FRM

EXPLANATIONS – FULL LENGTH TEST - 2

PART I

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 Explanations – FRM Part I – Full Length - 2

Answer 1: Correct answer is C

Funding liquidity risk refers to the risk that an institution will not be able to:

§ raise cash necessary to make debt payments;

§ fulfill cash, margin, and collateral requirements of counterparties;
§ and meet capital withdrawals resulting in loss.

Answer 2: Correct answer is C

VAR is an ex-ante measure of risk. Notional limits cannot be aggregated across assets. An exposure limit
is not a predictive risk management measure. A stop-loss limit seeks to eliminate a position after a
cumulative loss threshold is exceeded.

Answer 3: Correct answer is D

VAR is the maximum expected loss for a given confidence level assuming normal market returns.

Answer 4: Correct answer is C

24 = 8 + β (16 − 8)
24 = 8 + 8β
16 = 8β
16 / 8 = β
β=2

Answer 5: Correct answer is B

The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This
straight efficient frontier line is called the capital market line (CML). Since the line is straight, the math
implies that any two assets falling on this line will be perfectly, positively correlated with each other. Note:
When ra,b = 1, then the equation for risk changes to sport = WAsA + W BsB, which is a straight line.
Answer 6: Correct answer is C

The measure of systematic risk is beta, and beta is proportional to the covariance of a security’s return
with the return on the market portfolio.

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Answer 7: Correct answer is D

When the uncertainty about firm performance that is not a result of management decisions and actions is
reduced, incentive compensation for management is a less-risky source of compensation for managers,
and they will accept a contract with lower expected incentive compensation as a result.

Answer 8: Correct answer is A

Financial distress will take up management time and energy and possibly lead to stricter terms from
suppliers and loss of Therefore, reducing the probability of financial distress can customers. increase firm
value.

Answer 9: Correct answer is A

The weak-form EMH assumes the price of a security reflects all currently available historical information.
Thus, the past price and volume of trading has no relationship with the future, hence technical analysis is
not useful in achieving superior returns.

The other statements are true. The strong-form EMH states that stock prices reflect all types of
information: market, non-public market, and private. No group has monopolistic access to relevant
information; thus no group can achieve excess returns. For these assumptions to hold, the strong-form
assumes perfect markets – information is free and available to all.

Answer 10: Correct answer is A

The strong-form EMH assumes all information, both public and private, is cost-free and available to all
investors at the same time.

Answer 11: Correct answer is D

The weak-form EMH suggests that technical analysis will not provide excess returns while the semi-
strong form suggests that fundamental analysis cannot achieve excess returns. The weak-form EMH
assumes the price of a security reflects all currently available historical information. Thus, the past price
and volume of trading has no relationship with the future, hence technical analysis is not useful in
achieving superior returns.

The other choices are correct. The strong-form EMH states that stock prices reflect all types of
information: market, non-public market, and private. No group has monopolistic access to relevant
information; thus no group can achieve excess returns. For these assumptions to hold, the strong-form
assumes perfect markets – information is free and available to all.

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Answer 12: Correct answer is A

E(R) = (0.03 × 1) + (-0.02 × -0.5) + (0.02 × 0.5) = 0.05

Answer 13: Correct answer is C

The CAPM assumes that:

§ investors are risk adverse.

§ there are no taxes or transaction costs.
§ returns are normally distributed.
§ investors’ expectations for risk and return are identical.

Answer 14: Correct answer is C

The collapse of Barings Bank was not an instance of flawed hedging models, but one of poor operational
control. Leeson had previously incurred huge trading losses that, if revealed, would have cost him his job.
In an effort to recover those losses, he abandoned his hedging strategies and speculated to recoup these
losses. His influence and authority in back office operations allowed him to hide his speculative losses
and report phantom profits. Leeson ignored and exceeded risk control limits, and senior management’s
lack of understanding about Leeson’s role and oversight allowed his schemes to go undetected.

Answer 15: Correct answer is C

In general, the Barings Bank collapse was the result of poor operational controls characterized by poor
reporting systems, weak management oversight, and poor organizational structure. Leeson’s dual
responsibility for trading and settlement enabled him to hide trading losses in accounts that were not
reported to management. Although a history of legal problems would have precluded him from trading on
the LIFE, he was permitted to trade in Singapore. Model risk and leverage were issues in LTCM. Using
short-term instruments to hedge long-term risk exposure was an issue in Metallgesellschaft.

