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FRM Part I Exam

By AnalystPrep

Questions with Answers - Foundations of Risk Management

Last Updated: Mar 20, 2023

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Table of Contents

1 - The Building Blocks of Risk Management 3

2 - How Do Firms Manage Financial Risk? 15
3 - The Governance of Risk Management 27
4 - Credit Risk Transfer Mechanisms 41
Modern Portfolio Theory (MPT) and the Capital Asset Pricing
5 - 53
Model (CAPM)
The Arbitrage Pricing Theory and Multifactor Models of Risk
6 - 98
and Return
7 - Risk Data Aggregation and Reporting Principles 114
8 - Enterprise Risk Management and Future Trends 129
9 - Learning From Financial Disasters 144
10 - Anatomy of the Great Financial Crisis of 2007-2009 169
11 - GARP Code of Conduct 210

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Reading 1: The Building Blocks of Risk Management

Q.1 Which of the following liquidity definitions is most likely associated with market liquidity?

A. T he risk that a bank will not be able to roll over a repo to finance their short-term cash
flow needs.

B. T he risk that depositors will flock into banks and withdraw their funds or that
shareholders will redeem their shares en masse.

C. T he risk that the collateral value of an asset will decline after a derivative position is
established, resulting in an increase in the margin requirement.

D. T he risk that an investor who lends out an asset will be forced to sell at a lower price
once the asset is returned.

T he correct answer is D.

Market liquidity risk (trading liquidity risk) is the risk of a loss in asset value when markets
temporarily seize up. In these circumstances, a market participant cannot execute a trade or
liquidate a position immediately while hitting the best price. T he seller may be forced to accept an
abnormally low price, and in some cases, the ability to convert the asset into cash may be taken
away from them entirely. If an investor lends out an asset (to facilitate a short sale), they may be
forced to sell it at a much lower price after getting it back if the trading volume declines due to
changes in one or more market factors (e.g., interest rates and inflation).

Opti ons A, B and C are i ncorrect since they all describe funding liquidity risk.

Thi ngs to Remember

Funding liquidity risk is all about liabilities, including short-term debt sought in form of repos. It's all

to do with the ability of a firm to fund its liabilities. In fact, the International Monetary Fund (IMF)

defines funding liquidity as "the ability of a solvent institution to make agreed-upon payments in a

timely fashion."

On the other hand, market or asset liquidity risk is all about asset illiquidity. Can you sell an asset

when you want to, and in so doing, does the sale fetch the asset's fair price? For example, a property

you own may, due to poor market conditions, need to be sold at a fire sale price. Certainly, there's

value in the asset, but as buyers have temporarily disappeared, not all of that value can be realized.

Q.2 Which of the following is NOT a type of market risk?

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A. Interest rate risk

B. Foreign exchange risk

C. Equity price risk

D. Liquidity risk

T he correct answer is D.

Market risk is the possibility of loss resulting from market movements, whereas liquidity risk is the
risk that a financial instrument cannot be traded quickly enough to avoid a loss (or take advantage of a
price increase and make a profit). Market risks include equity risk, currency risk, interest rate risk,
and commodity price risk.
Further expl anati on

Market risk refers to the risk that the value of an investment or portfolio may fluctuate due to

changes in the market, such as changes in the price of the underlying assets, interest rates, or

exchange rates. Market risk can be caused by a variety of factors, including economic conditions,

political events, and natural disasters.

T here are several types of market risk that investors and portfolio managers may need to consider

when making investment decisions. Some common types of market risk include:

Interest rate risk: T he risk that changes in interest rates will affect the value of an

investment. For example, an investor holding a bond with a fixed interest rate may

experience a decrease in the value of their investment if market interest rates rise.

Foreign exchange risk: T he risk that changes in exchange rates will affect the value of an

investment. For example, an investor holding a foreign currency may experience a

decrease in the value of their investment if the value of the currency falls relative to the

investor's domestic currency.

Equity price risk: T he risk that changes in the prices of stocks or other equity

instruments will affect the value of an investment. For example, an investor holding a

portfolio of stocks may experience a decrease in the value of their investment if the stock

market declines.

Liquidity risk, on the other hand, refers to the risk that an asset or financial instrument cannot be

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sold or traded quickly enough to avoid a loss or take advantage of an opportunity. T his can occur if

there are not enough buyers or sellers in the market to facilitate the trade, or if the asset is difficult

to value or assess.

Q.3 After the United Kingdom voted to leave the European Union in 2016, the British pound
weakened against other currencies like the U.S dollar and the Chinese Yuan. Which one of the
following risks best explains this observation?

A. Interest rate risk

B. Foreign exchange risk

C. Reputation risk

D. Equity risk

T he correct answer is B.

Foreign exchange risk is the risk that the foreign exchange rate will change, which in turn affects

the value of a financial instrument or asset held in that currency. In the aftermath of ''Brexit,''

investors were generally pessimistic about the economic stability of the U.K, for instance, because

of the anticipated shattering of decades-old trade deals between the U.K and other European

countries, coupled with the uncertainty associated with renegotiating new bilateral links with

individual countries. T his loss of confidence led to the weakening of the pound.

Opti on A i s i ncorrect: Interest rate risk is the risk that arises from fluctuations in the market

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

Opti on C i s i ncorrect: Reputation risk is the risk that a business will suffer a sudden fall in its

brand which may lead to loss of customers.

Opti on D i s i ncorrect: Equity risk is the risk associated with the volatility in the stock prices.

T he market risk component is the sensitivity of the equity or a portfolio to a change in the level of a

market index.

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Q.4 Which of the following is an example of market risk?

A. Inadequate/malfunctioning computer systems

B. Circumvention of issued regulations and guidelines

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

D. An increase in the price of gas

T he correct answer is D.

An increase in the price of gas is an example of market risk. Market risk is the risk that results due
to continuous movements in market prices and rates.

Operational risk refers to the possibility of incurring losses resulting from operational breakdowns

caused by either internal or external factors. Operational risks include legal risk, anti-money

laundering risk, cyber risk, and rogue trading. Moreover, operational include corporate disasters such

as operational mishaps and corporate governance scandals.

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

because it refers to a failure within the organization's internal processes or systems that can result

in losses.

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

because it refers to the possibility of incurring losses due to non-compliance with regulations and

guidelines.

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

risk because it refers to the possibility of losses due to external events beyond the control of the

organization.

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Q.5 Which of the following best describes enterprise-wide risk management?

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

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

C. A structured and consistent set of principles or risk management that are applied across
the whole of a company.

D. Risk management that encompasses all business units.

T he correct answer is C.

Enterprise-wide risk management involves the development of structured and consistent business

principles that govern the way different business units of a company do business, in regard to risk by

applying consistent risk management principles across the whole of a company, all risks, including

inter-departmental risks, are taken into account.

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

form of silo-approach, in which different departments/business units are left to manage risks on their

own.

B i s i ncorrect: Enterprise risk management includes not only major departments in a company but

also other minor departments.

D i s i ncorrect: Enterprise risk management involves applying risk management to all business

units.

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Q.6 Which of the following is the correct definition of risk management in the context of financial
markets?

A. T he practice of creating economic value by identifying and investing in risky projects that
could earn a profit.

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

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

formulating robust plans to address and manage these risks.

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

T he correct answer is C.

Risk management entails creating economic value by qualitatively and quantitatively identifying and
measuring all major risks associated with a business. It goes further to suggest ways of addressing
these risks. It differs from risk-taking, which only entails investing in risky but profitable financial
ventures.

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Q.7 Tohonday, a motor vehicle production company, has historically channeled most of its earnings
and spare cash into short-term government bonds maturing in less than a year. T he board wishes to
change its investment policy substantially and intends to tap the riskier but more profitable long-term
bond market. Assuming you're the risk manager for the company, which of the following risks would
be of utmost (immediate) concern from an operational point of view?

A. T rading liquidity risk

B. Funding liquidity risk

C. Interest rate risk

D. Market risk

T he correct answer is B.

Financial institutions do not always fail because of the inability to generate a profit. Rather, it's the

inability to meet short-term financial obligations that often leads to bankruptcy. T his is known as

fundi ng l i qui di ty ri sk . Suppose Tohonday decides to invest in long-term assets, in that case, it

must take into account its day-to-day funding requirements, especially because funds invested in long-

term assets cannot be realized quickly enough to meet short-term debts and other unforeseen

obligations, such as lawsuits. T his is particularly true when we consider that over the last couple of

years, several motor-vehicle production companies like Toyota have had to recall some models due

to mechanical glitches, sometimes compensating customers in the process.

A i s i ncorrect.T rading liquidity risk (also called market liquidity risk) is the risk associated with the

inability of a firm to execute transactions at the prevailing market price. It may reduce the

institution's ability to hedge market risk, and also it is the capacity to liquidate assets when

necessary.

C i s i ncorrect: Interest rate risk is the risk that arises from fluctuations in the market interest

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

D i s i ncorrect: Market risk is the risk that results due to movements in market prices and rates

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Q.8 Distinguish between expected loss and unexpected loss.

A. Expected loss is the average credit loss we expect from an exposure while unexpected
loss is the loss that occurs over and above the expected loss.

B. Unexpected loss is the average credit loss we expect from an exposure while expected
loss is the loss that occurs over and above the unexpected loss.

C. Expected loss is the average credit loss that we would expect from an exposure while
unexpected loss is the loss that would occur without a quantitative expression.

D. Expected loss is the average credit loss that we would expect from an exposure while
unexpected loss is the sum of expected losses from several time periods.

T he correct answer is A.

Expected l oss is simply the average loss that we would expect from a given exposure over a period

of time.

Unexpected l oss is the amount of loss that actually exceeds the expected amount.

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Q.9 Which of the following statements best explains the relationship between investment risk and
reward?

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

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

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

D. T he relation between investment risk and reward depends on the financial product.

T he correct answer is C.

Investment risk and reward often move together.

T he amount of risk and the potential for return are positively correlated. In other words, an increase

in the amount of risk increases the amount of potential reward. However, there is no guarantee that

an increase in the amount of risk increases the amount of reward. Greater risks may result in losing

large amounts of capital.

It is worth noting that, there is a high trade-off between risk and return.

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Q.10 Which of the following risks does not fall under the larger category of credit risk?

A. Settlement risk

B. Downgrade risk

C. Upward risk

D. Default risk

T he correct answer is C.

Credit risk results from the failure of a counterparty to meet contractual obligations. It is subdivided

into default risk, bankruptcy risk, downgrade risk, and settlement risk.

Upward risk refers to the possibility that a particular situation or decision could result in outcomes

that are more positive than expected or planned. It is often used in the context of financial risk

management, where it describes the possibility of unexpected gains or losses that exceed

expectations.

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Q.11 Which of the following combinations correctly matches a quantifiable risk with a non-
quantifiable (qualitative) risk?

A. Quantifiable: Interest rate risk; Non-quantifiable: Default risk

B. Quantifiable: Civil war; Non-quantifiable: Liquidity risk

C. Quantifiable: Equity price risk; Non-quantifiable: Risk of terrorist attack

D. Quantifiable: Civil war; Non-quantifiable: Settlement risk

T he correct answer is C.

Quantifiable risks are those that can be measured in some way. For instance, we can specify the

likelihood of borrower default and even specify the distribution function. On the other hand, non-

quantifiable risks are those risks that cannot be measured.

Opti on A i s i ncorrect: both interest rate risk and default risk are quantifiable risks.

Opti on B i s i ncorrect: civil war is a non-quantifiable risk while liquidity risk is a quantifiable risk.

Opti on D i s i ncorrect: civil war is a non-quantifiable risk while settlement risk is a quantifiable

risk

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Q.12 T he following scenarios describe conflicts of interest in risk management. Which one does not?

A. T he risk manager whose remuneration package includes stock options may overlook some
risks inherent in a project with an eye on higher earnings when the stock price rises.

B. Lenders wish to see the company invest in less risky projects while shareholders support
more risky ones.

C. T he risk manager deliberately avoids riskier investments in favor of less risky ones to
reduce chances of business failure and, therefore, safeguard their job security.

D. T he risk manager sidelines environmentally harmful projects in order to safeguard the

company's reputation and brand value.

T he correct answer is D.

A conflict of interest occurs when the interests of one party are in direct collision with those of
another party within the business environment. Such conflicts usually manifest in the form of
objectives that are at variance with the desires of some other stakeholder in the organization. While
choices A, B, and C clearly outline possible conflicts of interest, an attempt to avoid environmentally
harmful projects does not constitute a conflict of interest. In fact, it bodes well with the interests of
the government and the community in general.

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Q.14 Distinguish between systemic and specific risks.

A. Systemic risk refers to the risks that affect the entire economy, while specific risks are
risks that affect only a particular company or line of business.

B. Systemic risks are risks borne by a single entity while specific risks are borne by the
economy as a whole.

C. Systemic risks are quantifiable while specific risks are non-quantifiable.

D. Systemic risk can be minimized with diversification while specific risk can not be
diversified away.

T he correct answer is A.

Systemi c ri sk s are associated with the failure of a major company e.g. the failure of a major

financial institution which may cause other inter-linked banks to fail hence causing harm to the

entire economy. Another example could also be the oil and gas industry.

Speci fi c ri sk s, on the other hand, refer to risks that affect only a single business sector or

company. Such risks may include employee strikes and the scarcity of individual inputs.

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Q.15 At the center of every financial institution's focus lies the need to instill confidence in all
stakeholders, including customers, lenders, shareholders, and others. Each party should feel that its
interests are safeguarded. Which type of risk do companies face in this regard?

A. Legal and regulatory risk

B. Reputation risk

C. Specific risk

D. Operational risk

T he correct answer is B.

Reputation risk concerns itself with the need to fulfill promises made to counterparties and

creditors and adherence to fair and ethical business practices. Departure from these things can

damage the reputation of the company and reduce its brand value.

Opti on A i s i ncorrect: Legal and regulatory risk entails going against stipulated laws, rules, and

regulations. T he government, through designated regulatory bodies, enforces these rules to

safeguard the safety of consumers and ensure fair competition among businesses in the same

industry.

Opti on C i s i ncorrect: Specific risk is a risk that occurs to a particular business, firm, industry, or

sector only.

Opti on D i s i ncorrect: Operational risk refers to the risk that arises due to operational

weaknesses like management failure, faulty controls, inadequate systems etc. Human factor risk is

one of the essential operational risks, and it results from human errors like entering wrong

parameter values, using wrong controls etc.

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Q.31 During a job interview for the position of risk analyst, Lee Yung was asked to state the stages of
the risk management process. Which of the following statement made by Lee is correct?

A. the risk management process ends with identifying the risk

B. the second stage of the risk management process is rank and measure the risks

C. transferring risks to first parties is the third stage

D. assessing effects and repercussions of the risks is the third stage

T he correct answer is D.

T he risk management process has four stages:

i. Identi fy. T his involves naming, categorizing, and understanding the risks.
ii. Anal yze. T his involves ranking, scoring, measuring and quantifying the risks.
iii. Assess i mpact. T his involves assessing the impacts, knock-on effects, and repercussions
of risks.
iv. Manage. T his involves avoiding, retaining, mitigating or transferring the risks.

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Q.33 T he purpose of economic capital is to absorb:

A. economic losses

B. expected loss

C. unexpected loss

D. tail loss

T he correct answer is C.

Economic capital is the amount of capital a bank needs to maintain to absorb the impact of

unexpected l osses during a time horizon at a certain level of confidence.

It should be noted that economic capital is the amount of capital required by a firm based on its

understanding of its economic risk. Economic capital enables the firm to balance between risk and

reward.

A i s i ncorrect. Economic losses refer to the financial costs or damages incurred as a result of an

event that negatively impacts the economy or an economic entity.

B i s i ncorrect. Expected loss refers to the estimated loss that an individual or an organization is

likely to incur from a particular event or activity. It is a calculation that takes into account the

probability of an event occurring and the potential impact it would have on the individual or

organization.

D i s i ncorrect. Tail losses are events that are unlikely to occur, but if they do, they can have a

significant impact on an individual or organization.

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Q.34 Which of the following is NOT the definition of risk measurement tools and procedures used by
a firm to measure and manage risk?

A. VAR is the maximum loss over a target horizon such that there is a low, prespecified
probability that the actual loss will be larger.

B. Scenario Testing is a quantitative risk measurement that takes into consideration potential
risk factors such as interest rate, payroll data, etc. that are often quantifiable and focussed
on frequency.

C. Stress Testing is both a qualitative and quantitative risk measurement tool that analyses
the financial outcome of a firm based on a given stress

D. Enterprise Risk Management (ERM) is an integrative risk measure approach that

considers entity-wide risk factors and integrates all the risk factors in entity-wide decisions

T he correct answer is B.

T he definition of Scenario Testing is incorrect: It is a risk measure that considers the potential risk

factors that are often quantifiable, but the numbers are all focused on assessing severity rather than

frequency". All other definitions of risk measurement tools are correct.

Further information:

Scenario testing is a software testing activity that uses scenarios: hypothetical stories to help the

tester work through a complex problem or test system. T he ideal scenario test is a credible,

complex, compelling, or motivating story, the outcome of which is easy to evaluate.

Additionally,

Enterprise management risk (ERM) is the process of planning, organizing, leading, and controlling the

activities of an organization in order to minimize the effects of risk on an organization's capital and

earnings as a whole. It overcomes the challenge of "siloed" risk management, where each unit of an

institution manages its own risk independently.

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Q.35 T he relationship between risk and return is simple for some assets and complex for others.
T he public perception of risk and return trade-off is that higher risk will lead to higher returns.
However, in some asset classes like fixed-income securities, a large number of factors such as
market risk, inflation, interest rate risk, and risk tolerance are considered. Which of the following
options is most appropriate for a market with investors having a high risk tolerance?

A. As the risk tolerance of investors is high, more investors will choose corporate bonds
over government bonds

B. As the risk tolerance of investors is high, more investors will choose government bonds
over corporate bonds

C. As the risk tolerance of investors is high, all investors will choose a good mix of corporate
and government bonds

D. As the risk tolerance of investors is high, all investors will choose not to buy corporate
bonds

T he correct answer is A.

When the risk tolerance of the investors is high (or their willingness to take the risk is high),
investors will choose to buy more corporate bonds, which have higher risk and higher reward as
compared to government bonds. In practice, government bonds of financially stable countries are
treated as risk-free bonds, as governments can raise taxes or indeed print money to repay their
domestic currency debt. For instance, United States T reasury notes and United States T reasury
bonds are often assumed to be risk-free bonds.

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Q.36 Equity price risk is the type of market risk that refers to the variability in the prices of equity
or stocks. Equity price risk is further subdivided into specific risk and systematic risk. Which of the
following is most likely a type of specific risk?

A. T he risk of changes in the consumer price index (CPI).

B. T he risk of change in the aggregate demand of a specific sector.

C. T he risk of strategic weaknesses in a business.

D. T he risk of changes in tax rates.

T he correct answer is C.

T he risk of strategic weaknesses in a business is a specific risk to the firm. T herefore, it is the most

likely form of specific risk from the given choices.

Opti on A i s i ncorrect because changes in CPI or inflation will affect the overall market prices.

Opti on B i s i ncorrect because the change in the aggregate demand of a sector will change the

general market risk of that sector.

Opti on D i s i ncorrect as the changes in tax regulations will change the general market risk.

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Q.37 BT Motors and New Atlas bank are two parties of a derivative contract to hedge exchange rate
risk. At the end of the contract, BT Motors has a net loss position of $6.9 million but refused to pay
the entire amount. Which of the following sub-types of credit risk best describes this situation?

A. Bankruptcy risk.

B. General market Risk.

C. Settlement risk.

D. Default risk.

T he correct answer is C.

Settlement risk arises when a counterparty refuses or is unable to pay its commitments at the

settlement date.

Opti on A i s i ncorrect: Bankruptcy risk refers to the case when the liquidation value of assets is

less than liabilities.

Opti on B i s i ncorrect: General market risk is the risk associated with the potential reduction in

the value of a portfolio or security due to changes in financial market prices and rates

Opti on D i s i ncorrect: Default risk refers to non-payment of interest or loan by a borrower.

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Reading 2: How Do Firms Manage Financial Risk?

Q.16 In the modern world, it's common to find companies using derivatives for risk management. T he
following are theoretical arguments against the use of derivatives to manage risks. Which one is not a
direct objection to their use?

A. Hedging using derivatives requires specialized skills, knowledge and infrastructure,

besides involving massive data acquisition and processing.

B. Aggressive hedging may distract a company's management from its core business leading to
low productivity.

C. Risk managers may prioritize personal interests at the expense of the shareholders.

D. T rading in derivatives comes with compliance costs, strict accounting regulations and
compulsory financial disclosures that can reveal key business strategies to competitors.

T he correct answer is C.

T he use of derivatives for risk management has practical objections. However, the interests of
managers and shareholders do not prominently feature in such a strategy. Furthermore, the
shareholders may put in place the so-called 'motivators' to streamline their interests with those of
the managers.

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Q.18 Which of the following statements best describes the concept of hedging in risk management?

A. Buying an asset to offset a decline in value of another asset.

B. Holding an asset that appreciates in value to offset the decrease in the value of another
asset.

C. Selling a loss-making asset and replacing it with a profitable one.

D. Holding an offsetting position in an asset or portfolio whose value we expect to move in

line with market changes.

T he correct answer is D.

Hedging entails any action taken to safeguard the value of an asset in the face of changing market

prices. It's actually an attempt to "lock-in" the value of an asset. T he investor protects their

investment by holding assets that have a predetermined future price.

Opti on A i s i ncorrect: Buying an asset to offset a decline in the value of another asset refers to

diversification.

Opti on B i s i ncorrect: Holding an asset that appreciates in value to offset the decrease in the

value of another asset is also a diversification method.

Opti on C i s i ncorrect: Selling a loss-making asset and replacing it with a profitable one is a form of

Profit/Loss strategy.

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Q.19 An international construction company places a bid for a major construction project. Top
management is convinced the company will secure the contract but are also wary of currency
fluctuations during the bids evaluation process, which would make the project more costly and
reduce the profit margin. Which of the following actions do you think can reduce this risk?

A. Negotiating the price of construction materials with sellers in advance

B. Purchasing construction materials in advance with the option to sell them if the bid turns
out unsuccessful

C. Getting into a currency futures contract

D. Adding a risk premium to the bid amount

T he correct answer is C.

Using a currency futures contract, the company can price the bid quoting current market rates and

then use the futures contract to hedge its exposure to currency fluctuation. T his way, the company

would ensure that even if the market rates change, the bid would be sufficient to undertake the

project and earn a profit.

Opti on A i s i ncorrect: prices may be negotiated in advance; however, without a contract, then you

will still buy the materials at the prevailing market prices in case the prices rise, since stocks may

also rise in price.

Opti on B i s i ncorrect: A lot may happen with time. T he price of the materials may rise, and

therefore purchasing construction materials in advance with the option to sell them if the bid turns

out unsuccessful will not help reduce the risk.

Opti on D i s i ncorrect: the owner of the project pays the risk premium in advance and if the risk

does not materialize, then this will only benefit the contractor of the project

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Q.20 Pick the piece of information likely to be omitted from a firm's risk appetite description.

A. T he types of risks the firm is willing to tolerate, specifying the risks to hedge and the ones
to assume

B. T he preferred risk management tools e.g, insurance, derivatives, etc.

C. T he maximum loss the firm is willing to incur at a given confidence limit and time

D. T he timings of cash flows from the firm's projects

T he correct answer is D.

A firm's risk appetite statement details:

its risk management framework,

specifying the tolerated risks and hedging tools,

the desirable rates of return. and also

the loss limit of projects.

T he timings of cash flows may not be quoted in advance as each project is likely to have its unique

capital outlay and duration.

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Q.22 Swiss Inc. is an international company that sells goods to international customers, sometimes
under suitable credit agreements. As a result, the company usually hedges the resulting currency and
interest rate risks using various instruments like futures. Which of the following actions is l east
l i k el y to form part of the company's risk mapping exercise at the start of the financial year?

A. Developing the risk appetite statement

B. Developing a list of assets and liabilities, specifying the relevant currencies

C. Developing appropriate financial instruments to hedge the risks

D. Map out the risks in every undertaking

T he correct answer is A.

Developing a risk appetite statement does not form part of the risk mapping process. Instead, it

comes way before. In general, the risk management process takes several steps:

1. Devel opi ng a ri sk appeti te statement, where the firm sets out the risks it is willing to

tolerate, that is, which risks should be hedged and which risks the company should assume as

part of its business strategy.

2. Ri sk mappi ng, where the firm identifies all its existing exposures and maps out the risks in

every undertaking, as guided by the risk appetite statement. In other words, at this stage, the

firm looks at its engagements and asks: "In each of these engagements, what risks do we face

that are within the dictates of our risk appetite statement?"

For example, let us assume that the risk appetite statement developed by the board has

decided to hedge currency risks arising from current positions and expected transactions in

the next year. At the risk mapping stage, the office of the chief financial officer of the firm

will have to map the specific risks likely to arise from exchange rate fluctuations. It should

mak e a record of al l assets and l i abi l i ti es with values that are sensitive to exchange

rate changes and should classify all these positions in terms of the relevant currency.

After this, it can fi nd the appropri ate fi nanci al i nstrument to hedge these ri sk s.

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Q.23 Distinguish between exchange-traded and over-the-counter risk management instruments.

A. Exchange-traded instruments are standardized and exchange-tradable while over-the-

counter instruments are non-standardized, privately negotiated financial contracts that
cannot be traded on an exchange.

B. Over-the-counter instruments are standardized and exchange-tradable while exchange-

traded instruments non-standardized, privately negotiated financial contracts that cannot be
traded on an exchange.

C. Exchange-traded instruments are those instruments that only deal with intangible financial
assets while over-the-counter instruments only deal with commodities such as coffee.

D. Exchange-traded instruments have time to maturity of less than one year while over-the-
counter instruments have longer maturity periods.

T he correct answer is A.

As the name suggests, exchange-traded instruments can be traded on an official exchange (such as the

New York Stock Exchange) because they are standardized and only comprise a limited number of

assets. T he strike price and maturity values are set in advance to ''commoditize'' the assets and

promote a liquid market. A good example might be options.

Over-the-counter instruments are negotiated privately between two parties who agree to trade an

asset at a specified price in the future. Negotiations help the parties to come up with a tailor-made

contract that suits the interests of both parties. A good example might be forwards.

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Q.24 A reputable bank is approached by a newly-formed private company wishing to enter into an
option contract on the British pound. T he bank's risk managers prefer an exchange-traded option to
an over-the-counter one. Which of the following statements least likely explains the managers'
preference?

A. Price discovery

B. Counterparty risk

C. Flexibility in settlement

D. Liquidity

T he correct answer is C.

Exchange-traded derivatives have several disadvantages over over-the-counter (OT C) derivatives.

T hese include:

T ransparency. Exchange-traded contracts are transparent, as the exchange publishes

information on trading volumes and prices.

Liquidity. Exchange-traded contracts are usually more liquid than OT C contracts, as there

are many market participants

Standardization. In exchange-traded contracts are standardized, meaning that the terms and

conditions of the contract are the same for all market participants.

Price discovery. Exchange-traded contracts provide a mechanism for price discovery, as

buyers and sellers interact in a centralized market.

Flexibility in settlement is an advantage of over over-the-counter (OT C) derivatives over Exchange-

traded derivatives. OT C contracts can be settled in a variety of ways, such as cash settlement,

physical delivery, or a combination of the two.

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Q.25 A firm borrows funds at a variable interest rate. Buying which of the following instruments
would help the firm protect itself against increases in the market rate of interest?

A. Currency forward contracts

B. Options on interest rate futures

C. Currency swaps

D. Currency futures contracts

T he correct answer is B.

T he risk that a firm faces when borrowing money is that the interest rates may increase so that it

has to pay more interest on its loan.

T he price of an interest rate future moves inversely to the change in interest rates. If interest rates

go down, the price of the interest rate future goes up and vice-versa.

A put option on one of these interest rate futures (the right to sell an interest rate future at a later

date) would effectively hedge the position. If the rate of interest falls, the firm will not exercise its

right to sell and just enjoy paying the lower interest rate.

A i s i ncorrect: Currency forward contracts helps to mitigate foreign exchange risk.

C i s i ncorrect: Currency swap is also used to hedge against foreign currency risk.

D i s i ncorrect. Currency futures contracts also referred to as foreign exchange futures are a type

of futures contract to exchange a currency for another at a fixed exchange rate on a specific date in

the future. T his is not optional and therefore the firm would incur losses if interest rates were to

decrease.

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Q.26 Which of the following is not a common characteristic of interest rate swaps?

A. Payments made by both parties are in different currencies

B. T he contract is usually based on a ''notional'' principal amount

C. T hey trade over the counter

D. Interest rate swaps are used to hedge against or speculate on changes in interest rates.

T he correct answer is A.

Payments made by counterparties in an interest rate swap must be in the same currency. T his is one

of the main differences between currency swaps and interest rate swaps.

T he following are characteristics of interest rate swaps:

i. T he contract is usually based on a ''notional'' principal amount which remains the same over
the entire lifetime of the swap.
ii. T hey are over-the-counter financial instruments.
iii. Interest rate swaps are used to hedge against or speculate on changes in interest rates
iv. Counterparties negotiate and agree on the fixed-rate and day-count conventions at the
conclusion of the swap contract
v. T he swap duration can go from one week to 30 years.

Q.29 A construction firm wishes to enter into cleared derivative positions to manage risks such as
price variation of raw materials and increase interest rates. However, the firm is aware of a few
problems that could accompany the decision to invest in exchange-traded derivatives. Which of the
following should not be worrisome for the management of the firm?

A. Liquidity risk

B. Counterparty risk

C. Market risk

D. T ransaction costs

T he correct answer is B.

Counterparty risk basically refers to the possibility that one of the parties involved may default on

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the contact. In exchange-traded instruments, however, the exchange itself acts as the counterparty

for each transaction. It serves as the seller for every buyer, and buyer for every seller.

A i s i ncorrect: Investors who plan to close out a derivative prior to maturity may be faced with

liquidity risk. T he firm may not be able to trade the derivative product for a reasonable price in the

market. a possible reason could be a lack of sufficient orders in the market. T here may not be too

many traders willing to take the opposite position in the transaction. Another possibility is that the

price spread at which other investors are prepared to trade the derivative is very large. In some

cases, liquidity risk may boil down to a lack of liquidity of the underlying asset. Issuers of certain

products may have appointed a liquidity provider/market maker or the issuer itself may have

committed to “make” a market. T he main role of liquidity providers/market makers is to provide two-

way quotes to facilitate the trading of their products, but there can be no assurance that active

trading will be maintained. If a liquidity provider/market maker defaults or ceases to fulfill their role,

investors may not be able to trade the product until a new liquidity provider/market maker is

appointed.

C i s i ncorrect: T he market price of a derivative product is subject to the same risks that affect all

stock markets or the market of the underlying asset. T hese include interest rates, exchange rates,

volatility, market sentiment, movements in domestic and international markets, and the present and

anticipated economic environment. Principally if the underlying asset moves in a direction that defies

your expectations, the product will not perform. You may suffer losses compared to holding the

underlying asset.

D i s i ncorrect: Derivative contracts involve transaction costs which should always be considered.

A good example would be the dealer's/broker's fee.

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Q.30 Besides credit risk, counterparties in a derivative position face another major type of risk.
Which one is it?

A. Interest rate risk

B. Foreign exchange risk

C. Commodity price risk

D. Market risk

T he correct answer is D.

Besides credit risk and operational risk, market risk is the other major type of risk. It refers to

losses arising from changes in market risk factors. It encompasses other risks such as interest rate

risk, foreign exchange risk, and commodity price risk. T he market maker enters into an offsetting

agreement so as to hedge market risk. T his usually occurs in the form of a second agreement that

works in exactly the opposite direction, thus canceling out the potential loss that could be incurred

in the first agreement.

Interest rate risk refers to the risk that changes in interest rates will affect the value of an

investment.

Foreign exchange risk, also known as currency risk, refers to the risk that changes in exchange

rates will affect the value of an investment denominated in a foreign currency.

Commodity price risk refers to the risk that changes in commodity prices will affect the value of an

investment.

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Q.39 Celina John is a junior analyst at Franklin Investments. She is studying the advantages and
disadvantages of hedging in order to propose hedging practices for her clients. Following are some of
the points she has written down in her email. Which of the following disadvantages of hedging is not
correct?

A. Hedging can divert management's focus from its core business activities.

B. Hedging can increase the variability of the firm's value instead of decreasing the
variability.

C. Hedging and derivatives is a zero-sum game of transferring risk.

D. Hedging can result in multiplied losses if flawed hedging strategies are used.

T he correct answer is C.

Hedging and derivatives are not always zero-sum games of transferring risk from one period to

another or from one participant to another.

Disadvantages of hedging includes:

Hedging can divert management's focus from its core business activities.

Hedging can increase the variability of the firm's value instead of decreasing the variability.

Hedging can result in multiplied losses if flawed hedging strategies are used.

Hedging can be complex financial instruments that require specialized knowledge and

expertise.

