P1. Mock Exam A

P1.
Mock Exam A FRM 2012 Practice Questions
By David Harper, CFA FRM CIPM www.bionicturtle.com
Table of Contents
Question 1: When does risk management add value? .............................................. 3 Question 2: Portfolio alpha ............................................................................ 3 Question 3: Portfolio information ratio (IR) ........................................................ 3 Question 4: Metallgesellschaft causal factors ...................................................... 3 Question 5: Risk model versus derivatives pricing ................................................. 4 Question 6: GARCH volatility forecast ................................................................ 4 Question 7: Random normal variables ................................................................ 4 Question 8: Lognormal Property of Stocks ........................................................... 5 Question 9: Two-asset portfolio value at risk (VaR) ................................................ 5 Question 10: Linear regression interpretation ...................................................... 6 Question 11: Bond portfolio duration ................................................................. 7 Question 12: Commodity futures price ............................................................... 7 Question 13: Put-call parity ........................................................................... 7 Question 14: Hedge coffee purchase ................................................................. 8 Question 15: Eurodollar futures price ................................................................ 8 Question 16: Interest rate swap value ................................................................ 8 Question 17: Short volatilty strategies ............................................................... 9 Question 18: Delta gamma neutral portfolio ....................................................... 9 Question 19: Value at risk (VaR) of inverse floater ................................................. 9 Question 20: Binomial option pricing tree ......................................................... 10 Question 21: Forward rate implied by bond prices ............................................... 10 Question 22: Taylor Series approximation for option price ..................................... 10 Question 23: Credit rating migration (transition) matrix ........................................ 11 Question 24: Unexpected loss ....................................................................... 11 Question 25: Stress testing ........................................................................... 12 www.bionicturtle.com FRM 2012 PART 1: MOCK EXAM A 1
Candidate Answer Sheet: Mark an X under your answer of choice.
Question # 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Answer A
Answer B
Answer C
Answer D
www.bionicturtle.com
FRM 2012 PART 1: MOCK EXAM A 2
Question 1: When does risk management add value?

1. In each of the following cases according to theory (Stulz), a good risk management program should create firm value, EXCEPT for: a) The program reduces idiosyncratic (firm-specific) risk while the firm depends on a large, active shareholder who is not diversified (e.g., private equity firm) b) The program hedges the firm's exposure to oil prices--a common (systematic) risk factor--with a short position in oil futures contracts while the firm is owned by shareholders who are well-diversified c) The program reduces the volatility of taxable earnings, effectively avoiding progressively higher tax rates in higher tax brackets d) The program reduces the debt overhang which causes shareholders to avoid positive net present value projects
Question 2: Portfolio alpha

2. While the risk-free rate was 4.0%, a portfolio's realized a return of 14.0% exactly matched the return of its benchmark, the market index, which also returned 14.0%. The portfolio's covariance (of returns) with the market index was 0.01440 and the market's volatility was 20.0%. What was the Jensen's alpha of the portfolio? a) b) c) d) -1.6% Zero +3.2% +6.4%
Question 3: Portfolio information ratio (IR)

3. A portfolio has an expected return of 11.0% with volatility of 24.0%. The benchmark has an expected return of 5.0% with volatility of 15%. The expected returns correlation is 0.80. What is the expected (ex ante) information ratio (IR)? a) b) c) d) 0.40 0.55 0.69 0.80
Question 4: Metallgesellschaft causal factors

4. Which of the following factors LEAST contributed to the disaster at Metallgesellschaft? a) Failure to deliver on a few high-profile customer contracts incurred unexpected reputational risk b) Basis risk implied by short-term hedges against long-term exposures c) Roll return on long futures contract was negative (creates losses) under contango in the oil forward curve d) Unlike forwards, futures contracts required daily cash settlement
Question 5: Risk model versus derivatives pricing

5. You colleague Roger is building a customized variation of the Merton model to estimate the credit risk of a portfolio of bonds issued by publicly-traded companies: the "structural" model will estimate each company's probability of default (EDF) by estimating the one- and three-year distance-to-default (DD), a measure of solvency which compares the predicted firm's asset value to a debt threshold. As the portfolio company have traded equities, the model does not perform any pricing; e.g., the value and volatility are exogenous inputs (given as assumptions). The model is strictly an application of risk measurement, not valuation or derivatives valuation. Roger makes four statements about his credit risk measurement model. Which is most likely problematic? a) It is not precise b) It does not discount to present value, it only estimates a future distribution c) Justified by no arbitrage, it avoids the actual expected return and a physical distribution; and instead assumes the risk-free rate and a risk-neutral distribution d) It replaces the Merton assumption of a lognormal asset price distribution with a alternative distribution
Question 6: GARCH volatility forecast

6. The following parameters have been estimated for a GARCH(1,1) model which gives an estimate of today's daily volatility (today = day n):
Yesterday's (n-1) daily volatility was 2.0% and yesterday's daily return was -7.0%. What is the GARCH(1,1) estimate of the daily volatility in 20 days (that is, the estimated volatility on day n+20)? a) b) c) d) 1.50% 2.85% 3.91% 4.23%
Question 7: Random normal variables

7. Let B and Y represent random normal variables: B ~ N(300, 200^2) and Y ~ N(200,150^2). Let A characterize the average of a random sample of 100 draws (trials) from B, and let X characterize the average of a random sample of 100 draws from Y. We can assume that A and X are independent. What is the joint probability Pr[ A < 253.40, X < 170.60]? a) b) c) d) 0.0250% 0.2250% 0.6667% 1.3050%
Question 8: Lognormal Property of Stocks

