of an investment will
decrease due to changes in the absolute level of interest rates, in the spread between two rates, in
the shape of the yield curve, or in any other interest rate relationship.
Choi ce C i s i ncorrect because reputation risk is the risk of loss resulting from damages to a firm's
reputation, in lost revenue; increased operating, capital or regulatory costs; or destruction of
shareholder value, consequent to an adverse or potentially criminal event even if the company is not
found guilty. Adverse events typically associated with reputation risk include ethics, safety, security,
sustainability, quality, and innovation. Reputation risk is more relevant to individual companies or
organizations and is often associated with the company's operational practices, ethical stance, or
response to a specific event or crisis.
Choi ce D i s i ncorrect because equity risk is the risk of loss because of a drop in the market price
of shares. Equity risk often refers to equity investment risk, which is the risk associated with the
investment in shares/stocks of a company. T his risk arises from fluctuations in the share price and
the risk of the issuer defaulting.
Thi ngs to Remember
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Financial risk management is a practice that involves identifying potential risks, measuring them, and
creating strategies to manage and mitigate those risks. It's important for businesses and investors to
understand the different types of financial risks and how they can affect their investments. T he four
types of risks mentioned in the question are all different types of financial risks, each with its own
characteristics and implications. Understanding these risks can help investors make informed
decisions and protect their investments. For example, an investor with a high exposure to foreign
exchange risk might consider using financial instruments like futures or options to hedge against
potential losses caused by currency fluctuations. Similarly, an investor with a high exposure to
interest rate risk might consider diversifying their portfolio to include a mix of fixed-income
securities with different maturities and credit qualities. Ultimately, effective financial risk
management involves a combination of knowledge, strategy, and careful monitoring of the financial
markets.
Q.4 Market risk, also known as systematic risk, is a type of risk that is inherent to the entire market
or market segment. Which of the following scenarios would be considered an example of market
risk?
A. Inadequate/malfunctioning computer systems
B. Circumvention of issued regulations and guidelines
C. Occurrence of a natural disaster, such as a tornado
D. An increase in the price of gas
An increase in the price of gas is an example of market risk, also known as systematic risk. T his is
the potential for an investor to experience losses due to factors that affect the overall performance
of financial markets. T hese factors are typically broad-based, beyond the control of individual
companies or investors, and impact a large number of assets simultaneously. It includes risks
associated with changes in interest rates, foreign exchange rates, commodity prices, and equity
prices. Market risk can affect the value of a portfolio or individual security, resulting in losses for
investors or traders.
Operational risk refers to the possibility of incurring losses resulting from operational breakdowns
caused by either internal or external factors. Operational risks include legal risk, anti-money
laundering risk, cyber risk, and rogue trading. Moreover, operational include corporate disasters such
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as operational mishaps and corporate governance scandals.
A i s i ncorrect. Inadequate/malfunctioning computer systems is an example of operational risk
because it refers to a failure within the organization's internal processes or systems that can result
in losses.
B i s i ncorrect. Circumvention of issued regulations and guidelines is an example of compliance
risk, which is a type of operational risk. Compliance risk refers to the possibility of incurring losses
due to non-compliance with laws, regulations, and internal policies and procedures.
C i s i ncorrect. Occurrence of a natural disaster, such as a tornado, is an example of operational
risk because it refers to the possibility of losses due to external events beyond the control of the
organization.
Thi ngs to Remember
Market risk, also known as systematic risk, is the risk that an investor's portfolio might suffer losses
due to broad market factors that affect the overall performance of financial markets. T hese factors
are typically beyond the control of individual companies or investors and impact a large number of
assets simultaneously. It includes risks associated with changes in interest rates, foreign exchange
rates, commodity prices, and equity prices. Market risk can be mitigated through diversification, as
the impact of market risk is reduced when investments are spread across different asset classes and
sectors.
Operational risk refers to the risk of loss resulting from inadequate or failed internal processes,
people, and systems, or from external events. T his includes legal risk but excludes strategic and
reputational risk. Operational risk can be managed through effective internal controls, risk
management systems, and business continuity planning.
Compliance risk is the potential for losses arising from non-compliance with laws or regulations.
T his can result from the company failing to follow laws, regulations, and guidelines, or from changes
in the regulatory environment. Compliance risk can be managed through effective compliance
programs, which include policies and procedures, training, monitoring, and reporting.
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Q.5 In the context of business operations, risk management plays a crucial role in ensuring the
stability and sustainability of an organization. One approach to risk management is the enterprise-
wide risk management. T his approach is characterized by certain features that distinguish it from
other risk management strategies. Based on your understanding of enterprise-wide risk management,
which of the following best describes enterprise-wide risk management?
A. Applying risk management within individual departments on a piecemeal basis.
B. Risk management that includes all major departments in a company.
C. A structured and consistent set of principles or risk management that are applied across
the whole of a company.
D. Risk management that encompasses all business units.
T he correct answer is C.
Enterprise-wide risk management involves the development of structured and consistent business
principles that govern the way different business units of a company do business, in regard to risk by
applying consistent risk management principles across the whole of a company, all risks, including
inter-departmental risks, are taken into account.
A i s i ncorrect: Applying risk management within individual departments on a piecemeal basis is a
silo approach in which different departments/business units are left to manage risks on their own
without considering the impact on other departments or the company as a whole.
B i s i ncorrect: Enterprise risk management includes not only major departments in a company but
also minor departments and all other areas of the company that may be exposed to risks.
D i s i ncorrect: Enterprise risk management involves applying risk management to all business
units, but it also includes a structured and consistent set of principles that guide the way risks are
identified, assessed, monitored, and managed across the entire organization.
Thi ngs to Remember
Enterprise-wide risk management is a holistic approach to managing risks that involves the entire
organization. It is not limited to certain departments or business units, but encompasses the entire
organization. T his approach ensures that all risks are identified, assessed, and managed in a consistent
and coordinated manner. It involves the development and application of a consistent set of risk
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management principles that are used throughout the company. T he goal of enterprise-wide risk
management is to create a risk-aware culture within the organization where every decision made
takes into consideration the potential risks and how they can be mitigated. T his approach allows for
better coordination and communication of risk management strategies and practices across all levels
of the organization, leading to more effective risk management.
Q.6 In financial markets, risk management plays a pivotal role in safeguarding investments and
financial activities from potential losses. It involves a series of activities that aim to create economic
value. Among the following options, which one best encapsulates the definition of risk management
in the context of financial markets?
A. T he practice of creating economic value by identifying and investing in risky projects that
could earn a profit.
B. T he practice of avoiding an extremely risky financial undertaking to prevent a loss.
C. T he practice of creating economic value by identifying and measuring risks, and

formulating robust plans to address and manage these risks.
D. Setting risk limits beyond which an entity should not operate.
Risk management in the context of financial markets involves identifying and measuring risks
associated with a business, both qualitatively and quantitatively, and formulating robust plans to
address and manage these risks. T he goal of risk management is to create economic value by
minimizing the negative impact of risks on the business while maximizing the positive outcomes of
risk-taking. T his involves a range of activities, including risk identification, risk assessment, risk
mitigation, risk monitoring, and risk reporting.
A i s i ncorrect: Risk management is not about investing in risky projects to earn a profit. Instead, it
is about identifying and managing risks associated with a business to minimize negative outcomes and
maximize positive outcomes.
B i s i ncorrect: Risk management is not about avoiding all risky financial undertakings to prevent a
loss. Instead, it is about identifying and managing risks associated with a business to minimize negative
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outcomes and maximize positive outcomes.
D i s i ncorrect: Setting risk limits is an important part of risk management, but it is not the only
aspect. Risk management also involves risk identification, risk assessment, risk mitigation, risk
monitoring, and risk reporting.
Thi ngs to Remember
Risk management is a comprehensive process that involves identifying, assessing, mitigating,
monitoring, and reporting risks. It is not about avoiding risk entirely or merely setting risk limits.
Instead, it is about managing risks in a way that minimizes negative outcomes and maximizes positive
outcomes. T his involves a range of activities, including risk identification (identifying potential risks
that could negatively impact the business), risk assessment (evaluating the likelihood and potential
impact of these risks), risk mitigation (developing strategies to manage these risks), risk monitoring
(keeping track of the identified risks and the effectiveness of the mitigation strategies), and risk
reporting (communicating information about the risks and the risk management activities to relevant
stakeholders). By understanding and effectively managing risks, businesses can create economic
value and ensure their long-term sustainability.
Q.7 Tohonday, a motor vehicle production company, has historically channeled most of its earnings
and spare cash into short-term government bonds maturing in less than a year. T he board wishes to
change its investment policy substantially and intends to tap the riskier but more profitable long-term
bond market. Assuming you're the risk manager for the company, which of the following risks would
be of utmost (immediate) concern from an operational point of view?
A. T rading liquidity risk
B. Funding liquidity risk
C. Interest rate risk
D. Market risk
Financial institutions do not always fail because of the inability to generate a profit. Rather, it's the
inability to meet short-term financial obligations that often leads to bankruptcy. T his is known as
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fundi ng l i qui di ty ri sk . Suppose Tohonday decides to invest in long-term assets, in that case, it
must take into account its day-to-day funding requirements, especially because funds invested in long-
term assets cannot be realized quickly enough to meet short-term debts and other unforeseen
obligations, such as lawsuits. Northern Rock, a significant UK mortgage lender, encountered a severe
funding liquidity crisis in 2007, a situation that signaled the onset of the global financial crisis. T he
bank heavily relied on wholesale markets instead of depositor funds to finance its mortgage lending, a
strategy that backfired amidst the global credit crunch triggered by the US subprime mortgage crisis.
With most of its assets tied up in long-term mortgages, Northern Rock found itself unable to liquidate
these assets swiftly enough to meet its short-term obligations, particularly the short-term debts it
had incurred to finance long-term loans. T his liquidity crisis led to the first bank run in the UK in
over a century, resulting in a loss of customer confidence, a government bailout, and eventually
nationalization in February 2008.
A i s i ncorrect.T rading liquidity risk (also called market liquidity risk) is the risk associated with the
inability of a firm to execute transactions at the prevailing market price. It may reduce the
institution's ability to hedge market risk, and also it is the capacity to liquidate assets when
necessary.
C i s i ncorrect: Interest rate risk is the risk that arises from fluctuations in the market interest
rates, which may cause a decline in the value of interest-rate-sensitive portfolios.
D i s i ncorrect: Market risk is the risk that results due to movements in market prices and rates.
Thi ngs to Remember
When a company decides to change its investment strategy, it must consider a variety of risks. In the
case of Tohonday, the company's decision to invest in long-term bonds introduces several new risks,
including trading liquidity risk, interest rate risk, and market risk. However, the most immediate
concern for the company should be its funding liquidity risk. T his is because the company's ability to
meet its short-term financial obligations is crucial for its survival. If the company invests its funds in
long-term assets, it may not be able to quickly convert these assets into cash to meet its short-term
debts and other unexpected liabilities. T herefore, when changing its investment strategy, the
company must carefully consider its funding needs and ensure that it has sufficient liquidity to meet
its short-term obligations.
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Q.8 In financial risk management, particularly in relation to credit risk, two key concepts are
'expected loss' and 'unexpected loss'. T hese terms are used to estimate potential credit losses and
are integral to the risk management strategies of financial institutions. Which of the following
accurately differentiates between expected loss and unexpected loss?
A. Expected loss is the average credit loss we expect from an exposure while unexpected
loss is the loss that occurs over and above the expected loss.
B. Unexpected loss is the average credit loss we expect from an exposure while expected
loss is the loss that occurs over and above the unexpected loss.
C. Expected loss is the average credit loss that we would expect from an exposure while
unexpected loss is the loss that would occur without a quantitative expression.
D. Expected loss is the average credit loss that we would expect from an exposure while
unexpected loss is the sum of expected losses from several time periods.
T he correct answer is A.
Expected l oss is the average credit loss that we would expect from an exposure over a given
period of time. It is calculated as the product of the probability of default (PD), the loss given default
(LGD), and the exposure at default (EAD). Expected loss is a key component of credit risk
management and is used to estimate the amount of capital that a bank needs to hold to cover potential
credit losses.
Unexpected l oss is the amount of loss that actually exceeds the expected amount. It is the
difference between the expected loss and the actual loss incurred. Unexpected loss is also known as
the tail risk or the potential loss in extreme scenarios. It represents the risk that the actual losses
may be much higher than the expected losses, which can have a significant impact on a bank's capital
and profitability.
Choi ce B i s i ncorrect. It reverses the definitions of expected loss and unexpected loss.
Choi ce C i s i ncorrect. Unexpected loss is quantitatively expressed as the difference between the
expected loss and the actual loss incurred. It is not a nebulous or unquantifiable concept, but a
specific measure used in financial risk management.
Choi ce D i s i ncorrect. Unexpected loss is not a cumulative measure of expected losses over time.
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Instead, it is the difference between the expected loss and the actual loss incurred in a given period.
Thi ngs to Remember
Expected loss and unexpected loss are fundamental concepts in financial risk management,
particularly in relation to credit risk. Understanding the difference between these two measures is
crucial for effective risk management. Expected loss is a measure of the average credit loss that a
financial institution expects from an exposure over a given period of time. It is a key component of
credit risk management and is used to estimate the amount of capital that a bank needs to hold to
cover potential credit losses.
Unexpected loss, on the other hand, is the amount of loss that exceeds the expected loss. It
represents the risk that the actual losses may be much higher than the expected losses, which can
have a significant impact on a bank's capital and profitability. Unexpected loss is also known as tail
risk or the potential loss in extreme scenarios.
Both expected loss and unexpected loss are calculated using statistical models and historical data.
T hey are used to estimate potential credit losses and to develop risk management strategies.
Misunderstanding or misrepresenting these concepts can lead to inaccurate risk assessments and
ineffective risk management strategies.
Q.9 T he concept of risk and reward is a fundamental principle that governs investment decisions.
T his principle suggests a certain relationship between the level of risk an investor is willing to take
and the potential reward they might receive. Which of the following statements accurately describes
this relationship between investment risk and potential reward?
A. As the investment risk increases, the reward decreases.
B. As the investment risk decreases, the reward increases.
C. As the investment risk increases, the potential for reward increases.
D. T he relation between investment risk and reward depends on the financial product.
T he principle of risk-reward tradeoff in finance suggests that the potential for higher returns comes
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with a higher level of risk. T his means that as the investment risk increases, the potential for reward
also increases. However, it's important to note that higher risk doesn't guarantee higher returns; it
merely provides the potential for higher returns. T he actual outcome may still result in a loss. T his
is because the risk in investments is the uncertainty that an investment's actual future returns will
deviate from its expected returns. T he greater the degree of risk, the greater the possible deviation
from the expected return, and thus the greater the range of possible outcomes, including both losses
and gains. T herefore, investors who are willing to accept higher levels of risk do so with the
expectation of achieving higher potential returns.
A i s i ncorrect because, typically, risk and potential reward are directly related, not inversely. If
you're taking on more risk, it's usually because you expect the possibility of a higher return to
compensate for that risk. T his doesn't guarantee a higher return, but the potential is greater.
B i s i ncorrect because it contradicts the basic principle of the risk-reward tradeoff. Lower-risk
investments generally yield lower potential returns. For example, a government bond (low risk)
typically offers lower returns than investing in a new tech startup (high risk).
D i s i ncorrect because it suggests there is no general correlation between risk and reward in
investments, and it boils down to individual assets. While the specific level of risk and potential
reward can vary between different financial products, the general principle that higher risk is
associated with a higher potential for reward holds true across virtually all types of investments.
Thi ngs to Remember
T he risk-reward tradeoff is a fundamental concept in finance that suggests a direct relationship
between the level of risk an investor is willing to take and the potential reward they might receive.
T his principle is based on the premise that in order to achieve higher potential returns, an investor
must be willing to accept a higher level of risk. However, it's important to note that higher risk
doesn't guarantee higher returns; it merely provides the potential for higher returns. T he actual
outcome may still result in a loss. T his is because the risk in investments is the uncertainty that an
investment's actual future returns will deviate from its expected returns. T he greater the degree of
risk, the greater the possible deviation from the expected return, and thus the greater the range of
possible outcomes, including both losses and gains. T herefore, investors who are willing to accept
higher levels of risk do so with the expectation of achieving higher potential returns.
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Q.10 Credit risk is a primary category that encompasses several sub-types of risk. Among the
following options, which one would most likely be classified as credit risk?
A. Commodity price risk
B. Currency exchange risk
C. Interest rate risk
D. Default risk
Default risk is a form of credit risk. It refers to the risk that a borrower will not be able to meet
scheduled repayments of interest or principal on a debt obligation. T his is the most direct form of
credit risk. In such a case, the lender or investor may lose the principal and interest, disrupt cash
flows, and increase the cost of collection. Default risk is a significant factor in determining the
interest rate on a loan or on a bond.
A i s i ncorrect. Commodity price risk is a form of market risk, not credit risk. It refers to the
uncertainty stemming from changes in the price of a commodity.
B i s i ncorrect. Currency exchange risk, also known as foreign exchange risk, it is a market risk
posed by an exposure to unanticipated changes in the exchange rate between two currencies.
Businesses that operate internationally often face currency exchange risk.
C i s i ncorrect. Interest rate risk is the risk that an investment's value will change due to a change
in the absolute level of interest rates, the spread between two rates, or the shape of the yield curve.
While this risk can impact the value of fixed-income investments (like bonds) and therefore
indirectly impact a borrower's ability to repay debt, it is considered a type of market risk rather than
a form of credit risk.
Thi ngs to Remember
Credit risk is a significant category of risk in financial risk management. It primarily deals with the
potential that a borrower may not fulfill their contractual debt obligations. T here are several sub-
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types of credit risk, including default risk, which is the risk that a borrower will not be able to meet
scheduled repayments of interest or principal on a debt obligation. Understanding these different
types of risks is crucial for any financial institution or individual involved in lending or investing
activities.
It's also important to note that not all financial risks fall under the category of credit risk. Other
categories of financial risk include market risk (which includes commodity price risk, currency
exchange risk, and interest rate risk) and operational risk. Each of these categories of risk requires
different risk management strategies and techniques. T herefore, a comprehensive understanding of
the different types of financial risks and how to manage them is crucial for anyone involved in
financial decision-making.
Q.11 In risk management, risks are often categorized as either quantifiable or non-quantifiable.
Quantifiable risks can be measured in numerical terms and are often associated with financial or
market risks. Non-quantifiable risks, on the other hand, are difficult to measure numerically and are
often associated with event or operational risks. Given this context, which of the following pairs
correctly associates a quantifiable risk with a non-quantifiable risk?
A. Quantifiable: Interest rate risk; Non-quantifiable: Default risk
B. Quantifiable: Civil war; Non-quantifiable: Liquidity risk
C. Quantifiable: Equity price risk; Non-quantifiable: Risk of terrorist attack
D. Quantifiable: Civil war; Non-quantifiable: Settlement risk
Equity price risk is a quantifiable risk because it can be measured in numerical terms. For instance,
if a stock's price drops from $100 to $90, the equity price risk is quantifiable as a 10% loss. On the
other hand, the risk of a terrorist attack is a non-quantifiable risk. It's a type of event risk that is
inherently unpredictable and difficult to measure numerically. Its impact on investments is uncertain
and cannot be precisely quantified.
Opti on A i s i ncorrect because both interest rate risk and default risk are quantifiable risks.
Interest rate risk, the risk that an investment's value will change due to a change in the absolute
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level of interest rates, can be measured in numerical terms. Default risk, the risk that a borrower
will be unable to make the required payments on their debt obligations, can also be quantified, often
using credit ratings or credit spreads.
Opti on B i s i ncorrect because civil war is a non-quantifiable risk, while liquidity risk is a
quantifiable risk. A civil war is a type of political risk that is inherently uncertain and hard to
quantify. On the other hand, liquidity risk, the risk of not being able to quickly realize an investment
without a substantial loss in value, can be quantified in terms of bid-ask spread, market depth, or
impact cost.
Opti on D i s i ncorrect because civil war is a non-quantifiable risk due to its unpredictable nature
and broad impacts. Settlement risk, the risk that one party will fail to deliver the terms of a contract
with another party at the time of settlement, can be quantified, often in terms of potential losses if a
counterparty defaults at various points during the settlement process.
Thi ngs to Remember
1. Quantifiable risks are those that can be measured in numerical terms. T hey are often associated
with financial or market risks, such as interest rate risk, equity price risk, and liquidity risk. T hese
risks can be managed using financial hedging strategies, such as derivatives and portfolio
diversification.
2. Non-quantifiable risks are those that are difficult to measure numerically. T hey are often
associated with event or operational risks, such as the risk of a terrorist attack or civil war. T hese
risks are unpredictable and their impacts on investments are uncertain. T hey are often managed
through insurance, contingency planning, and other risk mitigation strategies.
3. Risk management involves identifying, assessing, and managing both quantifiable and non-
quantifiable risks. It is a critical practice in finance and investment to safeguard against potential
losses.
Q.13 A public company is evaluating several projects for potential implementation. T he risk manager,
during his appraisal, identifies that some of these projects may lead to conflicts with the Food and
Drug Administration due to potential ethical issues and violations of human safety standards. Which
type of risk is the company primarily exposed to in this situation?
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A. Operational risk
B. Credit risk
C. Market risk
D. Liquidity risk
Operational risk refers to the risk of loss resulting from inadequate or failed internal processes,
people, and systems, or from external events. In this scenario, if the company's projects could
potentially violate ethical standards and safety regulations, leading to conflicts with the Food and Drug
Administration (FDA), this would be classified as an operational risk. T his is because these issues
stem from the company's internal operations and processes. It's also worth noting that regulatory
compliance is a key aspect of operational risk.
Opti on B i s i ncorrect: Credit risk is the possibility of a loss resulting from a borrower's failure to
repay a loan or meet contractual obligations. In this scenario, the company's potential conflicts with
the FDA do not involve the risk of not receiving payment from a borrower or counterparty, so credit
risk does not apply.
Opti on C i s i ncorrect: Market risk, also called systematic risk, refers to the risk that the value of
an investment will decrease due to changes in market factors such as interest rates, stock prices, or
exchange rates. T he scenario presented doesn't involve these factors.
Opti on D i s i ncorrect: Liquidity risk is the risk that a company or individual will not be able to
meet short-term financial demands. T his could occur because the individual or company cannot
convert an asset to cash without a substantial loss in value. In the context of the question, the
company's potential regulatory issues with the FDA have nothing to do with its ability to quickly
convert assets to cash to meet immediate financial obligations.
Thi ngs to Remember
Risk management is a critical aspect of any business operation. It involves identifying, assessing, and
prioritizing risks, and implementing strategies to manage or mitigate them. T he four major types of
risk mentioned in the question - operational, credit, market, and liquidity risk - are all integral parts of
18
risk management. Understanding these risks and how they can impact a business is crucial for
effective risk management. It's also important to note that these risks are not mutually exclusive and
can often be interconnected. For example, a company facing operational risk due to regulatory issues
may also face liquidity risk if it has to pay hefty fines. T herefore, a comprehensive approach to risk
management that considers all types of risks and their potential interactions is essential for the long-
term success of a business.
Q.14 In finance and investment, risks are often categorized into different types based on their nature
and impact. T wo such categories are systemic risks and specific risks. T hese two types of risks
differ in terms of their scope and the entities they affect. T he difference between systemic and
specific risks is that:
A. Systemic risk refers to the risks that affect the entire economy, while specific risks are
risks that affect only a particular company or line of business.
B. Systemic risks are risks borne by a single entity while specific risks are borne by the
economy as a whole.
C. Systemic risks are quantifiable while specific risks are non-quantifiable.
D. Systemic risk is diversifiable while specific risk is non-diversifiable.
Systemic risk and specific risk are two fundamental concepts in finance and investment. Systemic
risk refers to the risk that can affect the entire economy. It is often associated with significant
events or disruptions that have far-reaching impacts, such as the failure of a major financial
institution, a significant disruption in a critical market or infrastructure, global pandemics, natural
disasters, and geopolitical events that can disrupt global trade and financial flows. T hese risks are
non-diversifiable, meaning they cannot be eliminated through diversification. On the other hand,
specific risks are risks that affect only a particular company or line of business. T hese risks are
often related to the company's operations, management, or industry-specific factors. Examples of
specific risks include product recalls, labor strikes, and changes in consumer preferences. Unlike
systemic risks, specific risks are typically diversifiable, meaning that investors can reduce their
exposure to these risks by investing in a diversified portfolio of assets.
Choi ce B i s i ncorrect because it reverses the definitions of systemic and specific risks. Systemic
risks are not borne by a single entity; instead, they affect the entire economy. Conversely, specific
risks are not borne by the economy as a whole; they are risks that affect only a particular company
or line of business.
19
Choi ce C i s i ncorrect because it inaccurately suggests that systemic risks are quantifiable while
specific risks are non-quantifiable. Both systemic and specific risks can be quantified, albeit with
varying degrees of precision. Systemic risks can be quantified using macroeconomic indicators and
financial market data, while specific risks can be quantified using company-specific data and industry
analysis.
Choi ce D i s i ncorrect because it inaccurately suggests that systemic risk is diversifiable while
specific risk is non-diversifiable. In fact, the opposite is true. Systemic risks, which affect the entire
economy, are non-diversifiable, meaning they cannot be eliminated through diversification. On the
other hand, specific risks, which affect only a particular company or line of business, are
diversifiable.
Thi ngs to Remember
Understanding the difference between systemic and specific risks is crucial for investors and
financial professionals. Systemic risks, which affect the entire economy, are non-diversifiable and
can have far-reaching consequences. T hey are often associated with significant events or
disruptions, such as the failure of a major financial institution or a significant disruption in a critical
market or infrastructure. On the other hand, specific risks, which affect only a particular company
or line of business, are diversifiable and can be managed through diversification strategies. T hese
risks are often related to the company's operations, management, or industry-specific factors. By
understanding these differences, investors can better manage their risk exposure and make more
informed investment decisions.
Q.15 Financial institutions are constantly striving to maintain and enhance the trust and confidence of
their stakeholders, which include customers, lenders, shareholders, among others. T his trust is
crucial as it ensures that each party feels secure about their interests. What type of risk is most
relevant that companies need to manage to ensure the confidence of all stakeholders is not
compromised?
A. Legal and regulatory risk
B. Reputation risk
C. Specific risk
20
D. Operational risk
Reputation risk refers to potential losses and negative impacts to a firm's financial condition and
overall operations due to damage to its reputation. T his damage can be the result of a failure to meet
stakeholders' expectations, which can be caused by a wide range of events, such as legal issues, poor
customer service, unethical conduct, poor governance, or operational failures. If stakeholders lose
confidence in a company, it can lead to lost business, legal issues, a drop in share price, and other
negative outcomes.
Opti on A i s i ncorrect: Legal and regulatory risk refers to the potential for losses due to non-
compliance with laws or regulations. While such non-compliance could harm a company's reputation,
it's a more specific type of risk that doesn't necessarily address the broader issue of stakeholder
confidence in the company.
Opti on C i s i ncorrect: Specific risk, also known as unsystematic risk or idiosyncratic risk, refers
to the risk associated with individual assets within a portfolio, as opposed to the market as a whole.
T hese risks can be mitigated through diversification. Specific risk is not directly related to the
general confidence of stakeholders in a company's ability to safeguard their interests.
Opti on D i s i ncorrect: Operational risk is the risk of loss resulting from inadequate or failed
internal processes, people, and systems, or from external events. While failures in these areas could
impact stakeholder confidence, it doesn't fully capture the broader idea of maintaining stakeholder
confidence across all aspects of a company's operations.
Thi ngs to Remember
Reputation risk is a crucial aspect of risk management for any company, especially financial
institutions. It is directly linked to the confidence and trust of stakeholders in the company. A
company's reputation can be damaged by various factors, including legal issues, poor customer
service, unethical conduct, poor governance, or operational failures. T herefore, companies need to
have robust risk management strategies in place to manage and mitigate reputation risk. T his includes
having strong corporate governance structures, ethical business practices, effective customer
service, and compliance with all relevant laws and regulations. Additionally, companies should also
21
have crisis management plans in place to manage any potential damage to their reputation.
Q.31 In the context of credit risk, which of the following statements best distinguishes between
expected loss (EL) and unexpected loss (UL)?
A. Expected loss is the average loss that occurs due to defaults, while unexpected loss is the
maximum possible loss due to defaults.
B. Expected loss is the potential loss during normal market conditions, while unexpected loss
is the potential loss during extreme market events.
C. Expected loss is the average loss that a bank anticipates to occur due to credit events,
while unexpected loss represents the variability around that average.
D. Expected loss is the loss incurred from credit events that have already occurred, while
unexpected loss is the loss from potential future credit events.
Expected loss (EL) and unexpected loss (UL) are two fundamental concepts in credit risk
management. Expected loss is the average loss that a financial institution anticipates to occur due to
credit events such as defaults or delinquencies. It is calculated as the product of the probability of
default (PD), exposure at default (EAD), and loss given default (LGD). T his means that it is a measure
of the average loss that the bank expects to incur over a certain period due to credit events. On the
other hand, unexpected loss represents the variability or uncertainty around the expected loss. It is
the potential deviation from the average loss and is usually associated with extreme or rare credit
events. While banks typically set aside provisions to cover expected losses, they maintain capital
buffers to absorb unexpected losses.
Choi ce A i s i ncorrect. While expected loss does refer to the average loss due to defaults,
unexpected loss is not the maximum possible loss. Instead, it represents the variability or
uncertainty around that average.
Choi ce B i s i ncorrect. Expected and unexpected losses are not differentiated by normal versus
extreme market conditions. Rather, expected loss refers to anticipated losses from credit events,
while unexpected loss measures the potential deviation from this expectation.
22
Choi ce D i s i ncorrect. Expected loss does not pertain only to losses from already occurred credit
events; it also includes anticipated future credit events based on historical data and models.
Unexpected loss refers to potential deviations from these expectations due to unforeseen
circumstances or errors in prediction.
23
Q.33 T he purpose of economic capital is to absorb:
A. economic losses
B. expected loss
C. unexpected loss
D. tail loss
Economic capital is designed to absorb unexpected losses. T hese are losses that are not anticipated
and can occur due to various unforeseen circumstances. T he concept of economic capital is based
on the premise that a bank or financial institution should have enough capital to absorb such losses
and continue its operations without any significant disruption. T his is why economic capital is often
calculated based on a certain level of confidence, which represents the probability that the capital
will be sufficient to cover the unexpected losses.
It's important to note that economic capital is not a fixed amount. It varies depending on the risk
profile of the bank or financial institution. T he higher the risk, the more economic capital is needed.
Choi ce A i s i ncorrect. Economic capital does not serve the purpose of economic losses.
Economic losses are a result of poor financial decisions or market downturns, which are not directly
related to the concept of economic capital.
Choi ce B i s i ncorrect. Economic capital does not cover expected loss. Expected loss is typically
covered by provisions and reserves set aside as part of normal business operations, and it's not the
primary purpose of economic capital.
Choi ce D i s i ncorrect. While tail loss refers to extreme events with low probability but high
impact, it's too specific to be the main purpose of economic capital. Economic capital serves a
broader role in covering unexpected losses that may arise from various sources, not just extreme
events.
24
Q.34 Which of the following is NOT the definition of risk measurement tools and procedures used by
a firm to measure and manage risk?
A. VAR is the maximum loss over a target horizon such that there is a low, prespecified
probability that the actual loss will be larger.
B. Scenario Testing is a quantitative risk measurement that takes into consideration potential
risk factors such as interest rate, payroll data, etc. that are often quantifiable and focussed
on frequency.
C. Stress Testing is both a qualitative and quantitative risk measurement tool that analyses
the financial outcome of a firm based on a given stress
D. Enterprise Risk Management (ERM) is an integrative risk measure approach that

considers entity-wide risk factors and integrates all the risk factors in entity-wide decisions
T he definition provided for Scenario Testing is not accurate. Scenario Testing, in the context of risk
management, is a tool that considers potential risk factors that are often quantifiable. However, the
focus of Scenario Testing is not on frequency, as stated in the option, but rather on severity. It is
used to assess the potential severity of a risk by considering various hypothetical scenarios. T he
scenarios are designed to mimic possible situations that the firm might face, and the impact of these
situations on the firm's financial health is then assessed. T his allows the firm to prepare for a variety
of potential risks and to develop strategies to mitigate these risks.
Choi ce A i s i ncorrect. Value at Risk (VaR) is indeed defined as the maximum loss over a target
horizon such that there is a low, pre-specified probability that the actual loss will be larger. T his
definition accurately represents VaR's purpose and function in risk management.
Choi ce C i s i ncorrect. Stress Testing does involve both qualitative and quantitative risk
measurement tools to analyze the financial outcome of a firm based on given stress scenarios. It
helps firms understand their vulnerability to adverse events or market conditions.
Choi ce D i s i ncorrect. Enterprise Risk Management (ERM) accurately describes an integrative
approach to risk management that considers entity-wide risk factors and integrates all these risks
into entity-wide decisions. ERM aims to manage risks and seize opportunities related to the
achievement of an organization's objectives.
25
Q.35 T he relationship between risk and return is simple for some assets and complex for others.
T he public perception of risk and return trade-off is that higher risk will lead to higher returns.
However, in some asset classes like fixed-income securities, a large number of factors such as
market risk, inflation, interest rate risk, and risk tolerance are considered. Which of the following
options is most appropriate for a market with investors having a high risk tolerance?
A. As the risk tolerance of investors is high, more investors will choose corporate bonds
over government bonds
B. As the risk tolerance of investors is high, more investors will choose government bonds
over corporate bonds
C. As the risk tolerance of investors is high, all investors will choose a good mix of corporate
and government bonds
D. As the risk tolerance of investors is high, all investors will choose not to buy corporate
bonds
When investors have a high tolerance for risk, they are more likely to invest in assets that offer
higher potential returns despite the increased risk. Corporate bonds typically offer higher yields than
government bonds to compensate for the additional risk. T his risk comes from the possibility that
the issuing corporation may default on its obligations. T herefore, in a market where investors have a
high risk tolerance, it is reasonable to expect that more investors will choose corporate bonds over
government bonds. T his is because these investors are willing to accept the higher risk associated
with corporate bonds in exchange for the potential of higher returns.
Choi ce B i s i ncorrect. T his choice suggests that investors with a high risk tolerance would prefer
government bonds over corporate bonds. However, this contradicts the general understanding of risk
and return in finance. Government bonds are typically considered safer investments with lower
returns, while corporate bonds carry higher risk but also offer higher potential returns. T herefore,
investors with a high tolerance for risk would be more likely to choose corporate bonds over
government ones.
Choi ce C i s i ncorrect. While it's true that diversification can help manage risk, this choice
assumes that all investors will choose a mix of corporate and government bonds regardless of their
individual risk tolerances. T his is not necessarily the case as some high-risk tolerant investors might
prefer to invest more heavily in higher-risk assets like corporate bonds for potentially greater
26
returns.
Choi ce D i s i ncorrect. T his option suggests that all high-risk tolerant investors will avoid buying
corporate bonds altogether which contradicts the basic principles of investment theory where
higher risks are associated with potentially higher returns. Investors who have a high tolerance for
risk are generally more willing to invest in risky assets such as corporate bonds because they offer
the potential for greater return.
27
Q.36 Equity price risk is the type of market risk that refers to the variability in the prices of equity
or stocks. Equity price risk is further subdivided into specific risk and systematic risk. Which of the
following is most likely a type of specific risk?
A. T he risk of changes in the consumer price index (CPI).
B. T he risk of change in the aggregate demand of a specific sector.
C. T he risk of strategic weaknesses in a business.
D. T he risk of changes in tax rates.
T he risk of strategic weaknesses in a business is a type of specific risk. Specific risk, also known as
unsystematic risk, idiosyncratic risk, or diversifiable risk, refers to the risk associated with
individual stocks in a portfolio. T his risk can be reduced or eliminated from a portfolio through
diversification. Strategic weaknesses in a business, such as poor management decisions, failed
investments, or operational inefficiencies, are examples of specific risks as they directly impact the
individual business and not the entire market.
Choi ce A i s i ncorrect. T he risk of changes in the consumer price index (CPI) is a type of
systematic risk, not specific risk. Systematic risks are market-wide risks that affect all companies,
such as inflation or interest rate changes. Changes in CPI represent inflationary trends and impact all
firms rather than a specific one.
Choi ce B i s i ncorrect. T he risk of change in the aggregate demand of a specific sector also falls
under systematic risk as it affects all companies within that sector and not just one particular
company.
Choi ce D i s i ncorrect. T he risk of changes in tax rates is another example of systematic risk
because tax policies usually apply to an entire economy and thus affect all businesses operating
within that economy, not just one particular firm.
28
Q.37 BT Motors and New Atlas bank are two parties of a derivative contract to hedge exchange rate
risk. At the end of the contract, BT Motors has a net loss position of $6.9 million but refused to pay
the entire amount. Which of the following sub-types of credit risk best describes this situation?
A. Bankruptcy risk.
B. General market Risk.
C. Settlement risk.
D. Default risk.
Settlement risk is a type of credit risk that arises when one party in a transaction fails to honor their
financial obligations on the settlement date. In the context of the scenario described, BT Motors,
despite being in a net loss position of $6.9 million, refuses to pay the entire amount. T his refusal to
fulfill their financial commitment is a clear example of settlement risk. Settlement risk is a
significant concern in financial transactions, particularly in derivative contracts like the one
between BT Motors and New Atlas bank. It can lead to substantial financial losses for the party that
is left unpaid, in this case, New Atlas bank. T herefore, it is crucial for financial institutions to
manage and mitigate settlement risk effectively to protect their financial interests.
Choi ce A i s i ncorrect. Bankruptcy risk refers to the risk that a firm will be unable to meet its
financial obligations due to insolvency. While BT Motors is refusing to pay, there's no information
suggesting it's because they are insolvent or facing bankruptcy.
Choi ce B i s i ncorrect. General market risk refers to the potential for losses due to changes in
market conditions such as interest rates, exchange rates, commodity prices etc. In this case, while
the derivative contract was indeed meant as a hedge against exchange rate fluctuations, the issue at
hand isn't about general market risk but rather BT Motors' refusal to settle its obligations.
Choi ce D i s i ncorrect. Default risk pertains to the possibility that a party will not fulfill their
contractual obligations. Although BT Motors has not fulfilled its obligation by refusing payment, this
situation specifically relates more closely with settlement risk which involves one party fulfilling
their part of deal and other party failing/refusing to do so after conclusion of contract.
29
Q.5298 Which of the following definitions of bankruptcy risk is correct?
A. T he potential risk of harm to a company's brand or reputation resulting from negative

public perception or publicity.
B. T he potential risk of financial, operational, or reputational harm to a company resulting

from cyber threats or attacks.
C. T he likelihood that a company will become insolvent and unable to meet its financial
obligations to creditors and investors.
D. T he likelihood that a borrower will default on their debt obligations, resulting in financial
losses for the lender.
Bankruptcy risk refers to the probability that a company will become insolvent, meaning it will be
unable to meet its financial obligations to its creditors and investors. T his risk arises when a
company's liabilities exceed its assets, and it is unable to generate sufficient cash flow to fulfill its
financial commitments. Bankruptcy risk is a critical consideration for creditors, investors, and other
stakeholders, as it directly impacts their financial interests and decision-making processes.
Understanding and managing bankruptcy risk is a key aspect of financial risk management, and it
involves assessing a company's financial health, monitoring its cash flow and liabilities, and taking
proactive measures to mitigate potential risks.
Choi ce A i s i ncorrect. While harm to a company's brand or reputation can indeed have financial
implications, this does not directly relate to bankruptcy risk. Bankruptcy risk specifically pertains to
the likelihood of a company becoming insolvent and unable to meet its financial obligations, rather
than potential damage to its reputation.
Choi ce B i s i ncorrect. T his option describes cyber risk, which involves potential harm from
cyber threats or attacks. Although such risks could potentially lead to financial instability and even
bankruptcy if severe enough, they are not synonymous with bankruptcy risk itself.
Choi ce D i s i ncorrect. T his choice refers more closely to credit risk - the likelihood that a
borrower will default on their debt obligations - rather than bankruptcy risk. While these two types
of risks are related (as default can lead towards insolvency), they are distinct concepts within the
field of financial management.
30
Q.5299 An analyst is concerned about a decline in the bank's credit rating as this would result in an
increase in its cost of debt. Which of the following risks is the analyst concerned about?
A. Interest Rate Risk
B. Equity Price Risk
C. Bankruptcy Risk
D. Downgrade Risk
A financial analyst is analyzing a bank's financial health and is particularly worried about the potential
increase in the bank's cost of debt due to a possible decline in its credit rating. T his concern is
associated with which type of risk among the following options?
Q.5300 Which of the following risks is associated with uncertainties in demands, the cost of
production, and the cost of delivery of products?
A. Operational Risk
B. Business Risk
C. Strategic Risk
D. Liquidity Risk
Business risk is the risk associated with the uncertainties of operating a business. T hese
uncertainties can arise from various factors, including fluctuations in customer demand, changes in
production costs, and variations in delivery expenses. T he level of business risk a company faces can
significantly impact its profitability and financial stability. T herefore, effective management of
business risk is crucial for a company's success.
Business risk can be influenced by both internal and external factors. Internal factors include
operational efficiency, cost management, and product quality. External factors include market
conditions, customer preferences, and competitive landscape. Companies can manage business risk
31
by implementing effective strategic planning, optimizing production and delivery processes, and
maintaining a strong brand image.
It's important to note that while all businesses face some level of business risk, the degree of risk
can vary significantly depending on the industry, market conditions, and the specific business model
of the company.
Choi ce A i s i ncorrect. Operational risk refers to the risk of loss resulting from inadequate or
failed internal processes, people and systems, or from external events. It does not directly link to
uncertainties in customer demand, production costs, or delivery expenses.
Choi ce C i s i ncorrect. Strategic risk involves the potential for loss due to a company's strategic
business decisions such as mergers and acquisitions, partnerships, and geographic expansion. While
these decisions can indirectly affect customer demand and production costs, they are not directly
linked to these uncertainties.
Choi ce D i s i ncorrect. Liquidity Risk pertains to a company's ability to meet its short-term
financial obligations when they fall due without incurring unacceptable losses. T his type of risk does
not have a direct connection with uncertainties in customer demand or the cost of producing
goods/services.
32
Q.5303 Which statement best describes a benefit of using the Risk-Adjusted Return on Capital
(RAROC)?
A. It considers systemic risk.
B. It helps financial institutions allocate their capital effectively.
C. It considers non-financial risks, such as operational risk.
D. It is simple to calculate.
T he primary benefit of using the Risk-Adjusted Return on Capital (RAROC) is that it aids financial
institutions in effectively allocating their capital. T he RAROC metric is calculated by dividing the
risk-adjusted profit (net income minus expected losses and allocated capital costs) by the economic
capital, which represents the amount of capital required to cover unexpected losses given a specific
confidence level. By using RAROC, financial institutions can compare the risk-adjusted returns of
different investments or business units, allowing them to allocate capital more effectively and
pursue opportunities with the optimal balance of risk and return. T his helps in achieving a balance
between risk and return, and in making informed decisions about where to invest capital for
maximum return on investment.
Choi ce A i s i ncorrect. T he RAROC framework does not specifically consider systemic risk.
Systemic risk refers to the risk that could collapse an entire financial system or market, and it is not
directly incorporated into the RAROC model.
Choi ce C i s i ncorrect. While RAROC can be used to evaluate various types of risks, it primarily
focuses on financial risks rather than non-financial risks such as operational risk. T herefore, this
statement is not accurate.
Choi ce D i s i ncorrect. RAROC isn't necessarily simple to calculate as it requires complex
calculations and data inputs related to different types of risks and capital costs associated with a
particular investment or business decision.
33
Q.5304 Which of the following methods of risk management involves derivative products where a
company pays a premium to a party to accept a certain level of risk?
A. Avoiding the risk.
B. Retaining the risk.
C. T ransferring the risk.
D. Mitigating the risk.
T his method of risk management involves shifting the risk from one party to another. In the context
of the question, the company is transferring its risk to another party through the use of derivative
products. By paying a premium, the company is essentially buying insurance against a certain level of
risk. T he party receiving the premium is accepting the risk and is obligated to compensate the
company if the risk event occurs. T his method is commonly used in financial markets where risks
can be quantified and priced. It allows companies to focus on their core business activities without
worrying about potential financial losses from risks that can be transferred.
Choi ce A i s i ncorrect. Avoiding the risk involves not taking any action that could lead to the risk in
the first place. T his strategy does not involve paying a premium to transfer risk, but rather avoiding
situations or decisions that could potentially lead to financial instability.
Choi ce B i s i ncorrect. Retaining the risk means accepting and managing it internally within the
company, without transferring it to another party. In this case, there would be no need for a
derivative product or payment of a premium.
Choi ce D i s i ncorrect. Mitigating the risk involves taking steps to reduce its potential impact or
likelihood of occurrence, but not necessarily transferring it entirely as described in this scenario
with derivative products.
Q.5305 A risk analyst is analyzing a company’s risks. T he analyst is using the following factors: T he
probability of occurrence of a risk event, the size (severity) of the loss, and the exposure to risk.
Which of the following metrics is the analyst attempting to calculate?
34
A. Value at risk
B. Expected loss
C. Unexpected loss
D. Tail loss
Expected loss is a key metric in risk analysis that represents the average amount of loss that an
institution can anticipate to incur on a portfolio of assets over a specified time period. T he
calculation of expected loss involves three components: the probability of default (PD), the loss-
given default (LGD), and the exposure at default (EAD). T he probability of default represents the
likelihood of a risk event occurring. T he loss-given default is an estimate of the potential severity of
the loss if the risk event occurs. T he exposure at default represents the total value that is at risk if
the default occurs. By multiplying these three components together, the analyst can estimate the
expected loss, which provides a measure of the potential financial impact of the risk events that the
company is exposed to.
Choi ce A i s i ncorrect. Value at Risk (VaR) is a statistical technique used to measure and quantify
the level of financial risk within a firm or investment portfolio over a specific time frame. T his
metric is most commonly used by investment and commercial banks to determine the extent and
occurrence rate of potential losses in their institutional portfolios. However, it does not take into
account the severity of loss, which is one of the factors considered by the analyst.
Choi ce C i s i ncorrect. Unexpected Loss (UL) represents potential loss due to unexpected events
or risks that are not covered under normal business operations or risk models. While this metric
does consider both likelihood and severity, it doesn't factor in overall exposure to risk as required by
our analyst's comprehensive assessment.
Choi ce D i s i ncorrect. Tail Loss refers to risks occurring at the tail end of a distribution curve -
these are extreme events with low probability but high impact. While this concept considers
severity, it doesn't necessarily incorporate likelihood or overall exposure in its calculation making it
an unsuitable choice for our analyst's needs.
35
Q.5306 An analyst is calculating the expected loss using the following information.
Probability of default 2%
Loss given default 50%
Z-Score 1.645
Standard deviation 2.59
Exposure at default $1, 000, 000
T he expected loss is closest to?
A. $20,000
B. $500,000
C. $10,000
D. $51,800
T he expected loss is calculated by multiplying the probability of default (PD) by the loss given default
(LGD) and the exposure at default (EAD).
Expected Loss = P D × LGD × EAD

= 2% × 50% × $1, 000, 000
= $10,000
36
Reading 2: How Do Firms Manage Financial Risk?
Q.17 A Canadian company harbors an ambitious plan to launch a project in the U.S. in twelve months.
T he company uses the Canadian dollar as the functional currency, and the project would most likely
be executed in U.S. dollars. However, the company's top management is worried that the CAD will
weaken against the USD in the months leading up to the beginning of the project, which might, in
turn, increase the amount the company will have to pay for the project. As the company's risk
manager, which of the following business strategies would work best regarding the foreign exchange
risk?
A. Launching the project earlier than planned.
B. Take a hedging position in the form of a currency futures contract.
C. Advise the company to purchase stock index futures.
D. Immediately pay for some upfront costs of the project.
A lot can change in 12 months. If the USD appreciates significantly against the CAD, the project will
become more expensive, and its internal rate of return will decrease. To hedge that risk, the
company could take a position in a currency futures contract to lock in the value of the CAD versus
the USD.
Opti on A i s i ncorrect: Launching the project earlier than planned, may help for some time but
the company will still suffer when the CAD depreciates over the USD.
Opti on C i s i ncorrect: purchasing stock index futures is used to hedge against the risk of
fluctuation in market prices.
Opti on D i s i ncorrect: Paying for some upfront costs of the project immediately may reduce
future costs however, the company will still suffer from the effects of the currency depreciation.
Thi ngs to Remember
Foreign exchange risk, also known as currency risk, is a financial risk that arises from potential
changes in the exchange rate between two currencies. Companies that do business internationally
are exposed to this risk because the value of their foreign revenues and expenses can fluctuate due
to changes in exchange rates. T here are several strategies that companies can use to manage foreign
37
exchange risk, including forward contracts, futures contracts, options, and swaps. T hese financial
instruments allow companies to hedge their currency risk by locking in the exchange rate for a
future date. It's important to note that while these strategies can provide protection against
currency fluctuations, they also involve costs and can limit the potential upside from favorable
currency movements. T herefore, companies need to carefully consider their risk tolerance and
financial objectives when deciding how to manage their foreign exchange risk.
38
Q.18 In risk management, the term 'hedging' is often used to describe a specific strategy aimed at
protecting the value of an asset or portfolio against potential losses due to market fluctuations.
Which of the following options most accurately captures the essence of this concept?
A. Buying an asset to offset a decline in value of another asset.
B. Holding an asset that appreciates in value to offset the decrease in the value of another
asset.
C. Selling a loss-making asset and replacing it with a profitable one.
D. Holding an offsetting position in an asset or portfolio whose value we expect to move in

line with market changes.
Hedging entails any action taken to safeguard the value of an asset in the face of changing market
prices. It's actually an attempt to "lock-in" the value of an asset. T he investor protects their
investment by holding assets that have a predetermined future price.
Opti on A i s i ncorrect: Buying an asset to offset a decline in the value of another asset refers to
diversification.
Opti on B i s i ncorrect: Holding an asset that appreciates in value to offset the decrease in the
value of another asset is also a diversification method.
Opti on C i s i ncorrect: Selling a loss-making asset and replacing it with a profitable one is a form of
Profit/Loss strategy.
Thi ngs to Remember
Hedging is a risk management strategy employed to offset losses in investments by taking an opposite
position in a related asset. T he reduction in risk provided by hedging also typically results in a
reduction in potential profits. Hedging strategies typically involve derivatives, such as options and
futures contracts. Diversification and profit/loss strategies are different from hedging.
Diversification involves spreading investments around so that the performance of one investment
does not affect the overall performance of the portfolio. Profit/loss strategy involves selling assets
that are not performing well and replacing them with assets that are expected to perform better.
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Q.19 An international construction company places a bid for a major construction project. Top
management is convinced the company will secure the contract but are also wary of currency
fluctuations during the bids evaluation process, which would make the project more costly and
reduce the profit margin. Which of the following actions do you think can reduce this risk?
A. Negotiating the price of construction materials with sellers in advance
B. Purchasing construction materials in advance with the option to sell them if the bid turns
out unsuccessful
C. Getting into a currency futures contract
D. Adding a risk premium to the bid amount
Using a currency futures contract, the company can price the bid quoting current market rates and
then use the futures contract to hedge its exposure to currency fluctuation. T his way, the company
would ensure that even if the market rates change, the bid would be sufficient to undertake the
project and earn a profit.
Opti on A i s i ncorrect: prices may be negotiated in advance; however, without a contract, then you
will still buy the materials at the prevailing market prices in case the prices rise, since stocks may
also rise in price.
Opti on B i s i ncorrect: A lot may happen with time. T he price of the materials may rise, and
therefore purchasing construction materials in advance with the option to sell them if the bid turns
out unsuccessful will not help reduce the risk.
Opti on D i s i ncorrect: the owner of the project pays the risk premium in advance and if the risk
does not materialize, then this will only benefit the contractor of the project
Thi ngs to Remember
Currency risk, also known as exchange rate risk, is a financial risk that arises from potential changes
in the exchange rate of one currency in relation to another. Companies that conduct business
internationally are exposed to currency risk as the value of their revenues, costs, assets, and
liabilities can be affected by currency fluctuations. T here are several strategies that companies can
use to manage currency risk, including the use of financial derivatives like futures, forwards,
40
options, and swaps. T hese instruments allow companies to hedge their exposure to currency risk,
effectively locking in the exchange rate at which they can buy or sell a particular currency in the
future. T his can help protect the company's profit margins and ensure the financial viability of their
international operations.
Q.20 In a company's risk management strategy, the risk appetite statement plays a crucial role. It
outlines the types of risks the company is willing to take, the risk management tools it prefers to
use, and the maximum loss it is prepared to bear within a certain confidence limit and timeframe.
Given these elements, which of the following is most likely to be excluded from a company's risk
appetite statement?
A. T he types of risks the firm is willing to tolerate, specifying the risks to hedge and the ones
to assume
B. T he preferred risk management tools e.g, insurance, derivatives, etc.
C. T he maximum loss the firm is willing to incur at a given confidence limit and time
D. T he timings of cash flows from the firm's projects
T he timings of cash flows from the firm's projects are not typically included in a firm's risk appetite
statement. T his is because each project that a firm undertakes is likely to have its unique capital
outlay and duration. T herefore, it would be impractical and potentially misleading to include specific
timings of cash flows in the risk appetite statement. T he risk appetite statement is more concerned
with outlining the types of risks the firm is willing to take, the risk management tools it prefers to
use, and the maximum loss it is prepared to bear within a certain confidence limit and timeframe. It is
not intended to provide detailed financial projections for individual projects.
Choi ce A i s i ncorrect because the types of risks the firm is willing to tolerate, specifying the
risks to hedge and the ones to assume, are indeed a crucial part of a firm's risk appetite statement.
T his information helps stakeholders understand the firm's approach to risk management and the
types of risks it is willing to take on in pursuit of its business objectives. T herefore, it is unlikely to
be omitted from the risk appetite statement.
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Choi ce B i s i ncorrect because the preferred risk management tools, such as insurance and
derivatives, are also typically included in a firm's risk appetite statement. T hese tools are part of the
firm's overall risk management strategy and provide insight into how the firm plans to mitigate and
manage the risks it faces.
Choi ce C i s i ncorrect because the maximum loss the firm is willing to incur at a given confidence
limit and time is a key component of a firm's risk appetite statement. T his information provides a
clear indication of the firm's tolerance for risk and its capacity to absorb losses.
Thi ngs to Remember
A risk appetite statement is a key document in a firm's risk management framework. It outlines the
types of risks the firm is willing to take, the risk management tools it prefers to use, and the
maximum loss it is prepared to bear within a certain confidence limit and timeframe. T he statement
is intended to provide a clear and comprehensive overview of the firm's approach to risk
management, and it is typically shared with stakeholders to ensure transparency and accountability. It
is important to note that while the risk appetite statement provides a broad overview of the firm's
approach to risk management, it does not include detailed financial projections for individual projects,
such as the timings of cash flows.
Q.23 Distinguish between exchange-traded and over-the-counter risk management instruments.
A. Exchange-traded instruments are standardized and exchange-tradable while over-the-

counter instruments are non-standardized, privately negotiated financial contracts that
cannot be traded on an exchange.
B. Over-the-counter instruments are standardized and exchange-tradable while exchange-