Hedging exposes the investor to counterparty risk, which is the risk that the other party

involved in the transaction may default or fail.

Hedging is often subject to complex regulations that can limit their use or make them more

difficult to implement.

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Q.41 T he board of directors of BRT Inc. is determining the risk appetite of the firm. It believes
increasing the firm's risk appetite will introduce BRT to new potential business opportunities and
increase the rewards to stakeholders. However, changing the risk appetite of a firm can be a cause
of conflict between parties. Determining the risk appetite of a firm can cause the greatest conflict
between:

A. Management and debtholders.

B. Management and shareholders.

C. Shareholders and the board of directors.

D. Shareholders and debtholders.

T he correct answer is D.

Determining the risk appetite of a firm can be a cause of the greatest conflict between shareholders

and debtholders.

Debtholders will prefer minimizing the risk appetite as their upside potential of reward is limited to

the interest rate while shareholders will prefer maximizing the risk appetite as their upside potential

is unlimited. Debtholders and shareholders are typically on opposite sides of the risk appetite

spectrum

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Q.42 Anadolu T ire Company is the market leader in the tires manufacturing sector in T urkey. It
acquires its raw material from its neighbor, Iran, on fixed trade terms and pays the supplier in the
local T urkish currency. Anadolu also sells its tires to some eastern European countries and accepts
payments in Euro. Based on the business perspective of Anadolu, determine which of the following
risk it should hedge.

A. Pricing risk.

B. Foreign currency risk.

C. Interest rate risk.

D. Market risk.

T he correct answer is B.

Anadolu must hedge against foreign currency risk as it makes sales in Euros in European markets. If

the value of the Euro devalues against the T urkish currency, the firm will face losses. T herefore,

the firm must hedge the foreign currency risk.

Opti on A i s i ncorrect as the firm pays the supplier in local currency and it has fixed trade terms

with the suppliers.

Opti on C i s i ncorrect because interest rate risk is related to the risk of changes in the rate of

interest and cost of capital.

Opti on D i s i ncorrect because market risk arises when there is a change in the general demand

or price in the market

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Q.43 Which of the following statements are incorrect regarding static hedging and dynamic hedging
strategies?

A. In static hedging, the risk is recognized at the beginning, and the appropriate hedging
position is opened

B. A dynamic hedging strategy is more complex as the underlying risky position may change
with time

C. Static hedging requires more time and monitoring effort

D. Dynamic hedging requires additional transaction costs to maintain the risky position
hedged

T he correct answer is C.

Option C is correct because dynamic hedging requires more time and monitoring effort.

Dynamic hedging:

requires more time and monitoring effort

is more complex as the risky position may change over time

and may also change accordingly which requires additional transaction costs

In Static hedging

the risk is recognized and hedged at the beginning,

it is more of a hedge and forget strategy that remains in place till the exposure ends

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Q.44 Which of the following is not an attribute of exchange-traded and over-the-counter (OT C)
financial instruments?

A. Exchange-traded instruments are more simple and standardized.

B. Over-the-counter financial instruments are more liquid than exchange-traded instruments.

C. Exchange-traded instruments are easier to price than OT C instruments.

D. Over-the-counter financial instruments contain default risk.

T he correct answer is B.

OTC i nstruments are less liquid and more customized, which is why they are more difficult to
price compared to exchange-traded instruments. Since OT C instruments are privately traded
between two counterparties, they have a higher probability of default.

It worth noting that, In the over-the-counter market, trading occurs between participants who
contact each other either directly or through a broker. Participants may be able to privately without
the other party being aware of the terms, including the price. Stocks traded in an OT C market could
belong to a small company that’s yet to satisfy the conditions for listing on the exchange. T he OT C
market is also popular for large trades. Since the 2007-2009 financial crisis, OT C markets are,
however, increasingly being regulated

In the exchange-traded markets, Investors trade in contracts that have been identified in the
exchange. T raditionally, trading was done using the outcry system (Investors met at the exchange
floor and used signals to indicate their proposed trades.) Currently, trading is done electronically
through a computer.

Exchange-traded i nstruments are standardized products with maturities and strikes set in
advance while over-the-counter derivatives are traded by investment banks, among others, and can
be tailored to the firm’s needs.

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Q.5036 A firm has a total risk capacity of $600 million. Senior managers have set a risk appetite at
$300 million. Which of the following would most likely be within the acceptable risk profile for the
firm?

A. $400 million

B. $250 million

C. $900 million

D. $450 million

T he correct answer is B.

Risk appetite is the amount and type of risk that an organization is prepared to pursue, retain or take.
It should not be confused with risk capacity (the maximum amount of risk that an organization is able
to take on) and risk profile (a firm’s current risk exposure). T he risk profile of a firm should be less
than its risk appetite, which in turn should be less than the total risk capacity. T his leaves 'B' as the
only correct answer.

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Reading 3: The Governance of Risk Management

Q.21 Which of the following statements best describes the role of the board in risk management?

A. Issuing guidelines on how to manage risks

B. Developing the risk appetite statement and objectives the managers should strive to meet
within the risk management framework

C. Regularly reviewing decisions made by managers regarding risk exposures

D. Choosing the risk exposures to hedge, the risks to mitigate, and those to avoid altogether

T he correct answer is B.

T he board sits above the managers in the hierarchy of management in most for-profit organizations.

T he board assembles and develops a comprehensive risk appetite statement, specifying the risks the

company should assume and those to avoid, including the preferred methods of risk mitigation. T he

managers consult the risk appetite statement when choosing the projects to undertake.

T he board also delegates the responsibility for approving and reviewing the risk levels to the board

risk management committee.

Opti on A i s i ncorrect: Issuing guidelines on managing risks is the role of risk advisory managers.

Opti on C i s i ncorrect: Regularly reviewing decisions made by managers regarding risk exposures

is the role of the board risk management committee.

Opti on D i s i ncorrect: Choosing the risk exposures to hedge, the risks to mitigate, and those to

avoid altogether is the role of the risk advisory directors.

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Q.45 Which of the following statements best describes corporate governance in today's business
world?

A. T he process by which the board of directors delegates duties to hired professionals who
oversee the day-to-day running of the company.

B. T he system of rules, practices, processes, and regulations guiding risk managers when
determining a company's risk appetite.

C. T he system of rules, regulations, and processes by which a company's board of directors

looks after the needs of various stakeholders within the broader agenda of meeting business
objectives.

D. T he tools used by the board of directors to drive business strategy, corporate

responsibility, and streamline the interests of the company's shareholders.

T he correct answer is C.

Corporate governance is the system of rules and regulations that help the board of directors balance
the interests of the company's many stakeholders and ensure objectives are met. In practice,
corporate governance entails every aspect of management - internal controls, business plans,
performance appraisal, and business disclosure. Managing diverging interests of the many parties
involved is normally an uphill task, but one that's absolutely necessary for any organization which
wishes to make progress in business.

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Q.46 In the aftermath of the 2007/2009 financial crisis, most companies created the position of Chief
Risk Officer (CRO). Which of the following statements about the CRO is INCORRECT ?

A. T he CRO reports directly to the shareholders.

B. T he CRO acts as the chief advisor to the board on all matters of risk.

C. T he CRO gives guidance to lower level (line) managers about risk identification and
management, making suggestions for risk mitigation.

D. T he CRO plays a starring role when determining the company's risk appetite.

T he correct answer is A.

In most companies, the chief risk officer reports directly to the board, and not to shareholders.

T herefore, Option A is incorrect.

In fact, it is the risk sub-committee of the board that delegates authority to the CRO, who is tasked

with overseeing the risk management function in its entirety.

T he following are the roles of a CRO

Designing of the risk management program of a firm

CRO is responsible for risk policies, analysis dimensions, and methodologies.

CRO is responsible for risk management infrastructure and governance in a firm.

monitoring of the firm’s risk limits set by the senior risk management

In many financial institutions such as banks, CRO is an intermediary between the board and

the management. T he CRO keeps the board informed on the firm’s risk tolerance and

condition of the risk management infrastructure and informs the management on the state

of the risk management.

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Q.48 Which of the following is most likely a role of finance and operations?

A. Taking on and managing exposure to approved risk

B. Setting business level risk tolerances

C. Managing risk policy development and implementation

D. Overseeing official valuations including independent verification

T he correct answer is D.

Overseeing official valuations including independent verification is a role of finance & operations.

Other roles include:

Setting and managing valuations & finance policies

Managing and supporting analysis required for business planning

Ensuring proper settlement /deal capture and documentations

A i s i ncorrect.Taking on and managing exposure to approved risk is a role of the business line.

B i s i ncorrect. Setting business level risk tolerances is a role of senior management.

C i s i ncorrect. Managing risk policy development and implementation is a role of risk management.

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Q.49 T he following are some of the roles of a bank's audit committee of the board. Which one is not?

A. Developing the bank's risk appetite statement.

B. Scrutinizing financial statements to ensure the accuracy of the reported figures.

C. Ensuring that the bank complies with the minimum/best-practice standards in all key
activities.

D. Continuously reviewing the independence of the statutory auditor/audit firm.

T he correct answer is A.

T he audit committee of the board is charged with oversight of the bank's audit and control functions.

As such, the committee's role does not entail the actual development of the risk appetite statement.

Rather, it monitors the bank's various risk management processes to ensure compliance with

stipulated rules, regulations, and the risk appetite statement itself.

T he following are the roles of the audit committee of the board :

To look into the accuracy of financial and regulatory reporting of the firm and the quality

of processes that underlie such activities.

It also ensures that a bank complies with regulatory, risk management, legal, and

compliance activities.

T he audit committee verifies the activities of the firm to see if the reports outline the

same.

T he members should ideally be nonexecutives to keep the audit committee clear from executive

influence. T he audit committee should interact with the management productively and should keep

all channels of communication open.

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Q.50 Most organizations have both executive and non-executive directors. Which one of the
following is not a valid difference between the two categories?

A. While executive directors work full-time, non-executive directors work on a part-time

basis.

B. While executive directors get involved in the day-to-day management of the company, non-
executive directors do not participate in management responsibilities.

C. Executive directors are usually not independent, whereas non-executives should be

independent.

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

directors are appointed by the nomination committee.

T he correct answer is D.

Statement D: Executive directors are appointed to the board by the nomination committee or

shareholders. On the other hand, non-executive directors are appointed to the board by shareholders

only.

It is worth noting that, Executive directors are members of the board and who are ful l -ti me

employees of the firm and who take part actively in the management of the business. Executive

directors ensure that the rest of the board is well represented in the management and in the overall

operations of the company. Executive directors are not i ndependent and their remunerations are

sal ari es.

Non-executive directors, on the other hand, are not employees of the company, however, they are

selected to monitor the executive directors and act in the interest of the company’s stakeholders and

employees. Non-executive members are, in most cases, i ndependent, and their remunerations are

servi ce fees.

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Q.52 In which way can suppliers and customers reward good corporate governance?

A. Purchase from a competitor offering lower prices

B. Demanding a higher rate of return on their investment.

C. Actively doing business with the company in favorable terms.

D. Giving extra benefits to company executives.

T he correct answer is C.

Good corporate governance increases the level of confidence among suppliers and customers. It
effectively serves as an incentive that encourages them to do business with the company in the long
term and in favorable terms.

Q.53 Which of the following committees is charged with approving and authorizing compensation of
top company executives?

A. Audit committee.

B. Risk Management committee.

C. Compensation committee.

D. Audit Function

T he correct answer is C.

After the 2007/2009 financial crisis, most institutions saw the need to constitute a board's

compensation committee. T his was prompted by realizing that prior compensation schemes

encouraged disproportionate risk-taking with undue regard to long-term risks. Executives would

reward themselves with short-term profits and would front-load fees but back-load the risks. Ideally,

the compensation committee is charged with exercising an oversight role on all matters of

remuneration. T he committee ensures that compensation schemes take into account risks faced by

the company, hence safeguarding long-term financial health.

Opti on A i s i ncorrect: T he audit committee’s responsibility is:

to look into the accuracy of financial and regulatory reporting of the firm and the quality of

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processes that underlie such activities.

to ensure that a bank complies with regulatory, risk management, legal, and compliance

activities.

to verify the activities of the firm to see if the reports outline the same.

Opti on B i s i ncorrect: T he risk management committee in a bank is responsible for:

independently reviewing different forms of risks like liquidity risk, market risk, etc., and

the policies related to them and approving individual credits.

monitoring securities portfolios and significant trends in the market as well as breakdowns

in the industry, liquidity crunch, etc.

it is responsible for reporting to the board about matters related to risk levels, credits and

it also provides opportunities for direct interaction with the external auditor, management

committees.

D i s i ncorrect. T he audit function is responsible for an independent assessment of the framework

and implementation of risk management.

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Q.54 T he effective oversight role of the audit committee least likely contributes to:

A. Reliable financial reporting

B. More effective corporate governance

C. Credible audit functions

D. Monitoring the firm's risk limits

T he correct answer is D.

T he responsibility of the audit committee is:

to look into the accuracy of financial and regulatory reporting of the firm and the quality of

processes that underlie such activities.

to ensures that a bank complies with standards in regulatory, risk management, legal, and

compliance activities.

to verify the activities of the firm to see if the reports outline the same.

T he audit committee of the board, therefore, contributes to the accuracy of financial reporting and

ensuring compliance with the minimum standards in other key activities and it also contributes to

more effective corporate governance.

Monitoring the firm's risk limits set by the senior risk management is the role of the of the Chief

Risk Officer (CRO)

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Q.55 Explain the meaning of a 'fiduciary duty' within the bounds of corporate governance.

A. A duty that arises out of a contractual agreement.

B. A duty that is not stipulated in a company's constitution, but nonetheless expected to be

performed by management.

C. A duty imposed on a person because of the position of trust and confidence in which they
stand in relation to another.

D. T he duty to prioritize the interests of the government over those of one's clients

T he correct answer is C.

A fiduciary duty is basically a legal obligation to act in the best interest of another. T he duty is

imposed on a person entrusted with cutting-edge decision-making or valuable assets. Such persons

must disclose all the information they hold, account for any proceeds/profits received, and avoid

conflict of interest.

It is the duty to act in the best interests of the client, even if it conflicts with the personal interests

of the fiduciary.

A i s i ncorrect: A duty that arises out of a contractual agreement refers to a contractual duty.

B i s i ncorrect: A fiduciary duty is stipulated in the constitution of the company and as such you are

expected to act in good faith and in the interest of the firm.

D i s i ncorrect:T his option is incorrect because fiduciary duty is a duty owed to the client, not to

the government. Fiduciaries must act in the best interests of their clients and cannot prioritize the

interests of the government over those of their clients.

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Q.56 T he large-scale corporate collapses witnessed in the early 2000s, including the Global Financial
crisis of 2007/08, all had important themes (causal factors) that risk professionals must understand if
we are to avoid a recurrence of such financially crumbling events. Which of the following
statements about these past crises is inaccurate?

A. Most collapses occurred as a result of executives abusing their trust and a lack of
oversight.

B. Incentive payments and greed did not play any role in the collapses.

C. T here was a tendency of management to take on risks that were not fully understood.

D. T he collapses had a negative impact on the accounting profession.

T he correct answer is B.

T he incentive payments usually paid by banks and investment firms were typically tied to short-term

performance, which encouraged employees to take excessive risks to generate short-term gains,

without adequate consideration for the long-term consequences.

Prior to the Global Financial Crisis, corporate executives were taking huge risks that they did not

understand with an eye for inflated bonuses and other forms of remuneration linked to short-term

performance, which demonstrated fraud and greed in all of its ugly forms. T his was particularly

apparent in the case of Enron. T he accounting profession's credibility was also called into question.

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Q.57
Most companies now have several subsets of the board called 'board committees'.

Why are such committees formed?

A. To directly report to shareholders on specific issues.

B. To enable the directors to reduce their individual liability and therefore serve more
confidently.

C. To enhance the overall effectiveness of the board.

D. To introduce independence, thereby enabling verification of decisions/materials brought

to the attention of the entire board.

T he correct answer is C.

T he establishment of appropriate board committees - compensation committee, nomination

committee, management committee, and others - is likely to enhance the effectiveness of the board

in its entity, particularly the effectiveness of non-executive directors. Committees help the board

distribute the workload, hence enabling more detailed consideration of specific issues that need

special attention. Such issues may include risk tolerance, external financing, and director

remuneration.

Opti on A i s i ncorrect: T he board committees report directly to the board.

Opti on B i s i ncorrect: the board of directors is usually monitored by non-executive directors to

reduce their individual liability.

Opti on D i s i ncorrect: T he board committees report to the board, and therefore the committees

do not introduce independence.

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Q.58 T he following are examples of agency costs, except:

A. Dividends

B. Monitoring fees

C. Audit fees

D. Delegated authorities

T he correct answer is A.

Agency costs refer to the costs incurred when one party (the principal) hires another party (the

agent) to perform a task or make decisions on their behalf. In such a situation, the interests of the

principal and the agent may not always be aligned, which can lead to conflicts of interest and

additional costs.

Dividends do not form part of the costs of the principal-agent relationship. T hey represent the

return to shareholders for investing in the company.

However, dividends may be affected by agency costs – the profit available for distribution to

shareholders may be reduced by audit fees, monitoring costs, and even management laziness.

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Q.59 Which of the following statements about the board of directors' remuneration is correct?

A. Directors may award themselves such salary payments as they think fit

B. Directors must receive a salary, just like other junior employees of the company

C. Directors only receive a salary if the constitution of the company explicitly allows it

D. Directors salaries are set by the HR department of the firm

T he correct answer is C.

A director receives a salary payment only if they have a contractual right to remuneration.

T he board has the power to award contracts to directors and other personnel, subject to the
company's articles.

T here are companies that do not have written agreements that can allow directors to receive any
form of salary payment. In essence, the constitution is the sole determinant on matters
remuneration.

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Q.60 Muhammad Ismail, a research analyst, has recently learned in a seminar on the quality of
research report writing that the firm's corporate governance is as important as the valuation of the
firm's assets. He has noted the following points regarding the implication of good corporate
governance. Which of them are not considered best practices of corporate governance?

A. T he board of director should be comprised of a majority of independent members.

B. A director from outside of the industry should be provided training before joining the
board.

C. T he board will consider the interests of stakeholders, including debtholders, while taking
decisions.

D. T he CEO of the firm must also be the chairman of the board of directors in order to bring
consistency in the board decisions.

T he correct answer is D.

T he Chief Executive Officer must not be the chairman of the board of directors. T here will be no

objectivity and independence if the CEO and the chairman of the board is the same person.

Opti on A i s i ncorrect, as a board with a majority of independent members can oppose the

decisions of the management.

Opti on B i s i ncorrect: A member of the board who is outside of the firm's industry must be

trained.

Opti on C i s i ncorrect: T he board must consider the interest of all stakeholders including

shareholders and debtholders.

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Q.61 Which of the following combinations is likely to affect the independence of the board?

A. Chief Executive Officer as a member of the board of directors.

B. Chairman of the board as a member of the remuneration committee.

C. Chief Executive Officer as the Chairman of the remuneration committee.

D. Chairman of the board as the Chairman of the ethics committee.

T he correct answer is C.

A board that is comprised of a Chief Executive Officer (CEO) who is also the chairman of the
remuneration committee can potentially affect the independence and objectivity of the board and
also the quality of corporate governance. T he other 3 combinations will have no effect on the
board's independence and objectivity.

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Q.62 Woody Daren is an independent journalist who publishes his analysis on one blue-chip firm
every week on his blog. Recently, Woody published an article on the best practices of Arrow Corp's
risk management and its risk committee. Which of the following features that he published is an
incorrect practice?

A. T he business practices and risk management activities of Arrow Corp. strive for
economic performance instead of accounting performance.

B. T he compensation of the risk staff is based on risk-adjusted performance.

C. T he members of the risk committee have deep knowledge of risk issues and accounting
practices.

D. Most individuals that sit on the risk committee should also sit on the audit committee to
align incentives between the two entities.

T he correct answer is D.

T he board risk and audit committees should be two separate entities, given that each requires

different skills to meet its respective responsibilities. T he risk committee should have members

with enough analytic sophistication and business experience to properly analyze key risks. T he audit

committee should comprise members that are both independent and financially literate.

A i s a correct practice, as the business and risk management should focus on economic

performance rather than accounting performance.

B i s a correct practice as it bases the compensation of the risk staff on risk-adjusted-performance.

C i s a correct practice of risk management because the board members of the risk committee

should have basic training and knowledge of risk issues.

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Q.63 George Hitman is a Risk Advisory Director on the board of Temple Tools Inc. George has
passed FRM part 1 and is currently preparing for the FRM part 2 exam. Which of the following is
NOT a duty of the Risk Advisory Director?

A. To attend audit committee meetings and advise the committee to increase the firm's
effectiveness.

B. To Design the risk management program of a firm.

C. To review and analyze the firm's risk management policies and reports.

D. To review related parties and related-party transactions.

T he correct answer is B.

Designing the risk management program of a firm is the role of the CRO

T he following are the duties of the risk advisory director:

T he risk advisory director oversees risk management policies, reports, risks related to the

overall business.

Mitigation of risks like credit risk, market risk, etc. Risk advisory directors should be

familiar with financial statements and accounting principles.

T he risk advisory director should oversee financial reporting and the dealings between the

firm and its associates, including issues like intercompany pricing, transactions, etc.

T he risk advisory director should look into the requirements from regulatory agencies and

should lay appropriate directives for the firm to comply with the requirements.

Participation in audit committee meetings, outlining risk profiles of strategic business

segments, sharing insights into corporate governance and risk management policies, and

overseeing the conduct of business.

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Q.64 Due to the presence of agency risk in the majority of organizations, it is necessary for the
board to form a compensation committee to ensure appropriate risk is taken in relation to the long-
term risk objectives. Its principal role is to design and approve the remuneration plans of
management. Which of the following remuneration structures can be a potential cause of agency
risk?

A. Compensation with bonuses based on long-term revenues and objectives.

B. Compensation with no guaranteed bonuses.

C. Compensation with the clawback clause on previous bonuses if the long-term goals are
unachieved.

D. Compensation with the bonuses based on share prices.

T he correct answer is D.

A compensation plan with bonuses based on share prices can be a potential cause of agency risk

because there is an incentive for management to take excessive risk in order to increase the stock

prices.

Opti on A is an appropriate compensation plan as the remuneration is based on long-term revenues

and management does not have the incentive to take additional risk to increase short-term profits.

Opti ons B and C are also appropriate compensation plans as the bonuses are tied with a clawback

clause that motivates management to achieve and maintain long-term performance.

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Q.65 David Lennon, a corporate trainer, has finalized some of the roles and responsibilities of the
audit committee of the organizations which he is going to add in his presentation on the subject of the
audit committee of the board. Which of the following is least likely a role of the audit committee?

A. Ensuring the accuracy of financial and regulatory reporting of the firm

B. Ensuring that the firm complies with standards in regulatory, risk management, and
compliance activities.

C. Ensuring that the remuneration of key management must be aligned with the goals of other
stakeholders

D. Verifying the activities of the firm to see if the reports outline the same

T he correct answer is C.

Responsibility for ensuring that the remuneration of key management must be aligned with the goals

of other stakeholders is a role of the compensation committee to ensure that the remuneration of

key management must be aligned with the goals of other stakeholder.

T he audit committee's responsibilities are:

To look into the accuracy of financial and regulatory reporting of the firm and the quality

of processes that underlie such activities.

It also ensures that a bank complies with standards in regulatory, risk management, legal,

and compliance activities.

T he audit committee verifies the activities of the firm to see if the reports outline the

same.

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Q.66 Which of the following is least likely a role of the Chief Risk Officer (CRO)?

A. Designing the risk management program of the firm

B. Oversee financial reporting and the dealings between the firm and its associates

C. An intermediary between the board and the management.

D. Monitoring the firm's risk limits set by the senior risk management

T he correct answer is B.

T he CRO’s responsibilities include:

Designing the risk management program of the firm;

Risk policies, analysis dimensions, and methodologies;

Risk management infrastructure and governance in the firm;

Monitoring the firm's risk limits set by the senior risk management; and

T he CRO is an intermediary between the board and the management.

Overseeing financial reporting and the dealings between the firm and its associates is a role of the

Risk Advisory Director.

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Reading 4: Credit Risk Transfer Mechanisms

Q.3718 What are the contractual specifications for the protection seller of a credit default swap?

A. T he protection buyer pays a premium to the protection seller at regular time intervals
until a credit event occurs, in which case the protection seller pays the protection buyer
compensation for the credit event.

B. If a credit event occurs, the protection seller is obliged to exchange contractually

specified assets for government bonds.

C. T he protection seller pays a premium to the protection buyer at regular time intervals
until a credit event occurs, in which case the protection buyer pays the protection seller
compensation for the credit event.

D. If the underlying of the credit default swap is a bond issued by a specific corporation, only
this corporation can act as a protection seller.

T he correct answer is A.

In a CDS, one party makes payments to the other and receives in return the promise of
compensation if a third party defaults.
Example:
Suppose Bank A buys a bond issued by ABC Company. In order to hedge the default of ABC Company,
Bank A could buy a credit default swap (CDS) from insurance company X. T he bank keeps paying
fixed periodic payments (premiums) to the insurance company, in exchange for the default
protection. In the event of default, the bank would receive compensation from the insurance
company, usually equal to the face value of the bond.

D is incorrect. T he issuer of a bond cannot double up as the protection seller of the security issued.

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Q.3719 T he practice of approving mortgages in order to sell them as mortgage-backed securities is

known as:

A. Originate-to-distribute

B. Originate-to-keep

C. Principal-agent engineering

D. A credit default swap

T he correct answer is A.

T he originate-to-distribute (OT D) business model describes the practice where originators (owners)

of mortgages or other types of loans repackage these assets and sell them to third parties. It is the

opposite of the traditional originate-to-keep (OT K) model where owners of mortgages and other loans

keep these assets in their balance sheets until maturity. From the perspective of the originator

(usually banks), the OT D model has several benefits:

It introduces specialization in the lending process. Functions initially designated for a single

firm are now split among several firms.

It reduces banks’ reliance on the traditional sources of capital, such as deposits and rights

issues.

It introduces flexibility into banks’ financial statements and helps them diversify some

risks.

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Q.3720 Which of the following best explains why the 2001-2002 economic slowdown did NOT result
in heavy losses for the banking sector?

A. Rapid foreclosure of insolvent/loss-making corporate borrowers.

B. A substantial increase in investment in government bonds.

C. Cash injections by the Federal Reserve.

D. Hedging through credit derivatives and securitization of assets.

T he correct answer is D.

Credit risk derivatives and securitization were the main reasons why the banking sector emerged
from the 2001-2002 economic slowdown largely unscathed. Most banks that had lent out cash to
various corporations had purchased protection against default in the form of credit default swaps and
total return swaps. Others had hived off a significant part of their balance sheets by issuing
securitized assets such as collateralized debt obligations and collateralized loan obligations.
When borrowers defaulted, those banks that had bought protection in the form of credit derivatives
were compensated. On the other hand, those that had securitized their assets had already received
payments from third-party investors, which helped offset the total loss.

Q.3721 Global Tech has declared its intention to bring to the market a 10-year senior bond issue at
par with a coupon rate of 23%, offering a spread of 1200 basis points over the corresponding 10-year
T reasury issue. An investor is keen to enter into a total return swap that matures in one year with
the senior bonds that are about to be issued as the reference obligation. Under the terms of the
contract, payments will be exchanged semiannually, where the total return receiver will pay the six-
month T reasury rate plus 328 basis points. What is the 10-year T reasury rate at the time the bonds
are issued?

A. 10%

B. 12%

C. 11%

D. 13%

T he correct answer is C.

We know that Global Tech will be coming to market with a 10-year senior bond issue at par with a
coupon rate of 23%, offering a spread of 1200 basis points over the 10-year T reasury issue. Because
1200 basis points is 12%, this means the 10-year T reasury issue will have a rate of 23% - 12% =
11%. At the time of issuance, therefore, the 10-year T reasury yield is 11%.
Note that the question has a bit of nugatory information.

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Q.3722 Which of the following is most likely correct?

Credit default swaps contributed to the financial crisis of 2007-2009 by:

A. Allowing protection buyers to specify who bears the credit risk on a given security.

B. Requiring no collateral from both protection buyers and sellers.

C. Making it easier for sellers of insurance to assume and conceal risk.

D. Identifying those who took concentrated positions on one side of a trade.

T he correct answer is C.

A major reason why credit default swaps share some blame for the 2007/2009 financial crisis has

much to do with a largely untethered market where rules and regulations were virtually absent, and

where present, such regulations were not strictly enforced. In particular, protection sellers had a lot

of ease while doing business.

Opti on A i s i ncorrect: For starters, they were not required to maintain reserves to cover the

protection sold. T his left them vulnerable to serious funding problems following a claim of

compensation by the protection buyer. In fact, this was a principal cause of AIG's financial distress

in 2008; it had insufficient reserves to meet the "run" of expected payouts caused by the housing

bubble collapse.

Opti on B i s i ncorrect: We had collateralized debt obligations (CDOs), however, these were

abused.

Opti on D i s i ncorrect: T he seller didn’t have to belong in the category of highly regulated

institutions such as banks. T his made it even more difficult for the authorities to monitor

transactions.

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Q.3723 Which of the following statements are correct? Credit default swaps:

A. Present high levels of risk and are only be used by the wealthy

B. Allow lenders to insure themselves against the risk that a borrower will default.

C. It should only be used by people seeking high returns from low risk.

D. Do not require collateral to be posted by either the buyer or the seller of the insurance.

T he correct answer is B.

In a CDS, the protection buyer (lender) makes payments to the protection seller and receives in

return the promise of compensation if a third party (borrower) defaults.

A i s i ncorrect. Although CDSs can be risky, such risks can be mitigated by putting in place adequate

regulation. T hey are certainly not a preserve for the wealthy.

C i s i ncorrect. CDS are either used for hedging by buyers who hold a position in the reference

asset, or speculators whose intent is to gamble on the creditworthiness of the reference entity in

the hope of making a profit.

D i s i ncorrect. CDS contracts do require collateral to be posted by either the buyer or the seller

of the insurance.

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Q.3724 T he purpose of credit derivatives is to:

A. T ransfer the risk from one party to another.

B. Increase the risk, so that the return is larger.

C. Postpone the risk for both parties in the transaction.

D. Eliminate risk for both parties in the transaction.

T he correct answer is A.

Credit derivatives are financial instruments that transfer the credit risk of an underlying portfolio

of securities from one party to another party without transferring the underlying portfolio. T hey are

usually privately held, negotiable contracts between two parties. A credit derivative allows the

creditor to transfer the risk of the debtor’s default to a third party.

Opti on B i s i ncorrect: Although derivatives are associated with some level of risk, their purpose

can not be aimed at increasing risk.

Similarly, Opti ons C and D are i ncorrect: Derivatives can not be used to postpone or eliminate

risks.

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Q.3725 Which of the following is NOT one of the methods of settling credit default swaps?

A. Auction

B. Physical

C. Cash

D. Separate entity

T he correct answer is A.

T here are two ways that can be used to settle a CDS contract:
Cash settlement: T he protection seller makes a payment equal to a pre-determined value to the
protection buyer. T he parties establish the value of the contract and the protection seller pays the
protection buyer the full face value of the reference obligation less its current value.

Physical settlement: the protection seller pays the face value of the asset to the buyer, and the
buyer surrenders the reference asset to the seller. T he contract may also specify the alternative
assets that can be delivered.

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Q.3726 Which of the following statements regarding Credit Default Swaps (CDS) is incorrect?

A. T heir payoff is contingent upon the performance of an underlying instrument

B. Examples of CDS’s underlying assets include corporate bonds and emerging market bonds.

C. T heir value rises and falls as opinions change about the likelihood of default.

D. T hey will be paid out in case of bankruptcy.

T he correct answer is D.

Credit Default Swaps (CDS) have the following characteristics.

T he payoff of a CDS is contingent upon the performance of an underlying instrument and

not necessarily only at bankruptcy.

T he most common underlying instruments include corporate bonds, emerging market

bonds, municipal bonds, and mortgage-backed securities.

T he value of a CDS rises and falls as opinions change about the likelihood of default.

CDSs are designed to protect creditors against credit events such as late payments and

payments not made in the stipulated form and not only declaration of bankruptcy.

Q.3727 In a credit default swap transaction:

A. T he protection buyer is long on risk.

B. T he protection seller is short on risk.

C. T he protection seller makes periodic payments.

D. T he protection buyer makes periodic payments.

T he correct answer is D.

In a CDS, the protection buyer makes payments to the protection seller and receives in return the
promise of compensation if a third party defaults. T he buyer is short on risk, i.e., they sell risk,
while the protection seller is long on risk, i.e., they buy risk.

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Q.3729 An investor wishes to purchase a 5-year BBB-rated bond issued by BAC Corporation but does
not want to bear the out-of-pocket costs and the inconvenience associated with long-term financing
arrangements, actually going long the bond, and taking delivery. Suppose also that a bank owns the
same bond and would like to extend a loan to BAC Corporation but its loans to BAC and investments in
BAC debt instruments have fully exhausted its capacity to lend to BAC. Which of the following
instruments would best suit the two parties in these circumstances?

