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2009FRMPracticeExams

2009FRMPracticeExams

TableofContents
2009FRMLevelIPracticeExamCandidateAnswerSheet.............................................3 2009FRMLevelIPracticeExamQuestions ...................................................................5 2009FRMLevelIPracticeExamAnswerKey...............................................................19 2009FRMLevelIPracticeExamAnswers&Explanations...........................................21 2009FRMFullExamFRMPracticeExamICandidateAnswerSheet ..........................47 2009FRMFullExamFRMPracticeExamIQuestions..................................................49 2009FRMFullExamFRMPracticeExamIAnswerKey ...............................................65 2009FRMFullExamFRMPracticeExamIAnswers&Explanations ...........................67 2009FRMFullExamFRMPracticeExamIICandidateAnswerSheet .........................99 2009FRMFullExamFRMPracticeExamIIQuestions...............................................101 2009FRMFullExamFRMPracticeExamIIAnswerKey ............................................117 2009FRMFullExamFRMPracticeExamIIAnswers&Explanations ........................119

Introduction
TheFRMexamisapracticeorientedexamination.Itsquestionsarederivedfromacombination oftheory,assetforthinthecorereadings,andrealworldworkexperience.Candidatesare expectedtounderstandriskmanagementconceptsandapproachesandhowtheywouldapply toariskmanagersdaytodayactivities. The FRM examination is also a comprehensive examination, testing a risk professional on a numberofriskmanagementconceptsandapproaches.Itisveryrarethatariskmanagerwillbe facedwithanissuethatcanimmediatelybeslottedintoonecategory.Intherealworld,arisk manager must be able to identify any number of riskrelated issues and be able to deal with themeffectively. The2009FRMPracticeExamshavebeendevelopedtoaidcandidatesintheirpreparationfor the FRM Examination in November 2009. These practice exams are based on a sample of questionsfromthe2007FRMExaminationandarerepresentativeofthequestionsthatwillbe in the 2009 FRM Examination. Wherever necessary and possible, questions, answers and referenceshavebeenupdatedtobetterreflectthetopicsandcorereadingslistedinthe2009 FRMExaminationStudyGuide. The2009FRMLevelIPracticeExamandtheFRMFullExamPracticeExamsIandIIcontain40 and 50 multiplechoice questions, respectively. Note that the 2009 FRM Level I and Full Examination will consist of a morning and afternoon session containing 50 and 70 multiple choice questions, respectively. The practice exams were designed to be shorter to allow candidatestocalibratetheirpreparednesswithoutbeingoverwhelming.
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2009FRMPracticeExams

The2009FRMPracticeExamsdonotnecessarilycoveralltopicstobetestedinthe2009FRM Examination. For a complete list of topics and core readings, candidates should refer to the 2009 FRM Examination Study Guide. Core readings were selected by the FRM Committee to assistcandidatesintheirreviewofthesubjectscoveredbytheexam.QuestionsfortheFRM examination are derived from the core readings. It is strongly suggested that candidates reviewthesereadingsindepthpriortosittingfortheexam.

SuggestedUseofPracticeExams
Tomaximizetheeffectivenessofthepracticeexams,candidatesareencouragedtofollow theserecommendations: Planadateandtimetotakeeachpracticeexam.Setdatesappropriatelytogive sufficientstudy/reviewtimebetweeneachpracticeexamandpriortotheactualexam. Simulatethetestenvironmentascloselyaspossible. o Takeeachpracticeexaminaquietplace. o Haveonlythepracticeexam,candidateanswersheet,calculator,andwriting instruments(pencils,erasers)available. o Minimizepossibledistractionsfromotherpeople,cellphonesandstudy material. o Allocate90minutesforeachpracticeexamandsetanalarmtoalertyouwhen 90minuteshavepassed.Completeeachexambutnotethequestionsanswered afterthe90minutemark. o FollowtheFRMcalculatorpolicy.YoumayonlyuseaTexasInstrumentsBAII Plus(includingtheBAIIPlusProfessional)calculatororaHewlettPackard12C (includingtheHP12CPlatinum)calculator. Aftercompletingeachpracticeexam, o Calculateyourscorebycomparingyouranswersheetwiththepracticeexam answerkey.Onlyincludequestionscompletedinthefirst90minutes. o UsethepracticeexamAnswers&Explanationstobetterunderstandcorrectand incorrectanswersandtoidentifytopicsthatrequireadditionalreview.Consult referencedcorereadingstoprepareforexam. o Pass/failstatusfortheactualexamisbasedonthedistributionofscoresfromall candidates,souseyourscoresonlytogaugeyourownprogressand preparedness.

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2009FRMPracticeExams

2009FRMLevelIPracticeExam CandidateAnswerSheet
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d.

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2009FRMLevelIPracticeExam Questions

1. Tohedgeagainstfuture,unanticipated,andsignificantincreasesinborrowingrates,whichofthe followingalternativesoffersthegreatestflexibilityfortheborrower?

a. b. c. d.

Fixedforfloatingswap Interestratecollar Interestratefloor Callswaption

2. AninvestmentbankusestheExponentiallyWeightedMovingAverage(EWMA)techniquewith lambdaof0.9tomodelthedailyvolatilityofasecurity.Thecurrentestimateofthedailyvolatilityis 1.5%.TheclosingpriceofthesecurityisUSD20yesterdayandUSD18today.Usingcontinuously compoundedreturns,whatistheupdatedestimateofthevolatility? a. b. c. d. 5.44% 3.62% 2.96% 1.31%


3. ConsidertwostocksAandB.Assumetheirannualreturnsarejointlynormallydistributed,the marginaldistributionofeachstockhasmean2%andstandarddeviation10%,andthecorrelationis 0.9.WhatistheexpectedannualreturnofstockAiftheannualreturnofstockBis3%?

a. b. c. d.

2.9% 2% 1.1% 4.7%

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4. InpricingaderivativeusingtheMonteCarlomethod,weneedtosimulateareasonablenumberof pathsforthepriceoftheunderlyingasset.Supposeweuseasimplemodelforthereturnofthe underlyingasset:
y(t)=drift*t+vol*t*e(t),ande(t)isdistributed~N(0,1),

wheredriftandvolareknownparametersandtisthestepsize. Thegenerationofeachpathrequiresanumberofsteps.Whichofthefollowingdescribesthe correctprocedure?

a. GeneratearandomnumberfromanormaldistributionN(0,1),usetheinversenormalfunction togete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedureuntilyouget thefulldesiredpath. b. GeneratearandomnumberfromanormaldistributionN(0,1),usethecumulativenormal functiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedure untilyougetthefulldesiredpath. c. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usetheinverse cumulativenormalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthe sameprocedureuntilyougetthefulldesiredpath. d. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usethecumulative normalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesame procedureuntilyougetthefulldesiredpath.

5. Ariskmanagerestimatesthedailyvariance(ht)usingaGARCHmodelondailyreturns(rt):
ht = 0 + 1r2t-1 + ht-1

Assumethemodelparametervaluesare0 = 0.005, = 0.04, = 0.94.Thelongrunannualized volatilityisapproximately: a. b. c. d.

25.00% 13.54% 72.72% 7.94%

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6. AsinglestockhasapriceofUSD10andacurrentdailyvolatilityof2%.Usingthedeltanormal method,theVaRatthe95%confidencelevelofalongatthemoneycallonthisstockovera1day holdingperiodisapproximately:

a. b. c. d.

USD0.23 USD1.645 USD0.33 USD0.16

7. Aportfolioconsistsoftwozerocouponbonds,eachwithacurrentvalueofUSD10.Thefirstbond hasamodifieddurationof1yearandthesecondhasamodifieddurationof9years.Theyieldcurve isflatandallyieldsare5%.Assumeallmovesoftheyieldcurveareparallelshifts.Giventhatthe dailyvolatilityoftheyieldis1%,whichofthefollowingisthebestestimateoftheportfoliodailyVaR atthe95%confidencelevel?

a. b. c. d.

USD2.33 USD1.65 USD0.82 USD1.16

8. ConsiderthefollowingthreemethodsofestimatingtheP&Lofabulletbond:fullrepricing,duration (PV01),anddurationplusconvexity.RankingtheestimatedP&Limpactofalargenegativeyield shockfromthelowestP&LimpacttothehighestP&Limpact,whatistherankingofthemethodsto estimatetheP&Limpact?

a. b. c. d.

Durationplusconvexity,duration,fullrepricing Fullrepricing,durationplusconvexity,duration Duration,durationplusconvexity,fullrepricing Duration,fullrepricing,durationplusconvexity

9. Considerapositionina5yearreceivefixedswapthatmakesannualpaymentsonaUSD100million notional.Thefloatingleghasjustbeenreset.Thetermstructureisflatat5%,theMacaulay durationofa5yearparbondis4.5years,andtheannualvolatilityofyieldchangesis100bp.Your bestestimateoftheswapsVaRwith95%confidenceoverthenextmonthis: a. USD1.6million b. USD2.0million c. USD5.5million d. USD7.1million


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10. Ifthegoldleaserateishigherthantheriskfreerate,whatisthemarketstructureoftheforward marketforgold?

a. b. c. d.

Contango Backwardation Inversion Needmoreinformationtodetermine

11. Thepriceofa3yearzerocoupongovernmentbondis85.16.Thepriceofasimilar4yearbondis 79.81.Whatistheoneyearimpliedforwardratefromyear3toyear4?

a. b. c. d.

5.4% 5.5% 5.8% 6.7%

12. AportfoliomanagerhasabondpositionworthUSD100million.Thepositionhasamodified durationof8yearsandaconvexityof150years.Assumethatthetermstructureisflat.Byhow muchdoesthevalueofthepositionchangeifinterestratesincreaseby25basispoints?

a. b. c. d.

USD1,953,125 USD1,906,250 USD2,046,875 UDS2,187,500

13. Afirmisgoingtobuy10,000barrelsofWestTexasCrudeOil.Itplanstohedgethepurchaseusing theBrentCrudefuturescontract.Thecorrelationbetweenthespotandfuturespricesis0.72.The volatilityofthespotpriceis0.35peryear.ThevolatilityoftheBrentCrudefuturespriceis0.27per year.Whatisthehedgeratioforthefirm?

a. b. c. d.

0.5554 0.9333 1.2099 0.8198

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14. ItisJune2ndandafundmanagerwithUSD10millioninvestedingovernmentbondsisconcerned thatinterestrateswillbehighlyvolatileoverthenextthreemonths.Themanagerdecidestouse theSeptemberTreasurybondfuturescontracttohedgethevalueoftheportfolio.Thecurrent futurespriceis95.0625.EachcontractisforthedeliveryofUSD100,000facevalueofbonds.The durationofthemanagersbondportfoliointhreemonthswillbe7.8years.Thecheapesttodeliver bondintheTreasurybondfuturescontractisexpectedtohaveadurationof8.4yearsatmaturityof thecontract.AtthematurityoftheTreasurybondfuturescontract,thedurationoftheunderlying benchmarkTreasurybondis9years.Whatpositionshouldthefundmanagerundertaketomitigate hisinterestrateriskexposure? a. Short94contracts b. Short98contracts c. Short105contracts d. Short113contracts

15. AbondtraderhasboughtapositioninTreasuryBondswitha4%annualcouponrateonFebruary 15,2015.TheDV01ofthepositionisUSD80,000.Thetraderdecidestohedgehisinterestraterisk withthe4.5%couponrateTreasuryBondsmaturingonMay15,2017whichhasaDV01of.076per USD100facevalue.Toimplementthishedge,approximatelywhatfaceamountofthe4.5% TreasurybondsmaturingonMay15,2017shouldthetradersell?

a. b. c. d.

USD80,000 USD10,500,000 USD80,000,000 USD105,000,000

16. SupposethatAandBarerandomvariables,eachfollowsastandardnormaldistribution,andthe covariancebetweenAandBis0.35.Whatisthevarianceof(3A+2B)?

a. b. c. d.

15.10 14.47 9.20 17.20

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17. ConsiderastockpriceSthatfollowsageometricBrownianmotiondS = S dt + S dz, with strictlypositiveand afixedvalue.Whichofthefollowingstatementsistrue?

a. b. c. d.

Ifthedriftisnegative,thepriceoneyearfromnowwillbebelowtodaysprice. Theinstantaneousrateofreturnonthestockfollowsauniformdistribution. ThestockpriceSfollowsalognormaldistribution. Thismodelimposesmeanreversion.

18. ThejointprobabilitydistributionofrandomvariablesXandYisgivenbyf(x,y)=kxyforx=1,2,3,y= 1,2,3,andkisapositiveconstant.WhatistheprobabilitythatX+Ywillexceed5?

a. b. c. d.

1/9 1/4 1/36 Cannotbedetermined

19. WhichofthefollowingstatementsregardingHypothesisTestingisincorrect?

a. Hypothesistestingisusedtomakeinferencesabouttheparametersofagivenpopulationon thebasisofstatisticscomputedforasamplethatisdrawnfromthatpopulation. b. TypeIIerrorreferstothefailuretorejectthenullhypothesiswhenitisactuallyfalse. c. Thepvaluedecisionruleistorejectthenullhypothesisifthepvalueisgreaterthanthe significancelevel. d. Allelsebeingequal,thedecreaseinthechanceofmakingaTypeIerrorcomesatthecostof increasingtheprobabilityofmakingaTypeIIerror.


20. Ifstockreturnsareindependentlyidenticallynormallydistributedandtheannualvolatilityis30%, thenthedailyVaRatthe99%confidencelevelofastockmarketportfolioisapproximately:

a. b. c. d.

2.41% 3.11% 4.40% 1.89%

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21. ThecurrentvalueoftheS&P500indexis1457,andeachS&PfuturescontractisfordeliveryofUSD 250timestheindex.AlongonlyequityportfoliowithmarketvalueofUSD300,100,000hasbetaof 1.1.Toreducetheportfoliobetato0.75,howmanyS&Pfuturescontractshouldyousell?

a. b. c. d.

618contracts 288contracts 574contracts 906contracts

Thefollowinginformationshouldbeusedforthenexttwoquestions. OnJanuary1,ariskmanagerobservesthatthe1yearcontinuouslycompoundedinterestrateis5% andstoragecostsofacommodityproductAisUSD0.05perquarter(payableateachquarterend). HefurtherobservesthefollowingforwardpricesforproductA: March 5.35 June 5.90 September 5.30 December 5.22

22. GiventhefollowingexplanationofsupplyanddemandforcommodityproductAhowwouldyou bestdescribeitsforwardpricecurvefromJunetoDecember? Marketdescription Explanation a. Backwardation ExcessdemandforAinearlysummer b. Backwardation Supplyisexpectedtodeclineaftersummer c. Contango ExcessdemandforAinearlysummer d. Contango Supplyisexpectedtodeclineaftersummer

23. WhatistheannualizedrateofreturnearnedonacashandcarrytradeenteredintoinMarchand closedoutinJune?

a. b. c. d.

8.9% 9.8% 35.7% 39.1%

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24. AninvestorsellsaJune2008callofABCLimitedwithastrikepriceofUSD45forUSD3andbuysa June2008callofABCLimitedwithastrikepriceofUSD40forUSD5.Whatisthenameofthis strategyandthemaximumprofitandlosstheinvestorcouldincur? a. BearSpread,MaximumLossUSD2,MaximumProfitUSD3 b. BullSpread,MaximumLossUnlimited,MaximumProfitUSD3 c. BearSpread,MaximumLossUSD2,MaximumProfitUnlimited d. BullSpread,MaximumLossUSD2,MaximumProfitUSD3

25. WhichofthefollowingproblemsareNOTinherentdisadvantagesofthehistoricalsimulation approachtoestimatingVaR?

I. Itgivestoolittleweighttomorerecentobservations II. Forlongonlyportfolios,itislikelytounderstateVaRfollowingarecentstructuralincrease involatilities III. Italwaysignoresthefattailspresentinthedistributionofreturnsonmanyfinancialassets IV. Becauseofthedeltaapproximation,itinadequatelymeasurestheriskofnonlinear instruments

a. b. c. d.

IandIIonly IIonly I,IIIandIVonly IIIandIVonly

26. AbankholdsUSD60millionworthof10year6.5%couponbondsthataretradingatacleanpriceof 101.82.Thebankisworriedbytheexposureduetothesebondsbutcannotunwindthepositionfor fearofupsettingtheclient.Therefore,itpurchasesatotalreturnswap(TRS)inwhichitreceives annualLibor+100bpsinreturnforthemarktomarketreturnonthebond.Forthefirstyear,the Liborsetsat6.25%andbytheendoftheyearthecleanpriceofthebondsisat99.35.Thenet receipt/paymentforthebankinthetotalreturnswapwillbe:

a. b. c. d.

ReceiveUSD2.23million ReceiveUSD1.93million PayUSD1.93million PayUSD2.23million

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27. Whichofthefollowingtrade(s)containbasisrisk?

Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsNov07NYMEXWTI CrudeOilcontracts II. Long1,000lotsNov07ICEBrentOilcontractsandlong2,000lotsNov07ICEBrentOilat themoneyput III. Long1,000lotsNov07BrentOilcontractsandshort1,000lotsDec07ICEBrentOil contracts IV. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07NYMEXWTI CrudeOilcontracts

I.

a. b. c. d.

I&III II&IV III&IV I,III&IV

28. Accordingtoputcallparity,buyingaputoptiononastockisequivalentto:

a. b. c. d.

Buyingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Sellingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. Sellingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate.

29. A3monthfuturescontractonanequityindexiscurrentlypricedatUSD1000,theunderlyingindex stocksarevaluedatUSD990andpaydividendsatacontinuouslycompoundedrateof2percent andthecurrentcontinuouslycompoundedriskfreerateis4percent.Thepotentialarbitrageprofit percontract,giventhissetofdata,isclosestto

a. USD10.00 b. USD7.50 c. USD5.00 d. USD1.50

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30. ResearchandmodelprojectionsindicatethataspecificeventislikelytomovetheCHFagainstthe USD.Whilethedirectionofthemoveishighlyuncertain,itishighlylikelythatmagnitudeofthe movewillbesignificant.Basedonthisinformation,whichofthefollowingstrategieswouldprovide thelargesteconomicbenefit?

a. LongacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate b. LongacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikepriceand expirationdate c. ShortacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate d. ShortacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate


31. Initially,thecalloptiononBigKahunaInc.with90daystomaturitytradesatUSD1.40.Theoption hasadeltaof0.5739.Adealersells200calloptioncontractsandtodeltahedgetheposition,the dealerpurchases11,478sharesofthestockatthecurrentmarketpriceofUSD100pershare.The followingday,thepricesofboththestockandthecalloptionincrease.Consequently,delta increasesto0.7040.Tomaintainthedeltahedge,thedealershould:

a. b. c. d.

Purchase2,602shares Sell2,602shares Purchase1,493shares Sell1,493shares

32. Whichofthefollowingstrategiescreatesacalendarspread? a. Sellacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice b. Buyacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice c. Sellacalloptionwithacertainstrikepriceandbuyashortermaturitycalloptionwiththesame strikeprice d. Buyacalloptionwithacertainstrikepriceandsellalongermaturitycalloptionwiththesame strikeprice

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33. Whichofthefollowingunderlyingmacroeconomicconditionswouldleaveanemergingmarket mostvulnerabletothecontagioneffectsofacurrencycrisis?

a. b. c. d.

Largecurrentaccountsurplus,lowforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountdeficit,lowforeignexchangereserves,fullyconvertiblecurrency Smallcurrentaccountdeficit,highforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountsurplus,highforeignexchangereserves,fullyconvertiblecurrency

34. ConsideranFRA(forwardrateagreement)withthesamematurityandcompoundingfrequencyasa Eurodollarfuturescontract.TheFRAhasaLIBORunderlying.Whichofthefollowingstatementsare trueabouttherelationshipbetweentheforwardrateandthefuturesrate?

a. b. c. d.

Theyshouldbeexactlythesame Theforwardrateisnormallyhigherthanthefuturesrate Theforwardrateisnormallylowerthanthefuturesrate Theyhavenofixedrelationship

35. Yourbankisanactiveplayerinthecommoditymarket.Theviewoftheeconomistofthebankis thatinflationisexpectedtorisemoderatelyintheneartermandmarketvolatilityisexpectedto remainlow.Thetradersareadvisedtoundertakedealsonthemetalsexchangetoalignyourbook toconformwiththeexpectationsoftheeconomistofthebank.Asriskmanager,youareaskedto monitorthepositionsofthetraderstomakesurethattheyhavetheexposurestoinflationand marketvolatilitysoughtbythebank.Whichtraderhastakenanappropriatepositionamongthe tradersyouaremonitoring?

a. TraderAboughtacallandaput,bothwith90daystoexpirationandwithstrikepriceequalto theexistingspotlevel b. TraderBboughtaputoptionwithadownandinknockinfeature c. TraderCboughtacalloptionattheexistingspotlevelsandsoldacallatahigherstrikeprice, bothwith90daystoexpiration d. TraderDsoldacallandboughtaputattheexistinglevels,bothwith90daystoexpiration


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36. TheinformationratiooftheSteroleUSFundfor2006againsttheS&P500,itsbenchmarkindex,is1. Forthesametimeperiod,thefundsSharperatiois2,thefundhasatrackingerrorof7%against theS&P500,andthestandarddeviationoffundreturnsis5%.TheriskfreerateintheUSis4%. CalculatethereturnfortheS&P500duringthetimeperiod.

a. b. c. d.

3.5% 7% 11% 14%

37. Afundmanagerrecentlyreceivedareportontheperformanceofhisportfoliooverthelastyear. Accordingtothereport,theportfolioreturnis9.3%,withastandarddeviationof13.5%,andabeta of0.83.Theriskfreerateis3.2%,thesemistandarddeviationL(Rp)oftheportfoliois8.4%,andthe trackingerroroftheportfoliotothebenchmarkindexis2.8%.Whatisthedifferencebetweenthe valueofthefundsSortinoratio(computedrelativetotheriskfreerate)anditsSharperatio?

a. b. c. d.

0.274 1.727 0.653 0.378

38. Whichofthefollowingstatementsaboutthelinearregressionofthereturnofaportfoliooverthe returnofitsbenchmarkpresentedbelowarecorrect?

Portfolioparameter Value Beta 1.25 Alpha 0.26 Coefficientofdetermination 0.66 Standarddeviationoferror 2.42

I. Thecorrelationis0.71 II. 34%ofthevariationintheportfolioreturnisexplainedbyvariationinthebenchmark return III. Theportfolioisthedependentvariable IV. Foranestimatedportfolioreturnof12%,theconfidenceintervalat95%is[7.16%;16.84%]

a. b. c. d.

IIandIV IIIandIV I,IIandIII II,IIIandIV

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39. YourBoardofDirectorswantsacomprehensivereviewofeachbusinessunitsoperationalrisk activities.Astheheadofthecorporateoperationalriskunit,youknowthatlittlehasbeendoneto implementanoperationalriskprocessatthebusinessunitlevelandthatyouneedtoimmediately comeupwithaframework.Whichofthefollowingstatementsoffersthebeststrategy?

TheauditcommitteeoftheBoardshouldfirstdefineitsobjectivestoensurethatallthe firmsbusinessunitsoperationalriskprogramsareprovidingrequiredinformation II. Theauditingdepartmentistobechargedwithdevelopinganoperationalriskprogramfor eachbusinessunit,withthebusinessunitbeingmadeclearlyawarethattheywillbeheld accountableforitsimplementation III. Thatyourdepartmentimmediatelyassesstheoperationalriskforeachbusinessunitusing independentdatafeedstoensuretheinformationfedintotheassessmentcannotbe manipulated IV. Aseniormanagerfromeachprofitcenteristobechargedwithdevelopingtheirown operationalriskselfassessmentprogrambasedonguidelinesyouprovide.

I.

a. b. c. d.

Ionly IandIVonly IandIIIonly IVonly

40. Whichofthefollowingriskmanagementstrategiesofafirmwhichhasprincipalpaymentstomake onitsdebtinoneyearthatsubstantiallyexceedthemarketvalueofitsassetsismostlikelytobein theinterestoftheshareholders?

a. b. c. d.

Reductionoftheoverallrisklevelofthefirm Increaseoftheoverallrisklevelofthefirm Keepthesamerisklevel Itisimpossibletosaywhichriskmanagementstrategytheshareholdersprefer

ENDOF2009FRMLevelIPRACTICEEXAM

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2009FRMLevelIPracticeExam AnswerKey
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d.

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2009FRMLevelIPracticeExam Answers&Explanations

1. Tohedgeagainstfuture,unanticipated,andsignificantincreasesinborrowingrates,whichofthe followingalternativesoffersthegreatestflexibilityfortheborrower?

a. b. c. d.

Fixedforfloatingswap Interestratecollar Interestratefloor Callswaption

CORRECT:D

Thequestionfocusesonflexiblemanagementofborrowingexpenses.Whileafixedforfloating swapcouldreduceborrowingexpenses,itisalongtermcontractualcommitmenttoexchange payments.Ifinterestratesdecline,theborrowermaygrossuptotheagreedfixedrate.Aninterest ratecollarisacombinationofaninterestratefloorandcap,i.e.,itlocksintheinterestexpenses withinatightrange.Moreover,collarsusuallyofferinterestrateprotectionatoneparticularpoint oftimeunlessseveralcontractswithdifferentmaturitiesareexchanged.Acallswaptiongivesthe companytherighttoenterintoaswapwhentheborrowingexpensesexceedacertainreference rate.Ifthereferencerateisbelowtheborrowingexpenses,theoptionisnotexercised.

Reference:Hull,Chapter7.


2. AninvestmentbankusestheExponentiallyWeightedMovingAverage(EWMA)techniquewith lambdaof0.9tomodelthedailyvolatilityofasecurity.Thecurrentestimateofthedailyvolatilityis 1.5%.TheclosingpriceofthesecurityisUSD20yesterdayandUSD18today.Usingcontinuously compoundedreturns,whatistheupdatedestimateofthevolatility?

a. b. c. d.

5.44% 3.62% 2.96% 1.31%

CORRECT:B Thecurrentreturnofthesecurityis=ln(18/20)=10.536%.

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UsinganEWMAmodel,theupdatedvolatilityisgivenas: V(t) ={lambda*((V[t1]^2)+(1lambda)*(currentreturn^2)}^0.5 ={0.9 *((0.015^2)+(10.9)*(0.10536^2)}^0.5 =3.62% INCORRECT:AForgetstosquarethevolatilityterms INCORRECT:CForgetstosquarethevolatilitytermsandtotakethesquarerootoftheresulting variance,thenmiscalculatesconversiontopercentage. INCORRECT:DForgetstotakethesquarerootofthevariance,thenmiscalculatesconversionto percentage. Reference:Hull,Chapter21.


3. ConsidertwostocksAandB.Assumetheirannualreturnsarejointlynormallydistributed,the marginaldistributionofeachstockhasmean2%andstandarddeviation10%,andthecorrelationis 0.9.WhatistheexpectedannualreturnofstockAiftheannualreturnofstockBis3%? a. 2.9% b. 2% c. 1.1% d. 4.7%

CORRECT:A E[ra | rb = x] = a + (abab/2a)(x b) = 0.02+0.9*(0.030.02)=0.029 Reference:DamodarGujarati,Chap2,3.


4. InpricingaderivativeusingtheMonteCarlomethod,weneedtosimulateareasonablenumberof pathsforthepriceoftheunderlyingasset.Supposeweuseasimplemodelforthereturnofthe underlyingasset: y(t)=drift*t+vol*t*e(t),ande(t)isdistributed~N(0,1), wheredriftandvolareknownparametersand t isthestepsize.

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Thegenerationofeachpathrequiresanumberofsteps.Whichofthefollowingdescribesthe correctprocedure?

a. GeneratearandomnumberfromanormaldistributionN(0,1),usetheinversenormalfunction togete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedureuntilyouget thefulldesiredpath. b. GeneratearandomnumberfromanormaldistributionN(0,1),usethecumulativenormal functiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedure untilyougetthefulldesiredpath. c. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usetheinverse cumulativenormalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthe sameprocedureuntilyougetthefulldesiredpath. d. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usethecumulative normalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesame procedureuntilyougetthefulldesiredpath.