traded instruments non-standardized, privately negotiated financial contracts that cannot be
traded on an exchange.
C. Exchange-traded instruments are those instruments that only deal with intangible financial
assets while over-the-counter instruments only deal with commodities such as coffee.
D. Exchange-traded instruments have time to maturity of less than one year while over-the-
counter instruments have longer maturity periods.
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Exchange-traded instruments are indeed standardized and can be traded on an exchange. T his
standardization is a key feature of these instruments, as it allows for a more liquid and transparent
market. T he standardization refers to the fact that the terms and conditions of the contracts are set
by the exchange, and therefore, all contracts of the same type and expiry date are identical. T his
makes them easily tradable on the exchange, as any buyer can be matched with any seller. Examples
of exchange-traded instruments include futures and options.
On the other hand, over-the-counter (OT C) instruments are non-standardized and are privately
negotiated. T his means that the terms and conditions of the contracts are agreed upon by the two
parties involved, making each OT C contract unique. Because of this, OT C contracts cannot be traded
on an exchange. Instead, they are traded directly between two parties, either through a dealer
network or in a decentralized manner. Examples of OT C instruments include forwards and swaps.
Choi ce B i s i ncorrect. Over-the-counter instruments are not standardized and exchange-tradable.
Instead, they are non-standardized, privately negotiated financial contracts that cannot be traded on
an exchange. T his is the opposite of what is stated in this choice.
Choi ce C i s i ncorrect. T he type of assets dealt with by exchange-traded or over-the-counter
instruments does not strictly depend on whether they are tangible or intangible. Both types of
instruments can deal with a variety of assets including both tangible commodities and intangible
financial assets.
Choi ce D i s i ncorrect. T he time to maturity for both exchange-traded and over-the-counter
instruments can vary widely and does not necessarily follow the pattern suggested in this choice. It
depends more on the specific terms agreed upon by the parties involved in each individual contract.
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Q.24 A reputable bank is approached by a newly-formed private company wishing to enter into an
option contract on the British pound. T he bank's risk managers prefer an exchange-traded option to
an over-the-counter one. Which of the following statements least likely explains the managers'
preference?
A. Price discovery
B. Counterparty risk
C. Flexibility in settlement
D. Liquidity
Exchange-traded derivatives are not as flexible in settlement as over-the-counter (OT C) derivatives.
OT C contracts can be settled in a variety of ways, such as cash settlement, physical delivery, or a
combination of the two. T his flexibility in settlement is an advantage of OT C derivatives over
exchange-traded derivatives. T herefore, flexibility in settlement is least likely to explain the bank's
risk managers' preference for an exchange-traded option over an OT C one.
Choi ce A i s i ncorrect. Price discovery is a significant advantage of exchange-traded options. T he
prices of these options are determined by the market, which ensures transparency and fairness.
T his process allows both parties to understand the value of the option contract better.
Choi ce B i s i ncorrect. Counterparty risk is lower in exchange-traded options as compared to
over-the-counter ones because the clearinghouse acts as a counterparty to both sides in each
transaction, reducing credit risk significantly.
Choi ce D i s i ncorrect. Liquidity tends to be higher for exchange-traded options due to their
standardized nature and large number of participants, making it easier for parties to enter or exit
positions.
Q.25 A firm borrows funds at a variable interest rate. Buying which of the following instruments
would help the firm protect itself against increases in the market rate of interest?
A. Currency forward contracts
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B. Options on interest rate futures
C. Currency swaps
D. Currency futures contracts
Interest rate futures are a type of derivative contract through which the holder agrees to buy or sell
an interest-bearing asset on a future date. T he price of an interest rate future moves inversely to
the change in interest rates. If interest rates go down, the price of the interest rate future goes up
and vice-versa. An option on an interest rate future gives the holder the right, but not the obligation,
to buy (call option) or sell (put option) the underlying interest rate future at a specified price (the
strike price) on or before a specified date (the expiration date).
In this case, a put option on an interest rate future would be an effective hedge for the firm. If
interest rates rise, the firm can exercise its option to sell the interest rate future at the strike price,
which would be higher than the market price. T his would offset the increased cost of borrowing due
to the rise in interest rates. If interest rates fall, the firm can choose not to exercise its option and
benefit from the lower borrowing cost.
Choi ce A i s i ncorrect. Currency forward contracts are used to hedge against the risk of exchange
rate fluctuations, not interest rate changes. T hey allow parties to buy or sell a specific amount of
foreign currency at a predetermined price on a future date, thus providing no protection against
rising interest rates.
Choi ce C i s i ncorrect. Currency swaps involve the exchange of one currency for another
between two parties, with an agreement to reverse the swap at a later date. While this can help
manage exposure to foreign exchange risk, it does not directly address the risk of rising interest
rates on a loan.
Choi ce D i s i ncorrect. Similar to currency forward contracts, currency futures contracts are
used primarily for hedging against foreign exchange risk and do not provide protection against
increasing market interest rates.
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Q.26 Which of the following is not a common characteristic of interest rate swaps?
A. Payments made by both parties are in different currencies
B. T he contract is usually based on a ''notional'' principal amount
C. T hey trade over the counter
D. Interest rate swaps are used to hedge against or speculate on changes in interest rates.
Payments made by counterparties in an interest rate swap must be in the same currency. T his is one
of the main differences between currency swaps and interest rate swaps.
T he following are characteristics of interest rate swaps:
i. T he contract is usually based on a ''notional'' principal amount which remains the same over
the entire lifetime of the swap.
ii. T hey are over-the-counter financial instruments.
iii. Interest rate swaps are used to hedge against or speculate on changes in interest rates
iv. Counterparties negotiate and agree on the fixed-rate and day-count conventions at the
initiation of the swap contract
v. T he swap duration can go from one week to 30 years.
Q.29 A construction firm wishes to enter into cleared derivative positions to manage risks such as
price variation of raw materials and increase interest rates. However, the firm is aware of a few
problems that could accompany the decision to invest in exchange-traded derivatives. Which of the
following should not be worrisome for the management of the firm?
A. Liquidity risk
B. Counterparty risk
C. Market risk
D. T ransaction costs
Counterparty risk is the risk that the other party in an agreement will default or fail to live up to
46
their obligations. In the context of exchange-traded derivatives, this risk is significantly mitigated
because the exchange itself acts as the counterparty for each transaction. T his means that the
exchange assumes the role of the buyer for every seller and the seller for every buyer. T herefore,
the risk of default is transferred from the individual parties to the exchange. T his is a key feature of
exchange-traded derivatives and one of the reasons why they are considered safer than over-the-
counter derivatives, where counterparty risk can be a significant concern.
Choi ce A i s i ncorrect. Liquidity risk is a valid concern for the company's management. T his risk
refers to the possibility that the company may not be able to quickly buy or sell its derivative
positions without causing a significant change in their prices. In other words, if the market for these
derivatives is not sufficiently liquid, it could negatively impact the company's ability to manage its
risks effectively.
Choi ce C i s i ncorrect. Market risk should also be a concern for the company's management. T his
type of risk refers to potential losses that can arise from movements in market prices, such as those
of raw materials and interest rates, which are exactly what this construction company aims to hedge
against by using cleared derivative positions.
Choi ce D i s i ncorrect. T ransaction costs are another potential issue that could arise from
investing in exchange-traded derivatives. T hese costs include brokerage fees and other charges
associated with buying and selling these financial instruments on an exchange, which can eat into any
profits made from these transactions or add to any losses incurred.
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Q.30 Besides credit risk, counterparties in a derivative position face another major type of risk.
Which one is it?
A. Interest rate risk
B. Foreign exchange risk
C. Commodity price risk
D. Market risk
Market risk, also known as 'systematic risk' or 'undiversifiable risk', is a type of risk that is inherent
to the entire market or market segment. It represents the potential for losses arising from changes
in market risk factors such as interest rates, exchange rates, and commodity prices. In the context
of derivative transactions, market risk is a major concern for counterparties as it can significantly
impact the value of their investments. Market risk encompasses other risks such as interest rate
risk, foreign exchange risk, and commodity price risk. T herefore, it is not uncommon for market
participants to enter into offsetting agreements or use other hedging strategies to mitigate their
exposure to market risk. T hese strategies typically involve entering into a second agreement that
works in exactly the opposite direction, effectively canceling out the potential loss that could be
incurred in the first agreement.
Choi ce A i s i ncorrect. Interest rate risk is a type of market risk, but it only pertains to the
potential losses that may arise due to fluctuations in interest rates. It does not encompass all the
market risk factors such as equity prices, commodity prices, and foreign exchange rates.
Choi ce B i s i ncorrect. Foreign exchange risk is also a type of market risk, but it specifically
refers to the potential losses that may occur due to changes in foreign exchange rates. It does not
cover all other types of market risks.
Choi ce C i s i ncorrect. Commodity price risk refers to the potential losses that can occur due to
changes in commodity prices. While this is a significant part of market risks for certain businesses, it
does not represent all forms of market risks faced by counterparties in derivative transactions.
48
Q.41 T he board of directors of BRT Inc. is determining the risk appetite of the firm. It believes
increasing the firm's risk appetite will introduce BRT to new potential business opportunities and
increase the rewards to stakeholders. However, changing the risk appetite of a firm can be a cause
of conflict between parties. Determining the risk appetite of a firm can cause the greatest conflict
between:
A. Management and debtholders.
B. Management and shareholders.
C. Shareholders and the board of directors.
D. Shareholders and debtholders.
T he conflict between shareholders and debtholders is the most intense when determining a firm's
risk appetite. T his is because their interests are diametrically opposed when it comes to risk.
Shareholders, as residual claimants, have an unlimited upside potential and therefore prefer a higher
risk appetite. T hey stand to gain more if the firm takes on more risk and succeeds. On the other
hand, debtholders, as fixed-income claimants, have a limited upside potential, which is confined to the
interest rate agreed upon. T herefore, they prefer a lower risk appetite to ensure the firm's ability
to meet its debt obligations. T his fundamental difference in risk preference creates a significant
conflict between shareholders and debtholders when determining the risk appetite of a firm.
Choi ce A i s i ncorrect. While management and debtholders may have differing views on the
company's risk appetite, it is not the most likely pair to experience the highest level of conflict.
Management typically has a higher risk tolerance as they are focused on growth and profitability,
while debtholders prefer lower risk to ensure repayment of their debt. However, these differences
can be managed through effective communication and negotiation.
Choi ce B i s i ncorrect. Although there might be disagreements between management and
shareholders regarding the company's risk appetite due to their different perspectives on risk-return
trade-off, this conflict is usually not as intense as that between shareholders and debtholders.
Shareholders generally favor higher risks for potentially higher returns while management might
prefer a more balanced approach.
Choi ce C i s i ncorrect. T he board of directors represents the interests of shareholders in setting
49
the company's strategic direction including its risk appetite. T herefore, conflicts between these two
parties are less likely compared to other pairs since they share common objectives in maximizing
shareholder value.
Q.42 Anadolu T ire Company is the market leader in the tires manufacturing sector in T urkey. It
acquires its raw material from its neighbor, Iran, on fixed trade terms and pays the supplier in the
local T urkish currency. Anadolu also sells its tires to some eastern European countries and accepts
payments in Euro. Based on the business perspective of Anadolu, determine which of the following
risk it should hedge.
A. Pricing risk.
B. Foreign currency risk.
C. Interest rate risk.
D. Market risk.
Anadolu T ire Company should prioritize hedging against foreign currency risk. T his is because the
company conducts business transactions in multiple currencies - it pays its suppliers in the local
T urkish currency and receives payments from its customers in Euros. If the value of the Euro
depreciates against the T urkish currency, the company's revenue from its sales in Eastern Europe
would decrease when converted back to the local currency. T his could potentially lead to financial
losses. T herefore, to protect itself from the potential adverse effects of currency fluctuations,
Anadolu T ire Company should hedge against foreign currency risk.
Choi ce A i s i ncorrect. Pricing risk refers to the potential for a change in the price of a product or
service due to market factors such as competition, supply and demand, among others. While Anadolu
T ire Company may face pricing risk, it is not directly related to their business model of sourcing raw
materials from Iran and exporting products to Eastern European countries.
Choi ce C i s i ncorrect. Interest rate risk pertains to the potential for changes in interest rates that
could affect a company's operations or its financial condition. Although this type of risk can impact
any business, there's no specific information given in the question that suggests Anadolu T ire
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Company should prioritize hedging against interest rate risk.
Choi ce D i s i ncorrect. Market risk involves exposure to changes in market prices, such as equity
prices or commodity prices. While Anadolu T ire Company might be exposed to some level of market
risk due its operations, it doesn't appear as significant as foreign currency risk given their business
model which involves transactions in multiple currencies.
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Q.43 Which of the following statements are incorrect regarding static hedging and dynamic hedging
strategies?
A. In static hedging, the risk is recognized at the beginning, and the appropriate hedging
position is opened
B. A dynamic hedging strategy is more complex as the underlying risky position may change
with time
C. Static hedging requires more time and monitoring effort
D. Dynamic hedging requires additional transaction costs to maintain the risky position
hedged
T he statement that static hedging requires more time and monitoring effort is incorrect. In fact, it is
dynamic hedging that requires more time and monitoring effort. T his is because dynamic hedging
involves adjusting the hedging position as the underlying risky position changes over time. T his
necessitates continuous monitoring of the market conditions and the risky position, and making
appropriate adjustments to the hedging position. T his can be a time-consuming and effort-intensive
process. On the other hand, static hedging involves recognizing the risk at the outset and opening the
appropriate hedging position. Once the hedging position is opened, it remains in place until the
exposure ends.
Choi ce A i s i ncorrect. T his statement is correct as static hedging involves identifying the risk at
the beginning and then opening a hedging position to mitigate that risk. T he hedge is set up once and
does not change over time, hence it's called 'static'.
Choi ce B i s i ncorrect. T his statement accurately describes dynamic hedging strategies. T hey are
indeed more complex because they require continuous adjustment of the hedge position as market
conditions change, which can be quite frequent.
Choi ce D i s i ncorrect. Dynamic hedging does indeed involve additional transaction costs due to its
nature of constant adjustments to maintain an effective hedge against changing market conditions.
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Q.44 Which of the following is not an attribute of exchange-traded and over-the-counter (OT C)
financial instruments?
A. Exchange-traded instruments are more simple and standardized.
B. Over-the-counter financial instruments are more liquid than exchange-traded instruments.
C. Exchange-traded instruments are easier to price than OT C instruments.
D. Over-the-counter financial instruments contain default risk.
T he statement that over-the-counter financial instruments are more liquid than exchange-traded
instruments is incorrect. Liquidity refers to the ease with which an asset or security can be bought
or sold in the market without affecting its price. Exchange-traded instruments are generally more
liquid than OT C instruments. T his is because exchange-traded instruments are standardized, traded in
a centralized market, and are subject to stringent regulatory oversight, which enhances their
liquidity. On the other hand, OT C instruments are customized contracts that are traded privately
between two parties. T his customization and lack of centralization often result in lower liquidity for
OT C instruments as compared to exchange-traded instruments.
Choi ce A i s i ncorrect. Exchange-traded instruments are indeed more simple and standardized. T his
is because they are traded on an exchange where the terms and conditions of the contracts are
standardized by the exchange itself.
Choi ce C i s i ncorrect. Exchange-traded instruments are generally easier to price than OT C
instruments due to their standardization and transparency of information available in exchanges.
Choi ce D i s i ncorrect. Over-the-counter financial instruments do contain default risk, as there's
no central clearing house to guarantee trades like in an exchange environment, increasing
counterparty risk.
53
Q.5036 A firm has a total risk capacity of $600 million. Senior managers have set a risk appetite at
$300 million. Which of the following would most likely be within the acceptable risk profile for the
firm?
A. $400 million
B. $250 million
C. $900 million
D. $450 million
T he risk profile of a company is the amount of risk it is currently exposed to. It should be less than
the company's risk appetite, which is the amount of risk the company is willing to take on. In this
case, the company's risk appetite is $300 million. T herefore, the risk profile should be less than this
amount. Option B, which is $250 million, is the only option that is less than the company's risk
appetite. T his is in line with the principle that a company's risk profile should always be less than its
risk appetite, which in turn should be less than its total risk capacity. T his ensures that the company
does not take on more risk than it can handle, thereby safeguarding its financial stability and long-
term viability.
Choi ce A i s i ncorrect. T he risk amount of $400 million exceeds the firm's risk appetite of $300
million, which means it falls outside the acceptable risk profile.
Choi ce C i s i ncorrect. T he risk amount of $900 million not only exceeds the firm's risk appetite
but also its total risk capacity of $600 million, making it an unacceptable level of risk for the
company.
Choi ce D i s i ncorrect. Similar to choice A, a risk amount of $450 million surpasses the company's
established risk appetite and therefore does not align with its acceptable risk profile.
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Q.5307 ABC Bank’s chief risk officer is trying to reduce the bank’s exposure to foreign exchange
fluctuations. He has suggested using an agreement where the bank gets the right without any
obligation to exchange a given amount of currency at a predetermined price in the future. Which of
the following derivatives is the chief risk officer suggesting?
A. Forwards
B. Futures
C. Options
D. Swap
Options are financial derivatives that provide the holder with the right, but not the obligation, to buy
or sell an underlying asset at a predetermined price within a specified period. In the context of
foreign exchange, an option would allow ABC Bank to hedge against potential adverse currency
movements. If the foreign exchange rate moves in a direction that is unfavorable to the bank, it can
exercise the option and exchange the currency at the predetermined rate. However, if the exchange
rate moves in a direction that is favorable to the bank, it can let the option expire and exchange the
currency at the prevailing market rate. T his flexibility is a key characteristic of options and
distinguishes them from other derivative instruments such as forwards, futures, and swaps, which
obligate the contracting parties to honor the contract.
Choi ce A i s i ncorrect. Forwards are a type of derivative instrument, but they do not provide the
right without an obligation. Instead, they involve an agreement to buy or sell an asset at a specified
future date for a price agreed upon today. T herefore, both parties are obligated to fulfill the contract.
Choi ce B i s i ncorrect. Futures are similar to forwards in that they involve an agreement to buy or
sell an asset at a specified future date for a price agreed upon today. However, futures contracts are
standardized and traded on exchanges, unlike forwards which are private agreements between two
parties. Like forwards though, futures also impose obligations on both parties involved.
Choi ce D i s i ncorrect. Swaps involve the exchange of cash flows between two parties based on
predetermined terms and conditions but do not grant any rights without obligations like options do.
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Reading 3: The Governance of Risk Management
Q.21 In risk management within an organization, the board plays a crucial role. T his role involves
various responsibilities and tasks that contribute to the overall risk management strategy of the
organization. Which of the following options best describes the primary role of the board in the risk
management process?
A. Issuing guidelines on how to manage risks
B. Developing the risk appetite statement and objectives the managers should strive to meet
within the risk management framework
C. Regularly reviewing decisions made by managers regarding risk exposures
D. Choosing the risk exposures to hedge, the risks to mitigate, and those to avoid altogether
T he board sits above the managers in the hierarchy of management in most for-profit organizations.
T he board assembles and develops a comprehensive risk appetite statement, specifying the risks the
company should assume and those to avoid, including the preferred methods of risk mitigation. T he
managers consult the risk appetite statement when choosing the projects to undertake.
T he board also delegates the responsibility for approving and reviewing the risk levels to the board
risk management committee.
Opti on A i s i ncorrect: Issuing guidelines on managing risks is the role of risk advisory managers.
Opti on C i s i ncorrect: Regularly reviewing decisions made by managers regarding risk exposures
is the role of the board risk management committee.
Opti on D i s i ncorrect: Choosing the risk exposures to hedge, the risks to mitigate, and those to
avoid altogether is the role of the risk advisory directors.
Thi ngs to Remember
Risk management is a critical aspect of any organization's operations. It involves identifying,
assessing, and managing potential risks that could negatively impact the organization's objectives. T he
board plays a crucial role in this process by setting the organization's risk appetite and guiding the
overall risk management strategy. However, the board's role is strategic in nature, and it typically
56
delegates the operational aspects of risk management to other bodies within the organization, such as
risk advisory managers, risk management committees, and risk advisory directors. Understanding the
roles and responsibilities of these different bodies can help ensure effective risk management within
an organization.
Q.45 Which of the following statements best describes corporate governance in today's business
world?
A. T he process by which the board of directors delegates duties to hired professionals who
oversee the day-to-day running of the company.
B. T he system of rules, practices, processes, and regulations guiding risk managers when
determining a company's risk appetite.
C. T he system of rules, regulations, and processes by which a company's board of directors

looks after the needs of various stakeholders within the broader agenda of meeting business
objectives.
D. T he tools used by the board of directors to drive business strategy, corporate

responsibility, and streamline the interests of the company's shareholders.
Corporate governance is indeed a system of rules, regulations, and processes that guide a company's
board of directors in managing the affairs of the company. It is designed to balance the interests of
the company's many stakeholders, such as shareholders, management, customers, suppliers,
financiers, government, and the community. T he board of directors is responsible for looking after
the needs of these various stakeholders within the broader agenda of meeting business objectives.
T his involves making decisions that affect the direction of the company, setting strategic goals, and
ensuring they are met. T he board also oversees the company's operations to ensure they are in line
with the company's strategic goals. T his includes monitoring the performance of the management
and taking corrective actions when necessary. T he board also ensures that the company complies
with all relevant laws and regulations and maintains high standards of ethics and corporate behavior.
Choi ce A i s i ncorrect. While the board of directors does delegate duties to professionals for the
day-to-day running of the company, this is only a small part of corporate governance. Corporate
57
governance encompasses much more than just delegation, including setting company objectives,
establishing policies and procedures, and ensuring accountability and transparency.
Choi ce B i s i ncorrect. T his choice incorrectly narrows down corporate governance to only risk
management aspects. Although risk management is an important part of corporate governance, it also
includes other elements such as strategic direction, performance monitoring and stakeholder
communication.
Choi ce D i s i ncorrect. Tools used by the board to drive business strategy or streamline
shareholder interests are components of corporate governance but they do not define it entirely.
Corporate Governance involves a broader set of rules and processes that ensure effective
management control over corporations in order to protect all stakeholders' interests.
58
Q.46 In the aftermath of the 2007/2009 financial crisis, most companies created the position of Chief
Risk Officer (CRO). Which of the following statements about the CRO is INCORRECT ?
A. T he CRO reports directly to the shareholders.
B. T he CRO acts as the chief advisor to the board on all matters of risk.
C. T he CRO gives guidance to lower level (line) managers about risk identification and
management, making suggestions for risk mitigation.
D. T he CRO plays a starring role when determining the company's risk appetite.
In most corporate structures, the CRO does not report directly to the shareholders. Instead, the
CRO typically reports to the board of directors or a risk sub-committee delegated by the board. T he
board, in turn, is responsible for communicating with the shareholders. T he CRO's primary
responsibility is to oversee the risk management function in its entirety, which includes designing
the risk management program, setting risk policies, and monitoring the firm's risk limits. T he CRO
also acts as an intermediary between the board and the management, keeping both parties informed
about the firm's risk tolerance and the condition of the risk management infrastructure.
Choi ce B i s i ncorrect. T he CRO does indeed act as the chief advisor to the board on all matters of
risk. T his includes providing insights and recommendations on risk management strategies, policies,
and procedures.
Choi ce C i s i ncorrect. It is part of the CRO's responsibilities to provide guidance to lower level
managers about risk identification and management. T hey are expected to make suggestions for risk
mitigation, helping line managers understand potential risks and how they can be managed or mitigated
effectively.
Choi ce D i s i ncorrect. T he CRO plays a significant role in determining the company's risk
appetite. T hey work closely with senior management and board members to establish a clear
understanding of the level of risk that the organization is willing to accept in pursuit of its business
objectives.
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Q.48 Which of the following is most likely a role of finance and operations?
A. Taking on and managing exposure to approved risk
B. Setting business level risk tolerances
C. Managing risk policy development and implementation
D. Overseeing official valuations including independent verification
Overseeing official valuations including independent verification is indeed a role of the finance and
operations department. T his department is responsible for ensuring that the company's financial
records are accurate and up-to-date. T his includes overseeing official valuations, which involves
assessing the worth of the company's assets, liabilities, and overall equity. Independent verification is
a part of this process, as it involves a third-party entity reviewing the company's financial records to
ensure their accuracy. T his is crucial for maintaining transparency and trust with stakeholders,
including investors, creditors, and regulatory bodies. Other roles of the finance and operations
department may include setting and managing valuations & finance policies, managing and supporting
analysis required for business planning, and ensuring proper settlement/deal capture and
documentations.
Choi ce A i s i ncorrect. While the finance and operations department may be involved in managing
exposure to approved risk, this responsibility typically falls under the purview of the risk
management department. T he finance and operations department's role is more focused on financial
planning, budgeting, cash flow management, etc.
Choi ce B i s i ncorrect. Setting business level risk tolerances is usually a strategic decision made
by senior management or board of directors rather than a function of the finance and operations
department. T his involves determining the amount of risk that an organization can tolerate or absorb
before it impacts its objectives.
Choi ce C i s i ncorrect. Managing risk policy development and implementation generally falls under
the domain of a company's risk management team or committee rather than being a responsibility of
the finance and operations department. T hey are responsible for developing policies to manage risks
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that could potentially impact an organization's ability to achieve its objectives.
Q.49 T he following are some of the roles of a bank's audit committee of the board. Which one is not?
A. Developing the bank's risk appetite statement.
B. Scrutinizing financial statements to ensure the accuracy of the reported figures.
C. Ensuring that the bank complies with the minimum/best-practice standards in all key
activities.
D. Continuously reviewing the independence of the statutory auditor/audit firm.
T he audit committee of a bank's board is not typically involved in developing the bank's risk appetite
statement. T he risk appetite statement is a strategic document that outlines the level and type of
risk a bank is willing to accept in pursuit of its business objectives. T his statement is usually
developed by the bank's senior management and approved by the board of directors. T he role of the
audit committee in relation to the risk appetite statement is more of an oversight nature. It monitors
the bank's risk management processes to ensure they are in line with the risk appetite statement and
comply with relevant regulations. T he committee does not directly participate in the development of
the risk appetite statement.
Choi ce B i s i ncorrect. T he audit committee indeed scrutinizes financial statements to ensure the
accuracy of the reported figures. T his is one of their primary responsibilities, as they need to
ensure that all financial information presented by the bank is accurate and reliable.
Choi ce C i s i ncorrect. Ensuring compliance with minimum/best-practice standards in all key
activities also falls under the purview of an audit committee. T hey are responsible for ensuring that
all operations within the bank adhere to established standards and regulations.
Choi ce D i s i ncorrect. Continuously reviewing the independence of the statutory auditor/audit
firm is another important task performed by an audit committee. T hey need to ensure that auditors
are independent and unbiased in their assessments, which helps maintain trust in their findings.
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Q.50 Most organizations have both executive and non-executive directors. Which one of the
following is not a valid difference between the two categories?
A. While executive directors work full-time, non-executive directors work on a part-time

basis.
B. While executive directors get involved in the day-to-day management of the company, non-
executive directors do not participate in management responsibilities.
C. Executive directors are usually not independent, whereas non-executives should be

independent.
D. While executive directors are appointed to the board by shareholders, non-executive

directors are appointed by the nomination committee.
Both executive and non-executive directors are appointed by the shareholders. T he nomination
committee, which is usually composed of non-executive directors, is responsible for identifying
suitable candidates for the board, but the final decision rests with the shareholders. T he nomination
committee can recommend candidates for both executive and non-executive positions. T herefore,
the appointment process does not differentiate between executive and non-executive directors.
Choi ce A i s i ncorrect. T he statement accurately represents a difference between executive and
non-executive directors. Executive directors are typically full-time employees of the company,
while non-executive directors often hold part-time positions, providing strategic guidance and
oversight without being involved in the day-to-day operations.
Choi ce B i s i ncorrect. T his statement correctly differentiates between executive and non-
executive directors. Executive directors are involved in the daily management of the company,
making operational decisions and implementing strategies. On the other hand, non-executive
directors do not participate in these management responsibilities; instead, they provide independent
oversight and advice to ensure that the company's strategic objectives align with shareholders'
interests.
Choi ce C i s i ncorrect. T his statement correctly identifies a key difference between executive
and non-executive directors regarding their independence status. Executive directors are usually not
considered independent as they are part of the management team of the company with potential
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conflicts of interest due to their roles within it. In contrast, non-executives should be independent to
provide unbiased oversight on behalf of shareholders.
Q.52 In which way can suppliers and customers reward good corporate governance?
A. Purchase from a competitor offering lower prices
B. Demanding a higher rate of return on their investment.
C. Actively doing business with the company in favorable terms.
D. Giving extra benefits to company executives.
Good corporate governance can significantly enhance a company's reputation and trust among its
stakeholders, including suppliers and customers. When a company practices good corporate
governance, it demonstrates transparency, accountability, and fairness in its business operations.
T his can lead to increased confidence among suppliers and customers, encouraging them to actively
do business with the company in favorable terms. T hey may offer better payment terms, discounts,
or other benefits, recognizing the reduced risk and increased reliability associated with doing
business with a well-governed company. T his choice correctly identifies how suppliers and
customers can reward a company for good corporate governance.
Choi ce A i s i ncorrect. Purchasing from a competitor offering lower prices does not express
appreciation for good corporate governance. Instead, it indicates a preference for lower prices over
the quality of governance.
Choi ce B i s i ncorrect. Demanding a higher rate of return on their investment does not show
appreciation for good corporate governance. It rather suggests dissatisfaction with the current
returns and may put undue pressure on the company, potentially leading to poor decision-making.
Choi ce D i s i ncorrect. Giving extra benefits to company executives can be seen as an attempt to
influence decisions rather than an appreciation of good corporate governance. Good corporate
governance promotes transparency and fairness, which could be compromised by such actions.
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Q.53 Which of the following committees is charged with approving and authorizing compensation of
top company executives?
A. Audit committee.
B. Risk Management committee.
C. Compensation committee.
D. Audit Function
After the financial crisis of 2007/2009, it became evident that the compensation schemes in place at
many institutions were encouraging excessive risk-taking without due consideration for long-term
risks. Executives were incentivized to prioritize short-term profits, front-loading fees while back-
loading risks. T his realization led to the establishment of compensation committees on most boards.
T he primary role of the compensation committee is to oversee all matters related to remuneration.
T he committee ensures that compensation schemes take into account the risks faced by the
company, thereby safeguarding its long-term financial health.
Choi ce A i s i ncorrect. T he Audit committee is primarily responsible for overseeing the financial
reporting process of a company, not for approving and authorizing the compensation of top
executives. T hey ensure that the financial statements are accurate and in compliance with
regulatory requirements.
Choi ce B i s i ncorrect. T he Risk Management committee's role involves identifying, assessing, and
managing risks that could potentially affect a company's operations or profitability. It does not have
any direct involvement in determining executive compensation.
Choi ce D i s i ncorrect. T he Audit Function refers to an internal department within a company that
conducts audits to assess whether the organization's processes are compliant with internal policies
and external regulations. T his function does not include deciding on executive compensation.
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Q.54 T he effective oversight role of the audit committee least likely contributes to:
A. Reliable financial reporting
B. More effective corporate governance
C. Credible audit functions
D. Monitoring the firm's risk limits
T he audit committee's primary responsibilities revolve around the accuracy of financial and
regulatory reporting of the firm and the quality of processes that underlie such activities. It ensures
that a bank complies with standards in regulatory, risk management, legal, and compliance activities.
It also verifies the activities of the firm to see if the reports outline the same. T herefore, the audit
committee contributes to the accuracy of financial reporting and ensuring compliance with the
minimum standards in other key activities. It also contributes to more effective corporate
governance. However, monitoring the firm's risk limits is not typically within the purview of the
audit committee. T his responsibility usually falls under the role of the Chief Risk Officer (CRO). T he
CRO is responsible for identifying, analyzing, and mitigating internal and external events that could
threaten the organization. T he CRO ensures that the organization is in compliance with applicable
regulations, that it has enough capital to cover potential losses, and that it is following its risk
appetite. T herefore, the audit committee's oversight role is least likely to contribute to monitoring
the firm's risk limits.
Choi ce A i s i ncorrect. T he audit committee plays a significant role in ensuring reliable financial
reporting. It oversees the financial reporting process to ensure that the financial statements are
accurate and complete, and comply with accounting standards and regulatory requirements.
Choi ce B i s i ncorrect. T he audit committee also contributes to more effective corporate
governance by providing an independent check on management, ensuring transparency in operations,
and enhancing accountability.
Choi ce C i s i ncorrect. Ensuring credible audit functions is another key responsibility of the audit
committee. It appoints, compensates, and oversees the work of any registered public accounting
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firm employed by the organization.
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Q.55 Explain the meaning of a 'fiduciary duty' within the bounds of corporate governance.
A. A duty that arises out of a contractual agreement.
B. A duty that is not stipulated in a company's constitution, but nonetheless expected to be

performed by management.
C. A duty imposed on a person because of the position of trust and confidence in which they
stand in relation to another.
D. T he duty to prioritize the interests of the government over those of one's clients
A fiduciary duty is a legal obligation that is imposed on an individual due to the position of trust and
confidence they hold in relation to another. T his duty is not just a moral obligation, but a legal one
that binds the individual to act in the best interest of the other party. T he individual, often referred to
as the fiduciary, is entrusted with the responsibility of making decisions or managing assets that
belong to the other party. T he fiduciary is expected to act with utmost good faith, honesty, and
loyalty, prioritizing the interests of the other party over their own. T his duty is often seen in various
professional relationships, such as between a trustee and a beneficiary, a director and a corporation,
or an attorney and a client. Breach of fiduciary duty can lead to legal consequences, including
damages and disgorgement of profits.
Choi ce A i s i ncorrect. While fiduciary duties can be part of a contractual agreement, they are not
exclusively derived from contracts. Fiduciary duties arise due to the position of trust and confidence
that an individual holds, which may or may not be contractually defined.
Choi ce B i s i ncorrect. Fiduciary duty does not necessarily have to be explicitly stated in a
company's constitution for it to exist. It arises from the relationship between two parties where one
party has placed trust in another who has a superior knowledge or power. T his duty exists regardless
of whether it is stipulated in the company's constitution.
Choi ce D i s i ncorrect. Fiduciary duty does not involve prioritizing the interests of the
government over those of clients. Rather, it involves acting in the best interest of another party
(such as clients or shareholders), often at personal expense or sacrifice.
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Q.56 T he large-scale corporate collapses witnessed in the early 2000s, including the Global Financial
crisis of 2007/08, all had important themes (causal factors) that risk professionals must understand if
we are to avoid a recurrence of such financially crumbling events. Which of the following
statements about these past crises is inaccurate?
A. Most collapses occurred as a result of executives abusing their trust and a lack of
oversight.
B. Incentive payments and greed did not play any role in the collapses.
C. T here was a tendency of management to take on risks that were not fully understood.
D. T he collapses had a negative impact on the accounting profession.
Incentive payments, particularly those tied to short-term performance, played a significant role in
the corporate collapses of the early 2000s. T hese incentives encouraged employees to take
excessive risks to generate short-term gains, often without adequate consideration for the long-term
consequences. T his was particularly evident in the banking and investment sectors. Furthermore,
corporate executives, driven by greed and the prospect of inflated bonuses and other forms of
remuneration linked to short-term performance, took on huge risks that they did not fully
understand. T his behavior was especially apparent in the case of Enron, where executive greed and
fraud were key factors in the company's collapse.
Choi ce A i s i ncorrect. T he statement accurately reflects the circumstances of these events.
Many of the collapses in the early 2000s were indeed due to executives abusing their trust and a lack
of oversight, as evidenced by scandals such as Enron and WorldCom.
Choi ce C i s i ncorrect. T his statement also accurately reflects the circumstances leading up to
these financial disasters. T here was indeed a tendency for management to take on risks that were
not fully understood, particularly in relation to complex financial instruments like derivatives.
Choi ce D i s i ncorrect. T he collapses did have a negative impact on the accounting profession,
with many questioning its role and effectiveness in preventing such disasters from occurring.
T herefore, this statement does accurately reflect the circumstances of these events.
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Q.57
Most companies now have several subsets of the board called 'board committees'.
Why are such committees formed?
A. To directly report to shareholders on specific issues.
B. To enable the directors to reduce their individual liability and therefore serve more
confidently.
C. To enhance the overall effectiveness of the board.
D. To introduce independence, thereby enabling verification of decisions/materials brought

to the attention of the entire board.
T he primary reason for the formation of board committees within a company is to enhance the
overall effectiveness of the board. T he board of directors in a company is responsible for making
key decisions and setting the strategic direction of the company. However, the board is often
comprised of individuals with diverse backgrounds and expertise, and it can be challenging for the
board to effectively manage all aspects of the company's operations. T herefore, board committees
are formed to distribute the workload and allow for more detailed consideration of specific issues.
T hese committees are typically focused on specific areas such as compensation, nomination,
management, and others. By delegating specific tasks to these committees, the board can ensure that
these issues receive the necessary attention and are handled effectively. T his, in turn, enhances the
overall effectiveness of the board in its entirety.
Choi ce A i s i ncorrect. While board committees may occasionally report to shareholders on
specific issues, this is not their primary purpose. T heir main role is to enhance the overall
effectiveness of the board by focusing on specific areas of responsibility and providing detailed
oversight and guidance.
Choi ce B i s i ncorrect. T he formation of board committees does not necessarily reduce the
individual liability of directors. Directors are still legally responsible for their actions and decisions,
regardless of whether they serve on a committee or not.
Choi ce D i s i ncorrect. Although introducing independence can be one benefit of forming board
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committees, it's not the primary reason for their formation. T he main objective remains enhancing
the overall effectiveness of the board by allowing more focused attention on key areas.
Q.58 T he following are examples of agency costs, except:
A. Dividends
B. Monitoring fees
C. Audit fees
D. Delegated authorities
Dividends are not considered an agency cost. T hey are a form of profit distribution to shareholders
for their investment in the company. Agency costs, on the other hand, are the costs incurred due to
the potential conflicts of interest between the principal (shareholders) and the agent (management).
T hese costs arise when the agent makes decisions that may not align with the best interests of the
principal. While dividends can be influenced by agency costs, they are not a direct cost of the
principal-agent relationship. For instance, if agency costs are high, the profits available for
distribution as dividends may be reduced. However, dividends themselves do not constitute an agency
cost.
Choi ce B i s i ncorrect. Monitoring fees are a type of agency cost. T hey are incurred when the
principal needs to supervise or monitor the agent's activities to ensure they align with their
interests.
Choi ce C i s i ncorrect. Audit fees also constitute an agency cost. T hese costs arise when an
external party is hired to review and verify the agent's actions and financial reports, ensuring that
they are in line with the principal's expectations and requirements.
Choi ce D i s i ncorrect. Delegated authorities can lead to agency costs as well. When authority is
delegated, there may be a risk of misuse or misalignment of interests between the principal and
agent, leading to potential conflicts and additional costs for resolution.
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Q.59 Which of the following statements about the board of directors' remuneration is correct?
A. Directors may award themselves such salary payments as they think fit
B. Directors must receive a salary, just like other junior employees of the company
C. Directors only receive a salary if the constitution of the company explicitly allows it
D. Directors salaries are set by the HR department of the firm
Directors only receive a salary if the constitution of the company explicitly allows it. T his statement
is accurate because the remuneration of directors is governed by the constitution of the company. A
director is entitled to receive a salary only if they have a contractual right to remuneration. T he
board of directors has the power to award contracts to directors and other personnel, but this is
subject to the company's articles. T here are companies that do not have written agreements that
can allow directors to receive any form of salary payment. In essence, the constitution is the sole
determinant on matters of remuneration. T herefore, it is crucial for companies to have clear and
explicit provisions in their constitution regarding the remuneration of directors to ensure
transparency and accountability.
Choi ce A i s i ncorrect. Directors cannot award themselves salaries as they see fit. T his would lead
to a conflict of interest and potential misuse of company funds. T he remuneration of directors is
usually determined by the board's remuneration committee or as per the company's constitution.
Choi ce B i s i ncorrect. It is not mandatory for directors to receive a salary like other employees
of the company. T he compensation structure for directors can include various components such as
fees, salary, bonuses, benefits in kind, pensions and share options depending on the constitution of
the company.
Choi ce D i s i ncorrect. T he HR department does not set director salaries in most organizations.
T his responsibility typically lies with either a dedicated remuneration committee within the board or
it may be outlined in the company's constitution.
Q.60 Muhammad Ismail, a research analyst, has recently learned in a seminar on the quality of
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research report writing that the firm's corporate governance is as important as the valuation of the
firm's assets. He has noted the following points regarding the implication of good corporate
governance. Which of them are not considered best practices of corporate governance?
A. T he board of director should be comprised of a majority of independent members.
B. A director from outside of the industry should be provided training before joining the
board.
C. T he board will consider the interests of stakeholders, including debtholders, while taking
decisions.
D. T he CEO of the firm must also be the chairman of the board of directors in order to bring
consistency in the board decisions.
T he CEO of the firm must not also be the chairman of the board of directors. T his is because having
the same person occupy both positions can lead to a lack of objectivity and independence in decision-
making. T he roles of the CEO and the chairman of the board are distinct and should be occupied by
different individuals to ensure checks and balances. T he CEO is responsible for the day-to-day
management of the company, while the chairman of the board is responsible for overseeing the
company's overall strategy and ensuring that the interests of shareholders are protected. If the same
person holds both positions, it can lead to a concentration of power and a potential conflict of
interest, as the person may prioritize their own interests over those of the shareholders. T herefore,
it is not considered a best practice in corporate governance for the CEO to also be the chairman of
the board of directors.
Choi ce A i s i ncorrect. T he board of directors being comprised of a majority of independent
members is indeed a best practice in corporate governance. Independent directors are not involved
in the day-to-day operations of the company and can therefore provide unbiased oversight and
decision-making.
Choi ce B i s i ncorrect. Providing training to a director from outside the industry before they join
the board aligns with good corporate governance practices. T his ensures that all board members
have an understanding of the industry, which enables them to make informed decisions for the
company.
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Choi ce C i s i ncorrect. Considering the interests of all stakeholders, including debtholders, while
making decisions is also a best practice in corporate governance. T his approach ensures that
decisions are made with consideration for their impact on all parties involved with or affected by the
company's operations.
Q.61 Which of the following combinations is most likely to affect the independence of the board?
A. Chief Executive Officer as a member of the board of directors.
B. Chairman of the board as a member of the remuneration committee.
C. Chief Executive Officer as the Chairman of the remuneration committee.
D. Chairman of the board as the Chairman of the ethics committee.
A board that is comprised of a Chief Executive Officer (CEO) who is also the chairman of the
remuneration committee can potentially affect the independence and objectivity of the board and
also the quality of corporate governance. T he other 3 combinations will have no effect on the
board's independence and objectivity.
Q.62 Woody Daren is an independent journalist who publishes his analysis on one blue-chip firm
every week on his blog. Recently, Woody published an article on the best practices of Arrow Corp's
risk management and its risk committee. Which of the following features that he published is an
incorrect practice?
A. T he business practices and risk management activities of Arrow Corp. strive for
economic performance instead of accounting performance.
B. T he compensation of the risk staff is based on risk-adjusted performance.
C. T he members of the risk committee have deep knowledge of risk issues and accounting
practices.
D. Most individuals that sit on the risk committee should also sit on the audit committee to
align incentives between the two entities.
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T he assertion that most individuals that sit on the risk committee should also sit on the audit
committee to align incentives between the two entities is incorrect. T he risk committee and the
audit committee should be two separate entities, each requiring different skills to meet its
respective responsibilities. T he risk committee should have members with enough analytic
sophistication and business experience to properly analyze key risks. On the other hand, the audit
committee should comprise members that are both independent and financially literate. Having the
same individuals on both committees could lead to a conflict of interest and compromise the
effectiveness of each committee. T herefore, it is not a recommended practice in risk management.
Choi ce A i s i ncorrect. Striving for economic performance instead of accounting performance is
indeed a recommended practice in risk management. T his approach ensures that the company's risk
management activities are aligned with its overall economic goals and not just focused on meeting
accounting standards.
Choi ce B i s i ncorrect. T he compensation of the risk staff based on risk-adjusted performance is
also a best practice in risk management. It aligns the incentives of the risk staff with those of the
company, encouraging them to manage risks effectively.
Choi ce C i s i ncorrect. Having members on the risk committee who have deep knowledge of both
risk issues and accounting practices is highly recommended in effective risk management. Such
individuals can provide valuable insights into how different risks might impact both financial
statements and broader business operations.
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Q.63 George Hitman is a Risk Advisory Director on the board of Temple Tools Inc. George has
passed FRM part 1 and is currently preparing for the FRM part 2 exam. Which of the following is
NOT a duty of the Risk Advisory Director?
A. To attend audit committee meetings and advise the committee to increase the firm's
effectiveness.
B. To Design the risk management program of a firm.
C. To review and analyze the firm's risk management policies and reports.
D. To review related parties and related-party transactions.
T he responsibility of designing the risk management program of a firm does not fall under the
purview of a Risk Advisory Director. T his task is typically assigned to the Chief Risk Officer (CRO)
of the company. T he CRO is responsible for identifying, analyzing, and mitigating internal and external
events that could threaten the organization. T he CRO works closely with other executives such as
the CEO, CFO, and COO to coordinate risk management efforts. T he CRO's duties include designing
and implementing an overall risk management process for the organization, which includes an impact
and likelihood assessment, risk mitigation strategies, and reporting mechanisms. T herefore, while the
Risk Advisory Director may provide input and advice on the risk management program, the design and
implementation of the program is not their primary responsibility.
Choi ce A i s i ncorrect. Attending audit committee meetings and advising the committee to increase
the firm's effectiveness is indeed a part of a Risk Advisory Director's responsibilities. T hey are
expected to provide insights and recommendations based on their understanding of risk management.
Choi ce C i s i ncorrect. Reviewing and analyzing the firm's risk management policies and reports
are key responsibilities for a Risk Advisory Director. T hey need to ensure that these policies align
with regulatory requirements, industry standards, and best practices.
Choi ce D i s i ncorrect. Reviewing related parties and related-party transactions also falls under the
purview of a Risk Advisory Director as it can have significant implications on an organization’s risk
profile.
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Q.64 Due to the presence of agency risk in the majority of organizations, it is necessary for the
board to form a compensation committee to ensure appropriate risk is taken in relation to the long-
term risk objectives. Its principal role is to design and approve the remuneration plans of
management. Which of the following remuneration structures can be a potential cause of agency
risk?
A. Compensation with bonuses based on long-term revenues and objectives.
B. Compensation with no guaranteed bonuses.
C. Compensation with the clawback clause on previous bonuses if the long-term goals are
unachieved.
D. Compensation with the bonuses based on share prices.
A remuneration structure that includes bonuses based on share prices can potentially lead to agency
risk. T his is because such a structure may incentivize management to take on excessive risk in an
attempt to boost the company's stock prices. T he desire to increase their personal bonuses may lead
managers to make decisions that are not in the best long-term interests of the company or its
shareholders. T his misalignment of interests between the managers and the shareholders is the
essence of agency risk. T herefore, while such a compensation structure may seem attractive in the
short term, it can lead to significant agency risk in the long term.
Choi ce A i s i ncorrect. Compensation with bonuses based on long-term revenues and objectives is
not likely to contribute to agency risk. T his type of compensation structure aligns the interests of
management with those of the organization, as it incentivizes managers to work towards achieving
long-term goals and objectives.
Choi ce B i s i ncorrect. Compensation with no guaranteed bonuses does not necessarily lead to
agency risk. In fact, this type of compensation structure can help mitigate agency risk by ensuring
that managers are only rewarded when they achieve certain performance targets or meet specific
objectives.
Choi ce C i s i ncorrect. Compensation with a clawback clause on previous bonuses if the long-term
goals are unachieved actually helps in reducing agency risk rather than contributing to it. T he
clawback clause acts as a deterrent for managers from taking excessive risks or engaging in short-
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term profit-making activities at the expense of long-term organizational goals.
Q.65 David Lennon, a corporate trainer, has finalized some of the roles and responsibilities of the
audit committee of the organizations which he is going to add in his presentation on the subject of the
audit committee of the board. Which of the following is least likely a role of the audit committee?
A. Ensuring the accuracy of financial and regulatory reporting of the firm
B. Ensuring that the firm complies with standards in regulatory, risk management, and
compliance activities.
C. Ensuring that the remuneration of key management must be aligned with the goals of other
stakeholders
D. Verifying the activities of the firm to see if the reports outline the same
T he responsibility of ensuring that the remuneration of key management aligns with the goals of
other stakeholders is typically not a role of the audit committee. Instead, this responsibility usually
falls under the purview of the compensation committee. T he compensation committee is a separate
entity within the organization that specifically focuses on determining and managing the
remuneration of key management personnel. Its primary goal is to ensure that the compensation
structure aligns with the organization's overall objectives and the interests of its stakeholders. T his
alignment is crucial for maintaining a balanced and effective management structure within the
organization. T herefore, while the audit committee plays a significant role in overseeing the
organization's financial and regulatory activities, it does not typically involve itself in matters related
to compensation.
Choi ce A i s i ncorrect. Ensuring the accuracy of financial and regulatory reporting of the firm is
indeed a key responsibility of the audit committee. T he committee oversees the integrity of these
reports, ensuring they are accurate and comply with all relevant regulations.
Choi ce B i s i ncorrect. Ensuring that the firm complies with standards in regulatory, risk
management, and compliance activities is also a core function of an audit committee. T hey play a
crucial role in overseeing that all operations are conducted within legal and ethical boundaries.
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Choi ce D i s i ncorrect. Verifying the activities of the firm to see if the reports outline them
accurately falls under an audit committee's purview as well. T his involves checking whether
operational activities align with what has been reported in financial statements or other official
documents.
78
Q.66 Which of the following is least likely a role of the Chief Risk Officer (CRO)?
A. Designing the risk management program of the firm
B. Oversee financial reporting and the dealings between the firm and its associates
C. An intermediary between the board and the management.
D. Monitoring the firm's risk limits set by the senior risk management
T he role of overseeing financial reporting and the dealings between the firm and its associates is not
typically a responsibility of the Chief Risk Officer (CRO). T his task is more likely to be handled by
the Risk Advisory Director or a similar role within the organization. T he CRO's primary focus is on
managing the firm's risk exposure and ensuring that the risk management program is effective. T his
includes designing the risk management program, monitoring the firm's risk limits set by senior risk
management, and acting as an intermediary between the board and management. While the CRO may
have some involvement in financial reporting and dealings with associates, this is not a primary
responsibility and is therefore the least likely role of the CRO among the options provided.
Choi ce A i s i ncorrect. T he CRO is indeed responsible for designing the risk management program
of the firm. T his includes identifying potential risks, developing strategies to mitigate these risks, and
implementing these strategies across the organization.
Choi ce C i s i ncorrect. T he CRO acts as an intermediary between the board and management,
communicating risk-related issues and ensuring that both parties are aware of the firm's risk
exposure.
Choi ce D i s i ncorrect. Monitoring the firm's risk limits set by senior management is a key
responsibility of a CRO. T hey need to ensure that all activities within the organization are conducted
within these established limits.
Q.5308 Simon Harvey has recently assumed the role of chairman for the audit committee at his bank.
In their initial meeting, a member highlights the committee's responsibilities. Which of the following
statements accurately reflects their role?
79
A. Identifying and assessing the organization's risks, including operational, financial, strategic,
reputational, and compliance risks.
B. Reviewing and approving risk management strategies and plans to mitigate and manage
risks.
C. Overseeing the financial reporting process to ensure accuracy, completeness, and

transparency of financial statements and disclosures.
D. Communicating executive compensation decisions to shareholders and other stakeholders

in the organization.
T he primary responsibility of an audit committee, such as the one Simon Harvey has been appointed
to chair, is to oversee the financial reporting process. T his involves ensuring the accuracy,
completeness, and transparency of the financial statements and disclosures made by the bank. T he
audit committee plays a pivotal role in assessing the internal controls in place, managing relationships
with external auditors, and evaluating the risk management strategies implemented by the bank.
Furthermore, the committee is also tasked with monitoring compliance with legal and regulatory
requirements, thereby safeguarding the organization's integrity and reputation. T his role is critical in
maintaining the trust of shareholders and other stakeholders in the financial health and management
of the bank.
Choi ce A i s i ncorrect. While identifying and assessing the organization's risks is a crucial part of
risk management, it is not typically the responsibility of the audit committee. T his task usually falls
under the purview of risk management teams or committees.
Choi ce B i s i ncorrect. T he audit committee does not generally review and approve risk
management strategies and plans to mitigate and manage risks. T his role belongs to senior
management or a dedicated risk committee, who are responsible for developing and implementing
these strategies.
Choi ce D i s i ncorrect. Communicating executive compensation decisions to shareholders and
other stakeholders in the organization does not fall within the scope of an audit committee's
responsibilities. T his task would typically be handled by either human resources or a compensation
committee.
80
Q.5309 Jane Doe has just been promoted to the position of Chief Risk Officer. At the beginning of her
tenure, she is handed her job description by the board of directors and Chief Executive. Which of the
following statements gives a correct description of her new role?
A. Verify the activities of the firm to see if the reports outline the same
B. Define the level of risk the organization is willing to accept.
C. Review and approve the organization’s policies.
D. Ensure compliance with regulations and standards.
T he primary responsibility of a Chief Risk Officer (CRO) is to ensure that the organization complies
with all relevant laws, regulations, and industry standards related to risk management. T his involves
developing and implementing effective risk management strategies and policies, overseeing risk
management activities across the organization, and ensuring that all business activities are conducted
in a manner that is compliant with regulatory requirements. T he CRO is also responsible for
communicating and reporting on risk-related issues to the board of directors and other key
stakeholders. T his role is critical in protecting the organization from potential risks and liabilities,
and in maintaining its reputation and credibility in the market.
Choi ce A i s i ncorrect. While verifying the activities of the firm may be part of a CRO's role, it is
not their primary responsibility. T he CRO's main duty is to manage and mitigate risk within the
organization, which goes beyond simply verifying reports.
Choi ce B i s i ncorrect. Defining the level of risk an organization is willing to accept falls under the
purview of senior management or board of directors rather than that of a CRO. T he CRO's role
would be more about managing and mitigating those defined risks.
Choi ce C i s i ncorrect. Reviewing and approving policies can be part of a CRO’s responsibilities
but it isn't their primary duty. T heir main task involves ensuring that these policies are in line with
regulatory standards and managing any associated risks.
81
Reading 4: Credit Risk Transfer Mechanisms
Q.3718 What are the contractual specifications for the protection seller of a credit default swap?
A. T he protection buyer pays a premium to the protection seller at regular time intervals
until a credit event occurs, in which case the protection seller pays the protection buyer
compensation for the credit event.
B. If a credit event occurs, the protection seller is obliged to exchange contractually