A. Credit spread swap option

B. Total return swap

C. Credit default swap

D. Collateralized loan obligation

T he correct answer is B.

A total return swap will allow the investor to receive the total economic return on this bond without

actually buying it. It will allow the bank to reduce its risk of exposure to BAC Corporation as if it had

sold the bond without actually selling it.

If the two entities enter into a total return swap structured around this bond’s total return stream,

the investor will be synthetically “long” the 5-year bond, and the bank will be synthetically “short”

the same bond.

Opti on A i s i ncorrect: In a credit spread swap option, a strategy that involves the purchase of one

option and the sale of another option.

Opti on C i s i ncorrect: A credit default swap is a derivative contract that enables investors to swap

credit risk from one party to another.

Opti on D i s i ncorrect: Collateralised loan obligations refer to a structured product backed by a

pool of commercial bank loans created using the securitization process.

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Q.3730 T wo parties decide to engage in a 2-year credit default swap. Assume that the reference
entity is BAC Corporation. T he notional amount of the contract is $10 million, and the contract is
cash-settled.
After one year, a default event occurs, and the bonds are valued at $8.5 million at the time of default.
Which of the following is most likely correct?

A. T he protection buyer receives $1.5 million in compensation.

B. T he protection buyer continues to pay premiums for one more year.

C. T he protection buyer delivers the bond to the protection seller .

D. T here is no compensation paid to the protection buyer.

T he correct answer is A.

Under cash settlement, the protection seller makes payments equal to a pre-determined value to the
protection buyer. T he buyer is not required to deliver the reference obligation to the seller. T he
parties establish the value of the contract and the protection seller pays the protection buyer a
termination amount equal to the full face value of the reference obligation less its current value. In
this case, the amount paid is $1.5 million (= $10m - $8.5m).
Option B is incorrect. If a credit event occurs, two things happen. First, there are no further
payments of the swap premium by the protection buyer to the protection seller. Second, a
termination value is determined for the swap.

Q.3731 An investor approaches a swap dealer wishing to engage in a total return swap. T he
underlying asset is $10 million principal amount of a 9% BB-rated 5-year corporate bond that has
semiannual interest payments. T he swap dealer agrees to pay the total return on this bond for the
coming 6 months in return for payments based on (1) an interest rate of 6-month LIBOR plus a
spread of 30 basis points and (2) a notional principal amount equal to the face value of the underlying
asset, $10 million.
At the swap date, the bond is worth par, and the 6-month LIBOR is 6%. Suppose that at the
termination date, the value of the bond has still not changed. Determine the net payment and the
party that is owed. (Use discrete compounding.)

A. Net payment = $315,000 ; owed party is the investor

B. Net payment = $450,000; owed party is the swap dealer

C. Net payment = $0; no owed party

D. Net payment = $135,000; owed party is the investor

T he correct answer is D.

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T he easiest way to see this swap is that one party is swapping the 9% coupons + capital gains against

LIBOR + 0.3%.

Assumptions:

Asset: $10 million principal amount of a 9% BB-rated 5-year corporate bond

Floating rate: 6-month LIBOR plus a spread of 0.3% (the 6-month LIBOR on the swap date

is 6%)

Term of the swap: 6 months (just one interest period)

Value of the bond: Swap date: 100% of the face value

Termination date: 100% of the face value

Here’s how we calculate the cash payment:

0.09
Interest on the bond:$10, 000, 000 × = $450, 000
2
(0.06 + 0.003)
Interest at LIBOR:$10, 000, 000 = $315, 000
2

T hus, the interest payment obligations are $315,000 for the investor and $450,000 for the swap

dealer. T he swap dealer must, therefore, make a net payment to the investor of $135,000 (=

$315,000 - $450,000).

Had there been a capital gain or loss on the reference obligation, this would have impacted the

payments made by the two parties.

Note that, in a total return swap, the payer(protection buyer) agrees to pay the total return swap

receiver, the total return derived from the underlying asset. In return, the receiver(protection

seller) pays the asset owner a Libor-based interest rate during the life of the total return swap.

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Reading 5: Modern Portfolio Theory (MPT) and the Capital Asset

Pricing Model (CAPM)

Q.38 Henry Ellen, an FRM candidate, has recently studied William Sharpe's Capital Asset Pricing
Model (CAPM) as part of the FRM books. As per his understanding of the model, he has come up with
a list of broad assumptions. Which of the following assumptions of the CAPM model is INCORRECT ?

A. CAPM assumes that all capital markets are perfectly competitive.

B. As per CAPM, investors should not be concerned with unsystematic risk.

C. CAPM does not consider transaction costs.

D. Beta can be decreased via diversification.

T he correct answer is D.

Beta risk is the systematic risk and, under the perfect capital market, investors' only concern should

be the systematic risk as it cannot be eliminated via diversification.

Option A is correct as CAPM assumes all capital markets are perfectly competitive.

Option B is also correct as unsystematic risk can be diversified so it should not concern investors.

Option C is correct as CAPM does not consider the transaction costs of diversification.

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Q.179 A property development company faces the following problems:

I. Labor costs
II. Interest rate risk
III. Environmental challenges
IV. Poor project management
V. Inflation

Which of the above risks would be taken into account when estimating the company's beta?

A. I, II, & IV

B. II & IV

C. II & V

D. I, III, & IV

T he correct answer is C.

Beta represents a company's systematic risk - the risks that cannot be eliminated by diversification.
Such risks affect the market as a whole, including interest rate fluctuations and inflation. Company-
specific risks such as labor costs, employee go-slows, and environmental challenges are considered
to have very little effect on a well-diversified portfolio - one that cuts across multiple companies and
industries.

Q.180 Which of the following is NOT an assumption of the standard Capital Assets Pricing Model
(CAPM)?

A. Investors incur some transactional costs when trading assets.

B. T here are no taxes, making investors indifferent between capital gains and
dividends/income.

C. Assets can be divided infinitely, making it possible to hold fractional shares.

D. T here's unlimited short selling/ a perfectly liquid market.

T he correct answer is A.

T he CAPM assumes that there are absolutely NO transactional costs. T his significantly simplifies the
computation of returns because if the transactional costs were present, the return would be a
function of such costs, which would then have to be estimated.

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Q.181 Consider a graph with expected return on the vertical axis and standard deviation on the
horizontal axis. What's the name of the line that connects the risk-free rate and the optimal risky
portfolio?

A. T he efficient frontier

B. T he characteristic line

C. T he indifference curve

D. T he capital market line

T he correct answer is D.

T he capital market line shows the relationship between risk (as measured by standard deviation) and

return of efficient (market) portfolios. T he line appears as a tangent from the intercept point on the

efficient frontier to the point where the risk-free rate of return equals the expected return.

Opti on A i s i ncorrect: An efficient frontier is a line that shows portfolios that offer the highest

expected return for a given level of risk.

Opti on B i s i ncorrect: A characteristic line is a straight line generated by regression analysis that

shows the systematic risk of a particular security and the equivalent rate of return

Opti on C i s i ncorrect: An indifference curve is a graph that shows the combination of two

commodities that leaves the customer equally satisfied hence indifferent in choosing any of the

combinations.

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Q.182 T he difference between the capital market line (CML) and the efficient frontier (EF) is that:

A. T he CML represents possible combinations of portfolios consisting of all possible

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

B. T he EF represents possible combinations of portfolios consisting of all possible

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

C. T he CML represents a few possible combinations of portfolios consisting of various

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

D. T he EF represents possible combinations of portfolios consisting of all possible

proportions between the market portfolio and a risk-free asset while the CML represents all
possible combinations of efficient portfolios, taking into account only risky assets in fixed
proportions.

T he correct answer is A.

T he most important point to note is that while the CML works with risk-free assets, the EF only

includes risky assets.

T he efficient frontier shows the optimal returns for each level of risk.

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Q.183 An investor holds a portfolio comprised of a risk-free asset and a market portfolio. Given the
following information, compute the expected return of the portfolio.
Risk-free rate = 5%
Expected market return = 25%
Standard deviation of market portfolio = 10%
Standard deviation of portfolio = 5%

A. 0.25

B. 0.0015

C. 0.1

D. 0.15

T he correct answer is D.

Rm −Rf
T he equation of the CML is R p = R f + { } σp
σm

Where:
R p is the expected portfolio return
R f is the risk-free rate
R m is the expected market return
And σm , σp are the standard deviations of the market and the portfolio, respectively

T herefore,

(25 − 5)
E(R p) = 5 + ×5
10
= 5+2×5
= 15%

Note: Any risk-free asset has a known, certain return (5% in this case). T his is the result of its

standard deviation being 0. T hus, the covariance of the risk-free asset with any risky asset, including

the market portfolio, is zero. With a zero covariance, the correlation between the risky asset and

the market portfolio is also zero.

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Q.184 According to the CAPM, the risk premium expected to be received by a stockholder
increases:

A. Directly with beta.

B. Inversely with beta.

C. Inversely with systematic risk.

D. Directly with total risk.

T he correct answer is A.

Return is the reward for taking on risk. Beta is a measure of the systematic risk of a stock. As such,
as beta increases so do the risk, hence the reward in the form of a premium.

Q.185 Under the CAPM, if a stock has a beta of 2, then for every percentage point performance
attained by the market over above the risk-free rate, we would expect the stock to achieve:

A. 1 percentage point return.

B. 2 percentage points extra return.

C. 1 percentage points lower return.

D. Impossible to determine.

T he correct answer is B.

If a stock has a value of beta of more than 1, then historically, the stock amplifies the return of the
whole market (both positive and negative). T hus, a 1% return above R f would be amplified to 2%
above R f . Similarly, a 1% return below R f would be amplified to 2% below R f .

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Q.186 A beta close to zero indicates:

A. A stock with a less stable return than the market as a whole.

B. A stock with a more stable return than the market as a whole.

C. An ET F replicating the corporate bond market.

D. A stock with historically higher returns compared to the market as a whole.

T he correct answer is B.

A beta close to zero indicates more stability compared to the market. Such a stock would show very

little price movements during periods of large market movements, either positive or negative.

Opti on A i s i ncorrect: A stock with a more stable return than the market as a whole has a beta

greater than 1.

Opti on D i s i ncorrect: A stock with historically higher returns compared to the market as a whole

has a beta greater than 1

Further Expl anati on

When a stock has a beta of zero, it means that the stock is not correlated to the overall market. Its

return is equal to the risk-free rate. T his can be seen as either a positive or negative attribute

depending on the investor's perspective. For example, an investor who is looking for little to no

correlation with the markets may find this situation desirable and could see it as a safe investment.

On the other hand, an investor who is hoping to benefit from market uptrends and downturns would

view this as a bad thing because they will not be exposed to any movements in the markets.

Additionally, stocks with a beta of zero tend to have lower liquidity compared to stocks with higher

betas since fewer investors are interested in stocks that don't move with the market.

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Q.188 An asset has a standard deviation of 30% and 0.8 as its correlation coefficient of returns with
the market index. Given that the standard deviation of the market return is 20%, calculate the asset's
beta.

A. 0.24

B. 2.4

C. 1.4

D. 1.2

T he correct answer is D.

T he formula for calculating the beta for stock i is:

σi
βi = ρi,m ( )
σm

Where i is the stock and m is the market.

T hus,

0.3
βi = 0.8( ) = 1.2
0.2

Q.189 You have been given the following asset weights and betas for a 4-asset portfolio:

Asset Beta Portfolio Weight

1 1.3 30%
2 0.97 23%
3 1.7 37%
4 1.4 10%

If the market risk-free rate is 5%, what is the portfolio beta?

A. 1.3

B. 2.3

C. 1.4

D. 0.3

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T he correct answer is C.

T he beta for a portfolio is the weighted average of the betas of individual assetsT hus, the beta for
the 4-asset portfolio above = 1.3 * 0.3 + 0.97 * 0.23 + 1.7 * 0.37 + 1.4 * 0.1 = 1.4Note: T he market
risk-free rate is useless in this question.

Q.190 An FRM exam candidate makes the following comments during an online discussion with
fellow candidates:

I. On the capital market line, investors are only compensated for bearing systematic risks
II. T he capital market line assumes that investors hold two portfolios:
i. a risky portfolio of all assets each weighted according to its market value relative to
the total market value and
ii. the risk-free asset
III. T he CML can be used to determine the required rate of return for individual securities.

Are the candidate's comments correct?

A. All the comments are correct.

B. Only II is correct.

C. Only I and II are correct.

D. None of the comments are correct.

T he correct answer is C.

Statement I is correct. On the CML, investors are only compensated for bearing systematic risks

because specific risks are eliminated via diversification.

Statement II is correct. T he CML assumes an investor holds a portfolio of all assets weighted

according to their individual market values as a proportion of the total market value as well as a risk-

free asset.

Statement III is incorrect. T he CML cannot be used to determine the required rate of return for

inefficient portfolios or individual assets; only the CAPM can be used to do that.

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Q.191 When a security is plotted on the security market line (SML) chart and found to appear above
the SML, it's considered:

A. Undervalued and a profitable buy for investors.

B. Overvalued and a profitable buy for investors.

C. Undervalued and a profitable short sell for investors.

D. Overvalue and a profitable short sell for investors.

T he correct answer is A.

T he security market line is a graphical representation of the CAPM. It's used to assess whether to

include an asset or security in a portfolio by matching the risk borne with the desired return. As

such, if a security is found to lie above the security market line, this means it's been undervalued - it

offers a return greater than its inherent risk. It is a great buy for investors.

Similarly, a security found to lie below the SML is considered overvalued as its inherent risk

outweighs the return it offers. It is considered a great short sell for investors.

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Q.192 You have been provided with the following information regarding the stock of T ranslink, an
international air transport company:

Risk-free rate = 3%

Expected market risk premium = 5%

T ranslink beta = 1.5

Use the capital asset pricing model to determine the expected return of T ranslink.

A. 7.5%

B. 10.5%

C. 6%

D. 8%

T he correct answer is B.

According to CAPM, the expected return on an asset is given by:

E(R i) = R f + (E(R m ) − R f ))βi

Where (E(R m ) − R f ) is the difference between the expected market return and the risk-free rate

(market risk premium) and βi is the beta for the stock.

T hus,

E(R i ) = 3% + 5% × 1.5 = 10.5%

Note that, what we are given in the question is the expected market risk premium and it should not

be confused with the expected market return.

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Q.193 John Powel gathers the following information regarding the stock of Swisscom, an internet
service provider:

Beta for Swisscom = 0.8

Risk-free rate = 5%

Powel's expected rate of return for Swisscom = 7%

Use this information to determine the expected market return.

A. 8%

B. 12%

C. 7.5%

D. 5%

T he correct answer is C.

According to CAPM,

E(R i) = R f + (E(R m ) − R f )βi

7% = 5% + (E(R m ) − 5%)0.8
2% = (E(R m ) − 5%)0.8
2%
= E(R m ) − 5%
0.8
E(R m ) = 2.5% + 5% = 7.5%

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Q.194 Which of the following is NOT included in the underlying assumptions of the Capital Asset
Pricing Model (CAPM)?

A. T here are no income taxes, which is why investors are indifferent between dividends and
capital gains.

B. Short selling is not allowed.

C. T here are no transactions costs.

D. Investors can borrow and lend unlimited amounts at the risk-free rate.

T he correct answer is B.

CAPM assumes that unlimited short selling is allowed so the investors can short as many assets they

want.

Opti on A is an appropriate assumption because CAPM does not assume income tax, which is why an

individual investor is indifferent between dividend income and capital gain.

Assumpti on C is also true because CAPM assumes there are no transaction costs and investors can

make unlimited transactions to balance their portfolios.

Opti on D is also an appropriate assumption. CAPM assumes that there is no limit on borrowing and

lending.

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Q.195 Julia and Frank are two traders that have recently joined the New York Stock Exchange
(NYSE). During their daybreak, they discussed their understanding of the Capital Market Line (CML)
and Market Portfolio T heory.
Julia, who is a senior trader, stated that the capital market line (CML) is the tangent line drawn from
the point of the risk-free asset to the feasible region for risky assets, and all investors invest in some
combination of risk-free assets and market securities, which lies on the CML.

Frank added that the market portfolio is a universally agreed upon optimal risky portfolio that lies on
the CML.

Determine if the explanations of Julia and Frank are correct.

A. Julia is correct, and Frank is also correct.

B. Julia is incorrect, while Frank is correct.

C. Julia is correct, while Frank is incorrect.

D. Julia is incorrect, and Frank is also incorrect.

T he correct answer is A.

T he statements of Julia and Frank are correct. When investors have a homogeneous expectation
(same estimates of risk, return, and correlations), all investors will have the same optimal risky
portfolio, known as the market portfolio. T he capital market line (CML) is the tangent line drawn
from the point of the risk-free asset to the feasible region for risky assets. All the investors invest in
some combination of risk-free assets and risky assets, which lies on the CML.

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Q.196 Steven T homson is the head of the portfolio risk management team. His team has recently
forwarded him an intra-departmental valuation report that contains expected return and standard
deviation calculations of one of the diversified portfolios he manages. Given that the team has used
different measures to compute the expected return of the portfolio, determine which of the
following is appropriate for measuring the expected return of individual securities.

A. Sharpe ratio

B. CML

C. CAPM

D. Beta

T he correct answer is C.

T he Capital Asset Pricing Model (CAPM) is used for computing expected returns of an individual
security.
Option A is incorrect because the Sharpe ratio is used to calculate the risk-to-reward ratio.

Option B is incorrect because the CML could be used to measure the expected return of an
undiversified portfolio, as proxied by the standard deviation.

Option D is incorrect because Beta is a risk measure that measures the sensitivity of an asset's
return as compared to the market return.

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Q.197 During an employment interview, a candidate is given the question to select the appropriate
formulas for the computation of an asset's beta. Out of the four following formulas for the beta, one
of them is INCORRECT. Which one?

A. Covariance of asset's return with the market return / Variance of the market returns.

B. (Correlation of asset's return and market return * Standard deviation of asset returns *
Standard deviation of market returns)/Variance of the market returns.

C. Correlation of asset's return and market return * (Standard deviation of asset returns /
Standard deviation of market returns).

D. Covariance of asset's return and market return * (Standard deviation of asset returns /
Standard deviation of market returns).

T he correct answer is D.

T he formula provided in Option D is incorrect for the computation of beta.

Option A is correct because of the standard formula for calculating an asset's beta = Covariance of
Asset's return with the market return / Variance of the market return.

Option B is also accurate since Covariance of asset's return with market return = Correlation of
asset's return and market return * Standard deviation of asset returns * Standard deviation of market
returns

Options C is also accurate because the alternative formula for the calculation of beta = Correlation
of asset's return and market return * (Standard deviation of asset returns / Standard deviation of
market returns)

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Q.198 Huma Ahmed is a junior portfolio analyst who has recently switched from the fixed income
portfolio management unit to his firm's equity portfolio management unit. On her first day, she was
asked by her senior portfolio analyst to compute the portfolio's beta that contains 5 assets. Using the
data provided in the table, determine the beta of the portfolio.

Asset Return Weight Beta

1 1.3% 0.10 0.35
2 10% 0.25 0.20
3 6% 0.25 0.15
4 9% 0.30 0.60
5 16% 0.10 0.40

A. 1.7

B. 0.34

C. 0.09

D. -1.1

T he correct answer is B.

T he beta (β) of the portfolio is calculated as:

βp = W 1β1 + W 2β2 + W 3 β3 + W 4β4 + W 5 β5

βp = 0.10 × 0.35 + 0.25 × 0.20 + 0.25 × 0.15 + 0.30 × 0.60 + 0.10 × 0.40 = 0.3425

Q.199 According to CAPM, which of the following risks should an investor be compensated for?

A. Systematic risk only.

B. Unsystematic risk only.

C. Both systematic and unsystematic risk.

D. Both systematic risk and asset-specific-risk.

T he correct answer is A.

T he investor should only be compensated for systematic risk or beta. Since CAPM assumes that
there are no transaction costs and an investor can diversify free of cost, the investor does not need
to be compensated for diversifiable risks, i.e., unsystematic or asset-specific-risk.

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Q.200 Assume you are a junior portfolio analyst for a Chinese asset management company based in
Beijing and you are given the task to evaluate the stock of Sun Cruise Inc. using CAPM. If the
expected return of the market is 17%, the stock beta is 0.89, the risk-free rate is 6%, and the
market risk premium is 11%, then the computed required rate of return of Sun Cruise Inc. is:

A. 17%

B. 15.8%

C. 10.45%

D. 11%

T he correct answer is B.

According to the Capital Asset Pricing Model (CAPM):

Expected return of a stock = Risk-free rate + Beta(Expected market return − Risk-free rate)

Expected return of Sun Cruise Inc. = 6% + 0.89(17% − 6%) = 15.79%

Note that,

Expected return = Beta ∗ Market risk premium + Risk-free rate

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Q.201 Which of the following is a maj or difference between T reynor and Sharpe measures?

A. While the T reynor measure uses beta as the risk measure to assess the volatility of a
portfolio relative to the market, the Sharpe measure takes into account the total risk
exposure and hence uses the standard deviation.

B. While the Sharpe measure uses beta as the risk measure to assess the volatility of a
portfolio relative to the market, the T reynor measure takes into account the total risk
exposure, hence uses the standard deviation.

C. T he T reynor measure is more straightforward and easier to calculate as compared to the

Sharpe measure.

D. All of the above.

T he correct answer is A.

T he question asks for the major difference between the two measures. As such, the main difference
between the two is that T reynor measure only considers systematic risk (through the use of beta)
while Sharpe considers both unsystematic risks and systematic risk(through the use of the standard
deviation).

Q.202 T he Jensen portfolio evaluation measure:

A. is a measure of return per unit of risk, as measured by standard deviation.

B. is an absolute measure of return over and above that predicted by the CAPM.

C. is a measure of return per unit of risk, as measured by beta.

D. B and C

T he correct answer is B.

T he Jensen's measure, or Jensen's alpha, is a risk-adjusted performance measure that represents the

average return on a portfolio or investment, above or below that predicted by the capital asset

pricing model (CAPM). T he value of the excess return can be positive, negative, or zero. T he CAPM

model itself takes into account the risk of the security, as represented by beta. T hus, if the security

is fairly priced, its actual returns will be the same as under the CAPM model.

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Q.203 John Cook, a retired surgeon, has the following assets:

A house and land worth $150,000 in total
An undiversified securities portfolio worth $700,000
A fleet of automobiles worth $160,000

Between the T reynor and the Sharpe measures, which measure would be of more concern to Mr.
Cook?

A. T he T reynor measure

B. T he T reynor measure for the portfolio and the Sharpe measure for the other assets

C. T he Sharpe measure

D. None of the two measures

T he correct answer is C.

A quick glance at the assets above reveals that the securities portfolio constitutes the major
proportion of Mr. Cook's assets. He is most likely interested in the safety of both income and
principal, regardless of the source of volatility. As a result, he would be more interested in the
Sharpe measure, since it takes into account the total risk - both systematic and unsystematic risks.
On the other hand, if the portfolio accounted for a relatively small proportion of the assets, the
T reynor measure would be of more concern since it focuses only on systematic/market risk.

Q.204 A 10-year research on 3 distinct portfolios and the market reveals the following information:

Portfolio Average Standard Beta

Annual Deviation
Return
1 14% 21 1.15
2 16% 24 1.00
3 20% 28 1.25
S&P500 12% 20

If the risk-free rate is 6%, then use the T reynor measure to rank the portfolios from the lowest to
the highest.
A. 1, 2, 3

B. 2, 3, 1

C. 3, 2, 1

D. 1, 3, 2

T he correct answer is A.

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T he T reynor measure of a portfolio,

(E(R p) − R f )
Tp =
βp

Hence:

(14% − 6%)
T1 = = 0.07
1.15
(16% − 6%)
T2 = = 0.1
1.0
(20% − 6
T3 = = 0.112
1.25

Q.205 A 10-year research on 3 distinct portfolios and the market reveals the following information:

Portfolio Average Standard Beta

Annual Deviation
Return
1 14% 21 1.15
2 16% 24 1.00
3 20% 28 1.25
S&P500 12% 20

If the risk-free rate is 6%, which portfolio carries the largest market risk?
A. 1

B. 2

C. 3

D. S&P 500

T he correct answer is C.

T he higher the beta, the larger the market risk. Portfolio 3 has the highest beta, which stands at
1.25.

Q.206 A 10-year research on 3 distinct portfolios and the market reveals the following information:

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Portfolio Average Standard Beta

Annual Deviation
Return
1 14% 21 1.15
2 16% 24 1.00
3 20% 28 1.25
S&P 500 12% 20

Given that the risk-free rate of return is 6%, use the Sharpe measure to rank the portfolios from the
lowest to the highest.
A. 1, 3, 2

B. 2, 3, 1

C. 2, 1, 3

D. 1, 2, 3

T he correct answer is D.

E(Rp)−Rf
T he formula for calculating the Sharpe ratio for a portfolio, Sp = Hence,
σp

(14% − 6%)
S1 = = 0.38
21%
(16% − 6%)
S2 = = 0.42
24%
(20% − 6%)
S3 = = 0.50
28%

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Q.207 Under Jensen's differential return measure, which of the following indicates superior market
timing on the part of the manager?

A. A zero alpha.

B. A positive alpha.

C. Statistically significant negative alpha.

D. Statistically significant positive alpha.

T he correct answer is D.

Alpha measures the share of additional returns brought about by the manager's decisions and skill. To
determine the statistical significance of alpha, we calculate the t-statistic - equal to the estimated
value of the alpha divided by its standard deviation. A t-statistic greater than 2 (assuming a normal
distribution) is associated with up to 95% probability of skill and less than 5% probability of mere
luck.

Q.208 Suppose you have two portfolios with the same average return, the same standard deviation of
returns, but portfolio Y has a lower beta than portfolio X. Which of the following statements is true
according to the Sharpe measure?

A. Portfolio X performs better than portfolio Y.

B. Portfolios X and Y perform equally.

C. Portfolio Y outperforms portfolio X.

D. None of these are correct.

T he correct answer is B.

T he Sharpe index measures the average portfolio return in excess of Rf (the risk-free rate) per unit

of total risk. T he total risk is measured by the standard deviation, not beta.

Opti ons A, C, and D are incorrect, considering the Sharpe ratio, then no portfolio outperforms the

other since they have the same standard deviation of returns.

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Q.209 You have been given the following data for a managed portfolio:

Beta = 1.2

Alpha = 1%

Average return = 14%

Risk-free rate = 4%

Calculate the return on the market portfolio basing your calculations on Jensen's measure of
portfolio performance.

A. 15.45%

B. 13%

C. 11.5%

D. 1.3%

T he correct answer is C.

According to Jensen's measure of performance:

α p = E(R p ) − [R f + [E(R m ) − R f ]βp]

1% = 14% − [4% + 1.2(x − 4%)]
1% = 14% − [4% + 1.2x − 4.8%]
1% = 14% − 4% − 1.2x + 4.8%
1.2x = 13.8%
x = E(R m ) = 11.5%

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Q.210 T he T reynor, Sharpe, and Jensen measures of portfolio performance are derived from CAPM.
Which of the following statements is correct regarding measures of portfolio performance?

A. All three measures are equally efficient at evaluating the performance of a manager.

B. All three measures have the same denominator.

C. Unlike the T reynor and Jensen measures, the Sharpe measure takes into account the total
risk of a portfolio.

D. T he T reynor and Sharpe measures use systematic risk, as represented by beta.

T he correct answer is C.

Under the Sharpe measure, the risk measure used is the total risk, as represented by the standard

deviation. Under the T reynor measure and Jensen's alpha, only the systematic risk is used, as

represented by beta.

Opti on A i s i ncorrect: T he three measures have different levels of efficiency at evaluating

performance as the inputs are different.

Opti on B i s i ncorrect: T he denominators of the three measures are different.

Opti on D is i ncorrect: Sharpe measure uses the standard deviation of market

returns(unsystematic risk) while T reynor measure uses beta(systematic risk)

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Q.211 What is the tracking error?

A. T he standard deviation of the return of the benchmark portfolio.

B. T he average of the differences between the returns of the risky portfolio and the
benchmark return.

C. T he standard deviation of the differences between portfolio return and the benchmark
return.

D. T he difference between the return based on the T reynor measure and Jensen's measure.

T he correct answer is C.

T racking error is the standard deviation of the difference between the returns of an investment and

its benchmark.

Mathematically:

T racking error = σ(R portfolio − R benchmark)

T racking error can be used as an indicator of active fund management.

Q.212 T ypically, the manager is required to keep the tracking error ______ a stated threshold. In this
regard, transaction costs should be _______.

A. Below, minimized

B. Above, minimized

C. Below, eliminated

D. Above, maximized

T he correct answer is A.

T he purpose of the tracking error is to ensure that the return earned by the manager does not
wander off too far below the benchmark return, while still giving room for performance that actually
outshines the benchmark portfolio. In this regard, the manager must minimize transaction costs.

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Q.213 A certain fund manager typically generates an alpha of 1% and a tracking error of 2.25%.
Determine the information ratio.

A. 0.3

B. 0.5

C. 2.25

D. 0.444

T he correct answer is D.

(Expected return of the portfolio − Expected return of the benchmark

T he information ratio =
T racking error
Alpha
=
T racking error
1
=
2.25
= 0.444

Q.215 Which of the following best explains how a manager can achieve superior portfolio
performance?

A. T he ability to time market returns.

B. T he ability to identify risk.

C. Superior timing and ability to select undervalued securities.

D. Neither selection nor timing: it is impossible to do this in any type of market.

T he correct answer is C.

A manager with an eye for undervalued securities and the ability to perfectly time market returns
can achieve superior performance. If an asset is undervalued, it means it offers a return that's
greater than its perceived risk level.

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Q.216 Nisha J. is a junior portfolio analyst at ABZ Investments located in Pakistan. She has been
directed by her head of department to use one of the four performance measure metrics, namely
CAPM, Sharpe ratio, T reynor ratio, and Jensen's alpha. She is further advised to use a more forward-
looking measure and more appropriate for comparing well-diversified portfolios. Which of the
following performance measures should she select?

A. CAPM

B. Sharpe Ratio

C. T reynor Ratio

D. Jensen Alpha

T he correct answer is C.

T he T reynor ratio measures the performance (return) of the portfolio with respect to its risk. T he

T reynor ratio is equal to the risk premium divided by systematic risk or beta.

Expected return of portfolio (E(R p ) − Risk-free rate (R f ))

T reynor measure =
Portfolio Beta

Since the T reynor ratio uses beta which must be estimated and the portfolio beta is the weighted

average of the betas a portfolio's assets, the T reynor measure is more appropriate for a well-

diversified portfolio and a more forward-looking measure. T he higher the T reynor ratio, the better it

is.

Opti on A i s i ncorrect: CAPM is backward-looking.

Opti on B i s i ncorrect: Sharpe ratio is used to measure historical performance.

Opti on D i s i ncorrect: Jensen Alpha assumes that investors hold well-diversified portfolios,

however, it measures past performance.

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Q.217 Sean and Adam are two asset managers in a specific firm. During their discussion with regard
to portfolio performance measures, Adam made the following statements:
Statement 1: If the Sharpe ratio of the portfolio is greater than the Sharpe ratio of the market
portfolio, it indicates the portfolio performs better for every additional unit of risk.
Statement 2: Jensen's alpha measure for the market portfolio is always 0.

Which of these statements is/are correct?

A. Statement 1 is correct, while statement 2 is incorrect

B. Statement 1 is incorrect, while statement 2 is correct

C. Both statements are correct

D. Both statements are incorrect

T he correct answer is C.

Both statements are correct.

(E(R p) − R f )
Sharpe ratio =
σp

If the Sharpe ratio of a portfolio is greater than the Sharpe ratio of the market portfolio, it indicates

the portfolio performs better for every additional unit of risk than the market portfolio. In other

words, the portfolio has a higher risk-adjusted return than the market portfolio.

Jensen measure = α p = E(R p ) − [R f + [E(R m ) − R f ]βp)

Since the beta of the market portfolio is always 1 and the expected return of the portfolio is the

same as the expected return of the market portfolio, the whole Jensen measure equation will cancel

out to 0.

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Q.218 As an analyst, you are analyzing the portfolio that focuses on the automotive industry. T he
portfolio contains 12 stocks in total with 6 stocks from the automotive industry, 3 stocks from car
financing firms, and 3 stocks from car lubricant manufacturers. T he expected return of the portfolio
is 31% with a standard deviation of 19% while the expected return of the market is 22% with a
standard deviation of 16%. Given that the risk-free rate is 5% and the portfolio's beta is 0.9, compute
the T reynor ratio of the portfolio.

A. 0.1

B. 1.37

C. 0.19

D. 0.29

T he correct answer is D.

(E(R p ) − R f ) (0.31 − 0.05)

T reynor ratio of portfolio = = = 0.288
βp 0.9

Q.219 T he expected return of an investor's portfolio is 31% with a standard deviation of 19% while
the expected return of the market is 22% with a standard deviation of 16%. Given that the risk-free
rate is 5% and the portfolio's beta is 0.9, determine the difference between the Sharpe ratio of the
portfolio and the Sharpe ratio of the market.