8. A stock has a price today of $52.00, an expected return of 14.0% per annum and a volatility of 36.0% per annum. We assume the stock's stochastic process is a geometric Brownian motion (GBM) with a consequent lognormal price distribution. What is the 95.0% confidence interval for the stock price in three months (today + 0.25 years), if we are careful to use the geometric return, which erodes the drift by one-half the variance (i.e., the geometric return is necessarily less than the arithmetic return for any nonzero volatility)? a) b) c) d) $29.54 < S(0.25) < $121.13 $37.24 < S(0.25) < $75.40 $45.33 < S(0.25) < $67.18 $49.60 < S(0.25) < $60.22
Question 9: Two-asset portfolio value at risk (VaR)

9. A portfolio holds two securities, LowProfile(A) and HighBeta(B). The expected annual returns, weights, and covariance matrix are given by the following:
The security returns are normally distributed and independent over time (i.e., zero autocorrelation). If the portfolio value is $10.0 million and we assume 250 trading days per year, which is nearest to the 10-day 99.0% relative portfolio value at risk (VaR)? a) b) c) d) $323,700 $716,490 $1,080,000 $3,065,250
Question 10: Linear regression interpretation

10. A portfolio manager regressed two years of monthly excess portfolio returns, R(P), against the excess returns of the index benchmark, R(B). The sample includes 24 months, n =24. The resulting regression, see below, is R(P,i) = 0.00830 + 0.86500*R(B,i) + e(i).
The portfolio manager infers the following from the regression results: I. II. III. IV. The intercept is significantly different than zero with 95% confidence The slope is significantly different than 1.0 with 95% confidence Assuming the total sum of squares (TSS) is 0.00420, the standard error of the regression (SER) is ~ 1.1940 The coefficient of determination (R^2) is ~ 0.8474
Which of the statements is (are) correct? a) b) c) d) None I. and IV. only II. and III. only All are correct
Question 11: Bond portfolio duration

11. Consider the following portfolio of three bonds, where par amounts are in millions of dollars (USD):
What is the portfolio's dollar value of one basis point (DV01)? a) b) c) d) $11,559 $13,111 $15,943 $17,000
Question 12: Commodity futures price

12. The spot price of platinum, S(0), is $1,530.00 per troy ounce, while the one-year futures price, F(1), is $1,690.00. Assume that ownership of platinum confers no convenience yield but the cost to store one ounce is $90.00 per year, payable at the end of the year (in arrears). The risk-free rate is 4.0% per annum continuously compounded, for all maturities. What is the arbitrage trade and implied future profit? a) Borrow cash to buy spot platinum and take short futures contract position: profit $7.56 per ounce in one year b) Borrow cash to buy spot platinum and take short futures contract position: profit $97.44 per ounce in one year c) Short platinum, lend cash and take long futures contract position: profit $3.20 per ounce in one year d) Short platinum, lend cash and take long futures contract position: profit $16.87 per ounce in one year
Question 13: Put-call parity

13. An American call option that expires in nine months (0.75 years) has a strike price of $20.00 and a price of $2.00. The underlying stock price is $18.00 and pays a one dollar ($1.00) dividend in nine months. The risk-free rate is 3.0%. What are the upper and lower bounds for the price of an American put option on the same stock with the same strike and expiration? a) b) c) d) $1.05 to $2.17 $2.99 to $3.75 $3.56 to $4.98 $4.25 to $6.18
Question 14: Hedge coffee purchase

14. A retailer is committed to the purchase of one million pounds (1,000,000 pounds) of coffee in November at the prevailing price at that time, but is concerned the price of coffee will increase and so wants to hedge this planned purchase with December futures. The standard deviation of monthly changes in the spot price of coffee $0.30 per pound, while the standard deviation of monthly changes in the futures price is $0.40 per pound. The correlation between spot and futures price changes is 0.60. Each coffee futures contract is for delivery of 37,500 pounds. What is the hedge trade? a) b) c) d) Short 18.0 contracts Short 9.0 contracts Long 7.5 contracts Long 12.0 contracts
Question 15: Eurodollar futures price

15. Assume the 12-month (one year) LIBOR zero rate is 3.00% per annum and the 15-month LIBOR zero rate is 4.40%, both with continuous compounding and an ACT/365 day count convention. The contract price (P) of a Eurodollar futures contract is based on the quote (Q) and given by: P = 10,000 * [100 - 0.25 * (100-Q)], where a Eurodollar contract is quoted (Q) with quarterly compounding and an ACT/360 day count convention. What is nearest to the estimate of the contract price (P) for a Eurodollar contract maturing in one year? a) b) c) d) $926,354 $975,032 $989,257 $1,024,361
Question 16: Interest rate swap value

16. One year ago, a bank entered into a plain vanilla three-year interest rate swap as the fixedpayer that references a notional amount of $400.0 million. The bank pays a fixed annual coupon of 6.0% and, in exchange, receives LIBOR annually. Today, the first payment was made. The oneand two-year LIBOR spot (zero) rates are 4.00% and 4.80%, respectively, with continuous compounding. Which is nearest to the value today, to the bank, of the swap? (source: variation on handbook example 10.9) a) b) c) d) -8.25 million -3.00 million +5.15 million +11.75 million
Question 17: Short volatilty strategies

17. A trader believes the market has over-estimated the likelihood of a dramatic movement, in either direction, of a stock. Consequently the trader wants to short the stock's implied volatility, seeking to profit if the stock is range-bound without a large move in either direction. Each of the following trades is short volatility EXCEPT which of the following trades is the LEAST effective at expressing the trader's view? a) b) c) d) Short (top) straddle Long calendar spread Short strap Short box spread
Question 18: Delta gamma neutral portfolio