CORRECT:C Thisquestionwantstotestifthecandidateknowsthebasicstepstogenerateaverysimplepath: answeringthisquestionmeansthatthecandidatewouldbeabletobuildasimplespreadsheet showingtheMonteCarlologic. Thecorrectprocedureistheonedescribedinc);whilea),b)andd)arenonsensicalcalculations. Reference:PhilippeJorion,ValueatRisk,TheNewBenchmarkforManagingFinancialRisk,3rdedition (NewYork:McGrawHill,2007),Chapter12.


5. Ariskmanagerestimatesthedailyvariance(ht)usingaGARCHmodelondailyreturns(rt): ht=0+1r2t1+ht1 Assumethemodelparametervaluesare0 =0.005,1=0.04,=0.94.Thelongrunannualized volatilityisapproximately: a. 25.00% b. 13.54% c. 72.72% d. 7.94%

CORRECT:D

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Thelongrunvarianceis0.005/(10.040.94)=0.005/0.02=0.25.Thedailyvolisthusthesquare root,or0.5%andannualvol7.935%. INCORRECT:AThedailyvarianceisindeed0.25%,andthedailyvolatility0.5%butthisneedstobe annualized. INCORRECT:BMiscalculatesvarianceassqrt(0.04/(10.940.005))*15.87=13.54% INCORRECT:CMiscalculatesvarianceas0.04/(10.940.005)=72.72% Reference:Hull,Chapter21.

6. AsinglestockhasapriceofUSD10andacurrentdailyvolatilityof2%.Usingthedeltanormal method,theVaRatthe95%confidencelevelofalongatthemoneycallonthisstockovera1day holdingperiodisapproximately:

a. b. c. d.

USD0.23 USD1.645 USD0.33 USD0.16

CORRECT:D ThisquestionrequirescandidatestoknowtheformulaforthedeltanormalVaRapproximation,and alsotoknowthatthedeltaofanatthemoneycallis0.5. VaR =| | 1.645 S = 0.5 1.645 0.02 10 = 0.1645 . INCORRECT:AWegetAbyusing2.326insteadof1.645. INCORRECT:BWegetBifweuse2insteadof2%forthevolatility. INCORRECT:CWegetCifweuseadeltaof1. Reference:Allenetal,Chapter3,8689

7. Aportfolioconsistsoftwozerocouponbonds,eachwithacurrentvalueofUSD10.Thefirstbond hasamodifieddurationof1yearandthesecondhasamodifieddurationof9years.Theyieldcurve isflatandallyieldsare5%.Assumeallmovesoftheyieldcurveareparallelshifts.Giventhatthe dailyvolatilityoftheyieldis1%,whichofthefollowingisthebestestimateoftheportfoliodailyVaR atthe95%confidencelevel?

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a. b. c. d.

USD2.33 USD1.65 USD0.82 USD1.16

CORRECT:B ThisquestionassessescandidatesabilitiestoapplythedurationVaRformulatotwobonds simultaneouslyandtorecallthatthedurationofazerocouponbondisequaltothebondmaturity. UsinganobviousextensionofJorionsequation9.5

VaR = D1 V1 1.645 + D2 V2 1.645 = ( D1 V1 + D2 V2 ) 1.645 = ( D1 + D2 ) 10 1.645 = 10 10 1.645 0.01 = 1.645


INCORRECT:AThe99%confidencelevelVaR INCORRECT:CArisesifthecandidatemistakenlydividesthecorrectanswerbythenumberofbond INCORRECT:DMakesbothmistakes Reference:Allenetal.

8. ConsiderthefollowingthreemethodsofestimatingtheP&Lofabulletbond:fullrepricing,duration (PV01),anddurationplusconvexity.RankingtheestimatedP&Limpactofalargenegativeyield shockfromthelowestP&LimpacttothehighestP&Limpact,whatistherankingofthemethodsto estimatetheP&Limpact?

a. b. c. d.

Durationplusconvexity,duration,fullrepricing Fullrepricing,durationplusconvexity,duration Duration,durationplusconvexity,fullrepricing Duration,fullrepricing,durationplusconvexity

CORRECT:C Theprice/yieldlinewithyieldonthexaxisandpriceontheyaxisisconvextotheorigin.The durationatanyyieldlevelisthetangenttothatcurve.Therefore,exceptattheexactpointof tangency,durationwillalwaysunderestimatethepricechange. INCORRECT:ADurationwillalwaysunderestimatepricechangefornegativeyieldshocks INCORRECT:BFullrepricingwillnevergenerateasmallerpositivepricechangethanduration becausedurationrepresentsthepointoftangency INCORRECT:DFullrepricingwillgenerateahigherpriceforalargenegativeyieldchangethanwill durationplusconvexity Reference:Allen,Boudoukh,Saunders,Chapter3
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9. Considerapositionina5yearreceivefixedswapthatmakesannualpaymentsonaUSD100million notional.Thefloatingleghasjustbeenreset.Thetermstructureisflatat5%,theMacaulay durationofa5yearparbondis4.5years,andtheannualvolatilityofyieldchangesis100bp.Your bestestimateoftheswapsVaRwith95%confidenceoverthenextmonthis a. USD1.6million b. USD2.0million c. USD5.5million d. USD7.1million CORRECT:A Becausethefloatingrateleghasjustbeenreset,itsdurationis1.Netdurationis4.51=3.5year,or modifieddurationof3.5/1.05=3.33.The95%VaRofmonthlychangesinyieldsis1.65*1%/12= 0.48%.Multiplying,thisgivesUSD100*0.48%*3.33=USD1.588 INCORRECT:BThisusesanetdurationof4.5yearsandignoresthedurationofthefloatingrate leg. INCORRECT:CThisistheannualVaR,butshouldbetranslatedtoamonthlyhorizon. INCORRECT:DThisistheannualVaRcomputedbyignoringthedurationofthefloatingrateleg. Reference:Allenetal. 10. Ifthegoldleaserateishigherthantheriskfreerate,whatisthemarketstructureoftheforward marketforgold?

a. b. c. d.

Contango Backwardation Inversion Needmoreinformationtodetermine

CORRECT:B Aleaseratehigherthantheriskfeeratewillforceanegativelyslopedforwardcurve,i.e. backwardation INCORRECT:ATheforwardprice=spot*exp(riskfreerateleaserate).Iftheleaserateishigher thantheriskfreerate,forwardswillbelowerthanspot,implyingcontango INCORRECT:CTheterminversionisusedtodescribeyieldcurves,notcommodityforwards INCORRECT:DThereisenoughinformationinthequestiontoprovideananswer Reference:MacDonald,Chapter6


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11. Thepriceofa3yearzerocoupongovernmentbondis85.16.Thepriceofasimilar4yearbondis 79.81.Whatistheoneyearimpliedforwardratefromyear3toyear4?

a. b. c. d.

5.4% 5.5% 5.8% 6.7%

CORRECT:D
1 + Forward rate = Price of three bond 85.16 = = 1.067034 Price of four year bond 79.81

Forward rate = 0.067034 or 6.7%

INCORRECT:AThisisB/C INCORRECT:BThisisthereturnofthe3yearbond INCORRECT:CThisisthereturnofthe4yearbond Reference:Tuckman


12. AportfoliomanagerhasabondpositionworthUSD100million.Thepositionhasamodified durationof8yearsandaconvexityof150years.Assumethatthetermstructureisflat.Byhow muchdoesthevalueofthepositionchangeifinterestratesincreaseby25basispoints?

a. b. c. d.

USD1,953,125 USD1,906,250 USD2,046,875 USD2,187,500

CORRECT:A

V = - D mod y V + 0.5 Convexity y 2 V V = - 8 0.0025 100M + 0.5 150 (0.0025) 2 100M V = - 2M + 46,875 V = - 1,953,125
INCORRECT:BOmits0.5fromthesecondterm INCORRECT:CSubtractsthesecondterm INCORRECT:DMakesbothmistakes Reference:Tuckman

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13. Afirmisgoingtobuy10,000barrelsofWestTexasCrudeOil.Itplanstohedgethepurchaseusing theBrentCrudefuturescontract.Thecorrelationbetweenthespotandfuturespricesis0.72.The volatilityofthespotpriceis0.35peryear.ThevolatilityoftheBrentCrudefuturespriceis0.27per year.Whatisthehedgeratioforthefirm?

a. b. c. d.

0.5554 0.9333 1.2099 0.8198

CORRECT:B
0.35 N = 0.72 0.27 N= 0.9333

INCORRECT:AInvertsthespotvolatilityandthefuturesvolatility INCORRECT:CUsesvariances INCORRECT:DUsessquarerootsofthevolatilities Reference:Hull,Chapter3


14. ItisJune2ndandafundmanagerwithUSD10millioninvestedingovernmentbondsisconcerned thatinterestrateswillbehighlyvolatileoverthenextthreemonths.Themanagerdecidestouse theSeptemberTreasurybondfuturescontracttohedgethevalueoftheportfolio.Thecurrent futurespriceis95.0625.EachcontractisforthedeliveryofUSD100,000facevalueofbonds.The durationofthemanagersbondportfoliointhreemonthswillbe7.8years.Thecheapesttodeliver bondintheTreasurybondfuturescontractisexpectedtohaveadurationof8.4yearsatmaturityof thecontract.AtthematurityoftheTreasurybondfuturescontract,thedurationoftheunderlying benchmarkTreasurybondis9years.Whatpositionshouldthefundmanagerundertaketomitigate hisinterestrateriskexposure?

a. b. c. d.

Short94contracts Short98contracts Short105contracts Short113contracts

CORRECT:B.

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10,000,000 7.8 N= 95,062.50 8.4

N = 97.68 or 98 contracts

INCORRECT:AThisismadeup. INCORRECT:CThisleavesoutthedurations INCORRECT:DThisinvertsthedurations Reference:Tuckman


15. AbondtraderhasboughtapositioninTreasuryBondswitha4%annualcouponrateonFebruary 15,2015.TheDV01ofthepositionisUSD80,000.Thetraderdecidestohedgehisinterestraterisk withthe4.5%couponrateTreasuryBondsmaturingonMay15,2017whichhasaDV01of.076per USD100facevalue.Toimplementthishedge,approximatelywhatfaceamountofthe4.5% TreasurybondsmaturingonMay15,2017shouldthetradersell?

a. b. c. d.

USD80,000 USD10,500,000 USD80,000,000 USD105,000,000

CORRECT:D USD105,000,000x.076/100=USD79,800,whichisprettyclosetothedesiredDV01ofUSD80,000. Tosolveforthehedge,solveforFintheequationUSD80,000=Fx.076/100,givingF=105,263,158 INCORRECT:ASellingthisamountwouldoffsetaDV01ofonlyUSD80,000x.076/100=USD61 INCORRECT:BUSD10,500,000x.076/100=USD7,980 INCORRECT:CUSD80,000,000x.076/100=USD60,800 Reference:Tuckman,Chapter5


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16. SupposethatAandBarerandomvariables,eachfollowsastandardnormaldistribution,andthe covariancebetweenAandBis0.35.Whatisthevarianceof(3A+2B)?

a. b. c. d.

15.10 14.47 9.20 17.20

CORRECT:D Sinceeachvariableisstandardized,itsvarianceis1.ThereforeV(3A+2B)=9V(A)+4V(B)+2x3x2 xCov(A,B)=9+4+4.2=17.2 INCORRECT:A9+4+6*0.35=15.1 INCORRECT:B9+4+12*0.35^2= INCORRECT:C3+2+12*0.35=9.2 Reference:DamodarGujarati


17. ConsiderastockpriceSthatfollowsageometricBrownianmotiondS = S dt + S dz, with strictlypositiveand afixedvalue.Whichofthefollowingstatementsistrue?

a. b. c. d.

Ifthedrift isnegative,thepriceoneyearfromnowwillbebelowtodaysprice. Theinstantaneousrateofreturnonthestockfollowsauniformdistribution. ThestockpriceSfollowsalognormaldistribution. Thismodelimposesmeanreversion.

CORRECT:C INCORRECT:ATheexpectedpriceislessthantodaysprice,butnotthepriceinallthestatesof world. INCORRECT:BTheinstantaneousrateofreturnonthestockfollowsnormaldistribution. INCORRECT:DThismodeldoesnotimposemeanreversion. Reference:PhilippeJorion,ValueatRisk:TheNewBenchmarkforManagingFinancialRisk,3 ed. (NewYork:McGrawHill,2007).Chapter12


rd

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18. ThejointprobabilitydistributionofrandomvariablesXandYisgivenbyf(x,y)=kxyforx=1,2,3,y= 1,2,3,andkisapositiveconstant.WhatistheprobabilitythatX+Ywillexceed5?

a. b. c. d.

1/9 1/4 1/36 Cannotbedetermined

CORRECT:B Note that

f ( x, y) = 1
x =1 y =1

Substitutingthevariousvaluesofxandy,wegetf(1,1)=k,f(1,2)=2k,f(1,3)=3k,f(2,1)=2k,f(2,2)=4k, f(2,3)=6k,f(3,1)=3k,f(3,2)=6k,andf(3,3)=9k.Therefore, k1+2k+3k+2k+4k+6k+3k+6k+9k=1 sothat,36k=1andk=1/36. P(X+Y>5)=f(3,3)=1/36x3x3=1/4 Reference:DamodarGujarati


19. WhichofthefollowingstatementsregardingHypothesisTestingisincorrect?

a. Hypothesistestingisusedtomakeinferencesabouttheparametersofagivenpopulationon thebasisofstatisticscomputedforasamplethatisdrawnfromthatpopulation. b. TypeIIerrorreferstothefailuretorejectthenullhypothesiswhenitisactuallyfalse. c. Thepvaluedecisionruleistorejectthenullhypothesisifthepvalueisgreaterthanthe significancelevel. d. Allelsebeingequal,thedecreaseinthechanceofmakingaTypeIerrorcomesatthecostof increasingtheprobabilityofmakingaTypeIIerror.

CORRECT:C ThetruestatementistorejectHoifthepvalueissmallerthanthesignificancelevel. INCORRECT:AStatementAiscorrectregardingtheprimaryuseofHypothesisTesting. INCORRECT:BStatementBiscorrectregardingthedefinitionoftypeIIerror. INCORRECT:DStatementDiscorrectbecausetypeIerrorandtypeIIerrorareintradeoff. Reference:DamodarGujarati

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20. Ifstockreturnsareindependentlyidenticallynormallydistributedandtheannualvolatilityis30%, thenthedailyVaRatthe99%confidencelevelofastockmarketportfolioisapproximately:

a. b. c. d.

2.41% 3.11% 4.40% 1.89%

CORRECT:C The1dayvolatilityiss*(1/252)^0.5=0.3*0.629941=0.018898.TheVaRatthe99%confidence levelisthenequalto2.32635*0.018898=4.40% INCORRECT:AOnegetsAifoneuses1.645insteadof2.326 INCORRECT:BOnegetsBifoneusesthemonthlyvolatilityinsteadofthedailyone INCORRECT:DOnegetsDisthedailyvolatility Reference:Allen,BoudoukhandSaunders,2004,chapter1,p68


21. ThecurrentvalueoftheS&P500indexis1457,andeachS&PfuturescontractisfordeliveryofUSD 250timestheindex.AlongonlyequityportfoliowithmarketvalueofUSD300,100,000hasbetaof 1.1.Toreducetheportfoliobetato0.75,howmanyS&Pfuturescontractshouldyousell?

a. b. c. d.

618contracts 288contracts 574contracts 906contracts

CORRECT:B Noofcontracts=[0.751.1)/1]*[300,100,000/{250*1,457}]=288.36 sell288contracts INCORRECT:A617.9135209=1*(0.75)*(300100000/(250*1457)) INCORRECT:C561.74=1(0.75/1.1)*(300100000/(250*1457)) INCORRECT:D906.273164=1*(1.1)*(300100000/(250*1457)) Reference:Hull,Options,FuturesandOtherDerivatives,Chapter3and4;AnthonySaunders, FinancialInstitutionsManagement,Chapter10

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Thefollowinginformationshouldbeusedforthenexttwoquestions. OnJanuary1,ariskmanagerobservesthatthe1yearcontinuouslycompoundedinterestrateis5% andstoragecostsofacommodityproductAisUSD0.05perquarter(payableateachquarterend). HefurtherobservesthefollowingforwardpricesforproductA: March 5.35 June 5.90 September 5.30 December 5.22

22. GiventhefollowingexplanationofsupplyanddemandforcommodityproductAhowwouldyou bestdescribeitsforwardpricecurvefromJunetoDecember?

Marketdescription Explanation Backwardation ExcessdemandforAinearlysummer Backwardation Supplyisexpectedtodeclineaftersummer Contango ExcessdemandforAinearlysummer Contango Supplyisexpectedtodeclineaftersummer CORRECT:A Aiscorrectwhenfurthertermcommodityforwardshavelowerpricethanneartermforwards,the marketissaidtobeinbackwardation.PossibleexplanationcanbeseasonalityofproductA excessdemandinearlysummercausesJuneforwardstohavehigherprice INCORRECT:BMarketdescriptioniscorrect,butexplanationisnotexpecteddeclineinsupply shouldincreasefurthertermcommodityforwardprice INCORRECT:CWrongmarketdescriptionofcontango INCORRECT:DWrongmarketdescriptionofcontango Reference:RobertLMcDonald,DerivativesMarkets,Chapter6

a. b. c. d.

23. WhatistheannualizedrateofreturnearnedonacashandcarrytradeenteredintoinMarchand closedoutinJune?

a. b. c. d.

8.9% 9.8% 35.7% 39.1%

CORRECT:C

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Byformula F0,T = S0erT + C, where F0,T = Juneforwardprice, S0 = Marchforwardprice,r=risk freeinterestrate,T=lengthofcashandcarry,C=storagecost Solving5.90=5.35er*3/12+0.05 Solutionisr=35.7% INCORRECT:A8.9=LN((5.90.05)/5.35)(forgetstoannualizethereturn) INCORRECT:B9.8=LN((5.9)/5.35)(forgetstoincludethestoragecostandtoannualizethereturn) INCORRECT:D39.1=(12/3)LN((5.9)/5.35)0.05(forgetstoincludethestoragecost) Reference:RobertLMcDonald,DerivativesMarkets,Chapter6

24. AninvestorsellsaJune2008callofABCLimitedwithastrikepriceofUSD45forUSD3andbuysa June2008callofABCLimitedwithastrikepriceofUSD40forUSD5.Whatisthenameofthis strategyandthemaximumprofitandlosstheinvestorcouldincur?

a. b. c. d.

BearSpread,MaximumLossUSD2,MaximumProfitUSD3 BullSpread,MaximumLossUnlimited,MaximumProfitUSD3 BearSpread,MaximumLossUSD2,MaximumProfitUnlimited BullSpread,MaximumLossUSD2,MaximumProfitUSD3

CORRECT:D BuyingacalloptionatlowerstockpriceandsellingcalloptionathigherstrikepriceiscalledasBull Spread.BearSpreadisbuyingthecalloptionathigherpriceandsellingthecallatlowerstrikeprice. TheCostofstrategywillbeUSD3USD5=USD2 ThePayoff,whenStockpriceSTUSD40willbeUSD2(thecostofstrategy)asnoneoftheoption willbeexercised. ThePayoff,whenstockpriceST45,(asbothoptionswillbeexercise)willbeUSD5, SincethecostofstrategyisUSD3,henceprofitwillbeUSD5USD2=USD3 WhenStockpriceisUSD40<ST>USD45,Onlythecalloptionboughtbytheinvestorwouldbe exercisedhencethepayoffwillbeST40,sincethecostofstrategyisUSD3,TheNetprofitwillbe ST43,whichwouldalwaysbelowerthanUSD3. Reference:Hull.Chapter10TradingStrategiesInvolvingOptions.

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25. WhichofthefollowingproblemsareNOTinherentdisadvantagesofthehistoricalsimulation approachtoestimatingVaR?

I. Itgivestoolittleweighttomorerecentobservations II. Forlongonlyportfolios,itislikelytounderstateVaRfollowingarecentstructuralincrease involatilities III. Italwaysignoresthefattailspresentinthedistributionofreturnsonmanyfinancial assets IV. Becauseofthedeltaapproximation,itinadequatelymeasurestheriskofnonlinear instruments

a. b. c. d.

IandIIonly IIonly I,IIIandIVonly IIIandIVonly

CORRECT:C ThedisadvantagewiththeHistoricalSimulationModelisthatitmaynotrecognizethechangesin volatilityandcorrelationfollowingrecentstructuralchanges.Themodelcanbeadjustedsothatit givesmoreweighttorecentobservations.Theotheroptions,i.e.III&IV,aredisadvantagesofMonte CarlomethodandDeltanormalmethod. Reference:Allenetal.


26. AbankholdsUSD60millionworthof10year6.5%couponbondsthataretradingatacleanpriceof 101.82.Thebankisworriedbytheexposureduetothesebondsbutcannotunwindthepositionfor fearofupsettingtheclient.Therefore,itpurchasesatotalreturnswap(TRS)inwhichitreceives annualLibor+100bpsinreturnforthemarktomarketreturnonthebond.Forthefirstyear,the Liborsetsat6.25%andbytheendoftheyearthecleanpriceofthebondsisat99.35.Thenet receipt/paymentforthebankinthetotalreturnswapwillbe:

a. b. c. d.

ReceiveUSD2.23million. ReceiveUSD1.93million. PayUSD1.93million. PayUSD2.23million.

CORRECT:B

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Itstheresultofthiscalculation:thenotionalamountis60millionUSD.Thereforethebankwill receivetheinterestpaymentlinkedtotheLIBORrate:60millionUSD*(6,25%+100bp)=4.35 millionUSD. Thebankwillpaythefixedcouponplusthechangeinthevalueofthebond:60millionUSD*6.5%+ 60million*(99.35%101.82%)=2.418millionUSD. Hencethetotalnetamountthebankwillreceiveis:4.35millionUSD2.418millionUSD=1.932 millionUSD. Reference:Hull,Chapter7 27. Whichofthefollowingtrade(s)containbasisrisk?

I. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsNov07NYMEXWTI CrudeOilcontracts II. Long1,000lotsNov07ICEBrentOilcontractsandlong2,000lotsNov07ICEBrentOilat themoneyput III. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07ICEBrentOil contracts IV. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07NYMEXWTI CrudeOilcontracts

a. b. c. d.

I&III II&IV IIII&IV I,III&IV

CORRECT:D BasisRiskisspreadrisk,whicharisefromtradingthespread(longandshort2positivelycorrelated assetsorsameassetwithdifferentexpiration) iisspreadtradeinhighlycorrelatedassetwithsameexpirationmonth iifaceswithgammaandvegarisk iiiisspreadtradeintradingtheflatteningoftheforwardcurve ivisspreadtradeintrading2assetswithdifferentexpirationdate Reference:RobertL.McDonald,DerivativesMarkets(Boston:AddisonWesley,2003),Chapter6.

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28. Accordingtoputcallparity,buyingaputoptiononastockisequivalentto:

Buyingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Sellingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. Sellingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. CORRECT:C Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate.Putcallparity statesP=CS+XeRT INCORRECT:ABuyingacalloptioniscorrect,buttherestofthestatementisincorrect. INCORRECT:BTheentirestatementisincorrect. INCORRECT:DSellingacalloptionisincorrect,buttherestofthestatementiscorrect. Reference:Hull,Chapter10

a. b. c. d.

29. A3monthfuturescontractonanequityindexiscurrentlypricedatUSD1000,theunderlyingindex stocksarevaluedatUSD990andpaydividendsatacontinuouslycompoundedrateof2percent andthecurrentcontinuouslycompoundedriskfreerateis4percent.Thepotentialarbitrageprofit percontract,giventhissetofdata,isclosestto

a. b. c. d.

USD10.00 USD7.50 USD5.00 USD1.50

CORRECT:C Accordingtothefundamentalpricingrelationshipbetweenspotassetsandtheassociatedfutures, thefuturesprice,topreventarbitrage,shouldequal990xe(0.040.02)x0.25or995.Hence,the futurescontractisovervalued,indicatingitshouldbesoldandtheindexshouldbepurchasedforan arbitrageprofitofUSD1000USD995=USD5 Reference:Hull,Chapters2,36.


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2009FRMPracticeExams
30. ResearchandmodelprojectionsindicatethataspecificeventislikelytomovetheCHFagainstthe USD.Whilethedirectionofthemoveishighlyuncertain,itishighlylikelythatmagnitudeofthe movewillbesignificant.Basedonthisinformation,whichofthefollowingstrategieswouldprovide thelargesteconomicbenefit?

a. LongacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate b. LongacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikepriceand expirationdate c. ShortacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate d. ShortacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate

CORRECT:B Thequestiontestsonunderstandingofastraddlestrategyanditsapplicationoncurrencytrading. Alongstraddlestrategyinvolvesbuying(long)acallandputoptionwiththesamestrikepriceand expirationdate,andwillbenefitmostwhentheunderlyingmovesawayfromthecurrentequlibrium. INCORRRECT:AItsellsaputoptionwhileitshouldbuyoneput INCORRECT:CItsellsacalloptionwhileitshouldbuyonecall INCORRECT:DItsellsboththecallandputoptionwhileitshouldbuyboth Reference:Hull,Chapter10.


31. Initially,thecalloptiononBigKahunaInc.with90daystomaturitytradesatUSD1.40.Theoption hasadeltaof0.5739.Adealersells200calloptioncontractsandtodeltahedgetheposition,the dealerpurchases11,478sharesofthestockatthecurrentmarketpriceofUSD100pershare.The followingday,thepricesofboththestockandthecalloptionincrease.Consequently,delta increasesto0.7040.Tomaintainthedeltahedge,thedealershould:

a. b. c. d.

Purchase2,602shares. Sell2,602shares. Purchase1,493shares. Sell1,493shares.

CORRECT:A Numberofcalls=200contractsx100=20,000calls.

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Numberofshares =(Numberofcalls)x(NewdeltaOlddelta) =20,000x(0.70400.5739) =+2,602shares Positivesignindicatesthatthemanagershouldpurchasenewshares. INCORRECT:BTheformulaisincorrect,i.e.olddeltaminusnewdelta INCORRECT:CThenumberofshares(insteadofnumberofcalls)isusedinthecalculation INCORRECT:DAsperexplanationinCaboveandsignerror Reference:HullChapters9and10 32. Whichofthefollowingstrategiescreatesacalendarspread?

a. Sellacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice b. Buyacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice c. Sellacalloptionwithacertainstrikepriceandbuyashortermaturitycalloptionwiththesame strikeprice d. Buyacalloptionwithacertainstrikepriceandsellalongermaturitycalloptionwiththesame strikeprice

CORRECT:A INCORRECT:BAsbuyacalloption INCORRECT:CAsbuyashortermaturitycalloption INCORRECT:DAsthisisareversecalendarspread Reference:JohnHull,Chapter10.


33. Whichofthefollowingunderlyingmacroeconomicconditionswouldleaveanemergingmarket mostvulnerabletothecontagioneffectsofacurrencycrisis?

a. b. c. d.

Largecurrentaccountsurplus,lowforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountdeficit,lowforeignexchangereserves,fullyconvertiblecurrency Smallcurrentaccountdeficit,highforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountsurplus,highforeignexchangereserves,fullyconvertiblecurrency

CORRECT:B

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INCORRECT:ALargecurrentaccountsurplusandnonconvertiblecurrencywouldprotectthelocal currency INCORRECT:CHighforeignexchangereservesandnonconvertiblecurrencywouldprotectthelocal currency INCORRECT:DLargecurrentaccountsurplusandhighforeignexchangewouldprotectthelocal currency Reference:Saunders,Chapter15,ForeignExchangeRisk

34. ConsideranFRA(forwardrateagreement)withthesamematurityandcompoundingfrequencyasa Eurodollarfuturescontract.TheFRAhasaLIBORunderlying.Whichofthefollowingstatementsare trueabouttherelationshipbetweentheforwardrateandthefuturesrate?

a. b. c. d.

