FRM Part II – Mock Exam I – Candidate Answer Sheet

1. 21. 41. 61.

2. 22. 42. 62.

3. 23. 43. 63.

4. 24. 44. 64.

5. 25. 45. 65.

6. 26. 46. 66.

7. 27. 47. 67.

8. 28. 48. 68.

9. 29. 49. 69.

10. 30. 50. 70.

11. 31. 51. 71.

12. 32. 52. 72.

13. 33. 53. 73.

14. 34. 54. 74.

15. 35. 55. 75.

16. 36. 56. 76.

17. 37. 57. 77.

18. 38. 58. 78.

19. 39. 59. 79.

20. 40. 60. 80.

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Reference Table: t-table

3
Market Risk Measurement and Management

1. You are assigned to calculate the daily VaR for the stock of Fooda Inc. You are provided with the
following data for the ten worst returns of the stock during the last 100 days:

-1.2% -0.7% -3.2% -2.6% -2.4% -2.0% -1.9% -1.7% -1.5% -1.5%

Which of the following is closest to the monthly VaR for Fooda Inc. using a confidence level of 95%?
(Assume there are 20 trading days in a month.)

A. -7.6%
B. -3.2%
C. -1.2%
D. -1.4%

2. An analyst has gathered the following information about a portfolio which has normally distributed
geometric returns:

Mean 12%
Standard deviation 32%
Portfolio value 85 million

What is the 95% lognormal VaR for this portfolio?

A. $ 33.40 million
B. $ 27.20 million
C. $ 56.61 million
D. $ 28.39 million

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3. A portfolio manager has gathered the following data about OilStok and Carbon Energy. He is
considering adding one of these two stocks to his existing portfolio.

Expected Return Annual Volatility Value ($millions) Correlation with

portfolio
Existing portfolio 8% 18% $500
OilStok 6% 22% $100 0.6
Carbon Energy 7% 23% $100 0.5

The manager will only add a stock to the portfolio if the VaR of the resultant portfolio does not
exceed a daily VaR limit of $15 at 99% confidence level. Given the information above, what should
the manager do?

A. Add OilStok
B. Add Carbon Energy
C. Add either, if only VAR limit is the consideration, as the VAR of the resultant portfolio will be
the same in both cases
D. Add neither, as the VAR exceeds the VAR limit of $15 in both cases

4. Michael Roy, a risk analyst at a large multinational bank, is backtesting the VaR model of the bank.
The model being tested is a daily, 98% VaR model. If the backtest is conducted for one year at a 95%
confidence level, and assuming 252 days in a year, what is the number of daily losses that will lead
Roy to conclude that the model is not calibrated correctly?

A. 8
B. 9
C. 10
D. All three choices

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5. A portfolio consists of two assets – A and B.

Value Return 99% 1 day VaR Correlation

A 5 million 5% 0.58 million
0.7
B 10 million 6% 1.86 million

The portfolio manager decides to rebalance the portfolio so that both the assets are equally weighted.
If there is no change in the volatility of the two assets, what will be the effect of this rebalancing on
the portfolio VaR?

A. 0.40 million
B. 0.17 million
C. 0.87 million
D. 0.20 million

6. Which of these is an example of a dynamic financial correlation?

A. Value at Risk
B. Correlation copulas for CDOs
C. Pairs trading
D. Binomial default correlation model

7. The buyer of a correlation swap with three assets and a maturity of one year pays a fixed rate of 2.5%.
The notional amount of the swap is $1 million. If the realized pairwise correlations of the daily log
returns for the three assets are ρ2,1 = 0.2, ρ3,1 = 0.4 and ρ3,2 = 0.3, what is the realized correlation?

A. 0.30
B. 0.20
C. 0.45
D. 0.16

8. Which of these statements is not accurate?

A. Exogenous liquidity risks represent the risk associated with market specific average transaction
costs.
B. Exogenous liquidity is particularly relevant for complex trading positions.
C. Endogenous liquidity risk can be addressed by calculating a liquidity adjusted VaR (LVaR).
D. Endogenous liquidity risk is related to transaction size and occurs when orders are large enough
to affect prices.

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 9. Given the following data about a variable S:

St 50
St-1 30
Mean reversion rate 0.4

Calculate the long-run mean value for the variable.

A. 60
B. 80
C. 100
D. 75

10. A model gives a VaR value of $5 million for a portfolio at a 99% confidence interval. A one-year
backtest conducted at the 95% confidence level reveals that losses exceeded $5 million on 8 occasions.
The model is accepted as accurate.

Assuming 252 days in a year, which of these statements is most likely true?