specified assets for government bonds.
C. T he protection seller pays a premium to the protection buyer at regular time intervals
until a credit event occurs, in which case the protection buyer pays the protection seller
compensation for the credit event.
D. If the underlying of the credit default swap is a bond issued by a specific corporation, only
this corporation can act as a protection seller.
In a credit default swap (CDS), the protection seller is essentially selling insurance against the default
risk of a specific credit instrument, such as a bond or loan. T he protection buyer pays a premium to
the protection seller at regular intervals. T his premium is essentially the cost of the insurance. If a
credit event, such as a default, occurs, the protection seller is obligated to compensate the
protection buyer. T he compensation is usually the face value of the credit instrument. T his
arrangement allows the protection buyer to hedge against the risk of default. T he protection seller,
on the other hand, earns a premium for taking on this risk.
Choi ce B i s i ncorrect. In a credit default swap, the protection seller does not exchange assets for
government bonds in the event of a credit event. Instead, they are obligated to compensate the
protection buyer for their loss.
Choi ce C i s i ncorrect. T his choice incorrectly reverses the roles of the protection buyer and
seller. In reality, it's the protection buyer who pays premiums to the seller until a credit event
occurs, at which point it's then up to the seller to compensate them.
Choi ce D i s i ncorrect. T he underlying asset of a CDS can be any kind of debt instrument - not just
corporate bonds - and any party (not just corporations) can act as a protection seller as long as they
are willing and able to fulfill their obligations under contract terms.
82
Q.3719 T he practice of approving mortgages in order to sell them as mortgage-backed securities is
known as:
A. Originate-to-distribute
B. Originate-to-keep
C. Principal-agent engineering
D. A credit default swap
T he originate-to-distribute (OT D) business model is a practice where the originators of mortgages or
other types of loans repackage these assets and sell them to third parties. T his model is the opposite
of the traditional originate-to-keep (OT K) model where the owners of mortgages and other loans
keep these assets in their balance sheets until maturity. T he OT D model has several benefits from
the perspective of the originator, usually banks. It introduces specialization in the lending process as
functions initially designated for a single firm are now split among several firms. It also reduces
banks’ reliance on the traditional sources of capital, such as deposits and rights issues. Furthermore,
it introduces flexibility into banks’ financial statements and helps them diversify some risks.
Choi ce B i s i ncorrect. Originate-to-keep refers to the traditional banking model where banks
originate loans and keep them on their balance sheets until they are repaid. T his is different from the
practice described in the question, which involves selling off the mortgages as securities.
Choi ce C i s i ncorrect. Principal-agent engineering does not refer to any specific practice in
financial markets. It's a term that might be used in discussions of agency theory, which deals with
issues like moral hazard and conflicts of interest between principals (like shareholders) and agents
(like managers or brokers). It doesn't have anything to do with mortgage origination or securitization.
Choi ce D i s i ncorrect. A credit default swap is a financial derivative contract that allows an
investor to "swap" or offset their credit risk with that of another investor. It does not involve
originating mortgages or creating mortgage-backed securities.
83
Q.3720 Which of the following best explains why the 2001-2002 economic slowdown did NOT result
in heavy losses for the banking sector?
A. Rapid foreclosure of insolvent/loss-making corporate borrowers.
B. A substantial increase in investment in government bonds.
C. Cash injections by the Federal Reserve.
D. Hedging through credit derivatives and securitization of assets.
T he banking sector was able to avoid heavy losses during the 2001-2002 economic slowdown largely
due to the use of credit risk derivatives and securitization of assets. Banks that had lent money to
various corporations had purchased protection against default in the form of credit default swaps and
total return swaps. T hese financial instruments provided a hedge against the risk of borrower
default. In addition, some banks had securitized a significant portion of their assets by issuing
collateralized debt obligations and collateralized loan obligations. When borrowers defaulted, banks
that had bought protection through credit derivatives were compensated. Meanwhile, banks that had
securitized their assets had already received payments from third-party investors, which helped
offset the total loss. T his strategy of hedging through credit derivatives and securitization of assets
was a key factor in the banking sector's resilience during the economic slowdown.
Choi ce A i s i ncorrect. Rapid foreclosure of insolvent/loss-making corporate borrowers would not
have necessarily contributed to the resilience of the banking sector during an economic downturn.
In fact, it could have potentially exacerbated the situation by causing a further decline in asset values
and increasing uncertainty in the market.
Choi ce B i s i ncorrect. While a substantial increase in investment in government bonds may
provide a safe haven for banks during times of economic instability, it does not directly contribute to
their resilience or ability to avoid heavy losses. It's more of a defensive strategy rather than one that
actively mitigates risk.
Choi ce C i s i ncorrect. Cash injections by the Federal Reserve can provide temporary relief but do
not fundamentally address the underlying risks that banks face during an economic downturn.
Moreover, such measures are typically reactive and come into play after losses have already been
84
incurred.
Q.3721 Global Tech has declared its intention to bring to the market a 10-year senior bond issue at
par with a coupon rate of 23%, offering a spread of 1200 basis points over the corresponding 10-year
T reasury issue. An investor is keen to enter into a total return swap that matures in one year with
the senior bonds that are about to be issued as the reference obligation. Under the terms of the
contract, payments will be exchanged semiannually, where the total return receiver will pay the six-
month T reasury rate plus 328 basis points. What is the 10-year T reasury rate at the time the bonds
are issued?
A. 10%
B. 12%
C. 11%
D. 13%
We know that Global Tech will be coming to market with a 10-year senior bond issue at par with a
coupon rate of 23%, offering a spread of 1200 basis points over the 10-year T reasury issue. Because
1200 basis points is 12%, this means the 10-year T reasury issue will have a rate of 23% - 12% =
11%. At the time of issuance, therefore, the 10-year T reasury yield is 11%.
Note that the question has a bit of nugatory information.
85
Q.3722 Which of the following is most likely correct?
Credit default swaps contributed to the financial crisis of 2007-2009 by:
A. Allowing protection buyers to specify who bears the credit risk on a given security.
B. Requiring no collateral from both protection buyers and sellers.
C. Making it easier for sellers of insurance to assume and conceal risk.
D. Identifying those who took concentrated positions on one side of a trade.
Credit default swaps indeed made it easier for sellers of insurance to assume and conceal risk. T his
was largely due to the lack of stringent regulations and oversight in the credit default swap market.
Sellers of protection were not required to maintain reserves to cover the protection sold, leaving
them vulnerable to serious funding problems following a claim of compensation by the protection
buyer. T his lack of reserves was a principal cause of the financial distress experienced by AIG in
2008, as it had insufficient reserves to meet the 'run' of expected payouts caused by the housing
bubble collapse. T he ease with which sellers could assume and conceal risk in this largely
unregulated market contributed significantly to the financial crisis of 2007-2009.
Choi ce A i s i ncorrect. Credit default swaps (CDS) do not allow protection buyers to specify who
bears the credit risk on a given security. T he buyer of a CDS receives credit protection, whereas
the seller of the CDS takes on the credit risk of the reference entity.
Choi ce B i s i ncorrect. T his statement is false as it was not a requirement for both parties in a
CDS contract to provide no collateral. In fact, collateral agreements were often part of these
contracts to mitigate counterparty risk.
Choi ce D i s i ncorrect. Credit default swaps did not necessarily identify those who took
concentrated positions on one side of a trade. While they could potentially expose such positions,
this was not their primary function or contribution during the financial crisis.
86
Q.3723 Which of the following statements are correct? Credit default swaps:
A. Present high levels of risk and are only be used by the wealthy
B. Allow lenders to insure themselves against the risk that a borrower will default.
C. It should only be used by people seeking high returns from low risk.
D. Do not require collateral to be posted by either the buyer or the seller of the insurance.
Credit default swaps (CDS) are a type of credit derivative contract that allows a lender to transfer
the credit risk of a borrower defaulting to another party. In a CDS contract, the buyer of the
protection (usually a lender) makes periodic payments to the seller of the protection. In return, the
seller agrees to compensate the buyer if a specified credit event, such as a default, occurs. T his
mechanism allows lenders to insure themselves against the risk of a borrower defaulting on their
obligations. It's a form of risk management strategy that helps lenders mitigate potential losses from
credit risk.
Choi ce A i s i ncorrect. Credit default swaps do not inherently present high levels of risk and are
not exclusively used by the wealthy. T hey are complex financial instruments used to manage credit
risk, and their usage depends on the risk appetite and strategy of the user, regardless of wealth.
Choi ce C i s i ncorrect. T he statement that credit default swaps should only be used by people
seeking high returns from low risk is misleading. While it's true that CDS can potentially provide high
returns, they also carry significant risks including counterparty risk, liquidity risk, and legal risks.
Choi ce D i s i ncorrect. It's not accurate to say that credit default swaps do not require collateral
to be posted by either the buyer or seller of the insurance. In fact, collateral agreements are
common in CDS contracts as a way to mitigate counterparty credit risk.
87
Q.3724 T he purpose of credit derivatives is to:
A. T ransfer the risk from one party to another.
B. Increase the risk, so that the return is larger.
C. Postpone the risk for both parties in the transaction.
D. Eliminate risk for both parties in the transaction.
Credit derivatives are primarily used to transfer the risk from one party to another. T hey are
financial contracts that allow a creditor to transfer the credit risk of an underlying portfolio of
securities to another party without transferring the underlying portfolio itself. T his is achieved
through a variety of credit derivative products, such as credit default swaps, credit linked notes, and
total return swaps. T hese products provide a mechanism for managing credit risk by transferring it
to another party who is willing and able to bear that risk. T his transfer of risk can help to reduce the
potential for losses due to credit events such as default, bankruptcy, or restructuring.
Choi ce B i s i ncorrect. Credit derivatives are not used to increase the risk for larger returns.
T hey are primarily used as a tool for managing and mitigating credit risk, not amplifying it.
Choi ce C i s i ncorrect. T he purpose of credit derivatives is not to postpone the risk for both
parties in the transaction. Instead, they allow one party (the buyer) to transfer specific credit risks
to another party (the seller).
Choi ce D i s i ncorrect. While credit derivatives can help manage risk, they do not eliminate it
entirely for both parties involved in the transaction. T he seller of a credit derivative assumes the
potential default or downgrade risk from the buyer, hence there's still an element of risk involved.
88
Q.3726 Which of the following statements regarding Credit Default Swaps (CDS) is incorrect?
A. T heir payoff is contingent upon the performance of an underlying instrument
B. Examples of CDS’s underlying assets include corporate bonds and emerging market bonds.
C. T heir value rises and falls as opinions change about the likelihood of default.
D. T hey will be paid out in case of bankruptcy.
T he statement that Credit Default Swaps (CDS) will be paid out in case of bankruptcy is incorrect.
While it is true that a CDS can be triggered by a bankruptcy event, it is not the only credit event that
can trigger a CDS. Other credit events such as failure to pay, restructuring, and obligation
acceleration can also trigger a CDS. T herefore, the payout of a CDS is not solely contingent upon the
declaration of bankruptcy. It is contingent upon the occurrence of a credit event as defined in the
terms of the CDS contract. T his misunderstanding could lead to a misinterpretation of the risk
protection provided by a CDS.
Choi ce A i s i ncorrect. T he payoff of a Credit Default Swap (CDS) is indeed contingent upon the
performance of an underlying instrument. If the underlying asset defaults, the protection buyer
receives a payout from the protection seller.
Choi ce B i s i ncorrect. Corporate bonds and emerging market bonds are common examples of
underlying assets for CDSs. T hese instruments can be used to hedge against credit risk associated
with these types of bonds.
Choi ce C i s i ncorrect. T he value of a CDS does rise and fall based on changing opinions about the
likelihood of default by the reference entity (the issuer of the underlying asset). As perceived credit
risk increases, so does the value or price of a CDS contract.
89
Q.3727 In a credit default swap transaction:
A. T he protection buyer is long on risk.
B. T he protection seller is short on risk.
C. T he protection seller makes periodic payments.
D. T he protection buyer makes periodic payments.
In a credit default swap (CDS) transaction, the protection buyer indeed makes periodic payments.
T his is a fundamental aspect of a CDS transaction. T he protection buyer, who is seeking to hedge
against the risk of a third party defaulting on its obligations, makes these payments to the protection
seller. In return, the protection seller promises to compensate the protection buyer if the third
party defaults. T his arrangement allows the protection buyer to transfer the credit risk associated
with the third party to the protection seller. T he periodic payments made by the protection buyer
are often referred to as 'premiums' or 'spreads' and are typically calculated as a percentage of the
notional amount of the CDS contract.
Choi ce A i s i ncorrect. T he protection buyer in a CDS transaction is actually short on risk, not
long. T his is because the protection buyer pays a premium to the protection seller to take on the
credit risk of a reference entity. If that entity defaults, the protection seller compensates the buyer,
thus reducing their exposure to risk.
Choi ce B i s i ncorrect. Contrary to this statement, the protection seller in a CDS transaction is
long on risk. T hey receive regular payments from the protection buyer and in return agree to cover
losses if a specified credit event occurs with respect to an underlying reference entity.
Choi ce C i s i ncorrect. In fact, it's just opposite of what happens in reality; it's not the protection
seller but rather it's actually the Protection Buyer who makes periodic payments (premiums) as part
of their agreement with Protection Seller.
Q.3729 An investor wishes to purchase a 5-year BBB-rated bond issued by BAC Corporation but does
not want to bear the out-of-pocket costs and the inconvenience associated with long-term financing
90
arrangements, actually going long the bond, and taking delivery. Suppose also that a bank owns the
same bond and would like to extend a loan to BAC Corporation but its loans to BAC and investments in
BAC debt instruments have fully exhausted its capacity to lend to BAC. Which of the following
instruments would best suit the two parties in these circumstances?
A. Credit spread swap option
B. Total return swap
C. Credit default swap
D. Collateralized loan obligation
A total return swap is a financial derivative that transfers both the credit risk and market risk of an
underlying asset. It involves two parties: the total return payer (or buyer) and the total return
receiver (or seller). T he total return payer receives the total return (including income and capital
gains or losses) from a specified asset, and in return, pays the total return receiver a regular fixed or
floating cash flow.
In this scenario, the investor can enter into a total return swap agreement with the bank. T he
investor, acting as the total return payer, will receive the total economic return on the BAC
Corporation bond without actually purchasing it. T his arrangement allows the investor to avoid the
costs and inconvenience associated with long-term financing arrangements and taking delivery of the
bond.
On the other hand, the bank, acting as the total return receiver, can reduce its risk exposure to BAC
Corporation as if it had sold the bond, without actually doing so. T his arrangement allows the bank to
extend a loan to BAC Corporation without exceeding its lending capacity. T herefore, a total return
swap is the most suitable instrument for both parties in these circumstances.
Choi ce A i s i ncorrect. A credit spread swap option would not be the most appropriate solution in
this scenario. T his financial instrument allows the holder to swap the credit risk of a bond with
another party, but it does not address the investor's unwillingness to bear long-term financing
arrangements and physical ownership of the bond.
Choi ce C i s i ncorrect. A credit default swap would also not be suitable in this case. While it
91
provides protection against default risk, it does not solve the issue of physical ownership and long-
term financing arrangements that are concerning for the investor.
Choi ce D i s i ncorrect. A collateralized loan obligation involves pooling various types of debt into a
single security sold to investors, which doesn't align with either party's needs in this scenario. T he
bank has already reached its lending capacity to BAC and wouldn't benefit from further exposure,
while for an investor who doesn't want to physically own bonds or deal with long-term financing
arrangements, buying into a pool of loans isn't an attractive proposition.
92
Q.3730 T wo parties decide to engage in a 2-year credit default swap. Assume that the reference
entity is BAC Corporation. T he notional amount of the contract is $10 million, and the contract is
cash-settled.
After one year, a default event occurs, and the bonds are valued at $8.5 million at the time of default.
Which of the following is most likely correct?
A. T he protection buyer receives $1.5 million in compensation.
B. T he protection buyer continues to pay premiums for one more year.
C. T he protection buyer delivers the bond to the protection seller .
D. T here is no compensation paid to the protection buyer.
In a credit default swap (CDS), the protection seller compensates the protection buyer in the event
of a default. T he compensation amount is typically the difference between the notional amount of
the contract and the market value of the defaulted bond. In this case, the notional amount is $10
million and the market value of the bond at the time of default is $8.5 million. T herefore, the
protection buyer receives $1.5 million in compensation. T his is the fundamental principle of a CDS -
it provides insurance against the risk of default. T he protection buyer pays a premium to the
protection seller for this insurance, and in return, the protection seller agrees to compensate the
protection buyer if a specified credit event, such as a default, occurs.
Choi ce B i s i ncorrect. T he protection buyer does not continue to pay premiums for one more
year. In a credit default swap agreement, once a default event occurs, the contract is terminated and
no further premiums are required to be paid by the protection buyer.
Choi ce C i s i ncorrect. T he protection buyer does not deliver the bond to the protection seller in
this scenario as it's a cash-settled contract. In cash settlement, the difference between par value and
market value of defaulted bond (recovery rate) is paid by the seller to the buyer, there's no physical
delivery of bonds.
Choi ce D i s i ncorrect. T here indeed is compensation paid to the protection buyer in case of a
credit event such as default. T his compensation equals to difference between notional amount and
recovery value which in this case amounts $1.5 million ($10 million - $8.5 million).
93
Q.3731 An investor approaches a swap dealer wishing to engage in a total return swap. T he
underlying asset is $10 million principal amount of a 9% BB-rated 5-year corporate bond that has
semiannual interest payments. T he swap dealer agrees to pay the total return on this bond for the
coming 6 months in return for payments based on (1) an interest rate of 6-month LIBOR plus a
spread of 30 basis points and (2) a notional principal amount equal to the face value of the underlying
asset, $10 million.
At the swap date, the bond is worth par, and the 6-month LIBOR is 6%. Suppose that at the
termination date, the value of the bond has still not changed. Determine the net payment and the
party that is owed. (Use discrete compounding.)
A. Net payment = $315,000 ; owed party is the investor
B. Net payment = $450,000; owed party is the swap dealer
C. Net payment = $0; no owed party
D. Net payment = $135,000; owed party is the investor
T he easiest way to see this swap is that one party is swapping the 9% coupons + capital gains against
LIBOR + 0.3%.
Assumptions:
Asset: $10 million principal amount of a 9% BB-rated 5-year corporate bond
Floating rate: 6-month LIBOR plus a spread of 0.3% (the 6-month LIBOR on the swap date
is 6%)
Term of the swap: 6 months (just one interest period)
Value of the bond: Swap date: 100% of the face value
Termination date: 100% of the face value
Here’s how we calculate the cash payment:
0.09
Interest on the bond:$10, 000, 000 × = $450, 000
2
(0.06 + 0.003)
Interest at LIBOR:$10, 000, 000 = $315, 000
2
94
T hus, the interest payment obligations are $315,000 for the investor and $450,000 for the swap
dealer. T he swap dealer must, therefore, make a net payment to the investor of $135,000 (=
$315,000 - $450,000).
Had there been a capital gain or loss on the reference obligation, this would have impacted the
payments made by the two parties.
Note that, in a total return swap, the payer(protection buyer) agrees to pay the total return swap
receiver, the total return derived from the underlying asset. In return, the receiver(protection
seller) pays the asset owner a Libor-based interest rate during the life of the total return swap.
95
Q.5310 ABC Bank has one of the best credit risk management strategies in the country. One way it
does this is by having a rigorous screening process at the application stage. Of the four ways that
banks deal with credit exposure, which one does the above strategy fall under?
A. Retain
B. Avoid
C. Mitigate
D. T ransfer
Mitigation in the context of credit risk management refers to the reduction of risk by implementing
measures that eliminate or reduce exposure. T his can be achieved through various strategies, one of
which is the adoption of a rigorous screening process at the application stage. T his process helps the
bank to assess the creditworthiness of potential borrowers, thereby reducing the likelihood of
default. By doing so, the bank can mitigate the potential losses that may arise from non-payment of
loans. T his strategy is particularly effective as it allows the bank to identify and address potential
risks before they materialize, thereby enhancing the overall effectiveness of the bank's credit risk
management framework.
Choi ce A i s i ncorrect. Retaining credit risk refers to the bank's decision to accept and manage the
risk internally, rather than transferring it to another party. It does not involve a stringent screening
process during the application phase.
Choi ce B i s i ncorrect. Avoiding credit risk means that the bank chooses not to engage in any
transaction that might expose it to potential credit losses. While a stringent screening process could
potentially help avoid risky borrowers, this method generally involves abstaining from certain types
of transactions or sectors altogether.
Choi ce D i s i ncorrect. T ransferring credit risk involves shifting the potential loss from a default
event onto another party, typically through financial instruments such as derivatives or
securitization. T his strategy does not directly involve a stringent screening process during the
application phase.
96
Q.5311 John T homas has recently learned about different derivative instruments he can use in his
stock trading business. He is particularly interested in an instrument that would give him the option
but not obligation to buy the underlying stock at an agreed upon strike price at the maturity date.
Which of the following derivative instruments is John T homas referring to?
A. American call option
B. European put option
C. American put option
D. European call option
A European call option is a type of derivative instrument that provides the holder with the right, but
not the obligation, to buy an underlying asset, such as a stock, at a predetermined price (known as
the strike price) on a specific date (the expiration date). T his type of option can only be exercised
on the expiration date, not before. T his characteristic aligns with the instrument that John T homas is
interested in, as he wants the flexibility to decide whether to buy the underlying stock at the agreed
price on the maturity date, depending on the prevailing market conditions.
Choi ce A (Ameri can cal l opti on) i s i ncorrect. While an American call option does provide the
holder with the right, but not the obligation, to purchase an underlying asset at a predetermined
price, it can be exercised any time before its expiration date. T his differs from John's requirement
of exercising only on the date of maturity.
Choi ce B (European put opti on) i s i ncorrect. A European put option gives its holder the right
to sell an underlying asset at a predetermined price on or before its expiration date, not buy it as
John intends to do.
Choi ce C (Ameri can put opti on) i s i ncorrect. Similar to a European put option, an American
put option also provides its holder with the right to sell an underlying asset at a predetermined price
any time before its expiration date. T his does not align with John's intention of buying and his
requirement for exercising only on maturity.
97
Q.5312 Coin Bank would like to decrease its credit risk by using credit derivatives. Which of the
following credit derivatives would the bank use to pool together multiple mortgage and bond loans,
package them into different tranches and sell them to investors?
A. Credit default swaps
B. Collateralized loan obligations
C. Collateralized debt obligations
D. Mortgage-backed security
A Collateralized Debt Obligation (CDO) is a type of structured financial product that pools together a
variety of assets, such as mortgages, bonds, and loans, and organizes them into different tranches
based on their risk and return profiles. T hese tranches are then sold to investors. T he tranches are
structured in such a way that the senior tranches (those with the lowest risk) receive payment first
from the cash flows generated by the underlying assets. T he junior tranches (those with higher risk)
receive payment only after the senior tranches have been fully paid. T his structure allows investors
to choose the level of risk and return that best suits their investment objectives. By using CDOs,
Coin Bank can effectively distribute its credit risk among a variety of investors, thereby reducing its
overall exposure.
Choi ce A i s i ncorrect. Credit default swaps are a type of credit derivative, but they do not allow
for the consolidation and tranching of multiple loans. Instead, they act as a form of insurance against
the default risk of a specific reference entity or credit instrument.
Choi ce B i s i ncorrect. Collateralized loan obligations (CLOs) are indeed used to consolidate
multiple loans into various tranches based on risk and return, but these are specifically for corporate
loans rather than mortgage and bond loans.
Choi ce D i s i ncorrect. Mortgage-backed securities (MBS) involve the pooling of mortgages which
are then sold to investors as securities. However, MBS do not involve categorizing these pooled
mortgages into various tranches based on risk and return like collateralized debt obligations do.
98
Reading 5: Modern Portfolio Theory (MPT) and the Capital Asset
Pricing Model (CAPM)
Q.38 Henry Ellen, an FRM candidate, has recently studied William Sharpe's Capital Asset Pricing
Model (CAPM) as part of the FRM books. As per his understanding of the model, he has come up with
a list of broad assumptions. Which of the following assumptions of the CAPM model is INCORRECT ?
A. CAPM assumes that all capital markets are perfectly competitive.
B. As per CAPM, investors should not be concerned with unsystematic risk.
C. CAPM does not consider transaction costs.
D. Beta can be decreased via diversification.
T he statement that 'Beta can be decreased via diversification' is incorrect in the context of the
Capital Asset Pricing Model (CAPM). Beta, in the CAPM, represents systematic risk, which is the
risk inherent to the entire market or market segment. Systematic risk, also known as non-
diversifiable risk, is the risk that affects all companies, regardless of the industry or sector they
belong to. T his risk cannot be eliminated through diversification. Diversification, a risk management
strategy that mixes a wide variety of investments within a portfolio, is effective in reducing
unsystematic risk, also known as company-specific or idiosyncratic risk. Unsystematic risk pertains
to a specific company or industry and can be nearly eliminated through diversification. T herefore,
the assumption that beta, which represents systematic risk, can be decreased through diversification
is incorrect.
Choi ce A i s i ncorrect. T he CAPM does indeed assume that all capital markets are perfectly
competitive. T his means that all investors have the same information and can buy or sell any amount
of securities without affecting the market price.
Choi ce B i s i ncorrect. According to the CAPM, investors should not be concerned with
unsystematic risk because it can be eliminated through diversification. Unsystematic risk refers to
company-specific or industry-specific risks that can be mitigated by holding a diversified portfolio.
Choi ce C i s i ncorrect. T he CAPM does not consider transaction costs in its assumptions, which
implies that buying and selling securities do not incur any costs for the investor.
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Q.179 A property development company faces the following problems:
I. Labor costs
II. Interest rate risk
III. Environmental challenges
IV. Poor project management
V. Inflation
Which of the above risks would be taken into account when estimating the company's beta?
A. I, II, & IV
B. II & IV
C. II & V
D. I, III, & IV
Thi ngs to Remember
1. Beta is a measure of a company's systematic risk, which is the risk that cannot be eliminated
through diversification. It is a key component in the Capital Asset Pricing Model (CAPM), which is
used to calculate the expected return on an investment given its systematic risk.
2. Systematic risks affect the entire market and include factors such as interest rate fluctuations and
inflation. T hese risks are relevant to all companies and cannot be eliminated through diversification.
3. Company-specific risks, also known as unsystematic risks, can be eliminated through
diversification. T hese risks are specific to a particular company and do not affect the entire market.
Examples include labor costs, poor project management, and environmental challenges.
4. When estimating a company's beta, it is appropriate to consider only the systematic risks that the
company faces. Company-specific risks are not taken into account.
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Q.180 Which of the following is NOT an assumption of the standard Capital Assets Pricing Model
(CAPM)?
A. Investors incur some transactional costs when trading assets.
B. T here are no taxes, making investors indifferent between capital gains and
dividends/income.
C. Assets can be divided infinitely, making it possible to hold fractional shares.
D. T here's unlimited short selling/ a perfectly liquid market.
T he standard Capital Asset Pricing Model (CAPM) assumes that there are no transaction costs. T his
assumption is made to simplify the model and make it more tractable. In reality, investors do incur
transaction costs when they trade assets. T hese costs can include brokerage fees, bid-ask spreads,
and other costs associated with buying and selling securities. If transaction costs were included in
the CAPM, the model would become more complex as the return on an investment would then be a
function of these costs. T his would require estimating the transaction costs, which can vary widely
depending on the type of asset, the trading platform, and other factors. T herefore, the assumption of
no transaction costs is a simplifying assumption that makes the CAPM more manageable, even though
it does not accurately reflect the realities of investing.
Choi ce B i s i ncorrect. T his statement accurately represents an assumption of the standard
CAPM. T he model assumes that there are no taxes, which means investors are indifferent between
capital gains and dividends/income. T his simplifies the model by eliminating tax considerations from
investment decisions.
Choi ce C i s i ncorrect. T his statement also accurately represents an assumption of the standard
CAPM. T he model assumes that assets can be divided infinitely, allowing investors to hold fractional
shares if desired. T his makes it possible for all investors to hold the market portfolio regardless of
their wealth level.
Choi ce D i s i ncorrect. Again, this statement accurately represents an assumption of the standard
CAPM. T he model assumes unlimited short selling and a perfectly liquid market, meaning that any
amount of securities can be bought or sold without affecting their price.
101
102
Q.181 Consider a graph with expected return on the vertical axis and standard deviation on the
horizontal axis. What's the name of the line that connects the risk-free rate and the optimal risky
portfolio?
A. T he efficient frontier
B. T he characteristic line
C. T he indifference curve
D. T he capital market line
T he CML is a line that illustrates the trade-off between expected return and standard deviation (risk)
for efficient portfolios. It is derived from the Modern Portfolio T heory and is an important concept
in financial investment. T he CML starts from the point representing the risk-free rate and extends to
the point representing the optimal risky portfolio. T his line shows the relationship between risk (as
measured by standard deviation) and return of efficient (market) portfolios. T he line appears as a
tangent from the intercept point on the efficient frontier to the point where the risk-free rate of
return equals the expected return. T he slope of the CML represents the market price of risk, or the
additional expected return per unit of standard deviation that an investor can expect to earn by
moving from a risk-free investment to a risky one. T he CML is used by investors to choose their
optimal portfolio, given their level of risk tolerance.
Choi ce A i s i ncorrect. T he efficient frontier is not a line but a set of optimal portfolios that offer
the highest expected return for a defined level of risk or the lowest risk for a given level of
expected return. It does not originate from the point representing the risk-free rate.
Choi ce B i s i ncorrect. T he characteristic line is used in the Capital Asset Pricing Model (CAPM)
to depict the systematic risk of an individual security as its correlation with market returns, and it's
not related to visualizing relationship between overall portfolio risk and return.
Choi ce C i s i ncorrect. An indifference curve represents combinations of risk and return that an
investor views as equally preferable, which doesn't necessarily extend from the point representing
the risk-free rate to optimal risky portfolio.
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Q.182 T he difference between the capital market line (CML) and the efficient frontier (EF) is that:
A. T he CML represents possible combinations of portfolios consisting of all possible

proportions between the market portfolio and a risk-free asset while the EF represents all
possible combinations of efficient portfolios, taking into account only risky assets in varying
proportions.
B. T he EF represents possible combinations of portfolios consisting of all possible

proportions between the market portfolio and a risk-free asset while the CML represents all
possible combinations of efficient portfolios, taking into account only risky assets in varying
proportions.
C. T he CML represents a few possible combinations of portfolios consisting of various

proportions between the market portfolio and a risk-free asset while the EF represents all
possible combinations of efficient portfolios, taking into account only risk-free assets in
varying proportions.
D. T he EF represents possible combinations of portfolios consisting of all possible

proportions between the market portfolio and a risk-free asset while the CML represents all
possible combinations of efficient portfolios, taking into account only risky assets in fixed
proportions.
T he Capital Market Line (CML) represents the trade-off between risk and return for efficient
portfolios that include a risk-free asset. T he CML is a straight line that originates from the point of
the risk-free rate and is tangent to the efficient frontier. T he slope of the CML represents the
market price of risk, or the reward per unit of risk that the market is offering. Any point along the
CML represents a portfolio that includes some combination of the market portfolio and the risk-free
asset.
On the other hand, the Efficient Frontier (EF) represents the set of optimal portfolios that offer the
highest expected return for a defined level of risk or the lowest risk for a given level of expected
return. T he EF only includes portfolios of risky assets. T he EF is a curve that forms the boundary of
the set of feasible portfolios. Any point along the EF represents a portfolio that is efficient, i.e., it
offers the highest possible expected return for its level of risk.
T herefore, the key difference between the CML and the EF is that the CML includes the risk-free
asset in its portfolio combinations, while the EF only includes risky assets.
104
Choi ce B i s i ncorrect. T he Efficient Frontier (EF) does not represent combinations of portfolios
consisting of all possible proportions between the market portfolio and a risk-free asset. Instead, it
represents all possible combinations of efficient portfolios, taking into account only risky assets in
varying proportions. On the other hand, the Capital Market Line (CML) represents possible
combinations of portfolios consisting of all possible proportions between the market portfolio and a
risk-free asset.
Choi ce C i s i ncorrect. T he Capital Market Line (CML) does not represent just a few possible
combinations but rather all potential combinations of portfolios consisting of various proportions
between the market portfolio and a risk-free asset. Additionally, EF does not take into account only
risk-free assets in varying proportions; it considers only risky assets.
Choi ce D i s i ncorrect. Similar to choice B, this option incorrectly states that EF represents
potential combinations involving both the market portfolio and a risk-free asset while CML involves
only risky assets in fixed proportions which contradicts with their actual definitions.
105
Q.183 An investor holds a portfolio comprised of a risk-free asset and a market portfolio. Given the
following information, compute the expected return of the portfolio.
Risk-free rate = 5%
Expected market return = 25%
Standard deviation of market portfolio = 10%
Standard deviation of portfolio = 5%
A. 0.25
B. 0.0015
C. 0.1
D. 0.15
Rm −Rf
T he equation of the CML is R p = R f + { } σp
σm
Where:
R p is the expected portfolio return
R f is the risk-free rate
R m is the expected market return
And σm , σp are the standard deviations of the market and the portfolio, respectively
T herefore,
(25 − 5)
E(R p) = 5 + ×5
10
= 5+2×5
= 15%
Note: Any risk-free asset has a known, certain return (5% in this case). T his is the result of its
standard deviation being 0. T hus, the covariance of the risk-free asset with any risky asset, including
the market portfolio, is zero. With a zero covariance, the correlation between the risky asset and
the market portfolio is also zero.
106
Q.184 According to the CAPM, the risk premium expected to be received by a stockholder
increases:
A. Directly with beta.
B. Inversely with beta.
C. Inversely with systematic risk.
D. Directly with total risk.
T he risk premium, according to the Capital Asset Pricing Model (CAPM), increases directly with
beta. Beta is a measure of a stock's systematic risk, or the sensitivity of the stock's returns to
changes in the market. A beta of 1 indicates that the stock's price will move with the market, while a
beta less than 1 indicates that the stock will be less volatile than the market, and a beta greater than
1 indicates that the stock will be more volatile than the market. T herefore, a higher beta implies a
higher risk, and investors require a higher risk premium for taking on this additional risk. T his is
consistent with the fundamental principle of finance that higher risk requires higher return as
compensation. T herefore, as beta increases, the risk premium expected by a stockholder also
increases directly.
Choi ce B i s i ncorrect. T he risk premium does not change inversely with beta. According to the
CAPM, the risk premium (the expected return above the risk-free rate) of a security increases as its
beta (systematic risk) increases. T herefore, there is a direct relationship between beta and the
expected risk premium, not an inverse one.
Choi ce C i s i ncorrect. T he statement that the risk premium changes inversely with systematic
risk contradicts CAPM's fundamental principle. Systematic Risk, represented by Beta in CAPM,
directly influences the Risk Premium - higher systematic risks lead to higher expected returns or
premiums and vice versa.
Choi ce D i s i ncorrect. According to CAPM, it's not total risk but rather systematic or market-
related risks (beta) that influence a security's expected return or Risk Premium directly. Total Risk
includes unsystematic risks which can be diversified away and hence do not contribute towards
earning additional premiums.
107
Q.185 Under the CAPM, if a stock has a beta of 2, then for every percentage point performance
attained by the market over above the risk-free rate, we would expect the stock to achieve:
A. 1 percentage point return.
B. 2 percentage points extra return.
C. 1 percentage points lower return.
D. Impossible to determine.
T he beta coefficient in the Capital Asset Pricing Model (CAPM) measures the sensitivity of a stock's
returns to changes in the market returns. A beta of 1 indicates that the stock's price will move with
the market. A beta less than 1 indicates that the stock will be less volatile than the market, while a
beta greater than 1 indicates that the stock will be more volatile than the market. In this case, a beta
of 2 means that the stock is expected to return twice the market's excess return over the risk-free
rate. T herefore, for every percentage point performance attained by the market over above the
risk-free rate, we would expect the stock to achieve 2 percentage points extra return. T his is
because the stock's returns are twice as sensitive to market movements as indicated by its beta of 2.
Choi ce A i s i ncorrect. A beta value of 2 indicates that the stock's return is expected to change by
2 percentage points for every percentage point change in the market, not just 1 percentage point.
Choi ce C i s i ncorrect. T he beta value does not indicate a lower return but rather a higher
sensitivity to market movements. In this case, a beta of 2 suggests that the stock's return would
increase or decrease by twice as much as any given market movement.
Choi ce D i s i ncorrect. T he CAPM model and its use of beta provide a clear method for estimating
expected returns based on market performance and risk relative to the market, making it possible to
determine an expected response.
108
Q.186 A beta close to zero indicates:
A. A stock with a less stable return than the market as a whole.
B. A stock with a more stable return than the market as a whole.
C. An ET F replicating the corporate bond market.
D. A stock with historically higher returns compared to the market as a whole.
A beta close to zero indicates a stock with a more stable return than the market as a whole. Beta is a
measure of a stock's volatility in comparison to the market as a whole. A beta of 1 indicates that the
stock's price will move with the market. A beta less than 1 indicates the stock will be less volatile
than the market, while a beta greater than 1 indicates the stock will be more volatile than the
market. T herefore, a beta close to zero would indicate a stock that is less volatile than the market,
meaning it has a more stable return. T his could be due to a variety of factors, such as the company's
strong financial health, stable earnings, or a lack of exposure to market and economic fluctuations.
Choi ce A i s i ncorrect. A stock with a beta close to zero does not imply less stability in returns
compared to the market. In fact, it suggests that the stock's returns are largely uncorrelated with
the market, and hence its volatility is independent of market movements.
Choi ce C i s i ncorrect. While an ET F replicating the corporate bond market may have a beta close
to zero due to its low correlation with equity markets, this choice does not necessarily describe a
characteristic of a stock with a beta close to zero. Beta measures the sensitivity of an asset's
returns relative to changes in the overall market return, and it can be applied across different types
of assets including stocks and bonds.
Choi ce D i s i ncorrect. A stock's beta value does not provide information about its historical
returns compared to those of the overall market. Rather, it measures how much the stock's return
tends to move relative to changes in overall market return. T herefore, having a beta close to zero
doesn't necessarily mean that this particular stock has historically higher or lower returns than
those of the overall market.
109
Q.188 An asset has a standard deviation of 30% and 0.8 as its correlation coefficient of returns with
the market index. Given that the standard deviation of the market return is 20%, calculate the asset's
beta.
A. 0.24
B. 2.4
C. 1.4
D. 1.2
T he formula for calculating the beta for stock i is:
σi
βi = ρi,m ( )
σm
Where i is the stock and m is the market.
T hus,
0.3
βi = 0.8( ) = 1.2
0.2
Q.189 You have been given the following asset weights and betas for a 4-asset portfolio:
Asset Beta Portfolio Weight

1 1.3 30%
2 0.97 23%
3 1.7 37%
4 1.4 10%
If the market risk-free rate is 5%, what is the portfolio beta?

A. 1.3
B. 2.3
C. 1.4
D. 0.3
110
T he beta for a portfolio is the weighted average of the betas of individual assetsT hus, the beta for
the 4-asset portfolio above = 1.3 * 0.3 + 0.97 * 0.23 + 1.7 * 0.37 + 1.4 * 0.1 = 1.4Note: T he market
risk-free rate is useless in this question.
Q.190 An FRM exam candidate makes the following comments during an online discussion with
fellow candidates:
I. On the capital market line, investors are only compensated for bearing systematic risks
II. T he capital market line assumes that investors hold two portfolios:
i. a risky portfolio of all assets each weighted according to its market value relative to
the total market value and
ii. the risk-free asset
III. T he CML can be used to determine the required rate of return for individual securities.
Are the candidate's comments correct?
A. All the comments are correct.
B. Only II is correct.
C. Only I and II are correct.
D. None of the comments are correct.
T he first two statements made by the candidate are indeed correct. T he Capital Market Line (CML)
is a line used in the capital asset pricing model (CAPM) to illustrate the rates of return for efficient
portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a
specific portfolio. T he CML assumes that investors are only compensated for bearing systematic
risks, which are risks that affect all companies in the market, such as interest rates, inflation, and
economic cycles. T his is because unsystematic risks, which are company-specific risks, can be
eliminated through diversification. T he second statement is also correct. T he CML assumes that
investors hold a combination of a risk-free asset and a risky portfolio. T he risky portfolio is a market
portfolio of all risky assets in the market, each weighted by its market value. T he risk-free asset is
typically a government bond or any other asset that provides a guaranteed return with zero risk.
111
Choi ce A i s i ncorrect. Not all comments made by the candidate are correct. While statements I
and II are accurate, statement III is not. T he Capital Market Line (CML) cannot be used to determine
the required rate of return for individual securities.
Choi ce B i s i ncorrect. T his choice suggests that only statement II is correct, which isn't true as
statement I also accurately describes a characteristic of the Capital Market Line (CML). On the
CML, investors are indeed only compensated for bearing systematic risks.
Choi ce D i s i ncorrect. T his choice implies that none of the candidate's comments are correct,
which isn't accurate as both statements I and II correctly describe aspects of the Capital Market
Line (CML).
112
Q.191 When a security is plotted on the security market line (SML) chart and found to appear above
the SML, it's considered:
A. Undervalued and a profitable buy for investors.
B. Overvalued and a profitable buy for investors.
C. Undervalued and a profitable short sell for investors.
D. Overvalue and a profitable short sell for investors.
A security that is plotted above the Security Market Line (SML) on a chart is considered undervalued
and a profitable buy for investors. T he SML is a representation of the Capital Asset Pricing Model
(CAPM), which is used to determine the appropriate required rate of return of an asset. If a security
is plotted above the SML, it means that the security's expected return is greater than the required
return given its level of risk as per the CAPM. T his indicates that the security is undervalued, as it is
providing a higher return than what would be expected given its risk level. T herefore, it would be a
profitable buy for investors, as they would be receiving a higher return for the level of risk they are
taking on.
Choi ce B i s i ncorrect. An overvalued security that plots above the SML would not be a profitable
buy for investors. Overvalued securities are typically considered to be priced higher than their
intrinsic value, meaning that they may not provide a good return on investment.
Choi ce C i s i ncorrect. While an undervalued security could potentially be a profitable short sell if
its price were expected to decrease, this scenario contradicts the assumption of the SML and CAPM
models which suggest that securities plotted above the SML are providing higher returns than
expected given their level of systematic risk, indicating they are undervalued and therefore likely to
increase in price.
Choi ce D i s i ncorrect. An overvalued security would not plot above the SML as it would offer
lower returns than what would be expected given its level of systematic risk. T herefore, it wouldn't
necessarily present a profitable short selling opportunity for investors as its price may already
reflect its true value.
113
Q.192 You have been provided with the following information regarding the stock of T ranslink, an
international air transport company:
Risk-free rate = 3%
Expected market risk premium = 5%
T ranslink beta = 1.5
Use the capital asset pricing model to determine the expected return of T ranslink.
A. 7.5%
B. 10.5%
C. 6%
D. 8%
According to CAPM, the expected return on an asset is given by:
E(R i) = R f + (E(R m ) − R f ))βi
Where (E(R m ) − R f ) is the difference between the expected market return and the risk-free rate
(market risk premium) and βi is the beta for the stock.
T hus,
E(R i ) = 3% + 5% × 1.5 = 10.5%
Note that, what we are given in the question is the expected market risk premium and it should not
be confused with the expected market return.
114
Q.193 John Powel gathers the following information regarding the stock of Swisscom, an internet
service provider:
Beta for Swisscom = 0.8
Risk-free rate = 5%
Powel's expected rate of return for Swisscom = 7%
Use this information to determine the expected market return.
A. 8%
B. 12%
C. 7.5%
D. 5%
According to CAPM,
E(R i) = R f + (E(R m ) − R f )βi

7% = 5% + (E(R m ) − 5%)0.8
2% = (E(R m ) − 5%)0.8
2%
= E(R m ) − 5%
0.8
E(R m ) = 2.5% + 5% = 7.5%
115
Q.194 Which of the following is NOT included in the underlying assumptions of the Capital Asset
Pricing Model (CAPM)?
A. T here are no income taxes, which is why investors are indifferent between dividends and
capital gains.
B. Short selling is not allowed.
C. T here are no transactions costs.
D. Investors can borrow and lend unlimited amounts at the risk-free rate.
CAPM assumes that unlimited short selling is allowed so the investors can short as many assets they
want.
Opti on A is an appropriate assumption because CAPM does not assume income tax, which is why an
individual investor is indifferent between dividend income and capital gain.
Assumpti on C is also true because CAPM assumes there are no transaction costs and investors can
make unlimited transactions to balance their portfolios.
Opti on D is also an appropriate assumption. CAPM assumes that there is no limit on borrowing and
lending.
Q.195 Julia and Frank are two traders that have recently joined the New York Stock Exchange
(NYSE). During their daybreak, they discussed their understanding of the Capital Market Line (CML)
and Market Portfolio T heory.
Julia, who is a senior trader, stated that the capital market line (CML) is the tangent line drawn from
the point of the risk-free asset to the feasible region for risky assets, and all investors invest in some
combination of risk-free assets and market securities, which lies on the CML.
Frank added that the market portfolio is a universally agreed upon optimal risky portfolio that lies on
the CML.
Determine if the explanations of Julia and Frank are correct.
A. Julia is correct, and Frank is also correct.
B. Julia is incorrect, while Frank is correct.
116
C. Julia is correct, while Frank is incorrect.
D. Julia is incorrect, and Frank is also incorrect.
Both Julia and Frank's statements are accurate.
T he Capital Market Line (CML) is indeed the tangent line drawn from the point of the risk-free asset
to the feasible region for risky assets. T his line represents the risk-return tradeoff for efficient
portfolios, considering the inclusion of a risk-free asset. All investors, according to the theory, invest
in some combination of risk-free assets and market securities, which lies on the CML. T his is
because the CML represents the best possible set of portfolios an investor can obtain, given the
risk-free rate and the market portfolio.
Frank's statement about the market portfolio is also correct. T he market portfolio is a universally
agreed upon optimal risky portfolio that lies on the CML. T his portfolio includes all risky assets, and
each asset is weighted by its market value as a proportion of total market value. T he market
portfolio is considered the optimal risky portfolio because it offers the highest expected return for a
given level of risk, according to the Market Portfolio T heory.
Choi ce B i s i ncorrect. Julia's explanation of the Capital Market Line (CML) is correct. T he CML
is indeed a tangent line drawn from the point of the risk-free asset to the feasible region for risky
assets, and all investors invest in some combination of risk-free assets and market securities, which
lies on the CML.
Choi ce C i s i ncorrect. Frank's explanation about market portfolio theory is also correct. T he
market portfolio does represent an optimal risky portfolio that lies on the CML, as it includes all
investable assets in proportion to their market values.
Choi ce D i s i ncorrect. Both Julia and Frank provided accurate explanations regarding their
respective topics - Capital Market Line (CML) and Market Portfolio T heory.
117
Q.196 Steven T homson is the head of the portfolio risk management team. His team has recently
forwarded him an intra-departmental valuation report that contains expected return and standard
deviation calculations of one of the diversified portfolios he manages. Given that the team has used
different measures to compute the expected return of the portfolio, determine which of the
following is appropriate for measuring the expected return of individual securities.
A. Sharpe ratio
B. CML
C. CAPM
D. Beta
T he Capital Asset Pricing Model (CAPM) is the most appropriate measure for calculating the
expected return of individual securities. T he CAPM is a model that describes the relationship
between systematic risk and expected return for assets, particularly stocks. It is used to determine a
theoretically appropriate required rate of return of an asset, if that asset is to be added to an already
well-diversified portfolio, given that asset's non-diversifiable risk. T he model takes into account the
asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often
represented by the quantity beta (β ) in the financial industry, as well as the expected return of the
market and the expected return of a theoretical risk-free asset. CAPM is a more comprehensive
measure as it considers the risk-free rate, the beta of the security, and the expected market return.
Choi ce A i s i ncorrect. T he Sharpe ratio is a measure of risk-adjusted return, not a measure for
determining the expected return of individual securities within a portfolio. It is used to understand
the portfolio's performance by adjusting for its risk.
Choi ce B i s i ncorrect. T he Capital Market Line (CML) represents portfolios that optimally
combine risk and return. CML is used in the capital asset pricing model to depict rates of return for
efficient portfolios depending on the risk-free rate of interest and levels of risk (standard deviation).
However, it does not directly determine the expected returns of individual securities.
Choi ce D i s i ncorrect. Beta measures a security's sensitivity to market movements and can be
used as part of CAPM to calculate expected returns, but Beta itself does not provide an estimate for
expected returns.
118
119
Q.197 During an employment interview, a candidate is given the question to select the appropriate
formulas for the computation of an asset's beta. Out of the four following formulas for the beta, one
of them is INCORRECT. Which one?
A. Covariance of asset's return with the market return / Variance of the market returns.
B. (Correlation of asset's return and market return * Standard deviation of asset returns *
Standard deviation of market returns)/Variance of the market returns.
C. Correlation of asset's return and market return * (Standard deviation of asset returns /
Standard deviation of market returns).
D. Covariance of asset's return and market return * (Standard deviation of asset returns /
Standard deviation of market returns).
T he beta of an asset is a measure of its systematic risk in relation to the market. It is calculated as
the covariance of the asset's return with the market return divided by the variance of the market
return. T his formula is used to quantify the asset's sensitivity to market movements. T he formula in
Option D incorrectly multiplies the covariance of the asset's return and market return with the ratio
of the standard deviation of asset returns to the standard deviation of market returns. T his is not a
recognized formula for calculating beta and does not provide a valid measure of systematic risk.
Choi ce A i s i ncorrect. T he formula for beta as the covariance of the asset's return with the
market return divided by the variance of the market returns is correct. T his formula accurately
captures how an asset's returns move in relation to changes in market returns, which is what beta
measures.
Choi ce B i s i ncorrect. T he formula provided here, which involves multiplying correlation of
asset's return and market return with standard deviation of both and then dividing by variance of
market returns, also correctly calculates beta. It essentially breaks down covariance into its
components (correlation and standard deviations), but still provides a valid measure for beta.
Choi ce C i s i ncorrect. T his choice correctly states that beta can be calculated as correlation
between asset's return and market return multiplied by ratio of their standard deviations. T his
formula also accurately reflects how an asset’s risk compares to that of the overall market.
120
Q.198 Huma Ahmed is a junior portfolio analyst who has recently switched from the fixed income
portfolio management unit to his firm's equity portfolio management unit. On her first day, she was
asked by her senior portfolio analyst to compute the portfolio's beta that contains 5 assets. Using the
data provided in the table, determine the beta of the portfolio.
Asset Return Weight Beta

1 1.3% 0.10 0.35
2 10% 0.25 0.20
3 6% 0.25 0.15
4 9% 0.30 0.60
5 16% 0.10 0.40
A. 1.7
B. 0.34
C. 0.09
D. -1.1
T he beta (β) of the portfolio is calculated as:
βp = W 1β1 + W 2β2 + W 3 β3 + W 4β4 + W 5 β5

βp = 0.10 × 0.35 + 0.25 × 0.20 + 0.25 × 0.15 + 0.30 × 0.60 + 0.10 × 0.40 = 0.3425
121
Q.199 According to CAPM, which of the following risks should an investor be compensated for?
A. Systematic risk only.
B. Unsystematic risk only.
C. Both systematic and unsystematic risk.
D. Both systematic risk and asset-specific-risk.
T he Capital Asset Pricing Model (CAPM) is a model used in finance to determine a theoretically
appropriate required rate of return of an asset, given that asset's systematic, non-diversifiable risk.
Systematic risk, also known as market risk or non-diversifiable risk, is the risk that affects all
companies in the market. It is the risk that cannot be eliminated by diversification. Examples of
systematic risk include interest rate changes, inflation, recessions, or political instability. According
to the CAPM, investors should be compensated for taking on systematic risk because it cannot be
eliminated through diversification. T he model assumes that the total risk of a portfolio can be divided
into systematic risk and unsystematic risk. Unsystematic risk, also known as specific risk,
diversifiable risk, idiosyncratic risk, or residual risk, is the risk associated with individual assets - it is
the risk that can be eliminated by diversification. Since the model assumes that investors hold
diversified portfolios, it argues that they should not expect to receive compensation for bearing
unsystematic risk because it can be eliminated by diversification.
Choi ce B i s i ncorrect. Unsystematic risk, also known as idiosyncratic risk or specific risk, is
unique to a particular company or industry. According to the CAPM, investors are not compensated
for bearing unsystematic risk because it can be eliminated through diversification.
Choi ce C i s i ncorrect. T he CAPM assumes that investors are compensated for systematic risk
only and not for unsystematic risk. T his is because unsystematic risks can be diversified away by
holding a well-diversified portfolio of investments.
Choi ce D i s i ncorrect. Asset-specific-risk falls under the category of unsystematic risks which
can be diversified away according to the CAPM model and hence investors should not expect
compensation for this type of risk.
122
Q.200 Assume you are a junior portfolio analyst for a Chinese asset management company based in
Beijing and you are given the task to evaluate the stock of Sun Cruise Inc. using CAPM. If the
expected return of the market is 17%, the stock beta is 0.89, the risk-free rate is 6%, and the
market risk premium is 11%, then the computed expected rate of return of Sun Cruise Inc. is:
A. 17%
B. 15.8%
C. 10.45%
D. 11%
According to the Capital Asset Pricing Model (CAPM):
Expected return of a stock = Risk-free rate + Beta(Expected market return − Risk-free rate)
Expected return of Sun Cruise Inc. = 6% + 0.89(17% − 6%) = 15.79%
Note that,
Expected return = Beta ∗ Market risk premium + Risk-free rate
Q.201 Which of the following is a maj or difference between T reynor and Sharpe measures?
A. While the T reynor measure uses beta as the risk measure to assess the volatility of a
portfolio relative to the market, the Sharpe measure takes into account the total risk
exposure and hence uses the standard deviation.
B. While the Sharpe measure uses beta as the risk measure to assess the volatility of a
portfolio relative to the market, the T reynor measure takes into account the total risk
exposure, hence uses the standard deviation.
C. T he T reynor measure is more straightforward and easier to calculate as compared to the

Sharpe measure.
D. All of the above.
T he T reynor measure and the Sharpe measure are both used to evaluate the performance of a
123
portfolio by comparing the risk-adjusted returns. However, they differ in the way they measure risk.
T he T reynor measure uses beta as the risk measure. Beta measures the volatility of a portfolio
relative to the market, thus it only considers systematic risk. Systematic risk is the risk that affects
all securities in the market and cannot be eliminated through diversification. On the other hand, the
Sharpe measure uses the standard deviation as the risk measure. T he standard deviation measures
the total risk of the portfolio, including both systematic and unsystematic risk. Unsystematic risk is
the risk that is unique to a particular security and can be eliminated through diversification.
T herefore, the Sharpe measure takes into account the total risk exposure of the portfolio, while the
T reynor measure only considers the systematic risk.
Choi ce B i s i ncorrect. T he Sharpe measure does not use beta as the risk measure to assess the
volatility of a portfolio relative to the market. Instead, it uses standard deviation which considers
total risk including both systematic and unsystematic risks. On the other hand, T reynor measure
uses beta which only accounts for systematic risk.
Choi ce C i s i ncorrect. T he complexity of calculation between T reynor and Sharpe measures is
not a primary distinction between them. Both measures are relatively straightforward to calculate
given that required data (returns, beta or standard deviation) are available.
Choi ce D i s i ncorrect. As explained above, choices B and C do not accurately describe the
primary distinction between T reynor and Sharpe measures.
124
Q.202 T he Jensen portfolio evaluation measure:
A. is a measure of return per unit of risk, as measured by standard deviation.
B. is an absolute measure of return over and above that predicted by the CAPM.
C. is a measure of return per unit of risk, as measured by beta.
D. B and C
T he Jensen's measure, or Jensen's alpha, is indeed an absolute measure of return over and above that
predicted by the Capital Asset Pricing Model (CAPM). T he CAPM is a model that describes the
relationship between systematic risk and expected return for assets, particularly stocks. It is used in
the pricing of risky securities, generating expected returns for assets given the risk of those assets
and calculating costs of capital. T he Jensen's measure takes this a step further by comparing the
actual returns of a portfolio or an investment with the returns predicted by the CAPM. If the actual
returns are higher than the predicted returns, the Jensen's measure is positive, indicating that the
portfolio or investment has outperformed the market. Conversely, if the actual returns are lower
than the predicted returns, the Jensen's measure is negative, indicating underperformance.
T herefore, the Jensen's measure provides an absolute measure of the portfolio's or investment's
performance, taking into account the risk as measured by the CAPM.
Choi ce A i s i ncorrect. Jensen's measure is not a measure of return per unit of risk as measured
by standard deviation. T his description fits more with the Sharpe ratio, which measures excess
return per unit of total risk (standard deviation).
Choi ce C i s i ncorrect. Jensen's alpha does not measure return per unit of systematic risk (beta).
T his description aligns more with the T reynor ratio, which measures excess return per unit of
systematic risk.
Choi ce D i s i ncorrect. As explained above, Jensen's alpha does not fit the descriptions provided in
both options B and C.
125
Q.203 John Cook, a retired surgeon, has the following assets:
A house and land worth $150,000 in total
An undiversified securities portfolio worth $700,000
A fleet of automobiles worth $160,000
Between the T reynor and the Sharpe measures, which measure would be of more concern to Mr.
Cook?
A. T he T reynor measure
B. T he T reynor measure for the portfolio and the Sharpe measure for the other assets
C. T he Sharpe measure
D. None of the two measures
T he Sharpe ratio is a measure of risk-adjusted return, which helps investors understand the return of
an investment compared to its risk. T he ratio is the average return earned in excess of the risk-free
rate per unit of volatility or total risk. In the context of Mr. Cook's assets, the Sharpe measure would
be more relevant because it takes into account the total risk - both systematic and unsystematic
risks. T his is important because Mr. Cook's securities portfolio, which constitutes the major
proportion of his assets, is undiversified. T his means it is exposed to both types of risks. T herefore,
the Sharpe measure would provide a more comprehensive assessment of the risk and return of his
portfolio. Furthermore, as a retired surgeon, Mr. Cook would be interested in the safety of both
income and principal, regardless of the source of volatility. T he Sharpe measure, by considering both
systematic and unsystematic risks, would provide a more accurate measure of the total risk to his
income and principal.
Choi ce A i s i ncorrect. T he T reynor measure is not the most relevant for Mr. Cook's situation
because it only considers systematic risk, which is more applicable to well-diversified portfolios. Mr.
Cook's portfolio, however, is not diversified.
Choi ce B i s i ncorrect. While it might seem logical to use the T reynor measure for the portfolio
and the Sharpe measure for other assets, this approach would be inappropriate given that Mr. Cook's
securities portfolio isn't diversified and therefore contains unsystematic risk which isn't captured by
the T reynor measure.
Choi ce D i s i ncorrect. It suggests that neither of these measures would be relevant in assessing
the risk and return of his investments which isn't true as Sharpe ratio can provide a useful
assessment of his investment's performance on a risk-adjusted basis.
126
Q.204 A 10-year research on 3 distinct portfolios and the market reveals the following information:
Portfolio Average Standard Beta

Annual Deviation
Return
1 14% 21 1.15
2 16% 24 1.00
3 20% 28 1.25
S&P500 12% 20
If the risk-free rate is 6%, then use the T reynor measure to rank the portfolios from the lowest to
the highest.
A. 1, 2, 3
B. 2, 3, 1
C. 3, 2, 1
D. 1, 3, 2
T he T reynor measure of a portfolio,
(E(R p) − R f )
Tp =
βp
Hence:
(14% − 6%)
T1 = = 0.07
1.15
(16% − 6%)
T2 = = 0.1
1.0
(20% − 6
T3 = = 0.112
1.25
127
Annual Deviation
Return
1 14% 21 1.15
2 16% 24 1.00
3 20% 28 1.25
S&P500 12% 20
If the risk-free rate is 6%, which portfolio carries the largest market risk?
A. 1
B. 2
C. 3
D. S&P 500
A comprehensive study spanning over a decade was conducted on three distinct investment
portfolios and the S&P 500 market index. T he study revealed specific data points for each portfolio
and the market index, including the average annual return, standard deviation, and beta. T he beta, in
particular, is a measure of a portfolio's sensitivity to market movements and is a key indicator of
market risk.

Annual Deviation
Return
1 14% 21 1.15
2 16% 24 1.00
3 20% 28 1.25
S&P500 12% 20
Given that the risk-free rate during this period was 6%, which among the three portfolios and the
S&P 500 market index carries the highest degree of market risk?

Annual Deviation
Return
1 14% 21 1.15
2 16% 24 1.00
3 20% 28 1.25
S&P 500 12% 20
128
Given that the risk-free rate of return is 6%, use the Sharpe measure to rank the portfolios from the
lowest to the highest.
A. 1, 3, 2
B. 2, 3, 1
C. 2, 1, 3
D. 1, 2, 3
E(Rp)−Rf
T he formula for calculating the Sharpe ratio for a portfolio, Sp = Hence,
σp
(14% − 6%)
S1 = = 0.38
21%
(16% − 6%)
S2 = = 0.42
24%
(20% − 6%)
S3 = = 0.50
28%
129
Q.207 Under Jensen's differential return measure, which of the following indicates superior market
timing on the part of the manager?
A. A zero alpha.
B. A positive alpha.
C. Statistically significant negative alpha.
D. Statistically significant positive alpha.
Alpha is a measure of the excess return or value that has been added or subtracted by a fund
manager. T he alpha coefficient indicates the performance of a portfolio relative to its benchmark. A
positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly,
a similar negative alpha would indicate an underperformance of 1%. When we say that the alpha is
statistically significant, it means that the chances of this alpha being a result of random chance (luck)
are very low. T herefore, a statistically significant positive alpha indicates that the manager has
consistently outperformed the market, which is a clear sign of superior market timing. T he
statistical significance is usually tested using the t-statistic, which is the estimated value of alpha
divided by its standard deviation. A t-statistic greater than 2 is generally considered statistically
significant at the 95% confidence level.
Choi ce A i s i ncorrect. A zero alpha indicates that the portfolio manager has neither
underperformed nor outperformed the market, implying no superior market timing skills.
Choi ce B i s i ncorrect. While a positive alpha does indicate that the portfolio manager has
outperformed the market, it does not necessarily signify superior market timing skills. It could be
due to other factors such as stock selection or sector allocation.
Choi ce C i s i ncorrect. A statistically significant negative alpha suggests that the portfolio manager
has consistently underperformed compared to what would be expected given their level of
systematic risk exposure, indicating poor performance rather than superior market timing skills.
130
Q.208 Suppose you have two portfolios with the same average return, the same standard deviation of
returns, but portfolio Y has a lower beta than portfolio X. Which of the following statements is true
according to the Sharpe measure?
A. Portfolio X performs better than portfolio Y.
B. Portfolios X and Y perform equally.
C. Portfolio Y outperforms portfolio X.
D. None of these are correct.
T he Sharpe ratio is a measure of risk-adjusted return, which is calculated as the average return of a
portfolio in excess of the risk-free rate, divided by the total risk of the portfolio. T he total risk is
measured by the standard deviation of the portfolio's returns, not its beta. In this scenario, both
portfolios X and Y have the same average return and the same standard deviation of returns, which
means they have the same total risk. T herefore, according to the Sharpe ratio, portfolios X and Y
perform equally. T he lower beta of portfolio Y does not affect the Sharpe ratio because the Sharpe
ratio does not consider systematic risk, which is what beta measures. Instead, the Sharpe ratio
considers total risk, which includes both systematic and unsystematic risk. T herefore, even though
portfolio Y has a lower beta, it does not outperform portfolio X according to the Sharpe ratio.
Choi ce A i s i ncorrect. T he Sharpe ratio measures the excess return per unit of risk, which in this
case is represented by standard deviation. Since both portfolios have the same average returns and
standard deviation, their Sharpe ratios would be equal regardless of their beta values. T herefore,
portfolio X does not perform better than portfolio Y according to the Sharpe ratio.
Choi ce C i s i ncorrect. Similarly, despite having a lower beta value (which indicates less market
risk), portfolio Y does not outperform portfolio X according to the Sharpe ratio because they have
identical average returns and standard deviations.
Choi ce D i s i ncorrect. As explained above, portfolios X and Y perform equally according to the
Sharpe ratio due to their identical average returns and standard deviations.
131
Q.209 You have been given the following data for a managed portfolio:
Beta = 1.2
Alpha = 1%
Average return = 14%
Risk-free rate = 4%
Calculate the return on the market portfolio basing your calculations on Jensen's measure of
portfolio performance.
A. 15.45%
B. 13%
C. 11.5%
D. 1.3%
According to Jensen's measure of performance:
α p = E(R p ) − [R f + [E(R m ) − R f ]βp]

1% = 14% − [4% + 1.2(x − 4%)]
1% = 14% − [4% + 1.2x − 4.8%]
1% = 14% − 4% − 1.2x + 4.8%
1.2x = 13.8%
x = E(R m ) = 11.5%
Q.210 T he T reynor, Sharpe, and Jensen measures of portfolio performance are derived from CAPM.
Which of the following statements is correct regarding measures of portfolio performance?
A. All three measures are equally efficient at evaluating the performance of a manager.
B. All three measures have the same denominator.
C. Unlike the T reynor and Jensen measures, the Sharpe measure takes into account the total
risk of a portfolio.
D. T he T reynor and Sharpe measures use systematic risk, as represented by beta.
132
T he Sharpe ratio, unlike the T reynor and Jensen measures, takes into account the total risk of a
portfolio. T he Sharpe ratio is a measure of risk-adjusted return, which compares the portfolio's
excess return (or risk premium) over the risk-free rate to the standard deviation of the portfolio's
return. T he standard deviation is a measure of total risk, including both systematic and unsystematic
risk. T herefore, the Sharpe ratio provides a more comprehensive measure of risk compared to the
T reynor and Jensen measures, which only consider systematic risk as represented by beta.
Systematic risk is the risk that affects all securities in the market, while unsystematic risk is the
risk that is specific to a particular security. By considering total risk, the Sharpe ratio provides a
more accurate measure of a portfolio's performance, especially for diversified portfolios where
unsystematic risk is significantly reduced.
Choi ce A i s i ncorrect. All three measures are not equally efficient at evaluating the performance
of a manager. T he efficiency of these measures depends on the specific circumstances and the type
of risk being considered. For example, Sharpe ratio is more appropriate when evaluating diversified
portfolios as it considers total risk, while T reynor and Jensen's alpha are more suitable for non-
diversified portfolios as they consider only systematic risk.
Choi ce B i s i ncorrect. All three measures do not have the same denominator. T he Sharpe ratio
uses standard deviation (total risk) in its denominator, while both T reynor measure and Jensen's alpha
use beta (systematic risk) in their denominators.
Choi ce D i s i ncorrect. It's not accurate to say that both T reynor and Sharpe measures use
systematic risk, as represented by beta. While it's true for T reynor measure, Sharpe measure uses
total portfolio risk (standard deviation), not just systematic risk (beta).
133
Q.211 What is the tracking error?
A. T he standard deviation of the return of the benchmark portfolio.
B. T he average of the differences between the returns of the risky portfolio and the
benchmark return.
C. T he standard deviation of the differences between portfolio return and the benchmark
return.
D. T he difference between the return based on the T reynor measure and Jensen's measure.
T racking error is indeed the standard deviation of the differences between the portfolio return and
the benchmark return. T his measure is used to quantify the risk associated with active management.
Active management involves making investment decisions that deviate from the benchmark index in
an attempt to generate excess returns. However, these decisions can also lead to underperformance,
which is captured by the tracking error. A higher tracking error indicates a greater deviation from
the benchmark returns, implying a higher level of active management and, consequently, a higher
level of risk. T herefore, tracking error serves as a useful tool for investors to assess the risk-return
trade-off of an actively managed fund.
Choi ce A i s i ncorrect. T he standard deviation of the return of the benchmark portfolio does not
represent tracking error. T racking error is a measure of how closely a portfolio follows its
benchmark, not the volatility of the benchmark itself.
Choi ce B i s i ncorrect. T he average difference between the returns of the risky portfolio and the
benchmark return does not accurately define tracking error. While it may give an indication about
performance relative to a benchmark, it doesn't account for variability in those differences over
time which is crucial in calculating tracking error.
Choi ce D i s i ncorrect. T he difference between T reynor's measure and Jensen's measure has
nothing to do with tracking error. T hese are both measures used to evaluate portfolio performance
based on risk-adjusted returns, but they do not provide information about how closely a portfolio
tracks its benchmark.
134
Q.212 T ypically, the manager is required to keep the tracking error ______ a stated threshold. In this
regard, transaction costs should be _______.
A. Below, minimized
B. Above, minimized
C. Below, eliminated
D. Above, maximized
In portfolio management, the tracking error is a measure of how closely a portfolio follows the index
to which it is benchmarked. T he smaller the tracking error, the closer the portfolio is following the
benchmark. T herefore, the tracking error should be kept below a stated threshold to ensure that the
portfolio's performance does not deviate significantly from the benchmark. On the other hand,
transaction costs refer to the costs incurred when buying or selling securities. T hese costs can
significantly impact the portfolio's returns, especially in the case of frequent trading. T herefore, it is
crucial for the manager to minimize these costs to maximize the portfolio's net returns.
Choi ce B i s i ncorrect. While it is true that transaction costs should be minimized, the tracking
error should not be kept above a specified threshold. T he tracking error measures the deviation of
the portfolio return from the benchmark return, and keeping it below a certain limit ensures that the
portfolio does not deviate too much from its benchmark.
Choi ce C i s i ncorrect. Although it would be ideal to eliminate transaction costs entirely, this is
often not feasible in practice due to various factors such as brokerage fees, bid-ask spreads etc.
T herefore, while efforts should be made to reduce these costs as much as possible, they cannot
typically be completely eliminated. Furthermore, similar to choice B, tracking error should ideally be
kept below a specified threshold.
Choi ce D i s i ncorrect. T his option contradicts both principles of effective portfolio management
mentioned in the question - tracking error should ideally be kept below (not above) a specified
threshold and transaction costs need to minimized (not maximized). Maximizing transaction costs
would lead to lower net returns for investors which goes against basic principles of investment
management.
135
Q.213 A certain fund manager typically generates an alpha of 1% and a tracking error of 2.25%.
Determine the information ratio.
A. 0.3
B. 0.5
C. 2.25
D. 0.444
(Expected return of the portfolio − Expected return of the benchmark