Theyshouldbeexactlythesame Theforwardrateisnormallyhigherthanthefuturesrate Theforwardrateisnormallylowerthanthefuturesrate Theyhavenofixedrelationship

CORRECT:C AsEurodollarfuturescontractismarkedtomarketandsettleddaily,normallyforwardrateis adjustedlower,socalledconvexityadjustment,by: Forwardrate=Futuresrate

1 2 T1T2 2

Reference:Hull,Chapter6. 35. Yourbankisanactiveplayerinthecommoditymarket.Theviewoftheeconomistofthebankis thatinflationisexpectedtorisemoderatelyintheneartermandmarketvolatilityisexpectedto remainlow.Thetradersareadvisedtoundertakedealsonthemetalsexchangetoalignyourbook toconformwiththeexpectationsoftheeconomistofthebank.Asriskmanager,youareaskedto monitorthepositionsofthetraderstomakesurethattheyhavetheexposurestoinflationand marketvolatilitysoughtbythebank.Whichtraderhastakenanappropriatepositionamongthe tradersyouaremonitoring?

a. TraderAboughtacallandaput,bothwith90daystoexpirationandwithstrikepriceequalto theexistingspotlevel b. TraderBboughtaputoptionwithadownandinknockinfeature c. TraderCboughtacalloptionattheexistingspotlevelsandsoldacallatahigherstrikeprice, bothwith90daystoexpiration d. TraderDsoldacallandboughtaputattheexistinglevels,bothwith90daystoexpiration

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CORRECT:C CIscorrect,asthestrategypopularlyknownasthebullspreadwillresultinpositivepayoffwhenthe spotrises.Asinflationincreases,spotlevelsincommoditiesareexpectedtorise.Sellingacallat higherlevelwillreducethecostofthestrategy.Althoughitmaylimittheupside,butthatwouldbe inlinewiththeviewasonlyamoderateriseisexpectedinspot. INCORRECT:AIsincorrect,asthestrategypopularlyknownasastraddleistobeusedwhenthe viewisthatthevolatilityinthemarketwillrise,andthereisnodirectionalviewonthespot INCORRECT:BIsincorrect,astheaboveoptionwillbesuitablewhenthespotisexpectedtofall fromtheexistinglevels INCORRECT:DIsincorrect,asthepayoffinthiscaseissimilartoshortpositioninspotandwould makesensewhentheunderlyingisexpectedtofall Reference:Hull,Chapter10.

36. TheinformationratiooftheSteroleUSFundfor2006againsttheS&P500,itsbenchmarkindex,is1. Forthesametimeperiod,thefundsSharperatiois2,thefundhasatrackingerrorof7% against theS&P 500,andthestandarddeviationoffundreturnsis5%.TheriskfreerateintheUSis4%. CalculatethereturnfortheS&P500duringthetimeperiod. a. 3.5% b. 7% c. 11% d. 14%

CORRECT:B SharpeRatio=2 (FundReturnRiskFreeRate)/SD=2 (FundReturn4%)/5%=2 FundReturn=14% InformationRatio=1 (FundReturnS&P500Return)/TrackingError=1 (14%S&P500Return)/7%=1 S&P500Return=7% INCORRECT:AIncorrectlydividesS&P500Returnby2 INCORRECT:CThecandidatemightusetheTrackingErrorastheNumeratorinboththeRatios
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SharpeRatio=2 (FundReturnRiskFreeRate)/TrackingError=2 (FundReturn4%)/7%=2 FundReturn=18% InformationRatio=1 (FundReturnS&P500Return)/TrackingError=1 (18%S&P500Return)/7%=1 S&P500Return=11% INCORRECT:DThecandidatecanstopwiththefundreturncalculation,andendupwith14% SharpeRatio=2 (FundReturnRiskFreeRate)/SD=2 (FundReturn4%)/5%=2 FundReturn=14% Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

37. Afundmanagerrecentlyreceivedareportontheperformanceofhisportfoliooverthelastyear. Accordingtothereport,theportfolioreturnis9.3%,withastandarddeviationof13.5%,andabeta of0.83.Theriskfreerateis3.2%,thesemistandarddeviationL(Rp)oftheportfoliois8.4%,andthe trackingerroroftheportfoliotothebenchmarkindexis2.8%.Whatisthedifferencebetweenthe valueofthefundsSortinoratio(computedrelativetotheriskfreerate)anditsSharperatio?

a. b. c. d.

0.274 1.727 0.653 0.378

CORRECT:A
Sharperatioequalsto

R p RF

(R p )

9 .3 % 3 .2 % = 0.452 13.5%

WhileSortinoratioequalsto

R p RF

L ( RP )

9.3% 3.2% = 0.726 8.4%

Trackingerrorisusedtocalculatethevalueoftheinformationratio,whichisdefinedas

R p RB

( RP RB )

, Thecalculationofinformationratioisnotrequiredinthisquestion.

0.7260.452=0.274 INCORRECT:B2.1780.452=1.727

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INCORRECT:C0.7260.0.73=0.653(0.073=(.0930.032)/0.83 INCORRECT:D0.730.452=0.378 Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

38. Whichofthefollowingstatementsaboutthelinearregressionofthereturnofaportfoliooverthe returnofitsbenchmarkpresentedbelowarecorrect? Portfolioparameter Value Beta 1.25 Alpha 0.26 Coefficientofdetermination 0.66 Standarddeviationoferror 2.42

I. Thecorrelationis0.71 II. 34%ofthevariationintheportfolioreturnisexplainedbyvariationinthebenchmarkreturn III. Theportfolioisthedependentvariable IV. Foranestimatedportfolioreturnof12%,theconfidenceintervalat95%is[7.16%;16.84%]

IIandIV IIIandIV I,IIandIII II,IIIandIV CORRECT:B Theportfolioreturnisthedependentvariableandforanestimatedportfolioreturnof12%,the95% confidenceintervalis[12%2*2.42%,12%+2*2.42%]or[7.16%,16.84%]. However,thecorrelationisthesquarerootofthecoefficientofdeterminationandisthereforeequal to0.81,and66%ofthevariationintheportfolioreturnsisexplainedbyvariationinthebenchmark return. Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

a. b. c. d.

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39. YourBoardofDirectorswantsacomprehensivereviewofeachbusinessunitsoperationalrisk activities.Astheheadofthecorporateoperationalriskunit,youknowthatlittlehasbeendoneto implementanoperationalriskprocessatthebusinessunitlevelandthatyouneedtoimmediately comeupwithaframework.Whichofthefollowingstatementsoffersthebeststrategy?

I. TheauditcommitteeoftheBoardshouldfirstdefineitsobjectivestoensurethatallthe firmsbusinessunitsoperationalriskprogramsareprovidingrequiredinformation II. Theauditingdepartmentistobechargedwithdevelopinganoperationalriskprogramfor eachbusinessunit,withthebusinessunitbeingmadeclearlyawarethattheywillbeheld accountableforitsimplementation III. Thatyourdepartmentimmediatelyassesstheoperationalriskforeachbusinessunit usingindependentdatafeedstoensuretheinformationfedintotheassessmentcannot bemanipulated IV. Aseniormanagerfromeachprofitcenteristobechargedwithdevelopingtheirown operationalriskselfassessmentprogrambasedonguidelinesyouprovide.

a. b. c. d.

Ionly IandIVonly IandIIIonly IVonly

CORRECT:D Thebeststrategyfordevelopinganoperationalriskframeworkistoempowerbusinessunitswith theresponsibility,accountabilityandauthoritytomanagetheirownoperationalrisks.Thebusiness unitsknowtheirrisksthebest. INCORRECT:AIisnottheresponsibilityoftheAuditCommitteeoftheBoard INCORRECT:BTheauditingdepartmentisnotthebestassessorofanindividualbusinessunitsrisk, infactmanyauditstaffdonotfullyunderstandtherisksofmanyofafirmsactivities INCORRECT:CIIIisduplicativeandshouldnotcomefromthecorporatedepartment Reference:RiskManagementandCapitalAdequacy,Gallati,2003.

40. Whichofthefollowingriskmanagementstrategiesofafirmwhichhasprincipalpaymentstomake onitsdebtinoneyearthatsubstantiallyexceedthemarketvalueofitsassetsismostlikelytobein theinterestoftheshareholders?

a. b. c. d.

Reductionoftheoverallrisklevelofthefirm Increaseoftheoverallrisklevelofthefirm Keepthesamerisklevel Itisimpossibletosaywhichriskmanagementstrategytheshareholdersprefer

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CORRECT:B Onceafirmisindistress,itisnotintheinterestsofshareholderstoreducerisk.Ifthefirmstaysin distressandeventuallydefaults,shareholderswillendupwithworthlessshares.Inthese circumstances,managementintentonmaximizingshareholdervaluewillseekoutnewrisks. Reference:RiskManagementandDerivatives,Stulz,2003


ENDOF2009FRMLevelIPRACTICEEXAM Questions&Explanations

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2009FRMFullExamPracticeExamI CandidateAnswerSheet

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

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2009FRMFullExamPracticeExamI Questions

1. Giventheinformationprovidedinthetablebelow,whatistheportfolioVaR,atthe99%confidence level,ofthefollowing100millionCHFequallyweightedinvestmentportfolio?

Asset Stocks Bonds


Expected Return 24.00% 15.00%

Volatility 18% 6%

Correlation Stocks 1 0.1 Bonds 1

a. b. c. d.

27.96millionCHF 22.77millionCHF 20.97millionCHF 13.98millionCHF


2. YouareaskedbyyourbosstoestimatetheexposureofahedgefundtotheS&P500.Thoughthe fundclaimstomarktomarketweekly,itdoesnotdosoandmarkstomarketonceamonth.The fundalsodoesnottellinvestorsthatitsimplyholdsanETFwhichisindexedtotheS&P500.Because oftheclaimsofthehedgefund,youdecidetoestimatethemarketexposurebyregressingweekly returnsofthefundontheweeklyreturnoftheS&P500.Whichofthefollowingpropertiescorrectly describesapropertyofyourregressionestimates?

a. ThebetaofyourregressionwillbeonebecausethefundholdstheS&P500. b. Thebetaofyourregressionwillbezerobecausethefundreturnsarenotsynchronouswiththe S&P500returns. c. Theinterceptofyourregressionwillbepositive,showingthatthefundhasapositivealpha whenestimatedusinganOLSregression. d. Thebetawillbemisestimatedbecausehedgefundexposuresarenonlinear.

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3. ThefollowingtableshowsthecompositionoftheGARPBondFund.Whataretheportfolioduration andportfolioyieldofthefund?
GARP Bond Fund Rating Amount Duration Mn USD in years AAA Company A 600 1.5 Company B 300 4 Company C 200 2.5 AA Company D 400 4 Company E 350 0.5 A Company F 150 1.5
Total 2000

Rating valuation matrix Years 0-1 Rating AAA 6.25% AA 6.75% A 7.75% 1-2 6.75% 7.35% 8.45% 2-3 7.35% 8.05% 9.15%

3-4 8.00% 8.80% 9.85%

a. b. c. d.

14years,46.1% 2.3years,7.5% 2.3years,7.7% 4.4years,15.4%%

4. AninvestmentbankusestheExponentiallyWeightedMovingAverage(EWMA)techniquewith lambdaof0.9tomodelthedailyvolatilityofasecurity.Thecurrentestimateofthedailyvolatilityis 1.5%.TheclosingpriceofthesecurityisUSD20yesterdayandUSD18today.Usingcontinuously compoundedreturns,whatistheupdatedestimateofthevolatility? a. 5.44% b. 3.62% c. 2.96% d. 1.31%


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5. ConsidertwostocksAandB.Assumetheirannualreturnsarejointlynormallydistributed,the marginaldistributionofeachstockhasmean2%andstandarddeviation10%,andthecorrelationis 0.9.WhatistheexpectedannualreturnofstockAiftheannualreturnofstockBis3%?

a. b. c. d.

2.9% 2% 1.1% 4.7%

6. InpricingaderivativeusingtheMonteCarlomethod,weneedtosimulateareasonablenumberof pathsforthepriceoftheunderlyingasset.Supposeweuseasimplemodelforthereturnofthe underlyingasset: y(t)=drift*t+vol*t*e(t),ande(t)isdistributed~N(0,1), wheredriftandvolareknownparametersandtisthestepsize. Thegenerationofeachpathrequiresanumberofsteps.Whichofthefollowingdescribesthe correctprocedure? a. GeneratearandomnumberfromanormaldistributionN(0,1),usetheinversenormalfunction togete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedureuntilyouget thefulldesiredpath. b. GeneratearandomnumberfromanormaldistributionN(0,1),usethecumulativenormal functiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedure untilyougetthefulldesiredpath. c. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usetheinverse cumulativenormalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthe sameprocedureuntilyougetthefulldesiredpath. d. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usethecumulative normalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesame procedureuntilyougetthefulldesiredpath.

7. SupposethatAandBarerandomvariables,eachfollowsastandardnormaldistribution,andthe covariancebetweenAandBis0.35.Whatisthevarianceof(3A+2B)?

a. b. c. d.

5.10 14.47 9.20 17.20

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8. YoudonthaveaccesstoKMVsdata.Yourbosswantsyoutotellhimyourestimateofthe probabilityofdefaultofacredit.Todoso,youusetheMertonModelbecausethecredityouare consideringhasnosystematicrisk.InMertonsModel,thedistancetodefault(DD)andthe expecteddefaultfrequency(EDF)are

a. b. c. d.

positivelyandlinearlyrelated negativelyandlinearlyrelated positivelyandnonlinearlyrelated negativelyandnonlinearlyrelated

9. SupposetherateonCompanyAsoneyearzerocouponbondis10.0%andtheoneyearTbillrate is8.0%.AssumetheTbillisrisklessandtheprobabilityofdefaultofCompanyAsbondis10%. WhatistheLGDofCompanyAsbond?

a. b. c. d.

18.18% 81.82% 20.01% 79.99%

10. Abankisconsideringwaysofsignificantlyreducingoreliminatingitscreditexposuretodefaultsona loanportfoliosothatthebanksshareholdersdonotabsorbthelossesarisingfromsuchdefaults. Ignoringinstitutionalissues(e.g.,tax,accounting,capitalrequirements),threeofthefollowing programshaveasimilarimpactonthecreditriskofthebank.Whichalternativefailstoreduce creditrisk?

a. b. c. d.

Selltheloanportfolioinitsentiretytoanotherbank. Borrowtofinanceanadditionalriskreservetosupplementexistingloanlossreserves. Securitizetheloanportfolio. Buycreditprotectionontheloanportfoliowithcreditdefaultswaps.

11. ConsiderastockpriceSthatfollowsageometricBrownianmotion dS = S dt + S dz, with strictlypositiveand afixedvalue.Whichofthefollowingstatementsistrue?

a. b. c. d.

Ifthedriftisnegative,thepriceoneyearfromnowwillbebelowtodaysprice. Theinstantaneousrateofreturnonthestockfollowsauniformdistribution. ThestockpriceSfollowsalognormaldistribution. Thismodelimposesmeanreversion.

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12. ThejointprobabilitydistributionofrandomvariablesXandYisgivenbyf(x,y)=kxyforx=1,2,3,y= 1,2,3,andkisapositiveconstant.WhatistheprobabilitythatX+Ywillexceed5? a. 1/9 b. 1/4 c. 1/36 d. Cannotbedetermined

13. WhichofthefollowingstatementsregardingHypothesisTestingisincorrect?

a. Hypothesistestingisusedtomakeinferencesabouttheparametersofagivenpopulationon thebasisofstatisticscomputedforasamplethatisdrawnfromthatpopulation. b. TypeIIerrorreferstothefailuretorejectthenullhypothesiswhenitisactuallyfalse. c. Thepvaluedecisionruleistorejectthenullhypothesisifthepvalueisgreaterthanthe significancelevel. d. Allelsebeingequal,thedecreaseinthechanceofmakingaTypeIerrorcomesatthecostof increasingtheprobabilityofmakingaTypeIIerror.


14. Ifstockreturnsareindependentlyidenticallynormallydistributedandtheannualvolatilityis30%, thenthedailyVaRatthe99%confidencelevelofastockmarketportfolioisapproximately:

a. b. c. d.

2.41% 3.11% 4.40% 1.89%

15. AsinglestockhasapriceofUSD10andacurrentdailyvolatilityof2%.Usingthedeltanormal method,theVaRatthe95%confidencelevelofalongatthemoneycallonthisstockovera1day holdingperiodisapproximately:

a. b. c. d.

USD0.23 USD1.645 USD0.33 USD0.16

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16. Aportfolioconsistsoftwozerocouponbonds,eachwithacurrentvalueofUSD10.Thefirstbond hasamodifieddurationof1yearandthesecondhasamodifieddurationof9years.Theyieldcurve isflatandallyieldsare5%.Assumeallmovesoftheyieldcurveareparallelshifts.Giventhatthe dailyvolatilityoftheyieldis1%,whichofthefollowingisthebestestimateoftheportfoliodailyVaR atthe95%confidencelevel?

a. b. c. d.

USD2.33 USD1.65 USD0.82 USD1.16

17. ConsiderthefollowingthreemethodsofestimatingtheP&Lofabulletbond:fullrepricing,duration (PV01),anddurationplusconvexity.RankingtheestimatedP&Limpactofalargenegativeyield shockfromthelowestP&LimpacttothehighestP&Limpact,whatistherankingofthemethodsto estimatetheP&Limpact?

a. durationplusconvexity,duration,fullrepricing b. fullrepricing,durationplusconvexity,duration c. duration,durationplusconvexity,fullrepricing d. duration,fullrepricing,durationplusconvexity 18. Considerapositionina5yearreceivefixedswapthatmakesannualpaymentsonaUSD100million notional.Thefloatingleghasjustbeenreset.Thetermstructureisflatat5%,theMacaulay durationofa5yearparbondis4.5years,andtheannualvolatilityofyieldchangesis100bp.Your bestestimateoftheswapsVaRwith95%confidenceoverthenextmonthis

a. b. c. d.

USD1.6million USD2.0million USD5.5million USD7.1million

19. Ifthegoldleaserateishigherthantheriskfreerate,whatisthemarketstructureoftheforward marketforgold?

a. b. c. d.

Contango Backwardation Inversion Needmoreinformationtodetermine

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20. Thepriceofa3yearzerocoupongovernmentbondis85.16.Thepriceofasimilar4yearbondis 79.81.Whatistheoneyearimpliedforwardratefromyear3toyear4?

a. b. c. d.

5.4% 5.5% 5.8% 6.7%

21. AportfoliomanagerhasabondpositionworthUSD100million.Thepositionhasamodified durationof8yearsandaconvexityof150years.Assumethatthetermstructureisflat.Byhow muchdoesthevalueofthepositionchangeifinterestratesincreaseby25basispoints?

a. b. c. d.

USD1,953,125 USD1,906,250 USD2,046,875 USD2,187,500

22. WhatistheannualizedrateofreturnearnedonacashandcarrytradeenteredintoinMarchand closedoutinJune?

a. b. c. d.

8.9% 9.8% 35.7% 39.1%

23. AninvestorsellsaJune2008callofABCLimitedwithastrikepriceofUSD45forUSD3andbuysa June2008callofABCLimitedwithastrikepriceofUSD40forUSD5.Whatisthenameofthis strategyandthemaximumprofitandlosstheinvestorcouldincur?

a. b. c. d.

BearSpread,MaximumLossUSD2,MaximumProfitUSD3 BullSpread,MaximumLossUnlimited,MaximumProfitUSD3 BearSpread,MaximumLossUSD2,MaximumProfitUnlimited BullSpread,MaximumLossUSD2,MaximumProfitUSD3

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24. WhichofthefollowingproblemsareNOTinherentdisadvantagesofthehistoricalsimulation approachtoestimatingVaR?

I. Itgivestoolittleweighttomorerecentobservations II. Forlongonlyportfolios,itislikelytounderstateVaRfollowingarecentstructuralincreasein volatilities III. Italwaysignoresthefattailspresentinthedistributionofreturnsonmanyfinancialassets IV. Becauseofthedeltaapproximation,itinadequatelymeasurestheriskofnonlinear instruments a. b. c. d.


IandIIonly IIonly I,IIIandIVonly IIIandIVonly

25. AbankholdsUSD60millionworthof10year6.5%couponbondsthataretradingatacleanpriceof 101.82.Thebankisworriedbytheexposureduetothesebondsbutcannotunwindthepositionfor fearofupsettingtheclient.Therefore,itpurchasesatotalreturnswap(TRS)inwhichitreceives annualLibor+100bpsinreturnforthemarktomarketreturnonthebond.Forthefirstyear,the Liborsetsat6.25%andbytheendoftheyearthecleanpriceofthebondsisat99.35.Thenet receipt/paymentforthebankinthetotalreturnswapwillbe:

a. b. c. d.

ReceiveUSD2.23million ReceiveUSD1.93million PayUSD1.93million PayUSD2.23million

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26. Whichofthefollowingtrade(s)containbasisrisk?

I. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsNov07NYMEXWTICrude Oilcontracts II. Long1,000lotsNov07ICEBrentOilcontractsandlong2,000lotsNov07ICEBrentOilatthe moneyput III. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07ICEBrentOil contracts IV. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07NYMEXWTICrude Oilcontracts

a. b. c. d.

I&III II&IV IIII&IV I,III&IV

27. Accordingtoputcallparity,buyingaputoptiononastockisequivalentto: a. Buyingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. b. Sellingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. c. Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. d. Sellingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate.


28. A3monthfuturescontractonanequityindexiscurrentlypricedatUSD1000,theunderlyingindex stocksarevaluedatUSD990andpaydividendsatacontinuouslycompoundedrateof2percent andthecurrentcontinuouslycompoundedriskfreerateis4percent.Thepotentialarbitrageprofit percontract,giventhissetofdata,isclosestto

a. b. c. d.

USD10.00 USD7.50 USD5.00 USD1.50

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29. ResearchandmodelprojectionsindicatethataspecificeventislikelytomovetheCHFagainstthe USD.Whilethedirectionofthemoveishighlyuncertain,itishighlylikelythatmagnitudeofthe movewillbesignificant.Basedonthisinformation,whichofthefollowingstrategieswouldprovide thelargesteconomicbenefit?

a. LongacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate b. LongacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikepriceand expirationdate c. ShortacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate d. ShortacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate


30. Initially,thecalloptiononBigKahunaInc.with90daystomaturitytradesatUSD1.40.Theoption hasadeltaof0.5739.Adealersells200calloptioncontractsandtodeltahedgetheposition,the dealerpurchases11,478sharesofthestockatthecurrentmarketpriceofUSD100pershare.The followingday,thepricesofboththestockandthecalloptionincrease.Consequently,delta increasesto0.7040.Tomaintainthedeltahedge,thedealershould:

a. b. c. d.

Purchase2,602shares Sell2,602shares Purchase1,493shares Sell1,493shares

31. Whichofthefollowingstrategiescreatesacalendarspread? a. Sellacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice. b. Buyacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice. c. Sellacalloptionwithacertainstrikepriceandbuyashortermaturitycalloptionwiththesame strikeprice. d. Buyacalloptionwithacertainstrikepriceandsellalongermaturitycalloptionwiththesame strikeprice.

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32. Whichofthefollowingunderlyingmacroeconomicconditionswouldleaveanemergingmarket mostvulnerabletothecontagioneffectsofacurrencycrisis?

a. b. c. d.

Largecurrentaccountsurplus,lowforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountdeficit,lowforeignexchangereserves,fullyconvertiblecurrency Smallcurrentaccountdeficit,highforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountsurplus,highforeignexchangereserves,fullyconvertiblecurrency

33. ConsideranFRA(forwardrateagreement)withthesamematurityandcompoundingfrequencyasa Eurodollarfuturescontract.TheFRAhasaLIBORunderlying.Whichofthefollowingstatementsare trueabouttherelationshipbetweentheforwardrateandthefuturesrate?

a. b. c. d.

Theyshouldbeexactlythesame. Theforwardrateisnormallyhigherthanthefuturesrate. Theforwardrateisnormallylowerthanthefuturesrate. Theyhavenofixedrelationship.


34. Yourbankisanactiveplayerinthecommoditymarket.Theviewoftheeconomistofthebankis thatinflationisexpectedtorisemoderatelyintheneartermandmarketvolatilityisexpectedto remainlow.Thetradersareadvisedtoundertakedealsonthemetalsexchangetoalignyourbook toconformwiththeexpectationsoftheeconomistofthebank.Asriskmanager,youareaskedto monitorthepositionsofthetraderstomakesurethattheyhavetheexposurestoinflationand marketvolatilitysoughtbythebank.Whichtraderhastakenanappropriatepositionamongthe tradersyouaremonitoring?

a. TraderAboughtacallandaput,bothwith90daystoexpirationandwithstrikepriceequalto theexistingspotlevel. b. TraderBboughtaputoptionwithadownandinknockinfeature. c. TraderCboughtacalloptionattheexistingspotlevelsandsoldacallatahigherstrikeprice, bothwith90daystoexpiration. d. TraderDsoldacallandboughtaputattheexistinglevels,bothwith90daystoexpiration.


35. Consideringoptionsgenerally(i.e.,notonlyplainvanillacallsandputs),whichofthefollowing statementsaboutvegaiscorrect? a. Anoptionholdercanneverbeveganegative. b. Adeepinthemoneyupandoutcalloptionhasanegativevega. c. Adeepoutofthemoneyupandoutcalloptionhasanegativevega. d. Adeepoutofthemoneydigitaloptionhasanegativevega.


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36. Tohedgeagainstfuture,unanticipated,andsignificantincreasesinborrowingrates,whichofthe followingalternativesoffersthegreatestflexibilityfortheborrower?

a. b. c. d.

Fixedforfloatingswap Interestratecollar Interestratefloor Callswaption

37. Assumingotherthingsconstant,bondsofequalmaturitywillstillhavedifferentDV01perUSD100 facevalue.TheirDV01perUSD100facevaluewillbeinthefollowingsequenceofhighestvalueto lowestvalue: a. Zerocouponbonds,parbonds,premiumbonds b. Premiumbonds,parbonds,zerocouponbonds c. Premiumbonds,zerocouponbonds,parbonds d. Zerocouponbonds,premiumbonds,parbonds 38. TheinformationratiooftheSteroleUSFundfor2006againsttheS&P500,itsbenchmarkindex,is1. Forthesametimeperiod,thefundsSharperatiois2,thefundhasatrackingerrorof7%against theS&P500,andthestandarddeviationoffundreturnsis5%.TheriskfreerateintheUSis4%. CalculatethereturnfortheS&P500duringthetimeperiod.

a. b. c. d.

3.5% 7% 11% 14%

39. Afundmanagerrecentlyreceivedareportontheperformanceofhisportfoliooverthelastyear. Accordingtothereport,theportfolioreturnis9.3%,withastandarddeviationof13.5%,andabeta of0.83.Theriskfreerateis3.2%,thesemistandarddeviationL(Rp)oftheportfoliois8.4%,andthe trackingerroroftheportfoliotothebenchmarkindexis2.8%.Whatisthedifferencebetweenthe valueofthefundsSortinoratio(computedrelativetotheriskfreerate)anditsSharperatio?

a. b. c. d.

0.274 1.727 0.653 0.378

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40. YourfirmhasnopriorderivativestradeswithitscounterpartySuperBank.Yourbosswantsyouto evaluatesometradessheisconsidering.Inparticular,shewantstoknowwhichofthefollowing tradeswillincreaseyourfirmscreditriskexposuretoSuperBank:

I. buyingaputoption II. sellingaputoption III. buyingaforwardcontract IV. sellingaforwardcontract

a. b. c. d.

I.andIIonly IIandIVonly IIIandIVonly I,IIIandIVonly

41. Considerthefollowingoneperiodtransitionmatrix:

Initial Period State

A B Default

NextPeriodState A B 95% 5% 10% 80% 0% 0%

Default 0% 10% 100%

IfacompanyisoriginallyinStateA,whatistheprobabilitythatthecompanywillhavedefaulted strictlybeforethefourthtransitionperiodfromnow?

a. b. c. d.