A. A Type I error has occurred

B. A Type II error has occurred
C. Both Type I and Type II errors have occurred
D. The model has been accepted correctly

11. In December 2016, a set of data is given such that the Dow correlation matrices have an averaged
correlation of 0.1925 with a long-term mean of 0.2723. Compute the expected correlation for January
2017 if the average mean reversion is 0.6715.

A. 20.00%
B. 52.12%
C. 51.22%
D. 24.61%

12. Which of these correctly describes the effects of maturity and volatility on convexity?

A. Convexity increases with maturity but decreases with volatility

B. Convexity increases with both maturity and volatility
C. Convexity decreases with maturity but increases with volatility
D. Convexity decreases with both maturity and volatility

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13. Using a term structure model with no drift and normally distributed rates assume that short term
interest rates are 5%, annual volatility is 75 bps and after one month the realization of dw (a normally
distributed random variable with mean 0 and standard deviation √𝑑𝑡 has an expected value of 0) is 0.2.
What is the new spot rate?

A. 5.15%
B. 4.85%
C. 3.50%
D. 6.50%

14. Given the following information, calculate the new short term rate for an interval of one month

Current short term rate (r0) 2.45%

Drift (λ) 0.24%
Volatility of rate change (σ) 80 bps
Realization of random variable (dw) over a 0.3
period of one month

A. 2.50%
B. 2.93%
C. 2.71%
D. 2.19%

15. A foreign currency is valued at $1.80. The foreign currency has a European call option with a market
price of $0.135, strike price of $1.70, and 1 year to maturity. In the US, the risk-free interest rate is 5%
per annum and 8% per annum in the foreign country. Assuming no arbitrage, determine the price of a
European put option with a strike price of $1.70 and 1-year to maturity for the foreign currency. (Tip:
Let the yield on the underlying stock be equal to the foreign risk-free rate.)

A. $0.254
B. $0.153
C. $2.5608
D. $0.0905

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16. Given the information below, use the Cox Ingersoll Ross model to find the short-term rate after one
month.

Current short term rate 5%

Long run value of the short term 7.5%
rate
Speed of mean revision adjustment 0.05
Volatility of rate change (σ) 0.8%
Random variable dw 0.3

A. 5.064%
B. 5.112%
C. 5.038%
D. 5.210%

9
 Credit Risk Measurement and Management

17. A portfolio consists of two bonds – A and B. The credit VaR is defined as the maximum loss due to
defaults at a confidence level of 99% over a one-year horizon. The probability of joint default of A and
B is 1.45%, with 25% default correlation. Further details of the bonds are given in the table below:

Bond Value Default probability Recovery rate

A £1,000,000 4% 70%
B £800,000 6% 60%

Determine the expected credit loss for the portfolio.

A. £12,000
B. £7,800
C. £31,200
D. £20,000

18. Which of the following statements about credit risk models is least accurate?

A. Credit risk+ models use a Poisson or Poisson-like distribution to describe default

B. Credit risk+ models offer an actuarial approach to measuring credit risk that treats the bankruptcy
and recovery process as exogenous
C. KMV models are an extension of Merton’s option pricing model and adopt equity price volatility
as a proxy for asset price volatility
D. KMV models present a structural avenue for measuring credit risk that’s largely based on credit
migration

19. A bond with a face value of 500 matures in 12 years. Using the Merton model, the bond is calculated
to be worth 250. The risk free rate is 4%. Determine the bond’s spread.

A. 1178 bps
B. 22 bps
C. 2 bps
D. 178 bps

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20. Since it was founded ten years ago, Bright Technologies pays no dividends to shareholders and is
financed with 100% equity. Recently, management decided to have the firm leveraged and issued a
zero-coupon bond with a principal amount of $100 million maturing in exactly three years. The firm is
currently valued at $80 million. Determine the values of the different components of the firm’s capital
structure at the maturity date of the bond.

A. Value of equity = $0; value of debt = $80million

B. Value of equity = $20 million; value of debt = $80
C. Value of equity = $180 million; value of debt = $100 million
D. Value of equity = $20 million; value of debt = $0

21. A pension fund subscribes for a bond issued by Bright Technologies Limited. To protect itself against
borrower default, the pension fund enters into a 1-year CDS with AC&C bank. According to the
contract, the pension fund will receive 80% of the face value of the bond from AC&C bank in the
immediate aftermath of a default by Bright Technologies. In return, the fund pledges to pay AC&C
bank the CDS spread – a percentage of the face value – once at the end of the year. AC&C analysts
have estimated the risk-neutral default probability for Bright Technologies at 5% per year. The rate of
return on risk-free government bonds is 2%. Determine an estimate for the CDS spread, given that
defaults can only occur half-way through the year and that the accrued premium is payable
immediately after a default event.