T he information ratio =
T racking error
Alpha
=
T racking error
1
=
2.25
= 0.444
Q.217 Sean and Adam are two asset managers in a specific firm. During their discussion with regard
to portfolio performance measures, Adam made the following statements:
Statement 1: If the Sharpe ratio of the portfolio is greater than the Sharpe ratio of the market
portfolio, it indicates the portfolio performs better for every additional unit of risk.
Statement 2: Jensen's alpha measure for the market portfolio is always 0.
Which of these statements is/are correct?
A. Statement 1 is correct, while statement 2 is incorrect
B. Statement 1 is incorrect, while statement 2 is correct
C. Both statements are correct
D. Both statements are incorrect
Both statements made by Adam are indeed correct. T he Sharpe ratio is a measure used to understand
the return of an investment compared to its risk. T he formula for the Sharpe ratio is (Expected
return of the portfolio - Risk-free rate) / Standard deviation of the portfolio's excess return.
(E(R ) − R )
136
(E(R p) − R f )
Sharpe ratio =
σp
If a portfolio's Sharpe ratio is higher than that of the market portfolio, it indicates that the portfolio
is performing better for each additional unit of risk compared to the market portfolio. T his means
that the portfolio is providing a higher risk-adjusted return than the market portfolio.
Jensen's alpha is a risk-adjusted performance measure that represents the average return on a
portfolio or investment above or below that predicted by the capital asset pricing model (CAPM)
given the portfolio's or investment's beta and the average market return.
Jensen measure = α p = E(R p ) − [R f + [E(R m ) − R f ]βp)
. For the market portfolio, the beta is always 1 and the expected return of the portfolio is the same
as the expected return of the market. T herefore, the Jensen's alpha for the market portfolio will
always be zero as the entire equation cancels out to zero.
Choi ce A i s i ncorrect. While the first statement is correct, the second statement is also correct.
Jensen's alpha measure for the market portfolio is always 0 because it measures the excess return
over what would be predicted by CAPM, and since the market portfolio is used as a benchmark in
CAPM, its alpha would naturally be zero.
Choi ce B i s i ncorrect. Both statements are correct. T he first statement correctly describes that
a higher Sharpe ratio indicates better performance per unit of risk compared to another portfolio or
benchmark (in this case, the market portfolio). T he second statement correctly states that Jensen's
alpha for the market portfolio will always be zero.
Choi ce D i s i ncorrect. As explained above both statements are accurate descriptions of these
performance measures in finance.
137
Q.218 As an analyst, you are analyzing the portfolio that focuses on the automotive industry. T he
portfolio contains 12 stocks in total with 6 stocks from the automotive industry, 3 stocks from car
financing firms, and 3 stocks from car lubricant manufacturers. T he expected return of the portfolio
is 31% with a standard deviation of 19% while the expected return of the market is 22% with a
standard deviation of 16%. Given that the risk-free rate is 5% and the portfolio's beta is 0.9, compute
the T reynor ratio of the portfolio.
A. 0.1
B. 1.37
C. 0.19
D. 0.29
(E(R p ) − R f ) (0.31 − 0.05)

T reynor ratio of portfolio = = = 0.288
βp 0.9
Q.219 T he expected return of an investor's portfolio is 31% with a standard deviation of 19% while
the expected return of the market is 22% with a standard deviation of 16%. Given that the risk-free
rate is 5% and the portfolio's beta is 0.9, determine the difference between the Sharpe ratio of the
portfolio and the Sharpe ratio of the market.
A. 0.31
B. 0.5
C. 1.06
D. 0.12
(E(R p) − R f )(0.31 − 0.05)

Sharpe ratio of the investor's portfolio = = = 1.37
σp 0.19
(E(R m ) − R f ) (0.22 − 0.05)
Sharpe ratio of market portfolio = = = 1.06
σm 0.16
Difference = 1.37 − 1.06 = 0.31
138
Q.220 Ross Linn is analyzing the performance of different stocks of a portfolio using the alpha
measure of performance. Linn has compiled the following data regarding UUA:
Covariance = 0.027
Variance of the stock = 12%
Risk-free rate of return = 6%
Expected market return = 13%
Actual stock's return = 14.5%
Beta =1.1
Determine the correct alpha of UUA's stock and its appropriate interpretation.
A. T he alpha of UUA is 0.8% and the stock has underperformed the market.
B. T he alpha of UUA is 0.8% and the stock has outperformed the market.
C. T he alpha of UUA is -4.625% and the stock has underperformed the market.
D. T he alpha of UUA is -4.625% and the stock has outperformed the market.
Jensen alphas or alpha of the stock = Actual return of stock − CAPM

Alpha = A(R) − [R f + [E(R m ) − R f ]βp ]
= 0.145 − [0.06 + [0.13 − 0.06]1.1]
= 0.008 or 0.8%
Since UUA has a positive alpha of 0.8%, it suggests that the stock has outperformed the market by
0.8%.
Q.221 Paul T homson is the Chief Investment Officer (CIO) of Continental Investments Inc., an asset
management company that supervises three portfolios managed by three different portfolio
managers. All the portfolios have the same level of risk as the benchmark index. If T homson is
interested in knowing which of the three portfolio managers possess the best stock-picking skills,
then which of the following statement is true?
A. T he manager with the highest tracking error has the best stock-picking skills.
B. T he manager with the lowest tracking error has the best stock-picking skills.
C. T he manager with the lowest information ratio has the best stock-picking skills.
D. T he manager with the lowest Sharpe ratio has the best stock-picking skills.
139
T he tracking error is a measure used to evaluate a manager's stock-picking skills. It is defined as the
standard deviation of the difference between the returns of the portfolio and the benchmark. Given
that the risk level of the portfolio is the same as that of the benchmark index or portfolio, a lower
tracking error indicates superior stock-picking skills. Managers often strive to keep the tracking
error below a certain limit, taking into account transaction costs and other portfolio management-
related expenses to maintain a low tracking error.
Choi ce A i s i ncorrect. T he tracking error is a measure of how closely a portfolio follows the
index to which it is benchmarked. T he higher the tracking error, the more the portfolio's
performance deviates from the benchmark. T herefore, a manager with a high tracking error does
not necessarily possess better stock-picking skills; instead, they may be taking on more risk than
necessary or deviating significantly from their benchmark.
Choi ce C i s i ncorrect. T he information ratio measures a portfolio manager's ability to generate
excess returns relative to a benchmark but also considers the consistency of this performance and
penalizes volatility. A lower information ratio indicates that either the manager has not been able to
generate sufficient excess returns or has taken on too much risk, neither of which are indicative of
good stock-picking skills.
Choi ce D i s i ncorrect. T he Sharpe ratio measures risk-adjusted performance and does not
specifically reflect stock-picking skills. A lower Sharpe ratio could indicate poor overall investment
strategy rather than poor stock selection.
Q.222 Bella Sean is a senior portfolio manager in a UK-based firm. She has recently rejoined the
office after her maternity leave. During her absence, her subordinate, Vikram Singh, was managing
one of her portfolios. She now notices that Vikram has significantly deviated from the benchmark
portfolio in order to earn higher gains than the portfolio. If Bella wants to assess if Singh's deviation
from the benchmark has reaped appropriate returns, then which of the following measures must she
use?
A. T racking error
B. Information ratio
140
C. Sortino ratio
D. Jensen alpha
T he Information Ratio (IR) is a measure that portfolio managers use to evaluate the returns that
they have achieved above the returns of a benchmark, compared to the volatility of those returns.
T he IR is calculated as the active return divided by the tracking error. T he active return is the
return of the portfolio minus the return of the benchmark. T he tracking error is the standard
deviation of the active return. In this case, Bella Sean would use the Information Ratio to assess
whether Vikram Singh's deviation from the benchmark portfolio has resulted in appropriate returns.
If the Information Ratio is high, it means that Vikram has managed to achieve higher returns than the
benchmark, taking into account the additional risk he has taken on by deviating from the benchmark.
If the Information Ratio is low, it means that the additional returns achieved do not justify the
additional risk taken.
Choi ce A i s i ncorrect. T racking error measures the standard deviation of the difference between
the returns of an investment and its benchmark. While it does provide a measure of risk associated
with deviating from a benchmark, it does not directly measure whether this deviation has resulted in
appropriate returns.
Choi ce C i s i ncorrect. T he Sortino ratio measures the risk-adjusted return of an investment, but it
specifically focuses on downside risk. It doesn't take into account how well or poorly an investment
performs relative to a specific benchmark, which is what Bella needs to evaluate in this case.
Choi ce D i s i ncorrect. Jensen's alpha measures the excess return that a portfolio generates over
its expected return as predicted by the Capital Asset Pricing Model (CAPM). Although Jensen's alpha
can indicate whether Vikram has generated positive or negative excess returns, it doesn't provide
information about how these returns compare to those of the benchmark portfolio.
141
Q.3468 A portfolio is constructed of two assets, including a risky asset with a standard deviation of
18% and a risk-free asset. Suppose the weight of the risk-free asset in the portfolio is 35%, and that
the two assets are uncorrelated. What is the standard deviation of the portfolio?
A. 18%
B. 6.3%
C. 11.7%
D. 5.75%
A risk-free asset has a standard deviation of zero.
We know that,
VP = w 21 σ12 + w 22σ22 + 2w 1w 2 σ1σ2 ρ1,2

2 2 2
= 0.35 × 0 + 0.65 × 18 + 2 ∗ 0.35 ∗ 0.65 ∗ 18 ∗ 0 ∗ ρ1,2
= 136.89
So that, the standard deviation of the portfolio is given by:
SDP = √VP = √136.89 = 11.7%
142
Q.3469 A portfolio manager is constructing a portfolio composed of two assets. Asset A is a risky
asset with an expected return of 14% and a standard deviation of 22%, and asset B is a risk-free asset
with an expected return of 9%. If the portfolio manager increases the weight of the risky asset to
130%, then the expected return of the portfolio is closest to:
A. 0.182
B. 0.155
C. 0.167
D. 0.1123
Expected return of the portfolio = (Weight of Asset A * Return of Asset A) + (Weight of Asset B *
Return of Asset B) = (1.3 * 14%) + (-0.3 * 9%) = 15.5%
Detailed explanation:
Recall that the capital market line represents the portfolios that optimally combine risk and return
by combining the risk-free asset with the risky asset(market portfolio). An investor can move up or
down this line by varying the weights that they invest in the risk-free asset and the risky asset.
Rather than just split their money between the two assets, an investor who is willing to take more
risk can borrow more money at the risk-free rate and invest it in the risky asset. Borrowing puts a
negative weight on the risk-free asset. Let's see how this comes about: Let the return on the risk-
free rate be X, and the return on the risky asset be Y. Let's say you have $100 in your pocket and
here's your initial plan: To invest $50 in the risk-free asset To invest $50 in risky asset But then you
decide to take more risk; you will borrow $80 at the risk-free rate X and invest it in the risky asset
What’s your total investment? Risk-free asset: = $50 - $80 = -$30 (essentially a “give and take”
scenario) Risky asset; $50 + $80 = $130 T hus, Expected Return = -$30/(-$30+$130)*X + $130/(-
$30+$130)*Y = -0.3*X + 1.3*Y In our case, X = 9%, Y = 14% Expected return = -0.3 * 0.09 + 1.3 *
0.14 = 0.155
143
Q.3470 T he expected return of the Karachi Stock exchange is 17%, and the rate on Pakistan's risk-
free bonds is 7.5%. Suppose the beta of Bata Corporation shares is 0.75, what is the required rate of
return on Bata Corporation's shares?
A. 0.1263
B. 0.2025
C. 0.1673
D. 0.1463
T he required rate of return on shares is calculated using the Capital Asset Pricing Model (CAPM).
Required rate of return = Risk-free rate + Beta (Market Return - Risk-free rate) = 7.5% + 0.75*
(17%7.5%) = 14.63%
144
Q.3471 Which of the following portfolios is/are most appropriately priced?
I. A portfolio with an estimated return above the securities market line (SML).
II. A portfolio with an estimated return plotted on the SML.
III. A portfolio with an estimated return below the SML.
A. Portfolios I & II
B. Portfolio II
C. Portfolios II & III
D. All of the above
T he Securities Market Line (SML) is a graphical representation of the market's risk and return
trade-off. In other words, it shows the expected return for each unit of risk (beta). When a
portfolio's estimated return is plotted on the SML, it indicates that the portfolio is appropriately
priced. T his is because the portfolio's expected return is in line with the market's risk-return trade-
off. T herefore, the portfolio is neither overpriced nor underpriced. It is important to note that the
SML is based on the Capital Asset Pricing Model (CAPM), which assumes that investors are rational
and markets are efficient. T herefore, any deviations from the SML would present arbitrage
opportunities, which should not exist in an efficient market.
Choi ce A i s i ncorrect. While Portfolio II is priced appropriately as its estimated return lies on the
SML, Portfolio I is not. A portfolio with an estimated return above the SML indicates that it's
overpriced, as it offers a higher return than what the CAPM would predict given its level of
systematic risk (beta).
Choi ce C i s i ncorrect. Similar to Choice A, while Portfolio II is priced appropriately, Portfolio III
isn't. An estimated return below the SML suggests that the portfolio is underpriced - it offers a lower
return than what should be expected for its level of systematic risk according to CAPM.
Choi ce D i s i ncorrect. As explained above in Choices A and C explanations, only portfolios whose
returns plot on the SML are priced appropriately according to CAPM. T herefore, all portfolios
cannot be correctly priced.
145
Q.3472 Which of the following measures of risk-adjust returns does NOT use beta?
A. T reynor measure
B. Jensen's alpha
C. Sharpe ratio
D. None of the above
T he Sharpe ratio measure of risk-adjust returns use standard deviation or total risk. T reynor and
Jensen's alpha use beta or systematic risk.
Q.3473 T wo portfolios have the following characteristics:
Portfolio Return Beta

A 8% 0.7
B 7% 1.1
Given a market return of 10% and a risk-free rate of 4%, calculate Jensen's Alpha for both portfolios
and comment on which portfolio has performed better.
A. -0.2% and -3.6% respectively

Portfolio A has performed better than Portfolio B.
B. -0.2% and -3.6% respectively

Portfolio B has performed better than Portfolio A.
C. 0.2% and 3.6% respectively

Portfolio B has performed better than Portfolio A.
D. 3.6% and 0.2% respectively

Portfolio A has performed better than Portfolio B.
Jensen's Alpha is calculated as follows:

Jensen's Alpha = Rp - [Rf + Bp (Rm - Rf)]
Jensen's AlphaPortfolio A = 0.08 - [0.04 + 0.7(0.1 - 0.04)] = -0.002
Jensen's AlphaPortfolio B = 0.07 - [0.04 + 1.1(0.1 - 0.04)] = -0.036
Jensen's Alpha is -0.2% and -3.6% for A and B, respectively. A higher Alpha indicates that a portfolio
has performed better.
146
Q.3474 Which of the following portfolio performance evaluation measures is (are) only based on
systematic risk?
A. Sharpe ratio
B. T reynor ratio
C. All of the above
D. None of the above
T he T reynor ratio is a performance metric for determining how well an investment has
compensated for each unit of systematic risk. It is calculated by subtracting the risk-free rate from
the portfolio's returns and then dividing by the portfolio's beta, which is a measure of systematic
risk. T he higher the T reynor ratio, the better the portfolio's performance has been on a risk-
adjusted basis. T he T reynor ratio is particularly useful for comparing the performance of different
portfolios or funds that are exposed to similar levels of systematic risk. It is important to note that
the T reynor ratio does not take into account unsystematic risk, as it assumes that the portfolio is
well-diversified and that any unsystematic risk has been eliminated.
Choi ce A i s i ncorrect. T he Sharpe ratio is not solely based on systematic risk. It measures the
excess return (or Risk Premium) per unit of deviation in an investment asset or a trading strategy,
typically referred to as risk (and correspondingly standard deviation). It considers both systematic
and unsystematic risks.
Choi ce C i s i ncorrect. As explained above, the Sharpe ratio does not solely base on systematic
risk, thus it's not correct to say all of the above measures are based only on systematic risk.
Choi ce D i s i ncorrect. T he T reynor ratio, which is one of the options provided, does measure
portfolio performance using only systematic risk. T herefore, it cannot be said that none of the
options are based solely on systematic risk.
147
Q.3476 T he line that shows all portfolios that an investor can create once we allow for a risk-free
asset is called the:
A. Efficient frontier
B. Capital allocation line
C. Capital market line
D. Beta
T he Capital Market Line (CML) is the line that represents all the portfolios that an investor can
create once we allow for a risk-free asset. T he CML is derived from the Capital Allocation Line
(CAL), which shows the risk and return trade-off for a specific investor. However, the CML is a
special case of the CAL where all investors have homogeneous expectations of risk and return. T his
means that all investors agree on the expected returns, variances, and covariances of all assets.
T herefore, they all hold the same optimal risky portfolio, which when combined with a risk-free
asset, results in the CML. T he CML is a critical component of the modern portfolio theory and plays
a significant role in determining an investor's optimal portfolio.
Choi ce A i s i ncorrect. T he Efficient Frontier refers to the set of optimal portfolios that offer the
highest expected return for a defined level of risk or the lowest risk for a given level of expected
return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide
enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are
also sub-optimal, because they have a higher level of risk for the defined rate of return.
Choi ce B i s i ncorrect. T he Capital Allocation Line (CAL) is a line created in graph where on one
axis there is portfolio risk (standard deviation), and on another axis there is expected return. T his
line illustrates all possible mixes between risky and risk-free assets, but it does not represent
portfolios including only risky assets as required by our question.
Choi ce D i s i ncorrect. Beta measures an investment's sensitivity to market movements and it's
used in CAPM model to determine an asset's expected returns based on its beta exposure to market
returns. It does not represent a range or line where different portfolios can be constructed with
inclusion of a risk-free asset.
148
Q.3477 Which of the following is NOT an assumption of the capital asset pricing model?
A. Investors require higher returns with higher risks
B. Unlimited short-selling is permissible
C. All investors have the same one period time horizon
D. Investors are subject to taxes and transaction costs
T he Capital Asset Pricing Model (CAPM) assumes that there are no taxes and no transaction costs.
T his assumption is made to simplify the model and focus on the relationship between risk and return.
In reality, investors do face taxes and transaction costs which can significantly impact their
investment decisions and returns. However, in the context of CAPM, these factors are ignored to
allow for a more straightforward analysis of risk and return. T his assumption is one of the main
criticisms of the CAPM as it does not accurately reflect the real-world investment environment.
Choi ce A i s i ncorrect. T his statement accurately represents an assumption of the Capital Asset
Pricing Model (CAPM). According to CAPM, there is a positive relationship between risk and return,
meaning that investors require higher returns for taking on higher risks.
Choi ce B i s i ncorrect. T his statement also accurately represents an assumption of the CAPM.
T he model assumes that there are no restrictions on borrowing or lending, including unlimited short-
selling.
Choi ce C i s i ncorrect. T he CAPM does indeed assume that all investors have the same one period
time horizon for their investments. T his simplifying assumption allows the model to focus on risk and
return without considering differing investment horizons.
149
Q.3478 Which of the following uses systematic risk on the X-axis?
A. Security market line
B. Capital market line
C. Capital allocation line
D. Capital asset pricing model
T he Security Market Line (SML) uses systematic risk, measured by Beta, on its X-axis. T he SML is a
graphical representation of the Capital Asset Pricing Model (CAPM), which depicts the relationship
between the expected return of a security and its systematic risk. T he Y-axis represents the
expected return of a security, while the X-axis represents its systematic risk, measured by Beta.
Beta is a measure of a security's sensitivity to market movements. A Beta of 1 indicates that the
security's price will move with the market, while a Beta less than 1 indicates that the security will
be less volatile than the market, and a Beta greater than 1 indicates that the security will be more
volatile than the market. T herefore, the SML helps investors understand the risk-return tradeoff for
a particular security in relation to the overall market.
Choi ce B i s i ncorrect. T he Capital Market Line (CML) uses total risk, which includes both
systematic and unsystematic risk, on its X-axis. It does not solely represent the relationship between
expected return and systematic risk.
Choi ce C i s i ncorrect. T he Capital Allocation Line (CAL) also uses total risk on its X-axis to depict
the trade-off between expected return and risk for a specific portfolio combined with a risk-free
asset. It does not specifically use systematic or market risk.
Choi ce D i s i ncorrect. T he Capital Asset Pricing Model (CAPM) is not a line or model that
graphically represents the relationship between expected return and any form of risk on an axis.
Instead, it's an equation that calculates the expected return of an asset based on its beta (systematic
risk), but it doesn't plot this relationship graphically like the Security Market Line does.
150
Q.3479 T he standard deviation of an asset's return is 10%, and the standard deviation of markets
return is 14%. If the correlation of returns with the market index is 0.7, then what is the beta of the
asset?
A. 1
B. 0.1
C. 1.8
D. 0.5
Assets beta = Correlation of markets return * (Standard deviation of the asset / Standard deviation of
market returns) = 0.7 * 10% / 14% = 0.5
Q.3480 T he expected return of a portfolio is 17% and the return on risk-free assets in the portfolio
is 8%. T he beta of the portfolio is 1.2, and the standard deviation of the portfolio is 5.5%. Assuming
that an investor invests 115% of his savings in this portfolio, what is his expected return?
A. 18.35%.
B. 19.55%.
C. 12.5%.
D. 0.1345
Since the weight of the market portfolio is more than 100%, the investor is borrowing 15% of funds
at the risk-free rate and investing 115% in the market portfolio.
E[r] = (-15%)(8%) + (115%)(17%) = 18.35%
151
Q.3481 Kate Williams is a portfolio risk analyst for Hampton Funds. She is assigned to calculate the
beta of Lion Inc. shares. What is its beta if the standard deviation of market returns is 19% and the
covariance of Lions returns with the market return is 0.163?
A. 0.85
B. 4.51
C. 0.0451
D. 2.55
Beta = Covariance of Asset's return with market return / Variance of market returns
Beta = 0.163/0.192 = 4.51
Q.3482 What is the expected return of a stock if the expected market return is 11%, the risk-free
rate is 9%, and the stock's beta is 0.91?
A. 0.11
B. 0.1991
C. 0.1082
D. 0.1753
According to CAPM:
Expected return of stock = Risk-free rate + beta (Market risk - Risk-free rate)
E[r] = 9% + 0.91(11%-9%) = 10.82%
152
Q.3483 What is the covariance of an asset's returns with the market if the beta of the asset is 1.7
and the variance of market returns is 0.20?
A. 0.34
B. 0.85
C. 0.12
D. 8.5
Covariance of asset returns with the market = Beta * Variance of market returns = 1.7 * 0.20 = 0.34
Q.3484 What is the market risk premium if the expected return on the market is 13%, the average
stock's beta is 1, and the risk-free rate is 8%?
A. 9%
B. 13%
C. 5%
D. 0%
Market risk premium = Expected return of market - Risk-free rate of return.

Risk premium = 13% - 8% = 5%
153
Q.3485 What is the market risk premium if the expected return on a stock is 12% while its beta is
1.5? Assume the risk-free rate is 6% and the return on the market, i.e. market risk is 10%.
A. 6%
B. 4%
C. 10%
D. 12%
Expected return on stock = Risk-free rate + Beta*Risk premium

Note: Market risk - Risk-free rate = Risk premium
Expected return on stock = Risk-free rate + Beta*(Market return - Risk-free rate)

12% = 6% + 1.5(10% - 6%)
Market return = (12% - 6%)/1.5 + 6% = 10%
Risk premium = Market return - Risk-free rate = 10% - 6% = 4%
Q.3486 What is the beta of a certain stock with a risk-free rate of 2.1% and a return of 14.2%, given
that the expected return of the market is 17%?
A. 1
B. 1.5
C. 1.2
D. 0.81
T he expected return on the stock is given by:
rf + β(rm − rf )
⇒ 14.2% = 2.1% + β (17% − 2.1%)
⇒ β = 0.81
154
Q.3487 T he standard deviation of a portfolio is 15%. If the portfolio's return is 22%, and the risk-free
return is 6%, then what is the Sharpe ratio of the portfolio?
A. 0.91
B. 1.07
C. 1.46
D. 1.98
Sharpe ratio = (Portfolio return - Risk-free return) / Standard deviation of portfolio = (22% - 6%) /
15% = 1.07
155
Q.3488 Which of the following measures excess return per unit of total risk?
A. Jensen's alpha
B. T reynor ratio
C. Sharpe ratio
D. Sortino ratio
T he Sharpe ratio is a risk-adjusted performance metric that measures the excess return of an
investment or portfolio relative to its total risk. T he total risk is measured by the standard deviation
of the investment or portfolio's returns. T he Sharpe ratio is calculated by subtracting the risk-free
rate from the expected return of the investment or portfolio, and then dividing the result by the
standard deviation of the investment or portfolio's returns. T his ratio provides a measure of the
excess return earned per unit of total risk, which includes both systematic and unsystematic risk.
T he higher the Sharpe ratio, the better the investment or portfolio's risk-adjusted performance.
Choi ce A i s i ncorrect. Jensen's alpha is a risk-adjusted performance measure that represents the
average return on a portfolio over and above that predicted by the capital asset pricing model
(CAPM), given the portfolio's beta and the average market return. T his metric does not specifically
measure excess return per unit of total risk.
Choi ce B i s i ncorrect. T he T reynor ratio, also known as reward-to-volatility ratio, measures
returns earned in excess of that which could have been earned on a riskless investment per each
unit of market risk. It does not take into account total risk but only systematic risk.
Choi ce D i s i ncorrect. T he Sortino ratio differentiates harmful volatility from total overall
volatility by using the asset's standard deviation of negative portfolio returns—downside deviation
instead of total standard deviation used in Sharpe Ratio. T herefore, it doesn't measure excess return
per unit of total risk but rather focuses on downside or harmful volatility.
156
Q.3489 T he 10-year US T reasury rate is 5% and the return on the S&P 500 index is 10%. If the beta
of Orange Inc. is 1.2, what is the expected return on shares of Orange Inc.?
A. 11%
B. 15%
C. 17%
D. 8%
According to CAPM,
Expected return of stock = Risk-free rate + Beta(Market risk - Risk-free rate)
E[r] = 5% + 1.2(10%-5%) = 11%
Note that the 10-year US T reasury bonds are considered the risk-free rate and the S&P 500 return
is considered the market return.
157
Q.3490 Which of the following statements is appropriate regarding the plot of undervalued stocks on
the security market line?
A. Undervalued stocks plot above the SML
B. Undervalued stocks plot under the SML
C. Stocks always plot on the SML
D. Valuation can not be determined.
Undervalued stocks plot above the Security Market Line (SML). T he SML is a graphical
representation of the Capital Asset Pricing Model (CAPM), which is used to determine the expected
return of an investment given its level of systematic risk, or beta. T he SML plots the expected
return of a security against its beta, providing a benchmark for assessing the performance of an
investment. Stocks that plot above the SML are considered undervalued because they offer a higher
return than what the CAPM would predict given their level of risk. T his means that these stocks are
providing more return for their level of risk than what is considered fair or average, making them
attractive investments. Investors seeking to maximize their returns for a given level of risk would
therefore look for stocks that plot above the SML.
Choi ce B i s i ncorrect. Undervalued stocks do not plot under the SML. If a stock plots below the
SML, it indicates that it is overvalued, as its expected return is less than what would be predicted by
the CAPM given its level of systematic risk (beta). T his suggests that investors are overpaying for
the amount of risk they are taking on.
Choi ce C i s i ncorrect. It's not accurate to say that stocks always plot on the SML. While the SML
represents an equilibrium condition where all securities are fairly priced, in reality, due to various
market imperfections and investor irrationality, some stocks may be undervalued or overvalued at
any given time and thus plot above or below the SML.
Choi ce D i s i ncorrect. Valuation can indeed be determined using the Security Market Line (SML).
T he position of a stock relative to this line provides valuable information about whether it might be
undervalued or overvalued based on its expected return and systematic risk.
158
Q.3491 Company ABC is expected to return 15% per year to its investors, the market expected
return is 8%, and the risk-free rate is 3.5%. What is ABC's stock beta?
A. 1.4375
B. 1.875
C. 2.5556
D. 3.3333
E(R i ) = R f + E(R m − R f )βi

15% = 3.5% + (4.5%)βi
11.5% = (4.5%)βi
⇒ βi = 2.5556
159
Q.5314 What would be the portfolio's beta, given that its return correlation with the benchmark is
0.65, the portfolio's return volatility is 6%, and the benchmark's return volatility is 3%?
A. 0.117
B. 1.3
C. 0.325
D. 14.08
σ (portfolio)
β=ρ
σ (benchmark)
Where:
β = beta of the portfolio
ρ = correlation between the portfolio and the benchmark
σ (portfolio) = standard deviation (volatility) of the portfolio
σ (benchmark) = standard deviation of the benachmark
0.06
β = 0.65 × = 1.3
0.03
160
Q.5315 Tom Peters has been evaluating the performance of his company’s portfolio. He has the
access to the below information.
Portfolio’s expected return 8.5%

Risk-free rate 4%
Beta of the portfolio 1.25
Return on the benchmark portfolio 7%
Standard deviation of returns of the portfolio 6%
From the above information, the Sharpe Performance Index (SPI) is closest to?
A. 0.75
B. 0.036
C. 0.025
D. 0.65
T he Sharpe Performance Index (SPI), also known as the Sharpe Ratio, measures the risk-adjusted
return of a portfolio. To calculate the Sharpe Ratio, use the following formula:
E (R p) − R f
SP I =
σ(R p )
where:
E (R p) = Expected return of the portfolio
R f = Risk-free rate
σ(R p ) = Standard deviation (volatility) of the portfolio
8.5% − 4%
SP I = = 0.75
6%
161
Q.5317 What is the T reynor Performance Index of a portfolio, given its expected return of 7.7%,
volatility of 17%, beta of 0.4, and a risk-free rate of 2.5%, as calculated by an investment
performance analyst?
A. 0.305
B. 0.052
C. 0.13
D. 3.72
T he T reynor Performance Index (T PI), also known as the T reynor Ratio, measures the risk-adjusted
return of a portfolio considering its systematic risk (beta). To calculate the T reynor Ratio, use the
following formula:
E (R p ) − R f
T PI =
βp
where:
E (R p) = Expected return of the portfolio
R f = Risk-free rate
βp = Beta of the portfolio
7.7% − 2.5%
T PI = = 0.13
0.4
162
Q.5318 An analyst examined the past performance of two commodity funds that follow the S&P500
as a benchmark. T he analyst collected monthly return data and utilized the Information Ratio (IR) to
evaluate which fund generated greater returns more effectively. T he analyst then presented the
results as follows:
Fund A Fund B Benchmark

Average monthly return 2.63% 2.54% 2.35%
Average excess return 0.28% 0.19% 0.00%
Standard deviation of returns 0.51% 0.48% 0.45%
T racking error 0.56% 0.53% 0.00%
What is the Information Ratio (IR) for each fund?
A. Fund A Information Ratio (IR) = 0.54, Fund B Information Ratio (IR) = 0.39
B. Fund A Information Ratio (IR) = 0.50, Fund B Information Ratio (IR) = 0.35
C. Fund A Information Ratio (IR) = 0.46, Fund B Information Ratio (IR) = 0.47
D. Fund A Information Ratio (IR) = 0.91, Fund B Information Ratio (IR) = 0.90
T he information ratio can be computed by comparing the residual return to the residual risk or the
excess return to the tracking error. T he greater the IR, the better the management is at selecting
assets to invest in.
E (R p − R b )
IR =
T racking error
Fund A:
2.63% − 2.35%
IR = = 0.50
0.56%
Fund B:
2.54% − 2.35%
IR = = 0.35
0.53%
163
Reading 6: The Arbitrage Pricing Theory and Multifactor Models of
Risk and Return
Q.223 T he following are inputs to a multifactor return model for any stock, EXCEPT :
A. Firm-specific return.
B. Deviation of macroeconomic factors from the expected values.
C. T he expected return for the stock.
D. Aggregate market risk.
Aggregate market risk is not an input to a multifactor return model for a stock. T he multifactor
model, unlike the Capital Asset Pricing Model (CAPM), does not consider aggregate market risk.
Instead, it uses factor loadings, also known as factor sensitivities or factor betas, to evaluate the
impact of certain dominant factors on the return of the stock. T he model is expressed as follows:
R i = E(R i) + βi1F1 + βi2 F2 + ⋯ + βik Fk + ei
Where:
R i = rate of return on stock i
E(R i ) = expected return on stock i
βik = sensitivity of the stock’s return to a one-unit change in factor k
Fk = Macroeconomic factor k
ei = the firm-specific return/portion of the stock’s return unexplained by macro factors
T he expected value of the firm-specific return is always zero. T herefore, aggregate market risk is
not a factor in this model.
Choi ce A i s i ncorrect. Firm-specific return is indeed an input to a multifactor return model for a
stock. T his factor represents the unique characteristics of the firm that may affect its stock
returns, such as its financial performance, industry position, and management quality.
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Choi ce B i s i ncorrect. Deviation of macroeconomic factors from the expected values is also an
input to this model. Macroeconomic factors such as inflation rate, GDP growth rate, and interest
rates can significantly influence stock returns. T he deviation of these factors from their expected
values can cause unexpected changes in stock returns.
Choi ce C i s i ncorrect. T he expected return for the stock is another important input to this model.
It represents the average return that investors expect to earn from holding the stock over a certain
period.
Choi ce D (Aggregate mark et ri sk ) was correctl y i denti fi ed as not bei ng an i nput i nto a
mul ti factor return model for stock s. Aggregate market risk refers to risks that affect all firms
in the market rather than specific individual firms or sectors which are typically considered in
multifactor models.
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Q.224 Define arbitrage as used in the context of security trading.
A. T he exploitation of undervalued assets so as to increase returns.
B. T he exploitation of security mispricing aimed at making risk-free profits.
C. T he skill of accurately timing returns so as to obtain optimal profit from a security.
D. T he exploitation of illegal trading channels aimed at making tax-free profits.
Arbitrage, in the context of security trading, refers to the exploitation of security mispricing with
the aim of making risk-free profits. T his is achieved by simultaneously buying and selling the same
security in different markets to take advantage of the price difference. T he key element of arbitrage
is that it involves no risk. T he profit is made from the price discrepancy and not from the movement
of the security's price. T herefore, it is considered a risk-free profit. T he arbitrageur, or the person
conducting the arbitrage, is essentially providing a service to the market by ensuring that prices
across different markets are in line with each other. If there is a price discrepancy, the arbitrageur
will step in to take advantage of the situation, thereby bringing the prices back into alignment. T his is
why arbitrage is considered an important mechanism in maintaining market efficiency.
Choi ce A i s i ncorrect. While the exploitation of undervalued assets can lead to increased returns,
this does not necessarily constitute arbitrage. Arbitrage specifically involves taking advantage of
price discrepancies in different markets for the same asset to make risk-free profits, not simply
investing in undervalued assets.
Choi ce C i s i ncorrect. T iming returns accurately to obtain optimal profit from a security refers
more to trading strategies based on market timing and prediction rather than arbitrage. Arbitrage does
not rely on timing or predicting market movements but rather exploits existing price discrepancies
between markets.
Choi ce D i s i ncorrect. T he exploitation of illegal trading channels for tax-free profits falls under
illicit activities and has nothing to do with the concept of arbitrage in security trading which is a legal
and commonly used strategy.
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Q.226 T he common stock of Swisscom Inc. is examined with a single factor model using unexpected
percent changes in GDP as the single factor. You have been provided with the following data:
Expected return for Swisscom = 10%
GDP factor-beta = 2
Expected GDP growth = 2%
Revised macroeconomic information strongly suggests that the GDP will grow by a whopping 5% as
opposed to the original prediction of 2%. Assuming there's no new information regarding firm-
specific events, calculate the revised expected return using a single factor model.
A. 10.6%
B. 6%
C. 20%
D. 16%
T he equation for a single factor model for stock i is given by:
R i = E(R i) + βi,jFj + ei
Where:
R i = revised return for stock i
E(R i ) = the expected return for stock i
βi,j = the jth factor beta for stock i
Fj = the deviation of the factor j from its expected value
ei = the firm-specific return for stock i
In our case:
R i = 0.10 + 2(0.05 − 0.02) = 0.10 + 0.06 = 0.16 or 16%
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Q.227 ShipLink, a United States cargo company, considers the return earned on its stock as heavily
sensitive to GDP and consumer sentiments. You have been given the following data:
Expected return for Shiplink stock = 10%
GDP factor beta = 2
Expected growth in GDP = 3%
Consumer sentiment factor beta = 2.5
Expected growth in consumer sentiment = 2%
Suppose revised macroeconomic data suggests the GDP will grow by 4% rather than 3% and that
consumer sentiments will grow by 3% rather than 2%. Determine the revised return for Shiplink
stock, assuming no new information is available regarding the firm-specific return.
A. 18%
B. 25%
C. 14.5%
D. 4.5%
T his is a multifactor model where the revised return, R i will be given by:
R i = E(R i ) + βS,G DP FG DP + βS ,CS FCS + ei

= 0.10 + 2(0.04 − 0.03) + 2.5(0.03 − 0.02)
= 0.10 + 0.02 + 0.025
= 0.145 or 14.5%
Q.228 A manager uses a two-factor model to examine the returns of two assets, X and Y. T he two
factors are unexpected percentage changes in inflation (IF) and consumer sentiment (CS). T he
following data has also been given:
E(R X ) = 10%
E(R Y ) = 12%
βX,I F = βY ,IF = 2
βX,CS = βY ,CS = 2
All other factors constant, which of the following statements is true?
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A. Asset Y is more sensitive to inflation than asset X.
B. Inflation and consumer sentiment have different effects on the returns of X and Y.
C. An arbitrage opportunity exists.
D. None of the above are true.
An arbitrage opportunity exists. Arbitrage is the practice of taking advantage of a price difference
between two or more markets, striking a combination of matching deals that capitalize upon the
imbalance, the profit being the difference between the market prices. In this case, the two assets, X
and Y, have identical systematic risks as indicated by their beta coefficients. However, they have
different expected returns, with asset Y having a higher expected return than asset X. T his
discrepancy creates an arbitrage opportunity. An investor can exploit this by shorting asset X (i.e.,
selling asset X now with the intention of buying it back later at a lower price) and using the proceeds
to take a long position in asset Y (i.e., buying asset Y now with the expectation that its price will
increase in the future). T his strategy allows the investor to make a risk-free profit, as they are
essentially borrowing at a lower rate (the expected return of asset X) and investing at a higher rate
(the expected return of asset Y).
Choi ce A i s i ncorrect. T he sensitivity of an asset to inflation is measured by its beta coefficient
with respect to inflation. Given that both Asset X and Asset Y have the same beta coefficient for
inflation (βX,I F = βY ,IF = 2), it implies that they are equally sensitive to unexpected changes in
inflation. T herefore, it is not correct to say that Asset Y is more sensitive to inflation than Asset X.
Choi ce B i s i ncorrect. T he effect of a factor on the returns of an asset is determined by its beta
coefficient with respect to that factor. Since both assets have the same beta coefficients for both
factors (βX,I F = βY ,IF = 2 and βX,CS = βY ,CS = 2), it means that unexpected changes in either inflation
or consumer sentiment will have the same effect on the returns of Assets X and Y. T hus, this
statement is false.
Choi ce D i s i ncorrect. As explained above
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Q.229 What is the three-factor model proposed by Eugene Fama and Kenneth French primarily used
to explain?
A. T he stock market's return volatility
B. T he long-term performance of a company
C. T he relationship between risk and return
D. T he stock market's direction of movement
T he three-factor model proposed by Eugene Fama and Kenneth French is an extension of the Capital
Asset Pricing Model (CAPM). T his model is used to explain the relationship between risk and
expected return in portfolio investments, by introducing two additional factors - size and value - that
are said to be associated with higher returns for investors. It states that, aside from market risk
(beta), size (smaller companies) and value (or book-to-market) have significant effects on expected
returns, which explains why certain portfolios may outperform others over time.
A i s i ncorrect.T he stock market's return volatility is not explained by the three-factor model
proposed by Eugene Fama and Kenneth French as it does not account for changes in volatility over
time.
B i s i ncorrect.T he long-term performance of a company is not explained by the three-factor model
as it does not focus on individual companies but rather how different portfolio combinations behave
over time.
D i s i ncorrect.T he stock market's direction of movement is also not explained by the three-factor
model as this depends on other factors such as economic news or investor sentiment, which are
outside its scope of analysis.
Q.230 Consider a single factor APT. Portfolio X has a beta of 1.2 and an expected return of 18%.
Portfolio Y has a beta of 1.0 and an expected return of 14%. You are further provided with a risk-free
rate of 6%. Assuming you wanted to exploit an arbitrage opportunity, you would take a short position
in:
A. Y and use the proceeds to take a long position in X.
B. Y and use the proceeds to take a long position in the risk-free asset.
C. X and use the proceeds to take a long position in Y.
D. X and use the proceeds to take a long position in the risk-free asset.
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T he Arbitrage Pricing T heory (APT ) is a multifactor model of asset pricing that holds that the
expected return of a financial asset can be modeled as a linear function of various macroeconomic
factors, where sensitivity to changes in each factor is represented by a factor-specific beta
coefficient. In this case, the expected return of a portfolio is calculated as the sum of the risk-free
rate and the product of the portfolio's beta and the factor premium. For portfolio X, the expected
return is 18%, which equals 1.2F (where F is the factor premium) plus the risk-free rate of 6%.
Solving for F gives us a factor premium of 10%. For portfolio Y, the expected return is 14%, which
equals 1.0F plus the risk-free rate of 6%. Solving for F in this case gives us a factor premium of 8%.
Since the factor premium for portfolio X is higher than that for portfolio Y, an arbitrage opportunity
exists. By shorting portfolio Y (selling it) and using the proceeds to take a long position in portfolio X
(buying it), you can exploit this arbitrage opportunity and earn a risk-free profit.
Choi ce B i s i ncorrect. Selling Portfolio Y and using the proceeds to take a long position in the risk-
free asset would not provide an arbitrage opportunity. T his is because the expected return of
Portfolio Y (14%) is higher than the risk-free rate (6%). T herefore, this strategy would result in a
lower return rather than an arbitrage profit.
Choi ce C i s i ncorrect. Shorting Portfolio X and using the proceeds to take a long position in
Portfolio Y would not yield an arbitrage opportunity either. T he expected return of Portfolio X
(18%) exceeds that of Portfolio Y (14%), despite having a higher beta value, which indicates more
systematic risk. T hus, this strategy would lead to lower returns instead of exploiting any pricing
inefficiencies for arbitrage gains.
Choi ce D i s i ncorrect. Shorting portfolio X and investing in the risk-free asset also does not
present an arbitrage opportunity as it will result in lower returns due to difference between
expected return on portfolio X(18%) and risk free rate(6%).
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Q.231 When the equilibrium price relationship is violated, an investor will try to take as large a
position as possible. T his is an example of:
A. Risk-free arbitrage.
B. T he capital asset pricing model.
C. T he mean-variance frontier.
D. T he single factor security market line.
Violation of the equilibrium price relationship will prompt an investor to buy the lower-priced asset
and simultaneously place an order to sell the higher-priced asset. T his is an example of risk-free
arbitrage. In fact, the larger the long position taken, the greater the risk-free profits.
Opti on B i s i ncorrect: CAPM explains that the market equilibrium is attained when all investors
hold portfolios whose constituents are a combination of riskless asset and the market portfolio
Opti on C i s i ncorrect: T he mean-variance frontier is a combination of securities that offer the
best possible returns at a minimum variance possible.
Opti on D i s i ncorrect: a single-factor model assumes there’s just one macroeconomic factor.
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Q.232 What is the major difference between CAPM and the APT ?
A. APT places more emphasis on systematic risks.
B. APT downplays the importance of diversification.
C. APT recognizes multiple systematic factors.
D. APT recognizes multiple unsystematic factors.
T he Arbitrage Pricing T heory (APT ) indeed recognizes multiple systematic factors. Unlike the
Capital Asset Pricing Model (CAPM), which is a single-factor model that only considers market risk,
APT is a multi-factor model. It assumes that the return of a financial asset can be modeled as a linear
function of various macroeconomic factors. T hese factors could include GDP growth, inflation rates,
interest rates, and others. Each of these factors has an associated sensitivity or 'beta' that measures
the asset's responsiveness to changes in that factor. By considering multiple systematic factors, APT
provides a more comprehensive view of the risks affecting asset returns. T his recognition of
multiple systematic factors is the primary distinction between CAPM and APT.
Choi ce A i s i ncorrect. Both CAPM and APT place emphasis on systematic risks. Systematic risk,
also known as market risk, affects the overall market and cannot be eliminated through
diversification. It is a key component in both models.
Choi ce B i s i ncorrect. T he statement that APT downplays the importance of diversification is not
accurate. In fact, both CAPM and APT assume that investors hold diversified portfolios to eliminate
unsystematic risk.
Choi ce D i s i ncorrect. Neither CAPM nor APT recognizes multiple unsystematic factors as they
are based on the assumption that unsystematic risks can be diversified away by holding a well-
diversified portfolio.
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Q.233 Which of the following statements is true regarding the security market line derived from the
arbitrage pricing theory?
A. It shows the expected return in relation to portfolio variance, represented by σ 2.
B. It has a downward slope.
C. T he x-axis intercept is equal to the expected return on the market portfolio.
D. Any well-diversified portfolio may serve as the benchmark portfolio.
T he arbitrage pricing theory (APT ) posits that the expected return of a financial asset can be
modeled as a linear function of various macroeconomic factors, where sensitivity to changes in each
factor is represented by a factor-specific beta coefficient. T he model-derived rate of return will
then be used to price the asset correctly - the asset price should equal the expected end of period
price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back
into line. In the context of APT, the benchmark portfolio does not necessarily have to be the market
portfolio. It can be any well-diversified portfolio. T his is because, in APT, we are looking at multiple
factors that influence the return of a security, not just the market return. T herefore, the
benchmark portfolio can be any portfolio that is well-diversified across these factors. T his means
that the portfolio should have a mix of securities that are influenced by these factors in different
ways, so that the overall risk of the portfolio is minimized.
Choi ce A i s i ncorrect. T he security market line (SML) does not show the expected return in
relation to portfolio variance. Instead, it depicts the relationship between systematic risk (beta) and
expected return of a security or a portfolio.
Choi ce B i s i ncorrect. T he SML does not have a downward slope; rather, it has an upward slope
indicating that higher risk (beta) is associated with higher expected returns.
Choi ce C i s i ncorrect. T he x-axis intercept of the SML is equal to the risk-free rate, not the
expected return on the market portfolio.
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Q.234 T he following are factors used by Fama and French in their multifactor model, EXCEPT :
A. T he Return on the market index (R m − R f ).
B. T he Return earned by small stocks over and above the return on large stocks.
C. T he Return earned by high book-to-market stocks over and above the low book-to-market
stocks.
D. None: All the above factors are used.
T he Fama-French 3-factor model indeed includes all the factors listed in the options. T he model was
developed by Eugene Fama and Kenneth French to better explain asset returns. T he three factors
used in the model are: (1) T he return on the market index (R m − R f ), which represents the excess
return of the market over the risk-free rate. T his factor is also used in the Capital Asset Pricing
Model (CAPM). (2) T he return earned by small stocks over and above the return on large stocks,
also known as the size premium. T his factor is based on the observation that smaller companies tend
to have higher returns than larger companies. (3) T he return earned by high book-to-market stocks
over and above the low book-to-market stocks, also known as the value premium. T his factor is
based on the observation that companies with high book-to-market ratios (value stocks) tend to
outperform companies with low book-to-market ratios (growth stocks). T herefore, all the factors
listed in the options are used in the Fama-French 3-factor model.
Choi ce A i s i ncorrect. T he return on the market index (R m − R f ) is indeed a factor in the Fama-
French 3-factor model. T his factor represents the excess return of the market portfolio over the
risk-free rate, which captures systematic risk.
Choi ce B i s i ncorrect. T he return earned by small stocks over and above that of large stocks, also
known as size premium, is another factor included in this model. It reflects that smaller firms tend to
have higher returns than larger firms due to their higher risk.
Choi ce C i s i ncorrect. T he return earned by high book-to-market stocks over and above low book-
to-market stocks, or value premium, is also a part of this model. It indicates that value stocks (high
book-to-market ratio) tend to outperform growth stocks (low book-to-market ratio).
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Q.235 A portfolio Z is subject to two risk factors, A and B, with factor betas of 0.3 and 0.5,
respectively. A fund manager wishes to hedge away all of the exposure to both A and B, yet he's not
ready to sell the portfolio at any cost. Choose the strategy best placed to achieve the manager's
desired goal.
A. Short sell a hedge portfolio with 50% allocation to factor A portfolio, 30% allocation to
factor B portfolio, and 20% allocation to the risk-free asset.
B. Short sell a hedge portfolio with 30% allocation to factor A portfolio, 50% allocation to
factor B portfolio, and 20% allocation to the risk-free asset.
C. Buy a hedge portfolio with 50% allocation to factor A portfolio, 30% allocation to factor B
portfolio, and 20% allocation to the risk-free asset.
D. Buy a hedge portfolio with 30% allocation to factor A portfolio, 50% allocation to factor B
portfolio, and 20% allocation to the risk-free asset.
T he correct strategy to hedge away all of the exposure to both risk factors A and B without selling
the portfolio is to short sell a hedge portfolio with 30% allocation to factor A portfolio, 50%
allocation to factor B portfolio, and 20% allocation to the risk-free asset. T his strategy is based on
the concept of factor portfolios. A factor portfolio is a well-diversified portfolio designed to have a
beta equal to 1 for one of the risk factors and betas equal to zero for all the remaining factors. By
short selling the hedge portfolio, the investor can offset the 0.30 and the 0.50 exposures to risk
factors A and B respectively. T he hedge portfolio also has similar exposures to the two factors,
which means that the risks inherent in the original portfolio can be effectively offset without the
need to sell the portfolio. T his strategy allows the fund manager to maintain the portfolio while
eliminating the exposure to the risk factors.
Choi ce A i s i ncorrect. Short selling a hedge portfolio with 50% allocation to factor A and 30%
allocation to factor B would not effectively eliminate the exposure to these risk factors. T he
allocations are reversed in relation to the factor betas of the risks, which means that this strategy
would over-hedge risk A and under-hedge risk B.
Choi ce C i s i ncorrect. Buying a hedge portfolio with 50% allocation to factor A and 30% allocation
to factor B would increase rather than decrease the exposure of portfolio Z to these risks. T his is
because buying increases exposure while short selling reduces it.
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Choi ce D i s i ncorrect. Similar to choice C, buying a hedge portfolio with 30% allocation to factor
A and 50% allocation to factor B would also increase the exposure of portfolio Z, which contradicts
the manager's objective of eliminating risk exposures.
Q.236 Which of the following best explains why the APT is considered more flexible than the
CAPM?
A. It uses multiple systematic factors, not just a single aggregated factor, to represent the
total market risk.
B. Just like the CAPM, the APT allows for the use of a single factor through the single factor
model which can be extended to include more factors.
C. With the APT, the benchmark portfolio in the security market line does not have to be the
true market portfolio.
D. None of the above.
T he Arbitrage Pricing T heory (APT ) is indeed more flexible than the Capital Asset Pricing Model
(CAPM) because the benchmark portfolio used in the security market line does not have to be the
true market portfolio. T his is a significant advantage of the APT over the CAPM. In the CAPM, the
benchmark return used to establish the security market line is typically the market portfolio, which
is often unobservable and therefore a source of potential error. However, the APT allows for any
well-diversified portfolio to be used as the benchmark, which provides a great deal of flexibility. T his
flexibility is particularly useful when there are concerns about the accuracy of the index portfolio as
a proxy for the true market portfolio. T herefore, the APT 's ability to use any well-diversified
portfolio as the benchmark makes it more flexible than the CAPM.
Choi ce A i s i ncorrect. While it's true that the APT uses multiple systematic factors to represent
total market risk, this does not necessarily make it more flexible than the CAPM. T he flexibility of a
model is determined by its ability to adapt and adjust to different scenarios and conditions, not just by
the number of factors it considers.
Choi ce B i s i ncorrect. Although both APT and CAPM can use a single factor model, this doesn't
177
inherently make APT more flexible than CAPM. T he single factor model in both theories can be
extended to include more factors but this extension doesn't provide additional flexibility in terms of
adjusting for different market conditions or scenarios.
Choi ce D i s i ncorrect. As explained above, choices A and B do not accurately describe why the
Arbitrage Pricing T heory (APT ) might be considered more flexible than the Capital Asset Pricing
Model (CAPM). T herefore, stating that none of these reasons are correct would also be inaccurate.
Q.238 Suzy Ye is a junior equity research analyst at a research firm based in South Korea. For the
first time, she is using the multifactor model to compute the stock return of the Wong Kong Corp
(WK). She has compiled the following data for the computation of the return:
Wong Kong's expected stock return: 7%
Expected GDP growth: 4.5%
Expected Inflation: 2.5%
GDP factor beta: 1.5
Inflation factor beta: 2
Risk-free rate: 2%
Suppose the actual GDP growth and actual inflation of South Korea are 3% and 2.9%, respectively,
then which of the following is an accurate estimate of the stock return?
A. 7.55%
B. 10.05%
C. 5.55%
D. 18.75%
A multifactor model (2-factor model in the given question) only includes the expected return of the
stock, macroeconomic factor and the factor-beta, and firm-specific risk, which in this case is zero.
R W K = E(R W K) + βG DP FG DP + βI FI
= 0.07 + 1.5(0.03 − 0.045) + 2(0.029 − 0.025)
= 0.07 − 0.0225 + 0.008
= 5.55%
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Q.239 T he single-factor model indicates that the return is based on a firm-specific variable and a
macroeconomic variable such as inflation, GDP growth, interest rates, consumer sentiments, etc.
T hese factors combined with the expected return of the asset allow hedging the risk of those assets
whose returns change with the changes in macroeconomic variables. In the single-factor model, the
macroeconomic variables are used as inputs in the form of:
A. Deviation of the macroeconomic variable from its expected value.
B. Actual value of the macroeconomic variable multiplied by its sensitivity to the asset.
C. Expected value the macroeconomic variable multiplied by the beta factor.
D. Deviation of the macroeconomic variable from its expected value multiplied by the beta
factor.
T he single-factor model uses the deviation of the macroeconomic variable from its expected value as
an input. T his is because the model is designed to capture the impact of unexpected changes in the
macroeconomic variable on the asset's return. T he expected return of the asset is already factored
into the model, so what matters is how the actual macroeconomic variable deviates from what was
expected. T his deviation represents the 'surprise' element in the macroeconomic variable that could
potentially affect the asset's return. T herefore, the model uses this deviation as an input to capture
this effect.
Choi ce B i s i ncorrect. T he actual value of the macroeconomic variable multiplied by its
sensitivity to the asset is not how these variables are incorporated in a single-factor model. In this
model, it's not about the actual value but rather about the deviation of this value from its expected
one that matters.
Choi ce C i s i ncorrect. T he expected value of the macroeconomic variable multiplied by the beta
factor is also not how these variables are incorporated in a single-factor model. Again, it's about
deviations from expectations, not just expectations themselves.
Choi ce D i s i ncorrect. While this choice seems close to being correct as it includes both
deviation and beta factor, it still misses out on an important aspect - there's no multiplication involved
between these two elements in a single-factor model.
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Q.240 As an analyst, you are analyzing a number of stocks of German Tech companies trading on the
TecDAX. You come across two stocks DESolars AG and GERTech Co., with expected returns of
4.9% and 5.1%, respectively. In order to assess if an arbitrage opportunity exists between two
stocks, you compile the following data to be used in the two-factor model:
Actual GDP Growth: 2%
Expected GDP Growth: 2%
Actual CPI: 1.7%
Expected CPI: 1.5%
DESolars (GDP) beta: 1.1
DESolars (CPI) beta: 0.9
GERTech (GDP) beta: 1.1
GERTech (CPI) beta: 0.9
Considering the given data, identify which of the following statement is true?
A. An arbitrage opportunity does not exist because both stocks have different expected
returns.
B. An arbitrage opportunity exists because both firms have the same beta factor.
C. An arbitrage opportunity does not exist because both firms have the same beta.
D. An arbitrage opportunity exists because both firms have different returns for the same
systematic risk.
An arbitrage opportunity exists because both firms have different returns for the same systematic
risk. Arbitrage opportunities arise when there is a discrepancy between the price of a security and
its intrinsic value. In this case, both DESolars AG and GERTech Co. have the same systematic risk,
as indicated by their identical beta values. However, they offer different returns. DESolars AG has an
expected return of 4.9%, while GERTech Co. offers a higher return of 5.1%. T his difference in
returns for the same level of risk indicates an arbitrage opportunity. An investor could exploit this by
short selling the lower-return stock (DESolars AG) and using the proceeds to buy the higher-return
stock (GERTech Co.). T his would allow the investor to pocket the difference in returns (0.2%) as
risk-free profit.
Choi ce A i s i ncorrect. T he existence of an arbitrage opportunity is not determined by whether
the stocks have different expected returns. T wo stocks can have different expected returns but still
not present an arbitrage opportunity if their risk-return profiles are in line with each other.
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Choi ce B i s i ncorrect. T he presence of an arbitrage opportunity does not solely depend on both
firms having the same beta factor. While it's true that identical betas suggest similar systematic risk,
this doesn't automatically imply an arbitrage opportunity unless there's a discrepancy in their
returns given this same level of risk.
Choi ce C i s i ncorrect. Similar to Choice B, the fact that both firms have the same beta does not
necessarily mean there isn't an arbitrage opportunity. An arbitrage situation arises when there's a
possibility to make a risk-free profit due to price discrepancies for equivalent risks and returns,
which isn't directly related to whether or not two firms share identical betas.
Q.241 Creative Investments Co. holds a brainstorming and strategy-building session before the trading
hours in order to prepare the analysts and traders for the day. While conducting the session Craig
Lee, head of the equity department, made the following statements regarding the impact of
diversification on the residual risk of a portfolio:
Statement 1: "T he part of the asset's risk that is uncorrelated with the volatility of the market
portfolio is called nonsystematic risk."
Statement 2: "T he part of the asset's risk that is due to the positive covariance of that asset's
returns with market returns is called the systematic risk or diversifiable risk."
Statement 3: "As the number of assets in a portfolio increases, the systematic risk of the portfolio
decreases."
Which of the following statement is/are correct?
A. Statement 1 only
B. Statement 3 only
C. Statements 1 and 2
D. Statements 2 and 3
Nonsystematic risk, also known as specific risk, diversifiable risk, idiosyncratic risk, or residual risk,
is the part of an asset's risk that is uncorrelated with the volatility of the market portfolio. T his type
of risk is unique to a particular asset or a small group of assets. Nonsystematic risk can be reduced
through diversification. By investing in a variety of assets, the impact of any one asset's performance
on the overall portfolio is minimized. T his is because the positive performance of some assets will,
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ideally, offset the negative performance of others. T herefore, the more diversified the portfolio, the
less impact any one asset (or group of assets) will have on the overall performance of the portfolio.
Choi ce B i s i ncorrect. Statement 3 is not correct because systematic risk, also known as non-
diversifiable risk, does not decrease with an increase in the number of assets in a portfolio.
Systematic risk is inherent to the entire market or market segment and cannot be eliminated through
diversification.
Choi ce C i s i ncorrect. Although Statement 1 is correct, Statement 2 contains an error. T he part
of the asset's risk due to positive covariance with market returns is indeed called systematic risk but
it's not diversifiable. It's actually non-diversifiable or market risk which cannot be eliminated by
adding more assets to a portfolio.
Choi ce D i s i ncorrect. As explained above both statement 2 and statement 3 are incorrect hence
this choice can't be correct.
Q.242 During a Securities Analysis seminar at one of the top business schools in Mumbai, a student
asked the moderator to define the assumptions that constitute the single-factor security market line.
T he moderator stated that the following assumptions are made while drawing the single-factor
security market line:
I. Returns follow a k-factor process
II. A mean-variance efficient market portfolio exists
III. Well-diversified portfolios can be created
IV. No arbitrage opportunities exist
Which of the above assumptions do(es) NOT hold true in the creation of the single-factor security
market line?
A. Assumption I only
B. Assumption IV only
C. Assumptions I and II
D. Assumptions II and III
T he assumptions that do not hold true while drawing the single-factor security market line are
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Assumptions I and II. T he single-factor security market line is based on three primary assumptions:
1. Security returns can be explained by the single-factor model
2. Well-diversified portfolios can be created
3. No arbitrage opportunities exist
Assumption I, that returns follow a K-factor process, is not an assumption of the single-factor
security market line but is instead related to the Arbitrage Pricing T heory (APT ). T he APT is a
multi-factor model that explains the expected return of a security or a portfolio of securities as a
linear function of various macroeconomic factors. Each factor has a sensitivity and a risk premium
associated with it. T he K-factor process implies that there are multiple factors influencing the
returns, which contradicts the single-factor model assumption.
Assumption II, that a mean-variance efficient market portfolio exists, is also not an assumption of the
single-factor security market line. T his assumption is a part of the Capital Asset Pricing Model
(CAPM). T he CAPM is a model that describes the relationship between systematic risk and expected
return for assets, particularly stocks. T he mean-variance efficient portfolio is a portfolio that has
the highest expected return for a given level of risk (standard deviation). T he existence of such a
portfolio is not a requirement for the single-factor security market line.
Choi ce A i s i ncorrect. T he assumption that returns follow a k-factor process is not applicable to
the single-factor security market line. T he single-factor model assumes that the return of a security
is dependent on a single factor, usually the market return, and not multiple factors (k-factors).
T herefore, this assumption does not apply when constructing the single-factor security market line.
Choi ce B i s i ncorrect. T he absence of arbitrage opportunities is an assumption that applies to
most financial models including the single-factor security market line. T his assumption ensures that
no investor can earn risk-free profits by simultaneously buying and selling securities at different
prices in different markets.
Choi ce D i s i ncorrect. T he existence of a mean-variance efficient market portfolio and possibility
of creating well-diversified portfolios are both assumptions relevant to portfolio theory but they do
not specifically apply to the construction of a single-factor security market line which focuses on
individual securities rather than portfolios.
183
Q.243 Kevin Brett is an American portfolio manager who manages an emerging factor market
portfolio that focuses on the blue-chip firms from Brazil. He fears that the stocks of these blue-chip
firms are highly dependent on factors like the GDP of Brazil and the value of the Brazilian Real. He
believes his portfolio can decline in value due to changes in these two main factors. T he portfolio's
Brazilian GDP beta is 0.40 and the Brazilian Real beta is 0.3. Which of the following strategies should
Brett accept in order to hedge both factors?
A. Short sell a hedge portfolio that allocates 40% exposure to the Brazilian GDP factor
portfolio, 30% to the Brazilian Real factor portfolio, and 30% to the risk-free asset.
B. Buy a hedge portfolio that allocates 40% exposure to the Brazilian GDP factor portfolio,
30% to the Brazilian Real factor portfolio, and 30% to the risk-free asset.
C. Buy a hedge portfolio that allocates 30% exposure to the first Brazilian GDP factor
portfolio, 40% to the Brazilian Real factor portfolio, and 30% to the market portfolio.
D. Short sell a hedge portfolio that allocates 70% exposure to the risk-free asset and 30% to
the market portfolio.
A factor portfolio can be hedged by opening opposite positions with the same factor exposure. A
factor portfolio has a factor-beta equal to one for a single risk factor, and factor betas equal to zero
on the remaining factors. By shorting the hedge portfolio, the investor will offset the factor risks of
the original portfolio. Since Kevin has a 0.4 exposure to the Brazilian GDP factor and a 0.3 exposure
to the Brazilian Real factor, he can hedge the risk by shorting a factor portfolio that allocates 40%
exposure to the Brazilian GDP factor portfolio, 30% to the Brazilian Real factor portfolio, and the
rest to the risk-free assets. T his strategy will effectively neutralize the risks associated with the
Brazilian GDP and the Brazilian Real, thereby protecting the value of his portfolio from potential
losses due to fluctuations in these two factors.
Choi ce B i s i ncorrect. Buying a hedge portfolio that allocates 40% exposure to the Brazilian GDP
factor portfolio and 30% to the Brazilian Real factor portfolio would increase Brett's exposure to
these factors, not decrease it. T his strategy would therefore amplify the risks associated with
fluctuations in these two factors, rather than hedging against them.
Choi ce C i s i ncorrect. T his choice suggests buying a hedge portfolio that misallocates exposures
184
to the Brazilian GDP and Real factors (30% and 40%, respectively), which does not align with Brett's
existing beta exposures (0.4 for GDP and 0.3 for Real). Moreover, allocating part of the hedge to the
market portfolio does not specifically address his concerns about these two particular risk factors.
Choi ce D i s i ncorrect. Short selling a hedge portfolio that primarily exposes Brett to risk-free
assets does not provide an effective hedge against his specific risks related to Brazilian GDP and Real
fluctuations. T he allocation of only 30% exposure towards market portfolios also fails in providing
adequate protection against his specific concerns.
185
Q.4452 All the following are factors of the Fama-French Model, EXCEPT :
A. Market factor.
B. T he difference in expected returns of high-beta stocks minus small-beta stocks.
C. T he difference in expected returns of a portfolio of high book-to-market stocks minus a

portfolio of low book-to-market stocks.
D. T he difference in expected returns of small stocks minus big stocks.
T he difference in expected returns of high-beta stocks minus small-beta stocks is not a factor in the
Fama-French three-factor model. T he Fama-French model was developed by Eugene Fama and
Kenneth French to better predict the returns of stocks and portfolios. It does this by adding two
factors to the original single-factor capital asset pricing model (CAPM). T hese two additional factors
are size and value. Size is measured by the market capitalization of a company, with smaller
companies expected to yield higher returns. Value is measured by the book-to-market ratio, with
companies having a high book-to-market ratio expected to yield higher returns. T he original factor
from the CAPM, the market factor, is also included in the Fama-French model. T herefore, the three
factors of the Fama-French model are the market factor, the size factor, and the value factor. T he
difference in expected returns of high-beta stocks minus small-beta stocks is not one of these
factors.
Choi ce A i s i ncorrect. T he market factor, which is the excess return on the market portfolio
over the risk-free rate, is indeed one of the three factors in the Fama-French three-factor model.
Choi ce C i s i ncorrect. T he difference in expected returns of a portfolio of high book-to-market
stocks minus a portfolio of low book-to-market stocks represents value risk and it's one of the
factors included in this model.
Choi ce D i s i ncorrect. T he difference between expected returns on small-cap stocks and large-
cap stocks represents size risk, which also forms part of this asset pricing model.
186
Q.4454 In the Fama-French three-factor model, in addition to the market factor and the HML factor,
what is the other factor and what does it refer to?
A. T he momentum factor, WML, which captures the outperformance of past winners in

relation to past losers.
B. T he SMB factor, which captures the outperformance of high book-to-market stocks in

relation to low book-to-market stocks.
C. T he SMB factor, which captures the outperformance of small firms in relation to the
larger firms.
D. T he momentum factor, WML, which captures the outperformance of high-growth stocks

in relation to low-growth stocks.
In the Fama-French three-factor model, one of the factors is the SMB, which refers to small stock
returns minus big stock returns (Small Minus Big). T he market capitalization of the stocks gives rise
to small and big stocks.
T he last factor is the outperformance of small firms in relation to the large firms. T his is captured
by the SMB factor (Small Minus Big).
187
Q.5319 T he following estimates for the factor betas are prepared by an analyst who is estimating the
sensitivity of the return of stock X to different macroeconomic factors.
βindustrial production = 1.45