Answer 16: Correct answer is B

Metallgesellschaft committed all three errors in its handling of its liquidity crisis.
Answer 17: Correct answer is D

Predatory trading occurs when other firms in a market see that a large player in the market is in trouble
and the other firms attempt to push the price down further in order to hurt the large player. Such activity is
difficult to incorporate into risk metrics.

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Answer 18: Correct answer is D

The role of risk management involves performing the following tasks: (1) Assess all risks faced by the
firm, (2) Communicate these risks to risk-taking decision makers, and (3) Monitor and manage these risks
(make sure that the firm only takes the necessary amount of risk).

Answer 19: Correct answer is C

According to Standard 3.1 and 3.2, confidentiality, a Member shall not make use of confidential
information for inappropriate purposes and unless having received prior consent shall maintain the
confidentiality of their work, their employer, or client.

Answer 20: Correct answer is B

According to Standard 1.3, GARP members must take reasonable precautions to ensure that Member's
services are not used for improper, fraudulent or illegal purposes.

Answer 21: Correct answer is B

To comply with Standard 3.1, Johnson must not discuss with her charitable foundation anything regarding
her client and her client's intentions. It does not matter that her client intends to give money to charities in
the near future.

Answer 22: Correct answer is B

To test the quality of an observation, a researcher would use a X = 0 or 1 variable that indicates whether
a condition exists or not. One name for this type of variable is a dummy variable.

Answer 23: Correct answer is B

For the four independent events defined here, the probability of the specified outcome is 0.5000 × 0.5000
× 0.1667 × 0.1667 = 0.0069.

Answer 24: Correct answer is B

The characteristic function of the sum of independent random variables is equal to the product of the
individual characteristic functions. E(XY) = E(X) × E(Y).

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Answer 25: Correct answer is A

The standard error of the mean = σ/√n = 0.16/√64 = 0.02.

Answer 26: Correct answer is B

The population standard deviation is the square root of the variance (√0.49 = 0.7). Because we know the
population standard deviation, we use the z-statistic. The z-statistic reliability factor for a 95% confidence
interval is 1.960. The confidence interval is $1.00 ± 1.960($0.7 / √36) or $1.00 ± $0.2287.

Answer 27: Correct answer is A

For a given series of n trials, the variance of X for a binomial random variable is equal to: np(1 – p) = npq,
where q is the probability of failure.

Answer 28: Correct answer is C

Even though normal curves have different sizes, they all have identical shape characteristics. The
kurtosis for all normal distributions is three; an excess kurtosis of three would indicate a leptokurtic
distribution. The other choices are true.

Answer 29: Correct answer is B

The sample regression function has a residual and not an error term. Although the residual and error term
serve a similar purpose in their respective equations, there are distinctions.

Answer 30: Correct answer is D

The coefficient of determination (R-squared) is the percentage of variation in the dependent variable
explained by the variation in the independent variable. The larger R-squared (0.90) of the first regression
means that 90 percent of the variability in the dependent variable is explained by variability in the
independent variable, while 70 percent of that is explained in the second regression. This means that the
first regression has more explanatory power than the second regression. Note that the Beta is the slope
of the regression line and doesn’t measure explanatory power.
Answer 31: Correct answer is A

The critical t-values for 40-3-1 = 36 degrees of freedom and a 5% level of significance are ± 2.028.
Therefore, only TEEN is statistically significant.

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Answer 32: Correct answer is B

GARCH(1,1) models have been shown to be useful in forecasting future volatility, which may indicate to
an option trader the relative value of an option price.

Answer 33: Correct answer is C

A Monte Carlo simulation uses a computer to generate random variables from specified distributions.

Answer 34: Correct answer is A

In order to account for simulations with multiple variables, it is possible to generate simulated variables
that are related by a correlation coefficient. This process can be extended to more than two variables
through a process known as the Cholesky factorization. However, the Cholesky factorization requires that
the covariance matrix be positive-definite for this process to be effective. It is also possible to use
principal components method to overcome difficulties in the Cholesky factorization method. Note that the
Cox, Ingersoll, Ross (CIR) model is a one-factor model of interest rate dynamics.