18. A trader buys 100 call options; each of which has a percentage (per option) delta of 0.60 and percentage gamma of 1.20. The trader neutralizes the delta of this long call option position by shorting 60 shares. However, the net position is not gamma neutral. The trader wants to neutralize both delta and gamma and is willing to add put options to the position. The put options have a delta of -0.40 and gamma of 0.80. What trade(s) will result in a position that is both delta and gamma neutral? a) b) c) d) Short 90 call options and short 36 shares Long 90 call options and long 36 shares Long 150 put options and long 60 shares Short 150 put options and short 60 shares
Question 19: Value at risk (VaR) of inverse floater

19. A bond with principal of $150.0 million and modified duration of 5.0 years is priced at par, since the 4.0% coupon rate equals the flat yield curve at 4.0%. The bond is split into (becomes the collateral for) a floating-rate note (FRN) that pays LIBOR plus an inverse floater that pays 12% - 2*LIBOR. The FRN references a notional amount of $100 million and the inverse floater references the remaining notional amount of $50.0 million. The current value of the floater, just before reset, is effectively its par of $50.0 million. If the daily yield volatility is 1.0%, and normally distributed, which is nearest to an estimate of the one-day 99.0% relative value at risk (VaR) of the inverse floater? a) b) c) d) $9.8 million $14.0 million $17.5 million $23.9 million
Question 20: Binomial option pricing tree

20. Assume that a two-step binomial tree is used to price an American put option, on a nondividend-paying stock, with a strike price of $100.00 and two years to expiration (therefore, each step is one year). The current stock price is $100.00 with volatility of 40% per annum, which informs the magnitude of the up (u) and down (d) movements. The riskfree rate is 4.0% per annum. What is the estimated price of the American put according to a two-step binomial option pricing model? a) b) c) d) $8.20 $17.39 $25.16 $32.97
Question 21: Forward rate implied by bond prices

21. The price of a three-year zero-coupon government bond is $88.000 under semi-annual compounding. The price of a similar five-year zero-coupon bond is $78.125 (ie, 78 1/8). Under semi-annual compounding, what is the implied two-year forward rate from year three to year five? a) b) c) d) 3.25% 4.90% 5.55% 6.04%
Question 22: Taylor Series approximation for option price

22. For a European call option with an ATM strike price of $100.00 while the current stock price is $100.00, your colleague Lisa used Black-Scholes-Merton to compute an option price of $17.79. She also reports the following: the call option's price equals $17.79, N(d1) = 0.620, N(d2) = 0.460, option gamma = 0.020 and option vega = 40.0. She would like to estimate the change to the option price (df) using a Taylor expansion: df = f/S*dS + 0.5*^2f/S^2*dS^2 + f/*d. What is the estimated price change given both a simultaneous +$10.00 increase in the stock price and a +4.0% (+0.040) increase in volatility, using delta, gamma and vega (and neglecting any cross-term effects)? a) b) c) d) + $3.50 + $6.20 + $8.80 + $11.25
Question 23: Credit rating migration (transition) matrix

23. Assume the following credit rating migration (transition) matrix gives the transition probabilities of corporate bonds for one-year period:
What is the probability that an A-rated bond (blue row) will be AAA-rated (green row) at the end of two years? a) b) c) d) 0.950% 1.750% 1.810% 1.860%
Question 24: Unexpected loss

24. A bank had extended an original commitment (COM) of $40.0 million to a customer, of which 25% is currently outstanding and the remainder is an unused commitment. The usage given default (UGD) assumption is 70.0% and the estimated probability of default (EDF) is 4.0%. The loss given default (LGD) is estimated at 60.0% with a LGD standard deviation of 30.0%. If the unexpected loss (UL) is defined as one standard deviation of the (unconditional) value of the asset at the horizon, EACH of the following is true EXCEPT which is false? a) b) c) d) Expected loss (EL) is $744,000 Unexpected loss (UL) is $4,092,000 If the EDF were to double, the expected loss (EL) would also double (ceteris paribus) If the EDF were to double, the unexpected loss (UL) would also double (ceteris paribus)
Question 25: Stress testing

25. Consider the following statements about stress testing: I. II. III. IV. Backtesting is a type (sub-class) of stress testing which uses historical data Reverse stress testing starts with "spiking" all correlations to 1.0 Stress testing includes scenario analysis, which can be either historical or prospective (forward-looking) Stress testing can be conducted with either a local valuation or full valuation approach
Which of the statements is (are) true? a) b) c) d) None are true I. and II. III. and IV. All are true
Instructor Answer Sheet: An X is marked under the correct corresponding answer.
Question # 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Answer A X X
Answer B X
Answer C
Answer D X
X X X X X X X X X X X X X X X X X X X X X
Questions, Answers & Explanations:

Question 1: 1. In each of the following cases according to theory (Stulz), a good risk management program should create firm value, EXCEPT for: a) The program reduces idiosyncratic (firm-specific) risk while the firm depends on a large, active shareholder who is not diversified (e.g., private equity firm) b) The program hedges the firm's exposure to oil prices--a common (systematic) risk factor--with a short position in oil futures contracts while the firm is owned by shareholders who are well-diversified c) The program reduces the volatility of taxable earnings, effectively avoiding progressively higher tax rates in higher tax brackets d) The program reduces the debt overhang which causes shareholders to avoid positive net present value projects
Answer & Explanation:

1. B. This is a case where risk management, in theory, should not add value: the hedge will lower the firm's beta, but in offsetting fashion, it also reduces the firm's expected cash flow (the hedge, a short futures position, has an expected cost). Shareholders can diversify on their own. Each of the other answers exploits a FRICTION: a large, active shareholder who is not diversified and therefore would benefit from risk reduction; tax benefit; and the problem of debt overhang. This is a copy of question in forum here: BT2012.P1.01. When does risk management add
value?
Question 2: 2. While the risk-free rate was 4.0%, a portfolio's realized a return of 14.0% exactly matched the return of its benchmark, the market index, which also returned 14.0%. The portfolio's covariance (of returns) with the market index was 0.01440 and the market's volatility was 20.0%. What was the Jensen's alpha of the portfolio? a) b) c) d) -1.6% Zero +3.2% +6.4%