0.875% 0.500% 1.375% 1.875%

42. Asanapproximation,itistruethat

a. b. c. d.

Defaultswapspread=Returnofariskybond+Returnofariskfreebond Defaultswapspread=ReturnofariskybondReturnofariskfreebond Defaultswapspread=ReturnofariskybondxReturnofariskfreebond Defaultswapspread=Returnofariskybondx(1Returnofariskfreebond)


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43. InaCDO,theSPVistypically

a. b. c. d.

AAArated Arated BBBrated Notrated

44. Atraderwhoseriskyouaremonitoringtellsyouthathewantstobenefitfromacreditspread wideningduetoarecession.Whichofthefollowingwouldbegoodtradesforhisstrategy?

a. Golongriskybondsandshortriskfreebondsatthebeginningoftherecession. b. Shortriskybondsandgolongriskfreebondsatthebeginningoftherecession. c. Sellcreditdefaultswapsonbondswithalowcreditqualityandbuycreditdefaultswapson bondswithahighercreditqualityatthebeginningoftherecession. d. Sellcreditdefaultswapsonbondswithlowcreditqualityandgolonglowcreditqualitybonds. 45. BankBhasaEUR100millionloanportfolioandhassetasideareservetocoverthefirstEUR20 millionindefaultrelatedlosses.IfthebankwantstoacquireprotectionfortheremainingEUR80 millioninriskexposure,whichofthefollowingsolutionswouldworkandwouldexposethebankto theleastamountofcounterpartyrisk?

a. BuycreditprotectioninaseniorsubordinatedCDSthatcoversEUR80millioninlossesabove thefirstEUR20million. b. BuycreditinsuranceforlossesuptoEUR80millioninexcessofEUR20millionontheloan portfolio. c. Issueacreditlinkednoteinwhichinterestandprincipalmaybewithheldfrominvestorsto coveruptoEUR80millioninlossesabovethefirstEUR20millionontheloanportfolio. d. Allthreeoftheabovechoicesworkandexposethebanktothesameamountofcounterparty risk.


46. Mr.Rosenqvist,AssetManageratBCDBank,holdsaportfolioofSEK200million.Theportfolio consistsofBBBratedbonds.Assumethattheoneyearprobabilityofdefaultis4%,therecovery rateis60%,anddefaultsareuncorrelatedoveryears.Whatisthe2yearcumulativeexpectedcredit lossonMr.Rosenqvistsportfolio?

a. b. c. d.

SEK6.35million SEK6.40million SEK9.48million SEK9.60million

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47. UsingtheMertonmodel,thevalueofthedebtincreasesifallotherparametersarefixedand

I. Thevalueofthefirmdecreases II. Therisklessinterestratedecreases III. Timetomaturityincreases IV. Thevolatilityofthefirmvaluedecreases

a. b. c. d.

IandIIonly IandIVonly IIandIIIonly IIandIVonly

48. Afirmisgoingtobuy10,000barrelsofWestTexasCrudeOil.Itplanstohedgethepurchaseusing theBrentCrudefuturescontract.Thecorrelationbetweenthespotandfuturespricesis0.72.The volatilityofthespotpriceis0.35peryear.ThevolatilityoftheBrentCrudefuturespriceis0.27per year.Whatisthehedgeratioforthefirm?

a. b. c. d.

0.5554 0.9333 1.2099 0.8198

49. ItisJune2ndandafundmanagerwithUSD10millioninvestedingovernmentbondsisconcerned thatinterestrateswillbehighlyvolatileoverthenextthreemonths.Themanagerdecidestouse theSeptemberTreasurybondfuturescontracttohedgethevalueoftheportfolio.Thecurrent futurespriceis95.0625.EachcontractisforthedeliveryofUSD100,000facevalueofbonds.The durationofthemanagersbondportfoliointhreemonthswillbe7.8years.Thecheapesttodeliver bondintheTreasurybondfuturescontractisexpectedtohaveadurationof8.4yearsatmaturityof thecontract.AtthematurityoftheTreasurybondfuturescontract,thedurationoftheunderlying benchmarkTreasurybondis9years.Whatpositionshouldthefundmanagerundertaketomitigate hisinterestrateriskexposure?

a. b. c. d.

Short94contracts Short98contracts Short105contracts Short113contracts

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50. AbondtraderhasboughtapositioninTreasuryBondswitha4%annualcouponrateonFebruary 15,2015.TheDV01ofthepositionisUSD80,000.Thetraderdecidestohedgehisinterestraterisk withthe4.5%couponrateTreasuryBondsmaturingonMay15,2017whichhasaDV01of.076per USD100facevalue.Toimplementthishedge,approximatelywhatfaceamountofthe4.5% TreasurybondsmaturingonMay15,2017shouldthetradersell?

a. b. c. d.

USD80,000 USD10,500,000 USD80,000,000 USD105,000,000

ENDOF2009FRMFULLEXAMPRACTICEEXAMI

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2009FRMFullExamPracticeExamI AnswerKey

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25.

a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a.

b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b.

c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c.

d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d.

26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50.

a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a.

b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b.

c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c.

d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d.

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2009FRMFullExamPracticeExamI Answers&Explanations

1. Giventheinformationprovidedinthetablebelow,whatistheportfolioVaR,atthe99%confidence level,ofthefollowing100millionCHFequallyweightedinvestmentportfolio?

Asset Stocks Bonds

Expected Return 24.00% 15.00%

Volatility 18% 6%

Correlation Stocks 1 0.1 Bonds 1

a. b. c. d.

27.96millionCHF 22.77millionCHF 20.97millionCHF 13.98millionCHF

CORRECT:B Thevarianceoftheequallyweightedportfoliois0.5^2*0.18^2+0.5^2*0.06^2+2*0.5*0.5*0.1 *0.18*0.06=0.081+0.0009+0.0005=0.00954.Thevolatilityisthen9.77%.TheportfolioVaRor theriskbudgetis2.33*9.77%*100millionCHF=22.77millionCHF. Reference:Allenetal.Chapters2,3.


2. YouareaskedbyyourbosstoestimatetheexposureofahedgefundtotheS&P500.Thoughthe fundclaimstomarktomarketweekly,itdoesnotdosoandmarkstomarketonceamonth.The fundalsodoesnottellinvestorsthatitsimplyholdsanETFwhichisindexedtotheS&P500.Because oftheclaimsofthehedgefund,youdecidetoestimatethemarketexposurebyregressingweekly returnsofthefundontheweeklyreturnoftheS&P500.Whichofthefollowingpropertiescorrectly describesapropertyofyourregressionestimates?

a. ThebetaofyourregressionwillbeonebecausethefundholdstheS&P500. b. Thebetaofyourregressionwillbezerobecausethefundreturnsarenotsynchronouswiththe S&P500returns. c. Theinterceptofyourregressionwillbepositive,showingthatthefundhasapositivealpha whenestimatedusinganOLSregression. d. Thebetawillbemisestimatedbecausehedgefundexposuresarenonlinear.

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CORRECT:C Thealphaisspuriousandresultsfromthefactthatreturnsarenonsynchronous.d.isincorrect becausethetrueexposureislinear.Thebetaisgreaterthanzeroandlessthanonebecauseofnon synchroneity. Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

3. ThefollowingtableshowsthecompositionoftheGARPBondFund.Whataretheportfolioduration andportfolioyieldofthefund?
GARP Bond Fund Rating Amount Duration Mn USD in years AAA Company A 600 1.5 Company B 300 4 Company C 200 2.5 AA Company D 400 4 Company E 350 0.5 A Company F 150 1.5
Total 2000

Rating valuation matrix Years 0-1 Rating AAA 6.25% AA 6.75% A 7.75% 1-2 6.75% 7.35% 8.45% 2-3 7.35% 8.05% 9.15%

3-4 8.00% 8.80% 9.85%

a. b. c. d.

14years,46.1% 2.3years,7.5% 2.3years,7.7% 4.4years,15.4%%

Thecalculationofportfoliodurationandportfolioyieldisbasedontheproportionalweightageof respectivecompanytoitsdurationandyield.Theportfoliodurationandportfolioyieldaftermapping theyieldfromratingmatrixisasfollows; CORRECT:B

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Thisanswerreflectstheproportionofamounttakenasweightstocalculatetheportfolioduration andportfolioyield.

GARP Bond Fund Amount Proportion % Duration Yield AAA Co A 600 30% 1.5 6.75% Co B 300 15% 4 8.00% Co C 200 10% 2.5 7.35% AA Co D 400 20% 4 8.80% Co E 350 18% 0.5 6.75% A Co F 150 8% 1.5 8.45% Total 2000 100% 2.30 7.54%

INCORRECT:AIfthecandidatedoesasimpleadditionofthedurationandthemappedyield,he wouldgetthisanswer. INCORRECT:CThoughtheportfoliodurationiscorrect,butitisarrivedbytakingsimpleaverageof duration.However,ifthecandidatewouldtakesimpleaverageofmappedyieldinsteadof proportionhisanswerwouldbe7.7%andnot7.5% INCORRECT:DIfthecandidateaveragesbasedonratingclasses(3AAA/AA/A)insteadofthe companies,hewouldgetthisanswer. Reference:Tuckman;Chapter6.


4. AninvestmentbankusestheExponentiallyWeightedMovingAverage(EWMA)techniquewith lambdaof0.9tomodelthedailyvolatilityofasecurity.Thecurrentestimateofthedailyvolatilityis 1.5%.TheclosingpriceofthesecurityisUSD20yesterdayandUSD18today.Usingcontinuously compoundedreturns,whatistheupdatedestimateofthevolatility?

a. b. c. d.

5.44% 3.62% 2.96% 1.31%

CORRECT:B Thecurrentreturnofthesecurityis=ln(18/20)=10.536%.UsinganEWMAmodel,theupdated volatilityisgivenas:V(t) ={lambda*((V[t1]^2)+(1lambda)*(currentreturn^2)}^0.5 ={0.9*((0.015^2)+(10.9)*(0.10536^2)}^0.5


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=3.62% INCORRECT:AForgetstosquarethevolatilityterms INCORRECT:CForgetstosquarethevolatilitytermsandtotakethesquarerootoftheresulting variance,thenmiscalculatesconversiontopercentage. INCORRECT:DForgetstotakethesquarerootofthevariance,thenmiscalculatesconversionto percentage. Reference:Hull,Chapter21.

5. ConsidertwostocksAandB.Assumetheirannualreturnsarejointlynormallydistributed,the marginaldistributionofeachstockhasmean2%andstandarddeviation10%,andthecorrelationis 0.9.WhatistheexpectedannualreturnofstockAiftheannualreturnofstockBis3%?

a. b. c. d.

2.9% 2% 1.1% 4.7%

CORRECT:A
E[ra|rb=x]=a+(abab/ a)(xb)=0.02+0.9*(0.030.02)=0.029

Reference:DamodarGujarati,chapter2.

6. InpricingaderivativeusingtheMonteCarlomethod,weneedtosimulateareasonablenumberof pathsforthepriceoftheunderlyingasset.Supposeweuseasimplemodelforthereturnofthe underlyingasset:

y(t)=drift*t+vol*t*e(t),ande(t)isdistributed~N(0,1), wheredriftandvolareknownparametersandtisthestepsize. Thegenerationofeachpathrequiresanumberofsteps.Whichofthefollowingdescribesthe correctprocedure? a. GeneratearandomnumberfromanormaldistributionN(0,1),usetheinversenormalfunction togete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedureuntilyouget thefulldesiredpath.

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b. GeneratearandomnumberfromanormaldistributionN(0,1),usethecumulativenormal functiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedure untilyougetthefulldesiredpath. c. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usetheinverse cumulativenormalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthe sameprocedureuntilyougetthefulldesiredpath. d. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usethecumulative normalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesame procedureuntilyougetthefulldesiredpath.

CORRECT:C Thisquestionwantstotestifthecandidateknowsthebasicstepstogenerateaverysimplepath: answeringthisquestionmeansthatthecandidatewouldbeabletobuildasimplespreadsheet showingtheMonteCarlologic.Thecorrectprocedureistheonedescribedinc);whilea),b)andd) arenonsensicalcalculations. Reference:PhilippeJorion,ValueatRisk,TheNewBenchmarkforManagingFinancialRisk,3rdedition (NewYork:McGrawHill,2007),Chapter12.


7. SupposethatAandBarerandomvariables,eachfollowsastandardnormaldistribution,andthe covariancebetweenAandBis0.35.Whatisthevarianceof(3A+2B)?

15.10 14.47 9.20 17.20 CORRECT:D Sinceeachvariableisstandardized,itsvarianceis1.ThereforeV(3A+2B)=9V(A)+4V(B)+2x3x2 xCov(A,B)=9+4+4.2=17.2 INCORRECT:A9+4+6*0.35=15.1 INCORRECT:B9+4+12*0.35^2= INCORRECT:C3+2+12*0.35=9.2 Reference:DamodarGujarati

a. b. c. d.

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8. YoudonthaveaccesstoKMVsdata.Yourbosswantsyoutotellhimyourestimateofthe probabilityofdefaultofacredit.Todoso,youusetheMertonModelbecausethecredityouare consideringhasnosystematicrisk.InMertonsModel,thedistancetodefault(DD)andthe expecteddefaultfrequency(EDF)are

a. b. c. d.

positivelyandlinearlyrelated negativelyandlinearlyrelated positivelyandnonlinearlyrelated negativelyandnonlinearlyrelated

CORRECT:D Theriskneutralprobabilityofdefault,EDF,intheMertonModelis1N(d2).Thehigherthedistance

ln(

todefault,DDDDd2= thecontrary,thelowerDD,thehigherEDFis.Therelationshipisnonlinear.WhentheDDislow,EDF ishigh.IfDDisimminent,EDFishighaswell.Similarly,ifDDishigh,EDFissmallandnotimminent Reference:DeServignyandRenault,MeasuringandManagingCreditRisk,Chapter3.


V 1 ) 2 T V rT 2 De V T ,thelowertheriskneutralprobabilityofdefaultis.On

9. SupposetherateonCompanyAsoneyearzerocouponbondis10.0%andtheoneyearTbillrate is8.0%.AssumetheTbillisrisklessandtheprobabilityofdefaultofCompanyAsbondis10%. WhatistheLGDofCompanyAsbond?

18.18% 81.82% 20.01% 79.99% CORRECT:A (1+10%)*(1PD)+(1+10%)*PD*(1LGD)=1+8% 1.1x0.9+1.1x0.10x(1LGD)=1.08 0.99+0.11x(1LGD)=1.08 0.11x(1LGD)=1.080.99 (1LGD)=(1.080.99)/0.11 LGD=1(1.080.99)/0.11=18.18% or
Copyright2009GlobalAssociationofRiskProfessionals 72 Allrightsreserved.

a. b. c. d.

2009FRMPracticeExams
LGD=1((1+rf)(1+r)x(1PD))/((1+r)xPD) Reference:DeServignyandRenault,MeasuringandManagingCreditRisk,Chapter3,4.

10. Abankisconsideringwaysofsignificantlyreducingoreliminatingitscreditexposuretodefaultsona loanportfoliosothatthebanksshareholdersdonotabsorbthelossesarisingfromsuchdefaults. Ignoringinstitutionalissues(e.g.,tax,accounting,capitalrequirements),threeofthefollowing programshaveasimilarimpactonthecreditriskofthebank.Whichalternativefailstoreduce creditrisk?

a. b. c. d.

Selltheloanportfolioinitsentiretytoanotherbank. Borrowtofinanceanadditionalriskreservetosupplementexistingloanlossreserves. Securitizetheloanportfolio. Buycreditprotectionontheloanportfoliowithcreditdefaultswaps.

CORRECT:B Allthreeoftheotherchoicesareeconomicallyequivalent.Sellingloanstoanexternalparty eliminatesallcreditriskfortheinstitution.Similarly,securitizingtheloanportfolioremovesthe loansfromthebanksbooksandeliminatesthecreditriskfortheinstitution.Buyingcredit protectionusingcreditdefaultswapswillofferprotectionagainstcreditrisk.Thisalternativeimplies counterpartyrisk.Borrowingdoesnotworkinthelongrunbecauseshareholdersstillatsomepoint havetotakethehitfordefaultrelatedlosses.Additionally,theincreasedborrowingtofinancethe loanlossreserveswillincreasetheriskfortheshareholders. Reference:Culp,Chapter16


11. ConsiderastockpriceSthatfollowsageometricBrownianmotiondS=Sdt+ Sdz,withstrictly positiveandafixedvalue.Whichofthefollowingstatementsistrue?

a. b. c. d.

Ifthedriftisnegative,thepriceoneyearfromnowwillbebelowtodaysprice. Theinstantaneousrateofreturnonthestockfollowsauniformdistribution. ThestockpriceSfollowsalognormaldistribution. Thismodelimposesmeanreversion.

CORRECT:C

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INCORRECT:ATheexpectedpriceislessthantodaysprice,butnotthepriceinallthestatesof world. INCORRECT:BTheinstantaneousrateofreturnonthestockfollowsnormaldistribution. INCORRECT:DThismodeldoesnotimposemeanreversion. Reference:PhilippeJorion,ValueatRisk:TheNewBenchmarkforManagingFinancialRisk,3 ed. (NewYork:McGrawHill,2007).Chapter12

rd

12. ThejointprobabilitydistributionofrandomvariablesXandYisgivenbyf(x,y)=kxyforx=1,2,3,y= 1,2,3,andkisapositiveconstant.WhatistheprobabilitythatX+Ywillexceed5?

a. 1/9 b. 1/4 c. 1/36 d. Cannotbedetermined CORRECT:B Notethat

f ( x, y) = 1 .
x =1 y =1

Substitutingthevariousvaluesofxandy,wegetf(1,1)=k,f(1,2)=2k,f(1,3)=3k,f(2,1)=2k,f(2,2)=4k, f(2,3)=6k,f(3,1)=3k,f(3,2)=6k,andf(3,3)=9k.Therefore, k1+2k+3k+2k+4k+6k+3k+6k+9k=1 sothat,36k=1andk=1/36. P(X+Y>5)=f(3,3)=1/36x3x3=1/4 Reference:DamodarGujarati


13. WhichofthefollowingstatementsregardingHypothesisTestingisincorrect?

a. Hypothesistestingisusedtomakeinferencesabouttheparametersofagivenpopulationon thebasisofstatisticscomputedforasamplethatisdrawnfromthatpopulation. b. TypeIIerrorreferstothefailuretorejectthenullhypothesiswhenitisactuallyfalse. c. Thepvaluedecisionruleistorejectthenullhypothesisifthepvalueisgreaterthanthe significancelevel. d. Allelsebeingequal,thedecreaseinthechanceofmakingaTypeIerrorcomesatthecostof increasingtheprobabilityofmakingaTypeIIerror.

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CORRECT:C ThetruestatementistorejectHoifthepvalueissmallerthanthesignificancelevel. INCORRECT:AregardingtheprimaryuseofHypothesisTesting. INCORRECT:BregardingthedefinitionoftypeIIerror. INCORRECT:DtypeIerrorandtypeIIerrorareintradeoff. Reference:DamodarGujarati


14. Ifstockreturnsareindependentlyidenticallynormallydistributedandtheannualvolatilityis30%, thenthedailyVaRatthe99%confidencelevelofastockmarketportfolioisapproximately:

a. b. c. d.

2.41% 3.11% 4.40% 1.89%

CORRECT:C The1dayvolatilityiss*(1/252)^0.5=0.3*0.629941=0.018898.TheVaRatthe99%confidence levelisthenequalto2.32635*0.018898=4.40% INCORRECT:AOnegetsAifoneuses1.645insteadof2.326, INCORRECT:BOnegetsBifoneusesthemonthlyvolatilityinsteadofthedailyone INCORRECT:DOnegetsDisthedailyvolatility. Reference:Allen,BoudoukhandSaunders,2004,chapter1,p68


15. AsinglestockhasapriceofUSD10andacurrentdailyvolatilityof2%.Usingthedeltanormal method,theVaRatthe95%confidencelevelofalongatthemoneycallonthisstockovera1day holdingperiodisapproximately:

a. b. c. d.

USD0.23 USD1.645 USD0.33 USD0.16

CORRECT:D
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ThisquestionrequirescandidatestoknowtheformulaforthedeltanormalVaRapproximation,and alsotoknowthatthedeltaofanatthemoneycallis0.5. VaR =| | 1.645 S = 0.5 1.645 0.02 10 = 0.1645 . INCORRECT:AWegetAbyusing2.326insteadof1.645 INCORRECT:BWegetBifweuse2insteadof2%forthevolatility INCORRECT:CWegetCifweuseadeltaof1 Reference:Allenetal,Chapter3

16. Aportfolioconsistsoftwozerocouponbonds,eachwithacurrentvalueofUSD10.Thefirstbond hasamodifieddurationof1yearandthesecondhasamodifieddurationof9years.Theyieldcurve isflatandallyieldsare5%.Assumeallmovesoftheyieldcurveareparallelshifts.Giventhatthe dailyvolatilityoftheyieldis1%,whichofthefollowingisthebestestimateoftheportfoliodailyVaR atthe95%confidencelevel?

a. b. c. d.

USD2.33. USD1.65. USD0.82. USD1.16

CORRECT:B ThisquestionassessescandidatesabilitiestoapplythedurationVaRformulatotwobonds simultaneouslyandtorecallthatthedurationofazerocouponbondisequaltothebondmaturity. UsinganobviousextensionofJorionsequation9.5

VaR = D1 V1 1.645 + D2 V2 1.645 = ( D1 V1 + D2 V2 ) 1.645 = ( D1 + D2 ) 10 1.645 = 10 10 1.645 0.01 = 1.645


INCORRECT:AIsthe99%confidencelevelVaR INCORRECT:CArisesifthecandidatemistakenlydividesthecorrectanswerbythenumberofbonds INCORRECT:DMakesbothmistakes Reference:Tuckman

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17. ConsiderthefollowingthreemethodsofestimatingtheP&Lofabulletbond:fullrepricing,duration (PV01),anddurationplusconvexity.RankingtheestimatedP&Limpactofalargenegativeyield shockfromthelowestP&LimpacttothehighestP&Limpact,whatistherankingofthemethodsto estimatetheP&Limpact?

a. b. c. d.

durationplusconvexity,duration,fullrepricing fullrepricing,durationplusconvexity,duration duration,durationplusconvexity,fullrepricing duration,fullrepricing,durationplusconvexity

CORRECT:C Theprice/yieldlinewithyieldonthexaxisandpriceontheyaxisisconvextotheorigin.The durationatanyyieldlevelisthetangenttothatcurve.Therefore,exceptattheexactpointof tangency,durationwillalwaysunderestimatethepricechange. INCORRECT:ADurationwillalwaysunderestimatepricechangefornegativeyieldshocks INCORRECT:BFullrepricingwillnevergenerateasmallerpositivepricechangethanduration becausedurationrepresentsthepointoftangency INCORRECT:DFullrepricingwillgenerateahigherpriceforalargenegativeyieldchangethanwil durationplusconvexity Reference:Allen,Boudoukh,Saunders,Chapter3

18. Considerapositionina5yearreceivefixedswapthatmakesannualpaymentsonaUSD100million notional.Thefloatingleghasjustbeenreset.Thetermstructureisflatat5%,theMacaulay durationofa5yearparbondis4.5years,andtheannualvolatilityofyieldchangesis100bp.Your bestestimateoftheswapsVaRwith95%confidenceoverthenextmonthis

a. b. c. d.

USD1.6million USD2.0million USD5.5million USD7.1million

CORRECT:A Becausethefloatingrateleghasjustbeenreset,itsdurationis1.Netdurationis4.51=3.5year,or modifieddurationof3.5/1.05=3.33.The95%VaRofmonthlychangesinyieldsis1.65*1%/12= 0.48%.Multiplying,thisgivesUSD100*0.48%*3.33=USD1.588

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INCORRECT:BThisusesanetdurationof4.5yearsandignoresthedurationofthefloatingrate leg. INCORRECT:CThisistheannualVaR,butshouldbetranslatedtoamonthlyhorizon. INCORRECT:DThisistheannualVaRcomputedbyignoringthedurationofthefloatingrateleg. Reference:Hull,Chapter,Chapter7 19. Ifthegoldleaserateishigherthantheriskfreerate,whatisthemarketstructureoftheforward marketforgold?

a. b. c. d.

Contango Backwardation Inversion Needmoreinformationtodetermine

CORRECT:B Aleaseratehigherthantheriskfeeratewillforceanegativelyslopedforwardcurve,i.e. backwardation INCORRECT:ATheforwardprice=spot*exp(riskfreerateleaserate).Iftheleaserateishigher thantheriskfreerate,forwardswillbelowerthanspot,implyingcontango INCORRECT:CTheterminversionisusedtodescribeyieldcurves,notcommodityforwards INCORRECT:DThereisenoughinformationinthequestiontoprovideananswer Reference:MacDonald,Chapter6


20. Thepriceofa3yearzerocoupongovernmentbondis85.16.Thepriceofasimilar4yearbondis 79.81.Whatistheoneyearimpliedforwardratefromyear3toyear4?

a. b. c. d.

5.4% 5.5% 5.8% 6.7%

CORRECT:D

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1 + Forward rate = 85.16 Price of three bond = = 1.067034 Price of four year bond 79.81

Forward rate = 0.067034 or 6.7%

INCORRECT:AIsacombinationofBandC INCORRECT:BIsthereturnofthe3yearbond INCORRECT:CIsthereturnofthe4yearbond Reference:Hull,Tuckman


21. AportfoliomanagerhasabondpositionworthUSD100million.Thepositionhasamodified durationof8yearsandaconvexityof150years.Assumethatthetermstructureisflat.Byhow muchdoesthevalueofthepositionchangeifinterestratesincreaseby25basispoints?

a. b. c. d.

USD1,953,125 USD1,906,250 USD2,046,875 USD2,187,500

CORRECT:A

V = - D mod y V + 0.5 Convexity y 2 V V = - 8 0.0025 100M + 0.5 150 (0.0025) 2 100M V = - 2M + 46,875 V = - 1,953,125
INCORRECT:BOmits0.5fromthesecondterm INCORRECT:CSubtractsthesecondterm INCORRECT:DMakesbothmistakes Reference:Tuckman 22. WhatistheannualizedrateofreturnearnedonacashandcarrytradeenteredintoinMarchand closedoutinJune? a. 8.9% b. 9.8% c. 35.7% d. 39.1%
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CORRECT:C ByformulaF0,T=S0erT+C,whereF0,T=Juneforwardprice,S0=Marchforwardprice,r=riskfree interestrate,T=lengthofcashandcarry,C=storagecost Solving5.90=5.35er*3/12+0.05 Solutionisr=35.7% INCORRECT:A8.9=LN((5.90.05)/5.35)(forgetstoannualizethereturn) INCORRECT:B9.8=LN((5.9)/5.35)(forgetstoincludethestoragecostandtoannualizethereturn) INCORRECT:D39.1=(12/3)LN((5.9)/5.35)0.05(forgetstoincludethestoragecost) Reference:RobertLMcDonald,DerivativesMarkets,Chapter6


23. AninvestorsellsaJune2008callofABCLimitedwithastrikepriceofUSD45forUSD3andbuysa June2008callofABCLimitedwithastrikepriceofUSD40forUSD5.Whatisthenameofthis strategyandthemaximumprofitandlosstheinvestorcouldincur? a. BearSpread,MaximumLossUSD2,MaximumProfitUSD3 b. BullSpread,MaximumLossUnlimited,MaximumProfitUSD3 c. BearSpread,MaximumLossUSD2,MaximumProfitUnlimited d. BullSpread,MaximumLossUSD2,MaximumProfitUSD3

CORRECT:D BuyingacalloptionatlowerstockpriceandsellingcalloptionathigherstrikepriceiscalledasBull Spread.BearSpreadisbuyingthecalloptionathigherpriceandsellingthecallatlowerstrikeprice. TheCostofstrategywillbeUSD3USD5=USD2 ThePayoff,whenStockpriceSTUSD40willbeUSD2(thecostofstrategy)asnoneoftheoption willbeexercised. ThePayoff,whenstockpriceST45,(asbothoptionswillbeexercise)willbeUSD5, SincethecostofstrategyisUSD3,henceprofitwillbeUSD5USD2=USD3 WhenStockpriceisUSD40<ST>USD45,Onlythecalloptionboughtbytheinvestorwouldbe exercisedhencethepayoffwillbeST40,sincethecostofstrategyisUSD3,TheNetprofitwillbe ST43,whichwouldalwaysbelowerthanUSD3. Reference:Hull,Chapter10TradingStrategiesInvolvingOptions.