A. 0.31

B. 0.5

C. 1.06

D. 0.12

T he correct answer is A.

(E(R p) − R f )
(0.31 − 0.05)
Sharpe ratio of the investor's portfolio = = = 1.37
σp 0.19
(E(R m ) − R f ) (0.22 − 0.05)
Sharpe ratio of market portfolio = = = 1.06
σm 0.16
Difference = 1.37 − 1.06 = 0.31

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Q.220 Ross Linn is analyzing the performance of different stocks of a portfolio using the alpha
measure of performance. Linn has compiled the following data regarding UUA:
Covariance = 0.027
Variance of the stock = 12%
Risk-free rate of return = 6%
Expected market return = 13%
Actual stock's return = 14.5%
Beta = 1.1

Determine the correct alpha of UUA's stock and its appropriate interpretation.

A. T he alpha of UUA is 0.8% and the stock has underperformed the market.

B. T he alpha of UUA is 0.8% and the stock has outperformed the market.

C. T he alpha of UUA is -4.625% and the stock has underperformed the market.

D. T he alpha of UUA is -4.625% and the stock has outperformed the market.

T he correct answer is B.

Jensen alphas or alpha of the stock = Actual return of stock − CAPM

Alpha = A(R) − [R f + [E(R m ) − R f ]βp ]
= 0.145 − [0.06 + [0.13 − 0.06]1.1]
= 0.008 or 0.8%

Since UUA has a positive alpha of 0.8%, it suggests that the stock has outperformed the market by

0.8%.

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Q.221 Paul T homson is the Chief Investment Officer (CIO) of Continental Investments Inc., an asset
management company that supervises three portfolios managed by three different portfolio
managers. All the portfolios have the same level of risk as the benchmark index. If T homson is
interested in knowing which of the three portfolio managers possess the best stock-picking skills,
then which of the following statement is true?

A. T he manager with the highest tracking error has the best stock-picking skills.

B. T he manager with the lowest tracking error has the best stock-picking skills.

C. T he manager with the lowest information ratio has the best stock-picking skills.

D. T he manager with the lowest Sharpe ratio has the best stock-picking skills.

T he correct answer is B.

T he tracking error is used to assess managers' stock-picking skills. T racking error is described as

the standard deviation of the difference between the portfolio return and the benchmark return,

given that the risk of the portfolio is the same as the risk of the benchmark index or benchmark

portfolio. T ypically, managers try to keep the tracking error below a stated threshold because a

lower tracking error indicates better stock-picking skills. Managers must consider transaction costs

and other portfolio management-related costs to keep the tracking error closer.

Opti on A i s i ncorrect: It contradicts option B.

Opti on C i s i ncorrect: T he information ratio is used to state if the manager's deviation from the

benchmark portfolio has earned appropriate returns. T he information ratio is essentially the excess

return of the portfolio relative to its benchmark, divided by the tracking error.

Opti on D i s i ncorrect: Sharpe ratio helps investors understand the returns of an investment

compared to its risk.

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Q.222 Bella Sean is a senior portfolio manager in a UK-based firm. She has recently rejoined the
office after her maternity leave. During her absence, her subordinate, Vikram Singh, was managing
one of her portfolios. She now notices that Vikram has significantly deviated from the benchmark
portfolio in order to earn higher gains than the portfolio. If Bella wants to assess if Singh's deviation
from the benchmark has reaped appropriate returns, then which of the following measures must she
use?

A. T racking error

B. Information ratio

C. Sortino ratio

D. Jensen alpha

T he correct answer is B.

T he information ratio is used to state if the manager's deviation from the benchmark portfolio has

earned appropriate returns. T he information ratio is essentially the excess return of the portfolio

relative to its benchmark, divided by the tracking error.

(E(R p ) − E(R B ))
Information ratio =
σA

Opti on A i s i ncorrect: T racking error is used to assess the stock-picking skills of a portfolio or

investment manager.

Opti on C i s i ncorrect: because the Sortino ratio is similar to the Sharpe ratio. However, in the

Sortino ratio, the risk-free rate is replaced by the minimum acceptable return (MAR), and the

standard deviation of the returns is replaced by the standard deviation of the returns that are lower

than the minimum acceptable return.

Opti on D i s i ncorrect because Jensen's alpha is used to compare portfolios that have different

beta.

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Q.3468 A portfolio is constructed of two assets, including a risky asset with a standard deviation of
18% and a risk-free asset. Suppose the weight of the risk-free asset in the portfolio is 35%, then
calculate the standard deviation of the portfolio.

A. 18%

B. 6.3%

C. 11.7%

D. 5.75

T he correct answer is C.

A risk-free asset has a standard deviation of zero.

We know that,

VP = w 21 σ12 + w 22σ22 + 2w 1w 2 σ1σ2 ρ1,2

2 2 2
= 0.35 × 0 + 0.65 × 18 + 2 ∗ 0.35 ∗ 0.65 ∗ 18 ∗ 0 ∗ ρ1,2
= 136.89

So that, the standard deviation of the portfolio is given by:

SDP = √VP = √136.89 = 11.7%

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Q.3469 A portfolio manager is constructing a portfolio composed of two assets. Asset A is a risky
asset with an expected return of 14% and a standard deviation of 22%, and asset B is a risk-free asset
with an expected return of 9%. If the portfolio manager increases the weight of the risky asset to
130%, then the expected return of the portfolio is closest to:

A. 0.182

B. 0.155

C. 0.167

D. 0.1123

T he correct answer is B.

Expected return of the portfolio = (Weight of Asset A * Return of Asset A) + (Weight of Asset B *
Return of Asset B) = (1.3 * 14%) + (-0.3 * 9%) = 15.5%

Detailed explanation:

Recall that the capital market line represents the portfolios that optimally combine risk and return

by combining the risk-free asset with the risky asset(market portfolio). An investor can move up or

down this line by varying the weights that they invest in the risk-free asset and the risky asset.

Rather than just split their money between the two assets, an investor who is willing to take more

risk can borrow more money at the risk-free rate and invest it in the risky asset. Borrowing puts a

negative weight on the risk-free asset. Let's see how this comes about: Let the return on the risk-

free rate be X, and the return on the risky asset be Y. Let's say you have $100 in your pocket and

here's your initial plan: To invest $50 in the risk-free asset To invest $50 in risky asset But then you

decide to take more risk; you will borrow $80 at the risk-free rate X and invest it in the risky asset

What’s your total investment? Risk-free asset: = $50 - $80 = -$30 (essentially a “give and take”

scenario) Risky asset; $50 + $80 = $130 T hus, Expected Return = -$30/(-$30+$130)*X + $130/(-

$30+$130)*Y = -0.3*X + 1.3*Y In our case, X = 9%, Y = 14% Expected return = -0.3 * 0.09 + 1.3 *

0.14 = 0.155

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Q.3470 T he expected return of the Karachi Stock exchange is 17%, and the rate on Pakistan's risk-
free bonds is 7.5%. Suppose the beta of Bata Corporation shares is 0.75, what is the required rate of
return on Bata Corporation's shares?

A. 0.1263

B. 0.2025

C. 0.1673

D. 0.1463

T he correct answer is D.

T he required rate of return on shares is calculated using the Capital Asset Pricing Model (CAPM).
Required rate of return = Risk-free rate + Beta (Market Return - Risk-free rate) = 7.5% + 0.75*
(17%7.5%) = 14.63%

Q.3471 Which of the following portfolios is/are most appropriately priced?

I. A portfolio with an estimated return above the securities market line (SML).
II. A portfolio with an estimated return plotted on the SML.
III. A portfolio with an estimated return below the SML.

A. Portfolios I & II

B. Portfolio II

C. Portfolios II & III

D. All of the above

T he correct answer is B.

T he portfolio is underpriced if the portfolio's estimated return is above the SML. Conversely, a
portfolio with an estimated return below the SML is overpriced.
T he portfolio with an estimated return plotted on the SML is properly priced.

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Q.3472 Which of the following measures of risk-adjust returns does NOT use beta?

A. T reynor measure

B. Jensen's alpha

C. Sharpe ratio

D. None of the above

T he correct answer is C.

T he Sharpe ratio measure of risk-adjust returns use standard deviation or total risk. T reynor and
Jensen's alpha use beta or systematic risk.

Q.3473 T wo portfolios have the following characteristics:

Portfolio Return Beta

A 8% 0.7
B 7% 1.1

Given a market return of 10% and a risk-free rate of 4%, calculate Jensen's Alpha for both portfolios
and comment on which portfolio has performed better.

A. -0.2% and -3.6% respectively

Portfolio A has performed better than Portfolio B.

B. -0.2% and -3.6% respectively

Portfolio B has performed better than Portfolio A.

C. 0.2% and 3.6% respectively

Portfolio B has performed better than Portfolio A.

D. 3.6% and 0.2% respectively

Portfolio A has performed better than Portfolio B.

T he correct answer is A.

Jensen's Alpha is calculated as follows:

Jensen's Alpha = Rp - [Rf + Bp (Rm - Rf)]
Jensen's AlphaPortfolio A = 0.08 - [0.04 + 0.7(0.1 - 0.04)] = -0.002
Jensen's AlphaPortfolio B = 0.07 - [0.04 + 1.1(0.1 - 0.04)] = -0.036
Jensen's Alpha is -0.2% and -3.6% for A and B, respectively. A higher Alpha indicates that a portfolio
has performed better.

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Q.3474 Which of the following portfolio performance evaluation measures is (are) only based on
systematic risk?

A. Sharpe ratio

B. T reynor ratio

C. All of the above

D. None of the above

T he correct answer is B.

T he T reynor ratio uses beta (systematic risk).

On the other hand, the Sharpe ratio uses the portfolio's total risk as measured by the standard
deviation.

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Q.3476 T he line that shows all portfolios that an investor can create once we allow for a risk-free
asset is called the:

A. Efficient frontier

B. Capital allocation line

C. Capital market line

D. Beta

T he correct answer is C.

When all investors in the market have homogenous expectations of risk and return, the optimal

capital allocation line (CAL) for all investors is called the capital market line (CML).

Opti on A i s i ncorrect: An efficient frontier is the set of optimal portfolios that offer the highest

expected return for a given level of risk.

Opti on B i s i ncorrect: Capital allocation line is a l i ne drawn on a graph of all possible

combinations of risk-free and risky assets to show the expected return for a given level of risk.

Opti on D i s i ncorrect: Beta is just a measure of risk which describes the relationship between

systematic risk and expected return of assets.

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Q.3477 Which of the following is NOT an assumption of the capital asset pricing model?

A. Investors require higher returns with higher risks

B. Unlimited short-selling is permissible

C. All investors have the same one period time horizon

D. Investors are subject to taxes and transaction costs

T he correct answer is D.

CAPM assumes there are no taxes and no transaction costs.

Assumptions of the model include:

T here are no transaction costs

T here are no taxes

Assets are infinitely divisible

Unlimited short-selling is permissible

All assets are marketable/liquid

Investors are price takers whose individual buy and sell transactions have no effect on the

price

Investors’ utility functions are based solely on expected portfolio return and risk

T he only concern among investors are risk and return over a single period, and the single

period is the same for all investors

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Q.3478 Which of the following uses systematic risk on the X-axis?

A. Security market line

B. Capital market line

C. Capital allocation line

D. Capital asset pricing model

T he correct answer is A.

T he SML uses the Beta (or systematic risk) on the X-axis while the CML and the CAL use standard
deviation on the X-axis.

T he Security market line (SML) is a straight line that represents the expected return of an asset or

portfolio based on its beta, which is a measure of its systematic risk. T he SML is typically plotted on

a graph with the expected return on the y-axis and the beta on the x-axis.

B i s i ncorrect T he Capital market line(CML) is a straight line that represents the expected return

of an efficient portfolio based on its standard deviation, which is a measure of its total risk (both

systematic and unsystematic). T he CML is typically plotted on a graph with the expected return on

the y-axis and the standard deviation on the x-axis.

C i s i ncorrect. T he Capital Allocation Line (CAL) is a graphical representation of the portfolio

theory, which describes the relationship between the expected return and risk of a portfolio that

combines a risk-free asset and a risky asset. T he CAL is typically plotted on a graph with the

expected return on the y-axis and the standard deviation on the x-axis.

D i s i ncorrect. T he Capital Asset Pricing Model (CAPM) is a financial model that describes the

relationship between the expected return and risk of an asset or portfolio. T he model is based on the

principle that investors demand a higher return for taking on higher levels of risk.

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Q.3479 T he standard deviation of an asset's return is 10%, and the standard deviation of markets
return is 14%. If the correlation of returns with the market index is 0.7, then what is the beta of the
asset?

A. 1

B. 0.1

C. 1.8

D. 0.5

T he correct answer is D.

Assets beta = Correlation of markets return * (Standard deviation of the asset / Standard deviation of
market returns) = 0.7 * 10% / 14% = 0.5

Q.3480 T he expected return of a portfolio is 17% and the return on risk-free assets in the portfolio
is 8%. T he beta of the portfolio is 1.2, and the standard deviation of the portfolio is 5.5%. Assuming
that an investor invests 115% of his savings in this portfolio, what is his expected return?

A. 18.35%.

B. 19.55%.

C. 12.5%.

D. 0.1345

T he correct answer is A.

Since the weight of the market portfolio is more than 100%, the investor is borrowing 15% of funds
at the risk-free rate and investing 115% in the market portfolio.
E[r] = (-15%)(8%) + (115%)(17%) = 18.35%

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Q.3481 Kate Williams is a portfolio risk analyst for Hampton Funds. She is assigned to calculate the
beta of Lion Inc. shares. What is its beta if the standard deviation of market returns is 19% and the
covariance of Lions returns with the market return is 0.163?

A. 0.85

B. 4.51

C. 0.0451

D. 2.55

T he correct answer is B.

Beta = Covariance of Asset's return with market return / Variance of market returns
Beta = 0.163/0.192 = 4.51

Q.3482 What is the expected return of a stock if the expected market return is 11%, the risk-free
rate is 9%, and the stock's beta is 0.91?

A. 0.11

B. 0.1991

C. 0.1082

D. 0.1753

T he correct answer is C.

According to CAPM:
Expected return of stock = Risk-free rate + beta (Market risk - Risk-free rate)

E[r] = 9% + 0.91(11%-9%) = 10.82%

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Q.3483 What is the covariance of an asset's returns with the market if the beta of the asset is 1.7
and the variance of market returns is 20%?

A. 0.34

B. 0.85

C. 0.12

D. 8.5

T he correct answer is A.

Covariance of asset returns with the market = Beta * Variance of market returns = 1.7 * 0.20 = 0.34

Q.3484 What is the market risk premium if the expected return on the market is 13%, the average
stock's beta is 1, and the risk-free rate is 8%?

A. 9%

B. 13%

C. 5%

D. 0%

T he correct answer is C.

Market risk premium = Expected return of market - Risk-free rate of return.

Risk premium = 13% - 8% = 5%

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Q.3485 What is the market risk premium if the expected return on a stock is 12% while its beta is
1.5? Assume the risk-free rate is 6% and the return on the market, i.e. market risk is 10%.

A. 6%

B. 4%

C. 10%

D. 12%

T he correct answer is B.

Expected return on stock = Risk-free rate + Beta*Risk premium

Note: Market risk - Risk-free rate = Risk premium

Expected return on stock = Risk-free rate + Beta*(Market return - Risk-free rate)

12% = 6% + 1.5(10% - 6%)
Market return = (12% - 6%)/1.5 + 6% = 10%

Risk premium = Market return - Risk-free rate = 10% - 6% = 4%

Q.3486 What is the beta of a certain stock with a risk-free rate of 2.1% and a return of 14.2%, given
that the expected return of the market is 17%?

A. 1

B. 1.5

C. 1.2

D. 0.81

T he correct answer is D.

T he expected return on the stock is given by:

rf + β(rm − rf )

⇒ 14.2% = 2.1% + β (17% − 2.1%)

⇒ β = 0.81

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Q.3487 T he standard deviation of a portfolio is 15%. If the portfolio's return is 22%, and the risk-free
return is 6%, then what is the Sharpe ratio of the portfolio?

A. 0.91

B. 1.07

C. 1.46

D. 1.98

T he correct answer is B.

Sharpe ratio = (Portfolio return - Risk-free return) / Standard deviation of portfolio = (22% - 6%) /
15% = 1.07

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Q.3488 Which of the following measures excess return per unit of total risk?

A. Jensen's alpha

B. T reynor ratio

C. Sharpe ratio

D. Sortino ratio

T he correct answer is C.

T he Sharpe ratio is a risk-adjusted performance metric that measures the excess return of an

investment or portfolio relative to its total risk. T he Sharpe ratio measures excess return per unit

of total risk.

A i s i ncorrect. Jensen's alpha is a risk-adjusted performance metric that measures the excess

return of an investment or portfolio over its expected return, given its level of systematic risk

(beta).

B i s i ncorrect. T he T reynor ratio is a risk-adjusted performance metric that measures the excess

return earned by an investment or portfolio per unit of systematic risk (beta).

D i s i ncorrect . T he Sortino ratio is a risk-adjusted performance metric that measures the excess

return of an investment or portfolio relative to its downside risk, which is defined as the risk of

losses that are below a certain threshold.

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Q.3489 T he 10-year US T reasury rate is 5% and the return on the S&P 500 index is 10%. If the beta
of Orange Inc. is 1.2, what is the expected return on shares of Orange Inc.?

A. 11%

B. 15%

C. 17%

D. 8%

T he correct answer is A.

According to CAPM,
Expected return of stock = Risk-free rate + Beta(Market risk - Risk-free rate)
E[r] = 5% + 1.2(10%-5%) = 11%
Note that the 10-year US T reasury bonds are considered the risk-free rate and the S&P 500 return
is considered the market return.

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Q.3490 Which of the following statements is appropriate regarding the plot of undervalued stocks on
the security market line?

A. Undervalued stocks plot above the SML

B. Undervalued stocks plot under the SML

C. Stocks always plot on the SML

D. Valuation can not be determined.

T he correct answer is A.

Stocks plotted above the security market line are considered undervalued, while stocks plotted

below the security market line are considered overvalued. Stocks plotted on the security market

line are considered fairly valued.

T he security market line represents the expected return of an investment based on its level of risk.

T he line is derived from the capital asset pricing model (CAPM), which takes into account the risk-

free rate of return, the expected return of the market, and the stock's beta, or level of volatility

compared to the overall market.

Investments that offer higher returns than the security market line are considered attractive, as

they are providing higher returns for the level of risk. Conversely, investments that offer lower

returns than the security market line are considered unattractive, as they are not providing enough

returns for the level of risk.

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Q.3491 Company ABC is expected to return 15% per year to its investors, the market expected
return is 8%, and the risk-free rate is 3.5%. What is ABC's stock beta?

A. 1.4375

B. 1.875

C. 2.5556

D. 3.3333

T he correct answer is C.

E(R i ) = R f + E(R m − R f )βi

15% = 3.5% + (4.5%)βi
11.5% = (4.5%)βi
⇒ βi = 2.5556

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Reading 6: The Arbitrage Pricing Theory and Multifactor Models of

Risk and Return

Q.223 T he following are inputs to a multifactor return model for any stock, EXCEPT :

A. Firm-specific return.

B. Deviation of macroeconomic factors from the expected values.

C. T he expected return for the stock.

D. Aggregate market risk.

T he correct answer is D.

Unlike the CAPM, a multifactor model for a stock does not take into account aggregate market risk.

Instead, the model uses factor loadings/factor sensitivities/factor betas to assess the effect of certain

dominant factors on the return of the stock.

Note that a multifactor model is given by:

R i = E(R i) + βi1F1 + βi2 F2 + ⋯ + βik Fk + ei

Where:

R i = rate of return on stock i

E(R i ) = expected return on stock i

βik = sensitivity of the stock’s return to a one-unit change in factor k

Fk = Macroeconomic factor k

ei = the firm-specific return/portion of the stock’s return unexplained by macro factors

T he expected value of the firm-specific return is always zero.

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Q.224 Define arbitrage as used in the context of security trading.

A. T he exploitation of undervalued assets so as to increase returns.

B. T he exploitation of security mispricing aimed at making risk-free profits.

C. T he skill of accurately timing returns so as to obtain optimal profit from a security.

D. T he exploitation of illegal trading channels aimed at making tax-free profits.

T he correct answer is B.

Arbitrage opportunities exist when there are pricing discrepancies in the prices of equivalent
securities, enabling investors to pounce on the mispricing and earn risk-free profit. Arbitrage
involves simultaneous buying of a security in market A and selling of the security in market B at a
profit. A good example of an arbitrage opportunity would be the sale of a share for different prices
on different exchanges. Markets ought to exhibit a no-arbitrage condition.

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Q.226 T he common stock of Swisscom Inc. is examined with a single factor model using unexpected
percent changes in GDP as the single factor. You have been provided with the following data:
Expected return for Swisscom = 10%
GDP factor-beta = 2
Expected GDP growth = 2%

Revised macroeconomic information strongly suggests that the GDP will grow by a whopping 5% as
opposed to the original prediction of 2%. Assuming there's no new information regarding firm-
specific events, calculate the revised expected return using a single factor model.

A. 10.6%

B. 6%

C. 20%

D. 16%

T he correct answer is D.

T he equation for a single factor model for stock i is given by:

R i = E(R i) + βi,jFj + ei

Where:

R i = revised return for stock i

E(R i ) = the expected return for stock i

βi,j = the jth factor beta for stock i

Fj = the deviation of the factor j from its expected value

ei = the firm-specific return for stock i

In our case:

R i = 0.10 + 2(0.05 − 0.02) = 0.10 + 0.06 = 0.16 or 16%

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Q.227 ShipLink, a United States cargo company, considers the return earned on its stock as heavily
sensitive to GDP and consumer sentiments. You have been given the following data:
Expected return for Shiplink stock = 10%
GDP factor beta = 2
Expected growth in GDP = 3%
Consumer sentiment factor beta = 2.5
Expected growth in consumer sentiment = 2%

Suppose revised macroeconomic data suggests the GDP will grow by 4% rather than 3% and that
consumer sentiments will grow by 3% rather than 2%. Determine the revised return for Shiplink
stock, assuming no new information is available regarding the firm-specific return.

A. 18%

B. 25%

C. 14.5%

D. 4.5%

T he correct answer is C.

T his is a multifactor model where the revised return, R i will be given by:

R i = E(R i ) + βS,G DP FG DP + βS ,CS FCS + ei

= 0.10 + 2(0.04 − 0.03) + 2.5(0.03 − 0.02)
= 0.10 + 0.02 + 0.025
= 0.145 or 14.5%

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Q.228 A manager uses a two-factor model to examine the returns of two assets, X and Y. T he two
factors are unexpected percentage changes in inflation (IF) and consumer sentiment (CS). T he
following data has also been given:

E(R X ) = 10%

E(R Y ) = 12%

βX,I F = βY ,IF = 2

βX,CS = βY ,CS = 2

All other factors constant, which of the following statements is true?

A. Asset Y is more sensitive to inflation than asset X.

B. Inflation and consumer sentiment have different effects on the returns of X and Y.

C. An arbitrage opportunity exists.

D. None of the above are true.

T he correct answer is C.

Based on the information given, an arbitrage opportunity exists because despite the two assets

having equal systematic risks, they are priced based on different expected returns. To avoid the

making of risk-free profits, expected returns should be equal as long as systematic risks are identical.

In this case, an investor can make a risk-free profit by shorting asset X and using the proceeds to

take a long position in asset Y.

Opti ons A and B are i ncorrect: βX,I F = βY ,IF = 2, and βX,CS = βY ,CS = 2 which implies that

Inflation and consumer sentiment have the same effects on the returns of X and Y.

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Q.229 What is the three-factor model proposed by Eugene Fama and Kenneth French primarily used
to explain?

A. T he stock market's return volatility

B. T he long-term performance of a company

C. T he relationship between risk and return

D. T he stock market's direction of movement

T he correct answer is C.

T he three-factor model proposed by Eugene Fama and Kenneth French is an extension of the Capital

Asset Pricing Model (CAPM). T his model is used to explain the relationship between risk and

expected return in portfolio investments, by introducing two additional factors - size and value - that

are said to be associated with higher returns for investors. It states that, aside from market risk

(beta), size (smaller companies) and value (or book-to-market) have significant effects on expected

returns, which explains why certain portfolios may outperform others over time.

A i s i ncorrect.T he stock market's return volatility is not explained by the three-factor model
proposed by Eugene Fama and Kenneth French as it does not account for changes in volatility over
time.
B i s i ncorrect.T he long-term performance of a company is not explained by the three-factor model
as it does not focus on individual companies but rather how different portfolio combinations behave
over time.
D i s i ncorrect.T he stock market's direction of movement is also not explained by the three-factor
model as this depends on other factors such as economic news or investor sentiment, which are
outside its scope of analysis.

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Q.230 Consider a single factor APT. Portfolio X has a beta of 1.2 and an expected return of 18%.
Portfolio Y has a beta of 1.0 and an expected return of 14%. You are further provided with a risk-free
rate of 6%. Assuming you wanted to exploit an arbitrage opportunity, you would take a short position
in:

A. Y and use the proceeds to take a long position in X.

B. Y and use the proceeds to take a long position in the risk-free asset.

C. X and use the proceeds to take a long position in Y.

D. X and use the proceeds to take a long position in the risk-free asset.

T he correct answer is A.

For portfolio X, 18% = 1.2F + 6%; F = 10%

For portfolio Y, 14% = 1.0F + 6%; F = 8%
T hus, short Y and take a long position in X.

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Q.231 When the equilibrium price relationship is violated, an investor will try to take as large a
position as possible. T his is an example of:

A. Risk-free arbitrage.

B. T he capital asset pricing model.

C. T he mean-variance frontier.

D. T he single factor security market line.

T he correct answer is A.

Violation of the equilibrium price relationship will prompt an investor to buy the lower-priced asset

and simultaneously place an order to sell the higher-priced asset. T his is an example of risk-free

arbitrage. In fact, the larger the long position taken, the greater the risk-free profits.

Opti on B i s i ncorrect: CAPM explains that the market equilibrium is attained when all investors

hold portfolios whose constituents are a combination of riskless asset and the market portfolio

Opti on C i s i ncorrect: T he mean-variance frontier is a combination of securities that offer the

best possible returns at a minimum variance possible.

Opti on D i s i ncorrect: a single-factor model assumes there’s just one macroeconomic factor.

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Q.232 What is the major difference between CAPM and the APT ?

A. APT places more emphasis on systematic risks.

B. APT downplays the importance of diversification.

C. APT recognizes multiple systematic factors.

D. APT recognizes multiple unsystematic factors.

T he correct answer is C.

T he CAPM assesses portfolio performance based on market risk as a measure of the aggregate

systematic risk. APT uses multiple systematic factors like the GDP, inflation, and interest rates

where each factor has an associated beta.

Opti on A i s i ncorrect: APT does not place more emphasis on systematic risks; it puts emphasis on

multiple systematic factors.

Opti on B i s i ncorrect: One of the assumptions of APT is that investors can use diversification to

eliminate specific risks from their portfolios.

Opti on D i s i ncorrect: APT recognizes multiple systematic factors and not multiple unsystematic

factors.

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Q.233 Which of the following statements is true regarding the security market line derived from the
arbitrage pricing theory?

A. It shows the expected return in relation to portfolio variance, represented by σ 2.

B. It has a downward slope.

C. T he x-axis intercept is equal to the expected return on the market portfolio.

D. Any well-diversified portfolio may serve as the benchmark portfolio.

T he correct answer is D.

T he benchmark portfolio does not have to be the market portfolio, which may actually be

unobservable. Instead, it can be any other portfolio provided it is well-diversified.

Option B is incorrect. It has an upward slope, just like the CAPM.

Q.234 T he following are factors used by Fama and French in their multifactor model, EXCEPT :

A. T he Return on the market index (R m − R f ).

B. T he Return earned by small stocks over and above the return on large stocks.

C. T he Return earned by high book-to-market stocks over and above the low book-to-market
stocks.

D. None: All the above factors are used.

T he correct answer is D.

T he Fama-French 3-factor model uses all the three factors. T he two economists contend that the 3
factors adequately capture all systematic risks.

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Q.235 A portfolio Z is subject to two risk factors, A and B, with factor betas of 0.3 and 0.5,
respectively. A fund manager wishes to hedge away all of the exposure to both A and B, yet he's not
ready to sell the portfolio at any cost. Choose the strategy best placed to achieve the manager's
desired goal.

A. Short sell a hedge portfolio with 50% allocation to factor A portfolio, 30% allocation to
factor B portfolio, and 20% allocation to the risk-free asset.

B. Short sell a hedge portfolio with 30% allocation to factor A portfolio, 50% allocation to
factor B portfolio, and 20% allocation to the risk-free asset.

C. Buy a hedge portfolio with 50% allocation to factor A portfolio, 30% allocation to factor B
portfolio, and 20% allocation to the risk-free asset.

D. Buy a hedge portfolio with 30% allocation to factor A portfolio, 50% allocation to factor B
portfolio, and 20% allocation to the risk-free asset.

T he correct answer is B.

A factor portfolio is a well-diversified portfolio designed to have a beta equal to 1 for one of the risk
factors and betas equal to zero for all the remaining factors. To offset the factor risks inherent in the
original portfolio, the investor will have to short the hedge portfolio. T he 0.30 and the 0.50
exposures to risk factors A and B respectively will be offset by the hedge portfolio which also has
similar exposures to the two factors.

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Q.236 Which of the following best explains why the APT is considered more flexible than the
CAPM?

A. It uses multiple systematic factors, not just a single aggregated factor, to represent the
total market risk.

B. Just like the CAPM, the APT allows for the use of a single factor through the single factor
model which can be extended to include more factors.

C. With the APT, the benchmark portfolio in the security market line does not have to be the
true market portfolio.

D. None of the above.

T he correct answer is C.

Unlike in the CAPM, the benchmark return used to establish the security market line does not have

to be the usually unobservable market portfolio. Flexibility is achieved because any portfolio,

provided it's well-diversified, can be used in the APT. T his is especially helpful when questions are

raised about the accuracy of the index portfolio as a proxy for the true market portfolio.

One of the disadvantages of APT, is that, it requires a lot of data and statistical analysis hence it is

more difficult to apply it in practice.

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Q.238 Suzy Ye is a junior equity research analyst at a research firm based in South Korea. For the
first time, she is using the multifactor model to compute the stock return of the Wong Kong Corp
(WK). She has compiled the following data for the computation of the return:
Wong Kong's expected stock return: 7%
Expected GDP growth: 4.5%
Expected Inflation: 2.5%
GDP factor beta: 1.5
Inflation factor beta: 2
Risk-free rate: 2%

Suppose the actual GDP growth and actual inflation of South Korea are 3% and 2.9%, respectively,
then which of the following is an accurate estimate of the stock return?

A. 7.55%

B. 10.05%

C. 5.55%

D. 18.75%

T he correct answer is C.

A multifactor model (2-factor model in the given question) only includes the expected return of the

stock, macroeconomic factor and the factor-beta, and firm-specific risk, which in this case is zero.

R W K = E(R W K) + βG DP FG DP + βI FI
= 0.07 + 1.5(0.03 − 0.045) + 2(0.029 − 0.025)
= 0.07 − 0.0225 + 0.008
= 5.55%

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Q.239 T he single-factor model indicates that the return is based on a firm-specific variable and a
macroeconomic variable such as inflation, GDP growth, interest rates, consumer sentiments, etc.
T hese factors combined with the expected return of the asset allow hedging the risk of those assets
whose returns change with the changes in macroeconomic variables. In the single-factor model, the
macroeconomic variables are used as inputs in the form of:

A. Deviation of the macroeconomic variable from its expected value.

B. Actual value of the macroeconomic variable multiplied by its sensitivity to the asset.

C. Expected value the macroeconomic variable multiplied by the beta factor.

D. Deviation of the macroeconomic variable from its expected value multiplied by the beta
factor.

T he correct answer is A.

T he correct input of the macroeconomic variable/factor in the single-factor or multifactor model is

to use the deviation of the macroeconomic variable from its expected value.

R Asset = E(R Asset) + βEconomic variableFDeviation of economic variable + eAsset

Opti ons B and C are i ncorrect because they indicate to use the actual value and expected value

of the macroeconomic variable rather than the deviation of the variable from its expected value

Opti on D i s i ncorrect Even though the deviation of the macroeconomic variable from its expected

value is multiplied by the beta factor, but the beta coefficient is estimated (later) during model fitting

based on the deviations.

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Q.240 As an analyst, you are analyzing a number of stocks of German Tech companies trading on the
TecDAX. You come across two stocks DESolars AG and GERTech Co., with expected returns of
4.9% and 5.1%, respectively. In order to assess if an arbitrage opportunity exists between two
stocks, you compile the following data to be used in the two-factor model:
Actual GDP Growth: 2%
Expected GDP Growth: 2%
Actual CPI: 1.7%
Expected CPI: 1.5%
DESolars (GDP) beta: 1.1
DESolars (CPI) beta: 0.9
GERTech (GDP) beta: 1.1
GERTech (CPI) beta: 0.9

Considering the given data, identify which of the following statement is true?