A. 500 bps
B. 440 bps
C. 518 bps
D. 414 bps

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22. Richard Cooke, FRM, works at a mid-sized hedge fund based in Singapore. He intends to establish the
credit risks of several recently executed trading positions. It’s the hedge fund’s policy to wholesomely
invest in corporate debt. The fund also utilizes both relative value and long-only trades using bonds
and credit default swaps. One recent, high-profile trade involved a BBB+ rated long bond with a value
of SGD 20 billion. The fund also imposes a 5-year withdrawal restriction on all new clients, including
the BBB+ rated bond holders. Cooke is currently assessing the liquidity impacts of various default
scenarios. According to his estimates, the BBB+ rated bond has a marginal probability of default of
3% in year 1, 6% in year 2, 11% in year 3, 18% in year 4, and 28% in year 5. Determine the
probability that the bond makes coupon payments for 5 years and then defaults at the end of year 5.

A. 14.6%
B. 18.6%
C. 48%
D. 13.4%

23. Which of the following statements regarding frictions in the securitization of subprime mortgages is
correct?

A. One way to eliminate the risk of foreclosure entails the use of escrow accounts for insurance and
tax payments.
B. Credit rating agencies are usually remunerated by investors as a reward for their rating services of
mortgage-backed securities, creating a potential conflict of interest.
C. The originator of a security will typically have more borrower information than the arranger, and
may therefore be incentivized to collude with the borrower and submit loan applications laden
with falsified information.
D. The arranger will typically have more borrower information than the originator with regard to the
securitized assets.

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24. A hedge fund has the following credit risk exposures to AB&B, an A-rated corporation:

Contract Contract value (USD)

A 44,000,000
B 88,000,000
C 35,200,000
D 3,300,000
E 20,000,000

The fund is looking into ways of reducing counterparty credit risk. Which of the following credit risk
mitigation techniques would be most appropriate?

A. Implementing a netting framework

B. Increasing collateral
C. Use of credit triggers
D. Sell credit default swaps

25. An investment bank has significant exposure to credit risk. The bank has traditionally used netting
schemes to control risk exposures. Currently, the bank has 7 netting agreements – all on equity trading
positions. These positions have an average correlation of 0.32. The bank’s CRO believes there’s still
room for improvement with regard to the diversification benefit of netting, specifically by judiciously
choosing exposures with a favorable correlation coefficient. In this regard, the following trade
combinations have been put forward:

Trade Combination Number of Positions Average Correlation

KAB 6 0.22
UGX 9 0.18
POT 14 -0.05
EFG 17 -0.06
CDM 18 0.12

Determine the trade combinations that would optimize the expected netting benefit.

A. UGX
B. CDM
C. EFG
D. POT

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26. Bank of Baroda often enters into swap contracts with Bank of Panamba – a major provider of swaps.
In the last few months, Bank of Panamba was downgraded from a rating of A to a rating of A-, while
Bank of Baroda was downgraded from a rating of BB+ to a rating of BB. Following these changes, the
credit spread for Bank of Panamba has increased from 38bps to 128 bps, while the credit spread for
Bank of Baroda has increased from 118 bps to 228 bps. Which of the following actions will most
likely be taken by the counterparties with respect to their credit value adjustment?

A. Bank of Panamba requests an increase in the CVA charge it receives

B. Bank of Baroda requests a reduction in the CVA charge it pays
C. CVA is no longer as important a factor, and therefore the counterparties will most likely migrate
to other risk mitigation measures
D. Status quo remains because although the credit qualities of both institutions have migrated, the
overall change is not sufficient to warrant an amendment of the existing CVA arrangement

27. A risk analyst has performed extensive analysis of a firm and come up with a hazard rate of 0.15 per
year. Determine the probability of survival in the first year followed by a default in the second year.

A. 12.30%
B. 16.04%
C. 14.19%
D. 13.93%

28. An investment firm is contemplating taking positions in various tranches of a collateralized debt
obligation. The chief CDO analyst at the firm predicts that the default probability will increase
significantly and that default correlation will decrease. On this basis, the analyst will most likely
recommend the:

A. Purchase of the senior tranche and sale of the equity tranche

B. Purchase of the equity tranche and sale of the senior tranche
C. Purchase of the senior tranche and purchase of the equity tranche
D. Sale of the senior tranche and sale of the equity tranche

29. A Spanish bank has the following derivative positions with a local company:

Position Price (USD)

Long currency swaps 33 million
Short credit default swaps - 22 million
Long interest rate swaps 8 million
Short swaptions -17 million

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 In the event that the counterparty (company) defaults, what would be the loss to the financial
institution if netting is used compared to the loss without netting?