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24. WhichofthefollowingproblemsareNOTinherentdisadvantagesofthehistoricalsimulation approachtoestimatingVaR?

I. Itgivestoolittleweighttomorerecentobservations II. Forlongonlyportfolios,itislikelytounderstateVaRfollowingarecentstructuralincreasein volatilities III. Italwaysignoresthefattailspresentinthedistributionofreturnsonmanyfinancialassets IV. Becauseofthedeltaapproximation,itinadequatelymeasurestheriskofnonlinear instruments

a. b. c. d.

IandIIonly IIonly I,IIIandIVonly IIIandIVonly

CORRECT:C ThedisadvantagewiththeHistoricalSimulationModelisthatitmaynotrecognizethechangesin volatilityandcorrelationfollowingrecentstructuralchanges.Themodelcanbeadjustedsothatit givesmoreweighttorecentobservations.Theotheroptions,i.e.III&IV,aredisadvantagesofMonte CarlomethodandDeltanormalmethod. Reference:Allenetal.Chapters2,3. 25. AbankholdsUSD60millionworthof10year6.5%couponbondsthataretradingatacleanpriceof 101.82.Thebankisworriedbytheexposureduetothesebondsbutcannotunwindthepositionfor fearofupsettingtheclient.Therefore,itpurchasesatotalreturnswap(TRS)inwhichitreceives annualLibor+100bpsinreturnforthemarktomarketreturnonthebond.Forthefirstyear,the Liborsetsat6.25%andbytheendoftheyearthecleanpriceofthebondsisat99.35.Thenet receipt/paymentforthebankinthetotalreturnswapwillbe:

a. ReceiveUSD2.23million. b. ReceiveUSD1.93million. c. PayUSD1.93million. d. PayUSD2.23million. CORRECT:B

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itstheresultofthiscalculation:thenotionalamountis60millionUSD.Thereforethebankwill receivetheinterestpaymentlinkedtotheLIBORrate:60millionUSD*(6,25%+100bp)=4.35 millionUSD. Thebankwillpaythefixedcouponplusthechangeinthevalueofthebond:60millionUSD*6.5%+ 60million*(99.35%101.82%)=2.418millionUSD. Hencethetotalnetamountthebankwillreceiveis:4.35millionUSD2.418millionUSD=1.932 millionUSD. Reference:HullChapter7Swaps

26. Whichofthefollowingtrade(s)containbasisrisk?

I. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsNov07NYMEXWTI CrudeOilcontracts II. Long1,000lotsNov07ICEBrentOilcontractsandlong2,000lotsNov07ICEBrentOilat themoneyput III. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07ICEBrentOil contracts IV. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07NYMEXWTI CrudeOilcontracts

I&III II&IV IIII&IV I,III&IV CORRECT:D BasisRiskisspreadrisk,whicharisefromtradingthespread(longandshort2positivelycorrelated assetsorsameassetwithdifferentexpiration) Iisspreadtradeinhighlycorrelatedassetwithsameexpirationmonth IIfaceswithgammaandvegarisk IIIisspreadtradeintradingtheflatteningoftheforwardcurve IVisspreadtradeintrading2assetswithdifferentexpirationdate Reference:RobertL.McDonald,DerivativesMarkets(Boston:AddisonWesley,2003),Chapter6.

a. b. c. d.


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27. Accordingtoputcallparity,buyingaputoptiononastockisequivalentto:

Buyingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Sellingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. Sellingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. CORRECT:C Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. INCORRECT:ABuyingacalloptioniscorrect,buttherestofthestatementisincorrect. INCORRECT:BTheentirestatementisincorrect. INCORRECT:DSellingacalloptionisincorrect,buttherestofthestatementiscorrect. Reference:Options,Futures,andOtherDerivatives,6thedition,byJohnHull,Chapter10.

a. b. c. d.


28. A3monthfuturescontractonanequityindexiscurrentlypricedatUSD1000,theunderlyingindex stocksarevaluedatUSD990andpaydividendsatacontinuouslycompoundedrateof2percent andthecurrentcontinuouslycompoundedriskfreerateis4percent.Thepotentialarbitrageprofit percontract,giventhissetofdata,isclosestto

a. b. c. d.

USD10.00 USD7.50 USD5.00 USD1.50

CORRECT:C Accordingtothefundamentalpricingrelationshipbetweenspotassetsandtheassociatedfutures, thefuturesprice,topreventarbitrage,shouldequal990xe(0.040.02)x0.25or995.Hence,the futurescontractisovervalued,indicatingitshouldbesoldandtheindexshouldbepurchasedforan arbitrageprofitofUSD1000USD995=USD5 Reference:Hull,Options,Futures,andOtherDerivatives,6 ed.Chapter5



th

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29. ResearchandmodelprojectionsindicatethataspecificeventislikelytomovetheCHFagainstthe USD.Whilethedirectionofthemoveishighlyuncertain,itishighlylikelythatmagnitudeofthe movewillbesignificant.Basedonthisinformation,whichofthefollowingstrategieswouldprovide thelargesteconomicbenefit?

a. LongacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate b. LongacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikepriceand expirationdate c. ShortacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate d. ShortacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate

CORRECT:B Thequestiontestsonunderstandingofastraddlestrategyanditsapplicationoncurrencytrading. Alongstraddlestrategyinvolvesbuying(long)acallandputoptionwiththesamestrikepriceand expirationdate,andwillbenefitmostwhentheunderlyingmovesawayfromthecurrentequlibrium. Longcallandlongputcreateastraddle. INCORRECT:AItsellsaputoptionwhileitshouldbuyoneput.. INCORRECT:CItsellsacalloptionwhileitshouldbuyonecall. INCORRECT:DItsellsboththecallandputoptionwhileitshouldbuyboth. Reference:Hull.


30. Initially,thecalloptiononBigKahunaInc.with90daystomaturitytradesatUSD1.40.Theoption hasadeltaof0.5739.Adealersells200calloptioncontractsandtodeltahedgetheposition,the dealerpurchases11,478sharesofthestockatthecurrentmarketpriceofUSD100pershare.The followingday,thepricesofboththestockandthecalloptionincrease.Consequently,delta increasesto0.7040.Tomaintainthedeltahedge,thedealershould:

a. b. c. d.

Purchase2,602shares. Sell2,602shares. Purchase1,493shares. Sell1,493shares. CORRECT:A Numberofcalls=200contractsx100=20,000calls.


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Numberofshares =(Numberofcalls)x(NewdeltaOlddelta) =20,000x(0.70400.5739) =+2,602shares Positivesignindicatesthatthemanagershouldpurchasenewshares. INCORRECT:BBecausetheformulaisincorrect,i.e.olddeltaminusnewdelta. INCORRECT:CBecausethenumberofshares(insteadofnumberofcalls)isusedinthecalculation. INCORRECT:DAsperexplanationinCaboveandsignerror. Reference:Hull.

31. Whichofthefollowingstrategiescreatesacalendarspread? a. Sellacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice. b. Buyacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice. c. Sellacalloptionwithacertainstrikepriceandbuyashortermaturitycalloptionwiththesame strikeprice. d. Buyacalloptionwithacertainstrikepriceandsellalongermaturitycalloptionwiththesame strikeprice.

CORRECT:A INCORRECT:BAsbuyacalloption. INCORRECT:CAsbuyashortermaturitycalloption INCORRECT:DAsthisisareversecalendarspread. Reference:Hull.


32. Whichofthefollowingunderlyingmacroeconomicconditionswouldleaveanemergingmarket mostvulnerabletothecontagioneffectsofacurrencycrisis?

a. b. c. d.

Largecurrentaccountsurplus,lowforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountdeficit,lowforeignexchangereserves,fullyconvertiblecurrency Smallcurrentaccountdeficit,highforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountsurplus,highforeignexchangereserves,fullyconvertiblecurrency

CORRECT:B
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INCORRECT:ALargecurrentaccountsurplusandnonconvertiblecurrencywouldprotectthelocal currency INCORRECT:CHighforeignexchangereservesandnonconvertiblecurrencywouldprotectthelocal currency INCORRECT:DLargecurrentaccountsurplusandhighforeignexchangewouldprotectthelocal currency Reference:Saunders,Chapter15,ForeignExchangeRisk

33. ConsideranFRA(forwardrateagreement)withthesamematurityandcompoundingfrequencyasa Eurodollarfuturescontract.TheFRAhasaLIBORunderlying.Whichofthefollowingstatementsare trueabouttherelationshipbetweentheforwardrateandthefuturesrate?

a. b. c. d.

Theyshouldbeexactlythesame. Theforwardrateisnormallyhigherthanthefuturesrate. Theforwardrateisnormallylowerthanthefuturesrate. Theyhavenofixedrelationship.

CORRECT:C AsEurodollarfuturescontractismarkedtomarketandsettleddaily,normallyforwardrateis adjustedlower,socalledconvexityadjustment,by: Forwardrate=Futuresrate 2T1T2 Reference:Hull.


1 2

34. Yourbankisanactiveplayerinthecommoditymarket.Theviewoftheeconomistofthebankis thatinflationisexpectedtorisemoderatelyintheneartermandmarketvolatilityisexpectedto remainlow.Thetradersareadvisedtoundertakedealsonthemetalsexchangetoalignyourbook toconformwiththeexpectationsoftheeconomistofthebank.Asriskmanager,youareaskedto monitorthepositionsofthetraderstomakesurethattheyhavetheexposurestoinflationand marketvolatilitysoughtbythebank.Whichtraderhastakenanappropriatepositionamongthe tradersyouaremonitoring?

a. TraderAboughtacallandaput,bothwith90daystoexpirationandwithstrikepriceequalto theexistingspotlevel. b. TraderBboughtaputoptionwithadownandinknockinfeature. c. TraderCboughtacalloptionattheexistingspotlevelsandsoldacallatahigherstrikeprice, bothwith90daystoexpiration. d. TraderDsoldacallandboughtaputattheexistinglevels,bothwith90daystoexpiration.


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CORRECT:C Asthestrategypopularlyknownasthebullspreadwillresultinpositivepayoffwhenthespotrises. Asinflationincreases,spotlevelsincommoditiesareexpectedtorise.Sellingacallathigherlevel willreducethecostofthestrategy.Althoughitmaylimittheupside,butthatwouldbeinlinewith theviewasonlyamoderateriseisexpectedinspot. INCORRECT:AAsthestrategypopularlyknownasastraddleistobeusedwhentheviewisthatthe volatilityinthemarketwillrise,andthereisnodirectionalviewonthespot. INCORRECT:BAstheaboveoptionwillbesuitablewhenthespotisexpectedtofallfromthe existinglevels. INCORRECT:DAsthepayoffinthiscaseissimilartoshortpositioninspotandwouldmakesense whentheunderlyingisexpectedtofall. Reference:Hull,Chapter10.

35. Consideringoptionsgenerally(i.e.,notonlyplainvanillacallsandputs),whichofthefollowing statementsaboutvegaiscorrect?

Anoptionholdercanneverbeveganegative. Adeepinthemoneyupandoutcalloptionhasanegativevega. Adeepoutofmoneyupandoutcalloptionhasanegativevega. Adeepoutofmoneydigitaloptionhasanegativevega. CORRECT:B DeepinthemoneyUpandOutcalloptionbecauseanincreaseinthevolatilityofsuchoptionsleads totheincreasingchancesofoptioneitherbeingknockedout(ifthepriceincreasesbeyondthe barrier)orloosingitsmoneyness(ifthepricesfalls)andhencetheincreasingvolatilitytendstohave negativeimpactonthepriceoftheoption. INCORRECT:AAsanoptionholdercanbeVeganegativeasshownabove. INCORRECT:ChavepositiveVegaasanincreaseinthevolatilitywouldincreasethechancesof gettingtowardsmoneynessandhencepositiveVegafromaholdersperspective. INCORRECT:DhavepositiveVegaasanincreaseinthevolatilitywouldincreasethechancesof gettingtowardsmoneynessandhencepositiveVegafromaholdersperspective. Reference:Hull,Chapters17,1824.

a. b. c. d.

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36. Tohedgeagainstfuture,unanticipated,andsignificantincreasesinborrowingrates,whichofthe followingalternativesoffersthegreatestflexibilityfortheborrower?

a. b. c. d.

Fixedforfloatingswap Interestratecollar Interestratefloor Callswaption

CORRECT:D Thequestionfocusesonflexiblemanagementofborrowingexpenses.Whileafixedforfloating swapcouldreduceborrowingexpenses,itisalongtermcontractualcommitmenttoexchange payments.Ifinterestratesdecline,theborrowermaygrossuptotheagreedfixedrate.Aninterest ratecollarisacombinationofaninterestratefloorandcap,i.e.,itlocksintheinterestexpenses withinatightrange.Moreover,collarsusuallyofferinterestrateprotectionatoneparticularpoint oftimeunlessseveralcontractswithdifferentmaturitiesareexchanged.Acallswaptiongivesthe companytherighttoenterintoaswapwhentheborrowingexpensesexceedacertainreference rate.Ifthereferencerateisbelowtheborrowingexpenses,theoptionisnotexercised. Reference:Hull.

37. Assumingotherthingsconstant,bondsofequalmaturitywillstillhavedifferentDV01perUSD100 facevalue.TheirDV01perUSD100facevaluewillbeinthefollowingsequenceofhighestvalueto lowestvalue:

a. Zerocouponbonds,parbonds,premiumbonds b. premiumbonds,parbonds,zerocouponbonds c. Premiumbonds,zerocouponbonds,parbonds d. Zerocouponbonds,premiumbonds,parbonds CORRECT:B DV01iscertainmultipleofDirtyPrice(whichincludesCoupons)andnotCleanPrice.Thus,itis proportionaltoBasePrice,whichisDirtyPrice.Ordinarily,PremiumBondwillhavethehighest (dirty)pricefollowedbyParBondandwiththeleastpriceofZeroCouponBond.Hence,DV01of PremiumBondisthehighestwhilethatofZeroCouponBondsisthelowest. INCORRECT:APremiumBondwillhaveahigherBasePriceandhencehigherDV01thanthatof ZeroCouponBond. INCORRECT:CBasePriceofParBondishigherthanthatofZeroCouponBondandhence,itsDV01 cannotbelessthanthatofZeroCouponBond.
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INCORRECT:DDV01perUSD100FaceValueisanAbsoluteAmountofUSDbasedonactualBase PriceChange.Ordinarily,BasePriceofaZeroCouponBondwillbelowerthanthatofPar&Premium Bond.Hence,DV01ofZeroCouponBondislessthanthatofPremiumBondofsamematurity. Reference:Tuckman,FixedIncomeSecurities,Chapter5.

38. TheinformationratiooftheSteroleUSFundfor2006againsttheS&P500,itsbenchmarkindex,is1. Forthesametimeperiod,thefundsSharperatiois2,thefundhasatrackingerrorof7%against theS&P500,andthestandarddeviationoffundreturnsis5%.TheriskfreerateintheUSis4%. CalculatethereturnfortheS&P500duringthetimeperiod. a. 3.5% b. 7% c. 11% d. 14%

CORRECT:B SharpeRatio=2 (FundReturnRiskFreeRate)/SD=2 (FundReturn4%)/5%=2 FundReturn=14% InformationRatio=1 (FundReturnS&P500Return)/TrackingError=1 (14%S&P500Return)/7%=1 S&P500Return=7% INCORRECT:AIncorrectlydividesS&P500Returnby2 INCORRECT:CThecandidatemightusetheTrackingErrorastheNumeratorinboththeRatios. SharpeRatio=2 (FundReturnRiskFreeRate)/TrackingError=2 (FundReturn4%)/7%=2 FundReturn=18% InformationRatio=1 (FundReturnS&P500Return)/TrackingError=1 (18%S&P500Return)/7%=1 S&P500Return=11% INCORRECT:DThecandidatecanstopwiththefundreturncalculation,andendupwith14%. SharpeRatio=2

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(FundReturnRiskFreeRate)/SD=2 (FundReturn4%)/5%=2 FundReturn=14% Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

39. Afundmanagerrecentlyreceivedareportontheperformanceofhisportfoliooverthelastyear. Accordingtothereport,theportfolioreturnis9.3%,withastandarddeviationof13.5%,andabeta of0.83.Theriskfreerateis3.2%,thesemistandarddeviationL(Rp)oftheportfoliois8.4%,andthe trackingerroroftheportfoliotothebenchmarkindexis2.8%.Whatisthedifferencebetweenthe valueofthefundsSortinoratio(computedrelativetotheriskfreerate)anditsSharperatio?

a. 0.274 b. 1.727 c. 0.653 d. 0.378 CORRECT:A


Sharperatioequalsto

R p RF

(R p )

9 .3 % 3 .2 % = 0.452 13.5%

WhileSortinoratioequalsto

R p RF

L ( RP )

9.3% 3.2% = 0.726 8.4%

Trackingerrorisusedtocalculatethevalueoftheinformationratio,whichisdefinedas

R p RB

( RP RB )

,Thecalculationofinformationratioisnotrequiredinthisquestion.

INCORRECT:B2.1780.452=1.727 INCORRECT:C0.7260.0.73=0.653(0.073=(.0930.032)/0.83) INCORRECT:D0.0730.452=0.378 Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4


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40. YourfirmhasnopriorderivativestradeswithitscounterpartySuperBank.Yourbosswantsyouto evaluatesometradessheisconsidering.Inparticular,shewantstoknowwhichofthefollowing tradeswillincreaseyourfirmscreditriskexposuretoSuperBank: I. buyingaputoption II. sellingaputoption III. buyingaforwardcontract IV. sellingaforwardcontract

a. b. c. d.

I.andIIonly IIandIVonly IIIandIVonly I,IIIandIVonly

CORRECT:D Thistestsunderstandingofthetypeofpositionsthatcreatecreditrisk(andlinkstothefollowing question).Thekeyistoevaluateeachofthecomponenttrades.Buyingaputoptioncreatescredit risk.Buyingorsellingforwardcontractscreatescreditrisk.However,sellinganoptiondoesnot createcreditriskyouarenotsubjecttotheperformanceofthecounterparty. Reference:HullChapter22,StulzChapter18.


41. Considerthefollowingoneperiodtransitionmatrix:

Initial Period State

A B Default

NextPeriodState A B 95% 5% 10% 80% 0% 0%

Default 0% 10% 100%

IfacompanyisoriginallyinStateA,whatistheprobabilitythatthecompanywillhavedefaulted strictlybeforethefourthtransitionperiodfromnow?

a. 0.875% b. 0.500% c. 1.375% d. 1.875% CORRECT:C

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Theeasiestwaytodeterminetheanswerwouldbetomakethisasquarematrixincludingdefaultin initialstate.Thenselfmultiplyingthematrixthreetimesyieldsthreeperiodtransitionmatrix.We canalsomanuallydothecalculation; Afteryear1thereisa0%chanceofdefaultand5%chanceofbeinginstateB. Afteryear2thereis95%*5%+80%*5%chanceofbeinginstateBand5%*10%chanceofdefault. Afteryear3thereisa(95%*5%+80%*5%)*10%additionalchanceofdefault.AnswerAassumes justoneyear INCORRECT:AOnlyconsidersthethirdyeartransitionfromBtodefault. INCORRECT:BOnlyconsidersthesecondyeartransitionfromBtodefault. INCORRECT:DMistakenlydoublesthesecondyeartransitionfromBtodefault. Reference:DeServignyandRenault,MeasuringandManagingCreditRisk,Chapter2,Appendix2A, page4952.

42. Asanapproximation,itistruethat

a. b. c. d.

Defaultswapspread=Returnofariskybond+Returnofariskfreebond Defaultswapspread=ReturnofariskybondReturnofariskfreebond Defaultswapspread=ReturnofariskybondxReturnofariskfreebond Defaultswapspread=Returnofariskybondx(1Returnofariskfreebond)

CORRECT:B Thebuyerofariskybondcanhedgethecreditriskoftheriskybondusingadefaultswap.Entering intotheswaptradereducescreditrisk.Toprecludearbitrage,thebuyeroftheriskbondhasto receivethesamereturnastheriskfreeasset,or: Returnofariskybond=Returnofariskfreebond+Defaultswapspread Reference:Hull,Chapter23.


43. InaCDO,theSPVistypically

a. b. c. d.

AAArated Arated BBBrated Notrated

CORRECT:A

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InaCDOtransaction,theSpecialPurposeVehiclearespecialentitiesoffinancialinstitutionsandare usuallyAAArated.TheSPVandtheinstitutionarelegallydistinctandcreditqualitydeteriorationof thefinancialinstitutiondoesnotaffecttheSPV.InthiscaseSPVcounterpartyriskislow,whichis desiredbytheinvestor. Reference:Hullchapter23,CulpChapters16,17,18.

44. Atraderwhoseriskyouaremonitoringtellsyouthathewantstobenefitfromacreditspread wideningduetoarecession.Whichofthefollowingwouldbegoodtradesforhisstrategy?

a. Golongriskybondsandshortriskfreebondsatthebeginningoftherecession. b. Shortriskybondsandgolongriskfreebondsatthebeginningoftherecession. c. Sellcreditdefaultswapsonbondswithalowcreditqualityandbuycreditdefaultswapson bondswithahighercreditqualityatthebeginningoftherecession. d. Sellcreditdefaultswapsonbondswithlowcreditqualityandgolonglowcreditqualitybonds.

CORRECT:B Shortingriskybondsandgoinglonginriskfreebondsatthebeginningoftherecessionisthecorrect answer.Duringarecession,creditspreadstypicallystartwidening,andfinancingalongpositionin riskfreebondsthroughdecliningcreditqualityriskybondsreducestheeffectivefinancingcost. INCORRECT:AGoinglonginriskybondsandshortingriskfreebondsatthebeginningofthe recessionisincorrect.Thisstrategyispreferableatthebeginningofaneconomicexpansion,when thecreditspreadtypicallystartstightening. INCORRECT:CSellingcreditdefaultswapsonbondswithacertaincreditqualityandbuyingcredit defaultswapsonbondswithahighercreditqualityatthebeginningoftherecessionwouldbe preferableatthebeginningofaneconomicexpansion. INCORRECT:DSellingcreditdefaultswapsonbondswithlowcreditqualityandgoinglonginlow creditqualitybondseffectivelymagnifiesthecreditrisk,whichunderdeterioratingcreditconditions shouldbeavoided. Reference:Culp,Chapter12,13,16.

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45. BankBhasaEUR100millionloanportfolioandhassetasideareservetocoverthefirstEUR20 millionindefaultrelatedlosses.IfthebankwantstoacquireprotectionfortheremainingEUR80 millioninriskexposure,whichofthefollowingsolutionswouldworkandwouldexposethebankto theleastamountofcounterpartyrisk?

a. BuycreditprotectioninaseniorsubordinatedCDSthatcoversEUR80millioninlossesabove thefirstEUR20million. b. BuycreditinsuranceforlossesuptoEUR80millioninexcessofEUR20millionontheloan portfolio. c. Issueacreditlinkednoteinwhichinterestandprincipalmaybewithheldfrominvestorsto coveruptoEUR80millioninlossesabovethefirstEUR20millionontheloanportfolio. d. Allthreeoftheabovechoicesworkandexposethebanktothesameamountofcounterparty risk.

CORRECT:C BothCDSandinsuranceareunfunded,andexposethebanktotheriskofnonperformancebythe CDSprotectionsellerortheinsurancecompanyofferingcreditinsurance.Whenissuingacredit linkednote,however,thecashhasbeenpaidinupfrontbyinvestorstothebank,eliminating counterpartyrisk. Reference:Culp,Chapter16


46. Mr.Rosenqvist,AssetManageratBCDBank,holdsaportfolioofSEK200million.Theportfolio consistsofBBBratedbonds.Assumethattheoneyearprobabilityofdefaultis4%,therecovery rateis60%,anddefaultsareuncorrelatedoveryears.Whatisthe2yearcumulativeexpectedcredit lossonMr.Rosenqvistsportfolio?

a. b. c. d.

SEK6.35million SEK6.40million SEK9.48million SEK9.60million

CORRECT:A TheCreditLossYear1isSEKmillion[200*4%*(160%)]=3.2andtheCreditLossYear2isSEK million[(2003.2)*4%*(160%)]=3.15.Thecumulativeexpectedlossover2yearsthanis3.2+ 3.15=6.35. INCORRECT:BDoesnottakeintoaccountthecreditlossyear1whencalculatingthelossforyear2.

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INCORRECT:CWronglyinterpretstherecoveryrateasameasureofcreditloss,whilecreditloss equals(1recoveryrate).Inthiscaseitequals(10.60)=40%. INCORRECT:DIsacombinationofmistakeBandC. Reference:deServignyandRenault,MeasuringandManagingCreditRisk.

47. UsingtheMertonmodel,thevalueofthedebtincreasesifallotherparametersarefixedand

I. Thevalueofthefirmdecreases II. Therisklessinterestratedecreases III. Timetomaturityincreases IV. Thevolatilityofthefirmvaluedecreases

a. b. c. d.

IandIIonly IandIVonly IIandIIIonly IIandIVonly

CORRECT:D Accordingtothemodel,thevalueofthebondisB=VS,whereVisthevalueoftheassetsandSis thevalueoftheequity,orKertN(d2)+Vx(1N(d1)).d1=ln(V/Kert)/T+T/2andd2=1d1.Value ofthedebtwillincreaseifinterestratesdecreasesandvolatilityofthefirmdecreases. INCORRECT:AIIistruebutIisfalse.Valueofthedebtwillincreaseifvalueofthefirmincreases. Thevalueofthedebtwillincreaseifinterestratedecreases. INCORRECT:BVistruebutIisfalse. INCORRECT:CIIistruebutIIIisfalse.Thevalueofthedebtwillincreaseofthetimetomaturity decreases Reference:Stulz,RiskManagement&Derivatives,Chapter18,p.580 deServignyandRenault,MeasuringandManagingCreditRisk.

48. Afirmisgoingtobuy10,000barrelsofWestTexasCrudeOil.Itplanstohedgethepurchaseusing theBrentCrudefuturescontract.Thecorrelationbetweenthespotandfuturespricesis0.72.The volatilityofthespotpriceis0.35peryear.ThevolatilityoftheBrentCrudefuturespriceis0.27per year.Whatisthehedgeratioforthefirm?


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a. b. c. d.

0.5554 0.9333 1.2099 0.8198

CORRECT:B
0.35 N = 0.72 0.27 N= 0.9333

INCORRECT:AInvertsthespotvolatilityandthefuturesvolatility. INCORRECT:CUsesvariances INCORRECT:DUsessquarerootsofthevolatilities. Reference:Hull,Chapter3


49. ItisJune2ndandafundmanagerwithUSD10millioninvestedingovernmentbondsisconcerned thatinterestrateswillbehighlyvolatileoverthenextthreemonths.Themanagerdecidestouse theSeptemberTreasurybondfuturescontracttohedgethevalueoftheportfolio.Thecurrent futurespriceis95.0625.EachcontractisforthedeliveryofUSD100,000facevalueofbonds.The durationofthemanagersbondportfoliointhreemonthswillbe7.8years.Thecheapesttodeliver bondintheTreasurybondfuturescontractisexpectedtohaveadurationof8.4yearsatmaturityof thecontract.AtthematurityoftheTreasurybondfuturescontract,thedurationoftheunderlying benchmarkTreasurybondis9years.Whatpositionshouldthefundmanagerundertaketomitigate hisinterestrateriskexposure?

a. Short94contracts b. Short98contracts c. Short105contracts d. Short113contracts CORRECT:B


10,000,000 7.8 N= 95,062.50 8.4

N = 97.68 or 98 contracts

INCORRECT:AIsmadeup.
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INCORRECT:CLeavesoutthedurations INCORRECT:DInvertsthedurations. Reference:Hull,Chapter6.