Answer 35: Correct answer is D

The payoff to a put option buyer is max (0, X – ST). Max (0, ST – X) is the payoff to a call option buyer. -
Max (0, ST – X) and -max (0, X – ST) are the payoffs to a call option seller and to a put option seller,
respectively.

Answer 36: Correct answer is B

Arbitrageurs attempt to earn a riskless profit by exploiting the mispricing of securities.

Answer 37: Correct answer is C

The initial investment for futures consists of the initial margin requirement. Options are sold at the option
premium.

Answer 38: Correct answer is A

Marking to market refers to revaluing a participant’s portfolio to market value at the end of each trading
day.

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Answer 39: Correct answer is D

Futures trades are done through open outcry on the futures exchange and require a buyer (long) and a
seller (short) for a trade to take place. The other statements are generally true for forward contracts,
which are all individually negotiated.

Answer 40: Correct answer is B

Once account margin (based on the daily settlement price) falls below the maintenance margin level, it
must be returned to the initial margin level, regardless of subsequent price changes.

Answer 41: Correct answer is C

Basis is defined as the difference between the spot price and the futures price. Weakening of the basis
occurs when the futures price increases relatively faster than the spot price

Answer 42: Correct answer is D

First, calculate the daily percentage VAR for stocks and corporate bonds:

Stocks: VAR(2.5%)Percentage Basis = z2.5% ´ σ = 1.96(0.018) = 0.0353 = 3.53%

Bonds: VAR(2.5%)Percentage Basis = z2.5% ´ σ = 1.96(0.011) = 0.0216 = 2.16%

Next calculate the portfolio VAR using weights of 35% for bonds and 65% for stocks:

2 2 2 2 0.5
[0.65 (0.0353 ) + 0.35 (0.0216 ) + 2(0.35)(0.65)(0.0353)(0.0216)(0.43)] = 0.0271 = 2.71%

Answer 43: Correct answer is C

The farmer needs to be short the futures contracts. The source of basis risk for this farmer arises from the
fact that his contract and harvest dates do not perfectly match. As a result, he will be exposed to basis
risk due to a necessary rollover in his position.
Answer 44:

Part 1) Correct answer is B

First, we need to calculate the periodic rate, or 0.09 / 2 = 0.045.

2
Then, the effective semi-annual rate = (1 + 0.045) − 1 = 0.09203, or 9.20%.

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Part 2) Correct answer is B

First, we need to calculate the periodic rate, or 0.09 / 4 = 0.0225.

4
Then, the effective annual rate = (1 + 0.0225) − 1 = 0.09308, or 9.31%.

Part 3) Correct answer is B

r 0.09
The continuously compounded rate = e − 1 = e − 1 = 0.09417, or 9.42%.

t nd x
Calculator Keystrokes for e : Using the TI BA, enter [0.09] [2 ] [e ] (this is the key with LN on the face of
x
the button). On the HP, enter [0.09] [g] [e ] (this key is located in blue on the key with 1/x in white print).

Answer 45: Correct answer is B

rT (0.032)(0.25)
The formula is: F0 = S0e . Using this formula we calculate the forward price as 750e = $756.

Answer 46: Correct answer is A

(0.02-0.04)(0.25)
The formula is: 1.2217e = $1.2156.

Foreign currencies are similar to index futures when it comes to computing the futures price. Since
exchange rates are driven by interest-rate differentials, the exchange rate can be treated as an asset that
pays a continuous rate, rf . More simply, interest-rate parity states that the forward exchange rate
(measured in $/ unit of foreign currency), F, must be related to the spot exchange rate, S, and the
interest-rate differential between the U.S. and the foreign country.

Answer 47: Correct answer is C

The cost of carry must be reduced by the dividends that are expected to be received while holding the
underlying stock.

Answer 48: Correct answer is A

This is a correct definition of accrued interest on bonds. The other choices are false. Accrued interest can
occur on all bonds with periodic coupon payments, not just bonds with payment frequencies greater than
one year. Accrued interest is not discounted when calculating the price of the bond. The statement,
"covers the part of the next coupon payment not earned by seller," should read, "…not earned by buyer."