2. D. +6.4% Beta (P, M) = Cov(P,M)/Variance(M) = 0.01440/0.20^2 = 0.36. Jensen's alpha = 14% - 4% - 0.36*(14%-4%) = 6.4%. This is a copy of question in forum here: BT2012.P1.02. Portfolio alpha
Question 3: 3. A portfolio has an expected return of 11.0% with volatility of 24.0%. The benchmark has an expected return of 5.0% with volatility of 15%. The expected returns correlation is 0.80. What is the expected (ex ante) information ratio (IR)? a) b) c) d) 0.40 0.55 0.69 0.80

3. A. 0.40 Tracking error = SQRT(24%^2 + 15%^2 - 2*24%*15%*0.80) = 15.0% Information ration = E[R(P) - R(B)]/TE = (11%-5%)/15% = 0.40 This is a copy of question in forum here: BT2012.P1.03. Portfolio information ratio (IR) Question 4: 4. Which of the following factors LEAST contributed to the disaster at Metallgesellschaft? a) Failure to deliver on a few high-profile customer contracts incurred unexpected reputational risk b) Basis risk implied by short-term hedges against long-term exposures c) Roll return on long futures contract was negative (creates losses) under contango in the oil forward curve d) Unlike forwards, futures contracts required daily cash settlement

4. A. Customer interface (reputation) is not cited as an issue. However, each of (B), (C), and (D) contributed directly to MG's flawed hedge strategy and liquidity crunch. This is a copy of question in forum here: BT2012.P1.04. Metallgesellschaft causal factors
Question 5: 5. You colleague Roger is building a customized variation of the Merton model to estimate the credit risk of a portfolio of bonds issued by publicly-traded companies: the "structural" model will estimate each company's probability of default (EDF) by estimating the one- and three-year distance-to-default (DD), a measure of solvency which compares the predicted firm's asset value to a debt threshold. As the portfolio company have traded equities, the model does not perform any pricing; e.g., the value and volatility are exogenous inputs (given as assumptions). The model is strictly an application of risk measurement, not valuation or derivatives valuation. Roger makes four statements about his credit risk measurement model. Which is most likely problematic? a) It is not precise b) It does not discount to present value, it only estimates a future distribution c) Justified by no arbitrage, it avoids the actual expected return and a physical distribution; and instead assumes the risk-free rate and a risk-neutral distribution d) It replaces the Merton assumption of a lognormal asset price distribution with a alternative distribution

5. C. Derivatives pricing (valuation) justifies the risk-free rate; e.g., using the BlackScholes-Merton to estimate firm equity value by treating equity as a call option on firm assets with strike equal to the face value of debt. But risk measurement (see Jorion Table 1-5) wants the ACTUAL (physical) future distribution and therefore wants the actual expected return. In regard to (D), replacing a lognormal distribution, for example with a heavier-tail distribution, is perfectly acceptable. This is a copy of question in forum here: BT2012.P1.05. Risk model versus deriviatives
pricing
Question 6: 6. The following parameters have been estimated for a GARCH(1,1) model which gives an estimate of today's daily volatility (today = day n):
Yesterday's (n-1) daily volatility was 2.0% and yesterday's daily return was -7.0%. What is the GARCH(1,1) estimate of the daily volatility in 20 days (that is, the estimated volatility on day n+20)? a) b) c) d) 1.50% 2.85% 3.91% 4.23%

6. C. 3.91% Estimate of today's variance = 0.0001760 + 0.820*2%^2 + 0.070*(-7%)^2 = 0.0008470. Estimate of today's volatility = SQRT[0.0001760 + 0.820*2%^2 + 0.070*(-7%)^2] = 3.47851%. Implied long-run variance = omega/(1-alpha-beta) = 0.0001760/(1 - 0.820 - 0.070) = 0.00160. n+T day estimate of variance = Long-run Variance + (alpha + beta)^T*(Variance[n] - Long-run variance) = 0.00160 + [0.890^20*(0.0008470 - 0.00160) = 0.00152679, n+T day estimate of volatility = SQRT[0.00160 + [0.890^20*(0.0008470 - 0.00160)] = 3.907% Don't forget to SQRT[variance] to get the volatility. Three key formulas (in order of exam relevance, the first two are probably more relevant than the forecast formula) 1) GARCH(1,1) estimate of variance (n) = gamma*variance(long-run) + beta*variance(n-1) + alpha*return(n-1), where alpha+beta+gamma = 1.0, and variance(long-run) is also called the "unconditional variance" 2) Variance(long-run) = omega/gamma = omega/(1-alpha-beta) 3) GARCH(1,1) estimate of T-day forward variance (n+t) = variance(long-run) + (alpha+beta)^T * [variance(n) - variance(long-run)] This is a copy of question in forum here: BT2012.P1.06 GARCH volatility forecast
Question 7: 7. Let B and Y represent random normal variables: B ~ N(300, 200^2) and Y ~ N(200,150^2). Let A characterize the average of a random sample of 100 draws (trials) from B, and let X characterize the average of a random sample of 100 draws from Y. We can assume that A and X are independent. What is the joint probability Pr[ A < 253.40, X < 170.60]? a) b) c) d) 0.0250% 0.2250% 0.6667% 1.3050%