Loss if netting is used (USD) Loss without netting (USD)

A. 2 million 2 million
B. 2 million 41 million
C. 41 million 2 million
D. 29 million 41 million

30. A derivative trader in France sells a European-type call option on AB&B stock with a time to expiry of
11 months, an underlying asset price of EUR 45, a strike price of EUR 37, and implied annual
volatility of 23%. Given that the annual risk-free rate is 2.5%, determine the trader’s counterparty
credit exposure from this transaction:

A. EUR 22.50
B. EUR 35.00
C. EUR 7.45
D. EUR 0.00

31. An investment firm has sold default protection on the most senior tranche of a collateralized debt
obligation. Suppose the default correlation between assets held in the CDO increases sharply, but
everything else remains unchanged. How will the firm’s position be affected?

A. It will neither lose nor gain value because correlation does not affect default losses
B. It will lose significant value, since the probability of exercising the protection increases
C. It will either increase or decrease depending on market conditions
D. It will gain significant value because the probability of exercising the protection falls

32. Ben Gilford, a credit analyst at X&Y Bank, gathers the following information about a bond:

Face value $100

Years to maturity 10
Risk-free rate 2.5%

Gilford uses the Merton model to calculate the value of the bond as $72. What is the credit spread for
the bond?

A. 92 bps
B. 64 bps
C. 79 bps
D. 57 bps

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 Operational Risk and Resiliency

33. Angela Myer, FRM, works at Pinebridge Bank. She was recently reviewing the bank’s firewalls and
safety measures erected to guard against cyber-based data theft. The exercise also entailed an in-depth
outlook into governance processes in the bank. Ms Myer is most likely part of the bank’s:

A. Senior management
B. Risk management department
C. Board of directors
D. Internal audit team

34. The following information has been extracted from the P&L of a European bank over a 3-year period:

Year (ended) 20X6 20X7 20X8 20X9

Interest, leases and
€950 million €1.3 billion €1.8 billion €1.6 billion
dividends

Services €1.6 billion €2.2 billion €2.6 billion €1.8 billion

Financial (Net
Profit/Loss on the €500 million €1.1 billion €1.3 billion €1.5 billion
trading book)

Using the Standardized Measurement Approach, the bank’s Business Indicator (BI) for the year
ended 31 Dec 20X9 is closest to:

A. €4 billion
B. €5 billion
C. €3.2 billion
D. €500 million

35. Under the IRB approach, banks are allowed to use their internal rating systems conditional on approval
by their supervisors. If a bank was to use the foundation IRB approach, then it would have to use:

A. Its internal estimates of PD

B. A predetermined estimate of PD based on the size of the bank
C. Its internal estimates of exposure-at-default (EAD) and the loss-given-default (LGD)
D. Predetermined estimates of exposure-at-default (EAD) and the loss-given-default (LGD) based on
the size of the bank.

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36. A new bank is to be established in New York City. According to the Basel Committee, three of the
following are principles that should be considered in the operation of the new bank. Which one is does
NOT fit with the Basel’s principle?

A. The board of directors should establish, approve and periodically review the framework
B. The board of directors should take a strong lead in establishing a powerful risk management
culture
C. The bank should develop, implement and maintain a framework that is fully integrated into the
bank’s overall risks management processes
D. The bank should establish the number of customer loans that best fits its risk profile

37. Richard Brooke works as a financial analyst at Daytime Investments where he has accumulated over
seventeen years of experience. He was recently tasked with scenario analysis of the FX trading
department to establish the maximum losses that could be incurred under various circumstances. His
analysis repeatedly project losses of above $10 million on three different occasions, but he’s convinced
such a big loss would not occur, borrowing from his years of experience. Brooke’s belief most likely
forms part of:

A. Context bias
B. Overconfidence bias
C. Availability bias
D. Inexpert bias

38. A German Bank has chosen to use the standardized approach to calculate its capital charge for
operational risk. Its annual gross revenue is distributed across only three business lines – Corporate
Finance, Retail Banking, and Trading and Sales. The stated distribution of annual gross revenues (in $
million) is as follows:

Business Line Year 1 Year 2 Year 3 Beta factors

Corporate Finance 40 40 30 20%
Retail Banking 20 15 -50 18%
Trading and Sales 20 10 10 15%

The bank’s capital requirement for operational risk is closest to:

A. $8.50
B. $12.50
C. $13.40
D. $9.45

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39. Consider the following scenarios;
(I) An individual shows up in a banking hall to present a check purportedly written by a
customer for an amount that’s substantially more than the customer’s account balance. When
the bank attempts to reach out to the customer via a phone call in an attempt to recover the
funds, the call is disconnected and the bank is unable to recover the funds
(II) A financial analyst captures a corporate bond’s financial information incorrectly in the
proprietary credit risk model
(III) On a day of adverse market movement, a bank’s computer network system crumbles under
heavy traffic. As a result, only intermittent pricing information is relayed to the bank’s
trading desk. This leads to huge losses as traders are unable to adjust their positions in
response to real time price falls
(IV) A bank, acting as a trustee for a loan portfolio, receives less than the projected funds due to
delayed repayment of certain loans

Which of the above scenarios present operational risk loss events?