A. An arbitrage opportunity does not exist because both stocks have different expected
returns.

B. An arbitrage opportunity exists because both firms have the same beta factor.

C. An arbitrage opportunity does not exist because both firms have the same beta.

D. An arbitrage opportunity exists because both firms have different returns for the same
systematic risk.

T he correct answer is D.

An arbitrage opportunity exists when a single stock is traded on different markets or when different

stocks are traded in the same market, which gives the different rates of return for the identical

systematic risk or beta. In this example, DESolar and GERTech have the same beta factor or

identical systematic risk. However, the return on DESolar is 4.9% and 5.1% on GERTech. An

investor can short sell DESolar and use the proceeds to purchase GERTech and earn an arbitrage

profit (or risk-free profit) of 0.2%.

Opti on A i s i ncorrect: T he stocks don’t have to have the same return for there to be an arbitrage

opportunity.

Opti ons B and C are i ncorrect: Arbitrage opportunities occur when both firms have the same

beta but with different returns.

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Q.241 Creative Investments Co. holds a brainstorming and strategy-building session before the trading
hours in order to prepare the analysts and traders for the day. While conducting the session Craig
Lee, head of the equity department, made the following statements regarding the impact of
diversification on the residual risk of a portfolio:
Statement 1: "T he part of the asset's risk that is uncorrelated with the volatility of the market
portfolio is called nonsystematic risk."
Statement 2: "T he part of the asset's risk that is due to the positive covariance of that asset's
returns with market returns is called the systematic risk or diversifiable risk."
Statement 3: "As the number of assets in a portfolio increases, the systematic risk of the portfolio
decreases."

Which of the following statement is/are correct?

A. Statement 1 only

B. Statement 3 only

C. Statements 1 and 2

D. Statements 2 and 3

T he correct answer is A.

Both statements 2 and 3 are incorrect. Statement 2 is incorrect because the part of the asset or
security's risk that arises due to the positive covariance of the asset's returns with market returns
is called systematic risk or un-diversifiable risk. Diversifiable or nonsystematic risk is the security's
risk that is uncorrelated with the volatility of the market portfolio.
Statement 3 is incorrect because, with an increase in the number of assets in the portfolio,
nonsystematic risk (not systematic risk) of the portfolio decreases.

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Q.242 During a Securities Analysis seminar at one of the top business schools in Mumbai, a student
asked the moderator to define the assumptions that constitute the single-factor security market line.
T he moderator stated that the following assumptions are made while drawing the single-factor
security market line:
I. Returns follow a k-factor process
II. A mean-variance efficient market portfolio exists
III. Well-diversified portfolios can be created
IV. No arbitrage opportunities exist

Which of the above assumptions do(es) NOT hold true in the creation of the single-factor security
market line?

A. Assumption I only

B. Assumption IV only

C. Assumptions I and II

D. Assumptions II and III

T he correct answer is C.

Assumptions I and II are not made while drawing the single-factor security market line. T he three
assumptions of the single-factor security market line are:
1. Security returns can be explained by the single-factor model
2. Well-diversified portfolios can be created
3. No arbitrage opportunities exist

Assumption I, returns follow a K-factor process, is related to the Arbitrage Pricing T heory (APT ).

Assumption II, the mean-variance efficient market portfolio exists, is an assumption of the Capital
Asset Pricing Model (CAPM).

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Q.243 Kevin Brett is an American portfolio manager who manages an emerging factor market
portfolio that focuses on the blue-chip firms from Brazil. He fears that the stocks of these blue-chip
firms are highly dependent on factors like the GDP of Brazil and the value of the Brazilian Real. He
believes his portfolio can decline in value due to changes in these two main factors. T he portfolio's
Brazilian GDP beta is 0.40 and the Brazilian Real beta is 0.3. Which of the following strategies should
Brett accept in order to hedge both factors?

A. Short sell a hedge portfolio that allocates 40% exposure to the Brazilian GDP factor
portfolio, 30% to the Brazilian Real factor portfolio, and 30% to the risk-free asset.

B. Buy a hedge portfolio that allocates 40% exposure to the Brazilian GDP factor portfolio,
30% to the Brazilian Real factor portfolio, and 30% to the risk-free asset.

C. Buy a hedge portfolio that allocates 30% exposure to the first Brazilian GDP factor
portfolio, 40% to the Brazilian Real factor portfolio, and 30% to the market portfolio.

D. Short sell a hedge portfolio that allocates 70% exposure to the risk-free asset and 30% to
the market portfolio.

T he correct answer is A.

A factor portfolio can be hedged by opening opposite positions with the same factor exposure. A
factor portfolio has a factor-beta equal to one for a single risk factor, and factor betas equal to zero
on the remaining factors. By shorting the hedge portfolio, the investor will offset the factor risks of
the original portfolio. Since Kevin has a 0.4 exposure to the Brazilian GDP factor and a 0.3 exposure
to the Brazilian Real factor, he can hedge the risk by shorting a factor portfolio that allocates 40%
exposure to the Brazilian GDP factor portfolio, 30% to the Brazilian Real factor portfolio, and the
rest to the risk-free assets.

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Q.4452 All the following are factors of the Fama-French Model, EXCEPT :

A. Market factor.

B. T he difference in expected returns of high-beta stocks minus small-beta stocks.

C. T he difference in expected returns of a portfolio of high book-to-market stocks minus a

portfolio of low book-to-market stocks.

D. T he difference in expected returns of small stocks minus big stocks.

T he correct answer is B.

T he Fama-French model consists of three factors:

1. Market factor
2. T he difference in expected returns of small stocks minus the big stocks
3. T he difference in expected returns of a portfolio of high book-to-market stocks minus a
portfolio of low book-to-market stocks

Q.4454 In the Fama-French three-factor model, in addition to the market factor and the HML factor,
what is the other factor and what does it refer to?

A. T he momentum factor, WML, which captures the outperformance of past winners in

relation to past losers.

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

relation to low book-to-market stocks.

C. T he SMB factor, which captures the outperformance of small firms in relation to the
larger firms.

D. T he momentum factor, WML, which captures the outperformance of high-growth stocks

in relation to low-growth stocks.

T he correct answer is C.

In the Fama-French three-factor model, one of the factors is the SMB, which refers to small stock
returns minus big stock returns (Small Minus Big). T he market capitalization of the stocks gives rise
to small and big stocks.
T he last factor is the outperformance of small firms in relation to the large firms. T his is captured
by the SMB factor (Small Minus Big).

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Reading 7: Risk Data Aggregation and Reporting Principles

Q.245 T he following are some of the benefits of having an effective risk data aggregation and
reporting system, EXCEPT :

A. An increased ability to avoid losses.

B. An increased ability to identify the routes to return to financial health after a tumultuous
period.

C. An increased ability to make strategic decisions, reduce the chances of loss, and increases
efficiency.

D. An increased ability to identify projects with optimal returns for investment purposes.

T he correct answer is D.

T he four most important benefits of an elaborate and effective risk data aggregation system relate to
an increased ability to:
Anticipate business problems
Identify route back to good financial health
Make strategic decisions that positively impact the organization
Attain smooth resolvability in the event of duress or failure

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Q.247 Prime Bank, a global systematically important bank (G-SIB) has incurred big losses resulting
from a range of issues, including too many bad debts due to improper lending decisions and
investment in futures without prior due diligence. T he bank is now in deep capital problems and
struggling to meet day-to-day funding needs. T he bank's management turns to an expert of the Basel
committee recommendations for advice. Which of the following potential benefits would result from
risk data aggregation, particularly taking into account the bank's current situation?

A. Increased bank efficiency.

B. A clearer definition of the bank's risk appetite.

C. Improved resolvability of the bank's problems.

D. Improved data confidentiality, integrity and availability.

T he correct answer is C.

Having aggregated risk data would help the regulators to resolve the current undercapitalization and

liquidity issues.

Opti on A i s i ncorrect: Improved capability of the risk function to make judgments that can bring

about increased efficiency and profitability-However this does not fit the current situation

Si mi l arl y, Opti ons B and D are i ncorrect since they don’t address the capital problems that

the bank is facing.

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Q.248 After making losses in two consecutive financial years, the board of a G-SIB bank directs the
bank's chief supervisor to submit a report containing position and risk exposure information for all
relevant risks. T he supervisor proceeds to summarize a report that includes detailed information
about specific risks such as credit risk, operational risk, and market risk. However, the report falls
short of adequate stress tests and forecasts. Which of the following effective risk data aggregation
principle set forth by the Basel Committee on Banking Supervision did the supervisor most likely
violate?

A. Principle 3 - Accuracy and integrity

B. Principle 8 - Comprehensiveness

C. Principle 9 - Clarity and usefulness

D. Principle 4 - Completeness

T he correct answer is B.

According to the principle of comprehensiveness, risk management reports should cover all material

risk areas within the organization. T he depth and scope of these reports should be consistent with

the size and complexity of the bank’s operations and risk profile, as well as the requirements of the

recipients.”

Opti on A i s i ncorrect: According to the principle of accuracy and integrity, a bank should be able

to generate accurate and reliable risk data to meet normal and stress/crisis reporting accuracy

requirements. Data should be aggregated on a largely automated basis so as to minimize the

probability of errors

Opti on C i s i ncorrect: According to the principle of clarity and usefulness, risk management

reports should communicate information clearly and concisely. Reports should be easy to understand

yet comprehensive enough to facilitate informed decision-making. In addition, reports should include

meaningful information tailored to the needs of the recipients.

Opti on D i s i ncorrect: According to the principle of completeness, a bank should be able to

capture and aggregate all material risk data across the banking group. Data should be available by

business line, legal entity, asset type, industry, region and other groupings, as relevant for the risk in

question, that permit identifying and reporting risk exposures, concentrations and emerging risks.

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Q.249 Mike Harvey is the risk management supervisor at an Indian bank. He wishes to establish
principles for effective risk data aggregation in line with Basel committee recommendations. T he
bank has historically been lenient regarding risk data gathering and processing and Harvey intends to
remedy the situation. Which of the following statements is incorrect concerning the accuracy
principle?

A. Risk reports should exclude mathematical descriptions and logistical relationships so as to

make them less sophisticated and enhance comprehension.

B. Error reports should be created to highlight and explain errors in the data.

C. T he bank should clearly define the process used to create risk reports.

D. T he risk reports should include reasonable checks of the data.

T he correct answer is A.

According to the accuracy principle, mathematical or logistical relationships should be included in a

report whenever such inclusion has a significant impact on the understanding of the report's

contents. T he relationships ensure the accuracy of the facts and figures presented.

Opti ons B, C, and D are accurate: according to the principle of data architecture and

infrastructure, a bank should design, build and maintain data architecture and IT infrastructure which

fully supports its risk data aggregation capabilities and risk reporting practices not only in normal

times but also during times of stress or crisis, while still meeting the other Principles.

According to the principle, banks should also:

Make risk data aggregation and reporting practices a key part of the bank’s planning

processes.

Establish integrated data classifications and architecture across the banking group.

Appoint individuals tasked with various data management responsibilities. For example, risk

managers, business managers, and/or IT specialists should be tasked with ensuring the data

is relevant, entered correctly, and aligned with data taxonomies

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Q.250 According to the committee, “A bank's risk data aggregation capabilities and risk reporting
practices should be subject to strong governance arrangements consistent with the other principles
and guidance established by the Basel Committee.” Which of the following statements is in
divergence with the governance principle?

A. Risk data aggregation should form an integral part of the risk management framework.

B. It is ideal to have multiple sources of risk data for each type of risk facing the organization
so as to enhance reliability.

C. T imely integration of risk data should be carried out immediately a new firm is acquired.

D. Human and financial resources should be directed towards risk data aggregation and
therefore the board should approve the framework.

T he correct answer is B.

T here should be only one source of risk data, NOT multiple sources.

According to the principle of governance, a bank’s risk data aggregation capabilities and risk reporting

practices should be subject to strong governance arrangements consistent with other principles and

guidance established by the Basel Committee.

T his principle suggests that risk data aggregation should be a central part of risk management, and

senior management should make sure the risk management framework incorporates data aggregation

before approving it for implementation.

A bank’s risk data aggregation capabilities and risk reporting practices should be:

Fully documented

Validated and independently reviewed by individuals well versed in IT and data and risk

reporting functions.

Unaffected by the bank’s group structure.

A priority of senior management who should go to great lengths to make sure risk data

aggregation is part and parcel of the risk management function.

Considered as part of any new initiatives, including acquisitions and/or divestitures, IT change

initiatives and new product development

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Q.251 Olive Park is the head of risk management at a Korean Bank. She has been tasked with
preparing a report for the bank's board of directors scheduled to meet in the near future. T he report
will inform several important decisions to be made by the board regarding relevant bank risks.
In an email sent to the directors prior to the meeting, Park assures them of the accuracy,
reasonableness, and completeness of her submission. She points out that a large amount of
quantitative data in the report will make it hard for the report to be fully understood by non-risk
management professionals. She also plans to distribute the report to all the relevant parties in a
timely manner while still maintaining confidentiality. Which of the following effective risk data
aggregation principle set forth by the Basel Committee on Banking Supervision did Park most likely
violate?

A. Principle 11 - Distribution

B. Principle 9 - Clarity and usefulness

C. Principle 8 - Comprehensiveness

D. Principle 1 - Governance

T he correct answer is B.

According to principle 9, it is paramount to tailor reports to fit the needs of the final user. In her

email, Park suggested that the report would not be tailored to fit the board because of the large

amount of quantitative data that would be hard to be interpreted by non-risk management specialists.

T he board usually comprises many financial experts, but not all of them all well- versed in risk

management. It's important to understand that the different final users – managers, the board, junior

employees, interns, and others – have different needs in terms of reporting. In particular, there is a

greater need for qualitative interpretation and explanation as the report moves up the hierarchy of

leadership in an organization.

Opti on A i s i ncorrect: According To the principle of Distribution, risk management reports should

be distributed to the relevant parties while ensuring confidentiality is maintained. Banks should strike

a balance between the need to ensure confidentiality and the timely dissemination of reports to all

appropriate recipients

Opti on C i s i ncorrect: According to the principle of comprehensiveness, risk management reports

should cover all material risk areas within the organization. T he depth and scope of these reports

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should be consistent with the size and complexity of the bank’s operations and risk profile, as well as

the requirements of the recipients

Opti on D i s i ncorrect: According to the principle of governance, a bank’s risk data aggregation

capabilities and risk reporting practices should be subject to strong governance arrangements

consistent with other principles and guidance established by the Basel Committee.

T his principle suggests that risk data aggregation should be a central part of risk management, and

senior management should make sure the risk management framework incorporates data aggregation

before approving it for implementation.

Q.252 Which of the following goes against the principle of accuracy and integrity as set forth by the
Basel Committee?

A. It's most desirable to have a single authoritative source of risk data for each type of risk
facing an organization.

B. Data should be aggregated manually at all times so as to minimize the probability of errors.

C. Risk personnel should have direct access to risk data so as to effectively refine, validate,
reconcile, and process the data for use in reports.

D. Controls put in place to monitor risk data should be as robust as those used in financial
accounting.

T he correct answer is B.

Data should be aggregated on a largely automated basis to reduce the risk of errors brought about by
human input. However, human intervention is necessary when professional judgment is to be made.

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Q.253 According to the Basel committee, who bears the responsibility of setting the frequency of
risk management report and distribution?

A. T he chief risk officer only

B. T he bank supervisor only

C. T he board of directors and senior management

D. T he risk management department

T he correct answer is C.

It's the work of the board/senior management to specify how often the risk report should be

produced as well as set out guidelines on how to proceed in times of financial stress/crisis.

Opti on A i s i ncorrect: T he CRO is responsible for designing the firm's risk management program

and monitoring the firm’s risk limit set by the senior risk management.

Opti on B i s i ncorrect: Supervisors provide guidance for cooperate governance at banks through

comprehensive evaluations and working closely with the board.

Opti on D i s i ncorrect: T he risk management department identifies, monitors, and controls risk.

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Q.254 In an attempt to promote and institute strong and effective data aggregation capabilities, the
Basel committee has put forth several principles. Which of the following principles is correctly
matched with a recommendation to be followed in accordance with the given principle?

A. T he timeliness principle recommends that an organization should continually update its

system to accommodate changes in best practices.

B. T he accuracy principle recommends that the risk data be reconciled with the supervisor's
estimates before aggregation.

C. T he integrity principle recommends that only automated processes should be used when
aggregating risk data.

D. T he completeness principle recommends that an organization should ensure it captures all

material risk exposures before risk data aggregation can be done.

T he correct answer is D.

T he completeness principle recommends the inclusion of all material risks into the risk data

aggregation process.

A i s i ncorrect. T he timeliness principle proposes that banks generate aggregate and up-to-date risk
data in a timely manner while also meeting the principles relating to accuracy and integrity,
completeness, and adaptability.

B and C are i ncorrect. In accordance with the Accuracy and Integrity principle, “a bank should be
able to generate accurate and reliable risk data to meet normal and stress/crisis reporting accuracy
requirements. Data should be aggregated on a largely automated basis so as to minimize the
probability of errors.”

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Q.255 Which of the following principles states that "data should be available by business line, legal
entity, asset type, industry, region and other groupings, as relevant for the risk in question, that
permit identifying and reporting risk exposures, concentrations and emerging risks?"

A. Data architecture and infrastructure

B. Clarity and usefulness

C. Completeness

D. Inclusivity

T he correct answer is C.

T he completeness principle states that "a bank should be able to capture and aggregate all material

risk data across the banking group. Data should be available by business line, legal entity, asset type,

industry, region and other groupings, as relevant for the risk in question, that permit identifying and

reporting risk exposures, concentrations and emerging risks."

Opti ons A i s i ncorrect: according to the principle of data architecture and infrastructure, a bank

should design, build and maintain data architecture and IT infrastructure which fully supports its risk

data aggregation capabilities and risk reporting practices not only in normal times but also during

times of stress or crisis, while still meeting the other Principles

Opti on B i s i ncorrect: according to the principle of clarity and usefulness, risk management

reports should communicate information in a clear and concise manner. Reports should be easy to

understand yet comprehensive enough to facilitate informed decision-making. Reports should include

meaningful information tailored to the needs of the recipients.”

Opti on D i s i ncorrect: According to the principle of comprehensiveness, risk management

reports should cover all material risk areas within the organization. T he depth and scope of these

reports should be consistent with the size and complexity of the bank’s operations and risk profile,

as well as the requirements of the recipients

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Q.256 While working on a risk report, two senior risk professionals made the decision to forego
automation and fill data entries by hand. T he two made that decision after a brainstorming exercise
alongside other junior employees. In their report, the pair gave details as to why it was necessary to
forego automation and why they had full confidence in the accuracy and integrity of the data. T his
scenario describes a:

A. T he justified exception to the principle of accuracy and integrity

B. Breach of regulations

C. Manual workaround

D. Breach of confidentiality

T he correct answer is C.

While automation is always preferred to manual input so as to minimize human error, it is up to the
bank to strike the right balance between the two. As such, any manual workarounds should be well
documented and satisfactorily explained.

Q.257 Which of the following is NOT a valid reason as to why senior management and the board of
directors should keep accurate and timely risk data aggregation reports?

A. T he report helps the management to track the organization's risk exposure and ensure
risk limits are observed.

B. T he board members may be asked to provide the reports during an impromptu visit by the
bank's supervisors.

C. T he management uses the reports to make important decisions regarding risk and
investment opportunities.

D. Senior management need reliable, relevant and up-to-date information when making
decisions during periods of financial stress and/or crisis.

T he correct answer is B.

T he board does not provide information to regulators or supervisors. T herefore, such requests can
only be made at the bank level.

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Q.258 According to the principle of adaptability, "a bank should be able to generate aggregate risk data
to meet a broad range of on-demand, ad-hoc risk management reporting requests, including requests
during stress/crisis situations, requests due to changing internal needs and requests to meet
supervisory queries." Which of the following is NOT included in the adaptability principle?

A. Data customization to fit the user's needs - takeaway, dashboards, anomalies, etc.

B. Flexible data aggregation processes that allow managers to swiftly assess risks for
decision-making purposes.

C. Capabilities to incorporate regulatory changes.

D. Capabilities to withhold some pieces of information that could paint the company in a bad
light.

T he correct answer is D.

T he risk data aggregation process should be transparent and not withhold crucial information as long

as such information is accurate and based on facts. T he process should instill confidence in

regulators and other stakeholders alike.

According to the principle of adaptability, “A bank should be able to generate aggregate risk data to

meet a broad range of on-demand, ad hoc risk management reporting requests, including requests

during stress/crisis situations, requests due to changing internal needs and requests to meet

supervisory queries.”

A bank's risk data aggregation capabilities should be flexible:

To assess emerging risks;

To incorporate changes in the regulatory framework;

To produce quick summary reports, etc.

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Q.259 Kevin Stanley, a senior risk consultant at Wansley Consultation Company, is currently
providing risk consultation to the RUSSBANK's recently opened retailed operations in Ukraine.
RUSSBANK is one the largest Russian banks that has recently started retail operations in the
Ukrainian market. Ukraine has a history of a large number of bank failures due to very low recovery
rates. Since RUSSBANK has entered the Ukrainian market for the first time and it is not familiar
with the retail market yet, Kevin referred the bank management and board to the Basel Committee's
recommendation to improve its aggregation and reporting of risk data. Given that the effective risk
data aggregation has several potential benefits, which of the following benefits is essential to
RUSSBANK's success?

A. Increased ability to anticipate problems.

B. Identify routes to return to financial health.

C. Improved resolvability.

D. Increased market share.

T he correct answer is A.

Opti on A increased ability to anticipate a problem is the correct option because currently, the bank

does not face a problem but the risk data aggregation will allow the risk managers to understand risks

holistically and it will increase management's ability to see problems and view the risks as a whole

rather than in isolation.

Opti on B i s i ncorrect because the benefit of identifying routes to return to financial health is

essential in times of financial stress when banks are looking for solutions to return to their past

status.

Opti on C i s i ncorrect because the benefit of resolvability is essential for those banks, which are

in stress or failure. T his benefit enables regulatory authorities to analyze aggregated data and resolve

bank's problems, especially global systematically important banks (G-SIBs).

Opti on D is not a benefit of risk data aggregation.

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Q.260 Which of the following is not a key governance principle related to risk data aggregation and
risk reporting practices that were provided by the Basel Committee?

A. Data architecture and infrastructure

B. Conciseness

C. Distribution

D. Frequency

T he correct answer is B.

Conciseness is not a key governance principle related to risk data aggregation and risk reporting

practices provided by the Basel Committee. T he key principles are:

1. Governance
2. Data Architecture and Infrastructure
3. Accuracy & Integrity
4. Completeness
5. T imeliness
6. Adaptability
7. Accuracy
8. Comprehensiveness
9. Clarity & Usefulness
10. Frequency
11. Distribution
12. Review
13. Remedial actions and supervisory measures
14. Home/host cooperation

Q.261 Muhammad Zubair, head of compliance at Miliyon Investment Bank, quoted a key governance
principle related to risk data aggregation provided by the Basel Committee, which states that "a bank
should be able to generate accurate and reliable risk data to meet normal and stress/crisis reporting
accuracy requirements. Furthermore, data should be aggregated on a largely automated basis so as to
minimize the probability of errors." Which of the following principles is Zubair referring to?

A. Governance

B. Completeness

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C. Accuracy & Integrity

D. T imeliness

T he correct answer is C.

According to the Basel Committee's 3rd Principle, "Accuracy & Integrity," a bank should be able to

generate accurate and reliable risk data to meet normal and stress/crisis reporting accuracy

requirements. Data should be aggregated on a largely automated basis so as to minimize the

probability of errors.

Opti on A i s i ncorrect: According to the principle of governance, a bank’s risk data aggregation

capabilities and risk reporting practices should be subject to strong governance arrangements

consistent with other principles and guidance established by the Basel Committee.

T his principle suggests that risk data aggregation should be a central part of risk management, and

senior management should make sure the risk management framework incorporates data aggregation

before approving it for implementation.

Opti on B i s i ncorrect: according to the principle of completeness, a bank should be able to

capture and aggregate all material risk data across the banking group. Data should be available by

business line, legal entity, asset type, industry, region and other groupings, as relevant for the risk in

question, that permit identifying and reporting risk exposures, concentrations and emerging risks.

Opti on D i s i ncorrect: T he principle of timeliness states that a bank should be able to generate

aggregate and up-to-date risk data in a timely manner while also meeting the principles relating to

accuracy and integrity, completeness and adaptability. T he precise timing will depend upon the nature

and potential volatility of the risk being measured as well as its criticality to the overall risk profile

of the bank. T he precise timing will also depend on the bank-specific frequency requirements for

risk management reporting, under both normal and stress/crisis situations, set based on the

characteristics and overall risk profile of the bank.

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Q.262 Vijay Kumar, Sonnet Bank's Chief Risk Officer, writes in the management discussion and
analysis (MD&A) section of the bank's annual report that Sonnet Bank, at all times, devotes its human
and financial resources to the improvement of risk data aggregation as it considers data aggregation
and reporting a part of the bank's planning processes. He also writes that the bank has established
multiple data models that are used as robust automated reconciliation measures. Kumar's comments
are aligned with one of the key principles of risk data aggregation. Identify that principle.

A. Adaptability

B. Comprehensiveness

C. Distribution

D. Data Architecture and Infrastructure

T he correct answer is D.

T he 2nd principle of risk data aggregation (i.e. Data Architecture and Infrastructure) requires that a
bank devotes its human and financial resources to risk data aggregation in times of stress. In addition,
it requires that risk data aggregation and reporting should be a part of the bank's planning processes
and subject to business impact analysis. Banks should establish integrated data classifications and
architecture across the banking group.

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Q.263 During a regular compliance meeting, a senior compliance manager made the following
comments related to the key governance principles of risk data aggregation:
Comment 1: "T he principle of completeness requires that the risk data should be aggregated in a
timely manner and data should meet all requirements for risk management reporting. It also requires
supervisors to review the timeliness and specific frequency requirements of bank risk data in
normal and crisis periods."
Comment 2: "T he principle related to adaptability requires banks to generate aggregate risk data that
is easier for managers to use in stress tests and scenario analyses. T he data should be flexible,
customizable, and available for ad hoc data requests to assess emerging risks."

Determine which of the following comments are correct.

A. Comment 1 is correct whereas comment 2 is incorrect.

B. Comment 1 is incorrect whereas comment 2 is correct.

C. Comment 1 is correct, and comment 2 is also correct.

D. Comment 1 is incorrect, and comment 2 is also incorrect.

T he correct answer is B.

Only comment 2 accurately defines a principle of risk data aggregation. Comment 1 is incorrect
because the principle of completeness requires the bank to be able to capture and aggregate all (off
and on the balance sheet) material risk data across the banking group. Moreover, the risk measures
and methods of aggregation should be clear enough for the understanding of senior managers. T he
principle of timeliness requires that the risk data should be aggregated in a timely manner and data
should meet all requirements for risk management reporting. Comment 2 correctly defines the
principle of adaptability.

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Q.264 Which of the following key principles of risk data aggregation requires banks to document
both the automated and the manual workarounds, and also requires banks to define why and when
human interventions are critical for data accuracy?

A. T imeliness

B. Adaptability

C. Accuracy and integrity

D. Clarity and usefulness

T he correct answer is C.

Principle 3, accuracy and integrity, requires that the banks should document both the automated and
the manual workarounds for the bank supervisor's understanding and also requires banks to define
why and when human interventions are critical for data accuracy. Option A, the principle of
timeliness, requires that the risk data should be aggregated in a timely manner and data should meet
all requirements for risk management reporting. It also requires supervisors to review the
timeliness and specific frequency requirements of bank risk data in normal and crisis periods. Option
B, adaptability, requires banks to generate aggregate risk data that is easier for managers and the
board to use in stress tests and scenario analyses. T he clarity and usefulness principle requires
banks to create risk data aggregation reports that are useful for supervisors and managers.

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Q.265 T he principle of comprehensive requires banks to create reports:

I. T hat contains position and risk exposure information for credit risk, liquidity risk, market risk, and
operational risk
II. T hat should satisfy senior management in terms of coverage, analysis, and comparability with
other banks
III. T hat should provide a historical review of the bank's risk appetite and past stress tests.

Which of the following statements is/are aligned with the principle of comprehensiveness?

A. Statement I

B. Statements II & III

C. Statements I & III

D. All statements are aligned with the principle of comprehensiveness

T he correct answer is A.

Statements II and III are not aligned with the definition of the principle of comprehensiveness.
T he principle of comprehensive requires banks to create reports:
1. T hat contains position and risk exposure information for credit risk, liquidity risk, market risk, and
operational risk
2. T hat should satisfy bank supervi sors, not the senior management in terms of coverage, analysis,
and comparability with other banks
3. T hat should provide a forward-l ook i ng, not the historical, review of the bank's risk appetite and
past stress tests

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Reading 8: Enterprise Risk Management and Future Trends

Q.67 Which of the following best explains the concept silo-based risk management?

A. T he process of managing each type of risk individually.

B. Management risks by subdividing the total exposure into specific and systematic risks.

C. T he process where each business unit within an organization manages only the risks
directly affecting its own functions.

D. T he process of subdividing the total risk exposure into major and minor risks of the
business.

T he correct answer is C.

T he silo approach to risk management describes a mechanism where the risk management function

in an organization is divided among departments or business units. Each department is charged with

managing selected risks, especially those that fall within its jurisdiction. For example, the IT

department can be charged with managing cybersecurity and privacy risks while the finance

department handles credit, market, liquidity, and interest risks.

Opti on A i s i ncorrect: In the silo approach, each risk is not managed individually, rather different

departments are expected to manage selected risks.

Opti ons B and D are al so i ncorrect: In the silo approach, the risks are distributed among various

departments but there is no subdivision of risk into various groups such as specific or systematic,

major or minor risks.

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Q.68 Which of the following arguments best explains why some companies prefer siloed risk
management to ERM?

A. T he silo approach simplifies the risk management process as each business unit works on
a small 'slice' of the total risk exposure.

B. T he silo approach promotes specialization, thus helps to develop a rich variety of risk
management expertise within the organization.

C. T he silo approach enables organizations to extensively analyze each risk without

overlooking important aspects.

D. Managing risks in silos is more efficient and takes a shorter time compared to ERM.

T he correct answer is B.

T he key reason why companies may want to manage risks in silos is because such an approach
enables the autonomous business units to specialize and develop top-notch expertise within their
jurisdiction. Specialization may lead to a more thorough analysis of each risk and therefore help the
organization to put in place the most efficient and reliable risk management tools.

Q.69 Define Enterprise Risk Management (ERM).

A. T he process of managing all the different categories of risks facing the organization.

B. T he process of dividing risks into different categories for analysis by the various
autonomous units within an organization.

C. Application of risk management across an enterprise in a holistic, consistent, and

structured way.

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

structured, consistent way.

T he correct answer is C.

ERM is an integrated approach to risk management that aims to analyze the risks facing an
organization across all its departments/units. It differs from the silo approach which subdivides risks
among departments for specialized analysis. ERM considers all the risks faced by the organization and
delves into interactions and interrelationships the risks have with each other. T he overall aim of
ERM is to integrate risk measurement and management into business processes so that the resulting
information can, in turn, be integrated into strategic business decisions.

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Q.70 In an online discussion between a risk manager and an international businessman, the
businessman makes the following comment: “I run several autonomous business units that manage
risks independently. I see no point in shifting to enterprise risk management, despite the current fad
about it. ERM is too complex and implementing it would just disrupt the smooth working of the
different units and hamper their progress.” T he risk manager feels that the businessman is wrong and
decides to write back to the businessman refuting his comments. Which of the following would NOT
form part of your response to the businessman?

A. ERM would bring out the interrelationships between the different units in terms of risk.

B. ERM would exclusively tackle downside risks, thus may help the company to offer
consistent returns to shareholders.

C. An elaborate ERM framework can give the company a bird's eye view of the marketplace,
thus enabling the company to identify and exploit favorable opportunities before competitors
are able to do so.

D. ERM can help to identify cross-business risks and help the company to learn from past
mistakes.

T he correct answer is B.

It's incorrect to say that ERM focuses only on downward risks that deal with losses. ERM also

delves into upward risks - the uncertain possibility of gain through the taking of profitable positions

before other market players catch up.

Opti ons A, C, and D are some of the benefits of ERM.

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Q.81 In the recent past, a certain bank has had a poor relationship with its regulator. T he CEO asks
the CRO to suggest some of the actions the company could take in a bid to improve this relationship
in the future. Which of the following presents a possible recommendation?

A. Sending a delegation to the regulator's office aimed at resetting relations between the two
sides.

B. Developing a robust internal supervisory policy.

C. Setting up a special board committee charged with improving relations with the regulator.

D. Forgetting the past and focusing on the future.

T he correct answer is B.