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Answer 49: Correct answer is C

The accrued interest is paid by the new owner of the bond to the seller of the bond. If the buyer must pay
the seller accrued interest, the bond is said to be trading cum-coupon. Otherwise, it is trading ex-coupon.

Answer 50: Correct answer is B

Using the actual/actual convention there are 184 days between coupon payments and 104 days from
March 1 and June 13.

Accured interest: 104/184 × $8/2 = $2.26.

Answer 51: Correct answer is C

In a standard swap, the interest rate used to determine the floating rate payment is set at the beginning of
each period.

Answer 52: Correct answer is D

Credit risk is the main criticism of the comparative advantage argument, which fails to take into account
the fact that a swap participant faces credit risk.

Answer 53: Correct answer is A

The initial value of a swap is always zero. As interest rates move and payments take place, the value of
the swap will change for both parties.

Answer 54: Correct answer is D

American and European options are virtually identical, except exercising the European option is limited to
its expiration date only. The American option can be exercised at anytime on or before its expiration date.
For the exam, the key concept relating to this difference is the value of the American option must be
equal or greater than the value of the corresponding European option, all else being equal.

Answer 55: Correct answer is A

–rt –0.03 × 0.25

p = c + Xe – S = 2.49 + 42 e – 40 = $4.18

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Answer 56: Correct answer is B

T
According to put-call parity we can write a European call as: C0 = P0 + S0 – X/(1+Rf)

We can then read off the right-hand side of the equation to create a synthetic position in the call. We
would need to buy the European put, buy the stock, and short or issue a riskless pure-discount bond
equal in value to the present value of the exercise price.

Answer 57: Correct answer is C

A long straddle consists of a long call and put with the same exercise price and the same expiration, at a
stock price of $125 the put will expire worthless and the call value will be $25.

Answer 58: Correct answer is B

Bear spreads are those in which an option trader buys a high strike call option and sells a lower strike
call.

Answer 59: Correct answer is D

The covered call: stock plus a short call, or a short put. The term covered means that the stock covers the
inherent obligation assumed in writing the call. Why would you write a covered call? You feel the stock’s
price will not go up any time soon, and you want to increase your income by collecting some call option
premiums. To add some insurance that the stock won’t get called away, the call writer can write out-of-the
money calls. You should know that this strategy for enhancing one’s income is not without risk. The call
writer is trading the stock’s upside potential for the call premium. The desirability of writing a covered call
to enhance income depends upon the chance that the stock price will exceed the exercise price at which
the trader writes the call. This is similar reasoning to selling (or going short) a put. A put is in-the-money
when the exercise price is above the stock price. Since the seller of a put prefers that the buyer just pay
the premium and never exercise, the seller wants the price of the stock to remain above the exercise
price.

Answer 60: Correct answer is B

An exchange-for-physicals involves an agreement between long and short contract holders to settle their
respective obligations by delivery and purchase of an asset. It is executed off the floor of the exchange
and reported to exchange officials who then cancel both positions.
Answer 61: Correct answer is A

Arbitrage is the opportunity to trade in identical assets that are momentarily selling for different prices.
Arbitrageurs act quickly to make a riskless profit, causing the price discrepancy to be instantaneously
corrected. No capital is required, because opposite trades are made simultaneously.

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Answer 62: Correct answer is D

An arbitrage opportunity exists when a combination of two securities will produce a certain payoff in the
future that produces a return that is greater than the risk-free rate of interest. Borrowing at the riskless
rate to purchase the position will produce a certain future amount greater than the amount required to
repay the loan.

Answer 63: Correct answer is B

Natural gas is an example of a commodity with constant production but seasonal demand.

Answer 64: Correct answer is A

The oil refiner could enter into a strip hedge, by obtaining a long futures contract position for every month
of the year for 50,000 barrels. Alternatively, the oil refiner could create a long position of a near-term
futures contract for approximately 600,000 barrels.

Answer 65: Correct answer is A

The 6-month forward rate is calculated as follows:

Answer 66: Correct answer is C

By matching both the maturity and currency positions on its balance sheet, the bank has created a
situation where a net return is essentially locked in, no matter what happens to the exchange rate.

Answer 67: Correct answer is D

More assets than liabilities are held, and in this instance, the financial institution faces the risk that the FX
will fall.