50. AbondtraderhasboughtapositioninTreasuryBondswitha4%annualcouponrateonFebruary 15,2015.TheDV01ofthepositionisUSD80,000.Thetraderdecidestohedgehisinterestraterisk withthe4.5%couponrateTreasuryBondsmaturingonMay15,2017whichhasaDV01of.076per USD100facevalue.Toimplementthishedge,approximatelywhatfaceamountofthe4.5% TreasurybondsmaturingonMay15,2017shouldthetradersell?

a. b. c. d.

USD80,000 USD10,500,000 USD80,000,000 USD105,000,000

CORRECT:D USD105,000,000x.076/100=USD79,800,whichisprettyclosetothedesiredDV01ofUSD80,000. Tosolveforthehedge,solveforFintheequationUSD80,000=Fx.076/100,givingF=105,263,158. INCORRECT:ASellingthisamountwouldoffsetaDV01ofonlyUSD80,000x.076/100=USD61. INCORRECT:BUSD10,500,000x.076/100=USD7,980. INCORRECT:CUSD80,000,000x.076/100=USD60,800. Reference:Tuckman

ENDOF2009FRMFULLEXAMPRACTICEEXAMI Questions&Explanations

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2009FRMFullExamPracticeExamII CandidateAnswerSheet

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

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2009FRMFullExamPracticeExamII Questions

1. ThecurrentvalueoftheS&P500indexis1457,andeachS&PfuturescontractisfordeliveryofUSD 250timestheindex.AlongonlyequityportfoliowithmarketvalueofUSD300,100,000hasbetaof 1.1.Toreducetheportfoliobetato0.75,howmanyS&Pfuturescontractshouldyousell?

a. b. c. d.

618contracts 288contracts 574contracts 906contracts

2. Theriskfreerateis5%peryearandacorporatebondyields6%peryear.Assumingarecoveryrate of75%onthecorporatebond,whatistheapproximatemarketimpliedoneyearprobabilityof defaultofthecorporatebond? a. 1.33% b. 4.00% c. 8.00% d. 1.60%

3. ThefollowingtablefromFitchRatingsshowsthenumberofratedissuersmigratingbetweentwo ratingscategoriesduringoneyear.Basedonthisinformation,whatistheprobabilitythatanissue witharatingofAatthebeginningoftheyearwillbedowngradedbytheendoftheyear?

Year 0 rating

Year1rating AAA AAA 45 AA 3 A 2 BBB 0 Default 0

AA 4 30 5 1 0

A 2 4 40 2 0

BBB 0 3 2 30 0

Default 0 2 3 1 0

Total 51 42 52 34 0

a. b. c. d.

13.46% 13.44% 9.62% 3.85%

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4. BetaBankownsaportfolioof10AAratedbondswithatotalvalueof200millionUSD.Theoneyear probabilityofdefaultforeachissueris5%andtherecoveryrateforeachissueequals40%.Theone yearexpectedlossoftheportfoliois:

a. b. c. d.

USD4.0million USD5.0million USD6.0million USD8.0million

5. RiskAverseBank(RAB)hasmadealoanofUSD100millionat8%perannum.RABwantstoenter intoatotalreturnswapunderwhichitwillpaytheinterestontheloanplusthechangeinthemark tomarketvalueoftheloanandinexchange,RABwillgetLIBOR+30basispoints.Settlement paymentsaremadeannually.WhatisthecashflowforRABonthefirstsettlementdateifthemark tomarketvalueoftheloanfallsby2%andLIBORis6%?

a. b. c. d.

NetinflowofUSD0.3million NetoutflowofUSD0.3million NetinflowofUSD1.7million NetoutflowofUSD1.7million

6. Determinethepercentageofthefollowingportfoliothatisinvestmentgrade:

Moody's Rating Aa2 A3 Caa1 Baa3 Ba1 D Aaa A1 Baa1 Aa3

Percentage of Portfolio 25% 10% 2% 10% 5% 3% 10% 15% 10% 10%

a. b. c. d.

70% 80% 90% 95%

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7. Aspartofacurrencyhedgingstrategy,aU.S.portfoliomanagerenteredaoneyearforward contractwithabanktodeliverEUR5,000,000forUSdollarsattheendoftheyear.Atthebeginning oftheyear,theoneyearforwardratewas0.9216USD/EUR.Sixmonthsintothecontractthespot rateis0.9201USD/EUR,theU.S.interestrateis6.5%,andtheEurointerestrateis6.25%.Ifthe currentspotrate(0.9201USD/EUR)weretocontinueforthenextsixmonths,whatisthecreditrisk thattheportfoliomanagerwouldbearatmaturity?

a. b. c. d.

USD7,042 USD7,264 USD7,273 USD7,500

8. Realizingthebenefitsofnettingofthecounterpartyexposuremaybechallengingbecauseof:

a. b. c. d.

Potentialdowngradeorwithdrawalofthecounterpartyrating Differencesinratingsbetweentheratingagencies Tradesbeingbookedindifferentjurisdictions Crossproductnetting

9. Inpricingafirsttodefaultcreditbasketswap,whichofthefollowingistrue,allelsebeingequal?

a. b. c. d.

Thelowerthecorrelationbetweentheassetsofthebasket,thelowerthepremium. Thelowerthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Thehigherthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Thecorrelationbetweentheassetshasnoimpactinthepremiumofafirsttodefaultcredit basketswap.

10. ThespreadonaoneyearBBBratedbondrelativetotheriskfreetreasuryofsimilarmaturityis2%. Itisestimatedthatthecontributiontothisspreadbyallnoncreditfactors(e.g.,liquidityrisk,taxes) is0.8%.Assumingthelossgivendefaultratefortheunderlyingcreditis60%,whatisapproximately theimplieddefaultprobabilityforthisbond?

a. b. c. d.

3.33% 5.00% 3.00% 2.00%

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11. YouaregiventhefollowinginformationaboutfirmA:

MarketValueofAssetattime0=1000 MarketValueofAssetattime1=1200 ShorttermDebt=500 LongtermDebt=300 AnnualizedAssetVolatility=10% AccordingtotheKMVmodel,whataretheDefaultPointandtheDistancetoDefaultattime1? Default Distanceto Point Default a. 800 3.33 b. 650 7.50 c. 650 4.58 d. 500 5.83

12. SupposethereturnonUStreasuriesis3%andariskybondiscurrentlyyielding15%.Atraderyou superviseclaimsthathewouldbeabletomakeanarbitragetradeearning5%usingUStreasuries, theriskybondandthecreditdefaultswap.Whichofthefollowingcouldbethetradersstrategy andwhatisthecreditdefaultswappremium?Assumetherearenotransactioncosts.

a. b. c. d.

Golongthetreasury,shorttheriskybond,andbuythecreditdefaultswapwithpremiumof6%. Golongthetreasury,shorttheriskybond,andsellthecreditdefaultswapwithpremiumof7%. Shortthetreasury,investintheriskybond,andsellthecreditdefaultswapwithpremiumof6%. Shortthetreasury,investintheriskybond,andbuythecreditdefaultswapwithpremiumof 7%.

13. BankAmakesa10millionUSDfiveyearloanandwantstooffsetthecreditexposuretotheobligor. Afiveyearcreditdefaultswapwiththeloanasthereferenceassettradesonthemarketataswap premiumof50basispointspaidquarterly.InordertohedgeitscreditexposureBankA:

a. b. c. d.

Sellsthe5yearCDSandreceivesaquarterlypaymentofUSD50,000. Buysthe5yearCDSandmakesaquarterlypaymentofUSD12,500. Buysthe5yearCDSandreceivesaquarterlypaymentofUSD12,500. Sellsthe5yearCDSandmakesaquarterlypaymentofUSD50,000.

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14. Abankisconsideringbuying(i.e.sellingprotectionon)aAAAratedsuperseniortranche[10% 11%]ofasyntheticCDOreferencinganinvestmentgradeportfolio.Thepricingofthetranche assumesafixedrecoveryof40%forallnames.Allelsebeingequal,whichoneofthefollowingfour changeswillmaketheprincipalinvestedmorerisky?

a. b. c. d.

Anincreaseinsubordinationof1%,i.e.investinginthe[11%12%]tranche Anincreaseinthetranchethicknessfrom1%to3%,i.e.investinginthe[10%13%]tranche Usingarecoveryrateassumptionof50% Anincreaseindefaultcorrelationbetweennamesintheportfolio

15. Twobanksenterintoafiveyearfirsttodefaultbasketcreditdefaultswaptransaction.Thebasket containsthreeuncorrelatedcredits,W,XandY,eachwithaUSUSD25millionnotionalamount.The protectionsellerhastosettleonthecreditthatdefaultsfirstduringthetransaction.Afterthat,the protectionsellerhasnoobligationandthetransactionterminates.Supposethecreditshavethe following5yearcumulativeprobabilityofdefaults. 5YearProbabilities Credit ofDefault W 9.68% X 8.97% Y 8.02% Whichofthefollowingistheprobabilityofatleastonedefaultinthebasketduringthe5years? a. 8.02% b. 9.68% c. 24.38% d. 26.67%

16. BankAhasexposureto100millionUSDofdebtissuedbyCompanyR.BankAentersintoacredit defaultswaptransactionwithBankBtohedgeitsdebtexposuretoCompanyR.BankBwouldfully compensateBankAifCompanyRdefaultsinexchangeforapremium.Assumethatthedefaultsof BankA,BankBandCompanyRareindependentandthattheirdefaultprobabilitiesare0.3%,0.5% and3.6%,respectively.WhatistheprobabilitythatBankAwillsufferacreditlossinitsexposureto CompanyR?

a. b. c. d.

3.6% 4.1% 0.0180% 0.0108%

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17. A3yearcreditlinkednotewithunderlyingcompanyZhasaLIBOR+60bpssemiannualcoupon. ThefacevalueoftheCLNisUSD100.LIBORis5%forallmaturities.Current3yearcreditdefault swap(CDS)spreadforcompanyZis90bps.ThefairvalueoftheCLNisclosestto:

a. b. c. d.

USD99.19 USD100.00 USD101.65 USD111.05

18. Ariskmanagerestimatesthedailyvariance(ht)usingaGARCHmodelondailyreturns(rt): ht=0+1r2t1+ht1 Assumethemodelparametervaluesare0 =0.005, =0.04,=0.94.Thelongrunannualized volatilityisapproximately: a. 25.00% b. 13.54% c. 72.72% d. 7.94%

19. AbankassignscapitaltoitstradersusingcomponentVaR,whichisbasedonthetradingportfolios VaRestimatedatthe99%confidencelevel.ThemarketvalueofthebankstradingportfolioisHKD1 billionwithadailyvolatilityof2%.Ofthisportfolio,1%isinvestedinatradingbookwithabetaof 0.6relativetothetradingportfolio.Theclosestestimateofthecapitalassignedtothistradingbook is:

a. b. c. d.

HKD167,760 HKD279,600 HKD197,400 HKD1,977,070

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20. Considerthefollowingpotentialoperationalrisks.Duetoaroguetrader,weestimatethatovera1 yearperiodthereisa10%chancewecouldloseanywherebetween0and100MM(equal probabilityforallpointswithinthatrangeand0probabilityofanylossesoutsidethatrange).Due tomodelrisk,weestimatethatovera1yearperiodthereisa20%chancethatwewilllose25MM normallydistributedwithastandarddeviationof5MM.Whichofthefollowingstatementsis true?

a. Theexpectedlossfromaroguetraderislessthantheexpectedlossfrommodelrisk. b. Theexpectedlossfromaroguetraderisgreaterthantheexpectedlossfrommodelrisk. c. Themaximumunexpectedlossfromaroguetraderatthe95%confidencelevelislessthanthe maximumunexpectedlossatthe95%confidencelevelfrommodelrisk. d. Themaximumunexpectedlossatthe95%levelfromaroguetraderisgreaterthanthe maximumunexpectedlossatthe95%levelfrommodelrisk.


21. Whichofthefollowingstatementsaboutliquidityriskelasticity(LRE)isincorrect?

a. Incalculatingthesensitivityofafirmsnetassetstoachangeinitsfundingliquiditypremium, LREassumesaparallelshiftinfundingcostsacrossallmaturities. b. LREisprimarilyusefulforexaminingmarginalchangesinfundingcostsonanetasset/liability position. c. TheLREisacashflowliquidityriskmeasure,notapresentvalueliquidityriskmeasure. d. TheLREisonlyreliableforsmallchangesininterestcosts.


22. Theriskoftheoccurrenceofasignificantdifferencebetweenthemarktomodelvalueofacomplex and/orilliquidinstrument,andthepriceatwhichthesameinstrumentisrevealedtohavetradedin themarketisreferredtoas:

a. b. c. d.

DynamicRisk LiquidityRisk MarktoMarketRisk ModelRisk

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23. Whichofthefollowingstatementsregardingeconomiccapitalaretrue?

I. Economiccapitalisdesignedtoprovideacushionagainstunexpectedlossesataspecified confidenceleveloverasettimehorizon. II. Sinceregulatorycapitalmodelsandeconomiccapitalmodelshavedifferentobjectives, economiccapitalmodelscannothelpregulatorsinsettingregulatorycapital requirements. III. Firmswhosecapitalexceedstheirrequiredregulatorycapitalarefirmsthatemploytheir capitalinefficientlyandtheirshareholderswouldbenefitiftheyusedsomeoftheircapital torepurchasesharesorincreasedividends. IV. Economiccapitalcanbeusedtovalidateafirmsregulatorycapitalrequirementagainst itsownassessmentoftherisksitisrunning.

a. b. c. d.

IIIandIVonly I,IIandIIIonly I,IIIandIVonly IandIVonly

24. YouareananalystatBankAlpha.YouweregiventhetasktodeterminewhetherunderBaselIIyour bankcanusethesimplifiedapproachtoreportoptionsexposureinsteadoftheintermediate approach.Whichofthefollowingcriteriawouldyourbankhavetosatisfyinorderforittousethe simplifiedapproach?

a. Thebankpurchasesandwritesoptionsandhassignificantoptiontrading. b. Thebankwritesoptionsbutitsoptionstradingisinsignificantinrelationtoitsoverallbusiness activities. c. Thebankpurchasesandwritesoptionsbutitsoptiontradingisinsignificant. d. Thebanksolelypurchasesoptionsanditsoptionstradingisinsignificantinrelationtoitsoverall businessactivities.

25. Yourbankisusingtheinternalmodelsapproachtoestimateitsgeneralmarketriskcharge.The multiplicationfactork,setbytheregulator,is3andbanksareallowedtousethesquarerootrule toscaledailyVaR.Thepreviousdays1dayVaRestimateisEUR3million,andtheaverageofthe dailyVaRoverthelast60daysisEUR2million.Giventheaboveinformation,whatwillbethe marketriskchargeforyourbank? a. EUR18.97million b. EUR9.49million c. EUR6.32million d. EUR28.46million

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26. UndertheBaselIICapitalAccord,banksthathaveobtainedpriorregulatoryapprovalcanusethe internalmodelsapproachtoestimatetheirmarketriskcapitalrequirement.Whatapproachor methodologyisusedundertheinternalmodelsapproachtocomputecapitalrequirements?

a. b. c. d.

Stresstestingandbacktesting. Internalratingandvendormodels. VaRmethodology Expectedtailloss,asVaRisnotacoherentmeasureofrisk.

27. BankZ,amediumsizebank,usesonlyoperationallossdatafrominternalrecordstomodelitsloss distributionfromoperationalriskevents.Thebankrevieweditsrecordsand,afterconfirmingthat theywerecompleterecordsofitshistoricallossesandthatitslossescouldbeapproximatedbya uniformdistribution,itdecidedagainstusingexternallossdatatoestimateitslossdistribution. Basedonthatdecision,whichofthefollowingstatementsiscorrect?

a. TheestimatedlossdistributionlikelyoverstatesBankZsrealriskbecausemanyincidencesin thepastwerelikelyoneoff. b. TheestimatedlossdistributionlikelyaccuratelyrepresentsBankZsrealriskbecausethe recordsareaccurateandcomplete. c. TheestimatedlossdistributionlikelyunderstatesBankZsrealriskbecausethebankhasnot experiencedahugeloss. d. TheestimatedlossdistributionlikelyisthebestestimateofBankZsrealriskbecausethereisno betterlossdataforthebankthanitsown.


28. Alargeinternationalbankhasatradingbookwhosesizedependsontheopportunitiesperceivedby itstraders.ThemarketriskmanagerestimatestheonedayVaR,atthe95%confidencelevel,tobe USD50million.Youareaskedtoevaluatehowgoodofajobthemanagerisdoinginestimatingthe onedayVaR.Whichofthefollowingwouldbethemostconvincingevidencethatthemanageris doingapoorjob,assumingthatlossesareidenticallyindependentlydistributed?

a. b. c. d.

Overthelast250days,themeanlossisUSD60million. Overthelast250days,thereisnoexceedence. Overthelast250days,thereare8exceedences. Overthelast250days,thelargestlossisUSD500million.

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29. Tohandlethefinancingofalargecomplexproject,yourbankisestablishingaspecialpurposeentity (SPE)forwhichyourbankwillactastrustee.Whichofthefollowingcouldresultinliabilitytoyour bankthroughitsroleastrustee?

a. TheSPEwasformedtotakeadvantageofapreferablelegaljurisdiction. b. TheSPEprimarypurposewastoallowforthedeferralofincometaxes. c. TheSPEcontrolswereunabletodeterminewhetheritsinvestorsusedfundsderivedfrom legitimatebusinessopportunities. d. TheSPEstructureprovidedforfewercreditorsandareducedlikelihoodthattheprojectwould beforcedintobankruptcy.


30. YourbankisimplementingtheadvancedIRBapproachofBaselIIforcreditriskandtheAMA approachforoperationalrisk.Thebankusesthemodelapproachformarketrisk.TheChiefRisk Officer(CRO)wantstoestimatethebankstotalriskbyaddinguptheregulatorycapitalformarket risk,creditrisk,andoperationalrisk.TheCROasksyoutoidentifytheproblemswithusingthis approachtoestimatethebankstotalrisk.Whichofthefollowingstatementsaboutthisapproachis incorrect?

a. b. c. d.

Itignorestheinterestriskassociatedwiththebanksloans. Itassumesmarket,credit,andoperationalriskshavezerocorrelation. Itignoresstrategicrisks. Itusesatendayhorizonformarketrisk.

31. ThebankyouworkforhasaRAROCmodel.TheRAROCmodel,computedforeachspecificactivity, measurestheratiooftheexpectedyearlynetincometotheyearlyVaRriskestimate.Youareasked toestimatetheRAROCofitsUSD500millionloanbusiness.Theaverageinterestrateis10%.All loanshavethesameProbabilityofDefault,PD,of2%withaLossGivenDefault,LGD,of50%. OperatingcostsareUSD10million.ThefundingcostofthebusinessisUSD30million.RAROCis estimatedusingacreditVaRforloanbusinesses.Inthiscase,theappropriatecreditVaRforthe loansis7.5%.Theeconomiccapitalisinvestedandearns6%.TheRAROCis:

a. b. c. d.

32.67% 13.33% 19.33% 46.00%

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32. WhichofthefollowingstatementsregardingBaselIInonadvancedapproachesisincorrect?

a. Thestandardizedapproachusesdatafromthelastthreeyearsofgrossincometoobtaina banksoperationalriskcapitalcharge. b. Thestandardizedapproachmakesitadvantageousforabanktobooklossesearlyifdoingso reducesthisyearsgrossincomesufficientlytomakeitnegative. c. Thestandardizedapproachdividesthebankintobusinesslinesandusesdatafromthelast threeyearsofabusinesslinesgrossincomeandabetafactortoobtaintheregulatorycapital forthatbusinessline. d. Corporatefinance,tradingandsales,andpaymentandsettlementarethebusinesslineswith thehighestregulatorycapitalrequirements.


33. WhichoneofthefollowingstatementsdoesnotapplytotheBaselIIAdvancedMeasurement Approach(AMA)foroperationalrisk?

a. Incontrasttocreditriskregulatorycapitalforcorporateloans,banksusingtheAMAapproach mayhavetosetasidecapitalforbothexpectedandunexpectedoperationalrisklosses. b. IncontrasttothecreditriskIRBapproaches,banksusingtheAMAapproachmayestimatethe correlationbetweendifferenttypesofoperationalrisksiftheirmodelssatisfyregulatory requirements. c. Toevaluateexposuretohighseverityoperationalriskevents,banksusingtheAMAapproach mayuseeitherscenarioanalysisofexpertopinion,orVaRmodelestimatesbasedoninternal datausingextremevaluetheory. d. Reportingofoperationalriskexposuretoseniormanagementisanecessaryconditionfora banksabilitytousetheAMAapproach.

34. Whichofthefollowingapproachesforcalculatingoperationalriskcapitalchargesleadstoahigher capitalchargeforagivenaccountingincomeasriskincreases?

a. b. c. d.

Thebasicindicatorapproach Thestandardizedapproach Theadvancedmeasurementapproach(AMA) Alloftheabove

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35. Whichofthefollowingisnotincludedasanelementincalculatingoperationalriskcapitalunderthe AdvancedMeasurementApproach?

a. b. c. d.

Externaldata Keyriskindicators Factorsreflectingthebusinessenvironment Scenarioanalysis

36. YourfirmsfixedincomeportfoliohasinterestonlyCMOs(IO),callablecorporatebonds,inverse floaters,noncallablecorporatebonds.Yourbosswantstoknowwhichofthefollowingsecuritiescan losevalueasyieldsdecline.

a. b. c. d.

callablecorporateonly inversefloateronly IOandcallablecorporatebond IOandnoncallablecorporatebond

37. Abankwouldliketoestimatethenumberofoperationalriskeventsduetoproblemswithtellers (largemistakes,fraud,andsoon).Thebankdecidestomodeltelleroperationalriskeventsasa PoissonProcesswithrate (numberofeventsperyear).Withthismodel,telleroperationalrisk eventsareassumedtooccurindependentlyofoneanotherandthenumberoftelleroperationalrisk eventsinayearisPoissondistributedwithmean.OtherpropertiesofaPoissondistributionwith mean include:

Variance: Skewness: Excesskurtosis

0.5 1/

Basedonhistoricaldataregardingthenumberoftelleroperationalriskeventsthatoccurredin previousyears,thebankdeterminesthattheaveragenumberofeventshasbeen5peryearand decidestosetto5.Whichofthefollowingistrueregardingthatmodel? a. Thevarianceofthenumberoftelleroperationaleventsinayearis25. b. Thecorrespondingexponentialdistributionthatdescribesthetimebetweentwoteller operationalriskeventshasameanvalueof0.25years. c. Themodelisnotappropriateifatellerismorelikelytohaveanoperationalriskeventbecause hisfriendwhoisalsoatellerhasbeencaughtstealing. d. Thenumberoftelleroperationalriskeventsinayearcannotexceed25.



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38. Allthefollowingareoperationalrisklossevents,except:

a. Aloanofficerinaccuratelyentersclientfinancialinformationintothebanksproprietarycredit riskmodel b. Anindividualshowsupatabranchpresentingacheckwrittenbyacustomerforanamount substantiallyexceedingthecustomerslowcheckingaccountbalance.Whenthebankcallsthe customertoaskhimforthefunds,thephoneisdisconnectedandthebankcannotrecoverthe funds. c. Duringanadversemarketmovement,thecomputernetworksystembecomesoverwhelmed andonlyintermittentpricinginformationisavailabletothebankstradingdesk,leadingtolarge lossesastradersbecomeunabletoaltertheirhedgesinresponsetofallingprices d. Abank,actingasatrusteeforaloanpool,receiveslessthantheprojectedfundsduetodelayed repaymentofcertainloans.

39. Supposeyouareholding100WheelbarrowCompanyshareswithacurrentpriceofUSD50.The dailyhistoricalmeanandvolatilityofthereturnofthestockis1%and2%,respectively.Thebidask spreadofthestockvariesovertime.Thedailyhistoricalmeanandvolatilityofthespreadis0.5% and1%,respectively.CalculatethedailyliquidityadjustedVaR(LVaR)at99%confidencelevel:(Both thereturnandspreadofthestockarenormallydistributed):

a. b. c. d.

USD325 USD275 USD254 USD229

40. Supposeyouaregiventhefollowinginformationabouttheoperationalrisklossesatyourbank.

Frequencydistribution Probability Frequency 0.5 0 0.3 1 0.2 2

SeverityDistribution Probability Severity 0.6 USD1,000 0.3 USD10,000 0.1 USD100,000

WhatistheestimateoftheVaRatthe95%confidencelevel,assumingthatthefrequencyand severitydistributionsareindependent?

a. b. c. d.

USD200,000 USD110,000 USD100,000 USD101,000

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41. Tocontrolrisktakingbytraders,yourbanklinkstradercompensationwiththeircompliancewith imposedVaRlimitsontheirtradingbook.Whyshouldyourbankbecarefulintyingcompensation totheVaRofeachtrader?

a. Itencouragestraderstoselectpositionswithlowestimatedrisks,whichleadstoan underestimationoftheVaRlimits. b. Itencouragestraderstoselectpositionswithlowestimatedrisks,whichleadstoan overestimationoftheVaRlimits. c. Itencouragestraderstoselectpositionswithhighestimatedrisks,whichleadstoan underestimationoftheVaRlimits. d. Itencouragestraderstoselectpositionswithhighestimatedrisks,whichleadstoan overestimationoftheVaRlimits.


42. Thesurplusofapensionfundismostimportantfor:

a. b. c. d.

Adefinedcontributionfund Adefinedbenefitfund Ayoungworkforce Asponsoringcompanywithstrongfinancialstatusthatoperatesindifferentindustries

43. Amutualfundinvestingincommonstockshasadoptedaliquidityriskmeasurelimitingeachofits holdingstoamaximumof30%ofitsthirtydayaveragevaluetraded.IfthefundsizeisUSD3billion, whatisthemaximumweightthatthefundcanholdinastockwithathirtydayaveragevaluetraded ofUSD2.4million?

a. b. c. d.

24.00% 0.08% 0.024% 80.0%

44. Aninvestorisinvestigatingthreehedgefundsaspotentialinvestments.HedgefundAisanequity marketneutralfund,Bisaglobalmacrofundwithemphasisonequitymarkets,andCisa convertiblearbitragefund.Whichanswercorrectlyspecifiesthefundswiththehighestexposureto aworldwidevalueweightedequityindexandtoacreditdefaultswapsindex? Highestequityindexexposure Highestcreditdefaultswapindexexposure a. A B b. A C c. B A d. B C

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45. Whichofthefollowingisnotanapproachfordetectingstyledriftofhedgefunds?

a. b. c. d.

Performanceattribution Peergroupcomparison Cashflowanalysis Communicationwithfundmanager

46. Allofthefollowingstrategiesareexamplesofcapitalstructurearbitrage,except:

a. Longpositioninthebondsissuedbythecompany,andshortpositioninthecompanysstock. b. Shortpositioninthebondsissuedbythecompany,andlongpositioninthecompanysstock. c. Longpositioninacreditdefaultswaponthecompanyandwritingputoptionsonthecompanys stock. d. Shortpositioninthepreferredstockissuedbythecompanyandwritingcalloptionsonthe companysstock.


47. Youhavebeenaskedtoevaluatetheperformanceoftwohedgefunds:GlobalAssetManagementI andInternationalMomentumII.BotharebenchmarkedtoMSCIEAFE.Whichofthetwofundshad ahigherrelativeRiskAdjustedPerformance(RAP)lastyear,andwhatistheRAP?