7. A. 0.050% Per CLT, A ~ N(300, 200^2/100) and X ~ N(200, 150^2/100). Pr [A < 253.40] = Pr [ Z < (253.40 - 300)/SQRT(200^2/100) ] = Pr[Z < -2.33] ~= 1.0%. Pr [X < 170.60 ] = Pr [ Z < (170.60 - 200)/SQRT(150^2/100) ] = Pr[Z < -1.96] != 2.5% As A and X are independent, the joint probability is equal to the product of marginal probabilities, such that Pr[ A < 253.40, X < 170.60] = 1%*2.5% = 0.0250% This is a copy of question in forum here: BT2012.P1.07 Random normal variables Question 8: 8. A stock has a price today of $52.00, an expected return of 14.0% per annum and a volatility of 36.0% per annum. We assume the stock's stochastic process is a geometric Brownian motion (GBM) with a consequent lognormal price distribution. What is the 95.0% confidence interval for the stock price in three months (today + 0.25 years), if we are careful to use the geometric return, which erodes the drift by one-half the variance (i.e., the geometric return is necessarily less than the arithmetic return for any nonzero volatility)? a) b) c) d) $29.54 < S(0.25) < $121.13 $37.24 < S(0.25) < $75.40 $45.33 < S(0.25) < $67.18 $49.60 < S(0.25) < $60.22

8. B. $37.24 < S(+0.25) < $75.40 Lower 95% bound = $52.00*exp[(14% - 0.5*36%^2)*0.25 - 1.96*36%*SQRT(0.25)] = $37.24 Upper 95% bound = $52.00*exp[(14% - 0.5*36%^2)*0.25 + 1.96*36%*SQRT(0.25)] = $75.40 This is a copy of question in forum here: BT2012.P1.08 Lognormal Property of Stocks
Question 9: 9. A portfolio holds two securities, LowProfile(A) and HighBeta(B). The expected annual returns, weights, and covariance matrix are given by the following:
The security returns are normally distributed and independent over time (i.e., zero autocorrelation). If the portfolio value is $10.0 million and we assume 250 trading days per year, which is nearest to the 10-day 99.0% relative portfolio value at risk (VaR)? a) b) c) d) $323,700 $716,490 $1,080,000 $3,065,250

9. C. $1,080,000 Annual portfolio volatility = SQRT(60%^2*0.01440 + 40%^2*0.250 + 2*60%*40%*0.0180) = 23.20%. 10-day 99.0% VaR = $10.0 million * 23.20% * SQRT(10/250) * 2.33 = $1,081,120. This is a copy of question in forum here: BT2012.P1.09 Two-asset portfolio value at risk
(VaR)
Question 10: 10. A portfolio manager regressed two years of monthly excess portfolio returns, R(P), against the excess returns of the index benchmark, R(B). The sample includes 24 months, n =24. The resulting regression, see below, is R(P,i) = 0.00830 + 0.86500*R(B,i) + e(i).
The portfolio manager infers the following from the regression results: I. II. III. IV. The intercept is significantly different than zero with 95% confidence The slope is significantly different than 1.0 with 95% confidence Assuming the total sum of squares (TSS) is 0.00420, the standard error of the regression (SER) is ~ 1.1940 The coefficient of determination (R^2) is ~ 0.8474
Which of the statements is (are) correct? a) b) c) d) None I. and IV. only II. and III. only All are correct

10. B. I. and IV. Only I. II. III. IV. True: 0.00830/0.00210 = t-statistic of 3.952, two-sided p-value with 22 d.f. ~ 0.07% False: (1.0 - 0.8650)/0.07820 = t-statistic of 1.73, two-sided p-value with 22 d.f. = 9.8% False: SER = SQRT(SSR/df). SSR = (1-R^2)*TSS = (1-0.8474)*0.00420 = 0.000641, such that SER = SQRT(0.000641/22) ~= 0.00540 True: Beta(P w.r.t. B) = correlation*vol(P)/vol(B), such that correlation = beta(P,B)*vol(B)/vol(P) and R^2 = Beta^2*vol(B)^2/vol(P)^2. In this case, R^2 = 0.8650*1.4090%^2/1.3240%^2 = 0.8474
This is a copy of question in forum here: BT2012.P1.10 Linear regression interpretation
Answer 11: 11. Consider the following portfolio of three bonds, where par amounts are in millions of dollars (USD):
What is the portfolio's dollar value of one basis point (DV01)? a) b) c) d) $11,559 $13,111 $15,943 $17,000

11. D. $17,000
This is a copy of question in forum here: BT2012.P1.11. Bond portfolio duration
Question 12: 12. The spot price of platinum, S(0), is $1,530.00 per troy ounce, while the one-year futures price, F(1), is $1,690.00. Assume that ownership of platinum confers no convenience yield but the cost to store one ounce is $90.00 per year, payable at the end of the year (in arrears). The risk-free rate is 4.0% per annum continuously compounded, for all maturities. What is the arbitrage trade and implied future profit? a) Borrow cash to buy spot platinum and take short futures contract position: profit $7.56 per ounce in one year b) Borrow cash to buy spot platinum and take short futures contract position: profit $97.44 per ounce in one year c) Short platinum, lend cash and take long futures contract position: profit $3.20 per ounce in one year d) Short platinum, lend cash and take long futures contract position: profit $16.87 per ounce in one year

12. A. Borrow cash to buy spot platinum and take short futures contract position: profit $7.56 per ounce in one year Futures price (implied by cost of carry model) = $1,530*exp(4%) + 90 = $1,682.44. Or, PV of storage = 90*exp(-4%) = $86.471, and [$1,530 + $86.471]*exp(4%) = $1,682.44. The FV of arbitrage = $1,690.00 - 1,682.44 = $7.56. The futures price is "trading rich" which implies a "cash and carry" arbitrage trade: borrow to buy the asset and short the futures contract. In this case, borrow $1,616.47 to buy one ounce at $1,530.00 and have PV cash to pay for storage ($1,530.00 + $86.47 = $1,616.47) for zero cash inflow/outflow at time zero. In one year, repay the cash loan with $1,616.47*exp(4%*1) = $1,682.44, deliver the owned asset and collect the futures payment of $1,690.00 for guaranteed profit of $1,690 - $1,682.44 = $7.56. This is a copy of question in forum here: BT2012.P1.12. Commodity futures price
Question 13: 13. An American call option that expires in nine months (0.75 years) has a strike price of $20.00 and a price of $2.00. The underlying stock price is $18.00 and pays a one dollar ($1.00) dividend in nine months. The risk-free rate is 3.0%. What are the upper and lower bounds for the price of an American put option on the same stock with the same strike and expiration? a) b) c) d) $1.05 to $2.17 $2.99 to $3.75 $3.56 to $4.98 $4.25 to $6.18