βinterest rate = 0.81
With a 4% increase in industrial production and a 2.5% interest rate, the projected return for Stock
A is predicted to be 6.0%. T his is under the baseline expectations. T he economic research
department predicts that economic activity will pick up in the coming year, with GDP growing 5.2%
and interest rates rising to 2.85%. According to this forecast, what is the projected return on Stock
X for next year?
A. 7.55%
B. 8.02%
C. 11.93%
D. 14.05%
Stock X's expected return equals the stock's expected return under the baseline scenario plus the
impact of “shocks,” or excess returns. Because the baseline scenario assumes 4% industrial
production growth and a 2.5% interest rate, the “shocks” for the GDP factor are 1.2% and 0.35%,
respectively.
Expected return for the new scenario = Baseline scenario expected return
+ (βIndustrial production × Industrial production shock)
+ (βinterest rate × Interest rate shock)
= 6% + (1.45 × 1.2%) + (0.81 × 0.35%)
= 0.06 + 0.0174 + 0.002835 = 8.02%
188
Q.5320 An equities analyst at an asset management business is evaluating a prospective investment in
ABC Bank stock using an internal three-factor model. Each of the three factors is represented by an
exchange-traded fund (ET F) with a factor beta of one and a factor beta of zero for the others. T he
analyst gathers the following data:
Factor A Factor B Factor C

Expected annual return of ET F factor 6.5% 7.7% 4.0%
Factor beta for ABC Bank stock 0.88 −0.55 1.40
What is the predicted yearly return on ABC Bank shares using the internal model if the annualized
risk-free interest rate is 3.20% and the alpha is 0.60%?
A. 1.549%
B. 5.349%
C. 4.749%
D. 2.149%
T he first step is to determine the expected excess return for each element by subtracting the risk-
free rate from the expected return, as shown below:
Factor A: 6.5% − 3.20% = 3.30%
Factor B: 7.7% − 3.20% = 4.50%
Factor C: 4.0% − 3.20% = 0.80%
Multiplying the relevant factor betas for ABC Bank stock yields the factor exposures' contribution to
the stock's projected return:
0.88 × 3.30% + (−0.55) × 4.50% + 1.40 × 0.80% = 1.549%
T he total expected return for ABC Bank stock is calculated by adding the alpha and risk-free rate to
the stock's expected return from its factor exposures, yielding 1.549% + 0.60% + 3.20% for a total
expected return of 5.349%.
189
Q.5321 Greystone Asset Managers' investment analyst argues that a company's Fama-French main
dependencies are:
Value
HML −0.66
SMB 1.36
Beta 0.35
Because of its advantages over its competitors, the analyst believes the company can produce an
additional 2.5% return every year. T he market forecast is as follows:
Expected return on equities 11.5%

SMB 3.2%
HML 0.0%
Risk free rate 1.7%
T he expected return of the company is closest to?
A. 10.87%
B. 11.98%
C. 11.91%
D. 15.5%
E(R c ) = α + βc,M [E (R M ) − r] + βc,SMB E (SMB) + βC,HM L E (H ML)

= 1.7% + 2.5% + 0.35 [11.5% − 1.7%] + 1.36 × 3.2% − 0.66 × 0.0
E(R c ) = 11.98%
190
Reading 7: Risk Data Aggregation and Reporting Principles
191
Q.245 T he following are some of the benefits of having an effective risk data aggregation and
reporting system, EXCEPT :
A. An increased ability to avoid losses.
B. An increased ability to identify the routes to return to financial health after a tumultuous
period.
C. An increased ability to make strategic decisions, reduce the chances of loss, and increases
efficiency.
D. An increased ability to identify projects with optimal returns for investment purposes.
An increased ability to identify projects with optimal returns for investment purposes is not a direct
benefit of an effective risk data aggregation and reporting system. While these systems can provide
useful information to guide investment decisions, their primary goal is to identify and manage risks
rather than maximize investment returns. T hey are designed to provide a comprehensive view of
risk exposures, enabling organizations to anticipate business problems, identify routes back to good
financial health, make strategic decisions, and attain smooth resolvability in the event of duress or
failure. However, they do not directly contribute to the identification of projects with optimal
returns for investment purposes. T his task is typically the responsibility of investment analysts and
strategists who use a variety of tools and techniques, including but not limited to risk data, to identify
profitable investment opportunities.
Choi ce A i s i ncorrect. An effective risk data aggregation and reporting system indeed increases
the ability to avoid losses. It does so by providing comprehensive and timely information about
various risks, enabling the organization to take preventive measures.
Choi ce B i s i ncorrect. Risk data aggregation and reporting systems also increase an organization's
ability to identify routes back to financial health after a tumultuous period. T hey provide insights into
risk exposures, which can guide recovery strategies.
Choi ce C i s i ncorrect. T he systems do enhance strategic decision-making capabilities, reduce
chances of loss, and increase efficiency by providing accurate, timely, and comprehensive risk data
that informs management decisions.
192
Q.247 Prime Bank, a global systematically important bank (G-SIB) has incurred big losses resulting
from a range of issues, including too many bad debts due to improper lending decisions and
investment in futures without prior due diligence. T he bank is now in deep capital problems and
struggling to meet day-to-day funding needs. T he bank's management turns to an expert of the Basel
committee recommendations for advice. Which of the following potential benefits would result from
risk data aggregation, particularly taking into account the bank's current situation?
A. Increased bank efficiency.
B. A clearer definition of the bank's risk appetite.
C. Improved resolvability of the bank's problems.
D. Improved data confidentiality, integrity and availability.
Aggregating risk data can significantly enhance the ability of regulators to resolve the current
undercapitalization and liquidity issues that Prime Bank is facing. Risk data aggregation involves the
consolidation of data from various sources to provide a comprehensive view of the risk profile of an
organization. T his holistic view can help identify areas of vulnerability, assess the potential impact of
various risk scenarios, and develop effective mitigation strategies. In the context of Prime Bank, risk
data aggregation could provide valuable insights into the root causes of its current capital and liquidity
problems, thereby facilitating the development of targeted solutions. Moreover, it could also aid in
the identification of potential future risks, enabling the bank to take proactive measures to prevent
similar problems from arising in the future.
Choi ce A i s i ncorrect. While aggregation of risk data can lead to better decision-making and
potentially increase bank efficiency, it does not directly address the immediate capital and funding
problems that Prime Bank is facing. T he benefit of increased efficiency would likely be realized over
a longer term, rather than providing an immediate solution to the bank's current predicament.
Choi ce B i s i ncorrect. Aggregation of risk data could help in defining the bank's risk appetite by
providing a clearer picture of its overall risk exposure. However, this again does not directly address
the urgent issues at hand - namely, the capital and funding challenges that are threatening the bank's
solvency.
Choi ce D i s i ncorrect. Improved data confidentiality, integrity and availability are important
193
aspects of information security management but they do not necessarily contribute to resolving
financial or operational problems faced by a G-SIB like Prime Bank. T hese benefits are more related
to preventing cyber threats or ensuring compliance with data protection regulations rather than
addressing issues related to bad debts or inadequate due diligence in investment decisions.
194
Q.248 After making losses in two consecutive financial years, the board of a G-SIB bank directs the
bank's chief supervisor to submit a report containing position and risk exposure information for all
relevant risks. T he supervisor proceeds to summarize a report that includes detailed information
about specific risks such as credit risk, operational risk, and market risk. However, the report falls
short of adequate stress tests and forecasts. Which of the following effective risk data aggregation
principle set forth by the Basel Committee on Banking Supervision did the supervisor most likely
violate?
A. Principle 3 - Accuracy and integrity
B. Principle 8 - Comprehensiveness
C. Principle 9 - Clarity and usefulness
D. Principle 4 - Completeness
T he Basel Committee on Banking Supervision's Principle 8, known as the 'Comprehensiveness'
principle, stipulates that risk management reports should cover all material risk areas within an
organization. T he depth and breadth of these reports should be commensurate with the size,
complexity, and risk profile of the bank's operations, as well as the requirements of the recipients.
In this scenario, the supervisor's report, despite detailing specific risks, falls short on adequate
stress tests and forecasts. T his omission violates the comprehensiveness principle as it fails to
provide a complete picture of the bank's risk exposure, thereby hindering informed decision-making.
Choi ce A i s i ncorrect. Principle 3 - Accuracy and integrity refers to the need for data to be
accurate, reliable and maintained with integrity. T he question does not provide any information
suggesting that the data in the report was inaccurate or lacked integrity.
Choi ce C i s i ncorrect. Principle 9 - Clarity and usefulness refers to the need for risk management
data to be presented in a clear, concise, and useful manner for decision-making purposes. T here's no
indication from the question that the supervisor's report was unclear or not useful.
Choi ce D i s i ncorrect. Principle 4 - Completeness refers to capturing all material risk data across
the banking group. While it might seem like this principle has been violated due to lack of stress tests
and forecasts, it actually falls under Principle 8 - Comprehensiveness which includes conducting
stress tests and scenario analyses as part of a comprehensive view on risk exposure.
195
Q.249 Mike Harvey is the risk management supervisor at an Indian bank. He wishes to establish
principles for effective risk data aggregation in line with Basel committee recommendations. T he
bank has historically been lenient regarding risk data gathering and processing and Harvey intends to
remedy the situation. Which of the following statements is incorrect concerning the accuracy
principle?
A. Risk reports should exclude mathematical descriptions and logistical relationships so as to

make them less sophisticated and enhance comprehension.
B. Error reports should be created to highlight and explain errors in the data.
C. T he bank should clearly define the process used to create risk reports.
D. T he risk reports should include reasonable checks of the data.
T he statement that risk reports should exclude mathematical descriptions and logistical relationships
to simplify them and improve understanding is incorrect. According to the accuracy principle, these
elements should be included in a report if their inclusion significantly affects the comprehension of
the report's content. T hese relationships ensure the accuracy of the data and figures presented.
T herefore, excluding them would not enhance the accuracy of the report, but rather diminish it.
Choi ce B i s i ncorrect. Error reports are indeed a crucial part of maintaining accuracy in risk data
aggregation. T hey help identify and rectify errors in the data, thereby enhancing the overall accuracy
of risk reports.
Choi ce C i s i ncorrect. Clearly defining the process used to create risk reports is an essential
aspect of ensuring accuracy. It helps maintain consistency and reliability in the data, which are key
components of accurate risk reporting.
Choi ce D i s i ncorrect. Including reasonable checks on the data forms an integral part of ensuring
its accuracy. T hese checks help verify that the data being used for risk reporting is correct and
reliable.
196
Q.250 According to the committee, “A bank's risk data aggregation capabilities and risk reporting
practices should be subject to strong governance arrangements consistent with the other principles
and guidance established by the Basel Committee.” Which of the following statements is in
divergence with the governance principle?
A. Risk data aggregation should form an integral part of the risk management framework.
B. It is ideal to have multiple sources of risk data for each type of risk facing the organization
so as to enhance reliability.
C. T imely integration of risk data should be carried out immediately a new firm is acquired.
D. Human and financial resources should be directed towards risk data aggregation and
therefore the board should approve the framework.
T he statement that it is ideal to have multiple sources of risk data for each type of risk facing the
organization so as to enhance reliability is not in line with the governance principle established by
the Basel Committee. According to the principle, there should be only one source of risk data, not
multiple sources. T his is because having multiple sources can lead to inconsistencies and
discrepancies in the data, which can in turn lead to inaccurate risk assessments and ineffective risk
management strategies. T herefore, it is crucial for banks to have a single, reliable source of risk data
that is subject to strong governance arrangements.
Choi ce A i s i ncorrect. Risk data aggregation forming an integral part of the risk management
framework aligns with the governance principle set by the Basel Committee. It ensures that all risk
data is collected, processed and reported in a manner that supports risk management decision-making.
Choi ce C i s i ncorrect. T imely integration of risk data immediately after a new firm is acquired
aligns with the governance principle as it ensures continuity in monitoring and managing risks across
the organization.
Choi ce D i s i ncorrect. T he allocation of human and financial resources towards risk data
aggregation approved by the board also aligns with this principle as it demonstrates commitment at
highest level to effective risk management through proper resource allocation.
197
Q.251 Olive Park is the head of risk management at a Korean Bank. She has been tasked with
preparing a report for the bank's board of directors scheduled to meet in the near future. T he report
will inform several important decisions to be made by the board regarding relevant bank risks.
In an email sent to the directors prior to the meeting, Park assures them of the accuracy,
reasonableness, and completeness of her submission. She points out that a large amount of
quantitative data in the report will make it hard for the report to be fully understood by non-risk
management professionals. She also plans to distribute the report to all the relevant parties in a
timely manner while still maintaining confidentiality. Which of the following effective risk data
aggregation principle set forth by the Basel Committee on Banking Supervision did Park most likely
violate?
A. Principle 11 - Distribution
B. Principle 9 - Clarity and usefulness
C. Principle 8 - Comprehensiveness
D. Principle 1 - Governance
Principle 9 of the Basel Committee on Banking Supervision's effective risk data aggregation
principles emphasizes the importance of tailoring reports to meet the needs of the end user. In her
email, Park indicated that the report might not be tailored to the board's needs due to the large
amount of quantitative data that could be difficult for non-risk management specialists to interpret.
T he board typically includes many financial experts, but not all of them are proficient in risk
management. It's crucial to recognize that different end users - managers, the board, junior
employees, interns, and others - have varying reporting needs. As the report ascends the
organization's leadership hierarchy, there is an increasing need for qualitative interpretation and
explanation.
Choi ce A i s i ncorrect. Principle 11 - Distribution, states that risk management data should be
distributed among the relevant parties in a timely and secure manner. Park plans to distribute the
report promptly while ensuring confidentiality, which aligns with this principle.
Choi ce C i s i ncorrect. Principle 8 - Comprehensiveness, requires that all material risk data be
accurately and completely captured. Park has assured the accuracy, reasonableness, and
completeness of her report which complies with this principle.
198
Choi ce D i s i ncorrect. Principle 1 - Governance involves establishing a strong governance
framework to oversee the bank's risk data aggregation capabilities. T here's no information in the
question suggesting that Park breached this principle.
Q.252 Which of the following goes against the principle of accuracy and integrity as set forth by the
Basel Committee?
A. It's most desirable to have a single authoritative source of risk data for each type of risk
facing an organization.
B. Data should be aggregated manually at all times so as to minimize the probability of errors.
C. Risk personnel should have direct access to risk data so as to effectively refine, validate,
reconcile, and process the data for use in reports.
D. Controls put in place to monitor risk data should be as robust as those used in financial
accounting.
Data should be aggregated on a largely automated basis to reduce the risk of errors brought about by
human input. However, human intervention is necessary when professional judgment is to be made.
Q.253 According to the Basel committee, who bears the responsibility of setting the frequency of
risk management report and distribution?
A. T he chief risk officer only
B. T he bank supervisor only
C. T he board of directors and senior management
D. T he risk management department
According to the Basel Committee, the responsibility of setting the frequency of risk management
reports and their distribution lies with the board of directors and senior management. T his is because
these individuals are in a position of authority and have a comprehensive understanding of the bank's
199
operations and risk profile. T hey are responsible for setting the strategic direction of the bank,
including its risk management framework. T his involves determining how often risk reports should
be produced and distributed, as well as setting out guidelines on how to proceed in times of financial
stress or crisis. T he board and senior management are also responsible for ensuring that the bank's
risk management processes are effective and that risks are appropriately managed.
Choi ce A i s i ncorrect. While the chief risk officer plays a crucial role in risk management, the
responsibility of determining the frequency of risk management reports and their distribution is not
solely theirs according to Basel Committee guidelines. T his task involves strategic decisions that are
typically made by higher-level entities within a bank, such as the board of directors and senior
management.
Choi ce B i s i ncorrect. T he bank supervisor's role primarily involves overseeing and ensuring
compliance with banking regulations rather than determining the frequency and distribution of risk
management reports within a bank. T his responsibility lies with internal stakeholders like the board
of directors and senior management.
Choi ce D i s i ncorrect. T he risk management department does play an important role in preparing
these reports but it does not have sole authority to determine their frequency or distribution
according to Basel Committee guidelines. T hese decisions are typically made at higher levels within a
bank, specifically by the board of directors and senior management.
Q.254 In an attempt to promote and institute strong and effective data aggregation capabilities, the
Basel committee has put forth several principles. Which of the following principles is correctly
matched with a recommendation to be followed in accordance with the given principle?
A. T he timeliness principle recommends that an organization should continually update its

system to accommodate changes in best practices.
B. T he accuracy principle recommends that the risk data be reconciled with the supervisor's
estimates before aggregation.
C. T he integrity principle recommends that only automated processes should be used when
aggregating risk data.
D. T he completeness principle recommends that an organization should ensure it captures all

material risk exposures before risk data aggregation can be done.
200
T he completeness principle, as outlined by the Basel Committee, emphasizes the importance of
capturing all material risk exposures before proceeding with risk data aggregation. T his principle is
crucial because it ensures that no significant risk is overlooked during the aggregation process,
which could potentially lead to inaccurate risk assessments and flawed decision-making. T he
recommendation associated with this principle is accurately represented in choice D, which states
that an organization should ensure it captures all material risk exposures before risk data aggregation
can be done. T his means that all relevant and significant risk data should be included in the
aggregation process, regardless of the source or type of risk. T his comprehensive approach to risk
data aggregation is essential for providing a complete and accurate picture of an organization's overall
risk profile.
Choi ce A i s i ncorrect. T he timeliness principle does not recommend that an organization should
continually update its system to accommodate changes in best practices. Instead, it recommends that
risk data should be available when needed, even during times of stress/crisis.
Choi ce B i s i ncorrect. T he accuracy principle does not recommend that the risk data be
reconciled with the supervisor's estimates before aggregation. Rather, it suggests that risk data
should be accurate and reliable; it doesn't necessarily need to match with supervisor's estimates.
Choi ce C i s i ncorrect. T he integrity principle does not strictly recommend only automated
processes for aggregating risk data. It emphasizes on maintaining a strong governance framework to
ensure the integrity of risk data aggregation processes which can include both automated and manual
processes.
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Q.255 Which of the following principles states that "data should be available by business line, legal
entity, asset type, industry, region and other groupings, as relevant for the risk in question, that
permit identifying and reporting risk exposures, concentrations and emerging risks?"
A. Data architecture and infrastructure
B. Clarity and usefulness
C. Completeness
D. Inclusivity
T he principle of completeness in risk data management states that a bank should be able to capture
and aggregate all material risk data across the banking group. T his principle emphasizes the need for
data to be available by business line, legal entity, asset type, industry, region, and other relevant
groupings. T his organization is crucial for identifying and reporting risk exposures, concentrations,
and emerging risks. T he completeness principle ensures that all necessary data is included, leaving
no room for gaps or omissions that could potentially lead to inaccurate risk assessments or decisions
based on incomplete information.
Choi ce A i s i ncorrect. Data architecture and infrastructure refers to the design, structure, and
maintenance of data systems. While it does involve organizing data, it doesn't specifically emphasize
categorization for risk identification and reporting.
Choi ce B i s i ncorrect. Clarity and usefulness are important aspects of data management but they
do not directly relate to the organization of data across various categories for risk identification.
Choi ce D i s i ncorrect. Inclusivity in this context would mean that all relevant data should be
included in the risk management process. However, it does not necessarily imply that the data needs
to be organized across various categories as described in the question.
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Q.256 While working on a risk report, two senior risk professionals made the decision to forego
automation and fill data entries by hand. T he two made that decision after a brainstorming exercise
alongside other junior employees. In their report, the pair gave details as to why it was necessary to
forego automation and why they had full confidence in the accuracy and integrity of the data. T his
scenario describes a:
A. T he justified exception to the principle of accuracy and integrity
B. Breach of regulations
C. Manual workaround
D. Breach of confidentiality
In the given scenario, the two senior risk professionals decided to bypass automation and manually
input data. T his is referred to as a 'manual workaround'. A workaround is a method, sometimes used
temporarily, for achieving a task or goal when the usual or planned method isn't working. In this case,
the usual method would be automation. However, for reasons explained in their report, the
professionals decided to manually input the data. While automation is generally preferred to minimize
human error, it is up to the organization to find the right balance between automation and manual
input. Any manual workarounds should be well documented and satisfactorily explained, as was done
in this scenario.
Choi ce A i s i ncorrect. T he principle of accuracy and integrity in risk management refers to the
need for data to be accurate, complete, and reliable. In this scenario, the risk professionals have not
violated this principle as they have expressed their complete confidence in the accuracy and
integrity of the data. T herefore, their action cannot be considered a justified exception to this
principle.
Choi ce B i s i ncorrect. T here is no indication in the scenario that any regulations were breached
by manually inputting data instead of using automation. Regulations would typically specify what
needs to be done rather than how it should be done.
Choi ce D i s i ncorrect. Breach of confidentiality refers to unauthorized disclosure of confidential
information. In this case, there's no mention or implication that any confidential information was
disclosed improperly or without authorization.
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Q.257 Which of the following is NOT a valid reason as to why senior management and the board of
directors should keep accurate and timely risk data aggregation reports?
A. T he report helps the management to track the organization's risk exposure and ensure
risk limits are observed.
B. T he board members may be asked to provide the reports during an impromptu visit by the
bank's supervisors.
C. T he management uses the reports to make important decisions regarding risk and
investment opportunities.
D. Senior management need reliable, relevant and up-to-date information when making
decisions during periods of financial stress and/or crisis.
T he board members may be asked to provide the reports during an impromptu visit by the bank's
supervisors. T his statement is incorrect because the board of directors and senior management do
not provide information directly to regulators or supervisors. Such requests are typically made at
the bank level, not at the board level. T herefore, this is not a valid reason for maintaining accurate
and timely risk data aggregation reports. T he board's role is to oversee the bank's operations and
ensure that it is managed in a way that protects the interests of its shareholders. While they need to
be aware of the bank's risk profile, they are not responsible for providing this information to
regulators or supervisors.
Choi ce A i s i ncorrect. T he risk data aggregation reports are indeed used by management to track
the organization's risk exposure and ensure that risk limits are observed. T his helps in maintaining a
balance between the risks taken and the potential returns, thereby ensuring financial stability of the
organization.
Choi ce C i s i ncorrect. T hese reports are crucial for management as they provide insights into
various risks and investment opportunities. Based on these reports, management can make informed
decisions regarding investments, thereby optimizing returns while minimizing risks.
Choi ce D i s i ncorrect. During periods of financial stress or crisis, senior management needs
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reliable, relevant and up-to-date information to make critical decisions. Risk data aggregation reports
provide this necessary information in a consolidated manner which aids in effective decision making
during such times.
Q.258 According to the principle of adaptability, "a bank should be able to generate aggregate risk data
to meet a broad range of on-demand, ad-hoc risk management reporting requests, including requests
during stress/crisis situations, requests due to changing internal needs and requests to meet
supervisory queries." Which of the following is NOT included in the adaptability principle?
A. Data customization to fit the user's needs - takeaway, dashboards, anomalies, etc.
B. Flexible data aggregation processes that allow managers to swiftly assess risks for
decision-making purposes.
C. Capabilities to incorporate regulatory changes.
D. Capabilities to withhold some pieces of information that could paint the company in a bad
light.
T he principle of adaptability does not include the capability to withhold some pieces of information
that could paint the company in a bad light. T his is because the risk data aggregation process should
be transparent and not withhold crucial information as long as such information is accurate and based
on facts. T he process should instill confidence in regulators and other stakeholders alike.
Withholding information, especially if it is crucial to understanding the risk profile of the bank, would
be contrary to the principle of transparency, which is a key aspect of risk management. T herefore,
the ability to withhold information that could negatively impact the company's image is not included
in the adaptability principle.
Choi ce A i s i ncorrect. Data customization to fit the user's needs - takeaway, dashboards,
anomalies, etc., is indeed a part of the adaptability principle. It allows for flexibility and adaptability in
presenting risk data according to the specific requirements of different users or situations.
Choi ce B i s i ncorrect. Flexible data aggregation processes that allow managers to swiftly assess
risks for decision-making purposes also fall under the purview of the adaptability principle. T his
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ensures that risk management can be responsive and adaptable to changing circumstances or
demands.
Choi ce C i s i ncorrect. T he ability to incorporate regulatory changes into risk management
practices aligns with the adaptability principle as well. Regulatory environments are dynamic and
banks need to have systems in place that can quickly adjust and comply with new regulations.
Q.259 Kevin Stanley, a senior risk consultant at Wansley Consultation Company, is currently
providing risk consultation to the RUSSBANK's recently opened retailed operations in Ukraine.
RUSSBANK is one the largest Russian banks that has recently started retail operations in the
Ukrainian market. Ukraine has a history of a large number of bank failures due to very low recovery
rates. Since RUSSBANK has entered the Ukrainian market for the first time and it is not familiar
with the retail market yet, Kevin referred the bank management and board to the Basel Committee's
recommendation to improve its aggregation and reporting of risk data. Given that the effective risk
data aggregation has several potential benefits, which of the following benefits is essential to
RUSSBANK's success?
A. Increased ability to anticipate problems.
B. Identify routes to return to financial health.
C. Improved resolvability.
D. Increased market share.
T he 'increased ability to anticipate problems' is the most relevant benefit for RUSSBANK in this
scenario. As RUSSBANK is new to the Ukrainian market, it is crucial for them to understand the
risks involved in their operations. Effective risk data aggregation allows risk managers to have a
comprehensive view of the risks, enabling them to anticipate potential problems. T his holistic
understanding of risks is not limited to isolated incidents but extends to the overall risk landscape. By
anticipating problems, RUSSBANK can proactively implement measures to mitigate these risks,
thereby ensuring the success of their operations in Ukraine.
Choi ce B i s i ncorrect. While identifying routes to return to financial health is an important aspect
of risk management, it is not the most crucial benefit for RUSSBANK's operation in a market with
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high bank failure rates due to low recovery rates. Effective risk data aggregation would primarily
help in anticipating problems before they occur, which is more critical in such a volatile market.
Choi ce C i s i ncorrect. Improved resolvability refers to the ability of a bank to be resolved
without severe systemic disruption or taxpayer loss, which although important, does not directly
address the issue of high bank failure rates due to low recovery rates that RUSSBANK faces in
Ukraine. Anticipating problems through effective risk data aggregation would be more beneficial.
Choi ce D i s i ncorrect. Increased market share might be an indirect result of effective risk
management but it's not the primary benefit that comes from enhancing risk data aggregation and
reporting as recommended by Basel Committee. T he main advantage lies in being able to anticipate
potential issues and mitigate them proactively.
Q.260 Which of the following is not a key governance principle related to risk data aggregation and
risk reporting practices that were provided by the Basel Committee?
A. Data architecture and infrastructure
B. Conciseness
C. Distribution
D. Frequency
Conciseness is not a key governance principle related to risk data aggregation and risk reporting
practices provided by the Basel Committee. While conciseness is generally a desirable quality in
reporting, it is not specifically identified as a key principle by the Basel Committee. T he principles
outlined by the Basel Committee are intended to ensure that financial institutions have robust risk
management frameworks in place. T hese principles emphasize aspects such as governance, data
architecture and infrastructure, accuracy and integrity, completeness, timeliness, adaptability,
comprehensiveness, clarity and usefulness, frequency, distribution, review, remedial actions and
supervisory measures, and home/host cooperation. Each of these principles plays a crucial role in
ensuring that risk data is accurately aggregated and reported, thereby enabling effective risk
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management.
Choi ce A i s i ncorrect. Data architecture and infrastructure is indeed recognized as a key
governance principle by the Basel Committee. It refers to the systems and processes that are used
to collect, store, manage, and report risk data. T hese systems should be robust enough to handle
large volumes of data and flexible enough to adapt to changing regulatory requirements.
Choi ce C i s i ncorrect. Distribution is also recognized as a key governance principle by the Basel
Committee. T his principle emphasizes that risk reports should be distributed in a timely manner to
all relevant parties within an organization, including senior management and the board of directors.
Choi ce D i s i ncorrect. Frequency too is acknowledged as a key governance principle by the Basel
Committee. T he frequency of risk reporting should be determined based on the nature of an
institution's risks, its size, complexity, scope of operations etc., but it must at least meet minimum
regulatory requirements.
Q.261 Muhammad Zubair, head of compliance at Miliyon Investment Bank, quoted a key governance
principle related to risk data aggregation provided by the Basel Committee, which states that "a bank
should be able to generate accurate and reliable risk data to meet normal and stress/crisis reporting
accuracy requirements. Furthermore, data should be aggregated on a largely automated basis so as to
minimize the probability of errors." Which of the following principles is Zubair referring to?
A. Governance
B. Completeness
C. Accuracy & Integrity
D. T imeliness
Muhammad Zubair, the compliance chief at Miliyon Investment Bank, cited a crucial governance
principle related to risk data aggregation as outlined by the Basel Committee. T his principle
emphasizes that a bank should have the capability to generate precise and dependable risk data to
fulfill regular and stress/crisis reporting accuracy requirements. Moreover, the data should be
aggregated primarily on an automated basis to reduce the likelihood of errors. Which principle is
Zubair referring to from the following options?
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Q.262 Vijay Kumar, Sonnet Bank's Chief Risk Officer, writes in the management discussion and
analysis (MD&A) section of the bank's annual report that Sonnet Bank, at all times, devotes its human
and financial resources to the improvement of risk data aggregation as it considers data aggregation
and reporting a part of the bank's planning processes. He also writes that the bank has established
multiple data models that are used as robust automated reconciliation measures. Kumar's comments
are aligned with one of the key principles of risk data aggregation. Identify that principle.
A. Adaptability
B. Comprehensiveness
C. Distribution
D. Data Architecture and Infrastructure
T he comments made by Vijay Kumar, the Chief Risk Officer of Sonnet Bank, align with the second
principle of risk data aggregation, which is 'Data Architecture and Infrastructure'. T his principle
necessitates that a bank should dedicate its human and financial resources to improving risk data
aggregation, especially during stressful times. It also mandates that risk data aggregation and reporting
should be incorporated into the bank's planning processes and be subject to business impact analysis.
Furthermore, banks are required to establish integrated data classifications and architecture across
the banking group. In the context of Sonnet Bank, Kumar's statements about the bank's commitment
to enhancing risk data aggregation, considering data aggregation and reporting as integral parts of the
bank's planning processes, and the establishment of various data models for robust automated
reconciliation measures, all indicate adherence to the 'Data Architecture and Infrastructure'
principle.
Choi ce A i s i ncorrect. Adaptability refers to the ability of a bank's risk data aggregation
capabilities to change in response to varying business needs, which is not specifically mentioned in
Kumar's statements.
Choi ce B i s i ncorrect. Comprehensiveness pertains to the inclusion of all material risk data into
the scope of aggregation, but Kumar does not explicitly mention this aspect in his statements.
Choi ce C i s i ncorrect. Distribution refers to the dissemination of risk management reports at all
relevant levels within a bank, which again, isn't directly addressed by Kumar's comments.
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Q.264 Which of the following key principles of risk data aggregation requires banks to document
both the automated and the manual workarounds, and also requires banks to define why and when
human interventions are critical for data accuracy?
A. T imeliness
B. Adaptability
C. Accuracy and integrity
D. Clarity and usefulness
T his principle is one of the key principles of risk data aggregation. It emphasizes the importance of
maintaining the accuracy and integrity of risk data. T his principle requires banks to document both
automated and manual workarounds. T his is important because it allows for a clear understanding of
the processes involved in data aggregation. Furthermore, this principle also requires banks to define
the circumstances and reasons for which human interventions are critical for data accuracy. T his is
crucial because it ensures that the data is not only accurate but also reliable. It also ensures that
there is a clear understanding of the role of human intervention in maintaining data accuracy. T his
principle is fundamental in ensuring that banks have a robust and reliable risk data aggregation
process.
Choi ce A i s i ncorrect. T imeliness refers to the need for risk data to be reported in a timely
manner, allowing for prompt decision-making. It does not specifically require banks to maintain
records of both automated and manual workarounds or explain the circumstances and reasons for
human interventions.
Choi ce B i s i ncorrect. Adaptability pertains to the ability of risk data systems to adapt quickly and
efficiently to changing business needs, regulatory changes, or market conditions. While this may
involve some level of human intervention, it does not necessitate maintaining records of such
interventions or explaining their necessity.
Choi ce D i s i ncorrect. Clarity and usefulness refer to the requirement that risk data should be
clear, understandable, and useful for decision-making purposes. T his principle does not specifically
mandate banks to elucidate the circumstances and reasons for which human interventions are
deemed crucial for ensuring data accuracy.
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Q.265 T he principle of comprehensive requires banks to create reports:
I. T hat contains position and risk exposure information for credit risk, liquidity risk, market risk, and
operational risk
II. T hat should satisfy senior management in terms of coverage, analysis, and comparability with
other banks
III. T hat should provide a historical review of the bank's risk appetite and past stress tests.
Which of the following statements is/are aligned with the principle of comprehensiveness?
A. Statement I
B. Statements II & III
C. Statements I & III
D. All statements are aligned with the principle of comprehensiveness
Statements II and III are not aligned with the definition of the principle of comprehensiveness.
T he principle of comprehensive requires banks to create reports:
1. T hat contains position and risk exposure information for credit risk, liquidity risk, market risk, and
operational risk
2. T hat should satisfy bank supervi sors, not the senior management in terms of coverage, analysis,
and comparability with other banks
3. T hat should provide a forward-l ook i ng, not the historical, review of the bank's risk appetite and
past stress tests
Q.5322 A bank's CRO is assessing the bank's risk data management methods. T he CRO observes that
the Basel Committee has proposed numerous principles to encourage strong and effective risk data
aggregation capabilities when describing various dimensions of a bank's data. Which of the following
is a recommendation of Principle 1 on Governance of the Basel committee?
A. Banks should make risk data aggregation and reporting practices a crucial part of the
bank's planning processes.
B. Banks should establish integrated data classifications and architecture across the banking
group.
C. Banks should appoint individuals tasked with various data management responsibilities.
D. Banks’ risk data aggregation capabilities and risk reporting practices should be unaffected
by their group structure.
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According to Principle 1 on Governance of the Basel Committee, the risk data aggregation
capabilities and risk reporting practices of banks should be unaffected by their group structure. T his
principle emphasizes that these capabilities and practices should be fully documented, validated, and
independently reviewed by individuals who are knowledgeable in IT, data, and risk reporting
functions. Furthermore, senior management should make significant efforts to integrate risk data
aggregation into the risk management function. T his principle also stipulates that risk data
aggregation should be considered in any new initiatives, including acquisitions and divestitures, IT
change initiatives, and new product development.
Choi ce A i s i ncorrect. While risk data aggregation and reporting practices are important, the Basel
Committee's Principle 1 on Governance does not specifically state that these should be a crucial part
of the bank's planning processes. T his principle primarily focuses on the governance structure and
responsibilities related to risk data management.
Choi ce B i s i ncorrect. T he establishment of integrated data classifications and architecture across
the banking group is not a specific recommendation under Principle 1 on Governance by the Basel
Committee. T his aspect pertains more to technical infrastructure rather than governance.
Choi ce C i s i ncorrect. Although appointing individuals tasked with various data management
responsibilities can be part of good governance, it is not explicitly stated in Principle 1 by the Basel
Committee. T he principle emphasizes more on overall governance framework rather than individual
roles.
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Q.5323 According to Basel Committee, A bank should be able to generate aggregate risk data to meet
a broad range of on-demand, ad hoc risk management reporting requests, including requests during
stress or crises, requests due to changing internal needs, and requests to meet supervisory queries.
Which of the following Basel Committee Principles does the above statement refer to?
A. Principle 1 on Governance
B. Principle 6 on Adaptability
C. Principle 4 on Completeness
D. Principle 11 on Distribution
Principle 6, as outlined by the Basel Committee, emphasizes the need for banks to have adaptable
risk data aggregation capabilities and risk reporting practices. T his adaptability is crucial in order for
banks to meet changing needs, including during periods of stress or crisis. T he principle also
highlights the importance of being able to respond effectively to supervisory queries. T his
adaptability ensures that banks can effectively manage their risk data, regardless of the
circumstances they find themselves in. T his principle is directly related to the statement in the
question, which emphasizes the need for banks to be able to generate comprehensive risk data to
meet a variety of on-demand, ad hoc risk management reporting requests.
Choi ce A i s i ncorrect. Principle 1 on Governance refers to the need for a strong governance
framework to oversee the risk data aggregation capabilities and risk reporting practices of banks. It
does not specifically address the ability of banks to generate comprehensive risk data for ad hoc
requests.
Choi ce C i s i ncorrect. Principle 4 on Completeness emphasizes that a bank should be able to
capture and aggregate all material risk data across the banking group. While this principle does touch
upon comprehensive risk data, it doesn't specifically focus on generating such data for ad hoc
requests.
Choi ce D i s i ncorrect. Principle 11 on Distribution pertains to timely distribution of accurate and
reliable risk management reports within a bank's organization, but it doesn't directly relate to
generating comprehensive risk data for various ad hoc requests.
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Reading 8: Enterprise Risk Management and Future Trends
Q.67 Martin & Co., a multinational firm that specializes in the manufacturing of high-quality tech
products, has been experiencing high volatility in its business operations. T he board of directors has
noticed fluctuating profits, a high level of operational risks, inconsistent financial performance, and
potential regulatory concerns. T he board has hired David, a risk management consultant, to analyze
the current situation and recommend strategies to mitigate these risks and improve the company's
performance. David, after thorough evaluation, suggests the firm adopt an Enterprise Risk
Management (ERM) initiative. He believes it would help them manage and understand the risks
better while ensuring the firm's growth and sustainability. However, some members of the board are
skeptical about the ERM adoption and ask David to clarify the motivations for a firm like theirs to
adopt an ERM initiative. Based on David's understanding of Martin & Co., which of the following is
the most compelling reason for the firm to adopt an ERM initiative?
A. To ensure that the firm maintains the minimum risk levels needed to satisfy regulatory
requirements.
B. To provide a strategic, integrated approach to managing all risks facing the firm.
C. To focus on managing financial risks only, to stabilize the firm's financial performance.
D. To mitigate operational risks only, as these are the most direct threats to the firm's
manufacturing operations.
An ERM initiative is not just about meeting regulatory requirements or focusing on a particular type
of risk such as financial or operational risks. Instead, it provides a holistic, integrated framework for
managing all the risks a firm faces. ERM helps to align risk appetite and strategy, enhance risk
response decisions, reduce operational surprises and losses, and identify and manage multiple and
cross-enterprise risks. It improves the deployment of capital by providing the rigorous framework
needed for informed decision-making. T herefore, it's most compelling for a firm facing high volatility
and multiple types of risks, like Martin & Co., to adopt ERM.
A i s i ncorrect. While ERM does help in maintaining risk levels to satisfy regulatory requirements,
this is not its primary purpose. It is a broader initiative designed to manage all types of risks,
including strategic, operational, financial, and hazard risks. Focusing on regulatory requirements
alone wouldn't address the firm's broader risk challenges.
C i s i ncorrect. Managing financial risks is an important aspect of risk management, but ERM is a
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comprehensive approach that covers all types of risks. Focusing solely on financial risks may
overlook other potential risks that can have a significant impact on a firm's overall performance.
D i s i ncorrect. While operational risks are critical, especially for a manufacturing firm like Martin
& Co., focusing only on these risks through ERM would be a narrow approach. ERM's primary
motivation is to provide a comprehensive, integrated approach to managing all types of risks.
Mitigating operational risks alone may not fully leverage the benefits of ERM.
Thi ngs to Remember
Enterprise Risk Management (ERM) is a strategic, integrated approach to managing all
risks a firm faces. It is not just about meeting regulatory requirements or focusing on one
particular type of risk.
ERM helps align risk appetite and strategy, enhancing risk response decisions and reducing
operational surprises and losses. It provides a comprehensive view of risk, helping manage
multiple and cross-enterprise risks.
T he implementation of an ERM framework facilitates informed decision-making, improving
the deployment of capital by providing rigorous risk assessments.
T he adoption of ERM can be particularly compelling for firms facing high volatility and
multiple types of risks, as it provides a holistic risk management solution.
Q.68 Which of the following arguments best explains why some companies prefer siloed risk
management to ERM?
A. T he silo approach simplifies the risk management process as each business unit works on
a small 'slice' of the total risk exposure.
B. T he silo approach promotes specialization, thus helps to develop a rich variety of risk
management expertise within the organization.
C. T he silo approach enables organizations to extensively analyze each risk without

overlooking important aspects.
D. Managing risks in silos is more efficient and takes a shorter time compared to ERM.
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T he silo approach to risk management allows individual business units within an organization to
specialize in managing their specific risks. T his specialization can lead to the development of a
diverse range of risk management expertise within the organization. Each business unit can become
highly skilled in managing its unique risks, leading to more effective and efficient risk management
strategies. T his approach can also foster a culture of ownership and accountability for risk
management within each business unit. Furthermore, the silo approach can enable more thorough
and detailed risk analysis, as each business unit can focus on its specific risk landscape without being
distracted by the broader organizational risks. T his can lead to the identification and mitigation of
risks that might be overlooked in a more generalized, organization-wide risk management approach.
Choi ce A i s i ncorrect. While the silo approach may simplify the risk management process for
individual business units, it does not necessarily simplify the overall risk management process for the
organization. In fact, it can complicate matters as risks are not viewed holistically and
interdependencies between risks in different business units may be overlooked.
Choi ce C i s i ncorrect. T he silo approach does allow organizations to analyze each risk in detail
within its own context, but this doesn't mean that important aspects won't be overlooked. Risks
often have impacts across multiple areas of an organization and these cross-impacts might be missed
when using a siloed approach.
Choi ce D i s i ncorrect. Managing risks in silos might seem more efficient because each unit
handles its own risks, but this isn't necessarily true on an organizational level. ERM allows for a
comprehensive view of all risks and their interrelationships which can lead to more effective
mitigation strategies and potentially save time in the long run.
Thi ngs to Remember
T he siloed approach to risk management can lead to a lack of communication and
coordination among different business units, potentially resulting in overlooked risks or
duplicated efforts.
Enterprise Risk Management (ERM) provides a holistic view of the organization's risk
profile, allowing for better strategic decision-making. However, it may be more complex
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and time-consuming to implement compared to the siloed approach.
Both approaches have their pros and cons. T he choice between them should depend on
factors such as the nature of the organization's operations, its size, its risk tolerance level,
and available resources.
Risk management is not a one-time activity but an ongoing process that involves identifying
potential risks, assessing their impact on the organization's objectives, developing
strategies to manage these risks effectively and monitoring progress regularly.
Q.69 Which of the following best defines Enterprise Risk Management (ERM)?
A. T he process of managing all the different categories of risks facing the organization.
B. T he process of dividing risks into different categories for analysis by the various
autonomous units within an organization.
C. Application of risk management across an enterprise in a holistic, consistent, and

structured way.
D. Application of risk management across an autonomous business unit/department in a

structured, consistent way.
Enterprise Risk Management (ERM) is indeed the application of risk management across an
enterprise in a holistic, consistent, and structured way. ERM is an integrated approach to managing
risk that involves identifying, assessing, and preparing for any dangers, uncertainties, and risks that an
organization might face. It is not limited to a single department or business unit but spans across the
entire organization. T he aim of ERM is to provide a comprehensive view of all the risks faced by the
organization and their interrelationships. T his allows for better decision-making as it provides a more
accurate picture of the organization's risk profile. ERM integrates risk measurement and
management into business processes, which in turn can be integrated into strategic business
decisions. T his approach ensures that risk management is not an isolated activity but is embedded in
the organization's culture and operations.
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Choi ce A i s i ncorrect. While ERM does involve managing different categories of risks, it is not
just about managing them but also about applying risk management principles in a holistic, consistent
and structured way across the entire enterprise. T herefore, this choice does not fully capture the
essence of ERM.
Choi ce B i s i ncorrect. T his option describes a fragmented approach to risk management where
risks are divided and managed by various autonomous units within an organization. T his contradicts
the concept of ERM which advocates for a comprehensive and integrated approach to managing all
risks at an enterprise level.
Choi ce D i s i ncorrect. T he application of risk management principles in a structured and
consistent way across an autonomous business unit or department does not constitute ERM. ERM
involves applying these principles across the entire organization rather than just one department or
business unit.
Thi ngs to Remember
Enterprise Risk Management (ERM) is a holistic approach to risk management that
involves identifying, assessing, and preparing for any dangers or uncertainties an
organization might face.
ERM is not just about managing risks but also leveraging opportunities. It aims at creating a
balance between risk-taking and opportunity-seeking behaviors within the organization.
T he goal of ERM is to ensure that the risks taken by an organization are in line with its
strategic objectives and risk appetite. T his requires continuous monitoring and updating of
the risk profile as per changes in internal or external environment.
Risk categories under ERM typically include operational risks, financial risks, strategic
risks, compliance/legal/regulatory risks etc. T hese categories should not be managed in
silos but rather integrated into one comprehensive framework.
ERM promotes better decision-making through improved understanding of business
complexity and interdependencies among different types of risks. It helps organizations
anticipate what may go wrong (risks) as well as what must go right (opportunities).
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Q.70 Valley Bank, under scrutiny for risk management gaps leading to losses, plans to strengthen its
Enterprise Risk Management (ERM) program. T he board, recognizing the need for robust risk
management, appoints a new Chief Risk Officer (CRO), Sam. Sam proposes a comprehensive ERM
strategy encompassing five key dimensions: Targets, Structure, Identification and Metrics, ERM
Strategies, and Culture. Some board members, concerned about complexity and resources, question
the plan's necessity, tasking Sam to convince them. Which of the following arguments best supports
the need for a comprehensive approach to the ERM program?
A. It simplifies the regulatory compliance process and reduces the likelihood of regulatory
penalties.
B. It allows for the ERM program to be entirely led by the CRO, reducing the need for
involvement from other business areas.
C. It enables a strategic, integrated approach to managing risk at all levels of the organization,
which is key to avoiding, mitigating, or transferring risks efficiently.
D. It reduces the need for external audits as the ERM program itself can provide sufficient
assurance on risk management practices.
All five dimensions are necessary for an effective ERM program as they allow for a holistic approach
to risk management, aligning the risk management strategy with the firm's risk appetite and strategic
goals. T he different dimensions, from setting correct risk targets to defining the roles of key risk
officers to identifying and measuring risks, help create a comprehensive structure that considers all
facets of risk. T he ERM strategies help in deciding whether risk will be avoided, mitigated, or
transferred at the enterprise level, while a strong risk culture can foster risk-conscious decision-
making throughout the organization.
A i s i ncorrect. While a comprehensive ERM program can aid in regulatory compliance, this is not
the primary reason for its implementation. It is a broader initiative designed to manage all types of
risks and ensure the firm's strategic goals align with its risk appetite.
B i s i ncorrect. A successful ERM program requires involvement from all business areas, not just
the CRO. T he aim is to integrate risk management into the strategic planning and decision-making
processes across the entire organization, and not limit it to the purview of the CRO or risk
management department.
D i s i ncorrect. Although an effective ERM program can provide an internal check on risk
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management practices, it does not eliminate the need for external audits. External audits are an
integral part of the risk management process, providing independent assurance on the effectiveness
of the ERM program and compliance with regulatory requirements.
Q.81 In the recent past, a certain bank has had a poor relationship with its regulator. T he CEO asks
the CRO to suggest some of the actions the company could take in a bid to improve this relationship
in the future. Which of the following presents a possible recommendation?
A. Allocating additional funding to the compliance department to enhance monitoring

capabilities.
B. Developing a robust internal supervisory policy.
C. Implementing an internal public relations campaign to highlight the bank's commitment to

regulatory compliance.
D. Scheduling frequent meetings with the regulator to discuss the bank's progress and
initiatives.
Improving regulatory relations requires demonstrating commitment to compliance and risk
management. By developing robust internal supervisory policies, the bank shows proactive
management of regulatory risks. T his addresses potential regulatory concerns directly, which is
more likely to improve their perception of the bank. In addition, coordinating submissions with other
banks can help to demonstrate the willingness to adhere to guidelines and timelines.
A i s i ncorrect. While more funding for the compliance department might seem beneficial, it's not
necessarily the solution to improving relations with the regulator. T he key is how effectively these
resources are used in enhancing compliance, not merely the act of increasing budget. Without a
comprehensive plan for risk management, increased funding might not lead to improved regulatory
relations.
C i s i ncorrect. Public relations campaigns can improve the image of the bank among its
stakeholders, but they might not have a significant impact on the bank's relationship with its
regulator. T he regulator is more interested in the bank's adherence to regulatory standards, rather
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than its image or reputation.
D i s i ncorrect. While open communication with the regulator can be helpful, this is not a solution
in itself. T he regulator is primarily interested in seeing tangible improvements in the bank's risk
management and compliance procedures. Without the demonstration of such improvements, merely
discussing the bank's progress might not effectively improve relations.
Thi ngs to Remember
Improving regulatory relationships demands a firm demonstration of commitment to
compliance and risk management, rather than merely increasing the compliance
department's budget.
Developing robust internal supervisory policies can show proactive management of
regulatory risks. T his can address regulatory concerns directly and improve the regulator's
perception of the firm.
Coordinating submissions with other banks and adhering to guidelines and timelines can
further demonstrate a commitment to regulatory compliance.
Regulators are primarily interested in tangible improvements in a firm's risk management
and compliance procedures. Mere discussions or image improvement campaigns are not
sufficient in themselves.
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Q.3840 Which of the following statements is correct as far as Enterprise Risk Management is
concerned?
A. Independent operations of ERM dimensions motivate the success of the ERM framework
in a firm
B. ERM advocates viewing of risk across business lines by looking at the diversification and
the concentration of the risk
C. T he ERM looks at the level of each risk type in the firm and assesses them independently
D. All of the above
Enterprise Risk Management (ERM) is a comprehensive and integrated framework for managing risk
across an organization. It advocates for a holistic view of risk across business lines, considering both
the diversification and concentration of risk. T his approach allows for a more accurate and complete
understanding of the organization's overall risk profile. It enables the organization to identify and
manage potential risks and opportunities, thereby enhancing its ability to achieve strategic
objectives. T he ERM framework encourages organizations to consider all types of risk, including
strategic, operational, financial, and hazard risks, and to manage these risks in a coordinated and
integrated manner. By viewing risk across business lines, organizations can identify and manage
interdependencies and correlations among risks, which can lead to a more effective and efficient risk
management process.
Choi ce A i s i ncorrect. ERM does not operate on independent dimensions. Instead, it integrates all
risk dimensions to provide a comprehensive view of the firm's risk profile. T he success of the ERM
framework in a firm is not motivated by independent operations but by its ability to manage and
mitigate risks in an integrated manner.
Choi ce C i s i ncorrect. T his statement contradicts the holistic approach of ERM which advocates
for viewing and managing all types of risks as interrelated rather than assessing them independently.
Choi ce D i s i ncorrect. As explained above, choices A and C do not accurately reflect the
principles and practices of ERM, therefore this option cannot be correct.
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Q.5324 Vista Technologies, a global software company, is struggling with establishing a strong risk
culture within the organization. T he company's new Chief Risk Officer (CRO), Lisa, faces several
hurdles as she tries to navigate this issue. One of the challenges that Lisa mentions to the executive
board is the 'curse of data.' Which of the following scenarios best exemplifies Lisa's concern?
A. T he excessive data generated by various business lines may lead to confusion and
difficulty in identifying genuine risk indicators.
B. T here maybe a lack of data due to insufficient technological infrastructure, making it