ThevolatilityofEAFEis17.5%andtheannualizedperformanceis10.6%.Theriskfreerateis3.5%. Fund Volatility AnnualizedPerformance GlobalAssetManagementI 24.5% 12.5% InternationalMomentumII 27.3% 13.6%

a. b. c. d.

GlobalAssetManagement,4.85% GlobalAssetManagement,6.16% InternationalMomentum,5.42% InternationalMomentum,1.18%

48. OnJanuary1,2006,apensionfundhasassetsofEUR100billionandisfullyinvestedintheequity market.IthasEUR85billioninliabilities.During2006,theequitymarketdeclinedby15%andyields increasedby1.2%.Ifthemodifieddurationoftheliabilitiesis12.5,whatisthepensionfunds surplusonDecember31,2006?

a. b. c. d.

EUR15.00billion EUR12.93billion EUR12.75billion EUR12.57billion

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49. WhichofthefollowingstatementsregardingExtremeValueTheory(EVT)isincorrect?

a. ConventionalapproachesforestimatingVaRthatassumethatthedistributionofreturnsfollow auniquedistributionfortheentirerangeofvaluesmayfailtoproperlyaccountforthefattails ofthedistributionofreturns. b. IncontrasttoconventionalapproachesforestimatingVaR,EVTonlyconsidersthetailbehavior ofthedistribution. c. Bysmoothingthetailofthedistribution,EVTeffectivelyignoresextremeeventsandlosses whichcangenerallybelabeledoutliers. d. EVTattemptstofindtheoptimalpointbeyondwhichallvaluesbelongtothetailandthen modelsthedistributionofthetailseparately.


50. Consideraportfoliowith40%investedinassetXand60%investedinassetY.Themeanand varianceofreturnonXare0and25respectively.ThemeanandvarianceofreturnonYare1and 121respectively.ThecorrelationcoefficientbetweenXandYis0.3.Whatisthenearestvaluefor portfoliovolatility? e. f. g. h. 9.51% 8.60% 13.38% 7.45%

ENDOF2009FRMFULLEXAMPRACTICEEXAMI

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2009FRMFullExamPracticeExamII AnswerKey

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

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2009FRMFullExamPracticeExamII Answers&Explanations

1. ThecurrentvalueoftheS&P500indexis1457,andeachS&PfuturescontractisfordeliveryofUSD 250timestheindex.AlongonlyequityportfoliowithmarketvalueofUSD300,100,000hasbetaof 1.1.Toreducetheportfoliobetato0.75,howmanyS&Pfuturescontractshouldyousell?

a. b. c. d.

618contracts 288contracts 574contracts 906contracts

CORRECT:B Noofcontracts=[0.751.1)/1]*[300,100,000/{250*1,457}]=288.36 Henceweneedtosell288contracts INCORRECT:A617.9135209=1*(0.75)*(300100000/(250*1457)) INCORRECT:C561.74=1(0.75/1.1)*(300100000/(250*1457)) INCORRECT:D906.273164=1*(1.1)*(300100000/(250*1457)) Reference:Hull,Options,FuturesandOtherDerivatives,Chapter3and4;AnthonySaunders, FinancialInstitutionsManagement,Chapter10


2. Theriskfreerateis5%peryearandacorporatebondyields6%peryear.Assumingarecoveryrate of75%onthecorporatebond,whatistheapproximatemarketimpliedoneyearprobabilityof defaultofthecorporatebond?

a. b. c. d.

1.33% 4.00% 8.00% 1.60%

CORRECT:B Usingtheapproximationmethod,the1yearprobabilityofdefaultis(6%5%)/(10.75)=4% INCORRECT:AThisiscalculatedusing(6%5%)/0.75=1.33%


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INCORRECT:CThisiscalculatedusing0.06/0.75=0.08 INCORRECT:DThisiscalculatedusing0.06/(0.05*0.75)=1.6 Reference:Saunders,FinancialInstitutionsManagement,5thedition,Chapter11,p.313

3. ThefollowingtablefromFitchRatingsshowsthenumberofratedissuersmigratingbetweentwo ratingscategoriesduringoneyear.Basedonthisinformation,whatistheprobabilitythatanissue witharatingofAatthebeginningoftheyearwillbedowngradedbytheendoftheyear?


Year1rating AAA AAA 45 AA 3 A 2 BBB 0 Default 0 AA 4 30 5 1 0 A 2 4 40 2 0 BBB 0 3 2 30 0 Default 0 2 3 1 0 Total 51 42 52 34 0

Year0 rating

a. b. c. d.

13.46% 13.44% 9.62% 3.85%

CORRECT:C TotalNumberofAratedissuances=52 ProbabilityofAratedissuesdowngradedtoBBB(P1)=2/52=0.0385 ProbabilityofAratedissuesdowngradedtoDefault(P2)=3/52=0.0577 ProbabilityofAratedissuestobedowngradedinoneyear=P1+P2=0.0962=9.62%. INCORRECT:AIsthenumberofupgradesfromA(2+5)/52=13.46% INCORRECT:BIsthenumberofdowngradestoA2/51+4/42=3.92%+9.52%=13.44% INCORRECT:DIsthenumberofdowngradestoBBB2/52=3.85% Reference:Hull,Chapter22.

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4. BetaBankownsaportfolioof10AAratedbondswithatotalvalueof200millionUSD.Theoneyear probabilityofdefaultforeachissueris5%andtherecoveryrateforeachissueequals40%.Theone yearexpectedlossoftheportfoliois:

a. b. c. d.

USD4.0million USD5.0million USD6.0million USD8.0million

CORRECT:C ExpectedLossequalsexposuremultipliedbytheriskofdefaultandbytherecoveryrate,or E(L)=Exposure*PD*(1RecoveryRate) E(L)=200millionUSDx5%x60%=6millionUSD. Correlationamongstissuersdoesnotmatterforcomputingexpectedlosses. INCORRECT:AIncorrectlysetE(L)=200*0.05*0.4=4.0 INCORRECT:BIncorrectlysetE(L)=200*0.05*0.5=5.0 INCORRECT:DIncorrectlysetE(L)=200*0.05*0.8=8.0 Reference:Hull,Chapter22.


5. RiskAverseBank(RAB)hasmadealoanofUSD100millionat8%perannum.RABwantstoenter intoatotalreturnswapunderwhichitwillpaytheinterestontheloanplusthechangeinthemark tomarketvalueoftheloanandinexchange,RABwillgetLIBOR+30basispoints.Settlement paymentsaremadeannually.WhatisthecashflowforRABonthefirstsettlementdateifthemark tomarketvalueoftheloanfallsby2%andLIBORis6%?

a. b. c. d.

NetinflowofUSD0.3million NetoutflowofUSD0.3million NetinflowofUSD1.7million NetoutflowofUSD1.7million

CORRECT:A RABistheTRORpayerandpaystotheTRORreceivertheinterestitreceivesontheloanadjustedfor changesinthevalueoftheunderlyingloan.Ifthevalueoftheunderlyingloanincreases,RABasthe TRORpayerpaystotheTRORreceivertheinterestearnedontheloanaswellastheprice appreciation.Conversely,ifthevalueoftheunderlyingloandecreases,RABastheTRORpayerpays totheTRORreceivertheinterestearnedontheloanlessthepricedepreciation.Inreturn,astheTOR payer,itreceivesLIBORplusspreadfromtheTRORreceiver.


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Attheendofthefirstyear,RABwillpaytheinterestearnedontheloan,8millionUSD.Theloan valuedeclinedby2millionUSD,thusthereturnearnedbyRABis6millionUSD;thisisthepayment madebyRABtotheTRORreceiver. TheTRORreceiveswillpaytoRABLIBORplus30basispointsi.e.6.3%witha6%LIBOR;6.3%of100 millionUSD=6.3millionUSD. Sothepaymentsare+6.3millionUSD6.0millionUSDor+0.3millionUSD. Reference:Stulz,RiskManagement&Derivatives.Chapter18CreditRisksandCreditDerivatives 6. Determinethepercentageofthefollowingportfoliothatisinvestmentgrade:

Moody's Rating Aa2 A3 Caa1 Baa3 Ba1 D Aaa A1 Baa1 Aa3

Percentage of Portfolio 25% 10% 2% 10% 5% 3% 10% 15% 10% 10%

a. b. c. d.

70% 80% 90% 95%

CORRECT:C NoninvestmentgradeassetsarethoseratedbelowBaa3.ThusCaa1with2%,Ba1with5%,andD with3%,oratotalof10%arenoninvestmentgrade.Thustheinvestmentgradepartshouldequal 90%. Reference:Hull,Chapter22.

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7. Aspartofacurrencyhedgingstrategy,aU.S.portfoliomanagerenteredaoneyearforward contractwithabanktodeliverEUR5,000,000forUSdollarsattheendoftheyear.Atthebeginning oftheyear,theoneyearforwardratewas0.9216USD/EUR.Sixmonthsintothecontractthespot rateis0.9201USD/EUR,theU.S.interestrateis6.5%,andtheEurointerestrateis6.25%.Ifthe currentspotrate(0.9201USD/EUR)weretocontinueforthenextsixmonths,whatisthecreditrisk thattheportfoliomanagerwouldbearatmaturity?

a. b. c. d.

USD7,042 USD7,264 USD7,273 USD7,500

CORRECT:D Valuetothemanageratthesettlementdate=contractcashflowspotmarketcashflow[bothat contractmaturity]. Contractcashflow =EUR5,000,000x0.9216USD/EUR=4,608,000USD Spotmarketcashflow =Theamounttheportfoliomanagercouldreceiveifthespotrateafter6 monthsremainedineffectuntilthesettlementdate =EUR5,000,000x0.9201USD/EUR=4,600,500USD Valuetothemanager =USD4,608,000USD4,600,500=USD7,500 Asthevalueispositive,thebankowesthisamounttotheportfoliomanager.Sincethequestionasks theamountofcreditriskatmaturity,weneednotdiscountthisbacktosixmonths. INCORRECT:AThisanswerisarrivedatbydiscountingthecorrectanswerfortwelvemonthsatthe USDinterestrate,whichisnotarequirementofthequestion. INCORRECT:BThisanswerisarrivedatbydiscountingthecorrectanswerforsixmonthsattheUSD interestrate,whichisnotarequirementofthequestion. INCORRECT:CThecorrectanswerdiscountedattheEurorateforsixmonth. Reference:Stulz,RiskManagementandDerivatives,Chapter18

8. Realizingthebenefitsofnettingofthecounterpartyexposuremaybechallengingbecauseof:

a. b. c. d.

Potentialdowngradeorwithdrawalofthecounterpartyrating Differencesinratingsbetweentheratingagencies Tradesbeingbookedindifferentjurisdictions Crossproductnetting

CORRECT:C
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Thispresentsalegalchallengetoenforcingnettingagreement INCORRECT:AThesecrediteventsdonotmakenettingmorechallenging INCORRECT:BRatingsarenotrequiredtoestablishnetting INCORRECT:DOncontrary,crossproductnettingallowstorealizemorebenefitsinreducing exposuretocounterparty Reference:Culp

9. Inpricingafirsttodefaultcreditbasketswap,whichofthefollowingistrue,allelsebeingequal?

a. b. c. d.

Thelowerthecorrelationbetweentheassetsofthebasket,thelowerthepremium. Thelowerthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Thehigherthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Thecorrelationbetweentheassetshasnoimpactinthepremiumofafirsttodefaultcredit basketswap.

CORRECT:B Thelowerthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Inthecaseofafirsttodefaultswap,acrediteventoccursthefirsttimeanyoftheentitiesdefaults. Thisswapprovidesdefaultprotectionagainstlossesrelatedtothisfirstdefault,butnottoany subsequentdefaults.Thus,thequestioniswhetherthelevelofcorrelationbetweenassetsofthe basketincreasesordecreasesthelikelihoodofthetriggeringevent.Ifthecorrelationbetweenthe assetsinacreditbasketswapislower,thebasketwouldbeexposedtogreaterdefaultrisk.For example,thebasketcontainsassetsfromdifferentsectors,thenthebasketwouldbeexposedtothe defaultriskofeachandeverysectorinthebasket.Ifthebasketonlycontainsassetsfromonesector, thenthecorrelationishigher,andthedefaultriskislower. Reference:Hull,22,23

10. ThespreadonaoneyearBBBratedbondrelativetotheriskfreetreasuryofsimilarmaturityis2%. Itisestimatedthatthecontributiontothisspreadbyallnoncreditfactors(e.g.,liquidityrisk,taxes) is0.8%.Assumingthelossgivendefaultratefortheunderlyingcreditis60%,whatisapproximately theimplieddefaultprobabilityforthisbond?

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a. b. c. d.

3.33% 5.00% 3.00% 2.00%

CORRECT:D Theprobabilityofdefaultequalsthecreditriskspreaddividedbythelossgivendefault.PD=spread /LGDHere,thespreadduetocreditriskequals2.0%0.8%or1.2%andthelossgivendefaultis 60%.Theprobabilityofdefaultisthen2%. INCORRECT:AIncorrectlysetsPD=2.0/0.6=3.33. INCORRECT:BIncorrectlysetsPD=2.0/0.4=5.0. INCORRECT:DIncorrectlysetsPD=1.2/0.4=3.00. Reference:deServignyandRenault,MeasuringandManagingCreditRisk,(NewYork:McGrawHill, 2004)chapter3,4


11. YouaregiventhefollowinginformationaboutfirmA:

MarketValueofAssetattime0=1000 MarketValueofAssetattime1=1200 ShorttermDebt=500 LongtermDebt=300 AnnualizedAssetVolatility=10%

AccordingtotheKMVmodel,whataretheDefaultPointandtheDistancetoDefaultattime1? Default Distanceto Point Default a. 800 3.33 b. 650 7.50 c. 650 4.58 d. 500 5.83 CORRECT:C AccordingtoKMV, DefaultPoint=STD+LTD=500+1/2(300)=650. Distancetodefault

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=(Marketvalueofassetattime1DefaultPoint)/AnnualizedAssetvolatilityattime1 =(1200650)/(1200*0.1) =4.58 INCORRECT:AIncorrectlysetsDefaultPointasSTD+LTDinstead(500+300). INCORRECT:BIncorrectlysetsDefaultPointvalueasLTD,distancetodefault=(1200STD)/120= 7.50 INCORRECT:DIncorrectlysetsDefaultPointasSTDonly,distancetodefault=(1200500)/120= 5.83 Reference:deServignyandRenault,MeasuringandManagingCreditRisk,Chapter4.

12. SupposethereturnonUStreasuriesis3%andariskybondiscurrentlyyielding15%.Atraderyou superviseclaimsthathewouldbeabletomakeanarbitragetradeearning5%usingUStreasuries, theriskybondandthecreditdefaultswap.Whichofthefollowingcouldbethetradersstrategy andwhatisthecreditdefaultswappremium?Assumetherearenotransactioncosts.

a. b. c. d.

Golongthetreasury,shorttheriskybond,andbuythecreditdefaultswapwithpremiumof6%. Golongthetreasury,shorttheriskybond,andsellthecreditdefaultswapwithpremiumof7%. Shortthetreasury,investintheriskybond,andsellthecreditdefaultswapwithpremiumof6%. Shortthetreasury,investintheriskybond,andbuythecreditdefaultswapwithpremiumof 7%.

CORRECT:D Topreventarbitrage,thereturnontheriskfreegovernmentbondmustequalthereturnontherisky bondlessthepremiumonthedefaultswap,ortheriskcorporatebondreturnmustequalthereturn ontheriskfreegovernmentbondandthecreditdefaultswappremium. Riskfreebondreturn=riskybondreturndefaultswappremium. Inthiscase,adjustmentforthearbitrageprofitchangestherelationshipto Arbitrageprofit=riskybondreturndefaultswappremiumriskfreegovernmentbondreturn Riskfreebondreturn=3% Riskybondreturn=15% Defaultswappremium=X% ArbitrageProfit=5%. Theshortpositionintreasurycosts3%,returnfromtheriskycorporatebondis15%,thedefault swappremiumis7%,endsupinanarbitrageprofitof5%(3%+15%7%).Thisisavalidarbitrage strategy. Reference:Hull,Chapter23.
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13. BankAmakesa10millionUSDfiveyearloanandwantstooffsetthecreditexposuretotheobligor. Afiveyearcreditdefaultswapwiththeloanasthereferenceassettradesonthemarketataswap premiumof50basispointspaidquarterly.InordertohedgeitscreditexposureBankA:

a. b. c. d.

Sellsthe5yearCDSandreceivesaquarterlypaymentofUSD50,000. Buysthe5yearCDSandmakesaquarterlypaymentofUSD12,500. Buysthe5yearCDSandreceivesaquarterlypaymentofUSD12,500. Sellsthe5yearCDSandmakesaquarterlypaymentofUSD50,000.

CORRECT:B Tooffsetthecreditriskintheloan,thebankneedstobuycreditprotectionusingtheCDSwithsame maturity.Sincethebankisbuyingprotection,itpaystheinsurancepremiumquarterly.Theannual insurancepremiumswappaymentonthistransactionwouldbenotionalamountxswappremium or10,000,000*0.005=50,000.ThequarterlypremiumisUSD12,500. INCORRECT:ABankAneedstohedgeitscreditexposureandthereforehastobuythe5YearCDS (BankAbuyscreditprotection) INCORRECT:CThequarterlypaymentisUSD12,500=notionalxswappremiumx90/360=10USD millionx0.005x90/360 INCORRECT:DBankAneedstohedgeitscreditexposureandthereforehastobuythe5YearCDS (BankAbuyscreditprotection) Reference:HullChapter23.

14. Abankisconsideringbuying(i.e.sellingprotectionon)aAAAratedsuperseniortranche[10% 11%]ofasyntheticCDOreferencinganinvestmentgradeportfolio.Thepricingofthetranche assumesafixedrecoveryof40%forallnames.Allelsebeingequal,whichoneofthefollowingfour changeswillmaketheprincipalinvestedmorerisky?

a. b. c. d.

Anincreaseinsubordinationof1%,i.e.investinginthe[11%12%]tranche Anincreaseinthetranchethicknessfrom1%to3%,i.e.investinginthe[10%13%]tranche Usingarecoveryrateassumptionof50% Anincreaseindefaultcorrelationbetweennamesintheportfolio

CORRECT:D Theprobabilityofaseniortranchebeinghitdecreasesifthesubordinationincreasesorifthefixed recoveryrateincreases.Theexpectedlossofatranchedecreasesifthetranchethicknessincreases. Theseallleadtothetranchebeinglessrisky.Asportfoliocorrelationincreases,thelossdistribution

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exhibitsfattertailandtheprobabilityofaseniortranchebeinghitincreases,leadingtoamorerisky tranche. Reference:Culp,Chapters16,17,18.

15. Twobanksenterintoafiveyearfirsttodefaultbasketcreditdefaultswaptransaction.Thebasket containsthreeuncorrelatedcredits,W,XandY,eachwithaUSUSD25millionnotionalamount.The protectionsellerhastosettleonthecreditthatdefaultsfirstduringthetransaction.Afterthat,the protectionsellerhasnoobligationandthetransactionterminates.Supposethecreditshavethe following5yearcumulativeprobabilityofdefaults. 5YearProbabilitiesof Credit Default W 9.68% X 8.97% Y 8.02% Whichofthefollowingistheprobabilityofatleastonedefaultinthebasketduringthe5years? a. 8.02% b. 9.68% c. 24.38% d. 26.67%

CORRECT:C. Duringthe5years,theprobabilityofnodefaultis(19.68%)x(18.97%)x(18.02%)=75.62%. Theprobabilityofatleastonedefaultis(175.62%)=24.38%. Theanswerisneitherthemaximum(B)norminimum(A)northesum(D)ofthedefaultprobabilities. Reference:HullChapter23.


16. BankAhasexposureto100millionUSDofdebtissuedbyCompanyR.BankAentersintoacredit defaultswaptransactionwithBankBtohedgeitsdebtexposuretoCompanyR.BankBwouldfully compensateBankAifCompanyRdefaultsinexchangeforapremium.Assumethatthedefaultsof BankA,BankBandCompanyRareindependentandthattheirdefaultprobabilitiesare0.3%,0.5% and3.6%,respectively.WhatistheprobabilitythatBankAwillsufferacreditlossinitsexposureto CompanyR?

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a. b. c. d.

3.6% 4.1% 0.0180% 0.0108%

CORRECT:C BankAwillonlysufferalosswhenCompanyRandBankBjointlydefault.Withzerocorrelation,this probabilityisequalto0.5%x3.6%=0.018%. 3.6%isthemaximum,4.1%isthesum,and0.0108%=0.3%*3.6% Reference:Hull,Chapters22,23


17. A3yearcreditlinkednotewithunderlyingcompanyZhasaLIBOR+60bpssemiannualcoupon. ThefacevalueoftheCLNisUSD100.LIBORis5%forallmaturities.Current3yearcreditdefault swap(CDS)spreadforcompanyZis90bps.ThefairvalueoftheCLNisclosestto:

a. b. c. d.

USD99.19 USD100.00 USD101.65 USD111.05

CORRECT:A Thisquestionrequiresnocalculation.Becausethediscountfactor(0.5*(0.05+0.009)=0.0295)is greaterthanthecouponrate,thepresentvaluehastobelessthanthefacevaluethecorrect answerisA. Thisquestioncanbeworkedoutbyusingcalculator,whereN=6,I/Y=2.95,PMT=2.8,FV=100> PV=99.19. INCORRECT:BIsthefacevalue. INCORRECT:CIswhereonlyLiborrateisusedfordiscounting.N=6,I/Y=2.5,PMT=2.8,FV=100> PV=101.65. INCORRECT:DIswhereonlyCDSspreadisusedfordiscounting.N=6,I/Y=0.9,PMT=2.8,FV=100> PV=101.65. Reference:Hull,Culp

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18. Ariskmanagerestimatesthedailyvariance(ht)usingaGARCHmodelondailyreturns(rt): ht=0+1r2t1+ht1 Assumethemodelparametervaluesare0 =0.005, =0.04,=0.94.Thelongrunannualized volatilityisapproximately: a. 25.00% b. 13.54% c. 72.72% d. 7.94% CORRECT:D Thelongrunvarianceis0.005/(10.040.94)=0.005/0.02=0.25.Thedailyvolisthusthesquare root,or0.5%andannualvol7.935%. INCORRECT:AThedailyvarianceisindeed0.25%,andthedailyvolatility0.5%butthisneedstobe annualized. INCORRECT:BMiscalculatesvarianceassqrt(0.04/(10.940.005))*15.87=13.54% INCORRECT:CMiscalculatesvarianceas0.04/(10.940.005)=72.72% Reference:Hull

19. AbankassignscapitaltoitstradersusingcomponentVaR,whichisbasedonthetradingportfolios VaRestimatedatthe99%confidencelevel.ThemarketvalueofthebankstradingportfolioisHKD1 billionwithadailyvolatilityof2%.Ofthisportfolio,1%isinvestedinatradingbookwithabetaof 0.6relativetothetradingportfolio.Theclosestestimateofthecapitalassignedtothistradingbook is:

a. b. c. d.

HKD167,760 HKD279,600 HKD197,400 HKD1,977,070

CORRECT:B ThisquestionassessescandidatesabilitiestocarryoutCVaRcalculationscorrectly.

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Using,e.g.,equation7.29fromJorion2ndedition,wehave CVaR = VaRwi i ,where wi isthe shareoftheithassetintheportfolioand i isitsbeta.Usingtheinformationgiven,VaR=2.33* 0.02*1,000,000,000=46,600,000,soCVaR=46,600,000*0.01*0.6=279,600. INCORRECT:AIncorrectlymultipliesthevolatilitybybetaintheVaRcalculation. INCORRECT:CIncorrectlyuses1.645intheVaRcalculation. INCORRECT:DIncorrectlyusesthesquarerootofthevolatilityintheVaRcalculation. Reference:Jorion,VaR,2ndedition,p.160,chapter7(Portfoliorisk:analyticalmethods).

20. Considerthefollowingpotentialoperationalrisks.Duetoaroguetrader,weestimatethatovera1 yearperiodthereisa10%chancewecouldloseanywherebetween0and100MM(equal probabilityforallpointswithinthatrangeand0probabilityofanylossesoutsidethatrange).Due tomodelrisk,weestimatethatovera1yearperiodthereisa20%chancethatwewilllose25MM normallydistributedwithastandarddeviationof5MM.Whichofthefollowingstatementsis true?

a. Theexpectedlossfromaroguetraderislessthantheexpectedlossfrommodelrisk. b. Theexpectedlossfromaroguetraderisgreaterthantheexpectedlossfrommodelrisk. c. Themaximumunexpectedlossfromaroguetraderatthe95%confidencelevelislessthanthe maximumunexpectedlossatthe95%confidencelevelfrommodelrisk. d. Themaximumunexpectedlossatthe95%levelfromaroguetraderisgreaterthanthe maximumunexpectedlossatthe95%levelfrommodelrisk.

CORRECT:D Thisquestiontestsunderstandingofexpectedvs.unexpectedloss.Theroguetraderhasanexpected loss(severitymultipliedbyprobability)of5MMwhilethemodelriskhasanexpectedlossof5MM. ThereforebothAandBareincorrect.Wethereforemustexamineunexpectedlosses.Therogue traderhasamuchwiderdistribution(Uniform)andalowerprobabilityofoccurrencethanthemodel risk(normaldistribution).Thereforetheroguetraderhasagreaterriskofunexpectedlosses. Unexpectedlossforroguetraderat95%confidencelevel:50MM5MM=45MM Thelossfrommodelriskatthe95thpercentilecorrespondstothe75thpercentileforthenormal distributionwithmean25andstandarddeviation5,sounexpectedlossformodelriskat95% confidencelevel:<(25MM+1.645*5MM)5MM<30MM Reference:Dowd,Chapter16.

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21. Whichofthefollowingstatementsaboutliquidityriskelasticity(LRE)isincorrect?

a. Incalculatingthesensitivityofafirmsnetassetstoachangeinitsfundingliquiditypremium, LREassumesaparallelshiftinfundingcostsacrossallmaturities. b. LREisprimarilyusefulforexaminingmarginalchangesinfundingcostsonanetasset/liability position. c. TheLREisacashflowliquidityriskmeasure,notapresentvalueliquidityriskmeasure. d. TheLREisonlyreliableforsmallchangesininterestcosts.

CORRECT:C LREmeasuresliquidityriskforpresentvalues.Itisnotusefulifafirmisconcernedaboutperperiod cashflows. Reference:Dowd,Chapter14;Saunders,Chapter17.


22. Theriskoftheoccurrenceofasignificantdifferencebetweenthemarktomodelvalueofacomplex and/orilliquidinstrument,andthepriceatwhichthesameinstrumentisrevealedtohavetradedin themarketisreferredtoas:

a. b. c. d.

DynamicRisk LiquidityRisk MarktoMarketRisk ModelRisk

CORRECT:D Thisishowmodelriskisdefinedinthereading. INCORRECT:AUndefinedterm INCORRECT:BTheriskofnotbeingabletosellanassetquickly INCORRECT:CUndefinedterm Reference:Dowd,Chapter16.


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23. Whichofthefollowingstatementsregardingeconomiccapitalaretrue?

I. Economiccapitalisdesignedtoprovideacushionagainstunexpectedlossesataspecified confidenceleveloverasettimehorizon. II. Sinceregulatorycapitalmodelsandeconomiccapitalmodelshavedifferentobjectives, economiccapitalmodelscannothelpregulatorsinsettingregulatorycapital requirements. III. Firmswhosecapitalexceedstheirrequiredregulatorycapitalarefirmsthatemploytheir capitalinefficientlyandtheirshareholderswouldbenefitiftheyusedsomeoftheircapital torepurchasesharesorincreasedividends. IV. Economiccapitalcanbeusedtovalidateafirmsregulatorycapitalrequirementagainst itsownassessmentoftherisksitisrunning.

a. b. c. d.