A. I, II, and III

B. I, II, and IV
C. II, III and IV
D. All of the above

40. The Credit Bank of India (CBI) recently sought to revamp its risk management processes. To this end,
the bank has introduced a new decision-making framework on all matters to do with economic capital.
Going forward, the bank will assess risks (I) within and (II) across the different autonomous business
units, taking into account the correlations between various risks. In this regard, which of the following
statements is most likely true?

A. Total credit VaR will be less than or equal to the sum of individual loan credit VaRs.
B. Total credit VaR will be greater than or equal to the sum of individual loan credit VaRs.
C. The bank’s assessment of correlations between risks within a business unit is irrelevant because
correlations are only relevant between business units
D. There is zero correlation between broad risk types such as credit, market, and operational risk

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41. Assume that the following information on revenue has been provided by Jacque’s & Josh Bank (in
USD million). From the data, how much operational risk capital should be held by the bank under
Basel II by applying the Standardized Approach? The beta value for corporate finance and retail
banking are 17.99% and 12.11%, respectively.

Year one Year two Year three

Corporate finance 11.9 19.3 29.7
Retail banking -26.2 29.4 -31.7

A. USD 2.845 million

B. USD 4.043 million
C. USD 3.527 million
D. USD 4.119 million

42. Family Bank has entered a $100 million interest rate swap with a corporation. The swap has a
remaining maturity of five years. The current value of the swap is $4.5 million. The table below gives
add-on factors as a percentage of principal for derivatives.

Time remaining to maturity Interest rate Equity

< 1 year 0.0 6.0
1 to 5 years 0.5 8.0
> 5 years 1.5 10.0

Based on the table above, the equivalent risk-weighted asset (RWA) under Basel I is closest to:

A. $5,000,000
B. $1,125,000
C. $3,500,000
D. $2,500,000

43. Which of the following statements about the methodologies for calculating an operational risk capital
charge in Basel II is incorrect?

A. The basic indicator approach does not reflect the operational risk in a firm since is uses only
revenue as a driver
B. The standardized approach assumes that different business lines have different multipliers
C. Under no circumstances does Basel II allow a national regulator to permit a bank to use an
alternative standardized approach
D. Advanced measurement approaches allow an institution to adopt its own method of assessment of
operational risk

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44. Which of the following statements about economic and regulatory capital are valid?

(I) Regulatory capital is always greater than economic capital for an individual bank
(II) Economic capital provides protection against the various risks inherent in the business of
corporation, hence safeguarding its stability and soundness
(III) Economic capital ensures that an institution can absorb unexpected losses up to a level of
confidence in line with the dictates of important stakeholders
(IV) The level of confidence used in the calculation of economic capital is determined by trial and
error

A. (II), (III), and (IV)

B. (I), (II), and (III)
C. (II) and (III)
D. All of the above

45. Equity bank’s senior management intends to create a capital buffer enough to enable the bank to
absorb unexpected losses corresponding to a bank-wide VaR at the 1% level. The bank measures bank-
wide VaR by summing up individual VaRs for market risk, operational risk, and credit risk. There is a
risk that the bank has too little capital because:

A. Addition of VaRs is quantitatively meaningless

B. It does not take into account the correlations among these risks
C. VaR should only be used to measure operational and credit risks, not market risk
D. It ignores risks that are not market, operational, or credit risks

46. ABC Bank is planning to create and adopt a risk appetite and tolerance statement. Which of the
following is the most appropriate body to approve and review this risk appetite and tolerance
statement?

A. Share holders
B. The internal audit
C. The board of directors
D. Senior management

47. Trademark Bank uses insurance as a risk mitigation technique. Its risk management team points out
that risk transfer to an insurance company as a risk mitigation strategy could create a new risk to the
organization. Which one?

A. Market risk
B. Reputation risk
C. Counterparty risk
D. Forex exchange risk

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48. The use of an inaccurate model leads to valuation errors. What type of risk does valuation error fall
into?