challenging to identify risk trends.
C. Data privacy laws may prevent the company from fully utilizing the available data for risk
assessment.
D. T he inconsistency in the data formats received from different business lines may bring
about delays in risk assessment.
In today's digital age, organizations often have access to vast amounts of data generated by their
various business lines. T his data can include everything from financial metrics, customer behaviour,
operational performance to external data such as market trends, economic indicators, and regulatory
updates. While this data can potentially provide invaluable insights for risk management, it can also
become overwhelming and counterproductive - a situation referred to as the 'curse of data'.
B, C, and D are i ncorrect as per the explanation for A above.
Thi ngs to Remember
T he 'curse of data' implies that having too much data can actually hamper risk identification and
management. T he key challenges here include:
Volume: T he sheer volume of data can be overwhelming. It can be time-consuming and
resource-intensive to sift through massive data sets to identify the most relevant
information for risk management.
Quality: Not all data is useful or accurate. Some data may be outdated, incorrect, or
irrelevant, which can lead to inaccurate risk assessments if not properly filtered out.
Complexity: T he data may be complex and difficult to interpret, especially if it comes from
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multiple different sources or in different formats.
Distraction: T he abundance of data can distract from key risk indicators. It can lead to
information overload where critical risk indicators get lost in the noise of less important
data.
Q.5328 Atlas Bank's newly appointed risk analyst, Martin, has been discussing the benefits and
limitations of scenario analysis as a part of the bank's ERM framework during a strategy meeting. He
presents various facets of scenario analysis to the board members. Which of the following
statements made by Martin about scenario analysis is most likely correct?
A. It is fairly easy to determine the probability of events.
B. T he number of appropriate situations that can be developed is unlimited.
C. Imaginative future scenarios may be dismissed as inappropriate.
D. Scenario analysis does not depend on historical data.
In scenario analysis, teams try to imagine different futures to help organizations prepare for a range
of possibilities. However, in this process, certain proposed scenarios that seem too far-fetched,
imaginative, or divergent from the norm may be dismissed as improbable or inappropriate. T his is
especially true for scenarios that may be considered as "black swan" events - events that are
extremely rare but have severe consequences. Because these events are so rare and so difficult to
predict, they may be ignored in the scenario planning process, often due to cognitive biases like the
availability heuristic or normalcy bias.
Statement A i s i ncorrect. In reality, determining the probability of events in scenario analysis
can be quite challenging. Assigning probabilities to different scenarios often relies on subjective
judgments, expert opinions, or assumptions, which can introduce biases and uncertainties. T he
difficulty in determining the probability of events accurately is a disadvantage, as it can lead to less
reliable or less useful results.
Statement B i s i ncorrect. While it's true that there is no strict limit to the number of scenarios
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that can be developed, creating an excessive number of scenarios can lead to analysis paralysis,
where decision-makers are overwhelmed by too muchinformation and unable to make effective
decisions.
Statement D i s i ncorrect. While it's true that scenario analysis can be used to explore potential
future events that deviate from historical trends, it often still relies on historical data to some extent
to inform the development of scenarios or to provide a baseline for comparison.
Thi ngs to Remember
Scenario analysis involves imagining different futures to prepare for a range of
possibilities. However, scenarios that appear far-fetched or overly imaginative may be
dismissed as improbable or inappropriate, even when they could have significant
implications (like "black swan" events).
Determining the probability of events in scenario analysis can be quite challenging.
Assignments of probabilities often rely on subjective judgements, which can introduce
biases and uncertainties.
While there is no strict limit to the number of scenarios that can be developed, creating
excessive scenarios can lead to "analysis paralysis", overwhelming decision-makers and
hindering effective decisions.
T hough scenario analysis explores potential future events that deviate from historical
trends, it often relies on historical data to some extent for developing scenarios or
providing a baseline for comparison.
Q.5409 Which of the following observations correctly describes the fundamental differences
between Enterprise Risk Management (ERM) and a traditional silo-based risk management program?
A. ERM approach reduces the overall risks to the enterprise by focusing primarily on
operational risks while a silo-based approach often overlooks operational risks due to its
focus on individual business units.
B. ERM approach identifies, monitors, and manages all types of risks in an integrated manner,
while a silo-based approach manages risks in isolation.
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C. ERM approach tends to increase risk exposure due to its broad focus, while a silo-based
approach decreases risk exposure through focused, individualized risk management.
D. ERM approach and silo-based approach are essentially the same, with the only difference
being that the ERM approach is used by larger organizations while the silo-based approach is
used by smaller organizations.
Enterprise Risk Management (ERM) is a comprehensive and integrated approach for managing all
types of risks across an organization. It promotes better communication among various risk
management functions and helps in identifying the interdependencies among different risks. On the
other hand, a traditional silo-based risk management program manages each risk in isolation without
acknowledging the potential correlation among different risks. T his approach tends to lead to
inefficiencies and gaps in risk coverage.
A i s i ncorrect because the ERM approach does not primarily focus on operational risks. ERM
provides a holistic approach to managing all types of risks, including operational, financial, strategic,
and hazard risks, among others. T he silo-based approach, on the other hand, could overlook certain
risks due to its focus on individual business units, but it does not specifically overlook operational
risks.
C i s i ncorrect because the ERM approach does not tend to increase risk exposure. On the
contrary, its broad and integrated focus allows for a more comprehensive view of risk exposure and,
thus, better risk management. T he silo-based approach, while providing focused risk management,
does not necessarily decrease risk exposure as it might miss interdependent risks due to its isolated
view.
D i s i ncorrect because the size of the organization does not determine the use of ERM or a silo-
based approach. ERM and silo-based approaches are fundamentally different in their perspectives on
risk management. ERM is a more integrated and comprehensive approach, while a silo-based
approach manages risks in isolation, regardless of the size of the organization.
Thi ngs to Remember
Enterprise Risk Management (ERM) is a hol i sti c, comprehensi ve, and i ntegrated
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approach to risk management, addressing all types of risks across an organization.
ERM is marked by effecti ve communi cati on between various risk management
functions, which facilitates the identification of i nterdependenci es among risks.
T he si l o-based ri sk management approach manages each risk in isolation, potentially
leading to inefficiencies and coverage gaps due to a lack of consideration for risk
interdependencies.
The si ze of an organi zati on does not dictate whether ERM or a silo-based approach is
employed. Both approaches can be used by organizations of any size.
T he pri mary di sti ncti on between the ERM and silo-based approaches lies in their
perspectives on risk management: ERM advocates for a collective view, while the silo-
based approach advocates for an isolated view.
Q.5410 Atlas Capital Bank, a major financial institution with assets over $60 billion, is preparing for
its annual Comprehensive Capital Analysis and Reviews (CCAR). As part of its preparations, the
bank's risk management department has been tasked with integrating scenario analysis into the
bank's stress testing and capital planning programs. T his integration is aimed at ensuring the bank can
withstand severe economic downturns and satisfy regulatory requirements. T he bank's Chief Risk
Officer (CRO), Jennifer, has stressed the importance of employing diverse and realistic scenarios in
the stress testing program. She believes that this would provide a more comprehensive view of the
bank's potential vulnerabilities. Which of the following statements made by Jennifer during a planning
meeting is most likely correct?.
A. CCAR requires static forecasting of balance sheets and income statements.
B. Stress tests only need to be performed on the most profitable business lines.
C. T he adverse scenario in the bank's stress tests should assume a global recession.
D. If stress tests reveal the bank might fail to meet minimum capital standards, there's a need
to increase the risk appetite.
According to the information provided by the Federal Reserve, the "severely adverse" scenario for
stress testing should assume a global recession. T his would test the bank's resilience under extreme
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stress. Hence, Jennifer's statement about assuming a global recession in the adverse scenario aligns
with the guidelines for severe stress testing.
A i s i ncorrect. CCAR actually requires dynamic forecasting of balance sheets and income
statements, which means the bank must forecast revenues, loan loss provisions, rules for making
new loans, and regulatory ratios as they evolve over time.
B i s i ncorrect. Stress tests should be performed across all business lines, not just the most
profitable ones. T his is because stress testing aims to assess the potential impact of adverse
scenarios on the entire bank's financial health, not just the segments that currently bring in the most
revenue.
D i s i ncorrect. If stress tests indicate that a bank fails to meet minimum capital standards, it would
actually need to lower its risk appetite, not increase it. T his is because a failure to meet minimum
capital standards signifies that the bank is carrying too much risk relative to its capital, so the bank
would need to reduce its risk levels to bring them in line with its capital base.
Thi ngs to Remember
For severe stress testing under CCAR, the "severely adverse" scenario should assume a
global recession. T his allows institutions to test their resilience under extreme stress.
CCAR requires dynamic, not static, forecasting of balance sheets and income statements.
T his involves forecasting revenues, loan loss provisions, rules for making new loans, and
regulatory ratios over time.
Stress tests should be performed across all business lines, not just the most profitable
ones. T he objective is to assess the potential impact of adverse scenarios on the entire
bank's financial health.
If stress tests reveal that a bank might fail to meet minimum capital standards, it indicates a
need to reduce the bank's risk appetite, not increase it. T his is because failing to meet
minimum capital standards suggests the bank is carrying too much risk relative to its capital
base.
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Reading 9: Learning From Financial Disasters
Q.112 In the lead-up to the 2007/2009 financial crisis, Lehman Brothers had positioned itself as the
leading institution in the mortgage-backed securities market. Which of the following best explains
why the firm failed so spectacularly despite boasting huge amounts of capital?
A. T he firm was highly leveraged, reducing its ability to absorb losses
B. A large number of the firm’s mortgage-backed securities were built upon sub-prime
mortgage assets
C. T he firm was considered too big to fail
D. A lack of confidence among investors which in turn led to a lack of funding
Lehman Brothers' failure was primarily due to its high leverage, which significantly reduced its
ability to absorb losses. Leverage refers to the use of borrowed funds to finance the purchase of
assets, with the expectation that the income or capital gain from the new asset will exceed the cost
of borrowing. In the case of Lehman Brothers, the firm had taken on an excessive amount of short-
term debt to finance long-term assets, a strategy that exposed it to serious liquidity problems. When
the housing bubble burst, the value of these long-term assets plummeted, leading to substantial
losses. However, the firm's high leverage meant that it had a limited capacity to absorb these losses.
As a result, it was unable to meet its debt obligations, leading to its eventual bankruptcy.
Choi ce B i s i ncorrect. While it's true that a significant portion of Lehman Brothers' mortgage-
backed securities were built upon sub-prime mortgage assets, this was not the primary reason for
the firm's downfall. Many financial institutions had similar exposure to sub-prime mortgages but did
not fail as Lehman Brothers did. T he key difference was the level of leverage used by Lehman
Brothers, which amplified losses and reduced its ability to absorb them.
Choi ce C i s i ncorrect. T he concept of "too big to fail" refers to the idea that certain financial
institutions are so large and interconnected that their failure would be disastrous for the broader
economy, thus necessitating government intervention or bailout. However, in Lehman Brothers'
case, despite being a large institution, it was allowed to fail without any government intervention or
bailout.
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Choi ce D i s i ncorrect. Although lack of confidence among investors leading to a lack of funding
can contribute to a firm's downfall, it wasn't the primary reason in case of Lehman Brothers'. It was
rather an outcome triggered by their high leverage and exposure to subprime mortgages which led
investors losing confidence in them.
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Q.113 T he Barings incident came up mai nl y due to:
A. T he actions of a single trading official
B. T he lack of adequate control systems and the failure of management to exercise even the
basic oversight roles
C. Collusion between back-office staff and a junior level manager
D. T he massive earthquake that hit Japan in 1995, triggering unprecedented losses in the
stock market
T he Barings Bank collapse was primarily due to the lack of adequate control systems and the failure
of management to exercise even the basic oversight roles. T he bank allowed Nick Leeson, a junior
trader, to take on the dual role of head of trading and settlement operations. T his was a clear violation
of the segregation of duties principle, which is a basic tenet of internal control systems. T his allowed
Leeson to hide his trading losses and misrepresent the financial position of his trading activities.
Furthermore, the management failed to heed the warnings of auditors and did not question the
unusually high profits reported by Leeson. T his lack of oversight and control ultimately led to the
collapse of the bank when Leeson's hidden losses were eventually revealed.
Choi ce A i s i ncorrect. While the actions of a single trading official, Nick Leeson, did contribute to
the collapse of Barings Bank, it was not the main cause. His actions were only able to bring about
such disastrous consequences due to the lack of adequate control systems and failure of management
oversight.
Choi ce C i s i ncorrect. T here is no evidence or record suggesting that there was collusion
between back-office staff and a junior level manager leading to the collapse of Barings Bank. T his
choice seems more like an assumption rather than a fact based on historical events.
Choi ce D i s i ncorrect. T he massive earthquake that hit Japan in 1995 did trigger unprecedented
losses in the stock market but it was not directly related to or responsible for the collapse of Barings
Bank. T he bank's downfall was primarily due to internal factors such as poor risk management and
lack of oversight rather than external events.
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Q.114 T he trouble among Savings and Loans Associations (S&Ls) in the United States can be traced
down to an increase in interest rates and inflation, which collectively served to reduce the profit
margin initially enjoyed by the heavily regulated S&Ls. T he regulator responded by relaxing some of
the stringent rules. For example, the limit on deposit insurance coverage was raised from $40,000 to
$100,000 to make it easier for troubled or insolvent institutions to attract deposits to lend with.
Which of the following problems did this particular change create?
A. S&Ls engaged in even riskier lending activities
B. Taxpayers were forced to pay for the increase
C. T here was a huge bailout after a large number of S&Ls failed
D. All of the above
T he increase in deposit insurance coverage from $40,000 to $100,000 led to several problems.
Firstly, it created a moral hazard as S&Ls started engaging in riskier lending activities. T he higher
insurance coverage made it easier for these institutions to attract deposits, which they then lent out.
However, the riskier nature of these loans increased the probability of loss. Secondly, when a large
number of S&Ls failed, it led to one of the most expensive banking system bailouts in history, costing
around USD 160 billion. T his bailout was funded by taxpayers, thereby placing a significant financial
burden on them.
Choi ce A i s i ncorrect. While it's true that S&Ls engaged in riskier lending activities, this was not a
direct result of the increase in deposit insurance coverage. Rather, it was a consequence of the
overall deregulation and loosening of restrictions on S&Ls' activities. T he increased limit on deposit
insurance may have indirectly contributed to this by providing a safety net for risky behavior, but it
was not the primary cause.
Choi ce B i s i ncorrect. Although taxpayers did ultimately bear some of the cost of the S&L crisis
through government bailouts, this was not directly caused by the increase in deposit insurance
coverage. T he increased limit may have made bailouts more costly when they did occur, but it did not
force taxpayers to pay for them.
Choi ce C i s i ncorrect. While there indeed was a huge bailout after many S&Ls failed, this cannot
be solely attributed to the increase in deposit insurance coverage from $40,000 to $100,000. T he
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failure and subsequent bailout were due to a combination of factors including poor management
decisions and economic conditions such as rising interest rates and inflation.
Q.115 Which of the following served as the main source of funding for Lehman Brothers in the lead-
up to the 2007/2009 financial crisis?
A. Bond market
B. Repo market
C. Stock sale
D. Reserves
Lehman Brothers, like many other financial institutions, relied heavily on the repo market for
funding. A repo, or repurchase agreement, is a form of short-term borrowing for dealers in
government securities. In a typical repo transaction, a dealer sells government securities to
investors, usually on an overnight basis, and buys them back the following day at a slightly higher
price. T he difference in price is the dealer's overnight interest cost. Lehman Brothers was heavily
reliant on these short-term funding sources, borrowing billions of dollars each day in the overnight
wholesale funding markets to operate. T his reliance on short-term funding was a significant factor in
Lehman's collapse when the liquidity of these markets dried up during the financial crisis.
Choi ce A i s i ncorrect. While Lehman Brothers did use the bond market as a source of funding, it
was not their primary source during the period leading up to the financial crisis. T he bond market
can be a more expensive and less flexible form of financing compared to other sources.
Choi ce C i s i ncorrect. Stock sales were not the primary source of funding for Lehman Brothers
during this period. Selling stock is a way to raise equity capital, but it also dilutes existing
shareholders' ownership in the company, which can be undesirable from a management perspective.
Choi ce D i s i ncorrect. Reserves are typically used as a buffer against unexpected losses and are
not generally considered as a primary source of funding for ongoing operations in financial
institutions like Lehman Brothers.
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Q.117 T he following statements are true regarding Long-Term Capital Management (LT CM), except:
A. LT CM is categorized as a financial disaster caused by large market moves but not

misleading reporting.
B. T he incident highlighted the importance of stress testing to look at the effects of a

competitor holding similar assets unexpectedly exiting the market.
C. LT CM was founded with the aim of tapping short-term positions instead of focusing on the
long term.
D. LT CM models assumed that historical relationships were useful predictors of future

relationships, albeit in the absence of external economic shocks.
LT CM was, in fact, focused on long-term investment strategies. T he fund's investors were locked
into investments for extended periods of time to avoid illiquidity. T he partners at LT CM were so
confident in the success of their venture that they committed a significant portion of their net worth
to the fund. T his confidence was bolstered by the impressive results LT CM recorded in its initial
years. T herefore, the assertion that LT CM was aimed at short-term positions is incorrect.
Choi ce A i s i ncorrect. LT CM's collapse was indeed a financial disaster triggered by large market
moves, particularly in the bond market. It was not due to misleading reporting. T he firm had taken on
excessive risk with high leverage, and when the markets moved against their positions, they were
unable to meet their obligations.
Choi ce B i s i ncorrect. T he LT CM case did highlight the importance of stress testing for extreme
scenarios such as a major competitor unexpectedly exiting the market. T his event could lead to
sudden changes in asset prices and liquidity conditions that could adversely affect a firm's positions.
Choi ce D i s i ncorrect. LT CM did rely heavily on models that assumed historical relationships
would continue into the future, even in the absence of external economic shocks. T his assumption
proved to be one of their major downfalls when unexpected events occurred that disrupted these
historical relationships.
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Q.119 Consider the following statements:
I. LT CM models assumed that low frequency/high severity events were correlated over a period of
time
II. LT CM models accounted for the spikes in correlations among asset class prices during economic
shocks
Select the true statement(s):
A. I
B. II
C. Both I and II
D. None
Neither of the statements accurately reflect the assumptions made by LT CM's models. T he models
used by LT CM relied heavily on historical correlations to measure risk. T his approach failed to
account for the possibility of a spike in correlations among asset class prices during economic
shocks. An example of such a shock was when Russia defaulted on its debt, causing a global economic
downturn. Furthermore, the models did not consider the possibility of low frequency/high severity
events being correlated over time. T his led to an underestimation of risk in the tails of the
distribution. T herefore, both statements are incorrect.
Choi ce A i s i ncorrect. T he models used by LT CM did not assume that low frequency/high severity
events were correlated over a period of time. In fact, one of the key criticisms of LT CM's approach
was that it underestimated the likelihood and potential impact of these "tail risk" events.
Choi ce B i s i ncorrect. Similarly, LT CM's models did not account for spikes in correlations among
asset class prices during economic shocks. T his was another major flaw in their approach, as it led
them to underestimate the risk of simultaneous losses across different asset classes.
Choi ce C i s i ncorrect. As explained above, neither statement I nor II accurately reflects the
assumptions made by LT CM's models.
Q.120 Which of the following risks was realized in the Metallgesellschaft case study?
235
A. Credit risk.
B. Interest rate risk.
C. Funding liquidity risk.
D. Operational risk.
Funding liquidity risk refers to the risk that a company will not be able to meet its current and future
cash flow and collateral needs, both expected and unexpected, without affecting its daily operations
or financial condition. In the Metallgesellschaft case, the company offered its customers the
opportunity to buy oil and gasoline at a premium above the average price of futures contracts
expiring over the next 12 months. However, when the price of oil dropped sharply from about \$21
to \$14 per barrel, the company suffered losses of approximately \$900 million. T hese losses were
realized immediately as the futures contracts were marked to market. T he gains from customers,
which could have offset the losses, could not be realized until several years later. T his situation led
to a shortage of short-term cash outflows, thereby creating a funding liquidity risk. T herefore, the
Metallgesellschaft case is a classic example of funding liquidity risk, where the company was unable
to meet its short-term cash flow needs due to a sudden drop in oil prices.
Choi ce A i s i ncorrect. Credit risk refers to the potential that a borrower or counterparty will fail
to meet its obligations in accordance with agreed terms. In the Metallgesellschaft case, the
company's losses were not due to any default by its customers or counterparties, but rather due to a
sharp drop in oil prices.
Choi ce B i s i ncorrect. Interest rate risk pertains to the potential for investment losses due to a
change in interest rates. In this scenario, Metallgesellschaft's losses were not related to changes in
interest rates but were caused by significant price fluctuations of heating oil and gasoline.
Choi ce D i s i ncorrect. Operational risk involves loss resulting from inadequate or failed internal
processes, people and systems, or from external events. T he company's strategy was not flawed
because of operational failures; instead it suffered from an unexpected drop in oil prices which led
them into funding liquidity issues.
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Q.121 Metallgesellschaft Refining and Marketing (MGRM), a U.S. subsidiary of the German oil
company Metallgesellschaft, lost over $1.5 billion as a result of a poor dynamic hedging strategy.
What triggered the loss? T he company:
A. Adopted an outdated and largely ineffective hedging strategy called a “stack-and-roll hedge”.
B. Bought too many long terms futures contracts.
C. Failed to predict the significant rise in oil prices in 1993.
D. Suffered a significant decline in oil prices resulting in huge unrealized losses and
subsequent margin calls.
MGRM suffered a significant decline in oil prices, which led to massive unrealized losses and
subsequent margin calls. T he company used short-term futures to hedge its position due to a lack of
alternatives, as the long-term futures contracts available were highly illiquid. MGRM's open interest
in unleaded gasoline contracts was 55 million barrels in the fall of 1993, compared to an average
trading volume of 15-30 million barrels per day. T he company encountered problems in the timing of
cash flows required to maintain the hedge. Over the entire life of the hedge, these cash flows would
have canceled out. However, MGRM's problem was a lack of necessary funds needed to maintain its
position. T he fundamental issue manifested in the form of inadequate funds to mark positions to
market and meet margin requirements. T his situation was exacerbated by the significant decline in
oil prices, which led to huge unrealized losses and subsequent margin calls, ultimately resulting in a
loss of over $1.5 billion.
Choi ce A i s i ncorrect because although MGRM did adopt a dynamic hedging strategy, it was not
outdated or largely ineffective. T he strategy involved using short-term futures to hedge due to a lack
of alternatives, as the long-term futures contracts available were highly illiquid. T he problem was
not with the strategy itself, but with the company's inability to predict the significant decline in oil
prices and its lack of necessary funds to maintain its position and meet margin requirements.
Choi ce B i s i ncorrect because MGRM did not buy too many long-term futures contracts. In fact,
the company used short-term futures to hedge due to a lack of alternatives, as the long-term futures
contracts available were highly illiquid.
237
Choi ce C i s i ncorrect because MGRM did not fail to predict a significant rise in oil prices in 1993.
In fact, the company suffered a significant decline in oil prices, which led to massive unrealized
losses and subsequent margin calls.
Thi ngs to Remember
T he MGRM case is a classic example of the risks associated with dynamic hedging strategies. While
these strategies can be effective in managing risk, they require careful management and a thorough
understanding of the underlying market dynamics. In the case of MGRM, the company's inability to
predict the significant decline in oil prices and its lack of necessary funds to maintain its position and
meet margin requirements led to massive losses. T his case highlights the importance of not only
having a sound hedging strategy but also ensuring that the company has the necessary resources to
implement and maintain the strategy effectively. It also underscores the importance of understanding
and managing the cash flow requirements associated with such strategies, as well as the potential
risks associated with significant market fluctuations.
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Q.122 In the modern business world, it's not uncommon to find organizations recording phone
conversations between clients and staff. Which of the following best explains why firms must
exercise caution when engaging in such an exercise as highlighted by the Bankers T rust incident?
A. Taping conversations can have a negative impact on the ability of staff to freely and
candidly engage with clients.
B. T he recorded conversations can be used against the organizations as evidence during

lawsuits.
C. T he exercise may not yield significant results and may actually deal a heavy blow to
staff/management trust.
D. Taping conversations could consume considerable time and energy, which could otherwise
be channeled into more productive business.
T he Bankers T rust incident serves as a cautionary tale for organizations that record conversations
between their staff and clients. In this case, Procter and Gamble and Gibson Greetings sued Bankers
T rust for failing to customize derivative trades to suit their individual needs. T he plaintiffs used
recorded phone conversations of Bankers T rust employees as evidence in their lawsuits. Some of
these recordings contained employees boasting about how they had deceived clients with complex
and incomprehensible structures. T his case underscores the potential legal risks associated with
recording conversations, as these recordings can be used against the organization in legal
proceedings. T herefore, organizations must exercise caution when recording conversations to avoid
potential legal repercussions.
A, C, and D are i ncorrect as they all present scenarios unrelated to the Bankers T rust incident.
Q.123 In the history of financial disasters, there have been instances where companies have used
questionable accounting practices to misrepresent their financial health to investors. T hese
practices often involved disguising the size of borrowings, thereby creating a false impression of
financial stability. Among the following cases, which one is known for such practices?
A. Barings Bank
B. Continental Illinois
C. Enron
239
D. Orange County
Enron Corporation is infamous for its accounting scandal that led to its downfall. T he company took
on large loans but disguised them as oil futures contracts. T his allowed Enron to avoid accounting for
these borrowings on its financial statements, thereby presenting a misleading picture of its financial
health to investors and lenders. T he company's financial statements showed it to be in a much better
financial position than it actually was. When the truth came to light, it led to one of the biggest
corporate bankruptcies in U.S. history and a reevaluation of corporate accounting practices.
Choi ce A i s i ncorrect because Barings Bank's downfall was not due to questionable accounting
practices. Instead, it was associated with poor management oversight of the settlement process. T he
bank's collapse was primarily due to unauthorized and speculative trading activities by one of its
employees, Nick Leeson, who was based in Singapore. Leeson's activities led to losses amounting to
more than the bank's available trading capital, leading to the bank's insolvency in 1995.
Choi ce B i s i ncorrect because Continental Illinois's financial disaster was not a result of
questionable accounting practices. T he bank's problems were primarily associated with funding
liquidity risk. In the early 1980s, Continental Illinois had a high concentration of commercial real
estate loans and was heavily reliant on wholesale funding. When concerns about the bank's loan
portfolio arose, it led to a run on the bank by other financial institutions, leading to its eventual
failure in 1984. T his case is often cited as an example of the risks associated with relying too heavily
on wholesale funding.
Choi ce D i s i ncorrect because the financial disaster in Orange County was not due to
questionable accounting practices. Instead, it was a case of misuse of complex financial products
characterized by large amounts of leverage. T he county's treasurer, Robert Citron, invested heavily
in derivatives, believing that interest rates would remain low. However, when rates rose, the county
suffered significant losses and was forced to file for bankruptcy in 1994. T his case illustrates the
risks associated with financial engineering and complex derivatives.
Thi ngs to Remember
240
Each of these financial disasters highlights different risks and issues in the financial sector. Enron's
case underscores the importance of transparency and integrity in accounting practices. Barings
Bank's collapse highlights the need for effective management oversight and risk controls. T he
Continental Illinois case illustrates the risks associated with funding liquidity risk and over-reliance
on wholesale funding. Lastly, Orange County's bankruptcy demonstrates the potential dangers of
using complex financial products without fully understanding the associated risks.
241
Q.124 In the Metallgesellschaft case study, which factor played the most significant role in the
events that unfolded?
A. German accounting rules of the time.
B. Outright fraud.
C. Flawed computer-based software.
D. T iming differences in the cash flows of its long and short positions.
T he Metallgesellschaft case study is a classic example of a financial disaster caused by a timing
mismatch between futures contract losses and forward contract cash flows. Metallgesellschaft, a
German industrial conglomerate, had entered into long-term contracts to deliver oil products at fixed
prices. To hedge against the risk of oil price fluctuations, the company took short positions in oil
futures. However, the cash flows from these two positions did not match in terms of timing. T he
futures contracts required margin payments whenever the market price of oil increased, leading to
immediate cash outflows. On the other hand, the cash inflows from the long-term contracts were
spread out over several years. T his timing mismatch created a liquidity crisis for Metallgesellschaft
when oil prices rose significantly. T he company's positions were so large that it could not close
them without incurring substantial costs. T his situation ultimately led to a financial disaster for
Metallgesellschaft.
Choi ce A i s i ncorrect because while the German accounting rules of the time may have
influenced Metallgesellschaft's financial reporting, they were not the primary cause of the
company's financial disaster. T he company's problems stemmed from a timing mismatch between the
cash flows of its long and short positions, not from the accounting rules.
Choi ce B i s i ncorrect because there is no evidence to suggest that outright fraud was a factor in
the Metallgesellschaft case.
Choi ce C i s i ncorrect because flawed computer-based software was not a major factor in the
Metallgesellschaft case. T he company's financial disaster was primarily caused by a timing mismatch
between the cash flows of its long and short positions, not by problems with its software.
242
Q.126 Enron, once a leading energy company, faced a catastrophic downfall that led to its bankruptcy.
T his failure was attributed to various factors, primarily related to risk management. Among the
following types of risks, which one was the most significant contributor to Enron's collapse?
A. Governance risk
B. Liquidity risk
C. Foreign currency risk
D. Credit risk
Enron's failure was primarily due to governance risk.
Governance risk refers to the potential for losses due to a company's management decisions,
policies, and procedures. In Enron's case, the company's executives made decisions that were in
their personal interest, often at the expense of the company. T his led to a culture of greed and
corruption, which ultimately resulted in the company's downfall. T he executives' lack of
accountability and transparency, coupled with their unethical practices, created a high governance
risk that eventually led to Enron's collapse. T herefore, governance risk was the most significant
factor contributing to Enron's failure.
Choi ce B i s i ncorrect. Enron did face liquidity issues, particularly towards the end when it was
unable to pay its debts. However, these issues were a consequence of the larger governance issues
that plagued the company.
Choi ce C i s i ncorrect. While Enron was a multinational corporation with operations in various
countries, there is no evidence to suggest that foreign currency risk was a significant factor in its
downfall.
Choi ce D i s i ncorrect. While Enron did have significant debts, credit risk was not the primary
cause of its downfall. T he company's failure was primarily due to governance issues, not its inability
to repay its debts.
Q.127 In financial crises, certain patterns and behaviors often precede the onset of a disaster. T hese
243
behaviors can be seen in the attitudes of investors, market trends, and the overall economic climate.
Among the following options, which one best describes the typical characteristics observed in the
initial phases of a financial catastrophe?
A. Unfettered optimism and an overwhelmingly bullish sentiment regarding the trajectory of

future asset prices, often culminating in speculative bubbles.
B. A significant and sudden influx of novice investors, often driven by fear of missing out on a
rapidly rising market, thus inflating asset prices beyond their intrinsic values.
C. A systemic failure in a sector such as the housing mortgage market, precipitated by an

unsustainable build-up of high-risk loans and amplified by a lack of diversification in
investment portfolios.
D. A persistent pattern of stagnating or barely fluctuating share prices, potentially indicating

an imminent market correction or bear market phase.
Excessive optimism about future asset prices is a common characteristic of the early stages of a
financial disaster. T his optimism is often fueled by a belief that asset prices will continue to rise
indefinitely, leading to a rush of buyers into the market. T his behavior can create an asset bubble,
where the prices of assets like shares, mortgages, and other products inflate beyond their intrinsic
value. When this bubble eventually bursts, it can lead to a financial disaster.
Historically, this pattern has been observed in several financial crises. For instance, during the lead-
up to the 2008 financial crisis, there was excessive optimism about the housing market, with many
believing that house prices would continue to rise. T his led to a surge in risky lending and the
creation of a housing bubble. When the bubble burst, it triggered a financial disaster that had global
repercussions.
Similarly, in the case of the collapse of Lehman Brothers, the firm's entry into the mortgage-backed
securities market coincided with a period of rapid growth in the industry, fueled by the housing price
bubble. For a few years, Lehman Brothers experienced fast growth, but when the bubble burst, it
led to their downfall.
Choi ce B i s i ncorrect. While this scenario may contribute to financial instability, it is not the
primary characteristic of the initial phases of a financial catastrophe. It's typically a result of
excessive optimism.
244
Choi ce C i s i ncorrect because it refers more to a specific event during a financial crisis (like the
2008 subprime mortgage crisis) rather than a general characteristic of the initial phases of financial
catastrophes. Not all financial crises have such sector-specific triggers.
Choi ce D i s i ncorrect. Stagnating or barely fluctuating share prices may indicate a lack of market
activity or investor interest, but they're not necessarily indicative of an impending financial
catastrophe. Often, they're seen in mature markets or during economic downturns, not specifically
in the initial phases of a crisis.
Q.131 Which of the following dynamic hedging strategies was used by Metallgesellschaft Refining and
Marketing (MGRM)?
A. Stack-and-roll
B. Delta hedging
C. Stop-loss strategy
D. Dynamic delta-hedging
T he stack-and-roll strategy is characterized by the purchase of futures contracts for a nearby
delivery date and then rolling the position forward by purchasing a fewer number of contracts on
that date. T he process continues for future delivery dates until the exposure at each maturity date is
hedged. T his is exactly the strategy that was used by Metallgesellschaft Refining and Marketing
(MGRM). T he aim of this strategy is to hedge against price fluctuations in the market by maintaining
a position in futures contracts. T his strategy is particularly useful in volatile markets where prices
can change rapidly and unpredictably.
B, C, and D are i ncorrect as they represent strategies not adopted by MGRM. Here's a brief
description of each:
Delta hedging is a strategy that aims to reduce the risk associated with price movements of an
underlying asset, such as a stock, by offsetting long and short positions. For example, if a trader has a
long position on a stock, they can hedge against potential losses by taking a short position on the
245
same stock.
In a stop-loss strategy, a trader sets a pre-determined point at which they will sell a stock to avoid
further losses. T his strategy is used to limit potential losses on a position. However, this strategy is
not a dynamic hedging strategy and was not used by MGRM.
Dynamic delta-hedging is a strategy that adjusts the number of shares shorted as the price of the
underlying asset changes, in order to maintain a delta-neutral position. It is dynamic because the
number of shares shorted is continuously adjusted to maintain the delta-neutral position.
Thi ngs to Remember
MGRM essentially took long positions in short-dated futures contracts on oil to hedge against
possible increases in oil prices in the future. T he "stack and roll" strategy involved rolling over
these contracts every month, essentially selling the near-term contract before it expired and buying
the next month's contract. T his approach works well if prices increase or remain stable. However,
the oil market faced a significant downturn in the early 1990s. As oil prices fell, MGRM was forced
to meet large margin calls as its hedging position lost value, while its long-term supply contracts
remained unaffected as they were at fixed prices. With this, MGRM was effectively in a situation
where it was selling high and buying low, leading to significant losses. T he situation was further
exacerbated when Metallgesellschaft's lenders, nervous about the losses, demanded additional
collateral and eventually forced a liquidation of the futures position, turning paper losses into real
ones. T his chain of events eventually led to a liquidity crisis and the near-collapse of the entire
Metallgesellschaft conglomerate.
Q.132 In the history of financial markets, there have been numerous scandals that have had a
profound impact on the global economy. T hese scandals often involve a variety of risks, including
funding liquidity risk, which is the risk that a company will not be able to meet its short-term
financial needs. T his type of risk was a significant factor in one of the following financial scandals:
A. Orange County
B. Savings and Loans Crisis
C. SWIFT
D. Metallgesellschaft Refining and Marketing
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T he Metallgesellschaft Refining and Marketing (MGRM) scandal is a prime example of a financial
disaster caused by funding liquidity risk. MGRM, a subsidiary of Metallgesellschaft AG, a large
German industrial conglomerate, entered into long-term fixed price contracts with its customers to
supply heating oil, gasoline, and diesel fuel. To hedge its exposure to volatile oil prices, MGRM
implemented a stack-and-roll futures strategy. However, when the oil prices fell significantly, MGRM
faced margin calls on its futures contracts that it could not meet, leading to a liquidity crisis. T he
losses incurred by MGRM were fundamentally from cash flow timing differences associated with the
positions making up its hedge. T his case highlights the importance of understanding and managing
funding liquidity risk in financial markets.
Choi ce A i s i ncorrect because the Orange County bankruptcy was a case of financial
mismanagement and lack of risk management oversight. T he treasurer of Orange County, Robert
Citron, invested heavily in risky derivatives, betting that interest rates would remain low. When
interest rates rose, the county suffered significant losses and was unable to meet its financial
obligations, leading to bankruptcy.
Choi ce B i s i ncorrect because the Savings and Loan crisis in the United States during the 1980s
and 1990s was not primarily a case of funding liquidity risk. Instead, it was a case of poor regulatory
oversight, risky and fraudulent lending practices, and a sharp decline in real estate values.
Choi ce C i s i ncorrect because the SWIFT (Society for Worldwide Interbank Financial
Telecommunication) case is all about cyber risk, not funding liquidity risk. T his incident highlighted
the importance of cybersecurity in the financial sector.
Thi ngs to Remember
Funding liquidity risk is a crucial aspect of risk management in financial institutions. It refers to the
risk that a firm will not be able to meet its current and future cash flow and collateral needs, both
expected and unexpected, without affecting its daily operations or financial condition. T his risk can
arise from various sources, including market disruptions, changes in credit quality, and mismatches
between assets and liabilities. Effective management of funding liquidity risk involves maintaining an
247
adequate level of liquid assets, diversifying funding sources, and regularly monitoring and managing
liquidity risk exposures and funding needs within various time horizons.
248
Q.134 Which of the following involves the purchase of a hedging instrument that very closely
matches the position to be hedged and is typically held for as long as the underlying position is kept?
A. Dynamic hedge strategy
B. Static hedge strategy
C. Stack-and-roll hedge strategy
D. Delta-hedge strategy
A static hedge strategy is a type of hedging strategy that does not require constant rebalancing as the
price and other characteristics (such as volatility) of the securities it hedges change. T his strategy
typically involves the purchase of a hedging instrument that very closely matches the position to be
hedged. T he hedging instrument is held for as long as the underlying position is kept. T his strategy is
particularly useful in situations where the characteristics of the underlying position are not
expected to change significantly over time, thereby reducing the need for constant monitoring and
adjustment of the hedge. T he static hedge strategy is a cost-effective and efficient way to mitigate
risk, as it minimizes transaction costs associated with frequent rebalancing of the hedge.
Choi ce A i s i ncorrect because a dynamic hedge strategy involves frequent rebalancing of the
hedge position as market conditions change. T his strategy is typically used when the characteristics
of the underlying position are expected to change significantly over time.
Choi ce C i s i ncorrect because a stack-and-roll hedge strategy involves purchasing futures
contracts for a nearby delivery date and, on that date, rolling the position forward by purchasing a
fewer number of contracts for future delivery dates. T his process continues until the exposure at
each maturity date is hedged. T he stack-and-roll hedge strategy is typically used in situations where
the underlying position has a long duration and the futures contracts available for hedging have
shorter durations.
Choi ce D i s i ncorrect because a delta-hedge strategy involves the reduction of the directional
risks associated with the movements in the price of the underlying assets. T his strategy is typically
used in options trading, where the delta of an option represents the rate of change of the option
price with respect to changes in the price of the underlying asset.
249
Q.4318 T he trader known as the London Whale lost at least $6.2 billion for JPMorgan Chase & Co. in
2012. In the first three months of that year, the number of days reporting losses exceeded the
number of days reporting profits. In an attempt to conceal these losses, the CIO came up with a new
valuation system. T he CIO had hitherto (up to that point) valued credit derivatives by:
A. Marking them at or near the midpoint price in the daily range of prices.
B. Marking them above the midpoint price in the daily range of prices.
C. Marking them below the midpoint price in the daily range of prices.
D. Marking them at prices that were at significant variance to the midpoints of dealer quotes
in the market.
T he CIO had been valuing credit derivatives by marking them at or near the midpoint price in the
daily range of prices. T his method is also known as marking to market. T he midpoint price is the
average of the highest and lowest prices that a security reaches within a day, which is considered to
be the most representative of fair value. By using this method, the CIO was able to provide a more
accurate and fair valuation of the credit derivatives. T his method is commonly used in the financial
markets to ensure that the valuation of securities is reflective of the current market conditions.
Choi ce B i s i ncorrect. T he CIO was not marking the credit derivatives above the midpoint price
in the daily range of prices. T his would have resulted in overvaluation of these derivatives, which is
not consistent with standard financial risk management practices.
Choi ce C i s i ncorrect. T he CIO was also not marking them below the midpoint price in the daily
range of prices. T his would have led to undervaluation of these derivatives, which again contradicts
standard financial risk management practices.
Choi ce D i s i ncorrect. T he CIO did not mark them at prices that were at significant variance to
the midpoints of dealer quotes in the market until they devised a new valuation system to obscure
losses. Prior to this, they had been marking them at or near the midpoint price in the daily range of
prices as per standard practice.
250
Q.4319 After consistently breaching risk limits, CIO traders at JPMorgan Chase & Co. proposed a
total overhaul of the VaR model in use at the time, claiming that the model was too conservative. A
new VaR model was eventually developed. Which of the following statements is most likely correct?
A. T he new model was developed and by CIO traders in collaboration with the office of the
Comptroller of Currency.
B. T he new model resulted in risk numbers that were 50% higher than prior numbers.
C. T he new model successfully corrected the mathematical flaws present in the first model,
which had produced highly overstated risk estimates.
D. T he new model was eventually revoked and the prior one reinstated.
T he new VaR model developed by the CIO traders at JPMorgan Chase & Co. was eventually revoked
and the prior one reinstated. T his decision was made after the bank's Model Risk and Development
Office identified several mathematical and operational flaws in the new model. T hese flaws included
coding errors in the calculation of hazard rates and correlation estimates, the use of unrealistically
low volatility for illiquid securities, and the use of a Uniform Rate option instead of the Gaussian
Copula model required under Basel 2.5. T he new model had also resulted in risk numbers that were
50% lower than the previous numbers, which had encouraged more speculative trading and high-risk
strategies. T he revocation of the new model and the reinstatement of the old one was a significant
step taken by the bank to address these issues and mitigate the risks associated with the flawed
model.
Choi ce A i s i ncorrect. T he new model was not developed by CIO traders in collaboration with the
office of the Comptroller of Currency. In fact, it was developed internally within JPMorgan Chase &
Co., without any external collaboration.
Choi ce B i s i ncorrect. T he new model did not result in risk numbers that were 50% higher than
prior numbers. On the contrary, it significantly reduced the reported risk numbers, which was one
of the reasons for its eventual revocation and reinstatement of the prior model.
Choi ce C i s i ncorrect. T he new model did not successfully correct mathematical flaws present in
the first model that produced highly overstated risk estimates. Instead, it understated risks due to
flawed assumptions and methodologies used in its development.
251
Q.4320 In 2012, J.P. Morgan Chase lost more than $6.2 billion dollars from an exposure to a massive
credit derivatives portfolio in its London office. How did a lack of adequate management oversight
manifest?
A. Senior managers at the bank would receive daily risk reports from traders but never read
them.
B. T he bank had no risk committee to monitor the activities of CIO traders.
C. Senior management ignored the breaching of risk limits.
D. Senior management did not hold even a single meeting to evaluate the goings-on at the CIO.
T he case of J.P. Morgan Chase in 2012, often referred to as the 'London Whale' case, revealed a
culture of inadequate regulatory oversight. T he risk limits were consistently breached, risk metrics
were disregarded, and risk models were manipulated. Despite these glaring issues, the management
did not take any substantial steps to rectify these anomalies. T his lack of action on the part of the
management is a clear manifestation of ignoring the breaching of risk limits. T he Chief Investment
Office (CIO), which was not a client-facing unit of the bank, was not subject to the same level of
regulatory scrutiny as other portfolios. T his further contributed to the lack of adequate management
oversight.
Choi ce A i s i ncorrect. While it's true that senior managers receiving daily risk reports but not
reading them would demonstrate a lack of oversight, this was not the specific issue in the J.P. Morgan
Chase case. T he problem was not about ignoring daily risk reports, but rather about ignoring
breaches of risk limits.
Choi ce B i s i ncorrect. T he absence of a risk committee to monitor the activities of CIO traders
could indeed indicate insufficient management oversight, however, this was not the primary issue in
this particular case at J.P. Morgan Chase.
Choi ce D i s i ncorrect. Although holding meetings to evaluate ongoing activities at CIO would be an
important part of management oversight, it wasn't specifically mentioned as a factor contributing to
the loss suffered by J.P. Morgan Chase in 2012.
252
Q.4321 What was the main purpose of the Chief Investment Office, CIO, at J.P. Morgan Chase Bank in
the run-up to the London Whale scandal?
A. To monitor the operations of traders .
B. To invest excess deposits.
C. To look into ways in which the bank could reduce its regulatory capital requirements.
D. To raise funds for investment by floating long-term high-yield bonds.
T he Chief Investment Office (CIO) at J.P. Morgan Chase Bank was primarily established to invest the
bank's excess deposits. In the banking sector, excess deposits refer to the surplus cash that a bank
has after meeting its reserve requirements and providing for its lending activities. T hese excess
deposits can be invested in various ways to generate additional income for the bank. In the case of
J.P. Morgan Chase Bank, the CIO was specifically set up to manage these investments. T his strategy
allowed the bank to maximize the returns on its surplus cash, thereby enhancing its overall
profitability. T he role of the CIO became particularly significant in the run-up to the London Whale
scandal, as the office was responsible for making large-scale investments that ultimately led to
significant losses for the bank.
Choi ce A i s i ncorrect. While monitoring the operations of traders is an important function within
a bank, it was not the primary role of the CIO at J.P. Morgan Chase Bank during this period. T he CIO's
main responsibility was to manage excess deposits and invest them in a way that would generate
returns for the bank.
Choi ce C i s i ncorrect. Although banks often look for ways to reduce their regulatory capital
requirements, this was not the primary function of the CIO at J.P. Morgan Chase Bank during this
time period. T he main task of the CIO was to manage and invest excess deposits.
Choi ce D i s i ncorrect. Raising funds for investment by floating long-term high-yield bonds could be
one of many strategies employed by a bank's investment office, but it wasn't specifically what
defined the role of J.P.Morgan's Chief Investment Office during that time frame.
253
Q.4322 At the height of the 2007/2009 financial crisis, J.P. Morgan Chase Bank constructed a
synthetic credit portfolio (SCP) motivated by the need to protect itself against adverse credit
scenarios such as widening credit spreads. T he bank’s synthetic credit portfolio (SCP) was
comprised of:
A. Call options on stocks featured in the S&P 500 index.
B. Credit default swaps featured in standardized credit default swap indices.
C. Short and long oil futures positions.
D. Mortgage-backed securities .
J.P. Morgan Chase Bank's synthetic credit portfolio (SCP) was essentially a collection of credit
default swaps that were part of standardized credit default swap indices. T he bank assumed both
buyer and seller positions in these swaps. As a protection buyer (holding a short risk position), the
bank would pay premiums and, in return, receive a guarantee of compensation in the event of a
default. Conversely, as a protection seller (holding a long risk position), the bank would receive
premiums and, in return, promise to compensate the buyer if a default occurred. T his strategy
allowed the bank to hedge against adverse credit scenarios, such as widening credit spreads, which
were a significant concern during the 2007/2009 financial crisis.
Choi ce A i s i ncorrect. Call options on stocks featured in the S&P 500 index are not components
of a synthetic credit portfolio (SCP). An SCP typically consists of financial instruments that mimic
the performance of actual credit, such as credit default swaps, rather than equity derivatives like call
options.
Choi ce C i s i ncorrect. Short and long oil futures positions are not part of a synthetic credit
portfolio (SCP). T hese are commodity derivatives and do not have any direct relation to credit risk or
spreads. T hey would be more relevant in a commodities trading strategy rather than a defensive
strategy against unfavorable credit situations.
Choi ce D i s i ncorrect. Mortgage-backed securities (MBS) could potentially be part of an SCP if
they were being used to synthetically replicate the performance of specific credits or sectors
254
within the broader market. However, MBS themselves are actual securities backed by mortgages,
not synthetic representations of other credits or sectors.
255
Q.4323 T he infamous collapse of the oldest merchant bank in England, Barings Bank, in 1995 after
233 years of existence, can be traced down to one key reason:
A. A bank run
B. T he Kobe earthquake in Japan, which rattled financial markets in Asia and hence, severely
affected the bank’s activities.
C. Largely unchecked speculative trades.
D. A total overhaul of the board of directors which resulted in the loss of investor
confidence.
T he collapse of Barings Bank was primarily due to largely unchecked speculative trades. T he bank's
downfall can be traced back to the actions of one employee, Nick Leeson, who was the general
manager and head trader at Barings. Leeson had a reputation for hard work and an unrivaled
understanding of the market, which he had developed during his successful career elsewhere. After
joining Barings, Leeson initially earned massive profits for the bank through several unauthorized
trades in 1992. However, his speculative trading eventually led to losses of over $1 billion in
company capital. Leeson hid these losses from his superiors, which further exacerbated the
situation. When the losses were eventually discovered, they were so substantial that they led to the
bank's collapse. T his case highlights the dangers of unchecked speculative trading and the importance
of proper risk management and oversight in financial institutions.
Choi ce A i s i ncorrect. While a bank run can indeed lead to the collapse of a financial institution, it
was not the primary cause in the case of Barings Bank. T he bank's downfall was primarily due to
internal factors rather than external panic among depositors.
Choi ce B i s i ncorrect. Although the Kobe earthquake did have an impact on financial markets in
Asia, it was not directly responsible for Barings Bank's failure. T he bank's collapse was largely due to
speculative trades that were not properly monitored or controlled.
Choi ce D i s i ncorrect. A change in the board of directors can affect investor confidence and
potentially lead to instability within an organization, but this was not a key factor leading to Barings
Bank's downfall. T he main issue at hand was unchecked speculative trading which led to significant
256
losses for the bank.
Q.4324 Which of the following is the main reason that led to the scale of losses suffered by the
Orange County portfolio in 1994?
A. Excessive use of leverage.
B. Overreliance on equity.
C. An unexpected increase in interest rates by the Federal Reserve.
D. Stringent collateral demands by providers of emergency capital.
T he primary reason for the scale of losses suffered by the Orange County portfolio in 1994 was the
excessive use of leverage. Robert Citron, the treasurer of Orange County, decided to borrow heavily
in the repo market. Repos, or repurchase agreements, allow investors to finance a significant
portion of their investments with borrowed money, which is known as leverage. However, the use
of leverage can have a multiplicative effect on the profit or loss on any position. T his means that
even a small change in market prices can have a significant impact on the investor. When the Federal
Reserve announced an increase in interest rates, the fund could no longer borrow in the repo
market at favorable terms and was eventually forced to declare bankruptcy. T he excessive use of
leverage amplified the impact of the interest rate increase, leading to substantial losses for the
portfolio.
Choi ce B i s i ncorrect. Overreliance on equity was not the primary reason for the magnitude of
losses experienced by Orange County in 1994. T he county's investment portfolio was heavily
invested in derivative securities, not equities. T herefore, this option does not accurately reflect the
main cause of the financial crisis.
Choi ce C i s i ncorrect. While an unexpected increase in interest rates by the Federal Reserve did
contribute to Orange County's financial crisis, it was not primarily responsible for the magnitude of
losses experienced by the county's investment portfolio. T he main issue was that Orange County had
excessively used leverage to invest in derivative securities which were sensitive to interest rate
257
changes.
Choi ce D i s i ncorrect. Stringent collateral demands by providers of emergency capital were a
consequence, rather than a cause, of Orange County's financial crisis in 1994. T hese demands came
into play after significant losses had already been incurred due to excessive use of leverage and
subsequent market volatility.
258
Q.4325 T he Orange County case illustrates how complex financial products characterized by large
amounts of leverage can create significant losses. T he fund heavily invested in:
A. Mortgage-backed securities.
B. Equities.
C. Inverse floating-rate notes.
D. Credit default swaps.
T he Orange County investment fund, under the direction of Robert Citron, heavily invested in
inverse floating-rate notes. T hese are complex financial instruments whose coupon payments
decrease when interest rates rise. T his is in contrast to conventional floating-rate notes, where the
coupon payments increase when interest rates rise. T he fund's strategy was based on the
expectation that interest rates would remain low or decrease. However, when interest rates rose
unexpectedly, the value of the inverse floaters fell dramatically, leading to significant losses for the
fund.
Choi ce A i s i ncorrect. While mortgage-backed securities are indeed complex financial
instruments, they were not the primary investment made by Orange County's investment fund under
Robert Citron. T he fund primarily invested in inverse floating-rate notes.
Choi ce B i s i ncorrect. Equities, although a common type of financial instrument, were not the
main focus of Orange County's investment strategy under Robert Citron. T he fund was heavily
invested in inverse floating-rate notes which are more complex and carry higher risk.
Choi ce D i s i ncorrect. Credit default swaps are a type of derivative used to hedge against the risk
of a debtor defaulting on their loans. However, these were not the specific type of financial
instrument that Orange County's investment fund heavily invested in during Robert Citron's tenure
as treasurer.
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Q.4326 T he Orange County case illustrates how complex financial products characterized by large
amounts of leverage can create significant losses. Mr. Robert Citron, the fund’s treasurer, heavily
invested in inverse floating-rate notes expecting:
A. Interest rates to rise.
B. Interest rates to fall.
C. A recession in the near future.
D. T he corporation tax rate to rise.
Robert Citron, the treasurer of the fund, invested heavily in inverse floating-rate notes. T hese are a
type of debt instrument where the interest paid to the investor decreases when interest rates
increase. Conversely, when interest rates decrease, the interest paid to the investor increases. T his
is the opposite of what happens with conventional floating-rate notes, where the interest paid
increases with rising interest rates. T herefore, by investing in inverse floating-rate notes, Mr. Citron
was essentially betting on interest rates to fall or remain low. If his prediction had been correct, the
value of the inverse floating-rate notes would have increased, leading to significant profits for the
fund. However, if interest rates were to rise, the value of these notes would decrease, leading to
potential losses. T his is exactly what happened in the Orange County case, leading to significant
losses for the fund and eventually its bankruptcy.
Choi ce A i s i ncorrect. Inverse floating-rate notes increase in value when interest rates fall, not
rise. T herefore, Mr. Citron's investment in these instruments indicates an expectation of falling
interest rates.
Choi ce C i s i ncorrect. T he expectation of a recession would likely lead to a different investment
strategy altogether, as recessions typically result in lower interest rates rather than higher ones.
Choi ce D i s i ncorrect. T he corporation tax rate has no direct impact on the value of inverse
floating-rate notes and thus would not be a primary consideration for Mr. Citron's investment
decision.
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Q.4327 T he financial scandals at Bankers T rust and Orange County have one thing in common:
A. T hey involved the use of complex financial instruments with an eye on high returns.
B. Both collapsed as a result of a crippling run.
C. Both were eventually acquired and dismantled.
D. Both invested heavily in mortgage-backed securities.
Both the financial scandals at Bankers T rust and Orange County involved the use of complex financial
instruments with an aim to achieve high returns. Bankers T rust used complex derivatives trades to
promise Procter & Gamble (P&G) and Gibson Greetings a high probability of a small reduction in
funding costs in exchange for a low-probability, large loss. T hese derivatives were intentionally
complex to prevent P&G and Gibson Greetings from understanding their risks and overall
implications. Similarly, Orange County's treasurer, Robert Citron, used complex structured products,
specifically inverse floating-rate notes, to generate higher than average returns. T hese notes'
coupon payments would decrease when interest rates rose, effectively betting on interest rates
falling or staying low. However, when the Federal Reserve increased interest rates, the value of
Citron's portfolio decreased significantly, leading to substantial losses.
Choi ce B i s i ncorrect. While it's true that both Bankers T rust and Orange County faced significant
financial difficulties, they did not collapse as a result of a crippling run. A bank run occurs when a
large number of customers withdraw their deposits simultaneously due to fears that the institution
might become insolvent. However, in these cases, the financial scandals were primarily related to
risky investment strategies and misuse of complex financial instruments rather than mass
withdrawals by customers.
Choi ce C i s i ncorrect. Although Bankers T rust was eventually acquired by Deutsche Bank,
Orange County was not dismantled or acquired by another entity after its bankruptcy. Instead, it
implemented measures to recover from its financial crisis and continues to operate today.
Choi ce D i s i ncorrect. T he statement that both institutions invested heavily in mortgage-backed
securities is inaccurate. T he scandals at Bankers T rust and Orange County involved misuse of
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complex derivatives rather than investments in mortgage-backed securities specifically.
Q.4328 Which of the following lessons is most relevant to the Orange County case?
A. Every firm needs to have more than a basic understanding of the risks that are inherent in
its business models.
B. Reporting and monitoring of positions and risks (i.e., back-office operations) must be
separated from trading (i.e., front-office operations).
C. Risk managers have a responsibility to analyze reported business profits and determine if
they seem logical in light of the positions held.
D. Outsized or strangely consistent profits should be independently investigated and

rigorously monitored in order to verify that they are real, generated in accordance with the
firm’s policies and procedures.
T he main lesson learned from the Orange County case has much to do with the need for firms to
have a deep/detailed basic understanding of the inherent risks in their business models. Robert
Citron, Orange County’s treasurer, used complex structured products in an attempt to generate a
higher than average return. Citron later admitted he understood neither the position he took nor the
risk exposure of the fund with respect to these products.
Choices B, C, and D are all lessons under the Barings case study that revolves around Nick Leeson, a
trader.
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Q.4329 T he Volkswagen scandal of 2015 highlighted the need for companies to:
A. Invest in social media to ensure a fast spread of positive information.
B. Uphold ethical conduct and demonstrate their commitment to environmental, social, and
governance-related best practices.
C. To hire qualified professionals capable of detecting anomalies before it’s too late.
D. To nurture and protect their brand name by investing in research and development.
T he Volkswagen scandal of 2015 was a significant event that highlighted the importance of ethical
conduct and commitment to environmental, social, and governance-related best practices for
companies. Volkswagen, a renowned automobile manufacturer, was found to have cheated on
emissions tests, causing severe damage to its brand reputation. T he company's share price fell by
over a third, and it faced potential fines and penalties amounting to billions of dollars. T his scandal
underscored the need for companies to uphold ethical conduct and demonstrate their commitment to
environmental, social, and governance-related best practices. By doing so, companies can avoid such
scandals, maintain their reputation, and ensure their long-term success.
Choi ce A i s i ncorrect. While investing in social media can help spread positive information about a
company, it does not address the root cause of ethical issues or misconduct that may lead to scandals
like the Volkswagen case. It's more of a reactive approach rather than proactive.
Choi ce C i s i ncorrect. Hiring qualified professionals capable of detecting anomalies is important,
but it doesn't necessarily ensure ethical conduct or commitment to environmental, social, and
governance-related best practices. It's possible for anomalies to go undetected or be ignored if there
isn't a strong culture of ethics and responsibility within the company.
Choi ce D i s i ncorrect. Nurturing and protecting their brand name by investing in research and
development can contribute to a company's reputation, but it doesn't directly address ethical conduct
or commitment to ESG practices. In fact, without these commitments, any investment in R&D could
potentially be wasted if unethical behavior leads to reputational damage.
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Q.5038 In the early 1990s, Metallgesellschaft, a German oil company, suffered a loss of $1.33 billion
in their hedging program. T hey rolled over short-dated futures to hedge long term exposure created
through their long-term fixed-price contracts to sell heating oil and gasoline to their customers. After
a time, they abandoned the hedge because of large negative cash flow. T he cash-flow pressure was
due to the fact that MG had to hedge its exposure by:
A. Short futures and there was a decline in oil price.
B. Long futures and there was a decline in oil price.
C. Short futures and there was an increase in oil price.
D. Long futures and there was an increase in oil price.
Metallgesellschaft was using a long futures strategy to hedge its exposure. T his means that they
were buying futures contracts, betting that the price of oil would increase in the future. However,
the price of oil declined, which meant that the value of their futures contracts also declined. T his led
to margin calls, which are demands from a broker for additional funds or securities to cover possible
losses. Metallgesellschaft had to meet these margin calls, which led to a large negative cash flow and
ultimately forced them to abandon their hedging strategy. T his case is a classic example of the risks
associated with futures contracts and hedging strategies, and it highlights the importance of
understanding and managing these risks effectively.
Choi ce A i s i ncorrect. Metallgesellschaft was not short futures; they were long futures.
T herefore, a decline in oil price would not have caused the negative cash flow that led them to
abandon their hedging strategy.
Choi ce C i s i ncorrect. While it's true that being short futures and experiencing an increase in oil
price could lead to negative cash flow, this was not the case for Metallgesellschaft. T hey were long
futures, so this scenario does not apply.
Choi ce D i s i ncorrect. If Metallgesellschaft had been long futures and there was an increase in oil
price, this would have resulted in positive cash flow from their hedging strategy rather than negative
cash flow. T herefore, they would not have needed to abandon their strategy under these
circumstances.
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Q.5329 During a company’s annual general meeting, a shareholder asks the Chief Risk Officer to
elaborate on what she meant by funding liquidity risk. Which of the following definitions given by the
Chief Risk Officer is correct?
A. It is the possibility that a bank could find itself unable to settle obligations as soon as they
are due.
B. It is the danger that a change in rates will cause the value of assets to decline and that of
liabilities to increase.
C. It is the aim to ensure that banks have liquidity and funding strategies that will survive
system-wide stress scenarios.
D. It is the risk of loss resulting from the use of insufficiently accurate models to make
decisions when valuing financial securities.
Funding liquidity risk is indeed the possibility that a bank or any financial institution could find itself
unable to settle obligations as soon as they are due. T his risk arises when a company is unable to
meet its short-term financial obligations due to insufficient cash, cash equivalents, or limited access
to funding sources. T his inability to settle obligations on time can have severe consequences,
including reputational damage, loss of confidence from customers and investors, increased borrowing
costs, and, in extreme cases, insolvency or bankruptcy. T herefore, managing funding liquidity risk is
crucial for the survival and success of any financial institution.
Choi ce B i s i ncorrect. T his choice describes interest rate risk, not funding liquidity risk. Interest
rate risk refers to the potential for investment losses due to a change in interest rates, not the
inability to meet obligations as they come due.
Choi ce C i s i ncorrect. While this statement does relate to liquidity management strategies, it does
not define funding liquidity risk. Funding liquidity risk specifically refers to the possibility that a bank
could find itself unable to settle obligations as soon as they are due.
Choi ce D i s i ncorrect. T his choice describes model risk, which pertains to potential inaccuracies
and misapplications of models used in financial valuation and risk assessment, rather than funding
liquidity risk.
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Q.5330 T he hacking of the Society for Worldwide Interbank Financial Telecommunication, also
known as SWIFT that led to the loss of approximately $81 million from the Central Bank of
Bangladesh highlighted the exposure of individuals and institutions to cyber risk. Which of the
following is an appropriate definition of cyber risk?
A. T he potential for adverse consequences arising from unauthorized access, use, disclosure,
disruption, modification, or destruction of information systems, digital assets, or data.
B. T he potential for negative impacts on an individual or organization's reputation due to

factors such as data breaches, privacy violations, or unethical practices.
C. T he potential for losses or damages stemming from insufficient or malfunctioning internal