T he company could work with the regulator to develop a sound supervisory policy. Within such a

policy, the company could commit to submit responses to consultations in good a timely manner.

Perhaps coordinating submissions with other banks can help to demonstrate the willingness to

adhere to guidelines and timelines.

Opti ons A, B, and C are not policy actions, and therefore poor relationships are likely to re-occur

even after the current tiff is resolved.

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Q.3840 Which of the following statements is correct as far as Enterprise Risk Management is
concerned?

A. Independent operations of ERM dimensions motivate the success of the ERM framework
in a firm

B. ERM advocates viewing of risk across business lines by looking at the diversification and
the concentration of the risk

C. T he ERM looks at the level of each risk type in the firm and assesses them independently

D. All of the above

T he correct answer is B.

As compared to silo-based risk management techniques, in ERM risks are viewed across business

lines by looking at the diversification and the concentration of the risk.

Opti on A i s i ncorrect because the success of an ERM majorly depends on the interactions of the

above five dimensions. For instance, if a firm improves its stress testing and other risk

measurements, it does not guarantee the growth of effective risk management if the risk culture has

not been cultivated in the firm.

Opti on C i s i ncorrect because ERM leads to the organization and coordination of integrated risk

management.

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Reading 9: Learning From Financial Disasters

Q.112 In the lead-up to the 2007/2009 financial crisis, Lehman Brothers had positioned itself as the
leading institution in the mortgage-backed securities market. Which of the following best explains
why the firm failed so spectacularly despite boasting huge amounts of capital?

A. T he firm was highly leveraged, reducing its ability to absorb losses

B. A large number of the firm’s mortgage-backed securities were built upon sub-prime
mortgage assets

C. T he firm was considered too big to fail

D. A lack of confidence among investors which in turn led to a lack of funding

T he correct answer is A.

All of the above statements explain one aspect or the other about Lehman Brothers which
eventually contributed to the firm’s failure. However, the main reason why the firm failed can be
traced down to the relationship between leverage and illiquidity. To fund its aggressive growth
strategy, Lehman Brothers resorted to extreme l everage that far surpassed its capacity to repay.
T he firm took on huge amounts of short-term debt to fund long-term assets, exposing itself to serious
liquidity problems. Too much debt meant that the firm could not absorb losses when the housing
bubble burst.

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Q.113 T he Barings incident came up mai nl y due to:

A. T he actions of a single trading official

B. T he lack of adequate control systems and the failure of management to exercise even the
basic oversight roles

C. Collusion between back-office staff and a junior level manager

D. T he massive earthquake that hit Japan in 1995, triggering unprecedented losses in the
stock market

T he correct answer is B.

T he Barings incident involved the loss of approximately $1.25B within a period of less than 3 years,
resulting from the unmonitored speculative derivative trading by a junior officer. Although all the
above factors contributed to the final outcome, it is the failure of the management to exercise its
oversight role that stands out.
Nick Leeson, a British Barings junior trader based in Singapore, was originally tasked with running a
low-risk, arbitrage business. However, Nick gradually took more risky positions in Japanese stocks
and interest rate futures. T he 1995 Japanese earthquake definitely plunged the stock market,
although the warning bells had rung much earlier. Just how did the management ignorantly aid Nick in
executing his hidden motives?

1. Allowing Nick to double up as the head of trading and back office at an isolated branch in an
attempt to save money. T his created the perfect environment for Nick to influence the back-office
staff into hiding trading losses.
2. Allowing Nick to settle his own trades, thereby giving Nick a free hand in the settlement of losses.
Even after the auditors raised the issue with the senior management, their advice was largely
ignored.
3. T urning a blind eye to apparently astronomical profits gained from what was supposed to be a low-
risk business.

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Q.114 T he trouble among Savings and Loans Associations (S&Ls) in the United States can be traced
down to an increase in interest rates and inflation, which collectively served to reduce the profit
margin initially enjoyed by the heavily regulated S&Ls. T he regulator responded by relaxing some of
the stringent rules. For example, the limit on deposit insurance coverage was raised from $40,000 to
$100,000 to make it easier for troubled or insolvent institutions to attract deposits to lend with.
Which of the following problems did this particular change create?

A. S&Ls engaged in even riskier lending activities

B. Taxpayers were forced to pay for the increase

C. T here was a huge bailout after a large number of S&Ls failed

D. All of the above

T he correct answer is D.

T hese regulatory changes put in place to rescue S&Ls did not quite generate the intended effect. For

instance, the availability of a more generous amount of deposit insurance led to a moral hazard where

S&Ls engaged in even riskier lending activities, which in turn increased the probability of loss.

As the number of S&L fell to fewer than 2,200, it was necessary that one of the most expensive

banking system bailouts of USD 160 billion. T he taxpayers had to fund this bailout.

Q.115 Which of the following served as the main source of funding for Lehman Brothers in the lead-
up to the 2007/2009 financial crisis?

A. Bond market

B. Repo market

C. Stock sale

D. Reserves

T he correct answer is B.

Lehman was funding long-term assets with short-term debt, mainly in the form of repo agreements
and commercial paper. Lehman borrowed billions of dollars each day in the overnight wholesale
funding markets in order to operate.

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Q.117 T he following statements are true regarding Long-Term Capital Management (LT CM), except:

A. LT CM is categorized as a financial disaster caused by large market moves but not

misleading reporting.

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

competitor holding similar assets unexpectedly exiting the market.

C. LT CM was founded with the aim of tapping short-term positions instead of focusing on the
long term.

D. LT CM models assumed that historical relationships were useful predictors of future

relationships, albeit in the absence of external economic shocks.

T he correct answer is C.

T he hedge fund was focused on long-term investment strategies and investors were locked into

investments for long periods of time in order to avoid illiquidity. In fact, after recording impressive

results over the first few years, the partners at LT CM believed so strongly in the success of their

venture to the extent of committing to the fund a large portion of their net worth.

In summary, LT CM’s crisis could be attributed to the following:

Overreliance on historical models that did not simulate the occurrence of large economic

shocks.

LT CM’s models further assumed that low-frequency/high-severity events were

uncorrelated over time. As it turned out, one economic shock triggered another so that

extremely low probability events were occurring several times per week.

All of LT CM’s trading strategies were hinged on the assumption that risk premiums and

market volatility would ultimately decline. As a result, the firm had failed to diversify its

investments wide enough.

T he following are suggestions that have been put forth to avoid a recurrence of a similar crisis:

T here’s need for large-scale stress testing using not just historical data but also simulated

stress scenarios, even if such scenarios haven’t yet played out on the market.

T he initial margin in derivative contracts should always be enforced. In many cases, LT CM

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had to mark its positions to market, but the initial margin was waived.

Q.119 Consider the following statements:

I. LT CM models assumed that low frequency/high severity events were correlated over a period of
time
II. LT CM models accounted for the spikes in correlations among asset class prices during economic
shocks
Select the true statement(s):

A. I

B. II

C. Both I and II

D. None

T he correct answer is D.

To begin with, the LT CM models basically relied on historical correlations to measure risk. In so
doing, the firm inadvertently failed to account for the spike in correlations caused by economic
shocks. A good example of such a shock was the defaulting of Russia on its debt that initiated a
worldwide economic tumble. In addition, the models ignored the possibility of infrequent shocks
clustering together, one causing another. T he result was an underestimation of risk in the tails of the
distribution.

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Q.120 Which of the following risks was realized in the Metallgesellschaft case study?

A. Credit risk.

B. Interest rate risk.

C. Funding liquidity risk.

D. Operational risk.

T he correct answer is C.

Metallgesellschaft Refining and Marketing designed a marketing strategy with the aim of protecting
its customers from price fluctuations of heating oil and gasoline. T he company offered customers
the chance to buy oil and gasoline at a premium of $3 to $5 above the average price of futures
contracts expiring over the next 12 months. T wo years after rolling out the offer, the price of oil
sharply dropped from about $21 to $14 per barrel, resulting in losses of approximately $900m for the
company. T hese losses were realized immediately as the futures contracts were marked to market.
T he gains from customers which could have offset the losses (immediately) could not be realized
until several years later. T he situation led to a shortage of short-term cash outflows, thereby
creating funding liquidity risk.

Q.121 Metallgesellschaft Refining and Marketing (MGRM), a U.S. subsidiary of the German oil
company Metallgesellschaft, lost over $1.5 billion as a result of a poor dynamic hedging strategy.
What triggered the loss? T he company:

A. Adopted an outdated and largely ineffective hedging strategy called a “stack-and-roll hedge”.

B. Bought too many long terms futures contracts.

C. Failed to predict the significant rise in oil prices in 1993.

D. Suffered a significant decline in oil prices resulting in huge unrealized losses and
subsequent margin calls.

T he correct answer is D.

MGRM used short-term futures to hedge because of a lack of alternatives. Besides, the long-term
futures contracts available were highly illiquid. As it turned out, MGRM’s open interest in unleaded
gasoline contracts was 55 million barrels in the fall of 1993, compared to an average trading volume
of 15-30 million barrels per day.
MGRM encountered problems in the timing of cash flows required to maintain the hedge. Over the
entire life of the hedge, these cash flows would have canceled out. MG's problem was a lack of
necessary funds needed to maintain its position. T he fundamental problem manifested in the form of
inadequate funds to mark positions to market and meet margin requirements.

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Q.122 In the modern business world, it's not uncommon to find organizations recording phone
conversations between clients and staff. Which of the following best explains why firms must
exercise caution when engaging in such an exercise as highlighted by the Bankers T rust incident?

A. Taping conversations can have a negative impact on the ability of staff to freely and
candidly engage with clients.

B. T he recorded conversations can be used against the organizations as evidence during

lawsuits.

C. T he exercise may not yield significant results and may actually deal a heavy blow to
staff/management trust.

D. Taping conversations could consume considerable time and energy, which could otherwise
be channeled into more productive business.

T he correct answer is B.

Procter and Gamble and Gibson sued Bankers T rust over the latter's failure to tailor negotiated

derivative trades to meet their individual needs. P&G and Gibson actually used phone records of BT

staff as evidence in lawsuits. In particular, some of the employees were on record bragging about

how badly they'd fooled clients with complex, unfathomable structures. T he case study highlighted

the need to exercise caution when “wire-tapping” staff.

Opti on A i s i ncorrect: Apart from the negative effects associated, audio recording can impact a

business positively as the audio may be used for future reference.

Opti on C i s i ncorrect: Audio recording may be useful if used correctly only within the

organization among the staff.

Opti on D i s i ncorrect: Audio tapping is automatic and requires no time as it takes place at the

same time during a phone conversation, for example.

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Q.124 Which of the following was most influential in the Metallgesellschaft case study?

A. German accounting rules of the time.

B. Outright fraud.

C. Flawed computer-based software.

D. T iming differences in the cash flows of its long and short positions.

T he correct answer is D.

T he major problem at Metallgesellschaft was a timing mismatch between futures contract losses and
forward contract cash flows that the company was trying to hedge. T he mismatch was compounded
by the sheer size of Metallgesellschaft's positions which made it difficult to close the positions
without incurring substantial costs.

Q.126 Which of the following led to Enron failure

A. Governance risk

B. Liquidity risk

C. Foreign currency risk

D. Credit risk

T he correct answer is A.

Enron was a poster child of corporate governance failure and poor risk management.

Greed caused the downfall of both the corporation by developing a system where no one was

actually looking out for the good of the company. T he hunger fueled executives to make decisions in

their own personal interest, at the sacrifice of the company, which led to the Enron collapse.

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Q.127 Which of the following characterizes the early stages of a financial disaster?

A. Excessive optimism about future asset prices.

B. Excessive pessimism about future asset prices.

C. T he collapse of the housing mortgage market.

D. Stagnating share price.

T he correct answer is A.

In the early stages of a financial disaster, the future looks particularly bright with the prices of assets

such as shares, mortgages, and other products rising. An expectation takes root that prices will

continue to rise, and buyers rush into the market. Sellers get convinced that their expectations are

valid and that their market strategies are a good fit and will come to pass.

In the case of Lehman, for example, the firm’s entry into the mortgage-backed securities market

coincided with astronomical growth in the industry, where home prices were projected to increase

indefinitely. For the first few years, Lehman Brothers recorded fast growth fueled by the house

price bubble. In early 2007, the firm surpassed Bear Sterns and became the largest underwriter for

mortgage-backed securities.

In the case of Continental Illinois, the management engaged in an aggressive growth strategy that

prioritized large-scale (but risky) lending to institutional borrowers. In the 5 years prior to 1981, the

bank’s commercial and industrial lending jumped from USD 5 billion to over USD 14 billion. During

that time, the bank’s total assets grew from USD 21.5 billion to USD 45 billion.

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Q.128 Nick Leeson, a junior trader at the Singapore office of British Barings, took speculative
derivative positions in an effort to recover past losses that he was able to hide fraudulently. T he
speculative positions further increased the size of losses that lead to Barings bankruptcy in 1995.
Which of the following is the cause of the losses?
I. Little management oversight of the settlement process
II. T he speculative long-long futures positions

A. I only

B. II only

C. I & II

D. None of the above

T he correct answer is C.

T he speculative long-long futures positions exposed the bank to huge market risks when the market
prices of the Nikkei 225 fell after the 1995 earthquake in Japan. All the long-long positions were in
huge losses. Also, little management oversight of the settlement process allowed Nick to
fraudulently hide the trades in the error accounts.

Q.129 Between 1986 and 1995, nearly a third of the 3,234 savings and loan associations in the United
States failed. It is widely accepted that overregulation played a role in the crisis. How exactly did this
happen?

A. S&Ls were required to pay depositors a rate of interest that was significantly lower than
that offered elsewhere.

B. S&Ls were not allowed to offer commercial loans so as to avoid risky lending.

C. Only a very limited amount of deposit insurance was allowed .

D. All of the above.

T he correct answer is D.

S&Ls were governed by the so-called “Regulation Q,” which set their minimum capital requirements
and capital adequacy standards. Regulation Q prohibited thrifts from engaging in a variety of banking
activities. For example, they were required to pay depositors a rate of interest that was significantly
lower than that offered elsewhere. Furthermore, S&Ls were not allowed to offer commercial loans
so as to avoid risky lending. Deposited insurance had been limited, again, to discourage risky lending
behavior.

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Q.130 In the 1980s, the savings and loans industry in the United States suffered through a period of
distress. T he distress can be traced down to:

I. A decline in the effectiveness of Regulation Q in preserving the spread between the cost of
money and the rate of return on assets
II. An inability to vary the return on assets with increases in the rate of interest required to be
paid for deposits
III. Increased competition on the deposit gathering and mortgage origination sides of the business
IV. Elimination of regulations initially designed to prevent lending excesses and minimize failures

A. I, II, and IV

B. II and III

C. I and IV

D. All of the above

T he correct answer is D.

T he loan crisis of thrifts in the 80s can be traced down to limitations under Regulation Q under

which the thrifts operated.

First, since the 1930s, thrifts were required to maintain a predetermined spread between the cost of

money and the rate of return on assets by paying depositors a rate of interest that was significantly

lower than that offered elsewhere. In the 1970s, however, there was a dramatic increase in both

interest rates and inflation, which reduced the profit margin on which thrifts depended to remain in

business. To make the matter worse, the mortgages these thrifts were selling came with fixed

interest rates that could not be varied during the term of the mortgage.

What’s more, the level of competition sharply increased between thrifts and mainstream banks as

well as among the thrifts themselves. As inflation hit, the number of individuals applying for

mortgages was growing smaller by the day.

When some of these regulations were eventually lifted in the early 80s, they did not help the thrifts

“grow” out of their problems as intended but actually accelerated the downfall. Risk-taking increased

in an unprecedented manner, resulting in huge losses across the industry.

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Q.131 Which of the following dynamic hedging strategies was used by Metallgesellschaft Refining and
Marketing (MGRM)?

A. Stack-and-roll

B. Delta hedging

C. Stop-loss strategy

D. Dynamic delta-hedging

T he correct answer is A.

T he type of dynamic hedging strategy implemented by MGRM is known as a rolling hedge (also called
a stack-and-roll hedge). A stack -and-rol l hedge involves purchasing futures contracts for a nearby
delivery date and on that date rolling the position forward by purchasing a fewer number of
contracts. T he process continues for future delivery dates until the exposure at each maturity date
is hedged.

Q.132 Funding liquidity risk played a critical role in which of the following financial scandals?

A. Orange County

B. Savings and Loans Crisis

C. SWIFT

D. Metallgesellschaft Refining and Marketing

T he correct answer is D.

T he financial crisis at Metallgesellschaft is not a case of misleading information, but a case of large

market movements that resulted in funding liquidity risk and trading liquidity risk. T he losses

incurred by MGRM were fundamentally from cash flow timing differences associated with the

positions making up its hedge.

Opti ons A, B are classic cases of financial disasters due to misleading reporting and lack of risk

management oversight.

Opti on C presents a case of cyber risk.

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Q.133 Long-Term Capital Management, a hedge fund started by ex-employees of Citigroup, posted
returns of 43% and 41% in the first two years of its formation due to its positions in global equity,
derivatives, and fixed income assets. After the 1998 financial crisis in Russia, the fund lost 44% of its
capital. Which of the following factors lead to the financial disaster of LT CM?
I. Use of highly leveraged positions, which was possible due to waived initial margin requirements
II. Use of flawed trading models because it failed to account for the spike in correlations among asset
class prices during times of economic crisis/shock.

A. I only

B. II only

C. Both I & II

D. None of the factors

T he correct answer is C.

Both factors were involved in the financial disaster of Long-Term Capital Management (LT CM). T he
positions opened by LT CM were highly leveraged due to the waived initial margin requirements by
financial institutions and allowing the leverage of 28 to 1 to LT CM. T he model risk was also one of
the factors of LT CM's disaster, and the flawed trading models failed to account for the spike in
correlations among asset class prices during times of economic crisis.

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Q.134 Which of the following involves the purchase of a hedging instrument that very closely
matches the position to be hedged and is typically held for as long as the underlying position is kept?

A. Dynamic hedge strategy

B. Static hedge strategy

C. Stack-and-roll hedge strategy

D. Delta-hedge strategy

T he correct answer is B.

A stati c hedge is one that does not need constant re-balancing as the price and other

characteristics (such as volatility) of the securities it hedges change. A static hedge usually involves

the purchase of a hedging instrument that very closely matches the position to be hedged. T he

hedging instrument is typically held for as long as the underlying position is kept.

Opti on A i s i ncorrect: Dynamic hedging involves rebalancing hedge positions as market conditions

change.

Opti on C i s i ncorrect: A stack -and-rol l hedge involves purchasing futures contracts for a

nearby delivery date and, on that date, rolling the position forward by purchasing a fewer number of

contracts. T he process continues for future delivery dates until the exposure at each maturity date

is hedged.

Opti on D i s i ncorrect: A delta-hedge strategy involves the reduction of the directional risks

associated with the movements in the price of the underlying assets.

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Q.4318 T he trader known as the London Whale lost at least $6.2 billion for JPMorgan Chase & Co. in
2012. In the first three months of that year, the number of days reporting losses exceeded the
number of days reporting profits. In an attempt to conceal these losses, the CIO came up with a new
valuation system. T he CIO had hitherto (up to that point) valued credit derivatives by:

A. Marking them at or near the midpoint price in the daily range of prices.

B. Marking them above the midpoint price in the daily range of prices.

C. Marking them below the midpoint price in the daily range of prices.

D. Marking them at prices that were at significant variance to the midpoints of dealer quotes
in the market.

T he correct answer is A.

T he CIO had hitherto valued credit derivatives by marking them at or near the midpoint price in the
daily range of prices (bid-ask spread) offered in the market. By using midpoint values, the resulting
prices were considered to be the “most representative of fair value.”
T he new valuation system set marks that were at significant variance to the midpoints of dealer
quotes in the market. T he end goal was to paint a rosier picture of the outstanding derivative
positions and, therefore, a better than the actual marking-to-market picture on the books. In
particular, the new system resulted in smaller losses being reported in the daily profit/loss reports.

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Q.4319 After consistently breaching risk limits, CIO traders at JPMorgan Chase & Co. proposed a
total overhaul of the VaR model in use at the time, claiming that the model was too conservative. A
new VaR model was eventually developed. Which of the following statements is most likely correct?

A. T he new model was developed and by CIO traders in collaboration with the office of the
Comptroller of Currency.

B. T he new model resulted in risk numbers that were 50% higher than prior numbers.

C. T he new model successfully corrected the mathematical flaws present in the first model,
which had produced highly overstated risk estimates.

D. T he new model was eventually revoked and the prior one reinstated.

T he correct answer is D.

T raders argued that the existing models were too conservative and therefore overstated risk,
resulting in limit breaches. Senior management approved the migration to a new VaR model that had
been researched and built by CIO traders themselves. Crucially, the bank did not obtain approval
from the Office of the Comptroller of Currency. T hat means there had been little room for checks
and balances in the development process.
T he updated VaR model resulted in risk numbers that were 50% lower than prior numbers, paving
the way for even more speculative trading and high-risk strategies. Months later, the bank’s model
Risk and Development Office determined that the model had mathematical and operational flaws.
Some of the issues that came to light include:

EXCEL spreadsheets used required manual updates

T here were coding errors in the calculation of hazard rates and correlation estimates

Unrealistically low volatility was attached to illiquid securities, built upon the assumption

that prices for days on which trades did not occur would be the same as the price when

last traded.

Instead of using the Gaussian Copula model in the built-in analytics suite as required under

Basel 2.5, the model used a Uniform Rate option.

On May 10, the bank backtracked, revoking the new VaR model due to the above inaccuracies, and
the prior model was immediately reinstated.

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Q.4320 In 2012, J.P. Morgan Chase lost more than $6.2 billion dollars from an exposure to a massive
credit derivatives portfolio in its London office. How did a lack of adequate management oversight
manifest?

A. Senior managers at the bank would receive daily risk reports from traders but never read
them.

B. T he bank had no risk committee to monitor the activities of CIO traders.

C. Senior management ignored the breaching of risk limits.

D. Senior management did not hold even a single meeting to evaluate the goings-on at the CIO.

T he correct answer is C.

T he London whale case exposed a culture of poor regulatory oversight in which risk limits were
repeatedly breached, risk metrics disregarded, and risk models manipulated without any concrete
steps being taken by the management to correct these anomalies. Since the CIO wasn’t a client-
facing unit of the bank, it was not subject to the same regulatory scrutiny as other portfolios.
In addition, SCP traders did not have to prepare daily reports to senior management. What’s more,
risk committee meetings were rare, and in the few instances the committee happened to meet,
there appeared to be no specific charter, and only CIO personnel would attend.

Q.4321 What was the main purpose of the Chief Investment Office, CIO, at J.P. Morgan Chase Bank in
the run-up to the London Whale scandal?

A. To monitor the operations of traders .

B. To invest excess deposits.

C. To look into ways in which the bank could reduce its regulatory capital requirements.

D. To raise funds for investment by floating long-term high-yield bonds.

T he correct answer is B.

JPM set up the Chief Investment Office (CIO) with the sole purpose of investing the excess cash
(deposits) of the bank.

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Q.4322 At the height of the 2007/2009 financial crisis, J.P. Morgan Chase Bank constructed a
synthetic credit portfolio (SCP) motivated by the need to protect itself against adverse credit
scenarios such as widening credit spreads. T he bank’s synthetic credit portfolio (SCP) was
comprised of:

A. Call options on stocks featured in the S&P 500 index.

B. Credit default swaps featured in standardized credit default swap indices.

C. Short and long oil futures positions.

D. Mortgage-backed securities .

T he correct answer is B.

T he bank’s synthetic credit portfolio (SCP) was essentially a basket of credit default swaps featured
in standardized credit default swap indices. T he bank took both buyer and seller positions in these
swaps. As a protection buyer (short risk position holder), the bank would pay premiums and, in turn,
receive the promise of compensation in the event of default. As a protection seller (long risk
position holder), the bank would receive premiums and, in turn, promise to compensate the buyer in
the event of default.

Q.4323 T he infamous collapse of the oldest merchant bank in England, Barings Bank, in 1995 after
233 years of existence, can be traced down to one key reason:

A. A bank run

B. T he Kobe earthquake in Japan, which rattled financial markets in Asia and hence, severely
affected the bank’s activities.

C. Largely unchecked speculative trades.

D. A total overhaul of the board of directors which resulted in the loss of investor
confidence.

T he correct answer is C.

T he main reason behind the collapse of Barings Bank (1762-1995) was the large-scale speculative
trading perpetrated by one employee, Nick Leeson, on future contracts.
Leeson landed the post of general manager and head trader at Barings after a stellar career elsewhere
where he had nurtured a reputation for hard work and an unrivaled understanding of the market.
After initially earning massive profits for Barings via several unauthorized trades in 1992, Leeson
eventually lost over $1 billion in company capital while hiding the losses from his superiors.

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Q.4324 Which of the following is the main reason that led to the scale of losses suffered by the
Orange County portfolio in 1994?

A. Excessive use of leverage.

B. Overreliance on equity.

C. An unexpected increase in interest rates by the Federal Reserve.

D. Stringent collateral demands by providers of emergency capital.

T he correct answer is A.

At the root cause of the downfall in Orange County was Robert Citron’s decision to borrow heavily

in the repo market. Repos allow investors to finance a significant portion of their investments with

borrowed money (i.e., leverage). But the use of leverage has a multiplicative effect on the profit or

loss on any position; even a small change in market prices can have a significant impact on the

investor.

When the Federal Reserve announced an increase in interest rates, the fund could no longer borrow

in the repo market at favorable terms and was eventually forced to declare bankruptcy.

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Q.4325 T he Orange County case illustrates how complex financial products characterized by large
amounts of leverage can create significant losses. T he fund heavily invested in:

A. Mortgage-backed securities.

B. Equities.

C. Inverse floating-rate notes.

D. Credit default swaps.

T he correct answer is C.

Robert Citron, the fund’s treasurer, used the borrowed funds to purchase complex inverse floating-

rate notes. Coupons payments of inverse floating-rate notes decline when interest rates rise as

opposed to conventional floaters, whose payments increase in such a situation.

Opti on A i s i ncorrect: Mortgage-backed securities are associated with the Nothern Rock.

Opti on B i s i ncorrect: T he use of independent equity accounts is associated with the Enron

scandal.

Opti on D i s i ncorrect: Credit default swaps are associated with JP Morgan.

Q.4326 T he Orange County case illustrates how complex financial products characterized by large
amounts of leverage can create significant losses. Mr. Robert Citron, the fund’s treasurer, heavily
invested in inverse floating-rate notes expecting:

A. Interest rates to rise.

B. Interest rates to fall.

C. A recession in the near future.

D. T he corporation tax rate to rise.

T he correct answer is B.

Robert Citron, the fund’s treasurer used the borrowed funds to purchase complex inverse floating-
rate notes. Coupons payments of inverse floating-rate notes decline when interest rates rise as
opposed to conventional floaters, whose payments increase in such a situation. In effect, therefore,
Mr. Citron was betting in favor of interest rates falling or generally staying low.

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Q.4327 T he financial scandals at Bankers T rust and Orange County have one thing in common:

A. T hey involved the use of complex financial instruments with an eye on high returns.

B. Both collapsed as a result of a crippling run.

C. Both were eventually acquired and dismantled.

D. Both invested heavily in mortgage-backed securities.

T he correct answer is A.

T he Orange County case and the debacle at Bankers T rust illustrate how complex financial products

can bring down a seemingly thriving, low-risk business.

Bank ers Trust

Procter & Gamble (P&G) and Gibson Greetings sought the assistance of Bankers T rust (BT ) in an

attempt to reduce funding costs. BT used derivatives trades which promised P&G and GG a high

probability, a small reduction in funding costs in exchange for a low-probability, large loss.

BT ’s derivatives were designed to be intentionally complex to stop P&G and GG from understanding

their risks and overall implications. In fact, the trades were quite differentiated in form and

structure, making them incomparable to derivative trades of other companies. BT duped P&G and

GG into thinking that the trades were tailored to meet their individual needs. In the end, P&G and GG

came to the painful realization that they had been misled after taking in huge losses.

T he scandal dealt a huge blow to BT ’s reputation and forced senior managers to resign, including the

CEO. Eventually, BT was acquired by Deutsche Bank and dismantled.

Orange County

Robert Citron, Orange county’s treasurer, used complex structured products in an attempt to

generate a higher than average return. Top on the list were complex inverse floating-rate notes

whose coupon payments decline when interest rates rise (as opposed to conventional floaters,

whose payments increase in such a situation). In effect, therefore, Mr. Citron was betting in favor of

interest rates falling or generally staying low.

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Over the course of 1994, the Federal Reserve announced a hike in interest rates by 250-basis points.

As expected in this scenario, the increase in interest rates reduced the value of Citron’s portfolio

substantially, generating a loss of USD 1.5 billion by December 1994.

Ultimately, Orange County was forced to file for bankruptcy, effectively embarking on a slow path to

financial redemption.

Q.4328 Which of the following lessons is most relevant to the Orange County case?

A. Every firm needs to have more than a basic understanding of the risks that are inherent in
its business models.

B. Reporting and monitoring of positions and risks (i.e., back-office operations) must be
separated from trading (i.e., front-office operations).

C. Risk managers have a responsibility to analyze reported business profits and determine if
they seem logical in light of the positions held.

D. Outsized or strangely consistent profits should be independently investigated and

rigorously monitored in order to verify that they are real, generated in accordance with the
firm’s policies and procedures.

T he correct answer is A.

T he main lesson learned from the Orange County case has much to do with the need for firms to
have a deep/detailed basic understanding of the inherent risks in their business models. Robert
Citron, Orange County’s treasurer, used complex structured products in an attempt to generate a
higher than average return. Citron later admitted he understood neither the position he took nor the
risk exposure of the fund with respect to these products.
Choices B, C, and D are all lessons under the Barings case study that revolves around Nick Leeson, a
trader.

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Q.4329 T he Volkswagen scandal of 2015 highlighted the need for companies to:

A. Invest in social media to ensure a fast spread of positive information.

B. Uphold ethical conduct and demonstrate their commitment to environmental, social, and
governance-related best practices.

C. To hire qualified professionals capable of detecting anomalies before it’s too late.

D. To nurture and protect their brand name by investing in research and development.

T he correct answer is B.

T he revelation that Volkswagen had commissioned a scheme to cheat its way through emissions tests
resulted in untold damage to the Volkswagen brand. T he share price of the company fell by over a
third, and the firm faced billions of dollars in potential fines and penalties. T he scandal demonstrated
the need for firms to uphold ethical conduct and prove their commitment to environmental, social,
and governance-related best practices.

Q.5038 In the early 1990s, Metallgesellschaft, a German oil company, suffered a loss of $1.33 billion
in their hedging program. T hey rolled over short-dated futures to hedge long term exposure created
through their long-term fixed-price contracts to sell heating oil and gasoline to their customers. After
a time, they abandoned the hedge because of large negative cash flow. T he cash-flow pressure was
due to the fact that MG had to hedge its exposure by:

A. Short futures and there was a decline in oil price.

B. Long futures and there was a decline in oil price.

C. Short futures and there was an increase in oil price.

D. Long futures and there was an increase in oil price.

T he correct answer is B.

Metallgesellschaft's loss has been attributed to a flawed long hedge strategy in near term futures

contracts that was meant to protect against forward sales commitments. A fall in the spot prices of

oil forced margin calls for the company and the contracts were closed out at a loss. In the months

that followed, the spot price increased and the company suffered even greater losses covering its

customer commitments.

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Reading 10: Anatomy of the Great Financial Crisis of 2007-2009

Q.135 At the turn of the new millennium, mortgage lenders began offering customers adjustable
mortgage rates with “teaser rates.” What was the immediate effect of the move?

A. T he number of mortgage applications sharply decreased.

B. T he number of mortgage applications started to increase.

C. T he price of houses started to rise.

D. T he price of houses started to decline.

T he correct answer is B.

Mortgage lenders in the United States started to relax lending standards in about 2000. Part of the
new strategies involved restructuring repayment terms to allow borrowers to pay a small rate of
interest for the first 2-3 years followed by substantially higher rates in the later years. T he
immediate effect was an upturn in demand for homes as families previously unqualified could now
afford to repay borrowed funds. T he lenders deemed the move as a low-risk strategy because home
prices were continually increasing, meaning that potential borrower default was adequately mitigated
by an increasing collateral value.

Q.136 T he following are reasons why the demand for homes sharply increased between 2000 and
2006. Which one had the smallest impact?

A. Mounting pressure on lenders by the federal government to increase lending to low- and
medium-income families.

B. A change from fixed-rate repayment terms to more flexible terms, capped by the so-called
teaser rates.

C. A steadily increasing middle-class population.

D. A lack of adequate regulation of the real estate sector by the federal government.

T he correct answer is C.

Although the middle-class population had been steadily rising even before 2000, this fact alone did not
significantly impact mortgage applications. Instead, the demand for homes was pushed up in large part
due to a combination of government pressure on lenders and relaxation of lending standards across
the board. T he fact that the US government had (for years) been trying to influence lenders into
lending more, especially to low and medium-income families meant that the government was not
incentivized to regulate lending - when its efforts were finally starting to bear fruit.