A. Operation risk
B. Market risk
C. Both market and operation risk
D. None of the above

21
 Liquidity and Treasury Risk Measurement and Management

49. Joe Hart, a market analyst at Smart Investment Bank, has been tasked with the development of early
warning signals to help the bank to monitor potential liquidity stress events. At the preliminary stage,
Mr. Hart has researched on a set of background guidelines as follows:

I. All EWIs must be updated every two months to detect potentially threatening events
II. Their bank should conduct a variety of short-term and protracted bank-specific and market-wide
liquidity stress tests using conservative and regularly reviewed assumptions
III. The bank should establish a robust escalation policy so that critical decisions and transactions are
handled at an appropriate level of management.

As a risk analyst, which of the above proposals would you disagree with?

A. I.
B. II.
C. III
D. None of the above

50. An asset is thinly traded with an expected return of 0% and standard deviation of 1.75%. Its spread has
a volatility of 1.5%. Its liquidity adjusted VaR is 90% more than its VaR at the 95% confidence
interval. Determine the asset’s spread (constant) if returns are lognormally distributed and the asset’s
spread itself is normally distributed.

A. 0.542%
B. 0.936%
C. 1.729%
D. 5.12%

51. Bob Woolmer is a fund manager at Fortune Investment. He is analyzing shares of Bell Aviation which
currently have a bid price of $32.45 and an ask price of $32.90. The sample standard deviation of this
bid-ask spread is 0.004. Given this information, determine the expected transactions cost and 99%
spread risk factor for a transaction involving Bell Aviation.

A. Transactions Cost: $0.759; Spread Risk Factor: 0.0232

B. Transactions Cost: $0.759; Spread Risk Factor: 0.0139
C. Transactions Cost: $0.379; Spread Risk Factor: 0.0116
D. Transactions Cost: $0.379; Spread Risk Factor: 0.0139

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52. Your Chief Risk Officer asks you to come up with a list of early warning signs for liquidity problems
for your bank. Which of the following are early warning indicators of a potential liquidity problem?

(II) Narrowing credit default swap spreads

(III) Increasing redemptions of CDs prior to maturity
(IV) Growing concentrations in liabilities
(V) An increase of the weighted average maturity of liabilities
(VI) Request for additional collateral by counterparties

A. (I) and (II)

B. (II), (III), and (V)
C. (II), (III), (IV), and (V)
D. All of the above

53. A financial manager wishes to estimate the liquidity-adjusted VaR using the constant spread approach.
She gathers the following data:

0.49
𝜇 = 0, 𝜎 = , 𝑠𝑝𝑟𝑒𝑎𝑑 = 0.02, 𝛼 = 0.95
√490

Based on these data, which of the following statements is true?

A. The constant spread liquidity adjustment raises the VaR by almost 30%
B. The constant spread liquidity adjustment reduces the VaR by 28%
C. A small spread cannot translate into a large liquidity adjustment to the VaR
D. The constant spread liquidity adjustment raises the VaR by 50%

54. Capital Bank, based in Ireland, is a dealer bank. The bank has several revenue-generating segments,
including investment banking, deposit taking, and corporate lending. The CRO is wary of liquidity
problems that could be triggered by a run arising from unprecedented poor performance or some other
external shock. Which of the following steps could the bank take to mitigate the risk of loss of
liquidity from a run by short-term creditors?

A. Setting up a buffer stock of cash or securities

B. Establishing emergency lines of credit
C. Streamlining the maturities of its liabilities to cap the maximum number of liabilities that must be
settled with a given period of time.
D. All of the above

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55. John Carter has a well-balanced portfolio of securities. Which of the following categories of stocks
would most likely help him mitigate the effects of bad market performance? Stocks with:

A. a low 𝛽
B. 𝛽=1
C. 𝛽=0
D. A high 𝛽

56. Hedge Q is a database of hedge fund returns, constructed as follows. The first year of the database is
2002. All funds in existence as of 31 December 2002 are included in that year, preconditioned on their
willingness to report verified returns. Database managers decide to expand it even further. They ask
for return data for years before 2002. Subsequently, a funds inclusion in the database is premised only
on their willingness to report verified returns. What’s more, if a fund stops reporting returns in totality,
its returns are deleted from the system. And although the rules require submission of verified returns
on a monthly basis, funds that submit returns at quarterly intervals are also included in the system.

Which of the following five statements are correct?

I. The database suffers from infrequent trading bias

II. The database suffers from backfilling bias
III. The database suffers from an error-in-variables bias
IV. The database suffers from survivorship bias
V. The equally weighted annual return average of fund returns will overestimate the
performance one would expect from a hedge fund

A. I, II, and IV
B. III and V
C. I, II, IV, and V
D. All of the above

57. An investor wants to purchase a $1,500 par-value treasury note that has a 10% coupon rate and is
expected to mature in 4 years. If the current price of the Treasury note is $1,200, calculate the
yield to maturity of the note.
A. 15.22%
B. 16.38%
C. 16.59%
D. 17.34%

24
58. Which of the given options is the most accurate reason why banks choose to use pooled average costs
approach to LTP?