IIIandIVonly I,IIandIIIonly I,IIIandIVonly IandIVonly

CORRECT:C Economiccapitalisdefinedasacapitalbufferthatisrequiredtoabsorbtheimpactofunexpected lossesduringatimehorizonataportfoliomanagerslevelofconfidence.Afirmmayemploythe economiccapitalasitsowninternalassessmenttochecktheefficiencyofoverallamountofcapitalit holds.Therefore,IandIIIarecorrect. RecentregulatorychangessuchastheinternalratingsbasedapproachinBaselIIprovides encouragementforfirmstodeveloptheirinternalriskmanagementmodels.Therefore,economic capitalwillbecomeakeyregulatorytoolwithaconvergingtrendbetweeneconomiccapitaland regulatorycapitalmodels.IIisincorrectandIViscorrect Reference:Crouhy,Galai,andMark,RiskManagement.Chapter14CapitalAllocationand PerformanceMeasurement

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24. YouareananalystatBankAlpha.YouweregiventhetasktodeterminewhetherunderBaselIIyour bankcanusethesimplifiedapproachtoreportoptionsexposureinsteadoftheintermediate approach.Whichofthefollowingcriteriawouldyourbankhavetosatisfyinorderforittousethe simplifiedapproach?

a. Thebankpurchasesandwritesoptionsandhassignificantoptiontrading. b. Thebankwritesoptionsbutitsoptionstradingisinsignificantinrelationtoitsoverallbusiness activities. c. Thebankpurchasesandwritesoptionsbutitsoptiontradingisinsignificant. d. Thebanksolelypurchasesoptionsanditsoptionstradingisinsignificantinrelationtoitsoverall businessactivities.

CORRECT:D Thebankonlypurchasesoptionsanditsoptionstradingisnotsignificant. INCORRECT:AIfabankwritesoptions,theintermediateapproachmustbeused. INCORRECT:BIfbankwritesoptions,theintermediateapproachmustbeused. INCORRECT:CIfoptiontradingissignificant,theintermediateapproachmustbeused. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion


25. Yourbankisusingtheinternalmodelsapproachtoestimateitsgeneralmarketriskcharge.The multiplicationfactork,setbytheregulator,is3andbanksareallowedtousethesquarerootrule toscaledailyVaR.Thepreviousdays1dayVaRestimateisEUR3million,andtheaverageofthe dailyVaRoverthelast60daysisEUR2million.Giventheaboveinformation,whatwillbethe marketriskchargeforyourbank? a. EUR18.97million b. EUR9.49million c. EUR6.32million d. EUR28.46million

CORRECT:A Therequiredmarketriskchargewouldbesquarerootof10timesthemaximumofpreviousdayVaR andtheaveragedaily60daysVaR,timesk. 10*Max(3,3*2)=18.97 INCORRECT:B10*3=9.49 INCORRECT:C10*2=6.32


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INCORRECT:D10*Max(3*3,3*2)=28.46 Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006). 26. UndertheBaselIICapitalAccord,banksthathaveobtainedpriorregulatoryapprovalcanusethe internalmodelsapproachtoestimatetheirmarketriskcapitalrequirement.Whatapproachor methodologyisusedundertheinternalmodelsapproachtocomputecapitalrequirements?

a. b. c. d.

Stresstestingandbacktesting. Internalratingandvendormodels. VaRmethodology Expectedtailloss,asVaRisnotacoherentmeasureofrisk.

CORRECT:C BaselIIprescribesa10dayVaRat99%confidencelevelforcapitalchargecomputation.However, banksarefreetochoosethemethodtocomputeVaR. INCORRECT:AStresstestingandbacktestingareusedtosupplementandvalidatetheresultsof capitalcomputation,andarenotthemethodpersetobeadoptedforcapitalcomputation INCORRECT:BInternalratingapproachandvendormodelsaresomethingassociatedwithcredit riskratherthanmarketrisk INCORRECT:DRegulationprescribesVaRandnotETLorCVaR,evenwhenitisknownthatVaRis notsubadditiveatalltimes. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).

27. BankZ,amediumsizebank,usesonlyoperationallossdatafrominternalrecordstomodelitsloss distributionfromoperationalriskevents.Thebankrevieweditsrecordsand,afterconfirmingthat theywerecompleterecordsofitshistoricallossesandthatitslossescouldbeapproximatedbya uniformdistribution,itdecidedagainstusingexternallossdatatoestimateitslossdistribution. Basedonthatdecision,whichofthefollowingstatementsiscorrect?

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a. TheestimatedlossdistributionlikelyoverstatesBankZsrealriskbecausemanyincidencesin thepastwerelikelyoneoff. b. TheestimatedlossdistributionlikelyaccuratelyrepresentsBankZsrealriskbecausethe recordsareaccurateandcomplete. c. TheestimatedlossdistributionlikelyunderstatesBankZsrealriskbecausethebankhasnot experiencedahugeloss. d. TheestimatedlossdistributionlikelyisthebestestimateofBankZsrealriskbecausethereisno betterlossdataforthebankthanitsown.

CORRECT:C OneofthebiggestissuesofOperationalRiskmodelingisthatthereislikelynotenoughinternaldata torepresentlargeenoughlossassuchlossisextremelyrare.Usingexternallossdatabasecanhelp tomitigatethisproblem. Reference:Allenetal.,Chapter5.

28. Alargeinternationalbankhasatradingbookwhosesizedependsontheopportunitiesperceivedby itstraders.ThemarketriskmanagerestimatestheonedayVaR,atthe95%confidencelevel,tobe USD50million.Youareaskedtoevaluatehowgoodofajobthemanagerisdoinginestimatingthe onedayVaR.Whichofthefollowingwouldbethemostconvincingevidencethatthemanageris doingapoorjob,assumingthatlossesareidenticallyindependentlydistributed?

a. b. c. d.

Overthelast250days,themeanlossisUSD60million. Overthelast250days,thereisnoexceedence. Overthelast250days,thereare8exceedences. Overthelast250days,thelargestlossisUSD500million.

CORRECT:B UsingtheKupiectest,thereisanextremelylowprobabilityofnoexceedenceover250days. INCORRECT:AVaRtellsusnothingaboutthemeanlossovertimesincethesizeofthetradingbook variesovertimeasopportunitieschange. INCORRECT:CWiththesametest,theprobabilityof8exceedencesishigherthantheprobabilityof noexceedence. INCORRECT:DTheVaRdoesnottellusthedistributionofthemaximumloss. Reference:Jorion,Chapter6.


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29. Tohandlethefinancingofalargecomplexproject,yourbankisestablishingaspecialpurposeentity (SPE)forwhichyourbankwillactastrustee.Whichofthefollowingcouldresultinliabilitytoyour bankthroughitsroleastrustee?

a. TheSPEwasformedtotakeadvantageofapreferablelegaljurisdiction. b. TheSPEprimarypurposewastoallowforthedeferralofincometaxes. c. TheSPEcontrolswereunabletodeterminewhetheritsinvestorsusedfundsderivedfrom legitimatebusinessopportunities. d. TheSPEstructureprovidedforfewercreditorsandareducedlikelihoodthattheprojectwould beforcedintobankruptcy.

CORRECT:C Reference:Culp

30. YourbankisimplementingtheadvancedIRBapproachofBaselIIforcreditriskandtheAMA approachforoperationalrisk.Thebankusesthemodelapproachformarketrisk.TheChiefRisk Officer(CRO)wantstoestimatethebankstotalriskbyaddinguptheregulatorycapitalformarket risk,creditrisk,andoperationalrisk.TheCROasksyoutoidentifytheproblemswithusingthis approachtoestimatethebankstotalrisk.Whichofthefollowingstatementsaboutthisapproachis incorrect?

a. b. c. d.

Itignorestheinterestriskassociatedwiththebanksloans. Itassumesmarket,credit,andoperationalriskshavezerocorrelation. Itignoresstrategicrisks. Itusesatendayhorizonformarketrisk.

CORRECT:B Theapproachassumesacorrelationofone.Thereisnocapitalchargeforstructuralinterestraterisk underBaselII.Operationalriskincludeslegalrisk.Itusesatendayhorizonformarketrisk. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).


31. ThebankyouworkforhasaRAROCmodel.TheRAROCmodel,computedforeachspecificactivity, measurestheratiooftheexpectedyearlynetincometotheyearlyVaRriskestimate.Youareasked toestimatetheRAROCofitsUSD500millionloanbusiness.Theaverageinterestrateis10%.All


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loanshavethesameProbabilityofDefault,PD,of2%withaLossGivenDefault,LGD,of50%. OperatingcostsareUSD10million.ThefundingcostofthebusinessisUSD30million.RAROCis estimatedusingacreditVaRforloanbusinesses.Inthiscase,theappropriatecreditVaRforthe loansis7.5%.Theeconomiccapitalisinvestedandearns6%.TheRAROCis:

a. b. c. d.

32.67% 13.33% 19.33% 46.00%

CORRECT:C (0.1*50051030+0.06*37.5)/37.5=19.33% INCORRECT:A(0.1*5001030+0.06*37.5)/37.5=32.67% INCORRECT:B(0.1*50051030)/37.5=13.33% INCORRECT:D(0.1*500530+0.06*37.5)/37.5=46.00% Reference:Crouhy,Galai,Mark,Chapter14.

32. WhichofthefollowingstatementsregardingBaselIInonadvancedapproachesisincorrect?

a. Thestandardizedapproachusesdatafromthelastthreeyearsofgrossincometoobtaina banksoperationalriskcapitalcharge. b. Thestandardizedapproachmakesitadvantageousforabanktobooklossesearlyifdoingso reducesthisyearsgrossincomesufficientlytomakeitnegative. c. Thestandardizedapproachdividesthebankintobusinesslinesandusesdatafromthelast threeyearsofabusinesslinesgrossincomeandabetafactortoobtaintheregulatorycapital forthatbusinessline. d. Corporatefinance,tradingandsales,andpaymentandsettlementarethebusinesslineswith thehighestregulatorycapitalrequirements.

CORRECT:B Onlypositivegrossincomeisincludedintheformula.Everythingelseiscorrect. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).

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33. WhichoneofthefollowingstatementsdoesnotapplytotheBaselIIAdvancedMeasurement Approach(AMA)foroperationalrisk?

a. Incontrasttocreditriskregulatorycapitalforcorporateloans,banksusingtheAMAapproach mayhavetosetasidecapitalforbothexpectedandunexpectedoperationalrisklosses. b. IncontrasttothecreditriskIRBapproaches,banksusingtheAMAapproachmayestimatethe correlationbetweendifferenttypesofoperationalrisksiftheirmodelssatisfyregulatory requirements. c. Toevaluateexposuretohighseverityoperationalriskevents,banksusingtheAMAapproach mayuseeitherscenarioanalysisofexpertopinion,orVaRmodelestimatesbasedoninternal datausingextremevaluetheory. d. Reportingofoperationalriskexposuretoseniormanagementisanecessaryconditionfora banksabilitytousetheAMAapproach.

CORRECT:C Everythingiscorrectusingthe2006BaselIIdocumentexceptforc.TheBaselIIdocumentrequires theuseofscenariosobtainedwithexpertadviceforhighseverityeventswhenthebankusesonly internaldata. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).


34. Whichofthefollowingapproachesforcalculatingoperationalriskcapitalchargesleadstoahigher capitalchargeforagivenaccountingincomeasriskincreases?

a. b. c. d.

Thebasicindicatorapproach Thestandardizedapproach Theadvancedmeasurementapproach(AMA) Alloftheabove

CORRECT:C UnderAMA,thecapitalchargeisbasedonthebanksinternalmeasurementsystem.Underthe2 otherapproachesthecapitalchargeisbasedupontheGrossIncome,whichhasnothingtodowith riskexposure. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).


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35. Whichofthefollowingisnotincludedasanelementincalculatingoperationalriskcapitalunderthe AdvancedMeasurementApproach?

a. b. c. d.

Externaldata Keyriskindicators Factorsreflectingthebusinessenvironment Scenarioanalysis

CORRECT:B KRIisnotincludedintheBaseldocumentatall Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).


36. YourfirmsfixedincomeportfoliohasinterestonlyCMOs(IO),callablecorporatebonds,inverse floaters,noncallablecorporatebonds.Yourbosswantstoknowwhichofthefollowingsecuritiescan losevalueasyieldsdecline.

a. b. c. d.

callablecorporateonly inversefloateronly IOandcallablecorporatebond IOandnoncallablecorporatebond

CORRECT:C TheIOdecreasesinvaluebecauseadeclineinratesimpliesanincreaseinmortgageprepayments, whichdecreasesthenotionalprincipaluponwhichtheIOpaysitsinterest INCORRECT:AWhilethepriceofacallablecorporatemaydeclineasthecallgoesinthemoney,the IOalsodecreasesinvalue INCORRECT:BTheIOdecreasesinvalue,butsocanthecallablecorporate INCORRECT:DThenoncallablecorporatebondincreasesinvalueasyieldsdecline Reference:Tuckman,Chapter21


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37. Abankwouldliketoestimatethenumberofoperationalriskeventsduetoproblemswithtellers (largemistakes,fraud,andsoon).Thebankdecidestomodeltelleroperationalriskeventsasa PoissonProcesswithrate (numberofeventsperyear).Withthismodel,telleroperationalrisk eventsareassumedtooccurindependentlyofoneanotherandthenumberoftelleroperationalrisk eventsinayearisPoissondistributedwithmean . OtherpropertiesofaPoissondistributionwith mean include: Variance: Skewness: Excesskurtosis -0.5 1/

Basedonhistoricaldataregardingthenumberoftelleroperationalriskeventsthatoccurredin previousyears,thebankdeterminesthattheaveragenumberofeventshasbeen5peryearand decidestosetto5.Whichofthefollowingistrueregardingthatmodel?

a. Thevarianceofthenumberoftelleroperationaleventsinayearis25. b. Thecorrespondingexponentialdistributionthatdescribesthetimebetweentwoteller operationalriskeventshasameanvalueof0.25years. c. Themodelisnotappropriateifatellerismorelikelytohaveanoperationalriskeventbecause hisfriendwhoisalsoatellerhasbeencaughtstealing. d. Thenumberoftelleroperationalriskeventsinayearcannotexceed25.

CORRECT:C ThePoissonmodelimpliesthattellereventsareindependentofoneanother. INCORRECT:AThetelleroperationalriskeventhasavarianceof5. INCORRECT:BTheexponentialprobabilitydistributiondescribesthedistributionoftheperiod betweentwotellerevents.IfthePoissonProcesshasarateof5,thentheassociatedexponential distributionmodelhasameanvalueofM=1/5=0.2years. INCORRECT:DThereisnoboundonthenumberofeventsthatcanoccur. Reference:Rachev,Menn,Fabozzi;Chapter3.


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38. Allthefollowingareoperationalrisklossevents,except:

a. Aloanofficerinaccuratelyentersclientfinancialinformationintothebanksproprietarycredit riskmodel b. Anindividualshowsupatabranchpresentingacheckwrittenbyacustomerforanamount substantiallyexceedingthecustomerslowcheckingaccountbalance.Whenthebankcallsthe customertoaskhimforthefunds,thephoneisdisconnectedandthebankcannotrecoverthe funds. c. Duringanadversemarketmovement,thecomputernetworksystembecomesoverwhelmed andonlyintermittentpricinginformationisavailabletothebankstradingdesk,leadingtolarge lossesastradersbecomeunabletoaltertheirhedgesinresponsetofallingprices d. Abank,actingasatrusteeforaloanpool,receiveslessthantheprojectedfundsduetodelayed repaymentofcertainloans.

CORRECT:D AbroadinterpretationoftheFDICandBaselIIrulesdefiningoperationalriskswouldconsiderall,but alternatived,asoperationalriskeventsandoperationalrisklosses.Aloanofficerentering inaccurateclientfinancialinformationintothebanksproprietarycreditriskmodelisaprocessrisk andanylossesattributabletothisemployeeerrorshouldbeconsideredasanoperationalriskevent. Customerswritingchecksexceedingthebalanceofacheckingaccountanddepositingthefundsina savingsaccountisanexampleofcheckkiting.Ifduringtimesofadversemarketmovement,the computernetworkbecomesoverwhelmedandonlydelayedpricinginformationreachesthebanks tradingdeskandtradesarebasedontheavailableinformation,thebankissubjecttobusiness disruptionandsystemfailures.Whenabank,actingasatrusteeforaloanpool,receiveslessthan theprojectedfundsduetodelayedrepaymentofcertainloansinthepoolisnotanoperationalrisk lossevent. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).

39. Supposeyouareholding100WheelbarrowCompanyshareswithacurrentpriceofUSD50.The dailyhistoricalmeanandvolatilityofthereturnofthestockis1%and2%,respectively.Thebidask spreadofthestockvariesovertime.Thedailyhistoricalmeanandvolatilityofthespreadis0.5% and1%,respectively.CalculatethedailyliquidityadjustedVaR(LVaR)at99%confidencelevel:(Both thereturnandspreadofthestockarenormallydistributed):

a. b. c. d.

USD325 USD275 USD254 USD229

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CORRECT:C VaR=USD50*100*(2.33*0.020.01)=USD183 Liquidityadjusted=USD50*100*0.5*(2.33*0.01+0.005)=USD71 LVaR=VaR+Liquidityadjusted=USD254 Reference:Dowd:Chapter14.


40. Supposeyouaregiventhefollowinginformationabouttheoperationalrisklossesatyourbank.

Frequencydistribution Probability Frequency 0.5 0 0.3 1 0.2 2

SeverityDistribution Probability Severity 0.6 USD1,000 0.3 USD10,000 0.1 USD100,000

WhatistheestimateoftheVaRatthe95%confidencelevel,assumingthatthefrequencyand severitydistributionsareindependent?

a. b. c. d.

USD200,000 USD110,000 USD100,000 USD101,000

CORRECT:C Thelossdistributionis: Totalloss 0 1,000 2,000 10,000 11,000 20,000 100,000 101,000 110,000 200,000 Probability 0.5 0.18 0.072 0.09 0.072 0.018 0.03 0.024 0.012 0.002

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The95%VaRis100,000.Theotheranswersarefromthisdistribution,butnotcorrespondingtothe 95%VaR.

Reference:Allenetal.,chapter5.

41. Tocontrolrisktakingbytraders,yourbanklinkstradercompensationwiththeircompliancewith imposedVaRlimitsontheirtradingbook.Whyshouldyourbankbecarefulintyingcompensation totheVaRofeachtrader?

a. Itencouragestraderstoselectpositionswithlowestimatedrisks,whichleadstoan underestimationoftheVaRlimits. b. Itencouragestraderstoselectpositionswithlowestimatedrisks,whichleadstoan overestimationoftheVaRlimits. c. Itencouragestraderstoselectpositionswithhighestimatedrisks,whichleadstoan underestimationoftheVaRlimits. d. Itencouragestraderstoselectpositionswithhighestimatedrisks,whichleadstoan overestimationoftheVaRlimits.


CORRECT:A Ifatraderusesanestimatedvariancecovariancematrixtoselecttradingpositions,thetraderwould optforapositionwithlowestimatedrisks.Selectingpositionswithlowestimatedrisksbiasesthe variancecovariancematrix,andleadstoanunderestimationoftheVaRpositionlimits. Reference:Dowd,MeasuringMarketRisk.


42. Thesurplusofapensionfundismostimportantfor:

a. Adefinedcontributionfund b. Adefinedbenefitfund c. Ayoungworkforce d. Asponsoringcompanywithstrongfinancialstatusthatoperatesindifferentindustries CORRECT:B. Underadefinedcontribution,beneficiariesareentitledforapercentageregardlessofitsvalue. Underadefinedbenefitplan,theyareentitledforavalue.Theoldertheworkforceisandthelower thesurplusvalue,thehighertheriskofthepensionplanandthemoreimportantisthesurplus. Reference:Jorion,Chapter17.


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43. Amutualfundinvestingincommonstockshasadoptedaliquidityriskmeasurelimitingeachofits holdingstoamaximumof30%ofitsthirtydayaveragevaluetraded.IfthefundsizeisUSD3billion, whatisthemaximumweightthatthefundcanholdinastockwithathirtydayaveragevaluetraded ofUSD2.4million?

a. b. c. d.

24.00% 0.08% 0.024% 80.0%

CORRECT:C Thirtydayaveragevaluetraded=USD2.4million 30%ofthirtydayaveragevaluetraded=30%xUSD2.4=USD0.72million %ofPortfolio=USD0.72million/USD3billion=0.024% Reference:Grinold,Kahn,Chapters,14,17.


44. Aninvestorisinvestigatingthreehedgefundsaspotentialinvestments.HedgefundAisanequity marketneutralfund,Bisaglobalmacrofundwithemphasisonequitymarkets,andCisa convertiblearbitragefund.Whichanswercorrectlyspecifiesthefundswiththehighestexposureto aworldwidevalueweightedequityindexandtoacreditdefaultswapsindex? Highestequityindexexposure Highestcreditdefaultswapindexexposure a. A B b. A C c. B A d. B C

CORRECT:D HedgefundB,globalmacro,hashighestequityexposure.HedgefundA(equitymarketneutral)has nonetequityexposureaslongpositionsareoffsetbyshortpositionswithregardstoequity exposure.Similarly,littleoutrightmarketriskforconvertiblearbitragefundCasitinvolvesarbitrage toalargeextent. Withregardstocreditrisk,convertiblearbitragefundChashighestcreditrisk,sinceitinvestsin interestratesensitiveinstrumentshighlyaffectedbychangesincreditratings. Reference:LarsJaeger,ThroughtheAlphaSmokeScreens:AGuidetoHedgeFundReturnSources, Chapter5

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2009FRMPracticeExams
45. Whichofthefollowingisnotanapproachfordetectingstyledriftofhedgefunds? a. Performanceattribution b. Peergroupcomparison c. Cashflowanalysis d. Communicationwithfundmanager

CORRECT:C CashFlowanalysisforthefundcannotdetectstyledrift INCORRECT:APerformanceattributioncandetermineifeachperformancecomponentisconsistent withtheperdeterminedstyleoffund. INCORRECCT:BPeergroupcanbeusedtodeterminetheconsistencyofthefundsriskandreturn profile INCORRECT:DDiscussionwithfundmanagercanrevealchangeinstyleandstrategyofthefund. Reference:LarsJaeger,ed.,TheNewGenerationofRiskManagementforHedgeFundsandPrivate EquityInvestments,Chapter27


46. Allofthefollowingstrategiesareexamplesofcapitalstructurearbitrage,except:

a. Longpositioninthebondsissuedbythecompany,andshortpositioninthecompanysstock. b. Shortpositioninthebondsissuedbythecompany,andlongpositioninthecompanysstock. c. Longpositioninacreditdefaultswaponthecompanyandwritingputoptionsonthecompanys stock. d. Shortpositioninthepreferredstockissuedbythecompanyandwritingcalloptionsonthe companysstock.

CORRECT:D Alongpositioninthebondsissuedbythecompanyandshortpositioninthecompanysstock,anda shortpositioninthebondsissuedbythecompanyandalongpositioninthecompanysstockare bothcapitalizingonthedifferentspeedofadjustmenttoinformationinthebondandequities markets.Alongpositioninacreditdefaultswaponthecompanyandwritingputoptionsonthe companysstockcapitalizesonthedifferencesinthevolatilitysurfacebetweenbondsandequity. Shortpositioninthepreferredstockissuedbythecompanyandwritingcalloptionsonthe companysstockinfactisanetshortpositionwhichshouldnotbesensitivetorelativechangesinthe differencebetweenthetwoinstruments. Reference:Jaeger,ThroughtheAlphaSmokescreens,Chapter5

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2009FRMPracticeExams
47. Youhavebeenaskedtoevaluatetheperformanceoftwohedgefunds:GlobalAssetManagementI andInternationalMomentumII.BotharebenchmarkedtoMSCIEAFE.Whichofthetwofundshad ahigherrelativeRiskAdjustedPerformance(RAP)lastyear,andwhatistheRAP?

ThevolatilityofEAFEis17.5%andtheannualizedperformanceis10.6%.Theriskfreerateis3.5%. Fund Volatility AnnualizedPerformance GlobalAssetManagementI 24.5% 12.5% InternationalMomentumII 27.3% 13.6%

a. b. c. d.

GlobalAssetManagement,4.85% GlobalAssetManagement,6.16% InternationalMomentum,5.42% InternationalMomentum,1.18%

CORRECT:C Theannualizedriskadjustedperformanceism/p(RpRm)+Rf= mbenchmarkvolatility pportfoliovolatility Rpportfolioreturn Rmbenchmarkreturn Rfriskfreereturn TheriskadjustedperformanceforGlobalisthenm/p(RpRm)+Rf=17.5/24.5x(12.510.6)+3.5 =4.85% TheriskadjustedperformanceforInternationalisthenm/p(RpRm)+Rf=17.5/27.3x(13.610.6) +3.5=5.42%.InternationalhasagreaterRAP. Reference:Grinold,Kahn,Chapters14,17.

48. OnJanuary1,2006,apensionfundhasassetsofEUR100billionandisfullyinvestedintheequity market.IthasEUR85billioninliabilities.During2006,theequitymarketdeclinedby15%andyields increasedby1.2%.Ifthemodifieddurationoftheliabilitiesis12.5,whatisthepensionfunds surplusonDecember31,2006?

a. b. c. d.

EUR15.00billion EUR12.93billion EUR12.75billion EUR12.57billion

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CORRECT:C Thesurplusatthebeginningoftheyearwas10085or15billionEUR.Duringtheyear,theequity portfoliodeclines15%,or15billionEUR,to85billionEUR.Duetotheincreaseinyields,thedollar valueoftheliabilitiesdecreasesby12.5*1.2%*85billionEUR,or12.75.Thusattheendofthe year,theassetsareworth(10015)=85billionEURandtheliabilities(8512.75)=72.25billion. Thesurplusisthen12.75,adecreaseof2.25billionEUR. INCORRECT:A15istheequitylossin2006 INCORRECT:B12.93=15*(1(.15.012)) INCORRECT:D12.57=15*(1(.15+.012)) Reference:Jorion,VaR,3rded,Chapter17.

49. WhichofthefollowingstatementsregardingExtremeValueTheory(EVT)isincorrect?

a. ConventionalapproachesforestimatingVaRthatassumethatthedistributionofreturnsfollow auniquedistributionfortheentirerangeofvaluesmayfailtoproperlyaccountforthefattails ofthedistributionofreturns. b. IncontrasttoconventionalapproachesforestimatingVaR,EVTonlyconsidersthetailbehavior ofthedistribution. c. Bysmoothingthetailofthedistribution,EVTeffectivelyignoresextremeeventsandlosses whichcangenerallybelabeledoutliers. d. EVTattemptstofindtheoptimalpointbeyondwhichallvaluesbelongtothetailandthen modelsthedistributionofthetailseparately.

CORRECT:C Statementsa,b,anddarevalidstatements.Statementcisincorrectoutliersareabigconcernin riskanalysisandcannotbeignored. Reference:Dowd,Chapter7.

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2009FRMPracticeExams
50. Consideraportfoliowith40%investedinassetXand60%investedinassetY.Themeanand varianceofreturnonXare0and25respectively.ThemeanandvarianceofreturnonYare1and 121respectively.ThecorrelationcoefficientbetweenXandYis0.3.Whatisthenearestvaluefor portfoliovolatility? a. b. c. d. 9.51% 8.60% 13.38% 7.45%

CORRECT:D Theportfoliovolatilityiscalculatedasfollows:
2 2 2 2 portfolio variance = w x x + w y y + 2w x w y xy x y

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

portfoliovolatility=(portfoliovariance)0.5=(55.48)0.5=7.45 INCORRECT:AThissolutionincorrectlycalculatestheportfoliovarianceusingwxandwyinsteadof wx2andwy2. INCORRECT:BThissolutionincorrectlyomitsthecorrelationbetweenXandYintheportfolio variancecalculation. INCORRECT:CThissolutionincorrectlyomitstheweightingtermsintheportfoliovariance calculation. Reference:PhilippeJorion,ValueatRisk,3rdedition.Chapter7.

ENDOF2009FRMFULLEXAMPRACTICEEXAMII Questions&Explanations

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