controls, technology failures, or human errors in the context of an organization's operations.
D. T he potential for adverse outcomes arising from inaccuracies, limitations, or

misapplications of financial or statistical models employed by an organization in decision-
making or risk management.
Cyber risk is accurately defined as the potential for adverse consequences arising from unauthorized
access, use, disclosure, disruption, modification, or destruction of information systems, digital assets,
or data. T his definition encompasses a wide range of threats, including data breaches, hacking,
phishing attacks, malware, ransomware, and other forms of cyberattacks. T hese threats can
compromise the confidentiality, integrity, or availability of digital resources, leading to significant
financial and reputational damage for individuals and organizations. T he hacking of SWIFT and the
subsequent loss from the Central Bank of Bangladesh is a prime example of cyber risk.
Choi ce B i s i ncorrect. While reputation risk can be a consequence of cyber risk, it is not the
definition of cyber risk itself. Reputation risk refers to potential negative impacts on an
organization's reputation due to various factors, which may include but are not limited to cyber
incidents.
Choi ce C i s i ncorrect. T his choice describes operational risk, which includes losses from
inadequate or failed internal processes, people and systems or from external events. Although cyber
threats can lead to operational failures, they represent only one aspect of operational risk and do not
define the entirety of cyber risk.
Choi ce D i s i ncorrect. T his choice refers to model risk - the potential for adverse outcomes
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arising from inaccuracies or misapplications in financial models used by an organization for decision-
making or managing risks. While a poorly designed cybersecurity model could increase an
organization's vulnerability to cyber threats, this does not encompass the full scope of what
constitutes as 'cyber risk'.
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Q.5332 During the Global Financial Crisis of 2008, different types of institutions played different
roles in the financial services industry. Which of the following roles was played by mortgage brokers
during the financial crisis?
A. Bringing together mortgage borrowers and lenders, without using their own funds.
B. Originating mortgage-backed securities.
C. Securitizing mortgages by creating structured investment vehicles.
D. Providing credit ratings for various financial instruments.
During the Global Financial Crisis of 2008, mortgage brokers acted as intermediaries between
borrowers and lenders. T hey did not use their own funds but facilitated the mortgage application
process. T heir role was to help borrowers find suitable mortgage loans from various lenders. T hey
earned fees or commissions for their services. T his role was crucial in the financial services
industry as it helped to connect borrowers with potential lenders, thereby facilitating the flow of
funds in the economy. However, it's important to note that while they played a significant role in the
mortgage application process, they did not bear the credit risk associated with the loans. T hat risk
was borne by the lenders who provided the funds for the loans.
Choi ce B i s i ncorrect. Mortgage brokers do not originate mortgage-backed securities. T his role is
typically performed by investment banks or other financial institutions that pool together mortgages
and sell them as securities to investors.
Choi ce C i s i ncorrect. T he process of securitizing mortgages by creating structured investment
vehicles (SIVs) was not a function performed by mortgage brokers during the Global Financial Crisis
of 2008. T his was primarily done by large financial institutions, which used SIVs to offload risk from
their balance sheets.
Choi ce D i s i ncorrect. Providing credit ratings for various financial instruments, including
mortgage-backed securities, was the role of credit rating agencies and not mortgage brokers during
the crisis.
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Reading 10: Anatomy of the Great Financial Crisis of 2007-2009
Q.135 In the early 2000s, mortgage lenders introduced a new strategy to attract more customers by
offering adjustable mortgage rates with initial 'teaser rates'. T his strategy involved a lower interest
rate for the first few years, followed by a significantly higher rate in the subsequent years. What
was the immediate impact of this strategy on the mortgage market?
A. T ighter lending standards, making it more difficult for potential homeowners to secure a
mortgage.
B. T he number of mortgage applications started to increase.
C. T he price of houses started to rise.
D. A rapid increase in mortgage defaults.
Mortgage lenders in the United States started to relax lending standards in about 2000. Part of the
new strategies involved restructuring repayment terms to allow borrowers to pay a small rate of
interest for the first 2-3 years followed by substantially higher rates in the later years. T he
immediate effect was an upturn in demand for homes as families previously unqualified could now
afford to repay borrowed funds. T he lenders deemed the move as a low-risk strategy because home
prices were continually increasing, meaning that potential borrower default was adequately mitigated
by an increasing collateral value.
Choi ce A i s i ncorrect because the introduction of adjustable mortgage rates with initial 'teaser
rates' actually represented a relaxation, not a tightening, of lending standards. T his strategy aimed at
making mortgages more accessible to a broader range of potential homeowners by offering lower
initial costs, which in turn, increased the number of mortgage applications.
Choi ce C i s i ncorrect because while the introduction of adjustable mortgage rates with 'teaser
rates' did lead to an increase in demand for homes, it did not immediately cause house prices to rise.
T he increase in demand for homes was primarily due to the lower initial rates making mortgages
more affordable for many families who were previously unqualified.
Choi ce D i s i ncorrect because, while the adjustable mortgage rates with initial 'teaser rates' did
eventually contribute to a higher number of mortgage defaults, this was not the immediate effect.
Initially, the lower rates made mortgages more accessible and attractive, leading to an increase in
applications. T he rise in defaults happened later when the 'teaser rates' ended, and the higher rates
were applied, which many homeowners were unable to afford.
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Q.137 Which of the following options best describes the conditions under which a non-recourse
mortgage operates?
A. T he borrower is given flexible repayment terms, including variable interest rates and a
grace period.
B. If the borrower defaults, the lender can take possession of the assets used as collateral as
well as other assets of the borrower.
C. If the borrower defaults, the lender can only take possession of the assets used as
collateral and not any other assets of the borrower.
D. T he borrower can only sell the assets used as collateral with express authority from the
lender.
A non-recourse mortgage is a type of loan where the lender's ability to claim repayment in the event
of a default is limited to the collateral pledged for the loan. In other words, if the borrower defaults
on a non-recourse mortgage, the lender can only take possession of the assets used as collateral and
not any other assets of the borrower. T his is a key feature of non-recourse loans and distinguishes
them from recourse loans, where the lender can go after the borrower's other assets if the
collateral is insufficient to cover the outstanding loan balance. Non-recourse loans are less risky for
borrowers, but more risky for lenders, as they may not be able to recover the full amount of the
loan if the value of the collateral falls. As such, non-recourse loans often come with higher interest
rates or more stringent lending criteria to compensate for this increased risk.
Choi ce A i s i ncorrect. A non-recourse mortgage limits the lender in terms of the assets they can
possess in case the borrower defaults on the loan, the lender has few chances of reducing the risks
associated with the loan, and therefore they tend to charge fixed-interest rates.
Choi ce B i s i ncorrect because it describes a recourse mortgage, not a non-recourse mortgage. In
a recourse mortgage, if the borrower defaults, the lender can take possession of the assets used as
collateral as well as other assets of the borrower.
Choi ce D i s i ncorrect because it is not a defining characteristic of non-recourse mortgages. Both
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recourse and non-recourse loans can include clauses that restrict the borrower's ability to sell the
collateral without the lender's permission.
Q.140 An asset-backed security is usually divided into three tranches: the senior tranche, mezzanine
tranche, and equity tranche. Which of the following correctly categorizes the three tranches in
terms of risk, from the riskiest to the least risky?
A. Senior tranche; Equity tranche; Mezzanine tranche
B. Mezzanine tranche; Equity tranche; Senior tranche
C. Mezzanine tranche; Senior tranche; Equity tranche
D. Equity tranche; Mezzanine tranche; Senior tranche
Asset-backed securities are divided into tranches to distribute risk. T he equity tranche is the riskiest
as it is the first to absorb losses. T his tranche is often referred to as the 'first loss' piece as it takes
the first hit when there are defaults on the underlying assets. T he mezzanine tranche is less risky
than the equity tranche but riskier than the senior tranche. It absorbs losses only after the equity
tranche has been completely wiped out. T he senior tranche is the least risky as it is the last to
absorb losses. It is protected by both the equity and mezzanine tranches which absorb losses first.
T herefore, from the riskiest to the least risky, the order is: Equity tranche, Mezzanine tranche,
Senior tranche.
Q.141 Which of the following best explains how credit rating agencies contributed to the financial
crisis of 2007/2008?
A. Credit rating agencies colluded to give major financial institutions “undue” health.
B. Rating agencies did not sound the alarm bells early enough after detecting the deteriorating
financial stability of the economy's major players.
C. Rating agencies underestimated the risks inherent in asset-backed securities and CDOs.
D. Rating agencies overestimated the risks borne by asset-backed securities and CDOs,
leading to low demand for those financial instruments.
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Credit rating agencies played a significant role in the financial crisis of 2007/2008 by underestimating
the risks associated with asset-backed securities (ABSs) and collateralized debt obligations (CDOs).
T hese financial instruments were complex and relatively new to the market, and the agencies lacked
the necessary experience and expertise to accurately assess their risk levels. ABSs and CDOs were
primarily composed of subprime mortgages, which are loans given to borrowers with poor credit
histories. T he rating agencies, however, rated these securities as highly safe investments, leading
investors to believe that they were low-risk. When the housing market collapsed, the value of these
securities plummeted, causing significant losses for investors. T his underestimation of risk by the
rating agencies was a major factor that contributed to the severity of the financial crisis.
Choi ce A i s i ncorrect because while there were criticisms of the relationships between credit
rating agencies and the institutions they rated, there is no substantial evidence to suggest that there
was collusion to give major financial institutions 'undue' health. T he primary issue was not collusion
but rather a failure to accurately assess and communicate the risks associated with certain financial
instruments, particularly asset-backed securities and collateralized debt obligations.
Choi ce B i s i ncorrect because the issue was not that rating agencies failed to sound the alarm
early enough after detecting the deteriorating financial stability of the economy's major players. In
fact, many rating agencies did not recognize the severity of the risks associated with asset-backed
securities and collateralized debt obligations until it was too late.
Choi ce D i s i ncorrect because rating agencies actually underestimated the risks, which led to high
demand for these securities. When the true risk level of these securities became apparent, their
value plummeted, leading to significant losses for investors.
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Q.143 In the 2008 financial crisis, agency costs were a significant factor that contributed to the
unfolding of events. Which of the following scenarios best represents an instance of agency cost
during the 2008 financial crisis?
A. Prospective homeowners lying about their income and mortgage security.
B. A lack of government regulation of the property market in the period leading to the crisis.
C. Rating agencies were paid for their ratings and would overlook potential financial pitfalls
so as to impress their clients.
D. Failure by Congress and the Senate to crack down on relaxed lending even after a few
leaders brought the matter to the floors of the two houses.
Agency costs are incurred when there is a conflict of interest between two parties, often due to
misaligned incentives. In the context of the 2008 financial crisis, rating agencies were paid by their
clients to rate financial instruments. T hese agencies had a vested interest in providing favorable
ratings to keep their clients happy and secure future business. T his led to a situation where they
overlooked potential financial risks, thereby underestimating the inherent risks in Asset-Backed
Securities (ABSs) and Collateralized Debt Obligations (CDOs). By maximizing the number of AAA-
rated tranches, the agencies misled investors into purchasing overvalued and overrated instruments.
T his is a clear example of agency cost, where the rating agencies pursued their selfish interests at
the expense of the investors.
Choi ce A i s i ncorrect because the homeowners were not acting as agents for another party, and
their actions were driven by personal gain rather than a conflict of interest.
Choi ce B i s i ncorrect because the government's failure to regulate the property market does not
represent a conflict of interest between two parties, but rather a failure of oversight and regulation.
Choi ce D i s i ncorrect. T he actions of Congress and the Senate represent a failure of oversight and
regulation, not a conflict of interest between two parties.
Q.145 A financial institution has recently bundled subprime mortgages into three distinct tranches:
the senior, mezzanine, and equity tranches. In terms of risk and return, how would you characterize
the senior tranche in comparison to the other two tranches?
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A. Lower return than the equity tranche but higher return than the mezzanine tranche.
B. Higher return than the equity tranche but lower return than the mezzanine tranche.
C. Lower risk than both the equity and mezzanine tranches.
D. Lower risk than the mezzanine tranche but higher risk than the equity tranche.
T he senior tranche of an asset-backed security, such as a mortgage-backed security, is designed to
have the lowest risk among all tranches. T his is because the senior tranche has the highest priority
in the payment structure, meaning that it is the first to receive payments from the underlying assets.
T his priority payment structure significantly reduces the risk of loss for the senior tranche, making
it less risky than both the equity and mezzanine tranches. However, this lower risk also means that
the senior tranche typically offers lower returns compared to the other tranches. T his is because in
finance, there is a direct relationship between risk and return - the higher the risk, the higher the
potential return, and vice versa. T herefore, the senior tranche, with its lower risk, also has lower
returns compared to the equity and mezzanine tranches.
Choi ce A i s i ncorrect because it incorrectly states that the senior tranche has a higher return
than the mezzanine tranche. In reality, the senior tranche, due to its lower risk, offers lower returns
than both the mezzanine and equity tranches. T he mezzanine tranche, being riskier than the senior
tranche but less risky than the equity tranche, offers returns that are higher than the senior tranche
but lower than the equity tranche.
Choi ce B i s i ncorrect because it incorrectly states that the senior tranche has a higher return
than the equity tranche. T he equity tranche is the riskiest of the three tranches and therefore
offers the highest potential return. T he senior tranche, on the other hand, is the least risky and
therefore offers the lowest return. T his is in line with the fundamental principle in finance that
higher risk is associated with higher potential return.
Choi ce D i s i ncorrect because it incorrectly states that the senior tranche has a higher risk than
the equity tranche. T he equity tranche is the riskiest of the three tranches, as it is the last to
receive payments from the underlying assets and is therefore the most exposed to potential losses.
T he senior tranche, on the other hand, is the least risky as it is the first to receive payments,
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thereby significantly reducing its exposure to potential losses.
Thi ngs to Remember
In an asset-backed security, the tranches are structured in a way that the senior tranche
has the lowest risk and therefore the lowest return. T his is due to the priority payment
structure, where the senior tranche is the first to receive payments from the underlying
assets.
T he mezzanine tranche is riskier than the senior tranche but less risky than the equity
tranche. T herefore, it offers returns that are higher than the senior tranche but lower
than the equity tranche.
T he equity tranche is the riskiest of the three tranches and therefore offers the highest
potential return. T his is because it is the last to receive payments from the underlying
assets and is therefore the most exposed to potential losses.
T he relationship between risk and return is a fundamental principle in finance. T he higher
the risk, the higher the potential return, and vice versa.
Q.146 In the lending market, different categories of borrowers are identified based on their financial
standing, credit history, and ability to repay loans. One such category is referred to as 'Ninja
borrowers'. Which of the following best describes the characteristics of Ninja borrowers?
A. Borrowers who have not been subjected to vetting or any other attempt aimed at
ascertaining their credentials.
B. Borrowers who have a near-zero credit history.
C. Borrowers with assets insufficient to secure the mortgages awarded.
D. Borrowers with no income, no job, and no assets.
Ninja borrowers are individuals who have no income, no job, and no assets. T he term 'Ninja' is an
acronym derived from the first letters of the words 'No Income, No Job, No Assets'. T hese
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borrowers are considered high-risk because they lack a stable source of income and assets that could
be used as collateral for the loan. During the 2007/2008 financial crisis, the number of Ninja
borrowers increased significantly as lending standards were relaxed. T his allowed individuals who
would typically be barred from borrowing due to their high-risk status to secure loans. However,
these loans were often defaulted on after the first few months of the repayment schedule,
contributing to the financial crisis.
Choi ce A i s i ncorrect. While it's true that Ninja borrowers may not have been subjected to
rigorous vetting, this is not the defining characteristic of such borrowers. T he term 'Ninja' stands
for 'No income, No job, and No assets', which means these borrowers lack a stable source of
income, employment and significant assets.
Choi ce B i s i ncorrect. Having a near-zero credit history does not necessarily qualify one as a
Ninja borrower. Although it's possible for Ninja borrowers to have minimal or no credit history, the
key distinguishing feature of these individuals is their lack of income, job and assets.
Choi ce C i s i ncorrect. Insufficient assets to secure mortgages might be a characteristic of some
Ninja borrowers but it's not what primarily defines them. T he main attributes are no income, no job
and no assets regardless of whether they are seeking mortgages or other types of loans.
Thi ngs to Remember
Ninja borrowers are considered high-risk borrowers due to their lack of income, job, and
assets. T his makes it difficult for them to secure loans from traditional lenders.
T he term 'Ninja' is an acronym that stands for 'No Income, No Job or Assets'. It originated
from the subprime mortgage crisis in the United States.
Loans given to Ninja borrowers are often referred to as 'Ninja Loans'. T hese types of
loans were common during the housing bubble in the early 2000s.
Ninja Loans are typically unsecured because they lack collateral. T his increases the risk
for lenders as there is no asset to seize if a borrower defaults on their loan payments.
Credit risk management involves assessing and managing risks associated with lending
money or extending credit. It includes identifying potential risks, measuring those risks,
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and developing strategies to mitigate them.
Q.147 Capital M bank is involved in a process where it originates mortgages, securitizes them into
asset-backed securities, and then invests in these securities. T his process involves a series of
financial and investment activities. Which of the following terms term best describes this scenario in
the context of financial markets and banking operations?
A. Regulatory arbitrage
B. Securitization
C. Irrational exuberance
D. Agency costs
Regulatory arbitrage is a practice where firms capitalize on loopholes in regulatory systems in order
to circumvent unfavorable regulations. T his is often done by structuring transactions in a way that
presents lower regulatory capital requirements. In the context of the question, Capital M bank is
involved in regulatory arbitrage. T he bank originates mortgages and then securitizes these mortgages
to create asset-backed securities. It then invests in these securities. T he motivation behind such a
strategy is largely accounting-driven. By doing so, the bank can potentially achieve specific
accounting advantages, although the specifics of these advantages are beyond the scope of this
discussion. Regulatory arbitrage can be risky as it can lead to a lack of transparency and increased
systemic risk.
Choi ce B i s i ncorrect. T he bank is not just securitizing the mortgages, but also investing in the
securities it creates. T herefore, the term 'securitization' does not fully capture the scenario
described in the question.
Choi ce C i s i ncorrect. In the context of the question, there is no indication that the bank's actions
are driven by irrational exuberance.
Choi ce D i s i ncorrect. T here is no evidence to suggest that the bank's strategy of originating,
securitizing, and investing in mortgages is resulting in agency costs.
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Thi ngs to Remember
Securi ti zati on is a financial process that involves pooling various types of contractual
debt and selling their related cash flows to third-party investors as securities. It allows
banks to remove assets from their balance sheets and obtain fresh capital.
Irrati onal exuberance refers to a situation where the optimism of investors about the
market or an asset exceeds its fundamental value. It is often associated with asset price
bubbles.
Agency costs arise from the conflict of interest between stakeholders in an organization,
such as between shareholders and management. T hese costs can result from actions taken
by agents that may not align with the best interests of the principals.
Q.150 One of the factors associated with the Credit Crisis of 2007 is the relaxed lending standards of
lenders. Lenders began to attract new entrants in the housing market by offering adjustable-rate
mortgages (ARMs) and teaser rates. Teaser rates are defined as:
A. T he mortgage rates that are mentioned on the mortgage's promotional material.
B. T he very low rates that are offered for the first few years before the rates increased
significantly in later years.
C. T he fixed mortgage rate that is calculated as LIBOR plus specific basis points.
D. T he fixed rate at which a defaulting borrower can restructure the mortgage.
A teaser rate is a promotional interest rate offered by mortgage lenders for a specified initial period,
typically the first few years of the mortgage term. T his rate is significantly lower than the standard
mortgage rate, making the mortgage appear more attractive to potential borrowers. T he purpose of a
teaser rate is to entice borrowers into a mortgage by offering a low initial rate, which then increases
significantly after the initial period. T his practice was prevalent in the years leading up to the Credit
Crisis of 2007. Lenders offered these low initial rates to attract new entrants into the housing
market. However, when these rates increased after the initial period, many borrowers were unable
to meet their mortgage obligations, leading to a surge in defaults and contributing to the Credit Crisis.
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Choi ce A i s i ncorrect. While promotional materials may mention the teaser rates, this definition is
not comprehensive enough. Teaser rates are specifically low introductory rates that increase
significantly after a certain period, which is not captured in this choice.
Choi ce C i s i ncorrect. T his choice describes a type of adjustable-rate mortgage where the
interest rate is tied to a benchmark rate (like LIBOR) plus some fixed points. However, it does not
accurately define 'teaser rates' which are initially low and then increase significantly after an
introductory period.
Choi ce D i s i ncorrect. T his option refers to the restructuring of mortgages for defaulting
borrowers, which has no relation to 'teaser rates'. Teaser rates are used as an initial offering to
attract new borrowers and do not pertain to default or restructuring scenarios.
Thi ngs to Remember
'Teaser rates' are typically offered by lenders to attract new borrowers. T hese rates are
usually lower than the standard interest rate and last for a limited period, often the first
few years of the mortgage.
After the teaser rate period ends, the interest rate on an adjustable-rate mortgage (ARM)
will adjust periodically based on market conditions. T his could lead to significantly higher
payments for the borrower.
T he Credit Crisis of 2007 was largely triggered by such lending practices where borrowers
were initially attracted by low teaser rates but were unable to meet their payment
obligations when rates increased.
Understanding how different types of mortgages work, including ARMs and those with
teaser rates, is crucial in risk management. It helps in assessing potential risks associated
with these lending products.
T he London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major
global banks lend to one another in the international interbank market for short-term loans.
It's not directly related to 'teaser rates', but it's often used as a reference point for
adjustable-rate mortgages.
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Q.151 In mortgage lending in certain states within the United States, there exists a feature that
permits the lender to only seize the borrower's home, which is financed through a mortgage, in the
event of a default, but not any of the borrower's other assets. Which of the following options best
describes this feature?
A. Teaser rate
B. NINJA borrowing
C. Nonrecourse mortgage
D. Securitization
In several states of the United States, a nonrecourse mortgage is a type of loan where the lender can
only seize the borrower's home, which is financed through the mortgage, in the event of a default.
T he lender cannot go after the borrower's other assets. T his essentially provides the borrower with
an American-style put option on their home. If the housing prices fall, the borrower can sell their
home to the lender for the principal outstanding on the mortgage. T his feature of nonrecourse
mortgages provides a level of protection for borrowers, as it limits the lender's recourse to the
collateralized property only.
Choi ce A i s i ncorrect. A Teaser Rate is an initial low interest rate on a loan or mortgage that's
temporarily lower than the eventual standard rate. It does not relate to the seizure of assets in case
of default.
Choi ce B i s i ncorrect. NINJA borrowing refers to a type of lending where the borrower does not
need to provide proof of income, job, or assets (No Income, No Job or Assets). T his term doesn't
describe the feature where only the borrower's home can be seized in case of default.
Choi ce D i s i ncorrect. Securitization involves pooling various types of contractual debt such as
residential mortgages and selling their related cash flows to third-party investors as securities. It
doesn't refer specifically to any feature that allows lenders to seize only certain assets in case of
default.
Thi ngs to Remember
A Teaser Rate is an initial interest rate charged on a mortgage that is artificially low. It
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increases after a certain period, usually 2-3 years.
NINJA borrowi ng stands for No Income, No Job or Assets. It's a type of risky lending
practice where the borrower does not have to disclose income, job status, or assets to get
the loan.
A Nonrecourse mortgage is a type of home loan where the lender can only seize the
property in case of default and cannot go after other assets owned by the borrower. T his
feature protects borrowers from losing more than their homes in case they default on
their loans.
Securi ti zati on is a financial process that involves pooling various types of contractual
debt such as residential mortgages, commercial mortgages, auto loans, or credit card debt
obligations and selling them as bonds, pass-through securities, or Collateralized Mortgage
Obligation (CMO), to various investors.
Some states like California and Arizona are known as non-recourse states because lenders
can only seize properties tied to the mortgage but not any other assets in case of default by
borrowers.
T he opposite of a nonrecourse mortgage is a recourse mortgage where lenders can go
after other assets owned by borrowers if sale proceeds from seized property do not cover
the outstanding loan balance.
Q.152 In a recent seminar for graduate trainees at a leading Chinese investment bank, the facilitator
initiated a discussion on the concept of 'Securitization.' Several trainees offered their interpretations
of the term. Which of the following explanations provided by the trainees aligns most accurately
with the concept of securitization?
A. T rainee A: T he process of securing a mortgage with a security or collateral which the

lender can use in the case of default.
B. T rainee B: T he financial asset created from the cash flows of financial assets, including
mortgages, loans, auto loans, and bonds.
C. T rainee C: T he process of pooling mortgage loans into a pool, dividing the pool into smaller
units, and selling them as financial assets to investors in order to transfer risk.
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D. T rainee D: T he process of setting up a bankruptcy-remote entity with the sole purpose of
acquiring asset-backed securities (ABSs).
Securitization is the process of pooling various mortgage loans into a larger pool, dividing this pool
into smaller units, and then selling these units as financial assets to investors. T his process is
primarily carried out by large banks and financial institutions with the primary objective of
transferring the risk associated with these loans to the market. By doing so, these institutions are
able to mitigate the potential losses that could arise from defaults on these loans. Furthermore, the
process of securitization allows these institutions to free up capital that can be used for issuing more
loans, thereby facilitating a continuous cycle of lending and securitization.
Choi ce A i s i ncorrect. Securitization is not merely the process of securing a mortgage with a
security or collateral which the lender can use in case of default. T his explanation confuses
securitization with the concept of collateralized loans, where an asset (like a house in case of a
mortgage) serves as security for repayment.
Choi ce B i s i ncorrect. While it's true that securitized financial assets are created from cash flows
of underlying assets such as mortgages, loans, auto loans and bonds, this explanation misses out on
key aspects like pooling these assets and selling them to investors to transfer risk.
Choi ce D i s i ncorrect. T he creation of bankruptcy-remote entities (Special Purpose Vehicles or
SPVs) is indeed part of the securitization process but this explanation omits other crucial steps such
as pooling various types of contractual debt and selling their related cash flows to third party
investors.
Thi ngs to Remember
Securitization is a financial process that involves pooling various types of contractual debt
such as residential mortgages, commercial mortgages, auto loans or credit card debt
obligations and selling their related cash flows to third party investors as securities.
T he entity that issues the securitized assets is known as the issuer. T he issuer creates a
Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) for each securitization
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deal.
T he SPV which holds these assets serves as collateral in case of default. T his process
ensures that the investors have a claim on all future cash flows generated by the pooled
assets.
Securitization helps in risk transfer from an originator to multiple investors. It also
provides liquidity to markets and reduces risk through diversification.
Asset-Backed Securities (ABS), Mortgage-Backed Securities (MBS), Collateralized Debt
Obligations (CDOs) are some examples of instruments created through securitization.
Q.153 In Asset-Backed Securities (ABSs), the originator of the mortgage creates these securities
from the cash flow of its mortgages and loans. T hese ABSs are then sold to Special Purpose Vehicles
(SPVs) that distribute the cash flows of the ABS to different tranches. Generally, each security is
divided into three tranches: the senior tranche, the mezzanine tranche, and the equity tranche.
Considering the risk and return characteristics of these tranches, which tranche is expected to yield
the highest returns and which tranche is likely to be assigned the highest rating?
A. Senior tranches should receive the highest expected returns and highest ratings.
B. Equity tranches should receive the highest ratings, and senior tranches should have the
highest expected returns.
C. Senior tranches should receive the highest ratings, and equity tranches should have the
highest expected returns.
D. Equity tranches should receive the highest ratings, and mezzanine tranches should have
the highest expected returns.
In the structure of Asset-Backed Securities (ABSs), the senior tranche is typically assigned the
highest rating, while the equity tranche is expected to yield the highest returns. T his is due to the
risk-return trade-off inherent in these securities. T he senior tranche is considered the least risky
among the three tranches. It is the first to receive cash flows from the underlying assets and is
therefore less exposed to default risk. As a result, it is typically assigned the highest credit rating,
often AAA. On the other hand, the equity tranche is the most risky. It is the last to receive cash
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flows and bears the first losses if the underlying assets default. T herefore, it is often unrated.
However, to compensate for this higher risk, the equity tranche offers the highest expected
returns. T his structure allows investors to choose the tranche that best suits their risk tolerance
and return expectations.
Choi ce A i s i ncorrect. While it is true that senior tranches are assigned the highest ratings due to
their lower risk, they do not yield the highest returns. T he higher returns are typically associated
with higher risk, which in this case would be the equity tranches.
Choi ce B i s i ncorrect. Equity tranches do not receive the highest ratings; instead, they have the
highest expected returns due to their higher risk profile. Senior tranches, on the other hand, receive
high ratings because of their lower risk but do not offer high expected returns.
Choi ce D i s i ncorrect. Equity tranches cannot receive both the highest ratings and provide high
expected returns as there's a trade-off between risk and return in financial securities. Mezzanine
tranches also don't yield the highest return; instead, they fall between senior and equity tranche in
terms of both risks and return.
Thi ngs to Remember
T he senior tranche is the most secure part of an ABS, and it is typically assigned the
highest credit rating. T his tranche has the first claim on the cash flows from the underlying
assets.
T he mezzanine tranche carries a higher risk than the senior tranche but lower than equity
tranches. It offers higher yields to compensate for this increased risk.
T he equity or junior tranche carries the highest risk as it absorbs initial losses before any
other tranches. T herefore, it offers potentially high returns to compensate for this high
level of risk. It's usually unrated
Special Purpose Vehicles (SPVs) are legal entities created solely for holding these
securities and distributing cash flows to investors in different tranches. T hey play a crucial
role in securitization transactions by isolating financial risks.
Asset-Backed Securities (ABSs) are financial securities backed by a loan, lease, or
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receivables against assets other than real estate and mortgage-backed securities. T hey can
be based on various types of loans like auto loans, credit card debt, etc.
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Q.288 A novice risk analyst is tasked with summarizing the key events that precipitated the financial
crisis of 2007 – 2009. As part of their task, they delve into the role of subprime mortgages as a factor
influencing the crisis. Which of the following statements correctly characterizes the impact or role
of these mortgages in the period leading up to the financial crisis?
A. Rigid documentation requirements for prospective borrowers led to a liquidity crisis in

real estate due to a shortage of eligible borrowers.
B. T he loan-to-value ratios for new subprime borrowers consistently declined in the years
prior to the crisis.
C. T he majority of mortgage brokers received their compensation based on the performance

of the subprime mortgages they originated, and had to refund large commissions as these
loans started to default.
D. Many subprime mortgages experienced a sharp increase in interest rates after an initial
period of low rates, causing some borrowers to fall into default.
In the years leading up to the financial crisis, subprime mortgages often utilized adjustable-rate
mortgage (ARM) structures. T hese mortgages typically offered borrowers a low introductory
interest rate for a limited period, known as the teaser rate. However, once this initial period ended,
the interest rates on these mortgages would reset to significantly higher levels. As a result, many
borrowers who initially qualified for the mortgage based on the lower teaser rate found themselves
unable to afford the higher payments when the rates reset. T his led to a rise in defaults among
subprime borrowers, contributing to the overall crisis.
A i s i ncorrect. Strict documentation requirements were not a leading cause of the financial crisis.
In fact, the opposite was true, as there were instances of lax documentation requirements that
allowed unqualified borrowers to obtain subprime mortgages.
B i s i ncorrect. In the years preceding the crisis, loan-to-value ratios for subprime borrowers
actually tended to increase, meaning borrowers were taking on larger loans relative to the value of
their homes. T his increased their risk of default when home prices began to decline.
C i s i ncorrect. While mortgage brokers did receive commissions for originating subprime
mortgages, their compensation structure was typically not directly tied to the performance of the
loans. Instead, brokers often earned commissions upfront without being held financially accountable
for loan defaults. T his misalignment of incentives contributed to the proliferation of risky subprime
lending.
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Q.291 In the period leading up to the 2007/2008 financial crisis, lenders had to devise strategies to
align their interests with those of investors in asset-backed securities. T his was crucial to ensure
the sustainability of the financial markets and to prevent the occurrence of a crisis. One of the
strategies involved the lenders maintaining exposure to the performance of the loan pool. Which of
the following options best describes how lenders maintained their exposure?
A. Retaining a portion of the risk by holding onto the first-loss tranche of the securitized
assets.
B. Engaging in recourse lending, where they agreed to buy back non-performing loans.
C. Implementing interest rate swaps to maintain an indirect exposure to the underlying

assets.
D. Employing a "vertical slice" approach, where they maintained ownership of a proportional

share across all tranches, thus bearing a portion of any potential losses.
In the lead-up to the 2007/2008 financial crisis, one strategy lenders used to maintain exposure to the
performance of the loan pool was by retaining the "first-loss" or equity tranche of the securitized
assets. T his was the most junior tranche in a securitization, and was the first to absorb losses from
defaults on the underlying loans. By holding onto this tranche, lenders kept "skin in the game" and
aligned their interests with those of other investors. T his was meant to incentivize responsible
lending since lenders would be directly impacted by the performance of the loans.
B i s i ncorrect. While it's true that some loan agreements might have included a provision allowing
for the buyback of non-performing loans, this isn't typically how lenders maintained exposure to the
loan pool in the context of asset-backed securities. In fact, having to buy back non-performing loans
might represent a failure of the securitization process, which is intended to transfer risk away from
the lender.
C i s i ncorrect. Interest rate swaps are a type of financial derivative used to hedge interest rate
risk, not to maintain exposure to the performance of a loan pool. While interest rate swaps might be
used in the broader context of managing a securitized portfolio, they wouldn't directly align the
interests of lenders and investors in the way the question implies.
D i s i ncorrect. While a "vertical slice" approach could indeed represent a way for lenders to
maintain exposure to the performance of a securitized loan pool, this approach wasn't the primary
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method used leading up to the 2007/2008 financial crisis. In a "vertical slice" approach, the lender
maintains an interest in each tranche of the securitized assets, from most senior to most junior,
hence bearing some of the risk if the loans default. However, the most common practice was to
retain the first-loss or equity tranche, which is considered the riskiest part of the securitization and
the first to absorb any losses.
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Q.293 Which of the following best describes the concept of misaligned incentives in the outcome of
the 2007/2008 financial crisis?
A. Mortgage originators concentrated on high-quality loans, while investment banks were

interested in creating low-risk asset-backed securities.
B. Credit rating agencies, despite being paid by issuers, consistently provided conservative
and accurate ratings for asset-backed securities.
C. Mortgage originators prioritized issuing a high volume of loans, while credit rating agencies
were incentivized to provide optimistic ratings for these loans to retain business from the
issuers.
D. Investors were solely reliant on their own comprehensive risk analysis, dismissing ratings
provided by credit rating agencies.
Mortgage originators were incentivized to issue as many loans as possible, often overlooking
creditworthiness. Credit rating agencies, paid by the issuers of securities (the banks), had an
incentive to rate securities more optimistically to retain their business.
A i s i ncorrect as it presents a more ideal scenario rather than the actual situation. Leading up to
the crisis, mortgage originators often overlooked loan quality in favor of volume, and investment
banks created asset-backed securities from these loans, which were often risky.
D i s i ncorrect because it suggests an ideal role for credit rating agencies that was not evident in
the period leading to the crisis. In reality, there was a conflict of interest because credit rating
agencies were paid by the issuers of the securities they were rating, leading to over-optimistic
ratings.
B i s i ncorrect because, during the period leading to the crisis, many investors were heavily reliant
on ratings provided by credit rating agencies and often did not perform extensive independent risk
assessments of the securities they were buying. T he complexity of these products also made such
assessments difficult for many investors.
Q.294 In the midst of the housing boom in 2005, Ann, who had a less than stellar credit rating, sought
to ride the wave and purchase her own home. Despite her credit rating suggesting a higher-than-
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average probability of defaulting on loan repayments, the local bank decided to approve her mortgage
application. T his was a common practice during this period, and it ultimately contributed significantly
to the 2008/2009 financial crisis. Which of the following terms most accurately describes this type
of lending practice?
A. Unsecured mortgage lending
B. T ransactional lending.
C. Premium mortgage lending.
D. Subprime mortgage lending.
Subprime mortgage lending refers to the practice of lending to borrowers who are considered a
higher credit risk, often due to a lower credit rating, as in Ann's case. During the housing boom in the
years leading up to the 2008/2009 financial crisis, there was a significant increase in subprime
lending, which eventually contributed to the severity of the crisis.
Opti on A i s i ncorrect. "Unsecured mortgage lending" is not a recognized term in the context of
mortgage lending. Mortgages are by definition, secured loans, with the purchased property serving as
collateral.
Opti on B i s i ncorrect. "T ransactional lending" refers more broadly to any lending activity where a
lender provides a loan to a borrower for a specific purpose. It doesn't specifically refer to the risk
associated with the borrower.
Opti on C i s i ncorrect. "Premium mortgage lending" suggests that the loans are offered to high-
quality or 'prime' borrowers, which is the opposite of Ann's situation.
Thi ngs to Remember
Subprime mortgage lending refers to the practice of offering loans to borrowers who have
low credit scores and a high risk of defaulting on their payments.
T hese loans often come with higher interest rates than prime loans to compensate for the
increased risk of default. Subprime loans frequently feature adjustable-rate mortgages
(ARMs), where the initial interest rate is typically low, but it can increase significantly
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after a certain period.
T he subprime lending market played a major role in the 2008 financial crisis. An abundance
of these risky loans, bundled into securities and sold off to investors, led to widespread
defaults.
Subprime borrowers may also face additional loan terms that can be financially burdensome,
such as high loan origination fees or prepayment penalties.
Q.413 Which of the following statements best explains how banks created collateralized debt
obligations in the build-up to the 2007-2008 financial meltdown?
A. Forming a diversified portfolio of cash-flow generating assets, pooling them together, and
then repackaging the asset pool into discrete tranches that could be sold to investors.
B. Pooling together cash-generating assets, and then repackaging the asset pool into discrete
slices that could be sold to investors.
C. Forming a diversified portfolio of mortgage products, pooling them together, and then
repackaging the asset pool into discrete tranches that could be sold to investors.
D. Pooling together a well-diversified portfolio of mortgages, and then slicing the pool into
three tranches that could be sold to investors.
T he process of creating collateralized debt obligations (CDOs) involved forming a diversified
portfolio of cash-flow generating assets. T hese assets could include a variety of financial instruments
such as mortgages, corporate bonds, and different types of loans. T he next step in the process was
to pool these assets together. T his pooling created a large asset pool that could then be divided or
'tranched' into discrete sections. Each tranche represented a different level of risk and return,
allowing investors to choose the tranche that best matched their risk tolerance and investment
objectives. T he tranches were then sold to investors, effectively moving the risk of the underlying
assets off the bank's balance sheet and onto the investors who purchased the tranches. T his process
played a significant role in the build-up to the 2007-2008 financial crisis as the underlying quality of
the assets in the CDOs was often poorly understood or misrepresented.
Choi ce B i s i ncorrect. While this choice does mention the pooling and repackaging of cash-
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generating assets, it fails to mention the crucial step of forming a diversified portfolio. T his
diversification is key in spreading risk and making the CDOs more attractive to investors.
Choi ce C i s i ncorrect. T his choice incorrectly specifies that only mortgage products were used in
the creation of CDOs. In reality, a variety of cash-flow generating assets were used, not just
mortgages.
Choi ce D i s i ncorrect. Similar to Choice C, this option incorrectly implies that only mortgages
were used in creating these financial instruments. Additionally, it inaccurately suggests that there are
always three tranches created from the asset pool which isn't necessarily true as the number can
vary based on several factors.
Thi ngs to Remember
T he process of creating CDOs involves pooling together cash-flow generating assets,
which are then divided into different tranches based on their risk and return profiles.
T hese tranches are then sold to investors.
T ranching is a method used in finance to create different investment classes for the
securities of a company, based on the riskiness of their cash flows. T he senior tranche has
the least risk because it has first claim on the cash flows from the underlying assets.
CDOs can be composed of various types of debt including mortgages (residential or
commercial), corporate bonds, auto loans or credit card debt obligations.
T he diversification in CDOs comes from having a wide variety of underlying assets.
However, during the financial crisis, many CDOs were heavily concentrated in high-risk
mortgage products which led to significant losses when housing prices fell.
Investors need to understand that higher yielding tranches also come with higher risks.
During economic downturns these tranches can suffer severe losses.
Q.414 In 2005, a certain American investment firm decided to invest in an assortment of

collateralized debt obligations (CDOs). To protect itself, the firm also purchased a credit default
swap. T his implied that:
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A. T he firm would pay a periodic fixed fee and in turn receive a contingent payment in the
event of credit default.
B. T he firm was 100% protected against credit default, and therefore cash inflows from the
CDOs were guaranteed.
C. T he firm would pay a fixed fee at the onset of the contract and in turn receive a
contingent payment in the event of credit default.
D. T he firm would pay a periodic fixed fee and, in turn, receive a contingent payment at the
end of the CDO contract.
T he firm would pay a periodic fixed fee and in turn receive a contingent payment in the event of
credit default. T his is the fundamental principle of a credit default swap (CDS). A CDS is a financial
derivative that allows an investor to 'swap' their credit risk with that of another investor. In this
case, the investment firm is paying a fixed fee to another party (usually a bank or another financial
institution), who agrees to compensate them if a certain credit event, such as a default, occurs. T his
is akin to an insurance policy, where the firm pays a premium to protect itself against a potential
financial loss. T he periodic fixed fee is the 'premium' that the firm pays for this protection, and the
contingent payment is the 'claim' that the firm would receive if the credit event occurs. T his
strategy allows the firm to mitigate the credit risk associated with its investment in CDOs.
Choi ce B i s i ncorrect. While the firm did use a credit default swap as a risk mitigation strategy, it
does not imply that the firm was 100% protected against credit default. Credit default swaps can help
manage and mitigate risk, but they do not provide absolute protection against defaults. Furthermore,
cash inflows from CDOs are never guaranteed as they depend on the underlying assets' performance.
Choi ce C i s i ncorrect. In a typical credit default swap contract, the buyer does not pay a fixed fee
at the onset of the contract. Instead, they pay periodic premiums over the life of the contract in
return for a contingent payment in case of a credit event such as default.
Choi ce D i s i ncorrect. T he statement is misleading because it suggests that contingent payments
are only received at the end of CDO contracts which isn't accurate. In reality, contingent payments
under credit default swaps are triggered by specific credit events like defaults or downgrades and
aren't necessarily tied to when CDO contracts end.
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Thi ngs to Remember
A Credit Default Swap (CDS) is a financial derivative that allows an investor to 'swap' their
credit risk with that of another investor. It is essentially a form of insurance against the
default risk of a bond or loan.
In a CDS, the buyer makes periodic payments to the seller and in return receives a payoff
if an underlying financial instrument defaults.
Collateralized Debt Obligations (CDOs) are complex financial instruments that pool
together cash flow-generating assets and repackages this asset pool into discrete tranches,
which can then be sold to investors. T he risk level associated with CDOs varies greatly.
T he use of both CDOs and CDS indicates that the firm was attempting to diversify its
portfolio while also hedging against potential credit risks. T his shows an active approach
towards risk management.
However, it's important to note that while these strategies can mitigate some risks, they
do not provide 100% protection against credit default. T he effectiveness of these
strategies depends on various factors such as market conditions and the specific terms of
the contracts involved.
Q.415 During the period preceding the financial crisis of 2007-2008, banks experienced an increase
in the maturity mismatch on their balance sheets. T his situation, where the maturity of a bank's
assets does not align with that of its liabilities, led to a significant problem:
A. Exposure to massive cash withdrawals at short notice.
B. Exposure to credit default risk.
C. Exposure to funding liquidity risk.
D. Unprecedented legal confrontations with regulatory authorities.
A maturity mismatch is a situation where the maturity of a bank's assets does not align with that of
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its liabilities. T his imbalance can be either positive or negative. In the period leading up to the 2007-
2008 financial crisis, banks experienced an increase in maturity mismatches due to the use of off-
balance-sheet vehicles. T hese vehicles involved investing in long-term assets while borrowing with
short-term paper. T his strategy exposed banks to funding liquidity risk. Funding liquidity risk is the
risk that a firm will not be able to meet efficiently both expected and unexpected current and future
cash flow and collateral needs without affecting either daily operations or the financial condition of
the firm. In other words, it is the risk that a firm may not be able to settle its debts as they come
due. T his was the main problem that arose due to an increase in the maturity mismatch on the
balance sheet of banks during the period leading up to the financial meltdown.
Choi ce A i s i ncorrect. While massive cash withdrawals at short notice can indeed pose a problem
for banks, it was not the primary issue that emerged as a result of the increased maturity mismatch
in the banking sector during the period preceding the financial crisis of 2007-2008. T he main problem
was related to funding liquidity risk, which refers to a bank's ability to meet its liabilities as they
come due.
Choi ce B i s i ncorrect. Credit default risk refers to the risk that borrowers will default on their
loan repayments. Although this can be an issue for banks, it was not directly linked with the
increased maturity mismatch experienced by banks during this period.
Choi ce D i s i ncorrect. Legal confrontations with regulatory authorities were not primarily caused
by maturity mismatches on bank balance sheets. T hese confrontations are more likely to arise from
non-compliance with regulatory standards and requirements rather than from issues related to asset-
liability management.
Thi ngs to Remember
Maturity mismatch refers to the situation where a bank's assets (loans) have a longer
maturity than its liabilities (deposits). T his can lead to liquidity problems if depositors
demand their money back before the loans are repaid.
Funding liquidity risk is the risk that a firm will not be able to meet efficiently both
expected and unexpected current and future cash flow and collateral needs without
affecting either daily operations or the financial condition of the firm.
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Credit default risk, also known as counterparty credit risk, is the possibility that one party
in a financial transaction will fail to fulfill their obligation, causing financial loss for the
other party. T his is different from funding liquidity risk which arises due to maturity
mismatch.
Massive cash withdrawals at short notice can exacerbate funding liquidity risks caused by
maturity mismatches. However, this is more related to run-on-the-bank scenarios rather
than being directly linked with maturity mismatches.
Legal confrontations with regulatory authorities are usually consequences of non-
compliance with banking regulations rather than direct outcomes of increased maturity
mismatch in banks' balance sheets.
Q.416 Which of the following statements best explains why securitized products were especially
popular among money market and pension funds?
A. T hey allowed such institutions to hold assets that they were previously prevented from
holding by regulatory requirements.
B. T hey were more profitable compared to corporate bonds.
C. Securitization enabled the funds to hold assets without disclosing such information in the
balance sheet.
D. Securitized products were considered less risky compared to traditional cash-generating

assets such as corporate bonds.
Securitization was particularly popular among money market and pension funds because it enabled
them to invest in financial vehicles that they would normally not hold due to regulatory constraints.
For example, they might have been allowed to invest only in AAA-rated fixed-income securities.
T hrough securitization, they could now invest in the AAA-rated senior tranche of a portfolio
consisting of BBB-rated securities. T his allowed these institutions to diversify their portfolios and
potentially achieve higher returns without violating regulatory requirements.
Choi ce B i s i ncorrect. While securitized products can sometimes offer higher yields than
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corporate bonds, this is not always the case. It can depend on a wide range of factors including the
credit quality of the underlying assets, the structure of the securitized product, the interest rate
environment, and market conditions. T herefore, stating that they are more profitable as a rule is not
accurate.
Choi ce C i s i ncorrect. Securitization does not allow funds to hold assets without disclosing such
information in their balance sheet. In fact, regulatory requirements mandate that all financial
institutions disclose their holdings in a transparent manner. T herefore, this cannot be the primary
reason for these institutions' preference for securitized products.
Choi ce D i s i ncorrect. Although securitized products can be structured to reduce risk through
diversification and tranching, they are not inherently less risky than traditional cash-generating assets
like corporate bonds. T he perceived riskiness of an asset depends on various factors such as credit
quality and market volatility which may vary across different types of securities.
Thi ngs to Remember
Securitization is the process of transforming illiquid assets into securities. T his process
allows financial institutions to remove risky assets from their balance sheets.
Securitized products are often favored by money market and pension funds due to their
ability to diversify risk and generate steady cash flows.
T he primary reason for these institutions' preference for securitized products is not
necessarily profitability, but rather the ability to hold a diversified portfolio of assets that
can generate stable returns over time.
Regulatory requirements may prevent certain institutions from holding specific types of
assets. However, through securitization, these restrictions can be circumvented as the
underlying asset is transformed into a security that can be held by the institution.
While securitized products may appear less risky compared to traditional cash-generating
assets such as corporate bonds, it's important to note that they also carry risks such as
credit risk and liquidity risk. T herefore, understanding these risks is crucial when investing
in securitized products.
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Q.417 During the period leading up to the 2007-2008 financial crisis, credit rating agencies were
frequently observed to provide overly positive ratings and forecasts for structured financial assets.
T his practice was seen as problematic and indicative of a certain agency problem. What was the
specific agency problem that was at play in this scenario?
A. Structured financial assets initially had very low demand, and credit rating agencies wanted
to push that demand up.
B. Credit rating agencies were under considerable pressure from the federal government to
issue favorable ratings that would stir the economy and lead to growth.
C. Credit rating agencies depended heavily on sophisticated mathematical models, which failed
to accurately predict the risk of these structured financial assets.
D. Credit rating agencies would get paid by originators of structured financial assets for their
work, and also made more money than they would otherwise have made from rating
corporate bonds.
T he agency problem in question is one where the interests of the principal (the originator of the
structured financial assets) and the agent (the credit rating agency) are not aligned. In an ideal
scenario, a credit rating agency should provide an unbiased and accurate assessment of the financial
assets. However, in this case, the agencies were being paid by the originators for their services.
T his created a conflict of interest, as the agencies had a financial incentive to issue favorable ratings
to increase their chances of being rehired by the originators. T his is a classic example of an agency
problem, where the agent acts in their own best interest at the expense of the principal. T he fact
that the agencies were making more money from rating structured financial assets than they would
have from rating corporate bonds further exacerbated this problem.
Choi ce A i s i ncorrect. While it's true that credit rating agencies may have an interest in
promoting certain financial assets, this does not directly constitute an agency problem. An agency
problem arises when there is a conflict of interest between the agent (in this case, the credit rating
agency) and the principal (the investors relying on the ratings). T he demand for structured financial
assets does not inherently create such a conflict.
Choi ce B i s i ncorrect. T his statement suggests that government pressure was a primary factor
influencing credit rating agencies' overly positive ratings. However, while government policies can
influence market conditions and indirectly affect ratings, they do not represent an inherent agency
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problem within the structure of credit rating agencies themselves.
Choi ce C i s i ncorrect. Although mathematical modeling could potentially lead to flawed ratings,
this would not qualify as an agency problem. In addition, there's little evidence to suggest that credit
rating agencies were deploying flawed models. T hey could asess the proper rating correctly but
chose to go with exaggerated ratings in an attempt to appease issuers and continue making money.
Thi ngs to Remember
Credit rating agencies play a crucial role in the financial markets by providing an
independent evaluation and assessment of the creditworthiness of companies and their
financial instruments.
T he agency problem arises when there is a conflict of interest between the needs or
interests of the principal (investors) and agent (credit rating agencies). In this case, it
refers to credit rating agencies potentially giving overly positive ratings due to their own
vested interests.
Structured financial assets are complex instruments that derive their value from
underlying assets. T hey were at the heart of the 2007-2008 financial crisis. Understanding
these assets requires a deep understanding of both the underlying asset and how changes in
market conditions might affect them.
It's important to understand that credit ratings are just one tool investors can use when
assessing whether to invest in a particular security. Investors should also conduct their
own due diligence and not rely solely on these ratings.
Q.418 While the financial meltdown of 2007-2008 started in the US, it spread fast to other countries
leading to worldwide economic turmoil. Which of the following statements best describes why the
crisis spread so fast?
A. Banks in the US had been the main financiers of a multitude of smaller foreign banks, and
therefore when the financiers suffered liquidity problems, the smaller banks just couldn’t
obtain funding.
B. Global investors had overestimated the stability of emerging markets, which led to
widespread panic and sell-offs when the U.S. financial crisis began.
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C. T he US entered into a recession, and their demand for exports fell, and therefore many
countries experienced a major decline in exports, triggering a worldwide recession.
D. Foreign banks in Asia, Europe and other parts of the world had bought collateralized US
debt and therefore when defaults rose, these banks lost a lot of money and consequently
global lending, even among banks themselves, took a downward spiral.
T he global financial crisis of 2007-2008 was primarily caused by the collapse of the subprime
mortgage market in the United States. T his collapse led to a significant increase in defaults on
mortgage loans, which had a direct impact on the value of collateralized debt obligations (CDOs) held
by banks around the world. T hese CDOs were essentially bundles of mortgage loans that had been
sold to investors, including many foreign banks. When the defaults on the underlying mortgage loans
increased, the value of these CDOs plummeted, leading to significant losses for the banks that held
them. T his, in turn, led to a decrease in global lending, as banks became more cautious in the face of
these losses. T his decrease in lending had a significant impact on global economic activity, leading to a
worldwide recession. T his explanation is supported by the fact that the crisis spread rapidly to other
parts of the world, including Asia and Europe, where many banks had purchased these collateralized
US debt.
Choi ce A i s i ncorrect. While it's true that many US banks were significant financiers of smaller
foreign banks, this was not the primary reason for the swift global spread of the financial crisis. T he
crisis was not primarily a liquidity problem but rather a solvency issue related to defaults on
collateralized debt.
Choi ce B i s i ncorrect. T he global spread of the crisis was not primarily due to overestimation of
the stability of emerging markets. While investor sentiment and behavior can contribute to financial
instability, the main driver of the global financial crisis was widespread exposure to the U.S. housing
market through complex financial instruments like mortgage-backed securities and collateralized debt
obligations.
Choi ce C i s i ncorrect. T he decline in US demand for exports did contribute to economic
downturns in many countries, but it was not the primary cause of the rapid global spread of the
financial crisis. T he main driver was more directly related to financial market linkages and exposure
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to toxic assets.
Thi ngs to Remember
T he global financial crisis of 2007-2008 was primarily caused by the bursting of the United
States housing bubble, which led to high default rates on "subprime" and adjustable rate
mortgages (ARM).
Securitization is a process in which certain types of assets are pooled so that they can be
repackaged into interest-bearing securities. T he risk associated with these assets is then
divided among many investors.
Liquidity problems occur when a firm or individual does not have enough liquid assets (cash
or assets that can be quickly converted into cash) to meet their short-term obligations.
A recession is a significant decline in economic activity spread across the economy, lasting
more than a few months. It is visible in real GDP, real income, employment, industrial
production and wholesale-retail sales.
Collateralized debt obligations (CDOs) are financial tools that banks use to repackage
individual loans into a product sold to investors on the secondary market. T hese packages
consist of auto loans, credit card debt, mortgages or corporate debt.
Q.419 In finance, liquidity is a critical concept that pertains to the ease with which an asset can be
converted into cash without affecting its market price. T wo key types of liquidity that are often
discussed in this context are funding liquidity and market liquidity. T hese terms, while related, refer
to different aspects of financial liquidity:
A. Funding liquidity describes the ease with which expert investors can obtain funding from
financiers by using purchased assets as collateral, whereas market liquidity describes the
ease with which investors can raise money by selling their assets.
B. Funding liquidity refers to the total value of an investor's assets that can be quickly
converted into cash, while market liquidity refers to the overall ability of the market to
absorb the sale of large assets without significant price fluctuations.
C. Funding liquidity refers to the ability of an investor to raise funds for in-house operations
while market liquidity refers to the ability to raise funds for the specific investment projects
themselves.
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D. Funding liquidity describes the ability of an investor to raise short-term debt while market
liquidity is the ability to raise long term capital.
Funding liquidity and market liquidity are two distinct concepts in finance. Funding liquidity refers to
the ease with which investors can obtain funding from financiers by using purchased assets as
collateral. T his essentially means how easily an investor can borrow money against their assets. On
the other hand, market liquidity refers to the ease with which investors can raise money by selling
their assets. T his means how quickly and easily an asset can be sold without significantly affecting its
price.
B, C, and D are i ncorrect as per the explanation above.
Thi ngs to Remember
Funding liquidity and market liquidity are two different aspects of financial liquidity.
Understanding the difference between them is crucial for risk management and investment
decisions.
Funding liquidity refers to the ease with which a borrower can obtain funds. It is often
associated with the ability to meet obligations as they come due without incurring
unacceptable losses.
Market liquidity, on the other hand, refers to the ease with which an asset or security can
be bought or sold in a market without affecting its price. High market liquidity means that
transactions can be conducted quickly and with minimal impact on prices.
Liquidity risk arises from situations where a party interested in trading an asset cannot do
it because nobody in the market wants to trade for that asset. T his can be assessed by
looking at trade volume patterns, bid-ask spreads, or price movements.
In times of financial stress, both funding and market liquidity can dry up, leading to a
'liquidity crunch'. T his was evident during the 2008 global financial crisis when banks were
unwilling or unable to lend to each other due to fears over their own funding positions.
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Q.420 Which of the following statements best describes why interbank market interest rates rose
sharply relative to the T reasury bill rate during and in the aftermath of the 2007-2008 financial
crisis?
A. T he Federal Reserve Bank increased the rate of interest at which it was willing to lend to
banks.
B. Losses incurred by banks combined with uncertainty on the part of structured investment
vehicles meant that there was less money available for lending to other parties.
C. Interbank market interest rates were internationally linked while the T reasury bill rate
was largely local.
D. As demand for mortgages worsened, profit streams for banks took a hit, meaning that
there was less money for lending to other banks.
As it became apparent that off-balance-sheet investment vehicles, conduits, and other structured
investments would most likely require the injection of more capital than initially anticipated, each
bank’s uncertainty about its own funding needs took a sharp increase. Furthermore, the possibility of
a bank turning to its “colleagues” for cash boosts after a minor shock became more uncertain, in part
because the other banks most likely had similar financial issues. As a result, the interbank interest
rate, LIBOR, took a sharper spike compared to the T reasury bill rate.
Choi ce A i s i ncorrect. While the Federal Reserve Bank does have the power to influence interest
rates, it was not the primary reason for the sharp rise in interbank market interest rates relative to
the T reasury bill rate during the financial crisis of 2007-2008. T he Fed's actions are typically aimed
at stabilizing and controlling inflation, not directly influencing interbank lending rates.
Choi ce C i s i ncorrect. Although interbank market interest rates can be influenced by international
factors, this was not a significant factor during this period. T he T reasury bill rate is indeed largely
local but its relationship with interbank market interest rates isn't primarily determined by their
geographical scope.
Choi ce D i s i ncorrect. While it's true that banks' profit streams were affected as demand for
mortgages worsened, this did not directly lead to a sharp rise in interbank market interest rates
relative to the T reasury bill rate. T his choice incorrectly assumes a direct causal relationship
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between mortgage demand and interbank lending rates.
Thi ngs to Remember
T he interbank market is a system where banks lend to and borrow from each other. T his
system is crucial for the smooth functioning of the banking sector.
During a financial crisis, banks may become wary of lending to each other due to increased
risk of default. T his can lead to an increase in interbank market interest rates.
T he T reasury bill rate is determined by the U.S. government and is considered risk-free. It
does not directly reflect the conditions in the banking sector or interbank market.
Structured investment vehicles (SIVs) are entities set up by financial institutions that
invest in long-term assets financed by short-term debt. T he failure of SIVs during the 2007-
2008 financial crisis led to significant losses for banks.
T he Federal Reserve Bank can influence interbank lending rates through its monetary
policy tools, such as setting the discount rate at which it lends money to commercial
banks.
Q.422 T he mai n vulnerability of the repo market in the time period leading up to the financial crisis
had much to do with the fact that:
A. T he market was highly susceptible to fluctuations in foreign exchange rates, which