A. It is a more straightforward method

B. It is simple, thus makes it easier for banks to understand and comply with the LTP process.
C. The average cost of funds approach is vulnerable to transitional changes in banks’ real market
cost of funding, therefore, minimizing net interest income deviation across all businesses.
D. All of the above

59. The stretch to which banks invest in one currency and fund in another via F.X. swaps is known as:

A. Cross currency funding

B. Funding gap
C. Carry trading
D. Hedging

60. Banks borrow short (i.e., take on customers deposits) and lend long (i.e., issue mortgages). This
process is known as maturity transformation. During the 2007-2008 financial crisis, many banks fell
because they were unable to meet the demand of customers wishing to withdraw their deposits. From
an analyst’s perspective, this is most likely to represent:

A. Balance sheet risk

B. Transactions liquidity risk
C. Systematic risk
D. Maturity transformation risk

25
 Risk Management and Investment Management

61. Over the past year, ABC fund had a return of 22.4%, while its benchmark, the S&P 500 index, had a
return of 21.8%. Over this period, the fund’s volatility was 13.3% while the S&P index’s volatility was
12.06% and the fund’s tracking error volatility (TEV) was 1.21%. Assume a risk-free rate of 6%. What
is the information ratio for the ABC fund, and for how many years must this performance persist to be
statistically significant at 95% confidence level?

A. 0.48 and approximately 17.5 years

B. 0.50 and approximately 15.37 years
C. 0.38 and approximately 1.5 years
D. 2.50 and approximately 5 years

62. Excel Investment Firm recently hired an active manager for its pension fund. Her benchmark is the
Russel 2000 growth index. Which of the following statistics are most suitable to evaluating the
manager’s performance and risk?

A. VaR and information ratio

B. Tracking error and sharpe ratio
C. Tracking error and information ratio
D. VaR and sharpe ratio

63. You are given the following information:

Country Economic growth Inflation Volatility

X High Low Low
Y Low High High

Which of the following is the best investment avenue for investors in country Y?

A. High-yield bonds
B. Government bonds
C. Investment-grade corporate and local municipal bonds
D. Stocks

64. The FIR Fund provides a large positive alpha. The fund can take leveraged long and short positions in
stocks. Given that the market went up over the same period, which of the following statements is
correct?

A. If the fund has net negative beta, all of the alpha must come from the market
B. If the fund has net positive beta, part of the alpha comes from the market
C. If the fund has net positive beta, all of the alpha must come from the market
D. If the firm has net negative beta, part of the alpha must come from the market

26
65. Richard Cryer, FRM, is a fund manager in New York. During a workshop with junior managers, he
made the following comments:

I. The correct way to compare transactions costs incurred on the annual rate of gain from alpha and
the annual rate of loss from active risk is to amortize the transactions costs where the rate of
amortization depends on the anticipated holding period.
II. The annualized transactions cost is given by round trip cost divided by the holding period in
years.

A. Only I is correct
B. Only II is correct
C. Both I and II are correct
D. Both I and II are incorrect

66. The BC&C pension fund has 60%, or about $21 billion, invested in equities. The fund measures
absolute risk with a 95%, one-year VaR, which gives $3.4545 billion, assuming a normal distribution
and volatility of 10% per annum. The fund would like to allocate this risk to two of its experienced
equity managers, each with the same VaR budget. Determine what the VaR budget for each manager
should be, given that the correlation between them is 0.5.

A. $2.0 billion
B. $3.4545 billion
C. $2.4427 billion
D. $1.7273 billion

67. Suppose you have a portfolio consisting of four distinct assets. The risk contribution of each is as
follows:

Asset Contribution
US large cap 6.3%
US small cap 6.6%
US government bonds 1.9%
Non-US bonds 2.1%

Which of the following would not be a valid explanation for the relatively high risk contribution
values for US equities?

A. High volatilities of US equities

B. High expected returns of US equities
C. High weights on US equities
D. High correlation of US equities with other assets in the portfolio

27
68. Quincy Maxwell, FRM, assumes that the joint distribution of returns is multivariate normal. He goes
ahead to calculate the following risk measures for a two-asset portfolio – Assets A and B.