Answer 68: Correct answer is B

A bank has a negative currency exposure if it holds more liabilities than assets in a given currency.

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Answer 69: Correct answer is D

Variance of export (not import) revenue is used in sovereign risk probability models.

Answer 70: Correct answer is B

Brady Bonds are bond for loan swaps

Answer 71: Correct answer is C

Interest rate risk is the risk that interest rates will increase, decreasing the price of certain investments,
including fixed-coupon bonds.

The other choices are examples of event risk, which refers to the possibility that there may be a single
event or circumstance that could have a major effect on the ability of an issuer to repay a bond obligation.

Answer 72: Correct answer is C

Zero-coupon bonds are quite special. Because zero-coupon bonds have no coupons (all of the bond’s
return comes from price appreciation), investors have no uncertainty about the rate at which coupons will
be invested. An investor who holds a zero-coupon bond until maturity will receive a return equal to the
bond’s effective annual yield.

Answer 73: Correct answer is C

Regular redemption and general redemption price are identical and refer to bonds being called according
to the provisions specified in the bond indenture. When bonds are redeemed to comply with a sinking
fund provision or because of a property sale mandated by government authority, the redemption prices
(typically par value) are referred to as "special redemption prices." There is no such thing as a specific
redemption price.

Answer 74: Correct answer is D

The Treasury does not issue zero-coupon notes or bonds. That is why STRIPS were created. A 5-year
Treasury note can be stripped into 11 zero coupon securities, consisting of its 10 coupon payments and
the principal repayment. The U.S. Internal Revenue Service regards the accrued interest on a zero
coupon security as income on which the security holder must pay taxes even though he has not received
a cash interest payment.

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Answer 75: Correct answer is B

Using the current five-year spot rate and the current four-year spot rate, we can derive the one-year
5 4 1
forward rate starting four years from today. The formula is: (1.061) /(1.059) = (1+R) – 1 = 0.069, or 6.9
percent.

Answer 76: Correct answer is B

PMT = 120; N = 10; PV = -880; FV = 1,000; CPT → I = 14.3

Answer 77: Correct answer is A

The price value of a basis point is the price given a 1 basis point change in the discount rate.
N = 20; PMT = 35; FV = 1,000; I/Y = 7.01/2 = 3.505; CPT → PV = 999.29
$1,000 – $999.29 = $0.71.

Answer 78: Correct answer is B

σ√t (0.1825)(1)
First, we need to calculate the size of an upward movement in the asset’s price as e =e = 1.20.
The size of a downward movement in the stock’s price is 1/1.20 = 0.83.

Next, we project the various paths the stock’s price can follow over the 3 year period. The stock has 4
potential ending values:

Suuu = $75 × 1.2 × 1.2 × 1.2 = $129.60

Suud = Sduu = Sudu = $75 × 1.2 × 1.2 × 0.83 = $89.64

Sudd = Sdud Sddu = $75 × 1.2 × 0.83 × 0.83 = $62.00

Sddd = $75 × 0.83 × 0.83 × 0.83 = $42.89

The only point at which the option finishes in the money is after 3 upward moves, which as a probability of
(0.60)(0.60)(0.60) = 0.216.

(-0.05)(3)
The value of the option today is therefore ($129.60 - $90) × 0.216 × e = $7.36.

Answer 79: Correct answer is D

This value is obtained using the Black-Scholes model for call option without dividends:

2
So d1=(ln(100/90)+(0.05+0.20 /2))/0.2√1=0.8768 and using the table, N(0.88)=0.8106. d2=0.8768-
0.2√1=0.6768, so from the table,N(d2)=N(0.68)=0.7517.

(-0.05)
So the call value is 100(0.8106)-90e (0.7517)=$16.71.

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Answer 80: Correct answer is A

The above diagram is for a long stock, long put strategy (portfolio insurance). The loss is limited to the
cost of the option while the potential upside profit is unlimited. Note that the portfolio insurance payoff
diagram is identical to the profit/loss diagram for a long call option, however a long call is not one of the
answer choices.

Answer 81: Correct answer is B

All of these are properties of a Coherent risk metric.