created additional risk for international institutional investors.
B. T he market was large and unregulated, and many repo agreements were backed by
securitized mortgages as collateral.
C. T he market was dominated by a small number of large financial institutions, creating a lack
of competition and skewed pricing dynamics.
D. Most repo agreements were tied to specific equity indices, creating a direct link between
the stock market's performance and the stability of the repo market.
T he repo market was indeed large and unregulated, and many repo agreements were backed by
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securitized mortgages as collateral. Repo agreements are transactions where a large-scale depositor
or institutional investor puts money in a bank for a short term, usually overnight. T he bank agrees to
some “overnight interest” on the deposited amount. T he deposit is secured by an asset of roughly the
same value. Between 2000 and 2007, the repo market accounted for up to 30% of the U.S. GDP.
Despite the large scale of such transactions, the market was largely unregulated, making liabilities
among dealers and brokers grow sharply. A popular view is that the repo market collapsed when cash
depositors became concerned about the quality of the collateral backing repos and consequently
withdrew their funding. T his vulnerability was a significant factor that contributed to the financial
crisis.
Choi ce A i s i ncorrect. T he repo market is generally not directly affected by fluctuations in
foreign exchange rates. Repos are short-term borrowing agreements, typically collateralized with
government securities, not foreign currencies.
Choi ce C i s i ncorrect. While it's true that large financial institutions play a significant role in the
repo market, the primary vulnerability was not a lack of competition or skewed pricing. T he key
issue leading up to the financial crisis was the lack of regulation and the use of risky collateral, like
securitized mortgages.
Choi ce D i s i ncorrect. Repo agreements are typically collateralized by safer assets like
government securities, not equities. T herefore, the stability of the repo market is not directly tied
to the performance of specific equity indices.
Thi ngs to Remember
T he repo market is a form of short-term borrowing for dealers in government securities.
Repo agreements are essentially collateralized loans, where the borrower sells a security
to an investor with an agreement to repurchase it at a higher price at a later date.
T he primary vulnerability of the repo market during the financial crisis was that many of
these agreements were backed by securitized mortgages as collateral. When the housing
market collapsed, these securities lost their value, leading to significant losses for
investors.
Another vulnerability was that this market was largely unregulated. T his lack of oversight
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allowed risky practices to go unchecked and contributed to the instability of the financial
system during this period.
While liquidity can be an issue in some markets, it was not considered a primary
vulnerability in this case. T he repo market is typically highly liquid due to its short-term
nature and large volume of transactions.
Q.423 In September 2008, Lehman Brothers Holdings Inc. famously filed for Chapter 11 bankruptcy
protection. What was the immediate effect of the move?
A. Other large institutional investors also followed suit.
B. T he Federal Reserve moved with speed to inject capital into the firm.
C. It triggered a crisis of confidence in mortgage-backed securities.
D. It led to a run on the reserve primary money market funds after one large fund “broke the
buck” .
T he bankruptcy of Lehman Brothers Holdings Inc. led to a run on the reserve primary money
market funds after one large fund “broke the buck”. Lehman Brothers was a significant player in the
financial markets, with a substantial investment in mortgage-backed securities (MBSs). By 2007, the
firm had amassed an MBS portfolio worth over $85 billion. However, in the first half of 2008,
Lehman Brothers suffered massive losses due to a decline in the value of its commercial real estate
assets. T his led to the firm filing for bankruptcy in September 2008 after reporting a loss of $3.5
billion and a 42% plunge in its stock value.
Following the bankruptcy filing, there was a run on the reserve primary money market funds when
one large fund “broke the buck”. T his term refers to a situation where the net asset value of a
money market fund falls below $1, indicating a loss of principal. T his occurred when the money
market fund announced losses of $785 million in the commercial papers of Lehman Brothers. T he
announcement led to a loss of investor confidence in money market funds, triggering large-scale
withdrawals from these funds. T his was the immediate effect of Lehman Brothers' bankruptcy
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declaration.
Choi ce A i s i ncorrect. T he bankruptcy of Lehman Brothers did not lead to other large institutional
investors declaring bankruptcy as well. While the event did cause a significant shock in the financial
markets, it did not directly result in a domino effect of bankruptcies among other large institutions.
Choi ce B i s i ncorrect. T he Federal Reserve did not inject capital into Lehman Brothers after its
bankruptcy declaration. In fact, the Federal Reserve and other government authorities made a
conscious decision not to bail out Lehman Brothers, which was a significant departure from their
previous actions during the financial crisis.
Choi ce C i s i ncorrect. Although the collapse of Lehman Brothers contributed to an overall loss of
confidence in financial markets, it was not specifically tied to a crisis of confidence in mortgage-
backed securities. T he issues with mortgage-backed securities were already well underway by the
time Lehman declared bankruptcy.
Thi ngs to Remember
T he bankruptcy of Lehman Brothers was a major event in the global financial crisis of
2008. It is important to understand the role that large financial institutions play in the
stability of global markets.
"Breaking the buck" refers to a situation where a money market fund's net asset value
(NAV) falls below $1 per share, which can trigger panic among investors and lead to a run
on funds. T his happened with the Reserve Primary Fund following Lehman's bankruptcy.
Mortgage-backed securities (MBS) are complex financial instruments that played a
significant role in the 2008 financial crisis. T he collapse of Lehman Brothers led to
widespread doubt about their value and safety, triggering a crisis of confidence.
T he Federal Reserve often steps in during times of financial instability to provide liquidity
and prevent further market disruption. However, it did not inject capital into Lehman
Brothers before its bankruptcy.
Lehman's bankruptcy did not immediately cause other large institutional investors to
declare bankruptcy, but it did contribute significantly to an environment of fear and
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uncertainty within the global finance industry.
Q.424 T he period leading up to the financial crisis of 2007-2009 was characterized by historically low
interest rates in the United States. T his was a significant factor in the economic landscape of the
time. What was the primary reason for the low interest rates?
A. Low savings rates in the U.S.
B. High savings rates in the U.S.
C. Low demand for credit in the country
D. Accommodative monetary policy
In the years leading up to the financial crisis, the U.S. government had been striving to reduce
interest rates so as to increase lending rates and grow the economy. T his is known as an
accommodative monetary policy. T he goal of such a policy is to make money cheaper to borrow,
thereby encouraging spending and investment. T his can stimulate economic growth, but it can also
lead to inflation and asset bubbles if not managed carefully. In the case of the 2007-2009 financial
crisis, the low interest rates contributed to a housing bubble, as people were able to borrow money
cheaply to buy homes. When the bubble burst, it led to a severe economic downturn.
Choi ce A i s i ncorrect. Low savings rates in the U.S. would not necessarily lead to low interest
rates. In fact, it could potentially lead to higher interest rates as banks would need to incentivize
individuals to save more.
Choi ce B i s i ncorrect. High savings rates in the U.S. could potentially lead to lower interest rates
due to an increased supply of loanable funds, but this was not the primary reason for low interest
rates during this period.
Choi ce C i s i ncorrect. Low demand for credit in the country could theoretically result in lower
interest rates as lenders compete for borrowers, but during this period there was actually a high
demand for credit due to factors such as easy lending standards and a booming housing market.
Thi ngs to Remember
308
T he Federal Reserve controls the short-term interest rate in the United States, which can
influence longer-term rates.
Monetary policy is used to control inflation and stabilize the economy. An accommodative
monetary policy, as mentioned in option (d), often involves lowering interest rates to
stimulate economic growth.
High savings rates can lead to lower interest rates as banks have more funds available for
lending. However, this was not the primary reason for low interest rates during this
period.
Low demand for credit could potentially lead to lower interest rates as lenders compete
for borrowers. However, during the period leading up to the financial crisis of 2007-2009,
there was actually a high demand for credit due to factors such as easy access to loans and
a booming housing market.
Q.426 In the face of competition from money market funds and junk bonds towards the end of the
20th century, the traditional banking model became less profitable and partly contributed to the
emergence of the shadow banking system. T his system consisted of a set of institutions which:
A. Were not only illegal but also engaged in money laundering.
B. Were allowed to invest only in short-term financial assets such as T-bills.
C. Were non-depository, and not subject to banking regulations.
D. Were non-depository, and subject to more stringent regulations compared to banks.
T he shadow banking system is a network of non-depository financial institutions – investment banks,
structured investment vehicles, conduits, hedge funds, and other non-bank financial entities that
serve as intermediaries to channel savings into investments. Due to the fact that they do not take
deposits, they escape a myriad of limits and laws imposed on traditional banks. Before the crisis,
shadow institutions used to borrow via short-term, liquid markets and then used the funds to invest in
longer-term illiquid assets. When the housing bubble burst, lenders and investors started to avoid
309
taking on the credit risk, and short-term borrowing dried up almost overnight, making these
institutions unable to raise money for their own operations. Compounding their woes was the
inability to get funds from their collapsing investments in securitized assets, which were now
considered “toxic” in investment terms.
A i s i ncorrect because the shadow banking system, while operating outside of traditional banking
regulations, is not exclusively made up of institutions engaged in illegal activities or money
laundering. While the lack of regulation can make these institutions more susceptible to such
practices, it is incorrect and oversimplified to categorize the entire shadow banking system in this
way.
B i s i ncorrect because while some institutions in the shadow banking system, like money market
funds, may invest in short-term financial assets such as T reasury bills (T-bills), it is not a defining
characteristic. T he shadow banking system is broad and diverse, with different entities focused on
various types of assets and investments.
D i s i ncorrect because, unlike traditional banks, the institutions in the shadow banking system
typically do not operate under the oversight of central banks. Although these institutions may have
certain operational flexibilities, they are not directly regulated by central banks, which is one of the
reasons they fall under the umbrella of 'shadow banking'.
Q.428 T he financial crisis that began in 2007 had a significant impact on global markets. T he month of
August 2007 is often referred to as the first 'panic' month, marking the onset of the crisis. T his
period was characterized by a specific event that signaled the beginning of the crisis. Which of the
following events best describes the event that characterized this "panic" month?
A. An unprecedented spike in firms declaring bankruptcy.
B. T he sudden implosion of the market for asset-backed commercial papers.
C. A historic scale of federal bail-outs dispensed to prominent U.S. institutions.
D. A sudden, sharp contraction in the foreign exchange market.
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T he collapse of the market for asset-backed commercial papers was the defining event of August
2007, marking the onset of the financial crisis. Prior to the crisis, large institutions frequently funded
long-term investments through commercial papers, which are short-term loans, often unsecured.
Many investors in securitized assets obtained their funding in this manner, using mortgages and other
receivables as collateral. When a commercial paper matured, the borrowing institution would
typically refinance it with another one, often by mobilizing repeat lenders. Conceptually, an asset-
backed commercial paper program would experience a 'run' if lenders were unwilling to refinance it
upon maturity. Starting from August 7, 2008, the frequency of such runs dramatically increased, and
many programs found themselves unable to refinance.
Choi ce A i s i ncorrect. While numerous firms did declare bankruptcy during the financial crisis,
the high frequency of bankruptcy declarations did not specifically characterize the onset in August
2007. T he significant rise in bankruptcy filings followed the initial liquidity crisis and continued
throughout the crisis period.
Choi ce C i s i ncorrect. While there were indeed record federal bail-outs during the financial crisis,
these were responses to the crisis that took place after the initial 'panic' month of August 2007.
Major bail-outs such as that of AIG or the creation of the T roubled Asset Relief Program (TARP)
took place in late 2008.
Choi ce D i s i ncorrect. T he financial crisis was not marked by a contraction in the foreign
exchange market, especially not in August 2007. T he financial crisis primarily impacted the credit
market and had more of an indirect impact on the foreign exchange market.
Thi ngs to Remember
T he financial crisis of 2007-2008, also known as the Global Financial Crisis (GFC), was a
severe worldwide economic crisis. It was the most serious financial crisis since the Great
Depression (1929).
Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized
by other financial assets. ABCP is typically a short-term instrument that matures between
1 and 270 days from issuance and is typically issued by a bank or other financial institution.
T he collapse of the market for asset-backed commercial papers was one of the key events
311
that marked the onset of this crisis. T his led to significant liquidity issues in various
markets.
Bankruptcy refers to a legal process involving a person or business that is unable to repay
their outstanding debts. T he bankruptcy process begins with a petition filed by the debtor,
which is most common, or on behalf of creditors, which is less common.
Federal bailouts are measures taken by government bodies to provide financial assistance
or take over companies in danger of bankruptcy due to an economic downturn or bad
management decisions.
Q.432 During periods of economic downturn, governments often weigh the option of bailing out
financial institutions to prevent a complete collapse of the economy. Nonetheless, this approach is
not without its pitfalls. What is the principal challenge associated with the bailout of institutions
during economic crises?
A. It necessitates a significant write-off of toxic assets.
B. It amplifies the issue of adverse selection in financial markets.
C. It may instigate widespread public dissent or potentially disastrous protests.
D. It exacerbates the problem of moral hazard within financial institutions.
T he primary issue with bailing out institutions during economic crises is that it increases the
problem of moral hazard. Moral hazard refers to a situation where an entity is more likely to take
risks because the costs that could result will not be borne by the entity taking the risk. In the
context of financial institutions, if they are aware that they will be bailed out in times of crisis, they
may engage in riskier behavior, knowing that they will not bear the full brunt of the negative
consequences of their actions. T his can lead to a cycle of risky behavior and bailouts, which can
have detrimental effects on the economy. T he government's decision to bail out certain institutions
during the 2007-2009 financial crisis, such as AIG, Freddie Mac, and Fannie Mae, may have
inadvertently encouraged this kind of behavior.
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Choi ce A i s i ncorrect. While a significant write-off of assets can indeed be a consequence of a
financial crisis, it is not specifically a problem associated with the bailout of institutions. T he write-
off of assets often occurs before a bailout as a way to clear bad debt off the balance sheets.
Choi ce B i s i ncorrect. Adverse selection refers to a situation where one party in a transaction
has more information than the other party, leading to an imbalance in the transaction. Although
adverse selection can be an issue in financial markets, it's not directly related or increased by
government bailouts during economic crises.
Choi ce C i s i ncorrect. Public discontent or demonstrations can indeed occur as a result of
government bailouts; however, these are secondary issues and are more related to public perception
and social factors rather than being inherent drawbacks of bailout itself.
Thi ngs to Remember
T he term 'bailout' refers to financial support or rescue to a failing business or economy,
typically by government bodies. It is often seen as a last resort measure during economic
crises.
Moral hazard is a situation in which one party gets involved in risky situations knowing that
it is protected against the risk and the other party will incur the cost. In context of
bailouts, it refers to the risk that providing financial assistance to distressed institutions
may encourage irresponsible behavior in future.
Adverse selection refers to a situation where sellers have information that buyers do not
have, or vice versa, about some aspect of product quality. In terms of bailout, it could
mean financially weak institutions being more likely to seek aid thus increasing overall
risk.
Public discontent and demonstrations can occur if citizens perceive bailouts as unfair use
of taxpayer money or favoring certain institutions over others.
Asset write-off occurs when an asset's value becomes zero due to non-recovery. T his can
be a consequence of bailout if assets are overvalued during rescue operations.
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Q.433 Which one of the following characteristics is common in financial crises witnessed since the
Great Depression?
A. T hey have invariably led to the implementation of a gold standard.
B. T hey are characterized by scarcity or even absence of liquidity in financial markets.
C. T hey are invariably accompanied by a global rise in commodity prices.
D. T hey inevitably lead to a dissolution of the financial market's infrastructure.
Financial crises are often characterized by a lack of liquidity in markets. Liquidity refers to the ease
with which an asset, or security, can be converted into ready cash without affecting its market
price. In a financial crisis, firms and financial institutions may face difficulties in financing or
refinancing their operations due to a sudden and severe shortage of liquidity in the market. T his can
lead to a vicious cycle of asset sell-offs, falling asset prices, and further liquidity shortages,
exacerbating the crisis. T he Global Financial Crisis of 2007-2008 is a prime example of a liquidity
crisis, where the sudden collapse of liquidity in the subprime mortgage market led to a broader
financial meltdown.
A i s i ncorrect.While some financial crises have sparked discussions about monetary policy and the
nature of money itself, they have not invariably led to the implementation of a gold standard. For
example, the 2007-2008 financial crisis led to quantitative easing and other unconventional monetary
policies rather than a return to the gold standard.
C i s i ncorrect. Financial crises do not invariably lead to a global rise in commodity prices. In fact,
crises can lead to a decrease in commodity prices due to reduced demand, especially if the crisis
leads to a slowdown in economic activity.
D i s i ncorrect. Financial crises do not inevitably lead to a dissolution of the financial market's
infrastructure. Although crises often expose weaknesses in financial markets and lead to changes and
reforms, they do not typically result in the complete dissolution of existing financial market
structures.
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Q.435 T he second panic period of the 2007-2009 financial crisis was triggered by:
A. A total collapse of the commercial paper market.
B. A big number of bankruptcy filings among financial conglomerates.
C. T he declaration of bankruptcy by Lehman Brothers.
D. T he collapse of the shadow banking system.
T he second panic period of the 2007-2009 financial crisis was indeed triggered by the declaration of
bankruptcy by Lehman Brothers. T his event occurred in September 2008. Lehman Brothers was the
largest underwriter of securitized assets at the time. When news of their bankruptcy filing broke,
investors quickly lost confidence in financial institutions. T his loss of confidence triggered what is
known as 'runs', where many investors attempted to salvage their money by withdrawing it from
these institutions. T his mass withdrawal of funds further exacerbated the financial crisis, leading to
the second panic period.
Choi ce A i s i ncorrect. T he total collapse of the commercial paper market was a characteristic of
the first panic period, not the second. T his event had already occurred and thus could not have
triggered the second panic period.
Choi ce B i s i ncorrect. While there were indeed numerous bankruptcy filings among financial
conglomerates during this time, these were more a result of the crisis rather than a trigger for it.
Furthermore, these bankruptcies occurred throughout both panic periods and therefore cannot be
specifically linked to triggering the second one.
Choi ce D i s i ncorrect. T he collapse of shadow banking system was an outcome that spanned
across both periods but it wasn't a specific trigger for either one of them. It's more accurate to say
that it was an effect rather than cause of these panics.
Thi ngs to Remember
T he 2007-2009 financial crisis was a global banking crisis that led to the Great Recession.
It was triggered by a complex interplay of valuation and liquidity problems in the United
States banking system.
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T he first panic period was characterized by the collapse of short-term funding markets,
particularly commercial papers. Commercial paper is an unsecured, short-term debt
instrument issued by corporations, typically for financing accounts receivable and
inventories.
T he second panic period was triggered by different events which were more severe than
the first one. T his includes major bankruptcy filings among financial conglomerates and
other significant events in the financial sector.
Lehman Brothers' declaration of bankruptcy on September 15, 2008 marked a significant
turning point in the crisis. It resulted in a large drop in market confidence and led to
significant disruptions in financial markets.
T he shadow banking system also played a crucial role during this crisis. Shadow banks are
non-bank financial intermediaries that provide services similar to traditional commercial
banks but outside normal banking regulations.
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Reading 11: GARP Code of Conduct
Q.266 Jack Oboyo, FRM, is a manager at Somalia's largest investment bank, managing a portfolio that
focuses on stocks from Somalia's logistics and transportation sector. Oboyo has some close contacts
at the securities exchange commission of Somalia, providing him with non-public sales and profit-
related data of firms that file their reports with the commission before being distributed to the
general public. Oboyo uses this information to advise his employer on potential investment-grade
stocks. It is common and legal in Somalia to obtain material non-public information or insider
information related to public limited companies. Jack Oboyo's practice:
A. Has not violated the GARP's Code of conduct.
B. Has violated the Code related to confidentiality.
C. Has violated the Code related to professional integrity and ethical conduct.
D. Has violated the Code related to conflict of interest.
According to the code of professional integrity and ethical conduct, GARP members should endeavor
to be mindful of cultural differences regarding ethical behavior and customs, and to avoid any actions
that are, or may have the appearance of being unethical according to local customs. If there appears
to be a conflict or overlap of standards, the GARP member should always seek to apply the higher
standard.
Q.267 David Bremen, FRM, has recently joined one of Austria's largest jet engine manufacturers as a
Chief Risk Officer. Previously, Bremen had worked for 35 years in risk hedging and risk management
in the banking sector. Based on his vast experience, David recommends his team hedge all of its
foreign currency-denominated sales. He does not, however, state that this is just his opinion. He
believes that most foreign currencies are most volatile at the end of every financial year. David's
recommendation:
A. Has not violated the Code.
B. Has violated the Code because he has not clearly disclosed his expertise and knowledge
concerning risk assessment.
C. Has violated the Code because he failed to distinguish between fact and opinion in the
presentation of his recommendation.
D. Has violated the Code because he cannot delegate his team to perform hedging
transactions.
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David Bremen has indeed violated the Code of Conduct because he failed to distinguish between fact
and opinion in the presentation of his recommendation. T he Code of Conduct, which is a set of
ethical and professional guidelines that financial professionals are expected to adhere to, mandates
that members should clearly differentiate between facts and their personal opinions when presenting
recommendations. In this case, David Bremen made a recommendation to hedge all foreign currency-
denominated sales without explicitly stating that this was based on his personal opinion and
experience. T his could potentially mislead his team into believing that this recommendation is a
universally accepted fact in the field of risk management, rather than a strategy that is influenced by
David's personal beliefs and experiences. Furthermore, the Code of Conduct also requires members
to perform reasonable due diligence before making any recommendations. By basing his
recommendation solely on his personal experience, without providing any empirical evidence or
conducting a thorough analysis of the current market conditions, David Bremen has failed to meet
this requirement. T herefore, his actions are in violation of the Code of Conduct.
Choi ce A i s i ncorrect. David has indeed violated the Code of Conduct, but not for the reasons
stated in this option. His violation lies in his failure to distinguish between fact and opinion, not in his
decision to hedge all foreign currency-denominated sales.
Choi ce B i s i ncorrect. T he Code of Conduct does not require David to disclose his expertise and
knowledge concerning risk assessment explicitly. His violation pertains to the presentation of his
recommendation as a fact rather than an opinion.
Choi ce D i s i ncorrect. T he Code does not prohibit delegation of tasks such as hedging
transactions. David's violation stems from his failure to differentiate between facts and opinions
when presenting recommendations, not from delegating tasks to his team.
Q.268 Muhammad Aslam, FRM, is a risk analyst at Financial Angels, a venture capitalist firm that
invests in tech and health science-related startups and small-medium enterprises (SMEs). After
careful risk assessments, the manager has approved Aslam to initiate the first round of funding for
seven startups. Aslam's wife co-founded one of the selected startups. Without disclosing this
information, Aslam proceeded with the manager's recommendation. Determine if Muhammad Aslam's
actions are in violation of a Code.
A. No, because the recommendation of investing in seven startups, including the startup
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cofounded by Muhammad Aslam's wife, came from senior manager.
B. No, because the startup is founded by Muhammad Aslam's wife, not him. T herefore he can
invest without disclosing this information.
C. Yes, as the Code requires a member to disclose to their employer the matters that could
impair his independence and objectivity.
D. Yes, because Muhammad Aslam acted on the manager's recommendation without

performing self-analysis.
Muhammad Aslam's actions are indeed in violation of the Code. T he Code in question here is the
Global Association of Risk Professionals' (GARP) Code of Conduct, which stipulates that members
must disclose all matters that could potentially impair their independence and objectivity. In this
case, Aslam's wife's co-founding of one of the startups selected for funding could be seen as a
conflict of interest, which could impair Aslam's ability to objectively assess the risk and potential of
the startup. By failing to disclose this information to his employer, Aslam has violated this Code. It is
important to note that the Code is in place to ensure that all members act with the highest level of
integrity, and any violation of the Code could lead to disciplinary action.
Choi ce A i s i ncorrect. Even though the recommendation came from a senior manager, it does not
absolve Muhammad Aslam of his responsibility to disclose any potential conflicts of interest. T he
Code requires all members to disclose such matters regardless of who made the initial
recommendation.
Choi ce B i s i ncorrect. T he fact that the startup was founded by Muhammad Aslam's wife and not
him does not exempt him from disclosing this information. His wife's involvement in the startup
could potentially impair his independence and objectivity, which he is required to maintain as per the
Code.
Choi ce D i s i ncorrect. While performing self-analysis before acting on recommendations is good
practice, it isn't necessarily a requirement under the Code in this context. T he main issue here lies
with Muhammad Aslam's failure to disclose his wife's involvement in one of the startups, which
could potentially affect his objectivity and independence.
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Q.270 Which of the following GARP's Code of conduct requires a member to be diligent about not
overstating the accuracy or certainty of results or conclusions and clearly disclosing the limits of
their expertise and knowledge in areas of risk assessment?
A. Professional integrity and ethical conduct.
B. Fundamental responsibilities.
C. General accepted principles.
D. Conflict of interest.
T he section outlines the basic responsibilities that members of the GARP are expected to uphold in
their professional conduct. T hese responsibilities include compliance with all applicable laws, rules,
and regulations, including the Code itself. Members are also expected not to delegate or outsource
these responsibilities to others. Furthermore, this section specifically requires members to be
diligent about not overstating the accuracy or certainty of results or conclusions, and to clearly
disclose the limits of their expertise and knowledge in areas of risk assessment. T his requirement is
crucial in maintaining the integrity and credibility of the risk management profession, as it ensures
that risk assessments are conducted with the highest level of accuracy and transparency.
Choi ce A i s i ncorrect. While professional integrity and ethical conduct are indeed important
aspects of the GARP's Code of Conduct, they do not specifically address the requirement to exercise
diligence in not overstating the accuracy or certainty of results or conclusions, nor do they require
members to disclose their limits of expertise and knowledge in areas of risk assessment. T his
section primarily focuses on honesty, fairness, and respect for others.
Choi ce C i s i ncorrect. T he general accepted principles section does not specifically deal with the
requirement mentioned in the question either. It mainly outlines broad principles that all members
should adhere to such as maintaining a high standard of professional competence and treating
everyone fairly regardless of their race, religion, gender etc.
Choi ce D i s i ncorrect. Conflict of interest refers to situations where a member's personal
interests may interfere with their professional duties or judgement. It does not cover requirements
related to accuracy or disclosure about one's expertise and knowledge.
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Q.271 Jack Simpson, FRM, and John Philip, FRM, are two risk analysts and team members at Dark
Well Insurance Company. Simpson recently found out that John Philip shares the company's
confidential risk-related data with his friend, Louis Keynes, an investment manager at Verizon
Investment Company that regularly trades Dark Well's stocks. Keynes also uses this information for
personal gains. Which of the following action is in line with GARP's Code of conduct?
A. Simpson should bar John Philip from using the FRM designation as he shares the
company's confidential information with outsiders.
B. Simpson should ignore John Philip's action, as Simpson is not personally involved in sharing
the company's confidential information.
C. Simpson should not take any action against John Philip because the company's confidential
information is being used by an outsider for personal gains only.
D. Simpson should immediately report John Philip's activities to their employer.
T he Global Association of Risk Professionals (GARP) has a strict Code of Conduct that its members
are expected to adhere to. T his Code of Conduct includes a requirement that members should not
commit any act that compromises the integrity of GARP or the FRM designation. T his includes not
knowingly participating or assisting in any violation of the Code or laws. Furthermore, members are
not allowed to make use of their employer or client's confidential information for inappropriate
purposes or personal use. In this scenario, John Philip is clearly violating these rules by sharing
confidential information with an outsider for personal gain. As a fellow FRM and member of GARP,
Jack Simpson has a responsibility to report this violation to their employer. By doing so, he would be
upholding the integrity of the FRM designation and the GARP Code of Conduct. Ignoring the violation
or trying to punish John Philip himself would not be in line with the GARP Code of Conduct.
T herefore, the correct action for Simpson to take is to report John Philip's activities to their
employer.
Choi ce A i s i ncorrect. Simpson, despite being an FRM holder, does not have the authority to bar
John Philip from using the FRM designation. T his power lies with the Global Association of Risk
Professionals (GARP), which can revoke a member's designation if they are found to be in violation
of its Code of Conduct.
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Choi ce B i s i ncorrect. According to GARP's Code of Conduct, all members are obligated to uphold
professional integrity and report any unethical behavior they witness within their organization.
Ignoring such actions would be a breach of this code.
Choi ce C i s i ncorrect. T he fact that the company's confidential information is being used by an
outsider for personal gains only does not absolve John Philip from his misconduct. As per GARP’s
Code of Conduct, sharing confidential information without proper authorization itself constitutes a
violation irrespective of how it’s used.
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Q.272 A formal investigation that confirms violation of the GARP Code of Conduct can bring about
serious consequences. Which of the following is a potential consequence of such a violation?
A. Mandatory participation in ethical training.
B. A temporary suspension of the GARP member's right to work in the field of risk
management.
C. Withdrawal of the GARP member's right to use the FRM designation for any purpose.
D. A formal request to the GARP member's employer to withdraw certain benefits such as
bonuses and other fringe benefits.
T he Global Association of Risk Professionals (GARP) has a Code of Conduct that its members are
expected to adhere to. T his Code of Conduct is a set of ethical guidelines that governs the behavior
of GARP members in their professional activities. Violation of this Code can lead to serious
consequences. One such consequence, as stated in the Code, is the withdrawal of the GARP
member's right to use the FRM (Financial Risk Manager) designation for any purpose. T his means
that the member would no longer be able to refer to themselves as a FRM, which is a significant
professional designation in the field of risk management. T his consequence is intended to uphold the
integrity of the FRM designation and to deter members from violating the Code of Conduct. It is a
severe penalty that reflects the seriousness with which GARP views violations of its Code of
Conduct.
Choi ce A i s i ncorrect. While ethical training could be a potential consequence, it is not mandatory
according to the GARP Code of Conduct. T he code does not explicitly state that members who
violate the code must participate in ethical training.
Choi ce B i s i ncorrect. T he GARP does not have the authority to suspend a member's right to
work in the field of risk management. T his decision would typically fall under the jurisdiction of an
employer or regulatory body, not a professional association like GARP.
Choi ce D i s i ncorrect. T he GARP cannot request an employer to withdraw certain benefits such
as bonuses and other fringe benefits from its member for violating its Code of Conduct. Such actions
are beyond the scope and power of this professional association.
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Q.273 Kelvin White, FRM, works for a consultancy firm that specializes in pension fund management
in a certain city. Recently, one of his close friends who work for the city's planning and development
department approached him with an offer to work as an unpaid volunteer for the department's
pension fund. In turn, the department would grant White a free parking space just outside his office.
Which of the following is the most appropriate thing to do before accepting the offer?
A. Do nothing as this is a volunteer job.
B. Request the department not to grant him any fringe benefit, including the free parking
space.
C. Seek advice regarding the offer from one of his colleagues at the consultancy firm.
D. Disclose the details of the volunteer position to his employer.
Kelvin White should disclose the details of the volunteer position to his employer. T his is in line with
the GARP Code of Conduct, which states that members should 'make full and fair disclosure of all
matters that could reasonably be expected to impair independence and objectivity or interfere with
respective duties to their employer, clients, and prospective clients.' Although the department may
not be a current client of the firm, that could change in the future while White is still an employee of
the firm. By disclosing the details of the volunteer position to his employer, White ensures that he is
transparent about any potential conflicts of interest that may arise from his involvement with the
department's pension fund. T his allows his employer to make an informed decision about whether or
not to allow White to accept the volunteer position. Furthermore, it demonstrates White's
commitment to upholding the ethical standards of his profession, which include maintaining
independence and objectivity in all professional activities.
Choi ce A i s i ncorrect. Even though it's a volunteer job, White still has professional obligations to
his employer. He should disclose any potential conflicts of interest, including this offer.
Choi ce B i s i ncorrect. While refusing fringe benefits could potentially mitigate some conflicts of
interest, it does not address the primary issue here which is the potential conflict between White's
duties to his employer and his new role as a volunteer for the city's planning and development
department.
Choi ce C i s i ncorrect. Seeking advice from a colleague may be helpful but it does not replace the
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need for formal disclosure to his employer about this opportunity. It's important that he informs
those who can make an informed decision about potential conflicts of interest.
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Q.274 A GARP member working in a certain country establishes that the GARP Code of Conduct, the
country's laws, and the local law applicable within the region where she conducts business all
specify different requirements. T he member must abide by:
A. T he GARP Code of Conduct.
B. T he highest standard of local law, her country's laws, or the GARP Code of Conduct.
C. T he GARP Code of Conduct or the local law, whichever is higher.
D. T he country's law.
T he GARP Code of Conduct, as well as the local and national laws, all have their own unique
requirements. However, when these standards appear to be in conflict or overlap, the GARP
member should always seek to apply the highest standard. T his means that the member should adhere
to the most stringent requirement among the GARP Code of Conduct, the local law, and the country's
law. T his approach ensures that the member is always operating within the bounds of the law and the
professional code of conduct, thereby minimizing the risk of legal and professional repercussions. It
also demonstrates the member's commitment to maintaining high ethical standards in her
professional conduct, which is a key aspect of risk management.
Choi ce A i s i ncorrect. While the GARP Code of Conduct is important, it may not always represent
the highest standard when compared to local or national laws. T herefore, simply adhering to the
GARP Code of Conduct without considering other regulations could lead to non-compliance with
stricter standards.
Choi ce C i s i ncorrect. T his option suggests that the member should adhere either to the GARP
Code of Conduct or local law, depending on which one is higher. However, this choice neglects
consideration for national laws which might have stricter stipulations than both local law and GARP
code.
Choi ce D i s i ncorrect. Adhering only to the country's law would ignore potentially stricter
standards set by local laws or by professional codes such as the GARP Code of Conduct.
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Q.275 Jessica Pearson, FRM, works for an investment bank. At the end of a 2-year contractual
relationship between the bank and one of its clients, the client offers Jessica a car worth USD
43,200 in part because of her outstanding expertise and professionalism throughout the period of the
contract. How should Jessica proceed?
A. Accept the gift because the contract has lapsed.
B. Accept the gift but make sure that she informs her employer about it.
C. Reject the gift.
D. Reject the gift but request the client to redirect it to the bank itself.
Jessica should reject the gift. T he Global Association of Risk Professionals (GARP) Code of Conduct
clearly states that members should not offer, solicit, or accept any gift, compensation, or
consideration that could reasonably be expected to compromise their objectivity and independence.
T his rule applies regardless of whether a contract has lapsed or not. T he client could potentially
seek professional assistance in the future, and accepting the gift could create a conflict of interest or
the perception of one. T herefore, to maintain her professional integrity and adhere to the GARP
Code of Conduct, Jessica should politely decline the gift.
Choi ce A i s i ncorrect. Even though the contract has lapsed, accepting such a high-value gift can
create a conflict of interest and may be perceived as a bribe or an attempt to influence future
business decisions. T his would violate the professional ethics and standards of conduct that Jessica,
as an FRM, is expected to uphold.
Choi ce B i s i ncorrect. Informing her employer about the gift does not eliminate potential
conflicts of interest or ethical concerns. T he value of the gift is substantial enough to potentially
influence Jessica's decision-making in future dealings with this client, which could compromise her
professional integrity.
Choi ce D i s i ncorrect. While redirecting the gift to her employer might seem like a solution, it
still doesn't address potential ethical issues. It could still be seen as an attempt by the client to curry
favor with Jessica's employer for future contracts or business deals.
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Q.276 Green Belt Market Fund directs its two subsidiaries to buy and sell emerging market stocks
simultaneously. In its monthly investment outlook literature, the company points to the overall
emerging market volume as indicative of the market's liquidity. T he move prompts more investors to
participate in the emerging markets fund increasingly. Green Belt Market Fund most likely:
A. Did not violate the GARP Code of Conduct.
B. Violated the GARP Code of Conduct regarding conflict of interest.
C. Did not violate the GARP Code of Conduct but may have breached stock brokerage rules.
D. Violated the GARP Code of Conduct regarding professional integrity and ethical conduct.
T he Green Belt Market Fund's actions indicate a violation of the GARP Code of Conduct regarding
professional integrity and ethical conduct. T he company appears to be manipulating the market's
liquidity to attract investments in its own funds. T he increased participation in the emerging markets
fund is not a result of market forces such as supply and demand, nor does it reflect a genuine trading
strategy intended to benefit investors. Instead, it seems to be a concealed effort to increase the
assets under the company's management. T his conduct is not in line with the principles of
professional integrity and ethical conduct as stipulated in the GARP Code of Conduct.
Choi ce A i s i ncorrect. Green Belt Market Fund did violate the GARP Code of Conduct. T he
company's strategy of using its subsidiaries to simultaneously buy and sell stocks in emerging
markets can be seen as a form of market manipulation, which is against the principles of professional
integrity and ethical conduct outlined in the GARP Code.
Choi ce B i s i ncorrect. While it may seem that there could be a conflict of interest, this choice
does not accurately describe the violation committed by Green Belt Market Fund. T he GARP Code's
provisions on conflicts of interest primarily deal with situations where an individual or organization
might benefit at the expense of a client or other party, which does not appear to be the case here.
Choi ce C i s i ncorrect. Although it's possible that Green Belt Market Fund may have breached
stock brokerage rules with its trading strategy, this doesn't negate their violation of the GARP Code
regarding professional integrity and ethical conduct. T herefore, stating they didn't violate the GARP
code would be inaccurate.
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Q.277 T heresa Conway, FRM, is a trade manager of an investment fund specializing in currency
trading. In a report sent to investors, Conway outlines her trading strategy which is hinged on the
appreciation of the United States dollar against other world currencies. She quantifies expected
returns if the dollar appreciates by less than 5%, 5% - 10%, and by more than 10%. She also outlines
possible scenarios if the dollar depreciates by similar margins. Also explicitly stated therein is that
these projections are her professional opinion. Has Conway violated the GARP Code of Conduct with
respect to communication?
A. Yes.
B. No, because she disclosed the basic details of her investment strategy.
C. No, because she explicitly distinguishes fact from opinion, while still giving a range of
scenarios if the dollar appreciates or depreciates - therefore capturing most (or all) possible
scenarios.
D. No, because it's her legal duty to communicate the details of her strategy to investors.
Conway did not violate the GARP Code of Conduct with respect to communication. T he GARP Code
of Conduct requires members to disclose factual data that is devoid of falsehoods. In addition,
personal judgment or opinion must be clearly distinguished from facts. Conway adhered to these
requirements in her communication with her investors. She provided factual data about her trading
strategy and the potential scenarios based on the appreciation or depreciation of the United States
dollar. She also clearly distinguished her professional opinion from the facts by stating that the
projections are her professional opinion. T herefore, she did not violate the GARP Code of Conduct
with respect to communication.
Choi ce A i s i ncorrect. T heresa Conway did not violate any rules of the GARP Code of Conduct
regarding communication. She provided a clear explanation of her investment strategy and
distinguished fact from opinion, which is in line with the code's requirements.
Choi ce B i s i ncorrect. While it's true that Conway disclosed the basic details of her investment
strategy, this alone does not determine whether she violated any rules or not. T he key point here is
that she also distinguished facts from opinions and provided a range of scenarios, which aligns with
the GARP Code of Conduct.
Choi ce D i s i ncorrect. Although it may be part of Conway's legal duty to communicate her
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strategy to investors, this does not necessarily mean she didn't violate any rules under the GARP
Code of Conduct regarding communication. However, in this case, she did comply with all relevant
guidelines by providing clear information and distinguishing between facts and opinions.
Q.278 Richard Leakey, FRM, is an analyst with a large portfolio of stocks, including the stock of
Brighter World Limited (BWL). Leakey's uncle owns about 20,000 shares of BWL. He informs
Leakey that he has created a trust in his name and placed 5,000 BWL shares into the trust. T he
wording of the trust prevents Leakey from selling the shares until his uncle dies, but may
nonetheless vote for the shares. Leakey is due to give an updated research analysis on BWL in a
fortnight. Leakey should most appropriately:
A. Disregard the situation and proceed to update the report as usual because he is not a
beneficiary of the shares as of now.
B. Notify his superiors that he's no longer in a position to issue recommendations on BWL.
C. Request his uncle to amend the terms of the trust to allow him to sell the shares at any
time.
D. Disclose the situation to his employer and, if given the green light to prepare a report,
also disclose his new status as a beneficiary of BWL stocks.
Richard Leakey should disclose the situation to his employer and, if given the permission to prepare
a report, also disclose his new status as a beneficiary of BWL stocks. T his is because, as a member
of the Global Association of Risk Professionals (GARP), Leakey is obligated to disclose any actual or
potential conflict of interest to all affected parties. T his disclosure should be comprehensive and fair,
especially if there is a possibility that it could compromise his independence or objectivity, or
interfere with his employer's or clients' interests. In this case, Leakey has a financial interest in
BWL shares and also has voting rights. T herefore, he must inform his employer about the potential
conflict of interest and should only continue to monitor BWL after his employer has given him the
go-ahead.
Choi ce A i s i ncorrect. Even though Leakey is not a beneficiary of the shares at present, he still
has voting rights and stands to benefit in the future. T his could potentially influence his analysis and
recommendations, hence it's important to disclose this conflict of interest.
330
Choi ce B i s i ncorrect. While notifying superiors about potential conflicts of interest is a good
practice, completely abstaining from issuing recommendations on BWL may not be necessary if
proper disclosures are made and approved by his employer.
Choi ce C i s i ncorrect. Requesting his uncle to amend the terms of trust does not address the issue
at hand - potential conflict of interest due to Leakey's new status as a beneficiary of BWL stocks.
T he most appropriate course would be disclosure rather than changing terms of trust.
Q.279 Paul Lambert, FRM, serves as a financial analyst for Lakeside Investments. He has been
tasked with preparing a purchase recommendation on Brighter World Limited. Which of the following
statements about disclosure of conflicts of interest would Lambert have to disclose fully?
A. He co-owns 30,000 of Brighter World Limited with his brother.
B. He has a significant ownership in Brighter World Limited through a family trust.
C. Lakeside is an over-the-counter market maker for Brighter World Limited's stock.
D. All of the above.
According to the GARP Code of Conduct, members are required to make full and fair disclosure of all
matters that could reasonably be expected to impair their objectivity and independence or interfere
with their respective duties to their employers, clients, and prospective clients. T his includes all the
scenarios mentioned in the options.
In option (a), Lambert co-owns 30,000 shares of Brighter World Limited with his brother. T his
personal investment could potentially influence his analysis and recommendations, thereby creating a
conflict of interest.
In option (b), Lambert has a significant ownership in Brighter World Limited through a family trust.
Again, this personal stake could bias his analysis and recommendations, leading to a conflict of
interest.
In option (c), Lakeside Investments, Lambert's employer, is an over-the-counter market maker for
331
Brighter World Limited's stock. T his means that Lakeside Investments could potentially influence
the price of Brighter World Limited's stock, which again could create a conflict of interest for
Lambert.
T herefore, in all these scenarios, Lambert would be required to make a full and comprehensive
disclosure of potential conflicts of interest, as per the GARP Code of Conduct.
Choi ce A i s i ncorrect. While it's true that owning shares in Brighter World Limited with his
brother could potentially create a conflict of interest, this alone does not necessitate a full and
comprehensive disclosure according to the GARP Code of Conduct. T he ownership must be
significant enough to influence Lambert's professional judgement or create an appearance of
impropriety.
Choi ce B i s i ncorrect. Having a significant ownership in Brighter World Limited through a family
trust could indeed pose a potential conflict of interest for Lambert. However, the GARP Code of
Conduct requires disclosure only when such ownership is likely to impair his ability to make
unbiased and objective recommendations.
Choi ce C i s i ncorrect. Lakeside being an over-the-counter market maker for Brighter World
Limited's stock might present potential conflicts, but it doesn't automatically require full and
comprehensive disclosure under the GARP Code of Conduct unless it can significantly affect
Lambert's impartiality in making investment recommendations.
Q.280 Which of the following is NOT a fundamental responsibility of GARP members as stipulated in
the Code of Conduct?
A. Members must purpose, and encourage others, to operate at the highest level of
professional skills.
B. Members have a personal ethical responsibility and must maintain the highest ethical
standards.
C. Members cannot delegate or outsource their ethical responsibility to others.
D. Members do not have to continue perfecting their expertise once they have passed exams
and obtained all the necessary certifications.
332
T he statement that 'Members do not have to continue perfecting their expertise once they have
passed exams and obtained all the necessary certifications' is incorrect and does not align with the
GARP Code of Conduct. T he Code of Conduct emphasizes the importance of continuous learning and
professional development. It stipulates that members should always strive to improve their
expertise, even after they have passed their exams and obtained all necessary certifications. T his is
because the field of risk management is dynamic and constantly evolving. New risks emerge, and risk
management techniques and practices are continually being developed and refined. T herefore, to
effectively manage risks and uphold the highest standards of professional conduct, GARP members
must stay abreast of these developments and continually enhance their knowledge and skills. T his
commitment to lifelong learning and professional development is a fundamental responsibility of
GARP members, as stipulated in the Code of Conduct.
Choi ce A i s i ncorrect. T his statement accurately represents one of the fundamental
responsibilities as per the GARP Code of Conduct. Members are indeed expected to operate at the
highest level of professional skills and encourage others to do so.
Choi ce B i s i ncorrect. T his statement also correctly reflects a fundamental responsibility
according to the GARP Code of Conduct. Members are required to maintain high ethical standards and
have a personal ethical responsibility.
Choi ce C i s i ncorrect. As per the GARP Code of Conduct, members cannot delegate or outsource
their ethical responsibility to others, making this statement correct.
Q.281 Chris Jefferson, FRM, is the manager of a hedge fund. Over the last 3 days, he has been
investing the hedge fund by purchasing significant quantities of ABC's stock while simultaneously
selling the three-month futures contract (i.e. initiating a short position in it). Although his clients are
aware of the fund's general investment strategy to generate earnings, Jefferson did not inform them
of the trades. One of the following statements is most likely correct. Which one?
A. Jefferson violated the GARP Code of Conduct.
B. Jefferson did not violate the GARP Code of Conduct.
C. Manipulated the price of a publicly traded security hence violated the Code of Conduct.
333
D. Violated the GARP Code of Conduct by failing to keep his clients in the loop regarding the
transactions before they occurred.
Jefferson did not violate the GARP Code of Conduct. T he GARP Code of Conduct is a set of ethical
guidelines that professionals in the field of risk management are expected to adhere to. It emphasizes
the importance of integrity, objectivity, competence, fairness, confidentiality, professionalism, and
diligence. In this case, Jefferson's actions do not appear to contravene any of these principles. He
was not attempting to manipulate the price of a security or mislead market participants. Instead, he
was employing a legitimate investment strategy, seeking to exploit a potential arbitrage opportunity
between the spot price of ABC's stock and its futures price. T his is a common practice in the world
of hedge funds, where managers often use complex strategies to generate returns. Furthermore, the
clients of the hedge fund were aware of the general investment strategy, even if they were not
informed about the specific trades. T herefore, there was no breach of confidentiality or lack of
transparency. It's important to note that the GARP Code of Conduct does not require risk managers
to disclose every single trade or investment decision to their clients. Instead, it emphasizes the
importance of clear communication and transparency about the overall investment strategy and risk
management practices. In this case, Jefferson appears to have met these requirements, hence he did
not violate the GARP Code of Conduct.
Choi ce A i s i ncorrect. T here is no evidence in the scenario provided that Jefferson violated the
GARP Code of Conduct. T he GARP Code of Conduct does not require disclosure of every specific
trade to clients, but rather a general investment strategy.
Choi ce C i s i ncorrect. T he question does not provide any information suggesting that Jefferson
manipulated the price of a publicly traded security. Simply buying large volumes and initiating a short
position in futures contracts do not constitute price manipulation.
Choi ce D i s i ncorrect. As per the GARP Code of Conduct, it's not mandatory for risk managers to
inform their clients about each transaction before they occur. T hey are required to disclose their
general investment strategy which Jefferson has done in this case.
334
Q.282 Carol Bauer, FRM, serves as a portfolio manager for several wealthy clients with well-
diversified portfolios. Among her clients is Matthew Cook, for whom she manages a personal
portfolio of stocks and government bonds. Cook recently disclosed to Bauer that he is under
investigation for tax evasion related to his business, Cook Concrete. After a few days, Bauer shares
that information with a friend who works at a local bank that has plans to underwrite Concrete's IPO.
Carol Bauer has most likely:
A. Violated the GARP Code of Conduct with respect to confidentiality.
B. Not violated the GARP Code of Conduct with respect to confidentiality.
C. Not violated the GARP Code of Conduct because she revealed illegal activities on the part
of her client.
D. Violated the GARP Code of Conduct by failing to detect the tax evasion despite being
central to her client's business dealings.
Carol Bauer has indeed violated the GARP Code of Conduct with respect to confidentiality. T he
GARP Code of Conduct is a set of ethical guidelines that members of the Global Association of Risk
Professionals (GARP) are expected to adhere to. One of the key principles of this code is the
protection of confidential information. Members are required to take all reasonable precautions to
prevent both intentional and unintentional disclosure of confidential information. In this case, Bauer
was privy to confidential information about her client, Matthew Cook. When Cook informed her
about the investigation into his business for potential tax evasion, this information became part of
the confidential information that Bauer was obligated to protect. By sharing this information with a
friend at a bank that was considering underwriting an IPO for Cook's business, Bauer violated the
confidentiality principle of the GARP Code of Conduct. She did not have the right to disclose her
client's situation to anyone without his explicit consent, regardless of the circumstances. T his
violation could have serious consequences for Bauer, including disciplinary action by GARP and
potential legal repercussions.
Choi ce B i s i ncorrect. Bauer did violate the GARP Code of Conduct with respect to
confidentiality. As a certified FRM, she is expected to maintain the confidentiality of her client's
information unless there is legal or professional obligation to disclose it. In this case, she disclosed
sensitive information about her client's business without any such obligation.
335
Choi ce C i s i ncorrect. Even though Cook Concrete was under investigation for potential tax
evasion, Bauer was not justified in revealing this information without a legal or professional
obligation to do so. T he GARP Code of Conduct requires FRMs to maintain confidentiality unless
disclosure is required by law or consented by the client.
Choi ce D i s i ncorrect. While detecting and preventing illegal activities can be part of an FRM's
responsibilities, the GARP Code of Conduct does not specifically require them to detect tax evasion
in their clients' businesses. T herefore, Bauer did not violate the code by failing to detect Cook
Concrete's potential tax evasion.
Q.283 Donald Lee, FRM, is an exam proctor for the FRM part I exam. A few days before the exam,
Lee emails a copy of 5 questions to each of his two friends, Martin and Joseph, who are part 1
candidates in the FRM program. Lee and his two friends had planned the distribution of exam
questions months in advance. Martin proceeds to prepare for the exam. However, Joseph develops
cold feet and declines to load the questions and use them to his advantage. Which of the following
statements is most likely correct?
A. Donald Lee violated the GARP Code of Conduct, but Martin and Joseph did not.
B. All the three violated the GARP Code of Conduct.
C. Donald Lee and Martin violated the code, but Joseph did not.
D. Martin and Joseph violated the code, but Donald Lee did not.
All three individuals, Donald Lee, Martin, and Joseph, have violated the GARP Code of Conduct. T he
GARP Code of Conduct is a set of ethical guidelines that all members and candidates of the FRM
program are expected to adhere to. It is designed to uphold the integrity of the GARP and the validity
of the examinations that lead to the award of the FRM designation. In this scenario, Donald Lee has
clearly breached the security of the examination by sharing actual exam questions with Martin and
Joseph. T his act compromises the integrity of the examination and gives an unfair advantage to
Martin and Joseph over other candidates. Martin, by deciding to use these questions for his
preparation, is also in violation of the code. Joseph, despite his decision not to use the questions, is
still in violation of the code. His initial agreement to the plan makes him complicit in the act, even
336
though he later decided against using the questions. T herefore, all three individuals have violated the
GARP Code of Conduct.
Choi ce A i s i ncorrect. T his statement is not accurate because not only Donald Lee, but also
Martin and Joseph violated the GARP Code of Conduct. Donald Lee violated the code by sharing exam
questions in advance, which is a clear breach of confidentiality and integrity. Martin also violated the
code by deciding to use these questions for his preparation, thus participating in an unethical
practice. Joseph, despite deciding against using these questions, was aware of this unethical act and
did not report it to GARP authorities which makes him complicit.
Choi ce C i s i ncorrect. While it's true that Donald Lee and Martin violated the code, Joseph too
was in violation despite his decision against using these questions as he failed to report this unethical
act.
Choi ce D i s i ncorrect. T his statement inaccurately absolves Donald Lee from any wrongdoing
when he was actually at the center of this violation by sharing exam questions beforehand.
Q.284 T imothy Bradley, FRM, works as a full-time financial analyst at KenBright Actuarial Services
Limited(KBG). Recently, one of the company's business contacts offered him a part-time analytical
job at KPMG. T he work would entail establishing the right balance between equity and debt finance
for KPMG. T imothy should most appropriately:
A. Not accept the work as it violates the Code of Conduct by creating a conflict of interest.
B. Accept the work as long as he is interested and is familiar with the work.
C. Accept the work as long as his full-time employer, KenBright Limited, agrees to all the
terms of the engagement.
D. Accept the role as long as, in her own assessment, it does not interfere with her duties to
KenBright Limited.
According to the Code of Conduct for Financial Risk Managers, it is crucial for members to maintain
full transparency and fairness in all their professional dealings. T his includes disclosing any potential
conflicts of interest that could interfere with their duties to their employer, clients, or potential
337
clients. In T imothy's case, accepting the part-time role at KPMG could potentially create a conflict
of interest with his full-time role at KenBright. T herefore, the most appropriate course of action
would be for him to accept the role only if his current employer, KenBright, fully agrees to the
terms of the engagement. T his would ensure that his actions are in line with the principles of
independence, objectivity, and fairness as stipulated by the Code of Conduct.
Choi ce A i s i ncorrect. While conflicts of interest should be avoided, the mere acceptance of part-
time work does not necessarily create a conflict of interest. It would depend on the nature of the
work and whether it interferes with T imothy's duties at KenBright Limited.
Choi ce B i s i ncorrect. T he decision to accept additional employment should not solely be based on
personal interest and familiarity with the work. Professional conduct guidelines require that T imothy
consider potential conflicts of interest and obtain approval from his current employer, KenBright
Limited.
Choi ce D i s i ncorrect. Although it's important for T imothy to assess whether the part-time role
interferes with his duties at KenBright Limited, this alone isn't sufficient according to professional
conduct guidelines. He must also seek approval from his current employer before accepting
additional employment.
Q.285 Sally Spicer, FRM, acts as a liaison between Prime Financials (an investment management
firm) and Neiman Inc. (an investment bank). Neiman Inc. intends to issue an IPO and turns to Prime
Financials for underwriting services. As a way of increasing investor confidence, Sally Spicer has
Prime Financials issue a trove of vague and unrealistic financial information that paints its clients in
better health than it actually is. Which section of the GARP Code of conduct has most likely been
violated by Spicer and her company?
A. Best practices.
B. Professional integrity and ethical conduct.
C. Fundamental responsibilities.
D. Confidentiality.
338
T he GARP Code of Conduct, under the section of Professional integrity and ethical conduct,
stipulates that members must avoid any form of deceit in assessments, measurements, and processes
that are intended to provide a business advantage at the expense of honesty and truthfulness. In the
given scenario, Sally Spicer and Prime Financials have violated this section by issuing misleading
financial information to boost investor confidence. T his action is a clear contravention of the
principles of honesty and truthfulness, as it presents the clients in a better financial state than they
actually are. T he intention behind this action is to gain a business advantage, which is explicitly
prohibited under this section of the GARP Code of Conduct. T herefore, the most likely section of
the GARP Code of Conduct that has been violated by Spicer and her company is Professional
integrity and ethical conduct.
Choi ce A i s i ncorrect. Best practices refer to the recommended methods and strategies in risk
management that are accepted as superior to others because they produce results that are superior
to those achieved by other means. In this case, Sally Spicer is not breaching best practices but
rather she is engaging in unethical conduct by releasing misleading financial data.
Choi ce C i s i ncorrect. Fundamental responsibilities refer to the basic duties of a risk manager
such as maintaining professional competence, acting with integrity, and serving clients with diligence
and objectivity. While Spicer's actions may be seen as a breach of these responsibilities, her actions
more directly violate the principle of professional integrity and ethical conduct.
Choi ce D i s i ncorrect. Confidentiality refers to the obligation of professionals to protect sensitive
information from unauthorized disclosure. In this scenario, there's no indication that Spicer or Prime
Financials have disclosed confidential information without authorization.
Q.286 Romney Muriuki, FRM, works as an analyst for an African Insurance firm that has a presence
in 8 central African countries. In a recent report, Muriuki makes the following statements:
"Based on the fact that the firm has recorded steady growth in customer numbers over the last
decade, and that the insurance penetration currently stands at 3%, I expect the trend to continue for
the next 10 years. I also expect that the company will be able to translate the continually increasing
revenue into significant profits."
T he report describes in detail the risks facing the firm, particularly geopolitical risks associated with
African countries. Muriuki's report:
339
A. Violated the Code by failing to distinguish factual details from his opinion.
B. Did not violate the Code.
C. Violated the code by giving a shallow professional assessment of the insurance market in
Africa.
D. Violated the Code by failing to properly identify all the risks related to operations in
African countries.
Muriuki's report did not violate the Code of Conduct. T he Code of Conduct in question here is likely
referring to a professional standard that requires analysts to clearly distinguish between factual
information and their own opinions in their reports. In Muriuki's report, he presents the historical
growth of the firm and the current insurance penetration rate as facts, which they are since they
are based on actual data and events that have occurred. His projection of continued growth and
increased profits is presented as his opinion, which is based on his analysis of the factual information.
He does not present his opinion as a fact, thereby maintaining the distinction between the two. T his
is in line with the professional standard, and hence, he did not violate the Code of Conduct.
Choi ce A i s i ncorrect. Muriuki's report does not violate the Code by failing to distinguish factual
details from his opinion. He clearly states the facts about the firm's consistent growth and current
insurance penetration rate, and then provides his projection based on these facts. T his is a common
practice in risk analysis and does not constitute a violation of the Code of Conduct.
Choi ce C i s i ncorrect. T he claim that Muriuki violated the code by giving a shallow professional
assessment of the insurance market in Africa is unfounded. T here are no indications in the question
that suggest Muriuki's assessment was shallow or unprofessional. His report includes both historical
data and future projections, which are key components of a comprehensive market analysis.
Choi ce D i s i ncorrect. It cannot be concluded that Muriuki violated the Code by failing to properly
identify all risks related to operations in African countries based on this information provided in this
question alone. T he question mentions that he emphasized geopolitical risks, but it doesn't specify
whether other potential risks were ignored or overlooked.
340

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FRM Part I Exam

Questions with Answers - Foundations of Risk Management

Last Updated: Sep 19, 2023

prohibited. Infringers will be prosecuted in their local jurisdictions. ”

1 - The Building Blocks of Risk Management 3

Thi ngs to Remember

flow needs or the risk of mass withdrawals by depositors or redemptions by shareholders. T he

make agreed-upon payments in a timely fashion.'

due to changes in market factors.

A. Interest rate risk

B. Foreign exchange risk

in the question is foreign exchange risk.

reputation, in lost revenue; increased operating, capital or regulatory costs; or destruction of

response to a specific event or crisis.

the risk of the issuer defaulting.

Thi ngs to Remember

A. Inadequate/malfunctioning computer systems

B. Circumvention of issued regulations and guidelines

C. Occurrence of a natural disaster, such as a tornado

D. An increase in the price of gas

A i s i ncorrect. Inadequate/malfunctioning computer systems is an example of operational risk

B i s i ncorrect. Circumvention of issued regulations and guidelines is an example of compliance

C i s i ncorrect. Occurrence of a natural disaster, such as a tornado, is an example of operational

Thi ngs to Remember

management systems, and business continuity planning.

A. Applying risk management within individual departments on a piecemeal basis.

B. Risk management that includes all major departments in a company.

D. Risk management that encompasses all business units.

inter-departmental risks, are taken into account.

A i s i ncorrect: Applying risk management within individual departments on a piecemeal basis is a

without considering the impact on other departments or the company as a whole.

identified, assessed, monitored, and managed across the entire organization.

Thi ngs to Remember

of the organization, leading to more effective risk management.

B. T he practice of avoiding an extremely risky financial undertaking to prevent a loss.

C. T he practice of creating economic value by identifying and measuring risks, and

D. Setting risk limits beyond which an entity should not operate.

mitigation, risk monitoring, and risk reporting.

maximize positive outcomes.

monitoring, and risk reporting.

Thi ngs to Remember

Risk management is a comprehensive process that involves identifying, assessing, mitigating,

value and ensure their long-term sustainability.

A. T rading liquidity risk

B. Funding liquidity risk

C. Interest rate risk

nationalization in February 2008.

rates, which may cause a decline in the value of interest-rate-sensitive portfolios.

Thi ngs to Remember

its short-term obligations.

specific measure used in financial risk management.

Thi ngs to Remember

cover potential credit losses.

risk or the potential loss in extreme scenarios.

ineffective risk management strategies.

A. As the investment risk increases, the reward decreases.

B. As the investment risk decreases, the reward increases.

C. As the investment risk increases, the potential for reward increases.

expectation of achieving higher potential returns.

Thi ngs to Remember

T he risk-reward tradeoff is a fundamental concept in finance that suggests a direct relationship

A. Commodity price risk

B. Currency exchange risk

C. Interest rate risk