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Q.137 A non-recourse mortgage is a mortgage whereby:

A. T he borrower is given flexible repayment terms, including variable interest rates and a
grace period.

B. If the borrower defaults, the lender can take possession of the assets used as collateral as
well as other assets of the borrower.

C. If the borrower defaults, the lender can only take possession of the assets used as
collateral and not any other assets of the borrower.

D. T he borrower can only sell the assets used as collateral with express authority from the
lender.

T he correct answer is C.

A non-recourse mortgage limits the lender in terms of the assets they can possess in case the

borrower defaults on the loan. As such, the lender is only allowed to repossess the assets used as

collateral and should not touch any assets that belong to the borrower.

Opti on A i s i ncorrect: A non-recourse mortgage limits the lender in terms of the assets they can

possess in case the borrower defaults on the loan, the lender has few chances of reducing the risks

associated with the loan, and therefore they tend to charge fixed-interest rates.

Opti on B i s i ncorrect because it refers to a recourse mortgage.

Opti on D i s i ncorrect: Both recourse and non-recourse loans allow lenders to seize collateralized

assets if the borrower defaults.

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Q.139 Distinguish between an Asset-Backed Security (ABS) and a Collateralized debt obligation (CDO)

A. An asset-backed security is a security created from the cash flows of a financial asset
while a CDO is an ABS created from a financial asset whose income is variable.

B. An asset-backed security is a security created from the cash flows of a financial asset
while a CDO is an ABS created from a financial asset whose income is fixed.

C. An asset-backed security is a security created from the cash flows of a mortgage while a
CDO is an ABS created from a non-mortgage financial asset.

D. An asset-backed security is a security created from the cash flows of a secured financial
asset while a CDO is an ABS created from a non-secured financial asset.

T he correct answer is B.

An ABS is basically a secondary asset formed from the cash flows of a financial asset. CDOs are ABSs
where the underlying asset is subject to fixed income. Assets with fixed income include mortgages
and debentures.

Q.140 An asset-backed security is usually divided into three tranches: the senior tranche, mezzanine
tranche, and equity tranche. Which of the following correctly categorizes the three tranches in
terms of risk, from the riskiest to the least risky?

A. Senior tranche; Equity tranche; Mezzanine tranche

B. Mezzanine tranche; Equity tranche; Senior tranche

C. Mezzanine tranche; Senior tranche; Equity tranche

D. Equity tranche; Mezzanine tranche; Senior tranche

T he correct answer is D.

From a risk perspective, the equity tranche has the highest risk followed by the mezzanine tranche.
In case of any loss, the equity tranche absorbs the first 5% of the total loss. T he mezzanine tranche
absorbs the next 20% of total losses. Any loss above 25% is absorbed by the senior tranche.

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Q.141 Which of the following best explains how credit rating agencies contributed to the financial
crisis of 2007/2008?

A. Credit rating agencies colluded to give major financial institutions “undue” health.

B. Rating agencies did not sound the alarm bells early enough after detecting the deteriorating
financial stability of the economy's major players.

C. Rating agencies underestimated the risks inherent in asset-backed securities and CDOs.

D. Rating agencies overestimated the risks borne by asset-backed securities and CDOs,
leading to low demand for those financial instruments.

T he correct answer is C.

Subprime mortgages were securitized into ABSs and CDOs which were then rated by credit rating
agencies. However, the rating agencies had little/no experience in rating such complex instruments
and ultimately underestimated their risks. What followed were heavy losses incurred by investors as
a result of declining property prices.

Q.142 Experts attribute the 2007/2008 financial crisis to several causes that collectively aggravated
the economic strain resulting in a large-scale disaster. Which of the following is not a cause of the
crisis?

A. Relaxed lending requirements that increased the number of subprime mortgages that
would later default.

B. Irrational exuberance/False confidence - the perception that home prices would continue
to rise unabated and indefinitely.

C. Underestimation of risks inherent in ABSs and CDOs by major credit rating agencies.

D. T he collusion of middle east governments to intentionally hike the price of oil.

T he correct answer is D.

T he crisis had little to do with oil and gas. Neither was it caused by foreign governments. It was
caused in large part by internal (within the US) factors (A, B, and C above) that could have been
mitigated so as to avert the crisis.

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Q.143 Which of the following amounts to agency cost in regard to how the 2008 financial crisis
unfolded?

A. Prospective homeowners lying about their income and mortgage security.

B. A lack of government regulation of the property market in the period leading to the crisis.

C. Rating agencies were paid for their ratings and would overlook potential financial pitfalls
so as to impress their clients.

D. Failure by Congress and the Senate to crack down on relaxed lending even after a few
leaders brought the matter to the floors of the two houses.

T he correct answer is C.

Agency costs are incurred when incentives do not align, and one party chooses to pursue selfish
interests at the expense of the other party.
In the 2007/2008 financial crisis, rating agencies were liable for underestimating risks inherent in
ABSs and CDOs in a bid to "keep" their clients happy and hence continue to do business, thereby
guaranteeing long-term income. By maximizing the number of AAA-rated tranches, the agencies duped
investors into purchasing overvalued and overrated instruments.

Q.144 T he following are some of the key lessons learned by risk managers from the 2007/2008
financial crisis. Which one is not?

A. Human psychology plays a key role in financial markets. In particular, the assumption that
bullish markets will exist indefinitely is incorrect and borders on irrational exuberance.

B. T raditional correlations can be relied upon to give near-accurate predictions of markets.

C. T here's a need to align the compensation packages of traders with the interests of their
employers. In particular, bonuses should be spread out over several years, with a provision
to pay back part of the bonus if a year of good performance is followed by a downturn in
performance.

D. Instead of overreliance on data provided by rating agencies, investors should also do their
own market analysis before committing their resources that appear very profitable.

T he correct answer is B.

T raditional correlations can break down during periods of economic turmoil. Correlations between
assets and between asset classes can increase during a crisis leading to unforeseen losses. As such,
stress tests should be modeled to simulate additional correlations, not just the traditional ones.

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Q.145 A bank recently pooled together subprime mortgages and created three tranches: the senior,
mezzanine, and the equity tranches. T he senior tranche has:

A. Lower return than the equity tranche but higher return than the mezzanine tranche.

B. Higher return than the equity tranche but lower return than the mezzanine tranche.

C. Lower risk than both the equity and mezzanine tranches.

D. Lower risk than the mezzanine tranche but higher risk than the equity tranche.

T he correct answer is C.

T he “waterfall” nature of returns in an asset-backed security means that the higher the risk, the

higher the return. As such, the senior tranche bears the minimum risk among the three tranches. It's

also the tranche with the lowest return.

Opti on A i s i ncorrect: T he senior trance offers a lower return than the mezzanine tranche.

Opti ons B and D are i ncorrect: T hey contradict option C

Q.146 Ninja borrowers refer to:

A. Borrowers who have not been subjected to vetting or any other attempt aimed at
ascertaining their credentials.

B. Borrowers who have a near-zero credit history.

C. Borrowers with assets insufficient to secure the mortgages awarded.

D. Borrowers with no income, no job, and no assets.

T he correct answer is D.

Ninja borrowers refer to the category of borrowers without a regular source of income, livelihood,
and no assets to serve as mortgage security. Ninja borrowers during 2007/2008 increased after
lending standards were relaxed, making it possible for previously barred borrowers to afford loans at
least for the first few months of the repayment schedule.

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Q.147 Capital M bank originates and securitizes mortgages creating asset-backed securities. T he bank
then invests in these same securities. Which of the following best describes such a scenario?

A. Regulatory arbitrage

B. Securitization

C. Irrational exuberance

D. Agency costs

T he correct answer is A.

Regulatory arbitrage refers to a scenario where a bank originates mortgages and creates asset-

backed securities through securitization and then doubles as the investor in these securitized assets.

T he motivation behind such a strategy was, in large part, accounting-driven. T he specific accounting

advantage of such a move is beyond the scope of this topic's objectives.

Opti on B i s i ncorrect: Securitization involves repackaging of loans and other assets into new

securities can then be sold in the securities markets.

Opti on C i s i ncorrect: Irrational exuberance refers to a state where investors have confidence

that the prices of the stock will keep rising while they fail to pay attention to its underlying value.

Opti on D i s i ncorrect: An agency cost refers to an internal expense that comes from an agent

taking action on behalf of a shareholder.

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Q.148 What is the relationship between the senior tranche of an ABS and its ABS CDO equivalent
regarding risk?

A. T he senior tranche of an ABS is riskier than the senior tranche of the ABS CDO.

B. T he senior tranche of an ABS is less risky than the senior tranche of the ABS CDO.

C. T he senior tranche of an ABS and the senior tranche of an ABS CDO have the same level
of risk.

D. None of the above.

T he correct answer is B.

T he mezzanine tranche of an ABS can be further segmented into tranches in a process called

resecuritization. However, the senior tranche of the ABS CDO is normally riskier than the

corresponding tranche of an ABS.

An ABS CDO is usually created from the mezzanine tranche of an ABS due to the difficulty associated

with marketing the mezzanine tranche of the ABS. It follows that When the AAA-rated tranche of an

ABS experiences defaults, the mezzanine tranche of the ABS must have been wiped out. If all the

mortgage portfolios used to create the mezzanine tranches underlying an ABS CDO have similar

default rates, it must, therefore, be the case that the AAA-rated tranches of all underlying ABSs are

safer than the AAA-rated tranche of the ABS CDO.

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Q.149 In the aftermath of the 2007/2008 financial crisis, a lot of progress has been made so as to
avert future crises. Which of the following would be termed as a regulatory response aimed at
reducing the frequency and possibly the impact of future financial crises?

A. Improved transparency in financial markets.

B. Increased international cooperation.

C. Improved alignment of the objectives of traders and their employers.

D. All the above.

T he correct answer is D.

Some of the proposals put forth to be better prepared to withstand future financial crises include
alignment of incentives, macro-prudential regulation, enhanced transparency, and international
cooperation.

Q.150 One of the factors associated with the Credit Crisis of 2007 is the relaxed lending standards of
lenders. Lenders began to attract new entrants in the housing market by offering adjustable-rate
mortgages (ARMs) and teaser rates. T he teaser rates are defined as:

A. T he mortgage rates that are mentioned on the mortgage's promotional material.

B. T he very low rates that are offered for the first few years before the rates increased
significantly in later years.

C. T he fixed mortgage rate that is calculated as LIBOR plus specific basis points.

D. T he fixed rates at which a defaulting borrower can restructure the mortgage.

T he correct answer is B.

A teaser rate is referred to as a very low rate that is offered in the initial two to three years of the
mortgage before significant increases in rates in the subsequent years. From 2001 to 2006, the
teaser rate ranged from 1% to 2%. T his relaxation in lending/mortgage terms is considered one of the
main reasons for the credit crisis of 2007.

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Q.152 During the training session of newly selected graduate trainees of a reputable Chinese
investment bank, the moderator asked some trainees to explain their understanding of the term
"Securitization." Below are some of the explanations provided by trainees. Which of them is closely
related to securitization?

A. T rainee A: Securitization is the process of securing a mortgage with a security or

collateral which the lender can use in the case of default.

B. T rainee B: Securitization is the financial asset created from the cash flows of financial
assets including mortgages, loans, auto loans, and bonds.

C. T rainee C: Securitization is the process of pooling mortgage loans into a pool, dividing the
pool into smaller units, and selling them as financial assets to investors in order to transfer
risk.

D. T rainee D: Securitization is the process of setting a bankruptcy-remote entity with the

sole purpose of acquiring Asset-Backed Securities (ABS).

T he correct answer is C.

Securitization is the process used by large banks and financial institutions of pooling mortgage loans
into a large pool, dividing the pool into smaller units, and selling these units as financial instruments to
investors. Banks carry out this process to transfer the risk to the market. Option A is incorrect
because the security used to back a mortgage loan is called collateral. Option B is incorrect because
Asset-Backed Securities (ABS), not securitization, is the financial asset created from the cash flows
of financial assets including mortgages, loans, auto loans, and bonds. Option D is incorrect because
Special Purpose Vehicles (SPVs) are bankruptcy-remote entities that are set up with the sole
purpose of acquiring assets like Asset-Backed Securities (ABS).

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Q.153 Once the originator of the mortgage creates Asset-Backed Securities (ABSs) from the cash
flow of its mortgages and loans, these ABSs are sold to Special Purpose Vehicles (SPVs) that allocate
the cash flows of the ABS to different tranches. T ypically, each security has three tranches, namely
the senior tranche, the mezzanine tranche, and the equity tranche. Which tranches should have the
highest expected returns and which tranche should receive the highest rating?

A. Senior tranches should receive the highest expected returns and highest ratings.

B. Equity tranches should receive the highest ratings, and senior tranches should have the
highest expected returns.

C. Senior tranches should receive the highest ratings, and equity tranches should have the
highest expected returns.

D. Equity tranches should receive the highest ratings, and mezzanine tranches should have
the highest expected returns.

T he correct answer is C.

Securities under SPVs are divided into different segments based on the cash flows of the securities.
T hese segments are called tranches, and each security is divided into three tranches, namely the
senior tranche, the mezzanine tranche, and the equity tranche. From the risk perspective, the
equity tranche has the highest risk (usually the equity tranche is unrated), and the senior tranche has
the lowest risk with the highest rating (usually AAA). From the cash flow perspective, the equity
tranche receives the highest returns, followed by the mezzanine tranche, and the senior tranche
receives the lowest returns due to its less risky nature.

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Q.154 When the United States entered into a recession in 2008, the Federal Reserve and the
government implemented all of the following to prevent further liquidity issues, EXCEPT :

A. Bailing out major financial institutions.

B. Lowering interest rates.

C. Opening the discount window to all commercial banks

D. Acquiring assets issued by major financial institutions.

T he correct answer is C.

In the fall of 2008, the global financial system was on the brink of collapse. In an effort to prevent

further liquidity issues, the Federal Reserve and the U.S. government intervened in financial markets

by implementing a series of emergency measures. Among other things, they lowered interest rates,

injected billions of dollars of capital into the banking system to bail out the worst affected banks, and

acquired the assets issued by major financial institutions.

Option C is inaccurate because even though the discount window was available to banks in at the

peak of the crisis, the facility had been available even before the crisis began.

Note: T he Federal Reserve discount window is a lending facility provided by the central bank to
member banks. T he discount rate is the interest rate charged on loans that banks get from the Fed.
T his helps to ensure that banks have enough liquidity to meet customer demand and maintain
solvency. In times of economic stress, the discount window can be a vital source of funding for
banks. By providing loans at a lower than market rate, the Fed can help to stabilise the banking
system and prevent a financial crisis from developing.

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Q.155 Different players had different incentives/motivations for creating structured products like
asset-backed securities (ABSs) and collateralized debt obligations (CDOs) that played an important
role in the 2007 Credit Crisis. When these incentives and motivations do not align, it is known as
agency cost, which is the basis of all financial crises.
Which of the following is incorrect?

A. T he incentive for property valuators was to provide appropriate and honest home
valuations.

B. T he incentive for the creators of ABSs and ABS CDOs was profitability in the form of
excess cash inflow from these investments.

C. Rating agencies were incentivized to issue favorable ratings/recommendations on ABSs

and ABS CDOs.

D. Employees were highly incentivized for trading risky securitized products.

T he correct answer is A.

Property evaluators were incentivized to provide the highest possible valuations for homes instead

of honest valuations to get more business.

Opti ons B, C, and D present accurate incentives for the mentioned players during the 2007 credit

crisis.

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Q.156 Which of the following is NOT an implication of the crisis scenario?

I. During crises, default rates increases and recovery rates declines
II. Resecuritization results in investments that have risks that tend to exceed their expected returns

A. Statement I only

B. Statement II only

C. Statements I and II

D. None of the above

T he correct answer is D.

Statement I is appropriate because the default rates increase and the recovery rates decrease
during crises.

Statement II is appropriate because resecuritization refers to using the investment from a

previous round of securitization to create a new set of investments, resulting in investments that

have risks that tend to exceed their expected returns.

Q.287 Which of the following statements best describes how relaxed lending standards contributed to
the 2007/2008 financial crisis?

A. More people applied for mortgages resulting in liquidity problems within major American
banks.

B. T he demand for housing took a sharp increase causing the price to increase.

C. T he number of “liar” loans increased, eventually leading to default and losses among banks.

D. Banks violated federal laws leading to a major fallout between the government and the
private sector.

T he correct answer is C.

In the period leading up to the year 2000, lending requirements had been especially strict and
thoroughly enforced, therefore making many families unable to afford mortgages. In an attempt to
increase demand, lenders significantly relaxed lending standards but inadvertently opened doors for
fraud. Individuals without income, jobs, or worthy assets successfully applied for mortgages but
ultimately failed to repay the loans a few months into the contract. As a result, banks recorded huge
losses and mortgage prices began to fall.

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Q.288 Which of the following best describes the consequence of offering housing mortgages on a
low “teaser” interest rate in the short term followed by higher rates later during the agreed term?

A. High demand for housing in the short term and low demand in the long term.

B. Low demand for housing in the short term and high demand in the long term.

C. High borrower default rate in the short term and low default rate in the long term.

D. Low profit for the lender in the short term followed by supernormal profits in the long
term.

T he correct answer is A.

If loans are issued at variable rates with a low teaser rate applicable at the onset, a high number of
borrowers - including those with income levels that cannot meet payments required at slightly higher
interest rates - would express interest leading to high demand for housing. After the teaser rates
have ended, a good number of borrowers would no longer afford their mortgages forcing lenders to
foreclose on their loans. T his, in turn, would put downward pressure on demand and lead to a decline
in home prices. T hat, combined with an increasing supply of homes due to foreclosures, would
ultimately lead to low demand for homes. T his is exactly what happened between 2000 and 2006.

Q.289 In the years leading up to the 2007/2008 financial crisis, what was the main motivation behind
securitization of mortgage facilities by lenders in the United States?

A. To make more money from the mortgages by selling them to third-party investors.

B. To transfer risk to third-party investors.

C. To create investments opportunities for investors under recommendations by the federal

government.

D. To help borrowers pay their dues faster.

T he correct answer is A.

Securitization entails the pooling of mortgages into a large portfolio, then dividing it into smaller units
that can be sold as financial investments to investors. On most occasions, lenders do that so as to
transfer the pertinent risks to third-party investors. However, prior to the 2007/2008 crisis, lenders
were mainly driven by the possibility of making money from the pooled facilities. T he question
shifted from “Are we ready to take on these risks?” to “Can we make money from this mortgage by
selling it to someone else?” T hird-party buyers were only privy to the loan-to-value ratio and the
borrower’s credit score, and not to further borrower details that would have shed more light on
their ability to meet debt payments or provide adequate security for the loan. In fact, credit scores
were subject to manipulation so as to make the borrower look financially stable.

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Q.291 Before the 2007/2008 financial crisis, how did lenders ensure that their incentives aligned with
those of the investors in asset-backed securities?

A. Maintaining exposure to the performance of the loan pool by owning the tranche that
would absorb the first losses accrued – Equity tranche.

B. Agreeing to offer discounts on assets being sold.

C. Maintaining exposure to the performance of the loan pool by owning the tranche that
would absorb the last losses accrued – the senior tranche.

D. Maintaining exposure to the performance of the loan pool by owning the tranche that
would absorb 20% of total loss accrued.

T he correct answer is A.

So as to motivate and make lenders act in the best interests of investors in asset-backed securities,
the lenders would retain a certain proportion of the pooled loans. T he maintained portion would
usually be the one to absorb the first losses to accrue, subject to an upper limit.

Such a policy ensured that lenders only brought in credit-worthy borrowers who had high chances of
meeting their mortgage payments, hence helping investors in the pooled mortgages to make money.
However, with time, lenders started to remove all exposure to the performance of a given pool by
securitizing 100% of the pool.

Without exposure to potential losses, the incentives for lenders were now in direct conflict with
those of investors, creating material agency costs.

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Q.292 In the run-up to the 2007 financial crisis, banks offering mortgage facilities practiced the
unusual move of investing in the tranches formed from the mortgages. By so doing, the banks:

A. Engaged in regulatory arbitrage.

B. Engaged in unethical professional behavior.

C. Were able to hide losses accrued due to “liar” borrowers.

D. All of the above.

T he correct answer is A.

Regulatory arbitrage refers to the scenario where mortgage originators (banks) also doubled up as

the investors in securitized assets. T he aim was to exploit loopholes in accounting and financial

reporting requirements regarding capital.

Option B is incorrect: investing in tranches formed is not unethical.

Option C is incorrect: investing in trances had nothing to do with “liar” borrowers.

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Q.293 Which of the following best describes the concept of misaligned incentives in the outcome of
the 2007/2008 financial crisis?

A. While mortgage originators were hell-bent on creating loans that could be securitized,
those valuing homes were intent on providing the lowest possible valuation.

B. Mortgage originators were focused on offering loans to all credit-worthy clients, whereas
rating agencies had their focus set only on high net-worth individuals who could pay more for
rating services.

C. T he incentive for investors in ABSs and CDOs was to find secure but highly profitable
products but that of rating agencies of those products was to issue favorable
recommendations so as to retain their clients (issuers of the products).

D. Mortgage originators wanted to maximize profit but those valuing homes wanted to inflate
the value as much as possible so as to receive unduly high service fees.

T he correct answer is C.

T he crisis unfolded in part due to a lack of perfectly aligned interests/incentives among different
stakeholders. In other words, the parties had diverging interests, and each of them pursued their
interests while turning a blind eye to the effects of their actions on others. For instance, investors
wanted to find secure yet highly profitable ABSs and CDOs in which to invest and relied solely on
recommendations issued by rating agencies. But instead of issuing realistic and honest assessments,
the agencies erred on keeping their clients happy and most of the time issued favorable ratings that
would end up misguiding investors. T he agencies did that so as to retain the client hence “lock-in”
payments for a prolonged period.

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Q.294 In 2005, Ann applied for a mortgage at a local bank. T hough she had a larger-than-average risk
of defaulting, the bank still went ahead and issued her the mortgage. T his is an example of:

A. Illegal mortgage lending.

B. Agency costs.

C. Prime mortgage lending.

D. Subprime mortgage lending.

T he correct answer is D.

Subprime mortgage lending occurs when a lender issues a mortgage to a borrower whose credit

rating is low and, therefore, has higher-than-average chances of defaulting on the repayments. T his

financial vice was prevalent in the run-up to the 2007/2008 crisis in part because lenders were

mainly focused on creating as large a pool of mortgages as possible, which could be securitized and

earn higher profits.

Opti on A i s i ncorrect: Illegal mortgage lending refers to fraudulent practices during the loan or

mortgage servicing process.

Opti on B i s i ncorrect: Agency costs refer to internal expenses incurred due to the interests of

shareholders(principals) and the management team(agents)

Opti on C i s i ncorrect: Prime lending refers to lending associated with the lowest risks. In prime

lending, there is a low default risk and the borrowers have a high credit rating.

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Q.295 Assume that the senior tranche of a 5-year, asset-backed security collateralized debt obligation
(ABS CDO) is rated AAA. In addition, assume that we have a comparable 5-year gilt (government
bond) that’s also rated AAA. Which of the following is most likely incorrect?

A. T here’s a chance that some risks were left out while profiling the ABS CDO.

B. It’s highly likely that there’s irrational exuberance within financial markets.

C. T he equity tranche of the same ABS CDO is riskier than the senior tranche.

D. T he probability of loss under the ABS CDO is less than the probability of loss under the
government bond.

T he correct answer is D.

T he probability of loss under the ABS CDO is hi gher than the probability of loss under the
government bond since the former carries additional risks – such as the risk of borrower default as
well as subordination risk to the senior tranche of the ABS from which the ABS CDO has been
created. Considerable irrational exuberance within the housing market may lead market players into
thinking that the status quo will hold for an extended period of time, and therefore attach a risk level
that’s equal to that of government bonds. In the years prior to the financial crisis, some of the ABS
CDOs bearing the “AAA” rating did not consider all the risks, and any attempt to profile them alongside
non-securitized products was therefore erroneous.

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Q.411 Which of the following is NOT a key factor that led to the housing bubble of 2007-2008?

A. A low interest rate environment sponsored by the US federal government which was
aimed at encouraging individuals to borrow more.

B. A shift from the traditional banking system of issuer-held loans to the “originate and
distribute” model.

C. Major rating agencies issuing favorable ratings on asset-backed securities.

D. None of the above.

T he correct answer is D.

In the run-up to the 2007/ 2008 financial crisis, the US economy was experiencing low interest rates

in part due to long-held plans by the federal government to reduce rates, as well as a large flow of

capital from abroad, especially the Asian continent.

Furthermore, an overhaul of the traditional banking model of “offer and keep” in favor of the more

lucrative “originate and distribute” model paved the way for the issuance of mortgages without due

diligence, effectively leading to a decline in lending standards.

Rating agencies also played a role in the creation of the crisis by issuing favorable ratings. Creators

of structured products could pay rating agencies to give asset-backed securities higher ratings.

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Q.412 A severe liquidity squeeze engulfed the banking system as a result of two major trends in the
sector. First, instead of issuing and holding loans on their balance sheets until maturity, banks took up
the “originate and distribute” model so as to transfer risk to other investors. What was the other
trend?

A. Banks increasingly financed their asset holdings with longer maturity instruments.

B. Banks increasingly financed their asset holdings with shorter maturity instruments.

C. Banks increasingly disregarded borrower information while appraising loan applications.

D. Refusal by the Federal Reserve Bank to bail out financially-strained banks.

T he correct answer is C.

T he prime trend related to the OT D model of banks in 2008-2009 is that it reduced incentives to
screen loan applications. We show that banks with high involvement in the OT D market during the
pre-crisis did not take into consideration, borrowers' information while appraising loan applications.
T he reduced screening of incentives greatly contributed to the current subprime mortgage crisis.

Q.413 Which of the following statements best explains how banks created collateralized debt
obligations in the build-up to the 2007-2008 financial meltdown?

A. Forming a diversified portfolio of cash-flow generating assets, pooling them together, and
then repackaging the asset pool into discrete tranches that could be sold to investors.

B. Pooling together cash-generating assets, and then repackaging the asset pool into discrete
slices that could be sold to investors.

C. Forming a diversified portfolio of mortgage products, pooling them together, and then
repackaging the asset pool into discrete tranches that could be sold to investors.

D. Pooling together a well-diversified portfolio of mortgages, and then slicing the pool into
three tranches that could be sold to investors.

T he correct answer is A.

To create CDOs, banks first formed portfolios comprising various cash-generating assets such as
mortgages, corporate bonds, and various types of loans. T he next step was pooling the portfolios
together to make a large pool of assets that would then be sliced up into discrete tranches that could
be sold to investors willing to bear a certain level of risk.

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Q.414 In 2005, a certain American investment firm decided to invest in an assortment of

collateralized debt obligations (CDOs). To protect itself, the firm also purchased a credit default
swap. T his implied that:

A. T he firm would pay a periodic fixed fee and in turn receive a contingent payment in the
event of credit default.

B. T he firm was 100% protected against credit default, and therefore cash inflows from the
CDOs were guaranteed.

C. T he firm would pay a fixed fee at the onset of the contract and in turn receive a
contingent payment in the event of credit default.

D. T he firm would pay a periodic fixed fee and, in turn, receive a contingent payment at the
end of the CDO contract.

T he correct answer is A.

T he idea behind credit default swaps (CDSs) was to “insure” investors against potential losses that
might be incurred with respect to CDOs. In other words, the CDSs protected investors in the
securitized assets against default. T he CDS arrangement required the investor to make a series of
fixed payments to a gearing house in exchange for a contingent payment in the event of credit
default. For example, anyone who bought the AAA-rated tranche of a CDO and combined it with a CDS
had few reasons to feel worried, as far as the risk was concerned – the probability of the CDS
counterparty defaulting was believed to be very small.

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Q.415 In the period leading up to the 2007-2008 financial meltdown, what was the main problem that
arose due to an increase in the maturity mismatch on the balance sheet of banks?

A. Exposure to massive cash withdrawals at short notice.

B. Exposure to credit default risk.

C. Exposure to funding liquidity risk.

D. Unprecedented legal confrontations with regulatory authorities.

T he correct answer is C.

A maturity mismatch is basically a situation where the maturity of a bank’s assets does not match

that of its liabilities. T he imbalance can be positive or negative. In the run-up to the crisis, maturity

mismatches increased due to the use of off-balance-sheet vehicles – investing in long-term assets

while borrowing with short-term paper – which exposed banks to funding liquidity risk.

Options A, B and D are not the mains problems that resulted due to maturity mismatch on the balance

sheets of banks.

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Q.416 Which of the following statements best explains why securitized products were especially
popular among money market and pension funds?

A. T hey allowed such institutions to hold assets that they were previously prevented from
holding by regulatory requirements.

B. T hey were more profitable compared to corporate bonds.

C. Securitization enabled the funds to hold assets without disclosing such information in the
balance sheet.

D. Securitized products were considered less risky compared to traditional cash-generating

assets such as corporate bonds.

T he correct answer is A.

Securitization was (and is) particularly popular among the money market and pension funds because

it enabled them to invest in financial vehicles that they would normally not hold due to regulatory

constraints. For example, they might have been allowed to invest only in AAA-rated fixed-income

securities. T hrough securitization, they could now invest in the AAA-rated senior tranche of a

portfolio consisting of BBB-rated securities.

Opti on C i s i ncorrect: One of the advantages of securitization is that it reduces asset-liability

mismatch.

Opti ons B and D are some of the advantages of securitization, however, they are not the reasons

for the popularity of securitization.

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Q.417 In the run-up to the 2007-2008 financial crisis, it was not uncommon to find credit rating
agencies issuing overly optimistic and favorable ratings and forecasts about structured financial
assets. Which agency problem was behind this habit?

A. Structured financial assets initially had very low demand, and credit rating agencies wanted
to push that demand up.

B. Credit rating agencies were under considerable pressure from the federal government to
issue favorable ratings that would stir the economy and lead to growth.

C. Most credit rating agencies also had an ulterior interest in the financial assets that they
had been paid to assess.

D. Credit rating agencies would get paid by originators of structured financial assets for their
work, and also made more money than they would otherwise have made from rating
corporate bonds.

T he correct answer is D.

Agency problem refers to a situation where the interests of a principal (such as an originator) do not
align with those of the agent (credit-rating agency). While the agencies ought to have issued fair
recommendations, they instead issued favorable ones so as to impress the originators and increase
their chances of being rehired.

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Q.418 While the financial meltdown of 2007-2008 started in the US, it spread fast to other countries
leading to worldwide economic turmoil. Which of the following statements best describes why the
crisis spread so fast?

A. Banks in the US had been the main financiers of a multitude of smaller foreign banks, and
therefore when the financiers suffered liquidity problems, the smaller banks just couldn’t
obtain funding.

B. Securitized assets had been held by different countries around the globe, and therefore
when borrowers defaulted, all the investors incurred massive losses.

C. T he US entered into a recession, and their demand for exports fell, and therefore many
countries experienced a major decline in exports, triggering a worldwide recession.

D. Foreign banks in Asia, Europe and other parts of the world had bought collateralized US
debt and therefore when defaults rose, these banks lost a lot of money and consequently
global lending, even among banks themselves, took a downward spiral.

T he correct answer is D.

Foreign banks bought US CDOs and, therefore, had exposure to mortgage loans. When the defaults
rose, these banks suffered huge losses. T he banking system is internationally linked, so financial
signals travel unbelievably fast. When some banks started to lose money, they became reluctant to
lend not just to other banks but to consumers as well. It became very difficult for consumers and
firms to obtain credit, leading to a decline in aggregate demand. In the end, even countries that didn’t
have any exposure to the US mortgage market were exposed to its effects, albeit in varying degrees.

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Q.419 Distinguish between funding liquidity and market liquidity.

A. Funding liquidity describes the ease with which expert investors can obtain funding from
financiers by using purchased assets as collateral, whereas market liquidity describes the
ease with which investors can raise money by selling their assets.

B. Funding liquidity describes the ease with which investors can raise money by selling their
assets, whereas market liquidity describes the ease with which expert investors can obtain
funding from financiers by using purchased assets as collateral.

C. Funding liquidity refers to the ability of an investor to raise funds for in-house operations
while market liquidity refers to the ability to raise funds for the specific investment projects
themselves.

D. Funding liquidity describes the ability of an investor to raise short-term debt while market
liquidity is the ability to raise long term capital.

T he correct answer is A.

When a lender, dealer, or investment bank purchases an asset, they may borrow against it – use it as

security for the borrowed funds, without the asset changing hands. T he ease with which that can

happen is termed funding liquidity. Alternatively, the investor may decide to sell the asset to obtain

funding instead of borrowing against it. T he ease with which that can happen is termed market

liquidity. A sudden dry-up of these two types of liquidity has the potential to trigger a full-blown

financial crisis.

Opti on B i s i ncorrect: T he definition for funding liquidity and market liquidity have been

interchanged.

Opti on C i s i ncorrect: funding liquidity and market liquidity do not refer to raising money for

operations or for investment in a specific project.