Answer 82: Correct answer is C

The following formula is used to calculate the VAR for a linear derivative: VARP = ΔVARf

The delta in the formula is a sensitivity factor that reflects the change in value of the derivatives contract
for a given change in the value of the underlying. The delta adjustment to the VAR of the underlying asset
accounts for the fact that the relative changes in value between the underlying and the derivatives may
not be one for one but nevertheless are linear in nature. Note that options are non-linear.

Answer :83 Correct answer is D

The value of a linear derivative has a constant linear relationship with the underlying asset. The
relationship does not need to be one-to-one but it must be constant (or approximately constant) and
linear. Forwards, futures, and swaps are generally linear. The value of a nonlinear derivative is a
function of the change in the underlying asset and depends on the state of the underlying asset. Options
generally are nonlinear.

Answer 84: Correct answer is A

Specific past losses may be less likely to be repeated in the future due to management attention and
response.

Answer 85: Correct answer is D

Scorecard data is developed by surveying the institution’s business line managers.

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Answer 86: Correct answer is C

Operating leverage models measure the risk that variable operating costs will increase by more than their
historical relation to asset growth would suggest. Although they are a class of expense-based models in
some sense, they do not relate expenses to macroeconomic factors. They are relatively objective (not
subjective) and do not capture reputational considerations or the opportunity costs. Scenario analysis
speculates about a set of possible catastrophic events.

Answer 87: Correct answer is C

Unidimensional scenario analysis evaluates the portfolio value for each scenario. The distinction between
unidimensional and multidimensional is that the latter incorporates correlation across risk factors for each
scenario. Unidimensional analysis quickly increases in computational burden as risk factors are added.

Answer 88: Correct answer is B

All statements are correct. Due to reputational concerns, in the context of overall stress conditions, a
bank may stand ready to inject credit or liquidity to an SPE or may take the structured assets on its
balance sheet from the SPE, which in turn may significantly increase liquidity pressures for a bank itself.

Deteriorating market stress conditions may inhibit a bank’s ability to liquidate assets, without loss, to fulfill
its liquidity needs.

During the recent turmoil, banks were forced to park assets on their balance sheets, which they could not
securitize due to deteriorating securitization markets conditions.

Ineffective hedge, due to change in basis, can result in significant loss as a result of unprotected decline
in underlying asset value giving rise to liquidity concerns.

Answer 89: Correct answer is C

Any investment rated below BBB is considered to be speculative. Therefore, the highest (least risky)
speculative rating as assigned by S&P is BB. Ba is the least risky speculative rating assigned by Moody’s.

Answer 90: Correct answer is A

The purpose of through-the-cycle approaches is to have a longer horizon that averages out the effect of
the business cycle.

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Answer 91: Correct answer is A

Political risk is the relationship between the constitution of a country and the means by which it is
enforced. In some countries, the constitution is held in high esteem, while in others the constitution is
used as a vehicle for governments to achieve their goals, not the wants and needs of its citizens.

Answer 92: Correct answer is A

Cross-default provisions treat a default on one loan as a default on all. This keeps sovereigns from
defaulting on obligations due to weak creditors and forcing concessions from them.

Answer 93: Correct answer is D

Decreasing the recovery rate and increasing the probability of default will increase expected loss.
Decreasing/increasing the recovery rate and decreasing/increasing the probability of default may increase
or decrease expected loss depending on the relative change in the factors. Finally, increasing the
recovery rate and decreasing the probability of default will unambiguously DECREASE expected loss.

Answer 94: Correct answer is D

The standard default model assumes a two-state (binary) default process. Therefore, the variance = EDF
0.5
× (1 − EDF) = (0.12) × (1 − 0.12) = 0.1056. Thus, standard deviation of default frequency (0.1056) =
0.3496.

Answer 95: Correct answer is C

In a simple regression, the coefficient of determination is calculated as the correlation coefficient squared
and ranges from 0 to +1.

Answer 96: Correct answer is B

The formulas are both correct, and it is not necessary to adjust for degrees of freedom:

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Answer 97: Correct answer is A

Increased volatility positively influences put and call option values, while a decrease in time to expiration
will negatively influence call and put prices. Note that an increase in the stock price and an increase in the
risk-free rate will cause the price of an American call to increase but will cause the price of an American
put to decrease.

Answer 98: Correct answer is C

Predicted sales = $10 + 1.25 + 1 – 10 + 16 = $18.25 million.

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