13. C. $3.56 to $4.98 Put-call parity for an American option with dividends is given by: S - D - K C - P S - K*exp(rT). D = $1.00*exp(-3%*0.75) = $0.977751 Such that put must be greater than (or equal to) $3.56 and less than (or equal to) $4.98. This is a copy of question in forum here: BT2012.P1.13. Put-call parity Question 14: 14. A retailer is committed to the purchase of one million pounds (1,000,000 pounds) of coffee in November at the prevailing price at that time, but is concerned the price of coffee will increase and so wants to hedge this planned purchase with December futures. The standard deviation of monthly changes in the spot price of coffee $0.30 per pound, while the standard deviation of monthly changes in the futures price is $0.40 per pound. The correlation between spot and futures price changes is 0.60. Each coffee futures contract is for delivery of 37,500 pounds. What is the hedge trade? a) b) c) d) Short 18.0 contracts Short 9.0 contracts Long 7.5 contracts Long 12.0 contracts

14. D. Long 12.0 contracts The optimal hedge ratio = 0.60 correlation * $0.30/$0.40 = 0.450. The number of contracts = 0.45 * 1,000,000 / 37,500 = 12; i.e., long 12 contracts This is a copy of question in forum here: BT2012.P1.14. Hedge coffee purchase
Question 15: 15. Assume the 12-month (one year) LIBOR zero rate is 3.00% per annum and the 15-month LIBOR zero rate is 4.40%, both with continuous compounding and an ACT/365 day count convention. The contract price (P) of a Eurodollar futures contract is based on the quote (Q) and given by: P = 10,000 * [100 - 0.25 * (100-Q)], where a Eurodollar contract is quoted (Q) with quarterly compounding and an ACT/360 day count convention. What is nearest to the estimate of the contract price (P) for a Eurodollar contract maturing in one year? a) b) c) d) $926,354 $975,032 $989,257 $1,024,361

15. B. $975,032 The implied forward rate = (1.25*4.40% - 1.0*3.00%)/(1.25-1.0) = 10.00%, continuous ACT/365. Test with: exp(3%*1)*exp(10%*0.25) =?= exp(4.4%*1.25) Translate to quarterly compounding: 4*[exp(10%/4)-1] = 10.1260%; Convert to ACT/360: 10.1260% * 360/365 = 9.98734%. Estimate of 12-month Eurodollar Quote (Q) = 100 - 9.98734 = 90.012665 Implied Eurodollar contract price (P) = 10,000 * [100 - 0.25 * (100-Q)] = 10,000 * [100 - 0.25 * (100-90.012665)] = $975,031.66 This is a copy of question in forum here: BT2012.P1.15. Eurodollar futures price Question 16: 16. One year ago, a bank entered into a plain vanilla three-year interest rate swap as the fixedpayer that references a notional amount of $400.0 million. The bank pays a fixed annual coupon of 6.0% and, in exchange, receives LIBOR annually. Today, the first payment was made. The oneand two-year LIBOR spot (zero) rates are 4.00% and 4.80%, respectively, with continuous compounding. Which is nearest to the value today, to the bank, of the swap? (source: variation on handbook example 10.9) a) b) c) d) -8.25 million -3.00 million +5.15 million +11.75 million

16. A. -8.25 million The present value of the fixed-rate leg = 6%*400*exp(-4.0%*1.0) + (1+6%)*400*exp(-4.8%*2.0) = $23.0589 + $385.1887 = $408.2477. The present value of the floating-rate leg is $400 (!). The value of the swap to the bank, today, is $400 - $408.25 ~= $8.25 This is a copy of question in forum here: BT2012.P1.16. Interest rate swap value www.bionicturtle.com FRM 2012 PART 1: MOCK EXAM A 24
Question 17: 17. A trader believes the market has over-estimated the likelihood of a dramatic movement, in either direction, of a stock. Consequently the trader wants to short the stock's implied volatility, seeking to profit if the stock is range-bound without a large move in either direction. Each of the following trades is short volatility EXCEPT which of the following trades is the LEAST effective at expressing the trader's view? a) b) c) d) Short (top) straddle Long calendar spread Short strap Short box spread

17. D. Box spread has fixed payoff, such that it is indifferent to realized volatility. Strategies that are long volatility (i.e., profit in the event of a large up or down move) include: long strangle, long straddle (aka, bottom straddle), long strip, long strap, reverse calendar spread, and reverse butterfly spread. Strategies that are short volatility include: short strangle (aka, top vertical combination), short straddle (aka, top straddle), short strip, short strap, long calendar spread, and long butterfly spread. This is a copy of question in forum here: BT2012.P1.17. Short volatilty strategies
Question 18: 18. A trader buys 100 call options; each of which has a percentage (per option) delta of 0.60 and percentage gamma of 1.20. The trader neutralizes the delta of this long call option position by shorting 60 shares. However, the net position is not gamma neutral. The trader wants to neutralize both delta and gamma and is willing to add put options to the position. The put options have a delta of -0.40 and gamma of 0.80. What trade(s) will result in a position that is both delta and gamma neutral? a) b) c) d) Short 90 call options and short 36 shares Long 90 call options and long 36 shares Long 150 put options and long 60 shares Short 150 put options and short 60 shares