Opti on D i s i ncorrect: Funding liquidity and Market liquidity do not refer to raising money for use

in the short term or long term, respectively.

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Q.420 Which of the following statements best describes why interbank market interest rates rose
sharply relative to the T reasury bill rate during and in the aftermath of the 2007-2008 financial
crisis?

A. T he Federal Reserve Bank increased the rate of interest at which it was willing to lend to
banks.

B. Losses incurred by banks combined with uncertainty on the part of structured investment
vehicles meant that there was less money available for lending to other parties.

C. Interbank market interest rates were internationally linked while the T reasury bill rate
was largely local.

D. As demand for mortgages worsened, profit streams for banks took a hit, meaning that
there was less money for lending to other banks.

T he correct answer is B.

As it became apparent that off-balance-sheet investment vehicles, conduits, and other structured
investments would most likely require the injection of more capital than initially anticipated, each
bank’s uncertainty about its own funding needs took a sharp increase. Furthermore, the possibility of
a bank turning to its “colleagues” for cash boosts after a minor shock became more uncertain, in part
because the other banks most likely had similar financial issues. As a result, the interbank interest
rate, LIBOR, took a sharper spike compared to the T reasury bill rate.

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Q.421 Distinguish between triggers and vulnerabilities that lead to the 2007-2009 financial meltdown.

A. T riggers refer to the events that touched off the crisis while vulnerabilities refer to the
fundamental/regulatory weaknesses in the financial system which amplified the initial shocks.

B. T riggers refer to the causal events of the crisis while vulnerabilities refer to the
institutions that bore the brunt of the crisis.

C. T riggers were the asset-backed securities created in the run-up to the crisis while
vulnerabilities refer to the institutions that bore the brunt of the crisis.

D. T riggers refer to the fundamental/regulatory weaknesses in the financial system which

amplified the initial shocks, while vulnerabilities refer to the causal events of the crisis.

T he correct answer is A.

T he crisis triggers were the particular events that touched off the crisis and unleashed the “tide.”
It’s widely accepted that the major trigger was the losses on subprime mortgages. On the other hand,
vulnerabilities refer to a range of structural/fundamental and regulatory weaknesses in the financial
system, which served to propagate the crisis and provided a platform on which the initial shocks
could thrive. Good examples of such vulnerabilities are the so-called shadow banks – financial entities
other than the regulated depository institutions which served as the intermediaries between
investors and investments.

Q.422 T he mai n vulnerability of the repo market in the time period leading up to the financial crisis
had much to do with the fact that:

A. T he market was largely illiquid.

B. T he market was large and unregulated, and many repo agreements were backed by
securitized mortgages as collateral.

C. T he market was small and strictly regulated.

D. Most dealers in repo agreements were based only in the US.

T he correct answer is B.

Repo agreements are transactions where a large-scale depositor or institutional investor puts money
in a bank for a short term, usually overnight. T he bank agrees to some “overnight interest” on the
deposited amount. T he deposit is secured by an asset of roughly the same value. Between 2000 and
2007, the repo market accounted for up to 30% of the U.S. GDP. Despite the large scale of such
transactions, the market was largely unregulated, making liabilities among dealers and brokers grow
sharply. A popular view is that the repo market collapsed when cash depositors became concerned
about the quality of the collateral backing repos and consequently withdrew their funding.

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Q.423 In September 2008, Lehman Brothers Holdings Inc. famously filed for Chapter 11 bankruptcy
protection. What was the immediate effect of the move?

A. Other large institutional investors also followed suit.

B. T he Federal Reserve moved with speed to inject capital into the firm.

C. It triggered a crisis of confidence in mortgage-backed securities.

D. It led to a run on the reserve primary money market funds after one large fund “broke the
buck” .

T he correct answer is D.

Lehman Brothers Holdings Inc. was the single largest investor in mortgage-backed securities (MBSs),

accumulating an MBS portfolio of more than $85 billion by 2007. In the first half of 2008, the firm

incurred massive losses resulting from a decline in the value of its commercial real estate assets, and

on September 15, the management filed for bankruptcy after reporting a loss of $3.5 billion and its

stock plunging by about 42%.

On September 16, following Lehman's filing for bankruptcy, a run on the reserve primary money

market funds after one large fund “broke the buck” was experienced. Investors lost confidence in

money market funds (MMF) when the MMF announced losses of $785 million in the commercial

papers of Lehman Brothers Holdings Inc.

On September 17, the MMF continued to collapse further. T his triggered investors to withdraw large

amounts of money from the MMF accounts.

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Q.424 In the run-up to the 2007-2009 financial meltdown, the interest rates in the United States had
historically been low, largely due to:

A. Low savings rates in the U.S.

B. High savings rates in the U.S.

C. Low demand for credit in the country

D. Accommodative monetary policy

T he correct answer is D.

In the years leading up to the financial crisis, the U.S. government had been striving to reduce
interest rates so as to increase lending rates and grow the economy. A high savings rate in China and
the rapidly growing economy also played a role in the installation of accommodative economic
policies in the U.S. so as to at least keep pace.

Q.426 In the face of competition from money market funds and junk bonds towards the end of the
20th century, the traditional banking model became less profitable and partly contributed to the
emergence of the shadow banking system. T his system consisted of a set of institutions which:

A. Were not only illegal but also engaged in money laundering.

B. Were allowed to invest only in short-term financial assets such as T-bills.

C. Were non-depository, and not subject to banking regulations.

D. Were non-depository, and subject to more stringent regulations compared to banks.

T he correct answer is C.

T he shadow banking system is a network of non-depository financial institutions – investment banks,

structured investment vehicles, conduits, hedge funds, and other non-bank financial entities that
serve as intermediaries to channel savings into investments. Due to the fact that they do not take
deposits, they escape a myriad of limits and laws imposed on traditional banks. Before the crisis,
shadow institutions used to borrow via short-term, liquid markets and then used the funds to invest in
longer-term illiquid assets. When the housing bubble burst, lenders and investors started to avoid
taking on the credit risk, and short-term borrowing dried up almost overnight, making these
institutions unable to raise money for their own operations. Compounding their woes was the
inability to get funds from their collapsing investments in securitized assets, which were now
considered “toxic” in investment terms.

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Q.427 Post-2008-2009 crisis research and analysis have established that the financial crisis was “not
special,” but was, in fact, reminiscent of prior crises. Among the key patterns noted in the build-up
was:

A. A sharp increase in housing prices.

B. Increase in public debt.

C. Negative current account balance.

D. All the above.

T he correct answer is D.

T he 2008-2009 financial crisis followed a pattern of build-ups of fragility typical of other crises that
happened before it in different parts of the world. In particular, there are important similarities
between the 2007-2009 crisis and the “T he Big Five Crisis” of Spain, Norway, Finland, Sweden, and
Japan. In all those crises, there were house price run-ups, notable increases in public debt, and
excessive borrowing from foreign institutions and governments, triggering negative current account
balances.

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Q.428 August 2007 is considered to be the first “panic” month when the effects of the crisis kicked
in. T he month was characterized by:

A. A high number of firms that were declared bankrupt.

B. Collapse of the market for asset-backed commercial papers.

C. A record number of federal bail-outs in aid of prominent U.S. institutions.

D. T he lowest dollar amount of U.S. imports.

T he correct answer is B.

In the lead-up to the crisis, big institutions increasingly funded long-term investments through

commercial papers – short-term (sometimes unsecured) loans. Most investors in securitized assets

obtain their funding this way and used mortgages and other receivables as collateral. Once a

commercial paper matured, the borrowing institutions would refinance it with another one, usually

by mobilizing repeat lenders. Conceptually, an asset-backed commercial paper program would suffer

a “run” if lenders are unwilling to refinance it when it matures. Starting from August 7, 2008, the

frequency of runs dramatically increased, and many programs could not refinance themselves.

Opti ons A, C, and D are the events that followed next just after the collapse of the market for

asset-backed commercial.

Q.429 Which of the following is not a monetary policy that was implemented by the U.S Federal
Reserve as a response to the 2007-2009 financial crisis?

A. Lowering the interest rate.

B. Offering grants to major financial institutions.

C. Creation of long-term lending services in case of a high-quality collateral.

D. Large-scale purchase of bonds denominated in the Chinese Yuan.

T he correct answer is D.

T here was no large-scale purchase of bonds denominated in the Chinese Yuan.

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Opti on A i s true: To provide liquidity to the financial system, the Fed lowered the federal fund's

rate from 5.25% to about 0.25%. T he rates were kept low for some considerable time to mitigate

the effects of the 2007-2009 financial crisis and its aftermath.

Opti on B i s true: T he T roubled Asset Relief Program (TARP) of October 2008. T his program saw

State Street, Bank of America, Citigroup, BNY Mellon, Morgan Stanley, Gold-man Sachs, J.P. Morgan

Chase, and Wells Fargo received a total of USD 115 billion on October 28, 2008. T he government

also took over Freddie Mac and Fannie Mae. However, the government declined to bail out Lehman

Brothers.

Opti on C i s true: Creation of long-term lending services in case of high-quality collateral was one

of the actions taken by the Fed in response to the crisis.

Other actions taken by the Fed include:

Provisions of liquidity to money market funds

Buying assets from Fannie Mae and Freddie Mac, which were the government-sponsored

enterprises that affected the mortgage market in the U.S.

Opening of a discount window to investment banks and securities firms. A discount window

is a federal reserve lending facility that aids financial institutions in managing short-term

liquidity requirements.

Financing the purchase of unsecured C.P. and ABCP

Provision of lending funds against high-quality asset-backed securities.

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Q.430 Which of the following government-financial sector stabilization measures had the biggest
short-term impact on markets during the second and the third crisis period?

A. Recapitalizations

B. Asset purchases

C. Liquidity guarantees

D. Asset guarantees

T he correct answer is A.

Evidence suggests that recapitalizations (capital injections) had the biggest stabilization impact during

the second and the third crisis period compared to other government-financial sector policies. In

particular, recapitalizations brought about significant improvements in an IMF-sponsored index of

bank Credit Default Swaps (CDS) spreads in many countries.

Asset purchases, on average, had a weaker impact.

T he study shows that liquidity guarantees were most effective during the early stages of the crisis,

i.e., before the fall of Lehman Brothers.

Q.431 Which one of the following statements is incorrect?

A. Bear Sterns financed its mortgage loans largely by tapping the repo market.

B. Northern Rock invested in too many mortgages with insufficient collateral, leading to the
inability to finance existing liabilities.

C. T he housing crisis was activated in part by low preliminary “teaser” rates which would be
increased later on during the term of repayment.

D. T he financial crisis of 2007-2009 was caused by the Chinese government buying too many
U.S. government bonds.

T he correct answer is D.

Although foreign governments had invested significantly in U.S. assets prior to the crisis, there is no
established connection between China and the financial crisis.

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Q.432 What is the main problem with bailing out institutions during economic crises?

A. A huge number of assets have to be written off.

B. It increases the problem of adverse selection.

C. It may trigger public discontent or even disastrous demonstrations.

D. It increases the problem of moral hazard.

T he correct answer is D.

Bailing out a troubled financial institution may set a bad precedent - other institutions may come
knocking, requesting for assistance, even when there are other options. It’s certainly not possible to
rescue everyone, as the U.S. government might have realized in the aftermath of the 2007-2009
financial crisis. Most notably, the government declined to bail out to Lehman Brothers, although it did
rescue a few other institutions like AIG, Freddie Mac, and Fannie Mae.

Q.433 Which one of the following characteristics is common in financial crises witnessed since the
Great Depression?

A. T hey have only occurred in developed economies.

B. T hey are characterized by an absence of liquidity in markets.

C. T hey always last for a maximum of 2 years.

D. All of the answers are correct.

T he correct answer is B.

In a financial crisis, firms fail not necessarily because of losses but due to liquidity issues – the

inability to finance or refinance themselves.

Opti on A i s i ncorrect: Although the crisis occurred majorly in developed economies, other

developing economies were also affected by the crisis.

Opti on C i s i ncorrect: Not all financial crises lasted for two years.

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Q.434 What is the most important role played by the Federal Reserve in the multi-agency efforts that
helped mitigate the effects of the credit crises?

A. It helped to weed out rogue traders and fraudulent dealings.

B. It restored confidence and liquidity to the financial markets.

C. It helped to limit foreign investments, therefore stabilized the current account of the U.S.

D. None of the above.

T he correct answer is B.

T he Federal Reserve deserves credit for ensuring the financial system continued to function beyond

the credit crises. Its actions such as lowering interest rates providing direct credit lines to financial

institutions helped to restore investor confidence and liquidity to financial markets.

T he following actions were also taken by the Central bank in response to the credit crisis.

Creation of long-term lending services in case of a high-quality collateral

Provisions of liquidity to money market funds

Buying assets from Fannie Mae and Freddie Mac, which were the government-sponsored

enterprises that affected the mortgage market in the US.

Opening of a discount window to investment banks and securities firms. A discount window

is a federal reserve lending facility that aids financial institutions in the management of

short-term liquidity requirements.

Financing the purchase of unsecured CP and ABCP

Provision of lending funds against high-quality asset-backed securities

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Q.435 T he second panic period of the 2007-2009 financial crisis was triggered by:

A. A total collapse of the commercial paper market.

B. A big number of bankruptcy filings among financial conglomerates.

C. T he declaration of bankruptcy by Lehman Brothers.

D. T he collapse of the shadow banking system.

T he correct answer is C.

While the first panic period featured the collapse of the short-term funding market, particularly that
of commercial papers, the second panic period, which happened in September 2008, was triggered
by news that the Lehman Brothers had filed for Chapter 11 bankruptcy protection. Since the firm
was the largest underwriter of securitized assets, investors quickly lost confidence in financial
institutions. T his triggered “runs” as many attempted to salvage their money.

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Reading 11: GARP Code of Conduct

Q.266 Jack Oboyo, a manager at Somalia's largest investment bank, is managing a portfolio that
focuses on stocks from Somalia's logistics and transportation sector. Oboyo has some close contacts
at the securities exchange commission of Somalia, providing him with non-public sales and profit-
related data of firms that file their reports with the commission before being distributed to the
general public. Oboyo uses this information to advise his employer on potential investment-grade
stocks. It is common and legal in Somalia to obtain material non-public information or insider
information related to public limited companies. Jack Oboyo's practice:

A. Has not violated the GARP's Code of conduct.

B. Has violated the Code related to confidentiality.

C. Has violated the Code related to professional integrity and ethical conduct.

D. Has violated the Code related to conflict of interest.

T he correct answer is C.

According to the code of professional integrity and ethical conduct, GARP members should endeavor
to be mindful of cultural differences regarding ethical behavior and customs, and to avoid any actions
that are, or may have the appearance of being unethical according to local customs. If there appears
to be a conflict or overlap of standards, the GARP member should always seek to apply the higher
standard.

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Q.267 David Bremen, FRM, has recently joined one of Austria's largest jet engine manufacturers as a
Chief Risk Officer. Previously, Bremen had worked for 35 years in risk hedging and risk management
in the banking sector. Based on his vast experience, David recommends his team hedge all of its
foreign currency-denominated sales. He believes that most foreign currencies are most volatile at
the end of every financial year. David's recommendation:

A. Has not violated the Code.

B. Has violated the Code because he has not clearly disclosed his expertise and knowledge
concerning risk assessment.

C. Has violated the Code because he failed to distinguish between fact and opinion in the
presentation of his recommendation.

D. Has violated the Code because he cannot delegate his team to perform hedging
transactions.

T he correct answer is C.

David Bremen has violated the Code as the Code requires the member to clearly distinguish between
the fact and opinion in the presentation of recommendations. Bremen made the hedging
recommendation based on his experience while the Code requires the member to perform
reasonable due diligence.

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Q.268 Muhammad Aslam, FRM, is a risk analyst at Financial Angels, a venture capitalist firm that
invests in tech and health science-related startups and small-medium enterprises (SMEs). After
careful risk assessments, the manager has approved Aslam to initiate the first round of funding for
seven startups. Aslam's wife co-founded one of the selected startups. Without disclosing this
information, Aslam proceeded with the manager's recommendation. Determine if Muhammad Aslam's
actions are in violation of a Code.

A. No, because the recommendation of investing in seven startups, including the startup
cofounded by Muhammad Aslam's wife, came from senior manager.

B. No, because the startup is founded by Muhammad Aslam's wife, not him. T herefore he can
invest without disclosing this information.

C. Yes, as the Code requires a member to disclose to their employer the matters that could
impair his independence and objectivity.

D. Yes, because Muhammad Aslam acted on the manager's recommendation without

performing self-analysis.

T he correct answer is C.

Muhammad Aslam has violated the GARP's Code of conduct related to conflict of interest by failing to
disclose his wife's relation with one of the recommended startups to its employer. T he Code
requires members to disclose all matters that could be expected to impair the independence and
objectivity of the member.

Q.270 Which of the following GARP's Code of conduct requires a member to be diligent about not
overstating the accuracy or certainty of results or conclusions and clearly disclosing the limits of
their expertise and knowledge in areas of risk assessment?

A. Professional integrity and ethical conduct.

B. Fundamental responsibilities.

C. General accepted principles.

D. Conflict of interest.

T he correct answer is B.

GARP's Code of conduct related to Fundamental responsibilities states that the member shall:
1. Comply with all applicable laws, rules, and regulations (including this Code) governing the GARP
Members' professional activities
2. Not outsource or delegate those responsibilities to others
3. Be diligent about not overstating the accuracy or certainty of results or conclusions
4. Clearly disclose the limits of their expertise and knowledge in areas of risk assessment

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Q.271 Jack Simpson, FRM, and John Philip, FRM, are two risk analysts and team members at Dark
Well Insurance Company. Simpson recently found out that John Philip shares the company's
confidential risk-related data with his friend, Louis Keynes, an investment manager at Verizon
Investment Company that regularly trades Dark Well's stocks. Keynes also uses this information for
personal gains. Which of the following action is in line with GARP's Code of conduct?

A. Simpson should bar John Philip from using the FRM designation as he shares the
company's confidential information with outsiders.

B. Simpson should ignore John Philip's action, as Simpson is not personally involved in sharing
the company's confidential information.

C. Simpson should not take any action against John Philip because the company's confidential
information is being used by an outsider for personal gains only.

D. Simpson should immediately report John Philip's activities to their employer.

T he correct answer is D.

GARP requires members not to commit any act that compromises the integrity of GARP or the FRM
designation. In addition, GARP requires its members not to knowingly participate or assist in any
violation of the Code or laws and not to make use of the employer or client's confidential information
for inappropriate purposes and personal use.

Opti ons A, B and C are a violation of the GARP code of conduct

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Q.272 A formal investigation that confirms violation of the GARP Code of Conduct can bring about
serious consequences. Which of the following is a potential consequence of such a violation?

A. Mandatory participation in ethical training.

B. A temporary suspension of the GARP member's right to work in the field of risk
management.

C. Withdrawal of the GARP member's right to use the FRM designation for any purpose.

D. A formal request to the GARP member's employer to withdraw certain benefits such as
bonuses and other fringe benefits.

T he correct answer is C.

GARP clearly states that:

"Violation(s) of this Code may result in, among other things, the temporary suspension or permanent
removal of the GARP Member from GARP's Membership roles, and may also include temporarily or
permanently removing from the violator the right to use or refer to having earned the FRM
designation or any other GARP granted designation, following a formal determination that such a
violation has occurred."

Q.273 Kelvin White, FRM, works for a consultancy firm that specializes in pension fund management
in a certain city. Recently, one of his close friends who work for the city's planning and development
department approached him with an offer to work as an unpaid volunteer for the department's
pension fund. In turn, the department would grant White a free parking space just outside his office.
Which of the following is the most appropriate thing to do before accepting the offer?

A. Do nothing as this is a volunteer job.

B. Request the department not to grant him any fringe benefit, including the free parking
space.

C. Seek advice regarding the offer from one of his colleagues at the consultancy firm.

D. Disclose the details of the volunteer position to his employer.

T he correct answer is D.

According to the GARP Code of Conduct, members should "make full and fair disclosure of all matters
that could reasonably be expected to impair independence and objectivity or interfere with
respective duties to their employer, clients, and prospective clients." Although the department may
not be a current client of the firm, that could change in the future while White is still an employee of
the firm.

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Q.274 A GARP member working in a certain country establishes that the GARP Code of Conduct, the
country's laws, and the local law applicable within the region where she conducts business all
specify different requirements. T he member must abide by:

A. T he GARP Code of Conduct.

B. T he highest standard of local law, her country's laws, or the GARP Code of Conduct.

C. T he GARP Code of Conduct or the local law, whichever is higher.

D. T he country's law.

T he correct answer is B.

If standards appear to be in conflict or overlap, the GARP member should ALWAYS seek to apply the
highest standard.

Q.275 Jessica Pearson, FRM, works for an investment bank. At the end of a 2-year contractual
relationship between the bank and one of its clients, the client offers Jessica a car worth USD
43,200 in part because of her outstanding expertise and professionalism throughout the period of the
contract. How should Jessica proceed?

A. Accept the gift because the contract has lapsed.

B. Accept the gift but make sure that she informs her employer about it.

C. Reject the gift.

D. Reject the gift but request the client to redirect it to the bank itself.

T he correct answer is C.

T he Code clearly stipulates that members must not offer, solicit or accept any gift, compensation, or
consideration that could be reasonably expected to bring about compromise or erode objectivity and
independence. T hat the contract has lapsed does not mean the code can be ignored because the
client could well come back seeking professional help in the future.

Opti ons A, B and D are a violation of the GARP code of conduct

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Q.276 Green Belt Market Fund directs its two subsidiaries to buy and sell emerging market stocks
simultaneously. In its monthly investment outlook literature, the company points to the overall
emerging market volume as indicative of the market's liquidity. T he move prompts more investors to
participate in the emerging markets fund increasingly. Green Belt Market Fund most likely:

A. Did not violate the GARP Code of Conduct.

B. Violated the GARP Code of Conduct regarding conflict of interest.

C. Did not violate the GARP Code of Conduct but may have breached stock brokerage rules.

D. Violated the GARP Code of Conduct regarding professional integrity and ethical conduct.

T he correct answer is D.

T he Green Belt Market Fund appears to be attracting investments in its own funds by manipulating

the market's liquidity. T he increased participation in the emerging markets fund does not emanate

from market forces (supply and demand), nor does it indicate a genuine trading strategy meant to

benefit investors. It's actually a veiled attempt to increase the assets under the management of the

company. T he action violates the Code of Conduct with regard to professional integrity and ethical

conduct.

Opti ons A and C are i ncorrect: Clearly, Green Belt Market Fund has violated the GARP Code of

Conduct.

Opti on B i s i ncorrect: T here is no conflict of interest between Green Belt Market Fund and the

investors.

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Q.277 T heresa Conway, FRM, is a trade manager of an investment fund specializing in currency
trading. In a report sent to investors, Conway outlines her trading strategy which is hinged on the
appreciation of the United States dollar against other world currencies. She quantifies expected
returns if the dollar appreciates by less than 5%, 5% - 10%, and by more than 10%. She also outlines
possible scenarios if the dollar depreciates by similar margins. Also explicitly stated therein is that
these projections are her professional opinion. Has Conway violated the GARP Code of Conduct with
respect to communication?

A. Yes.

B. No, because she disclosed the basic details of her investment strategy.

C. No, because she explicitly distinguishes fact from opinion, while still giving a range of
scenarios if the dollar appreciates or depreciates - therefore capturing most (or all) possible
scenarios.

D. No, because it's her legal duty to communicate the details of her strategy to investors.

T he correct answer is C.

T he Code of Conduct requires members to disclose factual data that is devoid of falsehoods. In
addition, personal judgment or opinion must be clearly distinguished from facts.

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Q.278 Richard Leakey, FRM, is an analyst with a large portfolio of stocks, including the stock of
Brighter World Limited (BWL). Leakey's uncle owns about 20,000 shares of BWL. He informs
Leakey that he has created a trust in his name and placed 5,000 BWL shares into the trust. T he
wording of the trust prevents Leakey from selling the shares until his uncle dies, but may
nonetheless vote for the shares. Leakey is due to give an updated research analysis on BWL in a
fortnight. Leakey should most appropriately:

A. Disregard the situation and proceed to update the report as usual because he is not a
beneficiary of the shares as of now.

B. Notify his superiors that he's no longer in a position to issue recommendations on BWL.

C. Request his uncle to amend the terms of the trust to allow him to sell the shares at any
time.

D. Disclose the situation to his employer and, if given the green light to prepare a report,
also disclose his new status as a beneficiary of BWL stocks.

T he correct answer is D.

GARP members are under the obligation to disclose any actual or potential conflict to all affected

parties. Such a disclosure must be fair and made in full, particularly if there's reason to believe that it

could affect the member's independence, objectivity, or interfere with the affairs of the employer or

clients. Leakey has a pecuniary interest in BWL shares and also has voting rights. He's obligated to

inform his employer of the potential conflict and only proceed to keep BWL under his docket after

the employer has allowed it.

Opti on A is a violation of the GARP Code of Conduct regarding conflict of interest.

Opti ons B and C are unprofessional acts; GARP members should act professionally, ethically and

with integrity when dealing with their employers, clients, and the general public.

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Q.279 Paul Lambert, FRM, serves as a financial analyst for Lakeside Investments. He has been
tasked with preparing a purchase recommendation on Brighter World Limited. Which of the following
statements about disclosure of conflicts of interest would Lambert have to disclose fully?

A. He co-owns 30,000 of Brighter World Limited with his brother.

B. He has a significant ownership in Brighter World Limited through a family trust.

C. Lakeside is an over-the-counter market maker for Brighter World Limited's stock.

D. All of the above.

T he correct answer is D.

According to the GARP Code of Conduct, members shall make full and fair disclosure of all matters
that could reasonably be expected to impair objectivity and independence or interfere with
respective duties to their employer, clients, and prospective clients.

Q.280 Which of the following is NOT a fundamental responsibility of GARP members as stipulated in
the Code of Conduct?

A. Members must purpose, and encourage others, to operate at the highest level of
professional skills.

B. Members have a personal ethical responsibility and must maintain the highest ethical
standards.

C. Members cannot delegate or outsource their ethical responsibility to others.

D. Members do not have to continue perfecting their expertise once they have passed exams
and obtained all the necessary certifications.

T he correct answer is D.

Members should ALWAYS continue to perfect their expertise even after certification. In addition,
they must keep up with the current generally accepted risk management practices.

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Q.281 Chris Jefferson, FRM, is the manager of a hedge fund. Over the last 3 days, he has been
investing the hedge fund by purchasing significant quantities of ABC's stock while simultaneously
selling the three-month futures contract (i.e. initiating a short position in it). Although his clients are
aware of the fund's general investment strategy to generate earnings, Jefferson did not inform them
of the trades. One of the following statements is most likely correct. Which one?

A. Jefferson violated the GARP Code of Conduct.

B. Jefferson did not violate the GARP Code of Conduct.

C. Manipulated the price of a publicly traded security hence violated the Code of Conduct.

D. Violated the GARP Code of Conduct by failing to keep his clients in the loop regarding the
transactions before they occurred.

T he correct answer is B.

Jefferson's actions do not amount to an attempt to manipulate the price of a security and mislead
market participants. It's actually a legitimate strategy and an attempt to exploit an arbitrage
opportunity that may exist between the ABC stock spot price and its futures price. T he hedge fund's
participants fully understand the investment strategy. T hus, Jefferson did not have to disclose his
plans before execution.

Q.282 Carol Bauer, FRM, serves as a portfolio manager for several wealthy clients with well-
diversified portfolios. Among her clients is Matthew Cook, for whom she manages a personal
portfolio of stocks and government bonds. Cook recently disclosed to Bauer that he is under
investigation for tax evasion related to his business, Cook Concrete. After a few days, Bauer shares
that information with a friend who works at a local bank that has plans to underwrite Concrete's IPO.
Carol Bauer has most likely:

A. Violated the GARP Code of Conduct with respect to confidentiality.

B. Not violated the GARP Code of Conduct with respect to confidentiality.

C. Not violated the GARP Code of Conduct because she revealed illegal activities on the part
of her client.

D. Violated the GARP Code of Conduct by failing to detect the tax evasion despite being
central to her client's business dealings.

T he correct answer is A.

According to the GARP Code of Conduct, members shall take "all reasonable precautionary measures
to prevent intentional and unintentional disclosure of confidential information." Carol Bauer did not
have the right to inform the bank of her client's situation.

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Q.283 Donald Lee, FRM, is an exam proctor for the FRM part I exam. A few days before the exam,
Lee emails a copy of 5 questions to each of his two friends, Martin and Joseph, who are part 1
candidates in the FRM program. Lee and his two friends had planned the distribution of exam
questions months in advance. Martin proceeds to prepare for the exam. However, Joseph develops
cold feet and declines to load the questions and use them to his advantage. Which of the following
statements is most likely correct?

A. Donald Lee violated the GARP Code of Conduct, but Martin and Joseph did not.

B. All the three violated the GARP Code of Conduct.

C. Donald Lee and Martin violated the code, but Joseph did not.

D. Martin and Joseph violated the code, but Donald Lee did not.

T he correct answer is B.

As members and candidates in the FRM exam, Donald Lee, Martin, and Joseph all violated the GARP
Code of conduct. T he code prohibits any action that compromises the integrity of GARP, or the
integrity/validity of the examinations leading to the award of the right to use the FRM designation.
Donald Lee clearly breached the exam security while Martin and Joseph both compromised the
integrity of the FRM exam by planning to use actual exam questions to prepare for the exam,
thereby giving them an unfair advantage over other candidates. T hat Joseph did plan to use the
questions at the beginning makes him an accomplice, even if he, later on, refused to use the material.

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Q.284 T imothy Bradley, FRM, works as a full-time financial analyst at KenBright Actuarial Services
Limited(KBG). Recently, one of the company's business contacts offered him a part-time analytical
job at KPMG. T he work would entail establishing the right balance between equity and debt finance
for KPMG. T imothy should most appropriately:

A. Not accept the work as it violates the Code of Conduct by creating a conflict of interest.

B. Accept the work as long as he obtains written consent from KBG and does it in his free
time.

C. Accept the work as long as his full-time employer, KenBright Limited, agrees to all the
terms of the engagement.

D. Accept the role as long as, in her own assessment, it does not interfere with her duties to
KenBright Limited.

T he correct answer is C.

T he Code of Conduct dictates members to make full and fair disclosure of all matters that could

either impair independence and objectivity or interfere with respective duties to their employer,

clients, or potential clients. Bradley should only accept the role if his current employer fully agrees

to the terms.

GARP members shall also act fairly in all situations and must fully disclose any actual or potential

conflict to all affected parties.

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Q.285 Sally Spicer, FRM, acts as a liaison between Prime Financials (an investment management
firm) and Neiman Inc. (an investment bank). Neiman Inc. intends to issue an IPO and turns to Prime
Financials for underwriting services. As a way of increasing investor confidence, Sally Spicer has
Prime Financials issue a trove of vague and unrealistic financial information that paints its clients in
better health than it actually is. Which section of the GARP Code of conduct has most likely been
violated by Spicer and her company?

A. Best practices.

B. Professional integrity and ethical conduct.

C. Fundamental responsibilities.

D. Confidentiality.

T he correct answer is B.

Under professional integrity and ethical conduct, the code states that "Members must avoid disguised

contrivances in assessments, measurements and processes that are intended to provide a business

advantage at the expense of honesty and truthfulness."

Opti on A i s i ncorrect: Under Best Practice, GARP Members should promote and adhere to

applicable "best practice standards," and will ensure that risk management activities performed

under his/her direct supervision or management satisfies these applicable standards.

Opti on C i s i ncorrect: Under Fundamental responsibilities, GARP Members must endeavor, and

encourage others, to operate at the highest level of professional skill, and that GARP Members

should always continue to perfect their expertise. GARP Members have a personal ethical

responsibility and cannot out-source or delegate that responsibility to others

Opti on D i s i ncorrect: According to confidentiality, ARP Members will take all reasonable

precautionary measures to prevent intentional and unintentional disclosure of confidential

information

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Q.286 Romney Muriuki, FRM, works as an analyst for an African Insurance firm that has a presence
in 8 central African countries. In a recent report, Muriuki makes the following statements:
"Based on the fact that the firm has recorded steady growth in customer numbers over the last
decade, and that the insurance penetration currently stands at 3%, I expect the trend to continue for
the next 10 years. I also expect that the company will be able to translate the continually increasing
revenue into significant profits."

T he report describes in detail the risks facing the firm, particularly geopolitical risks associated with
African countries. Muriuki's report:

A. Violated the Code by failing to distinguish factual details from his opinion.

B. Did not violate the Code.

C. Violated the code by giving a shallow professional assessment of the insurance market in
Africa.

D. Violated the Code by failing to properly identify all the risks related to operations in
African countries.

T he correct answer is B.

Historical growth can be presented as a fact since it actually happened. Muriuki states that the firm
should expect further growth in revenue and profits, which is an opinion. He does not claim that
these are facts. T herefore, he does not violate the standard regarding the separation of facts from
opinions.

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