Asset contribution Position Individual VaR Marginal VaR VaR contribution

A GBP 1,000 GBP 89.6 0.258 GBP 77.9
B GBP 1,000 GBP 179.2 0.546 GBP 175.0
Total GBP 2,000 GBP 268.8 GBP 252.9

𝜌𝑖𝑝 𝜎𝑖
Let 𝛽𝑖𝑝 =
𝜎𝑝

Where 𝜌𝑖𝑝 denotes the correlation between the return of asset i and the portfolio return, 𝜎𝑖 is the
volatility of the return of asset i, and 𝜎𝑝 is the volatility of the portfolio return.

The values of 𝛽𝐴 and 𝛽𝐵 are, respectively,

A. 0.5796 and 1.3021

B. 1.7388 and 1.9531
C. 0.1558 and 0.35
D. 0.1257 and 1.4512

69. Which of the following statements regarding the various portfolio construction techniques is correct?

A. Although screening ignores all information in alphas except the rankings, it limits transaction
costs through judicious choice of the buy, sell, and hold lists
B. The stratification technique provides superior risk control by overweighting the categories with
lower risks and underweighting the categories with higher risks
C. The linear programming approach characterizes stocks along dimensions of risk, and requires that
these dimensions distinctly and exclusively partition the stocks
D. Quadratic programming requires many more inputs than other portfolio construction techniques
and as a result minimizes both noise and the potential for poor calibration.

70. The following table presents selected financial information for a certain pension fund in India. The
fund has major investments in government and corporate bonds.

Pension Liabilities
Amount (in ₹ million) 500 410
Expected Growth Per Year 8% 9%
Modified Duration 14 12

28
 Annual Volatility of Growth 15% 8%

To establish whether the fund has sufficient surplus to meet its obligations to members, the fund’s
manager estimates the possible surplus values at the end of one year. The fund manager further
assumes that annual returns on assets and annual growth of liabilities follow a joint normal
distribution, and their correlation coefficient stands at 0.7. Based on this information, the manager can
report that, with 95% confidence, the surplus value will be less than or equal to:

A. ₹150 million
B. ₹205 million
C. ₹182 million
D. ₹187 million

71. Which of the following is most accurate about alpha?

A. Alpha is the average return of an asset in excess of the benchmark

B. Alpha is the return of an asset or a strategy in excess of the benchmark
C. Alpha is a measure of a portfolio manager's ability to generate excess returns relative to the
benchmark
D. None of the above

72. A portfolio has an alpha of 0.4 and a standard deviation per month for the nonsystematic risk equal to
3. What is the value of 𝑁 at a 95% level of significance?

A. 4 months
B. 14 months
C. 108 months
D. 216 months

29
 Current Issues in Financial Markets

73. The following methods are contained in elastic net regression as special cases, EXCEPT:

A. Logistic regression
B. Least absolute shrinkage and selection operator (LASSO)
C. Ridge regression
D. Ordinary least squares

74. Conventional statistical and econometric techniques work well in most cases regarding analysis of
computer-generated log data on economic transactions. However, there are particular difficulties in the
manipulation of those datasets. Name one of the troublesome factors.

A. Readability of datasets
B. Accessibility of datasets
C. Large amount of data in datasets
D. Human error factors in dataset generation

75. The following include some of the features of e-money that could lead to their rapid global adoption,
EXCEPT:

A. Ubiquity
B. Homogeneity
C. Convenience
D. None of the above

76. Which of the following is a more practical and potential regulatory and policy action that could
respond to the risks involved from the rapid adoption of e-money?

A. Require e-money providers to hold central bank reserves

B. Require e-money to be issued by commercial banks
C. Require e-money to be issued by central banks
D. None of the above

77. The people’s Bank of China and the China Securities Regulatory Commission introduced measures,
including redemption gates and liquidity fees, to reduce potential run risks associated with online
money market funds (MMFs). Which of the following is a key component of these measures?

A. Commercial banks were prohibited from selling online MMFs

B. NPIs were allowed to finance the T+0 redemption with their cash up to 50% of the amount.
C. NPIs were prohibited from engaging directly or indirectly in the sales of money market funds
D. All of the above.

30
78. Credit scoring tools that use machine learning are designed to speed up lending decisions, while
potentially limiting incremental risk. Which of the following would most likely be categorized as an
unstructured or semi-structured data source?

A. Social media activity

B. Credit scores
C. Data on financial transactions
D. Payment history from financial institutions

79. Which of the following is most likely what machine learning most likely deals with?

A. Whether the stock of a company will be higher one year from now
B. Which factors have driven the price of a particular stock
C. Which factors have driven the price of the overall bond market higher
D. Which economic factors positively influence the most the financial situation of developing
economies

80. Which of the following is a potential source of financial stability risks resulting from the emergence of
BigTech into financial services?

A. Issues arising from competition

B. Issues arising from dependencies
C. Issues arising from scale
D. All of the above

31