18. D. Short 150 put options and short 60 shares The original position is delta neutral but has a position gamma of +100 * +1.20 = +120. To neutralize the gamma, the trader needs to short 120/0.80 = short 150 put options. This neutralizes gamma, but creates - 150 * -0.40 = +60 position delta; i.e., shorting put options creates positive position delta. To neutralize this +60 delta, the trader needs to short 60 shares (which have zero gamma). The final portfolio consists of: long 100 call options, short 150 put options and short 120 shares. Position delta = long 100 call options * 0.60 + short 150 put options * -0.40 + short 120 shares * -1.0 = 60 + 60 - 120 = 0 Position gamma = long 100 call options * 1.2 + short 150 put options * 0.80 = 120 - 120 = 0
This is a copy of question in forum here: BT2012.P1.18. Delta gamma neutral portfolio
Question 19: 19. A bond with principal of $150.0 million and modified duration of 5.0 years is priced at par, since the 4.0% coupon rate equals the flat yield curve at 4.0%. The bond is split into (becomes the collateral for) a floating-rate note (FRN) that pays LIBOR plus an inverse floater that pays 12% - 2*LIBOR. The FRN references a notional amount of $100 million and the inverse floater references the remaining notional amount of $50.0 million. The current value of the floater, just before reset, is effectively its par of $50.0 million. If the daily yield volatility is 1.0%, and normally distributed, which is nearest to an estimate of the one-day 99.0% relative value at risk (VaR) of the inverse floater? a) b) c) d) $9.8 million $14.0 million $17.5 million $23.9 million

19. C. $17.5 million As the dollar duration of the FRN is effectively zero, and the dollar duration of the original bond is $750.0 million, the dollar duration of the floater is $750.0 million with modified duration of 750/50 = 15.0 years. The one-day 99.0% VaR = $50 million * 1.0% volatility * 2.33 deviate * 15.0 modified duration = $17.475 million This is a copy of question in forum here: BT2012.P1.19. Value at risk (VaR) of inverse
floater
Question 20: 20. Assume that a two-step binomial tree is used to price an American put option, on a nondividend-paying stock, with a strike price of $100.00 and two years to expiration (therefore, each step is one year). The current stock price is $100.00 with volatility of 40% per annum, which informs the magnitude of the up (u) and down (d) movements. The riskfree rate is 4.0% per annum. What is the estimated price of the American put according to a two-step binomial option pricing model? a) b) c) d) $8.20 $17.39 $25.16 $32.97

20. B. $17.39 Only two forward nodes have option value: down in the first year to 100*exp(-40%*SQRT[1]) = $67.03 and two consecutive down jumps to 100*exp(-40%*SQRT[1])^2 = $44.93. u = exp(40%*SQRT[1]) = 1.4918, d = exp(-40%*SQRT[1]) = 0.6703, , a = exp(40%*1) = 1.491825, p = (a-u)/(u-d) = 0.4510, and 1-p = 0.5490. The option price at S(d) = $32.97 because the intrinsic value is greater at this node. So the option price = 0.5490 * $32.97 *exp(-4%*1) = $17.39
This is a copy of question in forum here: BT2012.P1.20. Binomial option pricing tree
Question 21: 21. The price of a three-year zero-coupon government bond is $88.000 under semi-annual compounding. The price of a similar five-year zero-coupon bond is $78.125 (ie, 78 1/8). Under semi-annual compounding, what is the implied two-year forward rate from year three to year five? a) b) c) d) 3.25% 4.90% 5.55% 6.04%

21. D. 6.04% Price [3-year zero] = F/[(1+s[3]/2)^(3*2)], where s[3] is the three-year spot (aka, zero) rate, and Price [5-year zero] = F/[(1+s[5]/2)^(5*2)]. The no-arbitrage solution for the implied forward is given by: (1+s[3]/2)^(3*2)*(1+f[3,5]/2)^(2*2) =(1+s[5]/2)^(5*2). So that (1+f[3,5]/2) = [(1+s[5]/2)^(5*2)/(1+s[3]/2)^(3*2)]^[1/(2*2)], and The two-year forward rate = ([(1+s[5]/2)^(5*2)/(1+s[3]/2)^(3*2)]^[1/(2*2)] - 1) * 2. But [(1+s[5]/2)^(5*2)/(1+s[3]/2)^(3*2)] = Price [3-year] / Price [5-year], so that: Implied two-year forward rate = [(Price[3-year] / Price[5-year])^(1/4) - 1] * 2 = [(88.00/78.1250)^(1/4) - 1]*2 = 6.0408% This is a copy of question in forum here: BT2012.P1.21. Forward rate implied by bond
prices
Question 22: 22. For a European call option with an ATM strike price of $100.00 while the current stock price is $100.00, your colleague Lisa used Black-Scholes-Merton to compute an option price of $17.79. She also reports the following: the call option's price equals $17.79, N(d1) = 0.620, N(d2) = 0.460, option gamma = 0.020 and option vega = 40.0. She would like to estimate the change to the option price (df) using a Taylor expansion: df = f/S*dS + 0.5*^2f/S^2*dS^2 + f/*d. What is the estimated price change given both a simultaneous +$10.00 increase in the stock price and a +4.0% (+0.040) increase in volatility, using delta, gamma and vega (and neglecting any cross-term effects)? a) b) c) d) + $3.50 + $6.20 + $8.80 + $11.25

22. C. $8.80 First sentence is not needed. Using Taylor: df = f/S*dS + 0.5*^2f/S^2*dS^2 + f/*d Change in option price = delta*stock price change + 0.5*gamma*(stock price change)^2 + vega*volatility change. In this case: Change in option price = 0.620*$10 + 0.5*0.02*10^2 + 40*0.040 = $6.20 + $1.00 + $1.60 = $8.80 This is a copy of question in forum here: BT2012.P1.22. Taylor Series approximation for
option price
Question 23: 23. Assume the following credit rating migration (transition) matrix gives the transition probabilities of corporate bonds for one-year period:
What is the probability that an A-rated bond (blue row) will be AAA-rated (green row) at the end of two years? a) b) c) d) 0.950% 1.750% 1.810% 1.860%

23. C. 1.810% A --> AAA --> AAA = 1% * 95% A --> A --> AAA = 80% * 1% A --> AA --> AAA = 2%*3% Prob[migration from A --> AAA over two year period] = 1%*95% + 80%*1% + 2%*3% = 1.810% This is a copy of question in forum here: BT2012.P1.23. Credit rating migration (transition)
matrix
Question 24: 24. A bank had extended an original commitment (COM) of $40.0 million to a customer, of which 25% is currently outstanding and the remainder is an unused commitment. The usage given default (UGD) assumption is 70.0% and the estimated probability of default (EDF) is 4.0%. The loss given default (LGD) is estimated at 60.0% with a LGD standard deviation of 30.0%. If the unexpected loss (UL) is defined as one standard deviation of the (unconditional) value of the asset at the horizon, EACH of the following is true EXCEPT which is false? a) b) c) d) Expected loss (EL) is $744,000 Unexpected loss (UL) is $4,092,000 If the EDF were to double, the expected loss (EL) would also double (ceteris paribus) If the EDF were to double, the unexpected loss (UL) would also double (ceteris paribus)

24. D. False: EL is a linear function of EDF, but UL is a non-linear function of EDF. As AE = $10.0 million + 70% * $30.0 million = $31.0 million, EL = $31.0 million * 4.0% * 60% = $744,000 UL = SQRT(4%*30%^2 + 60%^2*4%*96%)*$31.0 million = $4,092,000 If EDF doubles to 8.0%, then EL = $1,488,000 but UL = $5,690,506 (i.e., UL increases about 1.4x). This is a copy of question in forum here: BT2012.P1.24. Unexpected loss Question 25: 25. Consider the following statements about stress testing: I. II. III. IV. Backtesting is a type (sub-class) of stress testing which uses historical data Reverse stress testing starts with "spiking" all correlations to 1.0 Stress testing includes scenario analysis, which can be either historical or prospective (forward-looking) Stress testing can be conducted with either a local valuation or full valuation approach
Which of the statements is (are) true? a) b) c) d) None are true I. and II. III. and IV. All are true

25. C. III and IV. are true, but I. and II. are false In regard to (I.), a backtest is NOT a type of stress testing, it compares predicted to actual outcomes. In regard to (II.), a reverse stress test starts with a known stress outcome (e.g., breach of regulatory capital ratio, insolvency) and then "reverse engineers" by asking what events could lead to the contemplated adverse outcome(s). This is a copy of question in forum here: BT2012.P1.25. Stress testing www.bionicturtle.com FRM 2012 PART 1: MOCK EXAM A 32

P1. Mock Exam A

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Mock Exam A FRM 2012 Practice Questions

By David Harper, CFA FRM CIPM www.bionicturtle.com

Candidate Answer Sheet: Mark an X under your answer of choice.

FRM 2012 PART 1: MOCK EXAM A 2

Question 1: When does risk management add value?

Question 2: Portfolio alpha

Question 3: Portfolio information ratio (IR)

Question 4: Metallgesellschaft causal factors

FRM 2012 PART 1: MOCK EXAM A 3

Question 5: Risk model versus derivatives pricing

Question 6: GARCH volatility forecast

Question 7: Random normal variables

FRM 2012 PART 1: MOCK EXAM A 4

Question 8: Lognormal Property of Stocks

Question 9: Two-asset portfolio value at risk (VaR)

FRM 2012 PART 1: MOCK EXAM A 5

Question 10: Linear regression interpretation

FRM 2012 PART 1: MOCK EXAM A 6

Question 11: Bond portfolio duration

Question 12: Commodity futures price

Question 13: Put-call parity

FRM 2012 PART 1: MOCK EXAM A 7

Question 14: Hedge coffee purchase

Question 15: Eurodollar futures price

Question 16: Interest rate swap value

FRM 2012 PART 1: MOCK EXAM A 8

Question 17: Short volatilty strategies

Question 18: Delta gamma neutral portfolio

Question 19: Value at risk (VaR) of inverse floater

FRM 2012 PART 1: MOCK EXAM A 9

Question 20: Binomial option pricing tree

Question 21: Forward rate implied by bond prices

Question 22: Taylor Series approximation for option price

FRM 2012 PART 1: MOCK EXAM A 10

Question 23: Credit rating migration (transition) matrix

Question 24: Unexpected loss

FRM 2012 PART 1: MOCK EXAM A 11

Question 25: Stress testing

FRM 2012 PART 1: MOCK EXAM A 12

Instructor Answer Sheet: An X is marked under the correct corresponding answer.

FRM 2012 PART 1: MOCK EXAM A 13

Questions, Answers & Explanations:

Answer & Explanation:

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FRM 2012 PART 1: MOCK EXAM A 14

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FRM 2012 PART 1: MOCK EXAM A 15

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FRM 2012 PART 1: MOCK EXAM A 16

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FRM 2012 PART 1: MOCK EXAM A 17

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FRM 2012 PART 1: MOCK EXAM A 18

Answer & Explanation:

FRM 2012 PART 1: MOCK EXAM A 19

Answer & Explanation:

This is a copy of question in forum here: BT2012.P1.10 Linear regression interpretation

FRM 2012 PART 1: MOCK EXAM A 20

Answer & Explanation:

This is a copy of question in forum here: BT2012.P1.11. Bond portfolio duration